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, 2003
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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
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(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 [ ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

On October 31, 2003, 24,409,810 shares of the Registrant's common stock,
$.001 par value, were outstanding.

Health Grades, Inc. and Subsidiaries

INDEX

PART I. FINANCIAL INFORMATION:

Item 1. Condensed Consolidated Balance Sheets
September 30, 2003 and December 31, 2002................... 3

Condensed Consolidated Statements of Operations -
Three and Nine Months Ended September 30, 2003 and 2002.... 4

Condensed Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 2003 and 2002.............. 5

Notes to Condensed Consolidated Financial
Statements................................................. 6

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................ 11

Item 3. Quantitative and Qualitative Disclosures About
Market Risk................................................ 15

Item 4. Controls and Procedures ................................... 16

PART II. OTHER INFORMATION:

Item 1. Legal Proceedings.......................................... 16

Item 6. Exhibits and Reports on Form 8-K........................... 16

2

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

See accompanying notes to condensed consolidated financial statements

3

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

See accompanying notes to condensed consolidated financial statements.

4

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

See accompanying notes to condensed consolidated financial statements.

5

Health Grades, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2003

NOTE 1 - BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Health
Grades, Inc. and subsidiaries ("HealthGrades") 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, 2003 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2003. 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, 2002.

Effective December 31, 2002, we liquidated our Healthcare Ratings, Inc. and
Providerweb.net subsidiaries. This liquidation had no impact on our financial
position or operations. All significant intercompany balances and transactions
for the periods presented prior to December 31, 2002 have been eliminated in
consolidation.

DESCRIPTION OF BUSINESS

HealthGrades provides healthcare ratings, advisory services and other healthcare
information. We grade, or provide the means to assess and compare the quality or
qualifications of, various types of healthcare providers. Our hospital ratings
are available free of charge on our website, www.healthgrades.com. Our customers
include healthcare providers, employers, health plans, insurance companies and
consumers.

We offer services to hospitals that are either attempting to build a 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 our ratings and trademarks and provide assistance in their marketing
programs. For hospitals that have not received high ratings, we offer quality
improvement services.

We also provide basic and expanded profile information on a variety of providers
and facilities. We make this information available to consumers, employers and
health plans to assist them in selecting healthcare providers. For a fee, we
offer healthcare quality reports with respect to certain healthcare providers.
These reports provide more detailed information than is available free of charge
on our website. Report pricing and content varies based upon the type of
provider and whether the user is a consumer or a healthcare professional (for
example, a medical professional underwriter).

We provide online integrated healthcare quality services for employers, health
plans and other organizations that license access to our database of healthcare
providers.

We have also entered into strategic arrangements with other service providers,
including GeoAccess and J.D. Power & Associates, in an effort to increase our
name recognition and market presence, as well as enhance our service offerings.

In addition to the services noted above, which constitute our ratings and
advisory business, we also provided, through September 2002, limited physician
practice management services to musculoskeletal practices under management
services agreements. As of December 31, 2002, all of these agreements had
expired or had been terminated.

FUTURE EFFECT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Revenue Recognition

At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF) reached a
final consensus regarding EITF issue number 00-21, Revenue Arrangements with
Multiple Deliverables (EITF 00-21). The consensus provides that revenue
arrangements with multiple deliverables should be divided into separate units of
accounting if certain criteria are met. The consideration for the arrangement
should be allocated to the separate units of accounting based on their relative
fair values, subject to different reporting guidance if the fair value of all
deliverables are not known or if the fair value is contingent on delivery of
specified items or performance conditions. Applicable revenue recognition
criteria should be considered separately for each separate unit of accounting.
EITF 00-21 is effective for revenue arrangements entered into in fiscal periods
beginning after June 15, 2003.

6

During the quarter ended March 31, 2003, we completed our analysis of EITF
00-21. We examined our QAI - Phase I contracts (which we formerly called Ratings
Quality Analysis or "RQA"), QAI - Phase II contracts (which we formerly called
Quality Assessment and Improvement or "QAI") and Strategic Quality
Initiative(TM) ("SQI") contracts to determine if the adoption of EITF 00-21
would have any impact on our current revenue recognition policies. As our QAI -
Phase I contracts consist of a single deliverable (as defined by EITF 00-21),
namely a comprehensive quality analysis, no change is required with respect to
our current policy of recognizing revenue under these arrangements at the point
in time that services are delivered. In addition, as our QAI - Phase II
contracts consist of consulting services provided over the term of the contract,
no change is required with respect to our current policy of recognizing revenue
under these arrangements over the term of the contract on a straight-line basis.

Our SQI contracts contain both an analysis of quality outcomes data as well as a
license to utilize our name and certain ratings information for an annual
period. Based upon our analysis, we concluded that there was not reliable and
verifiable evidence of fair value from which to allocate the consideration
received between the two deliverables. Moreover, we believe the primary
deliverable under these agreements clearly is the license to utilize our name
and certain ratings information for an annual term. In addition, although we
sell the analysis of quality outcomes data separately via our QAI - Phase I
contracts, these contracts are generally sold to clients that have lower quality
ratings (as rated by HealthGrades) and thus may be deemed to have a more
significant value than the quality analysis imbedded within our SQI contracts.
Furthermore, some of our SQI clients never choose to receive the quality
outcomes analysis included within our SQI contracts. Based upon these factors,
we have concluded that no change is required with respect to our current policy
of recognizing revenue under these arrangements over the term of the contract on
a straight-line basis.

In the second quarter of 2003, we announced the winners of our 2003
Distinguished Hospital Award for Clinical Excellence(TM) (DHA). Winners of the
DHA represent the highest-scoring of the nation's full-service hospitals based
on a proprietary, three-year, risk-adjusted analysis of the top procedures and
diagnoses in six major clinical specialties. Similar to our SQI program, we give
DHA winners the opportunity to enter into a licensing agreement with us so that
they can enhance their marketing efforts by publicizing this award. In addition,
these agreements also contain an analysis of quality outcomes data. Based upon
the factors described above with respect to our analysis of our SQI contracts,
we have concluded that the straight-line method of revenue recognition for these
agreements is appropriate as well.

In January 2003, the Financial Accounting Standards Board (FASB) issued
Financial Accounting Standards Board Interpretation No. FIN 46 (FIN 46),
Consolidation of Variable Interest Entities. FIN 46 clarifies the requirements
of Accounting Research Bulletin No. 51, Consolidated Financial Statements, and
provides guidance to improve financial reporting for enterprises involved with
variable interest entities. FIN 46 requires a variable interest entity to be
consolidated by the company that is subject to a majority of the risk of loss or
return from the variable interest entity's activities. The consolidation
requirements of FIN 46 apply immediately to variable interest entities created
after January 31, 2003. For the variable interest entities that existed prior to
February 1, 2003, the consolidation requirements are effective for financial
statements of interim or annual periods that end after December 15, 2003. We
have completed our initial evaluation and do not believe that adoption of FIN 46
will have a significant impact on our financial statements; therefore, no
transitional disclosures have been included herein.

In April 2003, the FASB issued Statement of Financial Accounting Standards No.
149 (SFAS 149), Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. SFAS 149 amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives) and for hedging
activities. The accounting and reporting requirements will be effective for
contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. Currently, we do not have any
derivative instruments and do not anticipate entering into any derivative
contracts. Accordingly, SFAS 149 is not expected to have a significant impact on
our financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150
(SFAS 150), Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity. SFAS 150 establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument within its scope as a liability (or an asset in some circumstances),
SFAS 150 is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. SFAS 150 is not expected to have a
significant impact on our financial statements.

7

RECLASSIFICATIONS

Certain reclassifications have been made to the 2002 financial statements and
notes to conform to the 2003 presentation with no effect on consolidated net
income, equity or cash flows as previously reported.

NOTE 2 - STOCK-BASED COMPENSATION

We account for our stock-based compensation arrangements using the intrinsic
value method under the provisions of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB No. 25), and related
interpretations.

In January 2003, the FASB issued Statement of Financial Accounting Standard No.
148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and
Disclosure. SFAS 148 amends FASB Statement No. 123, Accounting for Stock-Based
Compensation, to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS
123 to require prominent disclosure in both annual and interim financial
statements of the method of accounting for stock-based employee compensation and
the effect of the method used on reported results. SFAS 148 is effective for
fiscal years, including interim periods, beginning after December 15, 2002. SFAS
148 also requires disclosure of pro-forma results on an interim basis as if the
company had applied the fair value recognition provisions of SFAS 123. We do not
expect to change to the fair value based method of accounting for stock-based
employee compensation and therefore, adoption of SFAS 148 is not expected to
impact our financial results.

The Black-Scholes option valuation model was utilized for the disclosures
required by SFAS 148. The Black-Scholes model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. For purposes of pro forma disclosure, the estimated fair value of
the options is amortized to expense over the options' vesting period. Because
compensation expense associated with an award is recognized over the vesting
period, the impact on pro forma net (loss) income as disclosed below may not be
representative of compensation expense in future years.

The fair value for options awarded during the nine months ended September 30,
2003 and 2002 were estimated using an option pricing model with the following
assumptions: risk-free interest rate over the life of the options of between
1.32% to 2.23%; no dividend yield; and expected three year lives of the options.
The volatility factors utilized ranged from 1.91 to 2.04.

The following table illustrates the effect on net loss and loss per share if we
had applied the fair value recognition provisions of SFAS 123, to our
stock-based compensation plan.

As of September 30, 2003, we had approximately 5.5 million shares underlying
options and warrants that are currently exercisable, but were not included in
our calculation of weighted average common shares outstanding as they were
antidilutive.

NOTE 3 - GOODWILL IMPAIRMENT

Goodwill, which is stated at cost, was acquired in connection with two
transactions. During 1999, we purchased a number of shares of our then
majority-owned subsidiary, HG.com, Inc., which increased our ownership in
HG.com, Inc. to 90%. This transaction resulted in $4.0 million in recorded
goodwill. In connection with a merger transaction that took place during
February 2000 from which we acquired the remaining minority interest in HG.com,
we recorded goodwill in the amount of $1.85 million based on the fair value of
our common stock issued as of the transaction date.

As a result of the adoption of Statement of Financial Accounting Standards No.
142 (SFAS 142) Goodwill and Other Intangible Assets, we discontinued the
amortization of goodwill effective January 1, 2002. SFAS 142 also required
companies to perform a transitional test of goodwill for impairment as of
January 1, 2002, and we completed this test during the second quarter of 2002.

8

Based upon the results of the test, we recorded a charge of approximately $1.1
million in our condensed consolidated statement of operations for the quarter
ended June 30, 2002, as a cumulative effect of a change in accounting principle.
Goodwill in the accompanying condensed consolidated balance sheet, as of
September 30, 2003 and December 31, 2002, is shown net of the impairment charge
described above.

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

As our shares are very thinly traded, management believes that any analysis of
HealthGrades' fair value should include valuation techniques in addition to
overall market capitalization. We contemplated utilizing cost, market or income
approaches. However, utilization of cost or market approaches was not feasible,
particularly given the fact that HealthGrades does not fall into an easily
identifiable "peer group" of companies from which to compare valuations in the
form of price/earnings 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, we then applied an equal weighting to each model to derive an
overall fair value estimate of HealthGrades. Subsequent to this valuation, we
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.

As required under SFAS 142, we performed our annual test for impairment of our
goodwill during the fourth quarter of 2002. This test resulted in no additional
impairment to our goodwill balance. We will perform the annual impairment test
in the fourth quarter of subsequent years, or, if indicators of impairment arise
at an interim date, earlier in the year. Any impairment identified during the
impairment tests will be recorded as an operating expense in our consolidated
statement of operations. We expect to continue to utilize the combined market
capitalization and expected cash flow approach described above to perform our
annual impairment analysis and interim tests if necessary. For the nine months
ended September 30, 2003, no indicators of impairment were present; therefore,
no interim impairment test was performed.

NOTE 4 - STOCK AND WARRANT REPURCHASE AGREEMENT

Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003,
between Chancellor V, L.P. (Chancellor) and us, we repurchased from Chancellor
12,004,333 shares of our common stock and warrants to purchase 1,971,820 shares
of our common stock for a total purchase price of $500,000. Chancellor initially
acquired the common stock and warrants from us in two private transactions in
2000 and 2001. Immediately prior to the repurchase, Chancellor's ownership of
HealthGrades common stock represented 33% of our outstanding common stock, and
Chancellor's ownership of HealthGrades common stock and warrants represented 36%
of our total outstanding common stock (assuming full exercise of the warrants
held by Chancellor, but assuming no exercise of any other warrants or options).

NOTE 5 - LINE OF CREDIT AND NOTE PAYABLE

Effective March 11, 2003, we executed an amendment to our line of credit
arrangement with Silicon Valley Bank. The terms of the amendment provide for an
extension of the maturity date of the $1,000,000 line of credit arrangement to
February 20, 2004. To date, we have not borrowed any funds under the line of
credit. In addition, the amendment provided for a term loan of $500,000. The
term loan accrued interest at 5.94% and requires us to pay twenty-four equal
installments of principal and interest over the term, beginning on April 1,
2003. We have the ability, at our option, to prepay all, but not less than all,
of the term loan without penalty after August

9

21, 2003, provided we give Silicon Valley Bank at least thirty days written
notice prior to such repayment. As of September 30, 2003, the outstanding
balance under the term loan was approximately $379,000.

See also NOTE 8 - SUBSEQUENT EVENTS.

NOTE 6 - 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 leases. These leases
relate to two buildings in which one of our former affiliated practices,
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
leased office space. Park Place ceased the payment of its rental obligations
with respect to the two leases in May 2002, and subsequently filed a petition
for bankruptcy, under Chapter 11 of the Bankruptcy Code, in the United States
Bankruptcy Court, Southern District of Florida, Ft. Lauderdale Division. SPF-II
is seeking damages against HealthGrades in the amount of approximately $4.7
million.

The basis of the allegation against HealthGrades is that while under the
corporate name of Specialty Care Network, Inc., we entered into an Assignment,
Assumption and Release Agreement dated July 8, 1997, under which we assumed the
obligations of Orthopaedic Management Services, Inc., as lessee, under leases
with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The agreement
was executed in connection with our acquisition of most of the non-medical
assets of the Park Place practice. On October 1, 1997, the owner of the leased
properties 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 and entered into an Absolute Assignment and
Assumption Agreement with Park Place, under which Park Place agreed to indemnify
us in connection with the leasehold obligations. In addition, we entered into an
Indemnification Agreement with Park Place and its individual physician owners,
under which the individual physician owners (severally up to their ownership
interest in the practice) agreed to indemnify us in connection with the
leasehold obligations. SPF-II alleges that, notwithstanding the assignment of
our leasehold interests to Park Place, HealthGrades remains liable for all
lessee obligations under the leases.

We filed a response to the initial complaint instituted by SPF-II, denying all
liability with respect to the subject leases. In addition, we have filed a
third-party complaint against the individual physician owners seeking
indemnification from each of these individuals under the terms of the
Indemnification Agreement. The physician owners filed a response to our
complaint denying their liability under the Indemnification Agreement, and
asserted several affirmative defenses.

See Note 8 - SUBSEQUENT EVENTS for a description of developments after
September 30, 2003.

We are subject to other legal proceedings and claims that arise in the ordinary
course of our business. In the opinion of management, these actions are unlikely
to materially affect our financial position.

NOTE 7 - SUPPLEMENTAL CASH FLOW INFORMATION

Cash interest paid amounted to approximately $13,528 and $- for the nine months
ended September 30, 2003 and 2002, respectively. Cash paid for income taxes
amounted to approximately $400 for the nine months ended September 30, 2003 and
refunds received from income taxes amounted to approximately $1,000,000 for the
nine months ended September 30, 2002.

For the nine months ended September 30, 2002, participants in our 2002 Stock
Purchase Plan (the "Plan") paid approximately $151,000 for shares purchased
through payroll deductions. This amount has been included in cash received from
financing activities in our condensed consolidated statement of cash flows. The
Plan enabled participating employees to purchase shares of our 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 Plan terminated on December 31, 2002.

NOTE 8 - SUBSEQUENT EVENTS

NOTE PAYABLE

After giving notice to Silicon Valley Bank in September 2003, we repaid the
approximately $360,000 balance of our term loan in October 2003.

10

LEGAL PROCEEDINGS

In November 2003, we executed a Settlement Agreement and Mutual Release (the
"Settlement Agreement") with SPF-II and four of the physician owners. In
consideration for the dismissal of all claims and mutual releases, HealthGrades
agreed to pay approximately $441,000 into an escrow account to be released to
SPF-II upon the satisfaction of certain conditions of the Settlement Agreement.
Payment out of escrow will be contingent upon the occurrence, on or before
September 25, 2004 of (i) the bankruptcy court approval of Chapter 11 plans
relating to Park Place and the four physician owners and (ii) the payment of a
specified amount to SPF-II pursuant to the Chapter 11 plans. In addition,
HealthGrades agreed to pay $50,000 to SPF-II on or before September 25, 2004.
These amounts have been recorded as an expense in the accompanying condensed
consolidated financial statements as of September 30, 2003.

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 level of commission expense 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, customer turnover and other factors discussed below and in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002,
particularly under "Risk Factors" in Item 1.

Overview

In evaluating our financial results and financial condition, management has
focused principally on the following:

o Revenue growth - We believe this is the key factor affecting both our
results of operations and our liquidity. In the second quarter of 2003, we
announced the winners of our 2003 Distinguished Hospital Award for Clinical
Excellence (DHA). Winners of the DHA represent the highest-scoring of the
nation's full-service hospitals based on a proprietary, three-year,
risk-adjusted analysis of the top procedures and diagnoses in six major
clinical specialties. Similar to our Strategic Quality Initiative (SQI)
program, we give DHA winners the opportunity to enter into a licensing
agreement with us so that they can market this award. For the nine months
ended September 30, 2003, our increased revenues reflected our success in
adding new hospital customers to our DHA program. In addition, we also
continued to add new hospitals to our SQI and Quality Assessment and
Improvement (QAI) programs and obtained renewals from hospitals already
enrolled in these programs. Because we typically receive payment in advance
for the annual terms of these agreements, the addition of new customers
could significantly affect our liquidity. Management is focused on
increasing revenues in other areas of our business as well. We believe the
principal risk we confront in this regard is that we may be unable to
effect market penetration and growth in these other areas.

o Operating expense considerations - During the economic slowdown in the
United States, we were successful in controlling expenses, due largely to
personnel reductions in 2001. We do not anticipate that further significant
expense reductions are feasible or advisable, particularly because we want
to be positioned to accommodate increased business if our efforts to
increase revenues further are successful. During the first nine months of
2003, we have added and anticipate we will continue to add personnel who
provide client consulting and support for our DHA, SQI and QAI programs.
Moreover, we believe it is important to provide incentives to our
continuing and new employees to contribute to the further growth of our
company. Management recognizes, however, that any increases in expenses to
accommodate growth in our business must be applied in a disciplined fashion
so as to enable us to obtain meaningful benefits from the standpoint of our
operations and cash flows. In July 2003, we paid cash bonuses of
approximately $268,000. This amount was reflected in the consolidated
statement of operations for the three and six months ended June 30, 2003.
In addition, if certain revenue and cash flow targets are met for the
second half of 2003, additional bonuses will be paid in early 2004. Based
on our progress during the third quarter, we recorded an expense of
approximately $110,000 in the consolidated statement of operations for the
three months ended September 30, 2003 as an estimate of the potential bonus
payout that was earned during this period. During the fourth quarter, we
will again evaluate our progress toward these targets and we will accrue
for potential bonus amounts if it becomes probable that such targets will
be met.

o Liquidity - We believe that recent economic conditions and our depressed
market price have provided a very challenging environment for external
financing, although we have a maximum of $1,000,000 availability under our
line of credit with a bank. Therefore, we believe that our focus must be
devoted to generating cash flow from operations. During 2002, we benefited
from significantly reduced losses from operations, as well as a $1,000,000
tax refund resulting from tax legislation enacted last year.

11

For the first nine months of 2003, we utilized cash flow from operations of
approximately $57,000. As noted above under "revenue growth" we typically
receive payment in advance for the annual term of our agreements; as a
result of sales efforts during the first nine months of 2003, advance
payments received for the annual terms of most of our agreements
contributed substantially to our cash flow. Two recent events have affected
and will affect our cash balances after September 30, 2003. As more fully
described in Note 8 to our condensed consolidated financial statements
included in this report, in October 2003 we repaid the approximately
$360,000 balance under our term loan with Silicon Valley Bank and in
November 2003 we agreed to pay approximately $491,000 to settle our lawsuit
with SPF-II. The settlement amount has been recorded as an expense in the
accompanying condensed consolidated financial statements as of September
30, 2003, although payment of the amount is contingent upon the occurrence
of certain events.

We believe our cash resources are sufficient to support ongoing operations
for the next twelve months. Nevertheless, we confront the risk that our
inability to generate revenues as expected could compel us to seek
additional financing.

o Recent Financing Activities - Effective March 11, 2003, we executed an
amendment to our agreement with a bank as described in Note 5 to our
consolidated financial statements included in this report. The terms of the
amendment provide for an extension of the maturity date of the $1,000,000
line of credit arrangement to February 20, 2004. To date, we have not
borrowed any funds under the line of credit. In addition, the amendment
provided for a term loan of $500,000. As noted above, we repaid the
approximately $350,000 balance of a term loan in October 2003. In addition,
we entered into a Stock and Warrant Repurchase Agreement, dated March 11,
2003, with Chancellor V, L.P. ("Chancellor"). Under the terms of the Stock
and Warrant Repurchase Agreement, we repurchased from Chancellor 12,004,333
shares of our common stock and warrants to purchase 1,971,820 shares of our
common stock for a total purchase price of $500,000. Chancellor initially
acquired the common stock and warrants from us in two private transactions
in 2000 and 2001. Immediately prior to the repurchase, Chancellor's
ownership of HealthGrades common stock represented 33% of our outstanding
common stock, and Chancellor's ownership of HealthGrades common stock and
warrants represented 36% of the our total outstanding common stock
(assuming full exercise of the warrants held by Chancellor, but assuming no
exercise of any other warrants or options).

CRITICAL ACCOUNTING POLICIES

In preparing our financial statements, management is required to make estimates
and assumptions that, among other things, affect the reported amounts of assets,
revenues and expenses. These estimates are most significant in connection with
our critical accounting policies, namely those of our accounting policies that
are most important to the presentation of financial condition and results of
operations and that require the most difficult, subjective, complex judgments.
These judgments often result from the need to make estimates about the effects
of matters that are inherently uncertain. For the first nine months of 2003, we
have identified evaluation of goodwill impairment and revenue recognition as our
critical accounting policies.

Goodwill Impairment

As a result of the adoption of Statement of Financial Accounting Standards No.
142, Goodwill and Other Intangible Assets (SFAS 142), we discontinued the
amortization of goodwill effective January 1, 2002. SFAS 142 also required
companies to perform a transitional test of goodwill for impairment, and we
completed this test during the second quarter of 2002. Based upon the results of
the test, 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. Goodwill in the consolidated balance
sheets included in this report is shown net of the impairment charge described
above.

SFAS 142 describes various potential methodologies for determining fair value,
including market capitalization (if a public company has one reporting unit, as
is the case with HealthGrades), discounted cash flow analysis (present value
technique) and techniques based on multiples of earnings, revenue, EBITDA,
and/or other financial measures. SFAS 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).

Consistent with the methodology utilized in 2002, for our 2003 annual impairment
test, which will occur in the fourth quarter (or sooner, if any indicators of
impairment are then present), we plan to apply an approach that provides equal
weight to market capitalization (adjusted to reflect a 30% "control premium")
and a probability-weighted average of future cash flows. As the majority of our
outstanding shares are owned by management and a venture capitalist investor, we
believe a premium of 30% is reasonable to give effect to additional benefits a
purchaser would derive from control of HealthGrades.

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As our shares are very thinly traded, we believe that any analysis of
HealthGrades' fair value should include valuation techniques in addition to the
overall market capitalization. We contemplated utilizing cost, market or income
approaches. However, utilization of cost or market approaches was not feasible,
particularly given the fact that HealthGrades does not fall into an easily
identifiable "peer group" of companies from which to compare valuations in the
form of price to earnings ratios, sales of similar companies, etc. Therefore, we
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, we will,
consistent with our previously used methodology, develop a range of possible
cash flows and derive a probability-weighted average of the range of possible
amounts to determine the expected cash flow over a five-year period. Based upon
the inherent uncertainty of future cash flows, in particular for a growth
company, we feel the utilization of a longer time period would not be
appropriate. In connection with our utilization of the expected future cash flow
approach for our present value measurements, we believe that the appropriate
discount rate to utilize for application to future cash flow estimates is the
risk-free rate of interest over the time period of the expected cash flows (or
five years in our case). This is due to the fact that in our expected cash
flows, we have already built in our assumptions concerning the uncertainty of
cash flows. Therefore, these assumptions should not be taken into account again
in determining our discount rate.

As required under SFAS 142, we performed our annual test for impairment of our
goodwill during the fourth quarter of 2002. This test resulted in no additional
impairment to our goodwill balance. As noted above, we will perform the annual
impairment test in the fourth quarter of 2003 and subsequent years or, if
indicators of impairment arise at an interim date, earlier in the year. Any
impairment identified during the annual impairment tests will be recorded as an
operating expense in our consolidated statement of operations. We expect to
continue to utilize the combined market capitalization and expected cash flow
approach described above to perform our annual impairment analysis and interim
tests, if necessary. For the nine months ended September 30, 2003, as no
indicators of impairment were present, no interim impairment test was performed.

Revenue Recognition - Ratings and Advisory Revenue

We currently derive our ratings and advisory revenue principally paid by annual
fees from hospitals that participate in our Strategic Quality Initiative (SQI)
and Distinguished Hospital Award (DHA) programs. The SQI program provides
business development tools to hospitals that are highly rated on our website.
Under our SQI program, we license to hospital customers the use of the
HealthGrades name and our "report card" ratings. The license may be in a single
area (for example, Cardiac) or multiple areas (for example, Cardiac,
Neurosciences and Orthopedics.) 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. Similar to our SQI program, we give DHA winners the
opportunity to enter into a licensing agreement with us so that they can enhance
their marketing efforts by publicizing this award.

We recognize revenue related to these arrangements in a straight-line manner
over the term of the agreement. We 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 over the term of the agreement. As we typically receive a
non-refundable payment for the first year of the contract term upon execution of
the agreement, we record the cash payment as deferred revenue that is then
amortized to revenue over the first year of the contract term. Annual payments
made in connection with renewal of our agreements are treated in the same
manner.

At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF) reached a
final consensus regarding EITF 00-21, Revenue Arrangements with Multiple
Deliverables (EITF 00-21). The consensus provides that revenue arrangements with
multiple deliverables should be divided into separate units of accounting if
certain criteria are met. The consideration for the arrangement should be
allocated to the separate units of accounting based on their relative fair
values, subject to different reporting guidance if the fair value of all
deliverables are not known or if the fair value is contingent on delivery of
specified items or performance conditions. Applicable revenue recognition
criteria should be considered separately for each separate unit of accounting.
EITF 00-21 is effective for revenue arrangements entered into in fiscal periods
beginning after June 15, 2003.

During the quarter ended March 31, 2003, we completed our analysis of EITF
00-21. We examined our QAI - Phase I contracts (formerly known as Ratings
Quality Analysis or "RQA"), QAI - Phase II contracts (formerly known as Quality
Assessment and Improvement or "QAI") and SQI contracts to determine if the
adoption of EITF 00-21 would have any impact on our current revenue recognition
policies. As our QAI - Phase I contracts consist of a single deliverable (as
defined by EITF 00-21), namely a comprehensive quality analysis, no change is
required with respect to our current policy of recognizing revenue under these
arrangements at the point in time that the services are delivered. In addition,
as our QAI - Phase II contracts consist of consulting services provided over the
term of the contract, no change is required with respect to our current policy
of recognizing revenue under these arrangements over the term of the contract on
a straight-line basis.

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Our SQI and DHA contracts contain both an analysis of quality outcomes data as
well as a license to utilize our name and certain ratings information for an
annual period. Based upon our analysis, we concluded that there was not reliable
and verifiable evidence of fair value with which to allocate the consideration
received between the two deliverables. Moreover, the primary deliverable under
these agreements is the license to utilize our name and certain ratings
information for an annual term. In addition, although we do sell the analysis of
quality outcomes data separately via our QAI - Phase I contracts, these
contracts are sold to clients that have lower quality ratings (as rated by
HealthGrades) and thus may be deemed to have a more significant value than the
quality analysis imbedded within our SQI contracts. Furthermore, some of our SQI
clients never choose to receive the quality outcomes analysis included within
our SQI contracts. Based upon these factors, we have concluded that no change is
required with respect to our current policy of recognizing revenue under these
arrangements over the term of the contract on a straight-line basis.

Were we to recognize revenue for the quality outcomes data analysis in the
period in which the services were delivered, the amount of revenues reported in
any particular period would increase or decrease, depending on the timing of the
provision of these services.

RESULTS OF OPERATIONS

Ratings and advisory revenue. For the three and nine months ended September 30,
2003, ratings and advisory revenue was approximately $2.3 million and $6.0
million respectively, compared to ratings and advisory revenue of approximately
$1.3 million and $3.6 million for the three and nine months ended September 30,
2002, respectively. These increases are primarily due to the addition of
hospital clients under our SQI and DHA programs. For the third quarter of 2003
and 2002, approximately 73% and 80%, respectively, of our ratings and advisory
revenue was derived from these services. In addition, approximately 10% of our
ratings and advisory revenue for the third quarter of 2003 was derived from our
QAI services, compared to 12% for the same period in 2002. The remainder of our
revenue for the third quarter of 2003 was derived primarily from sales of
physician reports to consumers, sales of nursing home and hospital quality
reports to professionals and reimbursement of consultant travel expenses.

Cost of ratings and advisory revenue. For the three and nine months ended
September 30, 2003, cost of ratings and advisory revenue was $510,000 and
$1,416,000, respectively, or approximately 22% and 23% of ratings and advisory
revenue, compared to $393,000 and $1,097,000, respectively, or approximately 31%
for each of the three and nine month periods of 2002. This difference is
primarily due to a reduction in costs to acquire data. During 2002, we
renegotiated a data purchase agreement with a vendor, which substantially
reduced our cost to acquire certain physician data.

Sales and marketing expenses. Sales and marketing costs include salaries, wages
and commission expenses related to our sales efforts, as well as other direct
sales and marketing costs. For our SQI, DHA and QAI agreements, we pay our sales
personnel commissions as we receive payment from our hospital clients. We
typically receive a non-refundable payment for the first year of the contract
term upon execution of the agreement. Although we typically record revenue
earned from our SQI, DHA and QAI - Phase II agreements over the term of the
agreement (typically one year), we record the commission expense in the period
it is earned, which is typically upon contract execution. We record the
commission expense in this manner because once a contract is signed, the
salesperson has no remaining obligations to perform in order to earn the
commission.

Sales and marketing costs increased from approximately $602,000 and $1,566,000,
respectively, or 47% and 44% of ratings and advisory revenue for three or nine
months ended September 30, 2002, to approximately $817,000 and $2,307,000,
respectively, or 36% and 38% of ratings and advisory revenue for the same period
of 2003. Sales and marketing costs as a percentage of ratings and advisory
revenue has decreased over the prior year due to our increased renewal base of
business. We pay a lesser percentage of contract payments as commissions to our
sales group upon renewals of contracts than we pay with respect to new
contracts. Therefore, as our business expands, we anticipate that the overall
commission cost as a percentage of ratings and advisory revenue will decline.

General and administrative expenses. For the three and nine months ended
September 30, 2003, general and administrative expenses were approximately
$656,000 and $2,057,000, an increase of approximately $167,000 and $503,000 over
general and administrative expenses of approximately $489,000 and $1,554,000 for
the same period of 2002. The increase for the three months ended September 30,
2003 relates to a charge of $110,000 for the estimate of the potential bonus
payout expected to be paid in the first quarter of 2004, that was earned during
this period. In addition, legal fees were higher during the period due to the
SPF-II litigation described in Notes 6 and 8 to our condensed consolidated
financial statements included in this report. General and administrative
expenses do not include the amount we agreed to pay to settle this litigation,
which is reported as a separate line item. The increase for the nine months
ended September 30, 2003 is primarily the result of cash bonuses paid in July
2003 totaling $268,000, the accrual for anticipated bonuses described above of
$110,000 and increased legal fees.

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Loss from Operations. For the three and nine months ended September 30, 2003,
loss from operations was approximately $522,000 and $1,230,000, respectively,
compared to $537,000 and $1,452,000 for the same period of 2002. The 2003 loss
from operations for both periods includes the $491,000 that we agreed to pay to
SPF-II as described in Notes 6 and 8 to our condensed consolidated financial
statements included in this report.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2003, we had a working capital deficit of approximately
$1,609,000, a decrease of $1,653,000 from working capital of approximately
$44,000 as of December 31, 2002. For the first nine months of 2003, cash flow
used in operations was approximately $57,000 compared to $20,000 used for the
same period of 2002. Included in cash flow used in operations for the nine
months ended September 30, 2002 was an income tax refund of approximately
$1,000,000 related to the carryback of our 2001 tax loss to reduce taxable
income in 1997 made possible by the Job Creation and Worker Assistance Act of
2002. The decrease in working capital is primarily attributable to our loss from
operations of approximately $1,230,000 for the nine months ended September 30,
2003. Despite this loss, as noted above, our cash flow used in operations was
only $57,000. This apparent disparity between the decline in our working capital
and cash flow used in operations is due to an increase in deferred income of
approximately $1,356,000, reflecting increased contractual payments that we
received but will be recognized as revenue on a straight-line basis over the
term of the contract. The payments we received significantly offset the effect
of our operating loss on our cash balance. Also contributing to our decrease in
working capital, as described in more detail in Note 4 to our consolidated
financial statements included in this report, is our repurchase from Chancellor,
pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003, of
12,004,333 shares of our common stock and warrants to purchase 1,971,820 shares
of our common stock for a total purchase price of $500,000.

Two recent events have affected and will affect our cash balances after
September 30, 2003. As more fully described in Note 8 to our condensed
consolidated financial statements included in this report, in October 2003 we
repaid the approximately $360,000 balance under our term loan with Silicon
Valley Bank and in November 2003 we agreed to pay approximately $491,000 to
settle our lawsuit with SPF-II. The settlement amount has been recorded as an
expense in the accompanying condensed consolidated financial statements as of
September 30, 2003, although payment of the amount is contingent upon the
occurrence of certain events.

We have 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 term of the Agreement, subject to 75%
of Eligible Accounts (as defined in the Agreement) plus 50% of our cash invested
with Silicon Valley Bank. As of September 30, 2003, 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 our assets.
Interest is due monthly on advances outstanding and the principal balance of any
advances taken by us are due at February 20, 2004, 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, 2003, we were in compliance
with these covenants.

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 need
to 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, upon execution of our SQI, DHA
and QAI agreements, we typically receive a non-refundable payment for the first
year of the contract term. This payment is recorded as deferred revenue, which
is reflected as a current liability in our consolidated balance sheet. Revenues
related to these agreements are recorded ratably over the term of the agreement.
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 these agreements. For the reasons described above, failure to
achieve sales plan would have a material negative impact on our financial
position and cash flow. Moreover, as noted elsewhere in this report, we have
settled the SPF-II litigation, which related to property leased by a former
affiliated practice. While we did not anticipate an outcome that would
fundamentally affect our liquidity, in the event that the settlement agreement
is not effected and the litigation therefore continues, an unanticipated result
could be materially harmful to our financial position.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have certain investments in a treasury obligation fund maintained by Silicon
Valley Bank. As of September 30, 2003, our investment in this fund amounted to
approximately $2.0 million. This amount is included within the cash and cash
equivalent line item of our balance sheet and consists of investments in highly
liquid U.S. treasury securities with maturities of 90 days or less. For

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the nine months ended September 30, 2003, interest earned on this balance was
approximately $5,100. Any decrease in interest rates in this investment account
would not have a material impact on our financial position.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

Management, with the participation of our Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness the our disclosure controls and
procedures as of the end of the period covered by this report. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures as of the end of the period covered
by this report are functioning effectively to provide reasonable assurance that
the information required to be disclosed by us in reports filed under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commission's
rules and forms. A controls system, no matter how well designed and operated,
cannot provide absolute assurance that the objectives of the controls system are
met, and no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within a company have been
detected.

(b) Change in Internal Control over Financial Reporting

No change in our internal control over financial reporting occurred during our
most recent fiscal quarter that has materially affected, or is reasonably likely
to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In November 2003, we executed a Settlement Agreement and Mutual Release (the
"Settlement Agreement") with SPF-II and four of the physician owners. In
consideration for the dismissal of all claims and mutual releases, HealthGrades
agreed to pay approximately $441,000 into an escrow account to be released to
SPF-II upon the satisfaction of certain conditions of the Settlement Agreement.
Payment out of escrow will be contingent upon the occurrence, on or before
September 25, 2004 of (i) the bankruptcy court approval of Chapter 11 plans
relating to Park Place and the four physician owners and (ii) the payment of a
specified amount to SPF-II pursuant to the Chapter 11 plans. In addition,
HealthGrades agreed to pay $50,000 to SPF-II on or before September 25, 2004.
These amounts have been recorded as an expense in the accompanying condensed
consolidated financial statements as of September 30, 2003.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits -

3.1 Amended and Restated Certificate of Incorporation, as amended (Incorporated
by reference to Exhibit 3.1 to our Annual Report on Form 10-K for the year
ended December 31, 2001).

3.2 Amended and Restated Bylaws, as amended (Incorporated by reference to
Exhibit 3.2 to our Annual Report on Form 10-K for the year ended December
31, 2001).

31.1 Certificate of the Chief Executive Officer of Health Grades, Inc. required
by Rule 15d - 14(a).

31.2 Certificate of the Chief Financial Officer of Health Grades, Inc. required
by Rule 15d - 14(a).

32.1 Certificate of the Chief Executive Officer of Health Grades, Inc. required
by Rule 15d - 14(b).

32.2 Certificate of the Chief Financial Officer of Health Grades, Inc. required
by Rule 15d - 14(b).

(b) Reports on Form 8-K.

During the quarter ended September 30, 2003, we furnished a report on Form
8-K. The report, furnished on August 6, 2003 and dated August 6, 2003,
provided information responsive to Item 7 and 12 in connection with our
second quarter results of operations.

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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, 2003 By: ALLEN DODGE
---------------------------------
Allen Dodge
Senior Vice President - Finance
and Chief Financial Officer

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EXHIBIT INDEX