CAREMARK RX INC - 10-Q Quarterly Report

3000 Galleria Tower, Suite 1000
Birmingham, Alabama 35244
(Address and zip code of principal executive offices)

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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý No o

As of July 31, 2003, the registrant had 265,930,899 shares (including 6,307,243 shares held in trust to be utilized in employee benefit plans) of common stock, par value $.001 per share, issued and outstanding.

In passing the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), 15 U.S.C.A. Sections 77z-2 and 78u-5 (Supp. 1996), Congress encouraged public companies to make "forward-looking statements" by creating a safe harbor to protect companies from securities law liability in connection with forward-looking statements. Caremark Rx, Inc. ("Caremark Rx") intends to qualify both its written and oral forward-looking statements for protection under the Reform Act and any other similar safe harbor provisions. Unless the context indicates otherwise, the words "Company," "we," "our," and "us," whenever used in this Quarterly Report on Form 10-Q refer collectively to Caremark Rx and its wholly-owned subsidiaries.

"Forward-looking statements" are defined by the Reform Act. Generally, forward-looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events, and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected. Due to those risks and uncertainties, the investment community is urged not to place undue reliance on our written or oral forward-looking statements. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.

Forward-looking statements are contained in this document, primarily in "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") and in the "Notes to Condensed Consolidated Financial Statements." Moreover, through our senior management, we may from time to time make forward-looking statements about matters described herein or about other matters concerning us.

There are several factors which could adversely affect our operations and financial results, including, but not limited to, the following:

More detailed discussions of certain of these risk factors can be found in MD&A as well as in our 2002 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 31, 2003, under the captions: "Business—Government Regulation," "Legal Proceedings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations."

		Page
PART I—FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets—June 30, 2003 (Unaudited) and December 31, 2002	2
	Condensed Consolidated Statements of Income (Unaudited)—Three Months and Six Months Ended June 30, 2003 and 2002	3
	Condensed Consolidated Statements of Cash Flows (Unaudited)—Six Months Ended June 30, 2003 and 2002	4
	Notes to Condensed Consolidated Financial Statements (Unaudited)	5
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	20
Item 4.	Controls and Procedures	20
PART II—OTHER INFORMATION
Item 1.	Legal Proceedings	21
Item 4.	Submission of Matters to a Vote of Security Holders	21
Item 5.	Other Information	21
Item 6.	Exhibits and Reports on Form 8-K	22
Signature	23

CAREMARK RX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

			June 30, 2003			December 31, 2002
			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	525,778		$	306,804
	Accounts receivable, less allowance for doubtful accounts of $25,650 in 2003 and $23,239 in 2002			569,748			506,919
	Inventories			151,179			200,412
	Deferred tax asset, net			196,934			201,738
	Prepaid expenses and other current assets			14,583			9,772

		Total current assets		1,458,222			1,225,645
Property and equipment, net of accumulated depreciation of $150,034 in 2003 and $148,692 in 2002				144,142			139,002
Intangible assets, net of accumulated amortization of $17,114 in 2003 and $15,275 in 2002				60,260			61,604
Deferred tax asset, net				355,563			412,588
Other non-current assets				72,019			73,901

		Total assets	$	2,090,206		$	1,912,740

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable		$	310,009		$	294,758
	Claims and discounts payable			405,663			370,031
	Other accrued expenses and liabilities			153,901			180,685
	Income taxes payable			3,675			3,409
	Current portion of long-term debt			2,500			2,500
	Current liabilities of discontinued operations			—			25,622

		Total current liabilities		875,748			877,005
Long-term debt, net of current portion				694,375			695,625
Other long-term liabilities				80,970			82,417

		Total liabilities		1,651,093			1,655,047
Commitments and contingencies
Stockholders' equity:
	Common stock, $.001 par value per share; 400,000 shares authorized; issued—266,982 shares in 2003 and 263,005 shares in 2002			267			263
	Additional paid-in capital			1,720,150			1,665,155
	Treasury stock—1,855 shares in 2003 and 1,490 shares in 2002			(28,782	)		(22,671	)
	Shares held in trust—6,325 in 2003 and 6,376 in 2002			(101,963	)		(102,948	)
	Accumulated deficit			(1,140,524	)		(1,272,071	)
	Accumulated other comprehensive loss			(10,035	)		(10,035	)

		Total stockholders' equity		439,113			257,693

		Total liabilities and stockholders' equity	$	2,090,206		$	1,912,740

The accompanying Notes to Condensed Consolidated Financial Statements
are an integral part of these balance sheets.

CAREMARK RX, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share amounts)

		Three Months Ended June 30,				Six Months Ended June 30,
		2003		2002		2003		2002
Net revenue		$	2,204,039	$	1,626,466	$	4,367,835	$	3,240,583
Operating expenses:
	Cost of revenues*		2,019,399		1,488,061		4,011,100		2,978,911
	Selling, general and administrative expenses		48,785		41,075		94,888		77,917
	Depreciation and amortization		10,758		7,311		20,634		14,003
	Interest expense, net		10,875		11,645		21,969		23,816

Income before provision for income taxes			114,222		78,374		219,244		145,936
Provision for income taxes			45,688		5,878		87,697		10,945

Net income			68,534		72,496		131,547		134,991
Preferred security dividends			—		3,305		—		6,609

Net income to common stockholders		$	68,534	$	69,191	$	131,547	$	128,382

Average number of common shares outstanding—basic			256,391		228,115		255,864		227,473

Average number of common shares outstanding—diluted			263,606		265,895		262,696		264,973

Net income per common share—basic		$	0.27	$	0.30	$	0.51	$	0.56

Net income per common share—diluted		$	0.26	$	0.27	$	0.50	$	0.51

CAREMARK RX, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

			Six Months Ended June 30,
			2003			2002
Cash flows from continuing operations:
	Net income		$	131,547		$	134,991
	Adjustments to reconcile net income to net cash provided by continuing operations:
		Deferred income taxes		78,058			—
		Depreciation and amortization		20,634			14,003
		Non-cash interest expense		1,804			1,597
		Other non-cash expenses		541			—
		Changes in operating assets and liabilities, net of effects of acquisitions and disposals of businesses		34,807			36,344

		Net cash provided by continuing operations		267,391			186,935
Cash flows from investing activities:
	Capital expenditures, net			(26,589	)		(13,881	)
	Acquisitions of businesses, net of cash acquired			(319	)		(49,039	)

		Net cash used in investing activities		(26,908	)		(62,920	)
Cash flows from financing activities:
	Net proceeds from exercise of stock options and retirement of warrant			39,214			14,618
	Purchase of treasury stock			(6,111	)		—
	Net proceeds (repayments) under credit facility			(1,250	)		1,250
	Long-term debt issuance costs			(100	)		(1,230	)
	Net repayments under trade receivables sales facility			—			(99,200	)
	Dividend payments on Convertible Preferred Securities			—			(7,000	)

		Net cash provided by (used in) financing activities		31,753			(91,562	)
Cash used in discontinued operations				(53,262	)		(20,980	)

Net increase in cash and cash equivalents				218,974			11,473
Cash and cash equivalents—beginning of period				306,804			159,066

Cash and cash equivalents—end of period			$	525,778		$	170,539

The accompanying Notes to Condensed Consolidated Financial Statements
are an integral part of these statements.

Caremark Rx, Inc., a Delaware corporation, is one of the largest pharmaceutical services companies in the United States. The Company's operations are conducted primarily through Caremark Inc. ("Caremark"), a wholly-owned, indirect subsidiary of Caremark Rx. The Company's customers are primarily sponsors of health benefit plans (employers, insurance companies, unions, government employee groups, managed care organizations) and individuals located throughout the United States.

The accompanying unaudited condensed consolidated financial statements include the accounts of Caremark Rx and its wholly-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial reporting and in accordance with Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal recurring items) necessary for a fair presentation of results for the interim periods presented. The results of operations for any interim period are not necessarily indicative of results to be expected for a full year. The condensed consolidated balance sheet of the Company at December 31, 2002, has been derived from audited financial statements but does not include all disclosures required by GAAP. These financial statements and footnote disclosures should be read in conjunction with the Company's audited consolidated financial statements and notes thereto for the year ended December 31, 2002, which appear in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2003.

The preparation of financial statements in conformity with GAAP 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. Actual amounts could differ from those estimates and assumptions.

The Company accounts for options to purchase its common stock under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation ("FAS 123"). When the Company adopted FAS 123, it elected to continue using the intrinsic value method of expense recognition contained in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related interpretations, instead of the fair value method found in FAS 123, to account for employee stock options granted under its stock-based compensation plans.

The intrinsic value method requires the Company to recognize compensation expense based on the difference in the market price and the exercise price of options at their grant date. The exercise price of option grants under the Company's stock-based compensation plans is equal to or greater than the market price of the underlying stock on the grant date; therefore, no compensation expense related to the initial grant of these options has been recognized in the accompanying unaudited condensed consolidated financial statements. In the 2003 periods, the Company recognized approximately $174,000 of compensation expense, net of income tax benefit, related to one option grant for which the terms were modified in such a way as to create a new management date for accounting purposes.

FAS 123 requires companies which elected to continue applying the intrinsic value method to disclose pro forma information regarding net income and earnings per share as if the Company had recognized compensation expense for employee stock option grants using the fair value method described therein. The pro forma impact of applying this provision, using the Black-Scholes model (multiple-option method) to compute the fair value of stock option grants, on the Company's net income to common stockholders and net income per common share is as follows (dollars in millions, except per share amounts):

At December 31, 2002, the Company had a cumulative income tax net operating loss ("NOL") carryforward of approximately $1.75 billion available to reduce future amounts of taxable income. If not utilized to offset future taxable income, including amounts of taxable income generated through June 30, 2003, these NOL carryforwards will expire on various dates through 2020, with over 90% of the total NOL carryforward amount expiring from 2018 to 2020. In addition to these NOL carryforwards, the Company had approximately $101 million of future additional income tax deductions related to its discontinued operations. The Company also had a federal alternative minimum tax credit

carryforward of approximately $20 million, which may be used to offset its ordinary federal corporate income taxes in the future.

Prior to the fourth quarter of 2002, during which the Company eliminated the valuation allowance previously recorded against its net deferred tax asset, significant variations existed in the customary relationship between income tax expense and pretax income because the Company utilized its NOL to reduce its current tax provision. Consequently, the Company provided for income taxes at a rate of 7.5%, which represented its aggregate effective state and federal tax rate, in the 2002 periods.

The Company has arranged to sell an undivided percentage ownership interest in certain of its accounts receivable pursuant to a revolving period trade receivables sales facility with General Electric Capital Corporation ("GECC"). GECC's $125 million commitment under this facility expires in January 2006. The Chase Manhattan Bank's $25 million commitment under this facility expired in February 2003. There were no amounts outstanding under this facility at June 30, 2003, and the Company retained full availability of the $125 million committed thereunder.

The Company's long-term debt at June 30, 2003, and December 31, 2002, consisted of the following (in thousands):

The Company has a credit facility with Bank of America, N.A. as administrative agent. The credit facility is guaranteed by the Company's material subsidiaries, including Caremark, and the Company and its material subsidiaries have granted a lien on substantially all of their respective current and future personal property and pledged the capital stock of Caremark International Inc., the parent company of Caremark, as security for amounts outstanding.

The credit facility consists of: (i) a $250 million term loan facility maturing on March 15, 2006, with scheduled quarterly principal payments of $625,000, and (ii) a $300 million revolving credit facility maturing on March 15, 2005. At June 30, 2003, the Company had approximately $288.7 million available for borrowing under the revolving facility, exclusive of approximately $11.3 million reserved under letters of credit.

Borrowings under the credit facility currently bear interest at variable rates based on the London Inter-bank Offered Rate ("LIBOR"), plus varying margins. At the Company's option, or upon certain defaults or other events, borrowings under the credit facility may instead bear interest based on the prime rate plus varying margins.

The credit facility contains covenants that, among other things, restrict the Company's ability to incur additional indebtedness or guarantee obligations, engage in mergers or consolidations, dispose of assets, make investments or acquisitions, loans or advances, engage in certain transactions with affiliates, conduct certain corporate activities, create liens, make capital expenditures, prepay or modify the terms of other indebtedness, pay dividends and other distributions or change the nature of its business. In addition, the Company is required to comply with specified financial covenants, including a maximum leverage ratio, a minimum fixed charge coverage ratio and a minimum interest expense coverage ratio. The credit facility includes various customary and other events of default, including cross default provisions and defaults for any material judgment or change in control. The Company was in compliance with all debt covenants at June 30, 2003.

The following tables reconcile income (numerator) and shares (denominator) used in the Company's computations of net income per common share (in thousands, except per share amounts):

Options to purchase approximately 123,000 shares of the Company's common stock at $19.88 to $21.95 per share were outstanding during the six months ended June 30, 2003, but were excluded from the Company's computation of average number of common shares outstanding—diluted because the options' exercise prices were greater than the average market price of the common shares underlying such options during the period. Approximately 112,000 of these options were outstanding at June 30, 2003.

Overview. On November 11, 1998, the Company announced that Caremark, which operates the Company's pharmaceutical services business, would become its core operating unit. The Company also announced its intent to divest its PPM and contract services businesses. As a result, in 1998 the Company restated its prior period financial statements to reflect these businesses, as well as the international operations sold during 1998, as discontinued operations.

Remaining Obligations. The Company has accrued $52.2 million of estimated remaining discontinued operations exit costs, which are included in "Other accrued expenses and liabilities" ($45.1 million) and "Other long-term liabilities" ($7.1 million) in the accompanying unaudited condensed consolidated balance sheet at June 30, 2003. The Company expects to pay the majority of these obligations by the end of 2003. These amounts are estimates, and actual amounts could differ from those recorded.

The Company retained numerous operating leases, primarily for administrative and office space, related to its discontinued operations. As of June 30, 2003, the aggregate future gross rents related to such leases were approximately $45.7 million, with sublease arrangements of approximately $20.3 million in place. The Company has estimated the costs to terminate or sublease these facilities and has included the net amount in its accrual for remaining discontinued operations exit costs.

Contingencies. The Company and/or one or more of its subsidiaries, affiliates or former managed physician practices is a party to certain claims and proceedings related to its discontinued operations. The eventual outcome of these claims and proceedings could differ from the amounts accrued at June 30, 2003, and, if different, could result in the Company's recording additional losses on the disposal of its discontinued operations. Additionally, the Company has assigned to various parties approximately $83.7 million of lease obligations related to its discontinued operations. The Company and/or one or more of its subsidiaries or affiliates remain named as guarantor or obligor on these lease obligations.

The Company is party to certain legal actions arising in the ordinary course of business. The Company is named as a defendant in various legal actions arising from its continuing operations and its discontinued PPM and contract services operations, including employment disputes, contract disputes, personal injury claims and professional liability claims. Management does not view any of these actions as likely to result in an uninsured award that would have a material adverse effect on the operating results and financial condition of the Company.

On April 29, 2003, Caremark Rx and Caremark were served with a complaint by an individual named Robert Irwin. The plaintiff filed the action individually, purportedly as both a private attorney general on behalf of the general public of the State of California and as a class action. Nine other PBM companies are also named as defendants in this lawsuit, which alleges violations of the California unfair competition law. Specifically, the lawsuit challenges alleged business practices of PBMs, including practices relating to pricing, rebates, formulary management, data utilization and accounting and administrative processes. The lawsuit seeks injunctive relief, restitution and disgorgement of revenues. We believe that the lawsuit mischaracterizes the business practices of Caremark Rx and Caremark and that we have meritorious defenses to the claims alleged. We intend to vigorously defend this lawsuit.

On March 19, 2003, Caremark Rx and Caremark were served with a purported representative action filed by American Federation of State, County & Municipal Employees, a labor union comprised of numerous autonomous local unions and affiliations. Several other PBM companies are also named as defendants in this lawsuit. The lawsuit alleges violations of the California unfair competition law. Specifically, the lawsuit challenges alleged business practices of PBMs, including practices relating to rebates, pricing, formulary management and mail order services. The lawsuit seeks injunctive relief, restitution and disgorgement of revenues. The Company believes the lawsuit mischaracterizes the business practices of Caremark Rx and Caremark and that it has meritorious defenses to the claims alleged. The Company intends to vigorously defend this lawsuit. This case has been coordinated with the Irwin case described above before a single judge in Los Angeles County.

(MARK ONE)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		Three Months Ended June 30,						Six Months Ended June 30,
		2003			2002			2003			2002
As reported:
	Net income to common stockholders	$	68.5		$	69.2		$	131.5		$	128.4

	Stock-based employee compensation cost (1)	$	0.2		$	—		$	0.2		$	—

	Net income per common share—basic	$	0.27		$	0.30		$	0.51		$	0.56

	Net income per common share—diluted	$	0.26		$	0.27		$	0.50		$	0.51

Pro forma:
	Net income to common stockholders	$	66.4		$	65.8		$	127.6		$	119.9

	Stock-based employee compensation cost (2)	$	2.3		$	3.4		$	4.1		$	8.4

	Net income per common share—basic	$	0.26		$	0.29		$	0.50		$	0.53

	Net income per common share—diluted	$	0.25		$	0.26		$	0.48		$	0.48

Black-Scholes assumptions (weighted average):
	Risk-free interest rate		1.63	%		1.25	%		2.01	%		1.79	%
	Expected volatility		45	%		45	%		45	%		45	%
	Expected option lives (years)		2.3			2.0			3.1			3.4

		June 30, 2003			December 31, 2002
Credit facility:
	Term loan facility (3.37% at June 30, 2003)	$	246,875		$	248,125
	Revolving facility		—			—

			246,875			248,125
7.375% senior notes due 2006			450,000			450,000

			696,875			698,125
Less: amounts due within one year			(2,500	)		(2,500	)

		$	694,375		$	695,625