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MedcoHealth Solutions 10-K 2008 Documents found in this filing:
Table of Contents
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 29, 2007
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 if the registrant is a well-known seasoned issuer, as defined in Rule
405 of the Securities Act. Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section
13 or Section 15(d) of the Exchange Act. Yes o No þ
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 þ No o
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 Annual
Report on Form 10-K or any amendment to this Annual Report on Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in
Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ
The aggregate market value of the Registrant’s voting stock held by non-affiliates as of July
1, 2007 was $21,190,405,299. The Registrant has no non-voting common equity.
As of February 14, 2008, the registrant had 523,922,669 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Medco Health Solutions, Inc.’s Proxy Statement for its 2008 Annual Meeting of
Shareholders are incorporated by reference in this Annual Report on Form 10-K in response to Part
III (Items 10 through 14).
MEDCO HEALTH SOLUTIONS, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Table of Contents
PART I
Item 1. Business.
Overview
We are the nation’s leading pharmacy benefit manager based on net revenues. Medco’s
prescription drug benefit programs are designed to drive down the cost of pharmacy healthcare 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 Program (“Medicare Part D”). We
provide sophisticated traditional and specialty prescription drug benefit programs and services for
our clients and members. 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 pharmacy benefit management (“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”). In 2007, we introduced the Medco Therapeutic Resource
Centers®, staffed with hundreds of pharmacists who are trained and certified in specific
complex and chronic conditions and have expertise in the associated medications. 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 consolidated financial
statements included in Part II, Item 8 of this Annual Report on Form 10-K for more information.
When we use “Medco,” “we,” “us” and “our”, we mean Medco Health Solutions, Inc., a Delaware
corporation, and its consolidated subsidiaries.
Our clients are generally entities that provide prescription drug benefits to their underlying
membership, such as members of their plan or their employees. When we use the term “mail order”, we
mean Medco’s mail-order pharmacy operations, as well as Accredo’s specialty pharmacy operations.
We operate in a competitive environment as clients and other payors seek to control the growth
in the cost of providing prescription drug benefits. Our business model is designed to reduce the
level of drug cost increase, also known as drug trend. We help manage drug trend primarily by our
programs designed to maximize the substitution of expensive brand-name drugs by equivalent but much
lower cost generic drugs, obtaining competitive discounts from brand-name and generic drug
pharmaceutical manufacturers, obtaining rebates from brand-name pharmaceutical manufacturers,
securing discounts from retail pharmacies, applying our sophisticated clinical programs and
efficiently administering prescriptions dispensed through our mail-order pharmacies.
Traditional prescription programs include the dispensing of pills primarily in capsule or
tablet form. These medicines are produced by brand-name and generic pharmaceutical manufacturers,
and are not as complicated to dispense or administer as specialty products. Specialty pharmacy
drugs are generally manufactured by biopharmaceutical or biotechnology companies and tend to be
more expensive than traditional prescriptions and can cost as much as several hundred thousand
dollars per patient per year. These specialty drugs are often injectable and require special
handling, temperature control and ancillary equipment, as well as a higher level of individualized
patient care as compared to traditional prescriptions. Disease states treated by specialty drugs,
including for example hemophilia and autoimmune disorders, are often the most complex to manage.
The advanced technologies we have developed are instrumental to our ability to drive growth,
improve service and reduce costs. Our technology platform is designed to seamlessly integrate
prescription management at both mail order and retail with our client and member services. The
cornerstone of our mail-order pharmacy technology is our single networked information technology
platform, which connects prescription ordering functions at our prescription order processing
pharmacies with our state-of-the-art automated dispensing pharmacies in Willingboro, New Jersey and
Las Vegas, Nevada. Construction will commence in 2008 for a third automated dispensing pharmacy in
Indiana, which is expected to be operational in 2009. At our call center pharmacies or our
work-at-home locations, our experienced service
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representatives and consulting pharmacists use advanced technology to speed service and
provide members with specialized prescription and health information. Our Internet and integrated
voice-response phone technologies allow members to easily and quickly manage their prescription
drug benefits, from enrolling in mail-order pharmacy service, to submitting a refill or renewal
mail-order prescription for processing, tracking the status of a mail-order prescription, pricing a
medication and locating in-network retail pharmacies in their area, along with other features.
Advanced imaging technology enables service representatives to access an online image of a
member’s prescription to address a member’s needs more efficiently. Our data center links our
mail-order pharmacy operations, including our call center pharmacies and work-at-home sites, our
websites, and the retail pharmacies in our networks. The data center enables us to efficiently
receive, process and administer claims, and dispense prescription drugs with speed and accuracy in
a secure environment. It also allows us to easily detect potential adverse drug events and alert
the patients and prescribing physicians of potentially harmful drug interactions. We also have
reliability, change management and implementation programs that help drive excellence in execution
across our operations, reducing our time to market with new capabilities and increasing our ability
to implement timely, error-free updates and deliver client-oriented solutions.
Our proprietary Internet solutions improve client and member service by facilitating
prescription ordering and by providing important healthcare information and an efficient means of
communication. We support distinct websites for clients, members and pharmacists that provide
critical benefit information and interactive tools aimed at facilitating compliance with benefit
plan goals and simplifying benefit administration.
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:
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In 2007, we administered approximately 560 million prescriptions; had net revenues in excess
of $44 billion and net income of $912 million; and reported earnings before interest
income/expense, taxes, depreciation and amortization, or EBITDA, of $2 billion. See Note 9 under
Item 6, “Selected Financial Data,” for a definition and calculation of EBITDA and EBITDA per
adjusted prescription. Our net income is driven by our ability to generate favorable discounts on
generic prescription drugs dispensed from our mail-order pharmacies; earn discounts and rebates on
brand-name drugs; negotiate competitive client pricing, including rebate sharing terms,
administrative fees and price discounts, as well as favorable retail pharmacy reimbursement rates;
provide competitively-priced specialty pharmacy products and services; and provide services in a
cost-efficient manner.
Business segment information is set forth in Part II, Items 7, 7A and 8 of this Annual Report
on Form 10-K.
We were a wholly-owned subsidiary of Merck & Co., Inc. (“Merck”) until August 19, 2003 (the
“spin-off”), when we were spun off as an independent, publicly traded enterprise.
Industry Overview
PBMs emerged in the 1980s, primarily to provide cost-effective drug distribution and claims
processing for the healthcare industry. The PBM industry further evolved in response to the
significant escalation of healthcare costs in the 1990s, as sponsors of benefit plans sought to
more aggressively contain their costs. PBMs developed strategies to effectively influence both
supply and demand. On the supply side, PBMs leverage their buying power to negotiate purchase
discounts and rebates from manufacturers, discounts from distributors, and discounts from retail
pharmacies. On the demand side, PBMs educate clients, members and physicians on cost-effective
prescription medications and apply various techniques to encourage members to make cost-effective
choices, such as the use of less expensive generic drugs and the more efficient mail-order channel.
Generic substitution for drugs on which patents have expired is a significant and growing factor in
reducing costs.
Potential areas of growth for the PBM industry include increased participation in available
programs and services by existing clients, with a particular focus on expanding mail order and
generics as a means of maintaining high quality care at lower costs. In addition, there will be an
increased focus on the dispensing of specialty drugs.
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Business Strategy
Medco’s strategy for growth and profitability includes the following six main categories:
In order for our strategy to achieve maximum success, we must anticipate and respond to both
the common and unique needs of our clients and other payors, and we must continue to deliver
scalable yet flexible capabilities and solutions that are affordable for payors and profitable for
us. This will include delivering high quality client and member service; leveraging our significant
technology investments to drive growth; reducing costs; actively pursuing sources of growth from
new clients and increasing the use of our value-added services, including our mail-order
pharmacies; and making acquisitions, forming strategic alliances, and expanding into complementary,
adjacent markets.
We believe our competitive advantages enable us to deliver enhanced service to clients and
patients, and effectively manage drug trend, and ultimately the total cost of healthcare. These
advantages include our specialized Therapeutic Resource Centers; our highly automated mail-order
pharmacy capability; our specialty pharmacy scale; our investments in other systems technologies
including the Internet; our extensive value-added programs and services offerings; our ability to
generate significant discounts and rebates that translate into client and member savings; and the
cost-saving potential from our comprehensive generic substitution programs.
See “—Competition” below for a description of competition in the PBM industry.
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Products 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 of traditional and specialty drugs, quality and administration of prescription drug
benefits.
Plan Design
Our client teams take a consultative approach to assisting clients in their development and
implementation of plan designs that suit their specific needs. Each client has access to the skills
of various Medco professionals, including experienced clinical, financial and information
technology specialists. Each client’s success in achieving the business objectives of its specific
pharmacy benefit strategy ultimately depends on the design of its benefit plan. These designs take
into account formulary, pharmacy management, mail-order initiatives, specialty pharmacy, drug
coverage and exclusion, cost-share options, and generic drug utilization initiatives. Integrating
Medicare Part D considerations into plan designs is increasingly important to clients with
Medicare-eligible members. Medco has designed innovative plan designs and consultative services to
assist our clients in addressing this very complex government-funded program.
As an integral part of our 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. One such tool is Medco’s EXPERxT Advisor, which provides real-time plan design modeling
capability for our clients. Clients can use the output from these models to judge the impact of
specific plan design elements before they are implemented.
Clinical Management
We capitalize on our clinical expertise and advanced information technology infrastructure to
help reduce client costs for prescription drugs in a medically appropriate manner, while striving
to improve safety and the quality of care for patients. We do this by developing action-oriented,
evidence-based clinical programs and services based on clinical rationale reviewed by our Pharmacy
and Therapeutics Committee and Medical Advisory Board. 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. These independent advisory bodies guide 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.
Once developed, these programs are integrated into a client’s pharmacy benefit plan. To
monitor our success with these programs, we regularly report to clients on the success of our
actions on their behalf, review their clinical and financial data, and consult with our clients to
identify opportunities for improvement.
We offer utilization management, including drug utilization review (“DUR”), which is a
systematic evaluation of individual and population use of prescription drugs, to identify and
address over-use, under-use, and misuse of prescription drugs. As a result of these evaluations, we
alert pharmacists, physicians and patients to possible issues, such as drug-drug interactions,
drug-age problems, drug-pregnancy issues and opportunities to consider alternate therapies
including generics and formulary preferred drugs.
We have introduced a variety of innovative clinical programs. One of these is our proprietary
RationalMed service, an advanced patient safety program designed to improve patient care and lower
total healthcare costs. RationalMed analyzes patients’ available prescription, inpatient
and outpatient medical and laboratory records to detect gaps and errors in care, and engage
physicians, pharmacists and patients in making appropriate changes in care. Clients who participate
in RationalMed can save money by reducing inappropriate and unsafe prescription use, reducing gaps
in care and avoiding unnecessary medical costs, including possible hospitalization. We offer
RationalMed to health plans and plan sponsors, regardless of whether they are clients of our PBM
business.
Optimal Health® is Medco’s health and care support solution, offered through our
10-year alliance with Healthways, Inc. Optimal Health offers health plans and plan sponsors health
improvement solutions across the entire population including well, at risk, chronic and complex.
Through innovative engagement capabilities, Optimal Health helps patients
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to understand their health risks and take action with confidence to lead healthier lives.
Clients who participate in Optimal Health can save money by increasing the percent of their
population living healthier lifestyles, improving compliance with evidence-based care guidelines
for chronic conditions and avoiding unnecessary medical costs, particularly hospitalizations.
Clinical Services, Specialty Pharmacy
Where appropriate, we work with the patient and the patient’s physician to implement the
prescribed plan of care. Each patient is assigned to a team consisting of a pharmacist, a customer
service representative and a reimbursement specialist, and with certain therapies, a registered
nurse. Generally, each patient’s team members specialize only in that patient’s disease and work
only with payors and providers in that patient’s geographic region. We assist patients and their
families in coping with a variety of difficult emotional and social challenges presented by their
diseases, and in some cases participate in patient advocacy organizations, assist in the formation
of patient support groups, advocate legislation to advance patient interests and publish
newsletters for our patients.
Pharmacy Management
One of the core features of our PBM services is the management of prescription claims.
Mail-Order Service. Our mail-order service is the industry’s largest in terms of the number of
prescriptions dispensed. We dispensed approximately 95 million prescriptions in 2007 through our
mail-order pharmacies. For maintenance medications, mail order typically reduces costs for clients
as a result of Medco’s purchasing scale, increased generic dispensing and higher rebates through
enhanced formulary compliance. Many members prefer mail order for maintenance medications because
they can receive up to a 90-day supply instead of a 30-day supply as commonly dispensed by retail
pharmacies, and members also benefit from generally lower co-payments at mail order and the
convenience of receiving their prescriptions in the mail. Members can place first-fill, refill and
renewal orders through the mail. In addition, members can access resources necessary for
first-fill prescription orders and can place refill or renewal orders easily online through our
member website or through our integrated voice-response phone system.
Our mail-order pharmacy operations consist of nine PBM mail-order pharmacies that are located
in various states and dispense drugs throughout the United States. Prescription order processing
activities and mail-order dispensing are performed in our mail-order pharmacies. In our
prescription order 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
mail-order dispensing pharmacies. We also utilize image-based technology, which provides for quick
access to prescription orders and promotes efficient processing through our distribution process
protocols. In the dispensing pharmacies, including our highly automated pharmacies in Willingboro,
New Jersey and Las Vegas, Nevada, we focus on distribution processes such as prescription
dispensing and pre-sorting for shipment to patients by mail or courier. All of our PBM
mail-order pharmacies are electronically networked into our integrated systems platform. This
approach to mail-order operations 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. Construction will commence in 2008 for a third automated
dispensing pharmacy in Indiana, which is expected to be operational in 2009.
PolyMedica provides diabetes testing supplies and related products to patients with diabetes.
PolyMedica meets the needs of diabetes patients by providing delivery of supplies through two
locations in Florida and Virginia. For these services, PolyMedica bills Medicare, other government
agencies and/or private insurance companies directly for those diabetes-related supplies.
Medco Therapeutic Resource Centers. These centers, located within our mail-order pharmacy
operations, are designed around the theory that specialization leads to better pharmacy care for
members with chronic and complex conditions and pharmacy needs. To better serve these members and
their plans, our pharmacists are specialized in the chronic conditions that have significant gaps
in care and significant costs, such as diabetes, heart disease and asthma. Specialist pharmacists
of a given specialty practice together in centers dedicated to the pharmacy care of people with
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needs in that specialty. Our scale and technology allow us to dedicate entire pharmacy
practices to a single specialty and bring the services of our specialist pharmacists to the members
who need them, as they need them. The PolyMedica acquisition, which closed in October 2007, is
viewed as a complement to our Therapeutic Resource Center strategy, focusing on the rapidly-growing
diabetes patient base.
Specialty Pharmacy Management. Accredo Health Group provides an enhanced level of personalized
service to patients taking specialty medicines. Accredo Health Group’s specialty pharmacy
facilities are dedicated to the processing of specialty drug orders and the associated dispensing.
Accredo Health Group’s specialty pharmacies typically dispense a 30- to 90-day supply of
biopharmaceutical medications with ancillary supplies directly to the patient or the patient’s
physician with appropriate packaging. The package typically contains all of the supplies required
for administration in the patient’s home or in other alternate sites. Substantially all products
are processed or shipped from three specialty pharmacy distribution pharmacies in Memphis,
Tennessee; Nashville, Tennessee; and Warrendale, Pennsylvania. Accredo Health Group also maintains
multiple specialty branch pharmacy locations across the United States, including some associated
with our recent acquisition of Critical Care, and which may also include nursing services, walk-in
infusion centers and other services customized for individual patients. The products are primarily
shipped via courier services.
Retail Pharmacy Networks. We have contractual relationships covering 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 the current standard pricing unit used in the industry. In addition, we
determine a maximum allowable cost for most generic drugs. 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. Pharmacies in the network benefit, in turn, from increased
member traffic and sales.
Call Center Pharmacies. We operate 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 networks. Our call center pharmacies also provide
information and services to physicians and pharmacists who service our clients’ members. We have,
on a limited basis, outsourced some call handling capabilities to third-party vendors, including
the management of inbound calls from retail pharmacies.
Reimbursement Services. With Accredo Health Group’s focus on specialty drugs to treat
specific chronic diseases, significant expertise has been developed in managing reimbursement
issues related to the patient’s condition and treatment program. Due to the long duration and high
cost of therapy generally required to treat these chronic disorders, the availability of adequate
health insurance is a continual concern for chronically ill patients. Generally, the payor, such as
an insurance provider under a medical benefit, is contacted prior to each shipment to determine the
patient’s health plan coverage and the portion of costs that the payor will reimburse.
Reimbursement specialists review matters such as pre-authorization or other prior approval
requirements, lifetime limits, pre-existing condition clauses, and the availability of special
state programs. By identifying coverage limitations as part of an initial consultation, we can
assist the patient in planning for alternate coverage, if necessary. From time to time, we
negotiate with payors to facilitate or expand coverage for the chronic diseases we serve. In
addition, we accept assignment of benefits from numerous payors, which substantially eliminates the
claims submission process for most patients. Historically, drugs were primarily reimbursed by the
patient’s health insurance plan through a medical benefit. This has evolved where, based on the
type of drug dispensed, an increasing percentage of transactions are reimbursed through a
prescription card benefit, which typically results in accelerated reimbursement.
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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 education and sampling programs, Physicians Practice Summary Program and
e-Prescribing Connectivity Program.
We work closely with a variety of handheld and personal computer-based technology 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 2001, we formed
RxHub LLC (“RxHub”) with other PBMs. 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 sites for clients and retail pharmacists that provide interactive tools aimed at
improving compliance with plan goals, simplifying benefit administration, and providing critical
benefit and medical information. Our My Rx Choices prescription savings program provides members
with greater transparency around their benefits and facilitates more informed patient/physician
dialogue, leading to lower costs for our clients and their members.
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 was the first Internet
pharmacy site to be certified by the National Association of Boards of Pharmacy.
Client-Oriented Web Services. Our client website provides clients with online access to
Medco’s 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 retail network pharmacies. Clients also have the ability to 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 involved in managing the pharmacy benefit within
the client organization, limiting access to information only to authorized individuals.
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 information 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 use this
service to 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
Clients. 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 retail
pharmacies. Our PBM client contracts provide that a client will pay for drugs dispensed to its
members at specified discounts to average wholesale prices or other industry benchmarks, 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, generic
drug or a specialty drug, and whether the prescription is dispensed through our mail-order
pharmacies or a pharmacy in our retail networks. Clients may also pay an administrative fee or
other service fee for services we provide. These services include claims processing, eligibility
management, benefits management, formulary compliance management, clinical and utilization
management, pharmacy network management and other related services. Client contracts may also
provide that we will share with clients a portion of or all of the rebates received from
pharmaceutical manufacturers.
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Additionally, 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
may receive. Many of our client contracts also include guaranteed cost savings. These clients may
be entitled to performance penalties 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 2007. Our clients are generally entitled to audit our compliance with their
contracts.
CMS. Our product net revenues also include premiums associated with our Medicare Part D PDP
product offering, which are based on our annual bid and related contractual arrangements with CMS.
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 Congress, or (ii) enhanced coverage, on
behalf of certain clients, which exceeds the standard drug benefit in exchange for additional
premiums.
Pharmaceutical Manufacturers. Our contracts with pharmaceutical manufacturers provide us with
rebates and fees for prescription drugs dispensed through our mail-order pharmacies and retail
pharmacy networks, discounts for prescription drugs we purchase and dispense from our mail-order
pharmacies, and performance-based fees associated with certain biopharmaceutical drugs. Rebates and
fees are generally calculated as a percentage of the aggregate dollar value of a particular drug
that we dispensed, based on the manufacturer’s published wholesale price for that drug. Rebates and
fees are generally invoiced to the pharmaceutical manufacturer and paid to us on a quarterly basis.
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. In some instances, instead of rebates being passed back to clients, they are
passed back to members at the point of sale. 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 and Estimates—Critical Accounting
Policies and Estimates,” of this Annual Report on Form 10-K.
Retail Pharmacies. We have contractual relationships covering 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 the current standard pricing unit used in the industry. In addition, we determine a
maximum allowable cost for most generic drugs. 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. Pharmacies in the network benefit, in turn, from increased member traffic and
sales.
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 29, 2007, our ten largest clients based on
revenue accounted for approximately 45% of our net revenues, including UnitedHealth Group
Incorporated (“UnitedHealth Group”), our largest client, which represented approximately $9,900
million, or 22%, of our net revenues. The UnitedHealth Group account has much lower mail-order
penetration and, because of its size, much steeper pricing than the average client, and
consequently generates lower profitability than typical client accounts. None of our other clients
individually represented more than 10% of our net revenues in 2007, 2006 or 2005.
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Mail-Order Inventory Suppliers
We maintain an extensive inventory in our mail-order pharmacies primarily representing
brand-name, generic and specialty 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 our primary wholesaler, AmerisourceBergen Corp., which
accounted for approximately 56% of our 2007 drug purchases, or from manufacturers. Most of the
purchases from the primary wholesaler were for brand-name pharmaceuticals. Specialty and 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.
Accredo also has supply agreements with biopharmaceutical manufacturers. In addition,
Accredo’s supplier agreements may provide that during the term of the agreements, it will not
distribute any competing products, or it may be limited in the types of services that it can
provide with regard to competing products. In addition, our agreements with certain
biopharmaceutical manufacturers may contain minimum purchasing volume commitments. Certain
biopharmaceutical manufacturers may also make certain biopharmaceuticals available to only a
limited number of specialty pharmacies.
Competition
Competition in the PBM industry is widespread. We compete primarily on the basis of our
ability to design and administer innovative programs and services that provide a flexible, high
quality, affordable prescription drug benefit management offering to our clients and their members.
We believe the following factors are critical to our ongoing competitiveness:
We compete with a wide variety of market participants, including national, regional and local
PBMs, Blue Cross/Blue Shield plans, insurance companies, managed care organizations, large retail
chains, large retail stores with in-store pharmacy operations and Internet pharmacies. Our
competitors include many profitable and well-established companies that have significant financial,
marketing and other resources. Some of our specialty pharmacy and clinical service offerings
compete with similar services provided by smaller companies in niche markets. Our main competitors
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include CVS Caremark Corporation, Express Scripts, Inc., CIGNA Corporation, UnitedHealth
Group, WellPoint Health Networks Inc., Aetna Inc., Walgreen Co., Wal-Mart Stores, Inc. and Humana
Inc.
Consolidation within the PBM industry, as well as the acquisition of any of our competitors by
larger companies, may lead to increased competition. We believe, however, that our efficient and
integrated business model, our differentiating clinical programs, and the absence of channel
conflicts in our business model, will enable us to compete effectively.
Corporate Compliance and Government Regulation
Corporate Compliance and Ethics Program
We have always been committed to the highest levels of integrity in our business operations,
insisting on ethical behavior and compliance with statutory, regulatory and other legal
requirements. Medco’s Corporate Compliance and Ethics Program (“Compliance and Ethics Program”) is
designed to maintain a culture at Medco that promotes the prevention, detection and resolution of
potential violations of laws or Company policies. To achieve this goal, we are committed to an
effective compliance and ethics program tailored to our business and working environment. The
Compliance and Ethics Program is dynamic, involving regular review and assessment to ensure that it
is responsive to our changing business strategy and utilizes a broad risk management framework for
planning and decision-making.
The Compliance and Ethics Program supports a broad set of standards of business conduct
designed to reduce the prospect of criminal and other improper conduct and to promote compliance
with federal and state laws and regulations, including statutes, regulations and written directives
of Medicare, Medicaid and all other federal and state programs in which we participate. These
standards are embodied in our Code of Conduct, Conflict of Interest, Use and Disclosure of
Individual Health Information and other key policies. These standards are delivered through our
Standards of Business Conduct, which provide information about the Compliance and Ethics Program
and summarize key policies, and through training to employees and contingent workers regarding the
specific rules, regulations, policies and procedures that must be followed. In addition, the
Compliance and Ethics Program encourages adherence to business unit and departmental procedures
created to effect safe and efficient delivery of our products and services while operating our
business within a compliant environment.
Our Compliance and Ethics Program addresses the following elements of an effective program:
Oversight responsibility for our Compliance and Ethics Program is assigned to our Audit
Committee of the Board of Directors, along with our Corporate Compliance Committee, consisting of
members of senior management. Our Corporate Compliance Officer has day-to-day responsibility for
ensuring that we maintain an effective compliance and ethics program.
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Employees are encouraged to raise concerns about improper, illegal, or unethical conduct, as
well as specific instances of non-compliance. Our Compliance and Ethics Office is an available
resource, either directly or via the Compliance and Ethics Line, for all employees to report
compliance concerns or to raise questions about any business practices. Other reporting mechanisms
are available through the Accredo Compliance Office, the PolyMedica Compliance Office, the Medicare
Compliance Office or the Privacy Office. Once raised, we immediately review, investigate, and
resolve all concerns about non-compliant behavior. Reports to these lines are reported through the
Corporate Compliance Officer in a consolidated presentation to the Corporate Compliance Committee
and the Audit Committee.
Government Regulation
Federal and state laws and regulations govern many aspects of our business: our administration
of prescription drug benefits and our drug and health education programs and services; the
activities of our mail-order pharmacies; the provision of nursing services; and the operations of
laboratories. We believe we are in substantial compliance with all existing legal and regulatory
requirements material to the operation of our business. We have standard operating procedures and
controls designed to 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,
and we take prompt corrective and disciplinary action when appropriate. However, 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 and the application of complex standards to the operation of our
business creates areas of uncertainty.
Among the federal and state laws and regulations that affect aspects of our business are the
following:
Regulation of Our Pharmacy, Nursing, Home Health Agency, and Laboratory Operations. Our
mail-order pharmacies deliver prescription drugs and supplies to individuals in all 50 states. The
practice of pharmacy is generally regulated at the state level by state boards of pharmacy. Each of
our dispensing pharmacies, prescription processing centers and call center pharmacies must be
licensed in the state in which it is located. In some of the states where our dispensing pharmacies
are located, state regulations require compliance with standards promulgated by the United States
Pharmacopeia (“USP”). The USP creates standards in the packaging, storage and shipping of
pharmaceuticals. Also, many of the states where we deliver pharmaceuticals, including 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. In addition, some states have
proposed laws to regulate online pharmacies, and we may be subject to this legislation if it is
passed. Furthermore, those of our pharmacies that dispense durable medical equipment items, such
as infusion pumps, and that bear a federal legend requiring dispensing pursuant to a prescription,
are also regulated by applicable state and federal durable medical equipment laws.
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 (Food and Drug Administration) inspects
facilities in connection with procedures to effect recalls of prescription drugs. The FTC (Federal
Trade Commission) also has requirements for mail-order sellers of goods. The U.S. Postal Service
(“USPS”) 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-order operations. The USPS
historically has exercised this statutory authority only with respect to controlled substances. If
the USPS 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. The
Department of Transportation has regulatory authority to impose restrictions on drugs inserted in
the stream of commerce. These regulations generally do not apply to the USPS and its operations.
In addition, in those states that require home health or nursing licensure to provide in-home
patient education or in-home administration of the pharmaceuticals we dispense, we are also
regulated by those states’ Department of Health. Some states also require Certificates of Need in
order to be granted home health agency licensure. Finally, our laboratory business is also subject
to state and federal regulations.
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We believe that our operations have the appropriate licenses required under the laws of the
states in which they are located and that we conduct our pharmacy, laboratory and nursing
operations in accordance with the laws and regulations of these states.
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. 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. These
regulations generally require annual or more frequent reporting and licensure renewals and impose
other restrictions or obligations affecting PBM services. We have registered under these laws in
states in which we have concluded, after discussion with the appropriate state agency, that
registration is required.
Consumer Protection Laws. Most states have consumer protection laws designed to ensure that
information provided to consumers is adequate, fair and not misleading. We believe that our
practices conform to the requirements of state consumer protection laws. However, we may be subject
to further scrutiny under these laws as they are often interpreted broadly.
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. We will admit any licensed pharmacy
that meets our network’s terms, conditions and credentialing criteria.
Proposals for Direct Regulation of PBMs. Legislation directly regulating PBM activities in a
comprehensive manner has been introduced in a number of states. 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. Maine and the District of Columbia have each
enacted a statute imposing fiduciary and disclosure obligations on PBMs.
ERISA Regulation. We provide PBM services to a number of different corporations and other
sponsors of health plans. These plans are subject to ERISA (the Employee Retirement Income Security
Act of 1974), 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 U.S.
Department of Labor (“DOL”) regulations for claims payment and member appeals.
In addition, the DOL has recently issued proposed regulations under the provisions of ERISA
that regulate plan contracts with service providers, including PBMs. The proposed regulations
mandate specific disclosure by service providers. Failure to comply with the regulations could
also result in a prohibited transaction. The DOL is soliciting comments on the proposed
regulations and we anticipate that they will change before they are finalized. As a result, we are
not yet able to assess the impact on our business. We will comply with the regulations when they
are finalized.
A number of lawsuits have been filed against us, 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. For further information on this litigation and the proposed
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settlement, see Note 14, “Commitments and Contingencies,” to our consolidated financial
statements included in Part II, Item 8 of this Annual Report on Form 10-K.
Fraudulent Billing, Anti- Kickback, Stark, Civil Monetary Penalties, and False Claims Laws and
Regulations.
Billing. Our operations participate in federal and state programs such as Medicare and
Medicaid, where we are subject to extensive government regulation including numerous state and
federal laws and corresponding regulations directed at preventing fraud and abuse and regulating
reimbursement. The government’s Medicare and Medicaid regulations are complex and sometimes
subjective and therefore may require management’s interpretation. Our compliance with Medicare and
Medicaid regulations may be reviewed by federal or state agencies, including the United States
Department of Health and Human Services’ Office of the Inspector General (“OIG”), CMS, the
Department of Justice (“DOJ”), and the FDA. To ensure compliance with Medicare, Medicaid and other
regulations, government agencies conduct periodic audits of us to ensure compliance with various
supplier standards and billing requirements. Similarly, regional health insurance carriers
routinely conduct audits and request patient records and other documents to support claims
submitted by us for payment.
Anti-Kickback Laws and Regulations. 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, which
impose anti-kickback prohibitions on services not covered by federal healthcare programs.
Anti-kickback laws vary between states, and courts have rarely interpreted them.
Courts, the OIG, and some administrative tribunals have broadly interpreted the federal
anti-kickback statute and regulations. 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. It is possible that our practices in the commercial sector may not be appropriate in the
government payor sector.
The Ethics in Patient Referrals Law (Stark Law). Federal law prohibits physicians from
making a referral for certain health items or services if they, or their family members, have a
financial relationship with the entity receiving the referral. No bill may be submitted in
connection with a prohibited referral. Violations are punishable by civil monetary penalties upon
both the person making the referral and the provider rendering the service. Such persons or
entities are also subject to exclusion from Medicare and Medicaid. Many states have adopted laws
similar to the Stark Law, which restrict the ability of physicians to refer patients to entities
with which they have a financial relationship.
The False Claims Act. The Federal False Claims Act 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.
Civil monetary penalties may be assessed for many types of conduct, including conduct that is
outlined in the statutes above and other federal statutes in this section. Under the Deficit
Reduction Act of 2005 (“DRA”), states are encouraged to pass State False Claims Act laws similar to
the Federal statute.
Sanctions for fraudulent billing, kickback violations, Stark’s law violations or violations of
the False Claims Act include criminal or civil penalties. If we are found to have violated any
state or federal kickback, Stark’s or False Claims Act law, we could be liable for significant
damages, fines or penalties and potentially be ineligible to participate in federal payor programs.
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Regulation of Financial Risk Plans. We own two insurance companies: Medco Containment Life
Insurance Company (“Life”) and Medco Containment Insurance Company of New York (“NY”). On a
combined basis, these subsidiary insurance companies are licensed in 49 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. Since 2006, the Life and NY companies 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 Congress, or (ii) enhanced coverage, on behalf
of certain clients, which exceeds the standard drug benefit in exchange for additional premiums.
Historically, a client would occasionally seek to limit their exposure in providing
prescription drug benefits. In these instances, we would utilize our insurance company
subsidiaries in providing “stop-loss” insurance to limit their risk under a fee-for-service drug
plan. This activity was 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 over the past several years. At the federal level,
Congress enacted 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 payors (“Privacy Standards”). Our pharmacy
operations are covered entities, which are directly subject to these requirements. In our role as a
manager of the prescription benefit, we are a business associate of health plan clients which are
covered entities subject to the Privacy Standards. Additionally, regulation of the use of patient
identifiable information is likely to increase. Congress is currently reviewing proposals that
would alter HIPAA, which would create additional administrative burdens. Many states have passed
or are considering laws addressing 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.
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 regulations.
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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Legislation and Regulation Affecting Drug Prices and Potentially Affecting the Market for
Prescription Benefit Plans and Reimbursement for Durable Medical Equipment. Recently, the federal
government has increased its focus on methods drug manufacturers employ to 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 DOJ 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.
The DRA revised the formula used by the federal government to set the Federal Upper Limit
(FUL) for multiple source drugs by adopting 250 percent of the average manufacturer’s price (“AMP”)
without regard to customary prompt pay discounts to wholesalers for the least costly therapeutic
equivalent. On July 17, 2006, HHS published a Final Rule for the Medicaid Prescription Drug
Program implementing the DRA in which AMP was defined to exclude discounts and rebates to PBMs and
include sales to mail-order and specialty pharmacies in the AMP calculation by manufacturers.
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. They could also impact the
reimbursement our specialty pharmacies receive from government payors. In addition, they may affect
our relationships with pharmacies and health plans. In some circumstances, they might also impact
the reimbursement that we receive 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 payors 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.
Relative to our durable medical equipment operations, The Medicare Prescription Drug,
Improvement and Modernization Act of 2003 (P.L. 108-173) (the “Act”), established a program for the
competitive acquisition of certain covered items of durable medical equipment, prosthetics,
orthotics and supplies (“DMEPOS”). Diabetes testing supplies, including test strips and lancets,
which are commonly supplied via mail-order delivery, will be subject to the competitive acquisition
program. Only qualified suppliers that meet defined participation standards specified in the final
rule will be permitted to engage in the competitive acquisition program. In 2010, mail-order
diabetes testing supplies may be subject to a national or regional program, which would require
mail-order suppliers to bid on supplying certain DMEPOS items.
Medicare Part D and Part B. The Act also offers far-reaching changes to the Medicare program.
Important to us, the Act established a new Medicare Part D outpatient prescription drug benefit for
over 40 million Americans who are eligible for Medicare. Qualified beneficiaries, including senior
citizens and disabled individuals, have had the opportunity to enroll in Medicare Part D since
January 1, 2006.
Medco has been approved by CMS to participate in the Medicare Part D program as a national PDP
sponsor, and we are also a provider of prescription drugs and diabetes supplies to those of our
Medicare Part B patients who are also eligible for prescription drug coverage under the Medicare
Part D program. In addition, we have been supporting a significant number of Medco clients who have
elected to continue to offer a prescription drug benefit to their Medicare-eligible members as
primary coverage outside of the Medicare Part D benefit and receive a government subsidy.
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Furthermore, we support our clients with their Medicare Advantage programs that now include
the Medicare Part D benefit, and with their PDP programs as the pharmacy benefit manager.
State Prescription Drug Assistance Programs. Many states have expanded state prescription drug
assistance programs to increase access to drugs by those currently without coverage and/or
supplement the Medicare Part D benefit of those with coverage to offer options for a seamless
benefit. In accordance with applicable CMS requirements, we have entered into agreements with a
number of state prescription drug assistance programs and collaborated to coordinate benefits with
Medicare Part D plans. This endeavor supports the coordination of benefits of our clients’ Medicare
Part D offerings.
Prompt Pay Regulations. Many states have adopted prompt pay regulations that require health
plans to pay or deny claims within a certain timeframe. These laws apply to insurers and/or HMOs.
Medco currently pays pharmacies on an established two-week cycle basis as defined in the
Participating Pharmacy Agreement. Pharmacies receive payment within 26 days for 100% of successful
point-of-sale (POS) claims processed in a two-week cycle. Medco has a capability for off-cycle
payment to pharmacy providers due to prompt pay laws which accommodates those clients who desire
payment more often than the established two-week cycle.
Drug Importation. In the face of escalating costs for plan sponsors providing a prescription
drug benefit for their employees, and uninsured individuals seeking to lower their drug costs, the
issue of importing drugs from Canada or other foreign countries has received significant attention.
Drug importation, sometimes called drug re-importation, occurs when prescription medicines from
other countries are imported for personal use or commercial distribution. Our clients have
expressed interest in the potential for drug importation to reduce their drug benefit costs.
Individual importation activities are generally prohibited under U.S. law, and the FDA has issued
warnings and safety alerts to a number of entities seeking to promote or facilitate systematic
importation activities. However, there has been considerable legislative and political activity
seeking to change the FDA requirements to enable drug importation, and we are evaluating
appropriate actions if such legislation were to be enacted.
Health Management Services Regulation. All states regulate the practice of medicine and the
practice of nursing. We believe our nurses in our specialty pharmacy business are properly licensed
in the state in which they practice. We believe that the activities undertaken by specialty
pharmacy nurses comply with all applicable laws or rules governing the practice of nursing or
medicine. However, a federal or state regulatory authority may assert that some services provided
by a PBM 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 29, 2007, we had approximately 19,900 full-time employees and approximately 900
part-time employees. Approximately 33% of our employees are represented by labor organizations.
Collective bargaining agreements covering these employees expire at various dates through December
2010. Four collective bargaining agreements with various labor organizations will expire in 2008,
including the agreements at our Willingboro, New Jersey and Las Vegas, Nevada pharmacies.
Approximately 5,600 employees at our facilities in Florida, Washington, Nevada, New Jersey, Ohio,
Pennsylvania, and Texas are subject to collective bargaining with the United Steel, Paper and
Forestry, Rubber, Manufacturing, Energy, Allied Industrial & Service Workers International Union,
AFL-CIO (American Federation of Labor — Congress of Industrial Organizations); approximately 640
employees primarily at our Nevada call center are covered by collective bargaining agreements with
the Retail, Wholesale and Department Store Union, U.F.C.W. (United Food and Commercial Workers);
approximately 300 pharmacists at our Columbus, Ohio pharmacy are represented by the Association of
Managed Care Pharmacists; approximately 240 pharmacists at our Willingboro, New Jersey and Las
Vegas, Nevada pharmacies are represented by the Guild for Professional Pharmacists; and
approximately 100 maintenance and quality response technicians at our Willingboro, New Jersey
pharmacy are represented by the International Union of Operating Engineers, AFL-CIO. We consider
our relations with our employees and their unions to be good. Accredo, PolyMedica and Critical Care
employees are not represented by a labor union.
Available Information
Medco files annual, quarterly and current reports, proxy and information statements and other
information with the United States Securities and Exchange Commission (“SEC”). You may read and
copy any document Medco files with the
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SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW., Washington, DC 20549. You may
obtain information regarding the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. The SEC maintains an Internet site that contains annual, quarterly and current
reports, proxy and information statements and other information regarding issuers that file
electronically with the SEC. Medco’s electronic SEC filings are available to the public at
http://www.sec.gov.
Medco’s SEC filings are also available to the public through The New York Stock Exchange
(“NYSE”), 20 Broad Street, New York, New York 10005. Medco’s common stock is listed on the NYSE
and trades under the symbol “MHS.”
Medco’s public Internet site is http://www.medco.com. Medco makes available free of charge,
through the Investor Relations page of its Internet site (www.medco.com/investor), its annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to
those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act
of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after it electronically
files such material with, or furnishes it to, the SEC. Medco also makes available, through the
Investor Relations page of its Internet site, statements of beneficial ownership of Medco’s equity
securities filed by its directors, officers, 10% or greater shareholders and others under Section
16 of the Exchange Act. In addition, Medco currently makes available on the Investor Relations page
of its Internet site, its most recent proxy statement and its most recent annual report to
stockholders.
Information contained on Medco’s Internet site, or that can be accessed through its Internet
site, does not constitute a part of this Annual Report on Form 10-K. Medco has included its
Internet site address only as an inactive textual reference and does not intend it to be an active
link to its Internet site. Our corporate headquarters are located at 100 Parsons Pond Drive,
Franklin Lakes, New Jersey 07417 and the telephone number at that location is (201) 269-3400.
The certifications of our Chief Executive Officer and Chief Financial Officer required under
Section 302 of the Sarbanes-Oxley Act have been filed as Exhibits 31.1 and 31.2 to this report.
Additionally, in 2007 our Chief Executive Officer submitted a Section 303A.12 (a) CEO Certification
to the NYSE certifying that he was not aware of any violation by the Company of the NYSE’s
corporate governance listing standards.
Stock Split
On November 29, 2007, we announced that our Board of Directors approved 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 have been retrospectively adjusted to reflect the January 24, 2008 two-for-one stock split.
Our total authorized common stock and par value of the common stock were unchanged by this action.
For more information, 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.
Item 1A. Risk Factors.
This Annual Report on Form 10-K contains “forward-looking statements” as that term is defined
in the Private Securities Litigation Reform Act of 1995. These statements involve risks and
uncertainties that may cause results to differ materially from those set forth in the statements.
No forward-looking statement can be guaranteed, and actual results may differ materially from those
projected. We undertake no obligation to publicly update any forward-looking statement, whether as
a result of new information, future events, or otherwise. Forward-looking statements are not
historical facts, but rather are based on current expectations, estimates, assumptions and
projections about the business and future financial results of the PBM and specialty pharmacy
industries, and other legal, regulatory and economic developments. We use words such as
“anticipates,” “believes,” “plans,” “expects,” “projects,” “future,” “intends,” “may,” “will,”
“should,” “could,” “estimates,” “predicts,” “potential,” “continue” and similar expressions to
identify these forward-looking statements. Our actual results could differ materially from the
results contemplated by these forward-looking statements due to a number of factors, including
those discussed in this Item 1A, “Risk Factors,” Item 7, “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” and other sections of this Annual Report on Form
10-K.
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Competition in the PBM, specialty pharmacy and the broader healthcare industry is intense and could
impair our ability to attract and retain clients.
Competition in the PBM industry is widespread. We compete with a wide variety of market
participants, including national, regional and local PBMs, Blue Cross/Blue Shield plans, insurance
companies, managed care organizations, large retail chains, large retail stores with in-store
pharmacy operations and Internet pharmacies. Our competitors include many profitable and
well-established companies that have significant financial, marketing and other resources. Some of
our specialty pharmacy and clinical service offerings compete with similar services provided by
smaller companies in niche markets. Our main competitors include CVS Caremark Corporation, Express
Scripts, Inc., CIGNA Corporation, UnitedHealth Group, WellPoint Health Networks Inc., Aetna Inc.,
Walgreen Co., Wal-Mart Stores, Inc. and Humana Inc.
We compete based on innovation and service, as well as on price. To attract new clients and
retain existing clients, we must continually develop new products and services to assist clients in
managing their pharmacy benefit programs. We may not be able to develop innovative products and
services, including new Medicare Part D offerings, which are attractive to clients. Moreover,
although we need to continue to expend significant resources to develop or acquire new products and
services in the future, we may not be able to do so. We cannot be sure that we will continue to
remain competitive, nor can we be sure that we will be able to market our PBM services to clients
successfully at our current levels of profitability.
Consolidation within the PBM industry, as well as the acquisition of any of our competitors by
larger companies, may lead to increased competition.
Failure to retain key clients could result in significantly decreased revenues and could harm our
profitability.
Our largest client, UnitedHealth Group, represented approximately $9,900 million, or 22%, of
our net revenues during 2007. Our current agreement with UnitedHealth Group has an initial term
ending December 31, 2009 and, at UnitedHealth Group’s option, may be extended for two additional
years ending December 31, 2011. The UnitedHealth Group account has much lower mail-order
penetration and, because of its size, much steeper pricing than the average client, and
consequently generates lower profitability than typical client accounts. Although none of our other
clients individually represented more than 10% of our net revenues in 2007, our top 10 clients as
of December 29, 2007, including UnitedHealth Group, represented approximately 45% of our net
revenues during 2007.
Our larger clients frequently distribute requests for proposals and seek bids from other PBM
providers, as well as us, before their contracts with us expire. In addition, a client that is
involved in a merger or other business combination with a company that is not a client may not
renew, and in some instances may terminate, its PBM contract with us.
If several of our large clients terminate, cancel or do not renew their agreements with us or
stop contracting with us for some of the services we provide because they accept a competing
proposal or because they are involved in a merger or acquisition, and we are not successful in
generating new sales with comparable operating margins to replace the lost business, our revenues
and results of operations could suffer.
If we do not continue to earn and retain purchase discounts and rebates from manufacturers at
current levels, our gross margins may decline.
We have contractual relationships with pharmaceutical manufacturers or wholesalers that
provide us with purchase discounts on drugs dispensed from our mail-order pharmacies and rebates on
brand-name prescription drugs dispensed through mail order and retail. These discounts and rebates
are generally passed on to clients in the form of steeper price discounts and rebate pass-backs.
Manufacturer rebates often depend on our ability to meet contractual market share or other
requirements. Pharmaceutical manufacturers have also increasingly made rebate payments dependent
upon our agreement to include a broad array of their products in our formularies.
Competitive pressures in the PBM industry have also caused us and many other PBMs to share
with clients a larger portion of the rebates received from pharmaceutical manufacturers and to
increase the discounts offered to clients.
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Changes in existing federal or state laws or regulations or in their interpretation by courts
and agencies or the adoption of new laws or regulations relating to patent term extensions,
purchase discount and rebate arrangements with pharmaceutical manufacturers, as well as some of the
formulary and other services we provide to pharmaceutical manufacturers, could also reduce the
discounts or rebates we receive and adversely impact our business, financial condition, liquidity
and operating results.
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.
In October 2007, we acquired all of the outstanding common stock of PolyMedica and on November
14, 2007, we acquired Critical Care. PolyMedica is a leading provider of diabetes care, under its
Liberty brand, including blood glucose testing supplies and related services. Critical Care is one
of the nation’s largest providers of specialty infusion services for home-based and ambulatory
settings. In order to realize the intended benefits of the PolyMedica and Critical Care
acquisitions, or any acquisition we make in the future, we must effectively integrate these
businesses and any future acquired business into ours. We may not be able to successfully
integrate acquired businesses into ours. If we fail to successfully integrate these acquisitions
or if they fail to perform as we anticipated, our existing businesses and our revenue and operating
results could be adversely affected. If the due diligence of the operations of these acquired
businesses performed by us or by third parties on our behalf were inadequate or flawed, or if we
later discover unforeseen financial or business liabilities, the acquired businesses may not
perform as expected. Operating costs, customer loss and business disruption (including
difficulties in maintaining relationships with employees, customers, clients or suppliers) may be
greater than we anticipated. Finally, difficulties assimilating acquired operations and products
into ours could result in the diversion of capital and management’s attention away from other
business issues and opportunities.
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.
We are subject to numerous federal and state regulations. If we fail to comply with existing
or future applicable laws and regulations, we could suffer civil or criminal penalties, including
the loss of our licenses to operate our mail-order pharmacies and our ability to participate in
federal and state healthcare programs. As a consequence of the severe penalties we could face, we
must devote significant operational and managerial resources to complying with these laws and
regulations. Although we believe that we are substantially compliant with all existing statutes and
regulations applicable to our business, different interpretations and enforcement policies of these
laws and regulations could subject our current practices to allegations of impropriety or
illegality, or could require us to make significant changes to our operations. In addition, we
cannot predict the impact of future legislation and regulatory changes on our business or ensure
that we will be able to obtain or maintain the regulatory approvals required to operate our
business.
Government efforts to reduce healthcare costs and alter healthcare financing practices could lead
to a decreased demand for our services or to reduced profitability.
During the past several years, the U.S. healthcare industry has been subject to an increase in
governmental regulation at both the federal and state levels. Efforts to control healthcare costs,
including prescription drug costs, are underway at the federal and state government levels.
Congress frequently considers proposals to reform the U.S. healthcare system. These proposals may
increase governmental involvement in healthcare and PBM services and may otherwise change the way
our clients conduct business. Healthcare organizations may react to these proposals and the
uncertainty surrounding them by reducing or delaying the purchase of our PBM services, and
manufacturers may react by reducing rebates or reducing supplies of certain products. These
proposals could lead to a decreased demand for our services or to reduced rebates from
manufacturers.
In addition, both Congress and state legislatures are expected to consider legislation to
increase governmental regulation of managed care plans. Some of these initiatives would, among
other things, require that health plan members have greater access to drugs not included on a
plan’s formulary and give health plan members the right to sue their health plans for malpractice
when they have been denied care. The scope of the managed care reform proposals under
consideration by Congress and state legislatures and enacted by states to date vary greatly, and we
cannot predict the
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extent of future legislation. However, these initiatives could limit our business practices
and impair our ability to serve our clients.
Failure to execute our Medicare Part D prescription drug benefits strategy could adversely impact
our business and financial results.
Our agreements with CMS, as well as applicable Medicare Part D regulations and federal and
state laws, impose numerous requirements on us. 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.
In time, the Medicare Part D prescription benefit could have the effect of rendering existing
pharmacy benefit plans less valuable to beneficiaries and reduce the total market for PBM services.
In addition, some of our clients could decide to discontinue providing prescription drug benefits
to their Medicare-eligible members. If this occurs, the adverse effects of the Medicare Part D
benefit may outweigh any opportunities for new business generated by the new benefit. We are not
yet able to assess the long-term impact that Medicare Part D will have on our clients’ decisions to
continue to offer a prescription drug benefit to their Medicare-eligible members. Although we have
been approved by CMS as a national Medicare Part D prescription drug plan sponsor, we are not yet
in a position to predict the long-term impact of such participation on our business, financial
condition or results of operations.
The growth of our Medicare Part D business is an important component of our business strategy
and, accordingly, we have made substantial investments in the service personnel and technology
necessary to administer that business. Any failure to achieve growth in our Medicare Part D
business may have an adverse effect on our financial position, results of operations or cash flows.
PBMs could be subject to claims under ERISA if they are found to be a fiduciary of a health benefit
plan governed by ERISA.
PBMs typically provide services to corporations and other sponsors of health benefit plans.
These plans are subject to ERISA (the Employee Retirement Income Security Act of 1974), which
regulates employee pension benefit plans and employee welfare benefit plans, including health and
medical plans. The U.S. Department of Labor (“DOL”), which is the agency that enforces ERISA, could
assert that the fiduciary obligations imposed by the statute apply to some or all of the services
provided by a PBM. We are party to several lawsuits that claim we are a fiduciary under ERISA. See
Note 14, “Commitments and Contingencies,” to our consolidated financial statements included in Part
II, Item 8 of this Annual Report on Form 10-K. If a court were to determine, in litigation brought
by a private party or in a proceeding arising out of a position taken by the DOL, that we were a
fiduciary in connection with services we provide, we could potentially be subject to claims for
breaching fiduciary duties and/or entering into certain “prohibited transactions.”
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 party to various legal proceedings and are subject to material litigation risks. The
material legal proceedings to which Medco is a party are described in detail in Note 14,
“Commitments and Contingencies,” to our consolidated financial statements included in Part II, Item
8 of this Annual Report on Form 10-K. Although we believe we have meritorious defenses in each of
the matters described therein, we could in the future incur judgments or enter into settlements of
claims that could have a material adverse effect on our business, financial condition, liquidity
and results of operations in any particular period.
We are subject to corporate integrity agreements and noncompliance may impede our ability to
conduct business with the federal government.
As part of a civil settlement with the Department of Justice (“DOJ”) and other federal
government agencies, in October 2006, Medco entered into a five-year corporate integrity agreement
with the United States Department of Health and Human Services’ Office of the Inspector General
(“OIG”) and the U.S. Office of Personnel Management Office of
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Inspector General. On November 8, 2004, prior to our ownership, PolyMedica entered into a
five-year corporate integrity agreement as part of a civil settlement with the DOJ and the OIG.
Failure to comply with the obligations of these corporate integrity agreements could result in
debarment from participation in certain federal business arrangements, financial penalties and
damage to Medco’s reputation.
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.
Many of our products and services rely on our ability to use patient identifiable information
in various ways. In addition to electronically reviewing hundreds of millions of prescriptions each
year, we collect and process confidential information through many of our programs and alliances,
including RationalMed and point-of-care initiatives. There is currently substantial regulation at
the federal and state levels addressing the use and disclosure of patient identifiable medical and
other information. Sanctions for failing to comply with standards issued pursuant to state or
federal statutes or regulations include criminal penalties and civil sanctions. See Item 1,
“Business—Government Regulation” above. These and future regulations and legislation that severely
restrict or prohibit our use of patient identifiable medical and other information could limit our
ability to use information that is critical to the operation of our business. If we violate a
patient’s privacy or 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.
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.
We derive a substantial percentage of our specialty pharmacy segment revenue and profitability
from our relationships with Biogen Idec, Inc., Genzyme Corporation, GlaxoSmithKline, Inc.,
MedImmune, Inc., Genentech, Inc. and Baxter Healthcare Corporation. The majority of the IVIG
(intravenous immunoglobulin) and blood clotting factor products dispensed through our specialty
pharmacy business was purchased from Baxter Healthcare Corporation.
Our agreements with these suppliers may be short-term and cancelable by either party without
cause on 60 to 365 days prior notice. These agreements may limit our ability to distribute
competing drugs, or provide services related to competing drugs, during the term of the agreement,
while allowing the supplier to distribute through channels other than us. Further, these agreements
provide that pricing and other terms of these relationships be periodically adjusted for changing
market conditions or required service levels. Any termination or modification to any of these
relationships could have an adverse effect on a portion of our business, financial condition and
results of operations.
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 segment focuses on a limited number of complex and expensive drugs that
serve small patient populations. Due to the limited patient populations that use the drugs that
our specialty pharmacy business handles, our future growth is dependent on expanding our base of
drugs. Further, a loss of patient base or reduction in demand for any reason of the drugs we
currently handle could have a material adverse effect on a significant portion of our specialty
pharmacy business, financial condition and results of operations.
Our specialty pharmacy business, Medicare Part D offerings and certain revenues from diabetes
testing supplies expose us to increased credit risk.
Our specialty pharmacy business is funded through medical benefit coverage, the majority of
which is provided by private insurers, as well as reimbursement by government agencies. These
specialty pharmacy claims are generally for very high-priced medicines, and collection of payments
from insurance companies, members and other payors generally takes substantially longer than for
those claims administered through a PBM benefit. Because of the high cost of these claims, and the
nature of the medical benefit coverage determination process, these accounts receivable are
characterized by higher risk in collecting the full amounts due.
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Our Medicare Part D product offering requires premium payments from members for the ongoing
benefit, as well as amounts due from CMS. As a result of the demographics of the consumers covered
under the program and the complexity of the calculations for amounts due from CMS, these accounts
receivable are subject to realization risk in excess of what is experienced in the core PBM
business.
Revenues
from the sale of diabetes testing supplies under the Liberty brand depend on the continued
availability of reimbursement by government and private insurance plans. The government’s Medicare
regulations are complex and as a result, the collection process is time consuming and typically
involves the submission of claims to multiple payors whose payment of claims may be contingent upon
the payment of another payor. Because of the coordination with multiple payors and the complexity
in determining reimbursable amounts, these accounts receivable have higher risk in collecting the
full amounts due.
As a result of these risks, we may be required to record bad debt expenses that may impact
results of operations and liquidity.
Changes in industry pricing benchmarks could adversely affect our financial performance.
Contracts in the prescription drug industry generally use certain published benchmarks to
establish pricing for prescription drugs. These benchmarks include average wholesale price, which
is referred to as “AWP,” average selling price, which is referred to as “ASP,” and wholesale
acquisition cost, which is referred to as “WAC.” Most of Medco’s PBM client contracts currently
utilize the AWP standard.
Recent events have raised uncertainties as to whether payors, pharmacy providers, PBMs and
others in the prescription drug industry will continue to utilize AWP as it has previously been
calculated, or whether other pricing benchmarks will be adopted for establishing prices within the
industry. Specifically, in the proposed settlement in the case of New England Carpenters Health
Benefits Fund, et al. v. First DataBank, et al., a civil class action case brought against McKesson
Corporation and First DataBank (“FDB”), which is one of several companies that report data on
prescription drug prices, FDB had agreed to reduce the reported AWP of certain drugs by four
percent at a future time as contemplated by the settlement. In January 2008, the court declined to
approve this settlement, although a revised settlement may be submitted to the court. Over 90% of
Medco’s client contracts contain terms that Medco believes will enable it to mitigate any adverse
effects of this kind of settlement.
Legislation may lead to changes in the pricing for Medicare and Medicaid programs. See Item
1, “Business—Government Regulation—Legislation and Regulation Affecting Drug Prices and
Potentially Affecting the Market for Prescription Benefit Plans and Reimbursement for Durable
Medical Equipment,” above. At least one Medicaid program has adopted, and other Medicaid programs,
some states and some commercial payors may adopt, those aspects of the Act that either result in or
appear to result in price reductions for drugs covered by such programs. Adoption of ASP in lieu of
AWP as the measure for determining reimbursement by state Medicaid programs for the drugs sold in
our specialty pharmacy business could materially reduce the revenue and gross margins of this
business.
The terms and covenants relating to our existing indebtedness could adversely impact our financial
performance.
Like other companies that incur debt, we are subject to risks normally associated with debt
financing, such as the insufficiency of cash flow to meet required debt service payment obligations
and the inability to refinance existing indebtedness. Our credit facilities, accounts receivable
financing facility and the indenture governing our senior notes contain customary restrictions,
requirements and other limitations on our ability to incur indebtedness, including a maximum total
debt-to-EBITDA ratio. Our continued ability to borrow under our credit facilities and accounts
receivable financing facility is subject to our compliance with such financial and other covenants.
If we fail to satisfy these covenants, we would be in default under the credit facilities,
accounts receivable financing facility and/or indenture, and may be required to repay such debt
with capital from other sources. Under such circumstances, other sources of capital may not be
available to us, or be available only on unattractive terms.
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In addition, as of December 29, 2007, we had outstanding borrowings of approximately $3.2
billion that are impacted by variable interest rates. Increases in interest rates on variable rate
indebtedness would increase our interest expense and could adversely affect our results of
operations.
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 dispense significant volumes of brand-name and generic drugs from our mail-order pharmacies
and through our network of retail pharmacies. These volumes are the basis for our net revenues and
profitability. When increased safety risk profiles of specific drugs or classes of drugs result in
utilization decreases, physicians may cease writing or reduce the numbers of prescriptions written
for these drugs. Additionally, negative press regarding drugs with higher safety risk profiles may
result in reduced consumer demand for such drugs. On occasion, products are withdrawn by their
manufacturers. In cases where there are no acceptable prescription drug equivalents or
alternatives for these prescription drugs, our volumes, net revenues, profitability and cash flows
may decline.
We may be subject to liability claims for damages and other expenses that are not covered by
insurance.
Our product and professional liability insurance policies are expected to cover individual
claims of up to $85 million. Because of the difficulty in obtaining commercial insurance coverage,
as well as its high cost, our retained liability has been established at levels that require
certain self-insurance reserves to cover potential claims. We currently process any claims that
are included in self-insured retention levels through a captive insurance company. A successful
product or professional liability claim in excess of our insurance coverage could harm our
financial condition and results of operations. We believe that the claims described in Note 14,
“Commitments and Contingencies,” to our consolidated financial statements included in Part II, Item
8 of this Annual Report on Form 10-K are unlikely to be 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 are dependent on our infrastructure, including our information systems, for many aspects of
our business operations. A fundamental requirement for our business is the secure storage and
transmission of personal health information and other confidential data. Our business and
operations may be harmed if we do not maintain our business processes and information systems, and
the integrity of our confidential information. Although we have developed systems and processes
that are designed to protect information against security breaches, failure to protect such
information or mitigate any such breaches may adversely affect our operations. Malfunctions in our
business processes, breaches of our information systems or the failure to maintain effective and
up-to-date information systems could disrupt our business operations, result in customer and member
disputes, damage our reputation, expose us to risk of loss or litigation, result in regulatory
violations, increase administrative expenses or lead to other adverse consequences.
Currently, our automated pharmacies in Willingboro, New Jersey and Las Vegas, Nevada together
dispense over 90% of our mail-order prescriptions. Our data center, located in Fair Lawn, New
Jersey, provides primary support for all applications and systems required for our business
operations, including our integrated prescription claims processing, billing, communications and
mail-order systems. These facilities depend on local infrastructure and on the uninterrupted
operation of our computerized dispensing systems and our electronic data processing systems.
Significant disruptions at any of these facilities due to failure of our technology or any other
failure or disruption to these systems or to the infrastructure due to fire, electrical outage,
natural disaster, acts of terrorism or malice or some other catastrophic event could, temporarily
or indefinitely, significantly reduce, or partially or totally eliminate, our ability to process
and dispense prescriptions and provide products and services to our clients and members.
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.
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We have over $2.9 billion of recorded intangible assets, net, on our consolidated balance
sheet as of December 29, 2007. For our PBM segment, our intangible assets primarily represent the
value of client relationships that was recorded upon our acquisition in 1993 by Merck, and to a
lesser extent, intangible assets recorded upon our acquisition of PolyMedica in 2007, including the
value of the Liberty trade name, which is indefinite-lived, and customer relationships. For our
Specialty Pharmacy segment, we have intangible assets recorded primarily from our acquisition of
Accredo in 2005. Under current accounting rules, definite-lived intangible assets are amortized
over their useful lives. These assets may become impaired with the loss of significant clients or
biopharmaceutical manufacturer contracts. For definite-lived intangible assets, if the carrying
amount of the assets exceeds the undiscounted pre-tax expected future cash flows from the lowest
appropriate asset grouping, we would be required to record a non-cash impairment charge to our
statement of income in the amount the carrying value of these assets exceeds the discounted
expected future cash flows. In addition, while the definite-lived intangible assets may not be
impaired, the useful lives are subject to continual assessment, taking into account historical and
expected losses of relationships that were in the base at time of acquisition. This assessment may
result in a reduction of the remaining weighted average useful life of these assets, resulting in
potentially significant increases to non-cash amortization expense that is charged to our
consolidated statement of income, which could have a material adverse effect on our earnings. Our
indefinite-lived intangible will be reviewed for impairment annually or more frequently if a change
in events warrants such a review by comparing its carrying amount to its fair value. An impairment
charge would be recorded for the excess of the carrying value over the fair value of the
indefinite-lived intangible and this non-cash impairment charge could have a material adverse
effect on our earnings.
We also have recorded goodwill of $6.2 billion on our consolidated balance sheet as of
December 29, 2007. Goodwill is also assessed for impairment annually for each of our segments’
reporting units. This assessment includes comparing the fair value of each reporting unit to the
carrying value of the assets assigned to that reporting unit. If the carrying value of the
reporting unit were to exceed our estimate of fair value of the reporting unit, we would then be
required to estimate the fair value of the individual assets and liabilities within the reporting
unit to ascertain the amount of goodwill impairment. If we determine that our fair value is less
than our book value, we could be required to record a non-cash impairment charge to our statement
of income, which could have a material adverse effect on our earnings.
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.
The majority of our revenues under our Liberty brand depend on the continued availability of
reimbursement by government and private insurance plans. Any reduction in Medicare or other
government program or private plan reimbursements currently available for our products would reduce
our revenues. Without a corresponding reduction in the cost of such products, our profits would
also be reduced. Additionally, our profits could be affected by the imposition of more stringent
regulatory requirements for Medicare or other government program reimbursement or adjustments to
previously reimbursed amounts.
The Act provides for a program for competitive bidding of certain durable medical equipment
items, which includes diabetes testing supplies. Beginning July 1, 2008, diabetes testing supplies
delivered by mail will be bid only in 10 competitive bid areas. CMS intends to expand the entire
competitive bidding program and may specifically implement a national or regional mail-order
program for diabetes testing supplies in 2010, which could affect a substantial portion of
PolyMedica’s diabetes patient base. Only winning mail-order diabetes testing supply bidders will be
allowed to provide competitively bid items by mail to patients whose primary residence is in a
competitively bid area. Competitive bidding could cause our operating results to be negatively
affected through a combination of lower reimbursement rates for competitively bid items and/or our
failure to secure status as a contracted supplier.
The Act provides CMS additional authority, beginning in 2009, to use pricing information it
gathers during the initial competitive bidding phases for the purposes of establishing
reimbursement rates in geographic areas not subject to competitive bidding. CMS intends to issue
further guidance on whether and then how it intends to use this Inherent Reasonableness authority
through the formal rule making process. Our operating results could be negatively affected if CMS
uses this authority to impose lower reimbursement rates in geographic areas that would otherwise
have been excluded from the impact of competitive bidding.
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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.
Our certificate of incorporation and bylaws and various provisions of the DGCL may make it
more difficult to effect a change of control of our company or remove incumbent officers and
directors. The existence of these provisions may adversely affect the price of our common stock,
discourage third parties from making a bid to acquire our company or reduce any premium paid to our
shareholders for their common stock. Our Board of Directors has authority to issue up to 10,000,000
shares of “blank check” preferred stock and to attach special rights and preferences to this
preferred stock. The issuance of this preferred stock may make it more difficult for a third party
to acquire control of us.
Our Board of Directors is divided into three classes as nearly equal in size as possible with
staggered three-year terms. This classification of our Board of Directors could have the effect of
making it more difficult for a third party to acquire our company or of discouraging a third party
from acquiring control of our company because it will generally make it more difficult for
shareholders to replace a majority of the directors. On May 24, 2007, our shareholders approved a
proposal to amend the Company’s certificate of incorporation to de-stagger our Board of Directors
and provide for the phase-in of the annual election of directors over a three-year period, and
therefore all directors will be elected annually beginning at the annual meeting in 2010. In
addition, it is not possible to remove a director except for cause and only by a vote of holders of
at least 80% of the voting power of our outstanding shares of stock.
Additionally, as a result of our ownership of insurance companies, a third party attempting to
effect a change of control of our company may be required to obtain approval from the applicable
state insurance regulatory officials. The need for this approval may discourage third parties from
making a bid for our company or make it more difficult for a third party to acquire our company,
which may adversely affect the price of our common stock.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
As of December 29, 2007, we own or lease 162 facilities throughout the United States. We
believe our facilities are 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 3,500,000 square feet. Our corporate headquarters office is located in Franklin
Lakes, New Jersey and accommodates our executive and corporate functions.
Our mail-order pharmacy operations consist of nine PBM mail-order pharmacies that are located
in various states and dispense drugs throughout the United States. Prescription order processing
activities are performed in six of the pharmacies, and three engage in prescription order
processing and mail-order dispensing. In addition, as a result of our PolyMedica acquisition, we
have two pharmacies that dispense diabetic supplies. We also have three specialty pharmacy
distribution pharmacies and 87 specialty branch pharmacies, including 47 branch pharmacies
associated with our recent acquisition of Critical Care.
In our prescription order processing pharmacies, we receive and record prescriptions including
the use of imaging technologies, conduct clinical reviews, contact physicians to resolve any
questions and then approve and route the prescriptions to one of our dispensing pharmacies. In our
dispensing pharmacies, two of which are our automated pharmacies in Willingboro, New Jersey and Las
Vegas, Nevada, we dispense the medication and then pre-sort for shipment to members by mail or
courier.
The specialty branch pharmacies conduct all prescription order processing and dispensing
functions, and may also include nursing services, walk-in infusion centers and other services
customized for individual patients. We also operate six call center pharmacies with access 24 hours
a day, seven days a week to respond to calls from our clients, their members, retail pharmacists
and physicians.
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Construction will commence in 2008 for a third automated dispensing pharmacy in Indiana, which
is expected to be operational in 2009.
Insurance
We maintain insurance coverage with such deductibles and self-insurance that management
considers adequate for our needs under current circumstances, including product and professional
liability coverage of $85 million per individual claim. Such coverage reflects market conditions
(including cost and availability) existing at the time coverage is written. Because of the
difficulty in obtaining commercial insurance coverage, as well as its high cost, our retained
liability has been established at levels that require certain self-insurance reserves to cover
potential claims. We currently process any claims that are included in self-insured retention
levels through a captive insurance company. Our PBM operations, including, for example, the
dispensing of prescription drugs by our mail-order pharmacies, 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. We
believe that most of the claims described in Note 14, “Commitments and Contingencies,” to our
consolidated financial statements included in Part II, Item 8 of this Annual Report on
Form 10-K are unlikely to be covered by insurance. See Part I, Item 1A, 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.”
Item 3. Legal Proceedings.
In the ordinary course of business, the Company is involved in litigation, claims, government
inquiries, investigations, charges and proceedings, including, but not limited to, those relating
to regulatory, commercial, employment, employee benefits and securities matters. Descriptions of
certain legal proceedings to which the Company is a party are contained in Note 14, “Commitments
and Contingencies—Legal Proceedings,” to our consolidated financial statements included in Part
II, Item 8 of this Annual Report on Form 10-K and are incorporated by reference herein. Such
descriptions include the following recent development:
Contract Litigation. In July 2003, a lawsuit captioned Group Hospitalization and Medical
Services v. Merck-Medco Managed Care, L.L.C., et al. was filed against the Company in the Superior
Court of New Jersey. In this action, the Company’s 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. Following a summary judgment hearing in this matter on November 30,
2007, the judge dismissed the fiduciary duty, consumer fraud, and racketeering claims. On December
21, 2007, the Company and CareFirst Blue Cross Blue Shield agreed in principle to settle this
matter for an immaterial amount.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
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Executive Officers of the Company
The executive officers of the Company, and their ages and positions as of February 14, 2008
are as follows:
Bryan D. Birch has served as Group President, Employer Accounts since March 2006 and is
responsible for all activities related to Medco’s employer clients including sales, account
management, marketing, clinical and pricing areas. This group integrates the oversight of the
National Accounts Group with Systemed, of which Mr. Birch was Group President since July 2003.
Prior to joining the Company, Mr. Birch was Senior Vice President, Chief Sales Officer of
WellChoice, Inc. (formerly known as Empire BlueCross BlueShield) since June 2000. From January 1999
to June 2000, Mr. Birch was an Executive Vice President and Founder of iHealth Technologies, a
claims editing company. Mr. Birch also served as the Chief Executive Officer of Oxford Health
Plans’ Connecticut division from July 1995 to January 1999 and as the Corporate Director of Medical
Delivery for Oxford Health Plans, responsible for all contracting initiatives from August 1992 to
July 1995.
John P. Driscoll has served as President, New Markets since May 2006, and in this role is
responsible for the Company’s Medicare business, consumer-driven programs, insured solutions and
business development. Mr. Driscoll joined the Company in June 2003 as Senior Vice President,
Product and Business Development. Mr. Driscoll came to the Company from Oak Investment Partners, a
venture capital firm, where he served as an advisor on healthcare investments from January 2002
through May 2003. Mr. Driscoll held the position of Executive Vice President of Walker Digital from
January 2000 to December 2001. Mr. Driscoll served in a number of senior positions at Oxford Health
Plans from 1991 through 1999, including, most recently, as its Corporate Vice President, Government
Programs.
Robert S. Epstein, M.D., M.S. has served as the Company’s Senior Vice President, Medical and
Analytical Affairs and Chief Medical Officer since 1997. Dr. Epstein is responsible for formulary
development, clinical guidelines, drug information services and accreditation oversight. He is also
responsible for maintaining automated clinical informatics tools and heads the client and product
analytic and reporting groups. Dr. Epstein joined the Company in 1995 as Vice President of Outcomes
Research. Additionally, Dr. Epstein leads the Personalized Medicine programs. Dr. Epstein was
trained as an epidemiologist and worked in public health and academia before joining the private
sector.
Brian T. Griffin has served as the Company’s Group President, Health Plans since January 2004.
From January 1999 through December 2003 he served as Senior Vice President, Sales and was
responsible for sales on a national basis. From November 1995 to December 1998, Mr. Griffin led the
Insurance Carrier customer group and was responsible for sales
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within the Insurance Carrier Blue Cross/Blue Shield and Third-Party Administrator Markets. Mr.
Griffin joined the Company in 1987.
Kenneth O. Klepper has served as President and Chief Operating Officer since March 2006. He
joined the Company in June 2003 and served as Executive Vice President, Chief Operating Officer
from June 2003 through March 2006. Mr. Klepper oversees the Company’s sales and account groups,
information technology, customer service, pharmacy operations, and Accredo Health Group, Inc., the
Company’s primary specialty pharmacy operating subsidiary. Mr. Klepper came to the Company from
WellChoice, Inc. where he held the position of Senior Vice President, Process Champion from March
1995 to August 1999, and then held the position of Senior Vice President for Systems, Technology
and Infrastructure from August 1999 to April 2003.
Laizer Kornwasser has served as President of Liberty Medical since the Company’s acquisition
of PolyMedica Corporation in October 2007. In addition, Mr. Kornwasser has served as Senior Vice
President, Channel and Generic Strategy since August 2006, and oversees the Company’s mail and
retail channels and generic strategy. Mr. Kornwasser is responsible for developing and executing
generic strategies and optimizing channel distribution to significantly reduce client and member
pharmacy costs. Mr. Kornwasser joined the Company in August 2003, initially serving as Vice
President of Business Development, and later as Senior Vice President of Business Development and
Retail Networks. Prior to joining the Company, Mr. Kornwasser was the founder and Managing Partner
of Edgewood Consulting LLC, a turnaround/strategic advisory firm. Mr. Kornwasser is a director of
the National Bank of California and Bostwick Laboratories.
David S. Machlowitz has served as Senior Vice President and General Counsel since May 2000,
and is responsible for overseeing the Company’s legal affairs. Mr. Machlowitz was appointed as
Secretary in April 2002. Additionally, Mr. Machlowitz’s responsibilities include Government Affairs
and Regulatory Affairs. Mr. Machlowitz joined the Company from Siemens Corporation, a diversified
healthcare, information and electronics technology conglomerate, where he served as Deputy General
Counsel from October 1999 to May 2000. Previously, he served as General Counsel and Corporate
Secretary of Siemens Medical Systems Inc. from April 1992 to October 1998 and as Associate General
Counsel of Siemens Corporation from October 1994 to October 1999. Mr. Machlowitz will retire from
the Company effective March 7, 2008.
Thomas M. Moriarty has served as Senior Vice President, Pharmaceutical Contracting since
September 2007, with responsibility for negotiations with pharmaceutical manufacturers, drug
purchasing analysis and consulting with clients on formulary drug
lists and plan design. He has also served as Senior Vice President, Business Development responsible for mergers and
acquisitions and strategic alliances since August 2006. Prior to
that he was Deputy General Counsel, Vice President and Managing Counsel, responsible for mergers and acquisitions and client
and commercial contracting from December 2005 until August 2006. From November 2002 until December
2005, Mr. Moriarty served as Vice President and Counsel, Client Contracting. Mr. Moriarty joined
the Company in June 2000 as Assistant Counsel, Client Contracting. Prior to joining the Company,
Mr. Moriarty served as Assistant General Counsel, Pharma & North America for Merial Limited (a
Merck & Co., Inc. and Sanofi Aventis Company) and as Assistant Counsel for Merck & Co., Inc. In
March 2008 he will assume the position of General Counsel, Secretary and Senior Vice President,
Pharmaceutical Contracting.
Karin Princivalle has served as Senior Vice President, Human Resources since joining the
Company in May 2001, and is responsible for company-wide human resource activities. Ms. Princivalle
joined the Company from TradeOut.com, an online business-to-business marketplace, where she served
as Vice President for Human Resources from February 2000 to May 2001. Previously, she served as
Vice President of Human Resources for Citigroup’s North America bankcards business from May 1998 to
August 2000 and Vice President of Human Resources for Citigroup’s Consumer Businesses in
Central/Eastern Europe, Middle East, Africa and Asia from March 1997 to May 1998.
JoAnn A. Reed has served as Senior Vice President, Finance since 1992, and Chief Financial
Officer through March 15, 2008. Ms. Reed has oversight responsibility for all financial activities,
including accounting, reporting, treasury, tax, planning, analysis, procurement, audit, investor
relations and financial evaluation. Ms. Reed joined the Company in 1988, initially serving as
Director of Financial Planning and Analysis and later as Vice President/Controller for the
Company’s former subsidiary, PAID Prescriptions, L.L.C. Prior to joining the Company, she worked
for Aetna/American Re-
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Insurance Co., CBS Inc., Standard and Poor’s Corp., and Unisys/Timeplex Inc. Ms. Reed is a
member of the Board of Directors at Waters Corp., American Tower Corp. and the Board of Trustees of
St. Mary’s College of Notre Dame, Indiana. Ms. Reed will retire from her role as Senior Vice
President, Finance and Chief Financial Officer of the Company effective March 15, 2008.
Richard J. Rubino has served as Senior Vice President, Controller and Chief Accounting Officer
since April 2005 and in that role was directly responsible for accounting and financial reporting,
financial systems, and client and pharmaceutical manufacturer accounts receivable. From June 1998
to April 2005, Mr. Rubino served as Vice President and Controller with responsibility for
accounting and financial reporting. His previous roles with the Company include Vice President,
Planning with responsibility for financial, business and strategic planning, and Director of
Planning. Prior to joining the Company, Mr. Rubino held various positions at International Business
Machines Corporation and Price Waterhouse & Co. Mr. Rubino is a Certified Public Accountant and a
member of the American Institute of Certified Public Accountants. Mr. Rubino will assume the role
of Chief Financial Officer and Senior Vice President, Finance in March 2008.
Jack A. Smith has served as Senior Vice President, Chief Marketing Officer since joining the
Company in June 2003 and is responsible for all branding, corporate and product marketing and
communications, medco.com, and related creative and production services. Mr. Smith served as the
Senior Vice President, Chief Marketing Officer for WellChoice, Inc. from August 1999 to November
2002, and was the Senior Vice President, Marketing Director for RR Donnelley & Sons from June 1997
to July 1999. Mr. Smith worked as a consultant for the Gartner Group, an information and consulting
company, during 2003 prior to joining the Company. He has also held marketing positions at The
Readers Digest Association, Inc., Nestle Foods and Unilever.
Glenn C. Taylor has served as Group President, Key Accounts since January 2004. From April
2002 through December 2003, he served as Senior Vice President, Account Management. Mr. Taylor
served as President of the Company’s UnitedHealth Group Division from February 1999 to April 2002.
From April 1997 to January 1999, Mr. Taylor held positions with Merck & Co., Inc. as Regional Vice
President of the Southeast and Central business groups. From May 1993 to March 1997, Mr. Taylor was
the Company’s Senior Vice President of Sales and Account Management. Mr. Taylor joined the Company
in May 1993 as a result of the Company’s acquisition of FlexRx, Inc. a pharmacy benefit manager in
Pittsburgh, Pennsylvania, where Mr. Taylor was President.
Timothy C. Wentworth has served as the President and Chief Executive Officer of Accredo Health
Group, Inc. since March 2006. From January 2004 to March 2006, Mr. Wentworth served as the
Company’s Group President, National Accounts. From April 2002 through December 2003, he served as
Executive Vice President, Client Strategy and Service and was responsible for client relationships
and developing and implementing strategies to acquire and renew clients. Mr. Wentworth joined the
Company as Senior Vice President, Account Management in December 1998 from Mary Kay, Inc., where he
spent five years, serving initially as Senior Vice President of Human Resources and subsequently as
President-International.
Information concerning the Company’s directors (including Mr. Snow) and nominees is
incorporated by reference from the discussion under the heading “Proposal 1. Election of Directors”
in our Proxy Statement for the 2008 Annual Meeting of Shareholders.
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PART II
Market Information
The principal market for our Common Stock is the NYSE, where our Common Stock trades under the
ticker symbol “MHS.” The following table sets forth the range of high and low common stock market
prices for fiscal years 2007 and 2006:
The above table has been retrospectively adjusted to reflect the January 24, 2008 two-for-one
stock split. 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 for more information.
On February 14, 2008, the closing market price of our common stock on the NYSE was $49.00.
Holders
On February 14, 2008, there were 93,097 shareholders of record.
Dividend Policy
The Company currently does not pay cash dividends and does not plan to pay cash dividends in
the foreseeable future.
Securities Authorized for Issuance under Equity Compensation Plans
This information is discussed in Item 12 of this Annual Report on Form 10-K.
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Comparative Stock Performance
The following graph compares the cumulative total shareholder return on the Company’s Common
Stock with the cumulative total return (including reinvested dividends) of the Standard & Poor’s
Healthcare Index and the Standard & Poor’s 500 Index for the period August 20, 2003, to December
31, 2007. The graph assumes that $100 was invested on August 20, 2003, in the Company’s Common
Stock and in each index or composite. No cash dividends have been declared on the Company’s Common
Stock.
COMPARISON OF 52 MONTH CUMULATIVE TOTAL RETURN
Among Medco Health Solutions, Inc., The S&P 500 Index And The S&P Health Care Index 
The comparisons in the graph above are provided in response to disclosure requirements of the
SEC and are not intended to forecast or be indicative of future performance of the Common Stock.
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Share Repurchase Program
On February 21, 2007, the Company announced that its Board of Directors had authorized the
expansion of the Company’s share repurchase plan by an incremental $3 billion, bringing the amount
authorized under such repurchase plan to a cumulative total of $5.5 billion, and extended the term
of the program until December 31, 2008. The original share repurchase plan, which was approved in
August 2005, authorized share repurchases of $500 million. The plan was increased in $1 billion
increments in December 2005 and November 2006. The Company’s Board of Directors periodically
reviews the program and approves the associated trading parameters.
The following share and per share amounts have been retrospectively adjusted to reflect the
January 24, 2008 two-for-one stock split. 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 for more information.
The Company did not repurchase any shares during the fiscal three months ended December 29,
2007. During fiscal year 2007, the Company repurchased under the plan approximately 53.3 million
shares at a cost of approximately $2 billion. Inception-to-date repurchases through December 29,
2007 under this program total approximately 111.4 million shares at a cost of approximately $3.5
billion. The average price paid per share for repurchases initiated since inception is $31.56. The
approximate dollar value of shares that may yet be purchased under the program is $2 billion.
From January 1, 2008 through February 14, 2008, the Company repurchased approximately 13.5
million shares at an average price per share of approximately $50.10.
During the fiscal year ended December 29, 2007, no equity securities of the Company were sold
by the Company that were not registered under the Securities Act of 1933, as amended.
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Item 6. Selected Financial Data.
The following table presents our selected historical consolidated financial and operating
data. The selected historical financial and operating data should be read in conjunction with, and
is qualified in its entirety by reference to, Part II, Item 7, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” and our consolidated financial
statements and notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K ($ and
volumes in millions, except for per share data and EBITDA per adjusted prescription data):
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Overview
We are the nation’s leading pharmacy benefit manager based on net revenues. We provide
sophisticated traditional and specialty prescription drug benefit programs and services for our
clients and members. 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 pharmacy benefit management (“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”). In 2007, we introduced the Medco Therapeutic Resource Centers®, staffed
with hundreds of pharmacists who are trained and certified in specific complex and chronic
conditions and have expertise with the associated medications. 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 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 membership are paramount to our success; the retention of existing and
winning of new clients and members poses the greatest opportunity, and the loss thereof 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 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 patients, including our active participation
in the Medicare Part D benefit and the rapidly growing specialty pharmacy industry.
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.
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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; 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.
2007 Financial Performance Summary
Our net income increased 44.7% to $912.0 million and diluted earnings per share on a
split-adjusted basis increased 56.7% to $1.63 for 2007, compared to $630.2 million and $1.04 per
share, respectively, for 2006. The 2006 results reflect a pre-tax legal settlements charge of
$162.6 million recorded in the first quarter, with a $99.9 million after-tax effect, or $0.17 per
diluted share. Excluding the legal settlements charge from 2006, our 2007 net income increased
24.9% and diluted earnings per share increased 34.7%. These increases reflect higher generic
dispensing rates and mail-order penetration, and a decrease in the diluted weighted average shares
outstanding. In addition, 2007 includes the operating results of PolyMedica and Critical Care
Systems, Inc. (“Critical Care”) commencing October 31, 2007 and November 14, 2007, the dates of
acquisition, respectively.
The diluted weighted average shares outstanding, on a split-adjusted basis, were 560.9 million
for 2007 compared to 603.3 million for 2006, representing a decrease of 7.0% resulting from our
share repurchase program which commenced in 2005.
Total net revenues increased 4.6% to $44,506.2 million in 2007. Product net revenues increased
4.6% to $43,961.9 million, which reflects higher prices charged by pharmaceutical manufacturers,
and higher total volume including new business and incremental volume from PolyMedica, partially
offset by a greater representation of lower cost generic drugs and steeper client discounts
including higher levels of rebate sharing and client transitions. Additionally, our service
revenues increased 4.5% to $544.3 million in 2007, which is primarily attributable to higher client
and other service revenues, reflecting higher claims processing administrative fees, as well as
increased revenues for services associated with clinical programs.
Total prescription volume, adjusted for the difference in days supply between mail and retail,
increased 2.5% to 748.3 million for 2007, substantially the result of higher volumes from new
clients, partially offset by client terminations. The adjusted mail-order penetration rate
increased to 37.9% in 2007, from 36.4% in 2006.
Our overall generic dispensing rate increased to 59.7% in 2007 from 55.2% in 2006, reflecting
the introduction of new generic products during this period, the effect of client plan design
changes promoting the use of lower-cost and more steeply discounted generics, and our programs
designed to encourage generic utilization. The higher generic dispensing rate, which contributes to
lower costs for clients and members, resulted in a reduction of approximately $2.5 billion in net
revenues for 2007.
The increase in overall gross margin to 6.6% in 2007 from 5.7% in 2006 was primarily driven by
our increased generic dispensing rate and mail-order volume.
Selling, general and administrative (“SG&A”) expenses of $1,114.1 million for 2007 increased
from 2006 by $4.9 million, or 0.4%, including the $162.6 million pre-tax legal settlements charge
recorded in the first quarter of 2006. Excluding the pre-tax legal settlements charge, SG&A
expenses increased by $167.5 million, or 17.7%, reflecting higher employee-related costs associated
with business growth across the Company, including higher performance bonus expenses, in addition
to client and product support activities, and the addition of PolyMedica and Critical Care SG&A
expenses.
Amortization of intangible assets increased $9.6 million from 2006 as a result of the
PolyMedica and Critical Care acquisitions.
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Interest and other (income) expense, net, increased $33.9 million from 2006, attributable to
higher interest expense reflecting increased borrowings from our debt refinancing that we completed
on April 30, 2007 to fund our share repurchase program, PolyMedica and Critical Care acquisitions,
general corporate activities, working capital requirements, and capital expenditures.
Our effective tax rate (defined as the percentage relationship of provision for income taxes
to income before provision for income taxes) was 39.3% for 2007, up from 37.7% for 2006. The 2006
tax rate included the effect of a net non-recurring tax benefit of $20.0 million.
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. 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. Our product net revenues also include revenues from the sale of diabetic
supplies dispensed by PolyMedica.
In addition, our product net revenues include premiums associated with our Medicare Part D
Prescription Drug Program (“PDP”) risk-based product offering. 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 Congress, 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 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. In 2007, premium revenues for our PDP product, which exclude member
cost share, were $255 million, or less than
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1% of total net revenues. In 2006, premium revenues for our PDP product, excluding member cost
share, were $465 million, or approximately 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) adopt 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.
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 offering 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 $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. 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 swap
agreements on $200 million of the senior notes, partially offset by interest income generated by
cash and cash equivalent investments and short-term investments in marketable securities.
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.
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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 intangibles. 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 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 include premiums receivable from CMS for our Medicare Part D PDP product offering
and premiums from members. Additionally, we have receivables from Medicare and Medicaid for a
portion of our specialty pharmacy business, and diabetic 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 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 in 1993, the value of the Liberty trade name,
customer relationships and goodwill 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, cost share, and catastrophic reinsurance payments received in advance from CMS for our
Medicare Part D PDP product offering. This includes published amounts due to CMS associated with
the 2006 plan year reconciliation process. Our debt is primarily comprised of a senior unsecured
term loan 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 off-balance sheet arrangements, other than purchase commitments and lease obligations.
See “— Contractual Obligations” below.
Our stockholders’ equity includes an offset for treasury stock purchases under our share
repurchase program. The accumulated other comprehensive income component of stockholders’ equity
includes the net gains and losses and prior service costs and credits related to our pension and
other postretirement benefit plans in accordance with Statement of
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Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit
Pension and Other Postretirement Plans—an amendment of Financial Accounting Standards Board
(“FASB”) Statements No. 87, 88, 106, and 132(R),” and unrealized losses on cash flow hedges.
Consolidated Statements of Cash Flows
An important element of our operating cash flows is the timing of billing cycles, which are
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 result, this portion of the specialty
pharmacy business, which yields a higher margin than the PBM business, experiences slower accounts
receivable turnover than in the aforementioned PBM cycle. Additionally, a component of the PBM
business includes diabetic supplies dispensed by PolyMedica, which are reimbursed by Medicare,
Medicaid and insurance companies, which also experience slower accounts receivable turnover. We
also generate operating cash flows associated with our Medicare Part D PDP product offering,
including premiums, cost share, and various subsidies received in advance from CMS. In addition,
our operating cash flows include tax benefits associated with employee stock plans.
Ongoing operating cash flows are associated with expenditures to support our mail-order,
retail pharmacy network operations, call center pharmacies and other SG&A functions. The largest
components of these expenditures include mail-order inventory purchases, which are paid in
accordance with payment terms offered by our suppliers to take advantage of appropriate discounts,
payments to retail pharmacies, rebate and guarantee payments to clients, employee payroll and
benefits, facility operating expenses and income taxes. In addition, earned brand-name
pharmaceutical manufacturers’ rebates are recorded monthly based upon prescription dispensing, with
actual bills 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
brand-name pharmaceutical manufacturers, although some clients may receive more accelerated rebate
payments in exchange for other elements of pricing in their contracts.
Ongoing investing cash flows are primarily associated with capital expenditures including
technology investments, as well as purchases and proceeds from securities and other investments,
which relate to investment activities of our insurance companies. Acquisitions will also generally
result in cash outflows from investing activities. Our financing cash flows include share
repurchases, proceeds from debt, interest and principal payments on our outstanding debt, proceeds
from employee stock plans, and the benefits of realized tax deductions in excess of tax benefits on
compensation expense.
Client-Related Information
Revenues from UnitedHealth Group Incorporated (“UnitedHealth Group”), which is currently our
largest client, amounted to approximately $9,900 million, or 22%, of our net revenues in 2007, and
approximately $9,800 million and $8,800 million, or 23%, of our net revenues in 2006 and 2005,
respectively. The UnitedHealth Group account has much lower mail-order penetration and, because of
its size, much steeper pricing than the average client, and consequently generates lower
profitability than typical client accounts. None of our other clients individually represented more
than 10% of our net revenues in 2007, 2006 or 2005.
Segment Discussion
As a result of our acquisition of Accredo in August 2005, we have two reportable segments, PBM
and Specialty Pharmacy. The PBM segment involves sales of traditional prescription drugs and
supplies to our clients and members, either through our network of contractually affiliated retail
pharmacies or our mail-order pharmacies. The PBM segment also includes the operating results of
PolyMedica, a provider of diabetes testing supplies and related products to patients with diabetes,
commencing October 31, 2007, the date of the acquisition. The Specialty Pharmacy segment, which was
formed upon the Accredo acquisition and is also comprised of specialty pharmacy activity previously
included within Medco’s PBM business, includes the sale of higher margin specialty pharmacy
products and services for the treatment of
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chronic and complex (potentially life-threatening) diseases. The Specialty Pharmacy segment
also includes the operating results of Critical Care, a provider of specialty infusion services,
commencing November 14, 2007, the date of acquisition.
We define the Specialty Pharmacy segment based on a product set and associated services,
broadly characterized to include drugs that are high-cost, usually developed by biotechnology
companies and often injectable or infusible, and which require elevated levels of patient support.
When dispensed, these products frequently require ancillary administration equipment, special
packaging, and a higher degree of patient-oriented customer service than is required in the
traditional PBM business model, including in-home nursing services and administration. In addition,
specialty pharmacy products and services are often covered through medical benefit programs with
the primary payors being insurance companies and government programs, along with patients, as well
as PBM clients as payors.
The PBM segment is measured and managed on an integrated basis, and there is no distinct
measurement that separates the performance and profitability of mail order and retail. We offer
fully integrated PBM services to virtually all of our PBM clients and their members. The PBM
services we provide to our clients are generally delivered and managed under a single contract for
each client. Both the PBM and the Specialty Pharmacy segments operate in one geographic region,
which includes the United States and Puerto Rico.
As a result of the nature of our integrated PBM services and contracts, the chief operating
decision maker views Medco’s PBM operations as a single segment for purposes of making decisions
about resource allocations and in assessing performance.
Consolidated Results of Operations
The following table presents selected consolidated comparative results of operations and
volume performance ($ and volumes in millions):
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Net Revenues
Retail. The $544 million increase in retail net revenues for 2007 is attributable to net price
increases of $506 million driven by substantially higher prices charged by pharmaceutical
manufacturers, and net volume increases of $38 million from new business and increased utilization,
partially offset by client terminations. The aforementioned net price variance includes the
offsetting effect of approximately $1,625 million from a greater representation of generic drugs in
2007, as well as a reduction of $79 million related to higher levels of rebate sharing with
clients, which is further discussed in the gross margin section below. Also contributing as an
offset to the net price increase are the beneficial effects in 2006 of the closure of various
client-related matters amounting to $29 million recorded in the second quarter of 2006 and $16
million recorded in the first quarter of 2006.
The $2,444 million increase in retail net revenues for 2006 is attributable to net price
increases of $1,803 million driven by higher prices charged by pharmaceutical manufacturers, and
net volume increases of $596 million from new business, partially offset by the extra week of
volume in fiscal 2005, and client terminations. The aforementioned net price variance includes the
offsetting effect of approximately $1,215 million from a greater representation of generic drugs in
2006, as well as a reduction of $243 million related to higher levels of rebate sharing with
clients. Also contributing to the retail net revenue increase are the aforementioned beneficial
effects in 2006 of the closure of various client-related matters.
Mail-order. The $1,395 million increase in mail-order net revenues for 2007 reflects net
volume increases of $1,622 million primarily from new business and incremental volume from
PolyMedica, partially offset by net price reductions of $227 million. The net price reduction is
driven by reductions to mail-order revenues of approximately $880 million from a higher
representation of generic drugs for 2007. Also contributing to the net price reduction are higher
levels of rebate sharing with clients resulting in reductions to mail-order revenue of $188
million, partially offset by substantially higher prices charged by pharmaceutical manufacturers.
The $2,124 million increase in mail-order net revenues for 2006 reflects net volume increases
of $1,329 million, which include new business, increased utilization and incremental volume from
Accredo, as well as net price increases of $795 million. The volume increases were partially offset
by the extra week of volume in fiscal 2005 and client terminations. The revenue growth reflects a
full year of Accredo in 2006, compared to four months in 2005. The net price increases are driven
by higher prices charged by pharmaceutical manufacturers, partially offset by higher levels of
rebate sharing with clients resulting in reductions to mail-order revenue of $126 million, as well
as a decrease of approximately $505 million from a higher representation of generic drugs for 2006.
Our product net revenues include premium revenues for our Medicare Part D PDP risk-based
product offering, which exclude member cost share. In 2007, premium revenues for our PDP product
were $255 million, or less than 1% of total
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net revenues. In 2006, premium revenues for our PDP
product were $465 million, or approximately 1% of total net revenues. The 2007 decreases result
from lower CMS auto-assigned dual-eligible individuals who generally do not have a financial
incentive to use mail order or generics. There were no premium revenues for 2005 as our Medicare
Part D PDP product offering commenced on January 1, 2006.
Our overall generic dispensing rate increased to 59.7% for 2007, compared to 55.2% for 2006
and 51.5% for 2005. Mail-order generic dispensing rates increased to 50.0% for 2007, compared to
44.8% for 2006 and 41.7% for 2005. Retail generic dispensing rates increased to 61.7% for 2007,
compared to 57.2% and 53.3% for 2006 and 2005, respectively. These increases reflect the
introduction of new generic products during these periods, the effect of client plan design changes
promoting the use of lower-cost and more steeply discounted generics, and our programs designed to
encourage generic utilization.
Service revenues increased $23 million in 2007 as a result of higher client and other service
revenues of $47 million, partially offset by lower manufacturer service revenues of $24 million.
The higher client and other service revenues reflect higher claims processing administrative fees,
as well as increased revenues for services associated with clinical programs. The lower
manufacturer revenues result from lower administrative fees earned as a result of manufacturer
contract revisions.
Service revenues increased $105 million in 2006 as a result of higher client and other service
revenues of $100 million and manufacturer service revenues of $5 million. The higher client and
other service revenues reflect higher claims processing administrative fees, as well as increased
revenues for services including clinical programs and Medicare Part D-related support. The higher
manufacturer revenues result from incremental Accredo manufacturer service fees, partially offset
by lower administrative fees earned as a result of a manufacturer contract revision.
Gross Margin
Our product gross margin percentage was 5.8% for 2007 compared to 4.8% for 2006. The lower
rate of increase in the cost of product net revenues compared with product net revenues for 2007
primarily reflects the greater representation of lower-cost generic products. Also contributing to
the lower rate of increase in cost of product net revenues are higher mail-order volumes, and
favorable retail pharmacy reimbursement rates, as well as increased brand-name pharmaceutical
rebates, partially offset by higher prescription drug prices charged by pharmaceutical
manufacturers. Our gross margin percentage also reflects a reduction associated with higher levels
of rebate sharing with our clients, which increased $267 million for 2007. Also reflected in
product gross margin are costs associated with implementation efforts for large new clients
commencing in 2008, and primarily incurred in the fourth quarter.
Our product gross margin percentage was 4.8% for 2006 compared to 4.3% for 2005, with 2006
including a full year of Accredo product gross margin, compared to four months in 2005. The lower
rate of increase in the cost of product net revenues compared with product net revenues for 2006
reflects the greater representation of lower-cost generic products and higher mail-order volumes,
as well as increased brand-name purchasing discounts and pharmaceutical rebates, partially offset
by higher prescription drug prices charged by pharmaceutical manufacturers. Our gross margin
percentage also reflects a reduction associated with higher levels of rebate sharing with our
clients, which increased $369 million for 2006.
Rebates from brand-name pharmaceutical manufacturers, which are reflected as a reduction in
cost of product net revenues, totaled $3,561 million in 2007, $3,417 million in 2006 and $3,233 million in 2005, with
formulary rebates representing 50.1%, 51.9% and 50.8% of total rebates, respectively. The increases
in rebates earned for 2007 and 2006 reflect improved formulary management and patient compliance,
as well as favorable pharmaceutical manufacturer rebate contract revisions, partially offset by
brand-name drugs that have lost patent protection. We retained approximately $547 million, or
15.4%, of total rebates in 2007, $670 million, or 19.6%, in 2006, and $855 million, or 26.5%, in
2005.
The service gross margin percentage was 70.9% for 2007, compared to 75.9% for 2006. This
reflects the increase in service revenues of $23.2 million driven by the aforementioned client and
other service revenue increases, offset by
increases in cost of service revenues of $32.5 million reflecting higher labor and other costs
associated with client programs including Medicare Part D. Also reflected in service gross margin
are costs associated with implementation
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efforts for large new clients commencing in 2008, which
were primarily incurred in the fourth quarter. The service gross margin percentage of 75.9% for
2006 was consistent with 2005. This reflects the increase in service revenues, driven by the
aforementioned client and other service revenue increases, partially offset by an increase in cost
of service revenues reflecting higher expenses primarily associated with activities for our
Medicare Part D PDP product offering.
The following table presents additional selected comparative results of operations ($ in
millions):
Selling, General and Administrative Expenses
SG&A expenses for 2007 were $1,114 million and increased from 2006 by $5 million, or 0.4%,
including the aforementioned $163 million pre-tax legal settlements charge recorded in the first
quarter of 2006. Excluding the pre-tax legal settlements charge, SG&A expenses for 2007 increased
from 2006 by $168 million, or 17.7%, as a result of the higher employee-related costs of $97
million associated with business growth across the Company, including higher performance bonus
expenses and equity-based compensation, as well as client and product support activities. Also
contributing to the increase are PolyMedica SG&A expenses of $26 million, expenses associated with
strategic initiatives such as Medicare Part D of $17 million, and promotional-related costs,
including a branding campaign of $14 million, Critical Care SG&A expenses of $8 million, and other
expense increases of $6 million.
SG&A expenses for 2006 were $1,109 million and increased from 2005 by $352 million, or 46.4%,
which reflects the aforementioned $163 million pre-tax legal settlements charge, incremental
Accredo expenses of $110 million, higher employee-related costs of $89 million, including higher
equity-based compensation, associated with business growth and new products including Medicare Part
D, partially offset by other expense reductions of $10 million including the effect of the extra
week in fiscal 2005.
Amortization of Intangibles
Amortization of intangible assets was $228 million for 2007, $219 million for 2006, and
$193 million for 2005. The 2007 increase reflects the additional intangible amortization associated
with the PolyMedica and Critical Care acquisitions. The 2006 increase primarily reflects the
additional intangible amortization associated with the Accredo acquisition.
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Interest and Other (Income) Expense, Net
Interest and other (income) expense, net, for 2007 increased $34 million from 2006. The
variance results from higher interest expense of $38 million, partially offset by higher interest
income of $4 million. The interest expense variance reflects increased borrowings from our debt
refinancing that was effective April 30, 2007, to support acquisitions, our share repurchase
program, general corporate activities, working capital requirements, and capital expenditures. The
interest income variance reflects higher average daily cash balances primarily generated from
operations.
Interest and other (income) expense, net, for 2006 increased $26 million from 2005. The
variance results from higher interest expense of $22 million and lower interest income of $4
million. The higher interest expense reflects elevated average debt levels from a debt refinancing
in August 2005 related to the Accredo acquisition, higher interest rates on floating rate debt, and
increased short-term borrowing levels in 2006. The lower interest income reflects lower average
daily cash balances, partially offset by the benefit of higher interest rates in 2006.
The estimated weighted average interest rate on our indebtedness was approximately 6.3% for
both 2007 and 2006, and 5.7% for 2005, and reflects variability in floating interest rates on the
senior unsecured credit facilities and the accounts receivable financing facility.
Provision for Income Taxes. Our effective tax rate (defined as the percentage relationship of
provision for income taxes to income before provision for income taxes) was 39.3% in 2007, compared
with 37.7% in 2006 and 36.8% in 2005. The 2006 and 2005 rates include the effects of net
nonrecurring tax benefits of $20.0 million and $25.7 million, respectively. Excluding the
nonrecurring net tax benefits, the effective tax rates for the years ended December 30, 2006 and
December 31, 2005 would have been 39.7% and 39.5%, respectively.
The 2006 nonrecurring tax benefit of $20.0 million primarily results from the expiration of
the statute of limitations in several states, and the favorable resolution of income taxes payable
provided for prior to the spin-off from Merck. We believe it is probable that the aforementioned
pre-tax legal settlements charge of $162.6 million will be tax deductible. Accordingly, our 2006
provision for income taxes reflects an estimated tax benefit of approximately $63 million
associated with the charge. The 2005 income tax rate reflects a $25.7 million nonrecurring tax
benefit associated with a reduction in our state marginal income tax rate resulting primarily from
an enacted change in a state income tax law and the receipt of a favorable state income tax ruling.
Net Income and Earnings per Share. Net income as a percentage of net revenues was 2.0% in
2007, 1.5% in 2006 including a 0.2 percentage point reduction resulting from the legal settlements
charge, and 1.6% in 2005. The associated trending results from the aforementioned factors.
Diluted earnings per share, on a split-adjusted basis, increased 56.7% to $1.63 for 2007, from
$1.04 for 2006, including the legal settlements charge of $0.17 per share recorded in the first
quarter of 2006. Excluding the 2006 charge, the 2007 diluted earnings per share of $1.63 increased
34.7% compared to $1.21 for 2006. Diluted earnings per share increased 1.0% to $1.04 for 2006,
including the 2006 legal charge, compared to $1.03 for 2005, on a split-adjusted basis. Excluding
the charge, 2006 diluted earnings per share increased 17.5% to $1.21, compared to 2005.
The diluted weighted average shares outstanding were 560.9 million for 2007, 603.3 million for
2006 and 587.1 million for 2005, on a split-adjusted basis. The decrease in 2007 compared to 2006
results from the repurchase of approximately 111.4 million shares of stock in connection with our
share repurchase program since its inception in 2005 through the end of 2007, compared to an
equivalent amount of 58.1 million shares repurchased inception-to-date through the end of 2006.
There were approximately 53.3 million shares repurchased in 2007, compared to 42.6 million in 2006
and 15.5 million in 2005. The effect of these repurchases was partially offset by the dilutive
effect of stock options. The increase in the diluted weighted average shares outstanding for 2006
compared to 2005 results from shares issued in connection with the August 2005 Accredo acquisition
and the effect of share issuances associated with stock option exercises, partially offset by the
aforementioned share repurchases.
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Segment Results of Operations
PBM Segment
The PBM segment involves sales of traditional prescription drugs and supplies to our clients
and members, either through our network of contractually affiliated retail pharmacies or our
mail-order pharmacies. The following table presents selected PBM segment comparative results of
operations ($ in millions):
PBM total net revenues of $38,463 million for 2007 increased $1,356 million compared to 2006
revenues of $37,107 million. The increase primarily reflects higher prices charged by
pharmaceutical manufacturers, higher total volume including new business and incremental volume
from PolyMedica, partially offset by a greater representation of lower cost generic drugs and
steeper client discounts including higher levels of rebate sharing.
PBM total net revenues of $37,107 million for 2006 increased $1,011 million compared to 2005
revenues of $36,096 million. The increase primarily reflects higher prices charged by
pharmaceutical manufacturers, as well as higher total volume including new business, partially
offset by the extra week of volume in fiscal 2005. These revenue increases are partially offset by
a greater representation of lower cost generic drugs and steeper client discounts including higher
levels of rebate sharing. Also contributing as an offset to the 2006 PBM revenue increase are
eight fiscal months of specialty pharmacy activity included in the 2005 PBM results, as the
Specialty Pharmacy segment commenced on August 18, 2005, the date of the Accredo acquisition.
Gross margins were 6.4% of net revenues for 2007, compared to 5.3% for 2006, primarily driven
by increased generic dispensing rates and mail-order penetration. Gross margins were 5.3% of net
revenues for 2006, compared to 5.0% for 2005, primarily driven by increased generic dispensing
rates.
SG&A expenses for 2007 were $884 million and decreased from 2006 by $29 million. This
primarily reflects the aforementioned $163 million pre-tax legal settlements charge recorded in the
first quarter of 2006, partially offset by higher employee-related costs associated with business
growth across the Company and SG&A expenses associated with PolyMedica.
SG&A expenses for 2006 were $913 million and increased from 2005 by $217 million, which
primarily reflects the aforementioned $163 million 2006 pre-tax legal settlements charge and higher
employee-related costs, partially offset by the effect of the extra week in fiscal 2005 and the
aforementioned eight months of specialty pharmacy activity included in the 2005 PBM results.
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Operating income of $1,393 million for 2007 increased $504 million, or 56.8%, compared to
2006, including the first-quarter 2006 pre-tax legal settlements charge. Excluding the legal
settlements charge from 2006, 2007 operating income increased $342 million, or 32.5%. The increase
in operating income results from the aforementioned factors. Operating income of $889 million for
2006 decreased $41 million compared to 2005, including the 2006 pre-tax legal settlements charge.
Excluding the legal settlements charge, 2006 operating income increased $122 million, resulting
from the aforementioned factors.
For additional information on the PBM segment, see Note 13, “Segment Reporting,” to our
consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.
Specialty Pharmacy Segment
The Specialty Pharmacy segment, which was formed upon the Accredo acquisition and is also
comprised of specialty pharmacy activity previously included within Medco’s PBM business, includes
the sale of higher margin specialty pharmacy products and services for the treatment of chronic and
complex (potentially life-threatening) diseases. The following table presents selected Specialty
Pharmacy segment comparative results of operations ($ in millions):
The 2005 operating income of $63 million excludes eight fiscal months of specialty pharmacy
activity previously included in Medco’s PBM business, as the Specialty Pharmacy segment commenced
on August 18, 2005, the date of the Accredo acquisition. Prior to the acquisition, results for the
specialty pharmacy business were neither prepared nor provided to the chief operating decision
maker, as he managed Medco on a consolidated entity level. For 2005, we identified the revenues
associated with Medco’s pre-existing specialty pharmacy business based on a data extract of sales
for the specialty product set. As a result, we estimate that the specialty pharmacy results of
operations, including the effect of the pre-existing Medco specialty pharmacy results of
operations, reflect approximately $3.6 billion in total net revenues, with operating income
estimated at $99 million.
Specialty Pharmacy total net revenues of $6,043 million for 2007 increased $606 million
compared to the 2006 revenues of $5,437 million. The increase primarily results from higher
mail-order revenues, including the revenue from the acquisition of Critical Care, as well as
increased sales of higher margin products. Specialty Pharmacy total net revenues of $5.4 billion
for 2006 increased $1.8 billion compared to the aforementioned estimated 2005 revenues of $3.6
billion, resulting primarily from the Accredo acquisition, partially offset by the effect of the
extra week in fiscal 2005.
Gross margins were 7.9% of net revenues for 2007, compared to 7.8% for 2006. The increased
gross margin primarily results from increased volumes of higher margin product lines, including
intravenous immuno-globulin,
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hemophilia, and pulmonary arterial hypertension products. Gross margins of 7.8% for 2006 were
consistent with the fiscal four-month period for 2005.
SG&A expenses for 2007 were $230 million, and increased from 2006 by $34 million. This
increase primarily reflects higher employee-related costs and the aforementioned SG&A expenses
associated with Critical Care of $8 million. SG&A expenses for 2006 were $196 million compared to
$62 million for 2005, as the 2005 results exclude eight fiscal months of specialty pharmacy
activity previously included in Medco’s PBM business.
Operating income of $210 million for 2007 increased $21 million compared to the 2006 operating
income of $189 million, resulting from the aforementioned factors. Operating income of $189 million
for 2006 increased $90 million compared to the aforementioned estimated 2005 operating income of
$99 million, primarily resulting from the Accredo acquisition.
See Note 13, “Segment Reporting,” to our consolidated financial statements included in Part
II, Item 8 of this Annual Report on Form 10-K for additional information.
Liquidity and Capital Resources
Cash Flows
The following table presents selected data from our consolidated statements of cash flows ($ in
millions):
Operating Activities. Net cash provided by operating activities of $1,367 million for 2007
reflects net income of
$912 million, with adjustments for depreciation and amortization of $397 million. Additionally,
there were net cash inflows of $206 million for client rebates and guarantees payable resulting
from an increase in the liability to clients for rebates and guarantees payable, and cash inflows
from client accounts receivable, net, of $65 million primarily due to the timing of our billing
cycles. These cash inflows were partially offset by cash outflows of $218 million from an increase
in inventories, net, due to business growth and the timing of brand-name pharmaceutical purchases,
as well as cash outflows of $119 million resulting from a decrease in claims and other accounts
payable due to lower retail pharmacy volumes and the timing of payment cycles.
The $126 million increase in net cash provided by operating activities in 2007 compared to
2006 is primarily due to increased net income of $282 million. Additionally, there was an increase
in cash flows of $212 million from client accounts receivable, net, primarily due to the timing of
our billing cycles, and an increase in cash flows of $107 million associated with the
aforementioned increase in client rebates and guarantees payable. These increases were partially
offset by a decrease in cash flows of $368 million associated with the aforementioned decrease in
claims and other accounts payable, a decrease of $73 million from accrued expenses and other
current and noncurrent liabilities, resulting from the timing of income tax payments.
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Net cash provided by operating activities of $1,241 million for 2006 reflects net income of
$630 million, with adjustments for depreciation and amortization of $392 million. Additionally,
there was an increase of $248 million in claims and other accounts payable, primarily resulting
from higher retail pharmacy accounts payable due to higher retail volumes in 2006 compared to 2005,
as well as the timing of retail pharmacy payment cycles. In addition, there was a $111 million
increase in accrued expenses and other noncurrent liabilities associated with unearned premiums and
catastrophic reinsurance received in advance from CMS for our Medicare Part D PDP product offering.
These increases were partially offset by a $150 million decrease in cash flows from inventories,
net, primarily due to business growth and the timing of brand-name pharmaceutical purchases.
The increase in net cash provided by operating activities in 2006 compared to 2005 of $200
million primarily reflects an increase in cash flows related to prepaid expenses and other current
assets, primarily due to a significant prepaid client rebate occurring the week after the December
25, 2004 fiscal year-end, but within the fiscal year 2005.
In addition, while not having any impact on operating cash flows, the components of net cash
provided by operating activities in fiscal year 2006 reflect a decrease resulting from income
taxes receivable associated with the approval of a favorable accounting method change received from
the IRS in the third quarter of 2006 for the timing of the deductibility of certain rebates passed
back to clients. The decrease is offset within net cash provided by operating activities in the
deferred income taxes and prepaid expenses and other current assets components. Also, on October
24, 2006, we paid $155 million in connection with the legal settlements with the U.S. Attorney’s
Office for the Eastern District of Pennsylvania, which was recorded as a charge to expense in the
first quarter of 2006.
Investing Activities. The net cash used by investing activities of $1,714 million in 2007 is
primarily attributable to $1,313 million paid, net of cash acquired for the PolyMedica acquisition
in October 2007, and $218 million paid, net of cash acquired, for the Critical Care acquisition in
November 2007. Capital expenditures for the year of $178 million reflect base capital of $150
million, $18 million in software development capital associated with 2008 new client installations,
$5 million for a new automated dispensing pharmacy in Indiana, which is expected to be operational
in 2009, and $5 million for PolyMedica and Critical Care. The increase in net cash used by
investing activities in 2007 compared to 2006 of $1,558 million is primarily due to the
aforementioned acquisitions.
The net cash used by investing activities of $156 million in 2006 is primarily attributable to
capital expenditures associated with capitalized software development in connection with our
Medicare Part D PDP product offering, client-related programs, productivity initiatives, as well as
investments in customer service and pharmacy operations. The decrease in net cash used by investing
activities in 2006 compared to 2005 of $1,031 million is primarily due to the $989 million paid,
net of cash acquired, for the Accredo acquisition in August 2005, as well as $73 million paid for
the selected assets of Pediatric Services of America, Inc. (“Pediatric Services”) in November 2005.
Purchases and proceeds from securities and other investments, which relate to investment
activities of our insurance companies, are balanced in all years presented.
Financing Activities. The net cash provided by financing activities of $302 million in 2007
primarily results from proceeds from long-term debt of $2.4 billion as a result of our refinancing,
including draw downs under our revolving credit facility, proceeds under the accounts receivable
financing facility of $275 million, proceeds from employee stock plans of $208 million, and $70
million of excess tax benefits from stock-based compensation arrangements, partially offset by
$1,961 million in primarily treasury stock repurchases, and, in connection with our refinancing,
repayments on pre-existing long-term debt of $688 million, including pre-acquisition debt from
PolyMedica. The increase in net cash provided by financing activities of $1,458 million in 2007
compared to 2006 is primarily due to an increase in proceeds from debt of $2.5 billion, as well as
an increase in proceeds from employee stock plans of $47 million and an increase in excess tax
benefits from stock-based compensation arrangements of $37 million. These increases were partially
offset by an increase in share repurchases of $812 million, and an increase in repayments on debt
of $338 million.
The net cash used by financing activities of $1,155 million for 2006 primarily results from
$1,149 million in treasury stock repurchases and net debt pay downs of approximately $200 million,
including additional discretionary debt payments of $125 million, partially offset by proceeds from
employee stock plans of $162 million. The increase in net cash used by financing activities in 2006
compared with 2005 of $1,043 million is primarily due to an increase in treasury
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stock repurchases of $742 million, reflecting twelve months of activity in 2006 compared to
four months of activity through December 2005. Also contributing to the increase in net cash used
by financing activities for 2006 compared with 2005 were lower net proceeds from debt of $135
million as 2005 reflected financing for a portion of the Accredo purchase price. In addition,
proceeds from employee stock plans decreased by $202 million.
Total cash and short-term investments as of December 29, 2007 were $844 million, including
$774 million in cash and cash equivalents. Total cash and short-term investments as of December 30,
2006 were $887 million, including $819 million in cash and cash equivalents. The decrease of $43
million in cash and short-term investments in 2007 primarily reflects the use of cash associated
with share repurchase activity and the PolyMedica acquisition, partially offset by cash flows from
operations and the refinancing.
Financing Facilities
Five-Year Credit Facilities and Refinancing
On April 30, 2007, we entered into a senior unsecured credit agreement which, in addition to
replacing our existing senior unsecured credit facilities, is available to fund our share
repurchase program, acquisitions, general corporate activities, working capital requirements, and
capital expenditures. In connection with the refinancing, our pre-existing senior unsecured credit
facilities were extinguished and our indebtedness outstanding pursuant to such facilities was paid
in full. The current facilities consist of a $1 billion, 5-year senior unsecured term loan and a
$2 billion, 5-year senior unsecured revolving credit facility. The pre-existing facilities
consisted of a $750 million senior unsecured term loan and a $750 million senior unsecured
revolving credit facility. The current term loan matures on April 30, 2012, at which time the
entire facility is required to be repaid, compared with the pre-existing credit facility, under
which we had quarterly installments. At our current debt ratings, the current credit facilities
bear interest at London Interbank Offered Rate (“LIBOR”) plus a 0.45 percent margin, with a 10
basis point commitment fee due on the unused revolving credit facility. The pre-existing credit
facilities incurred interest at LIBOR plus a 0.5 percent margin, with a 12.5 basis point commitment
fee due on the unused revolving credit facility.
On October 31, 2007, we drew down $1 billion under the revolving credit facility in order to
partially fund the acquisition of PolyMedica. We also drew down an additional $400 million under
the revolving credit facility in the fourth quarter of 2007, primarily to pay down PolyMedica’s
outstanding debt balances and to acquire Critical Care. For more information on the acquisitions of
PolyMedica and Critical Care, see Note 3, “Acquisitions of Businesses,” to the consolidated
financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.
As of December 29, 2007, we had $1 billion outstanding under the term loan facility. In
addition, we had $1.4 billion outstanding under the revolving credit facility, and had $587 million
available for borrowing, after giving effect to $13 million in issued letters of credit, under the
revolving credit facility.
Accounts Receivable Financing Facility
Through a wholly-owned subsidiary, we have a $600 million, 364-day renewable accounts
receivable financing facility that is collateralized by our pharmaceutical manufacturer rebate
accounts receivable. At December 29, 2007, there was $600 million outstanding with no additional
amounts available for borrowing under the facility. We pay interest on amounts borrowed under the
agreement based on the funding rates of the bank-related commercial paper programs that provide the
financing, plus an applicable margin determined by our credit rating. The weighted average annual
interest rate on amounts borrowed under the facility as of December 29, 2007 and December 30, 2006
was 5.49% and 5.51%, respectively. During 2007, we drew down an additional $275 million under the
facility.
New 364-day Credit Facility
On November 30, 2007, we entered into an $800 million senior unsecured 364-day revolving
credit agreement (the “Credit Agreement”), the proceeds of which will be used for general corporate
purposes, including the repurchase of shares of our common stock under our existing share
repurchase program. We may from time to time borrow up to $800 million in revolving loans during
the availability period, effective beginning on January 2, 2008. At our current debt
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ratings, borrowings will bear interest at LIBOR plus a 0.55 percent margin, with a 10 basis
point commitment fee due on the unused portion of the facility. Repayment of the outstanding
revolving loans is due on November 28, 2008, though we may continually borrow, prepay and re-borrow
revolving loans during the life of the agreement and may terminate the Credit Agreement at any
time, without incurring prepayment penalties, by prepaying in full all outstanding revolving loans.
Interest Rates
The estimated weighted average annual interest rate on our indebtedness was approximately 6.3%
for both 2007 and 2006, and 5.7% in 2005. Several factors could change the weighted average annual
interest rate, including but not limited to a change in reference rates used under our bank credit
facilities and swap agreements. A 25 basis point change in the weighted average annual interest
rate relating to the bank credit facilities’ balances outstanding and interest rate swap agreements
as of December 29, 2007, which are subject to variable interest rates based on LIBOR, and the
accounts receivable financing facility, which is subject to the commercial paper rate, would yield
a change of approximately $8.0 million in annual interest expense.
Swap Agreements
On December 12, 2007, we entered into forward-starting interest rate swap agreements with a
notional amount of $750 million. These highly-effective cash flow hedges manage our exposure to
changes in future benchmark interest rates in contemplation of potentially obtaining long-term
fixed-rate financing. As of December 29, 2007, we included in accumulated other comprehensive
income an unamortized swap loss of $7.9 million ($4.8 million, net of tax).
In 2004, we entered into five interest rate swap agreements on $200 million of the $500
million in 7.25% senior notes. These swap agreements were entered into as an effective hedge to (i)
convert a portion of the senior note fixed rate debt into floating rate debt; (ii) maintain a
capital structure containing appropriate amounts of fixed and floating rate debt; and (iii) lower
the interest expense on these notes in the near term. We do not expect our cash flows to be
affected to any significant degree by a sudden change in market interest rates.
Covenants
Our senior unsecured credit facilities, senior notes, and accounts receivable financing
facility contain covenants, including, among other items, maximum leverage ratios. We were in
compliance with all financial covenants at December 29, 2007. As a result of the aforementioned
refinancing, our financial covenants are slightly less restrictive.
Debt Ratings
Medco’s debt ratings, all of which represent investment grade, reflect the following as of the
filing date of this Annual Report on Form 10-K: Moody’s Investors Service, Baa3; Fitch Ratings,
BBB; Standard & Poor’s, BBB. These ratings reflect our refinancing and recent acquisitions.
EBITDA
We calculate and use EBITDA and EBITDA per adjusted prescription as indicators of our ability
to generate cash from our reported operating results. These measurements are used in concert with
net income and cash flows from operations, which measure actual cash generated in the period. In
addition, we believe that EBITDA and EBITDA per adjusted prescription are supplemental measurement
tools used by analysts and investors to help evaluate overall operating performance and the ability
to incur and service debt and make capital expenditures. EBITDA does not represent funds available
for our discretionary use and is not intended to represent or to be used as a substitute for net
income or cash flows from operations data as measured under U.S. generally accepted accounting
principles. The items excluded from EBITDA, but included in the calculation of reported net income,
are significant components of the consolidated statements of income and must be considered in
performing a comprehensive assessment of overall financial performance. EBITDA, and the associated
year-to-year trends, should not be considered in isolation. Our calculation of EBITDA may not be
consistent with calculations of EBITDA used by other companies. Additionally, we have calculated
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the 2006 EBITDA excluding the legal settlements charge recorded in the first quarter, as the
charge is not considered an indicator of ongoing performance.
EBITDA per adjusted prescription is calculated by dividing EBITDA by the adjusted prescription
volume for the period. This measure is used as an indicator of EBITDA performance on a per-unit
basis, providing insight into the cash-generating potential of each prescription. EBITDA per
adjusted prescription is affected by the changes in prescription volumes between retail and
mail-order, the relative representation of brand-name, generic and specialty drugs, as well as the
level of efficiency in the business. Adjusted prescription volume equals the majority of mail-order
prescriptions multiplied by 3, plus retail prescriptions. These mail-order prescriptions are
multiplied by 3 to adjust for the fact that they include approximately 3 times the amount of
product days supplied compared with retail prescriptions.
The following table reconciles our reported net income to EBITDA and presents EBITDA per
adjusted prescription for each of the respective periods (in millions, except for EBITDA per
adjusted prescription data):
For 2007 compared to 2006, excluding the first-quarter 2006 legal settlements charge, EBITDA
increased by 22.5% and EBITDA per adjusted prescription increased 19.2%, consistent with the net
income increase of 24.9%. For 2006 excluding the legal settlements charge compared to 2005, EBITDA
increased by 20.9% and EBITDA per adjusted prescription increased 18.5%, consistent with the net
income increase of 21.3%.
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Commitments
Contractual Obligations
The following table presents our contractual obligations as of December 29, 2007, as well as our
long-term debt obligations ($ in millions):
Payments Due By Period
We have a minimum pension funding requirement of $18.4 million under the Internal Revenue Code
(“IRC”) during 2008.
We also have outstanding debt associated with our 364-day renewable accounts receivable
financing facility amounting to $600 million at December 29, 2007. This is classified as short-term
debt on our consolidated balance sheet. We may incur additional indebtedness by drawing down
additional amounts under our senior unsecured revolving credit facility or by obtaining financing
through other sources.
As of December 29, 2007, we had letters of credit outstanding of approximately $14.3 million,
of which approximately $13.3 million were issued under our senior unsecured revolving credit
facility.
On April 30, 2007, we used part of the proceeds of the $1 billion term loan to satisfy in full
our pre-existing term loan outstanding of $437.5 million. The current $1 billion senior unsecured
term loan matures in April 2012, at which time the outstanding balance is required to be repaid.
As of December 29, 2007, we have liabilities for income tax contingencies of $104.5 million,
for which the majority of the associated statutes of limitations are scheduled to expire by the end
of 2012.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements, other than purchase commitments and lease
obligations. See “—Contractual Obligations” above.
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Interest Rate and Foreign Exchange Risk
We have floating rate debt with our credit facility and investments in marketable securities
that are subject to interest rate volatility, which is our principal market risk. In addition, we
have interest rate swap agreements on $200 million of the $500 million in 7.25% senior notes. As a
result of these interest rate swap agreements, the $200 million of senior notes is subject to
interest rate volatility. A 25 basis point change in the weighted average annual interest rate
relating to the credit facilities’ balances outstanding and interest rate swap agreements as of
December 29, 2007, which are subject to variable interest rates based on LIBOR, and the accounts
receivable financing facility, which is subject to the commercial paper rate, would yield a change
of approximately $8.0 million in annual interest expense. We do not expect our cash flows to be
affected to any significant degree by a sudden change in market interest rates. We also have
highly-effective cash flow hedges that manage our exposure to changes in future benchmark interest
rates in contemplation of potentially obtaining long-term fixed-rate financing.
We operate our business within the United States and Puerto Rico and execute all transactions
in U.S. dollars and, therefore, we have no foreign exchange risk.
Share Repurchase Program
On February 21, 2007, we announced that our Board of Directors had authorized the expansion of
our share repurchase plan by an incremental $3 billion, bringing the amount authorized under such
repurchase plan to a cumulative total of $5.5 billion, and extended the term of the program until
December 31, 2008. We may draw down additional debt as a result of our share repurchase program.
The original share repurchase plan, which was approved in August 2005, authorized share repurchases
of $500 million. The plan was increased in $1 billion increments in December 2005 and November
2006. We repurchased approximately 53.3 million shares at a cost of approximately $2 billion during
2007. Inception-to-date repurchases through December 29, 2007 under this program total
approximately 111.4 million shares at a cost of approximately $3.5 billion and at an average
per-share price of $31.56. The share and per share amounts have been retrospectively adjusted to
reflect the January 24, 2008 two-for-one stock split. 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. Our Board of Directors periodically reviews the program and approves the
associated trading parameters. See Part II, Item 5, “Market for Registrant’s Common Equity, Related
Shareholder Matters and Issuer Purchases of Equity Securities,” for more information.
Looking Forward
We believe our ability to generate cash from operating activities is one of our fundamental
financial strengths. We believe that our operating cash flows will continue to be positive and
adequate to fund our ongoing operations, our debt service requirements and capital investments in
2008 and in the foreseeable future. However, we may incur additional indebtedness by drawing down
additional amounts under our senior unsecured revolving credit facility, by drawing down under the
new senior unsecured revolving credit facility, or by obtaining financing through other sources, in
order to, for example, fund strategic investments.
It is anticipated that our 2008 capital expenditures, for items such as capitalized software
development for strategic initiatives and infrastructure enhancements, will be approximately $285
million. The increase over 2007 capital expenditures is primarily associated with the construction
of our third automated dispensing pharmacy in Indiana, which is expected to be operational in 2009.
We have no plans to pay cash dividends in the foreseeable future.
Use of Estimates and Critical Accounting Policies and Estimates
Use of Estimates
The preparation of consolidated financial statements requires companies to include certain
amounts that are based on management’s best estimates and judgments. In preparing the consolidated
financial statements, management reviewed its
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accounting policies and believes that these accounting policies are appropriate for a fair
presentation of our financial position, results of operations and of cash flows. Several of these
accounting policies contain estimates, the most significant of which are discussed below. Actual
results may differ from those estimates, and it is possible that future results of operations for
any particular period could be materially affected by the ultimate actual results. We discuss the
impact and any associated risks related to these policies on our business operations throughout
this “Management’s Discussion and Analysis” section.
Critical Accounting Policies and Estimates
We describe below what we believe to be our critical accounting policies and estimates. (See
also 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.)
Revenue Recognition. Our product net revenues are derived principally from sales of
prescription drugs to our clients and members, either through our networks of contractually
affiliated retail pharmacies or through our mail-order pharmacies. 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. Our product net revenues also include
revenues from the sale of diabetic supplies dispensed by PolyMedica.
We recognize product revenues when the prescriptions are dispensed through our networks of
contractually affiliated retail pharmacies or through our mail-order pharmacies and received by
members and patients. We have determined that our responsibilities under our client contracts to
adjudicate member claims properly and control clients’ drug spend, our separate contractual pricing
relationships and responsibilities to the retail pharmacies in our networks, and our interaction
with clients’ members, among other indicators, qualify us as the principal under the indicators set
forth in EITF 99-19 in most of our transactions with clients. Our responsibilities under our client
contracts include validating that the patient is a member of the client’s plan and that the
prescription drug is in the applicable formulary, instructing the pharmacist as to the prescription
price and the co-payment due from the patient who is a member of a client’s plan, identifying
possible adverse drug interactions for the pharmacist to address with the physician prior to
dispensing, suggesting medically appropriate generic alternatives to control drug cost to our
clients and their members, and approving the prescription for dispensing. We recognize revenues
from our retail network contracts where we are the principal, and our mail-order pharmacies, on a
gross reporting basis, in accordance with EITF 99-19 at the prescription price (ingredient cost
plus dispensing fee) negotiated with our clients, including the portion of the price to be settled
directly by the member (co-payment) plus our administrative fees. Although we generally do not have
credit risk with respect to retail co-payments, all of the above indicators of gross treatment are
present. In addition, we view these co-payments as a plan design mechanism that we evaluate in
concert with our clients to help them manage their retained prescription drug spending costs, and
the level of co-payments does not affect our rebates or margin on the transaction. In the limited
instances where the terms of our contracts and nature of our involvement in the prescription
fulfillment process do not qualify us as a principal under EITF 99-19, our revenues on those
transactions consist of the administrative fee paid to us by our clients.
We deduct from our revenues the manufacturers’ rebates that are earned by our clients based on
their members’ utilization of brand-name formulary drugs. We estimate these rebates at period-end
based on actual and estimated claims data and our estimates of the manufacturers’ rebates earned by
our clients. We base our estimates on the best available data at period-end and recent history for
the various factors that can affect the amount of rebates due to the client. We adjust our rebates
payable to clients to the actual amounts paid when these rebates are paid, generally on a quarterly
basis, or as significant events occur. We record any cumulative effect of these adjustments against
revenues as identified, and adjust our estimates prospectively to consider recurring matters.
Adjustments generally result from contract changes with our clients, differences between the
estimated and actual product mix subject to rebates or whether the product was included in the
applicable formulary. Adjustments to our estimates have not been material to our quarterly or
annual results of operations. We also deduct from our revenues discounts offered and guarantees
regarding the level of service we will provide to the client or member or the minimum level of
rebates or discounts the client will receive, as well as other
payments made to our clients. Other payments include, for example, implementation allowances and
payments related to performance guarantees. Where we provide implementation or other allowances to clients upon
contract initiation, we capitalize these payments and amortize them, generally on a straight-line
basis, over the life of the contract as a reduction
of revenue. These payments are capitalized only in cases where they are refundable upon
cancellation or relate to
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noncancelable contracts.
Our product net revenues also include premiums associated with our Medicare Part D PDP product
offering. 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 Congress, 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 EITF 99-19 are met. For further details, see 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. In 2007, premium revenues for our PDP product, which exclude member
cost share, were $255 million, or less than 1% of total net revenues. In 2006, premium revenues for
our PDP product, excluding member cost share, were $465 million, or approximately 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) adopt 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.
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. Service revenues are recorded when performance occurs and
collectibility is assured.
Rebates Receivable and Payable. Rebates receivable from pharmaceutical manufacturers are
earned based upon the
dispensing of prescriptions at either pharmacies in our retail networks or our mail-order
pharmacies, are recorded as a
reduction of cost of revenues and are included in manufacturer accounts receivable, net. We accrue
rebates receivable by
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multiplying estimated rebatable prescription drugs dispensed by the pharmacies in our retail
networks, or dispensed by
our mail-order pharmacies, by the contractually agreed manufacturer rebate amount, which in certain
cases may be based on estimated market share data. We revise rebates receivable estimates to
actual, with the difference recorded to cost of revenues, when third-party market-share data is
available and final rebatable prescriptions are calculated, and rebates are billed to the
manufacturer, generally 30 to 90 days subsequent to the end of the applicable quarter.
Historically, the effect of adjustments resulting from the reconciliation of our estimated rebates
recognized and recorded to actual amounts billed has not been material to our results of
operations. Rebates payable to clients are estimated and accrued based upon the
prescription drugs dispensed by the pharmacies in our retail networks or by our mail-order
pharmacies. Rebates are generally settled on a quarterly basis with clients in the form of an
invoice credit, check or wire after collection of rebates receivable from manufacturers, at which
time rebates payable are revised to reflect amounts due.
Allowance for Doubtful Accounts. We estimate the allowance for doubtful accounts for our PBM
and Specialty Pharmacy segments based upon a variety of factors, including the age of the
outstanding receivables, trends of cash collections and bad debt write-offs, and our historical
experience of collecting the patient co-payments and deductibles. When circumstances related to
specific collection patterns change, estimates of the recoverability of receivables are adjusted.
The allowance associated with our PBM segment has historically been negligible because of the
contractual obligation for clients to pay outstanding accounts receivable in short duration. The
allowance for our PBM segment also reflects amounts associated with member premiums for our
Medicare Part D product offering and diabetic supplies dispensed by PolyMedica, which are
reimbursed by insurance companies and government agencies.
The relatively higher allowance for the Specialty Pharmacy segment reflects a different credit
risk profile than the PBM segment, and is characterized by reimbursement through medical coverage,
including government agencies, and higher patient co-payments. The products and services are often
covered through medical benefit programs with the primary payors being insurance companies and
government programs. These payors typically have a longer claims processing cycle and the ultimate
payor may not be initially identified until after several reviews by government and private payors.
Additionally, patient co-payments and deductibles are typically higher reflecting the higher
product costs.
Income Taxes, Including the Recently Adopted Financial Accounting Standard, FIN 48. We account
for income taxes under SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). Deferred tax
assets and liabilities are recorded based on temporary differences between the financial statement
basis and the tax basis of assets and liabilities using presently enacted tax rates. On December
31, 2006, the first day of our 2007 fiscal year, we adopted the provisions of FASB Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies the accounting for
uncertainty in income taxes recognized in companies’ financial statements in accordance with SFAS
109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to be taken in a tax
return. The evaluation of a tax position in accordance with FIN 48 is a two-step process. The first
step is recognition to determine whether it is more likely than not that a tax position will be
sustained upon examination. The second step is measurement whereby a tax position that meets the
more-likely-than-not recognition threshold is measured to determine the amount of benefit to
recognize in the financial statements. FIN 48 also provides guidance on derecognition of recognized
tax benefits, classification, interest and penalties, accounting in interim periods, disclosure and
transition. In May 2007, the FASB issued FASB Staff Position No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), which provides guidance on how a
company should determine whether a tax position is effectively settled for the purpose of
recognizing previously unrecognized tax benefits. We have applied the provisions of FSP FIN 48-1 in
our adoption of FIN 48.
We have unrecognized tax benefits associated with previously accrued income taxes for periods
before and after the spin-off from Merck on August 19, 2003. In connection with the spin-off from
Merck, we entered into a tax responsibility allocation agreement with Merck. The tax responsibility
allocation agreement includes, among other items, terms for the filing and payment of income taxes
through the spin-off date. Effective May 21, 2002, we converted from a limited liability company
wholly-owned by Merck, to a corporation (the “incorporation”). Prior to May 21, 2002, we were
structured as a single member limited liability company, with Merck as the sole member. We are
subject to examination in the U.S. federal jurisdiction from the date of incorporation. For state
income taxes prior to our incorporation, Merck was taxed on our income. This is also the case for the post incorporation period through the
spin-off date in states where Merck filed a unitary or combined tax return. While we are subject to
state and local examinations by tax authorities, we are indemnified by Merck for these periods and
tax filings. In states where Merck did not file a unitary or combined tax
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return, we are responsible for filing and paying the associated taxes since the incorporation. For the period up
to the spin-off date, Merck incurred federal taxes on our income as part of Merck’s consolidated
tax return. Subsequent to the spin-off, we have filed our own federal and state tax returns and
made the associated payments.
As a result of the implementation of FIN 48, we recognized a decrease of $43.4 million in the
liability for income tax contingencies, including interest, no longer required under the
more-likely-than-not accounting model of FIN 48, and a $29.3 million corresponding increase, net of
federal income tax benefit, to the December 31, 2006 (the first day of fiscal year 2007) balance of
retained earnings. Our total liabilities for income tax contingencies as of December 29, 2007
amounted to $104.5 million, remain subject to audit, and may be released on audit closure or as a
result of the expiration of statutes of limitations.
A reconciliation of the beginning and ending liabilities for income tax contingencies is as
follows ($ in millions):
We have liabilities for income tax contingencies that, if were reversed into income from
expense, would reduce income tax expense by $62.3 million, net of federal income tax expense, as of
December 29, 2007. The majority of these liabilities are subject to statutes of limitations that
are scheduled to expire by the end of 2012, including certain amounts scheduled to expire over the
next twelve months representing approximately 40% of the $104.5 million.
We recognize interest related to liabilities for income tax contingencies in the provision for
income taxes for which we had approximately $17.6 million accrued at December 29, 2007. Total
interest expense recognized in 2007 related to liabilities for income tax contingencies was $4.6
million. Our policy for penalties related to liabilities for income tax contingencies is to
recognize such penalties in the provision for income taxes. We have had no penalties for
liabilities for income tax contingencies.
In the third quarter of 2006, the IRS commenced a routine examination of our U.S. income tax
returns for the period subsequent to the spin-off, from August 20, 2003 through December 31, 2005,
that is currently anticipated to be completed in 2008. We have agreed to extend the statute of
limitations for the 2003 tax period from September 15, 2007 to September 15, 2008. The IRS has
proposed and we recorded certain adjustments to our above-mentioned tax returns, which did not have
a material impact on the consolidated financial statements. We are also undergoing various routine
examinations by state and local tax authorities for various filing periods.
We have income taxes receivable representing 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. We have accrued interest income of $27.3 million as of December 29, 2007, of which $12.2
million was recognized in 2007. We expect to collect the income taxes receivable plus interest when
the aforementioned IRS audit is completed.
Goodwill and Intangible Assets. Goodwill primarily represents, for our PBM segment, the
push-down of the excess of acquisition costs over the fair value of our net assets from our
acquisition by Merck in 1993, and, to a lesser extent, our acquisitions of PolyMedica in 2007 and
ProVantage Health Services, Inc., in 2000. Goodwill also includes, for our Specialty Pharmacy
segment, a portion of the excess of the Accredo purchase price over the fair value of net assets
acquired, and, to a significantly lesser extent, our acquisition of Critical Care in 2007, and the
acquisition of the selected
assets of Pediatric Services in 2005. Goodwill is also assessed for impairment annually for
each of our segments’ reporting units. This assessment includes comparing the fair value of each
reporting unit to the carrying value of the assets assigned to that reporting unit. If the
carrying value of the reporting unit were to exceed our estimate of fair value
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of the reporting
unit, we would then be required to estimate the fair value of the individual assets and liabilities
within the reporting unit to ascertain the amount of goodwill impairment. We would be required to
record an impairment charge to the extent recorded goodwill exceeds the amount of goodwill
resulting from this allocation. The most recent assessment of goodwill impairment for each of the
designated reporting units was performed as of September 29, 2007 and the recorded goodwill was
determined not to be impaired.
Our intangible assets, for our PBM segment, primarily represent the value of client
relationships that was recorded upon our acquisition in 1993 by Merck, and to a lesser extent,
intangible assets recorded upon our acquisition of PolyMedica in 2007, including the value of the
Liberty trade name, which is indefinite-lived, and customer relationships. For our Specialty
Pharmacy segment, we have intangible assets recorded primarily from our acquisition of Accredo in
2005. Our definite-lived intangible assets are reviewed for impairment whenever events, such as
losses of significant clients or biopharmaceutical manufacturer contracts, or other changes in
circumstances indicate that the carrying amount may not be recoverable. When these events occur, we
compare the carrying amount of the assets to the undiscounted pre-tax expected future cash flows
derived from the lowest appropriate asset grouping. If this comparison indicates that impairment
exists, the amount of the impairment is calculated using discounted expected future cash flows.
Further, we assess our indefinite-lived intangible asset on an annual basis, or more frequently if
changes in circumstances indicate that the carrying amount may not be recoverable. For our
indefinite-lived intangible, we compare the carrying value to the fair value and would record an
impairment equal to the excess of carrying value over fair value. Effective with the Accredo
acquisition on August 18, 2005, the weighted average useful life of intangible assets subject to
amortization was 23 years in total and by major asset class was approximately 23 years for the PBM
client relationships and approximately 22 years for the Accredo intangibles, with the annual
intangible amortization expense increasing to $218.5 million in 2006 from $192.5 million in 2005.
As of December 29, 2007, the weighted average useful life of intangible assets subject to
amortization is 22 years in total and by major asset class is approximately 22 years for the PBM
intangible assets and approximately 21 years for the Specialty-acquired intangible assets.
Amortization of intangible assets of $228.1 million for 2007 increased by $9.6 million compared to
2006 as a result of the PolyMedica and Critical Care acquisitions. The annual intangible
amortization expense is estimated to increase to $278.4 million in 2008 from $228.1 million in
2007, reflecting the full year effect of PolyMedica and Critical Care.
Pension and Other Postretirement Benefit Plans. The determination of our obligation and
expense for pension and other postretirement benefits is based on management’s assumptions, which
are developed with the assistance of actuaries, including an appropriate discount rate, expected
long-term rate of return on plan assets, and rates of increase in compensation and healthcare
costs.
We reassess our benefit plan assumptions on a regular basis. For both the pension and other
postretirement benefit plans, the discount rate is determined annually and is evaluated and
modified to reflect at the end of our fiscal year the prevailing market rate of a portfolio of
high-quality corporate bond investments that would provide the future cash flows needed to settle
benefit obligations as they come due. At December 29, 2007, we changed the discount rate from 5.75%
to 6.0% for our pension and other postretirement benefit plans to reflect the prevailing market
interest rate environment.
The expected rate of return for the pension plan represents the average rate of return to be
earned on the plan assets over the period the benefits included in the benefit obligation are to be
paid. In developing the expected rate of return, we consider long-term compounded annualized
returns of historical market data, as well as historical actual returns on our plan assets. Using
this reference information, we develop forward-looking return expectations for each asset category
and a weighted average expected long-term rate of return for a targeted portfolio allocated across
these investment categories. As a result of this analysis, for 2008, we will increase the expected
rate of return assumption to 8.25% from 8.0% for our pension plan.
Actuarial assumptions are based on management’s best estimates and judgment. A reasonably
possible change of plus (minus) 25 basis points in the discount rate assumption, with other assumptions held constant,
would have an estimated $0.3 million favorable (unfavorable) impact on net pension and postretirement benefit cost, and
would have (decreased) increased the year-end benefit obligations by approximately $4.1 million. A
reasonably possible change of plus (minus) 25 basis points in the expected rate of return assumption, with other assumptions held constant,
would have an estimated $0.4 million favorable (unfavorable) impact on net pension cost.
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We amended the cash balance retirement plan to reflect a change from graduated seven-year
vesting to three-year cliff vesting, as mandated by the Pension Protection Act of 2006, the effect
of which is reflected in the benefit obligation as of December 29, 2007. We amended the
postretirement healthcare benefit plan in 2003, which reduced and capped benefit obligations, the
effect of which is reflected in the amortization of prior service credit component of the net
postretirement benefit (credit) cost.
On December 30, 2006, the last day of fiscal year 2006, we adopted SFAS 158, which requires
employers to recognize the overfunded or underfunded status of a defined benefit postretirement
plan as an asset or liability on the balance sheet on a prospective basis and to recognize changes
in the funded status in the year in which the changes occur through other comprehensive income.
SFAS 158 is applicable to our pension and postretirement healthcare benefit plans and resulted in
the recording of a noncurrent liability of $6.5 million for the pension plan and a reduction in the
noncurrent liability for the postretirement healthcare benefits plan of $36.0 million. See Note 9,
“Pension and Other Postretirement Benefits,” to our consolidated financial statements included in
Part II, Item 8 of this Annual Report on Form 10-K for more information.
Contingencies. In the ordinary course of business, we are involved in litigation, claims,
government inquiries, investigations, charges and proceedings, including, but not limited to, those
relating to regulatory, commercial, employment, employee benefits and securities matters. In
accordance with SFAS No. 5, “Accounting for Contingencies,” we record accruals for contingencies
when it is probable that a liability will be incurred and the amount of loss can be reasonably
estimated. Our recorded reserves are based on estimates developed with consideration given to the
potential merits of claims, the range of possible settlements, advice from outside counsel, and
management’s strategy with regard to the settlement of such claims or defense against such claims.
See Note 14, “Commitments and Contingencies,” to our consolidated financial statements included in
Part II, Item 8 of this Annual Report on Form 10-K for additional information.
Stock-Based Compensation. On January 1, 2006, we adopted SFAS No. 123 (revised 2004),
“Share-Based Payment,” (“SFAS 123R”), which requires the measurement and recognition of
compensation expense for all stock-based compensation awards made to employees and directors,
including employee stock options and employee stock purchase plans. SFAS 123R supersedes our
previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued
to Employees” (“APB 25”), for periods subsequent to December 31, 2005. In March 2005, the
Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) which
provides interpretative guidance in applying the provisions of SFAS 123R. We have applied the
provisions of SAB 107 in our adoption of SFAS 123R.
We adopted SFAS 123R using the modified prospective transition method, which requires the
application of the accounting standard as of January 1, 2006, the first day of our 2006 fiscal
year. Our consolidated financial statements as of and for the fiscal years ended December 29, 2007
and December 30, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective
transition method, our consolidated financial statements for periods prior to January 1, 2006 have
not been restated to reflect, and do not include, the impact of SFAS 123R, as we did not record
stock-based compensation expense related to employee stock options and employee stock purchase
plans. Stock-based compensation expense related to employee stock options and employee stock
purchase plans recognized under SFAS 123R for the fiscal years ended December 29, 2007 and December
30, 2006 amounted to $50.3 million and $63.5 million on a pre-tax basis, respectively. See Note 2,
“Summary of Significant Accounting Policies—Stock-Based Compensation,” to our consolidated
financial statements included in Part II, Item 8 of this Annual Report on Form 10-K for more
information.
SFAS 123R requires companies to estimate the fair value of stock-based awards on the date of
grant using an option-pricing model. The portion of the value that is ultimately expected to vest
is recognized as expense over the requisite service period. Prior to the adoption of SFAS 123R, we
accounted for stock-based awards using the intrinsic value method in accordance with APB 25 as
allowed under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the
intrinsic value method, no stock-based compensation expense had been recognized related to options
because the exercise price of our stock options granted equaled the fair market value of the
underlying stock at the date of the grant.
In addition, SFAS 123R requires that the benefits of realized tax deductions in excess of tax
benefits on compensation
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expense, which amounted to $69.9 million and $33.1 million for the years ended December 29, 2007
and December 30, 2006, respectively, be reported as a component of cash flows from financing
activities rather than as an operating cash flow, as previously required. In accordance with SAB
107, we classify stock-based compensation within cost of product net revenues and SG&A expenses to
correspond with the line items in which cash compensation paid to employees and directors is
recorded.
Stock-based compensation expense recognized in our consolidated statements of income for the
fiscal years ended December 29, 2007 and December 30, 2006 includes compensation expense for
stock-based compensation awards granted prior to, but not yet vested as of December 31, 2005, based
on the grant-date fair value estimated in accordance with the pro forma provisions of SFAS 123.
Additionally, our consolidated statements of income for the years ended December 29, 2007 and
December 30, 2006 include compensation expense for the stock-based compensation awards granted
subsequent to December 31, 2005 based on the grant-date fair value estimated in accordance with the
provisions of SFAS 123R. In conjunction with the adoption of SFAS 123R, we changed our method of
attributing the value of stock-based compensation to expense from the accelerated multiple-option
approach under FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other
Variable Stock Option or Award Plans,” to the straight-line single option method.
Recent Accounting Pronouncements. In September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair
value in U.S. generally accepted accounting principles, and expands disclosures about fair value
measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair
value measurements, the FASB having previously concluded in those accounting pronouncements that
fair value is the relevant measurement attribute. SFAS 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal
years. Our adoption of SFAS 157 in 2008 is not expected to have a material impact on our
consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets
and Financial Liabilities, Including an Amendment of FASB Statement No. 115” (“SFAS 159”), which is
effective for fiscal years beginning after November 15, 2007. SFAS 159 permits entities to measure
eligible financial assets, financial liabilities and firm commitments at fair value, on an
instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value
under other U.S. generally accepted accounting principles. The fair value measurement election is
irrevocable and subsequent changes in fair value must be recorded in earnings. Our adoption of SFAS
159 in 2008 is not expected to have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), “Business Combinations” (“SFAS 141(R)”)
and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). The
standards are intended to improve, simplify, and converge internationally the accounting for
business combinations and the reporting of noncontrolling interests in consolidated financial
statements. SFAS 141(R) requires the acquiring entity in a business combination to recognize all
(and only) the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired and liabilities
assumed; and requires the acquirer to disclose to investors and other users all of the information
they need to evaluate and understand the nature and financial effect of the business combination.
SFAS 141(R) is effective for fiscal years, and interim periods within those fiscal years, beginning
on or after December 15, 2008. SFAS 141(R) applies prospectively to business combinations for which
the acquisition date is on or after the beginning of the first annual reporting period beginning on
or after December 15, 2008. Earlier adoption is prohibited.
SFAS 160 is designed to improve the relevance, comparability, and transparency of financial
information provided to investors by requiring all entities to report noncontrolling (minority)
interests in subsidiaries in the same way—as equity in the consolidated financial statements.
Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions
between an entity and noncontrolling interests by requiring they be treated as equity transactions.
SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on
or after December 15, 2008. Earlier adoption is prohibited. In addition, SFAS 160 shall be applied
prospectively as of the beginning of the fiscal year in which it is initially applied, except for
the presentation and disclosure requirements. The presentation and disclosure
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requirements shall be
applied retrospectively for all periods presented. We do not have an outstanding noncontrolling
interest in one or more subsidiaries and therefore, SFAS 160 is not applicable to us at this time.
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CONDENSED INTERIM FINANCIAL DATA (UNAUDITED)
(In millions, except per share amounts)
The fourth quarter of 2007 includes the operating results of PolyMedica and Critical Care
commencing October 31, 2007 and November 14, 2007, the dates of acquisition, respectively, as well
as costs associated with implementation efforts for large new clients commencing in 2008.
Additionally, the strategic purchasing benefit of a short-lived generic product primarily benefited
the fourth quarter of 2006 and the first quarter of 2007.
SG&A expenses for the first quarter of 2006 include a pre-tax legal settlements charge of
$162.6 million, which reflects an agreement with the U.S. Attorney’s Office for the Eastern
District of Pennsylvania to settle three previously disclosed federal legal matters. The
settlement agreements for these three matters were signed and approved by the District Court on
October 23, 2006.
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Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
A description of quantitative and qualitative disclosures about market risk is contained in
Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Liquidity and Capital Resources—Interest Rate and Foreign Exchange Risk.”
Item 8. Financial Statements and Supplementary Data.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS*
See Item 9A, “Controls and Procedures,” for Management’s Report on Internal Control over
Financial Reporting.
See Item 15, “Exhibits, Financial Statement Schedules,” for financial statement Schedule II,
Valuation and Qualifying Accounts.
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Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors of Medco Health Solutions, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying index present
fairly, in all material respects, the financial position of Medco Health Solutions, Inc. and its
subsidiaries (the “Company”) at December 29, 2007 and December 30, 2006 and the results of their
operations and their cash flows for each of the three years in the period ended December 29, 2007
in conformity with accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the accompanying index
presents fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. Also in our opinion, the Company
maintained, in all material respects, effective internal control over financial reporting as of
December 29, 2007, based on criteria established in Internal Control — Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s
management is responsible for these financial statements and financial statement schedule, for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting, included in Management’s Report on
Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to
express opinions on these financial statements, on the financial statement schedule, and on the
Company’s internal control over financial reporting based on our integrated audits, which were
integrated audits in 2007 and 2006. We conducted our audits in accordance with the standards of
the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audits to obtain reasonable assurance about whether the financial statements
are free of material misstatement and whether effective internal control over financial reporting
was maintained in all material respects. Our audits of the financial statements included
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. Our audit of internal control over
financial reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and evaluating the
design and operating effectiveness of internal control based on the assessed risk. Our audits also
included performing such other procedures as we considered necessary in the circumstances. We
believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2, “Summary of Significant Accounting Policies,” to the consolidated financial
statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
“Share-Based Payment,” on January 1, 2006.
A company’s internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
company’s internal control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company;
and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Florham Park, New Jersey
February 19, 2008 66
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MEDCO HEALTH SOLUTIONS, INC.
CONSOLIDATED BALANCE SHEETS (In millions, except for share data)
The accompanying notes are an integral part of these consolidated financial statements.
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MEDCO HEALTH SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF INCOME (In millions, except for per share data)
The accompanying notes are an integral part of these consolidated financial statements.
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MEDCO HEALTH SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Shares in thousands; $ in millions, except for per share data)
The accompanying notes are an integral part of these consolidated financial statements.
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MEDCO HEALTH SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)
The accompanying notes are an integral part of these consolidated financial statements.
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MEDCO HEALTH SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BACKGROUND AND BASIS OF PRESENTATION
Medco Health Solutions, Inc., (“Medco” or the “Company”), is the nation’s leading pharmacy
benefit manager (“PBM”) based on net revenues. Medco’s prescription drug benefit programs are
designed to drive down the cost of pharmacy healthcare 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 Program (“Medicare Part D”). Medco serves the needs of patients
with complex conditions requiring sophisticated treatment through its specialty pharmacy operation,
which became the nation’s largest with the Company’s 2005 acquisition of Accredo Health,
Incorporated (“Accredo”). On October 31, 2007, Medco acquired PolyMedica Corporation
(“PolyMedica”), through which Medco became the largest diabetes pharmacy care practice based on
covered patients. See Note 3, “Acquisitions of Businesses,” for more information. When the term
“mail order” is used, Medco means its mail-order pharmacy operations, as well as Accredo’s
specialty pharmacy operations.
Medco was spun off as an independent publicly traded enterprise on August 19, 2003, prior to
which it was a wholly-owned subsidiary of Merck & Co., Inc. (“Merck”) since November 18, 1993.
On November 29, 2007, the Company announced that its Board of Directors approved 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. The Company’s total
authorized common stock and the par value of the common stock were unchanged by this action. All
share and per share amounts have been retrospectively adjusted for the increase in issued and
outstanding shares after giving effect to the stock split. Stockholders’ equity has also been
restated to retroactively apply the effects of the stock split. For all periods presented, the par
value of the additional shares resulting from the stock split has been reclassified from additional
paid-in capital to common stock.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Years. The Company’s fiscal years ended on the last Saturday in December. Fiscal years
2007 and 2006 each are comprised of 52 weeks and 2005 is comprised of 53 weeks. Unless otherwise
stated, references to years in the consolidated financial statements relate to fiscal years.
Principles of Consolidation. The consolidated financial statements include the accounts of the
Company and all of its subsidiaries. Investments in affiliates over which the Company has
significant influence, but neither a controlling interest nor a majority interest in the risks or
rewards of the investee, are accounted for using the equity method. The Company’s equity
investments are not significant. Intercompany accounts have been eliminated in consolidation.
Cash and Cash Equivalents. Cash includes currency on hand and time deposits with banks or
other financial institutions. Cash equivalents represent money market mutual funds, a form of
highly liquid investments with original maturities of less than three months. As a result of the
Company’s normal payment cycle, cash disbursement accounts representing outstanding checks not yet
presented for payment of $1,186.9 million and $1,331.6 million are included in claims and other
accounts payable, and client and rebates and guarantees payable at December 29, 2007 and December
30, 2006, respectively, including certain amounts reclassified from cash. No overdraft or unsecured
short-term loan exists in relation to these negative balances.
Short-Term and Long-Term Investments. The Company holds short-term and long-term investments
in U.S. government securities to satisfy the statutory capital requirements for the Company’s
insurance subsidiaries. These short-term investments, totaling $70.3 million and $68.4 million as
of December 29, 2007 and December 30, 2006, respectively, have maturities of less than one year,
are classified as held-to-maturity securities and reported at amortized cost. These long-term
investments, which are included in other noncurrent assets on the consolidated balance sheets,
total $2.3 million
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and $0.5 million as of December 29, 2007 and December 30, 2006, respectively, have maturities
of one to two years, are classified as available-for-sale and are carried at fair value, with
unrealized gains and losses included as a separate component of equity, net of tax. The Company has
no exposure to or investments in any instruments associated with the sub-prime market.
Financial Instruments. The carrying amount of cash, long-term investments in marketable
securities, trade accounts receivable and claims and other accounts payable approximated fair
values as of December 29, 2007 and December 30, 2006. The Company estimates fair market value for
these assets and liabilities based on their market values or estimates of the present value of
their cash flows. The fair value of the Company’s $500 million senior notes was $551 million and
$541 million at December 29, 2007 and December 30, 2006, respectively, and was estimated based on
quoted market prices. The fair value of the term loan and revolving credit obligations outstanding
under the Company’s senior unsecured bank credit facilities approximates their carrying value and
was estimated using current interbank market prices. The fair value of the Company’s obligation
under its interest rate swap agreements, which hedge interest costs on the senior notes, was $3.0
million and $11.9 million at December 29, 2007 and December 30, 2006, respectively, and was based
on quoted market prices that reflect the present values of the differences between future fixed
rate payments and estimated future variable rate receipts. The fair value of the Company’s
obligation under its forward-starting interest rate swap agreements was $7.9 million ($4.8 million,
net of tax) as of December 29, 2007. The fair value of the accounts receivable financing facility
approximates its market value. See Note 8, “Debt and Refinancing,” for additional information.
Accounts Receivable. The Company reports accounts receivable due from manufacturers and
accounts receivable due from clients. Manufacturer accounts receivable, net, includes billed and
estimated unbilled receivables from manufacturers for earned rebates and other prescription
services. Unbilled rebates receivable from manufacturers are generally billed beginning 30 days
from the end of each quarter.
Client accounts receivable, net, includes billed and estimated unbilled receivables from
clients for the PBM and Specialty Pharmacy segments. Unbilled PBM receivables are primarily from
clients and are typically billed within 14 days based on the contractual billing schedule agreed
upon with each client. At the end of any given reporting period, unbilled PBM receivables from
clients may 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. Client accounts receivable, net, also
includes a reduction for rebates and guarantees payable to clients 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 balances, the net liability is reclassified to client rebates and guarantees
payable on the consolidated balance sheet. 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 on the consolidated balance sheet. The Company’s client accounts receivable
also include premiums receivable from the Center for Medicare & Medicaid Services (“CMS”) for the
Medicare Part D Prescription Drug Program (“PDP”) product offering and premiums from members. A
component of the PBM business includes diabetic supplies dispensed by PolyMedica with the
associated receivables primarily from insurance companies and
government agencies. This component of the PBM business also experiences
slower accounts receivable turnover.
As of December 29, 2007 and December 30, 2006, identified net specialty pharmacy accounts
receivable, primarily due from payors and patients, amounted to $457.2 million and $401.5 million,
respectively. 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 result, this
portion of the specialty pharmacy business, which yields a higher margin than the PBM business,
experiences slower accounts receivable turnover than in the aforementioned PBM cycle. See Note 13,
“Segment Reporting,” for more information on the Specialty Pharmacy segment.
The Company’s allowance for doubtful accounts as of December 29, 2007 and December 30, 2006 of
$130.0 million and $81.8 million, respectively, includes $70.8 million and $65.1 million,
respectively, related to the Specialty Pharmacy segment, and at December 29, 2007, $30.3 million
related to PolyMedica. The relatively higher allowance for the Specialty Pharmacy segment reflects
a different credit risk profile than the PBM business, and is characterized by reimbursement
through medical coverage, including government agencies, and higher patient co-payments. In
addition, the Company’s allowance for doubtful accounts also reflects amounts associated with
member premiums for the
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Company’s Medicare Part D product offering, as well as and diabetic supplies dispensed by
PolyMedica and reimbursed by insurance companies and government agencies. The Company regularly
reviews and analyzes the adequacy of the allowances based on a variety of factors, including the
age of the outstanding receivable and the collection history. When circumstances related to
specific collection patterns change, estimates of the recoverability of receivables are adjusted.
Concentrations of Risks. In 2007, the Company had one client that represented 22% of net
revenues. In each of 2006 and 2005, the Company had one client that represented 23% of net
revenues. None of the Company’s other clients individually represented more than 10% of net
revenues in 2007, 2006 or 2005. The Company has credit risk associated with certain accounts
receivable, which consists of amounts owed by various governmental agencies, insurance companies
and private patients. Concentration of credit risk relating to these accounts receivable is limited
by the diversity and number of patients and payors.
The Company derives a substantial portion of its Specialty Pharmacy segment revenue from the
sale of specialty drugs provided by a limited number of single-source biopharmaceutical
manufacturers.
Inventories, Net. Inventories, net, are located in the Company’s mail-order pharmacies and in
warehouses, consist solely of finished product (primarily prescription drugs), and are valued at
the lower of first-in, first-out (FIFO) cost or market.
Property and Equipment, Net. Property and equipment, net, is stated at cost, less accumulated
depreciation and amortization. Depreciation is calculated using the straight-line method for assets
with useful lives as follows: buildings, 45 years; machinery, equipment and office furnishings,
three to 15 years; and computer software, three to five years. Leasehold improvements are amortized
over the shorter of the remaining life of the lease or the useful lives of the assets. In
accordance with the provisions of the American Institute of Certified Public Accountants Statement
of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal
Use,” certain costs of computer software developed or obtained for internal use are capitalized and
amortized on a straight-line basis over three to five years. Costs for general and administrative
expenses, overhead, maintenance and training, as well as the cost of software coding that does not
add functionality to existing systems, are expensed as incurred.
Net Revenues. Product net revenues consist principally of sales of prescription drugs to
clients and members, either through the Company’s networks of contractually affiliated retail
pharmacies or through the Company’s mail-order pharmacies. The majority of the Company’s product
net revenues are derived on a fee-for-service basis. 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. The Company’s product net revenues also include
revenues from the sale of diabetic supplies dispensed by PolyMedica. The Company recognizes product
revenues when the prescriptions are dispensed through retail pharmacies in the Company’s networks
of contractually affiliated retail pharmacies or the Company’s mail-order pharmacies and received
by members and patients. The Company evaluates client contracts using the indicators of Emerging
Issues Task Force No. 99-19, “Reporting Gross Revenue as a Principal vs. Net as an Agent” (“EITF
99-19”), to determine whether the Company acts as a principal or as an agent in the fulfillment of
prescriptions through the retail pharmacy network. The Company acts as a principal in most of its
transactions with clients and revenues are recognized at the prescription price (ingredient cost
plus dispensing fee) negotiated with clients, including the portion of the price allocated by the
client to be settled directly by the member (co-payment), as well as the Company’s administrative
fees (“Gross Reporting”). Gross reporting is appropriate because the Company (a) has separate
contractual relationships with clients and with pharmacies, (b) is responsible to validate and
economically manage a claim through its claims adjudication process, (c) commits to set
prescription prices for the pharmacy, including instructing the pharmacy as to how that price is to
be settled (co-payment requirements), (d) manages the overall prescription drug relationship with
the patients, who are members of clients’ plans, and (e) has credit risk for the price due from the
client. In limited instances where the Company adjudicates prescriptions at pharmacies that are
under contract directly with the client and there are no financial risks to the Company, such
revenue is recorded at the amount of the administrative fee earned by the Company for processing
the claim (“Net Reporting”).
The Company’s product net revenues also include premiums associated with the Company’s
Medicare Part D PDP product offering. This product involves prescription dispensing for members
covered under the CMS-sponsored Medicare Part D benefit. Since 2006, two of the Company’s
insurance company subsidiaries have been operating under contracts
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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. The Company provides a Medicare drug benefit that represents either (i)
the minimum, standard level of benefits mandated by Congress, 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 the Company’s 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 the Company’s actual annual drug costs
incurred to the targeted premiums in the Company’s CMS-approved bid. Based on specific collars in
the risk corridor, the Company will receive from CMS additional premium amounts or be required to
refund to CMS previously received premium amounts. The Company calculates the risk corridor
adjustment on a quarterly basis based on drug cost experience to date and records 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 EITF 99-19 are met. In 2007, premium revenues for the Company’s PDP product, which
exclude member cost share, were $255 million, or less than 1% of total net revenues. In 2006,
premium revenues for the Company’s PDP product, excluding member cost share, were $465 million, or
approximately 1% of total net revenues.
The Company’s agreements with CMS, as well as applicable Medicare Part D regulations and
federal and state laws, require the Company 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) adopt a comprehensive Medicare and
Fraud, Waste and Abuse compliance program. As a CMS-approved PDP, the Company’s 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.
Rebates and guarantees regarding the level of service the Company will provide to the client
or member or the minimum level of rebates or discounts the client will receive are deducted from
product net revenues as they are earned by the client. Rebates are generally credited or paid to
clients subsequent to collections from pharmaceutical manufacturers, although there are certain
instances where rebates are paid to clients on a more accelerated basis. Other contractual payments
made to clients are generally made upon initiation of contracts as implementation allowances, which
may, for example, be designated by clients as funding for their costs to transition their plans to
the Company. The Company considers these payments to be an integral part of the Company’s pricing
of a contract and believes that they represent
only a variability in the timing of cash flows that does not change the underlying economics of the
contract. Accordingly, these payments are capitalized and amortized as a reduction of product net
revenues, generally on a straight-line basis, over the life of the contract where the payments are
refundable upon cancellation of the contract or relate to noncancelable contracts. Amounts
capitalized are assessed periodically for recoverability based on the profitability of the
contract.
Service revenues consist principally of administrative fees and clinical program fees earned
from clients and other
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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. Service revenues are
recorded by the Company
when performance occurs and collectibility is assured.
Cost of Revenues. Cost of product net revenues includes the cost of inventory dispensed from
the mail-order pharmacies, along with direct dispensing costs and associated depreciation. Cost of
product net revenues also includes ingredient costs of drugs dispensed by and professional fees
paid to retail network pharmacies. In addition, cost of product net revenues includes the operating
costs of the Company’s call center pharmacies, which primarily respond to member and retail
pharmacist inquiries regarding member prescriptions, as well as physician calls. Cost of product
net revenues also includes an offsetting credit for rebates earned from pharmaceutical
manufacturers whose drugs are included on the Company’s preferred drug lists, which are also known
as formularies. Rebates receivable from pharmaceutical manufacturers are accrued in the period
earned by multiplying estimated rebatable prescription drugs dispensed through the Company’s retail
network and through the Company’s mail-order pharmacies by the contractually agreed manufacturer
rebate amount.
Rebates receivable estimates are revised to actual, with the difference recorded to cost of
revenues, upon billing to the manufacturer, generally 30 to 90 days subsequent to the end of the
applicable quarter. These bills are not issued until the
necessary specific eligible claims and third-party market share data are received and thoroughly
analyzed. Historically,
the effect of adjustments resulting from the reconciliation of rebates recognized and recorded to
actual amounts billed has
not been material to the Company’s results of operations.
The Company’s cost of product net revenues also includes the cost of drugs dispensed by the
Company’s mail-order pharmacies or retail network for members covered under the Company’s Medicare
Part D PDP product offering and are recorded at cost as incurred. The Company receives 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 $3,850 million for coverage
year 2007 and $3,600 million 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. 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 consists principally of labor and operating costs for delivery of services
provided, and costs associated with member communication materials.
Goodwill. Goodwill of $6,230.2 million at December 29, 2007 and $5,108.7 million at December
30, 2006 represents, for the PBM segment, the push-down of the excess of acquisition costs over the
fair value of the Company’s net assets from the acquisition of the Company by Merck in 1993, and,
to a significantly lesser extent, the Company’s acquisitions of PolyMedica in 2007, and ProVantage
Health Services, Inc. (“ProVantage”) in 2000. Goodwill also includes, for the Specialty Pharmacy
segment, a portion of the excess of the Accredo purchase price over the fair value of net assets
acquired and, to a significantly lesser extent, the Company’s acquisition of Critical Care Systems,
Inc. (“Critical Care”) in 2007, and the acquisition of selected assets of Pediatric Services of
America, Inc. (“Pediatric Services”) in 2005. See Note 3, “Acquisitions of Businesses,” for more
information. The Company’s goodwill balance is also assessed for impairment using a two-step
fair-value based test annually or whenever events, or other changes in circumstances indicate that
the carrying amount may not be recoverable, for each of the Company’s segments’ reporting units by
comparing the fair value of each reporting unit to the carrying value of the assets assigned to
that reporting unit. If the carrying value of the reporting unit were to exceed our estimate of
the fair value of the reporting unit, the Company would then be required to estimate the fair value
of the individual assets and liabilities within the reporting unit for purposes of calculating the
amount of goodwill impairment. The most recent assessment of goodwill impairment for each of the
designated reporting units was performed as of September 29, 2007, and the recorded goodwill was
determined not to be impaired.
Intangible Assets, Net. Intangible assets, net, of $2,905.0 million at December 29, 2007 and
$2,523.1 million at December 30, 2006, (net of accumulated amortization of $1,670.7 million at
December 29, 2007 and $1,442.6 million at December 30, 2006) primarily reflect, for the PBM
segment, the value of client relationships that arose in connection with the acquisition of the
Company by Merck in 1993 and that have been pushed down to the consolidated balance sheets of the
Company, as well as intangible assets recorded upon our acquisition of PolyMedica in 2007,
including the value of the Liberty trade name, which is indefinite-lived, and customer
relationships. Additionally, for the Specialty Pharmacy
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segment, intangible assets primarily include the portion of the excess of the Accredo purchase
price over tangible net assets acquired that has been allocated to intangible assets. See Note 3,
“Acquisitions of Businesses,” for more information. Our definite-lived intangible assets are
recorded at cost and are reviewed for impairment whenever events, such as losses of significant
clients or biotechnology manufacturer contracts, or other changes in circumstances indicate that
the carrying amount may not be recoverable. When these events occur, the carrying amount of the
assets is compared to the pre-tax undiscounted expected future cash flows derived from the lowest
appropriate asset grouping. If this comparison indicates impairment exists, the amount of the
impairment would be calculated using discounted expected future cash flows. Our indefinite-lived
intangible will be reviewed for impairment annually or more frequently if a change in events
warrants such a review by comparing its carrying amount to its fair value. An impairment charge
would be recorded for the excess of the carrying value over the fair value of the indefinite-lived
intangible.
Effective with the Accredo acquisition on August 18, 2005, the weighted average useful life of
intangible assets subject to amortization was 23 years in total and by major asset class was
approximately 23 years for the PBM client relationships and approximately 22 years for the Accredo
intangibles, with the annual intangible amortization expense increasing to $218.5 million in 2006
from $192.5 million in 2005. As of December 29, 2007, the weighted average useful life of
intangible assets subject to amortization is 22 years in total and by major asset class is
approximately 22 years for the PBM intangible assets and approximately 21 years for the
Specialty-acquired intangible assets. The annual intangible amortization expense is estimated to
increase to $278.4 million in 2008 from $228.1 million in 2007, reflecting the full year effect of
PolyMedica and Critical Care.
Income Taxes, Including the Recently Adopted Financial Accounting Standard (FIN 48). The
Company accounts for income taxes under Statement of Financial Accounting Standards (“SFAS”) No.
109, “Accounting for Income Taxes” (“SFAS 109”). Deferred tax assets and liabilities are recorded
based on temporary differences between the financial statement basis and the tax basis of assets
and liabilities using presently enacted tax rates. On December 31, 2006, the first day of the
Company’s 2007 fiscal year, the Company adopted the provisions of Financial Accounting Standards
Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”),
which clarifies the accounting for uncertainty in income taxes recognized in companies’ financial
statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48
prescribes a recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a tax return. The
evaluation of a tax position in accordance with FIN 48 is a two-step process. The first step is
recognition to determine whether it is more likely than not that a tax position will be sustained
upon examination. The second step is measurement whereby a tax position that meets the
more-likely-than-not recognition threshold is measured to determine the amount of benefit to
recognize in the financial statements. FIN 48 also provides guidance on derecognition of recognized
tax benefits, classification, interest and penalties, accounting in interim periods, disclosure and
transition. In May 2007, the FASB issued FASB Staff Position No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), which provides guidance on how a
company should determine whether a tax position is effectively settled for the purpose of
recognizing previously unrecognized tax benefits. The Company has applied the provisions of FSP FIN
48-1 in its adoption of FIN 48.
The Company has unrecognized tax benefits associated with previously accrued income taxes for
periods before and after the spin-off from Merck on August 19, 2003. In connection with the
spin-off from Merck, the Company entered into a tax responsibility allocation agreement with Merck.
The tax responsibility allocation agreement includes, among other items, terms for the filing and
payment of income taxes through the spin-off date. Effective May 21, 2002, the Company converted
from a limited liability company wholly-owned by Merck, to a corporation (the “incorporation”).
Prior to May 21, 2002, the Company was structured as a single member limited liability company,
with Merck as the sole member. The Company is subject to examination in the U.S. federal
jurisdiction from the date of incorporation. For state income taxes prior to the Company’s
incorporation, Merck was taxed on the Company’s income. This is also the case for the post
incorporation period through the spin-off date in states where Merck filed a unitary or combined
tax return. While the Company is subject to state and local examinations by tax authorities, the
Company is indemnified by Merck for these periods and tax filings. In states where Merck did not
file a unitary or combined tax return, the Company is responsible for filing and paying the
associated taxes since the incorporation. For the period up to the spin-off date, Merck incurred
federal taxes on the Company’s income as part of Merck’s consolidated tax return. Subsequent to the
spin-off, the Company has filed its own federal and state tax returns and made the associated
payments.
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As a result of the implementation of FIN 48, the Company recognized a decrease of $43.4
million in the liability for income tax contingencies, including interest, no longer required under
the more-likely-than-not accounting model of FIN 48, and a $29.3 million corresponding increase, net of federal income tax benefit, to the
December 31, 2006 (the first day of fiscal year 2007) balance of retained earnings. The Company’s
total liabilities for income tax contingencies as of December 29, 2007 amounted to $104.5 million,
remain subject to audit, and may be released on audit closure or as a result of the expiration of
statutes of limitations.
A reconciliation of the beginning and ending liabilities for income tax contingencies is as
follows ($ in millions):
The Company has liabilities for income tax contingencies that, if were reversed into income
from expense, would reduce income tax expense by $62.3 million, net of federal income tax expense,
as of December 29, 2007. The majority of these liabilities are subject to statutes of limitations
that are scheduled to expire by the end of 2012, including certain amounts scheduled to expire over
the next twelve months representing approximately 40% of the $104.5 million.
The Company recognizes interest related to liabilities for income tax contingencies in the
provision for income taxes for which the Company had approximately $17.6 million accrued at
December 29, 2007. Total interest expense recognized in 2007 related to liabilities for income tax
contingencies was $4.6 million. The Company’s policy for penalties related to liabilities for
income tax contingencies is to recognize such penalties in the provision for income taxes. The
Company has had no penalties for liabilities for income tax contingencies.
In the third quarter of 2006, the IRS commenced a routine examination of the Company’s U.S.
income tax returns for the period subsequent to the spin-off, from August 20, 2003 through December
31, 2005, that is currently anticipated to be completed in 2008. The Company has agreed to extend
the statute of limitations for the 2003 tax period from September 15, 2007 to September 15, 2008.
The IRS has proposed and the Company recorded certain adjustments to the Company’s above-mentioned
tax returns, which did not have a material impact on the consolidated financial statements. The
Company is also undergoing various routine examinations by state and local tax authorities for
various filing periods.
The Company has income taxes receivable representing 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. The Company has accrued interest income of $27.3 million as of December 29, 2007,
of which $12.2 million was recognized in 2007. The Company expects to collect the income taxes
receivable plus interest when the aforementioned IRS audit is completed.
Use of Estimates. The consolidated financial statements include certain amounts that are based
on management’s best
estimates and judgments. Estimates are used in determining such items as accruals for rebates
receivable and payable, client guarantees, depreciable/useful lives, allowance for doubtful
accounts, testing for impairment of long-lived assets, testing for impairment of goodwill and
intangible assets, stock-based compensation, income taxes, pension and other postretirement benefit
plan assumptions, amounts recorded for contingencies, and other reserves, as well as CMS-related
activity, including the risk corridor adjustment and cost share and catastrophic reinsurance
subsidies. Because of the uncertainty inherent in such estimates, actual results may differ from
these estimates.
Operating Segments. In accordance with SFAS No. 131, “Disclosures about Segments of an
Enterprise and Related
Information,” the Company has two reportable segments, PBM and Specialty Pharmacy. See Note 13,
“Segment Reporting,” for more information. Both the PBM and Specialty Pharmacy segments operate in
one geographic region, which includes the United States and Puerto Rico.
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Earnings per Share (“EPS”). The Company reports EPS in accordance with SFAS No. 128, “Earnings
per Share” (“SFAS 128”). Basic EPS is computed by dividing net income by the weighted average
number of shares of common stock issued and outstanding during the reporting period. SFAS 128
requires that stock options and restricted stock units granted by the Company be treated as
potential common shares outstanding in computing diluted earnings per share. Under the treasury
stock method on a grant by grant basis, the amount the employee or director must pay for exercising
the award, the amount of compensation cost for future service that the Company has not yet
recognized, and the amount of tax benefit that would be recorded in additional paid-in capital when
the award becomes deductible, are assumed to be used to repurchase shares at the average market
price during the period.
The Company granted options of 7.1 million shares in fiscal 2007, 6.8 million shares in fiscal
2006, and 16.8 million shares in fiscal 2005, inclusive of 9.2 million shares as the result of the
conversion of the Accredo options outstanding, at the fair market value on the date of grant. For
the years ended December 29, 2007, December 30, 2006 and December 31, 2005, there were outstanding
options to purchase 6.7 million, 7.2 million and 2.2 million shares of Medco stock, respectively,
which were not dilutive to the EPS calculations when applying the SFAS 128 treasury stock method.
These outstanding options may be dilutive to future EPS calculations.
The following is a reconciliation of the number of weighted average shares used in the basic
and diluted EPS calculations (amounts in millions):
The decrease in the weighted average shares outstanding and diluted weighted average shares
outstanding for fiscal year 2007 compared to fiscal year 2006 results from the repurchase of 111.4
million shares of stock in connection with the Company’s share repurchase program since its
inception in 2005 through fiscal year-end 2007, compared to an equivalent amount of 58.1 million
shares repurchased inception-to-date as of fiscal year-end 2006. The Company repurchased
approximately 53.3 million shares of stock in fiscal 2007. These decreases in shares outstanding
were partially offset by the issuance of stock under employee stock plans and the dilutive effect
of outstanding stock options.
The increase in the weighted average shares outstanding and diluted weighted average shares
outstanding for fiscal year 2006 compared to fiscal year 2005 reflect approximately 48 million
shares issued in August 2005 in connection with the Accredo acquisition, as well as the issuance of
stock under employee stock plans and the dilutive effect of outstanding stock options, partially
offset by share repurchases. In accordance with SFAS 128, weighted average treasury shares are not
considered part of the basic or diluted shares outstanding.
The above share data has been retrospectively adjusted to reflect the January 24, 2008
two-for-one stock split. See Note 1, “Background and Basis of Presentation,” for more information.
Pension and Other Postretirement Benefit Plans. On December 30, 2006, the last day of fiscal
year 2006, the
Company adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”),
which requires employers to recognize the overfunded or underfunded status of a defined benefit
postretirement plan as an asset or liability on the balance sheet on a prospective basis and to
recognize changes in the funded status in the year in which the changes occur through other
comprehensive income. SFAS 158 is applicable to the Company’s pension and postretirement healthcare
benefit plans and resulted in the recording of a noncurrent liability of $6.5 million for the
pension plans and a reduction in the noncurrent liability for the postretirement healthcare
benefits plan of $36.0 million upon adoption.
The determination of the Company’s obligation and expense for pension and other postretirement
benefits is based on
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management’s assumptions, which are developed with the assistance of actuaries, including an
appropriate discount rate,
expected long-term rate of return on plan assets, and rates of increase in compensation and
healthcare costs. See Note 9,
“Pension and Other Postretirement Benefits,” for more information concerning the Company’s pension
and other postretirement benefit plans’ assumptions.
Other Comprehensive Income and Accumulated Other Comprehensive Income. Other comprehensive
income
includes unrealized investment gains and losses, unrealized gains and losses on cash flow hedges,
prior service costs or credits and actuarial gains or losses associated with pension or other
postretirement benefits that arise during the period, as well as the amortization of prior service
costs or credits and actuarial gains or losses, which are reclassified as a component of net
benefit expense, and the tax effect allocated to each component of other comprehensive income.
The accumulated other comprehensive income (“AOCI”) component of stockholders’ equity includes
the net losses and prior service costs and credits related to the Company’s pension and other
postretirement benefit plans in accordance with SFAS 158, net of tax, and unrealized losses on cash
flow hedges, net of tax. The year-end balances in AOCI related to the Company’s pension and other
postretirement benefit plans consist of amounts that have not yet been recognized as components of
net periodic benefit cost in the consolidated statement of income.
The amounts recognized in AOCI at December 30, 2006 and the components and allocated tax
effects included in other comprehensive income in fiscal 2007 are as follows ($ in millions):
See Note 9, “Pension and Other Postretirement Benefits,” for additional information.
Contingencies. In the ordinary course of business, the Company is involved in litigation,
claims, government inquiries, investigations, charges and proceedings, including, but not limited
to, those relating to regulatory, commercial, employment, employee benefits and securities matters.
In accordance with SFAS No. 5, “Accounting for Contingencies,” the Company records accruals for
contingencies when it is probable that a liability will be incurred and the amount of loss can be
reasonably estimated. The Company’s recorded reserves are based on estimates developed with
consideration given to the potential merits of claims, the range of possible settlements, advice
from outside counsel, and management’s strategy with regard to the settlement of such claims or
defense against such claims. See Note 14, “Commitments and Contingencies,” for additional
information.
Stock-Based Compensation. On January 1, 2006, the Company adopted SFAS No. 123 (revised
2004), “Share-Based Payment,” (“SFAS 123R”), which requires the measurement and recognition of
compensation expense for all stock-based
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compensation awards made to employees and directors, including employee stock options and
employee stock purchase plans. SFAS 123R supersedes the Company’s previous accounting under
Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”),
for periods subsequent to December 31, 2005. In March 2005, the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 107 (“SAB 107”) which provides interpretative guidance in
applying the provisions of SFAS 123R. The Company has applied the provisions of SAB 107 in its
adoption of SFAS 123R.
The Company adopted SFAS 123R using the modified prospective transition method, which requires
the application
of the accounting standard as of January 1, 2006, the first day of the Company’s 2006 fiscal year.
The Company’s consolidated financial statements as of and for the fiscal years ended December 29,
2007 and December 30, 2006 reflect the impact of SFAS 123R. In accordance with the modified
prospective transition method, the Company’s consolidated financial statements for periods prior to
January 1, 2006 have not been restated to reflect, and do not include, the impact of SFAS 123R as
the Company did not record stock-based compensation expense related to employee stock options and
employee stock purchase plans. Stock-based compensation expense related to employee stock options
and employee stock purchase plans recognized under SFAS 123R for the fiscal years ended December
29, 2007 and December 30, 2006 amounted to $50.3 million and $63.5 million on a pre-tax basis,
respectively.
SFAS 123R requires companies to estimate the fair value of stock-based awards on the date of
grant using an option-pricing model. The portion of the value that is ultimately expected to vest
is recognized as expense over the requisite service period. Prior to the adoption of SFAS 123R, the
Company accounted for stock-based awards using the intrinsic value method in accordance with APB 25
as allowed under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the
intrinsic value method, no stock-based compensation expense had been recognized related to options
because the exercise price of the Company’s stock options granted equaled the fair market value of
the underlying stock at the date of the grant.
In addition, SFAS 123R requires that the benefits of realized tax deductions in excess of tax
benefits on compensation
expense, which amounted to $69.9 million and $33.1 million for the years ended December 29, 2007
and December 30, 2006, respectively, be reported as a component of cash flows from financing
activities rather than as an operating cash flow, as previously required. In accordance with SAB
107, the Company classifies stock-based compensation within cost of product net revenues and
selling, general and administrative expenses (“SG&A”) to correspond with the line items in which
cash compensation paid to employees and directors is recorded.
Stock-based compensation expense recognized in the Company’s consolidated statements of income
for the fiscal
years ended December 29, 2007 and December 30, 2006 includes compensation expense for stock-based
compensation awards granted prior to but not yet vested as of December 31, 2005, based on the
grant-date fair value estimated in accordance with the pro forma provisions of SFAS 123.
Additionally, the Company’s consolidated statements of income for the years ended December 29, 2007
and December 30, 2006 include compensation expense for the stock-based compensation awards granted
subsequent to December 31, 2005 based on the grant-date fair value estimated in accordance with the
provisions of SFAS 123R. In conjunction with the adoption of SFAS 123R, the Company changed its
method of attributing the value of stock-based compensation to expense from the accelerated
multiple-option approach under FASB Interpretation No. 28, “Accounting for Stock Appreciation
Rights and Other Variable Stock Option or Award Plans” to the straight-line single option method.
As stock-based compensation expense recognized in the Company’s consolidated statements of
income for the years
ended December 29, 2007 and December 30, 2006 is based on awards ultimately expected to vest, it
has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the
time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. The Company estimates forfeitures in the same manner under SFAS 123R as it did
prior to its adoption.
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Stock-based compensation expense related to stock options and employee stock purchase plans
recognized as a result of the adoption of SFAS 123R was comprised as follows ($ in millions, except
for per share data):
The pro forma net income and earnings per share for fiscal year 2005, which reflect results as
if the Company had applied the fair value method for recognizing employee stock-based compensation
to the stock options and the employee stock purchase plan, are as follows ($ in millions, except
for per share data):
The above share and per share data has been retrospectively adjusted to reflect the January
24, 2008 two-for-one stock split. See Note 1, “Background and Basis of Presentation,” for more
information.
Net income, as reported, also includes stock-based compensation expense related to restricted
stock and restricted stock units for the years ended December 29, 2007, December 30, 2006 and
December 31, 2005 of $31.8 million ($52.2 million pre-tax), $19.5 million ($32.1 million pre-tax)
and $10.4 million ($17.2 million pre-tax), respectively. The increase in restricted stock and
restricted stock unit expense reflects restricted stock units becoming a larger component of total
employee stock compensation.
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See Note 11, “Stock-Based Compensation,” for additional information concerning the Company’s
stock-based compensation plans.
Recent Accounting Pronouncements. In September 2006, the FASB issued SFAS No. 157, “Fair
Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring
fair value in U.S. generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS 157 applies under other accounting pronouncements that require or permit
fair value measurements, the FASB having previously concluded in those accounting pronouncements
that fair value is the relevant measurement attribute. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. The Company’s adoption of SFAS 157 in 2008 is not expected to have a material
impact on its consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets
and Financial Liabilities, Including an Amendment of FASB Statement No. 115” (“SFAS 159”), which is
effective for fiscal years beginning after November 15, 2007. SFAS 159 permits entities to measure
eligible financial assets, financial liabilities and firm commitments at fair value, on an
instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value
under other U.S. generally accepted accounting principles. The fair value measurement election is
irrevocable and subsequent changes in fair value must be recorded in earnings. The Company’s
adoption of SFAS 159 in 2008 is not expected to have a material impact on its consolidated
financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), “Business Combinations” (“SFAS 141(R)”)
and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). The
standards are intended to improve, simplify, and converge internationally the accounting for
business combinations and the reporting of noncontrolling interests in consolidated financial
statements. SFAS 141(R) requires the acquiring entity in a business combination to recognize all
(and only) the assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired and liabilities
assumed; and requires the acquirer to disclose to investors and other users all of the information
they need to evaluate and understand the nature and financial effect of the business combination.
SFAS 141(R) is effective for fiscal years, and interim periods within those fiscal years, beginning
on or after December 15, 2008. SFAS 141(R) applies prospectively to business combinations for which
the acquisition date is on or after the beginning of the first annual reporting period beginning on
or after December 15, 2008. Earlier adoption is prohibited.
SFAS 160 is designed to improve the relevance, comparability, and transparency of financial
information provided to investors by requiring all entities to report noncontrolling (minority)
interests in subsidiaries in the same way—as equity in the consolidated financial statements.
Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions
between an entity and noncontrolling interests by requiring they be treated as equity transactions.
SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on
or after December 15, 2008. Earlier adoption is prohibited. In addition, SFAS 160 shall be applied
prospectively as of the beginning of the fiscal year in which it is initially applied, except for
the presentation and disclosure requirements. The presentation and disclosure requirements shall be
applied retrospectively for all periods presented. The Company does not have an outstanding
noncontrolling interest in one or more subsidiaries and therefore, SFAS 160 is not applicable to
the Company at this time.
3. ACQUISITIONS OF BUSINESSES
PolyMedica Corporation. On October 31, 2007, the Company acquired all of the outstanding
common stock of PolyMedica for $1.3 billion in cash. PolyMedica is a leading provider of diabetes
care, under its Liberty brand, including blood glucose testing
supplies and related services. Previously in 2006,
Medco formed a multi-pronged alliance with PolyMedica, enabling Medco
to become the direct mail dispensing pharmacy for their members, and
provide Polymedica’s Medicare Part B solution to Medco clients. This
acquisition is expected to support the Company’s ability to deliver advanced, specialized pharmacy
services by treating patients at the disease level. Under the terms of the Agreement and Plan of
Merger dated August 27, 2007, PolyMedica shareholders received $53 in cash for each outstanding
share of PolyMedica common stock. The Company funded the transaction on October 31, 2007 through a
combination of bank borrowings from its existing $2 billion revolving credit facility and cash on
hand.
The transaction was accounted for under the provisions of SFAS No. 141, “Business
Combinations” (“SFAS 141”). The purchase price has been allocated based upon the fair value of net
assets acquired at the date of the acquisition. A
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portion of the excess of the purchase price over tangible net assets acquired has been
allocated to intangible assets, consisting of the Liberty trade name of $392.0 million with an
indefinite life, customer relationships of $119.9 million with an estimated 8-year life, noncompete
agreements of $26.8 million with an estimated 3-year life, and customer lists of $2.8 million with
an estimated 4-year life. These assets are included in intangible assets, net, in the consolidated
balance sheets. The purchase price for PolyMedica was primarily determined on the basis of
management’s expectations of future earnings and cash flows, and resulted in the recording of
goodwill of $1.0 billion, which is not tax deductible. In accordance with SFAS No. 142, “Goodwill
and Other Intangible Assets,” (“SFAS 142”) the goodwill is not being amortized.
The Company retained third-party valuation advisors to conduct analyses of the assets acquired
and liabilities assumed in order to assist the Company in the determination of the preliminary
purchase price allocation. The preliminary purchase price allocation may be subject to further
refinement based on identification of any necessary changes or other acquisition-related
adjustments primarily related to contingencies. The Company expects that if any refinements become
necessary, they would be completed by November 2008. There can be no assurance that such
finalization will not result in material changes. The following table summarizes the Company’s
preliminary estimates of the fair values of the assets acquired and liabilities assumed in the
PolyMedica acquisition ($ in millions):
PolyMedica’s operating results from October 31, 2007, the date of acquisition, through
December 29, 2007, are included in the accompanying consolidated financial statements. The
unaudited pro forma results of operations of the Company and PolyMedica, prepared based on the
purchase price allocation for PolyMedica described above and as if the PolyMedica acquisition had
occurred at the beginning of each fiscal year presented, would have been as follows ($ in millions,
except for per share amounts):
The above per share data has been retrospectively adjusted to reflect the January 24, 2008
two-for-one stock split. See Note 1, “Background and Basis of Presentation,” for more information.
The pro forma financial information above is not necessarily indicative of what the Company’s
consolidated results of operations actually would have been if the PolyMedica acquisition had been
completed at the beginning of each period. In addition, the pro forma information above does not
attempt to project the Company’s future results of operations.
Critical Care. On November 14, 2007, Accredo acquired Critical Care, one of the nation’s
largest providers of home-based and ambulatory specialty infusion services, for approximately $220
million in cash. The Company acquired Critical Care because it believes the combination of the two
will expand Accredo’s capabilities and market presence related to infused agents. The transaction
was accounted for under the provisions of SFAS 141. The purchase price has been allocated based
upon the preliminary estimates of the fair value of net assets acquired at the date of the
acquisition. A
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portion of the excess of the purchase price over tangible net assets acquired, amounting to
$116.2 million, has been allocated to goodwill, and $68.0 million has been allocated to intangible
assets, which are being amortized using the straight-line method over an estimated weighted average
useful life of approximately 13.8 years. These assets are included in intangible assets, net, and
goodwill, respectively, in the consolidated balance sheets. The Company retained third-party
valuation advisors to conduct analyses of the assets acquired and liabilities assumed in order to
assist the Company in the determination of the preliminary purchase price allocation. The Company
expects that if any refinements to the preliminary purchase price allocation become necessary, they
would be completed by November 2008. There can be no assurance that such finalization will not
result in material changes. Pro forma financial statement results including the results of Critical
Care would not differ materially from our historically reported financial statement results.
Accredo. On August 18, 2005, the Company acquired all of the outstanding common stock of
Accredo. Accredo offers a limited number of high-cost drugs that are primarily injectable for the
recurring treatment of chronic and potentially life-threatening diseases. The Company acquired
Accredo because it believes the combination of the two companies will accelerate its growth in the
rapidly growing specialty pharmacy industry.
The aggregate purchase price amounted to $2.4 billion, including $1.2 billion in Medco common
stock, $1.1 billion in cash and $0.1 billion of converted options. The $0.1 billion of converted
options represents the acquisition date fair value of the Medco options issued in exchange for the
outstanding Accredo options under the terms of the Merger Agreement. The transaction was accounted
for under the provisions of SFAS 141. The purchase price has been allocated based upon the fair
value of net assets acquired at the date of the acquisition. A portion of the excess of the
purchase price over tangible net assets acquired has been allocated to intangible assets,
consisting of manufacturer relationships of $357.5 million, payor relationships of $204.6 million,
trade names of $153.2 million, patient relationships of $50.9 million, noncompete agreements of
$2.9 million and lease agreements of $1.0 million, which are being amortized using the
straight-line method over an estimated weighted average useful life of approximately 22 years.
These assets are included in intangible assets, net, in the consolidated balance sheets. The
purchase price for Accredo was primarily determined on the basis of management’s expectations of
future earnings and cash flows, and resulted in the recording of goodwill of $1.8 billion, which is
not tax deductible. In accordance with SFAS 142, the goodwill is not being amortized.
Accredo’s operating results from August 18, 2005, the date of acquisition, through December
30, 2006, are included in the accompanying consolidated financial statements. The unaudited pro
forma results of operations of the Company and Accredo, prepared based on the purchase price
allocation for Accredo described above and as if the Accredo acquisition had occurred at the
beginning of 2005, would have been as follows ($ in millions, except for per share amounts):
The above share and per share data has been retrospectively adjusted to reflect the January
24, 2008 two-for-one stock split. See Note 1, “Background and Basis of Presentation,” for more
information. The pro forma financial information above is not necessarily indicative of what the
Company’s consolidated results of operations actually would have been if the Accredo acquisition
had been completed at the beginning of 2005. In addition, the pro forma information above does not
attempt to project the Company’s future results of operations.
Pediatric Services. On November 21, 2005, Accredo acquired a portion of Pediatric Services’
specialty pharmacy business consisting of selected assets for $72.5 million. The transaction was
accounted for under the provisions of SFAS 141. The purchase price has been allocated based upon
the fair value of net assets acquired at the date of the acquisition. A portion of the excess of
the purchase price over tangible net assets acquired, amounting to $32.6 million, has been
allocated to goodwill, and $23.4 million has been allocated to intangible assets, which are being
amortized using the straight-line method over an estimated weighted average useful life of
approximately 20 years. These assets are included
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in intangible assets, net, and goodwill, respectively, in the consolidated balance sheets. The
pro forma amounts presented above exclude Pediatric Services due to immateriality.
4. LEGAL SETTLEMENTS CHARGE
On October 23, 2006, the Company entered into settlement agreements with the Department of
Justice on the following three previously disclosed matters handled by the U.S. Attorney’s Office
for the Eastern District of Pennsylvania. The three settlement agreements do not include any
finding or admission of wrongdoing on the part of the Company.
The first matter was a Consolidated Action pending in the Eastern District of Pennsylvania.
The Consolidated Action included a government complaint-in-intervention filed in September 2003 and
two pending qui tam, or whistleblower, complaints filed in 2000. The complaints alleged violations
of the False Claims Act and various other state statutes. Additional legal claims were added in an
amended complaint-in-intervention filed in December 2003, including a count alleging a violation of
the Public Contracts Anti-Kickback Act. This Consolidated Action was settled for $137.5 million.
The second matter was a qui tam that remains under seal in the Eastern District of
Pennsylvania. The U.S. Attorney’s Office had informed the Company that the Complaint alleges
violations of the federal False Claims Act, that the Company and other defendants inflated
manufacturers’ “best price” to Medicare and Medicaid, and that the Company and other defendants
offered and paid kickbacks to third parties to induce the placement on formularies and promotion of
certain drugs. This matter was settled for $9.5 million.
The third matter was an investigation that began with a letter the Company received from the
U.S. Attorney’s Office for the Eastern District of Pennsylvania in January 2005 requesting
information and representations regarding the Company’s Medicare Part B coordination of benefits
recovery program. This matter was settled for $8.0 million.
The Company had recorded reserves for these items, including a $162.6 million pre-tax charge
that was recorded in the first fiscal quarter of 2006 in SG&A expenses, to cover these settlement
charges and fees owed to the plaintiffs’ attorneys. The Company believes it is probable that the
legal settlements charge will be tax deductible.
Contemporaneous with the three above-referenced settlement agreements, the Company entered
into a Corporate Integrity Agreement with the Department of Health and Human Services and the
Office of Personnel Management. This five-year agreement is designed to ensure that the Company’s
Compliance and Ethics Program meets certain requirements. On October 24, 2006, the Company paid
$156.4 million, representing the settlement amount plus accrued interest of $1.4 million, to the
Department of Justice.
See Note 14, “Commitments and Contingencies,” for additional information on various lawsuits,
claims proceedings and investigations that are pending against the Company and certain of its
subsidiaries.
5. PROPERTY AND EQUIPMENT
Property and equipment, at cost, consist of the following ($ in millions):
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Depreciation expense for property and equipment totaled $168.9 million, $173.6 million and
$165.0 million in fiscal years 2007, 2006 and 2005, respectively.
6. LEASES
The Company leases pharmacy and call center pharmacy facilities, offices and warehouse space
throughout the United States under various operating leases. In addition, the Company leases pill
dispensing and counting devices and other operating equipment for use in its mail-order pharmacies,
as well as computer equipment for use in its data centers and corporate headquarters. Rental
expense was $61.8 million, $60.1 million and $54.3 million for fiscal years 2007, 2006 and 2005,
respectively. The minimum aggregate rental commitments under noncancelable leases, excluding
renewal options, are as follows ($ in millions):
In the normal course of business, operating leases are generally renewed or replaced by new
leases.
7. GOODWILL AND INTANGIBLE ASSETS
The following is a summary of the Company’s goodwill and other intangible assets ($ in
millions):
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The changes in the Company’s gross carrying amount of goodwill for the year ended December 29,
2007 are as follows ($ in millions):
As of December 29, 2007, aggregate intangible asset amortization expense in each of the five
succeeding fiscal years is estimated as follows ($ in millions):
The weighted average useful life of intangible assets subject to amortization is 22 years in
total. The weighted average useful life is approximately 22 years for the PBM client relationships
and approximately 21 years for the Specialty-acquired intangible assets. The Liberty trade name
acquired intangible asset of $392 million has an indefinite life.
8. DEBT AND REFINANCING
The Company’s debt consists of the following ($ in millions):
Five-Year Credit Facilities and Refinancing. On April 30, 2007, the Company entered into a
senior unsecured credit agreement which, in addition to replacing the Company’s existing senior
unsecured credit facility, is available to fund the Company’s share repurchase program,
acquisitions, general corporate activities, working capital requirements, and capital expenditures.
In connection with the refinancing, the Company’s pre-existing senior unsecured credit facilities
were extinguished and the Company’s indebtedness outstanding pursuant to such facilities was paid
in full. The current facilities consist of a $1 billion, 5-year senior unsecured term loan and a
$2 billion, 5-year senior unsecured revolving credit facility. The pre-existing facilities
consisted of a $750 million senior unsecured term loan and a $750 million senior
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unsecured revolving credit facility. The current term loan matures on April 30, 2012, at which
time the entire facility is required to be repaid, compared with the pre-existing credit facility,
under which the Company had quarterly installments. At the Company’s current debt ratings, the
current credit facilities bear interest at London Interbank Offered Rate (“LIBOR”) plus a 0.45
percent margin, with a 10 basis point commitment fee due on the unused revolving credit facility.
The weighted average LIBOR under the Company’s senior unsecured bank credit facilities was 5.0% as
of December 29, 2007. The fair value of the term loan and revolving credit obligations outstanding
under the senior unsecured bank credit facilities approximates its carrying value and was estimated
using current interbank market prices. The pre-existing credit facilities incurred interest at
LIBOR plus a 0.5 percent margin, with a 12.5 basis point commitment fee due on the unused revolving
credit facility.
On October 31, 2007, the Company drew down $1 billion under the revolving credit facility in
order to partially fund the PolyMedica acquisition. The Company drew down an additional $400
million under the revolving credit facility in the fourth quarter of 2007, primarily to pay down
PolyMedica’s outstanding debt balances and to acquire Critical Care. For more information on the
acquisitions of PolyMedica and Critical Care, see Note 3, “Acquisitions of Businesses.”
As of December 29, 2007, the Company had $1 billion outstanding under the term loan facility.
In addition, the Company had $1.4 billion outstanding under the revolving credit facility, and had
$587 million available for borrowing, after giving effect to $13 million in issued letters of
credit, under the revolving credit facility.
Senior Notes. Medco completed in August 2003, in connection with the spin-off, an underwritten
public offering of $500 million aggregate principal amount of 10-year senior notes at a price to
the public of 99.195 percent of par value. The senior notes bear interest at a rate of 7.25% per
annum, with an effective interest rate of 7.365%, and mature on August 15, 2013. The Company may
redeem the senior notes at its option, in whole or in part, at any time at a price equal to the
greater of: (i) 100% of the principal amount of the notes being redeemed, or (ii) the sum of the
present values of 107.25% of the principal amount of the notes being redeemed, plus all scheduled
payments of interest on the notes discounted to the redemption date at a semi-annual equivalent
yield to a comparable treasury issue for such redemption date plus 50 basis points.
Swap Agreements. The Company entered into five interest rate swap agreements in 2004. These
swap agreements, in effect, converted $200 million of the $500 million of 7.25% senior notes to
variable interest rates. The swaps have been designated as fair value hedges and have an expiration
date of August 15, 2013, consistent with the maturity date of the senior notes. The fair value of
the derivatives outstanding, which is based upon quoted market prices that reflect the present
values of the difference between estimated future fixed rate payments and future variable rate
receipts, represented a net payable of $3.0 million and $11.9 million as of December 29, 2007 and
December 30, 2006, respectively. These amounts were recorded in other noncurrent liabilities, with
an offsetting amount recorded in long-term debt, net. These are the amounts that the Company would
have had to pay to third parties if the derivative contracts had been settled. Under the terms of
the swap agreements, the Company receives a fixed rate of interest of 7.25% on $200 million and
pays variable interest rates based on the six-month LIBOR plus a weighted average spread of 3.05%.
The payment dates under the agreements coincide with the interest payment dates on the hedged debt
instruments, and the difference between the amounts paid and received is included in interest and
other (income) expense, net. Interest expense was increased by $2.6 million and $1.9 million for
the years ended December 29, 2007 and December 30, 2006, respectively, and was reduced by $1.8
million for the year ended December 31, 2005, as a result of the swap agreements. The weighted
average LIBOR associated with the swap agreements was 5.4%, 5.0% and 3.2% for the years ended
December 29, 2007, December 30, 2006 and December 31, 2005, respectively.
On December 12, 2007, the Company entered into forward-starting interest rate swap agreements
with a notional amount of $750 million. These highly-effective cash flow hedges manage the
Company’s exposure to changes in future benchmark interest rates in contemplation of potentially
obtaining long-term fixed-rate financing. As of December 29, 2007 the Company included in
accumulated other comprehensive income an unamortized swap loss of $7.9 million ($4.8 million, net
of tax).
Accounts Receivable Financing Facility. Through a wholly-owned subsidiary, the Company has a
$600 million, 364-day renewable accounts receivable financing facility that is collateralized by
the Company’s pharmaceutical manufacturer rebate accounts receivable. The Company pays interest on
amounts borrowed under the agreement based on the funding
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rates of the bank-related commercial paper programs that provide the financing, plus an
applicable margin determined by the Company’s credit rating. The weighted average annual interest
rate on amounts borrowed under the facility as of December 29, 2007 and December 30, 2006 was 5.49%
and 5.51%, respectively. At December 29, 2007, there was $600 million outstanding with no
additional amounts available for borrowing under the facility. During 2007, the Company drew down
an additional $275 million under the facility.
The accounts receivable financing facility was originally $500 million and effective July 31,
2006, the
facility was increased to $600 million. There was $325 million outstanding under the accounts
receivable financing facility on December 30, 2006. During the third and fourth quarters of 2006,
the Company drew down $150 million and repaid $275 million under the facility. At December 30,
2006, there was $275 million available for borrowing under the facility.
New 364-day Credit Facility. On November 30, 2007, the Company entered into an $800 million
364-day revolving credit agreement (the “Credit Agreement”), the proceeds of which will be used for
general corporate purposes, including the repurchase of shares of our common stock under the
Company’s existing share repurchase program. The Company may from time to time borrow up to $800
million in revolving loans during the availability period, effective beginning on January 2, 2008.
At the Company’s current debt ratings, borrowings will bear interest at LIBOR plus a 0.55 percent
margin, with a 10 basis point commitment fee due on the unused portion of the facility. Repayment
of the outstanding revolving loans is due on November 28, 2008, though the Company may continually
borrow, prepay and re-borrow revolving loans during the life of the agreement and may terminate the
Credit Agreement at any time, without incurring prepayment penalties, by prepaying in full all
outstanding revolving loans.
Covenants. The senior unsecured credit facilities, senior notes, and accounts receivable
financing facility contain covenants, including, among other items, maximum leverage ratios. The
Company was in compliance with all financial covenants at December 29, 2007.
Aggregate Maturities and Interest Expense. The aggregate maturities of long-term debt,
including current portion, are as follows ($ in millions):
Interest expense, primarily on debt, was $134.2 million in 2007, $95.8 million in 2006 and
$73.9 million in 2005.
9. PENSION AND OTHER POSTRETIREMENT BENEFITS
Net Pension and Postretirement Benefit Cost. The Company has various plans covering the
majority of its employees. The Company uses its fiscal year-end date as the measurement date for
most of its plans. The net cost for the Company’s pension plans consisted of the following
components ($ in millions):
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The Company maintains an unfunded postretirement healthcare benefit plan covering the majority
of its employees. The net (credit) cost of these postretirement benefits consisted of the following
components ($ in millions):
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