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| MHS > SEC Filings for MHS > Form 10-Q on 5-Nov-2008 | All Recent SEC Filings |
5-Nov-2008
Quarterly Report
Failure to retain key clients and their members, either as a result of economic conditions, increased competition or other factors, could result in significantly decreased revenues and could harm our profitability;
If we do not continue to earn and retain purchase discounts and rebates from manufacturers at current levels, our gross margins may decline;
Our acquisition activity has increased recently and if we are unable to effectively integrate acquired businesses into ours, our operating results may be adversely affected. Even if we are successful, the integration of these businesses has required, and will likely continue to require, significant resources and management attention;
If we fail to comply with complex and rapidly evolving laws and regulations, we could suffer penalties, or be required to pay substantial damages or make significant changes to our operations;
Government efforts to reduce healthcare costs and alter healthcare financing practices could lead to a decreased demand for our services or to reduced profitability;
Failure to execute our Medicare Part D prescription drug benefits strategy could adversely impact our business and financial results;
PBMs could be subject to claims under ERISA if they are found to be a fiduciary of a health benefit plan governed by ERISA;
Pending litigation could adversely impact our business practices and have a material adverse effect on our business, financial condition, liquidity and operating results;
We are subject to corporate integrity agreements and noncompliance may impede our ability to conduct business with the federal government;
Legislative or regulatory initiatives that restrict or prohibit the PBM industry's ability to use patient identifiable medical information could limit our ability to use information that is critical to the operation of our business;
Our Specialty Pharmacy business is highly dependent on our relationships with a limited number of biopharmaceutical suppliers and the loss of any of these relationships could significantly impact our ability to sustain or increase our revenues;
Our ability to grow our Specialty Pharmacy business could be limited if we do not expand our existing base of drugs or if we lose patients;
Our Specialty Pharmacy business, certain revenues from diabetes testing supplies and our Medicare Part D offerings expose us to increased credit risk;
Changes in industry pricing benchmarks could adversely affect our financial performance;
The terms and covenants relating to our existing indebtedness could adversely impact our financial performance;
Prescription volumes may decline, and our net revenues and profitability may be negatively impacted, if products are withdrawn from the market, if prescription drugs transition to over-the-counter products, or if increased safety risk profiles of specific drugs result in utilization decreases;
We may be subject to liability claims for damages and other expenses that are not covered by insurance;
The success of our business depends on maintaining a well-secured pharmacy operation and technology infrastructure and failure to execute could adversely impact our business;
We could be required to record a material non-cash charge to income if our recorded intangible assets or goodwill are impaired, or if we shorten intangible asset useful lives;
Changes in reimbursement rates, including competitive bidding for durable medical equipment suppliers, could negatively affect our PolyMedica diabetes testing supplies revenues and profits under our Liberty brand; and
Anti-takeover provisions of the Delaware General Corporation Law ("DGCL"), our certificate of incorporation and our bylaws could delay or deter a change in control and make it more difficult to remove incumbent officers and directors.
The foregoing list of factors is not exhaustive. You should carefully
consider the foregoing factors and the other risks and uncertainties that affect
our business described in our Annual Report on Form 10-K, Quarterly Reports on
Form 10-Q and other documents filed from time to time with the Securities and
Exchange Commission.
Overview
We are the nation's leading pharmacy benefit manager based on net revenues.
We provide sophisticated traditional and specialty prescription drug benefit
programs to serve the unique needs of our patients with chronic and complex
conditions. Our therapy management programs include the use of specialized
pharmacists focused on specific disease states in our Medco Therapeutic Resource
Centersฎ. Our business model requires collaboration with retail pharmacies,
physicians, the Centers for Medicare & Medicaid Services ("CMS") for Medicare,
and particularly in Specialty Pharmacy, collaboration with state Medicaid
agencies, and other payors such as insurers. Our programs and services help
control the cost and enhance the quality of prescription drug benefits. We
accomplish this by providing PBM services through our national networks of
retail pharmacies and our own mail-order pharmacies, as well as through our
Specialty Pharmacy segment, Accredo Health Group, which became the nation's
largest specialty pharmacy based on revenues with our 2005 acquisition of
Accredo Health, Incorporated ("Accredo") (the "Accredo acquisition"). The
Therapeutic Resource Center for diabetes was augmented with the 2007 acquisition
of PolyMedica Corporation ("PolyMedica"), through which we became the largest
diabetes pharmacy care practice based on covered patients. See Note 3,
"Acquisitions of Businesses," to our audited consolidated financial statements
included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal
year ended December 29, 2007 for more information.
In the first quarter of 2008, we completed a two-for-one stock split, which
was effected in the form of a 100% stock dividend and distributed on January 24,
2008, to shareholders of record at the close of business on January 10, 2008.
All share and per share amounts, including those as of and for the first nine
months of 2007, have been adjusted for the increase in issued and outstanding
shares after giving effect to the stock split. See Note 1, "Background and Basis
of
Presentation," to the audited consolidated financial statements included in
Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended
December 29, 2007 for additional information.
The complicated environment in which we operate presents us with
opportunities, challenges and risks. Our clients and members are paramount to
our success; the retention of existing clients and members and winning of new
clients and members poses the greatest opportunity to us and the loss thereof,
including as a result of economic conditions, represents an ongoing risk. The
preservation of our relationships with pharmaceutical manufacturers,
biopharmaceutical manufacturers and retail pharmacies is very important to the
execution of our business strategies. Our future success will hinge on our
ability to drive mail-order volume and increase generic dispensing rates in
light of the significant brand-name drug patent expirations expected to occur
over the next several years, and our ability to continue to provide innovative
and competitive clinical and other services to clients and members, including
through our active participation in the Medicare Part D benefit and the rapidly
growing specialty pharmacy industry. Additionally, our future success will
depend on our continued ability to generate positive cash flows from operations
with a keen focus on asset management and maximizing return on invested capital.
When we use "Medco," "we," "us" and "our," we mean Medco Health Solutions,
Inc., a Delaware corporation, and its consolidated subsidiaries. When we use the
term "mail order," we mean Medco's mail-order pharmacy operations, as well as
Accredo's Specialty Pharmacy operations.
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 dispensing rate; gross margin
percentage; cash flow from operations; return on invested capital; diluted
earnings per share; Specialty Pharmacy segment revenue and operating income;
Earnings Before Interest Income/Expense, Taxes, Depreciation, and Amortization
("EBITDA"); and EBITDA per adjusted prescription. See "-EBITDA" further below
for a definition and calculation of EBITDA and EBITDA per adjusted prescription.
We believe these measures highlight key business trends and are important in
evaluating our overall performance.
Financial Performance Summary for the Quarter and Nine Months Ended
September 27, 2008
Our diluted earnings per share increased 48.7% to $0.58 and net income
increased 37.7% to $295.7 million for the third quarter of 2008 compared to
$0.39 per share and $214.7 million, respectively, for the third quarter of 2007.
Our diluted earnings per share increased 26.4% to $1.58 and net income increased
17.6% to $828.6 million for the nine months of 2008 compared to $1.25 per share
and $704.5 million, respectively, for the nine months of 2007. These increases
primarily reflect higher generic dispensing rates, volume from new business,
higher mail-order penetration, and increased manufacturer rebate retention
rates. Also contributing to the increase is a third-quarter 2008 nonrecurring
state income tax benefit resulting from statute of limitations expirations in
certain states, increased Specialty Pharmacy business, and a decrease in the
diluted weighted average shares outstanding. These are partially offset by
steeper client price discounts associated with new clients and renewals of
existing clients, as well as, for the nine months, the benefit from the
short-term availability of generic Plavixฎ primarily in the first quarter of
2007. In addition, 2008 includes the operating results of PolyMedica, Critical
Care Systems, Inc. ("Critical Care"), and Europa Apotheek Venlo B.V. ("Europa
Apotheek") commencing on the October 31, 2007, November 14, 2007, and April 28,
2008 acquisition dates, respectively. For the nine months ended September 27,
2008, we generated cash flow from operations of $797.2 million and had cash and
cash equivalents of $440.8 million on our consolidated balance sheet at
September 27, 2008.
The diluted weighted average shares outstanding were 513.4 million for the
third quarter and 523.0 million for the nine months of 2008, compared to
547.9 million for the third quarter and 565.3 million for the nine months of
2007, representing decreases of 6.3% and 7.5%, respectively. These decreases
result from our $5.5 billion share repurchase program, which commenced in 2005
and was completed in October 2008.
Total net revenues increased 15.0% to $12,559.1 million for the third quarter
of 2008, and 15.6% to $38,296.6 million for the nine months of 2008, compared to
the same periods last year. Product net revenues increased 14.9% to
$12,390.3 million for the third quarter of 2008 and 15.5% to $37,804.3 for the
nine months of 2008, which reflects price inflation on
brand-name drugs, as well as higher total volume driven by new business and
acquisitions, partially offset by a greater representation of lower cost generic
drugs and higher client price discounts. Additionally, our service revenues
increased 24.6% to $168.8 million for the third quarter of 2008 and 21.2% to
$492.3 million for the nine months of 2008, which reflects higher client and
other service revenues primarily from formulary management fees, data sales,
clinical programs and nurse services. Also contributing are higher claims
processing administrative fees, in addition to revenue associated with Medicare
Part D-related product offerings for the nine months.
Total prescription volume, adjusted for the difference in days supply between
mail and retail, increased 5.6% to 193.0 million for the third quarter of 2008
and 7.1% to 597.8 million for the nine months of 2008, which substantially
reflects higher volumes from new clients. The adjusted mail-order penetration
rate increased to 40.4% and 39.5% for the third quarter and nine months of 2008,
respectively, compared to 38.4% and 37.7% for the third quarter and nine months
of 2007, respectively, resulting from a large mail-order-only client commencing
in 2008.
Our overall generic dispensing rate increased to 64.4% for the third quarter
and 63.8% for the nine months of 2008, compared to 60.3% for the third quarter
and 59.1% for the nine months of 2007. These increases reflect the introduction
of new generic products during these periods and the effect of client plan
design changes promoting the use of lower-cost and more steeply discounted
generics. Higher generic volumes, which contribute to lower costs for clients
and members, resulted in reductions of approximately $650 million and
$2,110 million in net revenues for the third quarter and nine months of 2008,
respectively.
Our overall gross margin increased to 7.4% for the third quarter and 7.2% for
the nine months of 2008, compared to 6.4% for the third quarter and 6.6% for the
nine months of 2007, primarily reflecting our increased generic dispensing rate,
mail-order volume, rebate retention rates, and Specialty Pharmacy business,
partially offset by the aforementioned client price discounts and, for the nine
months, the Plavix benefit in 2007.
Selling, general and administrative ("SG&A") expenses of $347.2 million for
the third quarter and $1,044.0 million for the nine months of 2008 increased by
$84.0 million, or 31.9%, from the third quarter of 2007, and $258.4 million, or
32.9%, from the nine months of 2007, primarily reflecting the addition of
PolyMedica, Critical Care, and Europa Apotheek SG&A expenses, as well as higher
employee-related costs to support the growing client base and strategic clinical
initiatives.
Amortization of intangible assets of $71.1 million for the third quarter and
$211.2 million for the nine months of 2008 increased $16.5 million and
$47.3 million from the third quarter and nine months of 2007, respectively, as a
result of the PolyMedica, Critical Care and Europa Apotheek acquisitions.
Interest and other (income) expense, net, of $58.2 million for the third
quarter and $169.9 million for the nine months of 2008 increased $32.7 million
and $107.6 million compared to the third quarter and nine months of 2007,
respectively, primarily attributable to higher interest expense reflecting
increased borrowings. Additionally, the nine months of 2008 reflect a
first-quarter 2008 charge for the ineffective portion of the forward-starting
interest rate swap agreements associated with our March 2008 issuance of senior
notes, which is described further below under "-Liquidity and Capital
Resources-Swap Agreements."
Our effective tax rate (defined as the percentage relationship of provision
for income taxes to income before provision for income taxes) was 34.0% for the
third quarter and 37.9% for the nine months of 2008, compared to 39.9% for the
third quarter and 39.7% for the nine months of 2007, primarily as a result of
the aforementioned state income tax benefit recorded in the third quarter of
2008.
Key Financial Statement Components
Consolidated Statements of Income
Our net revenues are comprised primarily of product net revenues and are
derived 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 discounts, rebates and guarantees
payable to clients and members. The majority of our product net
revenues are derived on a fee-for-service basis. Our product net revenues also
include revenues from the sale of diabetic supplies by PolyMedica. Specialty
Pharmacy product net revenues represent revenues from the sale of primarily
biopharmaceutical drugs and are reported at the net amount billed to third-party
payors and patients.
In addition, our product net revenues include premiums associated with our
Medicare Part D Prescription Drug Program ("PDP") risk-based product offerings.
This product involves prescription dispensing for members covered under the
CMS-sponsored Medicare Part D benefit. Since 2006, two of our insurance company
subsidiaries have been operating under contracts with CMS to offer a number of
Medicare Part D PDP products. The products involve underwriting the benefit and
charging member premiums for prescription dispensing covered under the
CMS-approved Medicare Part D benefit. We provide a Medicare drug benefit that
represents either (i) the minimum, standard level of benefits mandated by
statute, or (ii) enhanced coverage, on behalf of certain clients, which exceeds
the standard drug benefit in exchange for additional premiums.
The PDP premiums are determined based on our annual bid and related
contractual arrangements with CMS. The PDP premiums are primarily comprised of
amounts received from CMS as part of a direct subsidy and an additional subsidy
from CMS for low-income member premiums, as well as premium payments received
from members. These premiums are recognized ratably to product net revenues over
the period in which members are entitled to receive benefits. Premiums received
in advance of the applicable benefit period are recorded in accrued expenses and
other current liabilities on the consolidated balance sheets. There is a
possibility that the annual costs of drugs may be higher or lower than premium
revenues. As a result, CMS provides a risk corridor adjustment for the standard
drug benefit that compares our actual annual drug costs incurred to the targeted
premiums in our CMS-approved bid. Based on specific collars in the risk
corridor, we will receive from CMS additional premium amounts or be required to
refund to CMS previously received premium amounts. We calculate the risk
corridor adjustment on a quarterly basis based on drug cost experience to date
and record an adjustment to product net revenues with a corresponding account
receivable or payable to CMS reflected on the consolidated balance sheets.
In addition to premiums, there are certain co-payments and deductibles (the
"cost share") due by members based on prescription orders by those members, some
of which are subsidized by CMS in cases of low-income membership. The subsidy
amounts received in advance are recorded in accrued expenses and other current
liabilities on the consolidated balance sheets. At the end of the contract term
and based on actual annual drug costs incurred, subsidies are reconciled with
actual costs and residual subsidy advance receipts are payable to CMS. The cost
share is treated consistently as other co-payments derived from providing PBM
services, as a component of product net revenues in the consolidated statements
of income where the requirements of Emerging Issues Task Force ("EITF")
No. 99-19, "Reporting Gross Revenue as a Principal vs. Net as an Agent," are
met. For further details, see our critical accounting policies included in "-Use
of Estimates and Critical Accounting Policies and Estimates" and Note 2,
"Summary of Significant Accounting Policies," to our audited consolidated
financial statements included in Part II, Item 8 of our Annual Report on Form
10-K for the fiscal year ended December 29, 2007. In the third quarter and nine
months of 2008, premium revenues for our PDP products, which exclude member cost
share, were $75 million and $245 million, respectively, or less than 1% of total
net revenues. In the third quarter and nine months of 2007, premium revenues for
our PDP product were $61 million and $195 million, respectively, or less than 1%
of total net revenues.
Our agreements with CMS, as well as applicable Medicare Part D regulations
and federal and state laws, require us to, among other obligations: (i) comply
with certain disclosure, filing, record-keeping and marketing rules;
(ii) operate quality assurance, drug utilization management and medication
therapy management programs; (iii) support e-prescribing initiatives;
(iv) implement grievance, appeals and formulary exception processes; (v) comply
with payment protocols, which include the return of overpayments to CMS and, in
certain circumstances, coordination with state pharmacy assistance programs;
(vi) use approved networks and formularies, and provide access to such networks
to "any willing pharmacy;" (vii) provide emergency out-of-network coverage; and
(viii) implement a comprehensive Medicare and Fraud, Waste and Abuse compliance
program. As a CMS-approved PDP, our policies and practices associated with
executing the program are subject to audit, and if material contractual or
regulatory non-compliance was to be identified, applicable sanctions and/or
monetary penalties may be imposed. Additionally, each calendar year, payment
will vary based on the annual benchmark that applies as a result of Medicare
Part D plan bids for the applicable year, as well as for changes in the CMS
methodology for calculating risk adjustment factors.
Service revenues consist principally of administrative fees and clinical
program fees earned from clients and other non-product-related revenues, sales
of prescription services to pharmaceutical manufacturers and data to other
parties, and performance-oriented fees paid by specialty pharmacy manufacturers.
Cost of revenues is comprised primarily of cost of product net revenues and
is principally attributable to the dispensing of prescription drugs. Cost of
product net revenues for prescriptions dispensed through our network of retail
pharmacies are comprised of the contractual cost of drugs dispensed by, and
professional fees paid to, retail pharmacies in the networks, including the
associated member co-payments. Our cost of product net 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 fixed asset depreciation. The operating
costs of our call center pharmacies are also included in cost of product net
revenues. In addition, cost of product net revenues includes a credit for
rebates earned from brand-name 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.
Our cost of product net revenues also includes the cost of drugs dispensed by
our mail-order pharmacies or retail network for members covered under our
Medicare Part D PDP product offerings and are recorded at cost as incurred. We
receive a catastrophic reinsurance subsidy from CMS for approximately 80% of
costs incurred by individual members in excess of the individual annual
out-of-pocket maximum of $4,050 for coverage year 2008 and $3,850 for coverage
year 2007. The subsidy is reflected as an offsetting credit in cost of product
net revenues to the extent that catastrophic costs are incurred. Catastrophic
reinsurance subsidy amounts received in advance are recorded in accrued expenses
and other current liabilities on the consolidated balance sheets. At the end of
the contract term and based on actual annual drug costs incurred, residual
subsidy advance receipts are payable to CMS. Cost of service revenues consist
principally of labor and operating costs for delivery of services provided, as
well as costs associated with member communication materials.
SG&A expenses reflect the costs of operations dedicated to executive
management, the generation of new sales, maintenance of existing client
relationships, management of clinical programs, enhancement of technology
capabilities, direction of pharmacy operations, and performance of reimbursement
activities, in addition to finance, legal and other staff activities, and the
effect of certain legal settlements. SG&A also includes advertising expenses
associated with PolyMedica, which are expensed as incurred.
Interest and other (income) expense, net, primarily includes interest expense
on our senior unsecured credit facilities, accounts receivable financing
facility, senior notes, and amortization of the effective portion of our settled
forward-starting interest rate swap agreements. In addition, interest and other
(income) expense, net, for the first nine months of 2008 includes a loss on the
ineffective portion of the settled forward-starting interest rate swap
agreements recorded in the first quarter of 2008. Interest and other
(income) expense, net, also includes interest income or interest expense on our
interest rate swap agreements on $200 million of the 7.25% senior notes. This
net expense amount is partially offset by interest income generated by cash and
cash equivalent investments and short- and long-term investments in marketable
securities.
For further details, see our critical accounting policies included in "-Use
of Estimates and Critical Accounting Policies and Estimates" and Note 2,
"Summary of Significant Accounting Policies," to our audited consolidated
financial statements included in Part II, Item 8 of our Annual Report on Form
10-K for the fiscal year ended December 29, 2007.
Consolidated Balance Sheets
Our primary assets include cash and cash equivalents, short- and long-term
investments, manufacturer accounts receivable, client accounts receivable,
inventories, fixed assets, deferred tax assets, goodwill and intangible assets.
Cash and cash equivalents reflect the accumulation of net positive cash flows
from our operations, investing and financing activities, and primarily include
time deposits with banks or other financial institutions, and money market
mutual funds. Our short-term investments include U.S. government securities that
. . .
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