HEALTH GRADES INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

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FORM 10-Q

(Mark One)

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

For the quarterly period ended MARCH 31, 2004
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OR

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

For the transition period from to
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Commission file number 0-22019
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HEALTH GRADES, INC.
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(Exact Name of Registrant as Specified in its Charter)

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

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

Registrant's Telephone Number, Including Area Code (303) 716-0041
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Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

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

On April 30, 2004, 25,020,990 shares of the Registrant's common stock, $.001
par value, were outstanding.

Health Grades, Inc. and Subsidiaries

INDEX

PART I. FINANCIAL INFORMATION:

Item 1. Condensed Consolidated Balance Sheets
March 31, 2004 and December 31, 2003....................... 3

Condensed Consolidated Statements of Operations -
Three Months Ended March 31, 2004 and 2003................. 4

Condensed Consolidated Statements of Cash Flows -
Three Months Ended March 31, 2004 and 2003................. 5

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

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................ 9

Item 3. Quantitative and Qualitative Disclosure About
Market Risk................................................ 11

Item 4. Controls and Procedures.................................... 11

PART II. OTHER INFORMATION:

Item 1. Legal Proceedings.......................................... 13

Item 6. Exhibits and Reports on Form 8-K........................... 13

2

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

See accompanying notes to condensed consolidated financial statements.

3

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

See accompanying notes to condensed consolidated financial statements.

4

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

See accompanying notes to condensed consolidated financial statements.

5

Health Grades, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2004

NOTE 1 - BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Health
Grades, Inc. ("HealthGrades") have been prepared in accordance with accounting
principles generally accepted in the United States of America for interim
financial information and the instructions to Rule 10-01 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the United States of America for
complete financial statements. In the opinion of management, these statements
include all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation of the results of the interim periods reported
herein. Operating results for the three months ended March 31, 2004 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Annual Report on Form
10-K for the year ended December 31, 2003.

DESCRIPTION OF BUSINESS

HealthGrades provides proprietary, objective healthcare provider ratings and
quality improvement consulting services. We provide our clients with healthcare
information, including information relating to quality of service and detailed
profile information on physicians, that enables them to measure, assess, enhance
and market healthcare quality. Our clients include hospitals, employers,
benefits consulting firms, payers, insurance companies and consumers.

We offer services to hospitals that are either attempting to build a reputation
based upon quality of care or are working to identify areas to improve quality.
For hospitals that have received high ratings, we offer the opportunity to
license our ratings and trademarks and provide assistance in their marketing
programs. We also offer quality improvement consulting engagements for any
hospitals that are seeking to enhance quality.

In addition, we provide basic and expanded profile information on a variety of
providers and facilities. We make this information available to consumers,
employers, benefits consulting firms and payers to assist them in selecting
healthcare providers. Basic profile information for certain providers is
available free of charge on our website, www.healthgrades.com. For a fee, we
offer healthcare quality reports with respect to hospitals, nursing homes and
physicians. These reports provide more detailed information than is available
free of charge on our website. Report pricing and content varies based upon the
type of provider and whether the user is a consumer or a healthcare professional
(for example, medical professional underwriter).

We provide online integrated healthcare quality information for employers,
benefits consulting firms, payers and other organizations that license access to
our database of healthcare providers.

NOTE 2 - STOCK-BASED COMPENSATION

On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a
proposed Statement, Share-Based Payment, that addresses the accounting for
share-based payment transactions in which an enterprise receives employee
services in exchange for (a) equity instruments or (b) liabilities that are
based on the fair value of the enterprise's equity instruments or that may be
settled by the issuance of such equity instruments. The proposed statement would
eliminate the ability to account for share-based compensation transactions using
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB No. 25), and related interpretations, and generally would require
instead that such transactions be accounted for using a fair-value-based method.
The proposed statement would be applied prospectively for fiscal years beginning
after December 15, 2004, as if all share-based compensation awards granted,
modified, or settled after December 15, 1994 had been accounted for using the
fair-value-based method of accounting.

We account for our stock-based compensation arrangements using the intrinsic
value method under the provisions of APB No. 25, and related interpretations. We
are reviewing the proposed statement and have not yet determined the effect that
the adoption of the proposed statement would have on our financial statements.

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Pro forma information regarding net income and earnings per share is required by
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based
Compensation (SFAS 123) and has been determined as if we had accounted for our
employee stock options under the fair value method of that accounting
pronouncement. The Black-Scholes option valuation model was utilized for the
purpose of this disclosure. The Black-Scholes model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. For purposes of pro forma disclosure, the estimated fair value of
the options is amortized to expense over the options' vesting period. Because
compensation expense associated with an award is recognized over the vesting
period, the impact on pro forma net income (loss) as disclosed below may not be
representative of compensation expense in future years.

The fair value for options awarded were estimated at the date of grant using the
Black-Scholes option valuation model with the following assumptions:

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

The following table sets forth the computation of basic and diluted earnings per
share for the three months ended March 31, 2004 and 2003.

For the three months ended March 31, 2004, the number of our common shares
issued increased by 472,314 shares due to the exercise of certain stock options
by several individuals. We received approximately $42,000 from these individuals
which represents the exercise price of the options. Additionally, we recorded an
expense of $87,000 related to the fair-value of stock options granted to a
consultant for services rendered in connection with the sale of our Healthcare
Quality Report. Additional paid-in capital was also increased by the same
amount in the accompanying condensed consolidated balance sheet.

As of March 31, 2003, we had 55,000 shares underlying options that are currently
exercisable, but were not included in our calculation of weighted average
common shares outstanding as they were antidilutive.

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NOTE 3 - LINE OF CREDIT

In February 2004, we executed an amendment to our line of credit arrangement
with Silicon Valley Bank. The terms of the amendment provide for an extension of
the maturity date of the $1,000,000 line of credit arrangement to February 20,
2005. To date, we have not borrowed any funds under the line of credit.

NOTE 4 - LEGAL PROCEEDINGS

In November 2003, we executed a Settlement Agreement and Mutual Release (the
"Settlement Agreement") with Strategic Performance Fund - II ("SPF-II"),
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
and four of the physician owners of Park Place, in connection with a legal
proceeding concerning an alleged breach by us of two leases. In consideration
for the dismissal of all claims and mutual releases, we paid approximately
$441,000 into an escrow account to be released to SPF-II upon the satisfaction
of certain conditions of the Settlement Agreement. As the payment was made into
escrow prior to year end, this cash was removed from our consolidated balance
sheet as of December 31, 2003. Payment out of escrow was contingent upon the
occurrence, on or before September 25, 2004 of (i) the bankruptcy court approval
of Chapter 11 plans relating to Park Place and the four physician owners and
(ii) the payment of a specified amount to SPF-II pursuant to the Chapter 11
plans. In addition, HealthGrades agreed to pay an additional $50,000 to SPF-II
on or before September 25, 2004. The aggregate payment amount of $491,000 was
recorded as an expense in our consolidated statement of operations in the third
quarter of 2003. In April 2004, upon satisfaction of the conditions described
above, the $441,000 in the above mentioned escrow account was released to
SPF-II. The remaining amount due to SPF-II of $50,000 will be paid to SPF-II on
or before September 25, 2004.

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

NOTE 5 - SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for income taxes amounted to approximately $1,100 and $522 for the
three months ended March 31, 2004 and 2003, respectively.

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ITEM 2:

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

Statements in this section, including statements concerning the sufficiency of
available funds, anticipated future revenues, staff increases, arrangements with
other businesses, and sales and marketing costs as a percentage of revenues,
commencement of lease negotiations and capital expenditures are "forward looking
statements." Actual events or results may differ materially from those discussed
in forward looking statements as a result of various factors, including failure
to achieve revenue increases, unanticipated expenditures, client turnover,
inability to identify suitable businesses with which to enter into product or
distribution arrangements and other factors discussed below and in the Company's
Annual Report on Form 10-K for the year ended December 31, 2003, particularly
under "Risk Factors" in Item 1.

Introductory Commentary

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

o Revenue Growth and Client Retention - We believe these are key factors
affecting both our results of operations and our liquidity. During the
first quarter of 2004, our increased revenues reflected our success in
several product areas. We continued adding new hospital customers to our
Distinguished Hospital (DHP), Strategic Quality Initiative (SQI) and
Quality Assessment and Improvement (QAI) programs. In addition, we
continued to increase sales through the distribution of our quality
information in our Quality Ratings Suite, Healthcare Quality Reports for
Consumers and Healthcare Quality Reports for Professionals.

As our base of hospital clients grows, a principal objective for
HealthGrades will be to achieve a high rate of retention of these clients.
We believe one of the obstacles to maintaining high retention rates is that
clients who signed contracts with us several years ago, when we were
developing our provider services and charging significantly lower fees than
we do today, may be unwilling to accept our current pricing structure. In
addition, beginning in January 2004, we no longer offer exclusivity under
our hospital contracts. For hospitals that signed agreements with us during
2003 and prior years, we will continue to honor the exclusivity provisions
in their contracts solely for the remaining term of the agreement. As our
agreements are typically three years (with the ability to terminate on an
annual basis), we anticipate that all exclusivity provisions will expire by
the end of 2006. During the first quarter of 2004, we retained, or signed
new agreements with, 78% of the hospitals whose contracts had second or
third year anniversary dates or expired during the first three months of
the year.

We typically receive a non-refundable payment for the first year of the
contract term (which is typically three years, subject to a cancellation
right by either the client or us, on each annual anniversary date) upon
contract execution. Because we typically receive payment in advance for
each year of the term of these agreements, if we cannot continue to attract
new hospital clients and retain a significant portion of our current
clients, our liquidity could be adversely affected.

o Variable Expense Considerations - During 2003, we added personnel to
provide client consulting and support for our DHP, SQI and QAI programs, as
well as personnel in our information technology department who work on
existing and future client services. We anticipate that we will continue to
add client consultants, some information technology personnel and,
possibly, additional administrative support personnel during 2004 as we
continue to expand our revenue base. In this regard, we anticipate that we
will add client consultants and support personnel to serve our QAI
programs. Moreover, we believe it is important to provide appropriate
compensation and incentives to those employees who contribute to the
further growth of our company. Cash bonuses of approximately $708,000 were
reflected in the condensed consolidated statement of operations for the
year ended December 31, 2003. Additionally, we have in place a cash bonus
program for 2004, the amount of which will be dependent upon our company
performance. In light of the significant equity position of our executive
officers, the board of directors has expressed a disinclination to provide
significant additional equity incentives to our executives. Accordingly, as
was the case in 2003, we do not anticipate any additional options or any
other form of equity grants to our executive officers in 2004. Management
recognizes that any increases in expenses to accommodate future growth must
be applied in a disciplined fashion so as to enable us to obtain meaningful
benefits from the standpoint of our operations and cash flows.

o Distribution and Other Partnerships - As part of our revenue growth
strategy, we seek to enter into arrangements with well recognized
businesses to develop new products such as our Distinguished Hospital Award
Program, which we developed with J.D. Power and Associates, and to rely on
established distribution channels through relationships with companies such
as Hewitt Associates, which provides our quality information to over 100
corporations throughout the United States. We expect to continue

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to seek out arrangements such as these to increase the reach of our product
offerings as well as the awareness and market penetration of our QRS and
QAI programs.

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

Critical Accounting Estimates

In preparing our financial statements, management is required to make
estimates and assumptions that, among other things, affect the reported amounts
of assets, revenues and expenses. These estimates and assumptions are most
significant where they involve levels of subjectivity and judgment necessary to
account for highly uncertain matters or matters susceptible to change, and where
they can have a material impact on our financial condition and operating
performance. See Part II, Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations-Critical Accounting Estimates," in
our Annual Report on Form 10-K for the year ended December 31, 2003 for a
discussion of critical accounting estimates relating to goodwill impairment
analysis. For the three months ended March 31, 2004, no interim impairment test
was performed, as no indicators of impairment were present.

Evolving Accounting Guidance Regarding Revenue Recognition

See Part II, Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Evolving Guidance Regarding Revenue
Recognition," in our Annual Report on Form 10-K for the year ended December 31,
2003 for a discussion of this matter.

RESULTS OF OPERATIONS

Ratings and advisory revenue. For the three months ended March 31, 2004, ratings
and advisory revenue was approximately $3,217,000, an increase of $1,479,000 or
85%, over revenue of $1,738,000 for the three months ended March 31, 2003. This
increase is primarily due to the addition of hospital clients under our DHP and
SQI programs as well as increased sales of our Healthcare Quality Reports for
Consumers and Quality Ratings Suite. For the first quarter of 2004,
approximately 65% of our ratings and advisory revenue was derived from our DHP
and SQI services, compared to 76% for the same period of 2003. In addition,
approximately 12% of our ratings and advisory revenue was derived from our QAI
services for the three months ended March 31, 2004 and 2003. Sales of our
Healthcare Quality Reports for Consumers and Quality Ratings Suite totaled 20%
of our ratings and advisory revenue for the three months ended March 31, 2004
compared to 8% for the same period of 2003.

Cost of ratings and advisory revenue. For the three months ended March 31, 2004,
cost of ratings and advisory revenue was $662,000, or approximately 21% of
ratings and advisory revenue, compared to $440,000 or approximately 25% for the
same period of 2003. The decrease in cost of ratings and advisory revenue as a
percentage of ratings and advisory revenue is due to the fact that our revenue
growth was principally in areas that do not require a substantial amount of
incremental cost to deliver.

Sales and marketing costs increased from approximately $643,000, or 37% of
ratings and advisory revenue for the three months ended March 31, 2003, to
approximately $1,091,000, or 34% of ratings and advisory revenue for the same
period of 2004. The decrease as a percentage of ratings and advisory revenue is
primarily due to our increased renewal base of business. Since we pay a lesser
percentage of commissions to our sales group upon renewals of contracts than we
pay with respect to new contracts, as our business expands, the overall
commission cost as a percentage of ratings and advisory revenue should decline.
Included in sales and marketing cost for the three months ended March 31, 2004
is a non-cash expense of $87,000 related to the fair value of stock options
granted to a consultant for services rendered in connection with the sale of our
Healthcare Quality Reports.

General and administrative expenses. For the three months ended March 31, 2004,
general and administrative expenses were approximately $803,000, an increase of
approximately $213,000 over general and administrative expenses of approximately
$590,000 for the same period of 2003. Contributing to the increase in general
and administrative expenses were costs incurred totaling approximately $90,000
toward the settlement of two legal matters. In addition, general and
administrative expenses includes an accrual of approximately $83,000 related to
incentive compensation payable to employees based upon our estimate of the
current amount earned during the first quarter. We did not have a similar
incentive program in place during the three months ended March 31, 2003.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2004, we had a working capital deficit of approximately $1.6
million, a decrease of $.2 million from a working deficit of approximately $1.8
million as of December 31, 2003. For the first three months of 2004, cash flow
provided by operations was

10

approximately $18,000 compared to $301,000 used in operations for the same
period of 2003. Cash flow provided by operations reflects our payment, during
the quarter ended March 31, 2004, of bonuses totaling approximately $402,000
with respect to 2003 performance.

We have a line of credit arrangement (the "Agreement") with Silicon Valley Bank.
Under the terms of the Agreement, we may request advances not to exceed an
aggregate amount of $1.0 million over the term of the Agreement, subject to 75%
of Eligible Accounts (as defined in the Agreement) plus 50% of our cash invested
with Silicon Valley Bank. As of March 31, 2004, the entire $1.0 million is
available to us. Advances under the Agreement bear interest at Silicon Valley
Bank's prime rate plus .75% and are secured by substantially all of our assets.
In February 2004, we negotiated an extension of the maturity date of the
Agreement from February 20, 2004 to February 20, 2005. Interest is due monthly
on advances outstanding and the principal balance of any advances taken by us
are due on February 20, 2005. Our ability to request advances under the
Agreement is subject to certain financial and other covenants. As of March 31,
2004, we were in compliance with these covenants.

In February 2004, we added approximately 2,900 square feet of office space to
our existing lease of 12,200 square feet. Total annual lease costs are now
approximately $270,000. The lease expires in February 2005. We anticipate that
we will begin negotiations in the summer or fall of 2004 on a multi-year
extension to our current lease.

Operating lease obligations relate principally to our office space lease. In
addition to these obligations, we anticipate incurring capital expenditures
during 2004 primarily to upgrade certain information technology hardware and
software. We expect that total capital expenditures in 2004 will be less than
$300,000. For the three months ended March 31, 2004, capital expenditures
totaled approximately $127,000 and relate to leasehold improvements related to
the additional office space noted above as well as planned upgrades to our
information technology infrastructure.

Although we anticipate that we have sufficient funds available to support
ongoing operations for at least the next twelve months, if our revenues fall
short of our expectations or our expenses exceed our expectations, we may need
to raise additional capital through public or private debt or equity financing.
We may not be able to secure sufficient funds on terms acceptable to us. If
equity securities are issued to raise funds, our stockholders' equity may be
diluted. If additional funds are raised through debt financing, we may be
subject to significant restrictions. Furthermore, as noted above, upon execution
of our SQI, DHP and QAI agreements, we typically receive a non-refundable
payment for the first year of the contract term (which is typically three years,
subject to a cancellation right by either the client or us on each annual
anniversary date) upon contract execution. We record the cash payment as
deferred revenue, which is a current liability on our consolidated balance
sheet, that is then amortized to revenue over the first year of the term. Annual
renewal payments, which are made in advance of the year to which the payment
relates, are treated in the same manner. As a result, our operating cash flow is
substantially dependent upon our ability to continue to sign new agreements, as
well as continue to maintain a high rate of client retention. Our current
operating plan includes growth in new sales from these agreements. A significant
failure to achieve sales targets in the plan would have a material negative
impact on our financial position and cash flow.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We have certain investments in a treasury obligation fund maintained by Silicon
Valley Bank. As of March 31, 2004, our investment in this fund amounted to
approximately $2.8 million. This amount is included within the cash and cash
equivalent line item of our balance sheet and consists of investments in highly
liquid U.S. treasury securities with maturities of 90 days or less. For the
three months ended March 31, 2004, interest earned on this balance was $1,850.
Any decrease in interest rates in this investment account would not have a
material impact on our financial position.

ITEM 4. CONTROL PROCEDURES

a) Evaluation of Disclosure Controls and Procedures

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

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b) Change in Internal Control over Financial Reporting

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

12

PART II. OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

Reference is made to the disclosure under "Legal Proceedings" in Item 3 of our
Form 10-K for the fiscal year ended December 31, 2003 (the "Form 10-K),
particularly the Settlement Agreement and Mutual Release (the "Settlement
Agreement") we entered into with Strategic Performance Fund - II ("SPF-II"),
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
and four of the physician owners of Park Place. Pursuant to the Settlement
Agreement, we paid approximately $441,000 into an escrow account to be released
to SPF-II upon the satisfaction of certain conditions. The conditions were
satisfied in April 2004 and the funds were released to SPF-II. We will pay the
remaining $50,000 due from us to SPF-II on or before September 30, 2004.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.2/\ Loan Modification Agreement dated February 20, 2004 by and between
Health Grades, Inc. and Silicon Valley Bank.

31.1/\ Certification of the Chief Executive Officer pursuant to Rule
15d-14(a) under the Securities Exchange Act.

31.2/\ Certification of the Chief Financial Officer pursuant to Rule
15d-14(a) under the Securities Exchange Act.

32.1/\ Certification of the Chief Executive Officer pursuant to Rule
15d-14(b) under the Securities Exchange Act.

32.2/\ Certification of the Chief Financial Officer pursuant to Rule
15d-14(b) under the Securities Exchange Act.

(b) Reports on Form 8-K

During the quarter ended March 31, 2004, we furnished a report on Form 8-K.
The report, furnished on February 17, 2004 and dated February 12, 2004,
provided information responsive to Item 12 in connection with our fourth
quarter results of operations.

SIGNATURES

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

HEALTH GRADES, INC.

Date: May 17, 2004 By: /s/ Allen Dodge
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Allen Dodge
Senior Vice President - Finance and
Chief Financial Officer

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EXHIBIT INDEX