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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 27, 2003

Commission File Number: 1-31312

MEDCO HEALTH SOLUTIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: 201-269-3400

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

Securities registered pursuant to Section 12(g) of the Act: None

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 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. x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

The aggregate market value of the voting stock held by non-affiliates of the registrant as of March 18, 2004 was $8,900,731,908, based on the closing price of the registrant’s common stock on such date. There was no trading market for the registrant’s common stock as of the last business day of the registrant’s most recently completed second fiscal quarter.

As of March 18, 2004, the registrant had 270,950,743 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Medco Health Solutions, Inc.’s Proxy Statement for its 2004 Annual Meeting are incorporated by reference in this Annual Report on Form 10-K in response to Part III (Items 10 through 14).

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MEDCO HEALTH SOLUTIONS, INC.

ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 27, 2003

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PART I

Overview

We are one of the nation’s largest prescription benefit managers, and we provide sophisticated programs and services for our clients and the members of their prescription benefit plans, as well as for the physicians and pharmacies the members use. We were acquired as a wholly-owned subsidiary of Merck & Co., Inc., (“Merck”) on November 18, 1993, and were spun off as a separate publicly traded enterprise on August 19, 2003. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this by providing prescription benefit management (“PBM”) services through our national networks of retail pharmacies and our own mail order pharmacies. We have a large number of clients in each of the major industry categories, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans.

When we use “Medco,” “we,” “us” and “our,” we mean Medco Health Solutions, Inc., a Delaware corporation, and its consolidated subsidiaries.”

We operate in a competitive market in which clients seek to control the growth in the cost of providing prescription drug benefits to their members. Prescription drug costs have risen considerably over the past several years, largely as a result of inflation of brand-name products and the introduction of new products produced by pharmaceutical manufacturers. These prescription drug cost increases, known as drug trend, have garnered significant attention in the United States as they contribute significantly to the rise in the national cost of healthcare. Our business model is designed to reduce this level of drug trend, primarily by obtaining competitive discounts and rebates from pharmaceutical manufacturers, obtaining competitive discounts from retail pharmacies and efficiently administering prescriptions filled through our mail order pharmacies. In 2003, our network of mail order pharmacies filled approximately 78 million prescriptions, exceeding the number of mail order prescriptions filled by the mail order operations of our three largest competitors combined. We believe that our ability to consistently deliver high-quality service while effectively managing drug costs for our clients and their members has made us a market leader.

We seek to contain costs for our clients and their members by encouraging the use of medically appropriate generic drugs through our generic education and substitution programs. Our high-quality service, advanced technology and cost containment initiatives enabled us to limit the average drug trend for plans that include both retail and mail order to 10.2% in 2003, 12.9% in 2002 and 14.0% in 2001, compared to the national average of an estimated 13.4% in 2003, 15.3% in 2002 and 17.3% in 2001, as reported by the Centers for Medicare & Medicaid Services, or CMS.

The advanced technology and infrastructure we have developed is instrumental to our ability to drive growth, improve service and reduce costs. Our technology platform seeks to seamlessly integrate prescription management and processing with our client and member services. The cornerstone of our mail order technology is our single networked platform which connects prescription ordering functions at our prescription processing facilities with our automated dispensing pharmacies in Las Vegas, Nevada and Willingboro, New Jersey. At our specialized call center pharmacies, our experienced service representatives and consulting pharmacists use advanced technology to speed service and provide members personalized prescription and health information. For example, interactive voice recognition technology allows members to enroll for mail order service, process prescription orders, track the status of their orders, or locate in-network retail pharmacies in their area. Advanced imaging technology enables service representatives to access an online image of a member’s prescription to service that member more efficiently. Our data center links our dispensing and call center pharmacies, the retail pharmacies in our networks and our websites. As a result, our data center enables us to receive, process and administer claims and dispense prescription drugs efficiently. We have also deployed companywide reliability and change management programs that help drive excellence in execution across our operations, reducing our time to market with new capabilities and increasing our ability to implement error-free updates and customer oriented solutions to our systems.

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We also seek to improve client and member service and prescription ordering by providing important healthcare information and an efficient means of communication through our proprietary Internet solutions. For clients, members and pharmacists, we support distinct websites that provide critical benefit information and interactive tools aimed at facilitating compliance with benefit plan goals and simplifying benefit administration. In 2003, we processed 13.8 million patient prescription orders through our member website, a 27% increase over 2002.

Our innovative and flexible programs and services have enabled us to deliver effective drug trend management for our clients while, we believe, improving the quality of care for members. Our services focus on:

From 1999 to 2003, our net revenue increased on average approximately 20% per year. In 2003, we administered approximately 532 million prescriptions; had net revenues of approximately $34 billion and net income of more than $425 million; and had earnings before interest income/expense, taxes, depreciation and amortization, or EBITDA, of approximately $1,036 million. See Note 6 under Item 6, “Selected Financial Data” for a further description of EBITDA and a table that reconciles net income to EBITDA. Our net income is driven by our ability to earn rebates and negotiate favorable discounts on prescription drugs from pharmaceutical manufacturers; negotiate competitive client pricing, including rebate sharing terms; and provide services in a cost-efficient manner.

Financial information concerning our business segments and geographic regions for each of 2003, 2002 and 2001 is set forth in Part II, Items 5, 6, 7, 7A and 8 of this Annual Report on Form 10-K.

Industry Overview

Prescription drugs are the fastest growing component of healthcare costs in the United States. According to CMS, drug expenditures in the United States totaled over $184.1 billion during 2003; the cost of prescription drugs is expected to rise on average approximately 10.9% per year over the next ten years; and total expenditures could reach 15.5% of all healthcare costs by 2013, up from 11.0% in 2003.

We believe the key drivers of drug trend include:

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Increased generic substitution is partially offsetting the rise in drug spend. Between 2004 and 2007, patents are expected to expire on brand-name drugs representing about $38 billion in annual sales in the United States, based on the current release schedule. Generic substitution for drugs on which patents have expired is a significant factor in moderating drug spend, especially as efforts by payors, such as our clients, and generic drug manufacturers have led to an acceleration of generic drug substitution following the end of a branded drug’s marketing exclusivity.

PBMs emerged in the early 1980s, primarily to provide cost-effective drug distribution and claim processing for the healthcare industry. The PBM industry developed with the explosive growth of healthcare costs in the 1990s, as sponsors of benefit plans sought to more aggressively contain their costs. PBMs offered ways to influence both supply and demand. On the supply side, PBMs could leverage their buying power to secure manufacturer and distributor rebates and purchase discounts, as well as generating preferential discounts from retail pharmacies. On the demand side, PBMs could educate physicians on preferential prescribing options of formularies, and apply various clinical techniques to encourage members of health plans to implement more cost-effective usage habits, such as the use of less-expensive generic drugs, without jeopardizing their drug therapy.

Areas of potential growth for the PBM industry include increased use of available programs and services by existing clients, as well as entry or expansion in the specialty drugs, information services and health management markets. For example, we believe there is an opportunity to substantially increase the use of mail order pharmacies by members who use maintenance medications to treat chronic medical conditions. Mail order pharmacies currently fill only approximately 13.2% of total prescription drug sales in the United States, an increase from approximately 12.9% in 2002. Favorable demographics and increasing mail order capabilities should enable this trend to continue.

We believe that future growth within the PBM industry will also be driven by penetration into untapped categories of the overall U.S. prescription drug market, such as Medicare. The PBM industry is expected to benefit from the Medicare drug benefit that will initially take the form of a discount card program, and is expected to be introduced in mid-2004. The landmark legislation to modernize Medicare with a prescription drug benefit estimated at more than $530 billion over the next 10 years will enable us to more widely offer our market-based tools to America’s senior citizens.

Business Strategy

Our vision is to be an effective force in moderating healthcare costs for our clients and supporting improved patient care through the appropriate use of prescription drugs. Our strategy depends on our ability to understand both the common and unique needs of our customers, our ability to develop scalable yet flexible capabilities and solutions that are affordable for our clients and profitable for us, through our execution of the following:

Deliver high-quality client and member service. Our success in attracting and retaining clients depends on our ability to deliver high-quality client and member service. We assign a team to each of our clients that includes experienced clinical, financial and information technology specialists, all of whom are intimately aware of the needs of that specific client and industry category. A critical element of the service we offer clients is the development, implementation and management of a customized plan design that meets the client’s particular objectives. Our client teams work in consultation with each client and use our proprietary software tools to model the effects of different plan designs based on the client’s historical drug-use data. This allows clients to better analyze their options and helps them develop a plan design best suited to their needs. By capitalizing on the advanced technology and infrastructure we have developed, our individualized prescription drug benefit plan solutions enable us to deliver high-quality service to our clients and their members.

We also offer a wide range of clinical services. For example, since many plan designs cover drugs for only some of the conditions for which they may be prescribed, we have put in place rules that reduce the number of coverage determinations that pharmacists must make. These rules increase efficiency because pharmacists need to question fewer patients and physicians about their reasons for using a particular drug before filling a prescription. In addition, our integrated technology platform is capable of alerting members, pharmacists and physicians to potential negative drug interactions, drug recalls, allergy sensitivities or otherwise inappropriate pharmaceutical use. We regularly review our clinical services data and report to clients on our performance. We also use these reviews as an opportunity to identify drug utilization problems and suggest appropriate solutions.

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Our specialized call center pharmacies offer clients, members, pharmacists and physicians access 24 hours a day, seven days a week to service representatives and consulting pharmacists. As of February 1, 2004, we had approximately 300 pharmacists and approximately 2,600 service representatives who work in our seven call center pharmacies. In addition, our website contains tools and information that can be used by clients, members, pharmacists, physicians and the general public.

Take advantage of our significant technology investments to drive growth, improve service and reduce costs. Our technology platform offers the opportunity to enhance productivity and reduce costs for us and for our clients, provides more convenience for clients and their members and, we believe, improves overall patient care. A critical benefit of this technology platform is that it allows us to create and execute increasingly complex prescription drug benefit programs and services. Our mail order pharmacy service enables our professional pharmacists to focus on meeting the needs of our members and increases service efficiency by routing prescriptions electronically to the most appropriate pharmacies for processing and dispensing, including primarily our two highly automated dispensing pharmacies. Our technology platform also includes our data center, which enables us to provide sophisticated reporting and analysis to our clients. Our data center also helps us receive and process prescriptions and analyze data concerning drug utilization. Our specialized call center pharmacies use advanced technology to speed service and provide members personalized prescription and health information. Advanced Internet capabilities provide us with significant opportunities to improve services in e-commerce, as well as the ability to deliver timely, accurate and personalized health information to our members at a substantially lower cost than traditional communication methods. We have also implemented a suite of web-based applications for clients that provide sophisticated reporting, analytical and communications capabilities to enable them to manage more effectively the prescription drug benefits they provide.

We continue to encourage physician adoption of electronic prescribing, which involves physicians using hand-held or desktop computer technology and prescription writing software applications to write prescriptions for their patients. We believe that linking the physician electronically with the PBM’s patient-specific health and benefit information and the dispensing pharmacist will improve patient safety, enhance the quality of care and lead to improved patient satisfaction and convenience. Electronic prescribing may also reduce costs for plan sponsors by improving the speed and accuracy of ordering prescriptions, reducing medication errors and adverse drug events, and increasing formulary compliance and selection of generic medications. Physicians are also likely to benefit from electronic prescribing because it will reduce post patient visit prescription rework and improve the quality of patient care by giving physicians real-time access to a patient’s plan guidelines and prescription history to prevent adverse drug interactions and duplication of therapy. We believe that a universal channel is needed to provide an industry standard for the secure, electronic exchange of prescription information. In 2001, we formed RxHub with AdvancePCS and Express Scripts, Inc. to help develop this capability. RxHub has created a standardized electronic prescribing platform, enabling physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plans. In addition, we have alliances with several point-of-care vendors that allowed us to process approximately 2.7 million electronic prescriptions in 2003.

Actively pursue sources of growth from new clients and increased use of our value-added services, including our mail order pharmacies. We believe our high-quality service model, including our market-facing groups designed to address the special needs of our customers, and drug trend management track record will enable us to continue to attract new clients in all client categories, from large Blue Cross/Blue Shield plans, managed care organizations and insurance carriers, through our Systemed clients in the small and mid-size client market.

We also believe we have an opportunity to increase our mail order volume substantially. Of a potential user base of over 20 million members who use maintenance medications to treat chronic medical conditions and whose plans offer them the option of using retail or mail order, only approximately 5 million members currently use mail order. We will continue to seek to convert members who currently use retail pharmacies for maintenance medications to our mail order service. Filling a prescription through our mail order pharmacy reduces costs to our clients by increasing formulary compliance and, where appropriate, generic substitutions. We believe that our mail

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order pharmacy increases member satisfaction due to, among other things, the convenience of receiving a 90-day supply of a drug instead of the 30-day supply generally dispensed by retail pharmacies, as well as the typical annual cost savings associated with reduced co-payments.

We offer our clients a comprehensive suite of cost-management programs and services, which include prescriber management products and RationalMed, our proprietary service that analyzes patients’ prescription, medical and laboratory records to determine whether a prescription drug could be harmful. Through the use of these products and services, several of our significant clients limited their drug trend to less than 10% in 2003.

We are expanding our specialty pharmacy offerings to our clients, as further discussed below, and expect to participate in the Medicare prescription benefit program. We anticipate that this new benefit program will enable Medco to extend to America’s senior citizens the market-based tools that we have successfully used to manage drug spending in the private sector.

Selectively form strategic alliances and expand into complementary, adjacent markets. While our principal focus has been to expand our business through internal growth, we have also made targeted acquisitions and entered into strategic alliances. For example, as new and expensive biotech drugs are introduced into the market, we will continue to invest in our specialty pharmacy programs, such as through our own Specialty Care Pharmacy in Ohio, or through collaboration with business partners, such as our strategic alliance with Accredo Health, Inc. (“Accredo”) announced in February 2004. The specialty pharmacy market is currently estimated at $20 billion in annual U.S. sales and is expected to double to $40 billion over the next 3 years, and through our collaboration with Accredo in the role as a preferred retail and mail order provider of a select group of specialty drug therapies, combined with our core specialty capabilities, we are well positioned to reduce our clients’ specialty drug cost in the future. We intend to continue to expand into new markets and selectively form alliances and make targeted acquisitions to complement our internal growth.

Competitive Advantages

We believe we have several competitive advantages that enable us to deliver enhanced service to clients and their members while effectively managing drug trend for our clients at levels significantly below the national average.

We believe our competitive advantages include the following:

We have a highly automated mail order pharmacy service. Our pre-eminent mail order pharmacy service automates the prescription filling process using proprietary software, much of which we have developed in-house, and advanced robotics technology. At our mail order pharmacies, we can accept a prescription for processing, determine whether the prescribed drug is on a plan’s formulary and work with physicians to substitute less expensive clinically equivalent generic drugs for brand-name drugs, fill the prescription and deliver it by mail or courier to a member. These capabilities create a distinct cost advantage for us and our clients, while enhancing member convenience.

In 2003, our mail order pharmacies filled more prescriptions than the combined mail service operations of our three largest competitors. The accuracy of prescriptions dispensed from these facilities, which use our patented technology, exceeds the highest industry quality standard. Each of these two automated pharmacies has the individual capacity to dispense over 1.0 million prescriptions per week. Our weekly average mail order prescription volume was approximately 1.5 million in 2003.

Our investments in technology are reducing costs and providing enhanced client and member service. We have designed our technology to anticipate and respond quickly to client, member, physician and pharmacist needs and to reduce costs. We have invested in a new generation of technology to allow our specialized call center pharmacies to provide faster service and enhance the access our service representatives have to member information. Our integrated voice-response phone system allows members to enroll for mail order service, submit a mail order

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prescription for processing, track the status of their mail order prescription or locate an in-network retail pharmacy in their area.

We offer extensive value-added programs and services to our clients and their members. Our flexible programs and services enable us to deliver effective drug trend management for our clients while, we believe, improving the quality of care for their members. Our services focus on:

Our Pharmacy and Therapeutics Committee and Medical Advisory Board play an integral role in creating and administering our value-added programs and services. Our Pharmacy and Therapeutics Committee and Medical Advisory Board make decisions independently of us, and are each comprised of a distinguished independent group of clinicians. The Pharmacy and Therapeutics Committee guides us in maintaining a consistent and therapeutically appropriate approach to the clinical content of certain programs and services, including, for example, the development of formularies and coverage criteria. Our Medical Advisory Board reviews and evaluates the clinical relevance, quality and effectiveness of all our health management programs and services.

Our comprehensive generic substitution programs save our clients money. The substitution of medically appropriate generic drugs for brand-name drugs helps contain client and member prescription drug costs. Generic drugs save both clients and their members money because they are less expensive and generally require lower co-payments than brand-name drugs. Our Generics First^® program offers participating physicians the opportunity to obtain free generic samples and information on the value of generic drugs, and educates physicians and members

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about the cost savings as well as the availability of generic therapeutic equivalents and alternatives to brand-name drugs. Other aspects of our integrated generics strategy include alerting physicians to the availability of medically appropriate generic substitutes and substituting generic drugs as soon as legally permissible, generally when the marketing exclusivity on the brand-name drug ends. For example, within one month of a generic equivalent becoming available for Prinivil^®, we achieved a substitution rate of approximately 90% for prescriptions filled by our mail order pharmacies, and within two weeks of a generic equivalent becoming available for Glucophage^®, we achieved a substitution rate of over 91% for prescriptions filled by our mail order pharmacies. Between 2004 and 2007, patents are expected to expire on brand-name drugs that generate aggregate U.S. sales of approximately $38 billion.

We have a deep and experienced management team. Our management team has extensive experience in the PBM and healthcare industries and has established long-standing relationships with key constituents.

See “—Competition” below for a description of competition in the PBM industry.

Programs and Services

To support our efforts to control prescription drug costs for our clients while supporting the appropriate use of prescription drugs, we offer a wide range of programs and services that help manage the cost, quality and administration of the prescription drug benefits that our clients offer to their members. These programs and services are targeted at our key constituencies: clients, members, pharmacies and physicians.

Plan Design

Over the years, our customer teams have refined a consultative approach for helping clients develop and implement different plan designs. We assign each client a team that includes experienced clinical, financial and information technology specialists. Each client’s success in achieving the business objectives of its pharmacy benefit ultimately depends on the benefit plan design. These designs take into account formulary, pharmacy management, drug coverage and exclusion and cost-share options, as well as applicable state and federal laws. We also work closely with clients to determine how to introduce plan design changes to maximize member acceptance.

As an integral part of this consultative approach, our account teams use proprietary software tools that we have developed to model the effects of different plan designs based on historical data. Clients can then judge the impact of specific components before they are implemented. We provide a broad range of plan designs and the ability to customize plan design.

The following are descriptions of key plan design elements:

Formulary choice. A formulary is a list of preferred drugs from which our clients’ members and their physicians can choose. Our independent Pharmacy and Therapeutics Committee reviews drugs for formulary inclusion and exclusion based on clinical considerations. Clients can choose from one of our existing formularies or we will assist them in designing their own customized formulary. Our goal is to give members access to clinically appropriate drugs, while helping clients control plan costs. We look for client savings by focusing on lower-cost products and attractive rebates and discounts.

Generic options. Because generic drugs typically cost substantially less than brand-name drugs, generic equivalents can be an important part of a plan design. Clients can realize plan savings by implementing effective generic substitution incentive programs, such as differential co-payment plans that require members to pay for the difference between the cost of a brand-name drug and a less expensive, generic substitute.

Mandatory mail. Our mandatory mail programs combine plan design features and communications to encourage our clients’ members to use mail order for maintenance prescriptions, which patients generally take over a protracted period of time. The programs increase the use of mail order, providing substantial savings for our clients through better prescription pricing and superior generic substitution performance. Also, our clients’

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members benefit from lower annual co-payments, superior dispensing accuracy and 24 hour-a-day pharmacist availability.

Pharmacy networks. Our clients can realize plan savings by carefully selecting a retail pharmacy network and making use of our mail order service. In selecting a retail pharmacy network, clients generally consider the number and location of pharmacies in the network, the competitiveness of the reimbursement plan that the network offers and the quality of service and care provided to plan members.

Coverage rules. Coverage rules govern the conditions under which drugs are covered, aligned with each client’s benefit philosophy. In concert with our clinical experts, a client may set up a combination of coverage conditions establishing the quantity, dose and number of days’ supply of medication, the length of time for a therapy, and particular medical conditions that the plan will or will not cover. Our Coverage Management WorkStation software then helps clients, or us on their behalf, to efficiently administer coverage rules.

Cost-share decisions. Cost-share decisions also are aligned with a client’s benefit philosophy and govern the relative share of a drug therapy’s cost that is paid by the member. A number of cost-share options exist, including multi-tiered co-payment, percentage co-payments and payments for the difference between the cost of a brand-name drug and a less-expensive, generic equivalent. When properly structured, cost sharing can encourage members to make more cost-effective prescription drug choices.

Plan limitations and exclusions. Our clinical experts work with clients to determine appropriate limitations and exclusions on coverage of some medications, including many associated with lifestyle choices. For example, some clients will exclude coverage of impotence or baldness medications and treatments.

Clinical Management

Increases in the utilization rate of prescription drugs typically account for a significant portion of the rise in drug trend. Increased utilization rates are attributable to, among other things, the commercialization of new drugs and increased patient awareness and demand. We capitalize on our clinical expertise and advanced information technology infrastructure to help reduce client costs in a medically appropriate way, while striving to improve safety and the quality of care for members. We do this by developing action-oriented clinical programs and services based on clinical rationale reviewed by our Pharmacy and Therapeutics Committee. Once developed, these programs are integrated into a client’s pharmacy benefit plan. To monitor our success with these programs, we regularly consult with clients, review their clinical and financial data, and report to clients on the success of our actions on their behalf.

Clinical Information. Our Department of Medical Affairs tracks prescription drugs while they are still in the research and development phase, as well as the timing of patent expirations for brand-name drugs. This allows us to anticipate how the introduction of new prescription drugs and patent expirations will impact plan design and formulary content options, and gives us lead time on developing new programs and services for clients.

Clinical Decision Support Tools. Once a new prescription drug enters the market, our physicians and pharmacists use modeling software to provide clients with projections of drug spending under different scenarios. We have the ability to make client-specific changes to a benefit plan’s formulary or clinical rules within a few days of a new product’s introduction utilizing workstations that are linked to our data infrastructure.

Clinical Programs. To help clients manage drug trend, we have clinically based programs that identify drug claims on the basis of clinical rules that our clients use for coverage criteria. These rules have the potential to reduce unnecessary costs from uncovered drug use while minimizing impact on valid claims. The clinical basis for the criteria used to develop these rules are approved by our Pharmacy and Therapeutics Committee. Clients may choose standard bundles of rules or, using our formulary consulting capabilities, they may create their own program by choosing the rules most appropriate to their plan design.

We have introduced a variety of innovative clinical programs. One of these is our proprietary RationalMed service, an advanced software tool designed to reduce unnecessary drug-induced illness and hospitalizations and

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reduce overall healthcare expenses. We offer the RationalMed service to our PBM clients and to other healthcare providers. RationalMed analyzes patients’ available prescription, inpatient and outpatient medical and laboratory records to indicate whether a prescription drug could be harmful to them. Clients who implement the RationalMed technology can save money by reducing inappropriate prescription use and avoiding unnecessary medical costs, including possible hospitalization.

Drug Utilization Reviews. We conduct drug utilization reviews, or DURs, which is a systematic evaluation of individual or group use of prescription drugs, to help clients identify and address overuse, underuse, and misuse of prescription drugs. Concurrent DUR provides real-time online decision support for pharmacists at the time they are filling prescriptions that improves quality of care while lowering drug cost by reducing inappropriate dispensing. Our DURs alert us of possible problems, such as drug-drug interactions, drug-age problems, and drug-pregnancy issues based on our patient profiles. Retrospective DUR looks at prescription use over time to help identify and change patterns of prescribing drugs that are not formulary compliant, or prescribing brand-name drugs where there may be medically appropriate generic equivalents.

Pharmacy Management

One of the core features of our PBM services is the management and administration of the process by which prescription claims are received and processed on behalf of our clients and drugs are dispensed to their members.

Retail Pharmacy Networks. We have contractual relationships with approximately 60,000 independent and chain retail pharmacies that have agreed to participate in one or more of our retail network options. A network offers members access to a choice of pharmacies while providing clients with cost savings through contracted discount rates that we negotiate with retail pharmacies. In general, these rates for brand-name drugs are at a discount to the average wholesale price of the drug, which is a standard pricing unit used in the industry. In addition, we determine a maximum allowable cost for each type of generic drug. Our retail pharmacy network agreements also include professional dispensing fees to be paid to the pharmacy. Clients generally select a retail pharmacy network based on the number and location of pharmacies in the network and the competitiveness of the discounts that the network offers. Pharmacies in a network also agree to follow our policies and procedures designed to enhance specific performance standards regarding patient safety and service levels. Our retail specialists also regularly review changes in pharmacy plan rules and clinical protocols with retail pharmacists to help foster the health of members and maximize savings for our clients. Pharmacies in the network benefit, in turn, from increased member traffic and sales.

Following standard industry practice, retail pharmacies maintain online contact with us to process prescription drug claims. We confirm a member’s eligibility, determine the co-payment, update records as required, and conduct concurrent DURs to enhance patient safety. Our retail network department is available 24 hours a day, seven days a week to answer pharmacists’ questions and provide support for processing prescription claims.

Mail Order Service. Our mail order service is the industry’s largest in terms of the number of prescriptions filled. We dispensed approximately 78 million prescriptions in 2003 through our mail order pharmacies. For maintenance medications, mail order typically reduces costs for clients through volume purchasing, increased generic dispensing and higher rebates through greater formulary compliance. Many members prefer mail order for maintenance medications because they can typically receive a 90-day supply instead of a 30-day supply as commonly dispensed by retail pharmacies. Members can place orders easily online through our member website, through our integrated voice-response phone system, or through the mail.

Our mail order pharmacy infrastructure currently consists of 10 mail order pharmacies throughout the United States, eight of which contain prescription processing cognitive service centers and four of which engage in mail order dispensing activities. In our prescription processing centers, our pharmacists focus on “front-end” pharmacy activities such as reviewing, recording and interpreting incoming prescriptions, screening for interactions based on each patient’s drug history and medical profile, resolving benefit and clinical issues with plan sponsors and physicians and then approving and routing the prescriptions to one of our four mail order dispensing pharmacies. In the four dispensing pharmacies, including our automated pharmacies in Las Vegas, Nevada and Willingboro, New

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Jersey, we focus on distribution processes such as prescription dispensing and presorting for shipment to patients by mail or courier. All ten of our mail order pharmacies are electronically networked to provide national coverage.

We have capitalized on the efficiencies created by our two automated dispensing pharmacies, and our industry-leading operational platform. This platform separates the front-end processing activities and back-end dispensing processes by converting our integrated mail order pharmacies into front-end pharmacies and concentrating most back-end activities at our two automated dispensing pharmacies. This approach allows us to optimize the value of our professional pharmacist services to meet the needs of members and ensure faster and smoother service, as well as maximize the efficiency of the dispensing function.

Call Center Pharmacies. We operate seven call center pharmacies, each of which is licensed as a pharmacy in the state in which it is located and is staffed by service representatives and pharmacists. Personnel at our call center pharmacies are available to answer questions and provide information and support to members 24 hours a day, seven days a week, for members using either our mail order service or our retail pharmacy network. Our call center pharmacies also provide information and services to physicians and pharmacists who service our clients’ members. Service representatives and pharmacists at our call center pharmacies use advanced imaging technology and other Internet capabilities to access prescription and health information when providing service to members and encourage physicians to reduce costs through dose optimization, generic substitution and the interchange of formulary compliant drugs for non-formulary compliant drugs.

Health Management Programs

We offer a series of Positive Approaches^® health management programs as part of our prescription drug benefit package to help members with certain chronic conditions better understand their conditions and comply with their prescribed drug therapies. Enrolled members receive educational and behavioral interventions, including letters and phone calls, as well as clinical support through toll-free hotlines. We focus on illnesses that have high prevalence rates and high impact on clients in terms of drug and medical costs. These illnesses include asthma, cardiovascular problems, depression and diabetes. Clients benefit through lower or avoided medical costs.

Our Partners for Healthy Aging^® initiative focuses on older members and supports older adults with literature and drug information printed in easy-to-read, large type and with customer service representatives specially trained in senior health issues.

Physician Services

Motivating physicians to prescribe more cost-effective medications is a key objective of a number of our initiatives, including our Physician Service Center, integrated generics strategy featuring our Generics First^® education and sampling program, Physicians Practice Summary Program and Point-of-Care On-line Connectivity Program.

Physician Service Center. Our Physician Service Center provides a single toll-free number for physicians and office staff to call one of our specially trained and dedicated staff of pharmacists and service representatives who can answer questions relating to patients and their prescription drug benefits. The center is further supported by physicians in our Department of Medical Affairs. The center assists in improving physicians’ understanding of formularies, generics and utilization management. Typically, the center also fields general questions about our company and our clinical products and services, handles requests for educational or promotional materials, and routes calls to other experts in our company if more in-depth information is required. Our integrated communication platform includes a physician fax platform that analyzes and routes faxes to expedite resolution of physician inquiries regarding formulary compliance and other programs and services.

Integrated Generics Strategy. Our integrated generics strategy seeks to reduce our clients’ drug spend by increasing the use of generic medications, when clinically appropriate, in place of more expensive, brand-name medications. The strategy encompasses generic education, substitution, and interchange programs, as well as a host of other activities, including careful tracking of brand-name drugs about to lose their exclusivity. When patents for brand-name drugs expire, we act quickly to encourage physicians and members to use the new generic equivalent.

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For example, when the blood pressure medication Vasotec^® lost patent protection, our mail order pharmacies moved quickly to substitute the new generic equivalent, enalapril. In our mail order pharmacy business, generic conversions from Vasotec^® reached approximately 90% within one month of enalapril’s availability, providing savings to our clients. In our mail order pharmacy business, generic conversions from Prinivil^®/Zestril^® reached approximately 90% within one month of generic lisinipril’s availability, providing savings to our clients.

Introduced late in 2000, our Generics First^® program has been encouraging the use of generics, where medically appropriate, among approximately 20,000 physicians across the country. Of these physicians, approximately 3,500 receive periodic face-to-face informational visits from our specially trained pharmacists who discuss clinical guidelines for generics and facilitate the ordering of free samples of commonly prescribed generic medications from manufacturers. These pharmacists also provide educational brochures on the benefits of generics for patients in office waiting areas and exam rooms. As part of this program, in 2003, approximately 700 physicians nationwide participated in an innovative web-based educational program that provides online Generics First^® clinical and cost education.

Physician Practice Summary Program. Through our Physician Practice Summary Program, we are able to track physician prescribing histories and report summary and comparative data to both physicians and clients. This information, combined with meetings with physicians, is useful in encouraging physicians to improve the cost effectiveness of their prescribing.

Point-of-Care On-line Connectivity Program. More than 11,000 physicians are enabled with our point-of-care, or POC, electronic prescribing program. During 2003, these physicians submitted approximately 2.7 million prescriptions using electronic prescription writing tools. Key objectives of the strategy include improved accuracy of information transmitted to the pharmacy and enhanced patient safety. Physicians gain real-time access to a patient’s plan guidelines and prescription history to help prevent drug interactions and duplicate therapies. Physicians also benefit from electronic prescribing because it simplifies the prescription process and, we believe, improves the quality of patient care.

We work closely with a variety of handheld and PC based POC providers in recruiting new physician users. We also encourage the use of an open-access system to ensure that standardized solutions are available for varying physician office requirements. In February 2001, we formed RxHub LLC with AdvancePCS and Express Scripts, Inc. RxHub created a standardized electronic prescribing platform, enabling physicians to use electronic prescribing technology to link to pharmacies, PBMs and health plans.

Web-Based Services

We believe our web-based services are the most advanced and comprehensive in the PBM industry. Not only do we offer what we believe is the industry’s leading consumer website for members, we also offer client and pharmacist sites with interactive tools aimed at improving compliance with plan goals, simplifying benefit administration, and providing critical benefit and medical information.

Member-Oriented Web Services. Our member Internet capabilities are focused on keeping members informed about their prescription drug coverage while encouraging them to use safe, effective therapies that comply with their plan’s provisions.

Our member website provides members a broad set of features and capabilities, including:

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Our member website was the first Internet pharmacy site to be certified by the National Association of Boards of Pharmacy. The site processed more than 13.8 million prescription orders in 2003. The site also handled more than 49.7 million member service inquiries in 2003.

Client-Oriented Web Services. Our client website, an extranet introduced in 2001, provides clients online access to our proprietary tools for reporting, analyzing and modeling data, clinical- and decision-support, plan administration, including eligibility and claims reviews, the latest industry news, and easy submission and tracking of service requests. Clients who conduct their own member service can use our client website to update eligibility data and counsel members on all aspects of their pharmacy benefit, formularies, co-payments and coverage provisions, including the location of network retail pharmacies. Clients also can view detailed, consolidated claims for retail and mail order service and issue prior-authorization approval. We can tailor access to the specific needs of different users who play a role in managing the pharmacy benefit within the client organization, thereby limiting access to information to those who are authorized to view it.

Pharmacist-Oriented Web Services. Our Pharmacist Resource Center is an online service for retail pharmacies that participate in our national networks. This service provides pharmacists with the latest news on new benefit plans, plan design changes, pricing information, drug recalls and alerts, as well as online access to our pharmacy services manual. Pharmacists can check patient eligibility, determine coverage and review claims status for plan members. The center also gives participating pharmacies e-mail access to our pharmacy services help desk.

Contractual Relationships

Our net revenues are principally derived from contracting with clients to provide prescription drugs to their members through our mail order pharmacies and our networks of contractually affiliated retail pharmacies. Our client contracts provide that a client will pay for drugs dispensed to its members at specified discounts to average wholesale prices, plus the applicable dispensing fee. Both the specified discounts to average wholesale prices and the applicable dispensing fee vary based on whether the drug dispensed is a brand-name drug or generic drug and whether the prescription is filled through a mail order or retail pharmacy. Clients may also pay an administrative fee per prescription filled for services we provide. These services comprise claims processing, eligibility management, benefits management, pharmacy network management and other related customer services. Client contracts generally provide that we will share with clients formulary rebates received from pharmaceutical manufacturers. Additionally, many of our contracts with clients contain provisions that specify minimum levels of service we will provide to the client and associated penalties if we do not meet these levels.

Our contracts with pharmaceutical manufacturers provide us with rebates and fees for prescription drugs dispensed through our mail order pharmacies and retail pharmacies participating in our networks of contractually affiliated retail pharmacies, as well as discounts for prescription drugs we purchase and dispense from our mail order pharmacies. We typically purchase generic drugs directly from generic manufacturers pursuant to informal agreements and understandings under which we will provide the generic manufacturer with the right to be the exclusive supplier to our mail order pharmacies so long as such manufacturer’s prices remain competitive. Rebates and fees are predominantly equal to a percentage of the aggregate dollar value of all of a particular drug that we dispensed, based on the manufacturer’s published wholesale price for that drug. Rebates and fees are invoiced to the pharmaceutical manufacturer and paid to us on a quarterly basis. Although most rebates are payable on a product by product basis, some pharmaceutical manufacturers have agreed to pay rebates in respect of any given client only if all of the specified products of the manufacturer are included on that client’s formulary. Our contracts typically provide for two types of rebates:

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Formulary rebates are typically calculated based on an agreed percentage of the aggregate wholesale price of all prescriptions dispensed for clients, which include the applicable pharmaceutical products on their formularies and do not subject such products to restrictions which are not applicable to competing branded products. Market share rebates, a type of performance based rebate, are contingent upon us achieving the contractually specified market share level for a particular drug for all of our clients. We generally share a portion of rebates with our clients based on the provisions of the applicable client contract, and may also guarantee a minimum rebate per prescription dispensed to the client’s members. For a further discussion of the rebates we receive, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Use of Estimates and Critical Accounting Policies—Critical Accounting Policies”.

In addition to contracts with clients and pharmaceutical manufacturers, we have contractual relationships with independent and chain retail pharmacies that have agreed to participate in one or more of our retail networks. These retail pharmacies agree to fill prescriptions for our clients’ members at discounted prices and, in exchange, we pay them for the contracted cost of drugs they dispense, net of co-payments, and an agreed upon professional fee for filling each prescription and performing eligibility and benefit management and other services.

Clients

We have clients in a broad range of industry categories, including various Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. For the fiscal year ended December 27, 2003, our ten largest clients based on revenue accounted for approximately 46% of our net revenues, including UnitedHealth Group, our largest client, which represented approximately $6,100 million, or 18%, of our net revenues. In January 2004, we announced an early renewal agreement to provide pharmacy benefit administrative services to UnitedHealth Group effective January 1, 2004, for an initial five-year term. The agreement may be extended for three additional years through 2011 at UnitedHealth Group’s option. No other client accounted for 10% or more of our net revenue in this period. Our failure to retain key clients or satisfy contractual provisions with key clients could adversely affect our financial condition, business and results of operations, including the impairment or accelerated amortization of intangible assets associated with the value of our customer relationships at the time of our acquisition by Merck and pushed down to our balance sheet.

Many of our contracts with clients contain provisions that guarantee the level of service we will provide to the client or the minimum level of rebates or discounts the client will receive. Many of our client contracts also include guaranteed cost savings. An increase in drug costs, if the result is an overall increase in the cost of the drug plan to the client, may prevent us from satisfying contracts with guaranteed cost savings or minimum levels of rebates or discounts. Additionally, these clients may be entitled to performance penalties or the right to terminate their contracts with us if we fail to meet a service or cost guarantee we provide to them. Clients that are party to these types of contracts represented, in aggregate, over 90% of our net revenues in 2003.

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Our clients are generally entitled to have us audited under their contracts with us and on occasion a client or former client has claimed that it overpaid us for our services based on the results of an audit. Payment disputes may adversely affect our results of operations if they result in refunds or the termination or non-renewal of a client contract.

Mail Order Service Suppliers

We maintain an extensive inventory in our mail order pharmacies of brand-name and generic pharmaceuticals. If a drug is not in our inventory, we can generally obtain it from a supplier within one or two business days. We purchase our pharmaceuticals either directly from manufacturers or through wholesalers. During 2003, one wholesaler, AmerisourceBergen Corp., accounted for approximately 60% of the total dollar amount of our mail order pharmaceutical purchases, most of which were brand-name pharmaceuticals. Generic pharmaceuticals are generally purchased directly from manufacturers. Except to the extent that brand-name drugs are available to the market exclusively through the manufacturer, we believe that alternative sources of supply for most generic and brand-name pharmaceuticals are readily available.

Competition

Competition in the PBM industry is intense. We compete primarily on the basis of our ability to design and administer innovative programs and services that provide high-quality, affordable prescription drug care and health management services to health plan members. We believe plan sponsors generally consider the following key competitive factors:

We compete with a wide variety of companies for business in client categories broadly defined as Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. Although some of our competitors focus on a limited set of client categories, we have clients in all of these categories, and we have achieved significant plan retention and actively compete for new business in all categories.

Competitors fall into the following categories:

National Competitors. We compete with large national PBMs, such as AdvancePCS, Caremark Rx, Inc. and Express Scripts, Inc. Caremark Rx, Inc. completed its acquisition of AdvancePCS on March 24, 2004. These competitors conduct business in every market category and, like us, they have national sales and account teams, mail order pharmacies and extensive technology infrastructure.

Managed Care and Insurance Companies. We also compete with several managed care organizations, Blue Cross/Blue Shield plans and insurance companies that have their own internal full-service pharmacy benefit programs. Some of these competitors have national account capabilities and, in some cases, they may have access to greater financial, purchasing or distribution resources than we have.

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Other Competitors. Because we provide a wide variety of programs and services, there are many non-PBM firms that compete with us in various aspects of our business. Some of our health management and other member services compete with similar services offered by pharmaceutical companies and by smaller firms specializing in those service markets. Other firms that focus on large-scale claims processing also compete with us.

Government Regulation

Federal and state laws and regulations govern many aspects of our business. These laws and regulations apply to our administration of prescription drug benefits and our drug and health education programs and services. In addition, the activities of our mail order pharmacies are regulated under federal and state laws applicable to the purchase, distribution and dispensing of prescription drugs. Many of our clients, including insurers and health management organizations, or HMOs, are themselves subject to extensive regulations that affect the design and implementation of prescription drug benefit plans that they sponsor. We believe we are in substantial compliance with all existing legal and regulatory requirements material to the operation of our business. However, the application of complex standards to the operation of our business creates areas of uncertainty.

We have standard operating procedures and controls designed to enhance operating efficiencies and assist in ensuring compliance with existing contractual requirements and state and federal law. We diligently monitor and audit our adherence to these procedures and controls. From time to time, we have become aware that certain employees at some of our pharmacies did not follow certain of our procedures and controls regarding the processing of prescriptions, and we have taken prompt appropriate corrective and disciplinary actions. We believe that the actions of such employees did not result in any material violations of any contract or applicable law. Nevertheless, a determination that any such contractual breaches or violations of law occurred could adversely impact existing governmental or legal proceedings or otherwise have a material adverse effect on our business, financial condition or profitability.

Numerous new healthcare laws and regulations or modifications to existing laws or regulations have been proposed at the federal and state levels. We cannot predict how courts or regulatory agencies may interpret existing laws or regulations or what additional federal or state legislation or regulatory initiatives may be enacted in the future regarding healthcare or the PBM industry. Laws and regulations in these areas will continue to evolve. Federal or state governments may impose additional restrictions or adopt interpretations of existing laws directly affecting our operations or the market for our services that could have a material adverse affect on our business, profitability, liquidity or growth prospects.

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

Regulation of Our Pharmacy Operations. The practice of pharmacy is generally regulated at the state level by state boards of pharmacy. Our mail order pharmacy operations are located in eight states and dispense drugs throughout the United States. We have ten mail order pharmacies, eight of which contain prescription processing centers and four of which engage in mail order dispensing activities. In addition, we operate seven call center pharmacies that provide extensive support and counseling to members using either our mail order dispensing pharmacies or our retail pharmacy network. Each of our dispensing pharmacies, prescription processing centers and call center pharmacies must be licensed in the state in which it is located. Our pharmacies are located in Florida, Nevada, New Jersey, Ohio, Pennsylvania, Texas, Virginia and Washington. In some of the states where our dispensing pharmacies are located, state regulations require compliance with standards promulgated by the United States Pharmacopeia, or USP, a nonprofit organization whose members represent the healthcare professions, industry, government and academia. USP creates standards in the packaging, storage and shipping of pharmaceuticals. We believe that each of our pharmacies has the appropriate licenses required under the laws of the state in which it is located and that we conduct our pharmacy operations in accordance with the laws and regulations of these states.

Our mail order pharmacies deliver prescription drugs to the members of benefit plans sponsored by our clients in all 50 states. Many of the states into which we deliver pharmaceuticals and controlled substances have laws and regulations that require out-of-state mail order pharmacies to register with that state’s board of pharmacy or similar regulatory body. We have registered in every state that requires registration for the services we provide. To the extent some of these states have specific requirements for out-of-state mail order pharmacies that apply to us,

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we believe that we are in compliance with them. In addition, some states have proposed laws to regulate online pharmacies, and we may be subject to this legislation if it is passed.

Federal agencies further regulate our pharmacy operations. Pharmacies must register with the U.S. Drug Enforcement Administration and individual state controlled substance authorities in order to dispense controlled substances. In addition, the FDA inspects facilities in connection with procedures to effect recalls of prescription drugs. The FTC requires mail order sellers of goods to engage in truthful advertising and, generally, to stock a reasonable supply of the product to be sold, to fill mail orders within 30 days and to provide customers with refunds when appropriate. The U.S. Postal Service has statutory authority to restrict the transmission of drugs and medicines through the mail to a degree that could have an adverse effect on our mail service operations. The U.S. Postal Service historically has exercised this statutory authority only with respect to controlled substances. If the U.S. Postal Service restricts our ability to deliver drugs through the mail, alternative means of delivery are available to us. However, alternative means of delivery could be significantly more expensive.

Third-Party Administration and Other State Licensure Laws. Many states have licensure or registration laws governing companies that perform Third-Party Administration, or TPA, services on behalf of others. The definition of a TPA required to register and comply with these laws varies from state to state. We have obtained licenses in each of the states in which we believe a license is required based on the benefit management services we provide in those states.

In addition, many states have laws or regulations that govern ancillary healthcare organizations, including preferred provider organizations and companies that provide utilization review and related services. The scope of these laws differs significantly from state to state, and the application of these laws to the activities of PBMs is often unclear. We have registered under these laws in states in which we have concluded, after discussion with the appropriate state agency, that registration is required. These regulatory schemes generally require annual or more frequent reporting and licensure renewals and impose other restrictions or obligations affecting PBM services. Changes in these regulatory schemes could adversely affect our business, profitability and growth prospects.

Consumer Protection Laws. Most states have consumer protection laws designed to assure that information provided to consumers is adequate, fair and not misleading. In October 1995, we and Merck entered into settlement agreements with 17 states in which we and Merck agreed to require pharmacists affiliated with our mail order service to disclose to physicians and patients their identity, that they are calling on behalf of Medco and other information when they contact physicians to discuss branded alternatives to a drug the physician has prescribed. Our practices conform to the requirements of these settlement agreements and we believe they conform to other requirements of state consumer protection laws. However, we may be subject to further scrutiny under these consumer protection laws as they are often interpreted broadly. See Item 3, “Legal Proceedings” below.

Antitrust Laws. Since 1993, retail pharmacies have filed over 100 separate lawsuits against pharmaceutical manufacturers, wholesalers and other major PBMs, including us, challenging manufacturer discounting and rebating practices under various federal and state antitrust laws. These suits allege in part that the pharmaceutical manufacturers offered, and we and some other PBMs knowingly accepted, rebates and discounts on purchases of brand-name prescription drugs in violation of the federal Robinson-Patman Act and the federal Sherman Act. The Robinson-Patman Act generally prohibits discriminatory pricing practices. The Sherman Act generally prohibits contracts and combinations that unreasonably restrain trade or monopolization of any part of interstate commerce. Some pharmaceutical manufacturers have settled some of the Sherman Act cases brought on behalf of a nationwide class of retail pharmacies. The class action settlements generally provided for commitments to retail pharmacies by the manufacturers in connection with their discounting practices. The defendants who did not settle the Sherman Act class action cases won on a directed verdict. Some drug manufacturers have settled some actions filed by plaintiffs who opted out of the class action without disclosing the terms of the settlements. Approximately five Robinson-Patman Act cases to which we are a party remain pending. For further information on these cases, see Item 3, “Legal Proceedings—Antitrust Litigation” below.

In 1999, the FTC entered an order to resolve its antitrust concerns resulting from Merck’s acquisition of us in 1993. Among other things, the order requires us to maintain an open formulary that consists of drugs selected and approved by the Pharmacy and Therapeutics Committee. The order also requires that we accept, and accurately reflect on the open formulary, all concessions offered by any other manufacturer of pharmaceutical products. We

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and Merck also agreed pursuant to the order not to share proprietary or other non-public pricing information received from the other’s competitors unless such information is required for legal or auditing purposes.

Network Access Legislation. As part of our PBM services, we form and manage pharmacy networks by entering into contracts with retail pharmacies. A significant number of states have adopted legislation that may affect our ability to limit access to our retail pharmacy networks or to remove retail pharmacies from a network. This type of legislation, commonly known as “any willing provider” legislation, may require us or our clients to admit into our networks and retain any retail pharmacy willing to meet the price and other terms of our clients’ plans. To date, these statutes have not had a significant impact on our business because for most of our clients, we administer large networks of retail pharmacies and will admit any licensed pharmacy that meets our network’s terms, conditions and credentialing criteria, including adequate insurance coverage and good standing with the relevant state regulatory authorities.

Proposals for Direct Regulation of PBMs. Legislation directly regulating PBM activities in a comprehensive manner has been introduced recently in a number of states. These legislative initiatives have the support of associations representing independent pharmacies. In addition, legislation has been proposed in some states seeking to impose fiduciary obligations or disclosure requirements on PBMs. If enacted in a state in a form that is applicable to the operations we conduct there, this type of legislation could materially adversely impact us. Georgia has enacted a statute requiring PBMs engaged in the practice of pharmacy to obtain a Georgia pharmacy license. Compliance with this statute has not had a material impact on us. South Dakota has enacted a statute requiring PBMs to license as TPAs and imposing certain disclosure obligations. Maine has enacted a statute imposing fiduciary and disclosure obligations on PBMs; however, the U.S. District Court in Maine has preliminarily enjoined enforcement of the Maine statute.

ERISA Regulation. We typically provide services to a number of different corporations and other sponsors of health plans. These plans are subject to ERISA, which regulates employee pension benefit plans and employee welfare benefit plans, including health benefit and medical plans.

ERISA imposes duties on any person that is a fiduciary with respect to a plan that is subject to ERISA. We administer pharmacy benefit plans according to the plan design choices made by the plan sponsor. We believe that our activities are sufficiently limited that we are not a fiduciary except in those instances in which we have expressly contracted to act as a fiduciary for the limited purpose of addressing benefit claims and appeals, including our program to meet the Department of Labor, or DOL, regulations for claims payment and member appeals. If we are found to be a fiduciary and to have breached our fiduciary duty, or we are found to have breached our fiduciary duty in an instance in which we have contracted to act as a limited fiduciary, we could be subject to claims in connection with the services we provide to a plan, and our financial condition, business, and results of operations could be materially adversely affected.

Since December 1997, a number of lawsuits have been filed against us and Merck, alleging that we should be treated as a “fiduciary” under ERISA and that we have breached our fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs. In December 2002, we, Merck and the plaintiffs in five of the original six cases filed against us agreed to a proposed class action settlement of this litigation in order to avoid the significant cost and distraction of protracted litigation. Under the proposed settlement, Merck and we have agreed to pay $42.5 million and we have agreed to change or to continue certain specified business practices for a period of five years. For further information on this litigation and the proposed settlement, see Item 3, “Legal Proceedings—ERISA and Similar Litigation” below.

Anti-Kickback Laws. Subject to certain exceptions, federal law prohibits the payment, offer, receipt or solicitation of any remuneration that is knowingly and willfully intended to induce the referral of Medicare, Medicaid or other federal healthcare program beneficiaries for the purchase, lease, ordering or recommendation of the purchase, lease or ordering of items or services reimbursable under federal healthcare programs. These laws are commonly referred to as anti-remuneration or anti-kickback laws. Several states also have similar laws, known as “all payor” statutes, that impose anti-kickback prohibitions on services not covered by federal healthcare programs. Sanctions for violating these federal and state anti-kickback laws may include criminal and civil sanctions and exclusion from participation in federal healthcare programs. Anti-kickback laws vary between states, and courts

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have rarely interpreted them. However, where courts have reviewed these laws, they have generally ruled that contracts that violate anti-kickback laws are void as a matter of public policy.

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

On April 28, 2003, the OIG issued a final voluntary guidance for pharmaceutical manufacturers to consider when developing or implementing programs to assure compliance with laws and regulations pertaining to doing business with federal healthcare programs, such as Medicare and Medicaid. The guidance raises several questions and areas of risk that manufacturers should address in reviewing their business transactions with physicians and other health professionals who influence drug prescribing, drug purchasers such as hospitals and pharmacies, group purchasing organizations and PBMs. The key areas of risk identified by the guidance include discounts and rebates, product support services tied to the purchase of products, educational grants, research funding, and other remuneration to purchasers such as upfront payments, free or reduced-price goods or payments to cover the cost of converting from a competitor’s product. The guidance encourages manufacturers to structure their relationships to fall within several “safe harbors” established under the anti-kickback statute or regulations whenever possible, but also acknowledges that failure to comply with a safe harbor does not mean a business arrangement is illegal. The final guidance recognizes the value of formularies and formulary support activities to promote clinically appropriate, safe, and cost-effective drug therapy. The guidance says that formulary development is unlikely to raise significant anti-kickback issues as long as decisions about clinical efficacy and appropriateness precede and are paramount to considerations of costs. The guidance states that rebates or other payments by manufacturers to PBMs that are based on or otherwise related to a PBM’s customers’ purchases potentially implicate the anti-kickback statute.

We believe that we substantially comply with the legal requirements imposed by these laws and regulations, and that our programs do not involve practices that the OIG has questioned. However, on September 29, 2003, the U.S. Attorney’s Office for the Eastern District of Pennsylvania filed a complaint against us alleging violations of the federal False Claims Act and asserting other legal claims. On December 9, 2003, the U.S. Attorney’s Office filed an amended complaint, which adds two former employees of the Company as defendants and, among other additional legal claims, asserts a claim against the Company under the Public Contracts Anti-Kickback Act for allegedly making improper payments to health plans to induce such plans to select the Company as a PBM for government contracts. The Commonwealth of Massachusetts and the State of Nevada have intervened in the action. See Item 3, “Legal Proceedings—Government Proceedings and Requests for Information” below.

Regulation of Financial Risk Plans. Although the administration of fee-for-service prescription drug plans by PBMs is not subject to insurance regulation by the states, a few clients seek to limit their exposure in providing prescription drug benefits. In order to provide “stop-loss” insurance to our clients who seek to limit their risk under fee-for-service drug plans, we own three insurance companies: Medco Containment Insurance Company of New Jersey; Medco Containment Insurance Company of New York; and Medco Containment Life Insurance Company. These subsidiary insurance companies are licensed in 48 states and the District of Columbia and are subject to extensive regulatory requirements imposed under the insurance laws of the states in which they are domiciled as well as those in which they have obtained licenses to transact insurance business. These insurance subsidiaries only underwrite risk in connection with our own PBM services and do not represent a separate line of business. Historically, we have provided services to a limited number of our clients through these insurance companies. Premiums paid to the insurance companies and the losses incurred under the insurance coverage during this period were not material to our financial results.

Regulation Relating to Data Transmission and Confidentiality of Patient Identifiable Information. Dispensing of prescriptions and management of prescription drug benefits require the ability to utilize patient-specific information. Government regulation of the use of patient identifiable information has grown substantially

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over the past several years. At the federal level, Congress has enacted legislation, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, and the Department of Health and Human Services, or HHS, has adopted extensive regulation, governing the transmission, use and disclosure of health information by all participants in healthcare delivery, including physicians, hospitals, insurers and other payers. Additionally, regulation of the use of patient identifiable information is likely to increase. Many states have recently passed or are considering laws dealing with the use and disclosure of health information. These proposals vary widely, some relating to only certain types of information, others to only certain uses, and yet others to only certain types of entities. These laws and regulations have a significant impact on our operations, products and services, and compliance with them is a major operational requirement. Regulations and legislation that severely restrict or prohibit our use of patient identifiable information could materially adversely affect our business.

Under HIPAA, Congress required HHS to adopt standards governing the transmission, use and disclosure of individually identifiable health information. HHS adopted Privacy Standards under HIPAA with a compliance deadline of April 14, 2003. The Privacy Standards require covered entities to make available certain rights to individuals, including the right to receive notice of privacy practices describing how their health information may be used or disclosed, the right to access to a copy of health information maintained by the covered entity, the right to request amendment to such health information, the right to an accounting of certain disclosures of health information, and certain rights to request restrictions on how their health information may be used or disclosed. Additionally, the Privacy Standards specifically define permitted uses and disclosures of an individual’s health information, including for purposes of treatment, payment and healthcare operations, and generally require that a covered entity obtain valid written authorization from the individual for other uses and disclosures. The Privacy Standards require covered entities to establish administrative safeguards, including appointment of a privacy official, adoption of policies and practices to assure compliance with the HIPAA standards and to limit use or disclosure of health information in many cases to the minimum amount necessary to accomplish an activity permitted by the Privacy Standards. Medco Health’s pharmacy operations are covered entities which are directly subject to these requirements. In its role as a manager of the prescription benefit, Medco Health is a business associate of health plan clients which are covered entities subject to the Privacy Standards. We have invested considerable time and resources modifying our systems, policies and procedures in order to comply with our obligations under the HIPAA regulations as a covered entity and to develop the capabilities to support compliance by health plan clients.

HIPAA does not preempt state law privacy requirements that are generally conflicting and more restrictive. Therefore, in addition to meeting the requirements of the federal HIPAA privacy standards, we or our clients may be subject to additional requirements and restrictions under numerous state laws and regulations that impact healthcare information. These include applicable pharmacy laws, insurance laws, the federal Gramm-Leach-Bliley law and state regulations governing data use by financial institutions and specific legislation designed to protect the privacy of health data. In addition, legislation has been proposed in some states to further regulate use, disclosure or maintenance of healthcare information or to provide individuals with additional rights with respect to their health information. Such regulation could significantly impact our programs and service offerings and have an adverse effect on our business, profitability and growth prospects.

HHS has adopted Security Standards, National Health Care Provider Identifier Standards and National Employer Identifier Standards under HIPAA with compliance dates beginning April 21, 2005. We are in the process of assessing the requirements under these regulations and will take the steps needed to comply prior to the required date.

Sanctions for failing to comply with HIPAA standards include criminal and civil penalties. If we are found to have violated any state or federal statute or regulation with regard to the confidentiality, dissemination or use of patient medical information, we could be liable for significant damages, fines or penalties.

Regulation Applicable to Clients. We provide services to insurers, managed care organizations, Blue Cross/Blue Shield plans and many others whose ability to offer a prescription benefit may be subject to regulatory requirements and constraints under a number of federal or state regulatory schemes. While we may not be directly subject to these regulations, they can have a significant impact on the services we provide our clients.

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

Legislation and Regulation Affecting Drug Prices and Potentially Affecting the Market for Prescription Benefit Plans. The federal Medicaid rebate statute provides that manufacturers must provide rebates on all drugs purchased by the Medicaid program. Manufacturers of brand-name products must provide a rebate equivalent to the greater of (a) 15.1% of the “average manufacturer price”, or AMP, to wholesalers for products distributed to the retail class of trade and (b) the difference between AMP and the “best price” to customers other than the Medicaid

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program, with certain exceptions. Some manufacturers may see these policies as a disincentive to offering rebates or discounts to private purchasers, including the plans we represent.

In addition, under the Federal Supply Schedule, the federal government seeks and obtains favorable pricing based on manufacturers’ commercial prices and sales practices. Some states have adopted legislation or regulations providing that a pharmacy participating in the state’s Medicaid program must give program patients the best price that the pharmacy makes available to any third party plan. These requirements are sometimes referred to as “most favored nation” payment systems. Other states have enacted “unitary pricing” legislation, which mandates that all wholesale purchasers of drugs within the state be given access to the same discounts and incentives. A number of states have also recently introduced legislation seeking to control drug prices through various statutory limits, rebates or discounts extending to one or more categories of the state’s population. This legislation and regulation could adversely affect our ability to negotiate discounts from network pharmacies or manufacturers or otherwise discourage the use of the full range of our services by current or future clients.

Recently, the federal government has increased its attention to how drug manufacturers develop pricing information, which in turn is used in setting payments under the Medicare and Medicaid programs. One element common to many payment formulas, the use of Average Wholesale Price, or AWP, as a standard pricing unit throughout the industry, has been criticized as not accurately reflecting prices actually charged and paid at the wholesale or retail level. The Department of Justice is currently conducting, and the House Commerce Committee has conducted, an investigation into the use of AWP for federal program reimbursement, and whether the use of AWP has inflated drug expenditures by the Medicare and Medicaid programs. Federal and state proposals have sought to change the basis for calculating reimbursement of certain drugs by the Medicare and Medicaid programs. These proposals and other legislative or regulatory adjustments that may be made to the program for reimbursement of drugs by Medicare and Medicaid, if implemented, could affect our ability to negotiate discounts with pharmaceutical manufacturers. In addition, they may affect our relations with pharmacies and health plans. In some circumstances, they might also impact the reimbursement that our mail order pharmacy receives from managed care organizations that contract with government health programs to provide prescription drug benefits or otherwise elect to rely on the revised pricing information. Furthermore, private payers may choose to follow the government’s example and adopt different drug pricing bases. This could affect our ability to negotiate with plans, manufacturers and pharmacies regarding discounts and rebates and could have a material adverse effect on our financial condition and results of operations.

Medicare Prescription Drug Benefit. On December 8, 2003, President Bush signed into law H.R. 1, the “Medicare Prescription Drug, Improvement, and Modernization Act of 2003” (P.L. 108-173) (the “Act”). The Act offers far-reaching changes to the Medicare program, including changes to the current Medicare+Choice program, administrative and contracting reforms, changes to Medicare provider reimbursement and the creation of a new type of health savings account. Most notably, the Act establishes a new Medicare Part D outpatient prescription drug benefit for the approximately 35 million Americans who are age 65 and older, the most significant change to healthcare coverage for senior citizens since the inception of Medicare nearly 40 years ago. Starting January 1, 2006, senior citizens will have the opportunity to enroll in Medicare Part D. Although we are currently unable to assess the impact that Medicare Part D will have on our clients’ decisions to continue to offer a prescription drug benefit to their Medicare-eligible members, our clients will have a variety of options to consider for providing drug coverage to their retirees. For example, following the inception of Medicare Part D, our clients may continue to provide primary coverage for their Medicare-eligible members and receive a government subsidy if the client’s plan is actuarially equivalent to standard Medicare Part D coverage. In general, the implications for PBMs of the Medicare Part D benefit, as well as other aspects of the Act, will not be clear until the Centers for Medicare & Medicaid Services publishes rules in response to the Act.

State Prescription Drug Assistance Programs. Many states are also considering establishing or expanding state drug assistance programs that would increase access to drugs by those currently without coverage. We are not able to assess at this time whether any of these state proposals will be enacted, how they would address drug cost, how they would coordinate with the Medicare prescription drug legislation discussed above, the coordination of benefits with other coverage or the role of pharmacy benefit management, nor can we assess any impact such a benefit would have on the decision of any of our clients to offer a prescription drug benefit.

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Federal Statutes Prohibiting False Claims and Fraudulent Billing Activities. A range of federal civil and criminal laws targets false claims and fraudulent billing activities. One of the most significant is the federal False Claims Act, which prohibits the submission of a false claim or the making of a false record or statement in order to secure a reimbursement from a government-sponsored program. In recent years, the federal government has launched several initiatives aimed at uncovering practices that violate false claims or fraudulent billing laws. On September 29, 2003, the U.S. Attorney’s office for the Eastern District of Pennsylvania filed a complaint against us alleging violations of the federal False Claims Act and similar state laws and asserting other legal claims. See Item 3, “Legal Proceedings—Government Proceedings and Requests for Information” below.

Health Management Services Regulation. All states regulate the practice of medicine and the practice of nursing. To our knowledge, no PBM has been found to be engaging in the practice of medicine or the practice of nursing by reason of its health management services. However, a federal or state regulatory authority may assert that some services provided by a PBM, including us, constitute the practice of medicine or the practice of nursing and are therefore subject to federal and state laws and regulations applicable to the practice of medicine and/or the practice of nursing.

Employees

As of December 27, 2003, we had approximately 13,150 full time employees and approximately 500 part-time employees. We have collective bargaining agreements covering approximately 51% of our employees. These agreements, which have terms ranging from three to eleven years, expire at various dates through November 2008. Specifically, approximately 5,600 employees at our facilities in Florida, Nevada, New Jersey, Ohio, Pennsylvania, Texas and Washington are covered by collective bargaining agreements with the Paper, Allied-Industrial, Chemical & Energy Workers International Union, AFL-CIO, CLC, approximately 1,100 employees at our Nevada and New Jersey call center and claims processing and card production operations facilities are covered by collective bargaining agreements with the Retail, Wholesale and Department Store Union, AFL-CIO, CLC, and approximately 260 pharmacists at our Columbus, Ohio facility are represented by the Association of Managed Care Pharmacists. We have not experienced any work stoppages in more than six years and consider our relations with our employees and their unions to be good.

We own or lease 65 facilities throughout the United States and the Commonwealth of Puerto Rico. We believe our facilities are generally well-maintained and in good operating condition and have adequate capacity to meet our current business needs. Our existing facilities contain an aggregate of approximately 3,000,000 square feet. Our corporate offices are located in Franklin Lakes, New Jersey and accommodate our headquarters, including our executive, client support, information technology, financial, legal, and clinical support and operations support staff.

Our mail order pharmacy infrastructure consists of 10 mail order pharmacies throughout the United States, eight of which contain prescription processing centers and four of which engage in mail order dispensing activities. In our prescription processing centers, we receive and record prescriptions, conduct clinical utilization reviews, contact physicians to resolve any questions and then approve and route the prescriptions to one of our four mail order dispensing pharmacies. In the four dispensing pharmacies, two of which are our automated pharmacies in Las Vegas, Nevada and Willingboro, New Jersey, we dispense the medication and then pre-sort for shipment to patients by mail or courier. We also operate seven call center pharmacies with access 24 hours a day, seven days a week to respond to calls from our clients, their members, pharmacists and physicians.

The following table sets forth information with respect to our principal facilities:

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Insurance

The Company maintains insurance coverage with such deductibles and self-insurance as management believes adequate for its needs under current circumstances. Such coverage reflects market conditions (including cost and availability) existing at the time it is written. Our PBM operations, including the dispensing of pharmaceutical products by our mail order pharmacies, and our health management services, may subject us to litigation and liability for damages. Historically, we have not had any product or professional liability claims that have exceeded our insurance coverage amount, and any claims have not been material. We believe that our insurance coverage protection for these types of claims is adequate. However, we might not be able to maintain our professional and general liability insurance coverage in the future, and insurance coverage might not be available on acceptable terms or adequate to cover any or all potential product or professional liability claims. A successful product or professional liability claim in excess of our insurance coverage, or one for which an exclusion from coverage applies, could have a material adverse effect on our financial condition and results of operations. The Company believes that most of the claims described under Item 3, “Legal Proceedings” below are unlikely to be covered by insurance. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors—Risks Relating to Our Business—We may be subject to liability claims for damages and other expenses that are not covered by insurance”.

Government Proceedings and Requests for Information

On September 29, 2003, the U.S. Attorney’s Office for the Eastern District of Pennsylvania filed a complaint in the U.S. District Court for the Eastern District of Pennsylvania alleging violations of the federal False Claims Act and asserting other legal claims. The complaint alleges, among other things, that we canceled and later re-entered prescriptions in order to avoid violating contractual guarantees regarding prescription dispensing turnaround times in its mail order pharmacies; dispensed fewer pills than reported to the patient and charged clients based on the reported number of units dispensed; favored the products of certain manufacturers, including Merck, over less expensive products; and engaged in improper pharmacy practices. On December 9, 2003, the U.S. Attorney’s Office filed an amended complaint, which adds two of our former employees as defendants and, among

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other additional legal claims, asserts a claim against us under the Public Contracts Anti-Kickback Act for allegedly making improper payments to health plans to induce such plans to select us as a PBM for government contracts. The Commonwealth of Massachusetts and the State of Nevada have intervened in the action.

The U.S. Attorney’s Office’s filing of the complaint and amended complaint followed its June 23, 2003 filing of a notice of intervention with respect to two pending qui tam, or whistleblower, complaints originally filed in February 2000 under the federal False Claims Act and similar state laws. The qui tam actions are currently pending. In one of the actions, Merck is named as a defendant.

The U.S. Attorney’s Office seeks, among other things, to change our business practices and to impose monetary damages and fines that could have a materially adverse impact on the Company’s financial condition, business and results of operations. On December 19, 2003, we filed a motion to dismiss the U.S. Attorney’s Office’s complaint and the two qui tam actions discussed above. The court has not yet ruled on the motion.

On December 22, 2003, the Board of the State Teachers Retirement System of Ohio (STRS), a former client, filed a complaint against Merck and us in the Ohio Court of Common Pleas. STRS alleges, among other things, that we overcharged STRS on mail order dispensing fees; charged more for generic drugs filled through mail order than retail pharmacies charge for the same drugs; canceled and re-entered prescription orders in order to meet contractual performance guarantees regarding turnaround times; undercounted pills; and engaged in other unlawful pharmacy practices. Many of the allegations appear to be taken directly from the complaint filed by the U.S. Attorney’s Office discussed above. STRS asserts claims against us for breach of contract, against Merck for tortious interference with contract, and against both Merck and us for breach of fiduciary duties; violation of state consumer protection and deceptive trade practices laws; unjust enrichment; and fraud.

On April 16, 2003, we received a letter from the Office of the Maine Attorney General seeking information concerning our PBM practices. The letter was written on behalf of Maine and 21 other states, and is in connection with a review of the pharmaceutical industry and PBM practices. We understand that two additional states have joined the group of states conducting such review, and that three states have withdrawn from the group.

We are cooperating with Maine and the other states to provide them with more information about our business practices. Such cooperation includes informal discussions with various states from time to time and responses to requests from certain states for information specific to those states. We cannot predict the outcome of these investigations or whether any related actions challenging our business practices will be commenced.

We believe that our business practices comply in all material respects with applicable laws and regulations and we intend to vigorously defend the actions described above. Nevertheless, the outcome of the proceedings and requests for information discussed above is uncertain. The actions and requests for information are at an early stage, and we are unable to predict whether additional claims and actions (including actions seeking injunctive relief) will be asserted or to predict the total relief (including damages and fines) that could be made. These lawsuits and the investigations described above arise in an environment of rising costs for prescription drugs and heightened public scrutiny of the pharmaceutical industry, including the PBM industry and its practices. This public scrutiny is characterized by extensive press coverage, ongoing attention in Congress and in state legislatures, and investigations and public statements by law enforcement officials. These factors contribute to the uncertainty regarding the possible course and outcome of the litigation and investigations discussed above.

We are unable to predict the outcome of any of the lawsuits or investigations described above. In addition, in connection with our separation from Merck, we entered into an indemnification and insurance matters agreement with Merck. To the extent that we are required to indemnify Merck for liabilities arising out of a lawsuit, an adverse outcome with respect to Merck could result in our making indemnification payments in amounts that could be material, in addition to any damages that we are required to pay. For these reasons, an adverse outcome in one of these suits or in any proceeding arising from one of these investigations could result in material fines and damages; material changes to our business practices; loss of (or litigation with) clients; and other penalties; and any of those consequences could have a material adverse effect on our financial condition, business, liquidity and operating results.

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ERISA and Similar Litigation

On December 17, 1997, a lawsuit captioned Gruer v. Merck-Medco Managed Care, L.L.C. was filed in the U.S. District Court for the Southern District of New York against Merck and us. The suit alleges that we should be treated as a “fiduciary” under the provisions of ERISA and that we breached fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs. After the Gruer case was filed, six other cases have been filed in the same court asserting similar claims; one of these cases was voluntarily dismissed. The plaintiffs in these cases, who are individual plan members and claim to represent the interests of six different pharmaceutical benefit plans for which we are the PBM, contend that, in accepting and retaining certain rebates, we have failed to make adequate disclosure and have acted in our own best interest and against the interests of our clients. The plaintiffs also allege that we were wrongly used to increase Merck’s market share, claiming that under ERISA our drug formulary choices and therapeutic interchange programs were “prohibited transactions” that favor Merck’s products. The plaintiffs have demanded that Merck and we turn over any unlawfully obtained profits to a trust to be set up for the benefit plans.

In December 2002, Merck and we agreed to settle the Gruer series of lawsuits on a class action basis to avoid the significant cost and distraction of protracted litigation. We, Merck and the plaintiffs in five of these six cases filed a proposed class action settlement with the court. On July 31, 2003, the court granted preliminary approval to the settlement. Under the proposed settlement, we and Merck have agreed to pay $42.5 million, and we have agreed to change or to continue certain specified business practices for a period of five years. The proposed settlement would resolve litigation by pharmaceutical benefit plans against Merck and us based on ERISA and similar claims, except with respect to those plans that affirmatively opt out of the settlement. It does not involve the release of any potential antitrust claims. The release of claims under the settlement would cover the period from December 17, 1994 to the date that the settlement receives final approval. In September 2003, we paid $38.3 million to an escrow account, representing our portion, or 90%, of the proposed settlement. This payment was charged against accrued expenses and other current liabilities, as the liability was recorded in prior periods. On December 11, 2003, the court conducted a hearing for the purpose of entertaining objections to the settlement, several of which have been filed, and determining, among other things, whether the settlement should be finally approved. At the hearing, the court directed that additional notices of the settlement be mailed to certain members of the settlement class. The hearing will continue in or about May 2004. The settlement becomes final only if and when the court grants final approval and all appeals have been exhausted. The plaintiff’s plan in the sixth case discussed above has elected to opt out of the settlement.

Similar ERISA-based complaints against Merck and us have been filed in eight additional actions by ERISA plan participants, purportedly on behalf of their plans, and, in some of the actions, similarly situated self-funded plans. The complaints in these actions rely on many of the same allegations as the Gruer series of lawsuits discussed above. The ERISA plans themselves, which are not parties to these lawsuits, have elected to participate in the proposed settlement discussed above. In addition, a proposed class action complaint against Merck and us has been filed by trustees of another benefit plan in the U.S. District Court for the Northern District of California. This plan has elected to opt out of the settlement. These nine cases have been transferred and consolidated in the Southern District of New York by order of the Judicial Panel on Multi-district Litigation.

On April 2, 2003, a lawsuit captioned Peabody Energy Corporation v. Medco Health Solutions, Inc., et al. was filed in the U.S. District Court for the Eastern District of Missouri. The complaint, filed by one of our former clients, relies on allegations similar to those in the ERISA cases discussed above, in addition to allegations relating specifically to Peabody, which has elected to opt out of the settlement described above. The complaint asserts that we breached fiduciary duties under ERISA, violated a New Jersey consumer protection law, improperly induced the client into contracting with us, and breached the resulting agreement. The plaintiff seeks compensatory, punitive and treble damages, as well as rescission and restitution of revenues that were allegedly improperly received by us. On October 28, 2003, the Judicial Panel on Multidistrict Litigation transferred this action to the Southern District of New York to be consolidated with the ERISA cases pending against us in that court.

On December 23 2003, Peabody filed a similar action against Merck in the U.S. District Court for the Eastern District of Missouri. The complaint relies on allegations similar to those in the ERISA cases discussed above and in the case filed by Peabody against us. The complaint asserts claims that Merck violated federal and state racketeering laws, tortiously interfered with Peabody’s contract with us, and was unjustly enriched. The plaintiff

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seeks, among other things, compensatory damages of approximately $35 million, treble damages, and restitution of revenues that were allegedly improperly received by Merck.

On March 17, 2003, a lawsuit captioned American Federation of State, County and Municipal Employees v. AdvancePCS et al., based on allegations similar to those in the ERISA cases discussed above, was filed against us and other major PBMs in the Superior Court of California. The theory of liability in this action is based on a California law prohibiting unfair business practices. The plaintiff, which purports to sue on behalf of itself, California non-ERISA health plans, and all individual participants in such plans, seeks injunctive relief and disgorgement of revenues that were allegedly improperly received by us. The court recently denied the defendant PBMs’ motion to dismiss the action.

On June 11, 2002, a lawsuit captioned Miles v. Merck-Medco Managed Care, L.L.C., based on allegations similar to those in the ERISA cases discussed above, was filed against Merck and us in the Superior Court of California. The theory of liability in this action is based on a California law prohibiting unfair business practices. The plaintiff, who purports to sue on behalf of the general public of California, seeks injunctive relief and disgorgement of the revenues that were allegedly improperly received by Merck and us. The Miles case was removed to the U.S. District Court for the Southern District of California and, pursuant to the Multidistrict Litigation order discussed above, was later transferred to the Southern District of New York and consolidated with the ERISA cases pending against Merck and us in that court. The court has not yet ruled on the plaintiff’s motion to remand the case back to the California state court.

On October 25, 2002, we filed a declaratory judgment action, captioned Medco Health Solutions, Inc. v. West Virginia Public Employees Insurance Agency, in the Circuit Court of Kanawha County, West Virginia, asserting our right to retain certain cost savings in accordance with our written agreement with the West Virginia Public Employees Insurance Agency, or PEIA. On November 13, 2002, the State of West Virginia and PEIA filed a separate lawsuit against Merck and us, also in the Circuit Court of Kanawha County, West Virginia. This action was premised on several state law theories, including violations of the West Virginia Consumer Credit and Protection Act, conspiracy, tortious interference, unjust enrichment, accounting, fraud and breach of contract. The State of West Virginia and PEIA sought civil penalties; compensatory and punitive damages, and injunctive relief. In March 2003, in the declaratory judgment action, PEIA filed a counterclaim, and the State of West Virginia, which was joined as a party, filed a third-party complaint against Merck and us, raising the same allegations asserted by PEIA and the State of West Virginia in their November 2002 action described above. We and Merck filed a motion to dismiss the November 2002 action filed by the State of West Virginia and PEIA, and also filed a motion to dismiss the counterclaim and third-party complaint filed by the State of West Virginia and PEIA in our declaratory judgment action. On November 6, 2003, the court granted the motion to dismiss the Consumer Protection Act claims and certain other state law claims, including the claims for conspiracy and tortious interference. The court also dismissed without prejudice the various fraud claims. The court denied the motion to dismiss with respect to the claims for breach of contract, accounting and unjust enrichment. On December 2, 2003, PEIA filed an amended counterclaim and third-party complaint against Merck and us, seeking to reassert its fraud claims and restate certain of its other claims. On December 12, 2003, Merck filed a motion to dismiss all of the claims against it. The court has not yet ruled on that motion.

On July 21, 2003, a lawsuit captioned Group Hospitalization and Medical Services v. Merck-Medco Managed Care, et al., was filed against us in the Superior Court of New Jersey. In this action, our former client, CareFirst Blue Cross Blue Shield, asserts claims for violation of fiduciary duty under state law, breach of contract; negligent misrepresentation, unjust enrichment; violations of certain District of Columbia laws regarding consumer protection and restraint of trade, and violation of a New Jersey law prohibiting racketeering. The plaintiff demands compensatory damages, punitive damages, treble damages for certain claims, and restitution.

We do not believe that we are a fiduciary under ERISA, and we believe that our business practices comply with all applicable laws and regulations. We have denied all allegations of wrongdoing and are vigorously defending all of the lawsuits described above, although we have proposed to settle some of them as described above. Many of these lawsuits seek damages in unspecified amounts, which could be material, and some seek treble or punitive damages or restitution of profits, any of which could be material in amount. The outcome of each of these lawsuits is uncertain, and an adverse determination in any one of them could result in material damages or restitution and could materially limit our business practices. In addition, to the extent that we are required to indemnify Merck for

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liabilities arising out of a lawsuit, an adverse outcome with respect to Merck could result in us making indemnification payments in amounts that could be material, in addition to any damages that we are required to pay. For these reasons, an adverse determination in any one or more of these lawsuits could have a material adverse effect on our business, financial condition, liquidity and operating results.

Antitrust Litigation

On August 15, 2003, a lawsuit captioned Brady Enterprises, Inc., et al. v. Medco Health Solutions, Inc., et al., was filed in the U.S. District Court for the Eastern District of Pennsylvania against Merck and us. The plaintiffs, which seek to represent a national class of retail pharmacies that have contracted with us, allege that we have conspired with, acted as the common agent for, and used the combined bargaining power of, plan sponsors to restrain competition in the market for the dispensing and sale of prescription drugs. The plaintiffs allege that, through the alleged conspiracy, we have engaged in various forms of anticompetitive conduct, including, among other things, setting artificially low reimbursement rates to such pharmacies. The plaintiffs assert claims for violation of the Sherman Act and seek treble damages and injunctive relief. In November 2003, we and Merck filed motions to dismiss the complaint. The court has not yet ruled on those motions.

On October 1, 2003, a lawsuit captioned North Jackson Pharmacy, Inc., et al. v. Medco Health Solutions, Inc., et al., was filed in the U.S. District Court for the Northern District of Alabama against Merck and us. The plaintiffs, which seek to represent a national class of independent retail pharmacies that have contracted with us, allege in an amended complaint that we have engaged in price fixing and other unlawful concerted actions with others, including other PBMs, to restrain trade in the dispensing and sale of prescription drugs to customers of retail pharmacies who participate in programs or plans that pay for all or part of the drugs dispensed. The plaintiffs allege that, through such concerted action, we have engaged in various forms of anticompetitive conduct, including, among other things, setting reimbursement rates to such pharmacies at unreasonably low levels. The plaintiffs assert claims for violation of the Sherman Act and seek treble damages and injunctive relief.

On January 20, 2004, a lawsuit captioned Alameda Drug Company, Inc., et al. v. Medco Health Solutions, Inc., et al. was filed against Merck and us in the Superior Court of California. The plaintiffs, which seek to represent a class of all California pharmacies that have contracted with us and that have indirectly purchased prescription drugs from Merck, allege, among other things, that since the expiration of a 1995 consent injunction entered by the U.S. District Court for the Northern District of California, if not earlier, we have failed to maintain an Open Formulary (as defined in the consent injunction), and that we and Merck have failed to prevent nonpublic information received from competitors of Merck and us from being disclosed to each other. The complaint also copies verbatim many of the allegations in the Amended Complaint filed by the U.S. Attorney for the Eastern District of Pennsylvania, discussed above. The plaintiffs further allege that, as a result of these alleged practices, we have been able to increase our market share and artificially reduce the level of reimbursement to the retail pharmacy class members, and that the prices of prescription drugs from Merck and other pharmaceutical manufacturers that do business with us have been fixed and raised above competitive levels. The plaintiffs assert claims for violation of California antitrust law and California law prohibiting unfair business practices. The plaintiffs demand, among other things, compensatory damages, restitution, disgorgement of unlawfully obtained profits, and injunctive relief.

We deny all allegations of wrongdoing and intend to vigorously defend the Brady, North Jackson Pharmacy, and Alameda Drug Company cases. However, the outcome of these lawsuits is uncertain, and an adverse determination in any of them could result in material damages, which could be trebled, and could materially limit our business practices. In addition, to the extent that we are required to indemnify Merck for liabilities arising out of a lawsuit, an adverse outcome with respect to Merck could result in our making indemnification payments in amounts that could be material, in addition to any damages that we are required to pay. For these reasons, an adverse determination in any of these lawsuits could have a material adverse effect on our business, financial condition, liquidity and results of operations.

There remain approximately five lawsuits on behalf of fewer than ten plaintiffs, to which we are a party, filed by retail pharmacies against pharmaceutical manufacturers, wholesalers and other major PBMs, challenging manufacturer discounting and rebating practices under various state and federal antitrust laws, including the Robinson-Patman Act. These suits, which were a part of a consolidated Multidistrict Litigation, captioned In re Brand Name Prescription Drug Antitrust Litigation, allege that we knowingly accepted rebates and discounts on

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purchases of brand-name prescription drugs in violation of the federal Robinson-Patman Act. These suits seek damages and to enjoin us from future violations of the Robinson-Patman Act. Merck has agreed to indemnify us for any monetary liabilities related to these lawsuits. However, any adverse judgment or injunction could significantly limit our ability to obtain discounts and rebates.

Securities Litigation

We and Merck are named as defendants in a number of purported class action lawsuits, all relating to our revenue recognition practices for retail co-payments paid by members of plans for which we provide PBM services. The class action lawsuits were consolidated and amended to assert claims against Merck and us and certain of our officers and directors relating to our revenue recognition practices for retail co-payments, rebates received by us, and our independent status. We and Merck have filed a motion to dismiss these lawsuits.

On July 31, 2003, a shareholders derivative complaint was filed in the U.S. District Court for the District of New Jersey against Merck and us, certain of our officers and directors, and Arthur Andersen LLP. The lawsuit is based on allegations relating to our revenue recognition practices for retail co-payments, and it further alleges that certain individual defendants breached their fiduciary duty by failing to prevent such practices from occurring and also failing to prevent the conduct at issue in the Gruer complaint and related actions, the antitrust claims pending in the Northern District of Illinois, and the qui tam actions in which the U.S. Attorney’s Office for the Eastern District of Pennsylvania has intervened, each of which is described above. The complaint seeks monetary damages from Merck and us in an unspecified amount, as well as injunctive and other relief. Merck and we have filed a motion to dismiss the complaint.

We deny all allegations of wrongdoing and are vigorously defending each of the lawsuits described above. These lawsuits seek damages in unspecified amounts, which could be material. Merck has agreed to indemnify us for a significant portion of any monetary liabilities related to these lawsuits. However, we could be liable for a material amount of any residual liabilities not indemnified by Merck, and an adverse determination could materially limit our business practices. For these reasons, an adverse determination in any one or more of these lawsuits could have a material adverse effect on our business, financial condition and operating results.

Tamoxifen Litigation

On May 20, 2002, a lawsuit captioned Kessler v. Merck-Medco Managed Care, L.L.C. was filed in the Superior Court of New Jersey. The plaintiff, who purported to represent a member class, alleged that we improperly classified Tamoxifen as a brand-name drug, resulting in a higher co-payment for members. The complaint asserted claims under the New Jersey Consumer Fraud Act and for unjust enrichment. On December 18, 2002, a putative class action lawsuit containing substantially similar allegations to the Kessler case, captioned Smith v. Medco Health Solutions, Inc., was filed in the Superior Court of New Jersey. On June 17, 2003, a putative class action lawsuit containing substantially similar allegations, captioned Del Greco v. Medco Health Solutions, Inc., was filed in the U.S. District Court for the Southern District of New York. The plaintiff in this action, however, asserted that our alleged misclassification of Tamoxifen improperly denied plan benefits and breached an alleged fiduciary duty under ERISA. On December 5, 2003, the court granted our motion for summary judgment in the Smith and Kessler actions and dismissed all of the claims. On December 5, 2003, the court in the Del Greco action granted our motion to dismiss with respect to nearly all of the claims, including all monetary claims. The plaintiff in the Del Greco case has asked the court to reconsider that ruling, but the court has not yet ruled on that motion.

Other

We are also involved in various claims and legal proceedings of a nature considered normal to our business, principally employment and commercial matters. Although the range of loss for all of these unresolved matters above is not subject to reasonable estimation and it is not feasible to predict or determine the final outcome of all of the above proceedings with certainty, our management does not believe that they would result in a material adverse effect on our financial position or liquidity, either individually or in the aggregate. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by the ultimate resolutions of these matters, or changes in our assumptions or our strategies related to these proceedings.

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We believe that most of the claims made in these legal proceedings and government investigations would not likely be covered by insurance.

Not applicable.

PART II

Our common stock is listed on the New York Stock Exchange (the “NYSE”) under the ticker symbol MHS. The following table sets forth the range of high and low common stock market prices for fiscal 2003, beginning August 8, 2003, when “when-issued” trading commenced:

On March 18, 2004, the closing market price of our common stock on the NYSE was $32.85, and there were 140,597 shareholders of record.

We currently do not pay dividends and do not plan to pay dividends in the foreseeable future.

Information relating to compensation plans under which equity securities of the Registrant are authorized for issuance is set forth under Part III, Item 12 of this Form 10-K and such information is incorporated herein by reference.

The following table presents our selected historical consolidated financial and operating data. The selected historical financial and operating data should be read in conjunction with, and is qualified in its entirety by reference to, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

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Notes to Selected Historical Consolidated Financial and Operating Data:

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Overview

We are one of the nation’s largest prescription benefit managers, and we provide sophisticated programs and services for our clients and the members of their prescription benefit plans, as well as for the physicians and pharmacies the members use. We were acquired as a wholly-owned subsidiary of Merck and Co., Inc. (“Merck”) on November 18, 1993, and were spun off as a separate publicly traded enterprise (“the separation”) on August 19, 2003. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this by providing prescription benefit management (“PBM”) services through our national networks of retail pharmacies and our own mail order pharmacies. We have a large number of clients in each of the major industry categories, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans.

We operate in a competitive market that is characterized by pricing and margin pressures as clients seek to control the growth in the cost of providing prescription drug benefits to their members. Prescription drug costs have risen considerably over the past several years, largely as a result of inflation on brand-name products and the introduction of new products produced by pharmaceutical manufacturers. These prescription drug cost increases, known as drug trend, have garnered significant attention throughout the United States as they contribute significantly to the rise in the national cost of healthcare. Our business model is designed to reduce this level of drug trend.

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The complicated environment in which we operate presents us with opportunities, challenges and risks. Our customers are paramount to our success; the retention of these customers and winning new customers poses the greatest opportunity, and the loss thereof represents an ongoing risk. The preservation of our relationships with pharmaceutical manufacturers and retail pharmacies is very important to the execution of our business strategies going forward. In addition, in large part because of the current political focus in the United States on the cost of prescription drugs, we are the subject of lawsuits and negative press, even though our primary mission is to curb the costs at issue.

Key Indicators Reviewed By Management

Management reviews the following indicators in analyzing our consolidated financial performance: net revenues, with a particular focus on mail order revenue; adjusted prescription volume; generic penetration; gross margin percentage; diluted earnings per share; Earnings Before Interest Income/Expense, Taxes, Depreciation, and Amortization (“EBITDA”); and EBITDA per adjusted prescription.

We believe these measures highlight key business trends and are important in evaluating our overall performance. These measures are also reflective of the success of our execution of strategic objectives. See “—EBITDA” below.

2003 Financial Performance Summary

Our net income increased by 18% to $426 million in 2003. Our 2003 EBITDA per adjusted prescription increased 21% to $1.50. While our total net revenues grew by 4% to over $34 billion, our total cost of revenues increased at the lower rate of 3.7%, which resulted in a gross margin percentage improvement to 4.4% in 2003 from 3.9% in 2002. Our gross margin improvement contributed $221 million to our growth in income before provision for income taxes of $108 million, with a partial offset from $99 million in increased selling, general and administrative expenses, and interest and intangible amortization growth totaling $14 million. Our results of operations in 2003 also include $69 million of restructuring expenses on a pre-tax basis. Approximately $46 million of these restructuring costs are recorded in cost of revenues, with the remaining $23 million reflected in selling, general and administrative expenses.

Our revenue continued to increase despite a 4.4% decline in mail order prescription volume and a 2.7% decline in retail volume, with these volume declines primarily the result of the loss of clients in 2002 and the non-renewal of a mail order only client in early 2003. The revenue growth was caused by overall higher prices charged by brand-name pharmaceutical manufacturers, reflecting inflation and the introduction of newer higher-cost medications. This growth was partially offset by the volume declines from lost business and lower utilization growth and steeper discounting to our clients. The discounts are associated with increased utilization of generic drugs by our customers’ membership. Our percentage of prescriptions dispensed that were generics increased to 43.8% in 2003 compared to 40.5% in 2002.

This increase in generic utilization not only saves our clients and their membership in drug costs, but it also was a key contributor to our 2003 margin growth, particularly in mail order, because we were able to purchase significant quantities of generic drugs for our mail order pharmacies at greater volume discounts than brand-name drugs. Further contributing to our gross margin improvement were increased brand pharmaceutical manufacturer rebates, reflecting improved formulary management as well as the achievement of market share requirements. In 2002, market share requirements were reestablished as a result of new or renegotiated contracts, essentially increasing performance requirements for earning rebates. The majority of these rebates are shared with our clients in the form of direct rebate pass-backs, guarantees, and steeper pricing discounts, which ultimately benefit our clients and their members through lower drug costs.

The efficiency of our operations is critical to sustaining our profitability, since we are a low-margin business with only a small percentage of our revenue flowing to net income. We have continued to yield productivity improvements from our significant historical investments in pharmacy automation, Internet and integrated voice-response technologies. The drive to further optimize our efficiency resulted in charges against our cost of product net revenues of $46 million for severance and accelerated depreciation costs related to affected pharmacies and call centers from decisions to streamline our operations and maximize leverage from our automated technologies.

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Our selling, general and administrative expenses increased by $99 million, primarily from increased information technology and related depreciation expenses. Included in this expense category in 2003 were severance charges of $23 million from programs designed to further improve productivity in our corporate functions. Our intangible asset amortization expense increased over 2002 from a change in amortization lives, and our net interest expense increased due to debt we incurred as a result of our separation from Merck, with a debt balance of approximately $1.4 billion outstanding at year-end 2003.

Key Financial Statement Components

Consolidated Statements Of Income.

Our net revenues are derived primarily from the sale of prescription drugs through our networks of contractually affiliated retail pharmacies and through our mail order pharmacies, and are recorded net of certain rebates and guarantees payable to clients. For further details see our critical accounting policies included in “—Use of Estimates and Critical Accounting Policies” below and Note 2 to our consolidated financial statements included in this Annual Report on Form 10-K.

Cost of revenues for prescriptions dispensed through our network of retail pharmacies includes the contractual cost of drugs dispensed by, and professional fees paid to, retail pharmacies in the networks. Our cost of revenues relating to drugs dispensed by our mail order pharmacies consists primarily of the cost of inventory dispensed and our costs incurred to process and dispense the prescriptions, including the associated depreciation. The operating costs of our call center pharmacies are also included in cost of revenues. In addition, cost of revenues for both retail sales and mail order sales includes a credit for rebates earned from brand pharmaceutical manufacturers whose drugs are included in our formularies. These rebates generally take the form of formulary rebates, which are earned based on the volume of a specific drug dispensed, or market share rebates, which are earned based on the achievement of contractually specified market share levels for prescription drugs.

Selling, general and administrative expenses reflect the costs of operations dedicated to generating new sales, maintaining existing customer relationships, managing clinical programs, enhancing technology capabilities, directing pharmacy operations and other staff activities. Our historical financial statements also include allocations of costs relating to certain corporate functions provided by Merck prior to the separation date, including finance, legal, public affairs, executive oversight, human resources, procurement and other services.

Interest and other (income) expense, net primarily includes interest expense on debt incurred as a result of our separation from Merck, partially offset by interest income generated by short-term investments in marketable securities.

Balance Sheet

Our key assets include cash and short-term investments, accounts receivable, inventories, fixed assets, goodwill and intangibles. Cash reflects the positive cash flow from our operations. Accounts receivable primarily represents amounts due from clients for prescriptions dispensed from retail pharmacies in our networks or from prescription drugs received by members from our mail order pharmacies, including fees due to us, net of any rebate liabilities or payments due to clients under guarantees. Accounts receivable also include amounts due from pharmaceutical manufacturers for earned rebates and other prescription services. Inventories reflect the cost of prescription products held for dispensing by our mail order pharmacies and are recorded on a first-in, first-out basis. Fixed assets include our investment in mail order pharmacies, call center pharmacies, and information technology, including capitalized software development. The net goodwill and intangible assets are comprised primarily of the push-down of goodwill and intangibles related to our acquisition in 1993 by Merck.

Our primary liabilities include claims and other accounts payable, accrued expenses and other current liabilities, debt and deferred tax liabilities. Claims and other accounts payable primarily consist of amounts payable to retail network pharmacies for prescriptions dispensed and services rendered, and amounts payable for mail order prescription inventory purchases. Accrued expenses and other current liabilities primarily consist of employee- and facility-related cost accruals incurred in the normal course of business, as well as income taxes payable. In

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conjunction with our separation from Merck, we incurred debt, the proceeds of which were paid to Merck in the form of a dividend. In addition, we have a deferred tax liability primarily associated with our recorded intangible assets. We do not have any off-balance sheet arrangements.

Cash Flows

An important element of our operating cash flow is the timing of billing cycles, which are two-week periods of accumulated prescription administration billings for retail and mail order prescriptions. We bill the cycle activity to clients on this bi-weekly schedule and generally collect before we pay our obligations to the retail pharmacies for that same cycle. Thus, at the end of any given reporting period, unbilled receivables will represent up to two weeks of dispensing activity to clients and will fluctuate at the end of a fiscal month depending on the timing of these billing cycles. We pay for prescription drug inventory in accordance with payment terms offered by our suppliers to take advantage of appropriate discounts. Effective mail order inventory management further generates positive cash flows. Pharmaceutical manufacturers’ rebates are recorded as earned on a monthly basis, with actual bills generally rendered on a quarterly basis and paid by the manufacturers within an agreed-upon term. Payments of rebates to clients are generally made after our receipt of the rebates from the pharmaceutical manufacturers.

Prior to the separation, cash was swept by Merck on a daily basis and was reflected in our consolidated statement of cash flows in intercompany transfer from (to) Merck and in our consolidated balance sheet as “Due from Merck, net.” Subsequent to the separation, we are managing our own cash and investments. Our cash primarily includes demand deposits with banks or other financial institutions. Our short-term investments include certificates of deposit and U.S. government securities that have average maturities of less than one year and that are held to satisfy statutory capital requirements for our insurance subsidiaries.

Ongoing cash outflows are associated with expenditures to support our mail order and retail pharmacy network operations, call center pharmacies and other selling, general and administrative functions. The largest components of these expenditures include mail order inventory purchases primarily from a wholesaler, retail pharmacy payments, rebate and guarantee payments to clients, employee payroll and benefits, operating expenses, capital expenditures, interest and principal payments on our debt and income taxes.

Client-Related Information

We began providing PBM services in the second quarter of 2000 to UnitedHealth Group under a five-year contract. Revenues from UnitedHealth Group, which is currently our largest client, amounted to approximately $6,100 million, or 18% of our net revenues in 2003, approximately $5,300 million, or 16% of our net revenues in 2002, and approximately $4,600 million, or 16% of our net revenues in 2001. On January 12, 2004, we announced an early renewal agreement to provide PBM services, including mail order, to UnitedHealth Group effective January 1, 2004, for an initial five-year term. At UnitedHealth Group’s option, the agreement may be extended for three additional years through 2011. None of our other clients individually represented more than 10% of our net revenues in 2003.

Segment Discussion

We conduct our operations in one segment, which involves sales of prescription drugs to members of our clients, either through our networks of contractually affiliated retail pharmacies or by our mail order pharmacies, and in one geographic region: the United States and Puerto Rico. We offer fully integrated PBM services to virtually all of our clients and their members. The PBM services we provide to our clients are generally delivered and managed under a single contract for each client.

Rebate contracts with pharmaceutical manufacturers of brand-name drugs are negotiated on an enterprise-wide level based on our consolidated retail and mail order prescription volumes. We believe the level of rebates we are able to negotiate significantly benefits from our substantial mail order volume because we are able to achieve a higher level of formulary compliance in mail order than in retail. As a result, although the rebate contracts generate rebates on retail and mail order prescriptions equally on the basis of drug cost, it is not practicable to determine the true value of rebates earned specifically on retail or mail order prescription volume.

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Certain elements of our cost structure are identifiable between retail and mail order. In the case of retail, we are able to separately identify the drug ingredient costs and professional fees we pay to retail pharmacies in our networks of affiliated pharmacies. In the case of mail order, we are able to identify the costs to operate our mail order pharmacies, and inventory procurement costs. It is not practicable to separately identify certain other costs, the most substantial of which are our call center costs relating to retail and mail order. Calls from members may relate to general plan design or any combination of retail and mail order prescriptions. Additionally, our selling, general and administrative expenses are incurred on an enterprise-wide level.

As a result of the nature of our integrated PBM services and contracts, the chief operating decision maker views Medco as a single segment enterprise for purposes of making decisions about resource allocations and in assessing our performance.

Results of Operations

The following table presents selected comparative results of operations and volume performance: