QUOVADX INC - 10-Q Quarterly Report

6400 S. Fiddler’s Green Circle, Suite 1000, Englewood, Colorado 80111
(Address of principal executive offices)

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 x No o

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


			Page No.

Part I — Financial Information			3
	Item 1 - Condensed Consolidated Financial Statements:
		Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002	3
		Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2003 and 2002	4
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002	5
		Notes to Condensed Consolidated Financial Statements	6
	Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations		11
	Item 3 - Quantitative and Qualitative Disclosures About Market Risk		21
	Item 4 - Controls and Procedures		21
Part II — Other Information
	Item 1 - Legal Proceedings		22
	Item 2 - Changes in Securities and Use of Proceeds		22
	Item 3 - Defaults Upon Senior Securities		22
	Item 4 - Submission of Matters to a Vote of Security Holders		22
	Item 5 - Other Information		23
	Item 6 - Exhibits and Reports on Form 8-K		23
Signatures			24

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except for share and per share amounts)
(Unaudited)


					September 30,			December 31,
					2003			2002

				ASSETS
Current assets:
	Cash and cash equivalents				$	30,273		$	31,244
	Short-term investments					4,611			16,377
	Accounts receivable, net of allowance of $1,627 and $2,370, respectively					15,277			10,980
	Unbilled accounts receivable					7,425			5,571
	Other current assets					4,128			1,904

		Total current assets				61,714			66,076
	Property and equipment, net					5,907			5,326
	Software, net					23,027			20,465
	Other intangible assets, net					7,060			6,266
	Goodwill					14,325			—
	Other assets					6,063			6,476

		Total assets			$	118,096		$	104,609

				LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable				$	3,215		$	1,288
	Accrued liabilities					8,874			6,007
	Unearned revenue					13,734			8,241

		Total current liabilities				25,823			15,536
Deferred revenue						—			2,125

		Total liabilities				25,823			17,661

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 32,979,032 and 30,176,159 shares issued and outstanding					330			302
	Additional paid-in capital					236,383			226,685
	Other comprehensive income					84			—
	Accumulated deficit					(144,524	)		(140,039	)

		Total stockholders’ equity				92,273			86,948

			Total liabilities and stockholders’ equity		$	118,096		$	104,609

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

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share amounts)
(Unaudited)


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

				2003			2002			2003			2002

Revenue:
	License			$	7,791		$	2,751		$	20,373		$	8,118
	Services				4,396			4,778			13,267			18,240
	Recurring				7,696			7,444			23,020			21,658

		Total revenue			19,883			14,973			56,660			48,016

Cost of revenue:
	License				1,905			1,374			6,991			3,872
	Services				3,335			3,305			9,467			11,824
	Recurring				5,128			4,799			15,181			14,230

		Total cost of revenue			10,368			9,478			31,639			29,926

			Gross profit		9,515			5,495			25,021			18,090

Operating expenses:
	Sales and marketing				4,685			3,592			12,579			9,807
	General and administrative				3,001			3,422			9,177			10,021
	Research and development				2,669			1,807			7,162			5,016
	Amortization of acquired intangibles				307			599			1,071			1,722

		Total operating expenses			10,662			9,420			29,989			26,566

Loss from operations					(1,147	)		(3,925	)		(4,968	)		(8,476	)
	Gain on sale of assets				—			—			—			87
	Goodwill impairment				—			(93,085	)		—			(93,085	)
	Interest income, net				89			263			485			816

Net loss				$	(1,058	)	$	(96,747	)	$	(4,483	)	$	(100,658	)

Net loss per common share — basic and diluted				$	(0.03	)	$	(3.22	)	$	(0.15	)	$	(3.36	)

Weighted average common shares outstanding — basic and diluted					30,866			30,068			30,486			29,934

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


				Nine Months Ended
				September 30,

				2003			2002

Cash flows from operating activities
Net loss				$	(4,483	)	$	(100,658	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization				6,742			6,446
	Amortization of acquired intangibles				1,071			1,722
	Goodwill impairment				—			93,085
	Gain on sale of assets				—			(87	)
	Amortization of unearned compensation				—			178
	Bad debt expense				477			—
	Change in assets and liabilities:
		Accounts receivable			(2,924	)		(836	)
		Unbilled accounts receivable			(1,853	)		508
		Other assets			(779	)		195
		Accounts payable			1,260			(63	)
		Accrued liabilities			156			(5,438	)
		Unearned and deferred revenue			(1,922	)		(896	)

			Net cash used in operating activities		(2,255	)		(5,844	)

Cash flows from investing activities
	Purchase of property and equipment				(1,106	)		(1,148	)
	Capitalized software				(2,411	)		(3,121	)
	Sales of short-term investments				19,831			35,980
	Purchases of short-term investments				(8,065	)		(10,598	)
	Business acquisitions, net of acquired cash				(7,514	)		(1,633	)
	Other investing activities				—			7

			Net cash provided by investing activities		735			19,487

Cash flows from financing activities
	Proceeds from issuance of common stock				549			858

			Net cash provided by financing activities		549			858

Net increase (decrease) in cash and cash equivalents					(971	)		14,501
Cash and cash equivalents at beginning of period					31,244			25,383

Cash and cash equivalents at end of period				$	30,273		$	39,884

Supplemental disclosure of non-cash financing transactions
	Issuance of common stock in business acquisition			$	9,176		$	920
	Receipt of stock in asset sale				—			662

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 accounting principles generally accepted in the United States 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 accounting principles generally accepted in the United States. The results for the three and nine months ended September 30, 2003 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 Form 10-K for the year ended December 31, 2002.

Reclassifications. Certain prior year information has been reclassified to conform to the current year presentation.

On September 19, 2003, Quovadx consummated the acquisition of CareScience, Inc (“CareScience”). The primary reasons for the acquisition were as follows:

•

enhancing our ability to reach certain of our strategic objectives, which include extending our product and service offering to include CareScience products, enabling us to bring real time capabilities to care management application offerings;

•

enabling us to leverage our customer base and brand recognition to accelerate market penetration and growth;

•

enabling us to enhance our position in areas where Quovadx products and services are already strong by offering complementary products and services developed by CareScience;

Under the terms of the merger, a wholly owned subsidiary of Quovadx merged with CareScience and CareScience became a wholly owned subsidiary of Quovadx. 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 $31.1 million included 2,415,900 shares of Quovadx common stock issued in exchange for all outstanding shares of CareScience capital stock, cash of $18.6 million and $3.7 million in merger-related costs, including transaction fees, severance and stock option payout. This transaction was accounted for as a purchase. Through the acquisition, the Company acquired liabilities of $7.9 million and total assets of $18.5 million, including cash of $13.9.

In the third quarter of 2003, due to the acquisition, the Company initiated a headcount reduction of CareScience employees. As a result, we recorded a preliminary estimate of severance costs of $256,000 comprised of salary and employee-related expenses. At September 30, 2003, the balance of the accrual was $102,000. We believe that the remaining accrual for severance costs will be substantially paid out over the next two fiscal quarters.

The Company has retained an independent appraiser to assist with the assigning of the fair values to the identifiable intangibles acquired from CareScience. Our preliminary estimate of goodwill, software and identifiable intangible assets acquired is $14.3 million, $4.3 million and $1.9 million, respectively, and will be finalized upon receipt of the independent appraisal and reconciliation of merger costs. The goodwill recognized in the CareScience acquisition is not subject to amortization but will be tested for impairment annually or more frequently if events or changes in circumstances indicate the asset might be impaired. The identifiable intangible assets will be amortized over their estimated lives. Operating results for CareScience after the date of acquisition are included in our consolidated financial results as of and for the three and nine months ended September 30, 2003.

The unaudited pro forma results of operations as though the CareScience acquisition had been completed as of January 1, 2002 are as follows (in thousands except per share amounts):

The pro forma results above do not include any anticipated cost savings or other effects of the integration of acquired entities into the Company and are not necessarily indicative of the results which would have occurred if the acquisitions has been in effect on the date indicated, or which may result in the future.

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 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 and nine months ended September 30, 2003 and 2002 excludes 929,480 and 438,363 options, respectively, to purchase common stock because their effect would have been anti-dilutive.

The following table sets forth the computation of the numerators and denominators in the basic and diluted net loss per common share calculations for the periods indicated (in thousands):

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 for the year ended December 31, 2002.

The Company operates in three segments: professional services, software licenses and recurring revenue. The professional services segment includes revenue generated from software implementation, development and integration. The software license segment includes revenue from perpetual software license sales and software subscriptions. The recurring revenue segment includes revenue generated from outsourcing, hosting, maintenance, transactions, and other recurring services. The segment information for the three and nine months ended September 30, 2003 is reflected in the Condensed Consolidated Statement of Operations.

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company has not recorded amortization expense related to goodwill for acquisitions entered into after July 1, 2001 and has stopped recording amortization expense for all acquisitions as of January 1, 2002.

SFAS No. 142, requires that the Company test goodwill annually for impairment and more frequently if events or changes in circumstances indicate assets might be impaired. The Company performed a transitional impairment test upon the adoption of SFAS No. 142 on January 1, 2002 and recorded no impairment as a result of this test. The Company had identified the fourth quarter as the period for its annual impairment test. However, due to significant negative industry and economic trends affecting the market value of the Company’s common stock, the Company performed an interim test of goodwill impairment in the third quarter of 2002. As a result of this interim test, the Company recorded an impairment charge of $93.1 million to reduce goodwill based on the amount that the carrying value of the goodwill exceeded its fair value. This impairment charge eliminated goodwill associated with all previous acquisitions and related to each of the Company’s reportable segments.

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, 2003 (in thousands):

The following table provides information relating to the Company’s software as of September 30, 2003 (in thousands):

At September 30, 2003, the Company had three stock option plans and an 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 (in thousands except per share amounts).

During August 2003 the Company established a line of credit with a commercial bank which allows 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. The revolving line of credit is secured by the Company’s assets, exclusive of intellectual property assets. The line of credit contains covenants including a minimum cash requirement, restrictions on mergers and acquisitions, obtaining additional indebtedness and dividends. At September 30, 2003, the Company had no outstanding borrowings under the line of credit.

Total comprehensive income (loss) for the three and nine months ended September 30, 2003 and 2002 was as follows (in thousands):

The foreign currency translation amounts relate to our subsidiary in the United Kingdom.

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. The Company believes it has meritorious defenses. 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 and certain of its present and former officers are 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 seek compensatory and other damages, and costs and expenses associated with litigation. Although we cannot predict the ultimate outcome of the case or estimate the range of any potential loss that may be incurred in the litigation, we believe the lawsuits are without merit, CareScience denies all allegations or wrongdoing asserted by plaintiffs, and we believe CareScience has meritorious defenses to plaintiffs’ claims. CareScience intends to vigorously defend the lawsuits. The class action litigation is 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 election 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 purport to bring claims on behalf of all persons who allegedly purchased CareScience common stock between June 29, 2000 and November 1, 2000, for alleged violation 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. Specifically, the complaints allege, among other things, that the CareScience Prospectus and Registration Statement misrepresented and omitted to disclose material facts concerning its competitors, two of its prospective products and its contract with the California HealthCare Foundation. On July 25, 2003, the Judge granted CareScience’s motion to dismiss the claims under Section 12(a)(2) of the Securities Act, but denied its motion to dismiss the claims under Sections 11 and 15 of the Securities Act. CareScience has filed an answer denying all allegations of wrongdoing. Discovery has not yet commenced. 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 and its subsidiaries are engaged from time to time in routine litigation that arises in the ordinary course of our business.

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

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, 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.

On September 19, 2003, Quovadx purchased the outstanding stock of CareScience, Inc. (“CareScience”). 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 total purchase price for this acquisition was $31.1 million, including 2,415,900 shares of Quovadx common stock, cash of $18.6 million and $3.7 million in merger-related costs. Operating results for CareScience after the date of acquisition are included in our consolidated financial results as of and for the three and nine months ended September 30, 2003.

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States 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 relied on significant estimates in preparing the financial statements 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 of its significant accounting policies, the following 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.”

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

The methodology the Company uses to recognize 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 elements. 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.

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. The Company may encounter budget and schedule overruns caused by increased material, labor or overhead costs. 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 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.

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, 2003, the Company had $5.6 million of capitalized software development costs, net of amortization.

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

Comparison of the Company’s Results for the Three Months Ended September 30, 2003 and 2002.

Total revenue. Total revenue increased $4.9 million, or 33%, to $19.9 million for the three months ended September 30, 2003 from $15.0 million for the three months ended September 30, 2002. Software license revenue was $7.8 million for the three months ended September 30, 2003, an increase of $5.0 million or 183% from the three months ended September 30, 2002. The increase in software license revenue was primarily due to a software sale for $4.6 million and continued focus on software sales. The acquisition of CareScience increased license revenue by $0.2 million. Recurring revenue increased 3% to $7.7 million for the three months ended September 30, 2003 from $7.4 million in the comparable 2002 period. Professional services revenue decreased $0.5 million from the third quarter of 2002 due to the completion of several large contracts in the third quarter of 2002. The acquisition of CareScience added $0.1 million in services revenue for the third quarter of 2003.

Cost of revenue. Cost of revenue increased $0.9 million, or 9%, to $10.4 million for the three months ended September 30, 2003 from $9.5 million from the three months ended September 30, 2002. Cost of revenue for the license segment increased 39% or $0.5 million to $1.9 million from $1.4 million due to increased amortization expense from continued development of the Company’s software and the completion of several capitalized projects in the fourth quarter of 2002. Recurring revenue costs increased 7% to $5.1 million for the third quarter of 2003 from $4.8 million in the comparable period of 2002. The CareScience acquisition added $0.1 million of cost of revenue related to services for the three months ended September 30, 2003. As a percentage of revenue, cost of revenue decreased from 63.3% for the three months ended September 30, 2002 to 52.1% for the three months ended September 30, 2003.

Sales and marketing. Sales and marketing expenses increased $1.1 million, or 30%, to $4.7 million for the three months ended September 30, 2003 from $3.6 million for the three months ended September 30, 2002. Sales and marketing expenses increased due to an increase in the size of the Company’s sales force and product marketing professionals. Commission expense was also higher due to increased software sales and incremental costs incurred as a result of the realignment of the Company’s sales force around products from the previous geographic alignment. The acquisition of CareScience added $0.2 million of sales and marketing expense for the three months ended September 30, 2003. As a percentage of revenue, sales and marketing expense decreased 0.4% to 23.6% for the three months ended September 30, 2003 compared to 24.0% for the three months ended September 30, 2002.

General and administrative. General and administrative expenses decreased $0.4 million, or 12%, to $3.0 million for the three months ended September 30, 2003 from $3.4 million from the year earlier period. The decrease in general and administrative expenses was primarily due to a decrease in legal expenses. As a percentage of revenue, general and administrative expense decreased 7.7% to 15.1% for the three months ended September 30, 2003 compared to 22.8% for the three months ended September 30, 2002.

Research and development. Research and development expenses increased $0.9 million from, or 48%, to $2.7 million for the three months ended September 30, 2003 from $1.8 million for the three months ended September 30, 2002. This increase is due to personnel additions, mostly offshore. In addition, capitalized software costs decreased $0.3 million to $0.7 million for the third quarter of 2003 from $1.0 million for the third quarter of 2002. The acquisition of CareScience added $0.1 million of costs related to research and development for the third quarter of 2003. As a percentage of revenue, research and development expense increased 1.3% to 13.4% for the three months ended September 30, 2003 compared to 12.1% for the three months ended September 30, 2002.

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, 2003 and 2002 was $0.3 million and $0.6 million, respectively. The decrease is due to the full amortization of an intangible asset acquired in the Healthcare.com purchase.

Interest income. Interest income includes interest income on cash, cash equivalents and short-term investment balances. Interest income decreased $0.2 million, to $0.1 million for the three months ended September 30, 2003 from $0.3 million for the prior year period. The decrease in interest income is due to lower interest rates, the decrease in the Company’s cash and short-term investments balance used to fund operations and a shift in the company’s short-term investments to shorter maturities to be used for the CareScience acquisition.

Income tax benefit. A provision for federal and state income taxes has not been recorded for the three months ended September 30, 2003 and 2002, as we have incurred a net operating loss for the 2003 period and for the 2002 full year. 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, 2003 and December 31, 2002.

The increase in software license margin is primarily due to a high margin software sale for $4.6 million and continued focus on software sales. Margin for professional services decreased primarily due to the completion of several high margin contracts in the third quarter of 2002.

Comparison of the Company’s Results for the Nine Months Ended September 30, 2003 and 2002.

Total revenue. Total revenue increased $8.6 million, or 18%, to $56.7 million for the nine months ended September 30, 2003 from $48.0 million for the nine months ended September 30, 2002. Software license revenue increased $12.3 million over the first three quarters of 2002, which was primarily due to the acceleration of $2.9 million of deferred software revenue from the early termination of a 4-year customer agreement in the second quarter of 2003, a software sale for $4.6 million in the third quarter of 2003 and continued focus on software sales. Recurring revenue increased 6% to $23.0 million for the nine months ended September 30, 2003 from $21.7 million in the comparable 2002 period primarily due to an increase in revenue generated from the claims transaction and outsourcing businesses. Professional services revenue declined $5.0 million or 27% from the nine months ended September 30, 2002 to $13.3 million for the nine months ended September 30, 2003 due to the completion of several large contracts in the third quarter of 2002.

Cost of revenue. Cost of revenue increased $1.7 million, or 6%, to $31.6 million for the nine months ended September 30, 2003 from $29.9 million for the nine months ended September 30, 2002. Cost of revenue for the license segment increased $3.1 million due to an increase in software royalty expense resulting from increased sales of third party software in the nine months ended September 30, 2003. In addition, software amortization increased over the nine months ended September 30, 2002 primarily due an increase in the Company’s capitalized software balance from the continued development of the Company’s software and the completion of several capitalized projects in the fourth quarter of 2002. Recurring revenue costs increased 7% to $15.2 million for the nine months ended September 30, 2003 from the comparable period in 2002 due to an increase in the Company’s claims transaction business and increased royalty expense on sales of maintenance contracts for third party software. Professional services cost of revenue decreased due to a decline in headcount in 2003. Offsetting the decrease was the acquisition of CareScience, adding $0.1 million in cost of revenue for the professional services segment for the nine months ended September 30, 2003. As a percentage of revenue, cost of revenue decreased from 62.3% for the nine months ended September 30, 2002 to 55.8% for the nine months ended September 30, 2003.

Sales and marketing. Sales and marketing expenses increased $2.8 million, or 28%, to $12.6 million for the nine months ended September 30, 2003 from $9.8 million for the nine months ended September 30, 2002. Sales and marketing expenses increased due to an increase in the size of the Company’s sales force and product marketing professionals. Commission expense rose due to an increase in software sales and incremental costs incurred as a result of the realignment of the Company’s sales force around products from the previous geographic alignment. The

CareScience acquisition added $0.2 million of sales and marketing expense for the three quarters ended September 30, 2003. As a percentage of revenue, sales and marketing expense increased 1.8% to 22.2% for the nine months ended September 30, 2003 compared to 20.4% for the nine months ended September 30, 2002.

General and administrative. General and administrative expenses decreased $0.8 million, or 8%, to $9.2 million for the nine months ended September 30, 2003 from $10.0 million from the year earlier period. The decrease in general and administrative expenses was primarily due to lower spending on legal and telecommunications expense. Offsetting the decrease was the addition of $0.1 million of CareScience general administrative costs in the three quarters ended September 30, 2003. As a percentage of revenue, general and administrative expense decreased 4.7% to 16.2% for the nine months ended September 30, 2003 compared to 20.9% for the nine months ended September 30, 2002.

Research and development. Research and development expenses increased $2.1 million, or 43%, to $7.2 million for the nine months ended September 30, 2003 from $5.0 million for the nine months ended September 30, 2002. This increase is due personnel additions, mostly offshore. In addition, capitalized software development costs decreased from $3.1 million in the first three quarters of 2002 to $2.4 million in the first three quarters of 2003. The acquisition of CareScience added $0.1 million of costs related to research and development for the three quarters ended September 30, 2003. As a percentage of revenue, research and development expense increased 2.3% to 12.7% for the nine months ended September 30, 2003 compared to 10.4% for the nine months ended September 30, 2002.

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, 2003 and 2002 was $1.1 million and $1.7 million, respectively. The decrease is due to the full amortization of an intangible asset acquired in the Healthcare.com purchase in the first quarter of 2003.

Interest income. Interest income includes interest income on cash, cash equivalents and short-term investment balances. Interest income decreased $0.3 million, to $0.5 million for the nine months ended September, 2003 from $0.8 million for the prior year period. The decrease in interest income is due to lower interest rates and the decrease in the Company’s cash and short-term investments balance used to fund operations.

Income tax benefit. A provision for federal and state income taxes has not been recorded for the nine months ended September 30, 2003 and 2002, as we have incurred a net operating loss for the 2003 period and for the 2002 full year. 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, 2003 and December 31, 2002.

The increase in software license margin is primarily due to the acceleration of $2.9 million of deferred software revenue from the early termination of a 4-year customer agreement, a high margin software sale and continued focus on software sales, offset by increased royalties and amortization. Margin for professional services decreased from the nine months ended September 30, 2002 primarily due to the completion of several high margin contracts in the third quarter of 2002.

We have historically financed our operations through a combination of cash flow from operations, 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 with the proceeds of that offering and cash flow from operations.

We expect to use our cash, cash equivalents and short-term investments for general corporate purposes, working capital and capital expenditures, to fund our operations and to continue expanding our product offerings.

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, the amount of cash generated by our operations and competition. We may find it necessary or advisable to use portions of our cash, cash equivalents and short-term investments for other purposes. A portion of our cash, cash equivalents and short-term investments may also be used to acquire or invest in complementary businesses or products or to obtain the right to use synergistic technologies. 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.

Net cash used in operating activities for the nine months ended September 30, 2003 was $2.3 million compared to $5.8 million for the nine months ended September 30, 2002. The decrease in net cash used in operating activities for the nine months ended September 30, 2003 is primarily attributable to a decrease in the Company’s net loss from the nine months ended September 30, 2002.

Net cash provided by investing activities for the nine months ended September 30, 2003 was $0.7 million compared to $19.5 million in the same period of the prior year. Investing activities consist of purchases of computer hardware and software, office furniture and equipment, purchase and sales of investments, additions to capitalized software, and cash used in the acquisition of CareScience. There was a decrease of $13.6 million in net sales of short-term investments from the nine months ended September 30, 2002. In addition, there was an increase of $5.9 million of funds used for acquisition purposes in the nine months ended September 30, 2003 from the year earlier period.

Net cash provided by financing activities for the nine months ended September 30, 2003 decreased $0.3 million, due to a decrease in cash received from the exercise of stock options.

During August 2003 the Company established a line of credit with a commercial bank thereby allowing the Company to borrow up to $4.0 million on a secured basis. At September 30, 2003, the Company had no outstanding borrowings under the revolving line of credit which is secured by the Company’s assets, exclusive of intellectual property assets.

The Company has commitments pursuant to certain real property lease obligations, and these obligations have not materially changed since December 31, 2002. In connection with a software purchase in 2003, the company has minimum royalty payments of $500,000 over two years.

We expect our current cash resources will be sufficient to meet our requirements for the next 18 months. We may need to raise additional capital to support expansion, to develop new or enhanced applications, services and product offerings, to respond to competitive pressures, to acquire complementary businesses or technologies or to take advantage of unanticipated opportunities. If we need additional capital, we would try to raise the additional funds by selling debt or equity securities, by entering into strategic relationships or through other arrangements. We cannot assure you that we would be able to raise any additional amounts on reasonable terms, or at all, if they are needed.

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 sustain profitability.

Although we have had profitable quarters, we incurred losses for the nine months ended September 30, 2003 and the years ended December 31, 2002, 2001 and 2000. As of September 30, 2003, we had an accumulated deficit of $145 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 gross margin. 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.

Our quarterly 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 quarterly 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. 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;

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

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

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the announcement or introduction of new or enhanced products or services by our competitors.

We have embarked on a strategy to significantly increase software sales as our principal source of revenue. If that strategy is not successful, our business may be harmed.

We have invested and continue to invest significant financial and management resources in reorganizing and enhancing our software sales effort. In recent months, we have hired what we believe are top caliber sales talent, and we have reformulated our sales materials and our presentation strategy and we have reorganized our sales and marketing functions, all with a goal of generating an increased percentage of our revenue from sales of our software products. These efforts have been expensive and they have required, and we expect will continue to require, considerable executive management time and oversight, thus diverting resources from other aspects of our business. If for any reason this strategy is not successful, and we do not achieve increased software sales as anticipated, then our stock price will decline, and our business prospects and financial condition will be adversely affected.

The market for business process management and integration software may not grow as quickly as we anticipate, which would cause our revenue to fall below expectations.

The market for business process management and integration software is relatively new and evolving. We earn a substantial portion of our revenue from sales of our business process management software, including application integration software, and related services. We expect to earn substantially all of our revenue in the future from sales of these products and services. Our future financial performance will depend on continued growth in the number of organizations demanding software and services for business process management and integration, 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 market. If the market fails to grow, or grows more slowly than we expect, our sales will be adversely affected. In addition, a weakening global economy may lead to longer sales cycle and slower sales growth.

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technology, customer demands, and competitive pressures. To this end, we recently completed the CareScience acquisition and we may continue to acquire new and complementary businesses, products or technologies. We do not know if we will be able to complete any additional acquisitions or that we will be able to successfully integrate CareScience or any other acquired businesses, operate them profitably, or retain their key employees. Integrating CareScience and any newly acquired business, product or technology could be expensive and time-consuming, could disrupt our ongoing business, and could distract our management. We may face competition for acquisition targets from larger and more established companies with greater financial resources. In addition, in order to finance any acquisitions, we might need to raise additional funds through public or private financings. In that event, we could be forced to obtain equity or debt financing on terms that are not favorable to us and, in the case of equity financing, that result in dilution to our stockholders. If we are unable to integrate CareScience or any newly acquired entity, products or technology effectively, our business,

financial condition and operating results would suffer. In addition, the amortization of intangible assets or other charges resulting from the cost of acquisitions could harm our operating results.

If we cannot execute our strategy to establish and maintain our relationships with established healthcare industry participants, our applications, services and products may not achieve healthcare market acceptance.

The healthcare industry is our most important market. Relationships with established healthcare industry participants are critical to our success. These relationships include customer, vendor, distributor and co-marketer relationships. To date, we have established a number of these relationships. Once we have set up a relationship with an established healthcare industry participant, we rely on that participant’s ability to assist us in generating increased acceptance and use of our applications, services and product offerings. We have limited experience in maintaining relationships with healthcare industry participants. Additionally, 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. 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. Our arrangements generally do not establish minimum performance requirements, but instead rely on the voluntary efforts of the other party. Therefore, we cannot guarantee that these relationships will be successful. If we were to lose any of these relationships, or if the other parties were to fail to collaborate with us to pursue additional business relationships, we would not be able to execute our business plans and our business would suffer significantly. Moreover, we may not experience increased use of our applications, services and product offerings even if we establish and maintain these relationships.

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

In the past, our customers have experienced some interruptions with our 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 transactions and data at our facility in Albuquerque, New Mexico and the CareScience facility in Philadelphia, Pennsylvania, as well as in a third-party hosting facility in Santa Clara, 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 either facility 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 significant portion of our revenue to be derived from customers who use our hosting services. As a result, our business will suffer if we experience frequent or long system interruptions that result in the unavailability or reduced performance of our hosting capability. 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 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, 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 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, payer and plan 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 that may be required by the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), 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 utilization review services, 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.

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.

CareScience has licensed important technology from the University of Pennsylvania and the California HealthCare Foundation. Consequently, infringement claims against the University or the Foundation or disagreements between the University or the Foundation and CareScience pertaining to the licensed technology could have a material adverse effect on the combined company operations following the merger. Third parties may infringe upon CareScience’s intellectual property rights or the rights CareScience has licensed from the University or the Foundation. This unauthorized use may be undetected and the combined company may be unable to enforce its rights.

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. 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.

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.

CareScience currently depends on an exclusive license with the University of Pennsylvania and an exclusive license with the California HealthCare Foundation for some of its technology, and the loss of these licenses would impair our ability to develop the CareScience business.

Our ability to use some of the CareScience technology and complete effectively with its care management products would be impaired if CareScience’s exclusive license agreements with the University of Pennsylvania or the California HealthCare Foundation were terminated. Under these license agreements, CareScience is required to make royalty payments to the University and the Foundation, respectively, based on a percentage of the fees earned through the sublicensing and servicing of the technology and information received from the University or the Foundation, as applicable, under the relevant license agreement. In order to maintain the exclusivity of the license with the University, CareScience is required to pay a minimum of $75,000 per year in royalties. In order to maintain the exclusivity of the license with the Foundation, we are required to pay a minimum level of $57,500, $73,750 and $90,000 per year in royalties for the years 2003, 2004 and each year after 2004, respectively.

If we do not make these minimum royalty payments, the University or the Foundation may terminate the exclusive status of the license under the respective agreement, and in effect, license the technology to our competitors. In addition, under the license

agreement with the University, the University retains the right, after consultation and negotiation with CareScience, to publish a description of the technology without CareScience’s consent, whether or not any intellectual property protection on this technology has been filed. If the University or the Foundation were to license the technology to our competitors or the University were to publish the technology, our revenue may decrease significantly and we may not be able to develop or maintain CareScience customer and strategic relationships. In addition, if we pay the University less than $20,000 per year in royalties, the University may terminate CareScience’s license entirely. In the event that the University or the Foundation choose not to license the technology to CareScience at all, we may not be able to develop similar alternative technology or negotiate a new license agreement with another licensor. If we were not able to develop similar alternative technology or negotiate a new license, we may not be able to maintain the CareScience care management business operations.

We could be liable for information retrieved from the CareScience Care Management System websites and incur significant costs from resulting claims.

We may be subject to third party claims for defamation, negligence, copyright or trademark infringement or other theories based on the nature and content of the information CareScience supplies to its customers through its Internet-based Care Management System applications. We could be subject to liability with respect to content that may be accessible through the CareScience Care Management System website or third party websites linked from its website. For example, claims could be made against CareScience if a customer relies on health care information accessed through its Care Management System website to their detriment. Even if claims do not result in liability to CareScience, CareScience could incur significant costs in investigating and defending against them and in implementing measures to reduce exposure to any possible liability. Our insurance may not cover potential claims of this type or may not be adequate to cover all costs incurred in defense of potential claims or to indemnify us for all liability that may be imposed.

If we do not establish and maintain our brand, 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 brand. For us to be successful in establishing our brand, professionals in the healthcare and other targeted markets must perceive us as offering quality, cost-effective, communications, information and administrative services. Our reputation and brand name could be harmed if we experience difficulties in introducing new applications, services and product offerings, if these applications, services and product offerings, if customers do not accept these applications, services and product offerings, if we are required to discontinue existing applications, service and product offerings or if our products and services do not function properly.

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 material 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 act 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.

Our chief executive officer and our chief financial officer, after evaluating our “disclosure controls and procedures” (as defined in Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15-d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q (“Evaluation Date”) have concluded that as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially effect, our internal control over financial reporting.

CareScience and certain of its present and former officers are defendants in a 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 seek compensatory and other damages, and costs and expenses associated with litigation. Although we cannot predict the ultimate outcome of the case or estimate the range of any potential loss that may be incurred in the litigation, we believe the lawsuits are without merit, CareScience denies all allegations or wrongdoing asserted by plaintiffs, and we believe CareScience has meritorious defenses to plaintiffs’ claims. CareScience intends to vigorously defend the lawsuits. The class action litigation is 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 election 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 purport to bring claims on behalf of all persons who allegedly purchased CareScience common stock between June 29, 2000 and November 1, 2000, for alleged violation 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. Specifically, the complaints allege, among other things, that the CareScience Prospectus and Registration Statement misrepresented and omitted to disclose material facts concerning its competitors, two of its prospective products and its contract with the California HealthCare Foundation. On July 25, 2003, the Judge granted CareScience’s motion to dismiss the claims under Section 12(a)(2) of the Securities Act, but denied its motion to dismiss the claims under Sections 11 and 15 of the Securities Act. CareScience has filed an answer denying all allegations of wrongdoing. Discovery has not yet commenced. We do not believe that the outcome of this action will have a material adverse affect 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 and its subsidiaries are 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.

(i)

On July 24, 2003, we furnished a Current Report on Form 8-K to report that on July 23, 2003 we issued a press release announcing our financial results for the quarter ended June 30, 2003.

(ii)

On August 14, 2003, we filed a Current Report on Form 8-K to report that on August 14, 2003 we entered into an Agreement and Plan of Merger, dated as of August 13, 2003, with CareScience, Inc., a Pennsylvania corporation, and Carlton Acquisition Corp., a Pennsylvania corporation and a wholly owned subsidiary of Quovadx.

(iii)

On September 9, 2003, we filed a Current Report on Form 8-K to report that on September 8, 2003 we settled litigation among various parties in connection with a development contract entered into in October 1999 with the Hawaii Employees Retirement System.

(iv)

On September 24, 2003, we filed a Current Report on Form 8-K to report that on September 19, 2003 we and our wholly owned subsidiary Carlton Acquisition Corp. accepted for exchange and payment all shares of CareScience, Inc. validly tendered pursuant to the Registrar’s offer to exchange all of the outstanding shares of CareScience common stock for the right to receive cash and shares of the Registrant’s common stock.

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.


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, Corp. (incorporated by reference to Annex A to the Prospectus filed by the Registrant under Rule 424(b)(3) on September 18, 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 filed by the Registrant 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 filed by the Registrant as of July 28, 2000)

4.3		Registration Rights Agreement, dated as of December 14, 2001, between the Registrant and Francis Carden (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-3 filed by the Registrant as of January 23, 2002, Registration No. 333-81210)

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 filed by the Registrant as of May 16, 2002, Registration No. 333-88408)

10.2*		Amended and Restated 1999 Employee Stock Purchase Plan and related agreements.

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 filed by the Registrant as of May 16, 2002, Registration No. 333-88408)

10.4*		Amended and Restated 2000 Nonstatutory Stock Option Plan and related agreements (incorporated by reference to Exhibit 4.9 to the Registration Statement on Form S-8 filed by the Registrant 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 filed by the Registrant 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 filed by the Registrant 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 filed by the Registrant as of June 29, 2001, Registration No. 333-64282)

10.8*		Offer letter, dated as of February 20, 2002, with David E. Nesvisky (incorporated by reference to Exhibit 10.8 to the Annual Report on Form 10-K of the Registrant for the year ended December 31, 2002, filed as of March 31, 2003)

10.9		Office Lease Agreement, effective as of November 8, 1999, between Mountain States Mutual Casualty Company and the Registrant (incorporated by reference to Amendment 1 to the Registration Statement on Form S-1 filed by the Registrant as of December 17, 1999, Registration No. 333-90165)

10.10		Sublease, dated as of August 24, 2001, between Echo Bay Management Corp. and XCare.net, Inc. (incorporated by reference to Exhibit 12.1 to the Annual Report on Form 10-K of the Registrant for the year ended December 31, 2001, filed as of March 26, 2002)


Exhibit
Number		Description of Document

10.11*		Form of Healthcare.com Corporation Severance Compensation and Restrictive Covenant Agreement and Severance Compensation and Restrictive Covenant Agreement between Healthcare.com Corporation and Deborah Dean dated May 14, 2001 (incorporated by reference to Exhibit 2.6 to the Current Report on Form 8-K of the Registrant, filed as of May 18, 2001)

10.12		Form of Indemnification Agreement entered into by Quovadx, Inc. with each of its directors and executive officers (incorporated by reference to Exhibit 11.1 to the Annual Report on Form 10-K of the Registrant for the year ended December 31, 2001, filed as of March 26, 2002)

10.13		Restated License Agreement, dated as of April 1, 1995, between the Trustees of the University of Pennsylvania and Care Management Science Corporation (incorporated by reference to Exhibit 10.3 to the Registration Statement on Form S-1 filed by CareScience, Inc. as of March 14, 2000, Registration No. 333-32376)

10.14		License Agreement, dated as of October 2, 2000, between California HealthCare Foundation and CareScience, Inc. (incorporated by reference to Exhibit 10.14 to the Annual Report on Form 10-K of CareScience, Inc. for the year ended December 31, 2001, filed as of March 26, 2002)

31.1		Certification of Chief Executive Officer of the Registrant pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

31.2		Certification of Chief Financial Officer of the Registrant pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.

32.1**		Certification of Chief Executive Officer of the Registrant pursuant to Rule 13a-14(b) and Rule 15d-14(b), promulgated under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350.

32.2**		Certification of Chief Financial Officer of the Registrant pursuant to Rule 13a-14(b) and Rule 15d-14(b), promulgated under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. §1350.


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

		For the quarterly period ended September 30, 2003

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

		For the transition period from to


PART I FINANCIAL INFORMATION
	Item 1. Condensed Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EX-10.2 Amended 1999 Employee Stock Purchase Plan
EX-31.1 Certification of Chief Executive Officer
EX-31.2 Certification of Chief Financial Officer
EX-32.1 Certification of Chief Executive Officer
EX-32.2 Certification of Chief Financial Officer


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

	2003			2002			2003			2002

Revenue	$	22,897		$	18,689		$	65,983		$	58,544
Costs		28,423			116,439			79,927			163,398

Net loss	$	(5,526	)	$	(97,750	)	$	(13,944	)	$	(104,854	)

Shares		32,956			32,483			32,793			32,348

Net loss per share	$	(0.17	)	$	(3.01	)	$	(0.43	)	$	(3.24	)


				Accumulated
		Cost		Amortization

Amortizable intangible assets:
	Customer base	$	7,660	$	(1,661	)
	Tradenames, patents and other		1,913		(852	)

	Total	$	9,573	$	(2,513	)

Unamortizable intangible assets:
	Goodwill	$	14,325	$	—


				Accumulated
		Cost		Amortization

Software:
	Acquired Software	$	27,229	$	(9,817	)
	Capitalized Software		8,043		(2,428	)

	Total	$	35,272	$	(12,245	)

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Delaware (State or other jurisdiction of incorporation or organization)		85-0373486 (I.R.S. Employer Identification No.)


	Three Months Ended
	September 30,

					Increase/
	2003		2002		(Decrease)

Software license	$	5,886	$	1,377	$	4,509
Professional services		1,061		1,473		(412	)
Recurring revenue		2,568		2,645		(77	)

	$	9,515	$	5,495	$	4,020


		QUOVADX, INC.

		By:	/s/ LORINE R. SWEENEY

			Lorine R. Sweeney President and Chief Executive Officer (Principal Executive Officer)
Date:	October 31, 2003
		By:	/s/ GARY T. SCHERPING

			Gary T. Scherping Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
Date:	October 31, 2003

*		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.


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

			2003			2002			2003			2002

Revenue:
	License			39.2	%		18.4	%		36.0	%		16.9	%
	Service			22.1			31.9			23.4			38.0
	Recurring			38.7			49.7			40.6			45.1

		Total revenue		100.0			100.0			100.0			100.0

Cost of revenue:
	License			9.6			9.2			12.3			8.1
	Service			16.7			22.1			16.7			24.6
	Recurring			25.8			32.0			26.8			29.6

		Total cost of revenue		52.1			63.3			55.8			62.3