| NATIONAL MEDICAL HEALTH CARD SYSTEMS INC Item 1A Risk Factors Affecting Our Business We rely on third parties for our point of sale information system and transaction processing system, and any disruption in these services could materially disrupt our business and results of operations |
| Our operations utilize an electronic network connecting approximately 55cmam000 retail pharmacies to process third-party claims |
| This system is provided by a third-party adjudication vendor |
| Because claims are adjudicated in real time, systems availability and reliability are key to meeting customers’ service expectations |
| Any interruption in real time service, either through systems availability or telecommunications disruptions can significantly damage the quality of service we provide |
| Our PBM services also depend on third-party proprietary software to perform automated transaction processing |
| There can be no assurance that our business and results of operations will not be materially harmed by service interruptions or software performance problems |
| We are in the process of transitioning to new software provided by a third-party adjudication vendor and any severe interruption during the transition could materially disrupt our business and results of operations |
| All new clients joining us will utilize our new software, and we intend to migrate existing clients to this new software |
| It is possible that we may experience service interruptions in connection with the introduction of the new software, which may cause affected clients to become dissatisfied with us and seek services elsewhere |
| We face intense competition in the pharmacy benefit management industry |
| We and other PBM companies compete primarily on the basis of price, service, reporting capabilities and clinical services |
| The PBM industry is very competitive and dominated by, in most cases, a few large, profitable and well-established companies with significantly greater financial and marketing resources, purchasing power and other competitive advantages |
| Based on published reports, a limited number of national companies, including PBM companies such as Medco Health Solutions Inc, Express Scripts Inc |
| and Caremark Rx, Inc |
| have an aggregate market share of approximately 70prca of prescription volume |
| Our competitors also include drug retailers, physician practice management companies, and insurance companies/health maintenance organizations |
| We may also experience competition from new competitors in the future |
| If we do not compete effectively with our competitors, our business and results of operations may suffer |
| Uncertainty regarding the implementation and impact of Medicare Part D may adversely impact our business and financial results |
| The MMA created a new, voluntary prescription drug benefit for Medicare beneficiaries entitled to Medicare benefits under Part A or enrolled in Medicare Part B effective January 1, 2006 |
| We currently participate in the administration of the Medicare drug benefit: (i) through the provision of PBM services to our health plan clients and other clients that have qualified as a PDP or a MA-PD, and (ii) by assisting employers, unions and other health plan clients that qualify for the retiree drug subsidy available under Medicare Part D by collecting and submitting eligibility and/or drug cost data to CMS for them in order to obtain the subsidy |
| Our existing PBM business could be adversely affected if our clients decide to discontinue providing prescription drug benefits altogether to their Medicare-eligible members |
| We are not yet able to assess the impact that Medicare Part D will have on our clients’ decisions to continue to offer a prescription drug benefit to their Medicare-eligible members |
| 29 ______________________________________________________________________ [56]Table of Contents In addition, as an approved PDP sponsor for 2007, we intend to commence offering Medicare Part D pharmacy benefits to employer groups on January 1, 2007, subject to entering into a formal agreement with CMS during the fourth quarter of 2006 |
| This will be the first time we are a direct contractor to the federal government and subject to the rules, regulations and enforcement authority of the federal government over its contractors |
| In addition, under regulations established by CMS governing participation in the Medicare Part D program, our subsidiary, NMHC Group Solutions, must be a risk-bearing entity regulated under state insurance laws and must obtain licensure as a domestic insurance company prior to entering into a formal contract with CMS NMHC Group Solutions has been approved to operate as a risk-bearing entity in its domicile state, Delaware, and has filed applications for licensure in the 49 other states and Washington DC, and Puerto Rico |
| We are at various stages with these applications in the ancillary states as some states are considering our application, others we have not heard back from and others have been withdrawn for failure to meet certain requirements |
| We expect to operate under a three year wavier granted by CMS for these other states and territories |
| These applications are in various stages, and we can give no assurance that they will be approved |
| We have invested substantial amounts of time and resources to our Medicare drug benefit program which may impact our business and financial results |
| We have currently committed over dlra6dtta3 million in a cash account in connection with CMS requirements |
| As we become licensed as a risk-bearing entity in additional states, we expect to deposit an additional dlra8 million in the near future to fulfill statutory requirements in various states |
| The deposited cash is restricted and will not be available to fund our operations |
| In addition, we may not be able to realize any return on our investments in Medicare initiatives if the cost and complexity of recent changes by and requirements of CMS exceed our expectations or prevent effective program implementation; if the government alters or reduces funding of Medicare programs because of the higher-than-anticipated cost to taxpayers of the MMA or for other reasons; if we fail to become a risk bearing entity prior to the expiration of the CMS waivers for the 49 other states and territories; or if we fail to design and maintain programs that are attractive to our clients or individual Medicare participants; or if we are not successful in retaining employer groups and their enrollees, or winning contract renewals or new contracts under the MMA’s competitive bidding process |
| There are many uncertainties about the financial and regulatory risks of participating in the Medicare prescription drug program, and we can give no assurance that these risks will not be material to our business in future periods |
| We rely on a limited number of key clients for a significant portion of our revenues |
| The loss of any of these key clients as a result of competitive bidding for contracts, consolidation of clients or otherwise, could adversely affect our business, profitability and growth prospects |
| We depend on a limited number of clients for a significant portion of our revenue |
| Our top ten clients generated approximately 48prca, and our top twenty clients generated approximately 60prca, of the claims we processed in 2006, although no single client accounted for greater than 15prca of our revenues |
| Our client MVP, which consists of approximately 15prca of our gross dollar value of all prescriptions filled for fiscal year ended June 30, 2006, will not be renewing their contract with us which will expire on December 31, 2006 |
| Many of our clients put their contracts out for competitive bidding prior to expiration |
| Competitive bidding requires costly and time-consuming efforts on our behalf and, even after we have won such bidding processes, we can incur significant expense in proceedings or litigation contesting the adequacy or fairness of these bidding processes |
| We could lose clients if they cancel their agreements with us, if we fail to win a competitive bid at the time of contract renewal, if the financial condition of any of our clients deteriorates or if our clients are acquired by, or acquire, companies with which we do not have contracts |
| Over the past several years, self-funded employers, TPAs and other managed care companies have experienced significant consolidation |
| Consolidations by their very nature reduce the number of clients who may need our services |
| A client involved in a merger or acquisition by a company that is not a client of ours may not renew, and in some instances may terminate its contract with us |
| Our clients have been, and may continue to be, subject to consolidation pressures |
| Our business, results of operations and financial condition could be adversely affected if we were to lose one or more of our significant clients |
| 30 ______________________________________________________________________ [57]Table of Contents We may be liable for damages and other expenses that are not covered by our insurance policies |
| Various aspects of our business may subject us to litigation and liability for damages, for example, the performance of PBM services and the operation of our mail service and specialty service pharmacies |
| A successful product or professional liability claim in excess of our insurance coverage where we are required to pay damages, incur legal costs or face negative publicity could have a material adverse effect on our business, results of operations and financial condition, our business reputation and our ability to attract and retain clients, network pharmacies and employees |
| While we intend to maintain professional and general liability insurance coverage at all times, we cannot provide assurances that we will be able to maintain insurance in the future, that insurance will be available on acceptable terms or that insurance will be adequate to cover any or all potential product or professional liability claims |
| Specifically, due to the high cost of hurricane-related insurance premiums, we may not always be fully insured against these risks, including hurricane related risks in our Mail Service facility located in Miramar, Florida |
| While it is our goal to be fully insured against natural disasters at all times, we cannot provide assurances that we will be able to obtain coverage at favorable rates that outweigh the risks |
| Demands by our clients for enhanced service levels or possible loss or unfavorable modification of contracts with our clients could negatively affect our profitability |
| 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 PBM environment, and as a result, we may not be able to increase our fees to compensate for these increased services which could negatively affect our profitability |
| Due to the term of our contracts with clients, if we are unable to extend those contracts or replace any lost clients, our future business and results of operation would be adversely affected |
| We currently provide PBM 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 providers in advance of the expiration of their contracts |
| 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 PBM contract with us could be reduced |
| 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 results of operations would be adversely affected |
| Our results of operations could suffer if we lose our pharmacy network affiliations or if our specialty pharmacy is excluded from third party pharmacy networks |
| Our PBM operations are dependent to a significant extent on our ability to obtain discounts on prescription purchases from retail pharmacies that can be utilized by our clients and their participants |
| Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on short notice |
| If one or more of our top pharmacy chains elects to terminate its relationship with us or if we are only able to continue our relationship on terms less favorable to us, access to retail pharmacies by our clients and their health plan participants, and our business, results of operations and financial condition could suffer |
| In addition, some large retail pharmacy chains either own or have strategic alliances with PBMs or could attempt to acquire or enter into these kinds of relationships in the future |
| Ownership of, or alliances with, PBMs by retail pharmacy chains, particularly large pharmacy chains which control a significant amount of retail pharmacy business, could have material adverse effects on our relationships with those retail pharmacy chains, particularly the discounts they are willing to make available, and on our business, results of operations and financial condition |
| 31 ______________________________________________________________________ [58]Table of Contents Specialty Service contracts with third party payors, including other PBMs, state Medicaid, Medicare, and insurance companies, to become participants in their networks |
| We derive 52prca of specialty revenues from other third party payors |
| If the third party payor determines to carve out exclusive specialty agreements to a specific specialty vendor, we would no longer have access to the revenues generated through such relationship with such third party payor |
| We may be adversely affected by the loss of our relationships with one or more key pharmaceutical manufacturers or if rebate payments we receive from pharmaceutical manufacturers decline |
| We receive rebates from numerous pharmaceutical manufacturers based on the use of selected brand name drugs by participants of health plans sponsored by our clients, as well as fees for other programs and services |
| We believe our business, results of operations and financial condition may be adversely affected if: • we lose relationships with one or more key pharmaceutical manufacturers; • rebates decline due to the failure of our health plan clients to meet market share or other thresholds; • legal restrictions are imposed on the ability of pharmaceutical manufacturers to offer rebates or purchase our programs or services; or • pharmaceutical manufacturers choose not to offer rebates or purchase our programs or services |
| Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products will be introduced that may substantially reduce the market share of these brand name drugs |
| Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs |
| Our profitability could be adversely affected if the use of newly approved, brand name drugs added to formularies, does not offset any decline in use of brand name drugs whose patents expire or if rebates are not offered by the manufacturers of such newly approved brand name drugs |
| We may not be able to effectively manage our growth |
| Our growth in operations has placed significant demands on our management and other resources, which is likely to continue |
| Our business has grown rapidly since 2000, in part due to acquisitions, with total annual revenue increasing from dlra167dtta7 million during fiscal 2000 to dlra862dtta9 million during fiscal 2006 |
| Our business strategy is to continue to seek to expand our operations through strategic acquisitions and organic growth through the increased marketing of our services and by expanding the range of services we offer |
| We have acquired seven companies in the last six years |
| If we are unable to finance our continued growth or manage our future expansion, our business and results of operations could be adversely affected |
| Our success depends on our ability to retain our senior management and key personnel |
| We depend to a significant extent on certain key personnel and senior management, in particular those that have long-standing relationships within the PBM industry, which help us to obtain new clients |
| Accordingly, it is important for us to retain our existing management and to attract, hire and retain additional highly skilled and motivated officers, managers and employees |
| Therefore, losing the services of one or more members of our senior management or our key employees could adversely affect our business and results of operations |
| 32 ______________________________________________________________________ [59]Table of Contents Our success depends on our ability to manage potential problems and risks related to future acquisitions |
| Part of our growth strategy includes making acquisitions, including specialty pharmacy businesses and PBM businesses meeting specific criteria |
| Our ability to continue to expand successfully through acquisitions depends on many factors, including our ability to identify acquisition prospects and negotiate and close transactions |
| Even if we complete future acquisitions: • we could fail to successfully integrate the operations, services and products of an acquired company; • there could be inconsistencies in standards, controls, procedures and policies among the companies being combined or assimilated which would make it more difficult to implement and harmonize company-wide financial, accounting, billing, information technology and other systems; • we may experience difficulties maintaining the quality of products and services that acquired companies have historically provided; • we would be required to amortize the identifiable intangible assets of an acquired business, which will reduce our net income in the years following its acquisition, and we also would be required to reduce our net income in future years if we were to experience an impairment of goodwill or other intangible assets attributable to an acquisition; • we could be exposed to unanticipated liabilities of acquired businesses; • our management’s attention could be diverted from other business concerns; and • we could lose key employees or customers of the acquired business |
| There are risks associated with integrating and operating newly acquired businesses |
| We can give no assurance that we will successfully operate any new business we acquire in the future |
| If we are unable to overcome the potential problems and inherent risks related to our recent and future acquisitions, our business, results of operations and financial condition could suffer |
| Failure of our health plan clients to pay for prescription claims or a delay in payment of those claims could have a material adverse effect on our profitability |
| Our contracts with retail pharmacies that participate in our network generally obligate us to make payments for prescription claims even if we are not reimbursed by our clients |
| If our clients delay their reimbursement payments or fail to make payments for prescription claims, it could have a material adverse effect on our profitability |
| We could suffer civil and/or criminal penalties, lose clients, be required to pay substantial damages or make significant changes to our operations if we fail to comply with complex and rapidly evolving laws and regulations |
| During the past several years, the US health care industry has been subject to an increase in governmental regulation at both the federal and state levels |
| 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; • privacy and confidentiality laws and regulations, including those under HIPAA; • ERISA and related regulations, which regulate many health care plans; • potential regulation of the PBM industry by the US Food and Drug Administration; • the Medicare prescription drug coverage law and CMS regulations; • consumer protection and unfair trade practice laws and regulations; • various licensure laws, such as state insurance, managed care and third party administrator licensure laws; • pharmacy laws and regulations; • antitrust lawsuits challenging PBM pricing practices; • state legislation regulating PBMs or imposing fiduciary status on PBMs; 33 ______________________________________________________________________ [60]Table of Contents • drug pricing legislation, including “most favored nation” pricing and “unitary pricing” legislation; • other Medicare and Medicaid reimbursement regulations; • pending legislation regarding importation of drug products into the United States; • legislation imposing benefit plan design restrictions, which limit how our clients can design their drug benefit plans; • network pharmacy access laws, including “any willing provider” and “due process” legislation, that affect aspects of our pharmacy network contracts; and • formulary development and disclosure laws |
| These and other regulatory matters are discussed in more detail under “Business - Government Regulation” below |
| If we fail to comply with existing or future applicable laws and regulations, we could suffer civil or criminal penalties |
| We devote significant operational and managerial resources to comply with these laws and regulations |
| Although we believe that we are operating our business in substantial compliance with all existing legal requirements material to our business, different interpretations and enforcement policies of these laws and regulations could subject our current practices to allegations of impropriety or illegality, or could require us to make significant changes to our operations |
| In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business |
| Government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers |
| Efforts to control health care costs, including prescription drug costs, are underway at the federal and state government levels |
| Congress considers proposals to reform the US health care system on an on-going basis |
| These proposals may increase governmental involvement in health care and PBM services and may otherwise change the way our clients do business |
| Our clients and prospective clients may react to these proposals and the uncertainty surrounding them by cutting back or delaying the purchase of our PBM services, and manufacturers may react by reducing rebates or reducing supplies of certain products |
| These proposals could lead to a decreased demand for our services or to reduced rebates from manufacturers |
| In addition, both Congress and state legislatures are expected to consider legislation to increase governmental regulation of managed care plans |
| Some of these initiatives would, among other things, require that health plan participants have greater access to drugs not included on a plan’s formulary and give health plan participants the right to sue their health plans for malpractice when they have been denied care |
| The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by states to date vary greatly, and we cannot predict the extent of future legislation |
| However, these initiatives could greatly limit our business practices and impair our ability to serve our clients |
| 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 their 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, participants 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 |
| 34 ______________________________________________________________________ [61]Table of Contents Our leverage and debt service obligations could impede our operations and flexibility |
| In January 2005, we negotiated a dlra65 million credit facility with a syndicate of commercial banks led by JPMorgan Chase Bank, NA (“JPMorgan credit facility”) |
| As of June 30, 2006, we had no outstanding borrowings under the JPMorgan credit facility |
| If and when we borrow funds under the JPMorgan credit facility, we could incur 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 JPMorgan 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; and • 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 affect our results of operations, financial position and/or cash flow from operations |
| Our JPMorgan credit facility is secured by our assets |
| If we are unable to meet our obligations under the JPMorgan credit facility, these creditors could exercise their rights as secured parties and take possession of our assets |
| This would materially adversely affect our results of operations and financial condition |
| Risks related to bioterrorism and mail tampering, and mail irradiation and other procedures the government may implement to manage these risks, could adversely affect and limit the growth of our mail and specialty service business |
| Many prescription drugs are delivered directly to our consumers through the mail |
| In particular, our mail and specialty service pharmacies send thousands of parcels a week through the United States Postal Service (“USPS”) and other couriers |
| A number of our contracts also require us to deliver prescriptions within a designated period of time on average following receipt of an order |
| We have no control, however, over delays caused by disruptions to the USPS or other courier services |
| Moreover, should the risks related to bioterrorism or mail tampering increase or Mail Service experience interruptions or significant delays, we may have difficulty satisfying our contractual performance obligations and consumers may lose confidence in our mail and specialty service pharmacies |
| Additionally, the use of mail irradiation devices, if implemented, could be harmful to pharmaceutical products shipped via the mail |
| We understand that this technology is not in general use and the USPS has not announced plans to use irradiation screening on prescription medicines |
| However, should the federal government implement mail irradiation technology to protect national security due to the risks of bioterrorism via the mail or for other unforeseen reasons, safe and reliable delivery of prescription drugs through the mail may be difficult |
| If any of these events occur, we could be forced to temporarily or permanently discontinue our mail and specialty service operations and we would lose an important competitive advantage |
| 35 ______________________________________________________________________ [62]Table of Contents Any disruption of or failure in our automated mail service pharmacy or our data center could significantly reduce our ability to process and dispense prescriptions and provide products and services to our clients |
| Our automated pharmacy and Mail Service delivery system is located in Miramar, Florida |
| Our main data center, located in Port Washington, New York, provides primary support for all applications and systems required for our business operations, including our claims processing, billing and communications |
| These facilities depend on the infrastructure in the areas where they are located and on the uninterrupted operation of our computerized dispensing systems and our electronic data processing systems |
| Significant disruptions at any of these facilities due to failure of our technology or any other failure or disruption to these systems or to the infrastructure due to fire, electrical outage, natural disaster, acts of terrorism or some other catastrophic event could reduce our ability to process and dispense prescriptions and provide products and services to our clients |
| Although we maintain redundancies and other preventative measures to protect against disruption of these systems, there can be no assurance that redundant systems will in fact operate as intended or with the same effect as the primary systems |
| Product withdrawal from the market and utilization decreases based off of increased safety risk profiles of specific drugs may cause prescription volumes to decline and our net revenues and profitability may be negatively impacted |
| Our net revenues and profitability are based on the dispensing of brand-name and generic drugs by our Mail Service and Specialty Service pharmacies and retail pharmacies |
| Withdrawal of these products by the manufacturers or utilization decreases based off of increased safety risk profiles of specific drugs or classes of drugs may cause physicians to cease writing or reduce the numbers of prescriptions written for these drugs |
| In these cases, if there are no acceptable prescription drug equivalents or alternatives for these prescription drugs, our volumes, net revenues, profitability and cash flows may decline |
| The launch of generic pharmaceuticals into the marketplace may impact our financial results |
| A great deal of our earned rebates on drugs comes from drugs whose patents will expire over the next several years |
| When these patents expire, generic products will be introduced and may substantially reduce the market share of brand-name drugs and the rebates manufacturers provide to us for their brand-name drugs that are included on the formularies we manage |
| We may also be unable to negotiate rebates for new brand-name drugs comparable to the rebates we are receiving from brand-name drugs with expiring patents |
| Even though we generally earn higher margins on generic drugs than we earn on brand-name drugs, manufacturers of newly-introduced generic drugs sometimes benefit from an exclusive marketing period, generally six months, during which time we may be unable to earn these higher margins |
| Therefore, the typically higher margins we earn on generic drugs and rebates from newly-approved, brand-name drugs may not offset any decline in rebates for brand-name drugs with expired patents |