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



FORM 10-Q

(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, 2014

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 No. 1-6639

MAGELLAN HEALTH, INC.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
  58-1076937
(IRS Employer
Identification No.)

55 Nod Road, Avon, Connecticut
(Address of principal executive offices)

 

06001
(Zip code)

(860) 507-1900
(Registrant's telephone number, including area code)



        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 twelve 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ý   Accelerated filer o   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company o

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

        The number of shares of the registrant's Ordinary Common Stock outstanding as of June 30, 2014 was 28,816,061.

   


Table of Contents

FORM 10-Q
MAGELLAN HEALTH, INC. AND SUBSIDIARIES
INDEX

 
   
  Page No.  

PART I—Financial Information:

       

Item 1:

 

Financial Statements

    2  

 

Consolidated Balance Sheets—December 31, 2013 and June 30, 2014

    2  

 

Consolidated Statements of Income—For the Three and Six Months Ended June 30, 2013 and 2014

    3  

 

Consolidated Statements of Comprehensive Income—For the Three and Six Months Ended June 30, 2013 and 2014

    4  

 

Consolidated Statements of Cash Flows—For the Six Months Ended June 30, 2013 and 2014

    5  

 

Notes to Consolidated Financial Statements

    6  

Item 2:

 

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

    35  

Item 3:

 

Quantitative and Qualitative Disclosures about Market Risk

    54  

Item 4:

 

Controls and Procedures

    55  

PART II—Other Information:

       

Item 1:

 

Legal Proceedings

    56  

Item 1A:

 

Risk Factors

    56  

Item 2:

 

Unregistered Sales of Equity Securities and Use of Proceeds

    56  

Item 3:

 

Defaults Upon Senior Securities

    57  

Item 4:

 

Mine Safety Disclosures

    57  

Item 5:

 

Other Information

    57  

Item 6:

 

Exhibits

    58  

Signatures

    59  

1


Table of Contents


PART I—FINANCIAL INFORMATION

Item 1.    Financial Statements.

        


MAGELLAN HEALTH, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

 
  December 31,
2013
  June 30,
2014
(unaudited)
 

ASSETS

             

Current Assets:

             

Cash and cash equivalents

  $ 203,187   $ 185,777  

Restricted cash

    236,696     167,313  

Accounts receivable, less allowance for doubtful accounts of $5,447 and $5,197 at December 31, 2013 and June 30, 2014, respectively

    238,185     301,869  

Short-term investments (restricted investments of $117,674 and $138,929 at December 31, 2013 and June 30, 2014, respectively)

    175,883     147,861  

Deferred income taxes

    37,530     36,945  

Pharmaceutical inventory

    49,609     44,277  

Other current assets (restricted deposits of $25,009 and $29,340 at December 31, 2013 and June 30, 2014, respectively)

    48,268     72,732  
           

Total Current Assets

    989,358     956,774  

Property and equipment, net

    172,333     172,048  

Restricted long-term investments

    32,430     23,494  

Other long-term assets

    7,197     9,962  

Goodwill

    488,206     557,425  

Other intangible assets, net

    69,694     146,985  
           

Total Assets

  $ 1,759,218   $ 1,866,688  
           
           

LIABILITIES, REDEEMABLE NON-CONTROLLING INTEREST AND STOCKHOLDERS' EQUITY

             

Current Liabilities:

             

Accounts payable

  $ 42,853   $ 63,563  

Accrued liabilities

    134,652     144,588  

Medical claims payable

    228,341     234,645  

Other medical liabilities

    67,416     79,543  

Current maturities of long-term capital lease obligations

    3,005     2,909  
           

Total Current Liabilities

    476,267     525,248  

Long-term capital lease obligations

    23,720     21,947  

Deferred income taxes

    42,046     40,581  

Tax contingencies

    32,343     34,179  

Contingent consideration

        43,745  

Deferred credits and other long-term liabilities

    17,803     21,169  
           

Total Liabilities

    592,179     686,869  
           

Redeemable non-controlling interest

    10,554     8,555  

Preferred stock, par value $.01 per share

   
 
   
 
 

Authorized—10,000 shares at December 31, 2013 and June 30, 2014—Issued and outstanding—none

         

Ordinary common stock, par value $.01 per share

             

Authorized—100,000 shares at December 31, 2013 and June 30, 2014—Issued and outstanding—47,351 shares and 27,616 shares at December 31, 2013, respectively, and 49,688 and 28,816 shares at June 30, 2014, respectively

    474     497  

Multi-Vote common stock, par value $.01 per share

             

Authorized—40,000 shares at December 31, 2013 and June 30, 2014—Issued and outstanding—none

         

Other Stockholders' Equity:

             

Additional paid-in capital

    922,325     973,611  

Retained earnings

    1,100,493     1,131,199  

Accumulated other comprehensive (loss) income

    (93 )   20  

Ordinary common stock in treasury, at cost, 19,735 shares and 20,872 shares at December 31, 2013 and June 30, 2014, respectively

    (866,714 )   (934,063 )
           

Total Stockholders' Equity

    1,156,485     1,171,264  
           

Total Liabilities, Redeemable Non-Controlling Interest and Stockholders' Equity

  $ 1,759,218   $ 1,866,688  
           
           

   

See accompanying notes to consolidated financial statements.

2


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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except per share amounts)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Net revenue:

                         

Managed care and other

  $ 746,720   $ 682,274   $ 1,469,309   $ 1,511,865  

PBM and dispensing

    96,028     205,740     195,200     342,624  
                   

Total net revenue

    842,748     888,014     1,664,509     1,854,489  
                   

Cost and expenses:

                         

Cost of care

    537,630     481,617     1,062,657     1,087,325  

Cost of goods sold

    90,175     192,566     183,687     317,864  

Direct service costs and other operating expenses(1)

    144,497     179,034     284,124     343,756  

Depreciation and amortization

    16,946     22,480     33,116     42,709  

Interest expense

    792     2,004     1,402     2,840  

Interest income

    (358 )   (275 )   (711 )   (586 )
                   

Total costs and expenses

    789,682     877,426     1,564,275     1,793,908  
                   

Income before income taxes

    53,066     10,588     100,234     60,581  

Provision for income taxes

    21,586     6,261     40,696     31,874  
                   

Net income

    31,480     4,327     59,538     28,707  

Less: net income (loss) attributable to non-controlling interest

        (659 )       (1,999 )
                   

Net income attributable to Magellan Health, Inc. 

  $ 31,480   $ 4,986   $ 59,538   $ 30,706  
                   
                   

Net income per common share attributable to Magellan Health, Inc.:

                         

Basic (See Note B)

  $ 1.17   $ 0.18   $ 2.21   $ 1.13  

Diluted (See Note B)

  $ 1.15   $ 0.18   $ 2.17   $ 1.10  

(1)
Includes stock compensation expense of $4,602 and $9,550 for the three months ended June 30, 2013 and 2014, respectively, and $10,240 and $14,022 for the six months ended June 30, 2013 and 2014, respectively.

   

See accompanying notes to consolidated financial statements.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Net income

  $ 31,480   $ 4,327   $ 59,538   $ 28,707  

Other comprehensive income:

                         

Unrealized (losses) gains on available-for-sale securities(1)

    (70 )   70     (147 )   113  
                   

Comprehensive income

    31,410     4,397     59,391     28,820  

Less: comprehensive income (loss) attributable to non-controlling interest

        (659 )       (1,999 )
                   

Comprehensive income attributable to Magellan Health, Inc. 

  $ 31,410   $ 5,056   $ 59,391   $ 30,819  
                   
                   

(1)
Net of income tax (benefit) provision of $(47) and $46 for the three months ended June 30, 2013 and 2014, respectively, and $(99) and $75 for the six months ended June 30, 2013 and 2014, respectively.

   

See accompanying notes to consolidated financial statements.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30,

(Unaudited)

(In thousands)

 
  2013   2014  

Cash flows from operating activities:

             

Net income

  $ 59,538   $ 28,707  

Adjustments to reconcile net income to net cash provided by operating activities:

             

Depreciation and amortization

    33,116     42,709  

Non-cash interest expense

    368     1,572  

Non-cash stock compensation expense

    10,240     14,022  

Non-cash income tax expense (benefit)

    1,335     (1,558 )

Non-cash amortization on investments

    4,884     2,653  

Realized loss on sale of investments

        50  

Cash flows from changes in assets and liabilities, net of effects from acquisitions of businesses:

             

Restricted cash

    37,086     69,383  

Accounts receivable, net

    (27,361 )   (15,752 )

Pharmaceutical inventory

    (4,150 )   5,332  

Other assets

    (8,281 )   (27,675 )

Accounts payable and accrued liabilities

    (29,643 )   (5,434 )

Medical claims payable and other medical liabilities

    6,384     18,657  

Tax contingencies

    1,349     1,164  

Deferred credits and other long-term liabilities

    373     3,366  

Other

    1,671     (145 )
           

Net cash provided by operating activities

    86,909     137,051  
           

Cash flows from investing activities:

             

Capital expenditures

    (27,035 )   (32,007 )

Acquisitions and investments in businesses, net of cash acquired

    (7,900 )   (124,995 )

Purchase of investments

    (165,372 )   (112,088 )

Maturity of investments

    139,068     146,532  
           

Net cash used in investing activities

    (61,239 )   (122,558 )
           

Cash flows from financing activities:

             

Payments to acquire treasury stock

    (49,462 )   (65,254 )

Proceeds from exercise of stock options and warrants

    16,110     34,197  

Payments on capital lease obligations

    (1,816 )   (2,087 )

Other

    (747 )   1,241  
           

Net cash used in financing activities

    (35,915 )   (31,903 )
           

Net decrease in cash and cash equivalents

    (10,245 )   (17,410 )

Cash and cash equivalents at beginning of period

    189,464     203,187  
           

Cash and cash equivalents at end of period

  $ 179,219   $ 185,777  
           
           

Supplemental cash flow data:

             

Non-cash investing activites:

             

Property and equipment acquired under capital leases

  $ 29,323   $ 216  
           
           

   

See accompanying notes to consolidated financial statements.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2014

(Unaudited)

NOTE A—General

Basis of Presentation

        The accompanying unaudited consolidated financial statements of Magellan Health, Inc., a Delaware corporation ("Magellan"), include the accounts of Magellan, its majority owned subsidiaries, and all variable interest entities ("VIEs") for which Magellan is the primary beneficiary (together with Magellan, the "Company"). The financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the Securities and Exchange Commission's (the "SEC") instructions to Form 10-Q. Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the full year. All significant intercompany accounts and transactions have been eliminated in consolidation.

        The Company has evaluated subsequent events for recognition or disclosure in the consolidated financial statements filed on this Form 10-Q. Other than as described in Note G—"Subsequent Events", the Company did not have any material recognizable events during the period.

        These unaudited consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the year ended December 31, 2013 and the notes thereto, which are included in the Company's Annual Report on Form 10-K filed with the SEC on March 3, 2014.

Business Overview

        The Company is engaged in the healthcare management business, and is focused on meeting needs in areas of healthcare that are fast growing, highly complex and high cost, with an emphasis on special population management. The Company provides services to health plans, managed care organizations ("MCOs"), insurance companies, employers, labor unions, various military and governmental agencies, third party administrators, consultants and brokers. The Company's business is divided into the following five segments, based on the services it provides and/or the customers that it serves, as described below.

Managed Healthcare

        Two of the Company's segments are in the managed healthcare business. This line of business reflects the Company's: (i) management of behavioral healthcare services, and (ii) the integrated management of physical, behavioral and pharmaceutical healthcare for special populations, delivered through Magellan Complete Care ("MCC"). The Company's coordination and management of physical and behavioral healthcare includes services provided through its comprehensive network of medical and behavioral health professionals, clinics, hospitals and ancillary service providers. This network of credentialed and privileged providers is integrated with clinical and quality improvement programs to enhance the healthcare experience for individuals in need of care, while at the same time managing the cost of these services for our customers. The treatment services provided through the Company's provider network include outpatient programs, intermediate care programs, inpatient treatment and

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

crisis intervention services. The Company generally does not directly provide or own any provider of treatment services, although it does employ licensed behavioral health counselors to deliver non-medical counseling under certain government contracts.

        The Company's integrated management of physical and behavioral healthcare includes its full service health plans which provide for the holistic management of special populations. These special populations include individuals with serious mental illness, dual eligibles, those eligible for long term care and other populations with unique and often complex healthcare needs.

        The Company provides its management services primarily through: (i) risk-based products, where the Company assumes all or a substantial portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) administrative services only ("ASO") products, where the Company provides services such as utilization review, claims administration and/or provider network management, but does not assume responsibility for the cost of the treatment services, and (iii) employee assistance programs ("EAPs") where the Company provides short-term outpatient behavioral counseling services.

        The managed healthcare business is managed based on the services provided and/or the customers served, through the following two segments:

        Commercial.    The Managed Healthcare Commercial segment ("Commercial") generally reflects managed behavioral healthcare services and EAP services provided under contracts with health plans, insurance companies and MCOs for some or all of their commercial, Medicaid and Medicare members, as well as with employers, including corporations, governmental agencies, military and labor unions. Commercial's contracts encompass risk-based, ASO and EAP arrangements.

        Public Sector.    The Managed Healthcare Public Sector segment ("Public Sector") generally reflects: (i) the management of behavioral health services provided to recipients under Medicaid and other state sponsored programs under contracts with state and local governmental agencies, and (ii) the integrated management of physical, behavioral and pharmaceutical care for special populations covered under Medicaid and other government sponsored programs. Public Sector contracts encompass either risk-based or ASO arrangements.

Specialty Solutions

        The Specialty Solutions segment ("Specialty Solutions") generally reflects the management of the delivery of diagnostic imaging (radiology benefits management or "RBM") and a variety of other specialty areas such as radiation oncology, obstetrical ultrasound, cardiology and musculoskeletal management to ensure that such services are clinically appropriate and cost effective. The Company's Specialty Solutions services are currently provided under contracts with health plans and insurance companies for some or all of their commercial, Medicaid and Medicare members. The Company also contracts with state and local governmental agencies for the provision of such services to Medicaid recipients. The Company offers its Specialty Solutions services through risk-based contracts, where the Company assumes all or a substantial portion of the responsibility for the cost of providing services, and through ASO contracts, where the Company provides services such as utilization review and claims administration, but does not assume responsibility for the cost of the services.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)


Pharmacy Management

        The Pharmacy Management segment ("Pharmacy Management") comprises products and solutions that provide clinical and financial management of drugs paid under medical and pharmacy benefit programs. Pharmacy Management's services include (i) traditional pharmacy benefit management ("PBM") services; (ii) pharmacy benefit administration ("PBA") for state Medicaid and other government sponsored programs; (iii) specialty pharmaceutical dispensing operations, contracting and formulary optimization programs; (iv) medical pharmacy management programs; and (v) programs for the integrated management of drugs that treat complex conditions, regardless of site of service, method of delivery, or benefit reimbursement. In addition, the Company had a subcontract arrangement to provide PBM services on a risk basis for one of Public Sector's customers, which terminated on March 31, 2014.

        The Company's Pharmacy Management programs are provided under contracts with health plans, employers, Medicaid MCOs, state Medicaid programs, and other government agencies, and encompass risk-based and fee-for-service ("FFS") arrangements.

Corporate

        This segment of the Company is comprised primarily of operational support functions such as sales and marketing and information technology, as well as corporate support functions such as executive, finance, human resources and legal.

Summary of Significant Accounting Policies

Recent Accounting Pronouncements

        In July 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2011-06, "Other Expenses (Topic 720): Fees Paid to the Federal Government by Health Insurers (a consensus of the FASB Emerging Issues Task Force)" ("ASU 2011-06"), which addresses how fees mandated by the Patient Protection and the Affordable Care Act ("ACA"), as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, the "Health Reform Law"), should be recognized and classified in the income statements of health insurers. The Health Reform Law imposes a mandatory annual fee on health insurers for each calendar year beginning on or after January 1, 2014. ASU 2011-06 stipulates that the liability incurred for that fee be amortized to expense over the calendar year in which it is payable. This ASU is effective for calendar years beginning after December 31, 2013, when the fee initially becomes effective. The Company is currently pursuing rate adjustments to cover the direct costs of these fees and the impact from non-deductibility of such fees for federal and state income tax purposes. To the extent the Company has a state public sector customer that does not renew, there may be some impact due to taxes paid where the timing and amount of recoupment of these additional costs is uncertain. In the event the Company is unable to obtain rate adjustments to cover the financial impact of the annual fee, the fee may have a material impact on the Company. As of June 30, 2014, the Company has obtained signed commitments from four of its customers to recover the economic impact of the ACA fees. For 2014, the projected ACA fee is currently estimated to be $21.3 million and is included in accrued liabilities in the consolidated balance sheets. Of this amount $5.6 million and $10.7 million was expensed in the

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

three and six months ended June 30, 2014, respectively, which is included in direct service costs and other operating expenses in the consolidated statements of income. The Company has recorded revenues of $10.9 million and $14.1 million in the three and six months ended June 30, 2014, respectively, associated with the accrual for the reimbursement of the economic impact of the ACA fees from its customers. Of the revenues recorded in the three months ended June 30, 2014, $4.8 million are associated with the three months ended March 31, 2014, due to signed commitments obtained in the three months ended June 30, 2014.

        In July 2013, the FASB issued ASU No. 2013-11, "Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Carryforward Exists" ("ASU 2013-11"). ASU 2013-11 provides guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. An unrecognized tax benefit should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward with certain exceptions, in which case such an unrecognized tax benefit should be presented in the financial statements as a liability. The amendments in this ASU do not require new recurring disclosures. The amendments in this ASU are effective for reporting periods beginning after December 15, 2013 and were adopted by the Company during the quarter ended March 31, 2014. The effect of the guidance is immaterial to the Company's consolidated results of operations, financial position, and cash flows.

        In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)" ("ASU 2014-09), which is a new comprehensive revenue recognition standard that will supersede virtually all existing revenue guidance under GAAP. This ASU is effective for calendar years beginning after December 15, 2016. The Company is currently assessing the potential impact this ASU will have on the Company's consolidated results of operation, financial position, and cash flows.

        In June 2014, the FASB issued ASU No. 2014-12, "Compensation—Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved After the Requisite Service Period" ("ASU 2014-12), which revises the accounting treatment for stock compensation tied to performance targets. This ASU is effective for calendar years beginning after December 15, 2015. The guidance is not expected to materially impact the Company's consolidated results of operations, financial position, or cash flows.

Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realization, valuation allowances for deferred tax assets, valuation of goodwill and intangible assets, medical claims payable, other medical liabilities, contingent consideration, stock compensation assumptions, tax contingencies and legal liabilities. Actual results could differ from those estimates.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

Managed Care and Other Revenue

        Managed Care Revenue.    Managed care revenue, inclusive of revenue from the Company's risk, EAP and ASO contracts, is recognized over the applicable coverage period on a per member basis for covered members. The Company is paid a per member fee for all enrolled members, and this fee is recorded as revenue in the month in which members are entitled to service. The Company adjusts its revenue for retroactive membership terminations, additions and other changes, when such adjustments are identified, with the exception of retroactivity that can be reasonably estimated. The impact of retroactive rate amendments is generally recorded in the accounting period that terms to the amendment are finalized, and that the amendment is executed. Any fees paid prior to the month of service are recorded as deferred revenue. Managed care revenues approximated $654.6 million and $1,284.3 million for the three and six months ended June 30, 2013, respectively, and $595.1 million and $1,323.9 million for the three and six months ended June 30, 2014, respectively.

        Fee-For-Service and Cost-Plus Contracts.    The Company has certain fee-for-service contracts, including cost-plus contracts, with customers under which the Company recognizes revenue as services are performed and as costs are incurred. This includes revenues received in relation to ACA fees billed on a cost reimbursement basis. Revenues from these contracts approximated $51.0 million and $100.3 million for the three and six months ended June 30, 2013, respectively, and $73.0 million and $132.7 million for the three and six months ended June 30, 2014, respectively.

        Block Grant Revenues.    The Maricopa Contract (as defined below) was partially funded by federal, state and county block grant money, which represents annual appropriations. The Company recognizes revenue from block grant activity ratably over the period to which the block grant funding applies. Block grant revenues were approximately $31.4 million and $64.6 million for the three and six months ended June 30, 2013, respectively, and $0.0 million and $33.0 million for the three and six months ended June 30, 2014, respectively.

        Performance-Based Revenue.    The Company has the ability to earn performance-based revenue under certain risk and non-risk contracts. Performance-based revenue generally is based on either the ability of the Company to manage care for its clients below specified targets, or on other operating metrics. For each such contract, the Company estimates and records performance-based revenue after considering the relevant contractual terms and the data available for the performance-based revenue calculation. Pro-rata performance-based revenue may be recognized on an interim basis pursuant to the rights and obligations of each party upon termination of the contracts. Performance-based revenues were $1.5 million and $3.4 million for the three and six months ended June 30, 2013, respectively, and $2.4 million and $5.4 million for the three and six months ended June 30, 2014, respectively.

        Rebate Revenue.    The Company administers a rebate program for certain clients through which the Company coordinates the achievement, calculation and collection of rebates and administrative fees from pharmaceutical manufacturers on behalf of clients. Each period, the Company estimates the total rebates earned based on actual volumes of pharmaceutical purchases by the Company's clients, as well as historical and/or anticipated sharing percentages. The Company earns fees based upon the volume of rebates generated for its clients. The Company does not record as rebate revenue any rebates that are passed through to its clients. Total rebate revenues were $8.1 million and $16.8 million for the three

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

and six months ended June 30, 2013, respectively, and $9.2 million and $13.3 million for the three and six months ended June 30, 2014, respectively.

        In relation to the Company's PBM business, the Company administers rebate programs through which it receives rebates from pharmaceutical manufacturers that are shared with its customers. The Company recognizes rebates when the Company is entitled to them and when the amounts of the rebates are determinable. The amount recorded for rebates earned by the Company from the pharmaceutical manufacturers are recorded as a reduction of cost of goods sold.

PBM and Dispensing Revenue

        Pharmacy Benefit Management Revenue.    The Company recognizes PBM revenue, which consists of a negotiated prescription price (ingredient cost plus dispensing fee), co-payments collected by the pharmacy and any associated administrative fees, when claims are adjudicated. The Company recognizes PBM revenue on a gross basis (i.e. including drug costs and co-payments) as it is acting as the principal in the arrangement and is contractually obligated to its clients and network pharmacies, which is a primary indicator of gross reporting. In addition, the Company is solely responsible for the claims adjudication process, negotiating the prescription price for the pharmacy, collection of payments from the client for drugs dispensed by the pharmacy, and managing the total prescription drug relationship with the client's members. If the Company enters into a contract where it is only an administrator, and does not assume any of the risks previously noted, revenue will be recognized on a net basis. PBM revenues were $5.5 million and $10.5 million for the three and six months ended June 30, 2013, respectively, and $146.3 million and $227.5 million for the three and six months ended June 30, 2014, respectively. The increase mainly relates to the October 1, 2013 acquisition of Partners Rx Management, LLC ("Partners Rx").

        Dispensing Revenue.    The Company recognizes dispensing revenue, which includes the co-payments received from members of the health plans the Company serves, when the specialty pharmaceutical drugs are shipped. At the time of shipment, the earnings process is complete; the obligation of the Company's customer to pay for the specialty pharmaceutical drugs is fixed, and, due to the nature of the product, the member may neither return the specialty pharmaceutical drugs nor receive a refund. Revenues from the dispensing of specialty pharmaceutical drugs on behalf of health plans were $90.6 million and $184.7 million for the three and six months ended June 30, 2013, respectively, and $59.4 million and $115.1 million for the three and six months ended June 30, 2014, respectively.

Significant Customers

        Through March 31, 2014, the Company provided behavioral healthcare management and other related services to approximately 680,000 members in Maricopa County, Arizona as the Regional Behavioral Health Authority ("RBHA") for GSA6 ("Maricopa County") pursuant to a contract with the State of Arizona (the "Maricopa Contract"). The Maricopa Contract was for the management of the publicly funded behavioral health system that delivered mental health, substance abuse and crisis services for adults, youth, and children. The Maricopa Contract terminated on March 31, 2014. The

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

Maricopa Contract generated net revenues of $367.2 million and $209.5 million for the six months ended June 30, 2013 and 2014, respectively.

        In addition to the Maricopa Contract previously discussed, the following customers generated in excess of ten percent of net revenues for the respective segment for the six months ended June 30, 2013 and 2014 (in thousands):

Segment
  Term Date   2013   2014  

Commercial

 

 

             

Customer A

 

June 30, 2014(1)

  $ 103,460   $ 110,492  

Customer B

 

December 31, 2019

    70,919     90,923  

Customer C

 

August 14, 2017

    29,537 *   47,769  

Customer D

 

December 14, 2013(1)

    38,776      

Public Sector

 

 

   
 
   
 
 

Customer E

 

June 30, 2015

    129,471     213,000  

Specialty Solutions

 

 

   
 
   
 
 

Customer E

 

December 31, 2015

    60,602     69,988  

Customer F

 

June 30, 2016(2)

    30,580     26,515  

Customer G

 

July 31, 2015

    32,708     34,901  

Customer A

 

November 30, 2016

    1,154 *   26,577  

Customer H

 

January 31, 2016

    22,230     24,593  

Pharmacy Management

 

 

   
 
   
 
 

Customer I

 

November 30, 2014 to December 31, 2014(3)

    65,335     60,972  

Customer J

 

December 31, 2013(4)

    43,274     1,267 *

Customer K

 

March 31, 2014(1)(5)

    31,466     18,055 *

*
Revenue amount did not exceed ten percent of net revenues for the respective segment for the period presented. Amount is shown for comparative purposes only.

(1)
The contract has terminated.

(2)
This contract transitioned from risk to ASO based services effective July 1, 2014.

(3)
The customer has more than one contract. The individual contracts are scheduled to terminate at various points during the time period indicated above.

(4)
The contract has terminated, however, the Company continues to provide services as the contract is transitioned to the new vendor.

(5)
This customer represents a subcontract with a Public Sector customer and is eliminated in consolidation.

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JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        The Company also has a significant concentration of business with various counties in the State of Pennsylvania (the "Pennsylvania Counties") which are part of the Pennsylvania Medicaid program. Net revenues from the Pennsylvania Counties in the aggregate totaled $178.0 million and $179.0 million for the six months ended June 30, 2013 and 2014, respectively.

        In addition, the Company has a significant concentration of business with the State of Florida. The Company currently has behavioral healthcare contracts with various areas in the State of Florida (the "Florida Areas") which are part of the Florida Medicaid program. The State of Florida is implementing a new system of mandated managed care through which Medicaid enrollees will receive integrated healthcare services, and by July 31, 2014 it will phase out the behavioral healthcare programs under which the Florida Areas' contracts operate. The Company has a contract with the State of Florida to provide integrated healthcare services under the new program. Net revenues from the State of Florida in the aggregate totaled $66.3 million and $56.5 million for the six months ended June 30, 2013 and 2014, respectively.

        The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts may be immediately terminated with cause and many of the Company's contracts are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies generally are conditioned on legislative appropriations. These contracts generally can be terminated or modified by the customer if such appropriations are not made.

Fair Value Measurements

        The Company has certain assets and liabilities that are required to be measured at fair value on a recurring basis. These assets and liabilities are to be measured using inputs from the three levels of the fair value hierarchy, which are as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        In accordance with the fair value hierarchy described above, the following table shows the fair value of the Company's assets and liabilities that are required to be measured at fair value as of December 31, 2013 and June 30, 2014 (in thousands):

 
  December 31, 2013  
 
  Level 1   Level 2   Level 3   Total  

Assets

                         

Cash and cash equivalents(1)

  $   $ 101,028   $   $ 101,028  

Restricted cash(2)

        128,318         128,318  

Investments:

   
 
   
 
   
 
   
 
 

U.S. government and agency securities

    1,129             1,129  

Obligations of government-sponsored enterprises(3)

        8,440         8,440  

Corporate debt securities

        198,594         198,594  

Certificates of deposit

        150         150  
                   

Total assets held at fair value

  $ 1,129   $ 436,530   $   $ 437,659  
                   

 

 
  June 30, 2014  
 
  Level 1   Level 2   Level 3   Total  

Assets

                         

Cash and cash equivalents(4)

  $   $ 72,729   $   $ 72,729  

Restricted cash(5)

        71,911         71,911  

Investments:

   
 
   
 
   
 
   
 
 

U.S. government and agency securities

    2,078             2,078  

Obligations of government-sponsored enterprises(3)

        8,707         8,707  

Corporate debt securities

        159,420         159,420  

Certificates of deposit

        1,150         1,150  
                   

Total assets held at fair value

  $ 2,078   $ 313,917   $   $ 315,995  
                   
                   

Liabilities

                         

Contingent consideration

  $   $   $ 46,982   $ 46,982  
                   

Total liabilities held at fair value

  $   $   $ 46,982   $ 46,982  
                   
                   

(1)
Excludes $102.2 million of cash held in bank accounts by the Company.

(2)
Excludes $108.4 million of restricted cash held in bank accounts by the Company.

(3)
Includes investments in notes issued by the Federal Home Loan Bank.

(4)
Excludes $113.0 million of cash held in bank accounts by the Company.

(5)
Excludes $95.4 million of restricted cash held in bank accounts by the Company.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        For the six months ended June 30, 2014, the Company has not transferred any assets between fair value measurement levels.

        All of the Company's investments are classified as "available-for-sale" and are carried at fair value.

        The contingent consideration liability reflects the fair values of potential future payments related to the CDMI, LLC ("CDMI") acquisition. The CDMI purchase agreement provides for potential contingent payments up to a maximum aggregate amount of $165.0 million. The potential future payments are contingent upon CDMI meeting certain client retention, client conversion, and gross profit milestones through December 31, 2016. The fair value of contingent consideration is determined based on probabilities of payment, projected payment dates, discount rates, and projected revenues, gross profits, and client base. The projected revenues, gross profits, and client base are derived from the Company's latest internal operational forecasts. The Company used a probability weighted discounted cash flow method to arrive at the fair value of the contingent consideration. Changes in the operational forecasts, probabilities of payment, discount rates, or projected payment dates may result in a change in the fair value measurement. Any changes in the fair value measurement are reflected as income or expense in the consolidated statements of income. As the fair value measurement for the contingent consideration is based on inputs not observed in the market, these measurements are classified as Level 3 measurements as defined by fair value measurement guidance.

        The following unobservable inputs were used in the fair value measurement of contingent consideration: (i) discount rate of 14.5 percent; (ii) probabilities of payment of 0.2 percent to 75.9 percent; and (iii) projected payment dates of 2015 to 2017. As of the acquisition date, the Company estimated undiscounted future contingent payments of $61.7 million. As of June 30, 2014 the fair value of the contingent consideration was $47.0 million and is included in accrued liabilities and contingent liabilities in the consolidated balance sheet. The change in the present value of the contingent consideration was $1.2 million for the three months and six months ended June 30, 2014 and was recorded as interest expense in the consolidated statements of income.

        The following table summarizes the Company's liability for contingent consideration:

 
  June 30,
2014
 

Balance as of beginning of period

  $  

Acquisition of CDMI

    45,778  

Interest accretion

    1,204  
       

Balance as of end of period

  $ 46,982  
       
       

        If a debt security is in an unrealized loss position and the Company has the intent to sell the debt security, or it is more likely than not that the Company will have to sell the debt security before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded to other-than-temporary impairment losses recognized in income in the consolidated statements of income. For impaired debt securities that the Company does not intend to sell or it is more likely than not that the Company will not have to sell such securities, but the Company expects

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

that it will not fully recover the amortized cost basis, the credit component of the other-than-temporary impairment is recognized in other-than-temporary impairment losses recognized in income in the consolidated statements of income and the non-credit component of the other-than-temporary impairment is recognized in other comprehensive income.

        As of December 31, 2013 and June 30, 2014, there were no unrealized losses that the Company believed to be other-than-temporary. No realized gains or losses were recorded for the six months ended June 30, 2013. During the six months ended June 30, 2014, the Company recognized a $0.1 million loss on the sale of investments. The following is a summary of short-term and long-term investments at December 31, 2013 and June 30, 2014 (in thousands):

 
  December 31, 2013  
 
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair Value
 

U.S. government and agency securities

  $ 1,129   $   $   $ 1,129  

Obligations of government-sponsored enterprises(1)

    8,441     2     (3 )   8,440  

Corporate debt securities

    198,748     18     (172 )   198,594  

Certificates of deposit

    150             150  
                   

Total investments at December 31, 2013

  $ 208,468   $ 20   $ (175 ) $ 208,313  
                   
                   

 

 
  June 30, 2014  
 
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair Value
 

U.S. government and agency securities

  $ 2,078   $ 1   $ (1 ) $ 2,078  

Obligations of government-sponsored enterprises(1)

    8,707     2     (2 )   8,707  

Corporate debt securities

    159,387     64     (31 )   159,420  

Certificates of deposit

    1,150             1,150  
                   

Total investments at June 30, 2014

  $ 171,322   $ 67   $ (34 ) $ 171,355  
                   
                   

(1)
Includes investments in notes issued by the Federal Home Loan Bank.

        The maturity dates of the Company's investments as of June 30, 2014 are summarized below (in thousands):

 
  Amortized
Cost
  Estimated
Fair Value
 

2014

  $ 97,491   $ 97,489  

2015

    69,149     69,186  

2016

    4,682     4,680  
           

Total investments at June 30, 2014

  $ 171,322   $ 171,355  
           
           

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

Income Taxes

        The Company's effective income tax rates were 40.6 percent and 52.6 percent for the six months ended June 30, 2013 and 2014, respectively. These rates differ from the federal statutory income tax rate primarily due to state income taxes, permanent differences between book and tax income, and changes to recorded tax contingencies. The Company also accrues interest and penalties related to unrecognized tax benefits in its provision for income taxes. The effective income tax rate for the six months ended June 30, 2013 is lower than the effective rate for the six months ended June 30, 2014 mainly due to the non-deductible ACA fees and valuations allowances for certain deferred tax assets.

        The Company files a consolidated federal income tax return for the Company and its eighty percent or more owned subsidiaries, and the Company and its subsidiaries file income tax returns in various states and local jurisdictions. With few exceptions, the Company is no longer subject to income tax assessments by tax authorities for years ended prior to 2010.

Stock Compensation

        At December 31, 2013 and June 30, 2014, the Company had equity-based employee incentive plans, which are described more fully in Note 6 in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The Company recorded stock compensation expense of $4.6 million and $10.2 million for the three and six months ended June 30, 2013 and $9.5 million and $14.0 million for the three and six months ended June 30, 2014, respectively. Stock compensation expense recognized in the consolidated statements of income for the six months ended June 30, 2013 and 2014 has been reduced for forfeitures, estimated at four percent for both periods.

        The weighted average grant date fair value of all stock options granted during the six months ended June 30, 2014 was $13.61 as estimated using the Black-Scholes-Merton option pricing model, which also assumed an expected volatility of 26.20 percent based on the historical volatility of the Company's stock price.

        The benefits of tax deductions in excess of recognized stock compensation expense are reported as a financing cash flow, rather than as an operating cash flow. In the six months ended June 30, 2013 and 2014, $0.5 million and $2.4 million, respectively, of benefits of such tax deductions related to stock compensation expense were realized and as such were reported as financing cash flows. For the six months ended June 30, 2013, the net change to additional paid in capital related to tax benefits (deficiencies) was $(0.1) million, which includes $(0.6) million of excess tax deficiencies offset by the $0.5 million of excess tax benefits. For the six months ended June 30, 2014, the net change to additional paid in capital related to tax benefits (deficiencies) was $2.1 million, which includes the $2.4 million of excess tax benefits offset by $(0.3) million of excess tax deficiencies.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        Summarized information related to the Company's stock options for the six months ended June 30, 2014 is as follows:

 
  Options   Weighted
Average
Exercise
Price
 

Outstanding, beginning of period

    4,010,146   $ 47.23  

Granted

    654,636     60.22  

Forfeited

    (137,472 )   52.91  

Exercised

    (813,867 )   44.54  
           

Outstanding, end of period

    3,713,443   $ 49.90  
           
           

Vested and expected to vest at end of period

    3,670,859   $ 49.83  
           
           

Exercisable, end of period

    2,037,633   $ 46.00  
           
           

        All of the Company's options granted during the six months ended June 30, 2014 vest ratably on each anniversary date over the three years subsequent to grant. All options granted during the six months ended June 30, 2014 have a ten year life.

        Summarized information related to the Company's nonvested restricted stock awards for the six months ended June 30, 2014 is as follows:

 
  Shares   Weighted
Average
Grant Date
Fair Value
 

Outstanding, beginning of period

    192,165   $ 56.59  

Awarded(1)

    1,448,674     57.74  

Vested

    (16,569 )   52.82  

Forfeited

         
           

Outstanding, ending of period

    1,624,270   $ 57.65  
           
           

(1)
Includes 1,433,946 shares associated with the CDMI acquisition.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        Summarized information related to the Company's nonvested restricted stock units ("RSUs") for the six months ended June 30, 2014 is as follows:

 
  Shares   Weighted
Average
Grant Date
Fair Value
 

Outstanding, beginning of period

    194,913   $ 50.21  

Awarded

    76,306     60.39  

Vested

    (90,177 )   49.55  

Forfeited

    (11,293 )   54.05  
           

Outstanding, ending of period

    169,749   $ 54.88  
           
           

        RSAs generally vest on the anniversary of the grant. In general, RSUs vest ratably on each anniversary over the three years subsequent to grant, assuming that the associated performance hurdle(s) for that vesting year are met.

Long Term Debt and Capital Lease Obligations

        On December 9, 2011, the Company entered into a Senior Secured Revolving Credit Facility Credit Agreement with Citibank, N.A., Wells Fargo Bank, N.A., Bank of America, N.A., and U.S. Bank, N.A. that provides for up to $230.0 million of revolving loans with a sublimit of up to $70.0 million for the issuance of letters of credit for the account of the Company (the "2011 Credit Facility"). Citibank, N.A., has assigned a portion of its interest in the 2011 Credit Facility to Bank of Tokyo. The 2011 Credit Facility is guaranteed by substantially all of the non-regulated subsidiaries of the Company and is secured by substantially all of the assets of the Company and the subsidiary guarantors. The 2011 Credit Facility will mature on December 9, 2014.

        Under the 2011 Credit Facility, the annual interest rate on revolving loan borrowings is equal to (i) in the case of U.S. dollar denominated loans, the sum of a borrowing margin of 0.75 percent plus the higher of the prime rate, one-half of one percent in excess of the overnight "federal funds" rate, or the Eurodollar rate for one month plus 1.00 percent, or (ii) in the case of Eurodollar denominated loans, the sum of a borrowing margin of 1.75 percent plus the Eurodollar rate for the selected interest period. The Company has the option to borrow in U.S. dollar denominated loans or Eurodollar denominated loans at its discretion. Letters of credit issued under the Revolving Loan Commitment bear interest at the rate of 1.875 percent. The commitment commission on the 2011 Credit Facility is 0.375 percent of the unused Revolving Loan Commitment.

        On July 23, 2014, the Company entered into a $500.0 million Credit Agreement with various lenders that provides for Magellan Rx Management, Inc. to borrow up to $250.0 million of revolving loans, with a sublimit of up to $70.0 million for the issuance of letters of credit for the account of the Company, and a term loan in an original aggregate principal amount of $250.0 million (the "2014 Credit Facility"). See Note G—"Subsequent Events" for more information on the 2014 Credit Facility.

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JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

        There were $26.7 million and $24.9 million of capital lease obligations at December 31, 2013 and June 30, 2014, respectively. The Company had $33.7 million and $32.9 million of letters of credit outstanding at December 31, 2013 and June 30, 2014, respectively, and no revolving loan borrowings at December 31, 2013 or June 30, 2014.

Goodwill

        The Company is required to test its goodwill for impairment on at least an annual basis and more frequently if indicators of impairment exist. The Company has selected October 1 as the date of its annual impairment test. Goodwill for each of the Company's reporting units at December 31, 2013 and June 30, 2014 were as follows (in thousands):

 
  December 31,
2013
  June 30,
2014
 

Health Plan

  $ 120,485   $ 120,485  

Specialty Solutions

    104,549     104,549  

Pharmacy Management

    242,290     311,512  

Public Sector

    20,882     20,879  
           

Total

  $ 488,206   $ 557,425  
           
           

        The changes in the carry amount of goodwill for the year ended December 31, 2013 and the six months ended June 30, 2014 are reflected in the table below (in thousands):

 
  December 31,
2013
  June 30,
2014
 

Balance as of beginning of period

  $ 426,939   $ 488,206  

Acquisition of Partners Rx(1)

    40,385     254  

Acquisition of AlphaCare Holdings(1)

    20,882     (3 )

Acquisition of CDMI

        68,968  
           

Balance as of end of period

  $ 488,206   $ 557,425  
           
           

(1)
Activity for the period ended June 30, 2014 represents measurement period adjustments.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

Intangible Assets

        The following is a summary of intangible assets at December 31, 2013 and June 30, 2014, and the estimated useful lives for such assets (in thousands):

 
  December 31, 2013  
Asset
  Estimated
Useful Life
  Gross
Carrying
Amount
  Accumulated
Amortization
  Net
Carrying
Amount
 

Customer agreements and lists

  2.5 to 18 years   $ 163,990   $ (100,482 ) $ 63,508  

Provider networks and other

  1 to 16 years     11,593     (5,407 )   6,186  
                   

      $ 175,583   $ (105,889 ) $ 69,694  
                   
                   

 

 
  June 30, 2014  
Asset
  Estimated
Useful Life
  Gross
Carrying
Amount
  Accumulated
Amortization
  Net
Carrying
Amount
 

Customer agreements and lists

  2.5 to 18 years   $ 249,290   $ (109,407 ) $ 139,883  

Provider networks and other

  1 to 16 years     13,193     (6,091 )   7,102  
                   

      $ 262,483   $ (115,498 ) $ 146,985  
                   
                   

        Amortization expense was $2.3 million and $4.6 million for the three and six months ended June 30, 2013, respectively, and $5.7 million and $9.6 million for the three and six months ended June 30, 2014, respectively. The Company estimates amortization expense will be $22.8 million, $25.0 million, $20.7 million, $16.9 million and $15.4 million for the years ended December 31, 2014, 2015, 2016, 2017, and 2018, respectively.

Redeemable Non-Controlling Interest

        On December 31, 2013, the Company acquired a 65% equity interest in AlphaCare Holdings, Inc. ("AlphaCare Holdings"). The other shareholders of AlphaCare Holdings have the right to exercise put options, requiring the Company to purchase up to 50 percent of the remaining shares prior to January 1, 2017 provided certain membership levels are attained. After December 31, 2016 the other shareholders of AlphaCare Holdings have the right to exercise put options requiring the Company to purchase all or any portion of the remaining shares. In addition, after December 31, 2016 the Company has the right to purchase all remaining shares. Non-controlling interests with redemption features, such as put options, that are not solely within the Company's control are considered redeemable non-controlling interest. Redeemable non-controlling interest is considered to be temporary and is therefore reported in a mezzanine level between liabilities and stockholders' equity on the Company's consolidated balance sheet at the greater of the initial carrying amount adjusted for the non-controlling interest's share of net income or loss or its redemption value. The Company recorded $10.6 million of redeemable non-controlling interest in relation to the acquisition. The carrying value of the non-controlling interest as of June 30, 2014 was $8.6 million. The $2.0 million reduction in carrying

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE A—General (Continued)

value for the six months ended June 30, 2014 is a result of operating losses. The Company recognizes changes in the redemption value on a quarterly basis and adjusts the carrying amount of the non-controlling interest to equal the redemption value at the end of each reporting period. Under this method, this is viewed at the end of the reporting period as if it were also the redemption date for the non-controlling interest. The Company will reflect redemption value adjustments in the earnings per share calculation if redemption value is in excess of the carrying value of the non-controlling interest. As of June 30, 2014 the carrying value of the non-controlling interest exceeded the redemption value and therefore no adjustment to the carrying value was required.

Reclassifications

        Certain prior year amounts have been reclassified to conform with the current year presentation.

NOTE B—Net Income per Common Share Attributable to Magellan Health, Inc.

        The following tables reconcile income attributable to common shareholders (numerator) and shares (denominator) used in the computations of net income per share attributable to common shareholders (in thousands, except per share data):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Numerator:

                         

Net income attributable to Magellan Health, Inc. 

  $ 31,480   $ 4,986   $ 59,538   $ 30,706  
                   
                   

Denominator:

                         

Weighted average number of common shares outstanding—basic

    26,829     27,144     26,968     27,257  

Common stock equivalents—stock options

    497     554     482     574  

Common stock equivalents—restricted stock

    10     66     14     49  

Common stock equivalents—restricted stock units

            26     27  

Common stock equivalents—employee stock purchase plan

    2     1     2     1  
                   

Weighted average number of common shares outstanding—diluted

    27,338     27,765     27,492     27,908  
                   
                   

Net income attributable to Magellan Health, Inc. per common share—basic

  $ 1.17   $ 0.18   $ 2.21   $ 1.13  
                   
                   

Net income attributable to Magellan Health, Inc. per common share—diluted

  $ 1.15   $ 0.18   $ 2.17   $ 1.10  
                   
                   

        The weighted average number of common shares outstanding for the three and six months ended June 30, 2013 and 2014 were calculated using outstanding shares of the Company's common stock. Common stock equivalents included in the calculation of diluted weighted average common shares outstanding for the three and six months ended June 30, 2013 and 2014 represent stock options to purchase shares of the Company's common stock, restricted stock awards and restricted stock units, and stock purchased under the Employee Stock Purchase Plan.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE B—Net Income per Common Share Attributable to Magellan Health, Inc. (Continued)

        The Company had additional potential dilutive securities outstanding representing 1.2 million and 1.9 million options for the three and six months ended June 30, 2013, respectively, and 0.7 million and 0.5 million for the three and six months ended June 30, 2014, respectively, that were not included in the computation of dilutive securities because they were anti-dilutive for the period. Had these shares not been anti-dilutive, all of these shares would not have been included in the net income attributable to common shareholder per common share calculation as the Company uses the treasury stock method of calculating diluted shares.

NOTE C—Business Segment Information

        The accounting policies of the Company's segments are the same as those described in Note A—"General." The Company evaluates performance of its segments based on segment profit attributable to Magellan shareholders, which is defined as income before taxes, excluding stock compensation expense, non-controlling interest segment profit (loss), depreciation and amortization, interest expense, interest income, gain on sale of assets, and special charges or benefits ("Segment Profit"). Management uses Segment Profit information for internal reporting and control purposes and considers it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee compensation, among other matters. Public Sector subcontracts with Pharmacy Management to provide pharmacy benefits management services for certain of Public Sector's customers. In addition, Pharmacy Management provides pharmacy benefits management for the Company's employees covered under its medical plan. As such, revenue, cost of care, cost of goods sold and direct service costs and other related to these arrangements are eliminated. The Company's segments are defined above.

        The following tables summarize, for the periods indicated, operating results by business segment (in thousands):

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Three Months Ended June 30, 2013

                                     

Managed care and other revenue

  $ 199,538   $ 414,859   $ 92,715   $ 55,829   $ (16,221 ) $ 746,720  

PBM and dispensing revenue

                96,028         96,028  

Cost of care

    (123,227 )   (357,402 )   (58,742 )   (14,480 )   16,221     (537,630 )

Cost of goods sold

                (90,175 )       (90,175 )

Direct service costs and other

    (41,399 )   (28,934 )   (13,863 )   (31,374 )   (28,927 )   (144,497 )

Stock compensation expense(1)

    133     267     457     380     3,365     4,602  
                           

Segment profit (loss)

  $ 35,045   $ 28,790   $ 20,567   $ 16,208   $ (25,562 ) $ 75,048  
                           
                           

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE C—Business Segment Information (Continued)


 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Three Months Ended June 30, 2014

                                     

Managed care and other revenue

  $ 198,025   $ 319,954   $ 119,326   $ 44,969   $   $ 682,274  

PBM and dispensing revenue

                209,265     (3,525 )   205,740  

Cost of care

    (116,852 )   (275,108 )   (89,753 )   96         (481,617 )

Cost of goods sold

                (196,080 )   3,514     (192,566 )

Direct service costs and other

    (42,530 )   (45,391 )   (17,897 )   (41,605 )   (31,611 )   (179,034 )

Stock compensation expense(1)

    157     230     354     5,556     3,253     9,550  

Less: non-controlling interest segment profit (loss)(2)

        (648 )               (648 )
                           

Segment profit (loss)

  $ 38,800   $ 333   $ 12,030   $ 22,201   $ (28,369 ) $ 44,995  
                           
                           

 

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Six Months Ended June 30, 2013

                                     

Managed care and other revenue

  $ 387,375   $ 821,479   $ 182,993   $ 108,928   $ (31,466 ) $ 1,469,309  

PBM and dispensing revenue

                195,200         195,200  

Cost of care

    (236,498 )   (712,781 )   (116,809 )   (28,035 )   31,466     (1,062,657 )

Cost of goods sold

                (183,687 )       (183,687 )

Direct service costs and other

    (82,791 )   (54,577 )   (27,234 )   (60,935 )   (58,587 )   (284,124 )

Stock compensation expense(1)

    266     574     891     700     7,809     10,240  
                           

Segment profit (loss)

  $ 68,352   $ 54,695   $ 39,841   $ 32,171   $ (50,778 ) $ 144,281  
                           
                           

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE C—Business Segment Information (Continued)


 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Six Months Ended June 30, 2014

                                     

Managed care and other revenue

  $ 386,916   $ 817,897   $ 224,760   $ 100,347   $ (18,055 ) $ 1,511,865  

PBM and dispensing revenue

                348,889     (6,265 )   342,624  

Cost of care

    (228,054 )   (697,626 )   (163,405 )   (16,295 )   18,055     (1,087,325 )

Cost of goods sold

                (324,111 )   6,247     (317,864 )

Direct service costs and other

    (82,806 )   (88,349 )   (33,038 )   (77,156 )   (62,407 )   (343,756 )

Stock compensation expense(1)

    312     504     768     5,859     6,579     14,022  

Less: non-controlling interest segment profit (loss)(2)

        (1,978 )               (1,978 )
                           

Segment profit (loss)

  $ 76,368   $ 34,404   $ 29,085   $ 37,533   $ (55,846 ) $ 121,544  
                           
                           

(1)
Stock compensation expense is included in direct service costs and other operating expenses, however this amount is excluded from the computation of Segment Profit since it is managed on a consolidated basis.

(2)
The non-controlling portion of AlphaCare's segment profit (loss) is excluded from the computation of Segment Profit.

        The following table reconciles Segment Profit to income before income taxes (in thousands):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Segment profit

  $ 75,048   $ 44,995   $ 144,281   $ 121,544  

Stock compensation expense

    (4,602 )   (9,550 )   (10,240 )   (14,022 )

Non-controlling interest segment profit (loss)

        (648 )       (1,978 )

Depreciation and amortization

    (16,946 )   (22,480 )   (33,116 )   (42,709 )

Interest expense

    (792 )   (2,004 )   (1,402 )   (2,840 )

Interest income

    358     275     711     586  
                   

Income before income taxes

  $ 53,066   $ 10,588   $ 100,234   $ 60,581  
                   
                   

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE C—Business Segment Information (Continued)

        The following tables summarize those assets that are used in the operations of each segment. The remainder of the Company's assets cannot be specifically identified by segment (in thousands):

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Year Ended December 31, 2013

                                     

Restricted cash

  $ 25,107   $ 196,651   $   $   $ 14,938   $ 236,696  

Net accounts receivable

    50,407     62,977     7,368     115,527     1,906     238,185  

Investments

    16,491     92,966             98,856     208,313  

Pharmaceutical inventory

                49,609         49,609  

Goodwill

    120,485     20,882     104,549     242,290         488,206  

Other intangible assets, net

    3,513     4,590     3,686     57,905         69,694  

 

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Six Months Ended June 30, 2014

                                     

Restricted cash

  $ 11,630   $ 148,316   $   $   $ 7,367   $ 167,313  

Net accounts receivable

    52,625     71,993     9,839     160,916     6,496     301,869  

Investments

    35,838     129,575             5,942     171,355  

Pharmaceutical inventory

                44,277         44,277  

Goodwill

    120,485     20,879     104,549     311,512         557,425  

Other intangible assets, net

    2,772     6,831     3,012     134,370         146,985  

NOTE D—Non-GAAP Measures

        The Company reports its financial results in accordance with GAAP, however the Company's management also assesses business performance and makes business decisions regarding the Company's operations using certain non-GAAP measures. In addition to Segment Profit, as defined in Note C—"Business Segment Information", the Company also uses adjusted net income attributable to Magellan Health, Inc. ("Adjusted Net Income") and adjusted net income per common share attributable to Magellan Health, Inc. on a diluted basis ("Adjusted EPS"). Adjusted Net Income and Adjusted EPS reflect certain adjustments made for acquisitions completed after January 1, 2013 to exclude non-cash stock compensation expense resulting from restricted stock purchases by sellers as well as amortization of identified acquisition intangibles. The Company believes these non-GAAP measures provide a more useful comparison of the Company's underlying business performance from period to period and is more representative of the earnings capacity of the Company. Non-GAAP financial measures we disclose, such as Segment Profit, Adjusted Net Income, and Adjusted EPS, should not be considered a substitute for, or superior to, financial measures determined or calculated in accordance with GAAP.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE D—Non-GAAP Measures (Continued)

        The following table reconciles Adjusted Net Income to net income attributable to Magellan Health, Inc. (in thousands):

 
  Three Months
Ended June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Adjusted Net Income

  $ 31,480   $ 11,030   $ 59,538   $ 38,336  

Adjusted for acquisitions starting in 2013

                         

Amortization of acquired intangibles

        (3,426 )       (5,059 )

Stock compensation relating to acquisitions

        (6,373 )       (7,311 )

Tax impact

        3,755         4,740  
                   

Net income attributable to Magellan Health, Inc. 

  $ 31,480   $ 4,986   $ 59,538   $ 30,706  
                   
                   

        The following table reconciles Adjusted EPS to net income per common share attributable to Magellan Health, Inc.—diluted:

 
  Three Months
Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Adjusted EPS

  $ 1.15   $ 0.39   $ 2.17   $ 1.37  

Adjusted for acquisitions starting in 2013

                         

Amortization of acquired intangibles

        (0.12 )       (0.18 )

Stock compensation relating to acquisitions

        (0.23 )       (0.26 )

Tax impact

        0.14         0.17  
                   

Net income per common share attributable to Magellan Health, Inc.—Diluted

  $ 1.15   $ 0.18   $ 2.17   $ 1.10  
                   
                   

NOTE E—Commitments and Contingencies

Legal

        The Company's operating activities entail significant risks of liability. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to deaths and other serious incidents involving patients whose care is being managed by the Company. Such incidents occasionally give rise to malpractice, professional negligence and other related actions and claims against the Company or its network providers. Many of these actions and claims received by the Company seek substantial damages and therefore require the Company to incur significant fees and costs related to their defense.

        The Company is also subject to or party to certain class actions and other litigation and claims relating to its operations or business practices. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE E—Commitments and Contingencies (Continued)

asserted against the Company, and for which the outcome is probable and reasonably estimable. Management believes that the resolution of such litigation and claims will not have a material adverse effect on the Company's financial condition or results of operations; however, there can be no assurance in this regard.

Stock Repurchases

        On October 25, 2011 the Company's board of directors approved a stock repurchase plan which authorized the Company to purchase up to $200 million of its outstanding common stock through October 25, 2013. On July 24, 2013 the Company's board of directors approved an increase and extension of the stock repurchase plan which authorizes the Company to purchase up to $300 million of its outstanding stock through October 25, 2015.

        Stock repurchases under the program may be purchased from time to time in open market transactions (including blocks) or in privately negotiated transactions. The timing of repurchases and the actual amount purchased will depend on a variety of factors including the market price of the Company's shares, general market and economic conditions, and other corporate considerations. Repurchases may be made pursuant to plans intended to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, which could allow the Company to purchase its shares during periods when it otherwise might be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. Repurchases are expected to be funded from working capital and anticipated cash from operations. The repurchase authorization does not require the purchase of a specific number of shares and is subject to suspension or termination by the Company's board of directors at any time.

        Pursuant to this program, the Company made open market purchases as follows (aggregate cost excludes broker commissions and is reflected in millions):

Period
  Total number
of Shares
Purchased
  Average
Price Paid
per Share
  Aggregate
Cost
 

November 11, 2011 - December 31, 2011

    671,776   $ 48.72   $ 32.7  

January 1, 2012 - December 31, 2012

    459,252     50.27     23.1  

January 1, 2013 - December 31, 2013

    1,159,871     51.83     60.1  

January 1, 2014 - June 30, 2014

    1,137,037     59.20     67.3  
                 

    3,427,936         $ 183.2  
                 
                 

        During the period from July 1, 2014 through July 21, 2014, the Company made additional open market purchases of 223,821 shares of the Company's common stock at an aggregate cost of $14.0 million (excluding broker commissions).

Restructuring Activities

        As a result of restructuring activities initiated in 2013, the Company recorded liabilities for employee termination costs. The restructuring activities initiated in 2013 were related to contract terminations and organizational changes made in an effort to improve the Company's ability to execute

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE E—Commitments and Contingencies (Continued)

its strategy. The Company anticipates additional restructuring costs in 2014 associated with lease termination and exit costs of $1.0 million. The additional projected restructuring costs are associated with the Commercial segment. For the six months ended June 30, 2014, the Company incurred $1.1 million of employee termination costs and $1.2 million of lease termination and exit costs. The restructuring costs incurred by segment were Public Sector $1.5 million, Commercial $0.7 million and Corporate $0.1 million. As of June 30, 2014, the Company incurred cumulative restructuring costs of $17.6 million related to 2013 initiatives. As of June 30, 2014, the cumulative restructuring costs incurred by segment were Public Sector $8.3 million, Commercial $5.4 million, and Corporate $3.9 million. Restructuring costs are included in direct service costs and other operating expenses in the consolidated statements of income.

        The following table summarizes the activity related to the restructuring liabilities for the six months ended June 30, 2014, by reportable segment (in thousands):

 
  Commercial   Public
Sector
  Corporate   Consolidated  

Liability for employee termination costs at December 31, 2013

  $ 4,744   $ 4,296   $ 3,429   $ 12,469  

Additions

    738     653     123     1,514  

Payments

    (168 )   (1,813 )   (1,964 )   (3,945 )

Liability released

        (377 )   (20 )   (397 )
                   

Liability for employee termination costs at June 30, 2014

  $ 5,314   $ 2,759   $ 1,568   $ 9,641  
                   
                   

NOTE F—Acquisitions

Acquisition of Partners Rx Management, LLC

        Pursuant to the September 6, 2013 agreement and plan of merger (the "Partners Agreement") with Partners Rx Management, LLC ("Partners Rx"), on October 1, 2013 the Company acquired all of the outstanding ownership interests of Partners Rx. Partners Rx is a full-service commercial PBM with a strong focus on health plans and self-funded employers primarily through sales through third party administrators, consultants and brokers. As consideration for the transaction, the Company paid $100 million in cash, subject to working capital adjustments. The Company funded the acquisition with cash on hand.

        During the six months ended June 30, 2014, the Company made a measurement period adjustment of $0.3 million to decrease the deferred tax liability related to the Partners Rx acquisition.

        As of June 30, 2014, settlement of the working capital and certain contractual liabilities remain open and therefore are subject to further estimation. In addition, the amount recognized for deferred tax assets may be impacted by the determination of these items. The Company will make appropriate adjustments to the purchase price allocation prior to the completion of the measurement period as required.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE F—Acquisitions (Continued)

Acquisition of AlphaCare Holdings, Inc.

        Pursuant to the August 13, 2013 stock purchase agreement (the "AlphaCare Agreement"), on December 31, 2013 the Company acquired a 65% equity interest in AlphaCare Holdings, Inc. ("AlphaCare Holdings"), the holding company for AlphaCare New York, Inc. ("AlphaCare"), a Health Maintenance Organization ("HMO") in New York that operates a New York Managed Long-Term Care Plan in Bronx, New York, Queens, Kings and Westchester Counties, and Medicare Plans in Bronx, New York, Queens and Kings Counties.

        The Company previously held a 7% equity interest in AlphaCare through an equity investment of $2.0 million in preferred membership units of AlphaCare's previous holding company, AlphaCare Holdings, LLC on May 17, 2013. The Company also previously loaned $5.9 million to AlphaCare Holdings, LLC. As part of the AlphaCare Agreement, AlphaCare Holdings, LLC was reorganized into a Delaware corporation, the preferred membership units and the loan were converted into Series A Participating Preferred Stock ("AlphaCare Series A Preferred") of AlphaCare Holdings and the Company purchased an additional $17.4 million of AlphaCare Series A Preferred. The Company holds a 65% voting interest in AlphaCare Holdings.

        Based on the Company's 65% equity and voting interest in AlphaCare Holdings, the Company has included the results of operations in its consolidated financial statements. The Company reports the results of operations of AlphaCare Holdings within the Public Sector segment.

        During the six months ended June 30, 2014, the Company made net retrospective adjustments to provisional amounts related to the AlphaCare Holdings acquisition that were recognized at the acquisition date that, if known, would have affected the measurement amounts recognized as of that date.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE F—Acquisitions (Continued)

        The estimated fair values of AlphaCare Holdings assets acquired and liabilities assumed at the date of acquisition are summarized as follows (in thousands):

 
  Initial Amounts
Recognized at
Acquisition Date(1)
  Measurement
Period
Adjustments(2)
  Current Amounts
Recognized at
Acquisition Date
 

Assets acquired:

                   

Current assets (includes $6,249 of cash and $7,900 of restricted cash)

  $ 14,766   $ (548 ) $ 14,218  

Property and equipment, net

    310     (39 )   271  

Other assets

    475     66     541  

Other identified intangible assets

    4,590     2,600     7,190  

Goodwill

    20,882     (3 )   20,879  
               

Total assets acquired

    41,023     2,076     43,099  
               

Liabilities assumed:

                   

Current liabilities

    3,139     1,039     4,178  

Deferred tax liabilities

    1,830     1,037     2,867  
               

Total liabilities assumed

    4,969     2,076     7,045  
               

Net assets acquired

    36,054         36,054  

Less: net assets attributable to noncontrolling interest

    (10,554 )       (10,554 )
               

Net consideration

  $ 25,500   $   $ 25,500  
               
               

(1)
As previously reported in the Company's Form 10-K for the year ended December 31, 2013.

(2)
The measurement period adjustments were recorded to reflect a $2.6 million increase in the customer contracts identified intangible and a $1.0 million increase to the deferred tax liability as a result of finalization of the valuation and other net changes of ($1.6) as a result of changes in the estimated fair values of the associated assets acquired and liabilities assumed based on factors existing at the acquisition date.

Acquisition of CDMI, LLC

        Pursuant to the March 31, 2014 purchase agreement (the "CDMI Agreement") with CDMI, LLC ("CDMI") on April 30, 2014 the Company acquired all of the outstanding equity interests of CDMI. CDMI provides a range of clinical consulting programs and negotiates and administers drug rebates for managed care organizations and other customers. As consideration for the transaction, the Company paid a base price of $205.0 million in cash, subject to working capital adjustments. Pursuant to the CDMI Agreement, the sellers and certain key management of CDMI purchased a total of $80.0 million in Magellan restricted common stock, which will generally vest over a 42-month period, conditioned upon certain employment and performance targets. In addition to the base purchase price, the CDMI Agreement provides for potential contingent payments up to a maximum aggregate amount of $165.0 million. The potential future payments are contingent upon CDMI meeting certain client retention, client conversion, and gross profit milestones through December 31, 2016.

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE F—Acquisitions (Continued)

        The Company reports the results of operations of CDMI within its Pharmacy Management segment. The consolidated statements of income include total revenues and Segment Profit from CDMI of $6.9 million and $5.8 million for the two months subsequent to the acquisition.

        The purchase price has been allocated based upon the estimated fair value of net assets acquired at the date of acquisition. A portion of the excess purchase price over tangible net assets acquired has been allocated to identified intangible assets totaling $84.3 million, consisting of customer contracts in the amount of $82.7 million, which is being amortized over 8 years, non-compete agreements in the amount of $1.2 million, which is being amortized over 6.5 years and tradename in the amount of $0.4 million, which is being amortized over 20 months. The entire excess purchase price over tangible net assets acquired is amortizable for tax purposes, although the Company's effective rate will not be impacted by the tax amortization.

        The estimated fair values of CDMI assets acquired and liabilities assumed at the date of the acquisition are summarized as follows (in thousands):

Assets acquired:

       

Current assets (includes $41,998 of accounts receivable)

  $ 42,100  

Property and equipment, net

    457  

Other assets

    9  

Other identified intangible assets

    84,300  

Goodwill

    68,968  
       

Total assets acquired

    195,834  
       

Liabilities assumed:

       

Current liabilities

    29,483  

Contingent consideration

    45,778  
       

Total liabilities assumed

    75,261  
       

Net assets acquired

  $ 120,573  
       
       

        As of June 30, 2013 the Company established a working capital receivable of $4.4 million that was reflected as a reduction to goodwill.

        The fair value of contingent consideration is determined based on probabilities of payment, projected payment dates, discount rates, and projected revenues, gross profits, and client base. The projected revenues, gross profits, and client base are derived from the Company's latest internal operational forecasts. The Company used a probability weighted discounted cash flow method to arrive at the fair value of the contingent consideration. Changes in the operational forecasts, probabilities of payment, discount rates, or projected payment dates may result in change in the fair value measurement. Any changes in the fair value measurement are reflected as income or expense in the consolidated statements of income. As of the acquisition date, the Company estimated undiscounted future contingent payments of $61.7 million. As of June 30, 2014 the fair value of the contingent consideration was $47.0 million and is included in accrued liabilities and contingent liabilities in the consolidated balance sheet. The change in the present value of the contingent consideration was

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE F—Acquisitions (Continued)

$1.2 million for the three months and six months ended June 30, 2014 and was recorded as interest expense in the consolidated statements of income.

        The Company's estimated fair values of CDMI assets acquired and liabilities assumed at the date of acquisition are determined based on certain valuations and analyses that have yet to be finalized, and accordingly, the assets acquired and liabilities assumed, as detailed below, are subject to adjustment once the analyses are completed. The Company will make appropriate adjustments to the purchase price allocation prior to the completion of the measurement period as required.

        In connection with the CDMI acquisition, the Company incurred $1.2 million of acquisition related costs that were expensed during the six months ended June 30, 2014. These costs are included within direct service costs and other operating expenses in the accompanying consolidated statements of income.

Pro Forma Financial Information

        The following unaudited supplemental pro forma information represents the Company's consolidated results of operations for the three and six months ended June 30, 2013 as if the acquisition of CDMI had occurred on January 1, 2013, and for the three and six months ended June 30, 2014 as if the acquisition of CDMI had occurred on January 1, 2014, in all cases after giving effect to certain adjustments including interest income, depreciation and amortization, and stock compensation expense.

        Such pro forma information does not purport to be indicative of operating results that would have been reported had the acquisition of CDMI occurred on January 1, 2013 and 2014 (in thousands):

 
  Three Months
Ended June 30,
  Six Months
Ended June 30,
 
 
  2013   2014   2013   2014  

Net revenue

  $ 852,870   $ 891,241   $ 1,683,418   $ 1,866,082  

Net income

    29,122     2,523     54,369     22,834  

Income per common share attributable to Magellan Health, Inc.:

                         

Basic

  $ 1.09   $ 0.09   $ 2.02   $ 0.84  

Diluted

  $ 1.07   $ 0.09   $ 1.98   $ 0.81  

NOTE G—Subsequent Events

        On July 23, 2014, the Company entered into a $500.0 million Credit Agreement with various lenders that provides for Magellan Rx Management, Inc. to borrow up to $250.0 million of revolving loans, with a sublimit of up to $70.0 million for the issuance of letters of credit for the account of the Company, and a term loan in an original aggregate principal amount of $250.0 million (the "2014 Credit Facility"). At such point, the 2011 Credit Facility was terminated. The 2014 Credit Facility is guaranteed by substantially all of the non-regulated subsidiaries of the Company and will mature on

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MAGELLAN HEALTH, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

JUNE 30, 2014

(Unaudited)

NOTE G—Subsequent Events (Continued)

July 23, 2019, but the Company holds an option to extend the 2014 Credit Facility for an additional one year period. The term loan is also subject to certain quarterly amortization payments.

        Under the 2014 Credit Facility, the annual interest rate on revolving and term loan borrowings is equal to (i) in the case of base rate loans, the sum of a borrowing margin of 0.50 percent plus the higher of the prime rate, one-half of one percent in excess of the overnight "federal funds" rate, or the Eurodollar rate for one month plus 1.00 percent, or (ii) in the case of Eurodollar rate loans, the sum of a borrowing margin of 1.50 percent plus the Eurodollar rate for the selected interest period, which rates shall be adjusted from time to time based on the Company's total leverage ratio. The Company has the option to borrow in base rate loans or Eurodollar rate loans at its discretion. Letters of credit issued bear interest at the rate of 1.625 percent. The commitment commission on the 2014 Credit Facility is 0.20 percent of the unused Revolving Loan Commitment, which rate shall be adjusted from time to time based on the Company's total leverage ratio.

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Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations.

        The following discussion and analysis of the financial condition and results of operations of Magellan and its majority-owned subsidiaries and all VIEs for which Magellan is the primary beneficiary should be read together with the Consolidated Financial Statements and the notes to the Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q and the Company's Annual Report on Form 10-K for the year ended December 31, 2013, which was filed with the SEC on March 3, 2014.

Forward-Looking Statements

        This Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although the Company believes that its plans, intentions and expectations as reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include:

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        Further discussion of factors currently known to management that could cause actual results to differ materially from those in forward-looking statements is set forth under the heading "Risk Factors" in Item 1A of Magellan's Annual Report on Form 10-K for the year ended December 31, 2013. When used in this Quarterly Report on Form 10-Q, the words "estimate," "anticipate," "expect," "believe," "should," and similar expressions are intended to be forward-looking statements. Magellan undertakes 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, except as required by law.

Business Overview

        The Company is engaged in the healthcare management business, and is focused on meeting needs in areas of healthcare that are fast growing, highly complex and high cost, with an emphasis on special population management. The Company provides services to health plans, MCOs, insurance companies, employers, labor unions, various military and governmental agencies, third party administrators, consultants and brokers. The Company's business is divided into the following five segments, based on the services it provides and/or the customers that it serves, as described below.

Managed Healthcare

        Two of the Company's segments are in the managed healthcare business. This line of business reflects the Company's: (i) management of behavioral healthcare services, and (ii) the integrated management of physical, behavioral and pharmaceutical healthcare for special populations, delivered through MCC. The Company's coordination and management of physical and behavioral healthcare includes services provided through its comprehensive network of medical and behavioral health professionals, clinics, hospitals and ancillary service providers. This network of credentialed and

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privileged providers is integrated with clinical and quality improvement programs to enhance the healthcare experience for individuals in need of care, while at the same time managing the cost of these services for our customers. The treatment services provided through the Company's provider network include outpatient programs, intermediate care programs (such as intensive outpatient programs and partial hospitalization services), inpatient treatment and crisis intervention services. The Company generally does not directly provide or own any provider of treatment services, although it does employ licensed behavioral health counselors to deliver non-medical counseling under certain government contracts.

        The Company's integrated management of physical and behavioral healthcare includes its full service health plans which provide for the holistic management of special populations. These special populations include individuals with serious mental illness, dual eligibles, those eligible for long term care and other populations with unique and often complex healthcare needs.

        The Company provides its management services primarily through: (i) risk-based products, where the Company assumes all or a substantial portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) ASO products, where the Company provides services such as utilization review, claims administration and/or provider network management, but does not assume responsibility for the cost of the treatment services, and (iii) EAPs where the Company provides short-term outpatient behavioral counseling services.

        The managed healthcare business is managed based on the services provided and/or the customers served, through the following two segments:

        Commercial.    Commercial generally reflects managed behavioral healthcare services and EAP services provided under contracts with health plans, insurance companies and MCOs for some or all of their commercial, Medicaid and Medicare members, as well as with employers, including corporations, governmental agencies, military and labor unions. Commercial's contracts encompass risk-based, ASO and EAP arrangements. As of June 30, 2014, Commercial's covered lives were 4.1 million, 15.7 million and 13.0 million for risk-based, ASO and EAP products, respectively. For the six months ended June 30, 2014, Commercial's revenue was $235.0 million, $65.0 million and $86.9 million for risk-based, ASO and EAP products, respectively.

        Public Sector.    Public Sector generally reflects: (i) the management of behavioral health services provided to recipients under Medicaid and other state sponsored programs under contracts with state and local governmental agencies, and (ii) the integrated management of physical, behavioral and pharmaceutical care for special populations covered under Medicaid and other government sponsored programs. Public Sector contracts encompass either risk-based or ASO arrangements. As of June 30, 2014, Public Sector's covered lives were 1.5 million and 1.8 million for risk-based and ASO products, respectively. For the six months ended June 30, 2014, Public Sector's revenue was $789.9 million and $28.0 million for risk-based and ASO products, respectively.

Specialty Solutions

        Specialty Solutions generally reflects the management of the delivery of diagnostic imaging (radiology benefits management or "RBM") and a variety of other specialty areas such as radiation oncology, obstetrical ultrasound, cardiology and musculoskeletal management to ensure that such services are clinically appropriate and cost effective. The Company's Specialty Solutions services are currently provided under contracts with health plans and insurance companies for some or all of their commercial, Medicaid and Medicare members. The Company also contracts with state and local governmental agencies for the provision of such services to Medicaid recipients. The Company offers its Specialty Solutions services through risk-based contracts, where the Company assumes all or a substantial portion of the responsibility for the cost of providing services, and through ASO contracts, where the Company provides services such as utilization review and claims administration, but does not

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assume responsibility for the cost of the services. As of June 30, 2014, covered lives for Specialty Solutions were 6.8 million and 13.5 million for risk-based and ASO products, respectively. For the six months ended June 30, 2014, revenue for Specialty Solutions was $203.1 million and $21.7 million for risk-based and ASO products, respectively.

Pharmacy Management

        Pharmacy Management comprises products and solutions that provide clinical and financial management of drugs paid under medical and pharmacy benefit programs. Pharmacy Management's services include (i) traditional PBM services; (ii) PBA for state Medicaid and other government sponsored programs; (iii) specialty pharmaceutical dispensing operations, contracting and formulary optimization programs; (iv) medical pharmacy management programs; and (v) programs for the integrated management of drugs that treat complex conditions, regardless of site of service, method of delivery, or benefit reimbursement. In addition, the Company had a subcontract arrangement to provide PBM services on a risk basis for one of Public Sector's customers, which terminated on March 31, 2014.

        The Company's Pharmacy Management programs are provided under contracts with health plans, employers, Medicaid MCOs, state Medicaid programs, and other government agencies, and encompass risk-based and FFS arrangements. During the six months ended June 30, 2014, Pharmacy Management paid 3.6 million adjusted commercial network claims in the Company's PBM business. As of June 30, 2014, the Company had a generic dispensing rate of 83.6 percent within its commercial PBM business. In addition, during the six months ended June 30, 2014, the Company paid 36.2 million adjusted PBA claims and 47.6 thousand specialty dispensing claims. Adjusted claim totals apply a multiple of three for each 90-day and traditional mail claim. In addition, as of June 30, 2014, Pharmacy Management served 0.5 million commercial PBM members, 9.8 million members in its medical pharmacy management programs, and 25 states and the District of Columbia in its PBA business.

Corporate

        This segment of the Company is comprised primarily of operational support functions such as sales and marketing and information technology, as well as corporate support functions such as executive, finance, human resources and legal.

Significant Customers

        Through March 31, 2014, the Company provided behavioral healthcare management and other related services to approximately 680,000 members in Maricopa County, Arizona as the Regional Behavioral Health Authority ("RBHA") for GSA6 ("Maricopa County") pursuant to a contract with the State of Arizona (the "Maricopa Contract"). The Maricopa Contract was for the management of the publicly funded behavioral health system that delivered mental health, substance abuse and crisis services for adults, youth, and children. The Maricopa Contract terminated on March 31, 2014. The Maricopa Contract generated net revenues of $367.2 million and $209.5 million for the six months ended June 30, 2013 and 2014, respectively.

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        In addition to the Maricopa Contract previously discussed, the following customers generated in excess of ten percent of net revenues for the respective segment for the three months ended June 30, 2013 and 2014 (in thousands):

Segment
  Term Date   2013   2014  

Commercial

                 

Customer A

 

June 30, 2014(1)

 
$

103,460
 
$

110,492
 

Customer B

  December 31, 2019     70,919     90,923  

Customer C

  August 14, 2017     29,537 *   47,769  

Customer D

  December 14, 2013(1)     38,776      

Public Sector

 

 

   
 
   
 
 

Customer E

 

June 30, 2015

   
129,471
   
213,000
 

Specialty Solutions

 

 

   
 
   
 
 

Customer E

 

December 31, 2015

   
60,602
   
69,988
 

Customer F

  June 30, 2016(2)     30,580     26,515  

Customer G

  July 31, 2015     32,708     34,901  

Customer A

  November 30, 2016     1,154 *   26,577  

Customer H

  January 31, 2016     22,230     24,593  

Pharmacy Management

 

 

   
 
   
 
 

Customer I

 

November 30, 2014 to December 31, 2014(3)

   
65,335
   
60,972
 

Customer J

  December 31, 2013(4)     43,274     1,267 *

Customer K

  March 31, 2014(1)(5)     31,466     18,055 *

*
Revenue amount did not exceed ten percent of net revenues for the respective segment for the period presented. Amount is shown for comparative purposes only.

(1)
The contract has terminated.

(2)
This contract transitioned from risk to ASO based services effective July 1, 2014.

(3)
The customer has more than one contract. The individual contracts are scheduled to terminate at various points during the time period indicated above.

(4)
The contract has terminated, however, the Company continues to provide services as the contract is transitioned to the new vendor.

(5)
This customer represents a subcontract with a Public Sector customer and is eliminated in consolidation.

Concentration of Business

        The Company also has a significant concentration of business with various counties in the State of Pennsylvania (the "Pennsylvania Counties") which are part of the Pennsylvania Medicaid program. Net revenues from the Pennsylvania Counties in the aggregate totaled $178.0 million and $179.0 million for the six months ended June 30, 2013 and 2014, respectively.

        In addition, the Company has a significant concentration of business with the State of Florida. The Company currently has behavioral healthcare contracts with various areas in the State of Florida (the "Florida Areas") which are part of the Florida Medicaid program. The State of Florida is

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implementing a new system of mandated managed care through which Medicaid enrollees will receive integrated healthcare services, and it will phase out the behavioral healthcare programs under which the Florida Areas' contracts operate by July 31, 2014. The Company has a contract with the State of Florida to provide integrated healthcare services under the new program. Net revenues from the State of Florida in the aggregate totaled $66.3 million and $56.5 million for the six months ended June 30, 2013 and 2014, respectively.

        The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts may be immediately terminated with cause and many of the Company's contracts are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies generally are conditioned on legislative appropriations. These contracts generally can be terminated or modified by the customer if such appropriations are not made.

Critical Accounting Policies and Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates of the Company include, among other things, accounts receivable realization, valuation allowances for deferred tax assets, valuation of goodwill and intangible assets, medical claims payable, other medical liabilities, stock compensation assumptions, tax contingencies and legal liabilities. Actual results could differ from those estimates. Except as noted below, the Company's critical accounting policies are summarized in the Company's Annual Report on Form 10-K, filed with the SEC on March 3, 2014.

Income Taxes

        The Company's effective income tax rates were 40.6 percent and 52.6 percent for the six months ended June 30, 2013 and 2014, respectively. These rates differ from the federal statutory income tax rate primarily due to state income taxes, permanent differences between book and tax income, and changes to recorded tax contingencies. The Company also accrues interest and penalties related to unrecognized tax benefits in its provision for income taxes. The effective income tax rate for the six months ended June 30, 2013 is lower than the effective rate for the six months ended June 30, 2014 mainly due to the non-deductible ACA fees and valuations allowances for certain deferred tax assets.

        The Company files a consolidated federal income tax return for the Company and its eighty percent or more owned subsidiaries, and the Company and its subsidiaries file income tax returns in various states and local jurisdictions. With few exceptions, the Company is no longer subject to income tax assessments by tax authorities for years ended prior to 2010.

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Results of Operations

        The accounting policies of the Company's segments are the same as those described in Note A—"General." The Company evaluates performance of its segments based on Segment Profit. Management uses Segment Profit information for internal reporting and control purposes and considers it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee compensation, among other matters. Public Sector subcontracts with Pharmacy Management to provide pharmacy benefits management services for certain of Public Sector's customers. In addition, Pharmacy Management provides pharmacy benefits management for the Company's employees covered under its medical plan. As such, revenue, cost of care, cost of goods sold and direct service costs and other related to these arrangements are eliminated. The Company's segments are defined above.

        The following tables summarize, for the periods indicated, operating results by business segment (in thousands):

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Three Months Ended June 30, 2013

                                     

Managed care and other revenue

  $ 199,538   $ 414,859   $ 92,715   $ 55,829   $ (16,221 ) $ 746,720  

PBM and dispensing revenue

                96,028         96,028  

Cost of care

    (123,227 )   (357,402 )   (58,742 )   (14,480 )   16,221     (537,630 )

Cost of goods sold

                (90,175 )       (90,175 )

Direct service costs and other

    (41,399 )   (28,934 )   (13,863 )   (31,374 )   (28,927 )   (144,497 )

Stock compensation expense(1)

    133     267     457     380     3,365     4,602  
                           

Segment profit (loss)

  $ 35,045   $ 28,790   $ 20,567   $ 16,208   $ (25,562 ) $ 75,048  
                           
                           

 

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Three Months Ended June 30, 2014

                                     

Managed care and other revenue

  $ 198,025   $ 319,954   $ 119,326   $ 44,969   $   $ 682,274  

PBM and dispensing revenue

                209,265     (3,525 )   205,740  

Cost of care

    (116,852 )   (275,108 )   (89,753 )   96         (481,617 )

Cost of goods sold

                (196,080 )   3,514     (192,566 )

Direct service costs and other

    (42,530 )   (45,391 )   (17,897 )   (41,605 )   (31,611 )   (179,034 )

Stock compensation expense(1)

    157     230     354     5,556     3,253     9,550  

Less: non-controlling interest segment profit (loss)(2)

        (648 )               (648 )
                           

Segment profit (loss)

  $ 38,800   $ 333   $ 12,030   $ 22,201   $ (28,369 ) $ 44,995  
                           
                           

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  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Six Months Ended June 30, 2013

                                     

Managed care and other revenue

  $ 387,375   $ 821,479   $ 182,993   $ 108,928   $ (31,466 ) $ 1,469,309  

PBM and dispensing revenue

                195,200         195,200  

Cost of care

    (236,498 )   (712,781 )   (116,809 )   (28,035 )   31,466     (1,062,657 )

Cost of goods sold

                (183,687 )       (183,687 )

Direct service costs and other

    (82,791 )   (54,577 )   (27,234 )   (60,935 )   (58,587 )   (284,124 )

Stock compensation expense(1)

    266     574     891     700     7,809     10,240  
                           

Segment profit (loss)

  $ 68,352   $ 54,695   $ 39,841   $ 32,171   $ (50,778 ) $ 144,281  
                           
                           

 

 
  Commercial   Public
Sector
  Specialty
Solutions
  Pharmacy
Management
  Corporate
and
Elimination
  Consolidated  

Six Months Ended June 30, 2014

                                     

Managed care and other revenue

  $ 386,916   $ 817,897   $ 224,760   $ 100,347   $ (18,055 ) $ 1,511,865  

PBM and dispensing revenue

                348,889     (6,265 )   342,624  

Cost of care

    (228,054 )   (697,626 )   (163,405 )   (16,295 )   18,055     (1,087,325 )

Cost of goods sold

                (324,111 )   6,247     (317,864 )

Direct service costs and other

    (82,806 )   (88,349 )   (33,038 )   (77,156 )   (62,407 )   (343,756 )

Stock compensation expense(1)

    312     504     768     5,859     6,579     14,022  

Less: non-controlling interest segment profit (loss)(2)           

        (1,978 )               (1,978 )
                           

Segment profit (loss)

  $ 76,368   $ 34,404   $ 29,085   $ 37,533   $ (55,846 ) $ 121,544  
                           
                           

(1)
Stock compensation expense is included in direct service costs and other operating expenses, however this amount is excluded from the computation of Segment Profit since it is managed on a consolidated basis.

(2)
The non-controlling portion of AlphaCare's segment profit (loss) is excluded from the computation of Segment Profit.

        The following table reconciles Segment Profit to income before income taxes (in thousands):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2013   2014   2013   2014  

Segment profit

  $ 75,048   $ 44,995   $ 144,281   $ 121,544  

Stock compensation expense

    (4,602 )   (9,550 )   (10,240 )   (14,022 )

Non-controlling interest segment profit (loss)

        (648 )       (1,978 )

Depreciation and amortization

    (16,946 )   (22,480 )   (33,116 )   (42,709 )

Interest expense

    (792 )   (2,004 )   (1,402 )   (2,840 )

Interest income

    358     275     711     586