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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 December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to ___________
Commission File Number 0-31014
HEALTHEXTRAS, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-2181356
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(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
2273 Research Boulevard, 2nd Floor, Rockville, Maryland 20850
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(Address of principal executive offices, zip code)
(301) 548-2900
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(Registrant's phone number, including area code)
Not Applicable
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(Former name, former address and former fiscal year,
if changed since last report)
Securities registered pursuant to 12(b) of the Act: None
Securities registered pursuant to 12(g) of the Act:
Common Stock, $0.01 par value
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
---
Indicate by check mark 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 the 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: ( __ )
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the ACT) Yes X No ____
--
The market value of the voting and non-voting common equity held by
non-affiliates was $77,291,800 based upon the closing price of $5.07 as quoted
on the NASDAQ National Market as of June 28, 2002, the last business day of the
registrant's most recently completed second fiscal quarter. Solely for the
purposes of this calculation, directors and officers of the registrant are
deemed to be affiliates.
Documents incorporated by reference:
------------------------------------
The Company's Proxy Statement for its annual meeting of stockholders to be held
in June, 2003, a definitive copy of which will be filed within 120 days of
December 31, 2002, is incorporated by reference in Part III of this Report on
Form 10-K.
TABLE OF CONTENTS
Page
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PART I
Item 1. Business.....................................................3
Item 2. Properties..................................................16
Item 3. Legal Proceedings...........................................16
Item 4. Submission of Matters for a Vote of Security Holders........16
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters.......................................17
Item 6. Selected Financial Data.....................................18
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.......................19
Item 7A Quantitative and Qualitative Disclosures About Market
Risk......................................................33
Item 8. Financial Statements and Supplementary Data.................33
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.......................33
PART III
Item 10. Directors and Executive Officers of the Registrant..........33
Item 11. Executive Compensation......................................33
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................33
Item 13. Certain Relationships and Related Transactions..............34
Item 14. Controls and Procedures.....................................34
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on
Form 8-K..................................................34
SIGNATURES
This Form 10-K, including the documents incorporated by reference, contains
certain forward-looking statements, including without limitation, statements
concerning the Company's operations, economic performance and financial
condition. These forward-looking statements are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. The
words "believe," "expect," "anticipate" and other similar expressions generally
identify forward-looking statements. Readers are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of their
dates. These forward-looking statements are based largely on the Company's
current expectations and are subject to a number of risks and uncertainties,
including, without limitation, those identified under "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and elsewhere in
this Form 10-K, including the documents incorporated by reference. Actual
results could differ materially from results referred to in the forward-looking
statements. In addition, important factors to consider in evaluating such
forward-looking statements include changes in external market factors, changes
in the Company's business or growth strategy or an inability to execute its
strategy due to changes in its industry or the economy generally. In light of
these risks and uncertainties, there can be no assurances that the results
referred to in the forward-looking statements contained in this Form 10-K will
in fact occur. The Company undertakes no obligation to publicly revise these
forward-looking statements to reflect any future events or circumstances.
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
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PART 1
ITEM 1. BUSINESS
BUSINESS OVERVIEW
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HealthExtras, Inc. ("HealthExtras") is a provider of pharmacy benefit
management services ("PBM") and supplemental benefits. The Company's PBM
clients include managed-care organizations, self-insured employers, and third
party administrators ("payors"), who contract with HealthExtras to
cost-effectively administer the prescription drug component of their overall
health benefit programs. As a PBM, the Company provides access to a contracted
national network of over 50,000 pharmacies, maintains an electronic
point-of-sale system of eligibility verification and plan design while also
offering access to rebate arrangements for certain branded pharmaceuticals.
These services provide our clients' members with timely and accurate benefit
adjudication while controlling pharmacy spending trends through innovative plan
designs, physician orientation programs and member education.
Much of HealthExtras' competitive differentiation is attributable to a
strong local market presence in Nevada, New Mexico, Oklahoma, Texas and the
Carolinas. The Company's significant market share in each of these regions
allows it to offer attractive benefit pricing based on local pharmacy network
rates and formulary design. The Company maintains operational facilities in
Rockville, Maryland as well as Las Vegas, Nevada and Raleigh, North Carolina.
These offices provide account management, customer service and clinical support
programs including dedicated clinical pharmacists with expertise in plan
design, treatment protocols and various cost management initiatives. PBM
revenues have grown to more than $180 million or 73% of total revenue in 2002
from approximately $5 million or 11% of total revenue in 2000. The remainder of
the Company's revenues relate to the supplemental benefits segment of our
operations. HealthExtras has over 800 PBM clients and no single client
generated more than 8% of total revenue in 2002.
In 2002, the Company processed more than 4.5 million pharmacy claim
transactions and completed the year with an annualized claim rate in excess of
8 million transactions. The Company continues to develop its PBM service
offerings and has successfully integrated several strategic acquisitions over
the last three years. In each acquisition transaction the Company has executed
on its objectives by integrating operations, improving profitability and
growing the revenue base of the acquired businesses. In the most recent of
these transactions, HealthExtras acquired Pharmacy Network National Corporation
("PNNC"), a PBM company located in Raleigh, North Carolina, on December 1,
2002. The Company will continue to look for acquisition opportunities which
complement its existing operations and have the same or similar characteristics
as the previously acquired companies. These characteristics would include
geographic membership concentrations, opportunities to improve profitability
and a base from which to generate significant revenue growth.
The Company was incorporated in Delaware in July 1999, as the successor
to certain predecessor companies. Our principal executive offices are located
at 2273 Research Boulevard, Rockville, Maryland 20850. Our telephone number is
301-548-2900.
The Company's Internet website is www.healthextras.com. The Company
makes available free of charge on or through its website its annual reports on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after the Company electronically files such material with, or furnishes it to,
the Securities and Exchange Commission. This reference to the Company's website
is for the convenience of shareholders as required by the Securities and
Exchange Commission and shall not be deemed to incorporate any information on
the website into this report.
Pharmacy Benefit Management
---------------------------
The PBM industry has developed and grown in response to the increased
utilization of pharmaceuticals, increasing unit costs and broader application
of prescription drugs to various conditions. These factors have combined to
create a significant and recurring escalation in the cost of drug coverage
offered by managed-care organizations, self-insured employers and third party
administrators. In order to understand, manage and mitigate these trends, many
of these payor organizations have contracted for the specialized services
offered by PBMs.
3
According to 2003 survey data from national benefits consultants,
employer sponsored pharmacy benefit costs increased between 14.2% and 16.9%
annually in each of the four years ending in 2002. Current projections
generally anticipate that increases for 2003 will again be in excess of 15%. In
the context of overall employer-sponsored health care cost increases, pharmacy
costs have been escalating at a rate approximately 50% higher than that of
overall spending. The persistence of these trends has resulted in an increasing
willingness on the part of payors to embrace plan design changes and other
options to curb these levels of cost escalation.
The factors contributing to the increase in pharmacy spending include:
- The introduction of new and expensive drug therapies and greater
reliance on drug therapy by the physician community,
- Increased "preventative prescribing" to manage high cholesterol
levels and digestive disorders,
- Efforts by drug manufacturers to increase market share and extend
single-source brand use,
- The introduction of improvements over existing therapies, which
normally carry higher unit prices than existing formulations,
- Increased patient demand and education as a result of
direct-to-consumer advertising and other pharmaceutical marketing or
promotional efforts,
- An aging workforce,
- Increased obesity among all age groups, and
- Improved techniques and technology to detect and diagnose diseases.
Overall cost increases are a function of both the number of
pharmaceuticals dispensed and their unit cost. Each factor has contributed
approximately half of recent trend increases.
PBMs are responsible for implementing and administering benefit plans
that seek to lower overall prescription spending by encouraging generic
utilization, increasing the proportion of brand drugs dispensed from the
preferred category and encouraging, where appropriate, non-prescription therapy
and treatment alternatives. These objectives are accomplished through a
combination of administrative, educational and technology initiatives directed
towards pharmacies, physicians and members.
Over the past several years, plan design has increasingly focused on
the use of three-tier co-payment structures. Co-payments represent that portion
of the cost of a prescription paid for by the member at the time the drug is
dispensed. The purpose of these designs and the use of drug specific formulary
lists is to create financial incentives for members to utilize generic drugs
where available and to select the most cost-effective brand drugs indicated for
a specific diagnosis or condition. In general, these plans incorporate the
lowest member co-payments for generic drugs, with increases for preferred brand
drugs and reaching their highest level for non-preferred brands. Typically
these categories might require member co-payments of $10, $20 and $35
respectively. The use of these tiered plans has increased significantly over
the past several years and now applies to approximately 70% of
employer-sponsored members. As importantly, both the levels of member
co-payment and the differential between tiers has continued to increase.
While market share for PBM services in the U.S. is highly concentrated,
with a small number of firms controlling over 70% of prescription volume and
member lives, HealthExtras has demonstrated its ability to serve a broad range
of clients from large managed-care organizations to employer groups with fewer
than a thousand members.
BUSINESS STRATEGY
-----------------
Our strategy is to capitalize on our competitive differentiation in
addressing the challenges confronting payors. The increasing focus on pharmacy
cost management should contribute to an attractive and dynamic market for cost
effective pharmacy benefit programs such as ours. HealthExtras provides its
clients the tools, information, and specialized expertise needed to offer the
best drug therapy to their membership, while simultaneously working to lower
the costs associated with a pharmacy benefit plan. We believe that growth will
be driven by demonstrating the effectiveness of these programs as alternatives
to the programs currently utilized by employer groups, managed-care
organizations, and third party administrators.
4
Our PBM services entail managing member prescription drug utilization
to ensure high-quality, cost-effective pharmaceutical care through a
combination of managed-care principles, advanced data analysis and
technologies, and the management of client specific cost control initiatives.
Our PBM services include:
- Benefit plan design and consultation
- Formulary administration
- Formulary compliance and therapeutic intervention programs
- Retail pharmacy network contracting and administration
- Advanced decision support and data analysis services
- Flexible, customized reporting available via secure Internet
connection
- Contracted mail order pharmacy
- Prescription benefits and discount programs tailored for businesses
with a high percentage of low-wage or part-time employees
Because we are not affiliated with any pharmaceutical manufacturer, and
because we do not own a mail-order facility, the formulary and plan designs we
suggest to clients are free from exposure to certain potential conflicts of
interest. Our larger competitors are often subject to either or both conflicts
in that they may benefit from increasing the volume of drug utilization
generally or that of certain specific drugs. These conflicts arise where
revenues from pharmaceutical manufacturers may support the inclusion of certain
drugs on formulary where not otherwise indicated or may result from mail order
utilization serving as a visible and important profit center for the PBM. By
not actively pursuing pharmaceutical manufacturer revenue sources and by
outsourcing mail order as a cost center, we believe that our interests are more
fully aligned with the cost saving interests of our clients.
We Intend to Increase our PBM Client Base by Targeting Certain Market
Segments
- --------------------------------------------------------------------------
Our analysis of the market opportunity by segment is as follows:
- LARGE EMPLOYER GROUPS (SELF-INSURED): Representing over 12 million
lives, employers in this segment are large enough to need a
full-service PBM solution to manage their increasing prescription
benefits costs, but are not Fortune 500-size companies that the largest
PBMs typically serve. HealthExtras has a significant number of clients
in this segment. By utilizing the information-based cost containment
strategies described below, HealthExtras offers these clients favorable
results as compared to larger PBMs, and greater level of customer
service.
- THIRD PARTY ADMINISTRATORS (TPAS): There are hundreds of TPAs in the
U.S. which focus primarily on administering the health benefits of
their clients. TPAs provided services to over 17 million employees,
dependents, and retirees, paying over $17 billion in total health
claims. As the TPA market continues to consolidate, and TPA clients
increasingly seek out complete health benefits solutions from their
TPA, we believe an increasing number of TPAs will be seeking a PBM
partner to administer the prescription benefits of their clients.
- MID-TIER MANAGED-CARE ORGANIZATIONS (MCOS): There are hundreds of MCOs
which cover under 200,000 lives. These MCOs represent over 20 million
lives and $8 billion in annual drug spending. We are targeting these
MCOs as a source of significant growth. MCOs of this size are
increasingly dissatisfied with the level of service and results they
are receiving from larger PBM companies that devote most of their
attention to one-million-plus member MCOs. HealthExtras has
demonstrated that it can provide these MCOs with a complete,
full-service PBM that includes all of the features larger PBMs offer,
with superior customer service, market specific retail networks and
customized benefit plans.
- STATE AND LOCAL GOVERNMENTS: Clients in this market segment often have
fixed budgets for the prescription benefits that are offered to current
members as well as retirees. With some state governments having a
workforce and retiree population that rivals a Fortune 1000 employer,
these clients are seeking the same customer service, attention to
detail, and bottom line results. Because the vast majority of members
in this market segment are geographically concentrated, HealthExtras
can analyze the prescribing and utilization trends associated with a
state and local government entity and actively influence physicians'
prescribing practices in a particular region. These physician
interactions draw on peer-reviewed clinical studies, generic drug
5
utilization patterns, and the insights offered by the physicians
themselves to deliver better care at lower costs.
We Seek to Leverage Local Market Dynamics to Build Customized Networks and
Manage Drug Spending
- -------------------------------------------------------------------------------
Although clients contract with HealthExtras to provide PBM services
nationwide, capitalizing on local and regional market dynamics is an effective
way to manage drug spending and differentiate our PBM services from those
offered by our competitors.
- CUSTOMIZED PHARMACY NETWORKS: In order to obtain greater pharmacy
discounts for its clients, HealthExtras works with clients to identify
pharmacies that will agree to deeper prescription discounts in a
specific locality, based on the concentration of client members in that
area, and the `foot-traffic' those members represent to a drug,
grocery, or retail chain's non-pharmacy business. HealthExtras has
established customized pharmacy networks in the Texas, Nevada,
Virginia, New Mexico, Tennessee and Carolina regions and intends to
develop similar networks in other parts of the country.
- DATA ANALYSIS AND REPORTING TO IMPROVE COST EXPERIENCE AND QUALITY OF
CARE: HealthExtras performs client-specific data analysis to develop
trends, insights, and conclusions that result in improved care while
reducing costs. Many PBMs offer a variety of data analysis techniques
from both a clinical and financial perspective. HealthExtras
differentiates itself by using the information it derives from its
systems to obtain regionally favorable prescription pricing; to
actively influence the drivers of prescription drug utilization; and to
monitor clinical formulary and disease management trends.
- EXTENSIVE USE OF INTERNET FACILITIES TO ENHANCE ACCOUNT MANAGEMENT
EFFECTIVENESS: HealthExtras provides its clients Web-enabled decision
support for prescription benefit plan management, clinical evaluations,
disease management, and compliance monitoring. These data analysis and
reporting capabilities allow clients to assess top-level trend
information for total population management and to analyze detail in a
particular drug, physician, member, or pharmacy. This functionality
enables HealthExtras' clients to measure successes relative to
formulary and disease management initiatives and will assist in the
identification of specific patient populations that will benefit from
specialty pharmacy programs.
We Offer Our Clients a Variety of Specialized Services Focused On Improving
Health Outcomes
- -------------------------------------------------------------------------------
Clinical and Other Services. Our clinical services teams work closely
with clients to design and administer pharmacy benefit plans that use
formularies and other techniques to promote clinically appropriate and
cost-effective drug usage. We are often able to influence physician prescribing
patterns by comparing individual behavior to physician peer groups and
encouraging change where practices differ from peer group norms and medical
best practices. Because we operate with significant geographic focus the
consultations between our clinical pharmacists and local physicians tend to
have high levels of effectiveness compared with less concentrated initiatives.
Similarly, our programs with retail pharmacies support therapeutic interchange
programs that encourage the evaluation of cost-effective drug alternatives
where appropriate. We also offer consulting services to assist clients in
designing education and communication programs designed to support
cost-effective prescription drug programs.
Disease Management. We assist clients in managing the cost and
treatment of specific chronic diseases to improve medical outcomes and lower
the overall cost of health care. 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 the responsibility of a dedicated
team of clinicians and have been developed around three-key approaches:
- Data Analysis and Integration. We evaluate and identify medical,
laboratory, pharmacy and other relevant data within an identified
population.
- Case Identification. We identify patients who have the specific disease
and evaluate the appropriateness of targeted interventions.
6
- Clinical and Program interventions. We communicate with identified
patients and offer enhanced education about their condition and
effective management tools. We also integrate our recommendations with
physicians including treatment guidelines, patient profiles and patient
management tools. Case management intervention programs are coordinated
with other care-givers to monitor outcomes and improve overall care.
COMPETITION
-----------
We believe the primary competitive factors in our PBM businesses are
price, quality of service and scope of available services. Scale is an
important factor in negotiating prices with pharmacies and manufacturers.
Though we have other advantages to offset our comparatively small scale, we
could face more pricing competition in the future. We believe our principal
competitive advantages are our commitment to provide flexible and customized
service to our clients, our ability to leverage local market dynamics to build
customized networks and manage prescription drug spending, and the
information-based cost-containment methods we use to enhance care while
lowering costs.
There are a significant number of national and regional PBMs in the
United States, several of which have significantly greater financial, marketing
and technological resources at their disposal to expand their client base and
grow their businesses. The largest, national companies include Merck-Medco
Managed Care, L.L.C., a subsidiary of Merck & Co., Inc., ("Merck-Medco");
AdvancePCS, Express Scripts, and CaremarkRx, Inc.; as well as large health
insurers and certain HMOs which have their own PBM capabilities. In addition, a
competitor that is owned by a pharmaceutical manufacturer may have pricing
advantages that are unavailable to us and other independent PBMs. However, we
believe our independence from pharmaceutical manufacturer ownership allows us
to make unbiased formulary recommendations to our clients, balancing both
clinical efficacy and cost.
Consolidation has been, and may continue to be, an important factor in
all aspects of the pharmaceutical industry, including the PBM segment. We will
continue to evaluate additional acquisition and joint venture opportunities to
enhance our business strategy of differentiated pharmacy services.
Some of our PBM services, such as disease management services, informed
decision counseling services and medical information management services,
compete with those being offered by pharmaceutical manufacturers, other PBMs,
specialized disease management companies and information service providers.
Supplemental Benefits
---------------------
Approximately 25% of our revenues are attributable to the Supplemental
Benefits segment. Supplemental benefits programs developed by HealthExtras are
offered to individuals and small businesses through various direct marketing
initiatives. The Company has distribution agreements with many of the nation's
largest financial institutions (the "distributors"), along with leading
affinity groups and associations. Additionally, HealthExtras has a relationship
with actor and advocate Christopher Reeve to promote these benefits programs.
The marketing expenditures for these programs are now funded entirely by the
distributors. Accordingly an increasing percentage of total program revenues
are retained by the distributors as compensation and accounted for as direct
expenses by us.
Insurance companies underwrite the insurance components of these
programs. As a result, we do not assume any insurance underwriting risk. The
financial responsibility for the payment of claims resulting from a qualifying
event covered by the insurance features of our programs, is borne by
third-party insurers. All of the insurance and service features included in
these programs are supplied by outside vendors and the programs are marketed
through an independent, licensed and non-affiliated insurance agency.
Our agreements with the distributors are typically for a term of 12
months, with automatic annual renewal unless cancelled upon written notice 30
or 90 days prior to an anniversary date. Some contracts also provide for
termination by either party without cause upon 30 or 90 days prior written
notice. The significant majority of new enrollees in HealthExtras programs are
attributable to marketing initiatives funded entirely by the distributors.
Accordingly, the level of revenues from this segment will depend upon funding
levels for marketing campaigns that are not controlled by us.
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COMPETITION
-----------
We consider that our supplemental benefits programs compete with the
traditional distributors of insurance, such as captive agents, independent
brokers and agents, and direct distributors of insurance. Insurance companies
and distributors of insurance products are increasingly competing with banks,
securities firms and mutual fund companies that sell insurance or alternative
products to similar consumers. Traditionally, regulation separated much of the
activity in the financial services industry; however, recent regulatory changes
have begun to permit other financial institutions to sell insurance.
We believe that the principal competitive factors in our supplemental
benefits markets are price, brand recognition, marketing expenditures and
customer service. Many of our current and potential competitors have longer
operating histories, larger consumer bases, greater brand recognition and
significantly greater financial, marketing, technical and other resources than
our own. Certain of these competitors may be able to secure products and
services on more favorable terms than we can obtain.
Any of the distributors described above could seek to compete against
us in providing supplemental benefits through traditional channels or by
copying our products or business model. Increased competition may result in
reduced operating margins, loss of market share and damage to our brand. We
cannot assure you that we will be able to compete successfully against current
and future competitors or that competition will not harm our business, results
of operations and financial condition.
GOVERNMENT REGULATION
---------------------
Various aspects of our businesses are governed by federal and state
laws and regulations. Because sanctions may be imposed for violations of these
laws, compliance is a significant operational requirement. We believe we are in
substantial compliance with all existing legal requirements material to the
operation of our businesses. There are, however, significant uncertainties
involving the application of many of these legal requirements to our business.
In addition, there are numerous proposed health care laws and regulations at
the federal and state levels, many of which could adversely affect our business
or financial position. We are unable to predict what additional federal or
state legislation or regulatory initiatives may be enacted in the future
relating to our business or the health care industry in general, or what effect
any such legislation or regulations might have on us. We also cannot provide
any assurance that federal or state governments will not impose additional
restrictions or adopt interpretations of existing laws or regulations that
could have a material adverse effect on our business or financial position.
- PHARMACY BENEFIT MANAGEMENT FEDERAL REGULATION. Certain federal laws
and regulations affect or may affect aspects of our PBM business. Among
these are the following:
- ANTI-REMUNERATION/FRAUD AND ABUSE LAWS. The federal healthcare
anti-kickback statute (the "Statute") prohibits, among other things,
an entity from paying or receiving, subject to certain exceptions and
"safe harbors", any remuneration to induce the referral of
individuals covered by federally funded health care programs,
including Medicare, Medicaid and CHAMPUS or the purchase (or the
arranging for or recommending of the purchase) of items or services
for which payment may be made in whole or in part under Medicare,
Medicaid, CHAMPUS or other federally funded health care programs.
Sanctions for violating these federal laws and regulations may
include imprisonment, criminal and civil fines, and exclusion from
participation in the Medicare and Medicaid programs.
The Statute has been interpreted broadly by courts, the Office of
Inspector General ("OIG") within the Department of Health and Human
Services, and administrative bodies. Because of the Statute's broad
scope, federal regulations establish certain "safe harbors" from
liability. Safe harbors exist for certain properly disclosed and
reported discounts received from vendors, certain investment
interests, certain properly disclosed payments made by vendors to
group purchasing organizations, and certain discount and payment
arrangements between PBMs and HMO risk contractors serving Medicaid
and Medicare members. A practice that does not fall within a safe
harbor is not necessarily unlawful, but may be subject to scrutiny
8
and challenge. In the absence of an applicable exception or safe
harbor, a violation of the statute may occur even if only one purpose
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 certain "product
conversion programs" in which benefits are given by drug
manufacturers to pharmacists or physicians for changing a
prescription (or recommending or requesting such a change) from one
drug to another. Such laws have been cited as a partial basis, along
with state consumer protection laws discussed below, for
investigations and multi-state settlements relating to financial
incentives provided by drug manufacturers to retail pharmacies in
connection with such programs.
Additionally, it is a crime under the Federal Employees Health
Benefit Programs ("FEHBP") for any person to knowingly and willfully
include, directly or indirectly, the amount of any kickback in the
contract price charged by a subcontractor or prime contractor to the
United States. Violators of this law also may be subject to civil
monetary penalties.
To our knowledge, these anti-remuneration laws have not been applied
to prohibit PBMs from receiving amounts from drug manufacturers in
connection with drug purchasing, drug reimbursing, and formulary
management programs, therapeutic intervention programs conducted by
independent PBMs, or the contractual relationships such as those we
have with certain of our clients. However:
- In mid-2002, it was reported publicly that the U.S. Attorney's
Office in Boston, Massachusetts had issued subpoenas to Express
Scripts, Inc. and Caremark Rx, Inc., both PBMs, and to WellPoint
Health Networks, Inc., and PacifiCare Health Systems, Inc., both
managed care companies, in connection with documents related to TAP
Pharmaceuticals ("TAP"). TAP, a pharmaceutical manufacturer,
reached a public settlement with the federal and state governments
in late 2001, in a case that included allegations of
anti-remuneration law violations. At this time, there is no
indication that the PBMs and managed-care organizations are targets
of this investigation.
- In October 2002, the OIG published a "Draft OIG Compliance Program
Guidance for Pharmaceutical Manufacturers" (the "Compliance
Guidance"). The Compliance Guidance is voluntary and is directly
aimed at the compliance efforts of pharmaceutical manufacturers.
Moreover, the Compliance Guidance is in draft and has not yet been
finalized. However, the Compliance Guidance highlights several
compliance "risk areas" that include certain potentially prohibited
remuneration in connection with pharmaceutical manufacturer
financial relationships with other entities that might include
PBMs.
- In late 1999, it was reported publicly that the U.S. Attorney's
Office in Philadelphia, Pennsylvania had issued subpoenas to Medco
Managed Care, LLC (now Medco Health Solutions, Inc., "Medco") and
PCS (now "AdvancePCS"), both PBMs, and Schering-Plough Corp., a
pharmaceutical manufacturer. The investigation is reported to
involve, among other things, practices under certain
anti-remuneration statutes.
We believe that we are in substantial compliance with the legal
requirements imposed by such laws and regulations. However, there can
be no assurance that we will not be subject to scrutiny or challenge
under such laws or regulations. Any such challenge could have a
material adverse effect on us.
- ERISA REGULATION. The Employee Retirement Income Security Act of
1974 ("ERISA") regulates certain aspects of employee pension and
health benefit plans, including self-funded corporate health plans
with which we have agreements to provide PBM services.
- In late 2002, it was reported publicly that Medco, was preparing to
settle a class action suit, which suit alleged that Medco violated
"fiduciary" obligations under ERISA in steering clients towards
Merck products through a variety of means. Under the proposed
settlement, Medco reportedly will not admit any liability under
ERISA or otherwise.
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- Additionally, other PBMs, including Caremark and AdvancePCS, have
disclosed publicly that they are defending private litigant
lawsuits alleging that they are ERISA fiduciaries.
We believe that the conduct of our business generally is not subject
to the fiduciary obligations of ERISA. However, there can be no
assurance that the U.S. Department of Labor, which is the agency that
enforces ERISA, or a private litigant would not assert that the
fiduciary obligations imposed by the statute apply to certain aspects
of our operations.
In addition to its fiduciary provisions, ERISA imposes civil and
criminal liability on service providers to health plans and certain
other persons if certain forms of illegal remuneration are made or
received. These provisions of ERISA are similar, but not identical,
to the health care anti-remuneration statutes discussed in the
immediately preceding section; in particular, ERISA does not provide
the statutory and regulatory "safe harbor" exceptions incorporated
into the Statute. Like the health care anti-remuneration laws, the
corresponding provisions of ERISA are written broadly and their
application to particular cases is often uncertain. The Company has
implemented policies, which include disclosure to health plan
sponsors with respect to any commissions paid by or to us that might
fall within the scope of such provisions, and accordingly believe we
are in substantial compliance with these provisions of ERISA.
However, we can provide no assurance that our policies in this regard
would be found by the appropriate enforcement authorities and
potential private litigants to meet the requirements of the statute.
- FDA REGULATION. The U.S. Food and Drug Administration ("FDA")
generally has authority to regulate drug promotional materials that
are disseminated "by or on behalf of" a drug manufacturer. In January
1998, the FDA issued a Notice and Draft Guidance regarding its intent
to regulate certain drug promotion and switching activities of
pharmacy benefit managers that are controlled, directly or
indirectly, by drug manufacturers. After extending the comment period
due to numerous industry objections to the proposed draft, the FDA
has taken no further action on the Notice and Draft Guidance.
However, there can be no assurance that the FDA will not attempt
again to assert jurisdiction over certain aspects of our PBM business
in the future and, in such event, the impact could materially
adversely affect our operations, business or financial position.
- PHARMACY BENEFIT MANAGEMENT STATE REGULATION. Certain state laws and
regulations affect or may affect aspects of our PBM business.
Accordingly, compliance with state laws and regulations remains a
significant operational requirement for us. These state laws are
described below. Some of the state laws described below 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. We also provide services to certain
clients, such as governmental entities, that are not subject to the
preemption provisions of ERISA. Other state laws described below 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.
- ANTI-REMUNERATION/FRAUD AND ABUSE LAWS. Several states have laws
and/or regulations similar to those federal anti-remuneration and
fraud and abuse laws described above. Such state laws are not
necessarily limited to services or items for which federally funded
programs such as Medicare payment may be made. Sanctions for
violating these state anti-remuneration laws may include injunction,
imprisonment, criminal and civil fines, and exclusion from
participation in the state Medicaid programs. We believe that we are
in substantial compliance with the legal requirements imposed by such
laws and regulations. However, there can be no assurance that we will
not be subject to scrutiny or challenge under such laws or
regulations. Any such challenge could have a material adverse effect
on the Company.
- CONSUMER PROTECTION LAWS. Most states have consumer protection laws
that generally prohibit payments and other broad categories of
conduct deemed harmful to consumers. These statutes may be enforced
by the states and, in fact, have been the basis for state
investigations and at least one multi-state settlement relating to
financial incentives provided by drug manufacturers to retail
pharmacies in connection with drug switching programs.
10
- In January 2003, it was reported publicly that New York's Attorney
General is investigating Medco, in connection with therapeutic
interchange programs that may have been improper under state consumer
protection laws.
- In November 2002, it was reported publicly that West Virginia's
Attorney General sued Medco, for consumer protection violations,
allegedly in connection with misrepresentations and nondisclosures
regarding potential savings to the state public employees' drug
benefit plan.
- In 2002, it was reported publicly that Florida's Attorney General
initiated investigations into two separate drug discount card
companies, Medplan, Inc. and the "People's Prescription Plan",
regarding possible consumer protection violations.
- Pursuant to a settlement agreement entered into with seventeen states
on October 25, 1995, Medco, agreed to have pharmacists affiliated
with Medco mail service pharmacies disclose to physicians and
patients the financial relationships between pharmaceutical
manufacturer Merck (Medco's parent company), Medco and the mail
service pharmacy when such pharmacists contact physicians seeking to
change a prescription from one drug to another.
We do not believe that we have contractual relationships with drug
manufacturers and retail pharmacies that include the features that have
been identified as problematic in these settlement agreements and
investigations. However, no assurance can be given that we will not be
subject to scrutiny or challenge under one or more of these laws.
In addition to enforcement by state regulators, many of these state
consumer protection laws allow for enforcement by private litigants.
For example:
- In March 2003, the American Federation of State County and Municipal
Employees, a public employee union, and the Prescription Access
Litigation project, a nationwide coalition of consumer groups filed
suit in California state court against AdvancePCS, Caremark Rx,
Express Scripts, and Medco. The suit alleges that a variety of PBM
practices in connection with accepting various forms of payments from
pharmaceutical manufacturers violate the California Unfair
Competition Law. Some of the PBMs involved have asserted publicly
that the allegations are without merit.
No assurance can be given that we will not be subject to scrutiny or
challenge under similar consumer protection theories.
- COMPREHENSIVE PBM REGULATION. States continue to introduce
legislation to regulate PBM activities in a comprehensive manner. In
addition, certain quasi-regulatory organizations, such as the
National Association of Boards of Pharmacy ("NABP", an organization
of state boards of pharmacy), the National Association of Insurance
Commissioners ("NAIC", an organization of state insurance
regulators), and the National Committee on Quality Assurance ("NCQA",
an accreditation organization) are considering proposals to regulate
PBMs and/or PBM activities, such as formulary development and
utilization management. While the actions of the NABP and NAIC would
not have the force of law, they may influence states to adopt any
requirements or model acts they promulgate. In addition, standards
established by NCQA could materially impact us directly as a PBM, and
indirectly through the impact on our health plan clients, where
applicable. Many states have licensure or registration laws governing
certain types of ancillary health care organizations, including PPOs,
TPAs, companies that provide utilization review services, and
companies that engage in the practices of a pharmacy. The scope of
these laws differs significantly from state to state, and the
application of such laws to the activities of pharmacy benefit
managers often is unclear. We believe that we are in substantial
compliance with all such laws and requirements where required, and
continue to monitor legislative and regulatory developments. There
can be no assurance, however, regarding the future interpretation of
these laws and their applicability to the activities of our PBM
business. Future legislation or regulation, or interpretations by
11
regulatory authorities of existing laws and regulations could
materially affect the cost and nature of the business as currently
conducted.
- NETWORK ACCESS LEGISLATION. A majority of states now have some form
of legislation affecting our ability to limit access to a pharmacy
provider network or removal of a network provider. Such legislation
may require us or our clients to admit any retail pharmacy willing to
meet the plan's price and other terms for network participation ("any
willing provider" legislation); or may provide that a provider may
not be removed from a network except in compliance with certain
procedures ("due process" legislation). We have not been materially
affected by these statutes.
- LEGISLATION AFFECTING PLAN OR BENEFIT DESIGN. Some states have
enacted legislation that prohibits certain types of managed-care plan
sponsors from implementing certain restrictive design features, and
many states have legislation regulating various aspects of managed-
care plans, including provisions relating to the pharmacy benefit.
For example, some states, under so-called "freedom of choice"
legislation, provide that members of the plan may not be required to
use network providers, but must instead be provided with benefits
even if they choose to use non-network providers. Other states have
enacted legislation purporting to prohibit health plans from offering
members financial incentives for use of mail service pharmacies.
Legislation has been introduced in some states to prohibit or
restrict therapeutic intervention, or to require coverage of all
FDA-approved drugs. Other states mandate coverage of certain benefits
or conditions and require health plan coverage of specific drugs, if
deemed medically necessary by the prescribing physician. Such
legislation does not generally apply to us directly, but it may apply
to certain of our clients, such as HMOs and health insurers. If such
legislation were to become widely adopted and broad in scope, it
could have the effect of limiting the economic benefits achievable
through pharmacy benefit management. This development could have a
material adverse effect on our business.
- REGULATION OF FINANCIAL RISK PLANS. Fee-for-service prescription drug
plans are generally not subject to financial regulation by the
states. However, if the PBM offers to provide prescription drug
coverage on a capitated basis or otherwise accepts material financial
risk in providing the benefit, laws in various states may regulate
the plan. Such laws may require that the party at risk establish
reserves or otherwise demonstrate financial responsibility. Laws that
may apply in such cases include insurance laws, HMO laws or limited
prepaid health service plan laws. We do not believe that our PBM
business currently accepts financial risk of the type subject to such
regulation.
- DISCOUNT DRUG CARD REGULATION. Several states recently have enacted
laws and/or promulgated or proposed regulations regulating the
selling, marketing, promoting, advertising or distributing of
discount drug cards for cash purchases. Such laws and regulations
provide generally that any person may bring an action for damages or
injunction for violations. While we offer a very limited discount
drug card program which we do not consider material to our business,
there can be no assurance that the existence of such laws will not
materially impact our ability to offer certain new products and/or
services in the future.
- PHARMACY BENEFIT MANAGEMENT State and Federal Regulation. Certain
aspects of our PBM business are or may be affected by bodies of law
that exist at both the federal and state levels. Among these are the
following:
- PRIVACY AND CONFIDENTIALITY LEGISLATION. Our activities involve the
receipt or use of confidential medical information concerning
individual members. In addition, we use aggregated and anonymized
data for research and analysis purposes. Many states' laws restrict
the use and disclosure of confidential medical information, and new
legislative and regulatory initiatives are underway in several
states. To date, no such laws adversely impact our ability to provide
our services, but there can be no assurance that federal or state
governments will not enact legislation, impose restrictions or adopt
interpretations of existing laws that could have a material adverse
effect on our operations.
12
As of April 14, 2003, the final privacy regulations (the "Privacy
Rule") issued by the Department of Health and Human Services,
pursuant to the Health Insurance Portability and Accountability Act
of 1996 ("HIPAA"), become effective, and impose extensive
restrictions on the use and disclosure of individually identifiable
health information by certain entities known under the Privacy Rule
as "covered entities". While PBMs, in general, are not considered
covered entities, our clients are covered entities, and are
required to enter into "business associate agreements" with vendors,
such as PBMs, that perform a function or activity for the covered
entity that involves the use or disclosure of individually
identifiable health information. The business associate agreements
mandated by the Privacy Rule create a contractual obligation for the
PBM to perform its duties for the covered entity in compliance with
the Privacy Rule. As of October 16, 2002 (October 16, 2003 for those
who filed for an extension) the final transactions and code sets
regulation (the "Transactions Rule") promulgated under HIPAA became
effective. That regulation requires that all covered entities engaged
in electronic transactions use standardized formats and code sets. It
is incumbent upon PBMs to conduct all such transactions in accordance
with the Transaction Rule to satisfy the obligations of their covered
entity clients. We have made the necessary arrangements to offer
compliant electronic transactions to our clients. While
implementation of the Privacy Rule and the Transactions Rule (the
"HIPAA Regulations") is just beginning, and future regulatory
interpretations could alter our assessment, we currently believe that
compliance with the HIPAA Regulations should not have a material
adverse impact on our business operations. Also, pursuant to HIPAA,
state laws that are more protective of medical information are not
pre-empted by HIPAA. Therefore, to the extent states enact more
protective legislation, we could be required to make significant
changes to our business operations.
Independent of any regulatory restrictions, individual health plan
sponsor clients could increase limitations on our use of medical
information, which could prevent us from offering certain services.
- LEGISLATION AFFECTING DRUG PRICES. Various federal and state Medicaid
agencies, as well as legislators and private litigants have raised
the issue of how average wholesale price ("AWP") is determined. AWP
is a standard pricing unit published by third party data sources and
used throughout the industry as the basis for determining drug
pricing under contracts with clients, pharmacies and pharmaceutical
manufacturers. Changes to how AWP is determined and reported, as well
as the extent to which it is used in pricing, have been suggested at
both the state and federal levels and could alter the calculation of
drug prices for federal and/or state programs. We are unable to
predict whether any such changes will be adopted, and if so, if such
changes would have a material adverse impact on our financial
operations.
Additionally, some states have adopted so-called "most favored
nation" legislation providing that a pharmacy participating in the
state Medicaid program must give the state the best price that the
pharmacy makes available to any third-party plan. Such legislation
may adversely affect our ability to negotiate discounts in the future
from network pharmacies.
- VOLUNTARY INDUSTRY ETHICAL GUIDELINES. In June 2002, the
Pharmaceutical Research and Manufacturers of America published a
voluntary ethical code for its members governing their interactions
with healthcare professionals. Although it does not have the force of
law, this code provides guidance relating to several facets of
pharmaceutical manufacturers' marketing practices, particularly with
respect to payments to providers. We believe that these ethical
guidelines will not have a material adverse effect on our financial
operations.
- REGULATION OF SUPPLEMENTAL BENEFITS. Since the HealthExtras programs
include insurance benefits, distribution of our programs must satisfy
applicable legal requirements relating, among other things, to policy
form and rate approvals, the licensing laws for insurance agents and
insurance brokers, and the satisfaction by a HealthExtras member who
receives the insurance benefit of requisite criteria, for example being
a resident of a state which has approved the insurance policy. We
believe we satisfy applicable requirements. The underwriter of the
insurance benefits included in HealthExtras programs is responsible for
obtaining regulatory approvals for those benefits. Independent licensed
13
insurance agencies are responsible for the solicitation of insurance
benefits involved in HealthExtras programs.
Complex laws, rules and regulations of each of the 50 states and the
District of Columbia pertaining to insurance impose strict and
substantial requirements on insurance coverage sold to consumers and
businesses. Compliance with these laws, rules and regulations can be
arduous and imposes significant costs. Each jurisdiction's insurance
regulator typically has the power, among other things, to:
- administer and enforce the laws and promulgate rules and regulations
applicable to insurance, including the quotation of insurance
premiums;
- approve policy forms and regulate premium rates;
- regulate how, by which personnel and under what circumstances an
insurance premium can be quoted and published; and
- regulate the solicitation of insurance and license insurance
companies, agents and brokers who solicit insurance.
State insurance laws and regulations, including their application to
use of the Internet, are complex and broad in scope and are subject to
periodic modification as well as differing interpretations. There can
be no assurance that insurance regulatory authorities in one or more
states will not determine that the nature of our business requires us
to be licensed under applicable insurance laws. A determination to that
effect or that we or the distributors are otherwise not in compliance
with applicable regulations could result in fines, additional licensing
requirements or inability to market the products in particular
jurisdictions. Such penalties could significantly increase our general
operating expenses and harm our business. In addition, even if the
allegations in any regulatory or legal action against us turn out to be
false, negative publicity relating to any such allegation could result
in a loss of consumer confidence and significant damage to our brand.
One of the means by which distributors market the programs is
telemarketing, which the distributors may out source to third parties.
Telemarketing has become subject to an increasing amount of Federal and
state regulation as well as general public scrutiny in the past several
years. For example such regulation limits the hours during which
telemarketers may call consumers and prohibits the use of automated
telephone dialing equipment to call certain telephone numbers. The
Federal Telemarketing and Consumer Fraud and Abuse Prevention Act of
1994 and Federal Trade Commission ("FTC") regulations prohibit
deceptive, unfair or abusive practices in telemarketing sales. Both the
FTC and state attorneys general have authority to prevent certain
telemarketing activities deemed by them to violate consumer protection.
On January 29, 2003, the FTC published a final rule on telemarketing
sales that, among other things, provides for a national "do-not-call"
registry. While the registry will require additional federal funding to
become effective, and additional time to be implemented, it is
anticipated that as of October 2003 it will be illegal for most
telemarketers to call anyone who has elected to be listed on the
registry. Implementation of the registry could have an adverse effect
on the sale of the Company's programs. In addition, some states have
enacted laws and others are considering enacting laws targeted directly
at regulating telemarketing practices, and there can be no assurance
that any such laws, if enacted, will not adversely affect or limit the
Company's current or future operations. While compliance with these
regulations is generally the responsibility of the distributors and
subcontractors, there can be no assurance that the Company would have
no exposure to liability.
- FUTURE REGULATION. We are unable to predict accurately what additional
federal or state legislation or regulatory initiatives may be enacted
in the future relating to our businesses or the health care industry in
general, or what effect any such legislation or regulations might have
on us. There can be no assurance that federal or state governments will
not impose additional restrictions or adopt interpretations of existing
laws that could have a material adverse effect on our business or
financial position.
14
EMPLOYEES
---------
As of December 31, 2002, we had 105 personnel whose services are devoted
full time to HealthExtras and its subsidiaries. We have never had a work
stoppage. A collective bargaining unit does not represent our personnel. We
consider our relations with our personnel to be good. Our future success will
depend, in part, on our ability to continue to attract, integrate, retain and
motivate highly qualified technical and managerial personnel, for whom
competition is intense.
15
ITEM 2. PROPERTIES
Our offices are located in approximately 19,700 square feet of office space
in Rockville, Maryland under a sublease that expires on May 30, 2004. Our
subsidiaries lease a total of approximately 25,400 square feet under three
leases that expire in March 2003, February 2006, and October 2011. We believe
that our office space is adequate for our existing needs and that suitable
additional space on commercially reasonable terms will be available as
required.
ITEM 3. LEGAL PROCEEDINGS
From time to time we become subject to legal proceedings and claims in the
ordinary course of business. Such legal proceedings and claims could include
claims of alleged infringement of third party intellectual property rights,
notices from government regulators alleging that we may have violated certain
regulations, and employment-related disputes. Such claims, even if without
merit, could result in the significant expenditure of our financial and
managerial resources. We are not aware of any legal proceedings or claims that
we believe will, individually or in the aggregate, significantly harm our
business, financial condition or results of operations in any material respect.
ITEM 4. SUBMISSION OF MATTERS FOR A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
quarter ended December 31, 2002.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The common stock has been quoted on the NASDAQ National Market under the
symbol "HLEX" since the Company's initial public offering on December 14, 1999.
The following table sets forth for the period indicated the high and low sales
prices for the common stock:
High Low
------- ------
2001
First quarter............... $ 6.44 $ 3.25
Second quarter.............. $ 10.25 $ 4.88
Third quarter............... $ 11.01 $ 4.10
Fourth quarter.............. $ 6.80 $ 4.09
2002
First quarter............... $ 6.61 $ 2.69
Second quarter.............. $ 5.49 $ 2.40
Third quarter............... $ 5.45 $ 3.31
Fourth quarter............. $ 4.46 $ 3.80
2003
First quarter (through March 21, 2003)..... $ 4.30 $ 3.40
On March 21, 2003, the last closing sale price of the common stock, as
reported by the Nasdaq National Market was $3.99 per share. As of March 21,
2003, the Company had approximately 546 stockholders of record. The Company did
not pay any cash dividends in 2002 and has no plans to do so in the foreseeable
future.
17
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data has been derived from the audited
financial statements of the Company and its predecessor companies. The selected
financial data should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the audited
consolidated financial statements, including notes thereto.
For the Years Ended December 31,
--------------------------------
(In thousands except per share data)
1998 1999 2000 2001 2002
--------- --------- -------- --------- ---------
Statement of Operations Data
Revenues .................................... $ -- $ 5,327 $ 43,924 $ 118,226 $ 248,408
Direct expenses.............................. -- 3,096 24,049 87,543 209,523
Selling, general and administrative ......... 6,534 13,327 39,669 38,454 35,485
--------- --------- -------- --------- ---------
Operating income (loss) ..................... (6,534) (11,096) (19,794) (7,771) 3,400
Interest income (expense), net .............. (110) (351) 2,069 1,092 (82)
Other income (expense), net ................. -- (73) 499 -- --
--------- --------- -------- --------- ---------
Income (loss) before income taxes
and minority interest .................. (6,644) (11,520) (17,226) (6,679) 3,318
Income tax benefit .......................... -- -- -- -- 10,205
Minority interest ........................... -- -- -- (96) (45)
--------- --------- -------- --------- ---------
Net income (loss) .......................... $ (6,644) $ (11,520) $ (17,226) $ (6,775) $ 13,478
========== ========= ========= ========= ========
Basic and diluted net income (loss) per share -- $ (0.56) $ (0.62) $ (0.23) $ 0.42
Weighted average shares of
common stock outstanding, basic ........ -- 20,588 28,010 29,731 32,234
Weighted average shares of
common stock outstanding, diluted ...... -- 20,588 28,010 29,731 32,420
Pro forma basic and diluted net loss
per share (1) .......................... $ (0.38) $ -- $ -- $ -- $ --
Pro forma weighted average shares of
common stock outstanding (1) ........... 17,680 -- -- -- --
Balance Sheet Data:
Cash and cash equivalents ................... 219 46,971 28,921 33,009 17,531
Total assets ................................ 4,608 53,662 52,044 88,153 120,002
Total liabilities ........................... 5,531 6,298 15,806 42,372 60,478
Total stockholders' (members') equity
(deficit) .............................. (923) 47,364 36,238 45,237 59,524
- --------------
(1) Reflects the formation of HealthExtras, Inc. as if those events had taken
place at the beginning of the period, except that no effect is given to the
investment by Capital Z Healthcare Holding Corp. in HealthExtras prior to May
27, 1999.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Form 10-K may contain forward-looking statements (see "Certain Factors
That May Affect Future Operating Results or Stock Prices") within the meaning
of Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements involve a number of risks and uncertainties. We
undertake no obligation to revise any forward-looking statements in order to
reflect events or circumstances that may arise after the date of this report.
Readers are urged to carefully review and consider the various disclosures made
in this report and in our other filings with the Securities and Exchange
Commission that attempt to advise interested parties of the risks and factors
that may affect our business.
OVERVIEW
HealthExtras is a provider of PBM services and supplemental benefits.
The Company's clients include managed-care organizations, self-insured
employers, third party administrators, as well as individual customers. The PBM
segment now generates the significant majority of our revenues and is expected
to be the primary source of growth and profit potential in years ahead. The
acquisitions of International Pharmacy Management, Inc. ("IPM"), Catalyst Rx
("Catalyst") and PNNC have contributed significantly to the growth of our PBM
business.
PHARMACY BENEFIT MANAGEMENT
---------------------------
Our primary PBM services consist of the automated online processing of
prescription claims on behalf of our clients. When a member of one of our
clients presents a prescription or health plan identification card to a retail
pharmacist in our network, our system provides the pharmacist with accesses to
online information regarding eligibility, patient history, health plan
formulary listings, and contractual reimbursement rates. The member generally
pays a co-payment to the retail pharmacy and the pharmacist fills the
prescription. On behalf of our clients, we electronically aggregate pharmacy
benefit claims, which include prescription costs plus our claims processing
fees for consolidated billing and payment. We receive payments from clients and
remit the amounts owed to the retail pharmacies pursuant to our negotiated
rates and retaining the difference, including claims processing fees.
We have established a nationwide network of over 50,000 retail
pharmacies. In general, self-insured employers and managed-care organizations
contract with us to access our negotiated retail pharmacy network rates,
participate in certain rebate arrangements with manufacturers based on
formulary design and benefit from the other care enhancement protocols in our
system. Under these contracts, we have an independent obligation to pay network
retail pharmacies for the drugs dispensed and accordingly, have assumed that
risk independent of our clients. When the Company administers pharmacy
reimbursement contracts and does not assume a credit risk, the Company records
only its administrative or dispensing fees as revenue. Pharmacy benefit claim
payments from our clients are recorded as revenues, and prescription costs to
be paid to pharmacies are recorded as direct expenses. Member co-payments are
not recorded as revenue. Rebates earned under arrangements with manufacturers
are recorded as a reduction of direct expenses. The portion of manufacturer
rebates due to plan sponsors is recorded as a reduction of revenue.
Acquisitions
------------
The Company has supported the growth of its PBM segment through three
acquisitions. The revenues from this business segment are larger than those of
the supplemental benefits segment and are continuing to grow at a higher rate.
On December 1, 2002, the Company acquired 100% of the common stock of
PNNC. Total consideration for PNNC stock was $20.2 million. Total acquisition
cost included transaction costs of approximately $1.4 million. Funding for the
$21.6 million cash transaction was derived from the Company's working capital.
The acquisition of PNNC was accounted for using the purchase method of
accounting. The acquisition resulted in goodwill of approximately $10.6
million.
19
On November 14, 2001, the Company acquired an 80% interest in Catalyst
for an aggregate purchase price of approximately $14.3 million. Consideration
for the transaction consisted of $10.4 million in cash, $8.9 million of which
was payable at December 31, 2001, and the remainder consisted of the assumption
of debt and the issuance of common stock. The acquisition of Catalyst was
accounted for using the purchase method of accounting. The $9.1 million excess
of the purchase price paid over the net fair value of identifiable assets and
liabilities of Catalyst was recorded as goodwill.
During the first quarter of 2002, the Company purchased the outstanding
20% minority interest in Catalyst for 319,033 shares of the Company's stock
valued at $1.1 million and notes payable of $4.2 million. The stock was
transferred to the seller on April 1, 2002, and the $3.1 million in cash was
paid in 2002, with the final installment of $1.1 million paid on March 1, 2003.
Effective November 1, 2000, the Company completed the acquisition of
IPM for an aggregate purchase price of approximately $9.2 million.
Consideration for the transaction consisted of approximately 95% cash and the
remainder in common stock. The acquisition of IPM was accounted for using the
purchase method of accounting. Goodwill recorded at acquisition was $9.2
million.
Integration of Acquisitions
---------------------------
HealthExtras has successfully integrated IPM and Catalyst into the
Company's financial, organizational, management and technology structure. Our
acquisitions have provided the Company with a more diverse and complete set of
products and services to sell to a larger customer base. For example,
Catalyst's previously developed demand management, generic substitution and
other clinical programs have significantly enhanced the Company's ability to
serve larger and more sophisticated customers. The acquisitions have also
allowed us to better capture efficiencies in corporate overhead and information
technology investments. The Company has achieved cost savings from the
consolidation of certain corporate activities and the elimination of certain
duplicated components of the Company's corporate operations.
The Company has completed the initial steps of integrating PNNC that
are necessary for HealthExtras to operate as a single, combined company. We
intend to operate with a combined financial, organizational and management
structure so that all of our customers, employees and suppliers have access to
a consistent and reliable organizational infrastructure. Over the next several
quarters the Company expects to complete additional integration steps around
data processing platforms and other technology systems.
SUPPLEMENTAL BENEFITS PROGRAMS
------------------------------
The Company's supplemental benefits segment generates revenue from the
sale of membership programs which provide insurance and other benefits. The
Company has distribution agreements with many of the nation's largest financial
institutions (the "distributors"), along with leading affinity groups and
associations. Additionally, HealthExtras has a relationship with actor and
advocate Christopher Reeve to promote these benefits programs.
Revenue is generated by payments for program benefits and payments from
certain distributors. In general, program revenue is recognized based on the
number of members enrolled in each reporting period multiplied by the
applicable fee collected from the member or paid by the distributor for their
specific membership program. The program revenue recognized by HealthExtras
includes the cost of the membership benefits, which are supplied by others,
including the insurance components. Payments from the distributors related to
new member enrollments are recorded as revenue to the extent of the related
direct expenses, which to date have exceeded payments from the distributors.
Direct expenses consist principally of the cost of benefits provided to
program members, distributors' compensation, and transaction processing fees.
Direct expenses are a function of the level of membership during the period and
the specific set of program features selected by members. The coverage
obligations of our benefit suppliers and the related expense are determined
monthly, as are the remaining direct expenses.
20
Revenue from program payments received, and related direct expenses,
are deferred to the extent that they are applicable to future periods or to any
refund guarantee we offer. HealthExtras has committed to minimum premium
volumes with respect to the insurance features of its programs supplied by
others. In the event that there were insufficient members to utilize the
minimum premium commitment, the differential would be expensed by the Company
with out any related revenue. The Company believes that current enrollment
trends will allow the minimum future commitments at December 31, 2002, to be
fully utilized by current enrollment levels.
RESULTS OF OPERATIONS
- ---------------------
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
REVENUE. Revenue from operations for the year ended December 31, 2002, was
$248.4 million, compared to $118.2 million for the year ended December 31,
2001. The PBM segment contributed $135.4 million of this revenue increase,
while the supplemental benefits segment decreased by $5.2 million. Total
revenue for the year ended increased 289% and decreased 7.3% in the PBM segment
and the supplemental benefits segment, respectively. The PBM increase was
principally due to the Catalyst acquisition on November 14, 2001, which
increased revenues by $115.2 million from 2001 to 2002. Of the $115.2 million,
$49.8 million is attributed to new business for Catalyst in 2002. Due to the
Company's adoption of Emerging Issues Task Force Issue No. 01-9, "Accounting
for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors
Products" ("EITF 01-9"), revenues and direct expenses for 2001 have been
retroactively reduced by $6.2 million in the comparative financial statements.
For more information about the adoption of EITF 01-9, see Note 2 of the Notes
to Consolidated Financial Statements.
DIRECT EXPENSES. Direct expense for the year ended December 31, 2002 of
$209.5 million consisted of $168.0 million in direct costs associated with the
PBM segment and $41.5 million attributable to benefit costs and compensation to
our distributors for supplemental benefits products. Direct expenses for the
year ended 2001 were $87.5 million, consisting of approximately $43.6 million
and $43.9 million attributable to the pharmacy benefit management services and
supplemental benefits segments, respectively. The PBM increase is principally
due to the Catalyst acquisition, which increased direct expenses by $106.6
million from 2001 to 2002. Of the $106.6 million, $45.6 million is attributed
to new business for Catalyst in 2002. The direct expenses of $209.5 million and
$87.5 million for the years ended 2002 and 2001, represent 85.5% and 69.5% of
operating expenses for the respective periods.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses for the year ended December 31, 2002, totaled $35.5 million or 14.5%
of operating expenses, $7.0 million of which was related to the Company's PBM
segment, while the remaining $28.5 million related to the management of the
supplemental benefits segment. These expenses include $4.1 million for creative
development, product endorsement and market research, $12.6 million in direct
marketing, $8.2 million in compensation and benefits, $1.3 in professional
fees, insurance and taxes, $2.8 million in other expenses, $1.4 million in
facility costs, $826,000 in travel expenses and $1.7 million in depreciation
and amortization and $2.7 million related to the impairment of and write-off of
fixed assets.
Selling and general administrative expenses for the year ended 2001, were
approximately $38.5 million or 30.5% of total operating expenses, $3.7 million
which related to the Company's PBM segment, while the remaining $34.8 million
related to the supplemental benefits segment. These expenses included $5.8
million for creative development, product endorsements and market research,
$21.4 million in direct marketing, $6.1 million in compensation and benefits,
$1.1 million in professional fees, insurance and taxes, $1.0 million in other
expenses, $843,000 in facility costs, $466,000 in travel expenses, and $1.8
million in depreciation and amortization.
INTEREST INCOME (EXPENSE) NET. Interest expense, net for the year ended
December 31, 2002, was approximately $(82,000) compared to interest income, net
of $1.1 million for the year ended December 31, 2001. This was principally due
to lower invested balances, interest rates and interest on borrowings initiated
in 2002. Interest expense on borrowings for 2002 was $319,000.
21
INCOME TAX BENEFIT. Through 2001, the Company maintained a full valuation
allowance against the Company's deferred tax assets due to the uncertainly as
to their ultimate realization. In the fourth quarter of 2002, as a result of
the Company's current and projected profitability, the Company recognized
approximately a $10.2 million tax benefit principally resulting from the
Company releasing the valuation allowance for its deferred tax asset. See Note
7 to the Notes to Consolidated Financial Statements for further information.
MINORITY INTEREST. The minority interest charge for the years ended December
31, 2002 and 2001, was approximately $45,000 and $96,000, respectively. The
charges represent the net income attributable to the 20% minority interest
holder of Catalyst for the months of January and February 2002, and November
and December 2001, respectively. As the Company purchased the remaining
minority interest on March 1, 2002, no additional minority interest charge for
Catalyst will appear on the Company's future financial statements.
NET INCOME (LOSS). Net income for the year ended December 31, 2002, was
$13.5 million compared to a $(6.8) million net loss in 2001. As a percentage of
revenue, net income increased from (5.6)% to 5.4%.
December 31, 2002
Supplemental
PBM Benefits Total
------------- ------------- --------------
Revenue ............... $ 182,275,943 $ 66,131,523 $ 248,407,466
Operating expenses.... 174,993,333 58,162,480 233,155,813
Operating income ..... 7,282,610 7,969,043 15,251,653
Total assets ......... 103,174,621 16,827,515 120,002,136
Accounts receivable... 37,527,001 272,777 37,799,778
Accounts payable ..... 33,863,566 588,223 34,451,789
December 31, 2001
Supplemental
PBM Benefits Total
------------- ------------- --------------
Revenue ............... $ 46,893,749 $ 71,332,170 $ 118,225,919
Operating expenses .... 46,233,164 77,326,609 123,559,773
Operating income (loss) 660,585 (5,994,439) (5,333,854)
Total assets .......... 67,526,792 20,626,543 88,153,335
Accounts receivable ... 19,652,601 2,758,367 22,410,968
Accounts payable ...... 22,580,269 2,014,000 24,594,269
Operating expenses of the segments exclude $11.9 million and $2.4 million in
corporate overhead that was not allocated by management in assessing segment
performance for the years ended December 31, 2002 and 2001, respectively.
YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000
REVENUE. Revenue from operations for the year ended December 31, 2001 was
$118.2 million, compared to $43.9 million for the year ended December 31, 2000.
PBM segment revenue was $46.9 million, while revenue for the supplemental
benefits segment was $71.3 million. As the Company had increased its strategic
focus on pharmacy services during 2001, the majority of its revenue and revenue
growth were derived from such services at the end of 2001. Much of the growth
in the PBM segment was attributable to the acquisitions IPM and Catalyst during
the fourth quarters of 2000 and 2001, respectively. The 2001 increase in
revenue due to the IPM acquisition was approximately $28.9 million. Catalyst
revenue accounted for $13.0 million in 2001. Due to the Company's adoption of
EITF 01-9, revenue of previously reported 2001 and 2000 revenue has been
reduced by $6.2 million and $255,000,
22
respectively, in the comparative financial statements. For more information
about the adoption of EITF 01-9, see Note 2 of the Notes to Consolidated
Financial Statements.
DIRECT EXPENSES. Direct expense for the year ended December 31, 2001 of
$87.5 million consisted of $43.6 million in direct costs associated with the
PBM segment and $43.9 million attributable to benefit costs and compensation to
our distributors for supplemental benefits products. Direct expenses for the
year ended 2000 were $24.0 million, consisting of approximately $4.5 million
and $19.5 million attributable to the pharmacy benefit management services and
supplemental benefits segments, respectively. Much of the growth in the PBM
segment was attributable to the acquisitions of IPM and Catalyst during the
fourth quarters of 2000 and 2001, respectively. The 2001 increase in direct
expenses due to the IPM acquisition was approximately $22.7 million. Catalyst
direct expenses accounted for $12.2 million in 2001. The direct expenses of
$87.5 million and $24.0 million for the years ended 2001 and 2000, represent
69.5% and 37.7% of operating expenses for the respective periods. Due to the
Company's adoption of EITF 01-9, revenue of previously reported 2001 and 2000
direct expenses have been reduced by $6.2 million and $255,000, respectively,
in the comparative financial statements. For more information about the
adoption of EITF 01-9, see Note 2 of the Notes to Consolidated Financial
Statements.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses for the year ended December 31, 2001, totaled $38.5 million of 30.5%
of operating expenses, $3.7 million of which was related to the Company's PBM
segment, while the remaining $34.8 million related to the management of
supplemental benefits segment. These expenses include $5.8 million for creative
development, product endorsements, and market research, $21.4 million in direct
marketing, $6.1 million in compensation and benefits, $1.1 million in
professional fees, insurance and taxes, $1.0 million in other fees, $843,000
million in facility costs, $466,000 in travel expenses and $1.8 million in
depreciation and amortization.
Selling and general administrative expenses for the year ended 2000, were
approximately $39.7 million or 62.3% of total operating expenses, $448,000
which related to the Company's PBM segment, which $39.2 million related to the
supplemental benefits segment. These expenses included $5.1 million for
creative development, product endorsements and market research, $26.1 million
in direct marketing, $4.6 million in compensation and benefits, $2.5 million in
other fees and insurance and taxes, $467,000 in facility costs, $274,000 in
travel expenses, and $702,000 in depreciation and amortization.
INTEREST INCOME (EXPENSE) NET. Interest income, net for the year ended
December 31, 2001, was $1.1 million compared to interest income of $2.1 million
for the year ended December 31, 2000, a decrease of 48% principally due to
lower invested balances, interest rates and interest on borrowings initiated in
2001.
MINORITY INTEREST. The minority interest charge for the year ended December
31, 2001 was approximately $96,000. There was no minority interest charge for
the year ended December 31, 2000. The 2001 charge represents the net income
attributable due to the 20% minority interest holder of Catalyst for the months
November and December 2001.
23
NET LOSS. Net loss for the year ended December 31, 2001, was $6.8 million
compared to a $17.4 million net loss in 2000. As a percentage of revenue, net
loss decreased from 39.2% in 2000 to 5.6% in 2001.
December 31, 2001
Supplemental
PBM Benefits Total
------------- ------------- --------------
Revenue ............... $ 46,893,749 $ 71,332,170 $ 118,225,919
Operating expenses .... 46,233,164 77,326,609 123,559,773
Operating income (loss) 660,585 (5,994,439) (5,333,854)
Total assets .......... 67,526,792 20,626,543 88,153,335
Accounts receivable ... 19,652,601 2,758,367 22,410,968
Accounts payable ...... 22,580,269 2,014,000 24,594,269
December 31, 2000
Supplemental
PBM Benefits Total
------------- ------------- --------------
Revenue ............... $ 4,877,149 $ 39,046,762 $ 43,923,911
Operating expenses .... 4,988,403 51,031,389 56,019,792
Operating loss ........ (111,254) (11,984,627) (12,095,881)
Total assets .......... 32,356,816 19,687,290 52,044,106
Accounts receivable ... 101,944 3,697,326 3,799,270
Operating expenses of the segments exclude $2.4 million and $7.7 million in
corporate overhead that was not allocated by management in assessing segment
performance for the years ended December 31, 2001 and 2000, respectively.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
Cash and cash equivalents at December 31, 2002, totaled $17.5 million
compared to $33.0 million at December 31, 2001. During 2002, the Company
received $30.5 million in cash from borrowings, repaid $12.5 million on
borrowings, paid $31.6 million for business acquisitions and related costs,
paid $2.0 million in capital expenditures, and used $6.9 million of the
borrowed funds and $1.4 million of the Company's cash to reduce outstanding
payables and accrued expenses in order to negotiate more favorable rates with
specific vendors.
CASH USED IN OPERATING ACTIVITIES. Cash used for operating activities during
2002 was $22,000 compared to $2.0 million during 2001. The variance is
primarily due to a $10 million increase in income before taxes offset by a
large reduction in accounts payable and, accrued expenses, and an increase in
deferred charges.
CASH USED IN INVESTING ACTIVITIES. Cash used in investing activities for
2002 was $33.5 million compared to approximately $589,000 during 2001. The
increase is primarily attributed to the $19.6 million paid in cash for the PNNC
acquisition and related costs and the $12.1 million paid to satisfy the
Catalyst acquisition promissory notes.
CASH FROM FINANCING ACTIVITIES. Cash provided by financing activities for
2002 was approximately $18.0 million compared to $6.7 million at December 31,
2001. In January 2002, the Company arranged for a line of credit for $5.0
million to support the working capital requirements of the Company's
acquisition of Catalyst. In March 31, 2002, the Company arranged an $8.0
million revolving credit facility. In April 2002, the Company repaid the
outstanding principal of $4.5 million on the credit facility previously
arranged in January 2002. The Company repaid the remaining outstanding
principal of $8.0 million in the fourth quarter of 2002. In December 2002, the
24
Company arranged to an $18.0 million revolving credit facility. At December 31,
2002, the outstanding balance on the credit facility was $18.0 million. All
principal and accrued interest is due to the bank on May 31, 2004.
By managing accounts receivable to conform more closely to our payment
obligations to suppliers, the Company should be able to generate positive
operating cash flow which combined with available cash resources will be
sufficient to met our planned working capital, capital expenditures and
business expense requirements. However, there can be no assurance that we will
not require additional capital. Even if such funds are not required, we may
seek additional equity or debt financing. We cannot be assume that such
financing will be available on acceptable terms, if at all, of that such
financing will not be dilutive to our stockholders.
The Company has no off balance sheet transactions. The following table
reflects our current contractual commitments as of December 31, 2002.
Payments Due by Period
---------------------------------------------------------------------------------------
Total < 1 year 1-3 years 4-5 years After 5 years
---------------------------------------------------------------------------------------
Operating leases $ 4,409,494 $ 1,208,945 $ 1,656,248 $ 327,739 $ 1,216,562
Unconditional purchase
obligations 1,900,000 1,900,000 -- -- --
Other long-term obligations 2,000,000 1,000,000 1,000,000 -- --
------------------------------------------------------------------------------------
$ 8,309,494 $ 4,108,945 $ 2,656,248 $ 327,739 $ 1,216,562
====================================================================================
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
- ------------------------------------------
Management's Discussion and Analysis of the Financial Condition and Results
of Operations discusses the Company's consolidated financial statements. The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. The
most significant accounting estimates made by the Company in preparing its
financial statements include the following:
COMMON STOCK WARRANTS
In 2000 and 2001, the Company recorded as direct expense the fair
market value of common stock warrants earned, or expected to be earned by a
distributor. The Company estimated the value of the warrants at each balance
sheet date using an equity-pricing model with assumptions consistent with those
used in preparing the Company's fair value stock option compensation
disclosures. Direct expense was based on the number of warrants expected to be
issued, which is determined based on an estimate of annualized revenues as
defined under the agreement with the distributor. Effective January 1, 2002,
the Company adopted EITF 01-9, which was issued in November 2001. The Company's
adoption of EITF 01-9 resulted in changing the way the Company recognizes the
cost of consideration provided to a distributor under a warrant agreement.
Effective January 1, 2002, the charge for this consideration was recorded as a
reduction to revenue from the distributor rather than as a charge to direct
expense, as reflected in prior periods. To comply with EITF 01-9, the non-cash
warrant expenses of $6.2 million and $255,000 for 2001 and 2000, respectively
from prior years have been reclassified as a reduction to revenue from the
distributor.
PHARMACY BENEFIT MANAGEMENT REBATE REVENUES
Rebates earned under arrangements with manufacturers are recorded as a
reduction of direct expenses. The portion of such rebates due to plan sponsors
is recorded as a reduction of revenue. Manufacturers rebates are based on
estimates, which are subject to final settlement with the contracted party.
Member co-payments are not recorded as revenue.
25
ALLOWANCE FOR BAD DEBTS
The Company estimates reserves for doubtful PBM accounts receivable as
of each balance sheet date. The Company has historically had very limited
exposure to bad debts due to the nature of the employee benefits involved, the
necessity of maintaining benefit continuity for its customers employees, and
the general financial strength of its customer base. With respect to
supplemental benefits, substantially all revenues are collected in advance via
credit card and as such generate no accounts receivable exposure.
INTANGIBLE ASSETS
Intangible assets related to the acquisitions of Catalyst, and PNNC
were recognized under the provisions of FASB Statement No. 141 ("FAS 141").
Accordingly, a portion of the excess purchase price was assigned to intangible
assets that were recognizable apart from goodwill. This estimated fair value
and the weighted average useful-life of the intangible assets are based on
income-method valuation calculations, performed by an independent consulting
firm. The remaining useful life of intangible assets will be evaluated
periodically and adjusted as necessary to match the period that the assets are
expected to provide economic benefits.
GOODWILL
The Company adopted Statement of Financial Accounting Standards No.
142, Goodwill and Other Intangible Assets ("FAS No. 142"), and discontinued the
amortization of goodwill and indefinite-lived intangible assets effective
January 1, 2002. The Company completed its initial adoption impairment testing
of goodwill and concluded that no impairment of goodwill exists. The Company
performed a similar test as of December 31, 2002, and concluded that no
impairment of goodwill exists.
INCOME TAXES
The Company records deferred tax assets and liabilities based on
temporary differences between the financial statement and the tax bases of
assets and liabilities using enacted tax rates in effect in the year in which
the differences are expected to reverse. In 2000 and 2001, the Company
maintained a full valuation allowance against the Company's deferred tax assets
due to the uncertainty as to their ultimate realization. In the fourth quarter
of 2002, as a result of the Company's current and projected profitability, the
Company recognized approximately $10.2 million in tax benefits principally
resulting from the Company releasing the full valuation allowance for its
deferred tax asset.
RECENT ACCOUNTING PRONOUNCEMENTS
- --------------------------------
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"; however, it
retains many of the fundamental provisions of that Statement. SFAS No. 144 also
supersedes the accounting and reporting provisions of APB Opinion No. 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 the disposal of a segment of a business. However,
it retains the requirement in APB No. 30 to report separately discontinued
operations and extends that reporting to a component of an entity that either
has been disposed of (by sale, abandonment, or in a distribution to owners) or
is classified as held for sale. By broadening the presentation of discontinued
operations to include more disposal transactions, the FASB has enhanced
management's ability to provide information that helps financial statement
users to assess the effects of a disposal transaction on the ongoing operations
of an entity. SFAS No. 144 is effective for fiscal years beginning after
December 15, 2001 and interim periods within those fiscal years. Early
application is encouraged. The provisions of SFAS No. 144 generally are to be
applied prospectively. The Company recognized an impairment loss on fixed
assets of $2.6 million for the year ended December 31, 2002. See footnote
financial statement disclosure for additional detail.
26
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123", to provide alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. The
application of the transition provisions of SFAS No. 148 is effective for
fiscal years ending after December 15, 2002. The application of the disclosure
requirements is effective for financial reports for interim periods beginning
after December 15, 2002. We are currently evaluating the impact of SFAS No.
148 on our financial position, results of operations and liquidity.
In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees Including
Indirect Guarantees of Indebtedness of Others", which elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued.
It also clarifies that a guarantor is required to recognize, at the inception
of a guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The initial recognition and initial measurement
provisions of FIN No. 45 are applicable on a prospective basis to guarantees
issued or modified after December 31, 2002, irrespective of the guarantor's
fiscal year end. The disclosure requirements are effective for financial
statements of interim or annual periods ending after December 15, 2002. As of
December 31, 2002, there is no impact on the Company's financial statements as
a result of the issuance of FIN 45.
INTEREST RATE AND EQUITY PRICE SENSITIVITY
- ------------------------------------------
We are subject to interest rate risk on our short-term investments. We have
determined that a 10% move in the current weighted average interest rate of our
short-term investments would not have a material effect in our financial
position, results of operations and cash flows in the next year.
CERTAIN FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
- --------------------------------------------------------
FACTORS RELATED TO OUR BUSINESS
Our pharmacy benefit management operations face significant competition
-----------------------------------------------------------------------
The pharmacy benefit management industry is relatively consolidated and
dominated by large companies with significant resources. Many of the large
pharmacy benefit management companies are owned by large companies, including
pharmaceutical manufacturers, which can provide them with significant
purchasing power and other advantages, which we do not have. Competitors in
this industry include other pharmacy benefit management companies, drug
retailers, physician practice management companies, and insurance
companies/health maintenance organizations. We may also experience competition
from other sources in the future. Pharmacy benefit management companies compete
primarily on the basis of price, service, reporting capabilities and clinical
services. In most cases, the competitors referenced above are large, profitable
and well-established companies with substantially greater financial and
marketing resources than our resources. The significant majority of our PBM
revenues are generated by our twenty largest plan sponsors. The loss of any of
these significant customers could have an adverse affect on our revenues and
profitability.
If we do not manage our growth effectively, we may not be able to maintain
profitability
- -----------------------------------------------------------------------------
Our growth strategy, if successful, will result in further expansion of
our PBM operations. We can maintain profitable operations, however, only if we
are able to manage our growth effectively. Our growth in operations has placed
significant demands on our management and other resources, which is likely to
continue. Under these conditions, it is important for us to retain our existing
management, including those from Catalyst and PNNC, and to attract, hire and
retain additional highly skilled and motivated officers, managers and
employees.
We may not be successful in managing or expanding our operations or
maintaining adequate management, financial and operating systems and controls.
27
If we do not effectively manage and integrate our acquisition of PNNC our
business prospects could be damaged
- ----------------------------------------------------------------------------
Our recent acquisition of PNNC is important to achieving the scale and
operating leverage necessary to compete in this segment. Should we fail to
integrate these operations and realize the expected opportunities our prospects
could be damaged.
Our pharmacy benefit management business relies on real-time management
information systems
- -----------------------------------------------------------------------------
Our pharmacy operations utilizes an electronic network connecting
approximately 50,000 retail pharmacies to process third-party claims. The
systems we utilize are provided by a third-party. Because claims are
adjudicated in real time, systems availability and reliability are key to
meeting customers' service expectations. Any interruption in real time service,
either through systems availability or telecommunications disruptions can
significantly damage the quality of service we provide. Our pharmacy benefit
management services depend on third-party proprietary software to perform
automated transaction processing. While our pharmacy benefit management
services have not experienced significant or detrimental service interruptions,
and have significant back-up database capability, there can be no assurance
that the business will not be harmed by these service interruptions.
If we lose one or more of our distribution relationships, our access to
potential customers would decline and sales and revenues would suffer
- ----------------------------------------------------------------------------
A significant majority of all of our supplemental benefits program
sales is attributable to two distribution relationships. The relationships with
Aegon and American Express provide us with access to customer leads resulting
in sales to individual consumers. If we lose one or more of these marketing
relationships and are unable to replace them with other marketing outlets, our
access to potential customers would decline and sales and revenue would suffer.
Our supplemental benefits membership growth is dependent on telemarketing
-------------------------------------------------------------------------
A significant percentage of our membership growth during 2002 was
attributable to telemarketing sales. These sales involve a much higher
percentage of monthly rather than annual sales than was our previous
experience. The combination of these has resulted in higher initial
cancellation rates and reduced enrollment persistency. Moreover, it is possible
that FTC rule regarding a national "do-not-call" registry could adversely
affect telemarketing sales.
The loss of our relationship with Christopher Reeve to promote our programs
could significantly impair our brand recognition and, thus, our ability to sell
our Supplemental Benefits programs
- ------------------------------------------------------------------------------
Our agreement for Christopher Reeve to promote our programs currently
expires in July 2005. The loss of the Christopher Reeve identification with our
programs, upon termination of our contract or otherwise, could significantly
reduce the distribution of our programs.
If we lose our relationships with our benefit providers, we could have
difficulty meeting demand for the products and services included in our programs
- -------------------------------------------------------------------------------
We are dependent on the providers of benefits included in our programs.
These benefits are provided pursuant to arrangements with Unum Life Insurance
Company of America, The Chubb Group of Insurance Companies, Zurich American
Insurance Company and others that may be terminated on relatively short notice.
If we lose these relationships and are unable to replace them quickly and cost
effectively, we would not be able to satisfy consumer demand for our programs.
28
If the providers of the benefits included in the programs fail to provide
those benefits, or the extent of those benefits is deemed to be greater than the
providers are obligated to pay, we could become subject to liability claims by
program members
- -------------------------------------------------------------------------------
We arrange for the provision by others of the benefits included in the
member programs. If the firms with which we have contracted to provide those
benefits fail to provide them as required, or are negligent or otherwise
culpable in providing them, or if it is determined that the level of benefits
to which members are entitled exceeds the obligations of the providers, we
could become involved in any resulting claim or litigation.
We may experience significant fluctuations in our quarterly results of
operations, which will make it difficult for investors to make reliable
period-to-period comparisons and may contribute to volatility in our stock price
- --------------------------------------------------------------------------------
Our quarterly expenses have fluctuated significantly in the past, and
we expect our quarterly revenues and expenses to continue to fluctuate
significantly in the future. The causes for fluctuations could include, among
other factors:
- levels of pharmacy claims expenditures, seasonal fluctuations in
demand and enrollment levels;
- changing business mix between brand and generic prescriptions;
- changes in acceptance levels for our supplemental benefits program by
consumers;
- levels of marketing expenditures;
- renewal rate experience for our benefit programs;
We believe that quarter-to-quarter comparisons of our operating results
are not necessarily meaningful and not good indicators of our future
performance. Due to the above-mentioned and other factors, it is possible that
in one or more future quarters our operating results will fall below the
expectations of securities analysts and investors. If this happens, the trading
price of our common stock would likely decrease.
FACTORS RELATED TO REGULATION
If we fail to comply with all of the various and complex laws and
regulations governing our products and marketing techniques, including any use
of the Internet regarding products and marketing, we could be subject to fines,
additional licensing requirements or the inability to market in particular
jurisdictions
-------------------------------------------------------------------------------
Complex laws, rules and regulations of each of the 50 states and the
District of Columbia pertaining to insurance impose strict and substantial
requirements on insurance coverage sold to consumers and businesses. Compliance
with these laws, rules and regulations can be arduous and imposes significant
costs. The underwriter of the insurance benefits included in HealthExtras
programs is responsible for obtaining and maintaining regulatory approvals for
those benefits. If the appropriate regulatory approvals for the insurance
benefits included in the programs are not maintained, we would have to stop
including those benefits. An independent licensed insurance agency is
responsible for the solicitation of insurance benefits involved in the
programs.
One of the means by which distributors market the program is
telemarketing, which the distributors may out source to third parties.
Telemarketing has become subject to an increasing amount of Federal and state
regulation as well as general public scrutiny in the past several years. For
example such regulation limits the hours during which telemarketers may call
consumers and prohibits the use of automated telephone dialing equipment to
call certain telephone numbers. The Federal Telemarketing and Consumer Fraud
and Abuse Prevention Act of 1994 and Federal Trade Commission ("FTC")
regulations prohibit deceptive, unfair or abusive practices in telemarketing
sales. Both the FTC and state attorneys general have authority to prevent
certain telemarketing activities deemed by them to violate consumer protection.
On January 29, 2003, the FTC published a final rule on telemarketing sales
that, among other things, provides for a national "do-not-call" registry. While
the registry will require additional federal funding to become effective, and
additional time to be implemented, it is anticipated that as of October 2003 it
29
will be illegal for most telemarketers to call anyone who has elected to be
listed on the registry. Implementation of the registry could have an adverse
effect on the sale of the Company's programs. In addition, some states have
enacted laws and others are considering enacting laws targeted directly at
regulating telemarketing practices, and there can be no assurance that any such
laws, if enacted, will not adversely affect or limit the Company's current or
future operations. While compliance with these regulations is generally the
responsibility of the distributors and subcontractors, there can be no
assurance that the Company would have no exposure to liability.
We could be subject to legal liability based upon the information on our
website
- ----------------------------------------------------------------------------
Our members may rely upon the information published on our website
regarding insurance coverage, exclusions, limitations and ratings, and the
other benefits included in our programs. To the extent that the information we
provide is not accurate, we could be liable for damages. These types of claims
could be time-consuming and expensive to defend, divert management's attention,
and could cause consumers to lose confidence in our service. As a result, these
types of claims, whether or not successful, could harm our business.
Our pharmacy benefit management business must comply with a range of State
and Federal regulatory requirements
- -------------------------------------------------------------------------------
Various forms of legislation and government regulations affect or could
affect providers of pharmacy benefit management services. Among the most
prominent forms of such regulation are the following:
Network Access Legislation. A majority of states now have some form of
legislation affecting our ability to limit access to a pharmacy provider
network or removal of a network provider. Such legislation may require us or
our clients to admit any retail pharmacy willing to meet the plan's price and
other terms for network participation ("any willing provider" legislation); or
may provide that a provider may not be removed from a network except in
compliance with certain procedures ("due process" legislation).
Anti-Remuneration Legislation. "Anti-kickback" statutes at the federal
and state level prohibit an entity from paying or receiving any compensation to
induce the referral of healthcare plan beneficiaries or the purchase of items
or services for which payment may be made under such healthcare plans.
Additionally, state and federal regulations have been the basis for
investigations and multi-state settlements relating to financial incentives
provided by pharmaceutical manufacturers to retail pharmacies in connection
with pharmaceutical "switching" or "product conversion" programs. To our
knowledge, these laws have not been applied to prohibit pharmacy benefit
management companies from receiving amounts from pharmaceutical manufacturers
in connection with pharmaceutical purchasing and formulary management programs,
to prohibit therapeutic substitution programs conducted by independent pharmacy
benefit management companies, or to prohibit contractual relationships such as
we have regarding these types of programs.
ERISA Regulation. ERISA regulates certain aspects of employee pension
and health benefit plans, including self-funded corporate health plans with
which we have agreements to provide PBM services. We believe that the conduct
of our business generally is not subject to the fiduciary obligations of ERISA.
However, other PBMs, including Caremark and AdvancePCS, have disclosed publicly
that they are defending private litigant lawsuits alleging that they are ERISA
fiduciaries. There can be no assurance that the U.S. Department of Labor, which
is the agency that enforces ERISA, or a private litigant would not assert that
the fiduciary obligations imposed by the statute apply to certain aspects of
our operations.
In addition to its fiduciary provisions, ERISA imposes civil and
criminal liability on service providers to health plans and certain other
persons if certain forms of illegal remuneration are made or received. These
provisions of ERISA are similar, but not identical, to the health care
anti-remuneration statutes discussed in the immediately preceding section; in
particular, ERISA does not provide for any "safe harbor" exceptions. Like the
health care anti-remuneration laws, the corresponding provisions of ERISA are
written broadly and their application to particular cases is often uncertain.
The Company has implemented policies, which include disclosure to health plan
sponsors with respect to any commissions paid by or to us that might fall
within the scope of such provisions, and accordingly believe we are in
substantial compliance with these provisions of ERISA. However, we can provide
no assurance that our policies in this regard would be found by the appropriate
enforcement authorities and potential private litigants to meet the
requirements of ERISA.
30
Patient Choice and Benefit Design. Some states have enacted legislation
that prohibits the plan sponsor from implementing certain restrictive design
features, and many states have introduced legislation to regulate various
aspects of managed-care plans, including provisions relating to the pharmacy
benefit. Legislation has been introduced in some states to prohibit or restrict
therapeutic substitution, or to require coverage of all FDA approved drugs.
Other states mandate coverage of certain benefits or conditions. Such
legislation does not generally apply to us, but it may apply to certain of our
customers, such as HMOs and health insurers. If such legislation were to become
widespread and broad in scope, it could have the effect of limiting the
economic benefits achievable through pharmacy benefit management and
consequently make our services less attractive.
Legislation Affecting Drug Prices. Some states have adopted so-called
"most favored nation" legislation providing that a pharmacy participating in
the state Medicaid program must give the state the best price that the pharmacy
makes available to any third-party plan. Such legislation may adversely affect
our ability to negotiate discounts in the future from network pharmacies. In
addition, various Federal and state medicate agencies, as well as legislators
and private litigants have raised the issue of how average wholesale price
("AWP") is determined.
Consumer Protection Legislation. Most states have consumer protection
laws that generally prohibit payments and other broad categories of conduct
deemed harmful to consumers. These statutes may be enforced by the states and,
in fact, have been the basis for state investigations and at least one
multi-state settlement relating to financial incentives provided by drug
manufacturers to retail pharmacies in connection with drug switching programs.
We believe that we do not have contractual relationships with drug
manufacturers and retail pharmacies that include the features that have been
viewed adversely by enforcement authorities. However, no assurance can be given
that we will not be subject to scrutiny or challenge under one or more of these
laws.
Discount Drug Card Regulation. Several states recently have enacted
laws and/or promulgated or proposed regulations regulating the selling,
marketing, promoting, advertising or distributing of discount drug cards for
cash purchases. Such laws and regulations provide generally that any person may
bring an action for damages or injunction for violations.
Licensure. Many states have licensure or registration laws governing
certain types of ancillary healthcare organizations, including preferred
provider organizations, third party administrators and utilization review
organizations. Laws requiring registration and regulating the operations of
PBMs meeting certain criteria have also begun to appear. These laws differ
significantly from state to state, and the application of such laws to the
activities of pharmacy benefit managers is often unclear. We have registered
under such laws in those states in which we have concluded such registration is
required.
Confidential Information. Most of our activities involve the receipt or
use by us of confidential medical information concerning individual members,
including the transfer of the confidential information to the member's health
benefit plan. In addition, we use aggregated population data for research and
analysis purposes. The HIPAA Regulations require our PBM clients to enter into
business associate agreements with us that require us to assure confidential
treatment of health care information and to only use or disclose such
information as needed to provide our services and to use certain standard codes
and data sets in processing claims. We believe that we have taken all necessary
internal measures, and made all external vendor arrangements, to meet these
obligations. However the HIPAA Regulations are just becoming effective on April
14, 2003 regarding the privacy rule, and future interpretation could result in
expansion of our responsibilities. Moreover, any failure to meet current
requirements, because of the heightened profile given to the privacy issue by
HIPAA, could result in the loss of business by the Company. In addition, the
laws of many states also restrict the use and disclosure of confidential
medical information. Pursuant to HIPAA, state laws that are more protective of
medical information are not pre-empted by HIPAA. Therefore, to the extent
states enact more protective legislation, we could be required to make
significant changes to our business operations.
FACTORS RELATED TO THE INTERNET AND ELECTRONIC COMMERCE
If we experience failures of, or capacity constraints in, our systems or
the systems of third parties on which we rely, sales of our programs likely
would be reduced and our reputation could be damaged
- ------------------------------------------------------------------------------
We use both internally developed and third party systems to operate the
Internet aspects of our business. If the number of users of our service
increases substantially, we will need to significantly expand and upgrade our
technology, transaction processing systems and network infrastructure. We do
not know whether we will be able to accurately project the rate or timing of
any increases, or expand and upgrade our systems and infrastructure to
accommodate any increases in a timely manner. Our ability to facilitate
transactions successfully and provide high quality customer service also
31
depends on the efficient and uninterrupted operation of our computer and
communications hardware systems. Our service has experienced periodic system
interruptions, and it is likely that these interruptions will continue to occur
from time to time. Additionally, our systems and operations are vulnerable to
damage or interruption from human error, natural disasters, power loss,
telecommunication failures, break-ins, sabotage, computer viruses, acts of
vandalism and similar events. We may not carry sufficient business interruption
insurance to compensate for losses that could occur. Any system failure that
causes an interruption in service or decreases the responsiveness of our
service would impair our revenue-generating capabilities, and could damage our
reputation and our brand name.
If we are unable to safeguard the security and privacy of our program
members' information, our reputation would be damaged and we could be subject to
litigation and liability
- -------------------------------------------------------------------------------
A significant barrier to electronic commerce and online communications
has been the need for secure transmission of confidential information over the
Internet. Our ability to secure the transmission of confidential information
over the Internet is essential in maintaining consumer confidence in our
service. In addition, because we handle confidential and sensitive information
about our program members, any security breaches would damage our reputation
and could expose us to litigation and liability. We cannot guarantee that our
systems will prevent security breaches.
32
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
(Included in Management's Discussion and Analysis of Financial
Condition and Results of Operations)
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our audited Financial Statements are contained in a separate section of this
Annual Report on Form 10-K on pages F-1 through F-28, attached hereto.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required under this item will be contained in the section
entitled "Executive Officers and Directors" in our Proxy Statement for our 2003
Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information required under this item will be contained in the sections
entitled "Directors Compensation" and "Executive Compensation" in our Proxy
Statement for our 2003 Annual Meeting of Stockholders and is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required under this item by Item 403 of Regulation SK will be
contained in the section entitled "Stock Ownership" in our Proxy Statement for
our 2003 Annual Meeting of Stockholders and is incorporated herein by
reference.
Equity Compensation Plan Information
------------------------------ ---------------------------- --------------------------- ----------------------
Number of securities to be Weighted average exercise Number of securities
issued upon exercise of price of outstanding remaining available
outstanding options, options, warrants and for future issuance
Plan category warrants and rights rights
------------------------------ ---------------------------- --------------------------- ----------------------
(a) (b) (c)
------------------------------ ---------------------------- --------------------------- ----------------------
Equity compensation plans
approved by security holders 4,867,125 $5.16 293,500
------------------------------ ---------------------------- --------------------------- ----------------------
Equity compensation plans
not approved by security
holders -- -- --
------------------------------ ---------------------------- --------------------------- ----------------------
Total 4,867,125 $5.16 293,500
------------------------------ ---------------------------- --------------------------- ----------------------
33
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required under this item will be contained in the section
entitled "Certain Transactions" in our Proxy Statement for our 2003 Annual
Meeting of Stockholders and is incorporated herein by reference.
ITEM 14. CONTROLS AND PROCEDURES
a) Disclosure Controls and Procedures. The Registrant's Chief Executive
Officer and Chief Financial Officer have evaluated the Registrant's disclosure
controls and procedures within the 90 days prior to the date of filing of this
Annual Report on Form 10-K. Based upon such review, the Chief Executive Officer
and Chief Financial Officer have concluded that the Registrant has in place
appropriate controls and procedures designed to ensure that information
required to be disclosed by the Registrant in the reports it files or submits
under the Securities Exchange Act of 1934, as amended, and the rules
thereunder, is recorded, processed, summarized and reported within the time
periods specified in the Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by an issuer in reports it
files or submitted under the Securities Exchange Act is accumulated and
communicated to the Registrant's management, including its principal executive
officer or officers and principal financial officer or officers, or person
performing similar functions as appropriate to allow timely decisions regarding
required disclosure.
b) Internal Controls. Since the date of the evaluation described above,
there have not been any significant changes in our internal accounting controls
or in other factors that could significantly affect those controls.'
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report
(1) Financial Statements
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 2001 and 2002
Consolidated Statements of Operations and Comprehensive Income
(Loss) for the years ended December 31, 2000, 2001, and 2002
Consolidated Statements of Stockholders' Equity for the years
ended December 31, 2000, 2001, and 2002
Consolidated Statements of Cash Flows for the years ended
December 31, 2000, 2001 and 2002
Notes to Financial Statements
(2) Financial statement schedule:
Schedule II - Valuation and Qualifying Accounts
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K/A dated February 5, 2003
reporting items in connection with the acquisition of Pharmacy Network National
Corporation.
The Company filed a Current Report on Form 8-K dated December 16, 2002
reporting items in connection with the acquisition of Pharmacy Network National
Corporation.
The Company filed a Current Report on form 8-K dated December 4, 2002
reporting a complaint filed against the Company's exclusive placement agent for
the Company's private investment in public equity offering.
34
(c) Exhibits
The following exhibits are filed as part of this report unless noted
otherwise:
Exhibit No. Description
--------------------------------------------------------------------------
2.1 Form of Reorganization Agreement by and among HealthExtras,
Inc., HealthExtras, LLC and Capital Z Healthcare Holding
Corp (1)
2.2 Catalyst Rx, Inc. Securities Purchase Agreement Dated as of
November 14, 2001 by and among HealthExtras, Inc. as the
Purchaser, Catalyst Rx, Inc. and Kevin C. Hooks as the
Seller (2)
2.3 Catalyst Consultants, Inc. Securities Purchase Agreement
Dated as of November 14, 2001 by and among HealthExtras,
Inc. as the purchaser, Catalyst Consultants, Inc. and Kevin
C. Hooks as the Seller (2)
3.1(a) Certificate of Incorporation of HealthExtras, Inc( 1) 3.1
(b) Form of Amended and Restated Certificate of
Incorporation (1)
3.2 Bylaws of HealthExtras, Inc. (1)
4.1 Specimen Stock Certificate of HealthExtras, Inc. (1)
4.2 Form of Stockholders' Agreement (1)
10.1 Form of Employment Agreement between HealthExtras, Inc. and
David T. Blair (1)
10.2 Form of Employment Agreement between HealthExtras, Inc. and
certain Executive Officers (1)
10.3 Reserved
10.4 Reserved
10.5 Reserved
10.6 Agreement by and between Cambria Productions, Inc. f/s/o
Christopher Reeve and HealthExtras, Inc. (1) (3)
10.7 Indemnification Agreement (1)
10.8 Sublease Agreement by and between United Payors & United
Providers, Inc. and HealthExtras, Inc.
10.9 Form of HealthExtras, Inc. 1999 Stock Option Plan (1)
10.10 Form of Registration Rights Agreement (1)
10.11 Securities Purchase Agreement by and among HealthExtras,
Inc., as the Purchaser, and TD Javelin Capital Fund, L.P.,
Meriken Nominees, LTD, et. al, as the Sellers (4)
10.12 Form of HealthExtras, Inc. 2000 Stock Option Plan (5)
10.13 Form of HealthExtras, Inc. 2000 Directors' Stock Option
Plan (5)
10.14 Warrant Agreement by and among HealthExtras, Inc. and J.C.
Penney Life Insurance Company (5)
10.15 Amended Agreement by and between Cambria Productions, Inc.
f/s/o Christopher Reeve and HealthExtras, Inc. (5)
21.1 Subsidiaries of Registrant
23.1 Consent of Independent Accountants
99.1 Certifications Pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002
- --------------
(1) Incorporated herein by reference into this document from the Exhibits to
the Form S-1 Registration Statement, as amended, Registration No.
333-83761, initially filed on July 26, 1999.
(2) Incorporated herein by reference into this document from the Exhibits to
the Form 8-K initially filed on November 29, 2001.
(3) Confidential treatment requested for portion of agreement pursuant to
Section 406 of Regulation C. promulgated under the Securities Act of 1933,
as amended.
(4) Incorporated herein by reference into this document from the Exhibits to
the Form 8-K initially filed on November 21, 2000.
(5) Incorporated herein by reference into this document from the Exhibits to
the Form 10-K filed on April 2, 2001.
35
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
HEALTHEXTRAS, INC.
Date March 31, 2003 By: /s/ David T. Blair
-------------------------------
David T. Blair
Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated:
Date March 31, 2003 By: /s/ Thomas L. Blair
-------------------------------
Thomas L. Blair
Chairman of The Board
Date March 31, 2003 By: /s/ David T. Blair
-------------------------------
David T. Blair
Chief Executive Officer and Director
Date March 31, 2003 By: /s/ Michael P. Donovan
-------------------------------
Michael P. Donovan
Chief Financial Officer and
Chief Accounting Officer
Date March 31, 2003 By: /s/ Edward S. Civera
-------------------------------
Edward S. Civera
Director
Date March 31, 2003 By: /s/ Bette B. Anderson
-------------------------------
Bette B. Anderson
Director
Date March 31, 2003 By: /s/ William E. Brock
-------------------------------
William E. Brock
Director
Date March 31, 2003 By: /s/ Thomas J. Graf
-------------------------------
Thomas J. Graf
Director
Date March 31, 2003 By: /s/ Carey G. Jury
-------------------------------
Carey G. Jury
Director
Date March 31, 2003 By: /s/ Deanna D. Strable-Soethout
-------------------------------
Deanna D. Strable-Soethout
Director
Date March 31, 2003 By: /s/ Frederick H. Graefe
-------------------------------
Frederick H. Graefe
Director
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, David T. Blair, Chief Executive Officer of HealthExtras, Inc., certify that:
1. I have reviewed this annual report on Form 10-K of HealthExtras, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c. presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 31 2003 By: /s/ David T. Blair
------------------------------------------
David T. Blair
Chief Executive Officer and Director
CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Michael P Donovan, Chief Financial Officer of HealthExtras, Inc., certify
that:
1. I have reviewed this annual report on Form 10-K of HealthExtras, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 31, 2003 /s/ Michael P. Donovan
-------------------------------------
Michael P. Donovan
Chief Financial Officer and
Chief Accounting Officer
HEALTHEXTRAS, INC.
--------
CONSOLIDATED FINANCIAL STATEMENTS
at December 31, 2002 and 2001
AND REPORT THEREON
--------
Report of Independent Accountants
To the Board of Directors and Stockholders of HealthExtras, Inc.:
In our opinion, the accompanying consolidated balance sheets, and the related
consolidated statements of operations and comprehensive income (loss), of
stockholders' equity and of cash flows, present fairly, in all material
respects, the financial position of HealthExtras, Inc. and its subsidiaries (the
"Company") at December 31, 2001 and 2002, and the results of its operations and
its cash flows for each of the three years in the period ended December 31,
2002, in conformity with accounting principles generally accepted in the United
States of America. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audit of these
financial statements in accordance with auditing standards generally accepted in
the United States of America, which require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management and
evaluating the overall financial statement presentation. We believe our audit
provides a reasonable basis for our opinion.
As discussed in Note 4, the Company adopted the provisions of Statement of
Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets,"
effective January 1, 2002.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
McLean, Virginia
February 4, 2003
HEALTHEXTRAS, INC.
CONSOLIDATED BALANCE SHEETS
December 31,
2001 2002
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents .......................................................... $ 33,009,143 $ 17,531,051
Accounts receivable, net of allowance for doubtful accounts of
$457,390 and $424,540 in 2001 and 2002, respectively ............................. 22,410,968 37,799,778
Income taxes receivable ............................................................ -- 2,773,773
Deferred income taxes .............................................................. -- 1,286,313
Deferred charges ................................................................... 2,086,358 1,888,072
Other current assets ............................................................... 653,627 1,282,484
------------- -------------
Total current assets ........................................................ 58,160,096 62,561,471
Fixed assets, net .................................................................... 5,056,235 4,056,130
Deferred income taxes ................................................................ -- 3,759,152
Intangible assets, net of accumulated amortization of $45,713 and
$459,449 in 2001 and 2002, respectively ........................................... 4,449,487 14,185,751
Goodwill ............................................................................. 17,566,866 33,538,142
Restricted cash ...................................................................... 1,000,000 1,000,000
Other assets ......................................................................... 1,920,651 901,490
------------- -------------
Total assets ................................................................ $ 88,153,335 $ 120,002,136
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................................................... $ 24,594,269 $ 34,451,789
Notes payable ...................................................................... 8,883,069 1,056,000
Accrued expenses and other current liabilities ..................................... 4,385,666 2,156,165
Deferred revenue ................................................................... 4,509,055 4,813,555
------------- -------------
Total current liabilities ................................................... 42,372,059 42,477,509
Notes payable ........................................................................ -- 18,000,000
------------- -------------
Total liabilities ....................................................... 42,372,059 60,477,509
------------- -------------
Minority interest .................................................................... 543,800 --
Stockholders' equity:
Preferred stock, $0.01 par value, 5,000,000 shares authorized, none issued ......... -- --
Common stock, $0.01 par value, 100,000,000 shares authorized, 31,868,012 and
32,295,120 shares issued and outstanding at December 31, 2001 and 2002,
respectively ..................................................................... 318,680 322,951
Additional paid-in capital ......................................................... 69,747,302 70,460,184
Accumulated deficit ................................................................ (24,720,841) (11,243,127)
Deferred compensation .............................................................. (107,665) (15,381)
------------- -------------
Total stockholders' equity .................................................. 45,237,476 59,524,627
------------- -------------
Total liabilities and stockholders' equity .................................. $ 88,153,335 $ 120,002,136
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
F-2
HEALTHEXTRAS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE INCOME (LOSS)
--------
For the years ended December 31,
-------------------------------------------
2000 2001 2002
----------- ------------ ------------
Revenues ................................................. $ 43,923,911 $ 118,225,919 $ 248,407,466
----------- ------------ -----------
Direct expenses .......................................... 24,048,646 87,542,676 209,522,984
Selling, general and administrative ...................... 39,669,182 38,454,696 35,484,524
----------- ------------ ------------
Total operating expenses ...................... 63,717,828 125,997,372 245,007,508
----------- ------------ ------------
Operating income (loss) .................................. (19,793,917) (7,771,453) 3,399,958
Interest income (expense), net ........................... 2,068,421 1,092,446 (81,848)
Other income, net ........................................ 499,280 -- --
----------- ------------ ------------
Income (loss) before income taxes and minority interest .. (17,226,216) (6,679,007) 3,318,110
Income tax benefit-deferred .............................. -- -- 10,204,596
Minority interest ........................................ -- (95,642) (44,992)
----------- ------------ ------------
Net income (loss) ........................................ (17,226,216) (6,774,649) 13,477,714
Reclassification adjustment for realized gains included in
net loss ............................................... (132,669) -- --
----------- ------------ ------------
Comprehensive income (loss) .............................. $(17,358,885) $ (6,774,649) $ 13,477,714
============ ============== ==============
Earnings (loss) per share, basic ......................... $ (0.62) $ (0.23) $ 0.42
Earnings (loss) per share, diluted ....................... $ (0.62) $ (0.23) $ 0.42
Weighted average shares of common stock outstanding, basic
(in thousands) ......................................... 28,010 29,731 32,234
Weighted average shares of common stock outstanding,
diluted (in thousands) ................................. 28,010 29,731 32,420
The accompanying notes are an integral part of these consolidated financial
statements
F-3
HEALTHEXTRAS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
--------
for the years ended December 31, 2000, 2001, and 2002
Accumulated
Other Retained
Common Stock Additional Comprehensive Earnings
---------------------- Paid-in Income (Accumulated Deferred
Shares Amount Capital (Loss) Deficit) Compensation Total
---------- --------- ----------- --------- ------------- ---------- ------------
Balance at December 31, 1999..... 27,600,000 $ 276,000 $48,045,635 $ 132,669 $ (719,976) $ (370,232) $ 47,364,096
Amortization of deferred
compensation .................. -- -- -- -- -- 116,894 116,894
Warrants expected to be
issued in connection with
marketing agreement ........... -- -- 254,129 -- -- -- 254,129
Net proceeds from private
placement ..................... 1,302,600 13,026 5,849,304 -- -- -- 5,862,330
Reclassification adjustment
for realized gains
included in net loss .......... -- -- -- (132,669) -- -- (132,669)
Net loss for the year ........... -- -- -- -- (17,226,216) -- (17,226,216)
---------- --------- ----------- --------- ------------- ---------- ------------
Balance at December 31, 2000 .... 28,902,600 289,026 54,149,068 -- (17,946,192) (253,338) 36,238,564
---------- --------- ----------- --------- ------------- ---------- ------------
Stock issued pursuant to
stock grants................... 193,300 1,933 (1,933) -- -- -- --
Stock issued in exchange
for services .................. 2,300 23 12,512 -- -- -- 12,535
Warrants issued or expected
to be issued in
connection with marketing
agreement ..................... -- -- 6,125,137 -- -- -- 6,125,137
Amortization of deferred
compensation, net of
forfeitures ................... -- -- (72,537) -- -- 145,673 73,136
Exercise of employee stock
options ....................... 30,000 300 121,500 -- -- -- 121,800
Repurchase and retirement
of stock ...................... (765,000) (7,650) (4,297,350) -- -- -- (4,305,000)
Net proceeds from private
placement ..................... 3,020,782 30,208 10,862,295 -- -- -- 10,892,503
Stock issued to acquire
pharmacy management
contracts ..................... 40,000 400 194,800 -- -- -- 195,200
Stock issued pursuant to
Catalyst acquisition .......... 366,730 3,667 2,306,733 -- -- -- 2,310,400
Stock issued pursuant to
IPM acquisition ............... 77,300 773 347,077 -- -- -- 347,850
Net loss for the year ........... -- -- -- -- (6,774,649) -- (6,774,649)
---------- --------- ----------- --------- ------------- ---------- ------------
Balance at December 31, 2001 31,868,012 318,680 69,747,302 -- (24,720,84) (107,665) 45,237,476
---------- --------- ----------- --------- ------------- ---------- ------------
Exercise of employee
options........................ 9,375 94 33,375 -- -- -- 33,469
Stock issued pursuant to
stock grants .................. 81,700 817 (817) -- -- -- --
Stock issued pursuant to
Catalyst acquisition .......... 319,033 3,190 1,052,810 -- -- -- 1,056,000
Stock issued in exchange
for services .................. 17,000 170 236,030 -- -- -- 236,200
Reversal for warrants issued or
expected to be issued in
connection with
marketing agreement ........... -- -- (1,008,516) -- -- -- (1,008,516)
Issuance of common stock
warrants ...................... -- -- 400,000 -- -- -- 400,000
Amortization of deferred
compensation .................. -- -- -- -- -- 92,284 92,284
Net income for the year ......... -- -- -- -- 13,477,714 -- 13,477,714
---------- --------- ----------- --------- ------------- ---------- ------------
Balance at December 31, 2002..... 32,295,120 $ 322,951 $70,460,184 $ -- $ (11,243,127) $ (15,381) $ 59,524,627
---------- --------- ----------- --------- ------------- ---------- ------------
The accompanying notes are an integral part of these consolidated financial
statements
F-4
HEALTHEXTRAS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------
Year ended December 31,
---------------------------------------------
2000 2001 2002
------------- ------------ -------------
Cash flows from operating activities:
Net income (loss) ..................................... $ (17,226,216) $ (6,774,649) $ 13,477,714
Depreciation expense .................................. 599,337 1,110,281 1,294,663
Impairment of and loss on disposal of fixed assets .... -- -- 2,679,777
Deferred income taxes ................................. -- -- (10,204,596)
Noncash charges (credits) ............................. 371,023 6,210,808 (680,032)
Amortization of goodwill .............................. 102,473 614,839 --
Amortization of intangible and other assets ........... -- 95,138 547,692
Minority interest ..................................... -- 95,642 44,992
Gain on sale of marketable securities ................. (551,735) -- --
Changes in assets and liabilities, net of effects from
acquisitions of IPM in 2000, Catalyst in 2001 and PNNC
in 2002:
Accounts receivable, net ......................... (780,522) (4,045,099) (485,717)
Other assets ..................................... (89,823) 298,514 (794,995)
Deferred charges ................................. (38,705) 1,472,692 198,286
Accounts payable, accrued expenses and other
liabilities ...................................... 2,189,998 1,501,902 (6,404,585)
Deferred revenue ................................. 1,884,138 (2,612,294) 304,500
------------- ------------ -------------
Net cash used in operating activities ........ (13,540,032) (2,032,226) (22,301)
------------- ------------ -------------
Cash flows from investing activities:
Capital expenditures .................................. (3,061,247) (1,509,391) (1,991,400)
Purchase of intangible assets ......................... -- (300,000) (450,000)
Payments for purchase of IPM, net of cash acquired .... (7,406,398) (608,225) --
Cash acquired (paid) in Catalyst acquisitions ......... -- 2,242,370 (12,073,603)
Payments for purchase of PNNC, net of cash acquired ... -- -- (19,574,257)
Sales of available for sale marketable securities ..... 1,084,050 -- --
Restricted cash, deposits and other ................... (988,500) (414,000) 600,000
------------- ------------ -------------
Net cash used in investing activities (10,372,095) (589,246) (33,489,260)
------------- ------------ -------------
Cash flows from financing activities:
Proceeds from borrowings .............................. -- -- 30,500,000
Repayment of line of credit ........................... -- -- (12,500,000)
Proceeds from exercise of stock options ............... -- 121,800 33,469
Payments to reacquire common stock .................... -- (4,305,000) --
Net proceeds from sale of common stock ................ 5,862,333 10,892,503 --
------------- ------------ -------------
Net cash provided by financing activities ............. 5,862,333 6,709,303 18,033,469
------------- ------------ -------------
Net increase (decrease) in cash and cash equivalents .. (18,049,794) 4,087,831 (15,478,092)
Cash and cash equivalents at the beginning of year .... 46,971,106 28,921,312 33,009,143
------------- ------------ -------------
Cash and cash equivalents at the end of year ............ $ 28,921,312 $ 33,009,143 $ 17,531,051
============= ============ ============
Supplemental disclosure:
Cash paid for interest ............................. $ -- $ -- $ 318,783
Cash paid for estimated income taxes ............... $ -- $ -- $ --
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
1. COMPANY
HealthExtras is a provider of pharmacy benefit management services and
supplemental benefits. The Company's clients include managed-care
organizations, self-insured employers, third party administrators, as well
as individual customers.
The Company operates in two business segments, Pharmacy Benefit Management
("PBM") and Supplemental Benefits. The Company's largest revenue generating
segment is the PBM segment which provides managed-care organizations,
self-insured employers and third party administrators with access to the
Company's negotiated retail pharmacy network rates, participation in certain
rebate arrangements with manufacturers based on formulary design, and
benefits from other care enhancement protocols in our system.
The Company's supplemental benefits segment generates revenue from the sale
of membership programs which provide insurance and other benefits. The
Company has distribution agreements with many of the nation's largest
financial institutions (the "distributors"), along with leading affinity
groups and associations. Additionally, HealthExtras has a relationship with
actor and advocate Christopher Reeve to promote these benefits programs.
Revenues are generated from fixed monthly membership fees and payments from
distributors. The insurance component of the programs is underwritten
through group insurance agreements arranged by the Company. The Company does
not assume any insurance underwriting risk.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation
---------------------------
The accompanying consolidated financial statements include the accounts of
HealthExtras, Inc. and all its wholly owned subsidiaries. All intercompany
accounts and transactions have been eliminated.
Cash and cash equivalents
-------------------------
Cash and cash equivalents consist of cash and investments in highly liquid
instruments with maturities of three months or less when purchased. At
December 31, 2002 the Company had $1,000,000 on deposit in a restricted
account with the State of Nevada as security for performance of its pharmacy
benefit management obligations.
F-6
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
Marketable securities
---------------------
Prior to 1999, the Company purchased certain marketable securities of a
related entity. Management considered all of the common stock purchased to
be available for sale as defined by SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." Available for sale securities
are reported at fair value, with net unrealized gains and losses reported as
a component of other comprehensive income (loss). In 2000, the Company sold
its shares in the related entity for aggregate proceeds of $1,084,050,
resulting in a gain of $551,735.
Fixed assets
------------
Fixed assets are stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets, which
range from three to five years. Leasehold improvements are amortized using
the straight-line method over the shorter of the estimated lives of the
assets or the lease term. The Company capitalizes costs incurred for
software for internal use that is in the application development stage in
accordance with Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use".
In accordance with SFAS No. 144, the carrying values of the Company's assets
are re-evaluated when events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. In the first quarter of
2002, the Company consolidated its HealthExtrasRx Birmingham, Alabama
operations; at that time fixed assets were written-down by approximately
$116,000. In the fourth quarter of 2002, the Company recognized an
impairment charge related to a software and hardware system that had been
under development to support the supplemental benefits segment. In November
2002, the Company undertook a review of the costs to fully implement and
maintain the system. Management then made the business decision to
discontinue development of the system because the operating efficiencies
gained at implementation would not justify the further investment required
to complete the project. As the Company would not be implementing this
system into its primary segment, the Company recognized a $2.6 million
impairment charge related to the system. See Note 6.
Concentration of credit risk
----------------------------
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and cash
equivalents and accounts receivable. The Company maintains its cash and cash
equivalents in bank accounts, which, at times, may exceed federally insured
amounts. The Company has not experienced any losses related to its cash or
cash equivalents and believes it is not exposed to any significant credit
risk on its cash or cash equivalents.
F-7
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
Accounts receivable consists principally of amounts due from the Company's
PBM customers. Although, the Company does not hold collateral to secure
payment of its accounts receivable, its collection experience indicates
limited loss exposure due to the nature of the benefits involved and the
necessity of benefit continuity for plan sponsor employees. Management
performs ongoing credit evaluations of its customers and provides allowances
as deemed necessary. The Company has not experienced significant losses
related to receivables in the past.
Use of estimates
----------------
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires the
Company to make estimates and assumptions that affect the reported amounts
in the financial statements and disclosure of contingent assets and
liabilities. Actual results could differ from those estimates. The most
significant estimates included in these financial statements include the
following: rebates due from pharmaceutical manufacturing companies, the
value of intangible assets acquired in business combinations and related
amortization periods, bad debt provisions, income tax provisions and related
valuation allowances, and the estimate of the value and number of common
stock warrants to be issued to a distributor under a marketing compensation
agreement.
Goodwill and other intangible assets
------------------------------------
In July 2001, the Financial Accounting Standards Board issued SFAS No. 141,
"Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 141 changes the accounting principles for business
combinations. Some significant changes from the previous principles are: a)
the purchase method of accounting must be used for all business combinations
initiated after June 30, 2001; and b) specific criteria are provided for
recognizing intangible assets apart from goodwill. The Company's
acquisitions of Catalyst and PNNC have been accounted for in accordance with
SFAS No. 141. See Note 3.
SFAS No. 142 establishes the accounting principles for goodwill and
intangible assets subsequent to their initial recognition. The most
significant changes made by SFAS No. 142 were: a) goodwill and
indefinite-lived intangible assets are no longer amortized; b) goodwill and
intangible assets deemed to have an indefinite life are tested at least
annually for impairment; and c) the amortization period of intangible assets
with finite lives will no longer be limited to forty years. See Notes 4 and
5.
F-8
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
Income taxes
-------------
The Company records deferred tax assets and liabilities based on temporary
differences between the financial statement and the tax bases of assets and
liabilities using enacted tax rates in effect in the year in which the
differences are expected to reverse. In 2000 and 2001, the Company recorded
a full valuation allowance against the Company's deferred tax assets due to
the uncertainty as to their ultimate realization. In the fourth quarter of
2002, as a result of the Company's current and projected profitability, the
Company recognized approximately $10.2 million in tax benefits principally
resulting from the Company releasing the full valuation allowance for its
deferred tax asset. See Note 7.
Net income (loss) per share
---------------------------
Basic net income (loss) per share is based on the weighted average number of
shares outstanding during the year. Diluted net income (loss) per share is
based on the weighted average number of shares and dilutive common stock
equivalent shares outstanding during the year. In 2000 and 2001, diluted net
loss per share was equal to basic net loss per share since the Company
operated at a loss. For the year ended December 31, 2002, the dilutive
effect (186,000 shares using the treasury stock method) of stock options to
purchase 1.4 million shares of common stock was included in the computation
of diluted earnings per common share because the option price was less than
the average market price of the common shares during the year ended December
31, 2002. The dilutive effect of 5.3 million outstanding common stock
options and warrants for the year ended December 31, 2002, has been excluded
from the computation of 2002 diluted net income per share as the effect
would be anitdilutive.
Employee stock options
-----------------------
The Company accounts for the fair value of its stock options granted to
employees and directors in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, no
compensation expense has been recognized for stock options granted, as the
exercise price of the options was equal to the fair value of the underlying
common stock on the date of grant.
F-9
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The following table reflects pro forma net income (loss) and net income
(loss) per share for the years ended December 31, 2000, 2001, 2002 had the
Company elected to adopt the fair value approach of Financial Accounting
Standards Board issued Financial Accounting Standard No. 123, "Accounting for
Stock-Based Compensation":
2000 2001 2002
------------ ------------ -------------
Net income (loss)
As reported ..................... $(17,226,216) $ (6,774,649) $ 13,477,714
Stock-based compensation, net of
taxes in 2002 ................. 4,668,186 1,265,843 1,765,957
Pro forma ....................... (21,894,402) (8,040,492) 11,711,757
Net income (loss) per share
As reported - basic and diluted . $ (0.62) $ (0.23) $ 0.42
Pro forma - basic and diluted ... $ (0.78) $ (0.28) $ 0.36
The estimated fair value of each option was calculated using the modified
American Black-Scholes economic option-pricing model. The following table
summarizes the weighted-average of the assumptions used for stock options
granted during 2000, 2001 and 2002.
2000 2001 2002
------------- ----------------- ---------------
Risk-free interest rate 5.6-6.4% 3.8-5.2% 2.94-5.11%
Expected years until exercise 5 years 5 years 5 years
Expected volatility 95.9% 84.2% 87.0%
Dividend yield - - -
Weighted average fair value per share $3.47 $3.76 $3.72
Revenue and direct expense recognition
--------------------------------------
The Company recognizes revenues from PBM services, which include sales of
prescription drugs by pharmacies in the Company's nationwide network and
related claims processing fees, provided to managed-care organizations,
self-insured employers and third party administrators. Revenue is recognized
when the claims are adjudicated. Pharmacy claims are adjudicated at the
point-of-sale using the Company's on-line claims processing system. When the
Company has a contractual obligation to pay its network pharmacy providers
for benefits provided to its clients' members, total payments from these
clients are recorded as revenue and payments to the network pharmacy
provider are recorded as direct expenses. The contracts require the Company
to assume the credit risk of its clients' abilities to pay. In addition,
F-10
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
under most of its client contracts, the Company is at risk for the
difference between the payments the Company receives from its clients and
the negotiated reimbursements the Company pays to its pharmacies. When the
Company administers pharmacy reimbursement contracts and does not assume a
credit risk, the Company records only its administrative or dispensing fees
as revenue. Rebates earned under arrangements with manufacturers are
recorded as a reduction of direct expenses. The portion of such rebates due
to plan sponsors is recorded as a reduction of revenue. Manufacturers
rebates are based on estimates, which are subject to final settlement with
the contracted party. Member co-payments are not recorded as revenue.
The primary determinant of revenue recognition for supplemental benefits is
monthly program enrollment and payments from certain distributors related to
new member enrollments. In general, program revenue is recognized based on
the number of members enrolled in each reporting period multiplied by the
applicable monthly fee for their specific membership program. The program
revenue recognized by HealthExtras includes the cost of membership features
supplied by others, including the insurance components. Direct program
expenses consist of the costs that are a direct function of a period of
membership and a specific set of program features. The coverage obligations
of our benefit suppliers and the related expense are determined monthly, as
are the remaining direct expenses. Payments from distributors related to new
member enrollments are recorded as revenue to the extent of related direct
expenses, which to date have exceeded payments from distributors.
Revenue from supplemental benefit programs and related direct expenses
(principally marketing and processing fees and the cost of the benefits
provided to program members) are initially deferred during the period in
which a program member is entitled to obtain a refund (generally 90 days).
If a member requests a refund, HealthExtras retains any interest earned on
funds held during the refunded membership period. Total revenue and direct
expenses attributable to the initial deferral are recognized subsequent to
the end of the initial deferral period. After the initial deferral period,
revenue is recognized as earned and direct expenses as incurred.
The Company has historically maintained a prepaid balance for the cost of
insurance benefits included in its programs. The carrying value of the
prepayment was adjusted at the end of each quarter based on factors
including enrollment levels in each product, enrollment trends, and the
remaining portion of the unexpired prepayment period. In the event that a
period of coverage was purchased in advance, and there were insufficient
members to utilize the coverage, the value would expire and be expensed by
the Company without any related revenue. In 2002, these prepaid insurance
costs were fully utilized, however, the Company does maintain minimum
premium commitments to various underwriters covering $1.9 million in
annualized premiums. The Company believes that current enrollment levels
will allow it to fully utilize this commitment without losses for unused
coverage.
F-11
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
Effective January 1, 2002, the Company adopted Emerging Issues Task Force
Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a
Customer or a Reseller of the Vendor's Products" ("EITF 01-9"), which was
issued in November 2001. The Company's adoption of EITF 01-9 changed the way
the Company recognizes the cost of consideration provided to a distributor
under a warrant agreement. Effective January 1, 2002, the charge for this
consideration was recorded as a reduction to revenue from the distributor
rather than as a charge to direct expense, as reflected in prior periods.
See Note 9. During the years ended December 31, 2000 and 2001, the company
recorded approximately $255,000 and the $5.1 million in non-cash direct
expenses, respectively, related to warrants earned through June 30, 2001.
In the third and fourth quarters of 2001, the Company also recorded a total
of approximately $1.0 million in an estimated non-cash direct expense
related to common stock warrants expected to be issued to through June 30,
2002 contingent on a distributor exceeding a specific annualized threshold.
Due to the lower fair value of the warrants in the first quarter of 2002,
the Company recognized a non-cash credit of $477,000 in the first quarter.
In the second quarter of 2002, it was determined that the distributor did
not exceed the specific annualized revenue thresholds; thus, the Company
reversed the remaining charge of $531,000 for the warrant agreement. To
comply with EITF 01-9, the $1.0 million of total non-cash credits was
recorded as revenue in the year ended December 31, 2002. See Note 9.
Recent accounting pronouncements
--------------------------------
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", which addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"; however,
it retains many of the fundamental provisions of that Statement. SFAS No.
144 also supersedes the accounting and reporting provisions of APB Opinion
No. 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 the disposal of a
segment of a business. However, it retains the requirement in APB No. 30 to
report separately discontinued operations and extends that reporting to a
component of an entity that either has been disposed of (by sale,
abandonment, or in a distribution to owners) or is classified as held for
sale. By broadening the presentation of discontinued operations to include
more disposal transactions, the FASB has enhanced management's ability to
provide information that helps financial statement users to assess the
effects of a disposal transaction on the ongoing operations of an entity.
SFAS No. 144 is effective for fiscal years beginning after December 15, 2001
and interim periods within those fiscal years. Early application is
encouraged. The provisions of SFAS No. 144 generally are to be applied
prospectively. As discussed in Note 6, the Company recognized an impairment
loss on fixed assets of $2.6 million for the year ended December 31, 2002.
F-12
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123", to provide alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the disclosure requirements
of SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. The
application of the transition provisions of SFAS No. 148 is effective for
fiscal years ending after December 15, 2002. The application of the
disclosure requirements is effective for the Company as of December 31,
2002. We are currently evaluating the impact of SFAS No. 148 on our
financial position, results of operations and liquidity.
In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees Including
Indirect Guarantees of Indebtedness of Others", which elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has
issued. It also clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The initial recognition and initial
measurement provisions of FIN No. 45 are applicable on a prospective basis
to guarantees issued or modified after December 31, 2002, irrespective of
the guarantor's fiscal year end. The disclosure requirements are effective
for financial statements of interim or annual periods ending after December
15, 2002. As of December 31, 2002, there is no impact on the Company's
financial statements as a result of the issuance of FIN No. 45.
3. BUSINESS COMBINATIONS
Acquisition of Catalyst
-----------------------
On November 14, 2001, the Company executed securities purchase agreements
("the Agreements") to purchase 80% of the outstanding ownership of Catalyst
Rx and Catalyst Consultants ("Catalyst"). The results of Catalyst's
operations have been included in the consolidated financial statements from
such date. Catalyst provides PBM services to managed-care organizations,
self-insured employers and third-party administrators. Catalyst serves
members through a national network of approximately 50,000 pharmacies.
Total consideration for the Catalyst stock was $14,343,358, consisting of a
$8,883,069 promissory note payable, $1,500,000 in cash, 366,730 shares of
the Company's common stock valued at $2,310,400, and $1,649,889 in
liabilities assumed on behalf of Catalyst's owner. The value of the shares
was based on the Company's closing price on November 14, 2001. Transaction
costs of $550,000 were capitalized to make the total acquisition cost
$14,893,358. The Company issued the 366,730 common shares to the seller on
December 31, 2001. The note payable was settled in cash in January 2002.
F-13
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at the date of acquisition. The acquisition
was accounted for as a purchase.
At
November 14,
2001
-----------------
Current assets, including cash of $4,192,474 $ 20,438,962
Fixed assets 146,063
Intangible assets 4,000,000
Goodwill 9,061,601
----------------
Total assets acquired 33,646,626
Current liabilities assumed (18,305,110)
Minority interest at acquisition date (448,158)
-----------------
Net assets acquired $ 14,893,358
=================
During the first quarter of 2002, the Company purchased the outstanding 20%
minority interest in Catalyst for 319,033 shares of the Company's stock
valued at $1.1 million and notes payable of $4.2 million. The stock was
transferred to the seller on April 1, 2002, and the $3.1 million in cash was
paid in 2002, with the final installment of $1.1 million paid on March 1,
2003.
During the second quarter of 2002, the Company finalized its allocation of
the purchase price (including the acquisition of the remaining minority
interest) of the Catalyst acquisition resulting in an increase in intangible
assets and a decrease in goodwill of $700,000.
The acquisition of Catalyst provided growth in the Company's PBM business
and additional diversification of the Company's customer base. The purchase
price was determined based on the Company's assessment of Catalyst's
potential to generate future cash flows from its existing customer contracts
and through acquisition of new customers.
Acquisition of PNNC
-------------------
On December 1, 2002, the Company acquired 100% of the common stock of
Pharmacy Network National Corporation ("PNNC"). Total consideration for PNNC
stock was $20.2 million. Total acquisition cost included transaction costs
of approximately $1.4 million. Funding for the $21.6 million cash
transaction was derived from the Company's working capital. PNNC is a
provider of pharmacy benefit management services to a diverse client base
F-14
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
with significant geographic concentration in the Carolinas and Tennessee.
The acquisition of PNNC provides growth in the Company's PBM business and
additional diversification of the Company's customer base. The purchase
price was determined based on the Company's assessment of PNNC's potential
to generate future cash flows from its existing customer contracts and
through acquisition of new customers.
The acquisition resulted in goodwill of approximately $10.6 million. The
following table summarizes the estimated fair value of the assets acquired
and liabilities assumed at the date of acquisition. The Company is in the
process of finalizing third-party valuations of certain intangible assets;
thus, the allocation of the purchase price is subject to refinement.
At
December 1,
2002
-----------------
Current assets, including cash of $6,246,049 $ 24,037,736
Fixed assets 46,428
Intangible assets 8,000,000
Goodwill 10,578,728
Deferred income taxes 286,329
-----------------
Total assets acquired 42,949,221
Current liabilities assumed (18,294,316)
Deferred income tax liability (3,089,600)
----------------
Net assets acquired $ 21,565,305
=================
The following unaudited pro forma consolidated results of operations for the
years ended December 31, 2002 and 2001 are presented as though Catalyst and
PNNC had been acquired at the beginning of 2001, after giving effect to
purchase accounting adjustments relating to the amortization of intangible
assets. Results are in thousands, except for per share data.
2001 2002
--------- ---------
Revenue ............................. $ 280,193 $ 355,830
Net income (loss) ................... $ (1,860) $ 15,212
Net income (loss) per share - basic . $ (0.06) $ 0.47
Net income (loss) per share - diluted $ (0.06) $ 0.47
Weighted average shares - basic ..... 30,369 32,286
Weighted average shares - diluted ... 30,369 32,472
F-15
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The pro forma results of operations are not necessarily indicative of the
results that would have occurred had the Company owned 100% of Catalyst and
PNNC at January 1, 2001, nor are these results indicative of future
operating results.
4. GOODWILL
The changes in the goodwill for the year ended December 31, 2002 are as
follows:
Balance as of January 1, 2002 ........................ $17,566,866
Goodwill acquired in 20% minority interest acquisition
of Catalyst ......................................... 3,891,208
Adjustment to preliminary allocation of Catalyst
purchase price ....................................... 1,501,340
Goodwill acquired in acquisition of PNNC ............ 10,578,728
-----------
Balance as of December 31, 2002 33,538,142
===========
The Company adopted SFAS No. 142, and discontinued the amortization of
goodwill and indefinite-lived intangible assets effective January 1, 2002.
The Company completed its initial adoption impairment testing of goodwill
and concluded that no impairment of goodwill exists. The Company performed a
similar test as of December 31, 2002, and concluded that no impairment of
goodwill exists. The following table reflects consolidated results adjusted
as though the adoption of SFAS No. 142 occurred as of January 1, 2000:
F-16
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
----------------------------------
2000 2001
Net loss, as reported .................... $ (17,226,216) $ (6,774,649)
Goodwill amortization .................... 102,473 614,839
--------------- -------------
Net loss as adjusted ..................... $ (17,123,743) (6,159,810)
=============== =============
Net loss per share, basic, as reported ... $ (0.62) $ (0.23)
Goodwill amortization .................... 0.01 0.02
--------------- -------------
Net loss per share, basic, as adjusted ... $ (0.61) (0.21)
=============== ==============
Net loss per share, diluted, as reported . $ (0.62) $ (0.23)
=============== ==============
Goodwill amortization .................... 0.01 0.02
--------------- -------------
Net loss per share, basic, as adjusted ... $ (0.61) (0.21)
=============== =============
5. INTANGIBLE ASSETS
As of December 31, 2002, intangible assets consisted of the following:
Amortization
Period
------------
Catalyst customer contracts $ 5,700,000 20 years
PNNC customer contracts 8,000,000 20 years
Other PBM contracts 945,200 5 - 10 years
-------------
Total intangible assets 14,645,200
Accumulated amortization (459,449)
-------------
$ 14,185,751
=============
Catalyst and PNNC customer contracts represent the estimated fair value of
customer contracts held by Catalyst and PNNC at the dates of acquisition.
This estimated fair value and the weighted average useful-lives are based on
income-method valuation calculations, performed by an independent consulting
firm.
F-17
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
Other PBM contracts represent the cost of PBM contracts purchased by the
Company from a third party administrator, which allow it to provide PBM
services to the administrator and its customers. Consideration paid in 2001
for the contracts of $495,200 consisted of $300,000 in cash and 40,000
shares of the Company's common stock valued at $195,200. The amortization
period of 10 years is based on management's estimate of the period of future
cash flows from the contracts purchased. The remaining $450,000 of other PBM
contracts represents initial costs of two contracts and are being amortized
over the lives of the contracts.
The estimated aggregate amortization expense of intangible assets through
2007 is as follows:
2003 $ 815,949
2004 815,949
2005 815,949
2006 815,949
2007 775,949
----------
Total $4,039,745
==========
6. FIXED ASSETS
Fixed assets consist of the following:
2001 2002
----------- -----------
Computer equipment ........... $ 1,933,511 $ 2,256,915
Software development costs ... 1,901,747 --
Furniture, fixtures and office
equipment .................... 1,438,658 1,232,402
Medical equipment ............ 103,198 --
Leasehold improvements ....... 1,851,537 1,901,130
Transportation equipment ..... -- 1,666,413
----------- -----------
Total fixed assets ........ 7,228,651 7,056,860
Accumulated depreciation and
amortization ................ (2,172,416) (3,000,730)
----------- -----------
Fixed assets, net ........... $ 5,056,235 $ 4,056,130
=========== ===========
Depreciation expense for the years ended December 31, 2000, 2001 and 2002
was approximately $599,000, $1.1 million, and $1.3 million, respectively.
F-18
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
In the first quarter of 2002, the Birmingham, Alabama office was closed and
its operations were consolidated within the Company's Rockville, Maryland
and Las Vegas, Nevada offices. At that time, the Company disposed of company
assets with a net book value of approximately $116,000.
In the fourth quarter of 2002, the Company recognized a $2.6 million
impairment charge related to a software and hardware system that had been
under development. In November 2002, the Company undertook a review of the
costs to fully implement and maintain the system. Management then made the
business decision to discontinue development of the system because the
operating efficiencies gained at implementation would not justify the
further investment required to complete the project. As the Company would
not be implementing this system into its primary segment, the Company
recognized a $2.6 million impairment charge related to the system.
7. INCOME TAXES
The $10.2 million deferred tax benefit recorded in 2002 consists of $9.0
million in federal and $1.2 million in state deferred tax benefits.
A summary of the components of deferred income taxes at December 31, 2001
and 2002 computed at an effective tax rate of 38.6% is as follows:
2001 2002
----------- -----------
Deferred tax assets (liabilities):
Fixed assets ..................... $ (24,542) $ (126,328)
Accrued expenses ................. 6,840 78,580
Rebates payable .................. -- 95,758
Allowance for doubtful accounts .. 176,644 159,779
Deferred charges ................. (465,188) (536,073)
Deferred revenue ................. 1,741,397 1,858,995
Customer-based intangibles ....... (1,544,800) (5,135,237)
Rebates receivable ............... -- (239,390)
Non-compete agreements ........... -- 211,230
Net operating loss carryforwards . 9,996,554 8,530,189
Other ............................ 38,620 147,962
----------- -----------
9,925,525 5,045,465
Valuation allowance .............. (9,925,525) --
----------- -----------
Net deferred tax asset ....... $ -- $ 5,045,465
=========== ===========
The Company has net operating loss carryforwards of approximately $22.0
million at December 31, 2002, available for carryforward to future periods.
The carryforwards expire at various times beginning in 2010 through 2021.
F-19
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The effective tax rate varies from the U.S. Federal Statutory tax rate
principally due to the following:
2000 2001 2002
U. S. Federal Statutory tax rate... (34.0%) (34.0%) 34.0%
State tax, net of federal benefit.. (4.6) (4.2) 4.6
Non-deductible expenses ........... 1.5 3.3 (0.5)
Valuation allowance (release) ..... 37.0 34.9 (345.7)
Other ............................. 0.1 -- --
------ ------ -------
Effective tax rate ................ --% --% (307.6)%
====== ====== =======
Although no estimated tax payments were made for 2002, the Company did pay
approximately $126,000 in cash for income taxes in 2002, relating to
Catalyst for the short-year ended October 31, 2001. These were liabilities
that existed prior to the ownership of Catalyst.
8. NOTES PAYABLE
On January 22, 2002, the Company arranged a line of credit of $5.0 million
to support the working capital required for the Company's acquisition of
Catalyst. The line of credit was collateralized by a certificate of deposit
with an approximate balance of $5.6 million held by the lending financial
institution. Under the terms of the agreement, all outstanding principal and
accrued interest were to be paid on or before July 22, 2002. The note bore
interest at a rate of 4.59% per annum, which was paid monthly. The Company
repaid the outstanding principal of $4.5 million in April 2002.
In March 2002, the Company arranged an $8.0 million revolving credit
facility. Borrowings on the credit facility were collateralized by
substantially all of the Company's trade receivables. The credit facility
contains affirmative and negative covenants related to indebtedness, capital
expenditures, and consolidated net worth. The facility bore interest at
LIBOR plus 2.25%. Interest payable was payable in arrears on the fifth day
of each month. The Company repaid the outstanding principal in December
2002.
In December 2002, the Company arranged an $18.0 million revolving credit
facility. Borrowings on the credit facility are collateralized by
substantially all of the Company's trade receivables. The credit facility
contains affirmative and negative covenants related to indebtedness, other
liabilities, and consolidated net worth. The facility bears interest at
LIBOR plus 2.75%. The effective rate at December 31, 2002 was 4.17%.
Interest is payable in arrears on the fifth day of each month. The
F-20
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
outstanding balance on the credit facility at December 31, 2002 was $18.0
million. All principal and accrued interest is due to the bank on May 31,
2004. Interest expense related to notes payable for the year ended December
31, 2002 was approximately $319,000.
9. STOCKHOLDERS' EQUITY
Stock (member interests) grants
-------------------------------
In February 1999, certain management employees were granted effective member
interests aggregating 1.87% (equivalent to 413,333 common share of the
Company), after giving effect to an existing commitment to sell a 20%
interest in the Company to a third party for $5,000,000 cash. Such grants
vest over a four-year period commencing March 1, 1999. The Company recorded
the estimated fair value of these interests of $467,573 ($1.13 per common
share) as stockholders' equity and deferred compensation expense. During
2000, 2001, and 2002, amortization of deferred compensation expense amounted
to $116,894, $73,136 and $92,284, respectively. During 2001, two of the
employees left the Company and one of the employees restructured a
compensation package, forfeiting the interest in the unvested stock grants.
The value of interests forfeited of $72,537 was deducted from the additional
paid-in capital and deferred compensation in 2001.
Stock option plans
------------------
In 2000, the Company adopted the HealthExtras, Inc. 2000 Stock Option Plan
("2000 SOP") and the HealthExtras, Inc. Directors' Stock Option Plan
(Directors' SOP). The maximum number of the Company's common shares reserved
for issuance pursuant to the grant of options under the 2000 SOP and the
Directors' SOP are 1,000,000 and 200,000 shares, respectively. Under the
2000 SOP, options granted vest ratably over a period of four years from the
date of grant. The Directors' SOP provides for options granted to be
exercisable on the first anniversary date of the grant. The maximum
contractual life of all stock options granted under the 2000 SOP and the
Directors' SOP is ten years.
During 1999, the Company established the HealthExtras, Inc. 1999 Stock
Option Plan ("1999 SOP"). The maximum number of shares of the Company's
common stock reserved for issuance pursuant to the grant of options under
the 1999 SOP is 4,000,000 shares. All officers, employees and independent
contractors of the Company are eligible to receive option awards. A
Committee of the Board of Directors determines award amounts, option prices
and vesting periods, subject to the provisions of the 1999 SOP. Stock
options granted under the 1999 SOP vest ratably over a period of four years
and the contractual life of all of the stock options is ten years.
F-21
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
In 2001, the Board of Directors approved a voluntary plan by which qualified
individuals were offered an opportunity to surrender their 1999 stock option
awards, and receive, at a future grant date, six months and one day beyond
the surrender date, up to two-thirds of the number of options surrendered;
2.8 million options were surrendered in 2001 and 1.6 million options were
granted in 2002 under the plan.
The following table summarized stock option activity under all plans for the
four years ended December 31, 2002:
Number Weighted -
Of Shares Price Average
Of Common Per Exercise
Stock Share Price
------------- --------------- -------------
Initial grant of stock options, and
Balance at December 31, 1999 2,956,000 $ 13.20 $ 13.20
Granted 1,463,000 4.06-5.63 4.58
Forfeited (163,500) 13.20 13.20
------------- --------------- -------------
Balance, December 31, 2000 4,255,500 4.06 - 13.20 10.31
Granted 996,900 3.50 - 9.65 5.44
Exercised (30,000) 4.06 4.06
Forfeited (190,850) 3.56 - 4.62 3.90
Canceled (2,792,500) 13.20 13.20
------------------------------- -------------
Balance, December 31, 2001 2,239,050 3.50 - 9.65 5.02
------------- ---------------- --------------
Granted 2,957,000 2.42 - 6.62 5.23
Exercised (9,375) 3.57 3.57
Forfeited (319,550) 3.31 - 7.15 4.51
------------------------------- --------------
Balance, December 31, 2002 4,867,125 $ 2.42 - 9.65 $ 5.16
============= ================ =============
Exercisable, December 31, 1999 -- $ -- $ --
Exercisable, December 31, 2000 698,125 $ 13.20 $ 13.20
Exercisable, December 31, 2001 353,750 $ 4.06 - 5.63 $ 4.62
Exercisable, December 31, 2002 827,156 $ 3.25 - 9.65 $ 5.40
F-22
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The following table summarizes information about the outstanding options at
December 31, 2002:
Options Outstanding
--------------------------------------------
Weighted-
Average Weighted-
Remaining Average
Range of Exercise Contractual Exercise
Prices Number Life (years) Price
---------------------------- -------------- ------------- --------------
Stock options:
$2.42-5.63 2,843,625 8.4 $4.12
$6.55-9.65 2,023,500 9.3 $6.62
---------------------------- ------------- ------------ --------------
$2.42-9.65 4,867,125 8.9 $5.16
========= ============ ==============
Common Stock Warrants
---------------------
During 2000, the Company entered into an agreement whereby warrants to
acquire up to 4.2 million shares of common stock may be issued in three
tranches to a distributor at exercise prices ranging from $5.21 to $15.63
per share. The issuance of 3.4 million of these warrants is contingent on
the distributor exceeding specific annualized revenue thresholds to be
measured for the twelve-month periods ending June 30, 2001, 2002, and 2003.
The issuance of 800,000 of these warrants is contingent on the distributor's
revenue contributions relative to other Company revenues as defined in the
agreement for the years ending December 31, 2001 and 2002. The maximum
contractual life of the warrants from the date of grant is five years.
During 2001, warrants for 750,000 shares were issued with the exercise price
at $5.21 with an expiration date of July 22, 2006. In accordance with EITF
01-9, the Company recorded the $5.1 million expense related to these
warrants as a reduction of revenue from the distributor rather than as
a charge to direct expense.
Also in 2001, in accordance with EITF 01-9, the Company recorded a reduction
of revenue of $1.0 million related to common stock warrants expected to be
issued with respect to the annualized revenue threshold for the year ending
June 30, 2002. Annualized revenues under the contract for the year ending
June 30, 2002 were estimated based on the performance of the distributor
through December 31, 2001. Due to the lower fair value of the warrants in
the first quarter of 2002, the Company recognized a non-cash credit of
$477,000 in the first quarter of 2002. In the second quarter of 2002, it was
determined that the distributor had not exceeded the specific annualized
revenue thresholds; thus, the Company reversed the remaining charge of
$531,000 for the warrant agreement. To comply with EITF 01-9, the $1.0
million of total non-cash credits was recorded as revenue during 2002.
F-23
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
During 2002, the Company issued common stock warrants to Health Care
Horizon's Inc., d/b/a Cimarron Health Plan ("Cimarron") that give Cimarron
the right to purchase 250,000 shares of the Company's common stock for $5.22
per share. The warrants are exercisable at any time after the grant date,
with a condition that the Company must be the exclusive provider of PBM
services to Cimarron on the date of the exercise. The term of the PBM
contract is from July 1, 2002, to September 30, 2009. In accordance with
EITF 96-18, "Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring or in Conjunction With Selling Goods or Services,"
the measurement date was determined to be the grant date of April 1, 2002.
Using an equity-pricing model, the value of the 250,000 warrants was
estimated to be $400,000 and was recorded as a deferred charge at April 1,
2002. This deferred charge is being recognized over the life of the
seven-year contract beginning July 2002, on a straight-line basis. The
Company recorded $28,572 of contra-revenue related to amortization of the
cost of the warrants in 2002.
Private Placement
-----------------
In September of 2001, the Company issued 3,020,782 shares of the Company's
common stock to third parties in exchange for net proceeds of $10,893,000.
The purchase price was based on the price of the Company's stock at
September 26, 2001. Warrants to acquire 845,816 shares of common stock were
also granted in the private placement with the exercise price at $5.37,
which were vested immediately and expire on September 26, 2005.
10. LEASE COMMITMENTS
The Company maintains non-cancelable lease agreements for office space in
its three main operating locations. These agreements provide for annual
escalations and payment by the Company of its proportionate share of the
increase in the costs of operating the buildings. The Company also leases
certain office equipment. The Company recognizes rent expense on a
straight-line basis over the terms of the leases. The future minimum
payments due under non-cancelable leases are as follows:
2003 $ 1,208,945
2004 802,971
2005 481,057
2006 372,220
2007 327,739
Thereafter 1,216,562
------------
Total $ 4,409,494
============
Rent expense for the years ended December 31, 2000, 2001 and 2002, was
$364,000, $753,000, and $797,000 respectively.
F-24
11. COMMITMENTS AND CONTINGENCIES
In 2000, the Company extended a marketing agreement for a five-year term,
whereby the Company committed to total non-refundable payments of $5.0
million due in equal annual installments for an individual's participation
in various marketing campaigns. As of December 31, 2002, installments
totaling $2.0 million remained committed under this agreement. The Company
has the option to extend this agreement for another five-year period, which
would result in an additional commitment of $7.7 million. The Company must
also pay annual fees of $1.00 per supplemental benefits program member in
excess of one million members, in addition to the base payment of $1 million
per year.
In the ordinary course of business, the Company may become subject to legal
proceedings and claims. The Company is not aware of any legal proceedings or
claims, which, in the opinion of management, will have a material adverse
effect on the financial condition or results of operations of the Company.
F-25
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
12. SEGMENT REPORTING
The Company operates in two business segments, PBM and supplemental
benefits. The following table presents financial data by segment for the
years ended December 31, 2001 and 2002. PBM services operating results
include the results for Catalyst and PNNC from their respective dates of
acquisition. In 2002 the Company revised its methodology for evaluating
segment performance to exclude certain corporate overhead from segment
operating expenses. Segment reporting disclosure for the year ended December
31, 2001 has been modified to confirm to this new methodology.
December 31, 2002
Supplemental
PBM Benefits Total
------------- ------------- ---------------
Revenue ............. $ 182,275,943 $ 66,131,523 $ 248,407,466
Operating expenses... 174,993,333 58,162,480 233,155,813
Operating income .... 7,282,610 7,969,043 15,251,653
Total assets ......... 103,174,621 16,827,515 120,002,136
Accounts receivable... 37,527,001 272,777 37,799,778
Accounts payable ..... 33,863,566 588,223 34,451,789
December 31, 2001
Supplemental
PBM Benefits Total
------------- ------------- ---------------
Revenue ............... $ 46,893,749 $ 71,332,170 $ 118,225,919
Operating expenses .... 46,233,164 77,326,609 123,559,773
Operating income (loss) 660,585 (5,994,439) (5,333,854)
Total assets .......... 67,526,792 20,626,543 88,153,335
Accounts receivable ... 19,652,601 2,758,367 22,410,968
Accounts payable ...... 22,580,269 2,014,000 24,594,269
Operating expenses of the segments exclude $11.9 million and $2.4 million in
corporate overhead that was not allocated by management in assessing segment
performance for the years ended December 31, 2002 and 2001, respectively.
F-26
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
13. 401(K) SAVINGS PLAN
In April 2000, the Company authorized the establishment of an employee
401(k) Savings Plan (the "401(k)"). The 401(k) benefit is available to all
of the Company employees, including those of its subsidiaries, subject to
certain service requirements. For 2002, the Company matched the first $1,000
of the employee's contribution and 50% thereafter subject to statutory
limits. The Company's contribution vests ratably over 5 years for each
employee. For the years ended December 31, 2000, 2001 and 2002, the Company
expensed approximately $86,000, $105,000 and $165,000 respectively, under
this plan.
14. RELATED PARTY TRANSACTIONS
The Company previously held available for sale securities in a corporation
for which the Chairman of the Board of the Company was the Chairman of the
Board and Co-Chief Executive Officer. Investments held were $664,984 as of
December 31, 1999. All of these securities were sold in March 2000 for
aggregate proceeds of $1,084,050, resulting in a gain of $551,735.
Effective January 1, 1999, the Company entered into an agreement with United
Payors & United Providers, Inc. ("UP&UP"), a corporation for which the
Chairman of the Board of the Company was the Chairman of the Board and
Co-Chief Executive Officer, whereby UP&UP provided administrative services
for the Company and was reimbursed for the costs incurred. The amount
expensed for these services was $208,000 prior to the acquisition of UP&UP
by an unrelated third party in March 2000.
During 2000, the Company entered into a joint venture with Southern Aircraft
Leasing Corporation, owned by the Chairman of the Board of the Company,
whereby the Company invested $988,500 for a fractional interest of
approximately 45% in two aircraft used for corporate business purposes. The
carrying value of this investment was approximately $927,000 at December 31,
2001. This amount was included in other assets. In December 2002, the
Company dissolved the joint venture by acquiring the fractional ownership in
its entirety for approximately $725,000. The carrying value of the
investment of approximately $881,000 at the date of dissolution together
with the $725,000 payment to acquire the fractional interest in its
entirety, are recorded in fixed assets at December 31, 2002.
For corporate business purposes, the Company also utilizes the services of
an aircraft owned by Southern Aircraft Leasing Corporation. For the years
ended December 31, 2001 and 2002, the Company paid approximately $4,600 and
$49,000 respectively, for utilizing the services of such aircraft. As of
December 31, 2001, a deposit of $600,000 related to this arrangement was
held by Southern Aircraft Leasing Corporation. Southern Aircraft Leasing
Corporation returned this deposit to the Company in the first quarter of
2002.
F-27
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
In August of 2001 in anticipation of the exercise of certain warrants held
by a distributor (see Note 9), the Company repurchased and retired 750,000
shares of Company common stock from the Chairman of Board. The total amount
paid to repurchase the shares was $4,305,000 based upon a discount to the
market price of the stock. The purchase transaction and the price paid for
the stock were reviewed and approved by the Board of Directors.
During 2001, the Company maintained a corporate banking relationship with a
financial institution controlled by the Chairman of the Board. As of
December 31, 2001, the Company had approximately $12,911,000 in demand
deposits and a certificate of deposit for $5,371,000 with such institution.
In 2002, the Company withdrew all funds and discontinued its banking
relationship with the financial institution.
15. SUPPLEMENTAL DISCLOSURE OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Quarterly results of operations for the years ended December 31, 2001 and
2002 (in thousands, except per share amounts):
First Second Third Fourth
2002 Quarterly Operating Results Quarter Quarter Quarter Quarter
------- ------- ------- -------
Revenue ..................................... $ 54,652 $ 55,249 $ 63,907 $ 74,599
Operating income (loss) ..................... 573 1,587 1,540 (300)
Income (loss) before income taxes and
minority interest ....................... 629 1,527 1,517 (355)
Net income .................................. 584 1,527 1,517 9,850
Basic and diluted net income per common share $ 0.02 $ 0.05 $ 0.05 $ 0.30
First Second Third Fourth
2001 Quarterly Operating Results Quarter Quarter Quarter Quarter
-------- -------- ------- --------
Revenue ..................................... $ 21,771 $ 22,056 $ 28,403 $ 45,996
Operating loss .............................. (3,279) (4,160) (225) (107)
Income (loss) before income taxes and
minority interest ........................ (2,892) (3,824) 35 2
Net (loss) income ........................... (2,892) (3,824) 35 (94)
Basic and diluted net income per common share $ (0.10) $ (0.13) $ -- $ --
F-28
HEALTHEXTRAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------
The $300,000 loss from operations in the 2002 fourth quarter is a direct
result of the $2.6 million fixed asset impairment explained in Note 6.
16. NON-CASH TRANSACTIONS
Transactions that effected recognized assets and liabilities during 2001 and
2002 that did not result in cash receipts or payments are as follows:
2001
Goodwill and intangible assets acquired through
Issuance of notes payable, common stock, and
assumption of liabilities .................. $ 8,855,483
Fixed assets included in accounts payable ...... 158,909
Forfeitures under stock grant plan ............. 72,536
Issuance of common stock to settle purchase
consideration payable from IPM acquisition ... 347,850
Common stock issued for purchase of intangible
assets ...................................... 195,200
2002
Issuance of common stock warrants to Health Care
Horizons Inc. ...................................... $ 400,000
Issuance of notes payable and stock for minority
interest purchase of Catalyst ...................... 5,480,000
Issuance of common stock to settle notes payable
to Catalyst minority interest holder ............... 1,056,000
Increase to goodwill for deferred tax liabilities
related to intangibles at Catalyst and PNNC ........ 5,290,940
Increase to goodwill for accrued acquisition
transaction costs for PNNC ......................... 125,000
F-29
HEALTHEXTRAS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
--------
Balance Additions Additions
Beginning of Charge to Due to Balance End of
Description Period Expense Acquisition Deductions Period
- ------------------------------------- ------------ ------------ ------------ ------------ ------------
Deduction from asset account:
Allowance for doubtful accounts:
Year ended December 31, 2002 .. $ 457,390 $ 90,455 $ 145,305 $ (268,610) $ 424,540
Year ended December 31, 2001 .. 453,954 38,180 -- (34,744) 457,390
Year ended December 31, 2000... -- -- 453,954 -- 453,954
Deduction from asset account:
Allowance for Deferred Tax Assets
Year ended December 31, 2002 .. $ 9,925,525 $ 279,071 $ -- $(10,204,596) $ --
Year ended December 31, 2001 .. 9,215,434 710,091 -- -- 9,925,525
Year ended December 31, 2000 .. 1,563,155 7,652,279 -- -- 9,215,434
Additions to the valuation allowance in 2002 represent the net increases in
the Company's deferred tax asset before the decision was made to release the
reserve in the fourth quarter of 2002.
F-30