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Article by DailyStocks_admin    (03-24-08 06:39 AM)

Filed with the SEC from Mar 13 to Mar 19:

Magellan Health Services (MGLN)
HealthCor Management praised Magellan's growth, but called the company's plan to use its high cash balances to make acquisitions "problematic." HealthCor says that returning cash to shareholders would be the best means of maximizing value. It called for Magellan to use $300 million of its excess cash for this purpose. HealthCor reported holding 2.75 million shares (6.83% of the total outstanding).

BUSINESS OVERVIEW

Business Overview

The Company is engaged in the specialty managed healthcare business, and its principal offices and operations are in the United States. Through 2005, the Company predominantly operated in the managed behavioral healthcare business. During 2006, the Company expanded into radiology benefits management and specialty pharmaceutical management as a result of its January 31, 2006 acquisition of National Imaging Associates, Inc. ("NIA") and its July 31, 2006 acquisition of ICORE Healthcare LLC ("ICORE"), respectively. The Company provides services to health plans, insurance companies, corporations, labor unions and various governmental agencies. The Company's business is divided into the following six segments, based on the services it provides and/or the customers that it serves, as described below.

Managed Behavioral Healthcare. The Company's managed behavioral healthcare business is composed of three of the Company's segments, each as described further below. This line of business generally reflects the Company's coordination and management of the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, general medical facilities with psychiatric beds, residential treatment centers and other treatment facilities. The treatment services provided through the Company's provider network include outpatient programs (such as counseling or therapy), 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 except as relates to the Company's contract to provide managed behavioral healthcare services to Medicaid recipients and other beneficiaries of the Maricopa County Regional Behavioral Health Authority (the "Maricopa Contract"), which is discussed further in Note 10—"Commitments and Contingencies-Maricopa Contract" to the consolidated financial statements set forth elsewhere herein. Under the Maricopa Contract, the Company was required to assume the operations of twenty-four behavioral health direct care facilities for a transitional period and to divest itself of these facilities over the following two years pursuant to a schedule as set forth in the Maricopa Contract.

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 counseling.

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

Health Plan. The Managed Behavioral Healthcare Health Plan segment ("Health Plan") generally reflects managed behavioral healthcare services provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicaid and Medicare members. Health Plan's contracts encompass either risk-based or ASO arrangements or both. As of December 31, 2007, Health Plan's covered lives were 5.6 million, 0.2 million and 20.7 million for risk-based, EAP and ASO products, respectively. For the year ended December 31, 2007, Health Plan's revenue was $530.6 million, $1.3 million and $126.5 million for risk-based, EAP and ASO products, respectively.

Employer. The Managed Behavioral Healthcare Employer segment ("Employer") generally reflects the provision of EAP services and managed behavioral healthcare services under contracts with employers, including corporations and governmental agencies, and labor unions. Employer contracts can be for either EAP or managed behavioral healthcare services, or both. Employer contracts containing provision of managed behavioral healthcare services can be risk-based or ASO, but currently are primarily ASO. As of December 31, 2007, Employer's covered lives were 0.1 million, 13.6 million and 0.5 million for risk-based, EAP and ASO products, respectively. For the year ended December 31, 2007, Employer's revenue was $6.4 million, $102.7 million and $17.0 million for risk-based, EAP and ASO products, respectively.

Public Sector. The Managed Behavioral Healthcare Public Sector segment ("Public Sector") generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. Public Sector contracts encompass either risk-based or ASO arrangements. As of December 31, 2007, Public Sector's covered lives were 2.1 million and 0.2 million for risk-based and ASO products, respectively. For the year ended December 31, 2007, Public Sector's revenue was $1.0 billion and $4.4 million for risk-based and ASO products, respectively.

Radiology Benefits Management. The Company's Radiology Benefits Management segment generally reflects the management of the delivery of diagnostic imaging services to ensure that such services are clinically appropriate and cost effective. The Company's radiology benefits management services currently are provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicaid and Medicare members. The Company has bid and may bid in the future on contracts with state and local governmental agencies for the provision of such services to Medicaid recipients. The Company won one Medicaid contract last year; however, its implementation has been postponed by the agency. The Company offers its radiology benefits management services 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 imaging services and through risk-based contracts, where the Company assumes all or a substantial portion of the responsibility for the cost of providing diagnostic imaging services. The Company's first two risk-based radiology benefits management contracts became effective June 1, 2007 and July 1, 2007, respectively. As of December 31, 2007, covered lives for Radiology Benefits Management were 2.2 million and 19.1 million for risk-based and ASO products, respectively. For the year ended December 31, 2007, revenue for Radiology Benefits Management was $118.2 million and $52.0 million for risk-based and ASO products, respectively.

Specialty Pharmaceutical Management. The Company's Specialty Pharmaceutical Management segment generally reflects the management of specialty drugs used in the treatment of cancer, multiple sclerosis, hemophilia, infertility, rheumatoid arthritis, chronic forms of hepatitis and other diseases. Specialty pharmaceutical drugs represent high-cost injectible, infused, oral, or inhaled drugs which traditional retail pharmacies typically do not supply due to their high cost, sensitive handling, and storage needs. The Company's specialty pharmaceutical management services are provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicare and Medicaid members. The Company's specialty pharmaceutical services include (i) distributing specialty pharmaceutical drugs on behalf of health plans, (ii) administering on behalf of health plans rebate agreements between health plans and pharmaceutical manufacturers, and (iii) providing consulting services to health plans and pharmaceutical manufacturers. The Company's Specialty Pharmaceutical Management segment had contracts with 30 health plans as of December 31, 2007.

Corporate and Other. 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.

Acquisition of National Imaging Associates

On January 31, 2006, the Company acquired all of the outstanding stock of NIA, a privately held radiology benefits management ("RBM") firm, for approximately $121 million in cash, after giving effect to cash acquired in the transaction, and NIA became a wholly-owned subsidiary. The Company reports the results of operations of NIA in the Radiology Benefits Management segment. For further discussion, see Note 3—"Acquisitions and Joint Ventures" to the consolidated financial statements set forth elsewhere herein.

Acquisition of ICORE Healthcare, LLC

On July 31, 2006, the Company acquired all of the outstanding units of membership interest of ICORE, a specialty pharmaceutical management company, and ICORE became a wholly-owned subsidiary. The Company reports the results of operations of ICORE in the Specialty Pharmaceutical Management segment. For further discussion, see Note 3—"Acquisitions and Joint Ventures" to the consolidated financial statements set forth elsewhere herein.

The Company paid or agreed to pay to the previous unitholders of ICORE, all of whom are members of ICORE's management team, (i) $161 million of cash at closing; (ii) $24 million of cash that was used by the unitholders of ICORE to purchase Magellan restricted stock with such restricted stock vesting over three years, provided the unitholders do not earlier terminate their employment with Magellan; (iii) $25 million plus accrued interest (the "Deferred Payment") on the third anniversary of the closing, subject to any indemnity claims Magellan may have under the purchase agreement; (iv) the amount of positive working capital that existed at ICORE on the closing date (the "Working Capital Payments"), which was $18.2 million of which $17.8 million was paid during 2007 with the remainder paid in January 2008; and (v) a potential earn-out of up to $75 million (the "Earn-Out"), provided the unitholders do not earlier terminate their employment with the Company prior to the payment of the Earn-Out. The $161 million of cash paid at closing, the $25 million Deferred Payment and $18.2 million of Working Capital Payments were recorded as purchase price. The $24 million of restricted stock is being recognized as stock compensation expense over the three year vesting period. The $24 million in restricted stock paid at the closing was issued in a transaction pursuant to which the unitholders of ICORE at closing applied $24 million of the purchase price as cash consideration for their purchase of restricted shares of the Company's common stock. The unitholders subscribed to an aggregate of 543,879 restricted shares of the Company's common stock on a basis proportional to each unitholder's economic interest in ICORE at a purchase price of $44.13 per share, which was the average of the closing prices of the Company's common stock on NASDAQ for the twenty trading days immediately preceding the closing. The Deferred Payment and the remaining estimated Working Capital Payments are included in Deferred Credits and Other Long-Term Liabilities and in Accrued Liabilities, respectively, on the Company's accompanying consolidated balance sheets as of December 31, 2006 and 2007. The Earn-Out has two parts: (i) up to $25 million based on earnings for the 18 month period ended December 31, 2007 and (ii) up to $50 million based on earnings in 2008. The Earn-Out, if earned, is payable 33 percent in cash and 67 percent in Magellan restricted stock that vests over two years after issuance. Any Earn-Out will be recognized as compensation expense over the applicable period that it is earned, because in order for potential recipients to receive any Earn-Out consideration, they must be employed by the Company at the time such consideration is distributed. The unitholders did not earn any of the potential Earn-Out of $25 million for the 18 month period ended December 31, 2007, nor has any amount of Earn-Out pertaining to 2008 been accrued as of December 31, 2007.

Industry

According to the Centers for Medicare and Medicaid Services ("CMS"), U.S. healthcare spending was projected to increase 6.6 percent to over $2.2 trillion in 2007, representing more than 16 percent of the gross domestic product. Healthcare is a rapidly evolving field where clinical and technological advancements can create business opportunities for firms with specialized expertise in certain niches of care management. The Company has transformed itself into a specialty managed healthcare company by entering areas of healthcare cost management that represent a meaningful portion of the healthcare dollar and that are growing at a disproportionately higher rate than other areas of healthcare. The Company defines areas of healthcare that can be carved out for specialty healthcare management to be areas where:

•
The management and cost of care are separable from other areas of healthcare management;

•
The Company believes that it can provide value to its customers in managing the care beyond what such customers can achieve on their own;

•
The value that the Company provides to its customers is measurable.

The Company's first specialty healthcare product was the management of behavioral healthcare. In 2006 the Company added both radiology benefits management and specialty pharmaceutical management services to its product offering through acquisitions of companies in these businesses.

Business Strategy

The Company is engaged in the specialty managed healthcare business. It currently provides managed behavioral healthcare services, radiology benefit management services, and specialty pharmaceutical management services. The Company's strategy is to expand its participation in the healthcare management services market through the expansion of its existing businesses and diversification into new specialties and services. The Company believes that its clients would prefer to consolidate outsourced vendors and that as a vendor offering multiple outsourced products, it will have a competitive advantage in the market. The Company seeks to grow its specialty managed healthcare business through the following initiatives:

Expanding the radiology benefits management services business. The Company entered the RBM business through its acquisition of NIA on January 31, 2006. Since that time, the Company has embarked on its strategy of expanding NIA's current product offering into risk-based products. The Company has leveraged its information systems, call center, and claims infrastructure as well as its financial strength and underwriting expertise to facilitate the expansion into risk-based RBM products.

In that regard, the Company has modified its claims system, developed and continues to expand a proprietary network of providers, and upgraded its call centers. During 2007, the Company implemented its first two risk-based contracts. The Company intends to continue marketing its risk-based contracts to current ASO customers as well as to new RBM customers, including through cross-selling to its managed behavioral healthcare and specialty pharmaceutical management customer base.

Expanding the specialty pharmaceutical management business. The Company entered the specialty pharmaceutical management business through its acquisition of ICORE on July 31, 2006. The Company believes it can leverage its operational platform and expertise to expand and enhance ICORE's product offering. The Company intends to cross-sell ICORE's products to its current managed behavioral healthcare and radiology benefits management customer base.

Expanded penetration of products in new or growing markets. The Company seeks to expand its services in new and/or growing markets. In recent years, the Medicaid market has increased its use of specialty managed healthcare services. With Medicaid experience in managed behavioral healthcare, radiology benefits management and specialty pharmaceutical management, the Company believes it is positioned to grow its membership and revenues in the Medicaid market over the long term as a result of its proven expertise in managing these services. The Company also believes that it might be able to expand the use of radiology benefits management into new arenas such as Medicare and/or the direct-to-employer market at some time in the future.

Continued diversification of business. The Company continually evaluates opportunities to enter other specialty healthcare businesses or healthcare services that are complementary to its existing operations, that could accelerate its entrance into new products, and/or that could leverage its existing customer relationships.

The Company's current capital structure provides it with the flexibility to consider potential acquisitions that meet its strategic criteria as a possible means to accomplish its strategic objectives.

Customer Contracts

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. The Company's contracts for managed behavioral healthcare and radiology benefits management services generally provide for payment of a per member per month fee to the Company. See "Risk Factors—Risk-Based Products" and "—Reliance on Customer Contracts."

The Company's contracts with the State of Tennessee's TennCare program ("TennCare") and with subsidiaries of WellPoint, Inc. ("WellPoint"), each generated revenues that exceeded, in the aggregate, ten percent of revenues for the consolidated Company, for the years ended December 31, 2006 and 2007. See further discussion related to these significant customers in "Risk Factors—Reliance on Customer Contracts." In addition, see "Risk Factors—Dependence on Government Spending" for discussion of risks to the Company related to government contracts.

Provider Network

Except for certain services provided under the Maricopa Contract (see "Business—Managed Behavioral Healthcare"), the Company's managed behavioral healthcare services and EAP treatment services are provided by a contracted network of third-party providers, including psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, general medical facilities with psychiatric beds, residential treatment centers and other treatment facilities. The number and type of providers in a particular area depend upon customer preference, site, geographic concentration and demographic composition of the beneficiary population in that area. The Company's managed behavioral healthcare network consists of approximately 75,000 behavioral healthcare providers, including facility locations, providing various levels of care nationwide. The Company's network providers are almost exclusively independent contractors located throughout the local areas in which the Company's customers' beneficiary populations reside. Outpatient network providers work out of their own offices, although the Company's personnel are available to assist them with consultation and other needs.

Non-facility network providers include both individual practitioners, as well as individuals who are members of group practices or other licensed centers or programs. Non-facility network providers typically execute standard contracts with the Company under which they are generally paid on a fee-for-service basis.

Third-party network facilities include inpatient psychiatric and substance abuse hospitals, intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities, rehabilitative and support facilities and other intermediate care and alternative care facilities or programs. This variety of facilities enables the Company to offer patients a full continuum of care and to refer patients to the most appropriate facility or program within that continuum. Typically, the Company contracts with facilities on a per diem or fee-for-service basis and, in some limited cases, on a "case rate" or capitated basis. The contracts between the Company and inpatient and other facilities typically are for one-year terms and are terminable by the Company or the facility upon 30 to 120 days' notice.

Historically, the Company's radiology benefits management services were provided by a network of third-party providers that are contracted by the customers of the Company to provide such services to the customers' members or enrollees. To support its offering of risk-based arrangements, the Company has developed and continues to expand a proprietary network of providers directly, through the use of its internal networking resources, and indirectly through a network contracting company. Network providers include diagnostic imaging centers, radiology departments of hospitals that provide advanced imaging services on an outpatient basis, and individual physicians or physician groups that own advanced imaging equipment and specialize in certain specific areas of care. The Company contracts with these providers on a fee-for-service basis.

Joint Ventures

Prior to April 11, 2006, Premier Behavioral Systems of Tennessee, LLC ("Premier") was a joint venture in which the Company owned a 50 percent interest. On April 11, 2006, the Company purchased the other 50 percent interest in Premier for $1.5 million, so that Premier is now a wholly-owned subsidiary of the Company.

Premier was formed to manage behavioral healthcare benefits for a certain portion of TennCare. In addition, the Company contracted with Premier to provide certain services to the joint venture. Through 2003, the Company accounted for its investment in Premier using the equity method. Effective December 31, 2003, the Company adopted the Financial Accounting Standards Board's ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin ("ARB") No. 51" ("FIN 46"), under which the Company consolidated the balance sheet of Premier in its consolidated balance sheet as of December 31, 2003. Beginning in 2004, the Company consolidated the results of operations of Premier in its consolidated statement of income. The creditors (or other beneficial interest holders) of Premier have no recourse to the general credit of the Company.

As of December 31, 2005, the Company owned a 37.5 percent interest in Royal Health Care, LLC ("Royal"). Royal was a managed services organization that received management fees for the provision of administrative, marketing, management and support services to seven managed care organizations. Royal did not provide any services to the Company.

The Company accounted for its investment in Royal using the equity method. Effective February 2, 2006, the Company sold its Royal ownership interest back to Royal in exchange for cash proceeds of $20.5 million. See Note 3—"Acquisitions and Joint Ventures" to the consolidated financial statements set forth elsewhere herein for further information on Royal.

CEO BACKGROUND

Nancy L. Johnson formerly served in the U.S. House of Representatives as a 12-term Congresswoman from the 5 th District of Connecticut. She is currently a fellow at the Institute of Politics at Harvard University and in May 2007 will join the federal public policy group of the law firm of Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. Ms. Johnson was first elected to the House in 1982 and served on the Committee on Ways and Means for nine terms, where she chaired at various times the Oversight, Human Resources and Health Subcommittees. Prior to her election to the House of Representatives, she served in the Connecticut Senate from 1977 to 1983.

Steven J. Shulman is the Chairman of the board and Chief Executive Officer of the company. He became Chief Executive Officer of the company in December 2002 and Chairman of the board on the effective date of the company’s plan of reorganization, January 5, 2004. Prior to joining the company, Mr. Shulman founded Internet HealthCare Group (“ IHCG ”), an early stage healthcare technology venture fund, and served as its Chairman and Chief Executive Officer from 2000 to 2002. Prior to IHCG, he was employed by Prudential Healthcare, Inc. as its Chairman, President and Chief Executive Officer from 1997 to 1999. Prior thereto, Mr. Shulman co-founded Value Health, Inc., a New York Stock Exchange listed specialty managed health care company, and served as President of its Pharmacy and Disease Management Group and director from 1991 to 1997. From 1983 to 1986, Mr. Shulman was employed by CIGNA Healthplans as President of its East Central Division. Prior thereto, he served as Director of Medical Economics for Kaiser Permanente from 1974 to 1982. Mr. Shulman is a member of the board of directors of IHCG; Digital Insurance, a private employee benefit service company; BenefitPoint Inc., a private insurance software company; and Health Markets, Inc., a privately-held insurance provider for self-employed individuals and small businesses.

Michael P. Ressner is a retired Adjunct Professor of Finance & Accounting and an adviser at North Carolina State University and is an adviser at Southeast Interactive Technology Fund. Mr. Ressner was first appointed to the board in 2004. Between 1981 and 2003, he served in a variety of positions at Nortel Networks, holding leadership positions within operations and finance. Mr. Ressner currently serves on the boards of Entrust, Inc., an internet security software company; Tekelec, Inc., a publicly-traded telecommunications company; Exide Technologies, a NASDAQ-listed stored electrical energy company; and Arsenal Digital Solutions, a private storage management services company.

Michael Diament formerly served as Portfolio Manager and Director of Bankruptcies and Restructurings from January 2001 to February 2006 for Q Investments, an investment management firm. From February 2000 until January 2001, Mr. Diament was a Senior Research Analyst for Sandell Asset Management, an investment management firm, and served as Vice President of Havens Advisors, an investment management firm, from July 1998 to January 2000. He was first appointed to the board in 2004. He also serves on the board of J.L. French Automotive Castings, Inc., a privately-held auto parts company.

COMPENSATION

Compensation Program Components and Rationale for our Named Executive Officers

The compensation packages for our Named Executive Officers are designed to set total compensation at levels that reflect both personal and organizational performance and results. Each of our Named Executive Officers has an employment agreement that establishes his base salary and bonus opportunities that was agreed upon following arm’s length negotiations with the respective individual. See “ Executive Officers—Employment Contracts and Termination of Employment and Change of Control Payments ” below. The employment agreements with Mr. Shulman, Dr. Lerer and Mr. Demilio were negotiated with the company’s creditors and other parties in interest in connection with the company’s emergence from bankruptcy and, thus, before the committee was formed but have been reviewed by the committee, which takes these agreements into account in making salary adjustments, incentive awards and other discretionary compensation decisions. The employment agreements with our other Named Executive Officers have been approved by the committee. In determining annual adjustments to base salary, annual bonus awards (short-term incentive) and annual equity awards (long-term incentive) for our Named Executive Officers, the committee considers recommendations of the chief executive officer (except in the case of his own compensation) based on his assessment of each executive’s performance and results and in the context of market data provided by the committee’s independent compensation consultants.

Base Salary

Base salary is intended to provide basic financial security to our Named Executive Officers, so it is not made subject to substantial performance risk in any year. In determining the base salary for each of our Named Executive Officers, the committee considers such factors as existing contractual commitments; competitive market data; compensation opportunities perceived to be necessary to retain them; individual performance; and the scope, complexity, difficulty and criticality of the individual executive officer’s role with the company. Our employment agreements with Mr. Shulman, Dr. Lerer and Mr. Demilio, entered into in January 2004, specify an initial base salary amount subject to annual adjustment based on performance reviews. With regard to Messrs Shulman, Lerer, and Demilio, we determined their initial base salaries and total compensation based on their experience and demonstrated results, the scope, complexity, difficulty and criticality of their roles, as well as their prior compensation.

We also entered into employment agreements with our general counsel, Mr. Gregoire, and our chief sales and marketing officer, Mr. Majerik, when they joined the company in January 2005 and July 2006, respectively, which specify an initial base salary subject to annual adjustment based on performance reviews. We determined initial base salary for Messrs. Gregoire and Majerik by conducting a market assessment to determine an appropriate pay range for the position, using comparable company data, comparable talent data, and other survey data as appropriate. We also assessed the candidate’s experience and demonstrated results, the scope, complexity, difficulty, and criticality of the candidate’s role, as well as the candidate’s then-current compensation.

To determine the adjustment to base salary payable in 2006 and 2007 to Mr. Shulman, the committee developed and shared with Mr. Shulman criteria by which his performance was to be assessed, including both overall company targets, as well as areas on which he was to be individually assessed (e.g. leadership, strategic planning, succession planning, HR, communications, external relations, board communications, board governance and financial results). Toward the end of the fiscal year, the committee solicited input from the board on the degree to which the objectives were met, and approved compensation actions relating to the year. Adjustments to Mr. Shulman’s base salary for the next year were then determined based on an overall assessment of his performance in the context of market data regarding executive compensation range movement as provided by the compensation consultants.

To determine the adjustment to base salary payable in 2006 for Messrs. Lerer, Demilio and Gregoire, and for those officers and Mr. Majerik in 2007, Mr. Shulman articulated the overall company strategy, and each executive created a “scorecard” for his respective area of responsibility that reflected the company’s goals. At the end of each year, each executive completed a self-assessment based on his scorecard and arrived at a quantitative score for the year. Mr. Shulman then reviewed the self-assessments, and completed his own analysis of each executive’s performance, and assigned a quantitative rating resulting in a recommended increase percentage in the executive’s base salary. The committee reviewed Mr. Shulman’s recommendation for base salary increases, and adjusted the increases based on their discretion. As a result of this process, the committee decided to increase the base salary amounts for Mr. Shulman by 5%, Dr. Lerer by 7.5%, Mr. Demilio by 3% and Mr. Gregoire by 3%. These increases were generally in line with inflation and reflected that all of our Named Executive Officers had met and exceeded their performance scorecards and goals. Mr. Majerik did not receive an increase in base salary due to the fact that he assumed his current position in July 2006.

Annual Bonuses

We have established an annual short-term incentive plan, the STIP, which is described under “ Benefit Plans and Awards—Annual Incentive Plan ” below. The STIP provides cash bonuses and is available to all management, including our Named Executive Officers. The STIP was utilized in 2005 and 2006 as the primary vehicle for providing management with short-term incentives. At the beginning of each fiscal year, the committee, with input from the chief executive officer, other members of management and the compensation consultants, establishes performance goals which could result in a threshold, target or maximum bonus payout. At the end of the fiscal year, the committee then reviews the company’s and the individual’s performance relative to those performance goals and determines whether the goals were achieved and decides on the level of funding for the annual bonuses. Annual bonuses are paid in the first quarter of the year following the fiscal year to which the bonuses relate. The bonuses paid in 2007 were for work performed during 2006. The performance criterion for funding the 2006 annual bonus pool was the achievement of approximately $186 million in “segment profit,” including the effect of our acquisitions of our new subsidiaries, National Imaging Associates, Inc. and ICORE Healthcare, LLC.

We define “segment profit” as profit or loss from continuing operations before stock compensation expense, depreciation and amortization, interest expense, interest income, gain on sale of assets, special charges or benefits, income taxes and minority interest. We use segment profit information for internal reporting and control purposes and consider it important in making decisions regarding the allocation of capital and other resources, risk assessment and employee compensation, among other matters. Segment profit information referred to in this proxy statement may be considered a non-GAAP financial measure. Further information regarding this measure, including the reasons management considers this information useful to investors, is included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and filed with the SEC on February 28, 2007, and will be included in our Quarterly Reports on Form 10-Q to be filed with the SEC as required.

We believe that segment profit is an appropriate measure of company performance for purposes of determining annual bonuses because we discuss segment profit in announcing our financial results and many shareholders and analysts use it as an important measure of overall company performance. We also believe that setting annual bonus performance targets based upon segment profit properly aligns incentives of our executives and employees with the interests of our shareholders. The committee determined that the 2006 goals were exceeded. As a result, the committee determined to fund the aggregate bonus pools at 126.8% of target funding levels. Each individual’s bonus is determined based upon each individual’s bonus target (percent of base salary), an evaluation of each individual’s performance, and the overall company funding level. Targets for short-term incentive bonuses for each Named Executive Officer are determined by the committee after consideration of the total annual remuneration of the officer (including base salary, bonus, and equity awards). Total remuneration ranges are based on comparable company data, comparable talent data, and other survey data as appropriate. The individual bonus awards to Messrs. Shulman, Lerer, Demilio, and Gregoire described below reflected our favorable financial performance as measured by segment profit and their positive individual performance as measured by their individual performance criteria.

MANAGEMENT DISCUSSION FROM LATEST 10K

Business Overview

The Company is engaged in the specialty managed healthcare business. Through 2005, the Company predominantly operated in the managed behavioral healthcare business. During 2006, the Company expanded into radiology benefits management and specialty pharmaceutical management as a result of its acquisitions of NIA and ICORE, respectively, as discussed further below. The Company provides services to health plans, insurance companies, corporations, labor unions and various governmental agencies. The Company's business is divided into the following six segments, based on the services it provides and/or the customers that it serves, as described below.

Managed Behavioral Healthcare. The Company's managed behavioral healthcare business is composed of three of the Company's segments, each as described further below. This line of business generally reflects the Company's coordination and management of the delivery of behavioral healthcare treatment services that are provided through its contracted network of third-party treatment providers, which includes psychiatrists, psychologists, other behavioral health professionals, psychiatric hospitals, general medical facilities with psychiatric beds, residential treatment centers and other treatment facilities. The treatment services provided through the Company's provider network include outpatient programs (such as counseling or therapy), 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 except as relates to the Company's contract to provide managed behavioral healthcare services to Medicaid recipients and other beneficiaries of the Maricopa County Regional Behavioral Health Authority (the "Maricopa Contract"), which is discussed further in Note 10—"Commitments and Contingencies-Maricopa Contract" to the consolidated financial statements set forth elsewhere herein. Under the Maricopa Contract, the Company was required to assume the operations of twenty-four behavioral health direct care facilities for a transitional period and to divest itself of these facilities over the following two years pursuant to a schedule as set forth in the Maricopa Contract.

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 counseling.

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

Health Plan. The Managed Behavioral Healthcare Health Plan segment ("Health Plan") generally reflects managed behavioral healthcare services provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicaid and Medicare members. Health Plan's contracts encompass either risk-based or ASO arrangements or both. As of December 31, 2007, Health Plan's covered lives were 5.6 million, 0.2 million and 20.7 million for risk-based, EAP and ASO products, respectively. For the year ended December 31, 2007, Health Plan's revenue was $530.6 million, $1.3 million and $126.5 million for risk-based, EAP and ASO products, respectively.

Employer. The Managed Behavioral Healthcare Employer segment ("Employer") generally reflects the provision of EAP services and managed behavioral healthcare services under contracts with employers, including corporations and governmental agencies, and labor unions. Employer contracts can be for either EAP or managed behavioral healthcare services, or both. Employer contracts containing provision of managed behavioral healthcare services can be risk-based or ASO, but currently are primarily ASO. As of December 31, 2007, Employer's covered lives were 0.1 million, 13.6 million and 0.5 million for risk-based, EAP and ASO products, respectively. For the year ended December 31, 2007, Employer's revenue was $6.4 million, $102.7 million and $17.0 million for risk-based, EAP and ASO products, respectively.

Public Sector. The Managed Behavioral Healthcare Public Sector segment ("Public Sector") generally reflects managed behavioral healthcare services provided to Medicaid recipients under contracts with state and local governmental agencies. Public Sector contracts encompass either risk-based or ASO arrangements. As of December 31, 2007, Public Sector's covered lives were 2.1 million and 0.2 million for risk-based and ASO products, respectively. For the year ended December 31, 2007, Public Sector's revenue was $1.0 billion and $4.4 million for risk-based and ASO products, respectively.

Radiology Benefits Management. The Company's Radiology Benefits Management segment generally reflects the management of the delivery of diagnostic imaging services to ensure that such services are clinically appropriate and cost effective. The Company's radiology benefits management services currently are provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicaid and Medicare members. The Company has bid and may bid in the future on contracts with state and local governmental agencies for the provision of such services to Medicaid recipients. The Company won one Medicaid contract last year; however, its implementation has been postponed by the agency. The Company offers its radiology benefits management services 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 imaging services and through risk-based contracts, where the Company assumes all or a substantial portion of the responsibility for the cost of providing diagnostic imaging services. The Company's first two risk-based radiology benefits management contracts became effective June 1, 2007 and July 1, 2007, respectively. As of December 31, 2007, covered lives for Radiology Benefits Management were 2.2 million and 19.1 million for risk-based and ASO products, respectively. For the year ended December 31, 2007, revenue for Radiology Benefits Management was $118.2 million and $52.0 million for risk-based and ASO products, respectively.

Specialty Pharmaceutical Management. The Company's Specialty Pharmaceutical Management segment generally reflects the management of specialty drugs used in the treatment of cancer, multiple sclerosis, hemophilia, infertility, rheumatoid arthritis, chronic forms of hepatitis and other diseases. Specialty pharmaceutical drugs represent high-cost injectible, infused, oral, or inhaled drugs which traditional retail pharmacies typically do not supply due to their high cost, sensitive handling, and storage needs. The Company's specialty pharmaceutical management services are provided under contracts with managed care companies, health insurers and other health plans for some or all of their commercial, Medicare and Medicaid members. The Company's specialty pharmaceutical services include (i) distributing specialty pharmaceutical drugs on behalf of health plans, (ii) administering on behalf of health plans rebate agreements between health plans and pharmaceutical manufacturers, and (iii) providing consulting services to health plans and pharmaceutical manufacturers. The Company's Specialty Pharmaceutical Management segment had contracts with 30 health plans as of December 31, 2007.

Corporate and Other. 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.

Acquisition of National Imaging Associates

On January 31, 2006, the Company acquired all of the outstanding stock of NIA, a privately held RBM firm, for approximately $121 million in cash, after giving effect to cash acquired in the transaction, and NIA became a wholly-owned subsidiary. The Company reports the results of operations of NIA in the Radiology Benefits Management segment. For further discussion, see Note 3—"Acquisitions and Joint Ventures" to the consolidated financial statements set forth elsewhere herein.

Acquisition of ICORE Healthcare, LLC

On July 31, 2006, the Company acquired all of the outstanding units of membership interest of ICORE, a specialty pharmaceutical management company, and ICORE became a wholly-owned subsidiary. The Company reports the results of operations of ICORE in the Specialty Pharmaceutical Management segment. For further discussion, see Note 3—"Acquisitions and Joint Ventures" to the consolidated financial statements set forth elsewhere herein.

The Company paid or agreed to pay to the previous unitholders of ICORE, all of whom are members of ICORE's management team, (i) $161 million of cash at closing; (ii) $24 million of cash that was used by the unitholders of ICORE to purchase Magellan restricted stock with such restricted stock vesting over three years, provided the unitholders do not earlier terminate their employment with Magellan; (iii) $25 million plus accrued interest (the "Deferred Payment") on the third anniversary of the closing, subject to any indemnity claims Magellan may have under the purchase agreement; (iv) the amount of positive working capital that existed at ICORE on the closing date (the "Working Capital Payments"), which was $18.2 million of which $17.8 million was paid during 2007 with the remainder paid in January 2008; and (v) a potential earn-out of up to $75 million (the "Earn-Out"), provided the unitholders do not earlier terminate their employment with the Company prior to the payment of the Earn-Out. The $161 million of cash paid at closing, the $25 million Deferred Payment and $18.2 million of Working Capital Payments were recorded as purchase price. The $24 million of restricted stock is being recognized as stock compensation expense over the three year vesting period. The $24 million in restricted stock paid at the closing was issued in a transaction pursuant to which the unitholders of ICORE at closing applied $24 million of the purchase price as cash consideration for their purchase of restricted shares of the Company's common stock. The unitholders subscribed to an aggregate of 543,879 restricted shares of the Company's common stock on a basis proportional to each unitholder's economic interest in ICORE at a purchase price of $44.13 per share, which was the average of the closing prices of the Company's common stock on NASDAQ for the twenty trading days immediately preceding the closing. The Deferred Payment and the remaining estimated Working Capital Payments are included in Deferred Credits and Other Long-Term Liabilities and in Accrued Liabilities, respectively, on the Company's accompanying consolidated balance sheets as of December 31, 2006 and 2007. The Earn-Out has two parts: (i) up to $25 million based on earnings for the 18 month period ended December 31, 2007 and (ii) up to $50 million based on earnings in 2008. The Earn-Out, if earned, is payable 33 percent in cash and 67 percent in Magellan restricted stock that vests over two years after issuance. Any Earn-Out will be recognized as compensation expense over the applicable period that it is earned, because in order for potential recipients to receive any Earn-Out consideration, they must be employed by the Company at the time such consideration is distributed. The unitholders did not earn any of the potential Earn-Out of $25 million for the 18 month period ended December 31, 2007, nor has any amount of Earn-Out pertaining to 2008 been accrued as of December 31, 2007.

Results of Operations

The Company evaluates performance of its segments based on profit or loss from continuing operations before stock compensation expense, depreciation and amortization, interest expense, interest income, gain on sale of assets, special charges or benefits, income taxes and minority interest ("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. Intersegment sales and transfers are not significant. See Note 12—"Business Segment Information" to the consolidated financial statements set forth elsewhere herein. The Company's segments are defined above.

Year ended December 31, 2007 ("2007") compared to the year ended December 31, 2006 ("2006")

Health Plan

Net Revenue

Net revenue related to Health Plan increased by 0.4 percent or $2.4 million from 2006 to 2007. The increase in revenue is mainly due to revenue from new contracts implemented after (or during) 2006 of $43.1 million, favorable rate changes of $22.7 million, and increased membership from existing customers of $17.1 million, which increases were partially offset by terminated contracts of $73.3 million, revenue in 2006 of $6.2 million related to one-time transitional activities associated with a terminated contract and other net unfavorable decreases of $1.0 million.

Cost of Care

Cost of care increased by 0.6 percent or $2.0 million from 2006 to 2007. The increase in cost of care is primarily due to care from new contracts implemented after (or during) 2006 of $30.6 million, favorable contractual settlements affecting cost of care in 2006 of $5.1 million, increased membership from existing customers of $8.1 million, favorable prior period medical claims development recorded in 2006 of $3.8 million, and care trends and other net unfavorable variances of $5.5 million, which increases were partially offset by terminated contracts of $41.6 million, favorable prior period medical claims development recorded in 2007 of $5.9 million, and favorable medical claims development for 2006 which was recorded in 2007 of $3.6 million. Cost of care as a percentage of risk revenue (including EAP revenue) decreased from 69.1 percent in 2006 to 68.7 percent in 2007, mainly due to the impact of rate changes exceeding care trends partially offset by the favorable contractual settlements in the prior year. For further discussion of Health Plan care trends, see "Outlook—Results of Operations" below.

Direct Service Costs

Direct service costs decreased by 6.1 percent or $6.5 million from 2006 to 2007 primarily due to terminated contracts. Direct service costs decreased as a percentage of revenue from 16.2 percent in 2006 to 15.1 percent in 2007, mainly due to favorable rate changes and business mix.

Equity in Earnings of Unconsolidated Subsidiaries

The Company recorded $0.4 million of equity in earnings of unconsolidated subsidiaries in 2006. The Company sold its equity interest in Royal effective February 2, 2006. Accordingly, 2007 does not include any results for Royal.

Employer

Net Revenue

Net revenue related to Employer decreased by 2.0 percent or $2.6 million from 2006 to 2007. The decrease in revenue is mainly due to terminated contracts of $13.7 million, which decrease was partially offset by revenue from new contracts implemented after (or during) 2006 of $6.7 million, increased membership from existing customers of $2.3 million, and other net increases of $2.1 million.

Cost of Care

Cost of care decreased by 6.1 percent or $1.8 million from 2006 to 2007. The decrease in cost of care is mainly due to terminated contracts of $3.1 million, favorable prior period medical claims development recorded in 2007 of $0.8 million, and favorable medical claims development for 2006 which was recorded in 2007 of $0.8 million, which decreases were partially offset by care associated with new customers of $1.5 million, favorable prior period medical claims development recorded in 2006 of $0.7 million, care costs related to increased membership from existing customers of $0.5 million, and care trends and other net increases of $0.2 million. Cost of care decreased as a percentage of risk revenue (including EAP revenue) from 25.8 percent in 2006 to 24.9 percent in the 2007, mainly due to the net favorable impact of out-of-period medical claims development.

Direct Service Costs

Direct service costs decreased by 5.1 percent or $3.4 million from 2006 to 2007. The decrease is primarily due to expenses related to services and support required for Hurricane Katrina victims and related activities in 2006. Direct service costs deceased as a percentage of revenue from 52.6 percent for 2006 to 51.0 percent in 2007 mainly due to the decrease in costs associated with Hurricane Katrina activities and to business mix.

Public Sector

Net Revenue

Net revenue related to Public Sector increased by 26.2 percent or $212.2 million from 2006 to 2007. This increase is primarily due to revenue from new contracts implemented after (or during) 2006 of $294.8 million, favorable rate changes of $21.1 million, and membership increases from existing customers of $10.4 million, which increases were partially offset by a net loss of membership in connection with the Middle Grand Region of TennCare of $101.0 million, favorable prior period adjustments mainly related to membership recorded in 2006 of $10.2 million, and other net unfavorable variances of $2.9 million.

Cost of Care

Cost of care increased by 31.0 percent or $213.6 million from 2006 to 2007. This increase is primarily due to care associated with new contracts implemented after (or during) 2006 of $268.7 million (including Maricopa Contract implementation costs of $4.1 million), membership increases from existing customers of $9.1 million, care associated with rate changes for contracts that have minimum cost of care requirements of $8.3 million, favorable prior period medical claims development which was recorded in 2006 of $1.5 million, and care trends and other net variances of $18.8 million, which increases were partially offset by the net loss of membership in connection with the Middle Grand Region of TennCare of $83.3 million, prior period membership adjustments recorded in 2006 of $7.6 million, favorable medical claims development for 2006 which was recorded in 2007 of $1.0 million and favorable prior period medical claims development recorded in 2007 of $0.9 million. Cost of care increased as a percentage of risk revenue from 85.8 percent in 2006 to 88.8 percent in 2007.

Direct Service Costs

Direct service costs increased by 43.0 percent or $15.6 million from 2006 to 2007. The increase in direct service costs is primarily due to costs associated with new business, inclusive of one-time implementation costs related to new contracts. As a percentage of revenue, direct service costs increased from 4.5 percent in 2006 to 5.1 percent in 2007, primarily due to one-time implementation costs related to new contracts and business mix.

Radiology Benefits Management

Net Revenue

Net revenue related to the Radiology Benefits Management segment increased by 309.1 percent or $128.6 million from 2006 to 2007. This increase is primarily due to revenue from new customers implemented in 2007 of $62.7 million, increased revenue due to the conversion of an ASO contract to a risk contract of $61.0 million, increased membership from existing customers of $1.7 million, and the inclusion of only eleven months of operating results in 2006 due to the closing of the acquisition of NIA on January 31, 2006, which increases were partially offset by terminated contracts.

Cost of Care

Cost of care related to Radiology Benefits Management was $114.2 million for 2007 from the Company's risk-based contracts. In 2006, Radiology Benefits Management did not have any risk-based contracts. Cost of care as a percentage of risk revenue was 96.6 percent in 2007.

Direct Service Costs

Direct service costs increased 21.7 percent or $8.7 million from 2006 to 2007. This increase is primarily attributed to the inclusion of only eleven months of operating results in 2006 and to costs associated with new contracts implemented in 2007. As a percentage of revenue, direct service costs decreased from 96.4 percent in 2006 to 28.7 percent in 2007, mainly due to the implementation of two new risk contracts in 2007.

Specialty Pharmaceutical Management

Net Revenue

Net revenue related to the Specialty Pharmaceutical Management segment increased 226.5 percent or $125.1 million from 2006 to 2007. This increase is primarily attributed to the inclusion of only five months of operating results in 2006 due to the closing of the acquisition of ICORE on July 31, 2006. Other factors resulting in increased net revenue relate to revenue from new customers implemented in 2007 of $37.7 million and net increased revenue from existing customers of $10.4 million.

Cost of Goods Sold

Cost of goods sold increased 257.8 percent or $107.8 million from 2006 to 2007. This increase is primarily attributed to the inclusion of only five months of operating results in 2006 due to the closing of the acquisition of ICORE on July 31, 2006. Other factors resulting in increased cost of goods sold relate to cost of goods sold from new customers and increased sales from existing customers of $36.0 million and $7.9 million, respectively. As a percentage of the portion of net revenue that relates to distribution revenue, cost of goods sold increased from 90.3 percent in 2006 to 92.9 percent in 2007, mainly due to new business having higher cost of goods sold ratios than historic business and the mix of pharmaceuticals distributed in 2007 having higher cost of goods sold ratios than the mix of pharmaceuticals distributed in 2006.

Direct Service Costs

Direct service costs increased by 189.5 percent or $14.1 million from 2006 to 2007. The acquisition of ICORE closed on July 31, 2006 and thus 2006 only included five months of operating results from this segment of the Company. As a percentage of revenue, direct service costs decreased from 13.5 percent in 2006 to 11.9 percent in 2007, mainly due to the segment's stock compensation expense not varying due to new business and same store growth.

Corporate and Other

Other Operating Expenses

Other operating expenses related to the Corporate and Other segment decreased by 7.8 percent or $10.0 million from 2006 to 2007, primarily due to lower stock compensation expense for this segment. As a percentage of total net revenue, other operating expenses decreased from 7.6 percent for 2006 to 5.5 percent for 2007 primarily due to the leveraging of corporate functions in connection with the acquisitions of NIA and ICORE, lower stock compensation expense for this segment and the new contracts implemented after (or during) 2006.

Depreciation and Amortization

Depreciation and amortization expense increased by 17.7 percent or $8.7 million from 2006 to 2007, primarily due to asset additions, inclusive of assets related to the Maricopa County contract and the full year impact of the acquisitions of NIA and ICORE.

Interest Expense

Interest expense decreased by 12.4 percent or $0.9 million from 2006 to 2007, mainly due to reductions in outstanding debt balances as a result of scheduled payments.

Interest Income

Interest income increased by 35.2 percent or $6.2 million from 2006 to 2007, mainly due to an increase in average invested balances.

Other Items

A gain on the disposition of assets of $5.1 million was recognized in 2006 mainly as a result of the Company's sale of its equity interest in Royal.

Income Taxes

The Company's effective income tax rate was 42.1 percent in 2006 and 38.3 percent in 2007. The 2006 and 2007 effective income tax rates differ from the federal statutory income tax rates primarily due to state income taxes and permanent differences between book and tax income. The effective income tax rate in 2007 is lower than the prior year mainly due to the inclusion in 2006 of tax provision for certain tax contingencies related to executive compensation expense, as well as the reversal in 2007 of a portion of such tax contingency reserves.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations

The Company evaluates performance of its segments based on profit or loss from continuing operations before stock compensation expense, depreciation and amortization, interest expense, interest income, gain on sale of assets, special charges or benefits, income taxes and minority interest ("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. Intersegment sales and transfers are not significant.

Quarter ended September 30, 2007 ("Current Year Quarter"), compared to the quarter ended September 30, 2006 ("Prior Year Quarter")

Health Plan

Net Revenue

Net revenue related to Health Plan decreased by 2.9 percent or $4.8 million from the Prior Year Quarter to the Current Year Quarter. The decrease in revenue is mainly due to terminated contracts of $23.0 million, which decrease was partially offset by revenue from new contracts implemented after the Prior Year Quarter of $9.2 million, favorable rate changes of $4.3 million, an increase in membership from existing customers of $4.0 million, and other net increases of $0.7 million.

Cost of Care

Cost of care decreased by 10.7 percent or $10.3 million from the Prior Year Quarter to the Current Year Quarter. The decrease in cost of care is primarily due to terminated contracts of $13.4 million, favorable prior period care development recorded in the Current Year Quarter of $5.4 million, favorable care development for the Prior Year Quarter which was recorded after the Prior Year Quarter of $2.4 million, and unfavorable prior period care development recorded in the Prior Year Quarter of $1.3 million, which decreases were partially offset by care from new contracts implemented after the Prior Year Quarter of $6.4 million, an increase in membership from existing customers of $1.5 million, and care trends and other net variances of $4.3 million. Cost of care decreased as a percentage of risk revenue from 71.8 percent in the Prior Year Quarter to 66.6 percent in the Current Year Quarter, mainly due to the impact of out-of-period care development and business mix. For further discussion of Health Plan care trends, see "Outlook—Results of Operations" below.

Direct Service Costs

Direct service costs decreased by 8.7 percent or $2.2 million from the Prior Year Quarter to the Current Year Quarter mainly due to terminated contracts. Direct service costs decreased as a percentage of revenue from 15.7 percent in the Prior Year Quarter to 14.7 percent in the Current Year Quarter, mainly due to business mix.

Employer

Net Revenue

Net revenue related to Employer decreased by 1.1 percent or $0.4 million from the Prior Year Quarter to the Current Year Quarter. The decrease in revenue is mainly due to terminated contracts of $3.2 million, which decrease was partially offset by revenue from new customers of $2.2 million and other net increases of $0.6 million.

Cost of Care

Cost of care decreased by 3.8 percent or $0.3 million from the Prior Year Quarter to the Current Year Quarter. This decrease is mainly due to terminated contracts of $0.6 million and favorable prior period care development recorded in the Current Year Quarter of $0.6 million, which decreases were partially offset by care costs associated with new customers of $0.6 million and care trends and other net increases of $0.3 million. Cost of care decreased as a percentage of risk revenue from 24.6 percent in the Prior Year Quarter to 24.3 percent in the Current Year Quarter, mainly due to the impact of out-of-period care development.

Direct Service Costs

Direct service costs decreased by 5.0 percent or $0.8 million from the Prior Year Quarter to the Current Year Quarter. The decrease is primarily due to expenses associated with terminated contracts. Direct service costs as a percentage of revenue decreased from 51.8 percent for the Prior Year Quarter to 49.8 percent in the Current Year Quarter, mainly due to business mix.

Public Sector

Net Revenue

Net revenue related to Public Sector increased by 23.8 percent or $47.9 million from the Prior Year Quarter to the Current Year Quarter. This increase is primarily due to revenue from new contracts implemented after the Prior Year Quarter of $73.4 million, favorable rate changes of $5.1 million, and other net variances of $0.2 million, which increases were partially offset by the loss of membership in connection with the Middle Grand Region of TennCare and other net decreases in membership from existing customers of $30.8 million.

Cost of Care

Cost of care increased by 32.0 percent or $54.3 million from the Prior Year Quarter to the Current Year Quarter. This increase is primarily due to care associated with new contracts implemented after the Prior Year Quarter of $68.3 million, care associated with rate changes for contracts that have minimum cost of care requirements of $3.5 million, favorable prior period care development recorded in the Prior Year Quarter of $2.3 million, unfavorable care development for the Prior Year Quarter which was recorded after the Prior Year Quarter of $1.6 million, unfavorable prior period care development recorded in the Current Year Quarter of $1.2 million, and care trends and other net increases of $2.0 million, which increases were partially offset by the loss of membership in connection with the Middle Grand Region of TennCare and other net decreases in membership from existing customers of $24.6 million. Cost of care increased as a percentage of risk revenue from 84.8 percent in the Prior Year Quarter to 90.1 percent in the Current Year Quarter, mainly due to the impact of out-of-period care development and business mix.

Direct Service Costs

Direct service costs increased by 62.1 percent or $5.5 million from the Prior Year Quarter to the Current Year Quarter. The increase in direct service costs is primarily due to costs associated with new business, inclusive of one-time implementation costs. Direct service costs increased as a percentage of revenue from 4.4 percent for the Prior Year Quarter to 5.8 percent in the Current Year Quarter, mainly due to implementation costs related to new business.

Radiology Benefits Management

Net Revenue

Net revenue related to Radiology Benefits Management increased by 576.7 percent or $61.4 million from the Prior Year Quarter to the Current Year Quarter. This increase is primarily due to revenue from new contracts implemented after the Prior Year Quarter of $27.6 million, increased revenue due to the conversion of an ASO contract to a risk contract of $31.8 million, increased membership from existing customers of $1.2 million, and other net variances of $1.8 million, which increases were partially offset by terminated contracts of $1.0 million.

Cost of Care

Cost of care related to Radiology Benefits Management was $53.4 million for the Current Year Quarter from the Company's risk-based contracts. In the Prior Year Quarter, Radiology Benefits Management did not manage any risk-based contracts. Cost of care as a percentage of risk revenue was 92.7 percent in the Current Year Quarter.

irect Service Costs

Direct service costs increased by 43.2 percent or $4.3 million from the Prior Year Quarter to the Current Year Quarter. This increase is primarily attributed to costs associated with new business in the Current Year Quarter. As a percentage of revenue, direct service costs decreased from 92.5 percent in the Prior Year Quarter to 19.6 percent in the Current Year Quarter, mainly due to the implementation of two new risk contracts after the Prior Year Quarter.

Specialty Pharmaceutical Management

Net Revenue

Net revenue related to Specialty Pharmaceutical Management increased by 118.0 percent or $24.4 million from the Prior Year Quarter to the Current Year Quarter. The acquisition of ICORE closed on July 31, 2006 and thus the Prior Year Quarter only included two months of operating results from this segment of the Company.

Cost of Goods Sold

Cost of goods sold increased by 145.5 percent or $22.1 million from the Prior Year Quarter to the Current Year Quarter. The acquisition of ICORE closed on July 31, 2006 and thus the Prior Year Quarter only included two months of operating results from this segment of the Company. As a percentage of the portion of net revenue that relates to distribution activity, cost of goods sold increased from 88.1 percent in the Prior Year Quarter to 93.5 percent in the Current Year Quarter, mainly due to new business having higher cost of goods ratios than historic business, and the mix of pharmaceuticals distributed in the Current Year Quarter having higher cost of goods sold ratios than the mix of pharmaceuticals distributed in the Prior Year Quarter.

Direct Service Costs

Direct service costs increased by 109.3 percent or $2.9 million from the Prior Year Quarter to the Current Year Quarter. The acquisition of ICORE closed on July 31, 2006 and thus the Prior Year Quarter only included two months of operating results from this segment of the Company. As a percentage of revenue, direct service costs decreased from 12.7 percent in the Prior Year Quarter to 12.2 percent in the Current Year Quarter, mainly due to business mix.

Corporate and Other

Other Operating Expenses

Other operating expenses related to the Corporate and Other Segment decreased 11.6 percent or $3.8 million from the Prior Year Quarter to the Current Year Quarter. This decrease resulted primarily from lower stock compensation expense for this segment of $2.2 million, lower fixed asset disposals of $1.0 million, and other net favorable variances of $0.6 million. As a percentage of total net revenue, other operating expenses decreased from 7.7 percent for the Prior Year Quarter to 5.2 percent for the Current Year Quarter primarily due to the leveraging of corporate functions in connection with the acquisitions of NIA and ICORE, lower stock compensation expense for this segment and the additional revenue provided by the new Public Sector business.

Depreciation and Amortization

Depreciation and amortization expense increased by 9.9 percent or $1.3 million from the Prior Year Quarter to the Current Year Quarter, primarily due to asset additions since the Prior Year Quarter, inclusive of assets related to the acquisition of ICORE, for which there were only two months of depreciation in the Prior Year Quarter.

Interest Expense

Interest expense decreased by 13.1 percent or $0.2 million from the Prior Year Quarter to the Current Year Quarter, mainly due to reductions in outstanding debt balances as a result of scheduled payments.

Interest Income

Interest income increased by 50.3 percent or $2.2 million from the Prior Year Quarter to the Current Year Quarter, mainly due to an increase in yields on investments and an increase in average invested balances.

Income Taxes

The Company's effective income tax rate was 39.6 percent in the Prior Year Quarter and 37.0 percent in the Current Year Quarter. The Prior Year Quarter and Current Year Quarter effective income tax rates differ from federal statutory income tax rates primarily due to state income taxes and permanent differences between book and tax income. The effective income tax rate will vary between periods mainly due to the impact of permanent differences in each period and changes in the effective state income tax rate.

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