EX-99.1 3 dex991.htm INFORMATION STATEMENT Information Statement
Table of Contents
Index to Financial Statements

Raymond V. Gilmartin

Chairman, President & Chief Executive Officer

 

Merck & Co., Inc.

One Merck Drive

P.O. Box 100

Whitehouse Station, NJ 08889-0100

 

LOGO

 

                         , 2003

 

Dear Merck & Co., Inc. Stockholder:

 

I am pleased to inform you that on August 4, 2003, the Board of Directors of Merck & Co., Inc. approved the spin-off of Medco Health Solutions, Inc., a wholly owned subsidiary of Merck that provides pharmacy benefit management services to approximately 62 million members.

 

The spin-off of Medco Health, which creates two separate companies with significant growth prospects, will enhance the success of both Merck and Medco Health by enabling each one to pursue its unique and focused strategy. This transaction will provide our stockholders with equity in two very successful companies. We believe the spin-off will enhance the potential for success of both businesses, thereby increasing stockholder value.

 

The spin-off of Medco Health will occur on August 19, 2003 by way of a pro rata dividend to Merck stockholders. If you held Merck common stock at the close of business on the record date for the spin-off, August 12, 2003, you will receive a dividend of .1206 shares of Medco Health common stock for every one share of Merck common stock that you held on that date. The dividend will be paid in book-entry form, and physical stock certificates will be issued only upon request. No fractional shares of Medco Health common stock will be issued. If you would be entitled to a fractional share of Medco Health common stock in the distribution, you will receive its cash value instead. Based on a letter ruling we have received from the U.S. Internal Revenue Service, your receipt of Medco Health shares in the distribution will be tax-free for U.S. federal income tax purposes, but any cash you receive instead of fractional shares will be taxable to you. You should, of course, consult your own tax advisor as to the particular consequences of the distribution to you.

 

Stockholder approval of the spin-off is not required, and you are not required to take any action to receive your Medco Health common stock.

 

Following the spin-off, you will own shares in both Merck and Medco Health. Merck common stock will continue to trade on the New York Stock Exchange under the symbol “MRK”. Medco Health’s common stock has been authorized to be listed on the New York Stock Exchange under the symbol “MHS”.

 

The attached information statement, which is being mailed to all Merck stockholders, describes the spin-off in detail and contains important information, including financial statements, about Medco Health.

 

We look forward to your continued support as a stockholder in both Merck and Medco Health.

 

Sincerely,

 

Raymond V. Gilmartin

Chairman, President and Chief Executive Officer


Table of Contents
Index to Financial Statements

LOGO

 

                          , 2003

 

Dear Medco Health Solutions, Inc. Stockholder:

 

It is my pleasure to welcome you as a stockholder of Medco Health Solutions, Inc. We are the largest provider of prescription benefit management services in the United States, based on the net revenues we generated in 2002. We provide sophisticated prescription benefit programs and services for our clients and their 62 million members, as well as for the physicians and pharmacies the members use.

 

As a separate company, Medco Health will continue to provide high-quality, customer-oriented service while effectively managing drug costs for our clients and their members. We plan to focus our energies on continued innovation in controlling health care costs and driving improved patient care through the appropriate use of prescription drugs. With our talented and experienced employees and highly automated home delivery pharmacy and Internet technologies, we are well positioned to continue as a leader in our industry.

 

Medco Health Solutions, Inc.’s common stock has been authorized to trade on the NYSE under the symbol “MHS” following the spin-off.

 

I invite you to learn more about Medco Health by reviewing the enclosed information statement. We look forward to our future as a separately-traded public company and to your support as a holder of Medco Health Solutions, Inc. common stock.

 

Sincerely,

 

David B. Snow, Jr.

Chairman, President and Chief Executive Officer


Table of Contents
Index to Financial Statements

Exhibit 99.1

 

Preliminary and Subject to Completion, dated August 6, 2003

 

Information Statement

 

LOGO

 

Medco Health Solutions, Inc.

Common Stock

(Par Value $0.01 per share)

 

This information statement is being furnished in connection with the distribution of all the outstanding shares of Medco Health Solutions, Inc. common stock by Merck & Co., Inc. to holders of its common stock.

 

Shares of our common stock will be distributed to holders of Merck common stock of record as of the close of business on August 12, 2003, which will be the record date. These stockholders will receive .1206 shares of our common stock for every one share of Merck common stock held on the record date. The distribution of our shares will be made in book-entry form, and physical stock certificates will be issued only upon request. No fractional shares will be issued. Those stockholders who would otherwise be entitled to receive fractional shares will receive cash in lieu of fractional shares. The distribution will be effective at 11:59 p.m. on August 19, 2003. Merck has received a letter ruling from the U.S. Internal Revenue Service to the effect that the distribution will be tax-free to Merck and its stockholders for U.S. federal income tax purposes, except for any cash received in lieu of fractional shares.

 

No stockholder approval of the distribution is required or sought. We are not asking you for a proxy and you are requested not to send us a proxy. Merck stockholders will not be required to pay for the shares of our common stock to be received by them in the distribution, or to surrender or to exchange shares of Merck common stock in order to receive our common stock or to take any other action in connection with the distribution. There is no current trading market for our common stock. However, we expect that a limited market, commonly known as a “when-issued” trading market, for our common stock will develop on or shortly before the record date for the spin-off, and we expect “regular way” trading of our common stock will begin the first trading day after the spin-off. Our common stock has been authorized to be listed on the New York Stock Exchange under the symbol “MHS”.

 

In reviewing this information statement, you should carefully consider the matters described under the caption “ Risk Factors” beginning on page 17.

 


 

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved these securities or determined if this information statement is truthful or complete. Any representation to the contrary is a criminal offense.

 


 

This information statement does not constitute an offer to sell or the solicitation of an offer to buy any securities.

 


 

The date of this information statement is                     , 2003.

Merck first mailed this document to its stockholders on                     , 2003.


Table of Contents
Index to Financial Statements

TABLE OF CONTENTS

 

     Page

Summary

   1

Risk Factors

   17

Cautionary Note Regarding Forward-Looking Statements

   39

The Distribution

   40

Dividend Policy

   46

Capitalization

   47

Selected Historical Consolidated Financial and Operating Data

   48

Unaudited Pro Forma Condensed Consolidated Financial Data

   51

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   54

Business

   76

Management

   106

Relationships Between Our Company and Merck & Co., Inc.

   120

Security Ownership of Certain Beneficial Owners and Management

   139

Description of Capital Stock

   141

Description of Indebtedness

   146

Where You Can Find More Information

   150

Index to Financial Statements

   F-1

 


 

Unless otherwise indicated, all references in this information statement:

 

    to Medco Health, us or we include Medco Health Solutions, Inc., its subsidiaries and its predecessors, including Merck-Medco Managed Care, L.L.C., the company that historically operated our business and that converted to a corporation on May 21, 2002;

 

    to Merck & Co., Inc. or Merck include Merck & Co., Inc. and its subsidiaries;

 

    to years are to our fiscal years ended on the last Saturday in December of the year indicated; and

 

    to quarters are to our fiscal quarters ended on the last Saturday in March, June, September or December of the quarter indicated.

 

The transaction in which Medco Health will be separated from Merck and become a separately-traded public company is referred to in this information statement alternatively as the “distribution” or the “spin-off”.


Table of Contents
Index to Financial Statements

SUMMARY

 

The following is a summary of what we believe is the most important information contained in this information statement regarding our business and the distribution. For a complete understanding of our business and the distribution, we urge you to read this entire document carefully, including the risk factors, our historical and pro forma consolidated financial statements and the notes to those financial statements.

 

Medco Health Solutions, Inc.

 

We are the nation’s largest pharmacy benefit manager, or PBM, based on our 2002 net revenues. We provide sophisticated programs and services for our clients and the members of their pharmacy benefit plans, as well as for the physicians and pharmacies the members use. We believe that our ability to consistently deliver programs and services that help our clients provide a high-quality, cost-effective prescription drug program to their members has made us a market leader.

 

We actively pursue initiatives to reduce the rate of increase in our clients’ drug expenditures, referred to in our industry as “drug trend”, to save members money and to improve the services we provide both our clients and their members. We continue to expand our pre-eminent home delivery business, which reduces drug costs for our clients and provides enhanced reliability and service to their members. In 2002, our national network of home delivery pharmacies filled approximately 82 million prescriptions, representing about 30% more than the number of prescriptions filled by the mail service operations of our three largest competitors combined. We seek to contain costs for our clients and their members by encouraging the prescribing of drugs on a plan’s approved list of drugs, or “formulary”, and the use of medically appropriate generic drugs through our generic education and substitution programs. Our high-quality service, advanced technology and cost containment initiatives enabled us to limit the average drug trend for plans that include both retail and home delivery to 14.0% in each of 2000 and 2001 and 12.9% in 2002, compared to the national average of 17.3% in 2000, 15.7% in 2001 and an estimated 14.3% in 2002 as reported by the Centers for Medicare & Medicaid Services, or CMS.

 

We have a large number of clients in each of the major industry segments, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. As of June 2003, the plans we administered for our clients covered 190 of the Fortune 500, including 52 of the Fortune 100, 12 of the country’s 42 Blue Cross/Blue Shield plans and several large managed care organizations. In addition, our Systemed, L.L.C. subsidiary capitalizes on our extensive PBM capabilities to meet the specific needs of small to mid-size clients. Over the last three years, our aggregate revenue from small to mid-size clients increased an average of approximately 39% per year, excluding the impact of acquisitions, to approximately $1.6 billion in 2002.

 

From 1998 to 2002, our net revenues increased on average approximately 26.4% per year. In 2002, we filled or processed approximately 548 million prescriptions, had net revenues of approximately $33 billion and net income of more than $360 million, and had earnings before interest income/expense, taxes, depreciation and amortization, or EBITDA, of approximately $886 million. See Note 6 under “Selected Historical Consolidated Financial and Operating Data” for a further description of EBITDA and a table that reconciles net income to EBITDA on page 50 of this information statement. Our net income is driven by our ability to earn rebates and negotiate favorable discounts on prescription drugs from pharmaceutical manufacturers, obtain competitive discounts from retail pharmacies, negotiate competitive client pricing, including rebate sharing terms, shift dispensing volumes from retail to home delivery and provide services in a cost-efficient manner.

 

Our business is subject to significant risks. We summarize what we believe are the most important risks under “Some Important Risks Facing Our Company” later in this section. These and other risks facing our company are described in greater detail under “Risk Factors”.

 

1


Table of Contents
Index to Financial Statements

Questions and Answers about Medco Health and the Distribution

 

Why is Merck separating Medco Health from its business?

The board of directors of Merck has determined that the separation of Medco Health from Merck will enhance the success of both Merck and Medco Health, and thereby maximize stockholder value over the long term for each company, by:

 

    enabling each company to continue to pursue its unique and focused strategy; and

 

    enabling investors to evaluate the financial performance, strategies and other characteristics of Merck and Medco Health separately in comparison to companies within their respective industries.

 

See “The Distribution”.

 

Why is the separation of the two companies structured as a spin-off?

Merck’s board of directors believes that a tax-free distribution of shares in Medco Health offers Merck and its stockholders the greatest long-term value and is the most tax efficient way to separate the companies.

 

What do stockholders need to do to participate in the spin-off?

Nothing. You are not required to take any action to receive Medco Health common stock in the distribution, although we urge you to read this entire document carefully. You do not need to mail in Merck common stock certificates to receive Medco Health common stock. No stockholder approval of the distribution is required or sought. We are not asking you for a proxy and you are requested not to send us a proxy. You will not be required either to pay anything for the new shares or to surrender any shares of Merck common stock. If you own Merck common stock as of the close of business on the record date, you will receive Medco Health common stock in book-entry form, on or about August 19, 2003. Physical stock certificates will only be issued to you upon your request, without charge.

 

Are there risks to owning Medco Health common stock?

Yes. Medco Health’s business is subject both to general and specific business risks relating to its operations. In addition, Medco Health’s spin-off from Merck presents risks relating to it being a separately-traded public company as well as risks relating to the nature of the spin-off transaction itself. See “Risk Factors”.

 

Does Medco Health plan to pay dividends?

No. We do not plan to pay dividends in the foreseeable future other than cash dividends aggregating $2 billion that we will pay to Merck prior to or concurrently with the completion of the distribution. Moreover, the terms of the credit agreement governing our senior secured credit facility and the indenture governing our ten-year senior unsecured notes will limit the amount of dividends we may pay. Payment of future cash dividends, if any, will be at the discretion of our board of directors in accordance with applicable law. See “Dividend Policy” and “Description of Indebtedness”.

 

2


Table of Contents
Index to Financial Statements

What will the relationship between Merck and Medco Health be following the distribution?

After the distribution, Merck will not own any shares of Medco Health common stock and Medco Health will not own any shares of Merck common stock. However, in connection with the distribution, we and Merck are entering into a number of agreements that will govern our spin-off from Merck and our future relationship.

 

 

Under our managed care agreement with Merck, Merck provides us with rebates based, in part, on whether Merck products are included in the formularies we offer our clients and whether Merck products achieve specified market share targets under plans for which we provide PBM services. See “Relationships Between Our Company and Merck & Co., Inc.”

 

What are the U.S. federal income tax consequences of the distribution to Merck stockholders?

Based on the letter ruling that Merck has received from the U.S. Internal Revenue Service, or IRS, you will not recognize a gain or loss on the receipt of shares of Medco Health common stock in the spin-off, except to the extent you receive cash in lieu of fractional shares. Your tax basis in your Merck common stock will be apportioned between your Merck common stock and the Medco Health common stock received in the distribution in accordance with their relative fair market values. See “The Distribution—U.S. Federal Income Tax Consequences of the Distribution”.

 

Where can Merck stockholders get
more information?

  You should direct inquiries relating to the distribution to the information agent for the distribution at:

 

Georgeson Shareholder Communications, Inc.

17 State Street, 10th Floor

New York, NY 10004

1-(866) 216-0463

 

You should direct inquiries relating to your investment in Merck common stock to:

 

Merck & Co., Inc.

One Merck Drive

Whitehouse Station, New Jersey 08889-0100

Attention: Stockholder Services

www.merck.com

 

After the distribution, you should direct inquiries relating to an investment in our common stock to:

 

Medco Health Solutions, Inc.

100 Parsons Pond Drive

Franklin Lakes, New Jersey 07417-2603

Attention: Investor Relations

www.medcohealth.com

 

 

 

3


Table of Contents
Index to Financial Statements

The transfer agent and registrar for our common stock will be:

 

The Bank of New York

101 Barclay Street, 11 East

New York, New York 10286

(866) 808-8310

www.stockbny.com

 

The distribution agent for our common stock will be:

 

Wells Fargo Shareowner Services, a division of

Wells Fargo Bank Minnesota, N.A.

161 North Concord Exchange

South St. Paul, MN 55075

(800) 778-3303

www.wellsfargo.com/shareownerservices

 

Information on these websites does not constitute part of this information statement.

 

4


Table of Contents
Index to Financial Statements

Summary of the Distribution

 

The following is a brief summary of the terms of the distribution. Please see “The Distribution” for a more detailed description of the matters described below.

 

Distributing company

Merck & Co., Inc., which is a global research-driven pharmaceutical products and services company.

 

Distributed company

Medco Health Solutions, Inc., which is the nation’s largest provider of pharmacy benefit management services based on our 2002 net revenues.

 

Distribution ratio

Each holder of Merck common stock will receive a dividend of .1206 shares of our common stock for every one share of Merck common stock held on the record date.

 

Securities to be distributed

Approximately 270,000,000 shares of our common stock. The shares of our common stock to be distributed will constitute all of the outstanding shares of our common stock immediately after the distribution.

 

Transfer agent and registrar for the shares

The Bank of New York will be the transfer agent and registrar for the shares of our common stock.

 

Distribution agent for the shares

Wells Fargo Shareowner Services, a division of Wells Fargo Bank Minnesota, N.A., will be the distribution agent for the shares of our common stock.

 

Method of distribution

For registered Merck stockholders, our transfer agent will credit their shares of our common stock to book-entry accounts established to hold their shares of our common stock. Book-entry refers to a method of recording stock ownership in our records in which no physical certificates are issued. For stockholders who own Merck common stock through a broker or other nominee, their shares of our common stock will be credited to their accounts by the broker or other nominee. Following the distribution, stockholders whose shares are held in book-entry form may request the transfer of their shares of our common stock to a brokerage or other account at any time or the delivery of physical stock certificates for their shares, in each case without charge.

 

Fractional shares

Fractional shares of our common stock will not be distributed. Fractional shares to which Merck stockholders of record are entitled will be aggregated and sold in the public market by the distribution agent. The aggregate net cash proceeds of these sales will be distributed ratably to those stockholders who would otherwise have received fractional shares of our common stock. These sale proceeds generally will be taxable to those stockholders.

 

Record date

The record date is the close of business on August 12, 2003.

 

Distribution date

11:59 p.m. on August 19, 2003.

 

5


Table of Contents
Index to Financial Statements

Stock exchange listing

Currently there is no public market for our common stock. Our common stock has been authorized to be listed on the New York Stock Exchange, or NYSE, under the symbol “MHS”. We anticipate that trading will commence on a when-issued basis shortly before the record date. When-issued trading refers to a transaction made conditionally because the security has been authorized but not yet issued. On the first trading day following the distribution date, when-issued trading in respect of our common stock will end and regular way trading will begin. Regular way trading refers to trading after a security has been issued and typically involves a transaction that settles on the third full business day following the date of the transaction. We cannot predict the trading prices for our common stock before or after the distribution date. In addition, Merck’s common stock will remain outstanding and will continue to trade on the NYSE. We cannot predict any change that may occur in the trading price of Merck’s common stock as a result of the distribution.

 

Incurrence of debt

Prior to or concurrently with the completion of the distribution, we will offer $500 million aggregate principal amount of ten-year senior unsecured notes and enter into a $1,150 million senior secured credit facility consisting of:

 

    a $400 million five-year term loan;

 

    a $500 million seven-year term loan; and

 

    a $250 million five-year revolving credit facility.

 

 

The senior secured credit facility will be secured by a pledge of the capital stock of our subsidiaries, other than our receivables subsidiary and our subsidiaries that are engaged in insurance-related activities.

 

 

In addition, we have established a wholly owned subsidiary that will purchase our pharmaceutical manufacturer accounts receivable on a daily basis. This receivables subsidiary will in turn enter into a $500 million 364-day renewable accounts receivable financing facility prior to or concurrently with the completion of the distribution. The accounts receivable financing facility will be secured by our pharmaceutical manufacturer accounts receivable, which will be sold to our receivables subsidiary. The amount of borrowings available under the accounts receivable financing facility will be based upon the amount of eligible accounts receivable, our senior unsecured debt credit rating and other terms and conditions.

 

 

After giving effect to the notes offering, the term loans and the $100 million advance we plan to receive under our accounts receivable financing facility prior to or concurrently with the completion of the distribution, we expect to have approximately $1,500 million of indebtedness for borrowed money outstanding. We expect that all of the revolving credit facility will remain undrawn at the completion of the distribution and will be available for working capital and general corporate purposes. In the case of the accounts receivable financing facility, we expect to have between $250 million

 

6


Table of Contents
Index to Financial Statements
 

and $400 million available for working capital and general corporate purposes at the completion of the distribution, depending upon the amount of eligible receivables. However, on or prior to the distribution date, we may draw advances under our revolving credit facility or a larger advance under our accounts receivable financing facility to pay a portion of the cash dividends aggregating $2 billion to Merck. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”.

 

 

The agreements governing the senior secured credit facility and the accounts receivable financing facility are subject to ongoing negotiation. We cannot be certain the terms described herein will not change or be supplemented. See “Description of Indebtedness”.

 

Settlement of intercompany receivable and payment of dividends to Merck

Prior to or concurrently with the completion of the distribution, Merck will pay us the balance of our intercompany receivable and we will pay Merck cash dividends aggregating $2 billion. We intend to use the proceeds from the notes offering and the term loans, the advance under the accounts receivable financing facility and the proceeds of the intercompany receivable to pay these dividends.

 

Dividend policy

We presently intend to retain future earnings, if any, to finance the expansion of our business. Therefore, other than cash dividends aggregating $2 billion that we will pay to Merck prior to or concurrently with the completion of the distribution, we do not expect to pay any cash dividends in the foreseeable future. Moreover, the terms of the credit agreement governing our senior secured credit facility and the indenture governing our ten-year senior unsecured notes will limit the amount of dividends we may pay on our common stock. Payment of future cash dividends, if any, will be at the discretion of our board of directors in accordance with applicable law after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs, plans for expansion and contractual restrictions with respect to the payment of dividends.

 

Anti-takeover effects

Our managed care agreement with Merck contains provisions relating to assignment and change in control that could discourage third parties from acquiring us. Additionally, we will indemnify Merck under the tax responsibility allocation agreement we have entered into in connection with the distribution for the tax resulting from any acquisition or issuance of our stock that triggers the application of Section 355(e) of the U.S. Internal Revenue Code of 1986, or the Internal Revenue Code, and this could discourage, delay or prevent a change of control. Some provisions of our amended and restated certificate of incorporation, our amended and restated bylaws and Delaware law may also have the effect of making more difficult an acquisition of control of us in a transaction not approved by our board of directors. See “Relationships Between Our Company and Merck & Co., Inc.” and “Description of Capital Stock”.

 

7


Table of Contents
Index to Financial Statements

Industry Overview

 

Prescription drugs are the fastest growing component of health care costs in the United States. According to CMS, drug expenditures in the United States totaled over $160 billion during 2002 and the cost of prescription drugs is expected to rise on average approximately 11% per year over the next nine years.

 

PBMs provide management and other services for outpatient drug benefits on behalf of their clients to an estimated 200 million Americans, according to the U.S. General Accounting Office. These services include:

 

    design and implementation of formularies, which are lists of preferred drugs from which a PBM’s client’s members and their physicians can choose;

 

    large-scale, highly automated claims adjudication with retail and home delivery pharmacies;

 

    negotiated discounts and rebates from pharmaceutical manufacturers and discounts from drug wholesalers and retail pharmacies;

 

    increasingly, home delivery pharmacies; and

 

    programs to promote safe, economical use of pharmaceuticals and adherence to regimens to control chronic health conditions.

 

Areas of potential growth for the PBM industry include increased use of available programs and services by existing clients, as well as entry or expansion in the specialty drugs, information services and disease management markets.

 

Business Strategy

 

Our vision is to be an effective force in controlling health care costs for our clients and supporting improved patient care through the appropriate use of prescription drugs. We intend to achieve our objectives by successfully executing the business strategies outlined below. The following discussion of our business strategy summarizes the more detailed information under “Business—Business Strategy”:

 

Deliver high-quality client and member service.    We provide our clients with individualized prescription drug benefit plan solutions. We deliver customized plan design, clinical services, ongoing interactive monitoring and reporting, access to call center pharmacies and other services.

 

Take advantage of our significant technology investments to drive growth, improve service and reduce costs.    Our technology platform offers the opportunity to enhance productivity and reduce costs for us and our clients, provides more convenience for clients and their members and, we believe, improves overall patient care. The core elements of our technology platform include our automated home delivery pharmacies, specialized call center pharmacies and user-friendly Internet applications.

 

Actively pursue sources of growth from new clients and increased use of our value-added services, including our home delivery pharmacies.    We believe our high-quality service model and drug trend management track record are attractive to potential clients. We have a significant opportunity to promote additional cost management programs and services to many of our existing clients and to increase our home delivery service volume substantially.

 

Selectively form strategic alliances and expand into complementary, adjacent markets.    We intend to continue to expand into new markets and may selectively form alliances and make targeted acquisitions to complement our internal growth.

 

8


Table of Contents
Index to Financial Statements

Competitive Advantages

 

We believe we have several competitive advantages that enable us to deliver enhanced service to clients and their members while effectively managing drug trend for our clients. The following discussion of our competitive advantages summarizes the more detailed information under “Business—Competitive Advantages”:

 

We have a highly automated home delivery pharmacy service. Our pre-eminent home delivery pharmacy service automates the prescription filling process using proprietary software, much of which we have developed in-house, and advanced robotics technology. In 2002, our national network of home delivery pharmacies filled approximately 82 million prescriptions. These prescriptions represented only approximately 15% of the prescriptions we filled or processed, and we believe there is a substantial opportunity to increase the use of our home delivery service. The cornerstones of our home delivery pharmacy service are our two automated dispensing pharmacies. The accuracy of prescriptions dispensed from these facilities, which use our patented technology, exceeds Six Sigma levels, the highest industry quality standard, which requires at least a 99.99966% accuracy rate. During the first half of 2003, these two automated pharmacies collectively dispensed approximately 1.4 million prescriptions per week.

 

Our investments in technology are reducing costs and providing enhanced client and member service.    We have designed our technology to anticipate and respond quickly to client, member, physician and pharmacist needs and to reduce costs. Our technology includes:

 

    Specialized call center pharmacies.     Our specialized call center pharmacies provide faster service and enhance the access our service representatives have to member information.

 

    Integrated voice-response phone system.     Our integrated voice-response phone system allows members to enroll for home delivery service, submit a home delivery order for processing, track the status of their home delivery order, or locate an in-network retail pharmacy in their area.

 

    Online point-of-care technologies.    We encourage physicians to use online point-of-care technologies that reduce costs for clients by improving the speed and accuracy of ordering prescriptions and increasing the effectiveness of drug utilization management services such as encouraging the prescribing of drugs on a plan’s formulary and generic substitution.  

 

    Client web-based applications.    We have implemented a suite of user-friendly web-based applications that provide clients with sophisticated reporting, analytical and communications capabilities to enable them to more effectively control the cost and quality of the prescription drug benefits they provide.  

 

    Member website.    Our comprehensive, user-friendly member website was ranked fourth by comScore-Media Metrix among health sites in number of users over age 55 and eleventh among health sites in overall visitors. In 2002, through our member website, we processed more than 10.8 million prescriptions, a 51% increase over 2001.

 

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

 

    Providing customized plan designs.    We customize plan designs to meet the specific objectives of clients.

 

    Enhancing formulary compliance.    We encourage formulary compliance, which is the prescribing of drugs on a plan’s formulary, through physician, client and member communications and education programs, including therapeutic brand-to-brand interchange programs directed at physicians, the use of multi-tiered co-payment and other cost-sharing payment structures and our home delivery pharmacy service.

 

9


Table of Contents
Index to Financial Statements
    Effectively managing drug utilization, a key driver of drug trend.    Our wide range of drug trend management tools includes drug utilization review programs, rules governing which drugs are covered and our internally developed, clinically based programs.

 

    Offering convenience to members.    Dedicated service representatives and pharmacists at our call center pharmacies use advanced imaging technology and Internet capabilities to access a member’s prescription and health information to provide faster and more efficient service. Our comprehensive member website and integrated voice-response phone system allow members to obtain individualized patient information and use our home delivery pharmacy service.

 

    Providing enhanced personalized service to members.    Our Specialty Pharmacy Center of Excellence, opened during the first quarter of 2003 within our Columbus, Ohio home delivery pharmacy, provides an enhanced level of personalized service to members requiring specialty medicines. The Specialty Pharmacy provides more than 100 medications for 20 disease states, including hemophilia, rheumatoid arthritis, cancer, multiple sclerosis and Hepatitis C.

 

Our comprehensive generic substitution programs save our clients money.    The substitution of medically appropriate and less expensive generic drugs for brand name drugs, or generic substitution, helps contain client and member prescription drug costs. We alert physicians to the availability of a medically appropriate generic substitute and offer them the opportunity to obtain free generic samples and information on the use of generic drugs. We encourage the substitution of generic drugs as soon as legally permissible. For example, within two weeks of a generic equivalent becoming available for Glucophage, we achieved a substitution rate of over 91% for prescriptions filled by our home delivery pharmacies. Between 2003 and 2006, patents are expected to expire on approximately 40 major brand name drugs that generated aggregate U.S. sales of approximately $32.6 billion in 2002.

 

We have a deep and experienced management team.    Our management team has extensive experience in the PBM and health care industries and has established long-standing relationships with key constituents. David B. Snow, Jr., who has over 25 years of health care industry experience, was recently appointed as our new Chairman, President and Chief Executive Officer.

 

Some Important Risks Facing Our Company

 

Our business is subject to significant risks. The following risks, as well as other risks facing our company, are more fully described under “Risk Factors”, and all of these risks should be considered carefully together with all of the other information in this information statement.

 

We could be required to record a material non-cash charge to income if our recorded goodwill is impaired.    We have $3.3 billion of recorded goodwill, net, on our consolidated balance sheet as of March 29, 2003. Once trading in our common stock begins, we will consider the market price of our common stock as a factor for purposes of determining whether our goodwill has been impaired. Should we determine that our fair value is less than our book value, we could be required to record a non-cash impairment charge to earnings of up to $3.3 billion in the period in which our goodwill becomes impaired. Accordingly, a substantial goodwill impairment charge would have a material adverse effect on our earnings and stockholders’ equity in the period in which it is taken and could adversely affect the price of our common stock.

 

Pending and threatened legal proceedings and investigations challenge some of our important business practices.    We are involved in various claims, legal proceedings and investigations, a number of which could require us to pay damages that may be material or could materially limit our business practices. In particular, we

 

10


Table of Contents
Index to Financial Statements

are a party to a number of lawsuits in which the plaintiffs have alleged among other things that we have breached fiduciary obligations under the Employee Retirement Income Security Act of 1974, or ERISA. In addition, on June 23, 2003, the U.S. Attorney’s office for the Eastern District of Pennsylvania filed a notice of intervention with respect to two pending qui tam, or whistleblower, complaints, filed in February 2000, pursuant to the federal False Claims Act and similar state laws. These complaints allege improper pharmacy practices, violations of state pharmacy laws and inappropriate therapeutic interchanges. The government’s notice of intervention is limited to claims relating to the False Claims Act and states that the government will file its own complaint by September 30, 2003. The government’s complaint may assert additional allegations or claims under other statutes or common law. The outcome of each of these proceedings is uncertain, and an adverse determination in any one of them could result in our having to pay significant damages or otherwise materially limit our business practices.

 

Our profitability is dependent upon our ability to continue to earn and retain rebates from manufacturers.    We typically receive formulary access and other rebates and discounts from pharmaceutical manufacturers and generally pass formulary access rebates on to clients. Without rebates earned from pharmaceutical manufacturers based on performance, we would not have been profitable in each of 2000, 2001 and 2002.

 

Failure to retain key clients could result in significantly decreased revenues.    In each year from 1998 through 2002, we retained clients accounting for at least 94% of our net revenues. We expect our client retention rate to decline to 93% in 2003 as a result of some larger clients not renewing contracts with us. The estimated number of people who are eligible to receive prescription drug benefits, or covered lives, under our clients’ plans decreased from approximately 65 million as of December 29, 2001 to approximately 64 million as of December 28, 2002 and to approximately 62 million as of March 29, 2003. Competition in the PBM business is intense. 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, and we are not successful in generating sales with comparable operating margins to replace the lost business, our revenues and profitability could suffer materially.

 

Following the distribution, we will have substantial debt obligations that could restrict our operations.    Historically, we have not had any indebtedness for borrowed money. Giving effect to the senior unsecured notes offering and the borrowings or advances we plan to make under our senior secured credit facility and our accounts receivable financing facility prior to or concurrently with the completion of the distribution, our total indebtedness for borrowed money will be approximately $1,500 million. We will dedicate a substantial portion of our cash flow from operations to payments on our debt, which will reduce the funds available for working capital, capital expenditures, acquisitions and other purposes. In addition, the operating and financial restrictions imposed by our debt agreements could restrict our ability to finance operations and capital needs or to engage in other business activities. We may also incur future debt obligations that might subject us to additional restrictive covenants that could affect our financial and operational flexibility.

 

The industry in which we operate is heavily regulated and subject to a high level of scrutiny.    We are subject to numerous federal and state regulations. If we fail to comply with all applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate our home delivery pharmacies and our ability to participate in federal and state health care programs. In addition, government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers.

 

11


Table of Contents
Index to Financial Statements

Relationship with Merck & Co., Inc.

 

Our predecessor companies, including Merck-Medco Managed Care, L.L.C., have conducted our PBM business since 1983, and since 1993 we have been wholly owned by Merck & Co., Inc. Merck-Medco Managed Care, L.L.C. converted from a limited liability company to a Delaware corporation in May 2002 and subsequently changed its name to Medco Health Solutions, Inc.

 

In connection with the distribution, we and Merck will be parties to a number of agreements that will govern our spin-off from Merck and our future relationship. Under our managed care agreement with Merck, Merck provides us with rebates based, in part, on whether Merck products are included in the formularies we offer our clients and whether Merck products achieve specified market share targets under the plans for which we provide PBM services. Under other agreements, we will provide Merck with various services and information. These agreements have been and will be entered into with Merck in the context of our relationship to Merck as a wholly owned subsidiary. Accordingly, some of the terms and provisions of these agreements may be less favorable to us than terms and provisions we could have obtained in arm’s length negotiations with unaffiliated third parties. Under our managed care agreement, we may have to pay substantial liquidated damages if we fail to achieve specified market share levels. Additionally, compliance with our obligations under the agreement may have a substantial impact on our competitive position and may expose us to liabilities to clients and others.

 

In anticipation of the spin-off, we have developed and implemented systems and infrastructure to support our operation as a separately traded public company. However, these newly developed systems and infrastructure may be inadequate and we may be required to develop or otherwise acquire other systems and infrastructure. In the past, Merck has generally provided capital for our general corporate purposes and has at times guaranteed some of our contractual obligations under contracts with some clients. We have also periodically used cash from Merck to fund our operations. After the distribution, Merck will not provide funds to finance our operations or guarantee our contractual obligations.

 

For a further discussion of the spin-off and our relationship with Merck, and the related risks, see “Relationships Between Our Company and Merck & Co., Inc.” and “Risk Factors—Risks Relating to Our Relationship with and Spin-Off from Merck”.

 

Concurrent Transactions

 

Prior to or concurrently with the completion of the distribution, we will offer $500 million aggregate principal amount of ten-year senior unsecured notes and enter into a $1,150 million senior secured credit facility consisting of:

 

    a $400 million five-year term loan;

 

    a $500 million seven-year term loan; and

 

    a $250 million five-year revolving credit facility.

 

The senior secured credit facility will be secured by a pledge of the capital stock of our subsidiaries, other than our receivables subsidiary and our subsidiaries that are engaged in insurance-related activities.

 

In addition, we have established a wholly owned subsidiary that will purchase our pharmaceutical manufacturer accounts receivable on a daily basis. This receivables subsidiary will in turn enter into a $500 million 364-day renewable accounts receivable financing facility prior to or concurrently with the completion of the distribution. The accounts receivable financing facility will be secured by our pharmaceutical manufacturer accounts receivable, which will be sold to our receivables subsidiary. The amount of borrowings available under the accounts receivable financing facility will be based upon the amount of eligible accounts receivable, our senior unsecured debt credit rating and other terms and conditions.

 

The agreements governing the senior secured credit facility and the accounts receivable financing facility are subject to ongoing negotiation. We cannot be certain the terms described herein will not change or be supplemented. See “Description of Indebtedness”.

 

12


Table of Contents
Index to Financial Statements

We intend to use the net proceeds from the notes offering, together with the net proceeds of our term loans, the planned $100 million advance under our accounts receivable financing facility and the settlement of the intercompany receivable from Merck, to pay cash dividends aggregating $2 billion to Merck prior to or concurrently with the completion of the distribution. We expect that all of the revolving credit facility will remain undrawn at the completion of the distribution and will be available for working capital and general corporate purposes. In the case of the accounts receivable financing facility, we expect to have between $250 million and $400 million available for working capital and general corporate purposes at the completion of the distribution, depending upon the amount of eligible receivables. However, on or prior to the distribution date, we may draw advances under our revolving credit facility or a larger advance under our accounts receivable financing facility to pay a portion of the cash dividends aggregating $2 billion to Merck. At Merck’s request, we are paying the dividends to Merck, our sole stockholder prior to completion of the distribution, as part of its plan to maximize the value of Merck’s investment in our company to Merck and its stockholders. In determining the amount of the dividends, our board of directors and Merck considered our ability to service the debt we will incur to pay the dividends and the appropriate capital structure for our company to be able to compete effectively in our industry. For a further discussion of the dividends to Merck and our indebtedness, see “Dividend Policy”, “Unaudited Pro Forma Condensed Consolidated Financial Data”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Description of Indebtedness”.

 

Recent Developments

 

We had net revenues of $8.4 billion in the second quarter of 2003, which was substantially the same as our net revenues in the second quarter of 2002. Our net income during the second quarter of 2003 increased 1%, compared to the second quarter of 2002, to $105.2 million. Net income was higher in the second quarter of 2003 compared to the second quarter of 2002 due primarily to increased generic drug utilization, despite a decline in prescription volume. Generic drug usage increased to 43% of total prescriptions dispensed in the second quarter of 2003 from 39% of total prescriptions dispensed in the second quarter of 2002. For the first six months of 2003, our net revenues increased 2% compared to the first six months of 2002, to $16.7 billion, and our net income increased 26% compared to the first six months of 2002, to $207.2 million.


 

Our predecessor company, Merck-Medco Managed Care, L.L.C., was organized as a Delaware limited liability company in 1997 and converted to a corporation on May 21, 2002. Our principal executive offices are located at 100 Parsons Pond Drive, Franklin Lakes, New Jersey 07417. Our telephone number at that location is (201) 269-3400.

 

MEDCO HEALTH SOLUTIONS, INC., our logo, SYSTEMED, L.L.C. and GENERICS FIRST® are trademarks and service marks that belong to us. PARTNERS FOR HEALTHY AGING®, POSITIVE APPROACHES®, RATIONALMED® and PROVANTAGE® are registered trademarks and service marks that belong to us.

 

This information statement includes trademarks owned by third parties, including but not limited to: RXHUB, which is a trademark of RxHub LLC; MERCK®, PRINIVIL®, VASOTEC® and ZOCOR®, which are registered trademarks of Merck & Co., Inc.; GLUCOPHAGE®, which is a registered trademark of LIPHA S.A.; ZESTRIL®, which is a registered trademark of AstraZeneca UK Limited; and CLARITIN®, which is a registered trademark of Schering Corporation.

 

13


Table of Contents
Index to Financial Statements

Summary Historical and Pro Forma Financial Information

 

The table beginning on the following page presents our summary historical consolidated financial information and has been derived from our audited consolidated financial statements for the years ended December 30, 2000, December 29, 2001 and December 28, 2002, and our unaudited consolidated interim financial statements for the quarters ended March 30, 2002 and March 29, 2003, each of which is included elsewhere in this information statement. The unaudited consolidated interim financial statements have been prepared on a basis consistent with the audited consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such data. The results for the quarter ended March 29, 2003 are not necessarily indicative of the results to be expected for the full year. The table on the following page also presents our summary unaudited pro forma condensed consolidated financial information, which has been derived from our unaudited pro forma condensed consolidated financial information included elsewhere in this information statement and has been prepared to reflect adjustments to our historical financial information to give effect to the notes offering, the term loans, the advance under the accounts receivable financing facility, settlement of the intercompany receivable from Merck and dividend payments to Merck described above under “—Concurrent Transactions”, as if those transactions had been completed at earlier dates.

 

The unaudited pro forma condensed consolidated statement of income assumes that these transactions occurred as of December 30, 2001 and the unaudited pro forma consolidated balance sheet data assumes that these transactions occurred as of March 29, 2003. In addition, a pro forma presentation of income before provision for income taxes and net income has been included as if Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets” (SFAS No. 142) had been in effect for all periods.

 

You should read the summary and unaudited pro forma consolidated financial information in conjunction with our audited consolidated financial statements and the notes to the audited consolidated financial statements. You should also read the sections “Selected Historical Consolidated Financial and Operating Data”, “Unaudited Pro Forma Condensed Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. The summary and unaudited pro forma consolidated financial information is qualified by reference to these sections, the audited consolidated financial statements and the notes to the audited consolidated financial statements, each of which is included elsewhere in this information statement.

 

The unaudited pro forma consolidated financial information is not indicative of our future performance or what our results of operations and financial position would have been if we had operated as a separate company during the periods presented or if the transactions reflected therein had actually occurred as of December 30, 2001 or March 29, 2003, as the case may be. The unaudited pro forma condensed consolidated statement of income does not reflect the complete impact of one-time and ongoing incremental costs required to operate as a separate company. Merck allocated to us $25.4 million in 2000 and $26.4 million in 2001 of expenses it incurred for providing us consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. During 2002, Merck allocated to us $27.4 million of expenses and we directly incurred an additional $4.5 million for these services. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. We expect the total cost of these services to aggregate approximately $35 million to $40 million in 2003, including a charge from Merck of $0.4 million, and approximately $40 million to $45 million in 2004. In addition, during 2002 we incurred $7.7 million of non-recurring costs associated with our transition to operating as a separate company for systems implementation and conversion, the change of our corporate name and other matters. We expect to incur $2 million of non-recurring costs during 2003 as we complete our transition to a separate company.

 

14


Table of Contents
Index to Financial Statements
    Years Ended

  Quarters Ended

    December 30,
2000(1)


    December 29,
2001


    December 28,
2002


  Pro Forma
December 28,
2002


  March 30,
2002


    March 29,
2003


   

Pro Forma
March 29,

2003


    (in millions, except per share data)

Consolidated Statement of Income Data:

                                                 

Product net revenues

  $ 21,979.2     $ 28,709.3     $ 32,573.0   $ 32,573.0   $ 7,929.0     $ 8,237.9     $ 8,237.9

Service revenues

    287.1       361.3       385.5     385.5     87.1       96.2       96.2
   


 


 

 

 


 


 

Total net revenues

    22,266.3       29,070.6       32,958.5     32,958.5     8,016.1       8,334.1       8,334.1
   


 


 

 

 


 


 

Cost of operations:

                                                 

Cost of product net revenues

    21,010.8       27,601.1       31,483.9     31,483.9     7,713.8       7,939.5       7,939.5

Cost of service revenues

    143.4       185.6       173.8     173.8     44.0       45.1       45.1
   


 


 

 

 


 


 

Total cost of revenues

    21,154.2       27,786.7       31,657.7     31,657.7     7,757.8       7,984.6       7,984.6

Selling, general and administrative expenses

    483.1       578.4       587.7     587.7     135.2       163.0       163.0

Amortization of goodwill

    103.3       106.9       —       —       —         —         —  

Amortization of intangibles

    84.0       84.9       84.9     84.9     21.2       23.6       23.6

Other (income) expense, net

    (5.8 )     (4.6 )     7.9     82.0     (0.8 )     (11.7 )     6.4
   


 


 

 

 


 


 

Total cost of operations

    21,818.8       28,552.3       32,338.2     32,412.3     7,913.4       8,159.5       8,177.6
   


 


 

 

 


 


 

Income before provision for income taxes

    447.5       518.3       620.3     546.2     102.7       174.6       156.5

Provision for income taxes

    230.7       261.7       258.7     227.8     43.1       72.6       65.1
   


 


 

 

 


 


 

Net income

  $ 216.8     $ 256.6     $ 361.6   $ 318.4   $ 59.6     $ 102.0     $ 91.4
   


 


 

 

 


 


 

Earnings Per Share

                                                 

Data(2):

                                                 

Basic and diluted net income per share

  $ 0.80     $ 0.95     $ 1.34   $ 1.18   $ 0.22     $ 0.38     $ 0.34

Shares used in computing basic and diluted net income per share

    270.0       270.0       270.0     270.0     270.0       270.0       270.0

Pro forma presentation assuming SFAS No. 142 was in effect for all periods(3):

                                                 

Pro forma income before provision for income taxes

  $ 550.8     $ 625.2     $ 620.3   $ 546.2   $ 102.7     $ 174.6     $ 156.5

Provision for income taxes

    230.7       261.7       258.7     227.8     43.1       72.6       65.1
   


 


 

 

 


 


 

Pro forma net income

  $ 320.1     $ 363.5     $ 361.6   $ 318.4   $ 59.6     $ 102.0     $ 91.4
   


 


 

 

 


 


 

Pro forma basic and diluted net income per share

  $ 1.19     $ 1.35     $ 1.34   $ 1.18   $ 0.22     $ 0.38     $ 0.34
                                                   

 

15


Table of Contents
Index to Financial Statements
     As of
December 28,
2002


   As of March 29, 2003

        Historical

   Pro Forma

     (in millions)

Consolidated Balance Sheet Data:

                    

Working capital(4)

   $   1,171.5    $ 1,309.1    $ 678.1

Goodwill, net

   $ 3,310.2    $ 3,310.2    $   3,310.2

Intangibles, net

   $ 2,414.8    $ 2,391.3    $ 2,391.3

Total assets

   $ 9,922.5    $ 10,217.7    $ 9,717.7

Current liabilities

   $ 2,054.9    $ 2,258.9    $ 2,370.2

Long-term debt

   $ —      $ —      $ 1,388.7

Deferred tax liabilities

   $ 1,197.7    $ 1,182.2    $ 1,182.2

Total liabilities

   $ 3,286.9    $ 3,480.1    $ 4,980.1

Total stockholder’s equity

   $ 6,635.6    $ 6,737.6    $ 4,737.6

Total liabilities and stockholder’s equity

   $ 9,922.5    $ 10,217.7    $ 9,717.7

(1)   53 week fiscal year.
(2)   On May 21, 2002, we converted from a limited liability company wholly owned by Merck to a corporation wholly owned by Merck and issued 270,000,000 shares of $0.01 par value common stock. The financial information has been revised to retroactively reflect this transaction for all periods presented. In connection with the distribution, certain Merck stock options held by our employees will be converted into options to purchase our stock. These options would not have had a material effect on historical or pro forma earnings per share for the periods presented.
(3)   Effective December 30, 2001, we adopted SFAS No. 142. This pro forma financial information presents the impact of adopting SFAS No. 142 as if it had been adopted on December 26, 1999. The December 28, 2002 financial results and the March 30, 2002 and March 29, 2003 quarterly financial results already reflect the adoption of SFAS No. 142 and therefore no pro forma adjustment is necessary; these results are included in this pro forma presentation to facilitate comparisons with prior periods.
(4)   Calculated as current assets (primarily accounts receivable and inventories) less current liabilities (primarily claims and other accounts payable, short-term debt, current portion of long-term debt and other current liabilities). As of December 28, 2002 and March 29, 2003, we had no debt outstanding.

 

16


Table of Contents
Index to Financial Statements

RISK FACTORS

 

You should carefully consider the risks described below together with all of the other information in this information statement in evaluating us and our common stock. If any of the following risks actually occur, our business, financial condition or results of operations could suffer. In that event, the trading price of our common stock could decline.

 

Risks Relating to Our Business

 

We could be required to record a material non-cash charge to income if our recorded goodwill is impaired.

 

We have $3.3 billion of recorded goodwill, net, on our consolidated balance sheet as of March 29, 2003. In accordance with the adoption of recent accounting standards, we no longer amortize goodwill. Instead, we test our goodwill for impairment using a fair value based test.

 

Once trading in our common stock begins, we will consider the market price of our common stock as a factor for purposes of determining whether our goodwill has been impaired. If our net book value exceeds our market capitalization, this could indicate a potential impairment to goodwill. Should we determine that our fair value is less than our book value, we could be required to record a non-cash impairment charge to earnings of up to $3.3 billion in the period in which our goodwill becomes impaired. The amount of this non-cash charge could substantially exceed the difference between our book value and fair value. Accordingly, a goodwill impairment charge would have a material adverse effect on our earnings and stockholders’ equity in the period in which it is taken and could adversely affect the price of our common stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Use of Estimates and Critical Accounting Policies—Critical Accounting Policies”.

 

Pending and threatened litigation challenging some of our important business practices could significantly negatively affect our ability to obtain rebates that are essential to our profitability and could materially limit our business practices.

 

Merck and we are a party to six lawsuits filed by plaintiffs from six pharmaceutical plans for which we are the PBM. These plaintiffs contend that we are a fiduciary under ERISA, and that we have breached fiduciary obligations under ERISA in connection with our development and implementation of formularies, preferred drug listings and intervention programs. In particular, the plaintiffs contend that in accepting and retaining various rebates we have failed to make adequate disclosure and have acted in our own best interest and against the interests of our clients. The plaintiffs also allege that our company was wrongly used to increase Merck’s market share, claiming that under ERISA our drug formulary choices and therapeutic interchange programs were “prohibited transactions” that favor Merck’s products. The plaintiffs have demanded that we and Merck turn over any unlawfully obtained profits to a trust to be set up for the benefit plans. Although none has done so to date, some of the plaintiffs have indicated that they may amend their complaints against us and others to allege violations of the Sherman Act, the Clayton Act and various states’ antitrust laws due to alleged conspiracies to suppress price competition and unlawful combinations allegedly resulting in higher pharmaceutical prices.

 

In December 2002, Merck and we agreed to settle this series of lawsuits on a class action basis to avoid the significant cost and distraction of protracted litigation. We, Merck and the plaintiffs in five of these six cases filed a proposed class action settlement with the court. On June 12, 2003, the settling parties filed an amended settlement agreement and supporting documents with the court and requested that the court grant preliminary approval to the settlement. Under the proposed settlement, as amended, Merck and we have agreed to pay $42.5 million and we have agreed to change or to continue certain specified business practices for a period of five years. The proposed settlement would resolve litigation by plans against Medco Health and Merck based on ERISA and similar claims, except with respect to those plans that affirmatively opt out of the settlement. It does not involve the release of any potential antitrust claims. The release of claims under the settlement would cover the period from December 17, 1994 to the date the settlement receives final approval. The financial compensation discussed above is intended to benefit the ERISA plans for which we administered a pharmacy benefit at any time during that time period.

 

17


Table of Contents
Index to Financial Statements

On July 31, 2003, the court granted preliminary approval to the settlement. The class member plans will have the opportunity to participate in or opt out of the settlement. The court has scheduled a hearing to occur on December 11, 2003, for the purpose of determining, among other things, whether the settlement should be finally approved. The settlement becomes final only if and when the court grants final approval and all appeals have been exhausted. One of the initial plaintiffs in these lawsuits is expected to oppose the settlement.

 

Similar complaints against us and Merck have been filed in eight additional actions by ERISA plan participants, purportedly on behalf of their plans and, in some of the actions, similarly-situated self-funded plans. The complaints in these actions rely on many of the same theories as the litigation discussed above. The plans themselves, which could decide to opt out of or participate in the proposed settlement discussed above, are not parties to these lawsuits. In addition, a proposed class action complaint against Merck and us has been filed by trustees of another benefit plan in the U.S. District Court for the Northern District of California. The plaintiffs in these actions are expected to oppose the proposed settlement discussed above.

 

We have also been sued in two actions based on similar factual allegations with a theory of liability premised on a California law prohibiting unfair business practices. The plaintiffs in these actions seek injunctive relief and disgorgement of the revenues that were allegedly improperly received by us. A lawsuit based on similar allegations has also been filed in New Jersey state court by a municipal entity for which we previously administered the pharmacy benefit management services, on behalf of a proposed class of similarly-situated self-funded plans. The New Jersey action alleges, among other things, that we violated a New Jersey consumer protection statute. The plaintiff in the New Jersey action seeks, among other remedies, compensatory and treble damages.

 

In connection with our spin-off from Merck, we will agree to indemnify Merck for substantially all monetary liabilities related to these lawsuits, including substantially all of the proposed settlement payment discussed above. Although we have proposed to settle some of these claims as described above, the court may not approve the settlement, and even if approved, some class members may opt out of the settlement and institute or continue separate actions against us. We have denied all allegations of wrongdoing and, except with respect to any claims that may be settled, we will continue to vigorously defend these claims. These lawsuits seek damages in unspecified amounts, which could be material. In addition, the outcome of each of these lawsuits is uncertain, and an adverse determination in any one of them could significantly negatively affect our ability to obtain rebates that are essential to our profitability and could materially limit our business practices. See “Business—Legal Proceedings and Government Investigations” and “Relationships Between Our Company and Merck & Co., Inc.”

 

We are subject to government investigations challenging practices in our business under federal and state civil fraud, anti-kickback and other laws, and are a defendant in two qui tam cases in which the federal government has intervened, any of which could limit our business practices and harm our profitability.

 

On June 23, 2003, the U.S. Attorney’s office for the Eastern District of Pennsylvania filed a notice of intervention with respect to two pending qui tam, or whistleblower, complaints filed in February 2000 under the federal False Claims Act and similar state laws in the U.S. District Court for the Eastern District of Pennsylvania. The federal False Claims Act permits actions alleging that the defendant has defrauded the federal government. Sanctions for violating the federal False Claims Act include liability for treble damages, as well as mandatory civil penalties for each separate false claim.

 

The government’s notice of intervention is limited to claims relating to the False Claims Act arising out of our contract with the Blue Cross and Blue Shield Association, or BCBSA, to provide home delivery prescription drug benefits to federal employees, retirees and their families. In a related news release, the U.S. Attorney’s office for the Eastern District of Pennsylvania stated that according to the qui tam complaints, we allegedly canceled home delivery prescriptions that could not be filled or mailed in time, underfilled prescriptions, changed prescriptions based upon misleading or false information, made false statements to the BCBSA, induced physicians to engage in inappropriate therapeutic interchanges, favored Merck drugs, failed to comply with applicable state laws regulating procedures intended to prevent harmful drug interactions, fabricated records of

 

18


Table of Contents
Index to Financial Statements

calls by pharmacists to physicians, and did not call physicians as required by law when a prescription was ambiguous. The government’s notice of intervention states that the government will file its own complaint by September 30, 2003. The government’s complaint may assert additional allegations or claims under other statutes or common law.

 

The Civil Division of the U.S. Attorney’s office for the Eastern District of Pennsylvania has been examining some activities of the PBM industry in light of anti-kickback and other laws and regulations since 1998. Federal anti-kickback laws generally prohibit the receipt or solicitation of payment in return for purchasing or ordering of, or arranging for or recommending the purchasing or ordering of, items and services reimbursable by federal health care programs. Some states have similar laws relating to state health care programs. Sanctions for violating these laws may include criminal and civil sanctions, substantial monetary fines and exclusion from participation in federal health care programs. To date, these laws have not been applied to prohibit the types of business arrangements we have with pharmaceutical manufacturers, health plan sponsors or retail pharmacies. However, courts and enforcement authorities that administer the anti-kickback laws have historically interpreted these laws broadly.

 

In July 1999, we received a subpoena from the U.S. Attorney’s office seeking documents and information related to various aspects of our business in connection with an industry-wide investigation. Specifically, the focus of this investigation appears to be on PBMs’ relationships with pharmaceutical manufacturers and retail pharmacies and PBMs’ programs relating to drug formulary compliance, including rebate and other payments made by pharmaceutical manufacturers to PBMs and payments made by PBMs to retail pharmacies or others. The U.S. Attorney’s office has also contacted some of the pharmaceutical manufacturers with which we have agreements and has asked these manufacturers to provide copies of documents relating to their agreements with us.

 

On April 16, 2003, we received a letter from the Office of the Maine Attorney General seeking information concerning our pharmacy benefit management practices. This letter was written on behalf of Maine and 21 other states, and we have been advised that it is in connection with a review of the pharmaceutical industry and pharmacy benefit management practices. In addition, in June 2001, the State Attorney General’s Office of Tennessee requested information similar to that requested by the U.S. Attorney’s office for the Eastern District of Pennsylvania.

 

We have complied with the U.S. Attorney’s subpoena and the Tennessee Attorney General’s request to explain the nature of our business and the contributions we make to improve the quality and affordability of health care, and we are cooperating with Maine and the other states to provide them with more information about our business practices. The outcome of proceedings, requests for information or other actions pursuant to the investigation of the U.S. Attorney’s office for the Eastern District of Pennsylvania, the qui tam complaints and the government’s notice of intervention, the states’ request for information or other similar actions is uncertain. The qui tam lawsuits and government intervention are at a very early stage, and we are unable to predict what allegations the government may pursue, whether additional claims and actions (including actions seeking injunctive relief) will be asserted or the total relief (including damages and, possibly, fines) that will be sought. These lawsuits and the investigations described above arise in an environment of rising costs for prescription drugs and heightened public scrutiny of the PBM industry and its practices. See “Business—Government Regulations”. An adverse outcome or result in any of these proceedings could result in material fines and damages, material changes to our business practices, loss of (or litigation with) clients and other penalties and could have a material adverse effect on our business, financial condition and operating results.

 

See “Business—Legal Proceedings and Government Investigations”.

 

Pending litigation relating to our financial relationship with pharmaceutical manufacturers could significantly limit our ability to obtain discounts and rebates that are essential to our profitability.

 

We, together with a number of pharmaceutical manufacturers, wholesalers and other major PBMs, are defendants in approximately 100 lawsuits challenging manufacturer discount and rebate practices under various federal antitrust laws. These suits, all of which were filed prior to January 2000 and have been consolidated as

 

19


Table of Contents
Index to Financial Statements

part of a Multidistrict Litigation, allege in part that the pharmaceutical manufacturers offered, and we knowingly accepted, rebates and discounts on purchases of brand name prescription drugs in violation of the federal Robinson-Patman Act. These suits seek damages and to enjoin us from future violations of the Robinson-Patman Act. The outcome of these proceedings is uncertain, and the terms of any settlements, adverse judgments or injunctions could significantly limit our ability to obtain discounts and rebates that are essential to our profitability. In connection with our spin-off from Merck, Merck has agreed to indemnify us for substantially all monetary liabilities related to these lawsuits. See “Business—Legal Proceedings and Government Investigations” and “Relationships Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck”.

 

We are defendants in pending actions relating to our revenue recognition practices for retail co-payments.

 

We and Merck are named as defendants in a number of purported class action lawsuits relating to our revenue recognition practices for retail co-payments paid by members of plans for which we provide pharmaceutical benefit management services. Recently, the class action lawsuits were consolidated and amended to assert claims against Merck and us and certain of our officers and directors relating to our revenue recognition practices for retail co-payments, rebates received by us, and our independent status. We and Merck have filed a motion to dismiss these lawsuits. Although Merck has agreed to indemnify us for a significant portion of any damages or settlement payments in connection with this litigation, we could be liable for a material amount of any damages or settlement payment.

 

Competition in our industry is intense and could harm our ability to attract and retain clients.

 

Competition in the PBM industry is intense. Our competitors include many profitable and well-established companies that have significant financial, marketing and other resources. We compete with a wide variety of competitors, including three large national PBMs: AdvancePCS, Caremark Rx, Inc. and Express Scripts, Inc. Each of these companies has national sales and account teams, home delivery pharmacies and extensive technology infrastructure. Further consolidation within the PBM industry, as well as the acquisition of any of our competitors by larger companies, may also lead to increased competition. We also compete with insurers such as CIGNA Corporation and managed care organizations such as WellPoint Health Networks Inc., which offer prescription benefit plans in combination with other health benefits, using their own pharmacy benefit management facilities.

 

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 that 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 customers successfully at our current levels of profitability.

 

If we do not continue to earn and retain rebates from manufacturers at current levels, our gross margins may decline and we may not be profitable.

 

We have contractual relationships with Merck and many other pharmaceutical manufacturers that provide us discounts and rebates on prescription drugs. For example, we receive discounts on the drugs dispensed from our home delivery pharmacies and rebates and fees for formulary management and other services, as well as for achieving various performance criteria. See “—Risks Relating to Our Relationship with and Spin-Off from Merck—Under our managed care agreement with Merck, our rebates could decline by a substantial amount and we may have to pay substantial liquidated damages to Merck if we fail to achieve specified market share levels”.

 

We typically receive formulary access and other rebates and discounts from pharmaceutical manufacturers and generally pass formulary access rebates on to clients. Without rebates earned from pharmaceutical manufacturers based on performance, we would not have been profitable in each of 2000, 2001 and 2002. We earned total rebates from pharmaceutical manufacturers, including Merck, of $1,969 million in 2000,

 

20


Table of Contents
Index to Financial Statements

$2,535 million in 2001, $2,465 million in 2002 and $704 million in the first quarter of 2003, which, on an after tax basis, exceeded our net income of $216.8 million in 2000, $256.6 million in 2001, $361.6 million in 2002 and $102 million in the first quarter of 2003.

 

Some of our arrangements with pharmaceutical manufacturers, which typically have terms of three to five years, are terminable by the manufacturer on 180 days’ or shorter notice, and manufacturer rebates often depend on our ability to meet contractual market share or other requirements. Consolidation among pharmaceutical manufacturers, among other factors, has enabled manufacturers to decrease the amount of rebates they offer to us and other PBMs and increase the portion of their rebates that are formulary access rebates, which PBMs typically pass through to clients. Pharmaceutical manufacturers have also increasingly made rebate payments dependent upon including a broad array of their products in our formularies.

 

Rebates on drugs on which patents are expected to expire over the next several years currently contribute significantly to our earned rebates. Between 2003 and 2006, patents are expected to expire on approximately 40 major brand name drugs that currently have substantial market share in their respective classes. As these patents expire, the introduction of generic products may substantially reduce the market share of the brand name drugs and the rebates manufacturers provide to us for including their brand name drugs in the formularies we manage. We may also not be able to negotiate rebates for new brand name drugs comparable to those rebates we are earning on brand name drugs on which patents are expected to expire. We generally earn higher margins on generic drugs dispensed by our home delivery pharmacies than we earn on brand name drugs. However, manufacturers of newly-introduced generic drugs sometimes benefit from an exclusive marketing period during which we may be unable to earn these higher margins. The typically higher margins we earn on generic drugs and the rebates we earn by adding newly-approved, brand name drugs to our formularies may not offset any decline in rebates for brand name drugs on which patents expire.

 

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, increase the discounts offered to clients and reduce the prices charged to clients for core services. This combination of increased sharing of rebates and higher discounts to clients, as well as increased demand for enhanced service offerings and higher service levels, has caused our gross margin percent on net revenues to decline from 5.0% in 2000 to 3.9% in 2002. For further information regarding our margins, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations”.

 

Our ability to sustain the level of our gross margins depends to a significant degree upon our ability to earn rebates at levels at least equivalent to those in prior years. Our margins may decline further as we attract larger clients, who typically have greater bargaining power than smaller clients. Similarly, the amount of rebates that we earn may decline if pharmaceutical manufacturers decrease further the amount of rebates they offer and increase further the portion of those rebates that are formulary rebates, which we typically pass through to our clients. Our margins may decline further in response to these pressures from manufacturers and clients.

 

The U.S. Food and Drug Administration, or FDA, recently approved the marketing and sale of the drug Claritin without a prescription, or “over-the-counter”, and is considering granting over-the-counter status to other non-sedating antihistamines. As a result of the FDA’s decision, Claritin is no longer covered under the prescription drug benefit plans that we administer, and we no longer earn revenues or rebates on this product. If other non-sedating antihistamines or other major brand or generic drugs become available over-the-counter, the level of revenues that we generate from clients and the rebates and discounts that we earn from manufacturers will decline.

 

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, rebate arrangements with pharmaceutical manufacturers, as well as some of the formulary and other services we provide to pharmaceutical manufacturers, could also reduce the rebates we receive and harm our profitability and liquidity. See “—Pending and threatened litigation challenging some of our important business practices could significantly negatively affect our ability to obtain rebates that are essential to our profitability and could materially limit our business practices”.

 

21


Table of Contents
Index to Financial Statements

Failure to retain key clients could result in significantly decreased revenues and could harm our profitability.

 

Our largest client, UnitedHealth Group Inc., represented approximately $5,300 million, or 16%, of our net revenues during 2002. Although none of our other clients individually represented more than 10% of our net revenues in 2002, our top 10 clients as of December 28, 2002, including UnitedHealth Group, represented approximately 42% of our net revenues during 2002. Our current contract with UnitedHealth Group expires on December 31, 2005, and our contracts with other clients generally have terms of three years. Agreements with a few of our larger clients, representing approximately 7% of our net revenues in 2002, are terminable by the client on short notice.

 

Our contract with UnitedHealth Group grants UnitedHealth Group termination rights in the event of a change of control of our company. The termination or renegotiation of the UnitedHealth Group contract as a result of the spin-off could result in significantly decreased revenues and could harm our profitability.

 

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 each year from 1998 through 2002, we retained clients accounting for at least 94% of our net revenues. We expect our client retention rate to decline to 93% in 2003 as a result of some larger clients not renewing contracts with us. The estimated number of people who are eligible to receive prescription drug benefits, or covered lives, under our clients’ plans decreased from approximately 65 million as of December 29, 2001 to approximately 64 million as of December 28, 2002 and to approximately 62 million as of March 29, 2003.

 

In addition, a client that is involved in a merger or acquisition with a company that is not a client may not renew, and in some instances may terminate, its PBM contract with us. Trigon Healthcare, Inc., or Trigon, a client that represented approximately 3% of our net revenues in 2002, was acquired by Anthem, Inc. in 2002. Trigon’s decision to terminate its contract with us as of the end of 2003 will adversely affect our earnings beginning in 2004.

 

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 sales with comparable operating margins to replace the lost business, our revenues and profitability could suffer materially.

 

Failure to satisfy contractual provisions with clients representing, in aggregate, over 90% of our net revenues could require us to pay performance penalties and could result in the termination of their contracts.

 

Many of our contracts with clients contain provisions that guarantee the level of service we will provide to the client or the minimum level of rebates or discounts the client will receive. Many of our client contracts also include guaranteed cost savings. An increase in drug costs, if the result is an overall increase in the cost of the drug plan to the client, may prevent us from satisfying contracts with guaranteed cost savings or minimum levels of rebates or discounts. Additionally, these clients may be entitled to performance penalties or the right to terminate their contracts with us if we fail to meet a service, rebate or cost savings guarantee we provide to them. Clients that are party to these types of contracts represented, in aggregate, over 90% of our net revenues in 2002.

 

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

 

If we fail to comply with complex and rapidly evolving laws and regulations or increasingly sophisticated contractual obligations, we could suffer penalties, lose clients 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

 

22


Table of Contents
Index to Financial Statements

operate our home delivery pharmacies and our ability to participate in federal and state health care programs. We also continue to enter into increasingly detailed and complex contractual obligations. As a consequence of the severe penalties we could face, we must devote significant operational and managerial resources to comply with these laws and regulations and contractual obligations. Although we believe that we substantially comply 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 assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.

 

We have standard operating procedures and controls designed to enhance operating efficiencies and assist in ensuring compliance with existing contractual requirements and state and federal law, and we monitor and audit our adherence to these procedures and controls. As a result of our internal review processes, we have become aware that certain employees at some of our pharmacies did not follow certain of our procedures and controls with respect to recording the turnaround time between the receipt and processing of prescriptions, and we have taken appropriate corrective and disciplinary actions. We have recently commenced, with the assistance of outside counsel, an internal review of all of our significant home delivery pharmacy practices and will conduct similar reviews from time to time in the future. Based upon our review to date of the first quarter of 2003, while the turnaround times between receipt and processing of less than one-half of one percent of home delivery prescriptions at the pharmacies reviewed were not recorded in accordance with our standard operating procedures and controls, we believe that these actions did not result in any material violations of any contract or applicable law. Nevertheless, the review is ongoing and a determination that any such violations occurred could adversely impact existing governmental or legal proceedings or otherwise have a material adverse effect on our business, financial condition or profitability.

 

Our business could suffer if our newly developed systems and infrastructure are inadequate or we cannot replace the other benefits previously provided by Merck.

 

Since Merck acquired us in 1993, we have relied on it for various services which we have only recently developed for ourselves, including:

 

    consolidation accounting;

 

    legal;

 

    treasury;

 

    tax;

 

    public affairs;

 

    executive oversight;

 

    human resources; and

 

    procurement and other services.

 

Following the distribution, we will operate as a separate publicly traded company. We have developed and implemented systems and infrastructure to support our current and future business. However, these newly developed systems and infrastructure may be inadequate and we may be required to develop or otherwise acquire other systems and infrastructure to support our current and future business.

 

In addition, as a wholly owned subsidiary of Merck, we have benefited from the value and prestige of the Merck brand name, the expertise of Merck’s management, Merck’s significant financial resources and Merck’s guarantee of some of our contractual obligations. For example, Merck has guaranteed our performance obligations to UnitedHealth Group and the Federal Employee Program, or FEP, which is administered by the

 

23


Table of Contents
Index to Financial Statements

Blue Cross and Blue Shield Association. Following the distribution, Merck will not guarantee our performance under any new or renewed client contracts. As a result, we may not be able to obtain or renew client contracts that we might otherwise have obtained or renewed.

 

Our historical and pro forma financial information may not be representative of our results as a separate company.

 

The historical and pro forma financial information included in this information statement may not reflect what our results of operations, financial position and cash flows would have been had we been a separate, publicly traded company during the periods presented and may not be indicative of our future results of operations, financial position and cash flows. We believe there are a number of reasons for this, including:

 

    as a subsidiary of Merck, we received various services and Merck allocated expenses for these services to us in amounts that are not the same as the amounts of these expenses that would have been incurred had we performed or acquired these services ourselves or that we will incur as a separate company;

 

    we have entered into agreements with Merck that may be less favorable to us than either our previous arrangements with Merck or what we could have obtained in arm’s length negotiations with unaffiliated third parties for similar services. See “Relationships Between Our Company and Merck & Co., Inc.”;

 

    our historical financial information does not reflect many significant events and changes that will occur as a result of our spin-off from Merck, including the establishment of our capital structure, the incurrence of debt and interest expense and changes in our expenses as a result of new employee, tax and other functions we will assume; and

 

    the assumptions underlying our pro forma financial information do not reflect many of the one-time or ongoing incremental expenses we expect to incur and our estimates of these expenses may prove to be inaccurate.

 

For a further discussion of our financial information, see “Selected Historical Consolidated Financial and Operating Data” and “Unaudited Pro Forma Condensed Consolidated Financial Data”.

 

After the distribution, we will not be able to obtain financing from Merck.

 

Our plans to expand our business and to continue to improve our technology may require funds in excess of our cash flow and may require us to seek financing from third parties. In the past, Merck has generally provided capital for our general corporate purposes, including acquisitions and client development, and we have periodically used cash from Merck to fund our operations. After the distribution, Merck will not provide funds to finance our operations. Without the opportunity to obtain financing from Merck, we may in the future need to obtain additional financing from banks, or through public offerings or private placements of debt or equity securities, strategic relationships or other arrangements. We will have a credit rating that is lower than Merck’s credit rating and we will incur debt on terms and at interest rates that will not be as favorable as those historically enjoyed by Merck. Our inability to obtain financing on favorable terms could restrict our operations and reduce our profitability. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”.

 

Following the distribution we will have substantial debt obligations that could restrict our operations.

 

Historically, we have not had any indebtedness for borrowed money. Following the distribution, we will have substantial indebtedness. Giving effect to the senior unsecured notes offering and the borrowings and advances we plan to make under our senior secured credit facility and our accounts receivable financing facility prior to or concurrently with the completion of the distribution, our total indebtedness for borrowed money will be approximately $1,500 million. We expect that our available borrowing capacity will be approximately $250 million under our revolving credit facility and between approximately $250 million and $400 million under our accounts receivable financing facility, subject, in the case of the accounts receivable financing facility, to there being sufficient eligible receivables. We and our subsidiaries may also incur additional substantial indebtedness in the future.

 

24


Table of Contents
Index to Financial Statements

Our substantial indebtedness could have adverse consequences, including:

 

    increasing our vulnerability to adverse economic, regulatory and industry conditions;

 

    limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry;

 

    limiting our ability to borrow additional funds; and

 

    requiring us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for working capital, capital expenditures, acquisitions and other purposes.

 

If our cash flow and capital resources are insufficient to service our debt obligations, we may be forced to sell assets, seek additional equity or debt capital or restructure our debt. However, these measures might be unsuccessful or inadequate in permitting us to meet scheduled debt service obligations.

 

The operating and financial restrictions imposed by our debt agreements could restrict our ability to finance operations and capital needs or to engage in other business activities.

 

The terms of the indenture under which the senior unsecured notes will be issued will contain covenants that restrict or limit our and our restricted subsidiaries’ ability to:

 

    borrow money and issue preferred stock;

 

    pay dividends on our stock or repurchase our stock;

 

    make investments;

 

    create liens;

 

    enter into sale and leaseback transactions;

 

    create restrictions on the ability of our restricted subsidiaries to pay dividends or other amounts to us;

 

    engage in certain transactions with affiliates;

 

    consolidate, merge or sell all or substantially all of our or their assets; and

 

    designate our subsidiaries as unrestricted subsidiaries.

 

Most of these covenants will cease to be applicable if the senior unsecured notes attain investment grade status and we are not in default under the notes and the indenture. See “Description of Indebtedness”.

 

Our credit agreement governing the senior secured credit facility will also include covenants that restrict or limit our and our subsidiaries’ ability to:

 

    incur additional indebtedness;

 

    incur liens on property or assets;

 

    enter into sale and leaseback transactions;

 

    dispose of assets;

 

    make fundamental changes in our corporate existence and our principal business;

 

    make acquisitions, investments and capital expenditures;

 

    pay dividends;

 

    make restricted payments;

 

25


Table of Contents
Index to Financial Statements
    engage in transactions with affiliates;

 

    enter into agreements that restrict corporate activities;

 

    prepay or redeem any subordinated debt we may incur or amend agreements governing such subordinated debt; and

 

    use derivative instruments.

 

In addition, the agreements governing the senior secured credit facility and accounts receivable financing facility will require us to comply with specified financial ratios and tests including a maximum leverage ratio and a minimum fixed charge coverage ratio. These restrictive covenants and financial ratios and tests will restrict our financial flexibility. Furthermore, a downgrade of our senior unsecured debt rating below certain thresholds will increase pricing on, and decrease availability under, the accounts receivable financing facility.

 

We may also incur future debt obligations that might subject us to additional restrictive covenants that could affect our financial and operational flexibility. Our breach or failure to comply with any of these covenants could result in a default under the indenture or the agreements governing our senior secured credit facility and accounts receivable financing facility. If a default under the indenture occurs, the holders of the senior unsecured notes could elect to declare the notes due and payable, together with accrued and unpaid interest. If we default under the agreements governing the senior secured credit facility and accounts receivable financing facility, the lenders could cease to make further extensions of credit or advances and cause all of our outstanding debt obligations under the facilities to become immediately due and payable, together with accrued and unpaid interest. Because the indenture and the agreements governing our senior secured credit facility and accounts receivable financing facility will have customary cross-default provisions, if debt is accelerated under one of these agreements, debt under the other agreement may also be accelerated. If the indebtedness under the senior unsecured notes or under the facilities is accelerated, we may be unable to repay or finance the amounts due.

 

Risks related to bioterrorism and mail tampering, and mail irradiation and other procedures the government may implement to manage these risks, could adversely affect and limit the growth of our home delivery business.

 

Many prescription drugs are delivered to retail pharmacies or directly to consumers through the mail. In particular, our home delivery service sends over a million parcels a week through the U.S. Postal Service and other couriers. A number of our contracts also require us to deliver pharmaceutical products within a designated period of time on average following receipt of an order. We have no control, however, over delays caused by disruptions to the U.S. mail or other courier services. Moreover, should the risks related to bioterrorism or mail tampering increase or mail service experience interruptions or significant delays, we may have difficulty satisfying our contractual performance obligations and consumers may lose confidence in home delivery pharmacies.

 

Additionally, the use of mail irradiation or other scanning devices, if implemented, could be harmful to pharmaceutical products shipped via the mail. We understand that this technology is not in general use and the U.S. Postal Service has not announced plans to use irradiation screening on prescription medicines. However, should the federal government implement mail irradiation technology to protect national security due to the risks of bioterrorism via the mail or for other unforeseen reasons, safe and reliable delivery of prescription drugs through the mail may be difficult. See “Business—Government Regulations”. If any of these events occur, we could be forced to temporarily or permanently discontinue our home delivery operations and we would lose an important competitive advantage.

 

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 $50 million. A successful product or professional liability claim in excess of our insurance coverage could harm our profitability and liquidity.

 

Various aspects of our business may subject us to litigation and liability for damages, including:

 

    the dispensing of pharmaceutical products by our home delivery pharmacies;

 

26


Table of Contents
Index to Financial Statements
    the performance of PBM services, including formulary management and health improvement and clinical services; and

 

    the operation of our call center pharmacies and websites.

 

For example, a prescription drug dispensing error could result in a patient receiving the wrong or incorrect amount of medication, leading to personal injury or death. Misinformation from one of our call center pharmacies or our websites could also lead to adverse medical conditions. Our business, profitability and growth prospects could suffer if we face negative publicity or we pay damages or defense costs in connection with a claim that is outside the scope of any applicable contractual indemnity or insurance coverage.

 

Changes in technology could cause our products and services to become obsolete and, as a result, we may lose clients and members.

 

We rely heavily on our technology, which is subject to rapid change and evolving industry standards. For example, automated dispensing for home delivery, online pharmacies and electronic prescribing are among the recent technological innovations of our industry. To be successful, we must adapt to this rapidly evolving market by continually improving the responsiveness, functionality and features of our products and services to meet our clients’ changing needs. We may not be successful in developing or acquiring technology which is competitive and responsive to the needs of our clients and might lack sufficient resources to continue to make the necessary investments in technology to compete with our competitors. Without the timely introduction of new products and enhancements that take advantage of the latest technology, our products and services could become obsolete over time and we could lose a number of our clients and members.

 

If we are not able to protect our intellectual property rights or successfully defend claims of infringement against us or maintain our third party relationships, we may not be able to compete effectively.

 

We currently rely on a combination of patent, copyright, trade secret and trademark rights, as well as confidentiality agreements and other contractual arrangements with our employees, contractors, affiliates, business partners and clients, to establish and protect our intellectual property and similar proprietary rights. However, it is possible that third parties may copy or otherwise obtain and use our information and proprietary technology without authorization or otherwise infringe on our intellectual property rights. In addition, we may not be able to deter current and former employees, contractors and other parties from breaching confidentiality agreements and misappropriating proprietary information. We have licensed and may license in the future, patents, copyrights, trademarks, trade secrets and similar proprietary rights to and from third parties. While we attempt to ensure that our intellectual property and similar proprietary rights are protected and that the third party rights we need are licensed to us when entering into business relationships, our business partners, consultants or other third parties may take actions that could materially and adversely affect our rights or the value of our intellectual property, similar proprietary rights or reputation.

 

In the future, we may have to rely on litigation to enforce our intellectual property rights and contractual rights. In addition, we may face claims of infringement that could interfere with our ability to use technology or other intellectual property rights that are material to our business operations. Any litigation of this type, whether successful or unsuccessful, could result in substantial costs to us and diversions of our resources. If litigation we initiate is unsuccessful, we may not be able to protect the value of our intellectual property. Additionally, in the event a claim of infringement against us is successful, we may be required to pay royalties or license fees to continue to use technology or other intellectual property rights that we had been using or we may be unable to obtain necessary licenses from third parties at a reasonable cost or within a reasonable time.

 

We have formed relationships with and rely on the services and technology of a number of third party companies and consultants to ensure the integrity of our technology. Although we do not anticipate severing relations with any of these third parties, any of these providers may cease providing these services or technology

 

27


Table of Contents
Index to Financial Statements

in an efficient, cost-effective manner or be unable to adequately expand their services to meet our needs. In the event of an interruption in, or the cessation of, services or technology by an existing third party provider, we may not be able to make alternative arrangements for the supply of the services or technology that are critical to the operation of our business.

 

Although we believe that our intellectual property rights are sufficient to allow us to conduct our business without incurring liability to third parties, our programs and services may infringe on the intellectual property rights of third parties and our intellectual property rights may not have the value we believe them to have.

 

Any disruption of or failure in our two automated pharmacies or our data center could significantly reduce our ability to process and dispense prescriptions and provide products and services to our clients.

 

As of the second quarter of 2003, our automated pharmacies in Las Vegas, Nevada and Willingboro, New Jersey together dispensed approximately 88% of our home delivery prescriptions per week. Our data center, located in Fair Lawn, New Jersey, provides primary support for all applications and systems required for our business operations, including our claims processing, billing, communications and home delivery systems. These facilities depend on the infrastructure in the areas where they are located 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 some other catastrophic event could significantly reduce our ability to process and dispense prescriptions and provide products and services to our clients.

 

As a result of our discussions with the Pension Benefit Guaranty Corporation relating to the Medco Health Cash Balance Retirement Plan, our liabilities and obligations under the plan could accelerate.

 

On May 16, 2002, the Pension Benefit Guaranty Corporation, or PBGC, notified Merck that it had determined, on the basis of a hypothetical plan termination and actuarial assumptions, that the Medco Health Cash Balance Retirement Plan was underfunded by approximately $32 million. See “Management—Retirement Benefits—Cash Balance Plan”. The PBGC could require us, among other things, to make additional contributions to the plan, to provide security for the payment of our contributions to the plan or otherwise to assure the PBGC that benefits under the plan will be adequately funded if the plan were to be terminated. If the PBGC demands that we take action with respect to the plan in connection with the distribution and we are unable to reach a negotiated resolution with the PBGC, the PBGC could seek to terminate the plan. We would be liable for unfunded benefits under the plan if it is terminated by the PBGC. See note 7 to our audited consolidated financial statements included elsewhere in this information statement for a discussion of the funded status of the plan in accordance with generally accepted accounting principles.

 

Risks Relating to Our Industry

 

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, which regulates employee pension benefit plans and employee welfare benefit plans, including health and medical plans. The U.S. Department of Labor, 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. If a court were to determine 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”. See “—Risks Relating to Our Business—Pending and threatened litigation challenging some of our important business practices could significantly negatively affect our ability to obtain rebates that are essential to our profitability and could materially limit our business practices”.

 

28


Table of Contents
Index to Financial Statements

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, state and international 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 “Business—Government Regulations”. 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.

 

Although we have in place stringent policies and procedures to protect and secure patient identifiable medical and other information, new laws that may be enacted and new rules and regulations that may be adopted governing privacy and security may reduce the amount of information we may obtain or use without patient consent. Difficulties in obtaining patient consents could limit our ability to use some of our information technology products and services. Even without new legislation, our clients could prohibit us from including their members’ information in our various databases. These clients could also prohibit us from offering services to others that involve the compilation of that information.

 

Government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers.

 

During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation at both the federal and state levels. Efforts to control health care costs, including prescription drug costs, are underway at the federal and state government levels. Congress is also currently considering proposals to reform the U.S. health care system. These proposals may increase governmental involvement in health care and pharmacy benefit management services and may otherwise change the way our clients do business. Health care organizations may react to these proposals and the uncertainty surrounding them by cutting back or delaying the purchase of our pharmacy benefit management 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 extent of future legislation. However, these initiatives could greatly limit our business practices and impair our ability to serve our clients.

 

Legislation to provide Medicare recipients with outpatient drug benefits could reduce the total market for PBM services.

 

On June 27, 2003, both Houses of Congress passed bills which would provide Medicare recipients with outpatient drug benefits. The federal Medicare program provides a comprehensive medical benefit program for individuals age 65 and over, but currently covers only a few outpatient prescription drugs. Although they have significant differences, both bills call for a prescription drug benefit, provide consumers with improved access to

 

29


Table of Contents
Index to Financial Statements

generic drugs and permit the reimportation of drugs from Canada into the United States. The two bills also envision a larger role for private health plans and offer similar drug benefits to people in traditional Medicare, HMOs and preferred provider organizations. The final provisions of this legislation will be determined in conference committee and are subject to signature by President Bush. Depending on the legislation that is ultimately enacted, a Medicare prescription drug benefit could make policies or plans less valuable to seniors and reduce the total market for PBM services. Moreover, our clients could decide to discontinue providing prescription drug benefits to their Medicare-eligible members. If this occurs, the adverse effects of these legislative proposals may outweigh any opportunities for new business generated by the new benefit. We are not able to assess the impact any such law would have on the decision of any of our clients to continue to offer a prescription drug benefit to their Medicare-eligible members.

 

Risks Relating to Our Relationship with and Spin-Off from Merck

 

Under our managed care agreement with Merck, our rebates could decline by a substantial amount and we may have to pay substantial liquidated damages to Merck if we fail to achieve specified market share levels.

 

Our historical financial statements include recorded rebates from Merck based upon the volume of Merck patented products dispensed either by our home delivery pharmacies or through our retail pharmacy networks and the level of control we exercise over drugs utilized at our clients’ plans. The gross rebates recorded as received from Merck totaled $350.5 million in 2000, $439.4 million in 2001, $443.9 million in 2002 and $110.6 million in the first quarter of 2003. In 2002, rebates from Merck accounted for approximately 15% of the rebates we earned that contributed to our net income.

 

The five-year managed care agreement we entered into with Merck, effective as of July 2002, replaces our previous arrangements with Merck with respect to these rebates. We describe the managed care agreement in detail under “Relationships Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck—Managed Care Agreement”. Under the agreement, we have the opportunity to earn formulary access rebates and market share rebates. However, the provisions of the agreement relating to rebates may reduce the amount of rebates from Merck that we are able to earn as compared with prior periods, and some provisions of the agreement may also affect our business practices in ways that could have a significant impact on the amount of rebates we may be able to earn from other manufacturers. In some respects, the agreement also imposes greater obligations on us than similar agreements we have with other pharmaceutical manufacturers. Accordingly, the agreement may have a significant impact on our profitability.

 

Taking into account anticipated changes in volume and mix of Merck patented products dispensed to members of our clients’ plans and assumptions regarding aggregate sales of Merck patented products under the plans we manage or administer, we estimate that the level of gross rebates we have the opportunity to earn for 2003 will generally be comparable to the level of rebates we earned under the managed care agreement and other arrangements between us and Merck that were in effect in 2002. However, because the agreement became effective beginning in the third quarter of 2002, the actual rebates for the first two quarters of 2002 were calculated without taking into consideration the provisions regarding reduction or loss of rebates described below.

 

The agreement requires us to:

 

    ensure that all Merck patented products are included in each of our standardized formularies on the most preferred branded tier;

 

    make offers and proposals to potential, new or existing plans relating to the treatment of Merck patented products under those plans;

 

    use our best efforts to ensure that Merck patented products are made available to members under plans we manage or administer with no less favorable access, and on a no less favorable clinical or economic basis, than competitive patented products;

 

30


Table of Contents
Index to Financial Statements
    provide notices and information to Merck and our clients and afford Merck the opportunity to communicate with us and our clients regarding Merck products and the recommendations we make to our clients regarding those Merck products; and

 

    ensure that for each quarter the dollar-weighted ratio of (a) the market shares of Merck patented products under plans we manage or administer to (b) the national third-party market shares of Merck patented products (excluding prescriptions under plans we manage or administer), which we refer to as our aggregate market share differential, is at or above a minimum level.

 

The rebates that we may earn under the agreement may be reduced or eliminated if we do not comply with various obligations or our aggregate market share differential is below target or minimum levels. Merck has the right to terminate the managed care agreement at any time on 120 days’ notice. Merck may also at any time withdraw any of its patented products from the terms of the agreement, subject to certain restrictions with respect to Zocor. Merck’s termination of the agreement or withdrawal of products could substantially reduce our profitability and impair our financial condition.

 

In the past, the market share of Merck products under plans we manage or administer has in the aggregate exceeded the national third-party market shares of Merck patented products (excluding prescriptions under plans we manage or administer). The rebates we may earn under the managed care agreement may be reduced or eliminated if we do not achieve aggregate target and minimum market share differentials. The aggregate amount of formulary access rebates we receive from Merck for any quarter will be reduced to the extent that our aggregate market share differential is below an aggregate target market share differential, which reflects our aggregate market share differential for the last quarter of 2001 reduced by an agreed upon percentage and adjusted for the impact on our aggregate market share differential of plans that we began to manage or administer or ceased to manage or administer during 2002. For the fourth quarter of 2002, our aggregate market share differential was approximately 1.33 to 1. The aggregate target market share differential for the fourth quarter of 2002 was approximately 1.28 to 1. Declines in our aggregate market share differential will generally reduce the aggregate amount of market share rebates we receive under the agreement for any quarter. We will not receive any rebates for any quarter in which our aggregate market share differential is less than an aggregate minimum market share differential, adjusted as provided in the agreement. The aggregate minimum market share differential for the fourth quarter of 2002 was approximately 1.21 to 1. If we fail to achieve the aggregate minimum market share differential, we will be required to pay to Merck, as liquidated damages, 50% of the additional revenue Merck would have received if we had achieved this aggregate minimum market share differential for that quarter. For illustrative purposes only, based on the utilization of Merck products under our plans during the fourth quarter of 2002, if our aggregate market share differential had been below the aggregate minimum market share differential for that quarter, for each 0.01 increment (or portion of that increment) our aggregate market share differential had been below the aggregate minimum market share differential, we would have been required to pay approximately $3 million (or a ratable portion of that amount, as applicable) to Merck as liquidated damages.

 

We may not be able to maintain the aggregate target or aggregate minimum market share differential for any quarter or for the term of the agreement, and our aggregate market share differential may decline due to a variety of factors, some of which are beyond our control. The rebates we receive from Merck may vary substantially from quarter to quarter and may decline from historic levels, or we may not be entitled to receive rebates at all. Moreover, we cannot predict how Merck or other pharmaceutical manufacturers will price their products, and these pricing decisions could have a substantial impact on our ability to achieve the aggregate target market share differential and aggregate minimum market share differential.

 

We will not be entitled to receive any rebates for any quarter in which we breach some of the covenants contained in the agreement. These include covenants requiring us to:

 

    amend the agreement, as necessary, to assure Merck of its contemplated benefits to the extent that changes occur to the nature and scope of our services or manner of delivering pharmaceutical products so as to adversely affect, in Merck’s judgment, the benefits contemplated by Merck;

 

31


Table of Contents
Index to Financial Statements
    indemnify Merck; and

 

    retain information and data in support of rebate calculations in an orderly, accessible, complete and accurate format.

 

Moreover, we will be ineligible to receive rebates in the following circumstances:

 

    We will not receive any rebates for utilization of Merck patented products under plans we manage or administer for any quarter in which we breach any of our “standardized formulary” obligations or any of our obligations with respect to, among other things, providing notices and information to Merck and our clients, or affording Merck the opportunity to communicate with us and our clients regarding Merck products or the recommendations we make to our clients regarding those products.

 

    We will generally not be eligible to receive any rebates in the future for utilization of Merck patented products under a plan if we breach our obligations relating to offers and proposals with respect to that plan.

 

    We will not be eligible to receive any rebates for the utilization of a Merck patented product under a plan for any quarter in which we breach our “best efforts” obligations with respect to that Merck patented product under that plan.

 

Nor will we be eligible to receive any rebates for sales of a Merck patented product dispensed under a plan during any quarter if during the quarter that Merck product is:

 

    not included on the most preferred branded tier of the plan’s formulary from which members are encouraged to request, and/or physicians are encouraged to prescribe, pharmaceutical products;

 

    subject to a co-payment that is not as low as the lowest co-payment payable for any competitive patented product included in the therapeutic category which includes the affected Merck patented product; or

 

    not made available to members under the plan with at least as favorable access, and on at least as favorable a clinical or economic basis, as competitive patented products.

 

We believe that under most of the plans we manage or administer all or almost all of Merck patented products are eligible for rebates under the three criteria listed above. If Merck determines otherwise or if in the future this is not the case, the rebates we may earn under the agreement may be significantly reduced.

 

From and after the third quarter of 2003, we will be ineligible to receive any rebates for use of a Merck patented product by members of a plan we manage or administer if utilization controls not approved by Merck as eligible for rebates are implemented under the plan with respect to that Merck product and/or any competitive patented products. Merck has the right to determine whether the utilization controls that are currently or in the future implemented by plans we manage or administer are eligible for rebates. A decision by Merck not to approve all or some of these utilization controls could materially and adversely affect the amount of rebates we will be eligible to receive from Merck under the agreement. Under the agreement, with respect to the first and second quarters of 2003, Merck is still entitled to determine whether the plans we manage or administer implemented utilization controls during those quarters that restricted the use of a Merck patented product, encouraged the use of a competitive patented product or restricted the use of patented products in the therapeutic category that includes that Merck product. For the first quarter of 2003, to the extent Merck does not approve utilization controls implemented under plans we managed or administered or it is otherwise determined that we were not entitled to receive rebates which we believed we were entitled to receive for any use of Merck patented products, we could ultimately receive up to $10 million less in rebates than the amount reflected in our financial statements, possibly requiring us to record a charge to our future net income of up to the amount of any such shortfall. In addition, the rebates we receive for the second quarter of 2003 could be significantly less than we anticipate if similar adverse determinations are made with respect to that quarter.

 

32


Table of Contents
Index to Financial Statements

Furthermore, if, as a result of any of the foregoing disqualifying circumstances, we become ineligible in any quarter to receive formulary access rebates for sales of one or more Merck patented products under a plan we manage or administer (but were eligible to receive formulary access rebates for sales of those Merck products during the preceding quarter) and the sales for those Merck patented products under the plan during the preceding quarter represented 20% or more of the total sales of all Merck patented products eligible for formulary access rebates under that plan, Merck may elect not to pay us any rebates for any sales of Merck patented products under that plan for that particular quarter.

 

We may not have sufficient influence over a plan to prevent circumstances from arising that would result in our being ineligible to receive any rebates for utilization of Merck patented products under the plan. The loss of a material amount of rebates from Merck in any quarter or year could have a material adverse effect on our business, financial condition and growth prospects.

 

Historically, Zocor has had the highest sales revenue of all Merck patented products within the plans we manage or administer and has accounted for a higher proportion of rebates we have received than any other Merck patented product. Accordingly, the utilization of Zocor under plans we manage or administer has contributed significantly to our ability to exceed the aggregate minimum market share differential and achieve at least the aggregate target market share differential. If utilization of Zocor decreases under the plans we manage or administer, or if Merck, in its sole discretion, withdraws Zocor from the terms of the managed care agreement (which it may generally do when, for two consecutive quarters, our aggregate market share differential does not exceed the aggregate target market share differential, as adjusted), the amount of rebates we receive from Merck may decline materially. In addition, Merck’s patent right with respect to Zocor is currently expected to expire in mid-2006, at which time we will no longer receive any rebates for utilization of Zocor. Although the aggregate target and minimum market share differentials will be adjusted at that time to exclude the effect of Zocor and ameliorate the impact on us of the expiration of the Zocor patent right, this adjustment will not replace the lost rebates attributable to Zocor.

 

Finally, the managed care agreement contains a number of terms that are not contained in, or are substantially different from comparable provisions of, our agreements with other pharmaceutical manufacturers.

 

    Under rebate arrangements with other pharmaceutical manufacturers, generally only the market share rebates we have an opportunity to earn are contingent upon achieving specified aggregate market share differentials for the manufacturers’ products. The managed care agreement, however, makes the level of all rebates dependent upon our maintaining specified aggregate market share differentials.

 

    Liquidated damages provisions are not included under our agreements with other pharmaceutical manufacturers. Under the managed care agreement, however, if we fail to maintain the aggregate minimum market share differential in any quarter, we are required to pay to Merck, as liquidated damages, 50% of the additional revenue Merck would have received if we had achieved the aggregate minimum market share differential for that quarter.

 

    Under rebate arrangements with other pharmaceutical manufacturers, the pharmaceutical manufacturers generally may not unilaterally withdraw a product from the terms of the rebate agreement, as Merck is generally entitled to do under the managed care agreement.

 

    Other provisions of the managed care agreement absent from our agreements with other manufacturers include Merck’s unilateral right to terminate the agreement and our agreement to indemnify Merck for specified liabilities.

 

These provisions under the managed care agreement could substantially reduce our profitability and impair our financial condition. The terms and requirements of the agreement and consequences of noncompliance provided in the agreement are likely to have a more significant impact on the conduct of our business than those contained in agreements with other pharmaceutical manufacturers. Because of these provisions, if we breach the managed care agreement, the consequences may be more adverse to us than if we breach our agreements with other pharmaceutical manufacturers.

 

33


Table of Contents
Index to Financial Statements

Compliance with our obligations under the managed care agreement may have a substantial impact on our competitive position and may expose us to liabilities to clients and others.

 

To avoid losing rebates with respect to Merck patented products and paying substantial liquidated damages to Merck resulting from our failure to maintain the aggregate minimum market share differential under the agreement, we may have to take steps to comply with the agreement that create uncertainties and risks for our business relationships with other pharmaceutical manufacturers and with our clients. Our obligations under the managed care agreement may reduce our flexibility in negotiating agreements with other pharmaceutical manufacturers or our ability to earn rebates under agreements with them. Our obligations under the agreement may also make it more difficult for us to negotiate new agreements with our clients and may affect our competitive position.

 

Under the agreement, Merck has the right to engage in discussions with any client that indicates that it may be interested in working directly with Merck or that it is contemplating or in the process of terminating its relationship with us as it relates to Merck or any Merck patented product. If any of our major clients were to reach agreement directly with Merck, we could lose the opportunity to earn rebates with respect to sales of Merck patented products to that client’s members, and the adverse impact on our business and profitability could be significant.

 

If we do not realize anticipated rebates under our agreement with Merck, we may fail to meet financial performance standards that we have committed to achieve under certain plans we manage or administer, in which case we could incur substantial liabilities to those plans. As a result of our efforts to perform our obligations under the agreement, our competitive position could suffer and we may be unable to avoid reduction or elimination of our rebates under the agreement or the payment of liquidated damages.

 

Under the agreement, we are responsible for any liabilities to third parties arising from the performance of our obligations. While we do not believe that the agreement conflicts with any of our contractual obligations to third parties or with any laws or regulations applicable to our business, we are a party to a number of government investigations and legal proceedings and our adversaries may assert the contrary, potentially resulting in a less favorable outcome than we would otherwise expect. See “Business—Legal Proceedings and Government Investigations”.

 

Our managed care agreement with Merck contains provisions that may make it more difficult for us to sell stock or assets or for another company to acquire or merge with us.

 

Our rights or obligations under the agreement cannot be assigned, including by operation of law. We will be prohibited from selling to any party businesses or assets representing 5% or more of our net income or net revenues, or 15% or more of any class of our equity securities or of the equity securities of any subsidiary that generated 5% or more of our net revenues or net income, or more than 5% of our assets on a book value or fair value basis, measured in each case as of the end of the quarter preceding the transaction, unless, at Merck’s election, the acquiring party or its ultimate parent agrees to enter into an agreement with Merck containing provisions relating to that party, any plans managed or administered by it, and its affiliates, that are substantially similar to our managed care agreement with Merck (other than as relating to existing groups of members under those plans, which would not be required to be subject to the agreement). These provisions could limit our ability to engage in sales of our stock or assets, or to engage in a merger or change of control transaction, that our stockholders might consider favorable, and may discourage third parties from seeking to enter into business combination transactions with us.

 

Our executive officers and employees may have conflicts of interest because they own Merck stock or options to purchase Merck stock.

 

After the distribution, a number of our executive officers and other employees will continue to own Merck stock and options on Merck stock they acquired as employees of our company or Merck. As of July 1, 2003, our executive officers collectively beneficially owned 314,668 shares of Merck common stock (including

 

34


Table of Contents
Index to Financial Statements

phantom stock credited under the Merck Deferral Program) and options to purchase 2,105,722 shares of Merck common stock. Only a portion of these Merck stock options will be converted to Medco Health stock options in connection with the distribution. These ownership interests could create, or appear to create, potential conflicts of interest when these executive officers and other employees are faced with decisions that could have different implications for our company and Merck. See “Security Ownership of Certain Beneficial Owners and Management”.

 

The agreements we are entering into with Merck in connection with the distribution could restrict our operations.

 

In connection with the distribution, we and Merck are entering into a number of agreements that will govern our spin-off from Merck and our future relationship. Each of these agreements has been or will be entered into in the context of our relationship to Merck as a wholly owned subsidiary and our spin-off from Merck, and, accordingly, the terms and provisions of these agreements may be less favorable to us than terms and provisions we could have obtained in arm’s-length negotiations with unaffiliated third parties. These agreements commit us to take actions, observe commitments and accept terms and conditions that are or may be advantageous to Merck but are or may be disadvantageous to us. The terms of these agreements will include obligations and restrictive provisions, including, but not limited to:

 

    an agreement that restricts our ability, for a period of five years after the completion of the distribution, to engage in a business similar to the business of developing, manufacturing or marketing human or animal health products except to the extent these activities relate to the conduct of our PBM business. We will also be subject to some restrictions on our ability to make acquisitions of, and investments in, any company that conducts these prohibited activities or businesses. In addition, if we acquire a company that conducts prohibited businesses and activities and we subsequently determine to dispose of any of those prohibited activities or businesses within five years of the date of the distribution, we will be required to provide Merck with a right of first offer to acquire those activities or businesses;

 

    an agreement to indemnify Merck, its affiliates, and each of their respective directors, officers, employees, agents and representatives from certain liabilities arising out of some of the litigation we are involved in and all liabilities that arise from our breach of, or performance under, the agreements we are entering into with Merck in connection with the distribution and for any of our liabilities;

 

    an agreement that we will not change our accounting principles for periods in which our financial results are included in Merck’s consolidated financial statements, unless we are required to do so to comply, in all material respects, with generally accepted accounting principles and SEC requirements. We will also agree to use Merck’s auditors for a period of time, use reasonable commercial efforts to have our annual audit completed on the same date as Merck’s annual audit and provide information and access to Merck and its auditors; and

 

    an agreement with regard to tax matters between ourselves and Merck which restricts our ability to engage in certain strategic or capital raising transactions.

 

For a further discussion of our agreements with Merck, see “Relationships Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck”.

 

Risks Related to the Distribution

 

If the spin-off is determined to be a taxable transaction, you and Merck could be subject to material amounts of taxes.

 

Merck has received a private letter ruling from the IRS regarding the U.S. federal income tax consequences of the distribution, substantially to the effect that, for U.S. federal income tax purposes, the spin- off will qualify as a tax-free distribution under Section 355 and a tax-free reorganization under Section 368(a)(1)(D) of the Internal Revenue Code. While generally binding on the IRS, the letter ruling is subject to

 

35


Table of Contents
Index to Financial Statements

certain factual representations and assumptions. If these factual representations and assumptions were incorrect in any material respect, this letter ruling could be retroactively revoked or modified by the IRS. Neither Merck nor Medco Health is aware of any facts or circumstances that would cause these representations or assumptions to be untrue or incomplete in any material respect. If, notwithstanding the letter ruling, the spin-off is determined to be a taxable transaction, you and Merck could be subject to material amounts of taxes. See “The Distribution—U.S. Federal Income Tax Consequences of the Distribution”.

 

Under some circumstances, we could be prevented from engaging in strategic or capital raising transactions and we could be liable to Merck for any resulting adverse tax consequences.

 

It is possible that Merck would recognize a large taxable gain if the IRS were to assert that the distribution is part of a plan or series of related transactions pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50 percent or greater interest in either Merck or Medco Health. Any cumulative 50 percent change of ownership in either Merck or Medco Health within the four-year period beginning two years before the date of the spin-off will be presumed under applicable law to be part of such a plan. If this presumption applies, it would need to be rebutted to avoid a large taxable gain. A merger, recapitalization or acquisition, or issuance or redemption of our common stock, after the spin-off could, in some circumstances, be counted toward the 50 percent change of ownership threshold. As a result, we may be unable to engage in strategic or capital raising transactions that stockholders might consider favorable, or to structure potential transactions in the manner most favorable to us. Further, our tax responsibility allocation agreement with Merck precludes us from engaging in some of these transactions and requires us to indemnify Merck for the adverse tax consequences resulting from these types of transactions.

 

Risks Relating to Our Common Stock

 

Our common stock has no prior public market and we cannot predict the price range in which it will trade or its volatility after the distribution.

 

There has been no trading market for our common stock. There can be no assurance as to the price at which our common stock will trade. The securities of many companies have experienced extreme price and volume fluctuations in recent years, often unrelated to the companies’ operating performance. Accordingly, we cannot predict whether the market price of our common stock will be volatile.

 

The market price of our common stock could fluctuate significantly as a result of many factors related to the economy in general or the PBM industry in which we operate, including the following:

 

    economic and stock market conditions generally and specifically as they may affect PBMs;

 

    earnings and other announcements by PBMs, and changes in the market’s perception of PBMs; and

 

    changes in business or regulatory conditions affecting PBMs.

 

In addition, there are various factors related to our business in particular that could cause the market price of our common stock to fluctuate, including the following:

 

    the size and timing of significant contract signings;

 

    the non-renewal or termination of significant client contracts;

 

    announcements or implementation by us or our competitors of innovations or new programs or services;

 

    the timing of our new programs and services;

 

    the introduction by competitors of new services that make our services obsolete or less valuable;

 

   

litigation judgments or settlements;

 

36


Table of Contents
Index to Financial Statements
    our earnings and results of operations and other developments affecting our business;

 

    changes in financial estimates and recommendations by securities analysts that follow our stock; and

 

    trading volume of our common stock.

 

We believe that our quarterly revenues and operating results may vary significantly in the future and that period-to-period comparisons of our revenues and operating results are not necessarily meaningful indicators of the future. You should not rely on the results of one quarter as an indication of our future performance. It is also possible that in some future quarters, our revenues and operating results will fall below our expectations or the expectations of market analysts and investors. If we do not meet these expectations, the price of our common stock may decline significantly.

 

A portion of Merck’s common stock is held by index funds tied to the Standard & Poor’s 500 Index, the Dow Jones Industrial Average or other stock indices. If we are not included in these indices at the time of Merck’s distribution of our common stock, these index funds will be required to sell our stock, which could adversely affect the price at which our common stock will trade. Similarly, other institutional stockholders may not be allowed by their charters to hold the stock of companies that do not pay dividends. Because we currently do not intend to pay dividends, these institutional stockholders may be required to sell the shares of our common stock distributed to them. Sales of our common stock by these investors, or the perception that they will occur, may cause our stock price to decline.

 

The terms of our spin-off from Merck, anti-takeover provisions of the Delaware General Corporation Law, our amended and restated certificate of incorporation and our amended and restated bylaws could delay or deter a change in control and make it more difficult to remove incumbent officers and directors.

 

Our agreements with Merck may make it difficult to effect a change in control of our company. For example, the managed care agreement and the tax responsibility allocation agreement may restrict our ability to sell our company. For a more complete description of these agreements, see “Relationships Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck”.

 

Our amended and restated certificate of incorporation, our amended and restated bylaws and various provisions of the Delaware General Corporation Law, or the DGCL, may also 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 for our company or reduce any premiums paid to our stockholders 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. Immediately prior to the completion of the distribution, our board of directors will be 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 stockholders to replace a majority of the directors. Following the distribution, it will not be 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. For a more complete description of how provisions of our amended and restated certificate of incorporation, our amended and restated bylaws and the DGCL could hinder a third party’s attempt to acquire control of us, see “Description of Capital Stock—Preferred Stock” and “—Anti-Takeover Effects of Delaware Laws, Our Amended and Restated Certificate of Incorporation and Our Amended and Restated Bylaws”.

 

Additionally, as a result of our ownership of three insurance companies, a third party trying 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.

 

37


Table of Contents
Index to Financial Statements

Risks Relating to Arthur Andersen LLP

 

You may have no effective remedy against Arthur Andersen LLP in connection with a material misstatement or omission in our 2000 financial statements included in this information statement.

 

Arthur Andersen LLP, which audited our financial statements included in this information statement for the year ended December 30, 2000, was convicted on June 15, 2002 of federal obstruction of justice arising from the government’s investigation of Enron Corp. Arthur Andersen LLP did not participate in the preparation of the registration statement on Form 10 of which this information statement is a part, or reissue its report, dated  April 8, 2002, on our 2000 financial statements included in this information statement. You are unlikely to have any effective remedies against Arthur Andersen LLP in connection with a material misstatement or omission in these 2000 financial statements.

 

Our inability to include in future registration statements financial statements for one or more years audited by Arthur Andersen LLP or to obtain Arthur Andersen LLP’s consent to the inclusion of their report on our 2000 financial statements may impede our access to the capital markets after completion of the distribution.

 

Should we seek to access the public capital markets after we complete the distribution, SEC rules will require us to include or incorporate by reference in any prospectus three years of audited financial statements. Until our audited financial statements for the year ending December 27, 2003 become available in the first quarter of 2004, the SEC’s current rules would require us to present audited financial statements for one year audited by Arthur Andersen LLP. On August 31, 2002, Arthur Andersen LLP ceased practicing before the SEC, but the SEC has continued to accept financial statements audited by Arthur Andersen LLP. However, if the SEC ceases to accept financial statements audited by Arthur Andersen LLP, we would be unable to access the public capital markets unless PricewaterhouseCoopers LLP, our current independent accounting firm, or another independent accounting firm, is able to audit our 2000 financial statements, which Arthur Andersen LLP originally audited.

 

Additionally, Arthur Andersen LLP cannot consent to the inclusion or incorporation by reference in any prospectus of their report on our audited financial statements for the year ended December 30, 2000, and investors in any future offerings for which we use their audit report will not be entitled to recovery against them under Section 11 of the Securities Act of 1933 for any material misstatements or omissions in those financial statements. We may not be able to bring to the market successfully an offering of our securities in the absence of Arthur Andersen LLP’s participation in the transaction, including its consent. Consequently, our financing costs may increase or we may miss attractive market opportunities if either our annual financial statements for 2000 audited by Arthur Andersen LLP should cease to satisfy the SEC’s requirements or those statements are used in a prospectus but investors are not entitled to recovery against our auditors for material misstatements or omissions in them.

 

38


Table of Contents
Index to Financial Statements

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This information statement contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. We use words such as “anticipates”, “believes”, “plans”, “expects”, “future”, “intends”, “may”, “will”, “should”, “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 the sections of this information statement entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of this information statement. These factors include:

 

    competition in the PBM industry and in the health care industry generally;

 

    continued pressure on rebates from pharmaceutical manufacturers and margins in the PBM industry;

 

    the impact on our business and competitive position of our managed care agreement with Merck;

 

    our ability to obtain new clients and the possible termination of, or unfavorable modification to, contracts with key clients;

 

    possible contractual or regulatory changes affecting pricing, rebates, discounts or other practices of pharmaceutical manufacturers;

 

    risks associated with our relationship with and spin-off from Merck;

 

    risks associated with our indebtedness and debt service obligations;

 

    risks associated with our ability to continue to develop innovative programs and services;

 

    governmental investigations and qui tam actions filed against us;

 

    liability and other claims asserted against us;

 

    risks related to bioterrorism and mail tampering;

 

    risks related to rapid changes in technology and our ability to protect our technology and enforce our intellectual property and contract rights;

 

    developments in the health care industry, including the impact of increases in health care costs, changes in drug utilization and cost patterns and the introduction of new drugs;

 

    new or existing governmental regulations and changes in, or the failure to comply with, governmental regulations;

 

    the possibility of a material non-cash charge to income if our recorded goodwill is impaired;

 

    legislative proposals that impact our industry or the way we do business; and

 

    general economic and business conditions.

 

The foregoing list of factors is not exhaustive. When relying on forward-looking statements to make decisions with respect to investing in our common stock, you should carefully consider the foregoing factors and other uncertainties and potential events. We do not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by us or on our behalf. Neither the Private Securities Litigation Reform Act of 1995 nor Section 21E of the Securities Exchange Act of 1934 provides any protection for statements made in this information statement.

 

39


Table of Contents
Index to Financial Statements

THE DISTRIBUTION

 

General

 

Given the evolution of the distinct and highly competitive environments in which Merck and Medco Health operate, Merck believes the best way to enhance the success of both businesses and maximize stockholder value over the long term is to enable each one to pursue its unique and focused strategy. After the distribution, Merck will continue to focus on its priorities of discovering and developing novel medicines, while Medco Health will continue to provide high-quality service to its customers and will be able to pursue strategic initiatives and competitive pharmacy benefit management opportunities.

 

The separation of Medco Health from Merck will be accomplished through a pro rata distribution of 100% of our outstanding common stock to Merck stockholders, which we refer to as the distribution, or the spin-off, on August 19, 2003, the distribution date. As a result of the distribution, each Merck stockholder will:

 

    receive .1206 shares of our common stock for every one share of Merck common stock they own; and

 

    retain their shares in Merck.

 

Manner of Effecting the Distribution

 

The general terms and conditions relating to the distribution will be set forth in a master separation and distribution agreement between Merck and us. Under that agreement, the distribution will be effective at 11:59 p.m. Eastern time on the distribution date, August 19, 2003. As a result of the distribution, each Merck stockholder will receive .1206 shares of our common stock for every one share of Merck common stock they own. In order to be entitled to receive shares of our common stock in the distribution, Merck stockholders must be stockholders at the close of business of the NYSE on the record date, August 12, 2003. For registered Merck stockholders, our transfer agent will credit their shares of our common stock to book-entry accounts established to hold their shares of our common stock. Our distribution agent will send these stockholders a statement reflecting their ownership of our common stock. Book-entry refers to a method of recording stock ownership in our records in which no physical certificates are issued. For stockholders who own Merck common stock through a broker or other nominee, their shares of our common stock will be credited to their accounts by the broker or other nominee. As further discussed below, fractional shares will not be distributed. Each share of our common stock that is distributed will be validly issued, fully paid and nonassessable and free of preemptive rights. See “Description of Capital Stock”. Following the distribution, stockholders whose shares are held in book-entry form may request the transfer of their shares of our common stock to a brokerage or other account at any time as well as the delivery of physical stock certificates for their shares, in each case without charge.

 

Merck stockholders will not be required to pay for shares of our common stock received in the distribution or to surrender or exchange shares of Merck common stock in order to receive our common stock or to take any other action in connection with the distribution. No vote of Merck stockholders is required or sought in connection with the distribution, and Merck stockholders have no appraisal rights in connection with the distribution.

 

Fractional shares of our common stock will not be issued to Merck stockholders as part of the distribution nor credited to book-entry accounts. Instead, the distribution agent will as soon as practicable on or after the distribution date aggregate fractional shares of our common stock held by holders of record into whole shares, sell them in the open market at the prevailing market prices and then distribute the aggregate sale proceeds ratably to Merck stockholders who would otherwise be entitled to receive fractional shares. The amount of this payment will depend on the prices at which the aggregated fractional shares of our common stock are sold by the distribution agent in the open market shortly after the distribution date. We will be responsible for any payment of brokerage fees. The amount of these brokerage fees is not expected to be material to us. The receipt of cash in

 

40


Table of Contents
Index to Financial Statements

lieu of fractional shares of our common stock will generally be taxable to the recipient stockholder. For an explanation of the U.S. federal income tax consequences of the distribution, please see “—U.S. Federal Income Tax Consequences of the Distribution”.

 

In addition, at the time of the distribution, certain outstanding options to purchase Merck common stock held by our employees on the distribution date will be converted into options to purchase our common stock. The formula used in the conversion will be prescribed by accounting rules and will be designed to put the option holders in the same financial position immediately following the conversion as existed immediately before the conversion. See “Management—Treatment of Outstanding Merck Options Held by Our Employees”.

 

Reasons for the Distribution

 

The board of directors of Merck has determined that the spin-off of Medco Health from Merck will enhance the success of both Merck and Medco Health, and thereby maximize stockholder value over the long term for each company, by:

 

    enabling each company to continue to pursue its unique and focused strategy; and

 

    enabling investors to evaluate the financial performance, strategies and other characteristics of each of Merck and Medco Health separately in comparison to companies within their respective industries.

 

Historically, Medco Health’s pharmacy benefit management business has exhibited different financial and operating characteristics than Merck’s pharmaceutical business. Following the spin-off, each company should be better able to adopt strategies and pursue business opportunities and objectives appropriate to their respective needs.

 

Because Merck and Medco Health operate in different industries, the shares of each company may appeal to different classes of investors. Establishing two separate equity securities will allow investors to hold a direct investment in Medco Health and to value each of the companies separately. After the spin-off, investors will be able to evaluate the financial performance and strategies of each company separately within the context of its respective industry. This should help each company to achieve an appropriate market valuation.

 

Results of the Distribution

 

After the distribution, we will be a separately-traded public company. Immediately following the distribution, we expect to have approximately              beneficial holders of shares of our common stock, based on the number of beneficial stockholders of Merck common stock on                          , 2003, and approximately 270,000,000 shares of our common stock outstanding. The actual number of shares to be distributed will be determined on the record date and will reflect any exercise of Merck options between the date Merck’s board declares the dividend for the spin-off and the record date for the spin-off.

 

We and Merck will be parties to a number of agreements that govern our spin-off from Merck and our future relationship. For a more detailed description of these agreements, please see “Relationships Between Our Company and Merck & Co., Inc.”

 

The distribution will not affect the number of outstanding shares of Merck common stock or any rights of Merck stockholders.

 

Incurrence of Debt

 

Accounts Receivable Financing Facility and Senior Secured Credit Facility.    Prior to or concurrently with the completion of the distribution, we intend to enter into a $500 million 364-day renewable accounts receivable financing facility and a $1,150 million senior secured credit facility consisting of:

 

    a $400 million five-year term loan;

 

41


Table of Contents
Index to Financial Statements
    a $500 million seven-year term loan; and

 

    a $250 million five-year revolving credit facility.

 

The senior secured credit facility will be secured by a pledge of the capital stock of our subsidiaries, other than our receivables subsidiary and our subsidiaries that are engaged in insurance-related activities. The accounts receivable financing facility will be secured by our pharmaceutical manufacturer accounts receivable, which will be sold to our receivables subsidiary. We expect that all of the revolving credit facility will remain undrawn at the completion of the distribution and will be available for working capital and general corporate purposes. In the case of the accounts receivable financing facility, we expect to have between $250 million and $400 million available for working capital and general corporate purposes at the completion of the distribution, depending upon the amount of eligible receivables. However, on or prior to the distribution date, we may draw advances under our revolving credit facility or a larger advance under our accounts receivable financing facility to pay a portion of the cash dividends aggregating $2 billion to Merck. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” and “Description of Indebtedness” for more information.

 

Senior Unsecured Notes.    Prior to or concurrently with the completion of the distribution, we will publicly offer $500 million aggregate principal amount of ten-year senior unsecured notes. Interest on the senior unsecured notes will accrue at a fixed rate and will be payable semi-annually in arrears. The senior unsecured notes will be unsecured obligations and will rank equally with all of our existing and future unsecured senior indebtedness and senior to all of our future subordinated indebtedness. The senior unsecured notes will effectively rank junior to our secured indebtedness, including debt incurred under our senior secured credit facility, to the extent of the value of the assets securing such indebtedness. The terms of the indenture under which the senior unsecured notes are to be issued will restrict us and our subsidiaries from incurring additional indebtedness and will impose other restrictions on our operations, although some of these restrictions will not be applicable if we attain investment grade status and we are not in default. See “Description of Indebtedness” for more information.

 

U.S. Federal Income Tax Consequences of the Distribution

 

General.    The following general discussion summarizes the material U.S. federal income tax consequences of the distribution and is based on the U.S. Internal Revenue Code of 1986, as amended, the regulations promulgated thereunder, existing administrative interpretations and court decisions, all as in effect as of the date of this information statement. Future legislation, regulations, administrative interpretations or court decisions could significantly change such authorities either prospectively or retroactively. No information is provided in this summary with respect to the tax consequences, if any, of the distribution under applicable foreign, state, local and other tax laws.

 

The discussion of the tax consequences of the distribution to Merck stockholders is limited to consequences to “U.S. Holders”, who hold Merck common stock as a capital asset. As used in this discussion, a “U.S. Holder” means a beneficial owner of Merck common stock which for U.S. federal income tax purposes is:

 

    a citizen or individual resident of the United States;

 

    a corporation or other entity that has elected to be treated as a corporation organized in or under the laws of the United States or any state thereof; including the District of Columbia;

 

    an estate the income of which is subject to U.S. federal income taxation regardless of its source; or

 

    a trust if, in general, the trust is subject to the supervision of a court within the United States and the control of one or more U.S. persons as described in Section 7701(a)(30) of the Internal Revenue Code.

 

If a partnership is a beneficial owner of Merck common stock, the treatment of a partner in the partnership will generally depend upon the status of the partner and upon the activities of the partnership. A beneficial owner that is a partnership, and partners in such a partnership, are urged to consult their tax advisors about the U.S. federal income tax consequences of the distribution.

 

42


Table of Contents
Index to Financial Statements

This discussion does not address all aspects of U.S. federal income taxation that may be relevant to Merck stockholders to which special provisions of U.S. federal income tax law may apply based on their particular circumstances or status. For example, the discussion does not address all aspects of U.S. federal income taxation that may be relevant to:

 

    Merck stockholders liable for alternative minimum tax;

 

    Merck stockholders that hold their stock as part of a straddle, hedge, synthetic security, conversion transaction or other integrated investment;

 

    Merck stockholders whose “functional currency” is not the U.S. dollar;

 

    financial institutions;

 

    insurance companies;

 

    tax-exempt organizations;

 

    traders in securities that elect mark-to-market accounting treatment;

 

    broker-dealers;

 

    persons who acquired their shares of stock by exercising employee stock options or as some other form of compensation;

 

    qualified retirement plans;

 

    regulated investment companies; or

 

    real estate investment trusts.

 

Merck has received a letter ruling from the IRS as to the material federal income tax consequences of the distribution to the Merck stockholders, Merck and Medco Health to the effect that the distribution will qualify as a transaction described in Section 355(a) and as a reorganization under Section 368(a)(1)(D) of the Internal Revenue Code. The discussions of the material federal income tax consequences of the distribution set forth below under “ —Tax Consequences to Merck Stockholders” and under “—Tax Consequences to Merck and Medco Health” are based on the letter ruling Merck has received from the IRS.

 

The letter ruling, while generally binding upon the IRS, is subject to the accuracy of factual representations and assumptions described in the ruling and set forth in the ruling request. If the factual representations or assumptions are incorrect in any material respect, the holdings of the ruling would be jeopardized. We and Merck are not aware of any facts or circumstances which would cause the representations and assumptions to be untrue. Additionally, events occurring after the distribution could potentially cause some of the representations and assumptions to be untrue and the distribution to be taxable. In this regard, we have agreed to refrain from taking future actions (as specified in the tax responsibility allocation agreement to be entered into by us and Merck) to provide further assurances that the distribution will qualify as tax-free. In addition, we have agreed to indemnify Merck for taxes incurred by Merck from the distribution if the distribution becomes taxable to Merck as a result of future events involving our stock or assets, as set forth in the tax responsibility allocation agreement. See “Relationships Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck—Tax Responsibility Allocation Agreement”.

 

If the distribution were not to qualify as tax-free to Merck stockholders, each Merck Stockholder who receives our common stock in the distribution would be treated as if such stockholder received a taxable dividend equal to the value of our common stock received in the distribution. If the distribution were not to qualify as tax-free to Merck, a corporate level tax would be payable by Merck based upon the difference between the fair market value of the stock distributed and Merck’s adjusted basis in the stock.

 

43


Table of Contents
Index to Financial Statements

Tax Consequences to Merck Stockholders.    Based on the letter ruling Merck has received from the IRS:

 

    No income, gain or loss will be recognized by a Merck stockholder as a result of the distribution, except with respect to any cash received in lieu of a fractional share of our stock.

 

    The aggregate basis of a stockholder’s Merck common stock and our common stock immediately after the distribution will be the same as the basis of the stockholder’s Merck common stock immediately before the distribution, allocated between our common stock and the Merck common stock in proportion to their relative fair market values.

 

    The holding period of our common stock received by a Merck stockholder, will include the holding period of the Merck common stock with respect to which our common stock was distributed.

 

U.S Treasury regulations require each Merck stockholder that receives our stock in the distribution to attach to the stockholder’s U.S. federal income tax return for the year in which the distribution occurs a detailed statement setting forth information as may be appropriate to show the applicability of Section 355 of the Internal Revenue Code. Merck will provide Merck stockholders who receive our stock in the distribution with the information necessary to comply with this requirement.

 

Tax Consequences to Merck and Medco Health.    Based on the letter ruling Merck has received from the IRS:

 

    No material amount of gain or loss will be recognized by either Merck or Medco Health as a result of the distribution.

 

THE SUMMARY OF THE U.S. FEDERAL INCOME TAX CONSEQUENCES OF THE DISTRIBUTION SET FORTH ABOVE DOES NOT ADDRESS THE U.S. FEDERAL INCOME TAX CONSEQUENCES THAT MAY APPLY TO STOCKHOLDERS THAT ARE NOT U.S. HOLDERS AND DOES NOT ADDRESS ALL OF THE U.S. FEDERAL INCOME TAX CONSEQUENCES OF U.S. HOLDERS THAT ARE SUBJECT TO SPECIAL TREATMENT UNDER THE INTERNAL REVENUE CODE. ALL MERCK STOCKHOLDERS ARE URGED TO CONSULT THEIR OWN TAX ADVISORS TO DETERMINE THE PARTICULAR TAX CONSEQUENCES OF THE DISTRIBUTION TO THEM, INCLUDING THE EFFECT OF ANY STATE, LOCAL OR FOREIGN INCOME AND OTHER TAX LAWS.

 

Market for Our Common Stock

 

There is currently no public market for our common stock. Our common stock has been authorized to be listed on the NYSE under the symbol “MHS”. We anticipate that trading of our common stock will commence on a when-issued basis shortly before the record date. When-issued trading refers to a sale or purchase made conditionally because the security has been authorized but not yet issued. On the first trading day following the distribution date, when-issued trading with respect to our common stock will end and regular way trading will begin. Regular way trading refers to trading after a security has been issued and typically involves a transaction that settles on the third full business day following the date of the transaction. We cannot predict what the trading prices for our common stock will be before or after the distribution date. In addition, we cannot predict any change that may occur in the trading price of Merck’s common stock as a result of the distribution.

 

The shares of our common stock distributed to Merck stockholders will be freely transferable except for shares received by persons that may have a special relationship or affiliation with us. Persons that may be considered our affiliates after the distribution generally include individuals or entities that control, are controlled by or are under common control with us. This may include some or all of our officers and directors. Persons that are our affiliates will be permitted to sell their shares only pursuant to an effective registration statement under the Securities Act of 1933, as amended, or an exemption from the registration requirements of the Securities Act, such as the exemptions afforded by Section 4(1) of the Securities Act or Rule 144 thereunder.

 

44


Table of Contents
Index to Financial Statements

Distribution Conditions and Termination

 

We expect that the distribution will be effective on the distribution date, August 19, 2003, provided that, among other things:

 

    the SEC has declared effective our registration statement on Form 10, of which this information statement is a part, under the Securities Exchange Act of 1934, as amended, and no stop order relating to the registration statement is in effect;

 

    we and Merck have received all permits, registrations and consents required under the securities or blue sky laws of states or other political subdivisions of the United States or of foreign jurisdictions in connection with the distribution;

 

    the letter ruling Merck has received from the IRS with respect to the tax treatment of the spin-off has not been revoked or modified by the IRS in any material respect and continues to be in effect;

 

    we have paid to Merck, prior to or concurrently with the distribution date, cash dividends aggregating $2 billion; and

 

    no order, injunction or decree issued by any court of competent jurisdiction or other legal restraint or prohibition preventing consummation of the distribution or any of the transactions related thereto, including the transfers of assets and liabilities contemplated by the master separation and distribution agreement, is in effect.

 

The fulfillment of the foregoing conditions will not create any obligation on Merck’s part to effect the distribution, and Merck’s board of directors has reserved the right to amend, modify or abandon the distribution and the related transactions at any time prior to the distribution date. Merck’s board of directors may also waive any of these conditions.

 

Reason for Furnishing this Information Statement

 

This information statement is being furnished solely to provide information to Merck stockholders who will receive shares of Medco Health common stock in the distribution. It is not and is not to be construed as an inducement or encouragement to buy or sell any of our securities. We believe that the information contained in this information statement is accurate as of the date set forth on the cover. Changes may occur after that date and neither Merck nor we undertake any obligation to update the information except in the normal course of our respective public disclosure obligations.

 

45


Table of Contents
Index to Financial Statements

DIVIDEND POLICY

 

We presently intend to retain future earnings, if any, to finance the expansion of our business. Therefore, other than the cash dividends aggregating $2 billion that we will pay to Merck prior to or concurrently with the completion of the distribution, we do not expect to pay any cash dividends in the foreseeable future. Moreover, the terms of the credit agreement governing our senior secured credit facility and the indenture governing our ten-year senior unsecured notes limit the amount of dividends we may pay. Payment of future cash dividends, if any, will be at the discretion of our board of directors in accordance with applicable law after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs, plans for expansion and contractual restrictions with respect to the payment of dividends.

 

During each of the years ended December 30, 2000 and December 29, 2001, we credited Merck’s intercompany account with us for $400 million of dividends to Merck. We did not pay Merck any dividend for the fiscal year ended December 28, 2002. Of the cash dividends aggregating $2 billion that we will pay to Merck prior to or concurrently with the completion of the distribution, $500 million represents a significant portion of Medco Health’s earnings from the beginning of 2002 through the distribution date. These amounts are not indicative of our ability to pay dividends in the future. See Note 11 to our audited consolidated financial statements included elsewhere in this information statement.

 

46


Table of Contents
Index to Financial Statements

CAPITALIZATION

 

The following table sets forth our capitalization (1) on an actual basis as of March 29, 2003, (2) as adjusted to give effect to the cash dividends payable aggregating $2 billion to Merck and (3) as adjusted to give effect to the dividend payments and to:

 

    the settlement of our intercompany receivable from Merck at its value as of July 31, 2003; the value of the intercompany receivable as of June 28, 2003 was approximately $650 million and, as of the date of this information statement, we have not determined the value of the intercompany receivable as of July 31, 2003;

 

    the incurrence of an aggregate of $1,000 million of debt, and related debt issuance costs, comprised of the $100 million advance under the $500 million accounts receivable financing facility and $900 million of term loans under the $1,150 million senior secured credit facility to be entered into prior to or concurrently with the completion of the distribution; and

 

    the issuance of senior unsecured notes prior to or concurrently with the completion of the distribution in an aggregate principal amount of $500 million and related debt issuance costs.

 

This table should be read in conjunction with “Selected Historical Consolidated Financial and Operating Data”, “Unaudited Pro Forma Condensed Consolidated Financial Data”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to our consolidated financial statements included elsewhere in this information statement.

 

     As of March 29, 2003

     Actual

   As
adjusted
for
dividends
payable
only


   As adjusted
for dividend
payments,
settlement of
intercompany
receivable
and debt


     (in millions)

Cash and cash equivalents

   $ 7.7    $ 7.7    $ 206.6
    

  

  

Dividends payable

   $ —      $ 2,000.0    $ —  
    

  

  

Short-term debt

   $ —      $ —      $ 100.0
    

  

  

Current portion of long-term debt

   $ —      $ —      $ 11.3
    

  

  

Long-term debt:

                    

Credit facility

   $ —      $ —      $ 888.7

Notes

     —        —        500.0
    

  

  

Total long-term debt

     —        —        1,388.7
    

  

  

Total stockholder’s equity

     6,737.6      4,737.6      4,737.6
    

  

  

Total capitalization

   $ 6,737.6    $ 4,737.6    $ 6,126.3
    

  

  

 

We converted from a limited liability company to a Delaware corporation on May 21, 2002 and subsequently changed our name to Medco Health Solutions, Inc. As part of the conversion, we authorized 1,000,000,000 shares of common stock, $0.01 par value, and issued 270,000,000 shares of common stock to Merck. We also authorized 10,000,000 shares of preferred stock, $0.01 par value, none of which have been issued.

 

For information about options we may grant, see “Management—Executive Compensation”.

 

47


Table of Contents
Index to Financial Statements

SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OPERATING 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, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our historical consolidated financial statements and notes to our historical consolidated financial statements, each of which is included elsewhere in this information statement. The unaudited consolidated statements of income data for 1998 and for the quarters ended March 30, 2002 and March 29, 2003, and the unaudited consolidated balance sheet data as of the last day of each of these periods are derived from our unaudited accounting records for those periods and have been prepared on a basis consistent with the audited consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such data. The consolidated statements of income data for 1999, 2000, 2001 and 2002 and the consolidated balance sheet data as of the last day of each of these years are derived from our historical audited consolidated financial statements. The financial statements for 1999 and 2000 have been audited by Arthur Andersen LLP, independent public accountants, whose report is included elsewhere in this information statement. The financial statements for 2001 and 2002 have been audited by PricewaterhouseCoopers LLP, independent public accountants, whose report is included elsewhere in this information statement.

 

The historical financial information is not indicative of our future performance and does not reflect what our financial position and results of operations would have been had we operated as a separate company during the periods presented. The results for the quarter ended March 29, 2003 are not necessarily indicative of the results to be expected for the full year. For additional information, see “Unaudited Pro Forma Condensed Consolidated Financial Data”.

 

48


Table of Contents
Index to Financial Statements
    As of and for the Years Ended

    As of and for the
Quarters Ended


 
    December 26,
1998


    December 25,
1999


    December 30,
2000(1)


    December 29,
2001


    December 28,
2002


    March 30,
2002


   

March 29,

2003


 
   

(in millions, except per share amounts)

 

Consolidated Statement of Income Data:

                                                       

Product net revenues

  $ 12,688.0     $ 16,675.4     $ 21,979.2     $ 28,709.3     $ 32,573.0     $   7,929.0     $ 8,237.9  

Service revenues

    234.7       221.2       287.1       361.3       385.5       87.1       96.2  
   


 


 


 


 


 


 


Total net revenues

    12,922.7       16,896.6       22,266.3       29,070.6       32,958.5       8,016.1       8,334.1  
   


 


 


 


 


 


 


Cost of operations:

                                                       

Cost of product net revenues

    12,037.0       15,865.4       21,010.8       27,601.1       31,483.9       7,713.8       7,939.5  

Cost of service revenues

    76.3       106.1       143.4       185.6       173.8       44.0       45.1  
   


 


 


 


 


 


 


Total cost of revenues

    12,113.3       15,971.5       21,154.2       27,786.7       31,657.7       7,757.8       7,984.6  

Selling, general and administrative expenses

    417.9       415.1       483.1       578.4       587.7       135.2       163.0  

Amortization of goodwill

    99.1       99.1       103.3       106.9       —         —         —    

Amortization of intangibles

    82.9       82.9       84.0       84.9       84.9       21.2       23.6  

Other (income) expense, net

    (4.5 )     (3.7 )     (5.8 )     (4.6 )     7.9       (0.8 )     (11.7 )
   


 


 


 


 


 


 


Total cost of operations

    12,708.7       16,564.9       21,818.8       28,552.3       32,338.2       7,913.4       8,159.5  
   


 


 


 


 


 


 


Income before provision for income taxes

    214.0       331.7       447.5       518.3       620.3       102.7       174.6  

Provision for income taxes

    130.6       179.7       230.7       261.7       258.7       43.1       72.6  
   


 


 


 


 


 


 


Net income

  $ 83.4     $ 152.0     $ 216.8     $ 256.6     $ 361.6     $ 59.6     $ 102.0  
   


 


 


 


 


 


 


Earnings Per Share Data(2):

                                                       

Basic and diluted net income per share

  $ 0.31     $ 0.56     $ 0.80     $ 0.95     $ 1.34     $ 0.22     $ 0.38  

Shares used in computing basic and diluted net income per share

    270.0       270.0       270.0       270.0       270.0       270.0       270.0  

Pro forma presentation assuming SFAS No. 142 was in effect for all periods(3):

                                                       

Pro forma income before provision for income taxes

  $ 313.1     $ 430.8     $ 550.8     $ 625.2     $ 620.3     $ 102.7     $ 174.6  

Provision for income taxes

    130.6       179.7       230.7       261.7       258.7       43.1       72.6  
   


 


 


 


 


 


 


Pro forma net income

  $ 182.5     $ 251.1     $ 320.1     $ 363.5     $ 361.6     $ 59.6     $ 102.0  
   


 


 


 


 


 


 


Pro forma basic and diluted net income per share

  $ 0.68     $ 0.93     $ 1.19     $ 1.35     $ 1.34     $ 0.22     $ 0.38  

Consolidated Balance Sheet Data:

                                                       

Working capital(4)

  $ 726.2     $ 764.4     $ 868.3     $ 724.4     $ 1,171.5     $ 794.6     $ 1,309.1  

Goodwill, net

  $ 3,461.1     $ 3,362.1     $ 3,419.6     $ 3,310.2     $ 3,310.2     $ 3,310.2     $ 3,310.2  

Intangible assets, net

  $ 2,712.4     $ 2,629.5     $ 2,584.6     $ 2,499.7     $ 2,414.8     $ 2,478.5     $ 2,391.3  

Total assets

  $ 8,247.3     $ 8,464.4     $ 8,914.8     $ 9,251.8     $ 9,922.5     $ 9,504.6     $ 10,217.7  

Total debt(5)

  $ —       $ —       $ —       $ —       $ —       $ —       $ —    

Deferred tax liabilities

  $ 1,195.7     $ 1,158.7     $ 1,144.1     $ 1,154.2     $ 1,197.7     $ 1,150.6     $ 1,182.2  

Total stockholder’s equity

  $ 6,063.4     $ 6,070.2     $ 6,358.3     $ 6,268.3     $ 6,635.6     $ 6,327.9     $ 6,737.6  

Supplemental Information (Unaudited):

                                                       

EBITDA(6)

  $ 479.3     $ 591.5     $ 730.9     $ 836.6     $ 885.6     $ 161.3     $ 243.6  

Net cash provided by operating activities

  $ 433.0     $ 345.5     $ 365.5     $ 658.8     $ 470.3     $ 514.9     $ 516.7  

Net cash (used by) investing activities

  $ (141.1 )   $ (195.0 )   $ (415.0 )   $ (330.2 )   $ (240.4 )   $ (69.3 )   $ (36.6 )

Net cash (used by) provided by financing activities

  $ (309.1 )   $ (145.0 )   $ 67.1     $ (340.9 )   $ (231.8 )   $ (449.6 )   $ (486.8 )

Estimated covered lives

    50.6       52.3       65.0       65.0       64.0       65.0       62.0  

Prescriptions administered

    322.3       372.0       451.9       537.2       548.2       140.7       133.4  

Home delivery

    53.3       60.6       65.1       74.7       81.7       20.1       19.9  

Retail

    269.0       311.4       386.8       462.5       466.5       120.6       113.5  

 

(See notes on following page)

 

49


Table of Contents
Index to Financial Statements

Notes to Selected Historical Consolidated Financial and Operating Data

 

(1)   53 week fiscal year.
(2)   On May 21, 2002, we converted from a limited liability company wholly owned by Merck to a corporation wholly owned by Merck and issued 270,000,000 shares of $0.01 par value common stock. The financial information has been revised to retroactively reflect this transaction for all periods presented. In connection with the distribution, certain Merck stock options held by our employees will be converted into options to purchase our stock. These options would not have had a material effect on historical or pro forma earnings per share for the periods presented.
(3)   Effective December 30, 2001, we adopted SFAS No. 142. This pro forma financial information presents the impact of adopting SFAS No. 142 as if it had been adopted on December 28, 1997. The December 28, 2002 financial results and the March 30, 2002 and March 29, 2003 quarterly financial results already reflect the adoption of SFAS No. 142 and therefore no pro forma adjustment is necessary; these results are included in this pro forma presentation to facilitate comparisons with prior periods.
(4)   Calculated as current assets (primarily accounts receivable and inventories) less current liabilities (primarily claims and other accounts payable, short-term debt, current portion of long-term debt and other current liabilities). As of each balance sheet date presented, we had no debt outstanding.
(5)   See “Unaudited Pro Forma Condensed Consolidated Financial Data”.
(6)   EBITDA consists of earnings before interest income/expense, taxes, depreciation and amortization. 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 flow from operations data as measured under U.S. generally accepted accounting principles. The items excluded from EBITDA are significant components of our statement of income, and must be considered in performing a comprehensive assessment of our overall financial performance. EBITDA, and the associated year-to-year trends, should not be considered in isolation. Management uses EBITDA as an indicator of our ability to generate cash from our reported operating results. This measurement is used in concert with cash flow from operations, which measures actual cash generated in the period. In addition, we believe that EBITDA is a supplemental measurement tool used by analysts and investors to help evaluate overall operating performance, and the ability to incur and service debt and make capital expenditures. Our calculation of EBITDA may not be consistent with calculations of EBITDA used by other companies. The following table reconciles our reported net income to EBITDA for each of the respective periods.

 

    For the Years Ended

    For the Quarters
Ended


 
    December 26,
1998


    December 25,
1999


    December 30,
2000


    December 29,
2001


    December 28,
2002


   

March 30,

2002


   

March 29,

2003


 
    (in millions)  

Net income

  $ 83.4     $ 152.0     $ 216.8     $ 256.6     $ 361.6     $ 59.6     $ 102.0  

Add (deduct):

                                                       

Interest (income) expense, net

    (4.5 )     (3.7 )     (5.8 )     (4.6 )     7.9 *     (0.8 )     (0.7 )

Provision for income taxes

    130.6       179.7       230.7       261.7       258.7       43.1       72.6  

Depreciation expense

    87.8       81.5       101.9       131.1       172.5       38.2       46.1  

Amortization expense

    182.0       182.0       187.3       191.8       84.9       21.2       23.6  
   


 


 


 


 


 


 


EBITDA

  $ 479.3     $ 591.5     $ 730.9     $ 836.6     $ 885.6     $ 161.3     $ 243.6  
   


 


 


 


 


 


 



*   Includes approximately $11 million of interest rate swap termination costs and debt issuance costs expensed in 2002.

 

50


Table of Contents
Index to Financial Statements

UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA

 

The following unaudited pro forma condensed consolidated financial information is derived from our audited consolidated financial statements for the year ended December 28, 2002 and our unaudited consolidated interim financial statements for the quarter ended March 29, 2003, each of which is included elsewhere in this information statement. The unaudited consolidated interim financial statements are derived from our unaudited accounting records for that period and have been prepared on a basis consistent with the audited consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such data. The results for the quarter ended March 29, 2003 are not necessarily indicative of the results to be expected for the full year. The unaudited pro forma condensed consolidated financial information has been prepared to reflect adjustments to our historical financial information to give effect to the following transactions, each as described elsewhere in this information statement, as if those transactions had been completed at earlier dates:

 

    the settlement of our intercompany receivable from Merck at its value as of July 31, 2003; the value of the intercompany receivable as of June 28, 2003 was approximately $650 million and, as of the date of this information statement, we have not determined the value of the intercompany receivable as of July 31, 2003;

 

    the incurrence of an aggregate of $1,000 million of debt, and related debt issuance costs, comprised of the $100 million advance under the $500 million accounts receivable financing facility and $900 million of term loans under the $1,150 million senior secured credit facility to be entered into prior to or concurrently with the completion of the distribution; and

 

    the issuance of senior unsecured notes prior to or concurrently with the completion of the distribution in an aggregate principal amount of $500 million and related debt issuance costs.

 

To the extent that the proceeds of the notes offering and the term loans, our planned $100 million advance under the accounts receivable financing facility and the settlement of our intercompany receivable from Merck are insufficient to pay the cash dividends aggregating $2 billion to Merck prior to or concurrently with the completion of the distribution, we may draw a larger advance under our accounts receivable financing facility and draw advances under our revolving credit facility to cover the shortfall, subject in each case to availability under those facilities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”.

 

The unaudited pro forma condensed consolidated statements of income assume that these transactions occurred as of December 30, 2001 and the unaudited pro forma condensed consolidated balance sheet assumes that these transactions occurred as of March 29, 2003.

 

You should read the unaudited pro forma condensed consolidated financial information in conjunction with our audited consolidated financial statements and the notes to the audited consolidated financial statements. You should also read the sections “Selected Historical Consolidated Financial and Operating Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. The unaudited pro forma condensed consolidated financial information is qualified by reference to these sections, the audited consolidated financial statements and the notes to the audited consolidated financial statements, each of which is included elsewhere in this information statement.

 

The unaudited pro forma condensed consolidated financial information is not indicative of our future performance or what our results of operations would have been if we had been operated as a separate company during the periods presented or if the transactions reflected therein had actually occurred as of December 30, 2001 or March 29, 2003, as the case may be. The unaudited pro forma condensed consolidated statement of income does not reflect estimates of one-time and ongoing incremental costs required to operate as a separate company, which are described in Note 1 to the unaudited pro forma condensed consolidated statement of income.

 

We recorded gross rebates from Merck of $443.9 million during 2002 and $110.6 million during the first quarter of 2003. Through June 2002, these rebates were based upon an agreed-upon percentage rate applied to the volume of Merck prescription products dispensed either by our home delivery pharmacies or through our retail

 

51


Table of Contents
Index to Financial Statements

pharmacy networks. We are party to a five-year managed care agreement with Merck, which governs our ongoing rebate arrangements with Merck. The managed care agreement with Merck includes terms related to our commitment to maintain Merck market share levels, formulary access rebates and market share rebates payable by Merck, as well as other provisions. In addition, we may be required to pay liquidated damages to Merck if we fail to achieve specified market share levels. Had this managed care agreement been in effect for all of 2002, we do not believe that it would have had a significant impact on the recorded rebates from Merck in 2002. However, the rebates that we may earn under the managed care agreement may be reduced or eliminated if we do not comply with various obligations or do not achieve various minimum or target market share levels set forth in that agreement. See “Risk Factors—Risks Relating to Our Relationship with and Spin-Off from Merck—Under our managed care agreement with Merck, our rebates could decline by a substantial amount and we may have to pay substantial liquidated damages to Merck if we fail to achieve specified market share levels” and “Relationship Between Our Company and Merck & Co., Inc.—Agreements Between Us and Merck”.

 

Unaudited Pro Forma Condensed Consolidated Statements of Income

 

    Year Ended December 28, 2002

    Quarter Ended March 29, 2003

    Historical

  Adjustments

    Pro Forma

    Historical

    Adjustments

    Pro Forma

    (in millions, except per share amounts)

Product net revenues

  $ 32,573.0           $ 32,573.0     $ 8,237.9             $ 8,237.9

Service revenues

    385.5             385.5       96.2               96.2
   

         


 


         

Total net revenues

    32,958.5             32,958.5       8,334.1               8,334.1
   

         


 


         

Cost of operations:

                                           

Cost of product net revenues

    31,483.9             31,483.9       7,939.5               7,939.5

Cost of service revenues

    173.8             173.8       45.1               45.1
   

         


 


         

Total cost of revenues

    31,657.7             31,657.7       7,984.6               7,984.6

Selling, general and administrative expenses

    587.7             587.7 (1)     163.0               163.0

Amortization of intangibles

    84.9             84.9       23.6               23.6

Other (income) expense, net

    7.9   $ 74.1  (2)     82.0       (11.7 )   $ 18.1  (2)     6.4
   

         


 


         

Total cost of operations

    32,338.2             32,412.3       8,159.5               8,177.6
   

         


 


         

Income before provision for income taxes

    620.3             546.2       174.6               156.5

Provision for income taxes

    258.7     (30.9 )(3)     227.8       72.6       (7.5 )(3)     65.1
   

         


 


         

Net income

  $ 361.6           $ 318.4     $ 102.0             $ 91.4
   

         


 


         

Basic and diluted earnings per share(4):

                                           

Net income per share

  $ 1.34           $ 1.18     $ 0.38             $ 0.34

Weighted average shares outstanding

    270.0             270.0       270.0               270.0

 

Notes to Unaudited Pro Forma Condensed Consolidated Statements of Income

 

(1)   In 2002, Merck allocated to us $27.4 million of expenses it incurred for providing us consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services, and we directly incurred an additional $4.5 million for these services. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. We expect the total cost of these services to aggregate approximately $35 million to $40 million in 2003, including a charge from Merck of $0.4 million, and approximately $40 million to $45 million in 2004. In addition, during 2002 we incurred $7.7 million of non-recurring costs associated with our transition to operating as a separate company for systems implementation and conversion, the change of our corporate name and other matters. We expect to incur $2 million of non-recurring costs during 2003 as we complete our transition to a separate company.
(2)  

Includes estimated annual interest expense of $74.1 million related to $1,500 million of indebtedness that we expect to incur prior to or concurrently with the completion of the distribution, at an estimated weighted average annual interest rate of 4.94%. Several factors could change the weighted average annual interest

 

52


Table of Contents
Index to Financial Statements
 

rate, including but not limited to a change in our credit rating or a change in the reference rates used under the credit facilities. A 25 basis point change to the weighted average annual interest rate would change our annual interest expense by $3.8 million. We may incur additional interest expense if we draw down under the $250 million revolving credit facility or draw down further under the $500 million accounts receivable financing facility that we expect to enter into prior to or concurrently with the completion of the distribution.

(3)   Represents estimated tax benefit related to the estimated interest expense discussed in Note 2 above at our combined effective rate of 41.7% for the year ended December 28, 2002 and 41.6% for the quarter ended March 29, 2003.
(4)   On May 21, 2002 we converted from a limited liability company wholly owned by Merck to a corporation wholly owned by Merck and issued 270,000,000 shares of $0.01 par value common stock. In connection with the distribution, certain Merck stock options held by our employees will be converted into options to purchase our stock. These options would not have had a material effect on historical or pro forma earnings per share for the periods presented.

 

Unaudited Pro Forma Condensed Consolidated Balance Sheet as of March 29, 2003

 

     Historical

   Adjustments

    Pro Forma

     (in millions)

Assets:

                     

Cash and cash equivalents

   $ 7.7    $ 198.9  (1)   $ 206.6

Accounts receivable, net

     1,531.1              1,531.1

Due from Merck, net

     718.6      (718.6 )(2)     —  

Inventories, net

     932.6              932.6

Deferred tax assets

     238.5              238.5

Other current assets

     139.5              139.5

Property and equipment, net

     816.2              816.2

Goodwill, net

     3,310.2              3,310.2

Intangibles, net

     2,391.3              2,391.3

Other noncurrent assets

     132.0          19.7  (3)     151.7
    

          

Total assets

   $ 10,217.7            $ 9,717.7
    

          

Liabilities and Equity:

                     

Claims and accounts payable

   $ 1,959.7            $ 1,959.7

Short-term debt

     —        100.0  (4)     100.0

Current portion of long-term debt

     —        11.3  (4)     11.3

Other current liabilities

     299.2              299.2

Long-term debt

     —        1,388.7  (4)     1,388.7

Deferred tax liabilities

     1,182.2              1,182.2

Other noncurrent liabilities

     39.0              39.0

Total stockholder’s equity

     6,737.6      (2,000.0 )(4)     4,737.6
    

          

Total liabilities and stockholder’s equity

   $ 10,217.7            $ 9,717.7
    

          

 

Notes to Unaudited Pro Forma Condensed Consolidated Balance Sheet as of March 29, 2003

 

(1)   Represents the net effect on cash and cash equivalents of the other pro forma adjustments.
(2)   The net balance of intercompany receivables from Merck as of December 29, 2001 is included in total stockholder’s equity. From December 30, 2001 through the date we complete the distribution, we are recording intercompany transactions with Merck in “Due from Merck, net”. On May 21, 2002, in conjunction with our conversion to a corporation, we satisfied in full our gross intercompany receivable and payable with Merck by netting the balances as of that date into a net receivable due from Merck. The balance in “Due from Merck, net” will be settled on the distribution date.
(3)   We will record approximately $19.7 million in debt issuance costs in connection with the incurrence of the debt described in Note 4 below.
(4)   Prior to or concurrently with the completion of the distribution, we intend to incur $100 million in short-term indebtedness and $1,400 million in long-term indebtedness, of which $11.3 million represents the current portion. We may incur additional indebtedness if we draw down under the $250 million revolving credit facility or draw down further under the $500 million accounts receivable financing facility that we expect to enter into prior to or concurrently with the completion of the distribution.
(5)   Represents the impact on equity associated with the payment of the cash dividends aggregating $2 billion to Merck.

 

53


Table of Contents
Index to Financial Statements

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS

 

You should read the following discussion of our financial condition and results of operations together with the audited consolidated financial statements and notes to the financial statements included elsewhere in this information statement. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. 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 the sections of this information statement entitled “Risk Factors”, “Cautionary Note Regarding Forward-Looking Statements” and other sections in this information statement.

 

Basis of Presentation

 

Our consolidated financial statements reflect our historical results of operations and cash flows during each respective period. We prepared our historical financial statements using Merck’s historical basis in the assets and liabilities and the results of our operations. They also include allocations of expenses Merck incurred. These expenses include expenses for consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. We made these expense allocations on a basis that we, along with Merck, considered to be reasonable reflections of the utilization of services that Merck provided to us. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. For a discussion of the costs associated with operating as a separate company, see “—Results of Operations”.

 

On May 21, 2002, we converted from a limited liability company wholly owned by Merck to a corporation wholly owned by Merck. For financial reporting purposes, we calculated income tax expense and deferred income tax balances as if we were a separate company and had prepared our own separate tax returns as a corporation during the periods presented.

 

The financial information included in this information statement is not indicative of our consolidated financial position, operating results, changes in equity and cash flows for any future period, or what they would have been had we operated as a separate company during the periods presented.

 

Overview

 

We are the nation’s largest PBM based on our 2002 net revenues. We provide sophisticated programs and services for our clients and the members of their pharmacy benefit plans, as well as for the physicians and pharmacies the members use. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this primarily by negotiating competitive rebates and discounts from pharmaceutical manufacturers, obtaining competitive discounts from retail pharmacies and administering prescriptions filled through our national networks of retail pharmacies or our own home delivery pharmacies. We have a large number of clients in each of the major industry segments, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans.

 

We manage our business as a single operating segment, which primarily consists of sales of prescription drugs to members of clients either through our home delivery pharmacies or through our networks of contractually affiliated retail pharmacies. We offer fully integrated pharmacy benefit management services to substantially all of our clients and their members, offering members the convenience of obtaining their prescription medications either through home delivery or retail. The pharmacy benefit management services we provide to our clients are delivered and managed under a single contract for each client.

 

Rebate contracts with pharmaceutical manufacturers of brand drugs are negotiated on an enterprise-wide level based on the consolidated home delivery and retail prescription volumes we process. We believe the level

 

54


Table of Contents
Index to Financial Statements

of rebates we are able to negotiate significantly benefits from our substantial home delivery volume because we are able to achieve a higher level of formulary compliance in home delivery than in retail. This higher level of compliance is due to our ability to contact the physician and encourage prescribing of formulary medications prior to the dispensing of the prescription. As a result, although the rebate contracts generate rebates on home delivery and retail prescriptions equally on the basis of drug cost, it is not practicable to determine the true value of rebates earned specifically on home delivery or retail prescription volume.

 

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

 

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

 

We operate in a very competitive market that is characterized by increasing pricing and margin pressures as clients seek to control the growth in the cost of providing prescription drug benefits to their members.

 

Our net revenues are derived primarily from the sale of prescription drugs through our home delivery pharmacies and through our networks of contractually affiliated retail pharmacies and are recorded net of certain rebates and guarantees payable to clients. For further details see our critical accounting policies included in “—Use of Estimates and Critical Accounting Policies” below and the notes to our audited consolidated financial statements included elsewhere in this information statement.

 

Our cost of revenues relating to drugs dispensed by our home delivery pharmacies consists primarily of the cost of inventory dispensed and our costs incurred to process and dispense the prescriptions, including the associated depreciation. Cost of revenues for prescriptions filled through our network of retail pharmacies includes the contracted cost of drugs dispensed by, and professional fees paid to, retail pharmacies in the networks. The operating costs of our call center pharmacies are also included in cost of revenues. In addition, cost of revenues for both home delivery sales and retail sales includes a credit for rebates earned from pharmaceutical manufacturers whose drugs are included in our formularies. Price increases by manufacturers and wholesalers for pharmaceuticals have generally been recovered from our clients under our client contracts but could prevent us from satisfying contracts with guaranteed cost savings if the result is an overall increase in the cost of the drug plan to our client. Our home delivery inventory purchasing discounts on generic drugs allow us to generate a higher generic product margin in home delivery than in retail, while our clients also obtain a benefit through lower overall drug cost. The higher profit potential associated with generic drugs in home delivery is a key driver of our strategy to encourage the use of home delivery.

 

Selling, general and administrative expenses reflect the costs of operations dedicated to generating new sales, maintaining existing customer relationships, managing clinical programs, enhancing technology capabilities, directing pharmacy operations and other staff activities. Our historical financial statements also include allocations of costs relating to certain corporate functions historically provided by Merck, including consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. During the period from July 1, 2002 to March 31, 2003, we began to assume responsibility for these previously allocated services. These allocated expenses are not necessarily indicative of the higher expenses we expect to incur in the future in connection with these corporate functions as a separate company. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. For information on our expected incremental selling, general and administrative expenses after

 

55


Table of Contents
Index to Financial Statements

the distribution, see Note 1 to the Unaudited Pro Forma Condensed Consolidated Statement of Income included under “Unaudited Pro Forma Condensed Consolidated Financial Data”.

 

We began providing pharmacy benefit management services in the second quarter of 2000 to UnitedHealth Group under a five-year contract. Revenues from UnitedHealth Group, which is currently our largest client, amounted to approximately $1,300 million, or 6%, of our net revenues in 2000, approximately $4,600 million, or 16%, of our net revenues in 2001, and approximately $5,300 million, or 16%, of our net revenues in 2002. This agreement will expire on December 31, 2005. None of our other clients individually represented more than 10% of our net revenues in 2002.

 

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 each year from 1998 through 2002, we retained clients accounting for at least 94% of our net revenues. We expect our client retention rate to decline to 93% in 2003 as a result of some larger clients not renewing contracts with us. Covered lives under our clients’ plans decreased from approximately 65 million as of December 29, 2001 to approximately 64 million as of December 28, 2002 and to approximately 62 million as of March 29, 2003.

 

In addition, a client that is involved in a merger or acquisition with a company that is not a client may not renew, and in some instances may terminate, its PBM contract with us. Trigon, a client that represented approximately 3% of our net revenues in 2002, was acquired by Anthem, Inc. in 2002. Trigon’s decision to terminate its contract with us as of the end of 2003 will adversely affect our earnings beginning in 2004.

 

Our total prescription volumes declined 5% from the first quarter of 2002 to the first quarter of 2003 due to client terminations. We expect our total annual prescription volumes in 2003 to be lower than our total annual prescription volumes in 2002.

 

Our key assets include accounts receivable, inventories, fixed assets, goodwill and intangibles. Accounts receivable represent amounts due from clients for prescriptions shipped to members from our home delivery pharmacies or dispensed from retail pharmacies in our networks, including fees due to us, net of any rebate liabilities or payments due to clients under guarantees. Accounts receivable also include amounts due from pharmaceutical manufacturers for earned rebates and other fees. Inventories reflect the cost of prescription products held for dispensing by our home delivery pharmacies and are recorded on a first-in, first-out basis. Fixed assets include our investment in home delivery pharmacies, call center pharmacies, and information technology, including capitalized software development. The net goodwill of $3,310 million and intangible assets of $2,391 million as of March 29, 2003 are comprised primarily of the push-down of goodwill and intangibles related to Merck’s acquisition of us in 1993 and, to a significantly lesser extent, our acquisition of ProVantage Health Services, Inc., or ProVantage, in 2000. See “Risk Factors—Risks Relating to Our Common Stock—We could be required to record a material non-cash charge to income if our recorded goodwill is impaired”.

 

Liabilities primarily consist of amounts payable to retail network pharmacies for prescriptions dispensed and services rendered, amounts payable for home delivery prescription inventory purchases and other accruals and liabilities incurred in the normal course of business.

 

We conduct our operations in one segment of the PBM industry, which involves sales of prescription drugs to members of our clients, either by our home delivery pharmacies or through our networks of contractually affiliated retail pharmacies, and in one geographic region, the United States and Puerto Rico. Services to clients are delivered and managed under a single contract for each client.

 

We do not have any off-balance sheet entities. On June 13, 2002, two interest rate swap lock agreements were entered into on our behalf in expectation of the completion of our then-planned $1,000 million notes offering. On June 28, 2002, these swap agreements were terminated in accordance with their terms at a cost of $7 million. Except for these two agreements, we have not engaged in material transactions involving derivative financial instruments.

 

56


Table of Contents
Index to Financial Statements

Our fiscal year ends on the last Saturday in December, and our fiscal quarters end on the last Saturday in March, June, September or December. Fiscal years 1998, 1999, 2001 and 2002 each consisted of 52 weeks, and fiscal year 2000 consisted of 53 weeks.

 

The term “drug spend” used in this discussion refers to aggregate drug expenditure amounts based on retail prices paid by consumers and plan sponsors.

 

Use of Estimates and Critical Accounting Policies

 

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 the 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. We discuss the impact and any associated risks related to these policies on our business operations throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section.

 

Critical Accounting Policies.    We describe below what we believe to be our critical accounting policies.

 

Revenue recognition.    Our revenues are derived principally from sales of prescription drugs to members of our clients, either through our home delivery pharmacies or our networks of contractually affiliated retail pharmacies. We recognize these revenues when the prescriptions are dispensed through our home delivery pharmacies or retail pharmacies in our contractually affiliated networks. 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 members, among other indicators, qualify us as the principal under the indicators set forth in EITF 99-19 “Reporting Gross Revenue as a Principal vs. Net as an Agent” in most of our transactions with customers. 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, 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 home delivery pharmacies and our retail network contracts where we are the principal, 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 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 mechanism that we negotiate 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. 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 we pay to our clients when our clients earn these rebates. We estimate these rebates at period-end based on actual and estimated claims data and our estimates of the portion of those claims on which our clients can earn rebates. 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 have not been material to our quarterly or annual results of operations. We also deduct from our revenues discounts offered and

 

57


Table of Contents
Index to Financial Statements

other payments made to our clients. Other payments include, for example, implementation allowances, payments made under risk-sharing agreements with clients 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 against revenue over the life of the contract only if these payments are refundable upon cancellation or relate to non-cancelable contracts. In the limited instances where we enter into risk-sharing agreements whereby we agree to share in the risk of a client’s drug trend increasing above certain levels, we determine on a regular basis any potential deduction from revenue by comparing the client’s increase in drug spending for that period against a specified contractual or indexed target rate. Where the client’s rate of increase exceeds that target, we calculate a deduction from revenue in accordance with the terms of the contract, up to the contractual cap on our liability. We manage our risk from this type of arrangement by restricting the number of client contracts that include risk sharing, capping our responsibility under these provisions and requiring the client to implement drug cost management programs. Accordingly, our exposure under risk-sharing arrangements is not material to our financial position or liquidity.

 

Rebates receivable and payable.    Rebates receivable from pharmaceutical manufacturers are earned based upon dispensing of prescriptions at either home delivery pharmacies or pharmacies in our retail networks, are recorded as a reduction of cost of revenues and are included in accounts receivable. We accrue rebates receivable by multiplying estimated rebatable prescription drugs dispensed by our home delivery pharmacies, or dispensed by one of the pharmacies in our retail networks, by the contractually agreed manufacturer rebate amount. We revise rebates receivable estimates to actual, with the difference recorded to cost of revenues, when final rebatable prescriptions are calculated, and rebates are billed to the manufacturer generally 45 to 90 days subsequent to the end of the applicable quarter. Historically, the effect of adjustments resulting from the reconciliation of rebates recognized and recorded to actual amounts billed has not been material to our results of operations. Rebates earned by Medco Health from pharmaceutical manufacturers, including Merck, totaled $1,969 million in 2000, $2,535 million in 2001 and $2,465 million in 2002. Rebates payable to clients are estimated and accrued as a reduction in accounts receivable, net, based upon the prescription drugs dispensed by our home delivery pharmacies, or dispensed by one of the pharmacies in our retail networks. Rebates are paid to clients based on actual drug spend on a quarterly basis after collection of rebates receivable from manufacturers at which time rebates payable are revised to reflect amounts due. Typically, our client contracts give the client the right to audit our calculation of rebates owed to the client. To date, adjustments related to client audits have not been material.

 

Contract profitability.    We monitor contract profitability periodically throughout the term of each contract and if the contract would result in a loss over its total life, we would record a charge to earnings immediately for the entire amount of the loss. To date, no charges have been required.

 

Allocations from Merck.    Our historical financial statements include allocations of certain corporate functions historically provided by Merck, such as consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. These allocations were made using relative percentages of operating expenses, pre-tax income, headcount, the effort expended by Merck for us as compared to its other operations, or other reasonable methods. We and Merck consider these allocations to be reasonable reflections of the utilization of services provided to us. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses.

 

Income taxes.    We account for income taxes under SFAS No. 109 “Accounting for Income Taxes” (SFAS No. 109). Accordingly, we calculated income tax expense and the deferred income tax balances in the consolidated financial statements as if we had been taxed separately and had prepared our own separate tax returns as a corporation. Prior to May 21, 2002, we were structured as a single member limited liability company with Merck as the sole member. Effective May 21, 2002, we converted from a limited liability company wholly owned by Merck to a corporation wholly owned by Merck. Merck has been taxed on our taxable income as part of Merck’s consolidated tax return, with our liabilities for income taxes being reflected in “Due from Merck, net”. Subsequent to the distribution, we will continue to provide for and, in addition, will directly pay federal and state income taxes in accordance with the tax responsibility allocation agreement.

 

58


Table of Contents
Index to Financial Statements

Property and equipment.    We state property and equipment at cost less accumulated depreciation and amortization. We calculate depreciation using the straight-line method for assets with useful lives ranging from three to 45 years. We amortize leasehold improvements over the shorter of the remaining life of the lease or the useful lives of the assets.

 

Software developed for internal use.    We invest significantly in developing software to meet the needs of our clients. We have adopted 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 that does not add functionality to the existing system, are expensed as incurred.

 

Goodwill and intangible assets.    Goodwill primarily represents 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 significantly lesser extent, our acquisition of ProVantage in 2000. Effective December 30, 2001, we adopted SFAS No. 142 “Goodwill and Other Intangible Assets” (SFAS No. 142). SFAS No. 142 requires us to cease amortization of goodwill and to test goodwill for impairment upon adoption and at least annually thereafter. To determine whether goodwill has been impaired, we must first determine the fair value of the company. This determination involves significant judgment. If we conclude that our fair value is less than our book value, SFAS No. 142 requires us to allocate our fair value to our assets and liabilities as if we had been acquired at that fair value. We must record an impairment charge to the extent recorded goodwill exceeds the amount of goodwill resulting from this allocation. We tested our goodwill upon adoption of SFAS No. 142 and as of September 30, 2002 and determined that goodwill was not impaired.

 

Once trading in our common stock begins, we will consider the market price of our common stock as a factor in determining our fair value. Should we determine that our fair value is less than our book value, we would be required to allocate this fair value to our assets and liabilities as if we had been acquired at this fair value. To the extent that this allocation results in goodwill that is lower than the recorded amount, we would record an impairment charge. The value of our customer and other relationships has increased considerably since Merck acquired us in 1993. As a result, any allocation under SFAS No. 142 would likely assign a greater value to these intangible assets and substantially less, if any, value to goodwill. While SFAS No. 142 would require us to record the impairment to goodwill, it would not permit us to record any increase in value of the intangible assets. As a result, if we determine that our fair value is less than our book value, our impairment measured under SFAS No. 142 may result in a material non-cash charge to income that could substantially exceed the difference between our book value and fair value.

 

Our intangible assets primarily represent the value of customer relationships that was recorded at the time of the Merck acquisition. These assets are reviewed for impairment whenever events 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 undiscounted expected future cash flows. If this comparison indicates that there is an impairment, the amount of the impairment is calculated using discounted expected future cash flows. The most recent impairment test was performed as of December 28, 2002 and the intangible assets were determined not to be impaired. In addition, we continually evaluate the amortizable lives of our intangible assets to ensure they reflect current circumstances. Until December 28, 2002, the intangible assets from the Merck acquisition were being amortized over a weighted average useful life of 38 years. During the first quarter of 2003, we performed a re-evaluation of the useful life of these intangible assets taking into account historical turnover experience, including recent losses of clients, and expected future losses. As a result of this review, the weighted average useful life was revised to 35 years effective as of December 29, 2002, with the annual intangible amortization expense increasing by approximately $9 million.

 

Pension and Other Postretirement Benefit Plans.    Net pension and other postretirement benefit cost totaled $24.1 million in 2001 and $32.7 million in 2002. Pension and other postretirement benefit plan information for financial reporting purposes is calculated using actuarial assumptions including a discount rate for plan benefit obligations and an expected rate of return on pension plan assets.

 

59


Table of Contents
Index to Financial Statements

We reassess our benefit plan assumptions on a regular basis. For both the pension and other postretirement benefit plans, the discount rate is evaluated annually and modified to reflect the prevailing market rate at the end of our fiscal year of a portfolio of high-quality (AA and above) fixed-income debt instruments that would provide the future cash flows needed to pay the benefits included in the benefit obligation as they come due. At December 28, 2002, we changed the discount rate to 6.5% from 7.25% for our pension and other postretirement benefit plans.

 

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 compound 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 2003, we changed the expected rate of return from 10.0% to 8.75% for our pension plan.

 

The targeted investment portfolio of our pension plan is allocated 45% to 60% in U.S. equities, 20% to 30% in international equities, 13% to 16% in fixed income instruments, 4% to 6% in real estate, and up to 8% in cash and other investments. We believe the portfolio’s equity weighting is consistent with the long-term nature of the plan’s benefit obligation, and the expected annual standard deviation of returns of the targeted portfolio, which approximates 13%, reflects this equity allocation. At December 31, 2002, the cash component of the actual investment portfolio was slightly in excess of the targeted allocation. This excess has been subsequently reinvested according to the targeted allocation.

 

Holding all other assumptions constant, the 2003 net pension and other postretirement benefit cost for our plans is expected to increase by approximately $6.0 million, of which $5.0 million is attributable to the lower discount rate and approximately $1.0 million is attributable to the lower expected rate of return.

 

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 $1.7 million favorable (unfavorable) impact on net pension and postretirement benefit cost. 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 $0.2 million favorable (unfavorable) impact on net pension cost. We do not expect to have a minimum pension funding requirement under the Internal Revenue Code during 2003. The preceding hypothetical changes in discount rate and expected rate of return assumptions would not impact our funding requirements. Under assumptions used to develop our financial statements, the pension plan has a projected benefit obligation of $81.8 million and assets of $80.5 million at December 28, 2002. The postretirement benefit obligation was $104.2 million at December 28, 2002 and the benefit was unfunded.

 

Unrecognized net gain/loss amounts reflect experience differentials relating to differences between expected and actual returns on plan assets, differences between expected and actual health care cost increases, as well as the effects of changes in actuarial assumptions. Expected returns are based on the market value of assets. Total unrecognized net gain/loss amounts in excess of certain thresholds are amortized into net pension and other postretirement benefit cost over the average remaining service life of employees. Amortization of total unrecognized net losses for our plans at December 31, 2002 is expected to increase net pension and other postretirement benefit cost by approximately $2.0 million in 2003. See “Risk Factors—As a result of our discussions with the Pension Benefit Guaranty Corporation relating to the Medco Health Cash Balance Retirement Plan, our liabilities and obligations under the plan could accelerate.”

 

Legal contingencies.    We are currently involved in various legal proceedings. We have considered these proceedings in determining the necessity of any reserves for losses that are probable and reasonably estimable. Our estimates of necessary reserves have been developed in consultation with outside counsel assisting in the defense of these matters and are based upon an analysis of the potential results, assuming a combination of litigation and settlement strategies. We do not believe these proceedings will have a material adverse effect on our consolidated financial position or liquidity as set forth in our consolidated financial statements for the year

 

60


Table of Contents
Index to Financial Statements

ended December 28, 2002. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially adversely affected by the ultimate resolution of these matters or by changes in our assumptions or our strategies related to these proceedings.

 

Results of Operations

 

The following tables set forth, for the periods indicated, actual results and the percentage relationship to net revenues:

 

    Years Ended

    Quarters Ended

 
    December 30,
2000(1)


    December 29,
2001


    December 28,
2002


    March 30,
2002


    March 29,
2003


 
    (in millions)  

Product net revenues

  $ 21,979.2     $ 28,709.3     $ 32,573.0     $ 7,929.0     $ 8,237.9  

Service revenues

    287.1       361.3       385.5       87.1       96.2  
   


 


 


 


 


Total net revenues

    22,266.3       29,070.6       32,958.5       8,016.1       8,334.1  
   


 


 


 


 


Cost of operations:

                                       

Cost of product net revenues

    21,010.8       27,601.1       31,483.9       7,713.8       7,939.5  

Cost of service revenues

    143.4       185.6       173.8       44.0       45.1  
   


 


 


 


 


Total cost of revenues

    21,154.2       27,786.7       31,657.7       7,757.8       7,984.6  

Selling, general and administrative expenses

    483.1       578.4       587.7       135.2       163.0  

Amortization of goodwill

    103.3       106.9                    

Amortization of intangibles

    84.0       84.9       84.9       21.2       23.6  

Other (income) expense, net

    (5.8 )     (4.6 )     7.9       (0.8 )     (11.7 )
   


 


 


 


 


Total cost of operations

    21,818.8       28,552.3       32,338.2       7,913.4       8,159.5  
   


 


 


 


 


Income before provision for income taxes

    447.5       518.3       620.3       102.7       174.6  

Provision for income taxes

    230.7       261.7       258.7       43.1       72.6  
   


 


 


 


 


Net income

  $ 216.8     $ 256.6     $ 361.6     $ 59.6     $ 102.0  
   


 


 


 


 


    Years Ended

    Quarters Ended

 
    December 30,
2000(1)


    December 29,
2001


    December 28,
2002


    March 30,
2002


    March 29,
2003


 
    (percentage of net revenues)  

Product net revenues

    98.7 %     98.8 %     98.8 %     98.9 %     98.8 %

Service revenues

    1.3 %     1.2 %     1.2 %     1.1 %     1.2 %
   


 


 


 


 


Total net revenues

    100.0 %     100.0 %     100.0 %     100.0 %     100.0 %
   


 


 


 


 


Cost of operations:

                                       

Cost of product net revenues

    94.4 %     94.9 %     95.5 %     96.2 %     95.2 %

Cost of service revenues

    0.6 %     0.6 %     0.5 %     0.5 %     0.5 %
   


 


 


 


 


Total cost of revenues

    95.0 %     95.6 %     96.0 %     96.8 %     95.7 %

Selling, general and administrative expenses

    2.2 %     2.0 %     1.8 %     1.7 %     2.0 %

Amortization of goodwill

    0.5 %     0.4 %                  

Amortization of intangibles

    0.4 %     0.3 %     0.3 %     0.3 %     0.3 %

Other (income) expense, net

    0.0 %     0.0 %     0.0 %     0.0 %     (0.1 )%
   


 


 


 


 


Total cost of operations

    98.0 %     98.2 %     98.1 %     98.7 %     97.9 %
   


 


 


 


 


Income before provision for income taxes

    2.0 %     1.8 %     1.9 %     1.3 %     2.1 %

Provision for income taxes

    1.0 %     0.9 %     0.8 %     0.5 %     0.9 %
   


 


 


 


 


Net income

    1.0 %     0.9 %     1.1 %     0.7 %     1.2 %
   


 


 


 


 



(1)   53 week fiscal year.

 

61


Table of Contents
Index to Financial Statements

Results of Operations for the Quarters Ended March 30, 2002 and March 29, 2003

 

Total net revenues for the first quarter of 2003 of $8,334 million exceeded the first quarter of 2002 by $318 million, or 4.0%, as a result of the 3.9% growth in product net revenues to $8,238 million in the first quarter of 2003. Product net revenues for the first quarter of 2003 are comprised of $5,484 million in retail net revenues and $2,754 million in home delivery net revenues representing increases over the first quarter of 2002 of $24 million and $285 million, respectively. Retail product net revenues include co-payments of approximately $1,677 million in the first quarter of 2003 and approximately $1,640 million in the first quarter of 2002. The $24 million increase in retail net revenues in the first quarter of 2003 was attributable to net price increases of $345 million offset by a $321 million decrease due to a 5.9% reduction in prescription volumes. Retail price increases of $442 million were primarily due to higher prices charged by pharmaceutical manufacturers and greater representation of new and higher cost drugs in the brand prescription base, and were partially offset by $97 million due to steeper pricing discounts, higher rebates offered to clients, and greater representation in the overall product mix of generic drugs, which are more steeply discounted. The $285 million increase in home delivery net revenues in the first quarter of 2003 was attributable to net price increases of $299 million offset by a $14 million decrease due to a 1.0% reduction in prescription volumes. Home delivery price increases of $299 million were primarily due to higher prices charged by pharmaceutical manufacturers and greater representation of new and higher cost drugs in the brand prescription base.

 

Generic drug usage increased from 39.5% of total prescriptions dispensed in the first quarter of 2002 to 43.6% in the first quarter of 2003. The lower prescription volumes were due to a 9.2% decline from client terminations, offset by a 4.0% increase from higher prescription drug utilization. Home delivery prescription volume of approximately 20 million prescriptions in the first quarter of each of 2002 and 2003 increased as a percentage of total prescription volume, including retail prescriptions, from 14.3% in the first quarter of 2002 to 14.9% in the first quarter of 2003, primarily as a result of changes in client plan designs to encourage home delivery usage and the continued increase of home delivery utilization from existing clients.

 

The 10.4% or $9 million increase in service revenues to $96 million in the first quarter of 2003 was attributable to higher sales of prescription services and data to pharmaceutical manufacturers and other customers of $16 million, partially offset by a $7 million reduction from decreasing client administrative fees on a per prescription basis and the impact of lower total prescription volume.

 

Total cost of revenues for the first quarter of 2003 of $7,985 million exceeded the first quarter of 2002 by $227 million, or 2.9%, as a result of the 2.9% increase in the cost of product net revenues to $7,940 million in the first quarter of 2003. Cost of product net revenues includes amounts representing retail co-payments of approximately $1,677 million in the first quarter of 2003 and approximately $1,640 million in the first quarter of 2002. Cost of product net revenues increased at a lower rate than product net revenues largely due to increased usage of lower cost generic products and higher rebates earned from pharmaceutical manufacturers, which totaled $704 million in the first quarter of 2003 compared to $585 million in the first quarter of 2002. Rebates earned in the first quarter of 2002 were the lowest of all four quarters in 2002 as a result of higher market share requirements in re-negotiated multi-year pharmaceutical manufacturer contracts. In addition to reflecting earned rebates at a consistent level with those earned in the last three quarters of 2002, rebates earned in the first quarter of 2003 also reflect the impact of higher levels of rebates due to new products and re-negotiated terms on existing products. Cost of product net revenues also increased as a result of costs of $9 million to implement new pharmacy call center member servicing capabilities, and severance costs of $8 million and asset impairment charges of $5 million associated with closing the Mechanicsburg, Pennsylvania pharmacy, which was completed during the second quarter of 2003. The 2.4%, or $1 million, increase in cost of service revenues was lower than the rate of growth experienced in service revenue largely due to cost savings initiatives such as labor efficiencies and savings on member communication materials totaling $3 million, largely offsetting the overall $4 million increase in program costs.

 

62


Table of Contents
Index to Financial Statements

Gross margin (defined as net revenues minus cost of revenues) in the first quarter of 2003 of $349 million reflects a $91 million, or 35.3%, increase compared to the first quarter of 2002. The gross margin percent on net revenues in the first quarter of 2003 was 4.2%, compared to 3.2% in the first quarter of 2002. The gross margin percent on product net revenues in the first quarter of 2003 was 3.6%, compared to 2.7% in the first quarter of 2002, and 3.3% for the full year 2002. The product margin increase of $83 million in the first quarter of 2003 reflects a $121 million impact from the higher share of generic prescription dispensing in our home delivery pharmacies and the earned pharmaceutical manufacturer rebates and other items amounting to $6 million, offset by $22 million from continued pricing pressures and the $22 million in the other costs discussed above. In addition, our investments in technology over the past several years have resulted in increased depreciation charges, growing from $11 million in the first quarter of 2002 to $16 million in the first quarter of 2003. In an effort to respond strategically to these margin pressures, we have enhanced productivity by using technology to improve operational efficiencies in prescription processing and dispensing and pharmacy call center operations. The gross margin percentage on service revenues in the first quarter of 2003 was 53.1%, compared to 49.5% in the first quarter of 2002 due to increased revenue combined with the cost savings initiatives described above.

 

Selling, general and administrative expenses for the first quarter of 2003 of $163 million exceeded the first quarter of 2002 by $28 million, or 20.6%. These expenses increased from 1.7% of net revenues in the first quarter of 2002 to 2.0% in the first quarter of 2003 due to increased expenses related to information systems technology of $19 million, increased expenses of $5 million associated with our anticipated operation as a separate company and other fees and expenses of $10 million. These increases were partially offset by a $6.5 million decrease in costs allocated from Merck. Selling, general and administrative expenses include costs allocated to us by Merck of $6.9 million for the first quarter of 2002 and $0.4 million for the first quarter of 2003. See “—Results of Operations for 2000, 2001 and 2002”.

 

Amortization of intangible assets was $24 million in the first quarter of 2003, $2 million higher than the first quarter of 2002 because of a re-evaluation of the useful life of the intangible assets created at the time of the Merck acquisition, as described under “—Use of Estimates and Critical Accounting Policies—Critical Accounting Policies—Goodwill and intangible assets”.

 

Other (income) expense, net was $(11.7) million in the first quarter of 2003 and $(0.8) million in the first quarter 2002. The first quarter of 2003 includes a one-time gain of $11.0 million from the sale of a minority equity investment in a non-public company. In addition, the first quarters of 2003 and 2002 include interest income primarily generated by short-term investments in marketable securities.

 

For financial reporting purposes, we calculate our tax provision and related deferred tax accounts in our financial statements on a separate return basis. The effective tax rate (defined as the percentage relationship of provision for income taxes to income before provision for income taxes) decreased marginally to 41.6% in the first quarter of 2003, compared to 42.0% in the first quarter of 2002. This reduction resulted from cost controls designed to reduce non tax deductible expenses.

 

Net income as a percentage of net revenues was 1.2% in the first quarter of 2003 compared to 0.7% in the first quarter of 2002 as a result of the above factors.

 

Results of Operations for 2000, 2001 and 2002

 

Total net revenues for 2001 of $29,071 million exceeded 2000 by $6,804 million, or 30.6%, and total net revenues for 2002 of $32,959 million exceeded 2001 by $3,888 million, or 13.4%, primarily as a result of growth of product net revenues. Product net revenues totaled $21,979 million in 2000, $28,709 million in 2001 and $32,573 million in 2002. Product net revenues are comprised of $14,814 million in retail net revenues and $7,165 million in home delivery net revenues in 2000, $19,860 million in retail net revenues and $8,849 million in home delivery net revenues in 2001 and $22,061 million in retail net revenues and $10,512 million in home delivery net revenues in 2002. Retail net revenues include co-payments of approximately $4,036 million in 2000, approximately

 

63


Table of Contents
Index to Financial Statements

$5,537 million in 2001 and approximately $6,457 million in 2002. The $5,046 million increase in retail net revenues in 2001 was attributable to volume increases of $2,901 million and net price increases of $2,145 million. The $2,201 million increase in retail net revenues in 2002 was attributable to volume increases of $171 million and net price increases of $2,030 million. Retail price increases of $2,425 million in 2001 and $2,262 million in 2002 were primarily due to higher prices charged by pharmaceutical manufacturers and greater representation of new and higher cost drugs in the brand name prescription base. The price increases were partially offset by $280 million in 2001 and $232 million in 2002 due to steeper pricing discounts, higher rebates offered to clients and increased generic drug usage. The $1,684 million increase in home delivery net revenues in 2001 was attributable to volume increases of $1,057 million and net price increases of $627 million. The $1,663 million increase in home delivery net revenues in 2002 was attributable to volume increases of $832 million and net price increases in $831 million. Home delivery price increases of $810 million in 2001 and $1,154 million in 2002 were primarily due to higher prices charged by pharmaceutical manufacturers and greater representation of new and higher cost drugs in the brand name prescription base. The price increases were partially offset by $183 million in 2001 and $323 million in 2002 due to steeper pricing discounts, higher rebates offered to clients and increased generic drug usage.

 

Generic drug usage increased from 36.0% of total prescriptions dispensed in 2000 to 38.5% in 2001 and 40.5% in 2002. Prescription volume increased 18.8% to 537 million in 2001, reflecting a 14.7% increase in home delivery prescription volume and a 19.6% increase in retail prescription volume. Prescription volume increased 2.0% to 548 million in 2002, reflecting a 9.4% increase in home delivery prescription volume while retail prescription volume remained approximately unchanged. Higher prescription drug utilization contributed to increased volumes. The addition of UnitedHealth Group as a client in the second quarter of 2000 and the acquisition of ProVantage in June 2000 also contributed to the increase in prescription volumes and product revenues from 2000 to 2001.

 

Service revenues totaled $287 million in 2000, $361 million in 2001 and $386 million in 2002. The 2001 increase was due to $64 million in increased sales of prescription services and data to pharmaceutical manufacturers and other customers and $24 million in increased client administrative fees resulting from higher prescription volumes, partially offset by $14 million from decreasing client administrative fees on a per prescription basis. The 2002 increase resulted primarily from higher sales of prescription services and data to pharmaceutical manufacturers of $34 million, partially offset by an $11 million decline from decreasing client administrative fees on a per prescription basis.

 

Increases in utilization, changes in drug mix and inflation generated approximately 14.0% of the percentage change of product net revenues growth in 2001 compared to 2000, and 12.9% in 2002 compared to 2001. The acquisition of ProVantage in mid-year 2000 generated more than 2.0% of the percentage change of 2001 product net revenues growth over 2000. Home delivery prescription volume as a percentage of total volume including retail prescriptions approximated 14.0% in both 2000 and 2001, and approached 15.0% in 2002.

 

Total cost of revenues for 2001 of $27,787 million exceeded 2000 by $6,633 million, or 31.4%, and cost of revenues for 2002 of $31,658 million exceeded 2001 by $3,871 million, or 13.9%, primarily as a result of the 31.4% growth of cost of product net revenues in 2001 and the 14.1% growth of cost of product net revenues in 2002. Total cost of revenues includes cost of product net revenues of $21,011 million in 2000, $27,601 million in 2001 and $31,484 million in 2002. Included in cost of product net revenues are amounts representing retail co-payments of approximately $4,036 million in 2000, approximately $5,537 million in 2001 and approximately $6,457 million in 2002. Costs of revenues in 2001 and 2002 increased due to the business results addressed in the product net revenues discussion above. In addition, costs were further impacted early in 2002 by operating costs resulting from new business initiated at the beginning of the year, and reduced levels of earned rebates from pharmaceutical manufacturers. These rebates totaled $1,969 million in 2000, $2,535 million in 2001, and $2,465 million in 2002, an increase of 28.7% in 2001 and a decrease of 2.8% in 2002. The growth in 2001 reflects the volume of brand name products dispensed through our home delivery pharmacies and retail pharmacy networks, and the achievement of contractual market share rebate levels consistent with 2000. The decline in 2002 is primarily attributable to higher market share requirements in re-negotiated multi-year pharmaceutical manufacturer contracts. Also included in total cost of revenues are cost of service revenues of

 

64


Table of Contents
Index to Financial Statements

$143 million in 2000, $186 million in 2001 and $174 million in 2002. The $43 million increase from 2000 to 2001 resulted from higher prescription volumes and client installation costs, particularly driven by a $26 million increase in associated member communications materials costs, as well as an $11 million increase in costs to operate health management and other service offering programs. The $12 million decline from 2001 to 2002 is attributable to a reduction in member communications materials costs, which vary from period to period depending on the number of new client installations and plan changes of existing clients.

 

Gross margin (defined as net revenues minus cost of revenues) in 2001 of $1,284 million reflects a $172 million, or 15.5%, increase over 2000. Gross margin in 2002 of $1,301 million reflects a $17 million, or 1.3%, increase over 2001. The gross margin percent on net revenues was 5.0% in 2000, 4.4% in 2001 and 3.9% in 2002. The gross margin percent on product net revenues was 4.4% in 2000, 3.9% in 2001 and 3.3% in 2002. Pricing pressures, reduced levels of overall discounts and rebates from pharmaceutical manufacturers, and higher cost new brand products as described above together reduced margins by $120 million in 2001 and $148 million in 2002. In addition, the increased investment in technology resulted in increases in depreciation charges from $38 million in 2000 to $40 million in 2001 and to $56 million in 2002. In an effort to respond strategically to these margin pressures, we have focused on using technology to improve operational efficiencies in our prescription processing and dispensing resulting in productivity gains that have offset a portion of the margin erosion discussed above. The gross margin percentage on service revenues was 50.1% in 2000, 48.6% in 2001 and 54.9% in 2002. The decline from 2000 to 2001 is primarily due to the increased member communications costs from volume growth and client installations, the increased costs to operate the health management and other programs, and the declining client administrative fees on a per prescription basis. The improvement in the 2002 gross margin on service revenues results from the reduction in member communications materials costs.

 

Selling, general and administrative expenses for 2001 of $578 million were $95 million higher than in 2000. These expenses in 2002 were $588 million. As a percentage of net revenues, these expenses decreased over the three-year period, from 2.2% in 2000 to 2.0% in 2001 and 1.8% in 2002. The increase in 2001 reflects $31 million in expenses incurred to support increasing technology investments including Internet expansion, general business growth and expenses in preparation for compliance with the Health Insurance Portability and Accountability Act of 1996, or HIPAA. In addition, 2001 depreciation expenses exceeded 2000 by $27 million as a result of significant ongoing technology investments. The remaining expense growth of $37 million was the result of general business growth and inflation as well as additional expenses incurred to support United Health Group. The 1.6% or $10 million increase in 2002 primarily reflects $26 million in higher depreciation expenses, $14 million in higher technology related expenses, and the overall impact of inflation, partially offset by approximately $27 million in savings from the integration of ProVantage into Medco Health’s infrastructure and other cost savings initiatives. ProVantage was integrated into Medco Health in mid-year 2001, thus resulting in six months of expense in the first half of 2001, with significantly reduced expenses in the second half of 2001 and for all of 2002.

 

Amortization of goodwill was $103 million in 2000, $107 million in 2001 and $0 in 2002. In accordance with SFAS No. 142, effective December 30, 2001, goodwill is no longer amortized, but rather, is evaluated for impairment on an annual basis using a fair value based test. A fair value based test was performed at September 30, 2002 and the recorded goodwill was determined not to be impaired. Amortization of intangibles was $84 million in 2000, $85 million in 2001 and $85 million in 2002. The amortization of goodwill and intangible assets is primarily associated with the goodwill and intangibles created as a result of Merck’s acquisition of us in 1993 and pushed down to our balance sheet and, to a significantly lesser extent, our acquisition of ProVantage in 2000. See the discussion of goodwill amortization under “—Effects of Recent Accounting Pronouncements”.

 

Other (income) expense, net was $(6) million in 2000, $(5) million in 2001 and $8 million in 2002. The other (income), net in 2000 and 2001 is primarily interest income generated by short-term investments in marketable securities. The other expense amount recorded in 2002 includes $7 million in costs from the termination of two interest rate swap lock agreements originally entered into in anticipation of the notes offering in 2002, as well as expenses associated with the postponed public offering, offset by interest income.

 

65


Table of Contents
Index to Financial Statements

Merck allocated to us $25.4 million in 2000 and $26.4 million in 2001 of expenses it incurred for providing us consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. During 2002, Merck allocated to us $27.4 million of expenses and we directly incurred an additional $4.5 million for these services. By the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. We expect the total cost of these services to aggregate approximately $35 million to $40 million in 2003, including a charge from Merck of $0.4 million, and approximately $40 million to $45 million in 2004. In addition, during 2002, we incurred $7.7 million of non-recurring costs associated with our transition to operating as a separate company for systems implementation and conversion, the change of our corporate name and other matters. We expect to incur $2 million of non-recurring costs in 2003 as we complete our transition to a separate company.

 

For financial reporting purposes, we have calculated our tax provision and related deferred tax accounts in our financial statements on a separate return basis. Until completion of the distribution, we will continue to be a corporation wholly owned by Merck. Until we adopted SFAS No. 142 in 2002 and ceased to amortize goodwill, our effective tax rate was higher than our applicable combined statutory tax rate because we did not receive a tax deduction for our goodwill amortization expense. The impact of this non-deductible expense has decreased, however, because our taxable income increased as a result of growth in our operations. Accordingly, our effective tax rate (defined as the percentage relationship of provision for income taxes to income before provision for income taxes) decreased from 51.6% in 2000 to 50.5% in 2001. Our effective tax rate in 2000 and 2001, excluding the impact of goodwill amortization, would have been 41.9%. Our effective tax rate was 41.7% in 2002, or approximately equal to our combined statutory tax rate. See Note 8 to our audited consolidated financial statements included elsewhere in this information statement.

 

Net income as a percentage of net revenues was 1.0% in 2000, 0.9% in 2001 and 1.1% in 2002.

 

Transactions with Related Parties

 

We have been a wholly owned subsidiary of Merck since 1993. As a result, in the ordinary course of our business, Merck has provided us with various services, including consolidation accounting, treasury, tax, legal, public affairs, executive oversight, human resources, procurement and other services. Merck has also provided us with the services of a number of its executives and employees. Our historical financial statements include allocations by Merck of a portion of its overhead costs related to these services. These cost allocations have been determined on a basis that we and Merck consider to be reasonable reflections of the use of these services. As described above, by the end of the second quarter of 2003, we assumed responsibility for substantially all of these services and their related expenses. Costs allocated to us by Merck for services performed by Merck on our behalf totaled $25.4 million in 2000, $26.4 million in 2001, $27.4 million in 2002 and $0.4 million in the first quarter of 2003. As a result of infrastructure investments we have made in preparation for operation as a separate company, we do not expect any further cost allocations from Merck in 2003 beyond the amounts allocated in the first quarter.

 

In addition to the general and administrative costs described above, we recorded purchases of prescription drugs from Merck for sale through our home delivery pharmacies, at a price that we believe approximates the price an unrelated third party would pay. The cost of these products is included in our cost of revenues. Purchases of home delivery inventory from Merck included in cost of revenues totaled $1,106.4 million in 2000, $1,344.7 million in 2001, $1,415.0 million in 2002 and $354.2 million in the first quarter of 2003. The cost of purchases from Merck as a percentage of cost of revenues was 5.2% in 2000, 4.8% in 2001, 4.5% in 2002 and 4.4% in the first quarter of 2003. Historically, we recorded rebates from Merck in cost of revenues based upon the volume of Merck prescription drugs dispensed either by our home delivery pharmacies or through our retail pharmacy networks. The gross rebates recorded in cost of revenues as received from Merck totaled $350.5 million in 2000, $439.4 million in 2001, $443.9 million in 2002 and $110.6 million in the first quarter of 2003. In 2002, rebates from Merck accounted for approximately 15% of the rebates we earned that contributed to our net income.

 

66


Table of Contents
Index to Financial Statements

Merck has historically provided credit support arrangements and guarantees for our performance under certain client contracts and lease obligations. Under the terms of the master separation and distribution agreement with Merck, we will use commercially reasonable efforts to cause Merck to be released from those obligations.

 

We also generate revenues from sales to Merck of pharmaceutical benefit management and other services. These net revenues were $72.9 million in 2000, $99.9 million in 2001, $115.2 million in 2002 and $28.4 million in the first quarter of 2003. Revenues derived from sales to Merck were not material in relation to overall revenues in these periods.

 

In addition to the master separation and distribution agreement, prior to the completion of the distribution, we will have entered into a series of other agreements with Merck, such as an indemnification and insurance agreement, a tax responsibility allocation agreement and other related agreements which are intended to govern the ongoing relationship between us and Merck after the distribution. The aggregate fees payable to us from Merck under the other related agreements (or, in 2002, for performance of services prior to entering into these agreements) are expected to be approximately $50 million in 2003 and 2004, and approximately $35 million in 2005, subject to certain limitations. The amount earned by us in providing these services to Merck in 2002 amounted to approximately $42 million.

 

We are party to a managed care agreement with Merck. The managed care agreement includes terms related to our commitment to maintain Merck market share levels, formulary access rebates and market share rebates payable by Merck, as well as other provisions. In addition, we may be required to pay liquidated damages to Merck if we fail to achieve specified market share levels. Had this managed care agreement been in effect for all of 2002, we do not believe that it would have had a significant impact on the recorded rebates from Merck in 2002. However, the rebates that we may earn under the managed care agreement may be reduced or eliminated if we do not comply with various obligations or do not achieve various minimum or target market share levels set forth in that agreement.

 

For additional information about our relationship with Merck, see “Relationships Between Our Company and Merck & Co., Inc.”, Note 11 to our audited consolidated financial statements and Note 7 to our unaudited interim consolidated financial statements included elsewhere in this information statement.

 

Liquidity and Capital Resources

 

Net cash from operating activities was $366 million in 2000, $659 million in 2001 and $470 million in 2002. The increase from 2000 to 2001 resulted primarily from positive cash flows generated from a $377 million increase from changes in current liabilities relating to higher accounts payable for inventory purchases to support the opening of the Willingboro, New Jersey dispensing pharmacy, as well as $87 million for changes in deferred income taxes. This was partially offset by a $162 million corresponding increase from changes in inventory levels and a $40 million payment to a client related to a contractual guarantee. The decrease from 2001 to 2002 resulted from the cash flow impacts of a $553 million increase from changes in accounts receivable, primarily for rebates from pharmaceutical manufacturers and a $196 million decrease from changes in current liabilities reflecting lower accounts payable for inventory purchases. This was partially offset by a $351 million decrease from changes in inventory with 2001 reflecting the start-up inventory investments in the Willingboro, New Jersey dispensing pharmacy and an $85 million decrease from changes in other noncurrent assets with 2001 reflecting significant client implementation allowances. Net cash from operating activities was $515 million in the first quarter of 2002 compared with $517 million in the first quarter of 2003. Net cash from operating activities excludes various items paid to or by Merck on our behalf, such as tax payments made by Merck, and other items, which are reflected in the Intercompany transfer (to) from Merck, net in our cash flows from financing activities. Amounts so reflected for taxes, which represent the provision for income taxes in our consolidated statements of income, were $231 million in 2000, $262 million in 2001, $259 million in 2002, and $73 million in the first quarter of 2003. Accordingly, our net cash from operating activities does not reflect what our cash flows would have been had we been a separate company during the periods presented.

 

Cash flows used by investing activities declined by $85 million from 2000 to 2001, and by $90 million from 2001 to 2002. Investing activities were higher in 2000 as a result of the purchase of ProVantage for the net cash

 

67


Table of Contents
Index to Financial Statements

amount of $166 million. This was partially offset by $71 million in higher capital expenditures in 2001, due to technology and pharmacy infrastructure investments. The $90 million reduction in 2002 primarily results from lower capital expenditures in the amount of $87 million as the result of completion of key investment initiatives in 2001. Capital expenditure activity is discussed in further detail later in this section. Purchases and proceeds from securities and other investments remained balanced in all years, and relate to investment activity in our insurance subsidiaries. Cash flows used by investing activities declined by $33 million from the first quarter of 2002 to the first quarter of 2003 primarily due to lower capital expenditures.

 

Cash flows used by financing activities reflect Merck’s historical management of our treasury operations and cash position. Net cash provided to (received from) Merck was $(67) million in 2000, $341 million in 2001 and $232 million in 2002. The lower amount for 2000 results from cash provided by Merck to fund our purchase of ProVantage. The decrease from 2001 to 2002 in the net cash provided to Merck results from the factors discussed above for operating and investing activities. Net cash provided to Merck was $450 million in the first quarter of 2002 and $487 million in the first quarter of 2003. The increase in cash provided to Merck in the first quarter of 2003 resulted from the lower capital expenditures. Since December 30, 2001, we have been recording intercompany transactions with Merck in an intercompany account. As of the date of completion of the distribution, we will settle the balance of that account. These balances have fluctuated considerably from period to period based on the impact of the timing of billing cycles, inventory purchases and rebate activity on cash flows between Merck and us. We expect the approximately $650 million net receivable from Merck as of the end of the second quarter of 2003 to change as a result of normal recurring fluctuations. If the net intercompany receivable from Merck is less than approximately $500 million on the distribution date, we will draw a larger advance under our accounts receivable financing facility or draw advances under our revolving credit facility so that the proceeds from the senior unsecured notes offering and term loans, advances under the accounts receivable financing facility and the revolving credit facility and the net receivable from Merck are sufficient to pay the cash dividends aggregating $2 billion to Merck.

 

An important element of our cash flow is the timing of billing cycles, which are two-week periods of accumulated prescription administration billings for home delivery and retail prescriptions. We bill the cycle activity to clients on this bi-weekly schedule and generally collect before we pay our obligations to the retail pharmacies for that same cycle. We pay for drug inventory in accordance with payment terms offered by our suppliers to take advantage of appropriate discounts. Effective home delivery inventory management further generates positive cash flows.

 

Billings to pharmaceutical manufacturers for rebates are recorded as earned on a monthly basis, with actual bills generally rendered on a quarterly basis and paid by the manufacturers within an agreed upon term. Payments of rebates to clients are generally made after our receipt of the rebates from the pharmaceutical manufacturers. The amounts of rebates received from pharmaceutical manufacturers exceeded the amount of rebates paid to our clients for all historical periods presented. However, as a result of pricing pressures, the amount of rebates paid to clients and other forms of client discounts have increased at a higher rate than rebates received from manufacturers. The growth in accounts receivable, net, from $969 million at December 29, 2001 to $1,562 million at December 28, 2002 and $1,531 million at March 29, 2003 primarily results from increases in rebates receivable from pharmaceutical manufacturers. These increases are primarily attributable to new or renewed agreements that were effective in 2002 which upon initiation have required greater time for bill preparation. It is anticipated that while the pharmaceutical manufacturer rebate receivable will decrease on a going forward basis, this decrease will be offset by the future establishment of a rebate receivable from Merck. Rebate transactions with Merck are currently reflected in the “Due from Merck, net” in the Consolidated Balance Sheet.

 

Inventory decreased $143 million, or 11.9%, from December 29, 2001 to December 28, 2002, primarily due to one-time investments in inventory in 2001 to support the opening of the Willingboro, New Jersey dispensing pharmacy. Inventory decreased $130 million, or 12.2%, from December 28, 2002 to March 29, 2003, as a result of the timing of inventory receipts.

 

68


Table of Contents
Index to Financial Statements

Ongoing cash outflows are associated with expenditures to support our home delivery dispensing process, call center pharmacies and other selling, general and administrative functions, with the largest component of these expenditures being employee payroll and benefits. In the future, we expect to fund these ongoing expenditures from cash generated from operations and, to the extent necessary, from borrowings under our planned $250 million senior secured revolving credit facility and our planned $500 million accounts receivable financing facility.

 

Our capital expenditures were $251 million in 2000, $322 million in 2001 and $235 million in 2002. Our capital expenditures were $67 million in the first quarter of 2002 as compared to $34 million in the first quarter of 2003. Capital expenditures related primarily to developing new technologies and e-commerce capabilities and, in 2001, to building the new Willingboro, New Jersey home delivery facility and associated technology. In addition, the capital expenditures in the first quarter of 2002 as well as the full year 2002 reflected the impact of implementing capabilities required by HIPAA. The decrease from the first quarter of 2002 to the first quarter of 2003 results from the completion of technology initiatives associated with prescription order processing in our home delivery pharmacies and member servicing capabilities in our call center pharmacies. We expect our total capital expenditures for 2003 to be approximately $150 million, and to approximate that same level during each of the succeeding three years.

 

The increase in claims and other accounts payable of $213 million, or 14.1%, from December 29, 2001 to December 28, 2002 is associated with accounts payable for the inventory purchases and the timing of the billing cycle related to liabilities to retail pharmacies. The increase in claims and other accounts payable of $241 million, or 14.0%, from December 28, 2002 to March 29, 2003 is the result of timing of the retail pharmacy payment cycle.

 

As of December 28, 2002, we had contractual cash obligations for purchase commitments of $16 million for 2003 and $8 million for 2004, which relate primarily to contractual commitments to purchase pharmaceutical inventory from a manufacturer.

 

We lease pharmacy and call center pharmacy facilities, offices and warehouse space throughout the United States under various operating leases. In addition, we lease pill dispensing and counting machines and other operating equipment for use in home delivery dispensing facilities and computer equipment for use in our data center.

 

Total cash and short-term investments as of December 28, 2002 were $87 million, including $14 million in cash and cash equivalents. Total cash and short-term investments as of March 29, 2003 were $76.4 million, including $7.7 million in cash and cash equivalents. Our short-term investments include certificates of deposit and U.S. government securities that have maturities of not more than one year and that are held to satisfy minimum statutory capital requirements for some of our insurance subsidiaries.

 

Prior to or concurrently with the completion of the distribution, we intend to incur approximately $1,500 million in indebtedness at an estimated weighted average annual interest rate of 4.94%. Such indebtedness is expected to include $500 million in long-term fixed rate senior unsecured notes, an aggregate of $900 million in term loans under a $1,150 million senior secured credit facility and a $100 million advance under a $500 million accounts receivable financing facility. Several factors could change the weighted average annual interest rate, including but not limited to a change in our credit rating or a change in reference rates used under our credit facilities. A 25 basis point change in the weighted average annual interest rate would change our annual interest expense by $3.8 million. We will pay the entire proceeds from these transactions to Merck in the form of dividends. See “Dividend Policy”. At Merck’s request, we are paying the dividends to Merck, our sole stockholder prior to or concurrently with the completion of the distribution, as part of its plan to maximize the value of Merck’s investment in our company to Merck and its stockholders. In determining the amount of the dividends, our board of directors and Merck considered our ability to service the debt we will incur to pay the dividends and the appropriate capital structure for our company to be able to compete effectively in our industry. We may incur additional indebtedness if we draw down under the $250 million senior secured revolving credit facility or draw down further under the $500 million accounts receivable financing facility we expect to enter

 

69


Table of Contents
Index to Financial Statements

into prior to or concurrently with the completion of the distribution. It is expected that future cash flows will be adequate to service this debt and fund ongoing business operations and capital expenditures.

 

We believe that we will meet our cash requirements in 2003 and for at least each of the succeeding two to three years through cash generated from operations and, to the extent necessary, from borrowings under our planned $250 million senior secured revolving credit facility and $500 million accounts receivable financing facility.

 

Senior Secured Credit Facility.    We expect that our $1,150 million senior secured credit facility will consist of (1) a $400 million five-year term loan, (2) a $500 million seven-year term loan, and (3) a $250 million five-year revolving credit facility. The five-year revolving credit facility will provide for a letter of credit subfacility and swingline facility, drawings under which reduce the amount available under the revolving credit facility. Availability under the senior secured credit facility will be subject to various conditions precedent typical of syndicated loans, including, in the case of the revolving credit facility, the requirement that our business and its prospects have not suffered a material adverse change and the absence of any event of default. The senior secured credit facility will be secured by a pledge of the capital stock of our subsidiaries, other than our receivables subsidiary and our subsidiaries that are engaged in insurance-related activities.

 

We expect that borrowings under the senior secured credit facility will bear interest at floating rates equal, at our option in most cases, to either (1) the base rate, which is the greater of the prime rate offered by the administrative agent or the federal funds rate plus 0.50%, or (2) LIBOR, which is the rate paid on dollar deposits in the London interbank market, as adjusted for regulatory reserves, plus, in either case, an applicable margin. The applicable margin will be based on our credit ratings determined on specified reference dates. We expect the initial interest rate margins under our senior secured credit facility to be as follows:

 

     LIBOR Margin

   Base Rate Margin

Five-year revolving credit facility

   2.00%    1.00%

Five-year term loan

    2.00%     1.00%

Seven-year term loan

   2.25%    1.25%

 

Interest rates will be increased by 2% if there is an event of default. Interest on base rate loans will be payable quarterly on the last day of each March, June, September and December. Interest on LIBOR loans will generally be payable as of the last day of the interest period. We will pay a commitment fee based on the unfunded balance of the five-year revolving credit facility.

 

Scheduled repayments of amounts outstanding under the five-year term loan are expected to begin on December 31, 2003. We will repay principal on the five-year term loan in quarterly installments. Each of the first three quarterly installments will equal 2.50% of the original principal amount of the five-year term loan. We will repay an aggregate amount of 15% of the original principal amount of the five-year term loan in equal quarterly installments during the four quarters ending June 30, 2005, 20% in the four quarters ending June 30, 2006, 25% in the four quarters ending June 30, 2007 and 32.5% in the four quarters ending June 30, 2008. Scheduled repayments of amounts outstanding under the seven-year term loan are expected to begin on December 31, 2003 and we will repay principal in quarterly installments each equal to 0.25% of the original principal amount of the seven-year term loan, with the remaining 93.5% of the original principal amount of the seven-year term loan due on the final maturity date.

 

We will be permitted to prepay the term loans and to permanently reduce revolving credit commitments, in whole or in part, at any time without penalty. However, if a prepayment of principal is made with respect to a LIBOR loan on a date other than the last day of the applicable interest period, we will be required to compensate the lenders for losses and expenses incurred as a result of the prepayment. Amounts prepaid at our option will be applied, at our discretion, to prepay the term loans or revolving loans. Additionally, we will be required to make mandatory prepayments of the loans, subject to certain exceptions, in amounts equal to (1) 100% of the net cash proceeds of all asset sales or other dispositions of property, subject to our option to reinvest in the business within twelve months of the receipt of such proceeds, (2) 50% of annual excess cash flow (reducing to zero upon

 

70


Table of Contents
Index to Financial Statements

our reaching credit ratings of at least both BBB- by Standard & Poor’s Ratings Service, a division of The McGraw-Hill Companies, Inc., or S&P, and Baa3 by Moody’s Investors Service, Inc., or Moody’s), and (3) 100% of the net cash proceeds of issuances of debt obligations (reducing to zero upon our reaching credit ratings of at least both BBB- by S&P and Baa3 by Moody’s). Mandatory prepayments will be applied first pro rata to the term loans, provided that the seven-year term loan lenders may elect that their portion of proceeds be allocated to prepay the five-year term loan in full prior to the prepayment of the seven-year term loan, and second to outstanding loans under the revolving credit facility.

 

The senior secured credit facility will require us to meet certain financial tests, including without limitation a maximum leverage ratio and a minimum fixed charge coverage ratio. In addition, the senior secured credit facility will contain certain covenants customarily included in such agreements, including without limitation covenants that restrict or limit our and our subsidiaries’ ability to:

 

    incur additional indebtedness;

 

    incur liens on property or assets;

 

    enter into sale and leaseback transactions;

 

    dispose of assets;

 

    make fundamental changes in our corporate existence and our principal business;

 

    make acquisitions, investments and capital expenditures;

 

    pay dividends;

 

    make restricted payments;

 

    engage in transactions with affiliates;

 

    enter into agreements that restrict corporate activities;

 

    prepay or redeem any subordinated debt we may incur or amend agreements governing such subordinated debt; and

 

    use derivative instruments.

 

The credit agreement governing the senior secured credit facility is subject to ongoing negotiation. We cannot be certain the terms described herein will not change or be supplemented.

 

Accounts Receivable Financing Facility.    The $500 million accounts receivable financing facility will be secured by our pharmaceutical manufacturer accounts receivable, which will be sold to our receivables subsidiary. The amount of borrowings available under the accounts receivable financing facility will be based upon the amount of eligible accounts receivable, our senior unsecured debt credit rating and other terms and conditions. We expect to have between $250 million and $400 million available for working capital and general corporate purposes at the completion of the distribution. Availability will fluctuate over time given changes in eligible receivable balances.

 

The financing cost associated with the accounts receivable financing facility will depend on whether advances are funded through commercial paper conduits.

 

    To the extent advances are funded through commercial paper conduits, our cost will be based on the commercial paper conduits’ cost of funds for issuing commercial paper plus a usage fee.

 

    To the extent advances are not funded through commercial paper conduits, but instead are funded directly by the other financial institutions participating in the facility, our financing costs will be based on reserve-adjusted LIBOR plus 1.50%, or if LIBOR is unavailable, the lender’s alternate base rate.

 

In addition, we will pay a commitment fee based on the unfunded balance of the accounts receivable financing facility.

 

71


Table of Contents
Index to Financial Statements

A downgrade of our senior unsecured debt rating below certain thresholds will increase pricing on, and decrease availability under, the accounts receivable financing facility. In addition, the accounts receivable financing facility will require us to meet the same financial tests that we are required to meet under our senior secured credit facility.

 

The Financial Accounting Standards Board recently issued its Interpretation No. 46, which may affect the way in which sponsors, in this case the lending banks, account for their commercial paper conduits. Changes in accounting, if any, required of the conduit sponsors could result in increased regulatory capital or other costs for the sponsors of funding in the commercial paper conduit, which increased costs will be passed through to us. It is also possible that as a result of these accounting changes one or more of the commercial paper conduits may elect to discontinue funding, requiring our receivables subsidiary to obtain all or a portion of the financing directly from the other financial institutions participating in the accounts receivable financing facility. Consequently, the accounts receivable financing facility could become more expensive to us.

 

The agreements governing the accounts receivable financing facility are subject to ongoing negotiation. We cannot be certain the terms described herein will not change or be supplemented.

 

Senior Unsecured Notes.    Interest on the $500 million aggregate principal amount of ten-year senior unsecured notes will accrue at a fixed rate and will be payable semi-annually in arrears.

 

We will be able to redeem some or all senior unsecured notes at any time. If the senior unsecured notes are redeemed prior to maturity, the redemption price will be equal to the greater of (1) 100% of the principal amount of the senior unsecured notes to be redeemed plus accrued interest to the date of redemption, and (2) the sum of the present values of the principal and interest on the senior unsecured notes to be redeemed (assuming they remained outstanding to maturity), discounted to the redemption date in accordance with standard market practice at the treasury rate plus a specified number of basis points. On or before the third anniversary of the issuance of the senior unsecured notes, we may, on one or more occasions, redeem up to 35% of the senior unsecured notes issued under the indenture with the proceeds of one or more equity offerings at a price equal to a specified percentage of their principal amount plus accrued and unpaid interest to the redemption date. If we sell assets under some circumstances or experience a change of control resulting in a decline by at least one notch in or withdrawal of the rating of the notes by Standard & Poor’s Ratings Group or Moody’s Investors Service, Inc., we must offer to repurchase all of the senior unsecured notes at a price equal to 100% or 101%, respectively, of the principal amount plus accrued and unpaid interest to the repurchase date. We will not be required to make sinking fund payments with respect to the senior unsecured notes.

 

The terms of the indenture under which the senior unsecured notes will be issued will contain covenants that restrict our and our subsidiaries’ ability to:

 

    borrow money and issue preferred stock;

 

    pay dividends on our stock or repurchase our stock;

 

    make investments;

 

    create liens;

 

    enter into sale and leaseback transactions;

 

    create restrictions on the ability of our restricted subsidiaries to pay dividends or other amounts to us;

 

    engage in certain transactions with affiliates;

 

    consolidate, merge or sell all or substantially all of our assets; and

 

    designate our subsidiaries as unrestricted subsidiaries.

 

72


Table of Contents
Index to Financial Statements

Most of these covenants will cease to be applicable if the senior unsecured notes attain investment grade status and we are not in default under the notes and the indenture, which we refer to as a fall away event. However, after a fall away event, covenants contained in the indenture will, among other things, limit:

 

    the ability of our restricted subsidiaries to borrow money and issue preferred stock; and

 

    our ability and the ability of our restricted subsidiaries to:

 

    create liens;
    enter into sale and leaseback transactions; and
    consolidate, merge or sell all or substantially all of our or their assets.

 

If a fall away event occurs, the protections afforded to the holders of the senior unsecured notes by the covenants that have been released will not be restored, even if the credit rating on the notes subsequently falls below investment grade.

 

The notes have been authorized to be listed on the New York Stock Exchange under the symbol “MHS 13”.

 

Contractual Obligations

 

The following table presents certain of our contractual obligations as of December 28, 2002, as well as our pro forma long-term debt obligations, including the current portion of long-term debt, after giving effect to the senior unsecured notes offering and the term loans under our senior secured credit facility.

 

Payments due by Period

 

     Total

   2003

   2004-
2005


   2006-
2007


   Thereafter

     (in millions)

Long-term debt obligations, including current portion (Pro forma)

   $ 1,400.0      —      $ 131.3    $ 168.7    $ 1,100.0

Operating lease obligations

     108.4    $ 44.4      37.7      13.5      12.8

Purchase obligations

     24.0      16.0      8.0      —        —  
    

  

  

  

  

Total

   $ 1,532.4    $ 60.4    $ 177.0    $ 182.2    $ 1,112.8
    

  

  

  

  

 

Interest Rate and Foreign Exchange Risk

 

Interest Rate Risk.    On June 13, 2002, two interest rate swap lock agreements were entered into on our behalf in expectation of the completion of a then-planned $1,000 million notes offering. On June 28, 2002, these swap agreements were terminated in accordance with their terms at a cost of $7 million. Except as described above, we have not yet implemented a comprehensive strategy to manage interest rate market risk. We will assess the significance of interest rate market risk on a periodic basis and will implement strategies to manage risk as appropriate. We do not expect our cash flows to be affected to any significant degree by a sudden change in market interest rates.

 

Foreign Exchange.    We operate our business within the United States and Puerto Rico and execute all transactions in U.S. dollars.

 

Effects of Recent Accounting Pronouncements

 

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS No. 146), which is effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. We adopted this standard on January 1, 2003 and it did not have a material effect on our results of operations, cash flows or financial position.

 

73


Table of Contents
Index to Financial Statements

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45). FIN 45 requires that a liability be recorded in the guarantor’s balance sheet at fair value upon issuance of certain guarantees. The recognition provisions of FIN 45 are effective for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ended after December 15, 2002. We have determined that the guarantees we offer to our clients are outside the scope of FIN 45, as these guarantees relate to our own future performance under contractual agreements with our clients. As such, the adoption of FIN 45 did not have a material impact on our results of operations, cash flows or financial position.

 

In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21, “Revenue Arrangements With Multiple Deliverables” (EITF 00-21), which is effective for contracts entered into after June 15, 2003. EITF 00-21 establishes the criteria under which individual components of contractual arrangements with customers could be identified as “separate units of accounting” and accounted for as distinct revenue-generating events under the existing accounting standards governing revenue recognition, including SAB 101. Customers who contract with us for pharmaceutical benefits management may also contract with us for administrative and other services. These multiple deliverables are generally reflected in a single contract. Each component of the contract is separately and specifically priced, and has historically been accounted for as a separate unit of accounting for revenue recognition purposes. We, therefore, do not expect the adoption of EITF 00-21 in 2003 to have a material impact on our results of operations, cash flows or financial position.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation  —Transition and Disclosure—an amendment to SFAS No. 123” (SFAS No. 148) which provides alternative methods of transition for companies voluntarily planning on implementing the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123). SFAS No. 148 also revises the disclosure provisions of SFAS No. 123 to require more prominent disclosure of the method of accounting for stock-based compensation, and requires disclosure of pro forma net income and earnings per share as if the fair value recognition provisions of SFAS No. 123 had been applied from the original effective date of SFAS No. 123. We have adopted the disclosure provisions of SFAS No. 148.

 

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. We do not have any variable interest entities which would require consolidation under FIN 46. Accordingly, the adoption of FIN 46 did not have a material impact on our results of operations, cash flows or financial position.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

We previously have been a part of Merck’s consolidated group, whose financial statements for each of the years ended December 31, 2000 and 2001 were audited by Arthur Andersen LLP. On February 26, 2002, the board of directors of Merck and its audit committee dismissed Arthur Andersen LLP as its independent public accountants and engaged PricewaterhouseCoopers LLP to serve as its independent public accountants for the fiscal year 2002. On February 26, 2002, PricewaterhouseCoopers LLP was engaged as our independent public accountants for the year ended December 29, 2001, and prior to that date, Arthur Andersen LLP was engaged as our independent public accountants for the year ended December 30, 2000.

 

Arthur Andersen LLP’s reports on our consolidated financial statements for the year ended 2000, included elsewhere in this information statement, did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

 

During the years ended December 30, 2000 and December 29, 2001 and through the date of this information statement, there were no disagreements with Arthur Andersen LLP on any matter of accounting principle or

 

74


Table of Contents
Index to Financial Statements

practice, financial statement disclosure, or auditing scope or procedure which, if not resolved to Arthur Andersen LLP’s satisfaction, would have caused them to make reference to the subject matter in connection with their report on our consolidated financial statements for such years; and there were no reportable events as set forth in applicable SEC regulations.

 

We provided Arthur Andersen LLP with a copy of the above disclosures. In a letter dated April 17, 2002, Arthur Andersen LLP confirmed its agreement with these statements.

 

During the years ended December 30, 2000 and December 29, 2001 and through the date of their engagement, we did not consult PricewaterhouseCoopers LLP with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our consolidated financial statements, or any other matters or reportable events as set forth in applicable SEC regulations.

 

On June 15, 2002, Arthur Andersen LLP was convicted of federal obstruction of justice charges arising from the government’s investigation of its role as auditors for Enron Corp. None of the Arthur Andersen LLP personnel who were involved with the Enron account were involved with the audit of our financial statements for the year ended December 30, 2000.

 

Arthur Andersen LLP did not participate in the preparation of the registration statement on Form 10 of which this information statement is a part, or reissue its report, dated April 8, 2002, on our 2000 financial statements included in this information statement. You are unlikely to have any effective remedies against Arthur Andersen LLP in connection with a material misstatement or omission in these financial statements. See “Risk Factors—Risks Relating to Arthur Andersen LLP—You may have no effective remedy against Arthur Andersen LLP in connection with a material misstatement or omission in our 2000 financial statements included in this information statement”.

 

Although we do not believe that the conviction of Arthur Andersen LLP will materially adversely affect us, should we seek to access the public capital markets after we complete the distribution, SEC rules will require us to include or incorporate by reference in any prospectus three years of audited financial statements. Until our audited financial statements for the year ending December 27, 2003 become available in the first quarter of 2004, the SEC’s current rules would require us to present audited financial statements for one year audited by Arthur Andersen LLP. On August 31, 2002, Arthur Andersen LLP ceased practicing before the SEC, but the SEC has continued to accept financial statements audited by Arthur Andersen LLP. However, if the SEC ceases to accept financial statements audited by Arthur Andersen LLP, we would be unable to access the public capital markets unless PricewaterhouseCoopers LLP, our current independent accounting firm, or another independent accounting firm, is able to audit our 2000 financial statements, which Arthur Andersen LLP originally audited.

 

Additionally, Arthur Andersen LLP cannot consent to the inclusion or incorporation by reference in any prospectus of their report on our audited financial statements for the year ended December 30, 2000, and investors in any future offerings for which we use their audit report will not be entitled to recovery against them under Section 11 of the Securities Act of 1933 for any material misstatements or omissions in those financial statements. We may not be able to bring to the market successfully an offering of our securities in the absence of Arthur Andersen LLP’s participation in the transaction, including its consent. Consequently, our financing costs may increase or we may miss attractive market opportunities if either our annual financial statements for 2000 audited by Arthur Andersen LLP should cease to satisfy the SEC’s requirements or those statements are used in a prospectus but investors are not entitled to recovery against our auditors for material misstatements or omissions in them. See “Risk Factors—Risks Relating to Arthur Andersen LLP—Our inability to include in future registration statements financial statements for one or more years audited by Arthur Andersen LLP or to obtain Arthur Andersen LLP’s consent to the inclusion of their report on our 2000 financial statements may impede our access to the capital markets after completion of the distribution”.

 

75


Table of Contents
Index to Financial Statements

BUSINESS

 

Overview of the Company

 

We are the nation’s largest PBM based on our 2002 net revenues. We provide sophisticated programs and services for our clients and the members of their pharmacy benefit plans, as well as for the physicians and pharmacies the members use. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We accomplish this primarily by negotiating competitive rebates and discounts from pharmaceutical manufacturers, obtaining competitive discounts from retail pharmacies and administering prescriptions filled through our national networks of retail pharmacies or our own home delivery pharmacies. We believe that our ability to consistently deliver high-quality service while effectively managing drug costs for our clients and their members has made us a market leader.

 

We actively pursue initiatives to reduce the rate of increase in our clients’ drug spend, commonly referred to as “drug trend”, to save members money and to improve the services we provide both clients and their members. Our pre-eminent home delivery business reduces drug costs for our clients and provides enhanced reliability and service to members. In 2002, our national network of home delivery pharmacies filled approximately 82 million prescriptions, representing about 30% more than the number of prescriptions filled by the mail service operations of our three largest competitors, AdvancePCS, Caremark Rx, Inc. and Express Scripts, Inc., combined. We seek to contain costs for our clients and their members by encouraging the use of medically appropriate generic drugs through our generic education and substitution programs. For example, within one month of a generic equivalent becoming available for Prinivil, we achieved a substitution rate of approximately 90% for prescriptions filled by our home delivery pharmacies. Our high-quality service, advanced technology and cost containment initiatives enabled us to limit the average drug trend for plans that include both retail and home delivery to 14.0% in each of 2000 and 2001 and 12.9% in 2002, compared to the national average of 17.3% in 2000, 15.7% in 2001, and an estimated 14.3% in 2002 as reported by CMS.

 

We have a large number of clients in each of the major industry segments, including Blue Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. As of June 2003, the plans we administered for our clients covered 190 of the Fortune 500, including 52 of the Fortune 100, 12 of the country’s 42 Blue Cross/Blue Shield plans and several large managed care organizations. In addition, our Systemed, L.L.C. subsidiary capitalizes on our extensive PBM capabilities to meet the specific needs of small to mid-size clients. Over the last three years, our aggregate revenue from small to mid-size clients increased an average of approximately 39% per year, excluding the impact of acquisitions, to approximately $1.6 billion in 2002.

 

The advanced technology and infrastructure we have developed in-house is instrumental to our ability to drive growth, improve service and reduce costs. Our technology platform seeks to integrate prescription management and processing, including electronic prescribing tools, seamlessly with our client and member services. The cornerstones of our home delivery technology platform are our two automated dispensing pharmacies in Las Vegas, Nevada and Willingboro, New Jersey. The accuracy of prescriptions dispensed from these facilities, which use our patented technology, exceeds Six Sigma levels, the highest industry quality standard, which requires at least a 99.99966% accuracy rate. At our specialized call center pharmacies, our experienced service representatives and consulting pharmacists use advanced technology to speed service and provide members personalized prescription and health information. For example, interactive voice recognition technology allows members to enroll for home delivery service, process a home delivery order, track the status of their home delivery order, or locate an in-network retail pharmacy in their area. Advanced imaging technology enables service representatives to access an online image of a member’s prescription to service that member more efficiently. Our data center links our dispensing and call center pharmacies, the retail pharmacies in our networks and our websites. As a result, our data center enables us to receive, process and administer claims and dispense prescription drugs efficiently.

 

We also seek to improve client and member service and reduce their costs, as well as our own, by providing important health care information and an efficient means of communication through our proprietary Internet

 

76


Table of Contents
Index to Financial Statements

solutions. For clients, members and pharmacists, we support distinct websites that provide critical benefit and medical information and we offer customized interactive tools aimed at facilitating compliance with benefit plan goals and simplifying benefit administration. comScore-Media Metrix ranked our member website fourth among health sites in number of users over age 55 and eleventh among health sites in overall visitors. In 2002, through our member website, we processed more than 10.8 million prescriptions, a 51% increase over 2001.

 

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 life for members. Our services focus on:

 

    Providing customized plan design. We also offer ongoing consulting services and model clinical and financial outcomes for clients based on plan design and formulary choices.

 

    Enhancing formulary compliance through physician, client and member communications and education programs, including therapeutic brand-to-brand interchange programs directed at physicians. The use of multi-tiered co-payment and other cost-sharing payment structures and increased use of our home delivery pharmacy service further enhance formulary compliance.

 

    Effectively managing drug utilization, a key factor in controlling drug trend, through a wide range of trend management tools, including drug utilization review programs and rules governing the conditions under which drugs are covered. We also have clinically based programs that identify particular categories of questionable drug claims based on clinical rules that our clients use for coverage criteria. These rules have the potential to reduce unnecessary use while disrupting fewer claims compared with more commonly utilized and less precise rules.

 

From 1998 to 2002, our net revenue increased on average approximately 26.4% per year. In 2002, we filled or processed approximately 548 million prescriptions, had net revenues of approximately $33 billion and net income of more than $360 million, and had earnings before interest income/expense, taxes, depreciation and amortization, or EBITDA, of approximately $886 million. See Note 6 under “Selected Historical Consolidated Financial and Operating Data” for a further description of EBITDA and a table that reconciles net income to EBITDA. Our net income is driven by our ability to earn rebates and negotiate favorable discounts on prescription drugs from pharmaceutical manufacturers, negotiate competitive client pricing, including rebate sharing terms, and provide services in a cost-efficient manner.

 

Industry Overview

 

Prescription drugs are the fastest growing component of health care costs in the United States. According to CMS, drug expenditures in the United States totaled over $160 billion during 2002, the cost of prescription drugs is expected to rise on average approximately 11% per year over the next nine years and total expenditures could reach 14.5% of all health care costs by 2012, up from 9.9% in 2001.

 

We believe the key drivers of drug trend include:

 

    significant advances in pharmaceutical and biotechnology research and development, which are leading to the introduction of drugs that offer better safety and efficacy than previously available drugs and address previously unmet medical needs;

 

    the introduction of product line extensions, such as products reformulated to improve dosing convenience or optimize the duration of a drug’s action;

 

    higher costs for some new drug therapies or biotechnology drugs that require complex research and development or manufacturing; and

 

    increased patient awareness and demand accelerated by education campaigns and direct-to-consumer advertising by pharmaceutical manufacturers.

 

77


Table of Contents
Index to Financial Statements

Increased generic substitution is partially offsetting the rise in drug spend. Between 2003 and 2006, patents are expected to expire on approximately 40 major brand name drugs that generated aggregate U.S. sales of approximately $32.6 billion in 2002. Generic substitution for drugs on which patents have expired is a significant factor in moderating drug spend increases, especially as efforts by payors, such as our clients, and generic drug manufacturers have led to an acceleration of generic drug substitution following the end of a drug’s marketing exclusivity.

 

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

 

PBMs provide management and other services for outpatient drug benefits on behalf of their clients to an estimated 200 million Americans, according to the U.S. General Accounting Office. These services include:

 

    design and implementation of formularies, which are lists of preferred drugs from which a PBM’s client’s members and their physicians can choose;

 

    large-scale, highly automated claims adjudication with retail and home delivery pharmacies;

 

    negotiated discounts and rebates from pharmaceutical manufacturers and discounts from drug wholesalers and retail pharmacies;

 

    increasingly, home delivery pharmacies; and

 

    programs to promote safe, economical use of pharmaceuticals and adherence to regimens to control health conditions.

 

Areas of potential growth for the PBM industry include increased use of available programs and services by existing clients, as well as entry or expansion in the specialty drugs, information services and disease management markets. For example, we believe there is an opportunity to substantially increase the use of home delivery pharmacies by members who use maintenance medications to treat chronic medical conditions. Home delivery pharmacies currently fill only approximately 13% of total prescription drug sales in the United States, an increase from approximately 12% in 2001. Favorable demographics and increasing home delivery capabilities should enable this trend to continue.

 

We believe that future growth within the PBM industry will also be driven by penetration of untapped segments of the overall U.S. prescription drug market. For example, the industry is carefully monitoring various bills recently passed by both Houses of Congress to provide Medicare recipients with outpatient drug benefits. Covering approximately 40 million Americans, Medicare represents both opportunity and risk for PBMs, depending on their eventual role, if any, and their ability to help shape the structure of the prescription drug benefit. Legislative proposals in state legislatures to provide outpatient drug benefits to recipients of state-funded health programs represent similar opportunities and risks. See “Risk Factors—Risks Relating to Our Industry—Government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers”. The non-insured market is another segment of the prescription drug market that represents a growth opportunity for the PBM industry. The non-insured market represents sales of prescription drugs to individuals who do not have a prescription drug plan, as well as sales of prescription drugs that are not covered by a member’s prescription drug plan.

 

78


Table of Contents
Index to Financial Statements

Business Strategy

 

Our vision is to be an effective force in controlling health care costs for our clients and supporting improved patient care through the appropriate use of prescription drugs. We intend to achieve our objectives by successfully executing the following strategies:

 

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

 

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

 

Our specialized call center pharmacies offer clients, members, pharmacists and physicians access 24 hours a day, seven days a week to service representatives and consulting pharmacists. As of May 1, 2003, we had approximately 300 pharmacists and approximately 2,400 service representatives who work in our seven call center pharmacies. Our website also contains tools and information that can be used by clients, members, pharmacists, physicians and the general public.

 

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

 

We continue to encourage physician adoption of electronic prescribing, which involves physicians using hand-held devices and other electronic prescription tools to write prescriptions for members over the Internet. We

 

79


Table of Contents
Index to Financial Statements

believe that linking the physician electronically with the pharmacist and the member’s health data and prescription benefit will improve convenience and enhance quality of care. Electronic prescribing also reduces costs for plan sponsors by improving the speed and accuracy of ordering prescriptions and increasing formulary compliance, generic substitution and other drug utilization management services. Physicians are also likely to benefit from electronic prescribing because it simplifies the prescription process and improves the quality of patient care by giving physicians real-time access to a patient’s plan guidelines and prescription history to prevent adverse drug interactions and duplicate therapies. We believe that a universal channel is needed to provide a uniform industry standard for coding, collecting and transferring pharmacy-related information. We have formed RxHub with AdvancePCS and Express Scripts, Inc. to help develop this capability. RxHub has created a standardized electronic prescribing platform, enabling physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plans. In addition, we have alliances with several point-of-care businesses that allowed us to process approximately 1.6 million electronic prescriptions in 2002.

 

Actively pursue sources of growth from new clients and increased use of our value-added services, including our home delivery pharmacies.    We believe our high-quality service model and drug trend management track record will enable us to continue to attract new clients in the large client segment. Large clients include Blue Cross/Blue Shield plans, managed care organizations and insurance carriers. Through our Systemed, L.L.C. subsidiary, we continue to expand our business in the small and mid-size client market.

 

We also believe we have an opportunity to increase our home delivery volume substantially. Of a potential user base of approximately 20.5 million members who use maintenance medications to treat chronic medical conditions and whose plans offer them the option of using retail or home delivery, only approximately 4.7 million members currently use home delivery. We will continue to seek to convert members who currently use retail pharmacies for maintenance medications to our home delivery service. Filling a prescription through our home delivery pharmacy reduces costs to our clients by increasing formulary compliance and, where appropriate, generic substitutions. We believe that our home delivery pharmacy increases member satisfaction due to the convenience of receiving a 90-day supply of a drug instead of the 30-day supply generally dispensed by retail pharmacies, as well as the typical annual cost savings associated with reduced co-payments.

 

We offer our clients a comprehensive suite of cost-management programs and services, which include prescriber management products and RationalMed, our proprietary service that analyzes patients’ prescription, medical and laboratory records to determine whether a prescription drug could be harmful. Through the use of these products and services, several of our significant clients limited their drug trend to less than 10% in 2002. We promote the use of these programs and services with our new clients and our existing clients who have not yet implemented them.

 

Selectively form strategic alliances and expand into complementary, adjacent markets.    While our principal focus has been to expand our business through internal growth, we have also made targeted acquisitions and entered into strategic alliances. We intend to continue to expand into new markets and selectively form alliances and make targeted acquisitions to complement our internal growth. Typically, the objectives of these transactions were to expand our core business, to enter new markets and/or to acquire specific products and capabilities. Examples include our acquisitions of ProVantage, which enhanced our clinical capabilities and increased our presence in the third-party administrator market, and Systemed, L.L.C., which provided us with an infrastructure to expand our small to mid-size client base. Another example is our RxHub joint venture that we formed with two other PBMs to help further develop electronic prescribing technology.

 

Competitive Advantages

 

We believe we have several competitive advantages that enable us to deliver enhanced service to clients and their members while effectively managing drug trend for our clients. These advantages also enabled us to limit the average drug trend for plans that include both retail and home delivery to 14.0% in each of 2000 and 2001 and 12.9% in 2002, compared to the national average of 17.3% in 2000, 15.7% in 2001 and an estimated 14.3% in 2002 as reported by CMS.

 

80


Table of Contents
Index to Financial Statements

We believe our competitive advantages include the following:

 

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

 

In 2002, our national network of home delivery pharmacies filled approximately 30% more prescriptions than the mail service operations of our three largest competitors, AdvancePCS, Caremark Rx, Inc., and Express Scripts, Inc., combined. The cornerstones of our home delivery pharmacy service are our two automated dispensing pharmacies. The accuracy of prescriptions dispensed from these facilities, which use our patented technology, exceeds Six Sigma levels, the highest industry quality standard, which requires at least a 99.99966% accuracy rate. During the first half of 2003, these two automated pharmacies collectively dispensed approximately 1.4 million prescriptions per week.

 

Our investments in technology are reducing costs and providing enhanced client and member service.    We have designed our technology to anticipate and respond quickly to client, member, physician and pharmacist needs and to reduce costs. We have invested in a new generation of technology to allow our specialized call center pharmacies to provide faster service and enhance the access our service representatives have to member information. Our integrated voice-response phone system allows members to enroll for home delivery service, submit a home delivery order for processing, track the status of their home delivery order, or locate an in-network retail pharmacy in their area. In addition, our two automated pharmacies enable our staff pharmacists to focus on member needs and increase accuracy in filling prescriptions. We also encourage physicians to use online point-of-care technologies that reduce costs for clients by improving the speed and accuracy of ordering prescriptions and increasing the effectiveness of drug utilization management services such as formulary compliance and generic substitution. We have implemented a suite of user-friendly web-based applications that provide clients with sophisticated reporting, analytical and communications capabilities to enable them to more effectively control the cost and quality of the prescription drug benefits they provide. In addition, we have a comprehensive, user-friendly member website, which comScore-Media Metrix ranked fourth among health sites in number of users over age 55 and eleventh among health sites in overall visitors. In 2002, through our member website, we processed more than 10.8 million prescriptions, a 51% increase over 2001.

 

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

 

    Providing customized plan designs.    We customize plan designs to meet the specific objectives of clients. We also offer ongoing consulting services and model clinical and financial outcomes for clients based on plan design and formulary choices.

 

    Enhancing formulary compliance.    We enhance formulary compliance through physician, client and member communications and education programs, including therapeutic brand-to-brand interchange programs directed at physicians. We can create incentives for members to use formulary compliant drugs through the use of multi-tiered co-payment and other cost-sharing payment structures. Also, our home delivery pharmacy service can further enhance formulary compliance because our pharmacists at our prescription processing centers can review incoming prescriptions and then encourage physicians to prescribe formulary compliant drugs prior to approving and dispensing the prescription.

 

81


Table of Contents
Index to Financial Statements
    Effectively managing drug utilization, a key driver of drug trend.    Our wide range of drug trend management tools includes drug utilization review programs and rules governing the conditions under which drugs are covered. Our clinically based programs identify drug claims on the basis of clinical rules that our clients use for coverage criteria. These rules have the potential to reduce unnecessary drug use while disrupting fewer claims compared with more commonly utilized and less precise rules. In addition, we use our specialized call center pharmacies to encourage physicians to reduce costs through dose optimization, generic substitution and the interchange of formulary compliant drugs for non-formulary compliant drugs.

 

    Offering convenience to members.    Dedicated service representatives and pharmacists at our call center pharmacies use advanced imaging technology and Internet capabilities to access a member’s prescription and health information to provide faster and more efficient service. Our comprehensive member website and integrated voice-response phone system allow members to obtain individualized patient information and use our home delivery pharmacy service.

 

    Providing enhanced personalized service to members.    Our Specialty Pharmacy Center of Excellence, opened during the first quarter of 2003 within our Columbus, Ohio home delivery pharmacy, provides an enhanced level of personalized service to members requiring specialty medicines. The Specialty Pharmacy provides more than 100 medications for 20 disease states, including hemophilia, rheumatoid arthritis, cancer, multiple sclerosis and Hepatitis C. These medications often require sophisticated methods of administration and handling, which we are able to provide through our Specialty Pharmacy.

 

Our Pharmacy and Therapeutics Committee and Medical Advisory Board play an integral role in creating and administering our value-added programs and services. Our Pharmacy and Therapeutics Committee and Medical Advisory Board operate independently of us and Merck, and are each comprised of a distinguished group of clinicians. The Pharmacy and Therapeutics Committee guides us in maintaining a consistent and therapeutically appropriate approach to the administration of our clients’ drug benefit, including the development of formularies, prescribing guidelines, coverage criteria and drug utilization review interventions. Our Medical Advisory Board reviews and evaluates the clinical relevancy, impact and effectiveness of all our health management programs and services.

 

Our comprehensive generic substitution programs save our clients money.    The substitution of medically appropriate generic drugs for brand name drugs helps contain client and member prescription drug costs. Generic drugs save both clients and their members money because they are less expensive and generally require lower  co-payments than brand name drugs. Our Generics FirstSM program offers physicians the opportunity to obtain free generic samples and information on the use of generic drugs and educates physicians, clients and members about the cost savings and therapeutic equivalency of generic drugs. Other aspects of our integrated generics strategy include alerting physicians of the availability of a medically appropriate generic substitute and substituting generic drugs as soon as legally permissible, generally when the marketing exclusivity on the brand name drug ends. For example, within two weeks of a generic equivalent becoming available for Glucophage, we achieved a substitution rate of over 91% for prescriptions filled by our home delivery pharmacies. Between 2003 and 2006, patents are expected to expire on approximately 40 major brand name drugs that generated aggregate U.S. sales of approximately $32.6 billion in 2002.

 

We have a deep and experienced management team.     Our management team has extensive experience in the PBM and health care industries and has established long-standing relationships with key constituents. David B. Snow, Jr., who has over 25 years of health care industry experience, was recently appointed as our new Chairman, President and Chief Executive Officer.

 

Programs and Services

 

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

 

82


Table of Contents
Index to Financial Statements

Plan Design

 

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

 

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

 

The following are descriptions of key plan design elements:

 

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

 

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

 

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

 

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

 

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

 

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

 

Clinical Management

 

Increases in the utilization rate of prescription drugs typically account for a significant portion of the rise in drug trend. Increased utilization rates are attributable to, among other things, the commercialization of new drugs and increased patient awareness and demand. We capitalize on our clinical expertise and advanced information

 

83


Table of Contents
Index to Financial Statements

technology infrastructure to help reduce client costs in a medically appropriate way, while striving to improve safety and the quality of care for members. We do this by developing action-oriented clinical programs and services that are reviewed by our Pharmacy and Therapeutics Committee, comprised of a distinguished group of independent clinicians. Once developed, these programs are integrated into a client’s pharmacy benefit plan. To monitor our success with these programs, we regularly consult with clients, review their clinical and financial data, and report to clients on the success of our actions on their behalf.

 

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

 

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

 

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

 

We have introduced a variety of innovative programs. One of these is our proprietary RationalMed service, an advanced software tool designed to reduce unnecessary drug-induced illness and hospitalizations and reduce overall health care expenses. We offer the RationalMed service to our PBM clients and to other health care providers. RationalMed analyzes patients’ available prescription, inpatient and outpatient medical and laboratory records to indicate whether a prescription drug could be harmful to them. Clients who implement the RationalMed technology can save money by reducing inappropriate prescription use and avoiding unnecessary medical costs, including possible hospitalization.

 

Drug Utilization Reviews.    We conduct drug utilization reviews, or DURs, which are systematic evaluations of individual or group use of prescription drugs, to help clients identify and address overuse, underuse, and misuse of prescription drugs. Concurrent DUR provides real-time online decision support for pharmacists at the point-of-sale that improves quality of care while lowering drug cost by reducing inappropriate dispensing. Our DURs alert us of possible interactions—including drug-drug, drug-age, and drug-pregnancy—based on our patient profiles. Retrospective DUR looks at prescription use over time to help identify and change patterns of prescribing drugs that are not formulary compliant, or prescribing brand name drugs where there may be medically appropriate generic equivalents. Our Physician Practice Summaries identify physicians who demonstrate a pattern of non-compliant prescribing with the goal of changing prescribing behavior.

 

Pharmacy Management

 

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

 

Retail Pharmacy Networks.    We have contractual relationships with approximately 60,000 independent and chain retail pharmacies that have agreed to participate in one or more of our retail network options. A network offers members access to a choice of pharmacies while providing clients with cost savings through contracted discount rates that we negotiate with retail pharmacies. In general, these rates for brand name drugs are at a

 

84


Table of Contents
Index to Financial Statements

discount to the average wholesale price of the drug, which is a standard pricing unit used in the industry. In addition, we determine a maximum allowable cost for each type of generic drug. Clients generally select a retail pharmacy network based on the number and location of pharmacies in the network and the competitiveness of the discounts that the network offers. Pharmacies in a network also agree to follow our policies and procedures designed to enhance specific performance standards regarding patient safety and service levels. Our retail specialists also regularly review changes in pharmacy plan rules and clinical protocols with retail pharmacists to help foster the health of members and maximize savings for our clients. Pharmacies in the network benefit, in turn, from increased member traffic and sales.

 

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

 

Home Delivery Pharmacy Service.    Our home delivery pharmacy service is the industry’s largest in terms of the number of prescriptions filled. We dispensed approximately 82 million prescriptions in 2002 through our home delivery pharmacies. For maintenance medications, home delivery typically reduces costs for clients through volume purchasing, increased generic dispensing and higher rebates through greater formulary compliance. Many members prefer home delivery for maintenance medications because they can typically receive a 90-day supply instead of a 30-day supply as commonly dispensed by retail pharmacies. Members can place orders easily online through our member website, through our integrated voice-response phone system, or through the mail.

 

Our home delivery pharmacy infrastructure currently consists of 11 home delivery pharmacies throughout the United States, nine of which contain prescription processing centers and five of which engage in home delivery dispensing activities. In our prescription processing centers, our pharmacists focus on “front-end” pharmacy activities such as reviewing, recording and interpreting incoming prescriptions, screening for interactions based on each patient’s drug history and medical profile, resolving benefit and clinical issues with plan sponsors and physicians and then approving and routing the prescriptions to one of our five home delivery dispensing pharmacies. In the five dispensing pharmacies, including our automated pharmacies in Las Vegas, Nevada and Willingboro, New Jersey, we focus on “back-end” dispensing processes such as dispensing the medication and then presorting for shipment to patients by mail or courier. All 11 of our home delivery pharmacies are electronically networked to provide national coverage.

 

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

 

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

 

85


Table of Contents
Index to Financial Statements

Health Management Programs

 

We offer a comprehensive series of Positive Approaches® health management programs as part of our prescription drug benefit package to help members with certain chronic conditions better understand their conditions and comply with their prescribed drug therapies. Enrolled members receive educational and behavioral interventions, including letters and phone calls, as well as clinical support through toll-free hotlines. We have focused on illnesses that have high prevalence rates and high impact on clients in terms of drug and medical costs. These illnesses include depression, digestive, respiratory, hypertension and high cholesterol and other cardiovascular problems, diabetes, multiple sclerosis and hepatitis C. An additional program supports smoking cessation. Clients benefit through lower or avoided medical costs. Some of these programs are affiliated with the American College of Gastroenterology, the American Lung Association, the American Diabetes Association, the National Multiple Sclerosis Society, and the American Liver Foundation or other professional organizations.

 

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

 

Physician Services

 

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

 

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

 

Integrated Generics Strategy.    Our integrated generics strategy seeks to reduce our clients’ drug spend by increasing the use of generic medications, when clinically appropriate, in place of more expensive, brand name medications. The strategy encompasses generic education, substitution, and interchange programs, as well as a host of other activities, including careful tracking of brand name drugs about to lose their exclusivity. When patents for brand name drugs expire, we act quickly to encourage physicians and members to use the new generic equivalent. For example, when the blood pressure medication Vasotec lost patent protection, our home delivery pharmacies moved quickly to substitute the new generic equivalent, enalapril. In our home delivery pharmacy business, generic conversions from Vasotec reached approximately 90% within one month of enalapril’s availability, providing savings to our clients. In our home delivery pharmacy business, generic conversions from Prinivil/Zestril reached approximately 90% within one month of generic lisinipril’s availability, providing savings to our clients.

 

Introduced late in 2000, our Generics FirstSM program has been encouraging the use of generics, where medically appropriate, among approximately 20,000 physicians across the country. Of these physicians, approximately 3,800 receive periodic face-to-face informational visits from our specially trained pharmacists who discuss clinical guidelines for generics and facilitate the ordering of free samples of commonly prescribed

 

86


Table of Contents
Index to Financial Statements

generic medications from manufacturers. These pharmacists also provide educational brochures on the benefits of generics for patients in office waiting areas and exam rooms. As part of this program, over 500 physicians nationwide have participated in an innovative web-based educational program that provides online Generics First clinical and cost education.

 

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

 

Point-of-Care On-line Connectivity Program.    More than 10,000 physicians use our point-of-care, or POC, electronic prescribing program. During 2002, these physicians submitted more than 1.6 million prescriptions using electronic prescription writing tools. Key objectives of the strategy include improved accuracy of information transmitted to the pharmacy and enhanced patient safety. Physicians gain real-time access to a patient’s plan guidelines and prescription history to help prevent drug interactions and duplicate therapies. Physicians also benefit from electronic prescribing because it simplifies the prescription process and, we believe, improves the quality of patient care.

 

We work closely with a variety of handheld and PC based POC providers in recruiting new physician users. We also encourage the use of an open-access system to ensure that standardized solutions are available for varying physician office requirements. In February 2001, we formed RxHub LLC with AdvancePCS and Express Scripts, Inc. RxHub created a standardized electronic prescribing platform, enabling physicians to use electronic prescribing technology to link to pharmacies, PBMs and health plans. As of December 28, 2002, we have invested $9.5 million in RxHub with an additional $1.9 million during the first quarter of 2003. As of March 29, 2003, we have invested $11.4 million and anticipate investing an additional $2.2 million in 2003.

 

Web-Based Services

 

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

 

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

 

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

 

    the ability to handle first-fill prescriptions, refills and renewals for home delivery, as well as transfers from retail pharmacies to home delivery;

 

    access to prescription histories;

 

    plan-specific drug information, including coverage guidelines and co-payment comparisons for brand and generic medications;

 

    member-specific messaging on benefit changes and updates;

 

    dedicated online service representatives and pharmacists; and

 

    a wide offering of personal health information and tools, including specialized e-health websites providing information concerning specific diseases.

 

Our member website was the first Internet pharmacy site to be certified by the National Association of Boards of Pharmacy. The site processed more than 10.8 million prescription orders in 2002 and currently

 

87


Table of Contents
Index to Financial Statements

processes approximately 250,000 prescription orders per week. The site also handled more than 38 million member service inquiries in 2002, and was named one of the most trusted health care websites by Yahoo! Internet Life in February 2002.

 

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

 

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

 

Contractual Relationships

 

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

 

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

 

    formulary rebates, which are based on inclusion of the pharmaceutical manufacturer’s products on the formularies used by our clients; and

 

    performance based rebates, which are based on our achieving various performance criteria, such as contractually specified market share levels.

 

Formulary rebates are typically calculated based on an agreed percentage of the aggregate wholesale price of all prescriptions dispensed for clients which include the applicable pharmaceutical products on their formularies and

 

88


Table of Contents
Index to Financial Statements

do not subject such products to restrictions which are not applicable to competing branded products. Market share rebates, a type of performance based rebate, are contingent upon us achieving the contractually specified market share level for a particular drug for all of our clients. We generally share a portion of rebates with our clients based on the provisions of the applicable cli