QUOVADX INC - 10-Q Quarterly Report

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

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

The accompanying notes are an integral part of these condensed consolidated financial statements.

The accompanying condensed consolidated financial statements of Quovadx, Inc. (“Quovadx,” the “Company,” the “Registrant,” “we” or “us”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, we believe that the disclosures are adequate to make the information presented not misleading. The unaudited financial statements have been prepared on the same basis as our annual financial statements and reflect all adjustments, which include only normal recurring adjustments necessary for a fair presentation in accordance with U.S. generally accepted accounting principles. The results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results expected for the full year. These financial statements should be read in conjunction with the audited financial statements and accompanying notes included in our Annual Report on Amendment No. 3 to Form 10-K/A, for the year ended December 31, 2003.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The financial results for the years ended December 31, 2003 have been restated to properly account for transactions that were previously inaccurately reflected in the Company’s financial results. The cumulative effect of these restated financial statements increased the previously reported net loss by $1.8 million for the year ended December 31, 2003. These inaccuracies (a) overstated software license revenues due to the timing of delivery of software products and the accounting for certain reseller relationships (b) overstated professional services revenues due to the timing of adjustments to estimates used in determining the recognition of revenue under the percentage of completion method. The restatement also decreased current assets by $0.8 million and increased current liabilities by $1.0 million at December 31, 2003. A summary of the restatement quarterly impact is set forth below.

Net loss per common share (“EPS”) is calculated in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share.” Under the provisions of SFAS No. 128, basic EPS is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted EPS reflects the potential dilution that could occur if stock options were exercised, resulting in the issuance of common stock that would share in the earnings of the Company. Potential dilution of the stock options exercisable into common stock is computed using the treasury stock method based on the average fair market value of the stock. In periods where the Company has a net loss, the effect of all common stock equivalents is excluded from the computation of diluted EPS since

their effect would decrease the loss per share. The diluted weighted average common shares calculation for the three months ended September 30, 2004 and 2003 excludes 185,760 and 929,480 options, respectively, to purchase common stock because their effect would have been anti-dilutive under the treasury stock method and excludes all options to purchase common stock because their effect would have been anti-dilutive to the net loss.

The Company wrote down $4.4 million of capitalized software in the first quarter of 2004 due to a decision to discontinue products that resulted from management’s effort to refocus the Company’s resources to products that will generate revenues in the near term and conserve cash flows.

In the fourth quarter of 2003, the Company prepaid $0.9 million to Infotech Network Group (“Infotech”) for professional services. In March 2004, the Company paid Infotech an additional $2.1 million prepayment under an outsourcing agreement. Payments totaling $1.7 million were written off in the first quarter of 2004 because a portion of the asset was deemed not recoverable due to Infotech’s inability to provide assurances that it could deliver services in the future. The Company expensed $1.3 million of the prepaid services to cost of sales and research and development for the nine months ended September 30, 2004. As of September 30, 2004, the Company had utilized $1.3 million in prepaid services from Infotech.

The Company also wrote down $0.7 million of deferred costs related to its transaction business. The deferred costs were written down to their expected realizable value because the total balance of the asset was not recoverable due to the cancellation of certain contracts and lower than expected revenues on other contracts. As of September 30, 2004, the Company had remaining deferred costs related to its transactions business totaling $0.5 million.

On December 19, 2003, Quovadx consummated the acquisition of Rogue Wave Software, Inc. (“Rogue Wave”). In the acquisition, structured as an exchange offer, Quovadx acquired all of the outstanding stock of Rogue Wave for $4.09 in cash and 0.5292 of a share of Quovadx common stock for each share of Rogue Wave Common Stock. The total purchase price for this acquisition was $79.1 million, including 5,656,670 shares of Quovadx common stock, cash of $8.0 million, net of cash acquired, and $3.9 million in merger-related costs including transaction fees. The Company retained an independent appraiser to assist with assigning the fair values to the identifiable intangibles acquired from Rogue Wave. Goodwill, software and identifiable intangible assets acquired are $35.7 million, $5.2 million and $8.5 million, respectively.

On September 19, 2003, Quovadx consummated the acquisition of CareScience, Inc. CareScience stockholders received a fixed exchange rate of $1.40 cash and 0.1818 shares of Quovadx’s common stock for each share of CareScience common stock they owned. The purchase price, totaling $30.1 million, included 2,415,900 shares of Quovadx common stock issued in exchange for all outstanding shares of CareScience capital stock, cash of $4.7 million (net of cash acquired) and $2.3 million in merger-related costs (including transaction fees and stock option payout). The Company retained an independent appraiser to assist with assigning fair values to the identifiable intangibles acquired from CareScience. Based on this appraisal, we have recorded goodwill, software and customer base intangible assets at $12.7 million, $0.8 million and $8.6 million, respectively.

Operating results for Rogue Wave and CareScience after the date of acquisition are included in the consolidated financial statements.

The unaudited pro forma results of operations as though Rogue Wave and CareScience acquisitions had been completed as of January 1, 2003 are as follows (in thousands except for per share amounts):

In the second quarter of 2004, the Company sold its minority equity investment in Royal Health Care, LLC (“Royal”). Royal is a healthcare management services company in which Quovadx owned an equity position. The sale price of $3.1 million, paid in cash, was received on June 29, 2004. The Company recorded a $1.2 million gain on the sale of this asset. Royal continues to be a customer under a long-term ASP agreement. A director of the Company is on Royal’s board of directors.

Additionally in the second quarter, we sold technology and service contracts of Outlaw Technologies, Inc. (“Outlaw”) to a related party. Outlaw was acquired by the Company in March 2002 for $2.7 million, consisting of $1.8 million in cash and 138,575 shares of Quovadx stock. The Outlaw assets were sold to the former owner of Outlaw who is presently an employee of Quovadx for $0.2 million in cash and assumed liabilities. The Company had recorded an impairment charge on assets held for sale of $0.7 million in the first quarter of 2004; as a result, this transaction had no financial impact in second quarter 2004. Management deemed these assets did not fit into ongoing strategic plans.

Segment information has been prepared in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company defines operating segments as components of an enterprise for which discrete financial information is available and is reviewed regularly by the chief operating decision-maker or decision-making group, to evaluate performance and make operating decisions. The chief operating decision-making group reviews the revenue and margin by the nature of the services provided and reviews the overall results of the Company. Accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2003.

The Company operates in three segments: software license, professional services, and recurring services. The software license segment includes revenue from software license sales and software subscriptions. The professional services segment includes revenue generated from software implementation, development, and integration. The recurring services segment includes revenue generated from ASP outsourcing, hosting, software maintenance, transactions, and other recurring services. The segment information for the three and nine months ended September 30, 2004 is reflected in the condensed consolidated statements of operations.

Intangible assets recognized in the Company’s acquisitions are being amortized over their estimated lives ranging from three to eight years. The following table provides information relating to the Company’s intangible assets as of September 30, 2004:

The following table provides information relating to the Company’s capitalized and acquired software as of September 30, 2004:

Total capitalized software costs for the three and nine months ended September 30, 2004 and 2003 was as follows:

During the first quarter of 2004, the Company impaired $4.4 million of previously capitalized and acquired software cost due to management’s decision to discontinue marketing and developing the software products associated with these costs.

At September 30, 2004, the Company had three stock option plans and one employee stock purchase plan. The Company has elected to account for stock-based compensation arrangements using the intrinsic value method under the provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under this method, stock compensation is recognized to the extent that the exercise price is less than the market price for the underlying stock on the date of grant. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

The Company experienced a stock-compensation recovery for the forfeiture of unvested options under the fair value method due to the resignation of senior level executives during the second quarter of 2004.

In 2003, the Company established a line of credit with a commercial bank that allowed the Company to borrow cash, or issue letters of credit, up to a maximum of $4.0 million on a secured basis at the bank’s prime rate of interest. On December 9, 2003, the Company reduced the line of credit to $3.1 million. At March 31, 2004, $0.7 million of the line of credit was used to secure letters of credit on two leases, leaving the remaining $2.4 million available under the line. The revolving line of credit was secured by the Company’s assets, exclusive of intellectual property assets. The line of credit contained covenants including a minimum cash requirement, restrictions on mergers and acquisitions, obtaining additional indebtedness and dividends. At March 31, 2004, the Company received a waiver from the bank because the Company was not in compliance with the minimum cash requirement covenant. The waiver expired on May 28, 2004 and the Company terminated the line of credit.

Total comprehensive loss for the three and nine months ended September 30, 2004 and 2003 was as follows:

The foreign currency translation amounts relate to our subsidiaries in Europe and Asia.

On November 14, 2001, a shareholder class action complaint was filed in the United States District Court, Southern District of New York. On April 19, 2002, plaintiffs filed an amended complaint. The amended complaint asserts that the prospectus from the Company’s February 10, 2000 initial public offering (“IPO”) failed to disclose certain alleged improper actions by various underwriters for the offering in the allocation of the IPO shares. The amended complaint alleges claims against certain underwriters, the Company and certain officers and directors under the Securities Act of 1933 and the Securities Exchange Act of 1934 (Bartula v. XCare.net, Inc., et al., Case No. 01-CV-10075). Similar complaints have been filed concerning more than 300 other IPO’s; all of these cases have been coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. In a negotiated agreement, individual defendants, including all of the individuals named in the complaint filed against the Company, were dismissed without prejudice, subject to a tolling agreement. Issuer and underwriter defendants in these cases filed motions to dismiss and, on February 19, 2003, the Court issued an opinion and order on those motions that dismissed selected claims against certain defendants, including the Rule 10b-5 fraud claims against the Company, leaving only the Section 11 strict liability claims under the Securities Act of 1933 against the Company. A committee of our Board of Directors has approved a settlement proposal made by the plaintiffs, but the settlement is subject to a number of conditions. If the settlement is not achieved, the Company will continue to aggressively defend the claims. We do not believe that the outcome of this action will have a material adverse effect on our financial position, results of operations or liquidity; however, litigation is inherently uncertain and we can make no assurance as to the ultimate outcome or effect.

CareScience, Inc. and certain of its present and former officers were defendants in a purported shareholder class action lawsuit litigation pending in the United States District Court for the Eastern District of Pennsylvania for alleged violations of federal securities laws. The actions sought compensatory and other damages, and costs and expenses associated with litigation. The class action litigation was the result of several complaints filed with the court beginning on October 17, 2001. These actions were consolidated on November 16, 2001. The court approved the selection of the lead plaintiff in the litigation on March 12, 2002. CareScience filed a motion to dismiss the consolidated complaint on August 7, 2002. These complaints purported to bring claims on behalf of all persons who allegedly purchased CareScience common stock between June 29, 2000 and November 1, 2000, for alleged violations of the federal securities laws, including Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by issuing a materially false and misleading Prospectus and Registration Statement with respect to the initial public offering of CareScience common stock. In February 2004, an agreement was reached to settle this case, subject to court approval after notice to the former shareholders. On October 27, 2004, the Court approved the settlement and on November 1, 2004,

the Court entered its Final Order approving the settlement. The entire settlement amount will be paid by insurance, without any contribution from the Company.

On March 18, 2004, a purported class action complaint was filed in the United States District Court for District of Colorado, entitled Smith v. Quovadx, Inc. et al, Case No. 04-M-0509, against Quovadx, Inc., its now-former Chief Executive Officer and its now-former Chief Financial Officer. The complaint alleged violations of Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended, purportedly on behalf of all persons who purchased Quovadx common stock from October 22, 2003 through March 15, 2004. The claims are based upon allegations the Company (i) purportedly overstated its net income and earnings per share during the class period, (ii) purportedly recognized revenue from contracts between the Company and Infotech Network Group prematurely, and (iii) purportedly lacked adequate internal controls and was therefore unable to ascertain the financial condition of the Company. Eight additional, nearly identical class action complaints were filed in the same Court based on the same facts and allegations. The actions seek damages against the defendants in an unspecified amount. On May 17 and 18, 2004, the Company filed motions to dismiss each of the complaints. Since then, all but one of the actions, entitled Heller v. Quovadx, Inc., et al., Case No. 04-M-0665 (OES) (D. Colo.), have been dismissed. Thereafter, the plaintiff in Heller filed a first amended complaint, which asserts the same claims as those asserted in the original complaint, and includes allegations regarding the Company’s accounting for certain additional transactions. On September 8, 2004, the Court approved the appointment of David Heller as lead plaintiff. On September 29, 2004, the Court denied defendants’ motions to dismiss the first amended complaint and approved the appointment of Mr. Heller’s counsel as lead plaintiff’s counsel. On October 14, 2004, the Company and the other defendants filed answers to the first amended complaint, denying allegations of wrongdoing and asserting various affirmative defenses. The Court has set a scheduling conference in the case for November 18, 2004. The class action is still in the preliminary stages, and it is not possible for us to quantify the extent of potential liability, if any.

On March 22, 2004, a shareholder derivative action was filed in the District Court of Colorado, County of Arapahoe, entitled Marcoux v. Brown et al, against the members of the Board of Directors and certain now-former officers of Quovadx alleging breach of fiduciary duty and other violations of state law. The Company is named solely as a nominal defendant against which no recovery is sought. This complaint generally is based on the same facts and circumstances as alleged in the class action complaints discussed above, alleging that the defendants misrepresented Quovadx financial projections and that one of the defendants violated state laws relating to insider trading. The action seeks damages in an unspecified amount against the individual defendants, disgorgement of improper profits and attorney’s fees, among other forms of relief. On or about April 21, 2004, a second, nearly identical shareholder derivative complaint, seeking the same relief, was filed in the United States District Court for the District of Colorado, entitled Thornton v. Brown et al. The plaintiffs in both of the shareholder derivative actions are represented by the same local counsel. On or about May 20, 2004, a third, nearly identical shareholder derivative complaint, seeking the same relief, was filed in the District Court of Colorado, County of Arapahoe, entitled Jaroslawicz v. Brown, et al. The three shareholder derivative actions are now all pending in the Colorado state court. The Court has consolidated the three actions into a single consolidated action and has set February 1, 2005 as the deadline for the filing of a consolidated amended complaint. The shareholder derivative action is still in the preliminary stages, and it is not possible for us to quantify the extent of potential liability, if any.

claims are based upon the same theories and allegations as asserted in the Section 10(b) class actions described above. The Court denied plaintiff’s motion to consolidate this Section 11 action with the Section 10(b) cases and authorized the two competing lead plaintiff candidates to take discovery of each other in advance of a hearing on the appointment of lead plaintiff. On July 14, 2004, the Company and outside director defendants filed an answer to the complaint, denying allegations of wrongdoing and asserting various affirmative defenses. On September 8, 2004, the Court directed the plaintiff to publish new notice of pendency of this action inviting potential class members to submit motions for appointment as lead plaintiff. The deadline for filing lead plaintiff motions is November 12, 2004, the deadline for discovery related to competing lead plaintiff motions is December 15, 2004, and the deadline for further briefing on competing lead plaintiff motions is December 22, 2004. The Court stayed all discovery related to the merits of the litigation pending the appointment of a lead plaintiff. On October 4, 2004, the Company’s former CEO and CFO filed an answer to the complaint, denying allegations of wrongdoing and asserting various affirmative defenses. This class action also is in the preliminary stages, and it is not possible for us to quantify the extent of potential liability, if any.

On April 12, 2004, the Company announced that the Securities and Exchange Commission (“SEC”) had notified the Company that it’s previously announced informal inquiry has become a formal investigation pursuant to an “Order Directing Private Investigation and Designating Officers to Take Testimony.” The SEC is investigating transactions entered into during the third quarter of 2002, transactions entered into during 2003 including two distributor contracts totaling approximately $1 million and transactions between Quovadx and Infotech Network Group. The investigation is continuing, and the Company continues to provide documents and information to the SEC.

On July 28, 2004, Ronald Renjilian, a former employee, filed a Sarbanes-Oxley Whistle Blower Complaint against the Company with the US Department of Labor Occupational Safety and Health Administration. The complaint alleges that the Company’s April 30, 2004 termination of Mr. Renjilian’s employment was an action taken against Mr. Renjilian as a result of his engaging in protected activity. The Company denies any wrongdoing and intends to aggressively defend this claim. We do not believe that the outcome of this action will have a material adverse effect on our financial position, results of operations or liquidity; however, litigation is inherently uncertain and we can make no assurance as to the ultimate outcome or effect.

The Company is engaged from time to time in routine litigation that arises in the ordinary course of our business.

The Corporate Secretary of the Company is a partner of a law firm which performs legal services for the Company. The accompanying financial statements include expenses related to this law firm of $2.5 million for the nine months ended September 30, 2004.

The following discussion should be read in conjunction with the condensed financial statements and the related notes that appear elsewhere in this document.

All statements, trend analysis and other information contained in this Form 10-Q of Quovadx, Inc. (“Quovadx,” the “Company,” “we” or “us”) and the information incorporated by reference which are not historical in nature are forward-looking statements within the meaning of the Private-Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, discussion relative to markets for our products and trends in revenue, gross margins and anticipated expense levels, as well as other statements including words such as “anticipate,” “believe,” “plan,” “estimate,” “expect” and “intend” and other similar expressions. All statements regarding the Company’s expected financial position and operating results, business strategy, financing plans, and forecast trends relating to our industry are forward-looking statements. These forward-looking statements are subject to business and economic risks and uncertainties, and our actual results of operations may differ materially from those contained in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Risk Factors” below.

During the first and second quarters of 2004 a number of key events occurred that affected our business operations and business prospects and required significant senior management attention, including the restatement of previously published financial statements. Our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) resigned and were replaced by Harvey A. Wagner, Acting President & CEO, effective May 1, 2004 and Melvin L. Keating, Acting CFO, effective April 13, 2004. After these appointments, other management changes were made, primarily involving terminations and promotions in financial and sales management. On October 11, 2004, the Company announced that its board of directors appointed Harvey A. Wagner as President and CEO of the Company. Mr. Wagner’s role was made permanent effective October 8, 2004.

Internal Review. During the second quarter of 2004, we began an internal review of our historical accounting policies, practices and controls in preparation for our first quarter 2004 quarter-end closing and financial statement preparation under the new management team. As a result of this review, on May 13, 2004 we delayed reporting our first quarter 2004 Form 10-Q. Previously on March 15, 2004 we had announced the need to restate the third quarter of 2003 financial results. Our Audit Committee retained independent counsel to conduct a full investigation of our relationship with Infotech Network Group (“Infotech”) and the circumstances leading up to that restatement. Additionally, under the direction of our Board of Directors and with the advice of outside counsel and our independent registered public accounting firm, our new management conducted an internal review and investigation of prior periods to determine whether there were additional revisions to be made. As a result, we amended and refiled our 2003 annual report on Form 10-K/ A simultaneously with filing our 2004 Forms 10-Q for the first and second quarters of 2004.

SEC Proceedings. In December 2003, we were notified by the US Securities and Exchange Commission (SEC) that it was conducting an informal inquiry into selected transactions completed in the third quarter of 2002. In March 2004, we voluntarily notified the SEC that we would restate our financial results for the unaudited third quarter of 2003; after this notification, the SEC informed us that its informal inquiry would be expanded to include our relationship with Infotech Network Group and would become a formal investigation. In April 2004, we received notice from the SEC of a formal order of investigation and subpoena. The SEC has since expanded the investigation to include other customer relationships. This investigation is ongoing.

NASDAQ Listing Compliance. On August 23, 2004, the Company announced that the NASDAQ Listing Qualifications Panel confirmed that the Company had regained compliance with its periodic reporting

filing obligations and that it had satisfied all other requirements for continued listing on the NASDAQ National Market. NASDAQ will continue to monitor the Company to ensure its continued compliance with all listing requirements for the NASDAQ National Market. The Company’s trading symbol was changed from “QVDXE” to “QVDX” on August 25, 2004.

Legal Proceedings. Following our March restatement announcement, various shareholder class-action and derivative lawsuits have been filed against the Company, certain former officers and, in the case of certain of the lawsuits, against our independent directors. For a further description of the nature and status of these legal proceedings, see “Part II, Item 1 — Legal Proceedings.”

Enhanced Financial Disclosure Controls. Our ongoing internal review includes an evaluation of our policies and procedures for disclosure and internal controls, corporate governance and other processes, in order to ensure the quality, consistency and timeliness of our financial information and reporting. We continue to invest resources in upgrading our financial reporting processes and capabilities, including hiring additional personnel, utilizing outside consultants and implementing new review processes. We plan to continue investing significant resources on this initiative and in preparation for additional reporting on internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002.

We generate revenue from three segments: software licenses, professional services, and recurring services. The software license segment includes revenue from perpetual software license sales and from software subscriptions. The professional services segment includes revenue generated from software implementation, development, and integration. The recurring services segment includes revenue generated from outsourcing, hosting, software maintenance, transactions, and other recurring services.

The consolidated financial statements are prepared in conformity with United States generally accepted accounting principles which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The Company relies on significant estimates in preparing the financial statements in allocating the purchase price of its acquisitions to the assets and liabilities acquired and to evaluate the adequacy of the allowance for bad debt, the percentage of completion of fixed priced professional service contracts, the recoverability of deferred tax assets and the recoverability of capitalized software costs. Actual results could differ from those estimates. The Company believes that the following accounting policies involve a higher degree of judgment and complexity.

The Company recognizes revenue in accordance with the provisions of Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended, and SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”

Our license agreements generally provide either that customers pay a license fee based on a specified number of instances of the software on the type of software modules licensed or pay a subscription fee for a set number of years. Customers that purchase licenses, under a perpetual license agreement, generally enter into renewable one-year maintenance agreements that entitle the customer to receive unspecified updates on the licensed software, error corrections and telephone support, generally for a fixed fee.

The methodology the Company uses to recognize perpetual license software license and related services revenue is dependent on whether the Company has established vendor-specific objective evidence (“VSOE”) of fair value for the separate elements of a multiple-element agreement. If an agreement includes both license and service elements, the license fee is recognized on delivery of the software if the remaining services are not essential to the functionality of the software, the collection of the fees is probable, the fees are fixed and determinable, an agreement is signed and the Company has established VSOE of fair value for the remaining

services. Revenue from the related services is recognized as the services are provided. When the related services are essential to the functionality of the base product, or when the Company has not established VSOE of fair value for the remaining services, the software license fees are deferred and the entire contract is recognized as the services are provided. Utilizing the criteria provided in SOP 97-2, we evaluate the vendor specific objective evidence for contracts to determine the fair value of elements delivered in situations where multiple element arrangements exist.

Professional services revenue represents software development, implementation and consulting services. When derived from a fixed price contract and collection of fees is probable, the Company recognizes professional services revenue using the percentage-of-completion method of accounting. When derived from a time-and-materials contract, and the collection of fees is probable, the Company recognizes professional services revenue as the services are provided.

When revenue is recognized using the percentage-of-completion basis of accounting, the Company’s management estimates the costs to complete the services to be provided under the contract. Because the percentage-of-completion method is an estimation process, it has risks and uncertainties. The Company may encounter budget and schedule overruns caused by external factors beyond our control such as the utilization and efficiency of our consultants and the complexity of our customers’ IT environment. Adjustments to cost estimates are made in the period in which the facts requiring such revisions become known. Estimated losses, if any, are recorded in the period in which the current estimates of the costs to complete the services exceed the revenue to be recognized under the contract.

Maintenance revenue is derived from agreements for providing unspecified software updates, error corrections and telephone support. Maintenance revenue is recognized ratably over the maintenance period, which is generally 12 months.

Process management and services revenue represent application hosting, transaction processing and other services. When the fees are fixed and determinable, and collection of the fees is probable, revenue is recognized over the service period. When the fees are charged on a per-transaction basis and collection of the fees is probable, revenue is recognized as the transactions are processed.

When collection of fees is not probable, revenue is recognized as cash is collected. The Company does not require collateral from its customers.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of certain customers to pay their accounts receivable balances. The Company assesses the financial condition of its customers to determine if there is an impairment of their ability to make payments and additional allowances may be required if the financial condition of the Company’s customers deteriorates. A considerable amount of judgment is required in order to determine the realization of our receivables, including assessing the likelihood of collection and the creditworthiness of each customer.

In connection with acquisitions, we assess the fair value of assets acquired and liabilities assumed. Items such as accounts receivable, property and equipment, other intangible assets, certain accrued liabilities, and other reserves require a high degree of management judgment.

The Company recorded $48.5 million of goodwill resulting from its 2003 acquisitions. Effective January 1, 2002, SFAS No. 142 requires that goodwill be tested annually for impairment and more frequently if events or changes in circumstances indicate assets might be impaired. A significant decline in our stock price, projected revenue, projected earnings growth or projected cash flows are examples of such circumstances. The impairment test involves the use of estimates related to the fair value of the reporting units with which the goodwill is associated. The estimate of fair value requires significant judgment, including future cash flows and discount rates. Any loss resulting from an impairment test would be reflected in our statements of operations.

In connection with our acquisitions, we are required to recognize other intangible assets separate and apart from goodwill if such assets arise from contractual or other legal rights or if such assets are separable from the acquired businesses. Other intangible assets include, developed technology, customer-related assets such as order backlog, and trade name. Determining a fair value for such items requires a high degree of judgment, assumptions, and estimates, including future cash flows generated from the assets and discount rates. In certain situations, where deemed necessary, we may use third parties to assist us with such valuations. In addition, these intangible assets are to be amortized over the best estimate of their useful life. At September 30, 2004, we had intangible assets of $18.7 million, net of amortization.

We have estimated amounts for direct costs of our acquisitions, merger-related expenses, and liabilities related to our business combinations in accordance with Emerging Issues Task Force Issue 95-3, “Recognition of Liabilities in Connection with a Purchase Combination.” We also recorded significant acquisition-related restructuring charges, in connection with our abandonment of certain leased facilities acquired through our business combinations. The lease abandonment costs were estimated to include remaining lease liabilities offset by an estimate of sublease income. Estimates related to sublease costs and income are based on the assumptions regarding the period required to sublease the facilities and the likely sublease rates. Materially different reported results would be likely if any of the stated costs or expenses were different from our estimates.

Software development costs are required to be expensed until the point that technological feasibility of the product is established. Once technological feasibility is established, such costs are capitalized until the product has reached general availability. The establishment of technological feasibility and continuing evaluation of the recoverability of the capitalized software development costs requires management’s judgment with respect to the impact of external factors such as future revenue, estimated economic life and changes in software and hardware technologies. Capitalized software development costs are amortized on a straight-line basis over an estimated life, which is generally three years. The Company capitalizes internal and external labor costs incurred in developing the software once technological feasibility is attained. At September 30, 2004, the Company had $1.9 million of capitalized software development costs, net of amortization. The Company capitalized software development costs of $0.9 million and $2.2 million for the nine months ended September 30, 2004 and 2003, respectively.

The following table sets forth, for the periods indicated, certain items from the Company’s statements of operations as a percentage of total revenue:

Total revenue. Total revenue increased $6.6 million, or 46%, to $21.0 million for the three months ended September 30, 2004 from $14.4 million for the three months ended September 30, 2003. Software license revenue was $6.6 million for the three months ended September 30, 2004 an increase of $4.2 million or 184% from the three months ended September 30, 2003. The increase in software license revenue was due to the acquisitions of Rogue Wave and CareScience. The 2003 acquisitions added $5.5 million in software license revenue. A decrease in software license revenue from the Company’s legacy products partially offset the increase. Professional services revenue decreased from the third quarter of 2003 due to the completion of several large contracts in early 2004. Offsetting the decrease from contracts completion, was the addition of CareScience and Rogue Wave services revenue totaling $1.7 million for the three months ended September 30, 2004. Recurring services revenue increased 53% to $11.7 million for the three months ended September 30, 2004 from $7.7 million in the comparable 2003 period. The increase was due to the addition of CareScience and Rogue Wave which, added $4.1 million for the three months ended September 30, 2004.

Cost of revenue. Cost of revenue increased $2.1 million, or 20%, to $12.5 million for the three months ended September 30, 2004 from $10.4 million for the three months ended September 30, 2003. Cost of

revenue for the license segment increased 47% or $0.9 million to $2.8 million for the three months ended September 30, 2004 from $1.9 million for the three months ended September 30, 2004. Software amortization was $2.0 million for the three months ended September 30, 2004 an increase of 21% from $1.6 million for the period ended September 30, 2003. The increase in software amortization was caused by the addition of software acquired in the CareScience and Rogue Wave acquisitions. Professional services costs increased 9% to $3.7 million for the three months ended September 30, 2004 from $3.4 million in the comparable period of 2003. CareScience and Rogue Wave acquisitions added $1.2 million to cost of revenue related to services for the three months ended September 30, 2004. Partially offsetting the increase was a decrease in headcount. Recurring services costs increased 18% to $6.0 million for the third quarter of 2004 from $5.1 million in the comparable period of 2003. CareScience and Rogue Wave added $1.0 million to recurring services costs.

Sales and marketing. Sales and marketing expenses decreased $0.1 million, or 2%, to $4.2 million for the three months ended September 30, 2004 from $4.3 million for the three months ended September 30, 2003. The decrease is primarily related to decrease in headcount from 106 to 67 full time sales employees in third quarter of 2004 when compared to the third quarter of 2003.

General and administrative. General and administrative expenses increased $1.5 million, or 48%, to $4.5 million for the three months ended September 30, 2004 from $3.0 million from the year earlier period. The increase in general and administrative expenses was primarily due to an increase in legal and accounting expenses arising from the restatement of 2003 historical financial data, ensuing litigation and arising from our cooperation, and cooperation of our former officers, with the SEC investigation, increased costs related to Sarbanes Oxley compliance, and other consulting costs.

Research and development. Research and development expense was $3.1 million for the three months ended September 30, 2004 an increase of $0.4 million or 16% from $2.7 million for the three months ended September 30, 2003. The increase was related to the addition of CareScience and Rogue Wave research and development costs partially offset by a decrease in headcount.

Amortization of acquired intangibles. The amortization of acquired intangibles results from assets purchased through our business acquisitions. Intangible assets amortization for the three months ended September 30, 2004 increased $0.5 million from the three months ended September 30, 2003. The increase is due to the addition of CareScience and Rogue Wave intangibles assets acquired in 2003 totaling $8.6 million and $8.5 million, respectively.

Gain on sale of assets. In the third quarter of 2004, the Company sold the Healthcare.com domain name for a gain of $360,000.

Interest income. Interest income includes interest income on cash and cash equivalents. Interest income decreased for the three months ended September 30, 2004 when compared to the three months ended September 30, 2003. The decrease in interest income is due to the decrease in the Company’s cash and cash equivalents balance that were used to fund operations being partially offset by improved short term investment returns.

Income tax benefit. A provision for federal and state income taxes has not been recorded for the three months ended September 30, 2004 and 2003, as we have incurred a net operating loss for the three months ended September 30, 2004 and for the twelve months ended December 31, 2003. We believe that, based on the history of losses and other factors, the weight of available evidence indicates that it is more likely than not that we will not be able to realize our deferred tax assets, and thus a full valuation allowance has been recorded against such assets as of September 30, 2004 and December 31, 2003.

Total revenue. Total revenue increased $15.7 million, or 31%, to $66.2 million for the nine months ended September 30, 2004 from $50.5 million for the nine months ended September 30, 2003. Software license revenue was $19.5 million for the nine months ended September 30, 2004, an increase of $5.2 million or 37% from the nine months ended September 30, 2003. The increase in software license revenue was due to the addition of CareScience and Rogue Wave, which added license revenue of $3.6 million and $11.4 million,

respectively. This revenue contribution from CareScience and Rogue Wave was partially offset by slower sales in the remainder of the Company. Professional services revenue decreased from the nine months ended September 30, 2003 due to the completion of several large contracts in early 2004. Partially offsetting the decrease from contracts completion, was the addition of CareScience and Rogue Wave services revenue totaling $4.9 million for the nine months ended September 30, 2004. Recurring services revenue increased 53% to $35.2 million for the nine months ended September 30, 2004 from $23.0 million in the comparable 2003 period. The increase was primarily due to the addition of CareScience and Rogue Wave which, added $2.8 million and $8.9 million, respectively, for the nine months ended September 30, 2004.

Cost of revenue. Cost of revenue increased $15.0 million, or 47%, to $46.8 million for the nine months ended September 30, 2004 from $31.8 million from the nine months ended September 30, 2003.

$6.8 million of the increase in cost of revenue was attributable to a non-cash charge for asset impairments incurred during the first quarter of 2004. The Company wrote down $4.4 million of its internally developed and acquired capitalized software. The Company’s decision to discontinue products resulted from the new management’s effort to refocus the Company’s resources to products that would generate revenues in the near term and to conserve cash flows. In the fourth quarter of 2003, the Company prepaid $0.9 million to Infotech Network Group (“Infotech”), an Indian company, for professional services. In March 2004, the Company prepaid Infotech an additional $2.1 million for professional services; $1.7 million was written off in the first quarter of 2004 as a portion of the asset was deemed not recoverable due to the Company’s deteriorating relationship with Infotech and Infotech’s inability to provide assurances that it can deliver those services in the future. The Company also wrote down $0.7 million of deferred costs related to our transaction business. The deferred costs were written down because the total balance of the asset was not recoverable due to the cancellation of certain contracts and lower than expected revenues on other contracts.

Cost of revenue for the license segment increased 41% or $2.8 million to $9.8 million from $6.9 million. Software amortization was $6.3 million for the nine months ended September 30, 2004 an increase of 31% from $4.8 million for the nine months ended September 30, 2003. The increase in software amortization was caused by the addition of software acquired in the CareScience and Rogue Wave acquisitions. Recurring services costs increased 20% to $18.2 million for the nine month period ended September 30, 2004 from $15.2 million in the comparable period of 2003. CareScience and Rogue Wave added $3.4 million to recurring services costs. Professional services costs increased 25% or $2.4 million for the first three quarters of 2004 from $9.6 million in the comparable period of 2003. CareScience and Rogue Wave acquisitions added $3.9 million to cost of revenue related to services for the nine months ended September 30, 2004.

Sales and marketing. Sales and marketing expenses increased $3.4 million, or 28%, to $15.5 million for the nine months ended September 30, 2004 from $12.2 million for the nine months ended September 30, 2003. $6.0 million of the increase is primarily related to the CareScience and Rogue Wave acquisitions which, added 9 and 45 employees, respectively, to sales and marketing expense for the nine months ended September 30, 2004. Partially offsetting the increase was a reduction in sales employee headcount from 106 to 67 full time sales employees in third quarter of 2004.

General and administrative. General and administrative expenses increased $5.7 million, or 62%, to $14.9 million for the nine months ended September 30, 2004 from $9.2 million from the year earlier period. The increase in general and administrative expenses was primarily due to an increase in, legal and accounting expenses arising from the restatement of 2002 and 2003 historical financial data and ensuing litigation and arising from our cooperation and cooperation of our former officers, with the SEC investigation, increased costs related to Sarbanes Oxley compliance, and other consulting costs. Partially offsetting the increase in administrative expenses was a recovery of bad debt totaling $0.2 million.

Research and development. Research and development expenses increased $3.3 million, or 46%, to $10.4 million for the nine months ended September 30, 2004 from $7.2 million for the nine months ended September 30, 2003. This increase is due to personnel additions from the Rogue Wave and CareScience acquisitions that added a net increase of 14 full time employees. Capitalized software costs decreased $1.3 million to $0.9 million for the first three quarters of 2004 from $2.2 million for the first three quarters of 2003.

Amortization of acquired intangibles. The amortization of acquired intangibles results from assets purchased through our business acquisitions. Intangible assets amortization for the nine months ended September 30, 2004 increased $1.6 million from the nine months ended September 30, 2003. The increase is due to the addition of CareScience and Rogue Wave intangibles assets acquired in 2003 totaling $8.6 million and $8.5 million, respectively. The appraisal for the Rogue Wave intangible assets was completed in the third quarter of 2004.

Interest income. Interest income includes interest income on cash and cash equivalents. Interest income was flat for the nine months ended September 30, 2004 when compared to the nine months ended September 30, 2003. The lack of change in interest income is due to the decrease in the Company’s cash and cash equivalents balance that were used to fund operations being partially offset by improved short term investment returns.

Gain on sale of investment. In the second quarter of 2004, the Company sold its minority equity investment in Royal Health Care, LLC (“Royal”) Royal is a healthcare management services company in which Quovadx owned a minority equity interest. The sale price of $3.1 million in cash was received on June 29, 2004. The Company recorded a $1.2 million gain on the sale of this asset. A director of the Company is on the board of directors of Royal. In the third quarter of 2004, the Company sold the Healthcare.com domain name for a gain of $360,000.

Income tax benefit. A provision for federal and state income taxes has not been recorded for the nine months ended September 30, 2004 and 2003, as we have incurred a net operating loss for the nine months ended September 30, 2004 and for the twelve months ended December 31, 2003. We believe that, based on the history of losses and other factors, the weight of available evidence indicates that it is more likely than not that we will not be able to realize our deferred tax assets, and thus a full valuation allowance has been recorded against such assets as of September 30, 2004 and December 31, 2003.

We have historically financed our operations through a combination of private sales of common and convertible preferred stock, issuances of convertible promissory notes and public sales of common stock. Since our IPO in February 2000, we have financed our operations and acquisitions with the proceeds of that offering and cash obtained in acquisitions.

We expect to use our cash, cash equivalents and short-term investments for general corporate purposes, working capital and capital expenditures and to fund our operations. The amounts and timing of our actual expenditures will depend upon numerous factors, including the status of our product development efforts, marketing and sales activities, competition in the marketplace and the amount of cash generated by our operations. We may find it necessary or advisable to use portions of our cash, cash equivalents and short-term investments for other purposes. Pending use of our cash, cash equivalents and short-term investments for the above purposes, we intend to invest such funds in short-term, interest-bearing, investment-grade securities.

In the fourth quarter of 2003, the Company prepaid $0.9 million to Infotech Network Group (“Infotech”) for professional services. In March 2004, the Company prepaid Infotech an additional $2.1 million for professional services; $1.7 million was written off in the first quarter of 2004 as a portion of the asset was deemed not recoverable due to the deterioration of the Company’s relationship with Infotech and Infotech’s inability to provide assurances that it can deliver those services in the future.

Net cash used in operating activities was $7.4 million for the nine months ended September 30, 2004 compared to $2.4 million for the nine months ended September 30, 2003. The increase in net cash used in operating activities in 2004 compared to 2003 is mainly due to an increase in the net loss, and a $2.1 million prepayment to Infotech for professional services in March 2004.

Net cash used in investing activities was $4.5 million for the nine months ended September 30, 2004 , compared to $0.9 million provided by our investing activities for the nine months ended September 30, 2003. Net cash used in investing activities in for the nine months ended September 30, 2004 is primarily due to the

Net cash provided by financing activities was $1.1 million in for the nine months ended September 30, 2004 and $0.5 million for the nine months ended September 30, 2003. Cash provided in 2004 came from the exercise of stock options and the sale of stock through our employee stock purchase plan.

Commitments. On September 30, 2004, the Company had $0.7 million in open purchase commitments.

The Company acquired its WebAccel product from CMI Corporate Marketing, d/b/a Compuflex International (“Compuflex”) in August, 2003. An executive officer of the Company is the sole stockholder of Compuflex. Compuflex has received, and will continue to receive, royalty fees from the Company in accordance with the terms of the purchase agreement. Through September 30, 2004, the Company had paid Compuflex $0.3 million in royalty payments.

The Company’s cash, cash equivalents and short-term investment balances are expected to be sufficient to meet its anticipated liquidity needs for working capital and capital expenditures for at least the next 12 months. From January 2004 through September 30, 2004, the Company’s normal attrition and a reduction in its workforce decreased headcount by 169 positions as part of a focused effort to better align its total costs of doing business with its revenue stream and preserving cash. If additional capital resources were required for working capital or to grow our business internally, we may seek other financing arrangements. We cannot be assured that any financing arrangements will be available in amounts or on terms acceptable to us in the future.

The following risk factors could materially and adversely affect our operating results and could cause actual events to differ materially from those predicted in any forward-looking statements related to our business.

We have historically incurred losses and we may not be able to achieve profitability.

We incurred losses for the years ended December 31, 2003, 2002 and 2001. As of September 30, 2004, we had an accumulated deficit of $179.5 million. Since our IPO in February of 2000, we have funded our business primarily from the cash generated from the sale of our stock and cash flow from operations. We expect to continue to incur significant sales and marketing, research and development and general and administrative expenses that may exceed our revenue. As a result, we may experience losses and negative cash flows in the future. Failure to achieve and maintain profitability may cause our stock price to decline and impair our business and financial prospects.

We have been cooperating with the SEC with respect to a formal order of investigation and subpoena regarding certain transactions in 2002 and 2003. Cooperation with the SEC in its investigation and our own related internal investigation has required, and likely will continue to require, significant management attention and accounting and legal resources, which could adversely affect our business, results of operations and cash flows. In addition, negative developments or publicity with respect to such an investigation could cause our stock price to decline significantly. We cannot predict the outcome of the investigation. If the SEC finds wrongdoing on our part, a financial or administrative penalty may be imposed which could jeopardize our financial viability. In addition, such findings could provide basis for additional lawsuits.

Certain former officers, independent directors and the Company have been named defendants in various class action and derivative lawsuits resulting from our March 2004 restatement. The findings and outcome of the SEC investigations may affect these pending lawsuits. Under Delaware law, our charter and bylaws, we are generally obligated to indemnify our directors and officers who are named defendants in any of these lawsuits and advance legal fees and costs. We are unable to estimate our liability in these matters and we may be required to pay judgments or settlements and incur expenses in aggregate amounts that could have a materially adverse effect on our business, financial condition, results of operations and cash flows.

We currently have director and officer liability insurance that may pay a portion or all of the legal fees and costs incurred in defending against claims, settlement amounts, or, damages awarded. However, if the plaintiffs are successful, we may not have sufficient insurance to cover the judgment or our insurers may deny coverage.

For a further description of the nature and status of these legal proceedings see, “Part II, Item 1 — Legal Proceedings.”

We may encounter significant employee turnover that could reduce our ability to develop, sell, deliver, and support current and future commitments.

Due to issues experienced earlier in 2004 related to our restatements, late SEC filings, NASDAQ delisting activities and shareholder litigation, we have experienced and could continue to encounter a significant increase in departures of key employees from the Company. While we are taking steps to support employee retention, there can be no assurances that key employees will not leave the Company for other jobs thus impairing our ability to meet commitments and sustain revenue.

Our investors, customers, suppliers, current employees and prospective employees may react adversely to the restatement of our historical financial statements.

Our future success depends largely upon the support of our customers, suppliers, employees, prospective employees and investors. The restatement of our historical financial statements and our inability to file on a timely basis all of our first quarter 10-Q has resulted in negative publicity about us, could continue to have a negative impact on the market price of our common stock, and could cause some of our customers or potential customers to refrain from purchasing or defer decisions to purchase our products and services. Additionally, current or potential suppliers may re-examine their willingness to do business with us, to develop critical interfaces to our products or to supply products and services if they lose confidence in our ability to fulfill our commitments. Employees and prospective employees may factor in these uncertainties relating to our stability and the value of any equity-based incentives in their decisions regarding employment opportunities and decide to leave our employ. Any of these losses could have a material adverse effect on our financial and business prospects.

We may be immediately delisted from Nasdaq if we cannot meet the more stringent criteria Nasdaq recently established for our continued listing.

We failed to timely file our first quarter 2004 Form 10-Q with the SEC and NASDAQ. As a result, the NASDAQ Stock Market initiated delisting procedures. On August 9, 2004, NASDAQ informed us that we had been granted an exception to their continued listing standards. However, our continued listing depends on our ability to timely file all periodic reports for reporting periods ending on or before September 30, 2005, and we will not be able to request an automatic extension to prolong the deadline. If we are late in making any filing during that period, we may be delisted immediately with no right to a hearing or appeal. Additionally, we must continue to meet all other continued listing requirements; or failure to do so may result in a notice of delisting to which we would be able to request a hearing. Our continued delisting vulnerability may result in further loss of investor confidence, loss of analyst coverage and depression of our stock price, which could have a material adverse affect on our business and financial prospects.

Our operating results are likely to fluctuate significantly and may fail to meet the expectations of securities analysts and investors, causing our share price to decline.

Our operating results have fluctuated significantly in the past and are likely to fluctuate in the future. Moreover, our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that event, our stock price would likely decline. Further declines in our stock price may impair our business prospects and our financial condition. As a result of our limited history of profitable operations, our business strategy, and the evolving nature of the markets in which we compete, we may have difficulty accurately forecasting our revenue in any given period. In addition to the factors discussed elsewhere in this section, a number of factors may cause our revenue to fall short of our expectations or cause fluctuations in our operating results, including:


	•	delay in our introduction of new applications, services and products offerings and enhancements of our existing solutions;

	•	the capital and expense budgeting decisions of our existing and prospective customers;

	•	the loss of one or more major customers;

	•	the amount and timing of operating costs and capital expenditures relating to the implementation of our business strategy;

	•	increased product development and engineering expenditures required to keep pace with technological changes;

	•	overall economic conditions of the U.S. and the rest of the world;

	•	overall economic conditions in the software and information systems, healthcare, telecommunications, financial services and defense industries;


	•	the size, type and timing of individual license transactions;

	•	the adoption of new technologies;

	•	our success in expanding our direct sales force and indirect distribution channels;

	•	levels of international sales; and

	•	obsolescence of our products or the programming languages that our products are designed to enhance.

We operate in an industry with rapidly changing technology and, if we do not successfully modify our products to incorporate new technologies or introduce new products, our sales will suffer.

The software market in which we compete is characterized by (1) rapid technological change, (2) frequent introductions of new products, (3) changing customer needs and (4) evolving industry standards. To keep pace with technological developments, evolving industry standards and changing customer needs, we must support existing products and develop new products. We may not be successful in developing, marketing and releasing new products or new versions of our products that respond to technological developments, evolving industry standards or changing customer requirements. Further, we may face significant competition from open source software offerings, provided to users on a no-charge or extremely low-charge basis. We may also experience difficulties that could delay or prevent the successful development, introduction and sale of these enhancements. In addition, these new products or enhancements may not adequately meet the requirements of the marketplace and may not achieve any significant degree of market acceptance. If release dates of any future products or enhancements are delayed, or if these products or enhancements fail to achieve market acceptance when released, our business, operating results and financial condition could be materially adversely affected. In addition, new products or enhancements by our competitors and open source offerings may cause customers to defer or forego purchases of our products, which could have a material adverse effect on our business, financial condition and results of operations.

Our primary Enterprise Application Integration product offering is sold primarily to the hospital market, and sub-segments of this market are close to saturation, and therefore revenues may decrease within this market segment. In addition, the primary development tools sold by our Rogue Wave division target the C++ programming language, which is diminishing in usage when compared with other programming languages such as Java. We expect that the revenues for these tools may decline over time. In addition, our performance depends on organizations requiring information delivery, and seeking outside vendors to develop, manage and maintain this software for their critical applications. Many of our potential customers have made significant investments in internally developed systems and would incur significant costs in switching to our products, which may substantially inhibit the growth of our software. If the market fails to grow, becomes saturated, or declines, our sales will be adversely affected. In addition, a weakening global economy or diverted focus of information technology departments on issues related to regulatory compliance may lead to longer sales cycle and slower sales growth.

We are engaged in several large software development projects; failure to complete any one of these projects could have adverse consequences on our services revenues and business prospects.

We are engaged in several large, multi-year, custom software development projects. These projects require that we staff them with experienced personnel. Our relatively high levels of personnel turnover have affected our ability to staff and manage these projects. Additionally, this type of development project requires close collaboration with the client, particularly in managing the change-order process, and presents factors that are often outside of our control. The length and nature of these projects expose us to the risk of not completing the project on time or at all, or within budget or as expected by the client, any of which could result in our not being paid for work already performed or could lead to complex and expensive litigation, any of which could materially, adversely affect our financial and business prospects.

Professional services is a very competitive market that is highly dependent on the quality of our staff and service image. We face much larger competitors in this market segment who have considerably more resources to draw from than we have. As a result, the loss of key employees is a risk factor in this business which has the potential to be further impacted by any perceived corporate instability beyond what has already been encountered. These issues also impact our service image to present and prospective customers and could cause contract delays. Consequently, professional services revenue may continue to decline for the Company.

Our public stock price has fallen substantially and may fall further, negatively impacting its investment desirability.

Since the disclosure of our restatement of financial statements and the formal investigation by the SEC, our stock price has been trading well below the $5.00 per share minimum threshold established by many institutional investors as criteria for ownership . We have no assurance that the stock price will rise to previous levels. These factors may have contributed to reducing the trading activity in our stock and could further reduce the investment quality of our stock.

Several segments of our business rely on the effectiveness of channel partners and third-party influencers to help achieve revenue goals. If we fail to increase and maintain our channel relationships, our business may suffer.

Relationships with established channel partners are critical to our success. These relationships include independent software vendors (ISV), distributors, co-marketers and system integrator relationships. To date, we have established a number of these relationships and we rely on these partners’ ability to assist us in generating increased acceptance and use of our applications, services, and product offerings. The other parties to these relationships may not view these relationships with us as significant to their own business, and they may reassess their commitment to us or decide to compete directly with us in the future. We generally do not have agreements that prohibit them from competing against us directly or from contracting with our competitors. Additionally, we cannot guarantee that any such party will perform its obligations as agreed or contemplated or that we would be able to specifically enforce any agreement with it.

We are subjected to many risks because our business is dependent on our intellectual property rights.

We are exposed to infringement risks. Our intellectual property is important to our business. We may be subject to intellectual property infringement claims as the number of our competitors grows and the functionality of our applications overlaps with competitive offerings. These claims, whether or not meritorious, could be expensive, divert our attention from operating our company, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements, any of which could seriously harm our business, financial condition and results of operations. If we become liable to third parties for infringing on their intellectual property rights, we would be required to pay a substantial damage award and to develop non-infringing technology, obtain a license or cease selling the applications that contain the infringing intellectual property. We may be unable to develop non-infringing technology or obtain a license on commercially reasonable terms, or at all. In the event an intellectual property claim against us was successful and we could not obtain a license on acceptable terms, license a substitute technology or redesign to avoid infringement, most of our contracts would require us to refund a portion of the software license fees; our business, financial condition and results of operations would be seriously harmed. In addition, we may not be able to protect against misappropriation of our intellectual property. Third parties may infringe upon our intellectual property rights, we may not detect this unauthorized use and we may be unable to enforce our rights.

We rely on third parties for technology in our products. We depend upon third-party suppliers and licensors to provide software that is incorporated in certain of our products and the products that we distribute. We have no control over the scheduling and quality of work of these third-party software suppliers and licensors. Additionally, the third-party software may not continue to be available to us on commercially reasonable terms, or at all. Our agreements to license certain third-party software will terminate after specified

dates unless they are renewed. In the event we were to have a dispute with a third party regarding our rights under an agreement, the third party may have the right to terminate our use of such software and/or obtain damages. We expect to sell multiple products to the same customers and problems with the third party technology in one product may adversely affect sales of other products to the same customer.

Certain products include so called “open source” software. In some cases open source software imposes on us certain requirements to license others both the open source software as well as software that relates to, or interacts with, or is a derivative work of open source software. These open source license terms may be ambiguous and may result in unanticipated obligations regarding our products, including the obligation to make source code available. Because open source software is generally available, it cannot be protected as a trade secret and competitors and others would have access to such software and the right to modify or distribute such software. Also, in many instances where we obtain open source software, we would not be able to determine if the provider of such code has legal right to provide such code to the company on the open source license terms.

Our products may be affected by unknown software defects. Our products depend on complex software, both internally developed and licensed from third parties. Complex software often contains defects, particularly when first introduced or when enhancements or new versions are released. Although we conduct extensive testing, we may not discover software defects that affect our new or current products or enhancements until after they are deployed. To date, we have not experienced any material software defects, however despite continued testing, defects may occur in our software. These defects could cause performance interruptions, which could damage our reputation with existing or potential customers, increase our service costs, cause us to lose revenue, delay market acceptance or divert our development resources, any of which could cause our business to suffer.

If security of our customer and patient information is compromised, patient care could suffer, we could be liable for damages and our reputation could decline.

We retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that our facilities and infrastructure are perceived by the marketplace to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. If we fail to meet our clients’ expectations or violate any provision of our business associate relationship under the Health Insurance Portability and Accountability Act of 1996, we could be liable for damages and our reputation could suffer. In addition, patient care could suffer and we could be liable if our systems fail to deliver correct information in a timely manner. Our insurance may not protect us from this risk.

If our application and transaction hosting services suffer interruptions, our business and reputation could be harmed.

In the past, our customers have experienced some interruptions with our application and transaction hosting services. Similar interruptions may continue to occur from time to time. These interruptions could be due to hardware and operating system failures. We currently process customer applications, transactions and data at our facilities in Albuquerque, New Mexico and Philadelphia, Pennsylvania as well as in a third-party hosting facility in California. Although we have safeguards for emergencies in each location, we do not have fully operational procedures for information processing facilities if either primary facility is not functioning. The occurrence of a major catastrophic event or other system failure at any of these facilities could interrupt data processing or result in the loss of stored data. In addition, we depend on the efficient operation of Internet connections from customers to our systems. These connections, in turn, depend on the efficient operation of web browsers, Internet service providers and Internet backbone service providers, all of which have had periodic operational problems or experienced outages. Any system delays, failures, or loss of data, whatever the cause, could reduce customer satisfaction with our applications, services and product offerings.

We expect a portion of our recurring services to be derived from customers who use our application and transaction hosting services. As a result, our business will suffer if we experience frequent or long-term system interruptions that result in the unavailability or reduced performance of our hosting service. We expect to experience occasional temporary capacity constraints due to sharply increased traffic, which may cause unanticipated system disruptions, slower response times, impaired quality, and degradation in levels of customer service. If this were to happen on more than an occasional and temporary basis, our business and reputation could be seriously harmed.

If we fail to meet performance standards we may experience a decline in revenue.

Many of our transaction and hosting service agreements contain performance standards. If we fail to meet these standards, our customers could terminate their agreements with us. The loss of any of those service agreements would cause a decline in our revenue. Additionally, we may be unable to expand or adapt our transaction and hosting network infrastructure to meet new demands on a timely basis and at a commercially reasonable cost, or at all.

If compliance with government regulation of healthcare becomes costly and difficult for our customers, we may not be able to grow our business.

Participants in the healthcare industry are subject to extensive and frequently changing regulation under numerous laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. Furthermore, our healthcare service provider and payer customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

The healthcare market itself is highly regulated and subject to changing political, economic and regulatory influences. These factors affect the purchasing practices and operations of healthcare organizations. Changes in current healthcare financing and reimbursement systems, such as modifications which may be required by the Health Insurance Portability and Accountability Act of 1996, may cause us to make unplanned enhancements of software applications or services, result in delays or cancellations of orders, or result in the revocation of endorsement of our applications and services by healthcare participants. The effect of HIPAA is difficult to predict and there can be no assurances that we will adequately address the business risks created by HIPAA and its implementation or that we will be able to take advantage of any resulting business opportunities.

Federal and state legislatures have periodically considered programs to reform or amend the U.S. healthcare system at both the federal and state level. These programs may contain proposals to increase governmental involvement in healthcare, lower reimbursement rates or otherwise change the environment in which healthcare market participants operate. Healthcare market participants may respond by reducing their investments or postponing investment decisions, including investments in our applications and services. We do not know what effect any proposals would have on our business.

Because we provide software used within medical management processes, we may be liable for the denial of payments for medical claims or medical services.

One of the functions of our applications is automatic adjudication of whether a claim for payment or service should be denied or whether existing coverage should be continued based upon particular plans, contracts and industry-standard, clinical-support criteria. Our payer customers are ultimately responsible for deciding whether to deny claims for payment or medical services. It is possible, however, that our customers may assert that we are liable for denying payment of covered medical claims or medical service. The contractual protections included in our customer contracts and our insurance coverage may not be sufficient to protect us against such liability.

As we continue to build our international sales, we are subject to increased regulation and uncertainties in the international marketplace.

Among other things, our core products contain strong encryption technology that is subject to export control regulation. These regulations prohibit us from selling in certain countries and to certain persons. Our inadvertent failure to properly restrict our sales could subject us and our management to fines and other sanctions and impair our financial condition and our reputation. Additionally, in the international marketplace we face increased uncertainty of enforcement of contractual provisions and enforcement of judgments in our dealings with non-U.S. persons. Our inability to properly defend or enforce our contract rights could materially impair our business prospects and financial condition.

We may face product-related liabilities that could force us to pay damages, which would hurt our reputation and financial condition.

Although both we and our customers test our applications, services and product offerings, they may contain defects or result in system failures. These defects or problems could result in the loss of or delay in generating revenue, loss of market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation or increased insurance costs. In particular, we market software products that are designed to assist our healthcare customers in meeting their HIPAA compliance obligations. Failure of these products to perform as intended could cause our customers to incur significant fines and penalties for non-compliance, which in turn could result in damages and claims against us. Our contracts generally limit our liability arising from our errors; however, these provisions may not be enforceable and may not protect us from liability. While we have general liability insurance that we believe is adequate, including coverage for errors and omissions, we may not be able to maintain this insurance on reasonable terms in the future. In addition, our insurance may not be sufficient to cover large claims and our insurer could disclaim coverage on claims. If we are liable for an uninsured or underinsured claim or if our premiums increase significantly, our financial condition could be materially harmed.

If we do not establish and maintain our brands, our reputation could be adversely affected.

In order to increase our customer base and expand our online traffic, we must establish, maintain and strengthen our brands. For us to be successful in establishing and maintaining the awareness and reputation of our brands, professionals in the healthcare and other targeted markets must perceive us as offering quality, cost-effective products, services and solutions. Our reputation and brand names could be harmed if we experience difficulties in introducing new applications, services and solution offerings, if these offerings are not accepted by customers, if we are required to discontinue existing applications, offerings or if our products, services and solutions do not function properly.

Legislative and regulatory actions may continue to cause our operating expenses to increase.

The Sarbanes-Oxley Act of 2002 and newly proposed or enacted rules and regulations of the SEC or NASDAQ, impose duties on the Company and its executives, directors, attorneys and auditors. In order to comply with the Sarbanes-Oxley Act and any new rules promulgated by the SEC or NASDAQ, we have been and may continue be required to hire additional personnel and use additional outside legal, accounting and advisory services. Any of these developments that materially increase our operating expenses will, accordingly, reduce our net income.

We have made changes to our senior management team, diverting attention from strategic planning and business operations that could negatively affect our results of operations.

In April 2004 we replaced our chief executive officer and chief financial officer; in May we replaced our executive vice president of sales. It may take some time for this new management team to develop strong working relationships, re-establish momentum in sales efforts, and to reformulate and begin to execute our strategic plan and operating plan. In addition, new management’s ability to complete this process has been and continues to be hindered by its need to spend significant time and effort dealing with internal and external

investigations, enhancing corporate governance procedures, strengthening reporting lines and reviewing and enhancing internal controls. We cannot give assurance that this restructuring of the senior management team, and the accompanying distractions, will not adversely affect our results of operations.

Benefits expected from our 2003 acquisitions may not be fully realized because of integration and other challenges.

The benefits of the acquisitions completed during 2003 may not be fully realized which could have a material adverse effect on the combined business and results of operations because of the following challenges:


	•	incorporating and leveraging technology and products across Quovadx divisions;

	•	preserving acquired technical knowledge;

	•	maintaining momentum in the sales growth of Rogue Wave and CareScience product offerings;

	•	retaining essential staff from the acquisitions;

	•	realizing anticipated cost savings in a timely manner; and

	•	incurring unanticipated expenses related to the integration of the acquisitions.

Expenses related to the 2003 acquisitions could adversely affect the Company’s combined financial results.

Quovadx has incurred direct transaction costs of $6.9 million in connection with the acquisitions. If Quovadx does not achieve the expected benefits of the merger, the combined company’s financial results, including earnings per share, could be adversely affected.

We currently develop and market our products primarily in the United States. As a majority of sales are currently made in U.S. dollars, a strengthening of the dollar could make our product less competitive in foreign markets. Since the U.S. dollar is considered the primary currency for the Company’s international operations, transactions that are completed in a foreign currency are translated into U.S. dollars and recorded in the financial statements. Translation gains or losses were not significant in any of the periods presented and the Company does not believe it is currently exposed to any material risk of loss on this basis. The Company does not currently use any hedging strategies to minimize any translation risks.

Our interest income is sensitive to changes in the general level of U.S. interest rates. Due to the short term-term nature of our investments, we believe that there is no material interest risk exposure. Based on the foregoing, no quantitative disclosures have been provided.

The Company’s Chief Executive Officer and Acting Chief Financial Officer have evaluated the effectiveness of the company’s disclosure controls and procedures as of September 30, 2004. This included an evaluation of disclosure controls and procedures applicable to the period covered by and existing through the filing of this periodic report. Based on that review, the Company’s Chief Executive Officer and Acting Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information the Company is required to disclose in its reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported accurately. As noted below, however, we have identified weaknesses in our internal controls that existed during periods prior to September 30, 2004.

As more fully described elsewhere in this Form 10-Q, we postponed the release of our financial results for the quarter ended March 31, 2004. On March 15, 2004 we announced that we would delay the filing of our annual report on Form 10-K for the year ended December 31, 2003 to restate our 2003 third quarter financial results and revise our previously announced preliminary 2003 fourth quarter and full year financial results. On

April 12, 2004 we announced the resignation of the company’s President and Chief Executive Officer and of the Chief Financial Officer. On May 13, 2004, we announced that new management had identified certain issues that might further affect our 2003 financial statements. Additionally, we announced that the company was conducting a review of past accounting practices. During the course of our review, and with the assistance of our independent registered public accounting firm, we determined that the accounting with respect to certain prior period transactions required adjustments. As a result, we restated our consolidated financial statements for the years ended December 31, 2003 and 2002.

In connection with our restatements, we and our independent registered public accounting firm identified and reported to our audit committee significant internal control matters that collectively constitute “material weaknesses.” These internal control matters, any one or more of which may individually or together constitute a material weakness, included without limitation: inadequate management level controls; inadequate credit screening procedures and controls; inadequate shipping procedures and controls; inadequate procedures for adding new products to the products available for sale; inadequate controls over the price book and inadequate procedures for establishing revenue recognition on services. Additionally, in connection with our activities to comply with the requirements of Sarbanes-Oxley Section 404, we have identified areas where internal controls need to be enhanced.

Beginning in April 2004, through the filing date of this report, we have been implementing changes to address these internal control weaknesses. These measures include the following:


	•	We hired a new President and Chief Executive Officer and a new Acting Chief Financial Officer who have expertise in financial controls and reporting, to improve the overall quality and level of experience in our finance and accounting organization.

	•	We implemented a Code of Business Conduct and Ethics. We have communicated to senior management and all employees the importance of these requirements, which each has acknowledged, and we will be conducting training on the Code.

	•	We implemented a formal whistle blower reporting system through a third party provider to enable employees to identify potential concerns or ethical issues on an anonymous basis. We have communicated to employees the availability of this system and are conducting training on this system.

	•	We have made improvements to our shipping procedures to provide more detailed information regarding product shipments and we have consolidated our shipping function to one location. We have completed these changes in our Rogue Wave Software and Integration Solutions division; no changes were required in the CareScience division which licenses its software on an ASP basis.

	•	We have improved our procedures for verifying the creditworthiness of prospective customers.

	•	We have made changes to procedures for estimating fees and have established revenue recognition on our services work.

	•	We have initiated additional training of our sales organizations regarding revenue recognition rules.

	•	We have formed a multidisciplinary price book committee that will control new product introductions and determine legal and accounting requirements for all products; implementation of processes to improve communication among our various functional groups during the transaction approval and contract negotiation phases.

	•	We have enhanced our disclosure committee and increased the committee’s authority.

We plan to take additional steps to strengthen our internal controls, including; implementation of processes to improve communication among our various functional groups during the transaction approval and contract negotiation phases; and improved operating controls and reporting processes.

We also note, however, that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints. Because of the inherent limitations

in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our control systems as we develop them may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

In connection with the Company’s efforts to comply in 2004 with Section 404(a) of the Sarbanes-Oxley Act, we have retained an independent risk consulting firm to assist with the analysis and testing. We expect that in response to their findings we will implement changes in internal controls and procedures and that additional changes will be made on an ongoing basis as business needs require. Based on the control evaluation, testing and remediation performed to date, we have not identified any material control weaknesses, as defined under the standards and rules issued by the Public Company Accounting Oversight Board (PCAOB) and approved by the SEC. We have identified several control issues, which if not remediated before year-end, may be determined to be significant deficiencies. Such deficiencies, if any, would be reported to the Company’s independent external auditors and the audit committee of the board of directors.

Except for the improvements described above, there have been no other changes in our internal control over financial reporting during the quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. No significant changes were made in the Company’s internal controls during the third quarter of 2004.

Appearing as exhibits to this report are the certifications of our chief executive officer and acting chief financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures, and changes in internal control over financial reporting, referred to in paragraphs 4(c) and (d) of the certifications. This Item 4 should be read in conjunction with the certifications for a more complete understanding of the topics presented.

District Court of Colorado, County of Arapahoe, entitled Jaroslawicz v. Brown, et al. The three shareholder derivative actions are now all pending in the Colorado state court. The Court has consolidated the three actions into a single consolidated action and has set February 1, 2005 as the deadline for the filing of a consolidated amended complaint. The shareholder derivative action is still in the preliminary stages, and it is not possible for us to quantify the extent of potential liability, if any.

On May 17, 2004, a purported class action complaint was filed in the United States District Court for the District of Colorado, entitled Henderson v. Quovadx, Inc. et al, Case No. 04-M-1006 (OES), against Quovadx, Inc., its now-former Chief Executive Officer, its now-former Chief Financial Officer and its Board of Directors. The complaint alleged violations of Section 11 and Section 15 of the Securities Act of 1933, as amended, purportedly on behalf of all former shareholders of Rogue Wave Software, Inc. who acquired Quovadx common stock in connection with the Company’s exchange offer effective December 19, 2003. The claims are based upon the same theories and allegations as asserted in the Section 10(b) class actions described above. The Court denied plaintiff’s motion to consolidate this Section 11 action with the Section 10(b) cases and authorized the two competing lead plaintiff candidates to take discovery of each other in advance of a hearing on the appointment of lead plaintiff. On July 14, 2004, the Company and outside director defendants filed an answer to the complaint, denying allegations of wrongdoing and asserting various affirmative defenses. On September 8, 2004, the Court directed the plaintiff to publish new notice of pendency of this action inviting potential class members to submit motions for appointment as lead plaintiff. The deadline for filing lead plaintiff motions is November 12, 2004, the deadline for discovery related to competing lead plaintiff motions is December 15, 2004, and the deadline for further briefing on competing lead plaintiff motions is December 22, 2004. The Court stayed all discovery related to the merits of the litigation pending the appointment of a lead plaintiff. On October 4, 2004, the Company’s former CEO and CFO filed an answer to the complaint, denying allegations of wrongdoing and asserting various affirmative defenses. This class action also is in the preliminary stages, and it is not possible for us to quantify the extent of potential liability, if any.

On April 12, 2004, the Company announced that the Securities and Exchange Commission (“SEC”) had notified the Company that it’s previously announced informal inquiry has become a formal investigation pursuant to an “Order Directing Private Investigation and Designating Officers to Take Testimony.” The SEC is investigating transactions entered into during the third quarter of 2002 and transactions entered into during 2003 including two distributor contracts totaling approximately $1 million and transactions between Quovadx and Infotech Network Group. The investigation is continuing, and the Company continues to provide documents and information to the SEC.

The Company is engaged from time to time in routine litigation that arises in the ordinary course of our business.

The exhibits listed in the accompanying Exhibit Index to this quarterly report on Form 10-Q are filed, furnished or incorporated by reference as part of this quarterly report.

In accordance with 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 thereto duly authorized.


	By:	/s/ HARVEY A. WAGNER



	Harvey A. Wagner
	Chief Executive Officer
	(Principal Executive Officer)


	By:	/s/ MELVIN L. KEATING



	Melvin L. Keating
	Acting Chief Financial Officer
	(Principal Financial and Accounting Officer)


*	Constitutes a management contract or compensatory plan or arrangement.

**	This certification is furnished to, but not filed, with the Commission. This certification shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that the Registrant specifically incorporates it by reference.


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
		OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended September 30, 2004


Delaware		85-0373486
(State or other jurisdiction of incorporation)		(IRS Employer Identification No.)


			Page No.

PART I — FINANCIAL INFORMATION

Item 1	—	Condensed Consolidated Financial Statements		2
		Condensed Consolidated Balance Sheets (unaudited) as of September 30, 2004 and December 31, 2003		2
		Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2004 and 2003		3
		Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2004 and 2003		4
		Notes to Condensed Consolidated Financial Statements		5
Item 2	—	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3	—	Quantitative and Qualitative Disclosures About Market Risk		29
Item 4	—	Controls and Procedures		29
PART II — OTHER INFORMATION
Item 1	—	Legal Proceedings		31
Item 2	—	Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3	—	Defaults Upon Senior Securities		34
Item 4	—	Submission of Matters to a Vote of Security Holders		34
Item 5	—	Other Information		34
Item 6	—	Exhibits		34
Signatures				35
Certification of Chief Executive Officer
Certification of Acting Chief Financial Officer
Certification of Chief Executive Officer
Certification of Acting Chief Financial Officer


			September 30,			December 31,
			2004			2003


			(In thousands, except for share
			and per share amounts)
			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	12,918		$	23,688
	Short-term investments			6,025			—
	Accounts receivable, net of allowance of $1,355 and $2,765, respectively			14,805			17,593
	Unbilled accounts receivable			1,166			3,465
	Other current assets			2,763			4,304

		Total current assets		37,677			49,050
	Property and equipment, net			4,442			6,291
	Software, net			13,645			28,876
	Other intangible assets, net			18,695			17,735
	Restricted cash			550			—
	Goodwill			48,451			48,015
	Other assets			1,665			5,223

		Total assets	$	125,125		$	155,190

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	3,845		$	7,953
	Accrued liabilities			11,681			15,881
	Unearned revenue			17,976			19,066

		Total current liabilities		33,502			42,900
	Deferred revenue			—			315

		Total liabilities		33,502			43,215

Commitments and contingencies
Stockholders’ equity:
	Preferred stock, $.01 par value, 5,000,000 shares authorized; no shares issued and outstanding			—			—
	Common stock, $.01 par value; 100,000,000 authorized and 40,251,900 and 38,938,134 shares issued and outstanding, respectively			403			389
	Additional paid-in capital			270,209			269,011
	Unearned compensation			(67	)		(385	)
	Accumulated other comprehensive income			535			131
	Accumulated deficit			(179,457	)		(157,171	)

		Total stockholders’ equity		91,623			111,975

		Total liabilities and stockholders’ equity	$	125,125		$	155,190



				Three Months Ended						Nine Months Ended
				September 30,						September 30,

				2004			2003			2004			2003

							(Restated)						(Restated)

				(In thousands, except for per share amounts)

				(Unaudited)
Revenue:
	Software license			$	6,550		$	2,309		$	19,451		$	14,232
	Professional services				2,708			4,396			11,582			13,267
	Recurring services				11,729			7,662			35,198			22,986

		Total revenue			20,987			14,367			66,231			50,485

Cost of revenue:
	Software license				2,752			1,877			9,771			6,929
	Professional services				3,733			3,412			12,080			9,650
	Recurring services				6,027			5,128			18,160			15,181
	Asset impairments				—			—			6,765			—

		Total cost of revenue			12,512			10,417			46,776			31,760

			Gross profit		8,457			3,950			19,455			18,725

Operating expenses:
	Sales and marketing				4,177			4,260			15,541			12,154
	General and administrative				4,456			3,001			14,887			9,177
	Research and development				3,096			2,669			10,436			7,162
	Amortization of acquired intangibles				770			307			2,707			1,071

		Total operating expenses			12,499			10,237			43,571			29,564

Loss from operations					(4,024	)		(6,287	)		(24,116	)		(10,839	)
Gain on sales of assets					360			—			1,535			—
Interest income, net					50			89			295			485

Net loss				$	(3,614	)	$	(6,198	)	$	(22,286	)	$	(10,354	)

Net loss per common share — basic and diluted				$	(0.09	)	$	(0.20	)	$	(0.56	)	$	(0.34	)

Weighted average common shares outstanding — basic and diluted					40,249			30,866			39,764			30,486

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

		For the transition period from to


Item 1.	*Condensed Consolidated Financial Statements*


	Three Months Ended			Nine Months Ended
	September 30, 2003			September 30, 2003


	(In thousands except per share amounts)
Decrease in total revenue	$	(842	)	$	(1,501	)
Increase in net loss		(891	)		(1,622	)
Increase in net loss per share		(0.03	)		(0.05	)


				Accumulated
		Cost		Amortization			Total


		(In thousands)
Amortizable intangible assets:
	Customer base	$	22,496	$	(4,379	)	$	18,117
	Tradenames		560		(110	)		450
	Other		2,178		(2,050	)		128

	Total	$	25,234	$	(6,539	)	$	18,695


		Rogue Wave		CareScience			Total

Goodwill:
	Balance at December 31, 2003	$	34,697	$	13,318		$	48,015
	Reconciliation of opening balances		403		(218	)		185
	Acquisition expenses		—		(357	)		(357	)
	Lease restructuring		608		—			608

	Balance at September 30, 2004	$	35,708	$	12,743		$	48,451


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


	*Comparison of the Company’s Results for the Three Months Ended September 30, 2004 and 2003.*


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


Item 2.	*Unregistered Sales of Equity Securities and Use of Proceeds*


Item 4.	*Submission of Matters to a Vote of Security Holders*


1.	Interim Financial Statements


2.	Effect of Restatements


4.	Asset Impairments


5.	Acquisitions and Divestitures


Exhibit
Number			Description of Document

	2	.1	Agreement and Plan of Merger, dated as of August 13, 2003, by and among CareScience, Inc., the Registrant and Carlton Acquisition Corporation (incorporated by reference to Annex A to the Prospectus filed by the Registrant under Rule 424(b)(3) on September 18, 2003).
	2	.2	Agreement and Plan of Merger, dated as of November 3, 2003, by and among Rogue Wave Software, Inc., the Registrant and Chess Acquisition Corporation (incorporated by reference to Annex A to the Prospectus filed by the Registrant under Rule 424(b)(3) on December 16, 2003).
	3	.1	Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 2003, filed as of May 13, 2003).
	3	.2	Bylaws of the Registrant (incorporated by reference to Exhibit 3.3 to the Registration Statement on Form S-1 of the Registrant, filed as of November 2, 1999, Registration No. 333-90165).
	4	.1	Specimen stock certificate representing shares of Common Stock of the Registrant (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K of the Registrant, filed as of October 16, 2001).
	4	.2	Preferred Stock Rights Agreement, dated as of July 24, 2000, between the Registrant and ChaseMellon Shareholder Services, L.L.C., as Rights Agent, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B, and C, respectively (incorporated by reference to Exhibit 1 to the Registration Statement on Form 8-A of the Registrant, filed as of July 28, 2000).
	10	.1*	Amended and Restated 1997 Stock Plan and related agreements (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-8 of the Registrant, filed as of May 16, 2002, Registration No. 333-88408).
	10	.2*	Amended and Restated 1999 Employee Stock Purchase Plan and related agreements (incorporated by reference to Exhibit 10.2. the Quarterly Report on Form 10-Q of the Registrant for the quarter ended September 30, 2003, filed as of November 3, 2003).
	10	.3*	Amended and Restated 1999 Director Option Plan and related agreements (incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-8 of the Registrant, filed as of May 16, 2002, Registration No. 333-88408).
	10	.4*	Amended and Restated 2000 Non statutory Stock Option Plan and related agreements (incorporated by reference to Exhibit 4.9 to the Registration Statement on Form S-8 of the Registrant, filed as of April 1, 2003, Registration No. 333-104184).
	10	.5*	Amended and Restated Healthcare.com Corporation Non-Employee Director Stock Option Plan (filed as of August 13, 1999, as Exhibit 10 to the Quarterly Report on Form 10-Q of Healthcare.com Corporation for the quarter ended June 30,1999, Commission File No. 0-27056, and incorporated by reference to Exhibit 10.42 to the Registration Statement on Form S-4 of the Registrant, filed as of June 29, 2001, Registration No. 333-64282).
	10	.6*	Healthcare.com Corporation Adjustment Stock Option Plan (filed as of October 24, 1995, as Exhibit 10.5 to Amendment No. 1 to the Registration Statement on Form S-1 of Healthcare.com Corporation, Registration No. 33-96478, and incorporated by reference to Exhibit 10.43 to the Registration Statement on Form S-4 of the Registrant, filed as of June 29, 2001, Registration No. 333-64282).
	10	.7*	Healthcare.com Corporation Restated Stock Option Plan Two (filed as of May 11, 1998, as Exhibit 10.2 to the Quarterly Report on Form 10-Q of Healthcare.com Corporation for the quarter ended March 31, 1998, Commission File No. 0-27056, and incorporated by reference to Exhibit 10.44 to the Registration Statement on Form S-4 of the Registrant, filed as of June 29, 2001, Registration No. 333-64282).
	10	.8*	Rogue Wave Software, Inc. 1996 Equity Incentive Plan (incorporated by reference to Exhibit 4.1 to the Post-Effective Amendment No. 1 to Form S-4 on Form S-8 Registration Statement of the Registrant, filed as of January 8, 2004, Registration No. 333-110388).
	10	.9*	Rogue Wave Software, Inc. 1997 Equity Incentive Plan (incorporated by reference to Exhibit 4.2 to the Post-Effective Amendment No. 1 to Form S-4 on Form S-8 Registration Statement of the Registrant, filed as of January 8, 2004, Registration No. 333-110388).