HEALTH GRADES INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

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FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the quarterly period ended SEPTEMBER 30, 2002
------------------

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the transition period from _________to__________

Commission file number 0-22019

HEALTH GRADES, INC.
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(Exact Name of Registrant as Specified in its Charter)

DELAWARE 62-1623449
-------- ----------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

44 UNION BOULEVARD, SUITE 600, LAKEWOOD, COLORADO 80228
- ------------------------------------------------- -----
(Address of Principal Executive Offices) (Zip Code)

Registrant's Telephone Number, Including Area Code (303) 716-0041
--------------

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

On October 31, 2002, 36,406,731 shares of the Registrant's common stock,
$.001 par value, were outstanding.

Health Grades, Inc. and Subsidiaries

INDEX

2

PART I. FINANCIAL INFORMATION
Health Grades, Inc. and Subsidiaries
Consolidated Balance Sheets

See accompanying notes to consolidated financial statements.

3

Health Grades, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)

See accompanying notes to consolidated financial statements.

4

Health Grades, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)

See accompanying notes to consolidated financial statements.

5

Health Grades, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

September 30, 2002

NOTE 1 - BASIS OF PRESENTATION

The accompanying unaudited consolidated condensed financial statements of Health
Grades, Inc. and subsidiaries (collectively the "Company") have been prepared in
accordance with accounting principles generally accepted in the United States of
America for interim financial information and the instructions to Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements. In the opinion of
management, these statements include all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation of the results
of the interim periods reported herein. Operating results for the three and nine
months ended September 30, 2002 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2002. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2001.

DESCRIPTION OF BUSINESS

Health Grades is a healthcare quality ratings, information and advisory services
company. The Company grades, or provides the means to assess and compare the
quality or qualifications of, various types of healthcare providers. The Company
also provides profile information for a variety of providers and facilities.

The Company offers services to hospitals that are either attempting to build a
brand name reputation based upon quality of care or are working to identify
areas to improve quality. For hospitals that have received high ratings, the
Company offers the opportunity to license its ratings and trademarks and provide
assistance in their marketing programs. For providers who have not received high
ratings, the Company offers quality improvement services.

The Company provides basic and expanded profile information for a variety of
providers and facilities. This information is made available to consumers,
employers and health plans to assist them in selecting healthcare providers. The
basic profile information is available free of charge on the Company's website,
www.healthgrades.com. For certain providers, the Company offers healthcare
quality reports. These reports provide more detailed information than is
available free of charge on the healthgrades.com website. Report pricing and
content varies based upon the type of provider and whether the user is a
consumer or a healthcare professional.

All significant intercompany balances and transactions have been eliminated in
consolidation.

NEW ACCOUNTING PRONOUNCEMENTS

Business Combinations. In June 2001, the Financial Accounting Standards Board
(the "FASB") issued Statement of Financial Accounting Standards No. 141,
Business Combinations ("Statement 141"), which requires the use of the purchase
method of accounting for all business combinations initiated after June 30,
2001, establishes specific criteria for the recognition of intangible assets
separately from goodwill and requires unallocated negative goodwill to be
written off immediately as an extraordinary gain. The adoption of this
accounting pronouncement on January 1, 2002 had no effect on the Company's
financial position or results of operations.

Goodwill and Other Long-Lived Assets. In June 2001, the FASB issued Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
("Statement 142"), which prohibits the amortization of goodwill and intangible
assets with indefinite useful lives. Statement 142 also requires that these
assets be reviewed for impairment at least annually. Under Statement 142,
intangible assets with finite lives continue to be to be amortized over their
estimated useful lives. The Company adopted Statement 142 on January 1, 2002.

Statement 142 also requires companies to perform a transitional test of goodwill
for impairment, and the Company completed its test during the second quarter of
2002. Based upon the results of the test, the Company recorded a charge of
approximately $1.1 million in

6

its consolidated statement of operations for the quarter ended June 30, 2002, as
a cumulative effect of a change in accounting principle (See Note 3 - GOODWILL
IMPAIRMENT).

In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets ("Statement
144"), which addresses financial accounting and reporting for the impairment or
disposal of long-lived assets and supersedes Statement of Financial Accounting
Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions
of Accounting Principles Board Opinion No. 30, Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, to
the extent that they relate to the disposal of a segment of a business. The
Company adopted Statement 144 on January 1, 2002. The adoption of Statement 144
did not have a material effect on the Company's results of operations or
financial position.

Management has reviewed all recently issued, but not yet effective, accounting
pronouncements and does not believe any such pronouncements will have a material
impact on the Company's consolidated financial statements.

CONSOLIDATED STATEMENT OF OPERATIONS PRESENTATION

Beginning with the quarter ended September 30, 2002, the Company made certain
modifications to the classification of expenses in the accompanying consolidated
condensed statements of operations. The primary changes made were to add line
items for cost of ratings and advisory revenue, cost of physician practice
management revenue to make certain reclassifications from general and
administrative expenses to both sales and marketing and product development.

Cost of ratings and advisory revenue consists primarily of the costs associated
with the delivery of services related to the Company's Strategic Quality
Initiative ("SQI") program and its Quality Assessment and Improvement ("QAI")
program, as well as the costs incurred to acquire the data utilized in
connection with these and other products. The Company's SQI program provides
business development tools to hospitals that are highly rated by the Company.
The Company's QAI program assists hospitals in identifying and implementing
quality improvements in selected service lines. The cost of delivery of services
relate primarily to the consultants and support staff that deliver the Company's
products.

In 2002, cost of physician practice management revenue primarily consist of
consulting costs related to the delivery of limited services to physician
practices under agreements that expired at various times through September 2002.
In 2001, these costs primarily consisted of costs related to litigation with
certain former affiliated practices as well as certain consulting costs as
described above. Total litigation costs included in cost of physician practice
management revenue were approximately $4,000 and $16,000 for the three and nine
months ended September 30, 2002, respectively and approximately $237,000 and
$607,000 for the three and nine months ended September 30, 2001, respectively.

Sales and marketing costs include salaries, wages and commission expenses
related to the Company's sales efforts as well as other direct sales and
marketing costs. Product development costs relate to the development and support
of the Company's website and as well as costs incurred with respect to
development of certain components of the Company's ratings and advisory
products.

The accompanying condensed consolidated financial statements have been
reclassified to conform to the current period presentation.

NOTE 2 - RECEIVABLE FROM OFFICERS

One of the Company's officers has an outstanding debt payable to the Company
with a principal balance of $12,726, bearing interest at 9.75% per annum. This
obligation was paid in full on October 31, 2002.

NOTE 3 - GOODWILL IMPAIRMENT

As a result of the adoption of Statement 142, the Company discontinued the
amortization of goodwill effective January 1, 2002. Statement 142 also requires
companies to perform a transitional test of goodwill for impairment, and the
Company completed its test during the second quarter of 2002. Based upon the
results of the test, the Company recorded a charge of approximately $1.1 million
in its consolidated statement of operations for the quarter ended June 30, 2002,
as a cumulative effect of a change in accounting principle. Goodwill, net in the
accompanying consolidated balance sheet is shown net of the impairment charge
described above as of September 30, 2002. As of December 31, 2001, accumulated
amortization was approximately $1.7 million.

Statement 142 describes various potential methodologies for determining fair
value, including market capitalization (if a public company has one reporting
unit), discounted cash flow analysis (present value technique) and techniques
based on multiples of

7

earnings, revenue, EBITDA, and/or other financial measures. Statement 142 also
states that if a valuation technique is used that considers multiple sources of
information, such as an average of the quoted market prices of the reporting
unit over a specific time period and the results of a present value technique,
the company should apply that technique consistently period to period (i.e. In
the required annual impairment analysis in subsequent years).

As the Company consists of only one reporting unit, and is publicly traded,
management began its fair value analysis with an evaluation of the Company's
market capitalization. The Company applied a market capitalization approach by
multiplying the number of actual shares outstanding by an average market price.
The Company applied an additional premium of 30% to this valuation to give
effect to the Company's best estimate of a "control premium". As the majority of
the Company's outstanding shares are owned by Company management and two venture
capitalist investors, management believes a premium of 30% is reasonable to give
effect to additional benefits a purchase would derive from control of the
Company.

As the Company's shares are very thinly traded, management believes that any
analysis of the Company's fair value should include valuation techniques in
addition to the overall market capitalization. The Company contemplated
utilizing cost, market or income approaches. However, utilization of cost or
market approaches was not feasible, particularly given the fact that the Company
does not fall into an easily identifiable "peer group" of companies from which
to compare valuations in the form of P/E ratios, sales of similar companies,
etc. Therefore management determined to utilize an approach using the present
value of expected future cash flows as an additional valuation technique. Due to
the inherent uncertainty involved in projecting cash flows, in particular for a
growth Company, management developed a range of possible cash flows and derived
a probability-weighted average of the range of possible amounts to determine the
expected cash flow.

After deriving the market capitalization and expected cash flow valuations as
described above, the Company then applied an equal weighting to each model to
derive an overall fair value estimate of the Company. Subsequent to this
valuation, the Company compared the implied fair value of goodwill to the
carrying amount of goodwill to arrive at the final impairment loss calculation
of approximately $1.1 million.

Through December 31, 2001, the Company had recorded accumulated goodwill
amortization of $1.7 million. Application of the non-amortization provisions of
Statement 142 is expected to result in a reduction of operating expenses of
approximately $839,000 ($0.02 per share) for the year ending December 31, 2002.

Net loss and net loss per share, adjusted to exclude amortization of goodwill,
and the cumulative effect of a change in accounting principle are as follows:

Under Statement 142, the Company is required to perform additional tests for
impairment of its goodwill annually, beginning with the year ending December 31,
2002. The Company anticipates that this test will be performed in the fourth
quarter of 2002 and future years. Any impairment identified during the annual
impairment tests will be recorded as an operating expense in the Company's
consolidated statement of operations. The Company will continue to utilize the
combined market capitalization and expected cash flow approach described above
to perform its annual impairment analysis.

8

NOTE 4 - INCOME TAX REFUND

On March 9, 2002, President Bush signed into law the Job Creation and Worker
Assistance Act of 2002 ("JCWA Act"). One of the provisions of the JCWA Act
extends the net operating loss carryback provisions of the Internal Revenue Code
from two years to five years for losses incurred in 2001 and 2002. Prior to the
passage of the JCWA Act, the Company did not have the ability to utilize its
2001 tax loss to reduce prior year taxable income because the Company had no
taxable income in 2000 or 1999. With the passage of the JCWA Act, the Company
was able to carryback its 2001 tax loss to reduce taxable income in 1997. The
tax refund, which amounted to approximately $1.0 million, was received in May
2002.

NOTE 5 - STOCK PURCHASE PLAN

In February 2002, the Company's stockholders approved the Health Grades, Inc.
Stock Purchase Plan (the "Plan"). The Plan enables participating employees (the
"Participants") to purchase shares of Company Common Stock by electing to have
payroll deductions in 2002 of up to 30 percent of their annual base rate of pay
(excluding bonuses, overtime pay, commissions and severance pay) as in effect on
January 1, 2002. The share price for shares purchased under the Plan was $0.1195
per share, based upon the average of the last reported sales price on each of
the 20 trading days ending on, and including February 15, 2002, as reported on
the OTC Bulletin Board. Participants purchased a total of 1,799,973 shares with
an aggregate purchase price of approximately $215,000. Shares purchased under
the Plan are voting shares and are restricted from sale until December 31, 2002.
Under the terms of the Plan, if a Participant terminates employment with the
Company prior to December 31, 2002, no further salary reduction will be made and
the Participant will forfeit a number of shares equal to the number of shares
that would have been purchased by the employee for the period beginning on the
employee's termination date and ending on December 31, 2002. The amount
remaining to be paid from future salary reductions by the Participants for the
purchase of shares under the Plan has been shown as a reduction to stockholders'
equity in the Company's consolidated balance sheet.

NOTE 6 - STOCK OPTIONS AND WARRANTS

Effective February 7, 2002, the Company granted to its employees options to
purchase 5,782,759 shares of Company common stock. The options were granted at
$0.10, which was the closing price per share of the Company's common stock on
the OTC Bulletin Board on the date of grant. Of the total options granted,
options to purchase 4,893,104 shares of Company common stock were granted to
certain Company officers and options to purchase 889,655 shares of Company
common stock were granted to additional Company employees. Of the options
granted to certain Company officers, 13.6% of the shares underlying stock
options fully vest six months following the date of grant; 13.6% of the shares
underlying stock options fully vest in 12 months following the date of grant;
54.6% of the shares underlying stock options vest after two years following the
date of grant, subject to acceleration if certain cash flow targets were met;
and 18.2% of the shares underlying stock options vest two years following the
date of grant, subject to acceleration if certain market price targets are met
with respect to the Company's common stock. As of June 30, 2002, the
above-mentioned cash flow targets were met and the shares underlying such stock
options became fully vested.

As of September 30, 2002, the Company had 11,206,516 common shares reserved for
future issuance related to outstanding stock options and 4,170,000 common shares
reserved for future issuance related to outstanding warrants.

NOTE 7 - BANK LINE OF CREDIT

On May 13, 2002, the Company completed a line of credit arrangement (the
"Agreement") with Silicon Valley Bank. Under the terms of the Agreement, the
Company may request advances not to exceed an aggregate amount of $1.0 million
over the one-year term of the Agreement. In addition, advances under the
Agreement are limited to 75% of Eligible Accounts (as defined in the Agreement)
plus 50% of the Company's cash invested with Silicon Valley Bank. As of
September 30, 2002, the entire $1.0 million is available to the Company.
Advances under the Agreement bear interest at Silicon Valley Bank's prime rate
plus 0.75% and are secured by substantially all of the Company's assets.
Interest is due monthly on advances outstanding and the principal balance of any
advances taken by the Company are due at the end of the Agreement term. The
Company's ability to request advances under the Agreement is subject to certain
financial and other covenants. As of September 30, 2002, the Company has no
advances outstanding.

NOTE 8 - SUPPLEMENTAL CASH FLOW INFORMATION

Cash interest paid amounted to approximately $0 and $78,000 for the nine months
ended September 30, 2002 and 2001, respectively. Refunds received from income
taxes amounted to approximately $1.0 million and $2,000 for the nine months
ended September 30, 2002 and 2001, respectively.

For the nine months ended September 30, 2002, Participants in the Stock Purchase
Plan paid $150,570 for shares purchased through payroll

9

deductions. This amount has been included in cash received from financing
activities in the Company's consolidated statement of cash flows. In addition,
the remaining receivable from Plan purchases of $64,529 will be included in cash
received from financing activities in the Company's consolidated statement of
cash flows as the payroll deductions occur during the remainder of 2002.

NOTE 9 - GAIN (LOSS) FROM SALE OF ASSETS AND OTHER

During the second quarter 2002, the Company received a payment of approximately
$150,000 related to the termination of a multi-year license and content
agreement. Approximately $142,000 of this payment was recorded as income from
sale of assets and other in the Company's Consolidated Statement of Operations.

NOTE 10 - SUBSEQUENT EVENT

On or about October 10, 2002, Strategic Performance Fund - II ("SPF-II")
commenced an action in the Circuit Court of the 17th Judicial Circuit in and for
Broward County, Florida, against the Company alleging breach of two lease
agreements. SPF-II is the owner of two buildings in which one of the Company's
former affiliated practices, Orthopaedic Associates, P.A. d/b/a Park Place
Therapeutic Center ("Park Place") has leased office space. The rental
obligations run through July 7, 2007, and total approximately $2.8 million,
excluding any rental increases during such term or common area maintenance
charges. The Company, while under the corporate name of Specialty Care Network,
Inc. ("SCN"), entered into an Assignment, Assumption and Release Agreement dated
July 8, 1997, under which SCN assumed the obligations of Orthopaedic Management
Services, Inc., as Lessee, under its Lease Agreement with the owner and lessor,
Park Place Orthopaedic Center II, Ltd. On October 1, 1997, the owner of the
leased property sold its interests in the leasehold estates to SPF-II, Inc.

On June 10, 1999, SCN sold the assets of the Park Place practice, including the
leasehold interests, back to Park Place. In connection with the lease
agreements, SCN entered into an Absolute Assignment and Assumption Agreement
with Park Place. Under the Absolute Assignment and Assumption Agreement, Park
Place agreed to indemnify SCN in connection with the leasehold obligations. In
addition, SCN entered into an Indemnification Agreement with Park Place and the
individual physician owners. Under the Indemnification Agreement, the individual
physician owners (severally up to their ownership interest in the practice)
agreed to indemnify SCN in connection with the leasehold obligations.

On November 5, 2002, Health Grades filed its Answer, Affirmative Defenses and
Third-Party Complaint seeking indemnification from each of the physician owners
with respect to their several obligations. The Company is in the process of
investigating the factual and legal arguments related to the July 8, 1997,
Assignment, Assumption and Release Agreement, as well as issues concerning the
Indemnification Agreement. The Company is currently unable to determine its
potential exposure. The Company will contest its obligations under the
Assignment, Assumption and Release Agreement, fully explore SPF-II's obligations
to mitigate damages and will vigorously pursue its rights against Park Place and
the individual physician owners.

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ITEM 2:

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Statements in this section, including statements concerning the sufficiency of
available funds, anticipated future revenues, and anticipated costs to further
develop and market our Internet sites are "forward looking statements." Actual
events or results may differ materially from those discussed in forward looking
statements as a result of various factors, including failure to achieve revenue
increases, unanticipated expenditures and other factors discussed below and in
the Company's Annual Report on Form 10-K for the year ended December 31, 2001,
particularly under "Risk Factors" in Item 1.

GENERAL

Health Grades is a healthcare quality ratings, information and advisory services
company. We grade, or provide the means to assess and compare the quality or
qualifications of, various types of healthcare providers. We also provide
profile information for a variety of providers and facilities.

We offer services to hospitals that are either attempting to build a brand name
reputation based upon quality of care or are working to identify areas to
improve quality. For hospitals that have received high ratings, we offer the
opportunity to license the ratings and our trademarks and provide assistance in
their marketing programs. For providers who have not received high ratings, we
offer quality improvement services.

We provide basic and expanded profile information for a variety of providers and
facilities. This information is made available to consumers, employers and
health plans to assist them in selecting healthcare providers. The basic profile
information is available free of charge on our website, www.healthgrades.com.
With respect to certain providers, we offer healthcare quality reports. These
reports provide more detailed information than is available free of charge on
the healthgrades.com website. Report pricing and content varies based upon the
type of provider and whether the user is a consumer or a healthcare
professional.

CRITICAL ACCOUNTING POLICIES

In accordance with the Securities and Exchange Commission financial reporting
release FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting
Policies, we performed an analysis of our financial statements to identify our
Critical Accounting Policies. FR-60 defines Critical Accounting Policies as
those most important to the financial statement presentation and that require
the most difficult, subjective, complex judgments. As facts, circumstances and
financial position are subject to change at each reporting period, we will
review our Critical Accounting Policies on a quarterly basis to determine which
policies should be included. Currently, we have identified revenue recognition
(with respect to our ratings and advisory revenue) and goodwill as our two
Critical Accounting Policies.

Revenue Recognition - Ratings and Advisory Revenue

We currently derive our ratings and advisory revenue principally from annual
fees from hospitals that participate in our Strategic Quality Initiative (SQI)
program. The SQI program provides business development tools to hospitals that
are highly rated on our website. Under our SQI program, we license the Health
Grades name and our "report card" ratings to hospitals. The license may be in a
single area (for example, Cardiac) or multiple areas (for example, Cardiac,
Neurosciences and Orthopaedics.) We also assist hospitals in promoting their
ratings and measuring the success of their efforts utilizing our team of
in-house healthcare consultants. Another key feature of this program is a
detailed comparison of the data underlying a hospital's rating to local and
national benchmarks.

We recognize revenue related to these arrangements in a straight-line manner
over the term of the agreement (typically one year). We

11

follow this method because the primary deliverable under the agreement is the
license to utilize our rating over the contract term. In addition, consulting
services are performed as requested by the client as needed over the term of the
agreement. As we typically receive a non-refundable payment for the contract
term upon execution of the agreement, we record the cash payment as deferred
revenue that is then amortized on a straight-line basis to revenue over the
contract term.

Currently, the Emerging Issues Task Force (EITF) is working to reach a final
consensus regarding EITF 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables, which addresses how to account for multiple-deliverable
revenue arrangements and focuses on when a revenue arrangement should be
separated into different revenue-generating deliverables or "units of
accounting" and if so, how the arrangement considerations should be allocated to
the different deliverables or units of accounting. We continue to follow the
status of EITF 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables and, based on the tentative conclusions reached by the EITF, do not
believe the final consensus will have an impact on how we currently account for
our SQI agreements.

Goodwill

In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
(Statement 142), effective for fiscal years beginning after December 15, 2001.
Under Statement 142, goodwill is no longer amortized but is subject to annual
impairment testing. Statement 142 also requires companies to perform a
transitional test of goodwill for impairment, and the Company completed the test
during the second quarter of 2002. Based upon the results of the test, the
Company recorded a charge of approximately $1.1 million in its consolidated
statement of operations for the quarter ended June 30, 2002, as a cumulative
effect of a change in accounting principle (See Note 3 to our Consolidated
Financial Statements).

Statement 142 describes various potential methodologies for determining fair
value, including market capitalization (if a public company has one reporting
unit), discounted cash flow analysis (present value technique) and techniques
based on multiples of earnings, revenue, EBITDA, and/or other financial
measures. As described in Note 3 to our Consolidated Financial Statements,
management utilized a market capitalization and expected cash flow valuation
approach, giving equal weighting to each method, to derive its overall fair
value estimate of Health Grades. Subsequent to this valuation, we compared the
implied fair value of goodwill to arrive at the final impairment loss
calculation of approximately $1.1 million. The process of determining the fair
value of goodwill involved significant subjectivity and judgment. Various
judgments were made relating to the methodologies available for determining fair
value (including market capitalization, present value analysis, techniques based
on multiples of earnings, revenue, etc.), assumptions imbedded in our cash flow
analysis, weighting given to the various cash flow analyses generated, as well
as overall weighting given to the final combined market capitalization and
expected cash flow approach utilized by management.

Although management believes its approach of applying equal weighting to both
the market capitalization and expected cash flow valuations was reasonable,
applying different weightings to the valuations could have resulted in a range
of no impairment charge recorded to an impairment charge of approximately $2.2
million.

CONSOLIDATED STATEMENT OF OPERATIONS PRESENTATION

Beginning with the quarter ended September 30, 2002, the Company made certain
modifications to the classification of expenses in the accompanying consolidated
condensed statements of operations. The primary changes made were to add line
items for cost of ratings and advisory revenue, cost of physician practice
management to make certain reclassifications from general and administrative
expenses to both sales and marketing and product development.

Cost of ratings and advisory revenue consists primarily of the costs associated
with the delivery of services related to the Company's Strategic Quality
Initiative ("SQI") program and its Quality Assessment and Improvement ("QAI")
program, as well as the costs incurred to acquire the data utilized in
connection with these and other products. The Company's SQI program provides
business development tools to hospitals that are highly rated by the Company.
The Company's QAI program assists hospitals in identifying and implementing
quality improvements in selected service lines. The cost of delivery of services
relate primarily to the consultants and support staff that deliver the Company's
products.

In 2002, cost of physician practice management revenue primarily consists of
consulting costs related to the delivery of limited services to physician
practices under agreements that expired at various times through September 2002.
In 2001, these costs primarily consisted of costs related to litigation with
certain former affiliated practices as well as certain consulting costs as
described above.

12

Sales and marketing costs include salaries, wages and commission expenses
related to the Company's sales efforts as well as other direct sales and
marketing costs. Product development costs relate to the development and support
of the Company's website and as well as costs incurred with respect to
development of certain components of the Company's ratings and advisory
products.

The condensed consolidated statements of operations for the three and nine
months ended September 30, 2001 have been reclassified to conform with the
current period presentation.

RESULTS OF OPERATIONS

Ratings and advisory revenue. For the three and nine months ended September 30,
2002, ratings and advisory revenue was approximately $1.3 million and $3.6
million, respectively, compared to ratings and advisory revenue of approximately
$894,000 and $2.1 million for the three and nine months ended September 30,
2001, respectively. These increases are primarily the result of an increase in
the number of hospitals under our strategic quality initiative program. For the
third quarter of 2002, approximately 80% of our ratings and advisory revenue was
derived from our strategic quality initiative services, compared to 76% for the
same period of 2001. In addition, approximately 12% of our ratings and advisory
revenue was derived from our quality assessment and improvement services,
compared to 5% for the same period of 2001. Finally, 8% of our ratings and
advisory revenue was derived from licensing access to our database of
healthcare information and other services, compared to 19% for the same period
of 2001.

Physician practice service fee revenue. Physician practice service fee revenue
is recognized based upon the service agreements between the Company and the
physician practices. As of July 2002, all service agreements have expired, we
are no longer providing any practice services and we will no longer have any
revenue from practice service fees.

Cost of ratings and advisory revenue. For the three and nine months ended
September 30, 2002, cost of ratings advisory revenue was approximately 31% of
ratings and advisory revenue. For the same periods of 2001, cost of ratings and
advisory revenue as a percentage of ratings and advisory revenue was 36% and
44%, respectively. The decrease in 2002 is primarily due to the fact that we
renegotiated a data contract at the end of 2001 that reduced our cost to acquire
certain data by approximately $350,000 annually.

Sales and marketing. Sales and marketing costs decreased from $883,000 for the
three months ended September 30, 2001 to $602,000 for the same period of 2002,
and from $2.5 million to $1.6 million for the nine months ended September 30,
2001 and 2002, respectively, primarily due to personnel reductions that occurred
in the second half of 2001.

General and administrative expenses. For the three and nine months ended
September 30, 2002, general and administrative expenses were $489,000 and
$1,554,000, respectively. For the same periods of 2001, general and
administrative expenses were $774,000 and $3,191,000, respectively. Contributing
to these decreases was a significant reduction in salaries and wages expenses in
2001, due to certain voluntary and involuntary employee reductions during 2001.
Professional fees also decreased substantially as a result of cost reductions
made to areas such as consulting, legal and investor relations. During the
second quarter of 2001, we also incurred a non-recurring financing fee of
approximately $146,000. Finally, we decreased costs in several additional areas
as a result of a cost reduction effort initiated during 2001.

Amortization of goodwill. Due to the non-amortization provisions of Statement
142, we did not record amortization expense related to goodwill for the three
and nine months ended September 30, 2002, while we incurred approximately
$210,000 and $629,000, respectively, in amortization expense for the same
periods of 2001.

Income on sale of assets and other. For the nine months ended September 30,
2002, we recorded a gain of approximately $142,000 related to the termination of
a multi-year license and content agreement.

Cumulative effect of a change in accounting principle. Based upon the results of
the transitional impairment test performed on our goodwill as required by
Statement 142, we recorded a charge of approximately $1.1 million in our
consolidated statement of operations for the quarter ended June 30, 2002, as a
cumulative effect of a change in accounting principle.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2002, we had working capital of approximately $233,000, an
increase of approximately $72,000 from $161,000 as of December 31, 2001. For the
first nine months of 2002, cash flow used in operations was approximately
$20,000 compared to $3.5

13

million used in operations for the same period of 2001. This decrease in cash
flow used in operations is due principally to a decrease in our net loss from
approximately $6.6 million for the nine months ended September 30, 2001 to a net
loss of approximately $1.3 million for the same period of 2002. Included in the
net loss amount for the nine months ended September 30, 2002 is a charge related
to the cumulative effect of a change in accounting principle of approximately
$1.1 million (See Note 3 to our Consolidated Financial Statements) and an income
tax refund received of approximately $1.0 million (See Note 4 to our
Consolidated Financial Statements).

On May 13, 2002, we completed a line of credit arrangement (the "Agreement")
with Silicon Valley Bank. Under the terms of the Agreement, we may request
advances not to exceed an aggregate amount of $1.0 million over the one-year
term of the Agreement. In addition, advances under the Agreement are limited to
75% of Eligible Accounts (as defined in the Agreement) plus 50% of our cash
invested with Silicon Valley Bank. As of September 30, 2002, the entire $1.0
million is available to us. Advances under the Agreement bear interest at
Silicon Valley Bank's prime rate plus .75%. and are secured by substantially all
of the Company's assets. Interest is due monthly on advances outstanding and the
principal balance of any advances taken by us are due at the end of the
Agreement term. Our ability to request advances under the Agreement is subject
to certain financial and other covenants. As of September 30, 2002, we have no
advances outstanding.

During the second quarter of 2002, we resolved a dispute with respect to one of
our license and content agreements. In exchange for the termination of the
agreement, we received a payment of $150,000 during the second quarter.

Although we anticipate that we have sufficient funds available to support
ongoing operations for at least the next twelve months, if our revenues fall
short of our expectations or our expenses exceed our expectations, we may be
required to draw on the credit line available under the Agreement described
above, and/or raise additional capital through public or private debt or equity
financing. We may not be able to secure sufficient funds on terms acceptable to
us. If equity securities are issued to raise funds, our stockholders' equity may
be diluted. If additional funds are raised through debt financing, we may be
subject to significant restrictions. Furthermore, we typically receive a
non-refundable payment for the contract term upon execution of our strategic
quality initiative agreements. As a result, our operating cash flow is
substantially dependent upon our ability to continue to sign new agreements. Our
current operating plan includes growth in new sales from our strategic quality
initiative and quality assessment and improvement agreements. For the reasons
described above, failure to achieve our new sales plan would have a material
negative impact on our financial position and cash flow.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

None.

ITEM 4. CONTROL PROCEDURES

Kerry R. Hicks, our President and Chief Executive Officer, and Allen Dodge, our
Senior Vice President-Finance and Chief Financial Officer, have evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures within 90 days prior to the filing date of this report in accordance
with Rule 15d-15 under the Securities Exchange Act of 1934 (the "Exchange Act").
Based on their evaluation, they have concluded that our disclosure controls and
procedures provide reasonable assurance that information required to be
disclosed by us in reports we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms

There were no significant changes in our internal controls or in other factors
that could affect these controls subsequent to the evaluation described above.

PART II. OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

On or about October 10, 2002, Strategic Performance Fund - II ("SPF-II")
commenced an action in the Circuit Court of the 17th Judicial Circuit in and for
Broward County, Florida, against us alleging breach of two lease agreements.
SPF-II is the owner of two buildings in which one of our former affiliated
practices, Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center
("Park Place") has leased office space. The rental obligations run through July
7, 2007, and total approximately $2.8 million, excluding any rental increases
during such term or common area maintenance charges. While under the corporate
name of Specialty Care Network, Inc. ("SCN"), we entered into an Assignment,
Assumption and Release Agreement dated July 8, 1997, under which we assumed the

14

obligations of the owner and Lessor, Orthopaedic Management Services, Inc., as
Lessee, under its Lease Agreement with Park Place Orthopaedic Center II, Ltd. On
October 1, 1997, the owner of the leased property sold its interests in the
leasehold estates to SPF-II, Inc.

On June 10, 1999, we sold the assets of the Park Place practice, including the
leasehold interests, back to Park Place. In connection with the lease
agreements, we entered into an Absolute Assignment and Assumption Agreement with
Park Place. Under the Absolute Assignment and Assumption Agreement, Park Place
agreed to indemnify us in connection with the leasehold obligations. In
addition, we entered into an Indemnification Agreement with Park Place and the
individual physician owners. Under the Indemnification Agreement, the individual
physician owners (severally up to their ownership interest in the practice)
agreed to indemnify us in connection with the leasehold obligations.

On November 5, 2002, we filed our Answer, Affirmative Defenses and Third-Party
Complaint seeking indemnification from each of the physician owners with respect
to their several obligations. We are in the process of investigating the factual
and legal arguments related to the July 8, 1997, Assignment, Assumption and
Release Agreement, as well as issues concerning the Indemnification Agreement.
We are currently unable to determine our potential exposure. We will contest our
obligations under the Assignment, Assumption and Release Agreement, fully
explore SPF-II's obligations to mitigate damages and will vigorously pursue our
rights against Park Place and the individual physician owners.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits - The following exhibits are being filed as part of this
quarterly report on Form 10-Q.

99.1 -- Certificate of the CEO of Health Grades, Inc. pursuant to
Title 18, Section 1350 of the United States Code.

99.2 -- Certificate of the CFO of Health Grades, Inc. pursuant to
Title 18, Section 1350 of the United States Code

(b) Reports on Form 8-K - During the period covered by this report, the
Company did not file any reports on Form 8-K with the Commission.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

HEALTH GRADES, INC.

Date: November 14, 2002 By: /s/ ALLEN DODGE
-----------------------------------------------
Allen Dodge Senior Vice President - Finance and
Chief Financial Officer

15

CERTIFICATIONS

I, Kerry R. Hicks, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Health Grades,
Inc.;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:

(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and

(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: 11/14/02
---------------------------

/s/ KERRY R. HICKS
- ------------------------------------
[Signature]
President and Chief Executive Officer

16

I, Allen Dodge, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Health Grades,
Inc.;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:

(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and

(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: 11/14/02
---------------------------

/s/ ALLEN DODGE
- ------------------------------------
[Signature]
Senior Vice President - Finance and Chief Financial Officer

17

EXHIBIT INDEX