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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, 2004, OR
 o
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 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 an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes X   No ___

The aggregate market value of Registrant’s voting stock held by non-affiliates as of June 30, 2004, was $6,027,976,464 based on 76,081,995 such shares held on such date by non-affiliates and the average sale price for the Common Stock on such date of $79.23 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, 2005:
73,375,592
   Shares

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates by reference portions of the definitive proxy statement for the Registrant’s 2005 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, 2004.


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” 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, the fastest growing component of health care costs in the United States, accounted for approximately 11.6% of U.S. health care expenditures in 2004 and are expected to increase to about 23.1% in 2013 according to U.S. Centers for Medicare & Medicaid (“CMS”) estimates. Based upon information included in our 2003 Annual Drug Trend report, described below under “Company Operations—Clinical Support”, annual per member drug spending rose 15.5% in 2003. 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:

 
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evaluating drugs for price, value and efficacy in order to assist clients in selecting a cost-effective formulary;
 
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leveraging purchasing volume to deliver discounts to health benefit providers;
 
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promoting the use of generics and low-cost brands; and
 
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offering cost-effective mail pharmacy 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 mail pharmacy services to create an integrated product offering to manage the prescription drug benefit for payers. Some PBMs have broadened their service offerings to include disease management programs, compliance programs, outcomes research, drug therapy management programs, sophisticated data analysis and specialty 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, mail pharmacy 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:

 
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retail network pharmacy management
 
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mail pharmacy services, including distribution of specialty drugs
 
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benefit design consultation
 
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drug utilization review
 
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formulary management programs
 
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disease management
 
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compliance and therapy management programs for our clients

Non-PBM services provided through our Pharma Business Solutions (“PBS”) segment include:

 
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distribution of pharmaceuticals requiring special handling or packaging
 
•
distribution of pharmaceuticals to low-income patients through manufacturer-sponsored and company-sponsored generic patient assistance programs
 
•
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, mail pharmacy services and specialty distribution services. In 2004, 2003 and 2002, revenues from the delivery of prescription drugs to our members represented 98.5%, 98.6% and 98.5% of our total revenues, respectively. Revenues from services, such as the administration of some clients’ retail pharmacy networks, sample distribution services and certain services provided by our specialty distribution 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 seven mail pharmacy service centers and seven specialty drug pharmacies that we operated as of December 31, 2004. More than 57,700 retail pharmacies, representing more than 98% o of all United States retail pharmacies, participate in one or more of our networks.  In 2004, we processed 398.8 million network pharmacy claims and dispensed 39.1 million mail pharmacy prescriptions. We also dispensed 3.5 million specialty distribution prescriptions.

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:

 
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retail network pharmacy management
 
•
mail pharmacy services, including distribution of specialty drugs
 
•
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 mail 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 mail pharmacy in exchange for a smaller share of the pharmaceutical manufacturer rebates.

During 2004, 98.4% of our revenues were derived by our PBM operations, compared to 98.5% and 98.8% during 2003 and 2002, respectively. The number of retail pharmacy network claims processed and mail pharmacy claims dispensed increased to 398.8 million and 39.1 million, respectively, in 2004 from 378.9 million and 32.3 million claims, respectively, in 2003.

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. We manage one nationwide 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:

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

Mail Pharmacy. As of December 31, 2004, we operated seven mail pharmacies located in Maryland Heights, Missouri; Albuquerque, New Mexico; Bensalem, Pennsylvania; Harrisburg, Pennsylvania; Troy, New York; and two in Tempe, Arizona. These pharmacies provide members with convenient access to maintenance and specialty medications and enable us to manage our clients’ drug costs through operating efficiencies and economies of scale. In addition, CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc. (collectively, “CuraScript) operate seven specialty distribution pharmacies located in Orlando, Florida; Omaha, Nebraska; Pleasanton, California; Pittsburgh, Pennsylvania; Bethel Park, Pennsylvania; Amherst, New York; and Brewster, New York. Through our mail service pharmacies we are directly involved with the prescriber and member 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.

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:

 
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financial incentives and reimbursement limitations on the drugs covered by the plan, including drug formularies, tiered co-payments, deductibles or annual benefit maximums
 
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generic drug utilization incentives
 
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incentives or requirements to use only network pharmacies or to order certain maintenance drugs (i.e. therapies for diabetes, high blood pressure, etc.) only by mail
 
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reimbursement limitations on the amount of a drug that can be obtained in a specific period

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 - 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 2004, about 60% of all claims fell into three-tier or closed categories compared to 54% for 2003 and 52% for 2002. Use of formulary drugs can be encouraged in the following ways:

 
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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
 
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through prescriber education programs, in which we or the client actively seek to educate the prescribers about formulary drugs
 
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through our drug choice management program, which promotes lower cost therapeutic and generic interchanges to clinically appropriate cost-effective products

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”). 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.

We have two different types of rebate contracts with pharmaceutical manufacturers. The rebates paid by pharmaceutical manufacturers under both types of contracts are a function of the brand drugs dispensed to our clients’ members in our retail pharmacy networks and from our mail order pharmacies. The contracts primarily differ in the manner in which the rebates are calculated.

The first type of rebate contract is called the “preferred savings grid” (“PSG”) program. Under the PSG program, rebates are based on the characteristics of the formulary design selected by the client. The second type of rebate contract is called the “market share” program. Under the market share program we negotiate with manufacturers for rebates to be paid based upon the market share of the brand drugs sold by those manufacturers in our clients’ plans, as compared to the national market share of the drugs. In both cases manufacturers pay us administrative fees for certain services we perform in administering the formulary program.

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. For those clients that choose to enroll in our drug choice management program, we may contact the physician’s office to provide information about drugs which are on the clients’ formulary and to request that the physician consider changing the prescription to the appropriate formulary drug. The doctor has the final decision-making authority in prescribing the medication and we never recommend a change to a higher cost medication. The doctor will consider the recommended substitution in light of the patient’s medical history and approve or deny the recommended substitution.

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, proactive patient prescription compliance education, physician profiling, academic detailing, prior authorization, disease care management, and clinical guideline dissemination to physicians.

Historically, we received funding from pharmaceutical manufacturers in support of certain formulary support programs, such as our drug choice management program and our therapy adherence program. Starting in January 2003, we began eliminating manufacturer funding for these programs and as of October 1, 2003, such funding was completely phased out. We continue to provide formulary support programs for our clients without this targeted manufacturer funding.

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. In 1999, we launched www.DrugDigest.org, a public website dedicated to helping consumers make informed decisions about using drugs. During 2004, the Health on the Net Foundation granted DrugDigest.org HON Code accreditation for providing reliable online health information. Also in 2004, it was rated among the best websites for unbiased drug information by Business Week, Reader’s Digest, the Wall Street Journal and other publications.

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 2004, DrugDigest.org expanded its offerings to include not only drug safety information, but also interactive tools that give consumers a more active role in maintaining their own health. The consumer-friendly information on DrugDigest.org includes:

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

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 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 even before the plan’s benefit year begins. They can determine how variables such as generic usage, mandatory mail programs and step therapy would 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.

Non-PBM Services 

In addition to PBM services, we also provide certain non-PBM services through our Pharma Business Solutions unit including:

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

In 2004, we filled 3.5 million specialty distribution prescriptions, compared to 3.6 million in 2003 and 3.1 million in 2002. During 2004, 1.6% of our revenues were derived from non-PBM services, compared to 1.5% and 1.2% during 2003 and 2002, respectively.

Express Scripts Specialty Distribution Services. 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 13 of the notes to our consolidated financial statements.

Suppliers

We maintain a large inventory of brand name and generic pharmaceuticals in our mail 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 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.

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. Our top five clients represented 22.8%, 17.8%, and 19.6% of revenues during 2004, 2003 and 2002 respectively. None of our clients accounted for 10% or more of our consolidated revenues in fiscal years 2004, 2003 or 2002.

Medicare Prescription Drug Coverage

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law by President Bush on December 8, 2003. The Act created a new voluntary prescription drug benefit under the Medicare program by adding a new Part D to the Social Security Act. Beginning on January 1, 2006, eligible Medicare beneficiaries will be able to obtain prescription drug coverage under Part D by enrolling in a prescription drug plan (“PDP”) in their geographic region. The Act also established a Medicare managed care program called “Medicare Advantage,” which will replace the current Medicare + Choice program. Enrollees in a Medicare Advantage plan that offers prescription drug coverage will be able to obtain drug coverage through the plan and will not be eligible to enroll in a PDP.

The Act imposes various requirements on PDP sponsors and Medicare Advantage plans that offer drug coverage, including requirements relating to the prescription drug benefits offered, the disclosure of negotiated price concessions made available by drug manufacturers, pharmacy access and participation, and the development and application of formularies. Additional requirements are contained in regulations issued under the Act by CMS on January 21, 2005. To the extent that Express Scripts serves as a PDP sponsor or provides services to PDP sponsors and Medicare Advantage plans, it will be required to comply with the applicable provisions of the Act and CMS regulations.

The Act also created a voluntary Medicare prescription drug discount card program which will expire on December 31, 2005. Under the program, eligible Medicare beneficiaries are able to obtain a discount card from private card sponsors endorsed by CMS. The discount card enables the beneficiary to purchase covered prescription drugs at participating network pharmacies for negotiated prices under arrangements made by the card sponsor with pharmacies and drug manufacturers.

Together with the National Association of Chain Drugstores (“NACDS”), we sponsor a 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 also provide services to several of our clients who have submitted their own applications. The Act and the Medicare discount card program regulations issued by CMS contain various requirements that apply to our activities in connection with the program, including requirements relating to the types of drugs covered by a discount card program, disclosure to CMS of certain information related to prices and rebates negotiated by the sponsor with pharmacies and drug manufacturers, and oversight of endorsed card programs by CMS.

Acquisitions and Joint Ventures

On January 30, 2004, we purchased the capital stock of CuraScript for a purchase price of approximately $333.4 million. CuraScript is one of the nation’s largest specialty pharmacy 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.

On December 19, 2002, we entered into an agreement with Managed Pharmacy Benefits, Inc. (“MPB”) under which we acquired certain assets from MPB for approximately $11.1 million in cash, plus the assumption of certain liabilities. MPB is a St. Louis-based PBM and subsidiary of Medicine Shoppe International, Inc., a franchisor of apothecary-style retail pharmacies, owned by Cardinal Health, Inc.

On April 12, 2002, we completed the acquisition of National Prescription Administrators, Inc., a privately held full-service PBM, and certain related entities (collectively “NPA”), for a purchase price of approximately $466.0 million, which included the issuance of 552,000 shares of our common stock (fair value of $26.4 million upon the transaction announcement date), transaction costs and a working capital purchase price adjustment of $46.8 million. The addition of NPA brought us a strong presence in providing service to union and government populations.

On February 25, 2002, we purchased (through PMG) substantially all of the assets utilized in the operation of Phoenix Marketing Group (Holdings), Inc., a wholly-owned subsidiary of Access Worldwide Communications, Inc. for $34.1 million in cash, including acquisition-related costs, plus the assumption of certain liabilities. PMG, one of the largest prescription drug sample fulfillment companies, works with over 50 pharmaceutical manufacturers worldwide to deliver sample medicines and clinical information to physicians’ offices.

All of our acquisitions have been accounted for using the purchase method of accounting.

Company Operations

General. As of December 31, 2004, we operated seven mail pharmacies, nine member service/pharmacy help desk call centers out of leased and owned facilities; and CuraScript operated seven specialty distribution 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 pharmacy services to our PBM clients. 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. 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 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. We employ physicians, registered nurses, doctors of pharmacy and registered pharmacists to provide clinical support for our PBM services. Assisted by experienced data analysts, these health professionals provide direct clinical input for pharmacy services such as formulary development and management, drug information programs, clinical interventions with physicians and members, development of drug therapy guidelines and evaluation of drugs for inclusion in clinically-sound therapeutic intervention programs.

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 2003 Drug Trend Report in June 2004 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 Systems. Our Information Systems department supports our pharmacy claims processing 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. All domestic claims are presently processed through systems which are maintained, managed and operated domestically by EDS at their facilities. Canadian claims are processed through systems maintained, managed and operated by IBM. Disaster recovery services for all US systems are provided through our EDS services agreement and SunGard Availability Services. We have substantial capacity for growth in our US and Canadian claims processing facilities.

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 capabilities. Several of these competitors may have greater financial, marketing and technological resources than us.

Consolidation, including the acquisition of AdvancePCS by Caremark in 2004, has been, and may continue to be an important factor in the PBM industry. 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 non-PBM 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, 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 group purchasing organizations, 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 mail pharmacy 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.