10-K 1 form10k2005.htm 2005 FORM 10K 2005 Form 10K

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

 
X
 
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005, OR
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO _____________.

Commission File Number: 0-20199

EXPRESS SCRIPTS, INC.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction
of incorporation or organization)
43-1420563
(I.R.S. employer identification no.)
13900 Riverport Dr., Maryland Heights, Missouri
(Address of principal executive offices)
63043
(Zip Code)

Registrant’s telephone number, including area code: (314) 770-1666

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

None

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

Common Stock, $0.01 par value
(Title of Class)

Preferred Share Purchase Rights
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X No ___

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ___ No X

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation of S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (check one):
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   No X  

The aggregate market value of Registrant’s voting stock held by non-affiliates as of June 30, 2005, was $7,250,871,541 based on 145,075,461 such shares held on such date by non-affiliates and the average sale price for the Common Stock on such date of $49.98 as reported on the Nasdaq National Market. Solely for purposes of this computation, the Registrant has assumed that all directors and executive officers of the Registrant and New York Life Insurance Company are affiliates of the Registrant. The Registrant has no non-voting common equity.

Common stock outstanding as of January 31, 2006:
146,371,022
Shares

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates by reference portions of the definitive proxy statement for the Registrant’s 2006 Annual Meeting of Stockholders, which is expected to be filed with the Securities and Exchange Commission not later than 120 days after the registrant’s fiscal year ended December 31, 2005.





Information included in or incorporated by reference in this Annual Report on Form 10-K, other filings with the Securities and Exchange Commission (the “SEC”) and our press releases or other public statements, contain or may contain forward looking statements. Please refer to a discussion of our forward looking statements and associated risks in “Item 1 —Forward Looking Statements and Associated Risks” and "Item 1A —Risk Factors" in this Annual Report on Form 10-K. 

PART I

THE COMPANY

Item 1 — Business 

Industry Overview

Prescription drugs are playing an ever-greater role in healthcare and today constitute the first line of treatment for many medical conditions.  As pharmaceutical research opens the potential for even more effective drugs, demand can be expected to increase.  For millions of people, prescription drugs equate to the hope of improved health and quality of life.  At the same time, rising prescription drug costs are gradually shaping one of the most persistent challenges to health care financing.  Even as pharmaceutical development opens new paths to better healthcare, we confront the possibility that high costs may limit access to these therapies.

Prescription drug costs, one of the fastest growing components of health care costs in the United States, accounted for approximately 12.2% of U.S. health care expenditures in 2005 and are expected to increase to about 15.5% in 2013 according to U.S. Centers for Medicare & Medicaid (“CMS”) estimates.  Based upon information included in our 2004 Annual Drug Trend report, described below under “Company Operations—Clinical Support,” annual per member unmanaged drug spending rose 10.6% in 2004.  In response to cost pressures being exerted on health benefit providers such as HMOs, health insurers, employers and unions, pharmacy benefit management (“PBM”) companies develop innovative strategies designed to keep medications affordable.

We help health benefit providers address access and affordability concerns resulting from rising drug costs.  We manage the cost of the drug benefit by performing the following functions:

 
evaluating drugs for price, value and efficacy in order to assist clients in selecting a cost-effective formulary;
  leveraging purchasing volume to deliver discounts to health benefit providers;
 
promoting the use of generics and low-cost brands; and
 
offering cost-effective home delivery pharmacy and specialty services which result in drug-cost savings for plan sponsors and co-payment savings for members.

We work with clients, manufacturers, pharmacists and physicians to increase efficiency in the drug distribution chain, to manage costs in the pharmacy benefit, and to improve members’ health outcomes and satisfaction.

PBMs combine retail pharmacy claims processing, formulary management and home delivery pharmacy services to create an integrated product offering to manage the prescription drug benefit for payers.  Some PBMs now provide specialty services to provide treatments for diseases that rely upon high-cost injectible, infused, oral, or inhaled drugs which traditional retail pharmacies are unable to supply due to their high cost and sensitive handling and storage needs (“Specialty”).  PBMs also have broadened their service offerings to include disease management programs, compliance programs, outcomes research, drug therapy management programs, sophisticated data analysis and other distribution services.
 
Company Overview
 
We are one of the largest PBMs in North America and we provide a full range of pharmacy benefit management services, including retail drug card programs, home delivery pharmacy services, Specialty services, drug formulary management programs and other clinical management programs for thousands of client groups that include HMOs, health insurers, third-party administrators, employers, union-sponsored benefit plans and government health programs.

Our PBM services include:

 
retail network pharmacy management
 
home delivery pharmacy services
 
benefit design consultation
 
drug utilization review
 
formulary management programs
 
disease management
 
compliance and therapy management programs for our clients

Our Specialty services include:

 
patient care and direct specialty home delivery of injectible and infusion biopharmaceutical products to patients
 
distribution of infusion drugs to patient homes, physician offices and infusion centers
 
distribution of pharmaceuticals and medical supplies to providers and clinics
 
third party logistics services for contracted pharma clients
 
fertility services to providers and patients
 
bio-pharma services including reimbursement and customized logistics solutions
 
Specialty services do not include the fulfillment of specialty prescriptions at retail pharmacies participating in our networks.  These prescriptions are reflected in PBM retail pharmacies participating in our networks.
 
Pharma Business Solutions (“PBS”) services include:

 
distribution of pharmaceuticals to low-income patients through pharmaceutical manufacturer-sponsored and company-sponsored generic patient assistance programs
 
distribution of pharmaceuticals requiring special handling or packaging
 
distribution of sample units to physicians and verification of practitioner licensure through our wholly owned subsidiary, Phoenix Marketing Group, LLC (“PMG”)

Our revenues are generated primarily from the delivery of prescription drugs through our contracted network of retail pharmacies, home delivery pharmacy services and Specialty services.  In 2005, 2004 and 2003, revenues from the delivery of prescription drugs to our members represented 98.2% of revenues in 2005, and 98.6% of revenues in 2004 and 2003.  Revenues from services, such as the administration of some clients’ retail pharmacy networks, sample distribution services and certain services provided by our PBS subsidiary comprised the remainder of our revenues.

Prescription drugs are dispensed to members of the health plans we serve primarily through networks of retail pharmacies that are under non-exclusive contracts with us and through four home delivery fulfillment pharmacies and thirty-three specialty drug pharmacies that we operated as of December 31, 2005.  More than 58,000 retail pharmacies, representing more than 98% of all United States retail pharmacies, participate in one or more of our networks.  In 2005, we processed 437 million network pharmacy claims and dispensed 40 million home delivery pharmacy prescriptions.  We also dispensed 5 million PBS and Specialty claims.

We were incorporated in Missouri in September 1986, and were reincorporated in Delaware in March 1992.  Our principal executive offices are located at 13900 Riverport Drive, Maryland Heights, Missouri 63043.  Our telephone number is (314) 770-1666 and our web site is www.express-scripts.com.  Through our website, we make available access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, all amendments to those reports (when applicable), and other filings with the SEC.  Such access is free of charge and is available as soon as reasonably practicable after such information is filed with the SEC.  In addition, the SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers filing electronically with the SEC (which includes us).  Information included on our website is not part of this annual report.

Products and Services

Pharmacy Benefit Management Services 

Overview.  Our PBM services involve the management of outpatient prescription drug usage to foster high quality, cost-effective pharmaceutical care through the application of managed care principles and advanced information technologies.  We offer our PBM services to our clients in the United States and Canada.  Our PBM services include:

 
retail network pharmacy management
 
home delivery pharmacy services
 
benefit design consultation
 
drug utilization review
 
formulary management programs
 
disease management
 
compliance and therapy management programs for our clients

We consult with our clients to assist them in selecting plan design features that balance the client’s requirements for cost control with member convenience.  For example, some clients receive a smaller discount on pricing in the retail pharmacy network or home delivery pharmacy in exchange for receiving all or a larger share of the pharmaceutical manufacturer rebates.  Other clients receive a greater discount on pricing at the retail pharmacy network or home delivery pharmacy in exchange for a smaller share of the pharmaceutical manufacturer rebates.

During 2005, 88.2% of our revenues were derived by our PBM operations, compared to 94.3% and 98.5% during 2004 and 2003, respectively.  This decrease is mainly due to the acquisition of Priority in 2005 and the continued growth of CuraScript.  These entities comprise our Specialty segment.  The number of retail pharmacy network claims processed and home delivery pharmacy claims dispensed increased to 437 million and 40 million, respectively, in 2005 from 399 million and 38 million claims, respectively, in 2004.

Retail Pharmacy Network Administration.  We contract with retail pharmacies to provide prescription drugs to members of the pharmacy benefit plans we manage.  In the United States, we negotiate with pharmacies to discount the price at which they will provide drugs to members.  We manage nationwide networks in the United States that are responsive to client preferences related to cost containment and convenience of access for members.  We also manage networks of pharmacies that are customized for or under direct contract with specific clients.  In addition, we have contracted Medicare Part D provider networks that are intended to comply with or exceed CMS access requirements for the Medicare Part D Prescription Drug Program.  We manage one nationwide claims network in Canada.

All retail pharmacies in our pharmacy networks communicate with us online and in real time to process prescription drug claims.  When a member of a plan presents his or her identification card at a network pharmacy, the network pharmacist sends the specified member and prescription information in an industry-standard format through our systems, which process the claim and respond to the pharmacy.  The electronic processing of the claim includes, among other things, the following:

 
confirming the member’s eligibility for benefits under the applicable health benefit plan and the conditions to or limitations of coverage
 
performing a concurrent drug utilization review and alerting the pharmacist to possible drug interactions and reactions or other indications of inappropriate prescription drug usage
 
updating the member’s prescription drug claim record
 
if the claim is accepted, confirming to the pharmacy that it will receive payment for the drug dispensed
 
informing the pharmacy of the co-payment amount to be collected from the member based upon the client’s plan design

Home Delivery Pharmacy. As of December 31, 2005, we operated four home delivery pharmacies located in Maryland Heights, Missouri; Albuquerque, New Mexico; Bensalem, Pennsylvania; and Tempe, Arizona.  In addition to the front-end order processing that occurs at our home delivery pharmacies, we also operate two standalone front-end order processing facilities in Troy, New York and Harrisburg, Pennsylvania.  Our pharmacies provide patients with convenient access to maintenance medications and enable us to manage our clients’ drug costs through operating efficiencies and economies of scale.  Through our home delivery pharmacies, we are directly involved with the prescriber and patient and, as a result, we believe we are generally able to achieve a higher level of generic substitutions and therapeutic interventions than can be achieved through the retail pharmacy networks.

Patient Care Contact Centers.  Although we contract with health plans, the ultimate recipients of many of our services are the members of these health plans.  We believe that client satisfaction is dependent upon patient satisfaction.  Domestic patients can call us toll-free, 24 hours a day, 7 days a week, to obtain information about their prescription drug plan from our trained patient care advocates.

Benefit Plan Design and Consultation.  We offer consultation and financial modeling to assist our clients in selecting benefit plan designs that meet their needs for member satisfaction and cost control.  The most common benefit design options we offer to our clients are:

 
financial incentives and reimbursement limitations on the drugs covered by the plan, including drug formularies, tiered co-payments, deductibles or annual benefit maximums
 
generic drug utilization incentives
 
incentives or requirements to use only certain network pharmacies or to order certain maintenance drugs (i.e. therapies for diabetes, high blood pressure, etc.) only by mail
 
reimbursement limitations on the amount of a drug that can be obtained in a specific period
 
by implementing utilization management programs such as Step Therapy and Prior Authorization, that focus the use of medications according to clinically developed algorithms

The client’s choice of benefit design is entered into our electronic claims processing system, which applies the plan design parameters as claims are submitted and enables our clients and us to monitor the financial performance of the plan.

Formulary Development, Compliance and Therapy Management.  Formularies are lists of drugs for which coverage is provided under the applicable plan.  We have many years of formulary development expertise and maintain an extensive clinical pharmacy department.

Our foremost consideration in the formulary development process is the clinical appropriateness of the drug.  In developing formularies, we first perform a rigorous assessment of the available evidence regarding the drug’s safety and clinical effectiveness.  No drug is added to the formulary until it is approved by our National Pharmacy & Therapeutics Committee (“P&T”) - a panel composed of nineteen independent physicians and pharmacists in active clinical practice, representing a variety of specialties and practice settings, typically with major academic affiliations.  We fully comply with the Committee’s clinical recommendations.  The Committee does not consider any information regarding the discount or rebate arrangement that we might negotiate with the manufacturer in making its clinical recommendation.  This is designed to ensure that the clinical recommendation is not affected by our purchasing arrangements.  After the clinical recommendation is made, the drugs are evaluated on an economic basis to determine optimal cost-effectiveness.

We administer a number of different formularies for our clients that identify drugs whose use is encouraged through various benefit design features.  Historically, many clients selected a plan design that included an open formulary in which all drugs were covered by the plan.  Today, an increasing number of our clients are selecting formularies in which various financial or other incentives, such as three-tier co-payments, exist for the selection of formulary drugs over their non-formulary counterparts.  Some clients select closed formularies, in which benefits are available only for drugs listed on the formulary.  In 2005, about 69% of all claims fell into three-tier or closed categories compared to 60% for 2004 and 54% for 2003.  Use of formulary drugs can be encouraged in the following ways:

 
by restricting the formulary through plan design features, such as tiered co-payments, which require the member to pay a higher amount for a non-formulary drug
 
by educating members and physicians with respect to benefit design implications
 
by promoting the use of lower cost generic alternatives
 
by implementing utilization management programs such as Step Therapy and Prior Authorization, that focus the use of medications according to clinically developed algorithms

We also provide formulary compliance services to our clients.  For example, if a doctor has prescribed a drug which is not on a client’s formulary, we notify the pharmacist through our claims processing system.  The pharmacist may then contact the doctor to attempt to obtain the doctor’s consent to change the prescription to the appropriate formulary product.  The doctor has the final decision-making authority in prescribing the medication.

We also offer innovative clinical intervention programs to assist and manage patient quality of life, client drug trend, and physician communication/education.  These programs encompass comprehensive point of service and retrospective drug utilization review, physician profiling, academic detailing, prior authorization, disease care management, and clinical guideline dissemination to physicians.

Rebate Programs.  We develop, manage and administer rebate programs that allow pharmaceutical manufactures to provide rebates on utilization of their products by members of our clients’ benefit plans.  The level to which a client may choose to receive a portion of the rebates paid to us by participating manufacturers varies by client (see “Products and Services - Pharmacy Benefit Management Services - Overview”).  In situations where we pay all or a portion of rebates to the client, our clients have a contractual right to audit our calculation of their rebate payment to ensure they have received the amount to which they are entitled.

The platform upon which our rebate programs are currently built is called the “preferred savings grid” or “PSG” program.  Under the PSG program, rebates are determined based on the characteristics of the formulary design selected by the client and their pharmacy benefit structure.  Historically, we have also managed a separate rebate program under which rebate amounts were determined based on the relative market share of each product.  In addition, beginning in 2006, rebates available on utilization of pharmaceutical products paid for under the federal Medicare Part D benefit will be captured through a rebate program specifically designed and operated for that purpose.  This Medicare Part D rebate program is designed based on the PSG program.  The amount of rebates generated by these types of programs is a function of the particular product dispensed and the level of utilization that occurs.  Manufacturers participating in our rebate programs pay us administrative fees in connection with the services and systems we provide through the rebate program.

Once the formulary has been selected by the client, clients can participate in one of the rebate arrangements we offer.  The level of participation in our rebate programs varies by client (see “Products and Services - Pharmacy Benefit Management Services - Overview”).

Information Reporting and Analysis and Disease Management Programs.  Through the use of sophisticated information and reporting systems we are better able to manage the prescription drug benefit.  We analyze prescription drug data to identify cost trends and budget for expected drug costs, assess the financial impact of plan design changes and assist clients in identifying costly utilization patterns through an online prescription drug decision support tool.

We offer disease management and education programs to members in managing clinical outcomes and the total health care costs associated with certain conditions such as asthma, diabetes and cardiovascular disease.  These programs are based on the premise that better informed patient and physician behavior can positively influence medical outcomes and reduce overall medical costs.  We identify patients who may benefit from these programs through claims data analysis or self-enrollment.

We offer a tiered approach to member education and wellness, ranging from information provided through our Internet site, to educational mailings, to our intensive one-on-one registered nurse or pharmacist counseling.  The programs include providing patient profiles directly to their physicians, as well as measurements of the clinical, personal and economic outcomes of the programs.

Electronic Claims Processing System.  A significant tool in providing our PBM services is our electronic claims processing system which enables us to implement sophisticated intervention programs to assist in managing prescription drug utilization.  The system can alert the pharmacist to generic substitution and therapeutic intervention opportunities as well as formulary compliance issues, or administer prior authorization and step-therapy protocol programs at the time a claim is submitted for processing.  Our claims processing system also creates a database of drug utilization information that can be accessed both at the time the prescription is dispensed and also on a retrospective basis to analyze utilization trends and prescribing patterns for more intensive management of the drug benefit.

Consumer Health and Drug Information.  We maintain a public website, www.DrugDigest.org, dedicated to helping consumers make informed decisions about using drugs.  During 2004, the Health on the Net Foundation granted DrugDigest.org Health On the Net ("HON") Code accreditation for providing reliable online health information.  In 2004 and 2005, it was rated among the best websites for unbiased drug information by Business Week, Reader’s Digest, the Wall Street Journal, The Webby Award and others.

Much of the information on DrugDigest.org is written by pharmacists - primarily doctors of pharmacy who are also affiliated with academic institutions.  All the materials used on DrugDigest.org are reviewed for accuracy and timeliness.  In 2005, DrugDigest.org expanded its interactive tools providing consumers an opportunity to take an even more active role in maintaining their own health.  The consumer-friendly information on DrugDigest.org includes:

 
·
a drug interaction checker
 
·
a drug side effect comparison tool
 
·
audible drug name pronunciations
 
·
comparisons of different drugs used to treat the same health condition
 
·
information on health conditions and their treatments
 
·
instructional videos showing administration of specific drug dosage forms
 
·
monographs on drugs and dietary supplements
 
·
photographs of pills and capsules
 
·
interactive care pathways and health risk assessments

Many features of DrugDigest.org are available in the limited-access member website at www.express-scripts.com.  The member website gives our clients’ members access to personalized current and, in many cases, previous drug histories.  Members can use the interactive tools from DrugDigest.org to check for drug interactions and find possible side effects for all of the drugs they take.
 
To facilitate communications between members and physicians, health condition information from DrugDigest.org has been compiled into “For Your Physician Visit”, which is available on the member website.  Using it, members complete and print appropriate checklists on conditions such as diabetes and depression.  Discussing the completed checklists gives both the member and the physician a better understanding of the member’s true health status.

Additional tools that are available through www.express-scripts.com assist members in choosing and managing their prescription benefits.  In the member website, individual profiles include specific enrollment and copayment information.   Through Express Choice and Express Preview, members can compare benefit packages and estimate annual prescription costs before the plan’s benefit year begins.  They can determine how variables such as generic usage, mandatory mail programs and step therapy will affect their costs.  The separate Price Check feature informs members of current prescription costs based on exact benefit structures and also alerts members if more cost-effective options are available for the prescribed drug.

Specialty Services

Overview.  In 2005, our collective Specialty offering was greatly enhanced with the acquisition of Priority Healthcare (“Priority”).  Collectively under the CuraScript name, we now operate five integrated brands that service the patient through multiple paths: Payors, Providers and Pharma.  CuraScriptSP operates specialty pharmacies in eight states with primary operations located in Orlando, Florida.  These locations provide patient care and direct specialty home delivery to our patients.  CuraScriptIP, primarily based in Louisville, KY, sends infusion pharmaceuticals to multiple alternate pharmacy sites which then coordinate distributing the pharmaceuticals to patients’ homes, physicians’ offices and infusion centers.  CuraScriptSD provides specialty distribution of pharmaceuticals and medical supplies direct to providers and clinics, performs third-party logistics services for contracted pharmaceutical manufacturers and operates a Group Purchasing Organization (“GPO”) for many of our clients.  We currently operate CuraScriptSD specialty distribution centers located in Grove City, OH and Sparks, NV.  FreedomFP provides fertility services to both providers and patients and is located in Byfield, MA.  Finally, HealthBridge provides Bio-Pharma services including reimbursement and customized logistics solutions.  In total, the collective CuraScript brand diversely positions us solidly within the specialty market and truly serves as a pathway to the patient.

During 2005, 10.0% of our revenues were derived from Specialty services, compared to 4.1% during 2004.  This increase is mainly due to the acquisition of Priority in 2005 and the growth of CuraScript.
 
Patient Services.  Services to patients include coordinated delivery of specialty pharmaceuticals and management of multiple facets of a patient’s treatment which can include personal instruction on the self-administration of a patient’s therapy, clinical support, support with billing and reimbursement issues and a range of educational materials, including online information portals.  We employ a team of specialists including doctors of pharmacy, nurse clinicians, social workers, patient care coordinators and insurance specialists, who are involved in the care we provide to each patient.  We work closely with health care providers to monitor medications and dosages and our pharmacists screen each prescription for negative interactions.  We utilize clinically based CARELogic programs to provide therapy-specific care management of the injectible therapy, including appropriateness, compliance, dosing and cost control.  Our team of specialists is available to answer patients’ questions through our toll-free customer service center, including access to pharmacists 24 hours per day, 7 days a week.

Physician Services.  Through our CuraScriptsSD business unit we provide distribution services primarily to office and clinic-based physicians treating chronic disease patients who regularly order high-dollar-value pharmaceuticals.  We are able to provide to these physicians competitive pricing on pharmaceuticals and medical supplies.

Biotech Services.  In our June 2005 Specialty Pharmacy Management Guide and Trend Report, we reported at the end of 2004 there were more than 324 specialty drugs in clinical trials.  For new biopharmaceuticals being launched, we can provide biotech manufacturers product distribution management services.  We design strategies tailored to each product’s needs with a focus on identifying opportunities to educate the marketplace regarding drug effectiveness, proper utilization and payor acceptance.

We also provide a range of centralized supply chain services which can include sampling programs, patient assistance programs, and clinical trial assistance as well as specialized shipping and storage and customized dosing.

Payor Services.  We offer health plan providers and their members customized disease-specific treatment programs which cover both pharmacy and medical benefits.  In addition to helping payors design a customized plan, we assist with eligibility review, prior authorization coordination, monitoring and reporting of patient therapy adherence as well as electronic claims processing and billing.  Our monitoring and reporting of patient therapy includes clinical tracking, plan-specific reports, and provider treatment and dispensing patterns.  We are able to provide a clinical and financial picture of plan members with chronic illnesses which measures pharmacy expenses and patients’ treatment progress.

We have developed a comprehensive oncology program, OncoScripts, whereby we work with managed care organizations to help manage the cost of chemotherapy drugs and injectibles infused in physician offices and cancer centers.  We help managed care organizations develop a specific formulary based on the latest economic and clinical data.  Our services include clinical review of ordered drugs prior to dispensing and shipment based on dosing standards and protocols set by American Society of Clinical Oncology guidelines and specific stability standards established by the pharmaceutical manufacturer.  We also provide access to utilization and cost reports that can be customized based on customer needs.

PBS Services 

In addition to PBM and Specialty services, we also provide certain services through our PBS unit including:

 
distribution of pharmaceuticals to low-income patients through manufacturer-sponsored and company-sponsored generic patient assistance programs
 
distribution of pharmaceuticals requiring special handling or packaging on behalf of pharmaceutical manufacturers
 
distribution of sample units to physicians and verification of practitioner licensure through our wholly owned PMG subsidiary

During 2005, 1.9% of our revenues were derived from PBS services, compared to 1.6% and 1.5% during 2004 and 2003, respectively.

Express Scripts Specialty Distribution Services (“SDS”).  We provide specialty distribution services, consisting of the distribution of, and creation of a database of information for, products requiring special handling or packaging, products targeted to a specific physician or patient population, and products distributed to low-income patients.  Our services include eligibility, fulfillment, inventory, insurance verification/authorization and payment.  Specialty distribution revenues are derived from administrative fees received from drug manufacturers and from buying and selling pharmaceuticals.  We also administer sample card programs for certain manufacturers where the ingredient costs of pharmaceuticals dispensed from retail pharmacies are included in revenues, as well as costs of revenues.  SDS services are provided from our Maryland Heights, Missouri facility.

Phoenix Marketing Group.  PMG is a leader in sample accountability, database management and practitioner verification services for the pharmaceutical industry, operating the nation’s largest prescription drug sample fulfillment business.

Segment Information. 

Information regarding our segments appears in Note 11 of the notes to our consolidated financial statements.  Effective in October 2005, we began managing our Specialty business as a separate operating segment. Previously, our Specialty business was part of our domestic PBM operating segment. The change is primarily due to the acquisition of Priority (see “—Overview”) on October 14, 2005. As described above, our Specialty segment consists of our CuraScript (acquired in January 2004) and Priority businesses.

Suppliers

Home Delivery Pharmacy Suppliers.  We maintain a large inventory of brand name and generic pharmaceuticals in our home delivery pharmacies.  If a drug is not in our inventory, we can generally obtain it from a supplier within one business day.  We purchase our pharmaceuticals either directly from manufacturers or through wholesalers.  Currently, approximately 95% of our branded pharmaceutical purchases by our PBM segment are through one wholesaler.  Generic pharmaceuticals are generally purchased directly from manufacturers.  We believe that alternative sources of supply for most generic and brand name pharmaceuticals are readily available.

Specialty Suppliers.  We maintain a large inventory of biopharmaceutical and biotech injectibles in our specialty pharmacies along with other high cost oral agents used to treat patients with rare or chronic disease.  If a drug is not in our inventory, we can generally obtain it from a supplier within one business day.  We purchase our pharmaceuticals either directly from manufacturers or through wholesalers.  Currently, approximately 75% of our purchases by our Specialty segment are through one wholesaler.  Due to the unique nature of the specialty market, the services patients require and our reach nationally, we are able to purchase and supply most of the current limited distributed drugs.

Clients

We are a provider of PBM services to several market segments and our clients include HMOs, health insurers, third-party administrators, employers, union-sponsored benefit plans and government health programs.  We provide Specialty services to customers who include office-based oncologists, renal dialysis clinics, ambulatory surgery centers, primary care physicians, retina specialists, third party payors and patients.

Our top five clients represented 23.6%, 22.8%, and 17.8% of revenues during 2005, 2004 and 2003 respectively.  None of our clients accounted for 10% or more of our consolidated revenues in fiscal years 2005, 2004 or 2003.

Medicare Prescription Drug Coverage

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “MMA”) created the federal Voluntary Prescription Drug Benefit Program under “Part D” of the Social Security Act.  As of January 1, 2006, eligible Medicare beneficiaries are able to obtain prescription drug coverage under Part D by enrolling in a prescription drug plan (“PDP”) or a “Medicare Advantage” plan that offers prescription drug coverage (an “MA-PD”).  Employers offering eligible prescription drug coverage for their Medicare-eligible retirees can receive a subsidy payment under Part D for a portion of the costs associated with providing such coverage to beneficiaries who do not enroll in a PDP or MA-PD.

Our services support clients who have elected to become a PDP or an MA-PD.  Our services also support the needs of employers seeking subsidy payments available under Part D for coverage provided to their Medicare-eligible retirees.  We provide PBM services to these clients as well as new Part D functions that include managing member true out of pocket costs (“TrOOP”), creation of the prescription data event (“PDE”), medication therapy management (“MTM”) services, and various reporting required by CMS.  In addition, we have filed a Notice of Intent to become a PDP sponsor in 2007 and are evaluating our options in this regard.

The MMA also implemented a short-term prescription drug discount card program to provide certain Medicare beneficiaries with access to discounts and, in some cases, federally-funded assistance, in connection with their prescription drug purchases during 2004, 2005 and the beginning of 2006.  Together with the National Association of Chain Drug Stores (“NACDS”), beginning in 2004, we sponsored a Medicare-endorsed prescription drug discount card through Pharmacy Care Alliance, Inc. (“PCA”), a jointly controlled organization.  We provide PBM services to PCA, including the negotiation of discounts from individual retailers and pharmaceutical manufacturers, the enrollment of cardholders and the processing of claims.  We will continue to support the PCA card through termination of the program in May 2006. Currently, we have filed a Notice of Intent to become a PDP sponsor in 2007 and are evaluating our options.

Acquisitions and Joint Ventures

On October 14, 2005, we acquired the capital stock of Priority Healthcare Corporation, Inc. (“Priority”) in a cash transaction for $28 per share, or approximately $1.3 billion.  The acquisition was accomplished through the merger of one of our wholly-owned subsidiaries with and into Priority.  Priority, headquartered in Lake Mary, Florida, is among the nation’s largest Specialty and distribution companies, with approximately $1.7 billion in annual revenue during 2004 and approximately $1.1 billion in revenue for the six months ended July 2, 2005.  This acquisition is expected to enhance our Specialty business.  The $1.3 billion purchase price was financed with approximately $167 million of cash on hand and the remainder by adding $1.6 billion in Term A loans through a new credit facility which replaced our prior credit facility.  As a result of this refinancing, we wrote-off approximately $4 million in deferred financing fees relating to our prior credit facility in the fourth quarter of 2005.

Aetna Specialty Pharmacy, a joint venture existing between Priority and Aetna, Inc. (“Aetna”), was 60% owned by Priority and 40% by Aetna.  Upon a change in control of Priority, the joint venture agreement provided Aetna with an option to purchase Priority’s 60% ownership share of the joint venture.  Aetna exercised its option and on December 30, 2005 purchased Priority’s 60% ownership share of Aetna Specialty Pharmacy.  The gain on the assets sold, which was not material, reduced the amount of goodwill we recorded through the Priority acquisition.

On January 30, 2004, we purchased the capital stock of CuraScript, Inc. (“CuraScript”) for a purchase price of approximately $333 million.  CuraScript is one of the nation’s largest Specialty services companies, serving over 175 managed care organizations, 30 Medicaid programs and the Medicare program, and operating seven specialty pharmacies throughout the United States.  The acquisition enhances our ability to provide comprehensive clinical services in many disease states.

Company Operations

General.  As of December 31, 2005, we operated four home delivery pharmacies, two standalone front-end processing centers, and nine patient contact centers out of leased and owned facilities; and our Specialty segment operated thirty-three specialty drug pharmacies.  Electronic pharmacy claims processing takes place at facilities owned by EDS and by IBM.  At our Canadian facilities, we have sales and marketing, client services, pharmacy help desk, clinical, provider relations and certain management information systems capabilities.

Sales and Marketing.  In the United States, our sales managers and directors market and sell PBM services, supported by a team of client-service representatives, clinical pharmacy managers and benefit analysis consultants.  This team works with clients to make prescription drug use safer and more affordable.  A dedicated sales staff cross-markets Specialty services to our PBM clients.  In addition, sales personnel dedicated to our Specialty business unit use direct marketing to generate new customers and solidify existing customer relationships.  In Canada, marketing and sales efforts are conducted by our staff based in Mississauga, Ontario.

Client and Patient Services.  Although we contract with health plans, the ultimate recipients of many of our services are the members of these health plans.  We believe that client satisfaction is dependent upon member satisfaction.  Domestic members can call us toll-free, 24 hours a day, 7 days a week, to obtain information about their prescription drug plan from our trained member service representatives.

Provider Relations.  Our Provider Relations group is responsible for contracting and administering our pharmacy networks.  To participate in our retail pharmacy networks, pharmacies must meet certain qualifications, including the requirement that all applicable state and/or licensing requirements are being maintained.  Pharmacies can contact our pharmacy help desk toll-free, 24 hours a day, 7 days a week, for information and assistance in filling prescriptions for our clients’ members.  In addition, our Provider Relations group audits pharmacies in the retail pharmacy networks to determine compliance with the terms of their contracts.

Clinical Support for our PBM services is provided by our staff of pharmacists and physicians.  Assisted by experienced data analysts and a research team, these health professionals are responsible for pharmacy services such as the drug pipeline, emerging safety issues, drug information services, drug evaluation, formulary management, utilization management, and clinical interventions with physicians, pharmacists, and members.  These health professionals also interact with our P&T Committee - an independent group of practicing physicians that consists of generalists and specialists - to ensure that decisions are evidence-based, clinically sound, and meet current practice standards.

The mission of our Research Team is to conduct timely, rigorous and objective research that supports evidence-based pharmacy benefit management.  Using pharmacy and medical claims data together with member surveys, the research department conducts studies to evaluate clinical, economic and member impact of pharmacy benefits.  Topics of ongoing interest center on the impact of clinical offerings, the evolution of pharmacy benefit designs and the cost-effectiveness of drug therapies.  For example, the release of our 2004 Drug Trend Report in June 2005 marked our eighth consecutive year of tracking prescription drug trends.  Based on a large sample of our membership, the Report not only examines trends in pharmaceutical utilization and cost, it also investigates the factors that underlie those trends.  The current Drug Trend Report and results of our other studies are shared at our annual Outcomes Conference.  We also present at other client forums, speak at professional meetings and publish in health-related journals.

Information Technology.  Our Information Technology department supports our pharmacy claims processing systems, our specialty pharmacy systems and other management information systems that are essential to our operations.  Uninterrupted point-of-sale electronic retail pharmacy claims processing is a significant operational requirement for us.  Claims for our PBM segment are presently processed in the US through systems which are maintained, managed and operated domestically by EDS.  Canadian claims are processed through systems maintained, managed and operated by IBM.  We have substantial capacity for growth in our US and Canadian claims processing facilities.

Specialty pharmacy operations are supported by multiple pharmacy systems which are maintained, managed and operated internally.  We are currently in the process of standardizing our Specialty operations on a common application and platform.  Integration to a single Specialty platform is expected to be completed by the end of 2006.

Disaster recovery services for certain of our systems are provided through our EDS services agreement and SunGard Recovery Services.  For systems not covered by these outsourcing arrangements, disaster recovery and business continuity planning is managed internally under our corporate disaster recovery programs.

Competition

We believe the primary competitive factors in each of our businesses are price, quality and scope of service.  We believe our principal competitive advantages are our strong managed care and employer group customer base that supports the development of more sophisticated PBM services, and our commitment to provide flexible and distinctive service to our clients.

There are other PBMs in the United States, many of which are smaller than us and offer their services on a local or regional basis.  We also compete with a number of large, national companies, including Medco Health Solutions, Inc. (“Medco”) and CaremarkRx, Inc. (“Caremark”), as well as large health insurers and certain HMOs which have their own PBM and Specialty capabilities.  Several of these competitors may have greater financial, marketing and technological resources than us.

Consolidation, including the acquisitions of AdvancePCS by Caremark in 2004 and of Accredo Health, Inc. by Medco in 2005, has been, and may continue to be an important factor in the PBM and Specialty industries.  We believe the size of our membership base provides us with the necessary economies of scale to compete effectively in a consolidating market.

Some of our PBM services, such as disease management services, compete with those being offered by pharmaceutical manufacturers, other PBMs, large national companies, specialized disease management companies and information service providers.  Our Specialty and PBS services compete with a number of large national companies as well as with local providers.

Government Regulation

Many aspects of our businesses are regulated by federal and state laws and regulations.  Since sanctions may be imposed for violations of these laws, compliance is a significant operational requirement.  We believe we are operating our business in substantial compliance with all existing legal requirements material to the operation of our businesses.  There are, however, significant uncertainties involving the application of many of these legal requirements to our business.  In addition, there are numerous proposed health care laws and regulations at the federal and state levels, many of which could adversely affect our business or financial position.  We are unable to predict what additional federal or state legislation or regulatory initiatives may be enacted in the future relating to our business or the health care industry in general, or what effect any such legislation or regulations might have on us.  We cannot provide any assurance that federal or state governments will not impose additional restrictions or adopt interpretations of existing laws that could have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Pharmacy Benefit Management Regulation Generally.  Certain federal and state laws and regulations affect or may affect aspects of our PBM business.  Among the laws and regulations that impact or may impact our business are the following:

Anti-Kickback Laws.  Subject to certain exceptions and “safe harbors,” the federal anti-kickback statute generally prohibits, among other things, knowingly and willfully paying or offering any payment or other remuneration to induce a person to purchase, lease, order, or arrange for (or recommend purchasing, leasing, or ordering) items (including prescription drugs) or services reimbursable in whole or in part under Medicare, Medicaid or another federal health care program.  The anti-kickback statute also generally prohibits soliciting or receiving payments or other remuneration for these purposes.  Several states also have similar laws, some of which apply similar anti-kickback prohibitions to items or services reimbursable by HMOs, private insurers and other non-governmental payors.  These state laws vary and have been infrequently interpreted by courts or regulatory agencies.  Sanctions for violating these federal and state anti-kickback laws may include criminal and civil fines and exclusion from participation in the Medicare and Medicaid programs.

The federal anti-kickback statute has been interpreted broadly by courts, the Office of Inspector General (“OIG”) within the Department of Health and Human Services ("HHS"), and administrative bodies.  Because of the federal statute’s broad scope, federal regulations establish certain “safe harbors” from liability.  Safe harbors exist for certain properly reported discounts received from vendors, certain investment interests, certain payments for personal services, certain properly disclosed payments made by vendors to GPOs, and certain discount and payment arrangements with HMO risk contractors serving Medicaid and Medicare members.  A practice that does not fall within a safe harbor is not necessarily unlawful, but may be subject to scrutiny and challenge.  In the absence of an applicable exception or safe harbor, a violation of the statute may occur even if only one purpose of a payment arrangement is to induce patient referrals or purchases.  Among the practices that have been identified by the OIG as potentially improper under the statute are certain “product conversion programs” in which benefits were given by drug manufacturers to pharmacists or physicians for changing a prescription (or recommending or requesting such a change) from one drug to another.  Such laws have been cited as a partial basis, along with state consumer protection laws discussed below, for investigations and multi-state settlements relating to financial incentives provided by drug manufacturers to retail pharmacies in connection with such programs.  See Item 3 - Legal Proceedings for discussion of current proceedings relating to these laws or regulations.

The OIG issued the final Compliance Program Guidance for Pharmaceutical Manufacturers (the “Guidance”) on April 28, 2003.  The Guidance, which represents OIG’s general views and is not legally binding, contains guidelines for the design and operation of voluntary programs by pharmaceutical manufacturers to promote compliance with the laws relating to federal health care programs.  In addition, the Guidance identifies certain risk areas for pharmaceutical manufacturers, including certain types of arrangements between manufacturers and PBMs, pharmacies, physicians and others that have the potential to implicate the anti-kickback statute.  The Guidance contains a discussion of how manufacturers can structure their arrangements with PBMs, such as rebate programs and formulary support activities, to comply with the anti-kickback statute.

Stark Law.  The federal physician self-referral law, known as the “Stark Law,” prohibits physicians from referring Medicare or Medicaid beneficiaries for “designated health services” (which include, among other things, outpatient prescription drugs) to an entity with which the physician or an immediate family member of the physician has a financial relationship and prohibits the entity receiving a prohibited referral from presenting a claim to Medicare or Medicaid for the designated health service furnished under the prohibited referral.  Our mail service pharmacies dispense certain outpatient prescription drugs that may be directly or indirectly reimbursed by the Medicare or Medicaid programs, potentially making us subject to the Stark Law’s requirements with respect to such pharmacy operations.

Possible penalties for violation of the Stark Law include denial of payment, refund of amounts collected in violation of the statute, civil monetary penalties and Medicare and Medicaid program exclusion.  The Stark Law contains certain statutory exceptions for physician referrals and physician financial relationships, and the CMS has promulgated regulations under the Stark Law which provide some guidance on interpretation of the scope of and exceptions to the Stark Law.

State Self-Referral Laws.  Our home delivery services may also be subject to statutes and regulations that prohibit payments for referral of individuals from or by physicians to health care providers with whom the physicians have a financial relationship.  These state laws and their exceptions may vary from the federal Stark Law and vary significantly from state to state.  Some of these state statutes and regulations apply to items and services reimbursed by private payors.  Violation of these laws may result in prohibition of payment for items or services provided, loss of pharmacy or health care provider licenses, fines and criminal penalties.  State self-referral laws are often vague, and, in many cases, have not been widely interpreted by courts or regulatory agencies.

False Claims Act and Related Criminal Provisions.  The federal False Claims Act (the “False Claims Act”) imposes civil penalties for knowingly making or causing to be made false claims with respect to governmental programs, such as Medicare and Medicaid, for services not rendered, or for misrepresenting actual services rendered, in order to obtain higher reimbursement.  Private individuals may bring qui tam or “whistle blower” suits against providers under the False Claims Act, which authorizes the payment of a portion of any recovery to the individual bringing suit.  Such actions are initially required to be filed under seal pending their review by the Department of Justice.  A few federal district courts have recently interpreted the False Claims Act as applying to claims for reimbursement that violate the anti-kickback statute or federal physician self-referral law under certain circumstances.  The False Claims Act generally provides for the imposition of civil penalties and for treble damages, resulting in the possibility of substantial financial penalties for small billing errors that are replicated in a large number of claims, as each individual claim could be deemed to be a separate violation of the False Claims Act.  Criminal provisions that are similar to the False Claims Act provide that if a corporation is convicted of presenting a claim or making a statement that it knows to be false, fictitious or fraudulent to any federal agency it may be fined.  Some states also have enacted statutes similar to the False Claims Act which may include criminal penalties, substantial fines, and treble damages.

ERISA Regulation.  The Employee Retirement Income Security Act of 1974 (“ERISA”) regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans with respect to which we have agreements to provide PBM services.  We believe that the conduct of our business is not generally subject to the fiduciary obligations of ERISA, and our agreements with our clients provide that we are not the fiduciary of the applicable plan.  However, there can be no assurance that the U.S. Department of Labor (the “DOL”), which is the agency that enforces ERISA, would not assert that the fiduciary obligations imposed by ERISA apply to certain aspects of our operations or that courts in private ERISA litigation would not so rule.

In addition to its fiduciary provisions, ERISA imposes civil and criminal liability on service providers to health plans and certain other persons if certain forms of illegal remuneration are made or received.  These provisions of ERISA are similar, but not identical, to the health care anti-kickback statutes discussed in the preceding paragraphs; in particular, ERISA lacks the statutory and regulatory “safe harbor” exceptions incorporated into many of the above-discussed statutes.  Like the health care anti-kickback laws, the corresponding provisions of ERISA are broadly written and their application to particular cases is often uncertain.  See Item 3 - Legal Proceedings for discussion of current proceedings relating to these laws or regulations.

Effective January 2004, the DOL issued claims procedure regulations (“Claims Rules”) that create standards applicable to our clients that are regulated under ERISA for initial and appeal level decisions, time frames for decision making, and enhanced disclosure rights for claimants.  We have implemented, and will implement in the future, changes to our operational processes, as necessary to accommodate our clients’ compliance needs.

FDA Regulation.  The U.S. Food and Drug Administration (the “FDA”) generally has authority to regulate drug promotional materials that are disseminated “by or on behalf of” a drug manufacturer.  In January 1998, the FDA issued a Notice and Draft Guidance regarding its intent to regulate certain drug promotion and switching activities of PBMs.  The FDA withdrew the Draft Guidance in the fall of 1998, stating that it would reconsider the basis for such Guidance.  The FDA has not addressed the issue since the withdrawal of the Guidance.  The FDA also enforces federal laws restricting the importation of prescription drugs into the United States from Canada and other countries.

Comprehensive PBM Regulation.  Legislation regulating PBM activities in a comprehensive manner has been and continues to be considered in a number of states.  In the past, certain organizations, such as the National Association of Insurance Commissioners (“NAIC,” an organization of state insurance regulators), and the National Committee on Quality Assurance (“NCQA,” an accreditation organization) as well as certain state pharmacy boards have considered proposals to regulate PBMs and/or PBM activities, such as formulary development and utilization management.  While the actions of the NAIC would not have the force of law, they may influence states to adopt model legislation that such organizations promulgate.  In addition, standards established by NCQA could materially impact us directly as a PBM, and indirectly through the impact on our managed care and health insurance clients.

Consumer Protection Laws.  Most states have consumer protection laws that previously have been the basis for investigations and multi-state settlements relating to financial incentives provided by drug manufacturers to retail pharmacies in connection with drug switching programs.  See Item 3 - Legal Proceedings for discussion of current proceedings relating to these laws or regulations.

Network Access Legislation.  A majority of states now have some form of legislation affecting our ability to limit access to a pharmacy provider network or removal of a network provider.  Such legislation may require us or our clients to admit any retail pharmacy willing to meet the plan’s price and other terms for network participation (“any willing provider” legislation); or may provide that a provider may not be removed from a network except in compliance with certain procedures (“due process” legislation).  We have not been materially affected by these statutes.

Legislation Affecting Plan Design.  Some states have enacted legislation that prohibits managed care plan sponsors from implementing certain restrictive benefit plan design features, and many states have introduced legislation to regulate various aspects of managed care plans, including provisions relating to the pharmacy benefit.  For example, some states, under so-called “freedom of choice” legislation, provide that members of the plan may not be required to use network providers, but must instead be provided with benefits even if they choose to use non-network providers.  Other states have enacted legislation purporting to prohibit health plans from offering members financial incentives for use of mail service pharmacies.  Legislation has been introduced in some states to prohibit or restrict therapeutic intervention, or to require coverage of all FDA approved drugs.  Other states mandate coverage of certain benefits or conditions, and require health plan coverage of specific drugs if deemed medically necessary by the prescribing physician.  Such legislation does not generally apply to us directly, but it may apply to certain of our clients, such as HMOs and health insurers.  If such legislation were to become widely adopted and broad in scope, it could have the effect of limiting the economic benefits achievable through pharmacy benefit management.  This development could have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Licensure Laws.  Many states have licensure or registration laws governing certain types of managed care organizations, including preferred provider oganizations ("PPOs"), third party administrators ("TPAs"), and companies that provide utilization review services.  The scope of these laws differs from state to state, and the application of such laws to the activities of PBMs often is unclear.  We have registered under such laws in those states in which we have concluded, after discussion with the appropriate state agency, that such registration is required.  Because of increased regulatory requirements on some of our managed care clients affecting prior authorization of drugs before coverage is approved, we have obtained utilization review licenses in selected states through our subsidiary, ESI Utilization Management Co.  In addition, accreditation agencies’ requirements for managed care organizations and Medicare Part D regulations for PDP and MA-PDPs may affect the services we provide to such organizations. 

Legislation and Regulation Affecting Drug Prices.  Some states have adopted so-called “most favored nation” legislation providing that a pharmacy participating in the state Medicaid program must give the state the best price that the pharmacy makes available to any third party plan.  Such legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies.  Other states have enacted “unitary pricing” legislation, which mandates that all wholesale purchasers of drugs within the state be given access to the same discounts and incentives.  Such legislation has been introduced in the past but not enacted in Missouri, Arizona, Pennsylvania, New York, and New Mexico, all states where we operate mail service pharmacies.  Such legislation, if enacted in a state where one of our mail service pharmacies is located, could adversely affect our ability to negotiate discounts on our purchase of prescription drugs to be dispensed by our mail service pharmacies.

In addition, various federal and state Medicaid agencies and other enforcement officials are investigating the effects of pharmaceutical industry pricing practices such as how average wholesale price (“AWP”) is calculated and how pharmaceutical manufacturers report their “best price” on a drug under the federal Medicaid rebate program.  AWP is a standard pricing measure (calculated by a third-party such as First Data Bank) used throughout the industry, including us, as a basis for calculating drug prices under our contracts with health plans and pharmacies and rebates with pharmaceutical manufacturers.  Changes to the AWP standard have been suggested that could alter the calculation of drug prices for federal programs.  We are unable to predict whether any such changes will be adopted, and if so, if such changes would have a material adverse impact on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Further, the federal Medicaid rebate program requires participating drug manufacturers to provide rebates on all drugs purchased by state Medicaid programs.  Manufacturers of brand name products must provide a rebate equivalent to the greater of (a) 15.1% of the “average manufacturer price” (“AMP”) paid by wholesalers for products distributed to the retail pharmacy class of trade and (b) the difference between AMP and the “best price” available to essentially any customer other than the Medicaid program, with certain exceptions.  We negotiate rebates with drug manufacturers and, in certain circumstances, sell services to drug manufacturers.  Investigations have been commenced by certain governmental entities which question whether “best prices” were properly calculated, reported and paid by the manufacturers to the Medicaid programs.  We are not responsible for such calculations, reports or payments.  There can be no assurance, however, that our ability to negotiate rebates with, or sell services to, drug manufacturers will not be materially adversely affected by such investigations in the future.

Regulation of Financial Risk Plans.  Fee-for-service prescription drug plans generally are not subject to financial regulation by the states.  However, if a PBM offers to provide prescription drug coverage on a capitated basis or otherwise accepts material financial risk in providing the benefit, laws in various states may regulate the PBM.  Such laws may require that the party at risk establish reserves or otherwise demonstrate financial responsibility.  Laws that may apply in such cases include insurance laws, HMO laws or limited prepaid health service plan laws.

State Fiduciary Legislation.  Statutes have been introduced in several states which purport to declare that a PBM is a fiduciary with respect to its clients.  The fiduciary obligations that such statutes would impose would be similar, but not identical, to the scope of fiduciary obligations under ERISA.  To date only two jurisdictions -- Maine and the District of Columbia - have enacted such a statute.  Our trade association, Pharmaceutical Care Management Association (“PCMA”), has filed suit in federal courts in Maine and the District of Columbia alleging, among other things, that the statute is preempted by ERISA with respect to welfare plans that are subject to ERISA.  In the Maine case the United States District Court upheld the statute and recently that decision was affirmed by the United States Court of Appeals.  In the District of Columbia case, a preliminary injunction was obtained to stop enforcement of the statute.  No final decision has been issued by the court.  Widespread enactment of such statutes could have a material adverse effect upon our financial condition, results of operations and cash flows.

Regulation of Disease Management Services.  Our disease management programs are affected by many of the same types of state laws and regulations as our other activities.  In addition, all states regulate the practice of medicine and the practice of nursing.  We do not believe our disease management activities constitute either the practice of medicine or the practice of nursing.  However, there can be no assurance that a regulatory agency in one or more states may not assert a contrary position, and we are not aware of any controlling legal precedent for services of this kind.

ERISA Preemption.  Many of the state laws described above may be preempted in whole or in part by ERISA, with respect to self-funded plans which provides for comprehensive federal regulation of employee benefit plans.  However, the scope of ERISA preemption is uncertain and is subject to conflicting court rulings, and we provide services to certain clients, such as governmental entities, that are not subject to ERISA.  Other state laws may be invalid in whole or in part as an unconstitutional attempt by a state to regulate interstate commerce, but the outcome of challenges to these laws on this basis is uncertain.  Accordingly, compliance with state laws and regulations remains a significant operational requirement for us.

Home Delivery Regulation.  Our mail service pharmacies are located in Arizona, Missouri, New Mexico, New York, New Jersey, Pennsylvania, California, Texas, and Florida, and we are licensed to do business as a pharmacy in each such state.  Most of the states into which we deliver pharmaceuticals have laws that require out-of-state mail service pharmacies to register with, or be licensed by, the board of pharmacy or similar regulatory body in the state.  These states generally permit the home delivery service to follow the laws of the state in which the home delivery service is located, although certain states require that we also employ a pharmacist licensed in that state.  We believe we have registered each of our pharmacies in every state in which such registration is required.

Other statutes and regulations affect our mail service operations including the federal and state anti-kickback laws, federal Stark Law and state physician self-referral laws described above.  Federal and state statutes and regulations govern the labeling, packaging, advertising and adulteration of prescription drugs and the dispensing of controlled substances.  The Federal Trade Commission requires mail order sellers of goods generally to engage in truthful advertising, to stock a reasonable supply of the product to be sold, to fill mail orders within thirty days, and to provide clients with refunds when appropriate.  The United States Postal Service has statutory authority to restrict the delivery of drugs and medicines through the mail to a degree that could have an adverse effect on our mail service operations.

HIPAA and Other Privacy Legislation.  Most of our activities involve the receipt or use of confidential medical information concerning individual members.  In addition, we use aggregated and anonymized data for research and analysis purposes and in some cases provide access to such data to pharmaceutical manufacturers.  Various federal and state laws, including the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) (discussed below), currently regulate and restrict the use and disclosure of confidential medical information and new legislation is proposed from time to time in various states.  To date, no such laws have been adopted that adversely impact our ability to provide our services, but there can be no assurance that federal or state governments will not enact legislation, impose restrictions or adopt interpretations of existing laws that could have a material adverse effect on our operations.

In December 2000, the HHS issued final privacy regulations, pursuant to HIPAA, which, among other things, imposes restrictions on the use and disclosure of individually identifiable health information by certain entities.  The compliance date for the final privacy regulations was April 14, 2003. We believe we are in compliance, in all material respects, with the privacy regulations to the extent they apply to us.  HHS issued final regulations establishing certain electronic transaction standards and code sets in August 2000, with some modifications published in February 2003.  The compliance deadline for these regulations was October 16, 2002 (or, for certain small health care plans and entities that submitted an appropriate plan for compliance to the Secretary of HHS, October 16, 2003) and we believe we are in compliance, in all material respects, with the transaction standards.  Final security regulations under HIPAA were published on February 20, 2003, and the latest compliance date for these regulations was April 21, 2005.  We believe we are in compliance, in all material respects, with the regulations, to the extent they apply to us.

Specialty Services Environment.  Many of the laws and regulations cited above with respect to our PBM activities also apply with respect to our various specialty services through CuraScript.  Of particular relevance are the federal and state anti-kickback laws, federal Stark law, state physician self-referral laws, the state home delivery regulations and HIPAA, which are described above.  CuraScript’s pharmacists and nurses are licensed in those states where their activity requires it.  Various CuraScript pharmacy facilities also maintain certain Medicare licenses and state Medicaid licenses as pharmacies providing services under these programs.  Participation in these programs requires our pharmacies to comply with the applicable Medicare and state Medicaid provider rules and regulations, and exposes the pharmacies to various changes the federal and state governments may impose regarding reimbursement amounts to be paid to participating providers under these programs.  In addition, various CuraScript pharmacy facilities are participating providers under the new Part D Medicare program created pursuant to The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”).  As a condition to becoming a participating provider under Part D of the Act, the CuraScript pharmacies are required to adhere to certain requirements applicable to the Part D Medicare program.  In addition, as a condition to conducting its wholesale business, CuraScript must maintain various permits and licenses with the appropriate state and federal agencies, and is subject to various wholesale distributor laws that regulate the conduct of wholesale distributors, including, but not limited to, maintaining pedigree papers in certain instances.

PBS Regulatory Environment.  Our PBS activities operate in a regulatory environment that is quite similar to that of our PBM activities.  In particular, one of our subsidiaries, PMG, conducts certain activities, including the distribution of drug samples, that are subject to the requirements of the federal Prescription Drug Marketing Act and many of the other federal and state laws and regulations discussed above.

Future Regulation.  We are unable to predict accurately what additional federal or state legislation or regulatory initiatives may be enacted in the future relating to our businesses or the health care industry in general, or what effect any such legislation or regulations might have on us.  There can be no assurance that federal or state governments will not impose additional restrictions or adopt interpretations of existing laws that could have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Service Marks and Trademarks

We, and our subsidiaries, have registered the service marks “Express Scripts”, “Filled with Pride”, “Charting the Future of Pharmacy”, “PERx”, “National Prescription Administrators,” “PERxCare”, “RxWorkbench”, “DrugDigest”, “ValueRx”, “CuraScript”, “Priority Healthcare”, “CareLogic”, and “OncoScripts”, among others, with the United States Patent and Trademark Office.  Our rights to these marks will continue so long as we comply with the usage, renewal filing and other legal requirements relating to the renewal of service marks.  We are in the process of applying for registration of several other trademarks and service marks including, but not limited to, “CuraScriptSP”, “CuraScriptIP”, CuraScriptSD”, “FreedomFP” and “Healthbridge”.  If we are unable to obtain any additional registrations, we believe there would be no material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Insurance

Our PBM operations, including the dispensing of pharmaceutical products by our home delivery pharmacies, our Specialty operations, including the distribution of specialty drugs, and the services rendered in connection with our disease management and our PBS operations, may subject us to litigation and liability for damages.  Commercial insurance coverage has become more difficult to obtain, and accordingly, our retained liability has increased.  We have established certain self-insurance reserves to cover potential claims.  There can be no assurance that we will be able to maintain our professional and general liability insurance coverage in the future or that such insurance coverage, together with our self-insurance reserves, will be adequate to cover future claims.  A claim, or claims, in excess of our insurance coverage could have a material adverse effect upon our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Employees

As of January 1, 2006, we employed approximately 13,800 employees in the U.S. and 220 employees in Canada.  Approximately 1,800 of the U.S. employees are members of collective bargaining units.  Specifically, we employ members of the Service Employees International Union at our Bensalem, Pennsylvania facility, members of the United Auto Workers Union at our Farmington Hills, Michigan facility, members of the American Federation of State, County and Municipal Employees at our Harrisburg, Pennsylvania and East Hanover, New Jersey facilities and members of the United Food and Commercial Workers Union at our Albuquerque, New Mexico facility.  We believe our relationships with our employees and the unions that represent them are good.

Executive Officers of the Registrant

Our executive officers and their ages as of February 1, 2006 are as follows:

Name
 
Age
 
Position
George Paz
 
50
 
Chief Executive Officer and President
Edward Stiften
 
51
 
Senior Vice President, Chief Financial Officer
David A. Lowenberg
 
56
 
Chief Operating Officer
Thomas M. Boudreau
 
54
 
Senior Vice President, General Counsel and Corporate Secretary
Domenic A. Meffe
 
41
 
Senior Vice President - Specialty Services
C. K. Casteel
 
55
 
Senior Vice President - Supply Chain Management
Michael Holmes
 
47
 
Senior Vice President, Chief Human Resources Officer
Edward Ignaczak
 
40
 
Senior Vice President - Sales and Account Management
Patrick McNamee
 
46
 
Senior Vice President, Chief Information Officer
Brenda Motheral
 
36
 
Senior Vice President - Product Management
Douglas Porter
 
47
 
Senior Vice President - Client and Patient Services
Agnes Rey-Giraud
 
41
 
Senior Vice President - Strategy and Business Development
Kelley Elliott
 
33
 
Vice President, Chief Accounting Officer and Controller

Mr. Paz was elected President in October 2003 and Chief Executive Officer in April 2005.  Mr. Paz joined us and was elected Senior Vice President and Chief Financial Officer in January 1998.

Mr. Stiften was elected Senior Vice President and Chief Financial Officer in April 2004.  Prior to joining us, Mr. Stiften worked for BJC HealthCare, a hospital and health care organization, serving as Vice President and Chief Financial Officer since 1998.

Mr. Lowenberg was elected our Chief Operating Officer in September 1999, and served as our Senior Vice President and Director of Site Operations from November 1993 until September 1999.

Mr. Boudreau was elected Senior Vice President, General Counsel and Secretary in October 1994.  He has served as General Counsel since June 1994.

Mr. Meffe joined the Company as a result of our January 2004 acquisition of CuraScript, a Specialty business and PBM company.  Mr. Meffe was elected Senior Vice President - Specialty Services in February 2004.  Mr. Meffe served as President and Chief Executive Officer of CuraScript since August 2000.

Mr. Casteel was elected Senior Vice President - Supply Chain Management in September 2002.  Prior to joining us, Mr. Casteel worked for WorldCom, Inc., a telecommunications company, serving as Vice President, Law and Public Policy, between January 2001 and September 2002, and as Regional Executive, Public Policy, between January 1996 and January 2001.

Mr. Holmes joined us and was elected Senior Vice President and Chief Human Resources Officer in December 2005.  Prior to joining us, Mr. Holmes worked for Edward D. Jones & Co., L.P., a financial services company, as Principal from October 1996 through December 2004.

Mr. Ignaczak was elected Senior Vice President - Sales and Account Management in December 2002.  Mr. Ignaczak joined us in April 1998 and served as the Vice President and General Manager of our National Employer Division between April 1998 and December 2002.

Mr. McNamee joined us and was elected Senior Vice President and Chief Information Officer in February 2005.  Prior to joining us, Mr. McNamee worked for Misys Healthcare Systems, a healthcare technology company, as President and General Manager, Physician Systems, from September 2003 through February 2005.  Mr. McNamee was employed by various subsidiaries of General Electric Corporation from July 1989 through September 2003, including as President, GE OEC Medical Systems, a surgery x-ray manufacturing business, from July 2002 through September 2003; Senior Vice President, Chief Information Officer and Chief Quality Officer, NBC broadcast network from March 2001 to July 2002; and Chief Information Officer and General Manager of e-Business, GE Transportation Systems, a transportation manufacturing business, from March 1999 through March 2001.

Ms. Motheral was elected Senior Vice President - Product Management in January 2006.  Ms. Motheral previously served as Vice President - Product Development from January 2005 through January 2006, Vice President - Research and Trend Management from November 2003 through December 2004, Vice President - Research from June 2003 through November 2003, and Senior Director of Research from March 2000 through May 2002.

Mr. Porter joined us and was elected Senior Vice President - Client Services in July 2002 and assumed additional responsibilities as Senior Vice President - Client and Patient Services in September 2004.  Prior to joining us, Mr. Porter worked for CIGNA HealthCare, a managed healthcare company, as Vice President - Employer Services between March 2001 and June 2002 and as Vice President - Transformation between October 1999 and February 2001.

Ms. Rey-Giraud was elected Senior Vice President - Strategy and Business Development in January 2006, served as Senior Vice President of Product Management between December 2003 and January 2006, and served as Senior Vice President - Program Development between July 2002 and December 2003.  Ms. Rey-Giraud served as Vice President and General Manager - eBusiness between January 2000 and July 2002 and has served on the RxHub, LLC, Board of Directors since February 2000 (See “Rx-Hub”).  Ms. Rey-Giraud joined us in May 1999 as a Senior Director of Administration and Operations.
 
Ms. Elliott was elected Vice President, Chief Accounting Officer and Controller in December 2005.  Ms. Elliott previously served in our Internal Audit Department between February 2002 and December 2005, most recently as Vice President.
 
Forward Looking Statements and Associated Risks 

Information that we have included or incorporated by reference in this Annual Report on Form 10-K, and information that may be contained in our other filings with the Securities and Exchange Commission (the “SEC”) and our press releases or other public statements, contain or may contain forward-looking statements. These forward-looking statements include, among others, statements of our plans, objectives, expectations or intentions.

Our forward-looking statements involve risks and uncertainties. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. We do not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. Factors that might cause such a difference to occur include, but are not limited to:


 
risks associated with the integration of Priority Healthcare and CuraScript
 
costs of and adverse results in litigation, including a number of pending class action cases that challenge certain of our business practices
 
risks arising from investigations of certain PBM practices and pharmaceutical pricing, marketing and distribution practices currently being conducted by the U.S. Attorney offices in Philadelphia and Boston, and by other regulatory agencies including the Department of Labor, and various state attorneys general
 
risks and uncertainties regarding the implementation of the Medicare Part D prescription drug benefit, including financial risks to us to the extent that we participate in the program on a risk-bearing basis, risks of client or member losses to other providers under Medicare Part D, and increased regulatory risk
 
risks and uncertainties associated with CMS’ implementation of the Medicare Part B Competitive Acquisition Program (“CAP”), including the potential loss of clients/revenues to providers choosing to participate in the CAP
 
risks associated with our acquisitions (including our acquisition of Priority Healthcare), which include integration risks and costs, risks of client retention and repricing of client contracts, and risks associated with the operations of acquired businesses 
 
risks associated with our ability to maintain growth rates, or to control operating or capital costs 
 
continued pressure on margins resulting from client demands for lower prices, enhanced service offerings and/or higher service levels, and the possible termination of, or unfavorable modification to, contracts with key clients or providers 
 
competition in the PBM and specialty pharmacy industries, and our ability to consummate contract negotiations with prospective clients, as well as competition from new competitors offering services that may in whole or in part replace services that we now provide to our customers 
 
adverse results in regulatory matters, the adoption of new legislation or regulations (including increased costs associated with compliance with new laws and regulations), more aggressive enforcement of existing legislation or regulations, or a change in the interpretation of existing legislation or regulations 
 
increased compliance risks relating to our contracts with the DoD TRICARE Management Activity and various state governments and agencies
 
the possible loss, or adverse modification of the terms, of relationships with pharmaceutical manufacturers, or changes in pricing, discount or other practices of pharmaceutical manufacturers or interruption of the supply of any pharmaceutical products
 
risks associated with the possible loss, or adverse modification of the terms of, contracts with pharmacies in our retail pharmacy network
 
risks associated with the use and protection of the intellectual property we use in our business 
 
risks associated with our leverage and debt service obligations, including the effect of certain covenants in our borrowing agreements 
 
risks associated with our ability to continue to develop new products, services and delivery channels 
 
general developments in the health care industry, including the impact of increases in health care costs, changes in drug utilization and cost patterns and introductions of new drugs 
 
increase in credit risk relative to our clients due to adverse economic trends 
  risks associated with changes in average wholesale prices, which could reduce prices and margins
 
risks associated with our inability to attract and retain qualified personnel 
 
other risks described from time to time in our filings with the SEC
 
    These and other relevant factors, including those risk factors in “Item 1A—Risk Factors” in this Annual Report and any other information included or incorporated by reference in this Report, and information that may be contained in our other filings with the SEC, should be carefully considered when reviewing any forward-looking statement

Item 1A—Risk Factors
 
Failure to Maintain Growth Rates, or to Control Operating or Capital Costs, Could Adversely Affect Our Business 

      We have experienced rapid growth over the past several years.  Our ability to maintain our growth rate is dependent upon our ability to attract new clients, achieve growth in the membership base of our existing clients as well as cross-sell additional services to our existing clients.  If we are unable to continue our client and membership growth, and manage our operating and capital costs, our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations could be materially adversely affected.

Client Demands for Enhanced Service Levels or Possible Loss or Unfavorable Modification of Contracts with Clients or Providers, Could Pressure Margins

As our clients face the continued rapid growth in prescription drug costs, they may demand additional services and enhanced service levels to help mitigate the increase in spending.  We operate in a very competitive environment, and we may not be able to increase our fees to compensate for these increased services, which could put pressure on our margins.  

We currently provide services to thousands of clients.  Our contracts with clients generally do not have terms longer than three years and, in some cases, are terminable by the client on relatively short notice.  Our larger clients generally seek bids from other PBM or Specialty providers in advance of the expiration of their contracts.  If several of these large clients elect not to extend their relationship with us, and we are not successful in generating sales to replace the lost business, our future business and operating results could be materially adversely affected.  In addition, we believe the managed care industry is undergoing substantial consolidation, and another party that is not our client could acquire some of our managed care clients.  In such case, the likelihood such client would renew its contract with us could be reduced.

More than 58,000 retail pharmacies, which represent more than 98% of all United States retail pharmacies, participate in one or more of our networks.  However, the top ten retail pharmacy chains represent approximately 51% of the total number of stores in our largest network, and these pharmacy chains represent even higher concentrations in certain areas of the United States.  Our contracts with retail pharmacies, which are non-exclusive, are generally terminable on relatively short notice.  If one or more of the top pharmacy chains elects to terminate its relationship with us, our members’ access to retail pharmacies and our business could be materially adversely affected.  In addition, many large pharmacy chains either own PBMs today, or could attempt to acquire a PBM in the future.  Ownership of PBMs by retail pharmacy chains could have material adverse effects on our relationships with such pharmacy chains and on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.
 
Competition in the PBM Industry, Including Specialty, Could Reduce Profit Margins 

The PBM business is very competitive.  Our competitors include large and well-established companies that may have greater financial, marketing and technological resources than we do.  Competition may also come from other sources in the future.  We cannot predict what effect, if any, these new competitors may have on the marketplace or on our business.

Over the last several years competition in the marketplace has caused many PBMs, including us, to reduce the prices charged to clients for core services and share a larger portion of the formulary fees and related revenues received from pharmaceutical manufacturers with clients.  This combination of lower pricing and increased revenue sharing, as well as increased demand for enhanced service offerings and higher service levels, have put pressure on operating margins.  We expect to continue marketing our services to larger clients, who typically have greater bargaining power than smaller clients.  This might create continuing pressure on our margins.  We can give no assurance that new services provided to these clients will fully compensate for these reduced margins.

The Specialty industry is also highly competitive and is experiencing both horizontal and vertical consolidation.  The products we sell are available from multiple sources.  Competitors include other specialty distributors, regional and national full-line, full-service pharmaceutical and medical supply distributors, home infusion therapy companies, pharmaceutical manufacturers and others.  Our failure to maintain and expand relationships with payors, who can effectively determine the pharmacy source for their members, could materially adversely affect our competitive position.  Our competitive position could also be adversely affected by any inability to obtain access to new biotech pharmaceutical products.

State and Federal Regulations, and Their Interpretation or Application, Could Restrict Our Ability to Conduct Our Business

Numerous state and federal laws and regulations affect our business and operations.  The categories include, but are not necessarily limited to:

 
health care fraud and abuse laws and regulations, which prohibit certain types of payments and referrals as well as false claims made in connection with health benefit programs
 
ERISA and related regulations, which regulate many health care plans
 
state legislation regulating PBMs or imposing fiduciary status on PBMs
 
consumer protection and unfair trade practice laws and regulations
 
network pharmacy access laws, including “any willing provider” and “due process” legislation, that affect aspects of our pharmacy network contracts
 
wholesale distributor laws, including pedigree paper laws
 
legislation imposing benefit plan design restrictions, which limit how our clients can design their drug benefit plans
 
various licensure laws, such as managed care and third party administrator licensure laws
 
drug pricing legislation, including “most favored nation” pricing and “unitary pricing” legislation
 
pharmacy laws and regulations
 
privacy and confidentiality laws and regulations, including those under HIPAA
 
the Medicare prescription drug coverage law
 
other Medicare and Medicaid reimbursement regulations
 
potential regulation of the PBM industry by the U.S. Food and Drug Administration
 
pending legislation regarding importation of drug products into the United States

These and other regulatory matters are discussed in more detail under “Item 1—  Business — Government Regulation” above.

We believe we are operating our business in substantial compliance with all existing legal requirements material to the operation of our business.  There are, however, significant uncertainties regarding the application of many of these legal requirements to our business, and a number of state and federal law enforcement agencies and regulatory agencies have initiated investigations or litigation that involve certain aspects of our business or our competitors’ businesses.  Accordingly, we cannot provide any assurance that one or more of these agencies will not interpret or apply these laws differently, or, if there is an enforcement action brought against us, that our interpretation would prevail.  In addition, there are numerous proposed healthcare laws and regulations at the federal and state levels, many of which could materially affect our ability to conduct our business or adversely affect our consolidated results of operations.  We are unable to predict what additional federal or state legislation or regulatory initiatives may be enacted in the future relating to our business or the healthcare industry in general, or what effect any such legislation or regulations might have on us.

The OIG of HHS issued the final Guidance on April 28, 2003.  The Guidance, which represents OIG’s general views and is not legally binding, contains guidelines for the design and operation of voluntary programs by pharmaceutical manufacturers to promote compliance with the laws relating to federal health care programs.  In addition, the Guidance identifies certain risk areas for pharmaceutical manufacturers, including certain types of arrangements between manufacturers and PBMs, pharmacies, physicians and others that have the potential to implicate the anti-kickback statute.  The Guidance contains a discussion of how manufacturers can structure their arrangements with PBMs, such as rebate programs and formulary support activities, to comply with the anti-kickback statute.

The U.S. Attorney General’s Office in Philadelphia is conducting an investigation into certain PBM business practices.  Medco and AdvancePCS (since acquired by Caremark) have received subpoenas in connection with this investigation.  The U.S. Attorney’s office has also intervened in a qui tam (“whistle blower”) proceeding, challenging certain of Medco’s business practices.  We have received a subpoena from the U.S. Attorney’s Office in Boston, as have other PBMs including Caremark and Wellpoint Health Systems.  We have also received a letter of inquiry from the Department of Labor.  We cannot predict what effect, if any, these investigations may ultimately have on us or on the PBM industry generally (See Item 3 -Legal Proceedings).

The State of Maine and the District of Columbia each have enacted statutes that purport to declare that a PBM is a fiduciary with respect to its clients.  Our trade association, PCMA filed suit in Federal District Courts in Maine and the District of Columbia alleging, among other things, that these statutes are preempted by ERISA with respect to welfare plans that are subject to ERISA.  The Federal District Court in Maine ruled the statute valid, and the First Circuit Court of Appeals affirmed.  The case challenging the D.C. statute is still pending.  Other states are considering but have not yet enacted similar fiduciary statutes.

Most of our activities involve the receipt or use of confidential medical information concerning individual members.  In addition, we use aggregated and anonymized data for research and analysis purposes and in some cases provide access to such data to pharmaceutical manufacturers.  Various federal and state laws, including the HIPAA (discussed below), currently regulate and restrict the use and disclosure of confidential medical information and new legislation is proposed from time to time in various states.  To date, no such laws have been adopted that adversely impact our ability to provide our services, but there can be no assurance that federal or state governments will not enact legislation, impose restrictions or adopt interpretations of existing laws that could have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

In December 2000, HHS issued final privacy regulations, pursuant to HIPAA, which, among other things, imposes restrictions on the use and disclosure of individually identifiable health information by certain entities.  The compliance date for the final privacy regulations was April 14, 2003.  We believe we are in compliance, in all material respects, with the regulations to the extent they apply to us.  We are required to comply with certain aspects of these regulations.  For example, we are a “business associate” under HIPAA in some instances with respect to our health plan clients and a “covered entity” under HIPAA when service is provided through our home delivery pharmacies.  Other HIPAA requirements relate to electronic transaction standards and code sets and the security of protected health information when it is maintained or transmitted electronically.  HHS issued final regulations establishing certain electronic transaction standards and code sets in August 2000, with some modifications published in February 2003.  The compliance deadline for these regulations was October 16, 2002 (or, for certain small health care plans and entities that submitted an appropriate plan for compliance to the Secretary of HHS, October 16, 2003).  Final security regulations under HIPAA were published on February 20, 2003, and for most entities, the compliance date for these regulations was April 21, 2005.

Loss of Relationships with Pharmaceutical Manufacturers and Changes in the Regulation of Discounts and Formulary Fees Provided to Us by Pharmaceutical Manufacturers Could Decrease Our Profits 

We maintain contractual relationships with numerous pharmaceutical manufacturers that provide may provide us, among other things, with:

 
discounts at the time we purchase the drugs to be dispensed from our home delivery pharmacies
 
rebates based upon sales of drugs from our home delivery pharmacies and through pharmacies in our retail networks
 
administrative fees for managing rebate programs, including the development and maintenance of formularies which include the particular manufacturer’s products

        If several of these contractual relationships are terminated or materially altered by the pharmaceutical manufacturers, our results of operations, consolidated financial position and/or consolidated cash flow from operations could be materially adversely affected. In addition, formulary fee programs have been the subject of debate in federal and state legislatures and various other public and governmental forums. Changes in existing laws or regulations or in interpretations of existing laws or regulations or the adoption of new laws or regulations relating to any of these programs may materially adversely affect our business.

Pending and Future Litigation Could Subject Us to Significant Monetary Damages and/or Require Us to Change Our Business Practices

We are subject to risks relating to litigation and other proceedings in connection with our PBM operations, including the dispensing of pharmaceutical products by our home delivery pharmacies, and the services rendered in connection with our disease management and our PBS operations.  A list of a number of the more significant proceedings pending against us is included under Item 3 - Legal Proceedings.  These proceedings generally seek unspecified monetary damages and injunctive relief on behalf of a class of plaintiffs that are either our clients or individual members of health plans.  While we believe that these suits are without merit and intend to contest them vigorously, we can give no assurance that an adverse outcome in one or more of these suits would not have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations, or would not require us to make material changes to our business practices.  We are presently responding to several subpoenas and requests for information from governmental agencies, as described in "Item 3 - Legal Proceedings."  We cannot predict with certainty what the result of any such inquiry might be.  In addition to potential monetary liability arising from these suits and proceedings, we are incurring costs in the defense of the suits and in providing documents to government agencies.  Certain of the costs are covered by our insurance, but certain other costs are not insured.  Such costs have become material to our financial performances and we can give no assurance that such costs will not increase in the future.

Commercial Liability insurance coverage continues to be difficult to obtain for companies in our business sector which can cause unexpected volatility in premiums and/or retention requirements dictated by insurance carriers.  We have established certain self-insurance reserves to cover anticipated losses within our retained liability for previously reported claims and the cost to defend these claims.  There can be no assurance that general, professional, managed care errors and omissions, and/or other liability insurance coverage will be reasonably available in the future or that such insurance coverage, together with our self-insurance reserves, will be adequate to cover future claims.  A claim, or claims, in excess of our insurance coverage could have a material adverse effect upon our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Our Leverage and Debt Service Obligations Could Impede Our Operations and Flexibility

As of December 31, 2005, we had consolidated debt of approximately $1.5 billion and our debt to equity ratio was 103.1%.  In October 2005, we negotiated a $2.2 billion credit facility and refinanced our borrowings under our previous bank credit facility.  Our bank credit facility is guaranteed by certain of our subsidiaries.  We have substantial interest expense and future repayment obligations.

Our level of debt and the limitations imposed on us by our debt agreements could have important consequences, including the following:

 
we will have to use a portion of our cash flow from operations for debt service rather than for our operations
 
we may from time to time incur additional indebtedness under our revolving credit facility, which is subject to a variable interest rate, making us vulnerable to increases in interest rates
 
we could be less able to take advantage of significant business opportunities, such as acquisition opportunities, and react to changes in market or industry conditions
 
we could be more vulnerable to general adverse economic and industry conditions
 
we may be disadvantaged compared to competitors with less leverage

Furthermore, our ability to satisfy our obligations, including our debt service requirements, will be dependent upon our future performance.  Factors which could affect our future performance include, without limitation, prevailing economic conditions and financial, business and other factors, many of which are beyond our control and which could affect our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Failure to Develop New Products, Services and Delivery Channels May Adversely Affect Our Business 

We operate in a highly competitive environment.  We develop new products and services from time to time to assist our clients in managing the pharmacy benefit.  If we are unsuccessful in developing innovative products and services, our ability to attract new clients and retain existing clients may suffer.

Technology is also an important component of our business, as we continue to utilize new and better channels, such as the Internet, to communicate and interact with our clients, members and business partners.  If our competitors are more successful than us in employing this technology, our ability to attract new clients, retain existing clients and operate efficiently may suffer.

Efforts to Reduce Health Care Costs and Alter Health Care Financing Practices Could Adversely Affect Our Business

Certain proposals have been made in the United States to control health care costs, including prescription drug costs, in response to increases in prescription drug utilization rates and drug prices.  These proposals include “single-payer” government funded health care, and price controls on prescription drugs.  If these or similar efforts are successful or if prescription drug utilization rates were to decrease significantly, whether due to a reversal in the growing role of prescription drugs in medical treatment or otherwise, our business and consolidated results of operations could be materially adversely affected.

We have designed our business model to compete within the current structure of the U.S. health care system.  Changing political, economic and regulatory influences may affect health care financing and reimbursement practices.  If the current health care financing and reimbursement system changes significantly, our business could be materially adversely affected.  Congress periodically considers proposals to reform the U.S. health care system.  These proposals may increase government involvement in health care and regulation of PBM services, or otherwise change the way our clients do business.  Health plan sponsors may react to these proposals and the uncertainty surrounding them by reducing or delaying purchases of cost control mechanisms and related services that we provide.  We cannot predict what effect, if any, these proposals may have on our business.  Other legislative or market-driven changes in the health care system that we cannot anticipate could also materially adversely affect our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.

Future Implementation of Certain Government Initiatives Could Create Risks for our Business 

In connection with the enactment of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “MMA”), the Department of Health and Human Services Centers for Medicare and Medicaid Services (“CMS”) promulgated a substantial volume of new regulations implementing the federal government’s Voluntary Prescription Drug Benefit Program, known as Medicare “Part D.”  The OIG has also recently proposed new safe harbors and other regulation pursuant to the MMA.  Both of these federal regulatory agencies continue to issue guidance with regard to the Part D program and compliance with related federal laws and regulations by Part D sponsors and their subcontractors.  The receipt of federal funds made available through this program by Express Scripts, its affiliates, or clients may be subject to compliance with these new regulations as well as the established laws and regulations governing the federal government’s payment for health care goods and services, as discussed above under Government Regulation, including the Anti-Kickback Laws, the Stark Law, and the False Claims Act.  There are many uncertainties about the financial and regulatory risks of participating in the Medicare Part D program, and we can give no assurance that these risks will not be material to our business in future periods.

Failure to Integrate Recent Acquisitions Could Adversely Affect Our Business 

In October 2005 we acquired Priority for approximately $1.3 billion and in January 2004, we acquired CuraScript for approximately $333 million.  We are in the process of integrating these businesses with our other operations. There are risks associated with integrating and operating newly acquired businesses.  We can give no assurance that we will successfully operate this new business.

Increased Credit Risk Relative to Our Clients

We recorded revenues of $16.3 billion during 2005 and we bill substantial amounts to many of our clients.  A deterioration of credit risks of any of our larger clients could impact our ability to collect revenue or provide future services, which could negatively impact the results of our operations.  While we are focused on managing working capital, we can give no assurances that the deterioration of the credit risks relative to our clients would not have an adverse impact on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.
 
Item 1B—Unresolved Staff Comment Letters

There are no material unresolved written comments that were received from the SEC Staff 180 days or more before the end of our fiscal year relating to our periodic or current reports under the Securities Exchange Act of 1934.

Item 2 - Properties

We operate our United States and Canadian PBM, Specialty and PBS businesses out of leased and owned facilities throughout the United States and Canada. The Company’s main facilities are as follows:

 
PBM Facilities
 
Specialty Facilities
 
PBS Facilities
Maryland Heights, Missouri (six facilities)
Orlando, Florida (two facilities)
Maryland Heights, Missouri (two facilities)
Tempe, Arizona (three facilities)
Lake Mary, Florida (three facilities)
Lincoln Park, New Jersey (two facilities)
Bloomington, Minnesota (two facilities)
Grove City, Ohio (two facilities)
Montville, New Jersey
Bensalem, Pennsylvania (two facilities)
Louisville, Kentucky (two facilities)
PineBrook, New Jersey
Troy, New York
Braintree, Massachusetts
 
Albuquerque, New Mexico
Brewster, New York
 
Horsham, Pennsylvania
Byfield, Massachusetts
 
Montreal, Quebec
Dayton, Ohio
 
Mississauga, Ontario
Lexington, Kentucky
 
East Hanover, New Jersey
Marietta, Georgia
 
Swatara, Pennsylvania
Rancho Cucamunga, California
 
St. Mary’s, Georgia
Sparks, Nevada
 
Pueblo, Colorado
   
 
Our Maryland Heights, Missouri facility houses our corporate offices.  We believe our facilities generally have been well maintained and are in good operating condition.  At January 1, 2006, our existing facilities comprise approximately 2.5 million square feet in the aggregate.  This table does not reflect a lease agreement we signed during 2005 for a new corporate headquarters. The building is in the process of being built and we do not anticipate taking possession until the first quarter of 2007. The annual lease commitments will begin at approximately $4 million and the term of the lease is ten and a half years.

We own and lease certain of our computer systems at processing centers managed, maintained and operated by EDS in Plano, Texas and Auburn Hills, Michigan.  Our software for claims processing and drug utilization review, pharmacy operations and other products has been developed internally by us or purchased under perpetual, nonexclusive license agreements with third parties.  Our computer systems at each site are extensively integrated and share common files through local and wide area networks.  Uninterruptible power supply and diesel generators allow our computers, telephone systems and pharmacies at each major site to continue to function during a power outage.  To protect against loss of data and extended downtime, we store software and redundant files at both on-site and off-site facilities on a regular basis and have contingency operation plans in place.  We cannot, however, provide any assurance that our contingency or disaster recovery plans would adequately address all relevant issues.

Item 3 — Legal Proceedings

We and/or our subsidiaries are defendants in a number lawsuits that purport to be class actions.  Each case seeks damages in an unspecified amount.  We cannot ascertain with any certainty at this time the monetary damages or injunctive relief that any of the plaintiffs may seek to recover.  In addition, we are the subject of several governmental investigations described below.  Such investigations could result in civil damages, criminal penalties, or other sanctions, the nature and amount of which we cannot currently estimate.  We cannot, however, provide any assurance that the outcome of any of these matters, or some number of them in the aggregate, will not be materially adverse to our financial condition, consolidated results of operations, cash flows or business prospects.  In addition, the expenses of defending these cases may have a material effect on our financial results.

These matters are:

 
·
Multi-District Litigation - The Judicial Panel on Multi-District Litigation has transferred a number of previously disclosed cases to the Eastern District of Missouri for coordinated or consolidated pretrial proceedings including the following:  Minshew v. Express Scripts (Cause No. Civ.4:02-CV-1503, United States District Court for the Eastern District of Missouri); Lynch v. National Prescription Administrators, et al. (Cause No. 03 CV 1303, United States District Court for the Southern District of New York); Mixon v. Express Scripts, Inc. (Civil Action No. 4:03CV1519, United States District Court for the Eastern District of Missouri); Wagner et al. v. Express Scripts (Cause No. 04cv01018 (WHP))United States District Court for the Southern District of New York); Scheuerman, et al v. Express Scripts (Cause No. 04-CV-0626 (FIS) (RFT)) United States District Court for the Southern District of New York); Correction Officers’ Benevolent Association of the City of New York, et al. v. Express Scripts, Inc. (Cause No. 04-Civ-7098 (WHP)), United States District Court for the Southern District of New York); United Food and Commercial Workers Unions and Employers Midwest Health Benefits Fund, et al v. National Prescription Administrators, Inc., et al. (Cause No. 04-CV-7472, United States District Court for the Southern District of New York); Central Laborers’ Welfare Fund, et al v. Express Scripts, Inc., et al (Cause No. B04-1002240, United States District Court for the Southern District of Illinois); and Local 153 Health Fund, et al. v. Express Scripts Inc. and ESI Mail Pharmacy Service, Inc. (Cause No. B05-1004036, United States District Court for the Eastern District of Missouri).  The plaintiffs assert that certain of our business practices, including those relating to our contracts with pharmaceutical manufacturers for retrospective discounts on pharmaceuticals and those related to our retail pharmacy network contracts, constitute violations including fiduciary duties under the Federal Employee Retirement Income Security Act (ERISA), common law fiduciary duties, state common law, state consumer protection statutes, breach of contract, and deceptive trade practices.  The putative classes consist of both ERISA and non-ERISA health benefit plans as well as beneficiaries.  The various complaints seek money damages and injunctive relief.  Discovery is proceeding in these cases.  Plaintiffs in Minshew have filed motions for class certification and partial summary judgment on the issue of our fiduciary status under ERISA.

 
·
International Association of Firefighters, Local No. 22, et al. v. National Prescription Administrators and Express Scripts, Inc. (Cause No. L03216-02, Superior Court of New Jersey, Law Division, Camden County).  On or about August 16, 2002, we were served with this lawsuit alleging that our subsidiary, National Prescription Administrators, Inc. ("NPA"), had breached agreements with two benefit plans to whom NPA had provided services under an umbrella agreement with a labor coalition client.  We were also named as a defendant under a theory of de facto merger.  The plaintiffs purport to bring the action on behalf of a class of similarly situated plans.  The lawsuit alleges that NPA had not paid the plans the rebates to which they were entitled under the agreement.  Claims for unspecified money damages are asserted under the New Jersey Consumer Fraud Act (‘the CFA”), and for breach of contract and unjust enrichment.  We have filed answers denying liability.  On July 23, 2004, summary judgment was granted in favor of NPA and us on the customer fraud counts.  Plaintiff filed a motion to certify a class of all members of the labor coalition, which was denied by the court.  Plaintiff voluntarily dismissed all remaining class action claims.  This case has been resolved and dismissed.

 
·
Jerry Beeman, et al. v. Caremark, et al. (Cause No. 021327, United States District Court for the Central District of California).  On December 12, 2002, we were served with a complaint against us and several other pharmacy benefit management companies.  The complaint, filed by several California pharmacies as a putative class action, alleges rights to sue as a private attorney general under California law.  The complaint alleges that we, and the other defendants, failed to comply with statutory obligations under California Civil Code Section 2527 to provide our California clients with the results of a bi-annual survey of retail drug prices.  On July 12, 2004, the case was dismissed with prejudice on the grounds that the plaintiffs lacked standing to bring the action.  Plaintiffs have filed an appeal to the U.S. Court of Appeals for the Ninth Circuit.

 
·
Anthony Bradley, et al v. First Health Services Corporation, et al (Cause No. BC319292, Superior Court for the State of California, County of Los Angeles) On July 30, 2004, plaintiffs filed a complaint as a putative class action, alleging rights to sue as a private attorney general under California law.  The complaint alleges that we, and the other defendants, failed to comply with statutory obligations under California Civil Code Section 2527 to provide our California clients with the results of a bi-annual survey of retail drug prices.  Plaintiffs request injunctive relief, unspecified monetary damages and attorneys fees.  Several of the plaintiffs are the same as in Beeman, et al v. Caremark, et al, and the relief sought is substantially the same as that sought in Beeman. Our motion to dismiss the complaint was granted and plaintiffs appealed.
     
  · American Federation of State, County & Municipal Employees (AFSCME) v. AdvancePCS, et al. (Cause No. BC292227, Superior Court of the State of California for the County of Los Angeles).  This action was filed on March 17, 2003.  The case purports to be a class action on behalf of AFSCME, its California member unions having non-ERISA health plans, and all California public employees who participate in non-ERISA health plans.  The complaint alleges that certain business practices engaged in by us and other PBM defendants violated California’s Unfair Competition Law.  The suit seeks unspecified monetary damages and injunctive relief.  This case was coordinated with the Irwin case in this court, as described below.  A stipulated dismissal has been signed by the parties and an order of dismissal with prejudice has been entered by the court.  Plaintiff has appealed.  
 
 
·
Irwin v. AdvancePCS, et al. (Cause No. RG030886393, Superior Court of the State of California for Alameda County).  This action was filed on March 26, 2003.  This case is brought by plaintiff alleging his right to sue as a private attorney general under California law.  This case purports to be a class action against us and other PBM defendants on behalf of self-funded, non-ERISA health plans; and individuals with no prescription drug benefits that have purchased drugs at retail rates.  The complaint alleges that certain business practices engaged in by us and by other PBM defendants violated California’s Unfair Competition Law.  The suit seeks unspecified monetary damages and injunctive relief.  This case has been coordinated with the AFSCME case in Los Angeles County Superior Court.  Our motion for judgment on the pleadings in our favor was granted, with plaintiffs given leave to file an amended complaint which they did.

 
·
North Jackson Pharmacy, Inc., et al. v. Express Scripts (Civil Action No. CV-03-B-2696-NE, United States District Court for the Northern District of Alabama).  This action was filed on October 1, 2003.  This case purports to be a class action against us on behalf of independent pharmacies within the United States.  The complaint alleges that certain of our business practices violate the Sherman Antitrust Act, 15 U.S.C §1, et. seq.  The suit seeks unspecified monetary damages (including treble damages) and injunctive relief. Plaintiffs’ motion for class certification has been briefed and argued.

 
·
People of the State of New York, et al v. Express Scripts, Inc. (Cause No. 4669-04, Supreme Court of the State of New York, County of Albany)  On August 4, 2004, the State of New York filed a complaint against us and Cigna Life Insurance Co.  The complaint alleges certain breaches of contract and violations of civil law in connection with our management of the prescription drug plan for the State of New York and its employees.  The complaint also alleges certain violations of civil law in connection with the Company’s therapeutic interchange programs.  The State has requested injunctive relief, unspecified monetary damages and attorney’s fees.  We have filed a motion to dismiss the complaint.  The court originally stayed this action pending the outcome of the Wagner and Scheuerman cases, referred to above, both of which assert claims relating to the New York State prescription drug plan.  The court issued an order to lift the stay in February 2006.

 
·
In re Express Scripts Securities Litigation (Cause No. 4:04-CV-1009, United States District Court for the Eastern District of Missouri )  The shareholder lawsuits, Sylvia Childress, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01191, United States District Court for the Eastern District of Missouri) Lidia Garcia, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-1009, United States District Court for the Eastern District of Missouri); Robert Espriel, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01084, United States District Court for the Eastern District of Missouri); Raymond Hoffman, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01054, United States District Court for the Eastern District of Missouri); John R. Nicholas, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-1295, United States District Court for the Eastern District of Missouri); John Keith Tully, et al v. Express Scripts, Inc., et al (Cause No. 04-CV-01338, United States District Court for the Eastern District of Missouri), were consolidated.  Plaintiffs have filed an amended complaint.  The complaint alleges that Express Scripts and certain of our officers violated federal securities law.  The complaint alleges that we failed to disclose certain alleged improper business practices and issued false and misleading financial statements and that certain officers violated insider trading laws.  The complaint is brought on behalf of purchasers of our stock during the period October 29, 2003 to August 3, 2004.  The complaint requests unspecified compensatory damages, equitable relief and attorney’s fees.  Defendants have filed a motion to dismiss.

 
·
Derivative lawsuits: Scott Rehm, Derivatively on behalf of nominal Defendant, Express Scripts, Inc. v. Stuart Bascomb, et al (Cause No. 4:04-cv-01319-HEA, United States District Court for the Eastern District of Missouri) (filed 8/27/04); Charles Manzione, Derivatively on Behalf of Express Scripts, Inc. v. Barrett Toan et al United States District Court for the Eastern District of Missouri) (filed 10/22/04); Gary Miller Derivatively on behalf of nominal Defendant, Express Scripts, Inc. v. Stuart Bascomb, et al (Cause No 042-08632, Missouri Circuit Court, City of St. Louis) (filed 10/29/04). Judith Deserio, Derivatively on behalf of Nominal Defendant, Express Scripts, Inc. v. Stuart L. Bascomb, et al (Cause No. 042-09374, Missouri Circuit Court, City of St. Louis) (filed 12-22-04); Isidore Mendelovitz, Derivatively and on Behalf of Nominal Defendant, Express Scripts, Inc. v. Gary G. Benanav, et al (Cause No. 04-CV-8610, United States District Court for the Southern District of New York) (filed 11-1-04).  Plaintiffs have filed shareholder derivative lawsuits against cerain of our current and former directors and officers.  The cases make various allegations including that the defendants caused us to issue false and misleading statements, insider selling, breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment.  Plaintiffs demand unspecified compensatory damages, equitable relief and attorney’s fees.  Several cases have been removed to federal court.

 
·
Harry Silverman v. Priority Healthcare Corporation, et al (Case No. 05-CA-1628-16-K, Circuit Court of the Eighteenth District, Seminole County, Florida). On or about August 15, 2005, a purported shareholder class action lawsuit related to the merger agreement between us and Priority Healthcare Corporation ("Priority") was filed naming Priority and each of its directors as defendants.  Priority and its directors responded to the complaint by filing a Motion for Judgment on the Pleadings requesting that the lawsuit be dismissed. On September 19, 2005, the plaintiff filed a First Amended Class Action Complaint alleging, among other things, that Priority's directors breached their fiduciary duties of good faith, fair dealing, loyalty, due care and candor to Priority's shareholders and that Priority aided and abetted its directors' breaches of their fiduciary duties by entering into the merger agreement.  On September 20, 2005, the parties reached an agreement in principle providing for the settlement of the lawsuit based upon additional disclosures in Priority’s final proxy statement and the payment of plaintiff’s fees and expenses.
 
 
·
Pearson’s Pharmacy, Inc. and Cam Enterprises, Inc. d/b/a Altadena Pharmacy v. Express Scripts, Inc. (Case No. 3:06-CV-00073-WKW, United States District Court for the Middle District of Alabama). On February 15, 2005, a class action on behalf of all pharmacies reimbursed based upon Average Wholesale Price was filed. The complaint alleges that Express Scripts fails to fully, timely and properly reimburse pharmacies for filling prescriptions. Plaintiffs seek unspecified monetary damages and injunctive relief.
 
The investigation by the U.S. Attorney’s Office in Boston, Massachusetts of various possible health care offenses and other federal crimes continues. We believe the original subject matter of the investigation relating to TAP Pharmaceuticals is no longer at issue, but other issues remain the subject of the investigation. Specifically, the investigation now relates to our formulary development process and our business relationships with certain pharmaceutical manufacturers and others, among other matters, and we continue to receive subpoenas in connection with the investigation. We continue to comply with the subpoenas and are cooperating with the investigation.
 
The Company received several letters from the Kansas City, Missouri office of the DOL indicating that DOL is undertaking an investigation of the Company to determine whether any person has violated Title I of ERISA and directing the Company to produce documents relating to various aspects of the Company’s business.  The Company is cooperating with the investigation.

On July 21, 2004, we received a Civil Investigative Demand from the Attorney General of the State of Vermont.  A total of 27 states and the District of Columbia have now issued substantially identical civil investigative demands.  The civil investigative demands received to date seek documents regarding a wide range of our business practices.  We are cooperating with this multi-state investigation.
 
In November 2004, Priority Healthcare received a subpoena from the U.S. Department of Justice (the “DOJ”) requiring Priority to provide the DOJ with certain information regarding the promotion and marketing of Actimmune, a product manufactured by InterMune, Inc. Priority believes that the materials sought by the DOJ are part of an ongoing investigation being conducted by the United States Attorney’s Office for the Northern District of California. Priority is fully cooperating with the DOJ, however should the DOJ find that Priority acted improperly, it could subject Priority to fines, sanctions, and/or other obligations which could have a material adverse effect on our consolidated results of operations, consolidated financial position and/or consolidated cash flow from operations.
 
In addition, in the ordinary course of our business there have arisen various legal proceedings, investigations or claims now pending against our subsidiaries and us.  The effect of these actions on future financial results is not subject to reasonable estimation because considerable uncertainty exists about the outcomes.  Where insurance coverage is not available for such claims, or in our judgment, is not cost-effective, we maintain self-insurance reserves to reduce our exposure to future legal costs, settlements and judgments related to uninsured claims.  Our self-insured reserves are based upon estimates of the aggregate liability for the costs of uninsured claims incurred and the retained portion of insured claims using certain actuarial assumptions followed in the insurance industry and our historical experience.  It is not possible to predict with certainty the outcome of these claims, and we can give no assurance that any losses in excess of our insurance and any self-insurance reserves will not be material.

Item 4 — Submission of Matters to a Vote of Security Holders 

    No matters were submitted to a vote of security holders during the fourth quarter of 2005.



PART II

Item 5 — Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters

Market Information.  Our common stock is traded on the Nasdaq National Market (“Nasdaq”) under the symbol “ESRX”. The high and low prices, as reported by the Nasdaq, are set forth below for the periods indicated.  These prices have been adjusted to reflect the two-for-one stock split effective June 24, 2005, in the form of a stock dividend of one share for each outstanding share to holders of record on June 10, 2005.
 
 
Fiscal Year 2005
 
Fiscal Year 2004
 
Common Stock
High
 
Low
 
High
 
Low
 
First Quarter
$
43.88
 
$
36.54
 
$
38.10
 
$
31.56
 
Second Quarter
 
52.50
   
42.05
   
40.60
   
36.40
 
Third Quarter
 
62.47
   
45.04
   
38.95
   
29.92
 
Fourth Quarter
 
90.80
   
59.40
   
39.75
   
29.15
 

Holders.  As of December 31, 2005, there were 510 stockholders of record of our common stock.  We estimate there are approximately 108,288 beneficial owners of our common stock.

Dividends.  The Board of Directors has not declared any cash dividends on our common stock since the initial public offering.  The Board of Directors does not currently intend to declare any cash dividends in the foreseeable future.  The terms of our existing credit facility and the indenture under which our public debt was issued contain certain restrictions on our ability to declare or pay cash dividends.

Recent Sales of Unregistered Securities

None.


Issuer Repurchase of Equity Securities

The following is a summary of our stock repurchasing activity during the three months ended December 31, 2005 (share data in millions):

Period
Shares
purchased
 
Average
price paid
per share
 
Shares purchased
as part of a
publicly
announced
program
 
Maximum shares
that may yet be purchased under
the program
 
                 
10/1/2005 - 10/31/2005
 
-
 
$
-
   
-
   
8
 
11/1/2005 - 11/30/2005
 
-
   
-
   
-
   
8
 
12/1/2005 - 12/31/2005
 
-
   
-
   
-
   
8
 
Fourth quarter 2005 total
 
-
 
$
-
   
-
       
 
We have a stock repurchase program, originally announced on October 25, 1996, under which our Board of Directors has approved the repurchase of a total of 38 million shares.  There is no limit on the duration of the program.  Approximately 30 million of the 38 million total shares have been repurchased through December 31, 2005.  Additional share purchases, if any, will be made in such amounts and at such times as we deem appropriate based upon prevailing market and business conditions, subject to restrictions on the amount of stock repurchases contained in our bank credit facility.


Item 6 - Selected Financial Data 

The following selected financial data should be read in conjunction with our Consolidated Financial Statements, including the related notes, and “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

 
(in millions, except per share data)
2005(1)
 
2004(2)
 
2003
 
2002(3)
 
2001(4)
 
Statement of Operations Data (for the Year Ended December 31):
 
                     
Revenues (5)
$
16,266
 
$
15,115
 
$
13,295
 
$
12,271
 
$
8,588
 
Cost of revenues(5)
 
15,067
   
14,171
   
12,428
   
11,447
   
7,992
 
Gross Profit
 
1,199
   
944
   
867
   
824
   
596
 
Selling, general and administrative
 
556
   
451
   
417
   
452
   
359
 
Operating income
 
643
   
493
   
450
   
372
   
237
 
Other expense, net
 
(28
)
 
(43
)
 
(44
)
 
(44
)
 
(30
)
Income before income taxes
 
615
   
450
   
406
   
328
   
207
 
Provision for income taxes
 
215
   
172
   
155
   
125
   
83
 
Income before cumulative effect of
                             
accounting change
 
400
   
278
   
251
   
203
   
124
 
Cumulative effect of accounting change,
                             
net of tax
 
-
   
-
   
(1
)
 
-
   
-
 
Net income
$
400
 
$
278
 
$
250
 
$
203
 
$
124
 
                               
Basic earnings per share:(6)
                             
Before cumulative effect of
accounting change
$
2.72
 
$
1.82
 
$
1.61
 
$
1.30
 
$
0.80
 
Cumulative effect of accounting change
 
-
   
-
   
(0.01
)
 
-
   
-
 
Net income
$
2.72
 
$
1.82
 
$
1.60
 
$
1.30
 
$
0.80
 
                               
Diluted earnings per share:(6)
                             
Before cumulative effect of
accounting change
$
2.68
 
$
1.79
 
$
1.59
 
$
1.27
 
$
0.78
 
Cumulative effect of accounting change
 
-
   
-
   
(0.01
)
 
-
   
-
 
Net income
$
2.68
 
$
1.79
 
$
1.58
 
$
1.27
 
$
0.78
 
                               
Weighted average shares outstanding:(6)
                             
Basic
 
147
   
153
   
156
   
156
   
156
 
Diluted
 
149
   
155
   
158
   
159
   
160
 
                               
Balance Sheet Data (as of December 31):
Cash and cash equivalents
$
478
 
$
166
 
$
396
 
$
191
 
$
178
 
Working capital
 
(137
)
 
(371
)
 
(66
)
 
(150
)
 
(32
)
Total assets
 
5,493
   
3,600
   
3,409
   
3,207
   
2,500
 
Debt:
                             
Short-term debt
 
110
   
22
   
-
   
3
   
-
 
Long-term debt
 
1,401
   
412
   
455
   
563
   
346
 
Stockholders’ equity
 
1,465
   
1,196
   
1,194
   
1,003
   
832
 
                               
Selected Data (for the Year Ended December 31):
Network pharmacy claims processed
 
437
   
399
   
379
   
355
   
294
 
Home delivery pharmacy prescriptions filled
 
40
   
38
   
32
   
27
   
21
 
PBS, Specialty and Other prescriptions filled
 
5
   
5
   
4
   
3
   
2
 
                               
Cash flows provided by operating activities
$
793
 
$
496
 
$
458
 
$
426
 
$
281
 
Cash flows used in investing activities
 
(1,369
)
 
(397
)
 
(43
)
 
(549
)
 
(77
)
Cash flows provided by (used in)
                             
financing activities
 
887
   
(330
)
 
(212
)
 
136
   
(80
)
EBITDA(7) 
 
727
   
563
   
504
   
454
   
315
 


(1)   Includes the acquisition of Priority Healthcare Corporation, Inc. effective October 14, 2005.
(2)   Includes the acquisition of CuraScript, Inc. effective January 30, 2004.
(3)   Includes the acquisition of Phoenix Marketing Group effective February 25, 2002, National Prescription Administrators and certain related entities effective April 12, 2002 and Managed Pharmacy Benefits, Inc. effective December 20, 2002.
(4)   Includes the acquisition of Centre d’autorisation et de paiement des services de sante, Inc. by our Canadian subsidiary effective March 1, 2001.
(5)   Excludes estimated retail pharmacy copayments of $5,821, $5,546, $5,276, $4,350, and $2,881 for the years ended December 31, 2005, 2004, 2003, 2002, and 2001, respectively. These are amounts we instructed retail pharmacies to collect from members. We have no information regarding actual copayments collected.
(6)   Earnings per share and weighted average shares outstanding have been restated to reflect the two-for-one stock split effective June 24, 2005.
(7)   EBITDA is earnings before other income (expense), interest, taxes, depreciation and amortization, or operating income plus depreciation and amortization. EBITDA is presented because it is a widely accepted indicator of a company’s ability to service indebtedness and is frequently used to evaluate a company’s performance. EBITDA, however, should not be considered as an alternative to net income, as a measure of operating performance, as an alternative to cash flow, as a measure of liquidity or as a substitute for any other measure computed in accordance with accounting principles generally accepted in the United States. In addition, our definition and calculation of EBITDA may not be comparable to that used by other companies.
 
We have provided below a reconciliation of EBITDA to net income and to net cash provided by operating activities as we believe they are the most directly comparable measures calculated under Generally Accepted Accounting Principles:

 
Year Ended December 31,
 
(in millions)
2005
 
2004
 
2003
 
2002
 
2001
 
Net income
$
400
 
$
278
 
$
250
 
$
203
 
$
124
 
Income taxes
 
215
   
172
   
155
   
125
   
83
 
Depreciation and amortization
 
84
   
70
   
54
   
82
   
78
 
Interest expense, net
 
26
   
38
   
38
   
39
   
28
 
Undistributed loss from joint venture
 
2
   
5
   
6
   
5
   
2
 
Cumulative effect of accounting
                             
change, net of tax
 
-
   
-
   
1
   
-
   
-
 
EBITDA
 
727
   
563
   
504
   
454
   
315
 
Current income taxes
 
(197
)
 
(154
)
 
(120
)
 
(95
)
 
(64
)
Change in operating assets and
                             
liabilities (excluding effects of acquisitions)
 
220
   
81
   
83
   
63
   
11
 
Interest expense less amortization
 
(21
)
 
(30
)
 
(35
)
 
(35
)
 
(25
)
Bad debt expense
 
18
   
6
   
(3
)
 
18
   
8
 
Tax benefit from employee stock
                             
compensation
 
36
   
11
   
27
   
16
   
21
 
Amortization of unearned comp.
                             
under employee plans
 
11
   
12
   
8
   
10
   
11
 
Undistributed loss from joint venture
 
(2
)
 
(5
)
 
(6
)
 
(5
)
 
(2
)
Other, net
 
1
   
12
   
-
   
-
   
6
 
                               
Net cash provided by operating activities
$
793
 
$
496
 
$
458
 
$
426
 
$
281
 


Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations 

OVERVIEW

As one of the largest full-service pharmacy benefit management (“PBM”) companies we provide health care management and administration services on behalf of our clients, which include health maintenance organizations, health insurers, third-party administrators, employers, union-sponsored benefit plans and government health programs.  Our integrated PBM services include network claims processing, home delivery services, benefit design consultation, drug utilization review, formulary management, disease management, and drug data analysis services.  We provide specialty services, including patient care and direct specialty home delivery to patients; distribution of infusion drugs to patient homes, physician offices, and infusion centers; distribution of pharmaceuticals and medical supplies to providers and clinics; third party logistics services for contracted pharma clients; fertility services to providers and patients; and bio-pharma services including marketing, reimbursement and customized logistics solutions ("Specialty").  Specialty services do not include the fulfillment of specialty prescriptions at retail pharmacies participating in our networks.  These prescriptions are reflected in PBM retail pharmacies participating in our networks.  We also provide services through our Pharma Business Solutions (“PBS”) unit, which include distribution of specialty pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network; distribution of pharmaceuticals to low-income patients through manufacturer-sponsored and company-sponsored generic patient assistance programs, and distribution of sample units to physicians and verification of practitioner licensure.

Effective October 2005, we report three segments: PBM, Specialty and PBS (see "Results of Operations").   We derive revenues primarily from the sale of PBM and Specialty services in the United States and Canada.  Revenue generated by our segments can be classified as either tangible product revenue or service revenue.  We earn tangible product revenue from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks and from dispensing prescription drugs from our home delivery and specialty pharmacies.  Service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs, medication counseling services, certain specialty distribution services, and sample fulfillment and sample accountability services.  Tangible product revenue generated by through our PBM, Specialty and PBS segments represented 98.2% of revenues in 2005, and 98.6% of revenues in 2004 and 2003.

On October 14, 2005, we purchased the capital stock of Priority Healthcare, Inc. (“Priority”) in a cash transaction for $28 per share, or approximately $1.3 billion.  The acquisition was accomplished through the merger of one of our wholly-owned subsidiaries with and into Priority.  The $1.3 billion purchase price was financed with approximately $167 million of cash on hand and the remainder by adding $1.6 billion in Term A loans through a new credit facility which replaced our prior credit facility.  On January 30, 2004, we acquired the capital stock of CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc. (collectively, “CuraScript”), for $333 million in cash.  Consequently, our operating results include those of Priority from October 14, 2005 and CuraScript from January 30, 2004.  In addition to growth through acquisitions, we have been successful in adding significant new clients in recent years, including the contracts we were awarded by the Department of Defense (“DoD”) TRICARE Management Activity in 2003 to provide retail pharmacy services under the TRICARE Retail Pharmacy program starting in June 2004.

Aetna Specialty Pharmacy, a joint venture existing between Priority and Aetna, Inc. (“Aetna”), was 60% owned by Priority and 40% by Aetna.  Upon a change in control of Priority, the joint venture agreement provided Aetna with an option to purchase Priority’s 60% ownership share of the joint venture.  Aetna exercised its option and on December 30, 2005 purchased Priority’s 60% ownership share of Aetna Specialty Pharmacy.  The gain on the assets sold, which was not material, reduced the amount of goodwill we recorded through the Priority acquisition.

EXECUTIVE SUMMARY AND TREND FACTORS AFFECTING THE BUSINESS
 
Prescription drug costs have increased considerably over the past several years, primarily due to brand-name product inflation, the introduction of new products by pharmaceutical manufacturers and higher utilization of drugs. As a result, we face continuing pressures on margins resulting from client demands for better management of pharmacy trends, enhanced service offerings and/or higher service levels on contract renewals, and unfavorable modifications to contracts with key clients or providers.

Our business model is built around the alignment of interests with our clients and members in making the use of prescription drugs safer and more affordable. The improvement in our 2005 consolidated results of operations over 2004 was primarily driven by factors which also reduce pharmacy trends for our clients. In 2005 we benefited from higher generic utilization (54.4% in 2005 compared to 50.4% in 2004), increased home delivery volume, growth in Specialty services and better management of ingredient costs resulting from renegotiation of certain supplier contracts, increased competition among generic manufacturers and other actions which helped to reduce ingredient costs. In addition, our 2005 results of operations improved over 2004 as a result of increased labor efficiencies and the consolidation of certain of our facilities. We believe these factors will continue to generate improvement in our results of operations in 2006.
 
CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances.  Actual results may differ from our estimates.  Certain of the accounting policies that most impact our consolidated financial statements and that require our management to make difficult, subjective or complex judgments are described below.  This should be read in conjunction with Note 1, “Summary of Significant Accounting Policies” and with the other notes to the consolidated financial statements.

REBATE ACCOUNTING

ACCOUNTING POLICY
Historically, we have administered a rebate program based on actual market share performance in which rebates and the associated receivable from pharmaceutical manufacturers are estimated quarterly based on our estimate of the number of rebatable prescriptions and the rebate per prescription.  The portion of rebates payable to clients is estimated quarterly based on historical allocation percentages and our estimate of rebates receivable from pharmaceutical manufacturers.  With respect to our market share rebate program, estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid.  With respect to rebates that are not based on market share performance, the portion of rebates payable to clients is estimated based on historical and/or anticipated sharing percentages.  These estimates are adjusted to actual when amounts are paid to clients.

FACTORS AFFECTING ESTIMATE
The factors that could impact our estimates of rebates, rebates receivable and rebates payable are as follows:
·
Differences between the actual and the estimated number of rebatable prescriptions;
·
Differences between estimated aggregate allocation percentages and actual rebate allocation percentages calculated on a client-by-client basis;
·
Differences between actual and estimated market share of a manufacturer’s brand drug for our clients as compared to the national market share;
·
Drug patent expirations; and
·
Changes in drug utilization patterns.
Historically, adjustments to our original estimates have been relatively immaterial.


UNBILLED REVENUE AND RECEIVABLES

ACCOUNTING POLICY
We bill our clients based upon the billing schedules established in client contracts.  At the end of a period, any unbilled revenues related to the sale of prescription drugs that have been adjudicated with retail pharmacies are estimated based on the amount we will pay to the pharmacies and historical gross margin.

FACTORS AFFECTING ESTIMATE
Unbilled amounts are estimated based on historical margin.  Historically, adjustments to our original estimates have been immaterial.  Significant differences between actual and estimated margin could impact subsequent adjustments.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

ACCOUNTING POLICY
We provide an allowance for doubtful accounts equal to estimated uncollectible receivables.  This estimate is based on the current status of each customer’s receivable balance.

FACTORS AFFECTING ESTIMATE
We record allowances for doubtful accounts based on a variety of factors including the length of time the receivables are past due, the financial health of the customer and historical experience.  Our estimate could be impacted by changes in economic and market conditions as well as changes to our customers’ financial condition.


SELF-INSURANCE RESERVES

ACCOUNTING POLICY
We accrue self-insurance reserves based upon estimates of the aggregate liability of claim costs in excess of our insurance coverage.  Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience.  The majority of these claims are legal claims and our liability estimate is primarily related to the cost to defend these claims.  We do not accrue for settlements, judgments, monetary fines or penalties until such amounts are probable and estimable, in compliance with Financial Accounting Standard (“FAS”) No. 5, “Accounting for Contingencies.”  Under FAS 5, if the range of possible loss is broad, the liability accrual should be based on the lower end of the range.

FACTORS AFFECTING ESTIMATE
Self-insurance reserves are based on management’s estimates of the costs to defend legal claims.  We do not have significant experience with certain of these types of cases.  As such, differences between actual costs and management’s estimates could be significant.  In addition, actuaries do not have a significant history with the PBM industry.  Changes to assumptions used in the development of these reserves can affect net income in a given period.  In addition, changes in the legal environment and number and nature of claims could impact our estimate.


OTHER ACCOUNTING POLICIES

We consider the following information about revenue recognition policies important for an understanding of our results of operations:

·
Revenues from dispensing prescriptions from our home delivery pharmacies are recorded when prescriptions are shipped. These revenues include the co-payment received from members of the health plans we serve.
·
Revenues from the sale of prescription drugs by retail pharmacies are recognized when the claim is processed. We do not include member co-payments to retail pharmacies in revenue or cost of revenue.
·
When we independently have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ member, we act as a principal in the arrangement and we include the total payments we have contracted to receive from these clients as revenue and the total payments we make to the network pharmacy providers as cost of revenue.
·
When we merely administer a client’s network pharmacy contracts to which we are not a party and under which we do not assume credit risk, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions, drug ingredient cost is not included in our revenues nor in our cost of revenues.
·
Historically, we have administered two rebate programs through which we receive rebates and administrative fees from pharmaceutical manufacturers.
·
Gross rebates and administrative fees earned for the administration of our rebate programs, performed in conjunction with claim processing services provided to clients, are recorded as a reduction of cost of revenue and the portion of the rebate payable to customers is treated as a reduction of revenue.
·
When we earn rebates and administrative fees in conjunction with formulary management services, but do not process the underlying claims, we record rebates received from manufacturers, net of the portion payable to customers, in revenue.
·
We distribute pharmaceuticals in connection with our management of patient assistance programs and earn a fee from the manufacturer for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients.
·
We earn a fee for the distribution of consigned pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network.
·
Discounts and contractual allowances related to our Specialty revenues are estimated based on historical collections over a recent period for the sales that are recorded at gross charges. The percentage is applied to the applicable accounts receivable balance that contains gross charges for each period. Any differences between the estimates and actual collections are reflected in operations in the year payment is received. Differences may result in the amount and timing of revenues for any period if actual performance varies from estimates. Allowances for returns are estimated based on historical return trends. Financing charge revenue is recognized when received.
·
Specialty product revenues include revenues earned through the distribution of specialty drugs to clients as well as supplies provided through the distribution business.
·
Specialty service revenues include revenues earned through providing reimbursement solutions and product support to pharmaceutical manufacturers, biotechnology companies, and medical device companies, as well as revenues derived from our Group Purchasing Organization (“GPO”) development.
·
PBS product revenues include revenues earned through administering sample card programs for certain manufacturers. We include ingredient cost of those drug samples dispensed from retail pharmacies in our PBS revenues and the associated costs for these sample card programs in cost of revenues.
·
PBS service revenues include administrative fees for the verification of practitioner licensure and the distribution of consigned drug samples to doctors based on orders received from pharmaceutical sales representatives.

 

RESULTS OF OPERATIONS

Effective in October 2005, we began managing our Specialty business as a separate operating segment.  Previously, our Specialty business was part of our domestic PBM operating segment.  The change is primarily due to the acquisition of Priority (see “—Overview”) on October 14, 2005.  Our Specialty segment consists of our CuraScript (acquired in January 2004) and Priority businesses and 2004 data has been reclassified to reflect the change in our operating and reporting segments.

PBM OPERATING INCOME

 
Year Ended December 31,
 
(in millions)
 
2005
 
Increase/
(Decrease)
 
 
2004
 
Increase/
(Decrease)
 
 
2003
 
                     
Product revenue
                   
Network revenues
$
9,171
   
(2.3%
)
$
9,387
   
3.9%
 
$
9,037
 
Home delivery revenues
 
5,016
   
5.1%
 
 
4,771
   
19.6%
 
 
3,988
 
Service revenues
 
152
   
50.5%
 
 
101
   
38.4%
 
 
73
 
Total PBM revenues
 
14,339
   
0.6%
 
 
14,259
   
8.9%
 
 
13,098
 
Cost of PBM revenues
 
13,300
   
(0.8%
)
 
13,410
   
9.2%
 
 
12,282
 
PBM gross profit
 
1,039
   
22.4%
 
 
849
   
4.0%
 
 
816
 
PBM SG&A expenses
 
477
   
16.3%
 
 
410
   
3.0%
 
 
398
 
PBM operating income
$
562
   
28.0%
$
439
   
5.0%
 
$
418
 
                               
Total adjusted PBM Claims(1)
 
557
   
8.6%
 
 
513
   
8.0%
 
 
475
 
 
(1) PBM adjusted claims represent network claims plus mail claims, which are multiplied by 3, as mail claims are typically 90 day claims and network claims are generally 30 day claims. Excluded from the network claims are manual claims and drug formulary only claims where we only administer the clients formulary. We process approximately 2 million manual claims per year.

Network claims increased by 38.6 million, or 9.7%, in 2005 over 2004. The increase in network claims is primarily due to the implementation of our contract with the DoD TRICARE Retail Pharmacy (“TRICARE”) program in June 2004. Revenues for the TRICARE program are included in service revenue (see discussion below).

Network pharmacy revenues decreased $216 million, or 2.3%, from 2004 to 2005, primarily due to the following factors:

 
·
Network pharmacy revenues decreased $360 million from 2004 to 2005 as a result of a higher mix of lower-cost generic claims and a 2.5% increase in the average co-payment per retail pharmacy claim. Generic claims made up 55.4% of total network claims processed during 2005 as compared to 51.9% during 2004. As mentioned in our Critical Accounting Policies above, we do not include member co-payments to retail pharmacies in revenue or cost of revenue.
 
·
These factors were partially offset by an increase in pharmacy claims, resulting in a $144 million increase in overall network pharmacy revenues as compared to 2004.

Network pharmacy revenues increased $350 million, or 3.9%, in 2004 over 2003, primarily due to the following factors:

 
·
Average revenue per claim increased 4.9% in 2004 over 2003 resulting in a $438 million increase in overall network pharmacy revenues. Increases in average revenue per network pharmacy claim were due to drug price inflation and to the transition of one of our clients from use of their retail pharmacy network to an ESI retail pharmacy network in the first quarter of 2004. These increases were partially offset by a higher mix of generic claims and an increase in the average co-payment per retail pharmacy claims. Generic claims represented 51.9% of total network claims processed during 2004 as compared to 48.1% during 2003.
 
·
Network pharmacy claims included in network pharmacy revenues decreased slightly compared to 2003, resulting in an $88 million decrease in network pharmacy revenues. The decrease in network pharmacy claims volume is mainly due to client losses from 2003. One client, emerging from bankruptcy, discontinued providing retiree benefits, one client was lost through a competitive bidding process, and a one-year contract with a state agency expired, as expected, as future claims will be processed by the state. These decreases were partially offset by new business which started during 2004.

The $245 million, or 5.1%, increase in home delivery pharmacy revenues in 2005 over 2004 is attributable to the following factors:

 
·
We processed an additional 2.0 million claims in 2005 over 2004, resulting in a $250 million increase in home delivery pharmacy revenues. The increase in home delivery volume is primarily due to the increased usage of our home delivery pharmacies by members of existing clients.
 
·
A decrease in the average home delivery revenue per claim reduced home delivery pharmacy revenues by $5 million in 2005 from 2004. The decrease in average home delivery revenue per claim is primarily due to a higher mix of generic claims. Our generic fill rate increased to 43.6% in 2005 from 40.5% in 2004. Under our contract with the DoD we earn a fee per prescription filled by our home delivery facility. Revenues and cost of revenues from the DoD contract do not include ingredient cost as inventory is replenished by the DoD through agreements with its suppliers. As a result, these claims have a dilutive effect on the average revenue per home delivery pharmacy claim.
 
The $783 million, or 19.6%, increase in home delivery pharmacy revenues in 2004 over 2003 is attributable to the following factors:

 
·
We processed an additional 5.8 million claims in 2004 over 2003, resulting in a $717 million increase in home delivery pharmacy revenues. The increase in home delivery claim volume is primarily due to the implementation of new clients, including the contract with the DoD TRICARE Mail Order Pharmacy program in March 2003, as well as increased usage of our home delivery pharmacies by members of existing clients.
 
·
Average revenue per home delivery claim increased by approximately 1.4% in 2004 over 2003, representing additional home delivery pharmacy revenue of $66 million. Increases in home delivery revenue per claim from inflation was almost completely offset by the impact of our contract with the DoD TRICARE Mail Order Pharmacy program as mentioned above and by increases in our generic fill rate to 40.5% for 2004 from 37.2% for the same period of 2003.

PBM service revenues include amounts received from clients for therapy management services such as prior authorization and step therapy protocols and administrative fees earned for processing claims for clients utilizing their own retail pharmacy networks. PBM service revenues increased $51 million, or 50.5%, in 2005 as compared to 2004, and increased $28 million, or 38.4%, revenues in 2004 as compared to 2003, primarily due to the implementation of the TRICARE program in June 2004. The increase from the implementation of the TRICARE contract was partially offset by the elimination of revenues from pharmaceutical manufacturers in support of certain clinical programs. This funding was completely phased out as of October 1, 2003.
 
PBM cost of revenues decreased $110 million, or 0.8%, from 2004 to 2005 as a result of the following:

 
·
Net decreases in the average cost per claim and a higher mix of generic claims decreased cost of revenues by approximately $362 million from 2004 to 2005. The decrease in average cost per claim is due principally to reductions in our acquisition cost for retail pharmacy services and home delivery inventory. These cost reductions are expected to benefit future periods as well.
 
·
These decreases were partially offset by the increases in network and home delivery claims volume resulting in higher PBM cost of revenues of $252 million as compared to the same periods of 2004.

PBM cost of revenues increased $1,128 million, or 9.2%, in 2004 over 2003 primarily as a result of the following:

 
·
Net increases in the average ingredient cost per claim, mainly due to inflation and to the transition of one of our clients from their network to an ESI retail pharmacy network in the first quarter of 2004 (as discussed above), increased cost of revenues by $560 million in 2004 over 2003.
 
·
Increases in network and mail order claims volume resulted in higher PBM cost of revenues of $530 million in 2004 over 2003.

Our PBM gross profit increased $190 million, or 22.4%, in 2005 over 2004 and $33 million, or 4.0%, in 2004 over 2003. Increases in revenues from network inflation and higher home delivery volumes were partially offset by lower drug purchasing costs, increased generic claims and lower drug purchasing costs were only partially offset by margin pressures arising from the current competitive environment. Gross profit for 2003 was negatively impacted by a non-recurring reduction of $15 million relating to previously collected pharmaceutical manufacturer funds which we decided to share with our clients.

Selling, general and administrative expense (“SG&A”) for our PBM segment increased $67 million, or 16.3%, in 2005 as compared to 2004 primarily as a result of the following factors:

 
·
Increased spending of $56 million from 2004 to 2005 on costs to improve the operation and the administrative functions supporting the management of the pharmacy benefit, primarily through increased management incentive compensation.
 
·
Increased spending related to Medicare Part D, including costs to develop the capabilities necessary to support our PDP clients.
 
·
Increased spending on infrastructure primarily due to the development of a new Patient Care Contact Center in Pueblo, Colorado in 2005.  
 
·
Bad debt expense increased $8 million from 2005 from 2004, related to an increase in the allowance for receivables from our clients’ members.
 
·
Partially offsetting the increases noted above, prior year SG&A included a $25.0 million charge recorded in the third quarter to increase legal reserves and a $12 million increase in the PCA loss reserve recorded in December 2004 against the unsecured borrowings by PCA under the line of credit extended by ESI (see “—Liquidity and Capital Resources”).

Selling, general and administrative expense (“SG&A”) for our PBM segment increased $12 million, or 3.0%, in 2004 as compared to 2003 primarily as a result of the following factors:

 
·
An increase of $28 million in legal fees from $11 million in 2003 to $39 million in 2004. As previously reported, we are a defendant in litigation involving our contract to provide prescription drug benefits for the employees and retirees of the State of New York. In addition, we have received civil investigative demands from the Attorneys General of 25 states and the District of Columbia. In light of these developments, several shareholder class action lawsuits and additional class action lawsuits were filed against the Company (see “—Legal Proceedings”). Based on these developments, we recorded a $25 million increase in legal reserves during the third quarter in 2004 (see “—Critical Accounting Policies”).
 
·
A $12 million increase in the PCA loss reserve recorded in December 2004 against the unsecured borrowings by PCA under the line of credit extended by ESI (see “—Liquidity and Capital Resources”).
 
·
These increases in SG&A for 2004 were mostly offset by lower management incentive compensation due to the recording of the PCA loss reserve, and by cost saving measures implemented during 2004.

PBM operating income increased $123 million, or 28.0%, in 2005 over 2004 and $21 million, or 5.0%, in 2004 over 2003, based on the various factors described above.
 

 

SPECIALTY OPERATING INCOME

 
Year Ended December 31,
 
(in millions)
2005(1)
 
Increase/
(Decrease)
 
2004(2)
 
Increase/
(Decrease)
 
2003
 
                     
Product revenues
$
1,607
   
159.2%
$
620
   
-
 
$
-
 
Service revenues
 
13
   
-
   
-
   
-
   
-
 
Total Specialty revenues
 
1,620
   
161.3%
 
 
620
   
-
   
-
 
Cost of Specialty revenues
 
1,521
   
165.0%
 
 
574
   
-
   
-
 
Specialty gross profit
 
99
   
115.2%
 
 
46
   
-
   
-
 
Specialty SG&A expenses
 
60
   
130.8%
 
 
26
   
-
   
-
 
Specialty operating income
$
39
   
95.0%
 
$
20
   
-
 
$
-
 
 
(1) Includes the acquisition of Priority effective October 14, 2005.
(2) Includes the acquisition of CuraScript effective January 30, 2004.

Specialty revenues and cost of revenues increased $1,000 million, or 161.3%, and $947 million, or 165.0%, in 2005 over 2004, respectively.  These increases are primarily due to the acquisition of Priority in 2005, which increased Specialty revenue and cost of revenue by $562 million and $534, respectively.  The remaining increase is primarily due to the increased specialty penetration into the PBM book of business.

Our Specialty gross profit increased $53 million, or 115.2%, in 2005 over 2004, based on the various factors described above.

SG&A for our Specialty segment increased $34 million, or 130.8%, in 2005 as compared to 2004.  The acquisition of Priority represents $25 million of the increase.  The remaining increase is due to the growth in the legacy CuraScript business.

Specialty operating income increased $19 million, or 95.0%, in 2005, based on the various factors described above.
 

PBS OPERATING INCOME

 
Year Ended December 31,
 
(in millions)
2005
 
Increase/
(Decrease)
 
2004
 
Increase/
(Decrease)
 
2003
 
                     
Product revenues
$
175
   
36.7%
 
$
128
   
47.1%
 
$
87
 
Service revenues
 
132
   
22.2%
 
108
   
(1.8%
)
 
110
 
Total PBS revenues
 
307
   
30.1%
 
 
236
   
19.8%
 
 
197
 
Cost of PBS revenue
 
246
   
31.6%
 
 
187
   
28.1%
 
 
146
 
PBS gross profit
 
61
   
24.5%
 
 
49
   
(3.9%
)
 
51
 
PBS SG&A expense
 
19
   
26.7%
 
 
15
   
(21.1%
)
 
19
 
PBS operating income
$
42
   
23.5%
 
$
34
   
6.3%
 
$
32
 
                               

PBS product revenues increased $47 million, or 36.7%, in 2005 over 2004 and $41 million, or 47.1%, in 2004 over 2003.  The increase in 2005 is mainly due to a higher mix of specialty distribution volumes in which we include ingredient cost of pharmaceuticals dispensed in our revenues, including two new specialty distribution contracts in 2005.  The increase in 2004 is also due to a higher mix of specialty distribution volumes in which we include ingredient cost of pharmaceuticals dispensed in our revenues, as mentioned above.  This increase in Specialty Distribution Services (“SDS”) product revenues was partially offset by the discontinuance, during 2003, of two patient assistance programs (“PAP”) where we received fees for the delivery of certain drugs to doctors for their indigent patients.

PBS service revenues increased $24 million, or 22.2%, in 2005 over 2004 and decreased $2 million, or 1.8%, in 2004 from 2003.  The increase in 2005 reflects new eligibility and service programs initiated during 2005.  The decrease in 2004 was primarily due to the discontinuance, during the third quarter of 2003, of two PAP’s where we received fees for the delivery of certain drugs to doctors for their indigent patients.  This decrease was partially offset by increases due to additional volume in SDS, including new PAP’s, initiated during 2003, where eligibility and other services are being provided.

PBS cost of revenues increased $59 million, or 31.6%, in 2005 over 2004, and $41 million, or 28.1%, in 2004 over 2003.  These increases are mainly due to the additional volume in sample card programs where we include the ingredient costs of pharmaceuticals dispensed from retail pharmacies in our PBS revenues and cost of revenues (as discussed above).  The percentage increase in PBS cost of revenues grew faster than the percentage increase in revenues due to the additional volume in the sample card program (discussed above) where we include the ingredient costs of pharmaceuticals dispensed from retail pharmacies in our SDS revenues and cost of revenues.  The percentage increase in the PBS cost of revenues was partially offset by Phoenix Marketing Group (“PMG”), which does not purchase samples from the manufacturers, but records an administrative fee for verification of practitioner licensure and distribution of samples to those practitioners based on orders received from pharmaceutical sales representatives.

Gross profit increased $12 million, or 24.5%, in 2005 over 2004.  Gross profit decreased $2 million, or 3.9%, in 2004 from 2003.

PBS SG&A increased $4 million, or 26.7%, in 2005 over 2004, primarily due to an increase in marketing expenditures related to the RxOutreach program and increased sales expenses.  PBS SG&A decreased $4 million, or 21.1%, from 2003 to 2004, due to efforts to control costs by integrating certain functions within our PMG and SDS operations.

PBS operating income increased $8 million, or 23.5%, in 2005 over 2004, and increased $2 million, or 6.3%, in 2004 over 2003.


OTHER (EXPENSE) INCOME, NET 

In February 2001, we entered into an agreement with AdvancePCS (now owned by Caremark RX, Inc.) and Medco Health Solutions, Inc. (formerly, “Merck-Medco, L.L.C.”) to form RxHub, an electronic exchange enabling physicians who use electronic prescribing technology to link to pharmacies, PBMs and health plans.  We own one-third of the equity of RxHub (as do each of the other two founders) and have committed to invest up to $20 million over five years, with almost $20 million invested through December 31, 2005.  We have recorded our investment in RxHub under the equity method of accounting, which requires our percentage interest in RxHub’s results to be recorded in our Consolidated Statement of Operations.  Our percentage of RxHub’s loss for 2005, 2004 and 2003 is $2 million, $5 million, and $6 million, respectively, and has been recorded in other income (expense), net, in our Consolidated Statement of Operations.

Net interest expense decreased $12 million, or 31.6%, in 2005 as compared to 2004.  This was the net effect of several factors.  In 2004, we redeemed our $250 million Senior Notes, and as a result, we recorded a $12 million charge to interest expense for the redemption premium and the write-off of deferred financing fees.  In addition, we wrote-off $4 million in deferred financing fees as a result of refinancing our entire credit facility during the first quarter of 2004 (see “—Liquidity and Capital Resources”).  These increases in 2004 interest expense were offset by the October 2005 refinancing of our entire credit facility with a new $2.2 billion credit facility which includes $1.6 billion of Term A loans and a $600 million revolving credit facility.  As a result, we wrote-off $4 million in deferred financing fees in the fourth quarter of 2005.

Net interest expense remained relatively consistent from 2003 to 2004.  This was the net effect of several factors, as described above.
 
PROVISION FOR INCOME TAXES
 
Our effective tax rate decreased to 34.9% for the year ended December 31, 2005, as compared to 38.3% and 38.2% for the years ended December 31, 2004 and 2003, respectively.  The decrease in our effective tax rate reflects a net tax benefit $20 million resulting primarily from changes in the apportionment of our income for state income tax purposes as well as the recognition of expected state tax benefits associated with prior-year subsidiary losses and credits.  Excluding the $20 million net tax benefit, our effective tax rate would have been 38.1%.

Our effective tax rate increased slightly to 38.3% in 2004, from 38.2% in 2003.

NET INCOME AND EARNINGS PER SHARE 

Net income increased $122 million, or 43.9%, for the year ended December 31, 2005 over 2004 and increased $28 million, or 11.2% for the year ended December 31, 2004 over 2003.  During 2003, we recorded a cumulative effect of change in accounting principle of $1 million, net of tax, related to our implementation of FAS 143, “Asset Retirement Obligations,” (see “—Other Matters”).

Basic and diluted earnings per share increased 49.5% and 49.7%, respectively for the twelve months ended December 31, 2005 over 2004 and 13.8% and 13.3%, respectively for the twelve months ended December 31, 2004 over 2003.

On May 24, 2005, we announced a two-for-one stock split for stockholders of record on June 10, 2005, effective June 24, 2005.  The split was effected in the form of a dividend by issuance of one additional share of common stock for each share of common stock outstanding.  The earnings per share and the weighted average number of shares outstanding for basic and diluted earnings per share for each period have been adjusted for the stock split.

We account for employee stock options in accordance with Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees.”  We account for options using the intrinsic value method and have not recognized compensation expense for options granted.  We will adopt FAS 123R using the modified prospective method beginning January 1, 2006 (see “—Other Matters”). The impact of adopting FAS 123R on our consolidated results of operations is not expected to differ materially from the pro forma disclosures currently required by FAS 123 (see note 11 to our consolidated financial statements).  Had we used the fair value method and recognized compensation expense based on the fair value of options determined on the grant date, our net income and earnings per share for the twelve months ended December 31, 2005, 2004 and 2003 would have been $389 million, or $2.60 per diluted share, $270 million, or $1.73 per diluted share, and $238 million, or $1.50 per diluted share, respectively.
 
LIQUIDITY AND CAPITAL RESOURCES

OPERATING CASH FLOW AND CAPITAL EXPENDITURES

During 2005, net cash provided by operations increased $297 million to $793 million from $496 million in 2004.  This increase reflects a $139 million increase from net changes in our working capital components, increased earnings of $122 million, a $34 million increase in non-cash adjustments, and a $14 million increase in depreciation and amortization, partially due to the acquisition of Priority in October 2005.  The increase from changes in our working capital components primarily consists of an $84 million increase resulting from the timing of payments to vendors, a $27 million increase due to improved inventory management, and a $15 million increase due to a lower accounts receivable balance.  The increase in non-cash adjustments is mainly due to an increase of $25 million related to higher tax benefits from the exercise of employee stock options during 2005 and a $12 million increase in bad debt expense, offset by a decrease of $1 million in deferred taxes.  These increases were offset by a $12 million increase in 2004 as a result of establishing our PCA loss reserve.
 
On January 1, 2006, we will adopt FAS 123R (see "Other Matters"), which requires classification of the tax benefit from the exercise of stock options in cash flows from financing activities, rather than cash flows from operating activities.  In 2005, cash flows from operating activities included a cash inflow of $36 million related to tax benefits from the exercise of stock options.

During 2004, net cash provided by operations increased $38 million to $496 million from $458 million in 2003.  This increase reflects increased earnings of $29 million, a $16 million increase in depreciation and amortization, partially due to the acquisition of CuraScript in January 2004, and a $12 million increase as a result of establishing our PCA loss reserve.  These increases were partially offset by a $15 million decrease in deferred taxes and a $2 million decrease from net changes in our working capital components.  The decrease from changes in our working capital components was primarily due to a $76 million decrease from a higher inventory balance relating to increased home delivery volume.  Inventory days on hand remained consistent at December 31, 2004 compared to December 31, 2003.  This decrease was offset by a $74 million increase resulting from the timing of payments to vendors.

As a percent of accounts receivable, our allowance for doubtful accounts was 4.0% and 2.9% at December 31, 2005 and 2004, respectively.  The allowance at December 31, 2005 was higher, as a percentage of accounts receivable, primarily due to additional reserves for receivables from our clients’ members, as well as the acquisition of Priority in the fourth quarter of 2005.

Our capital expenditures in 2005 increased $9 million, or 17.6%, as compared to 2004, primarily due to the development of a new Patient Care Contact Center in Pueblo, Colorado in 2005.  Our capital expenditures in 2004 decreased $2 million, or 3.8%, as compared to 2003, primarily due to the new construction of a Tempe mail order facility to manage growth in 2003.  This decrease was partially offset by $9 million capitalized in 2004 due to the development of a new Patient Care Contact Center in St. Marys, Georgia.  We intend to continue to invest in technology that we believe will provide efficiencies in operations and facilitate growth and enhance the service we provide to our clients.  We expect future anticipated capital expenditures will be funded primarily from operating cash flow or, to the extent necessary, with borrowings under our revolving credit facility, discussed below.

As mentioned above, we developed a new Patient Care Contact Center in Pueblo, Colorado which was completed during the fourth quarter of 2005.  Total 2005 expenditures for the project were approximately $13 million, of which approximately $6 million was expensed and approximately $7 million was capitalized.  Of the $7 million that was capitalized for the project, approximately $6 million was reimbursed by the city of Pueblo and state of Colorado. 
 
STOCK REPURCHASE PROGRAM

We have a stock repurchase program, originally announced on October 25, 1996, under which our Board of Directors has approved the repurchase of a total of 38 million shares.  There is no limit on the duration of the program.  Approximately 30 million of the 38 million total shares have been repurchased through December 31, 2005.  Additional share purchases, if any, will be made in such amounts and at such times as we deem appropriate based upon prevailing market and business conditions, subject to restrictions on the amount of stock repurchases contained in our bank credit facility.
 
ACQUISITIONS AND RELATED TRANSACTIONS
 
      On October 14, 2005, we acquired the capital stock of Priority in a cash transaction for $28 per share, or approximately $1.3 billion (see “—Overview”). The acquisition was accomplished through the merger of one of our wholly-owned subsidiaries with and into Priority. The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets, consisting of customer contracts in the amount of $82 million and non-competition agreements in the amount of $1 million, which are being amortized using the straight-line method over estimated useful lives of ten years and three years, respectively, and trade names in the amount of $2 million, which are not being amortized. These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $991 million, which is not being amortized.

On January 30, 2004, we acquired the outstanding capital stock of CuraScript, for approximately $333 million, which includes a purchase price adjustment for working capital and transaction costs.  CuraScript is one of the nation’s largest Specialty services companies and has enhanced our ability to provide comprehensive pharmaceutical management services to our clients and their members.  CuraScript operates seven specialty pharmacies throughout the United States and serves over 175 managed care organizations, 30 Medicaid programs and the Medicare program.  The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of the acquisition.  A portion of the excess of purchase price over tangible net assets acquired has been allocated to intangible assets, consisting of customer contracts in the amount of $29 million and non-competition agreements in the amount of $3 million, which are being amortized using the straight-line method over estimated useful lives of ten years and three years, respectively, and trade names in the amount of $1 million, which are not being amortized.  These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired has been allocated to goodwill in the amount of $285 million, which is not being amortized.

Goodwill is evaluated for impairment annually or when events or circumstances occur indicating that goodwill might be impaired.  In addition, we evaluate whether events or circumstances have occurred that indicate the remaining estimated useful lives of other intangible assets may warrant revision or that the remaining balance of an asset may not be recoverable.  The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis.  Impairment losses, if any, would be determined based on the present value of the cash flows using discount rates that reflect the inherent risk of the underlying business.  No such impairment existed at December 31, 2005 or 2004.

We regularly review potential acquisitions and affiliation opportunities.  We believe available cash resources, bank financing or the issuance of additional common stock could be used to finance future acquisitions or affiliations.  There can be no assurance we will make new acquisitions or establish new affiliations in 2006 or thereafter.

In January 2004, we entered into an agreement to provide PBM services for the Medicare discount program of Pharmacy Care Alliance, Inc. (“PCA”), a nonstock, not-for-profit entity jointly controlled by the National Association of Chain Drugstores (“NACDS”) and us. Our PBM services include the negotiation of discounts from individual retailers and pharmaceutical manufacturers, the enrollment of cardholders and the processing of prescription claims.  During 2004, we entered into a lending agreement with PCA, whereby we committed to lend up to $17 million to PCA in the form of a revolving line of credit available through December 31, 2005.  Requests for borrowings on the revolving line of credit require the unanimous consent of PCA’s board of directors, which consists of representatives from NACDS and from our management team, or its designated representatives.  PCA will utilize the revolving line of credit to fund its operating expenditures. NACDS has agreed to guarantee $2 million on the revolving line of credit.  As of December 31, 2005, we have loaned PCA $15 million, and have received $3 million in interest and principal payments.
 
The Medicare discount program is scheduled to end by June of 2006.  In regard to the revolving line of credit extended to PCA, the collectibility of any unsecured borrowings will be a function of PCA's costs in closing out the program.  Enrollment as of December 31, 2005 was approximately 266,000 members.  Because enrollment and utilization to date was lower than expected, the outstanding balance of our receivable from PCA was fully reserved at the end of 2004 and 2005.

BANK CREDIT FACILITY 
 
At December 31, 2004, our credit facility with a commercial bank syndicate consisted of $185 million of Term A loans, $198 million of Term B loans, and a $400 million revolving credit facility (of which $50 million was outstanding at December 31, 2004). In October 2005, we refinanced our entire credit facility with a new $2.2 billion credit facility which includes $1.6 billion of Term A loans and a $600 million revolving credit facility. The proceeds from the $2.2 billion credit facility were used to finance the Priority acquisition and to prepay borrowings on the Term A Loan and Term B Loans outstanding under our existing credit facility. The newly established $600 million revolving credit facility (none of which was outstanding as of December 31, 2005) is also available for general corporate purposes. In the three months ended December 31, 2005, we made scheduled payments of $40 million and prepayments of $50 million on our Term A Loans.

Our new credit facility requires us to pay interest periodically on the London Interbank Offered Rates (“LIBOR”) or base rate options, plus a margin. The margin over LIBOR will range from 0.50% to 1.125%, depending on our consolidated leverage ratio or our credit rating. The margin over the base rate will range from 0% to 0.125% depending upon our consolidated leverage ratio. Initially, the margin over LIBOR will be 0.75% per annum. Under our new credit facility we are required to pay commitment fees on the unused portion of the $600 million revolving credit facility. The commitment fee will range from 0.10% to 0.25% depending on our consolidated leverage ratio or our credit rating. Initially, the commitment fee will be 0.15% per annum.

       At December 31, 2005, the weighted average interest rate on the new facility was 5.1%. Our new credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase, and dividends we may pay. The repurchase and dividend covenant applies if certain leverage thresholds are exceeded. The covenants also include a minimum interest coverage ratio and a maximum leverage ratio. At December 31, 2005, we were in compliance with all covenants associated with our credit facility.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The following table sets forth our schedule of current maturities of our long-term debt as of December 31, 2005, and future minimum lease payments due under noncancellable operating leases (in millions):

 
Payments Due by Period as of December 31, 2005
 
Contractual obligations
Total
 
2006
 
2007 - 2008
 
2009 - 2010
 
After 2010
 
                     
Long-term debt
$
1,511
 
$
110
 
$
440
 
$
960
 
$
1
 
Future minimum lease
Payments (1) (2)
 
120
   
28
   
43
   
16
   
33
 
                               
Total contractual cash obligations
$
1,631
 
$
138
 
$
483
 
$
976
 
$
34
 
                               

(1)        In July 2004, we entered into a capital lease with the Camden County Joint Development Authority in association with the development of our new Patient Care Contact Center in St. Marys, Georgia. At December 31, 2005, our lease obligation is $13 million. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation Number 39, “Offsetting of Amounts Related to Certain Contracts,” our lease obligation has been offset against $13 million of industrial revenue bonds issued to us by the Camden County Joint Development Authority.
(2)       This table does not reflect a lease agreement we signed during 2005 for a new corporate headquarters. The building is in the process of being built and we do not anticipate taking possession until the first quarter of 2007. The annual lease commitments will begin at approximately $4 million and the term of the lease is ten and a half years.

OTHER MATTERS  

In June 2005, the FASB issued FAS 154, “Accounting Changes and Error Corrections”, which superceded APB No. 20, “Accounting Changes”.  APB No. 20 previously required that most voluntary changes in accounting principle be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle.  In contrast, FAS 154 requires entities that voluntarily make a change in accounting principle to apply that change retrospectively to prior periods’ financial statements, unless this would be impracticable.  In addition, FAS 154 makes a distinction between retrospective application of an accounting principle and the restatement of financial statements to reflect the correction of an error.  FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.  We do not expect the implementation of FAS 154 to have an impact on our consolidated results of operations.

In December 2004, the FASB revised FAS 123, “Share-Based Payment” (“FAS 123R”), which replaced FAS 123, “Accounting for Stock-Based Compensation”, and superseded Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees.”  FAS 123R will require compensation cost related to share-based payment transactions to be recognized in the financial statements.  As permitted by FAS 123, we currently follow the guidance of APB 25, which allows the use of the intrinsic value method of accounting to value share-based payment transactions with employees.  FAS 123R requires measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and recognition of expense over the requisite service or vesting period.  FAS 123R allows implementation using a modified version of prospective application, under which compensation expense for the unvested portion of previously granted awards and all new awards will be recognized on or after the date of adoption.  FAS 123R also allows companies to implement by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in their pro forma footnote disclosures required under FAS 123.  We will adopt FAS 123R using the modified prospective method beginning January 1, 2006.  The impact of adopting FAS 123R on our consolidated results of operations is not expected to differ materially from the pro forma disclosures currently required by FAS 123 (see note 10 to our consolidated financial statements).  In addition, FAS 123R requires classification of the tax benefit from the exercise of stock options in cash flows from financing activities, rather than cash flows from operating activities.  In 2005, cash flows from operating activities include a cash inflow of $36 million related to tax benefits from the exercise of stock options.

In January 2003, the FASB issued Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities.”  FIN 46 requires a variable interest entity 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.  The consolidation provisions of FIN 46 were originally effective for financial periods ending after July 15, 2003.  In October 2003, the FASB issued Staff Position FIN 46-6, “Effective Date of FIN 46,” which delayed the implementation date to financial periods ending after December 31, 2003.  In December 2003, the FASB published a revision to FIN 46 (“FIN 46R”) to clarify some of the provisions of FIN 46, and to exempt certain entities from its requirements.  We do not have any variable interest entities requiring consolidation under FIN 46 and FIN 46R.  Therefore, adoption of these standards did not have a material impact on our consolidated financial position, consolidated results of operations or our consolidated cash flows.

In January 2003, we adopted FAS 143, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs.  FAS 143 requires the capitalization of the fair value of any legal or contractual obligations associated with the retirement of tangible, long-lived assets in the period in which the liabilities are incurred and the capitalization of a corresponding amount as part of the book value of the related long-lived asset.  In subsequent periods, we are required to adjust asset retirement obligations based on changes in estimated fair value, and the corresponding increases in asset book values are depreciated over the useful life of the related asset.  As required by FAS 143, we recorded an asset retirement obligation ($3 million at January 1, 2003) primarily related to equipment and leasehold improvements installed in leased, home delivery facilities in which we have a contractual obligation to remove the improvements and equipment upon surrender of the property to the landlord.  For certain of our leased facilities, we are required to remove equipment and convert the facilities back to office space upon surrender of the property.  We also recorded a net increase in fixed assets (net of accumulated depreciation) of $1 million and a $2 million ($1 million, net of tax) loss from the cumulative effect of change in accounting principle.  The $1 million asset is being depreciated, on a straight-line basis, over the remaining term of the leases, which range from seven months to ten years.

We make available through our website (www.express-scripts.com), access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, all amendments to those reports (when applicable), and other filings with the SEC.  Such access is free of charge and is available as soon as reasonably practicable after such information is filed with the SEC.  In addition, the SEC maintains an internet site (www.sec.gov) containing reports, proxy and information statements, and other information regarding issuers filing electronically with the SEC (which includes us).  Information included on our website is not part of this annual report.

IMPACT OF INFLATION

Changes in prices charged by manufacturers and wholesalers for pharmaceuticals affect our revenues and cost of revenues.  Most of our contracts provide that we bill clients based on a generally recognized price index for pharmaceuticals, and accordingly we have been able to recover price increases from our clients under the terms of our agreements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk. 

We are exposed to market risk from changes in interest rates related to debt outstanding under our credit facility.  Our earnings are subject to change as a result of movements in market interest rates.  At December 31, 2005, we had $1.0 billion of obligations, net of cash, which were subject to variable rates of interest under our credit facility.  A hypothetical increase in interest rates of 1% would result in an increase in annual interest expense of approximately $10 million (pre-tax), presuming that obligations subject to variable interest rates remained constant.

Item 8 — Consolidated Financial Statements and Supplementary Data 
 
Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Express Scripts, Inc.:

We have completed integrated audits of Express Scripts, Inc.’s December 31, 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its December 31, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Express Scripts, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
As described in Management’s Report on Internal Controls Over Financial Reporting, management has excluded Priority from its assessment of internal control over financial reporting as of December 31, 2005 because it was acquired by the Company in a purchase business combination during 2005. We have also excluded Priority from our audit of internal control over financial reporting. Priority is a wholly-owned subsidiary whose total assets and total revenues represent 28.9% and 3.2%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.



/s/PricewaterhouseCoopers LLP
St. Louis, MO
February 22, 2006

 

 
EXPRESS SCRIPTS, INC.
CONSOLIDATED BALANCE SHEET  
 
     
 
December 31,
 
 (in millions, except share data)
2005
 
2005
 
Assets
       
Current assets:
       
Cash and cash equivalents
$
478
 
$
166
 
Receivables, net
 
1,393
   
1,057
 
Inventories
 
273
   
159
 
Deferred taxes
 
53
   
33
 
Prepaid expenses and other current assets
 
60
   
28
 
Total current assets
 
2,257
   
1,443
 
Property and equipment, net
 
201
   
181
 
Goodwill, net
 
2,700
   
1,709
 
Other intangible assets, net
 
303
   
245
 
Other assets
 
32
   
22
 
Total assets
$
5,493
 
$
3,600
 
             
Liabilities and Stockholders’ Equity
           
Current liabilities:
           
Claims and rebates payable
$
1,380
 
$
1,237
 
Accounts payable
 
596
   
323
 
Accrued expenses
 
308
   
232
 
Current maturities of long-term debt
 
110
   
22
 
Total current liabilities
 
2,394
   
1,814
 
Long-term debt
 
1,401
   
412
 
Other liabilities
 
233
   
178
 
Total liabilities
 
4,028
   
2,404
 
             
Commitments and Contingencies (Note 8)
           
             
Stockholders’ equity:
           
Preferred stock, $0.01 par value, 5,000,000 shares authorized, and no shares
           
issued and outstanding
 
-
   
-
 
Common Stock, 275,000,000 shares authorized, $0.01 par value;
           
shares issued: 159,499,000 and 79,787,000, respectively;
           
shares outstanding: 145,993,000 and 73,858,000, respectively
 
2
   
1
 
Additional paid-in capital
 
474
   
467
 
Unearned compensation under employee compensation plans
 
(6
)
 
(18
)
Accumulated other comprehensive income
 
9
   
8
 
Retained earnings
 
1,543
   
1,143
 
   
2,022
   
1,601
 
Common Stock in treasury at cost, 13,506,000 and 5,929,000
           
shares, respectively
 
(557
)
 
(405
)
Total stockholders’ equity
 
1,465
   
1,196
 
Total liabilities and stockholders’ equity
$
5,493
 
$
3,600
 

See accompanying Notes to Consolidated Financial Statements. 






EXPRESS SCRIPTS, INC.
CONSOLIDATED STATEMENT OF OPERATIONS  

 
 
Year Ended December 31,
 
(in millions, except per share data)
2005
 
2004
 
2003
 
             
Revenues 1
$
16,266
 
$
15,115
 
$
13,295
 
Cost of revenues 1
 
15,067
   
14,171
   
12,428
 
Gross profit
 
1,199
   
944
   
867
 
Selling, general and administrative
 
556
   
451
   
417
 
Operating income
 
643
   
493
   
450
 
Other income (expense):