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| MHS > SEC Filings for MHS > Form 10-K on 24-Feb-2009 | All Recent SEC Filings |
24-Feb-2009
Annual Report
Overview
We are a leading health care company, serving the needs of more than 60 million people. Medco provides clinically-driven pharmacy services designed to improve the quality of care and lower total health care costs for private and public employers, health plans, labor unions and government agencies of all sizes, and for individuals served by the Medicare Part D Prescription Drug Plans. Through our unique Medco Therapeutic Resource Centers® in which our therapy management programs include the use of specialized pharmacists focused on specific disease states, and Accredo Health Group, Medco's Specialty Pharmacy, we are creating innovative models for the care of patients with chronic and complex conditions.
Our business model requires collaboration with retail pharmacies, physicians, the Centers for Medicare & Medicaid Services ("CMS") for Medicare, pharmaceutical manufacturers, 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 pharmacy benefit management ("PBM") services through our national networks of retail pharmacies and our own mail-order pharmacies, as well as through Accredo Health Group, which is the nation's largest specialty pharmacy based on revenues. 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. In 2008, we also expanded our capabilities abroad when we acquired a majority interest in Europa Apotheek Venlo B.V. ("Europa Apotheek"), a privately held company based in the Netherlands that provides mail-order pharmacy and clinical health care services in Germany and the Netherlands. See Note 3, "Acquisitions of Businesses," to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K for more information.
All share and per share amounts have been retrospectively adjusted for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective January 24, 2008. See Note 1, "Background and Basis of Presentation," to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.
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 Prescription Drug Plan ("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.
Our financial performance benefits from the diversity of our client base and our clinically-driven business model, which provides better clinical outcomes at lower costs for our clients during this period of economic uncertainty. We actively monitor the status of our accounts receivable and have mechanisms in place to minimize the potential for incurring material accounts receivable credit risk. To date, we have not experienced any deterioration in our client or manufacturer accounts receivable.
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 inventory dispensed through Medco, and its consolidated subsidiaries' mail-order 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.
2008 Financial Performance Summary
Our diluted earnings per share increased 30.7% to $2.13 and net income increased 20.9% to $1,102.9 million for 2008 compared to $1.63 per share and $912.0 million, respectively, for 2007. These increases primarily reflect higher generic dispensing rates, volume from new business, higher mail-order penetration, favorable retail pharmacy reimbursement rates, 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 the benefit from the short-term availability of generic Plavix® primarily in the first quarter of 2007. In addition, these results include the operating results of PolyMedica, Critical Care Systems, Inc. ("Critical Care"), and majority-owned Europa Apotheek commencing on the October 31, 2007, November 14, 2007, and April 28, 2008 acquisition dates, respectively. For the year ended December 27, 2008, we generated cash flow from operations of $1,635.1 million and had cash and cash equivalents of $938.4 million on our consolidated balance sheet at December 27, 2008.
The diluted weighted average shares outstanding were 518.6 million for 2008 compared to 560.9 million for 2007, representing a decrease of 7.5% resulting from our share repurchase programs which commenced in 2005.
Our total net revenues increased 15.2% to $51,258.0 million in 2008. Product net revenues increased 15.0% to $50,576.2 million, which reflects product price inflation primarily 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 25.3% to $681.8 million in 2008, which reflects higher client and other service revenues primarily from clinical programs, data sales, and formulary management fees. Also contributing are higher claims processing administrative fees, in addition to revenue associated with Medicare Part D-related product offerings.
The total prescription volume, adjusted for the difference in days supply between mail and retail, increased 6.4% to 795.9 million for 2008, which substantially reflects higher volumes from new clients. The adjusted mail-order penetration rate increased to 39.7% in 2008 from 37.9% in 2007, resulting from a large mail-order-only client commencing in 2008.
Our overall generic dispensing rate increased to 64.1% in 2008 from 59.7% in 2007, reflecting the impact of 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 a reduction of approximately $2,690 million in net revenues for 2008.
Our overall gross margin increased to 7.3% in 2008 from 6.6% in 2007, primarily reflecting our increased generic dispensing rate, mail-order volume, retail pharmacy reimbursement rates, rebate retention rates, and Specialty Pharmacy business, partially offset by the aforementioned client price discounts and the Plavix® benefit in 2007.
Selling, general and administrative ("SG&A") expenses of $1,425.0 million for 2008 increased by $310.9 million, or 27.9%, from 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 $285.1 million for 2008 increased $57.0 million from 2007 primarily as a result of the PolyMedica and Critical Care acquisitions and the acquisition of a majority interest in Europa Apotheek.
Interest expense of $233.7 million for 2008 increased $99.5 million from $134.2 million in 2007, primarily reflecting increased borrowings associated with our issuance of senior notes in the first quarter of 2008.
Interest (income) and other (income) expense, net, of ($6.2) million for 2008 decreased $28.2 million from ($34.4) million in 2007, primarily attributable to lower interest income reflecting lower interest rates. Additionally, 2008 reflects 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 38.4% for 2008 compared to 39.3% for 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 principally 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. Product net revenues also include revenues from the sale of diabetes supplies by PolyMedica. Our 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.
These products involve prescription dispensing for beneficiaries enrolled in the
CMS-sponsored Medicare Part D prescription drug benefit. Our two insurance
company subsidiaries have been operating under contracts with CMS since 2006,
and currently offer several Medicare PDP options. The products involve
underwriting the benefit, charging enrollees applicable premiums, providing
covered prescription drugs and administering the benefit as filed with CMS. We
provide three Medicare drug benefit plan options for beneficiaries, including
(i) a "standard Part D" benefit plan as
mandated by statute, and (ii) two benefit plans with enhanced coverage, that exceed the standard Part D benefit plan, available for an additional premium. We also offer numerous customized benefit plan designs to employer group retiree plans under the CMS Medicare Part D prescription drug benefit.
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 deferred and 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. For subsidies received in advance, the amount is deferred and recorded in accrued expenses and other current liabilities on the consolidated balance sheets. If there is cost share due from members or CMS, the amount is accrued and recorded in client accounts receivable, net, on the consolidated balance sheets. After the end of the contract year and based on actual annual drug costs incurred, cost share amounts are reconciled with CMS and the corresponding receivable or payable is settled. 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," ("EITF 99-19") are met. For further details, see our critical accounting policies included in "- Use of Estimates and Critical Accounting Policies and Estimates" below and Note 2, "Summary of Significant Accounting Policies," to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. Premium revenues for our PDP products, which exclude member cost share, were $317 million, or less than 1% of total net revenues, in 2008, $255 million, or less than 1% of total net revenues, in 2007, and $465 million, or approximately 1% of total net revenues, in 2006.
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, including suspension of enrollment and marketing, 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, $3,850 for coverage year 2007, and $3,600 for coverage year 2006. 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. If there are catastrophic reinsurance subsidies due from CMS, the amount is recorded in client accounts receivable, net, on the consolidated balance sheets. After the end of the contract year and based on actual annual drug costs incurred, catastrophic reinsurance amounts are reconciled with CMS and the corresponding receivable or payable is settled. 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 direct response advertising expenses associated with PolyMedica, which are expensed as incurred.
Interest expense is incurred on our senior unsecured credit facilities, accounts receivable financing facility, and senior notes, and includes net interest on our interest rate swap agreements on $200 million of the 7.25% senior notes. In addition, it includes amortization of the effective portion of our settled forward-starting interest rate swap agreements and amortization of debt issuance costs.
Interest (income) and other (income) expense, net, includes interest income generated by cash and cash equivalent investments, as well as short- and long-term investments in marketable securities. In addition, it includes a loss on the ineffective portion of the settled forward-starting interest rate swap agreements recorded in the first quarter of 2008.
For further details, see our critical accounting policies included in "- Use of Estimates and Critical Accounting Policies and Estimates" below and Note 2, "Summary of Significant Accounting Policies," to our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.
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 have average maturities of less than one year and that are held to satisfy statutory capital requirements for our insurance subsidiaries. We have no exposure to or investments in any instruments associated with the sub-prime loan market.
Manufacturer accounts receivable balances primarily include amounts due from brand-name pharmaceutical manufacturers for earned rebates and other prescription services. Client accounts receivable represent amounts due from clients, other payors and patients for prescriptions dispensed from retail pharmacies in our networks or from our mail-order pharmacies, including fees due to us, net of allowances for doubtful accounts, as well as contractual allowances and any applicable rebates and guarantees payable when such are settled on a net basis in the form of an invoice credit. In cases where rebates and guarantees are settled with the client on a net basis, and the rebates and guarantees payable are greater than the corresponding client accounts receivable balances, the net liability is reclassified to client rebates and guarantees payable. When these payables are settled in the form of a check or wire, they are recorded on a gross basis and the entire liability is reflected in client rebates and guarantees payable. Our client accounts receivable also includes receivables from CMS for our Medicare Part D PDP product offerings and premiums from members. Additionally, we have receivables from Medicare and Medicaid for a portion of our Specialty Pharmacy business, and diabetes supplies dispensed by PolyMedica.
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, net of allowances for losses. Deferred tax assets primarily represent temporary differences between the financial statement basis and the tax basis of certain accrued expenses, stock-based compensation, and client rebate pass-back liabilities. Income taxes receivable represents amounts due from the IRS and state and local taxing authorities associated primarily with the approval of a favorable accounting method change received from the IRS in 2006 for the timing of the deductibility of certain rebates passed back to clients. Fixed assets include investments in our corporate headquarters, mail-order pharmacies, call center pharmacies, account service offices, and information technology, including capitalized software development. Goodwill and intangible assets are comprised primarily of the push-down of goodwill and intangibles from our acquisition by Merck & Co., Inc. ("Merck") in 1993, goodwill and intangibles recorded upon our acquisition in 2007 of PolyMedica, and, for the Specialty Pharmacy segment, goodwill and intangible assets recorded primarily from our acquisition of Accredo in 2005.
Our primary liabilities include claims and other accounts payable, client rebates and guarantees 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 by the retail pharmacies, as well as amounts payable for mail-order prescription inventory purchases and other purchases made in the normal course of business. Client rebates and guarantees payable include amounts due to clients that will ultimately be settled in the form of a check or wire, as well as any residual liability in cases where the payable is settled as an invoice credit and exceeds the corresponding client accounts receivable balances. 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. Accrued expenses and other current liabilities are also comprised of certain premiums, and may also include cost share, and catastrophic reinsurance payments received in advance from CMS for our Medicare Part D PDP product offerings. Our debt is primarily comprised of a senior unsecured term loan facility, a senior unsecured revolving credit facility, senior notes and an accounts receivable financing facility. In addition, we have a net deferred tax liability primarily associated with our recorded intangible assets. We do not have any material off-balance sheet arrangements, other than purchase commitments and lease obligations. See "- Commitments and Contractual Obligations" below.
Our stockholders' equity includes an offset for purchases of our common stock under our share repurchase program. The accumulated other comprehensive income component of stockholders' equity includes: unrealized investment gains and losses, foreign currency translation adjustments resulting from the translation of Europa Apotheek's assets and liabilities and results of operations, unrealized gains and losses on effective cash flow hedges, and the net gains and losses and prior service costs and credits related to our pension and other postretirement benefit plans.
Consolidated Statements of Cash Flows
An important element of our operating cash flows is the timing of billing cycles, which are generally two-week periods of accumulated billings for retail and mail-order prescriptions. We bill the cycle activity to
clients on this bi-weekly schedule and generally collect from our clients before we pay our obligations to the retail pharmacies for that same cycle. At the end of any given reporting period, unbilled PBM receivables can represent up to two weeks of dispensing activity and will fluctuate at the end of a fiscal month depending on the timing of these billing cycles. A portion of the Specialty Pharmacy business includes reimbursement by payors, such as insurance companies, under a medical benefit, or by Medicare or Medicaid. These transactions also involve higher patient co-payments than experienced in the PBM business. As a . . .
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