HEALTH GRADES INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

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FORM 10-Q

(Mark One)

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

For the quarterly period ended SEPTEMBER 30, 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 _________________

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 Exchange Act). Yes [ ] No [X]

On October 31, 2004, 25,122,231 shares of the Registrant's common stock,
$.001 par value, were outstanding.

Health Grades, Inc. and Subsidiaries

INDEX

PART I. FINANCIAL INFORMATION:

Item 1. Condensed Consolidated Balance Sheets
September 30, 2004 and December 31, 2003.......... 3

Condensed Consolidated Statements of Operations -
Three and Nine Months Ended September 30, 2004 and
2003.............................................. 4

Condensed Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 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 Disclosures About
Market Risk....................................... 12

Item 4. Controls and Procedures .............................. 12

PART II. OTHER INFORMATION: 13

Item 6. Exhibits ............................................. 13

2

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

See accompanying notes to condensed consolidated financial statements.

3

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

See accompanying notes to condensed consolidated financial statements.

4

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

See accompanying notes to condensed consolidated financial statements.

5

Health Grades, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 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 and nine months ended September 30, 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 care of hospitals and
nursing homes and detailed profile information on physicians, that enables our
clients 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 tailored to address service areas (e.g.
cardiac, orthopedics, vascular, etc.) upon which they 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 physician-led quality improvement
consulting engagements for any hospitals that are seeking to enhance quality.

In addition, we provide basic and detailed 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, a medical professional underwriter).

We provide detailed online healthcare quality information for employers,
benefits consulting firms, payers and other organizations that license our
Quality Ratings Suite(TM) of products - Hospital Quality Guide(TM), Physician
Quality Guide(TM), Nursing Home Quality Guide(TM) and Home Health Quality
Guide(TM).

NOTE 2 - STOCK-BASED COMPENSATION

We account for our stock-based compensation arrangements using the intrinsic
value method under the provisions of APB No. 25 and related interpretations.

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.

For the nine months ended September 30, 2004, the fair value of options awarded
during this period were estimated using the Black- Scholes model with the
following assumptions: a risk-free interest rate over the life of the options of
between 2.44% to 3.16%; no

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dividend yield; and expected three year lives of the options. The volatility
factors utilized ranged from 1.51 to 1.78.

For the nine months ended September 30, 2003, the fair value of options awarded
during this period were estimated using the Black-Scholes model with the
following assumptions: a risk-free interest rate over the life of the options of
between 1.32% to 2.23%; no dividend yield; and expected three year lives of the
options. The volatility factors utilized ranged from 1.96 to 2.04.

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 and nine months ended September 30, 2004 and 2003.

During the nine months ended September 30, 2004, the number of our common shares
issued increased by 666,796 shares due to the exercise of stock options by
several individuals. We received approximately $70,000 from these individuals,
which represents the exercise price of the options. In addition, during the nine
months ended September 30, 2004, we granted options to purchase 150,000 shares
of our common stock to a consultant. We recorded an expense of approximately
$158,000 in the accompanying condensed consolidated statement of operations for
the nine months ended September 30, 2004 based upon the fair value of these
options. As of September 30, 2003, we had approximately 5.5 million shares
underlying options and warrants that were currently exercisable, but were not
included in our calculation of weighted average common shares outstanding as
they were antidilutive.

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.

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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. 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. As the
$441,000 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 April 2004, upon satisfaction of
the conditions described above, the $441,000 in the above mentioned escrow
account was released to SPF-II. In July 2004, we made the final $50,000 payment
to SPF-II, and an order of dismissal was entered on July 30, 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 $1,383 and $420 for the nine months ended
September 30, 2004 and 2003, respectively.

8

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, the addition of new service lines, anticipated future revenues
and anticipated additional personnel additions 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 unanticipated
expenditures, client turnover inability of management to identify or develop
additional service lines 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:

Revenue Growth and Client Retention - We believe these are key factors affecting
both our results of operations and our liquidity. Revenue growth during the
first nine months of 2004 reflects growth across all of our product areas. In
prior years, our revenue growth was principally due to increased sales of our
Strategic Quality Initiative (SQI) program to hospitals. Sales of our SQI
programs to hospitals were particularly strong in the period following our
annual release of our new ratings, which occurs during the fall for most of the
procedures and diagnoses for which we rate hospitals. This trend continued in
2004 as sales were strong in September. We also have added, and plan to continue
to add, new service lines and awards to market to hospitals. For example, in the
second quarter of 2003, we announced the recipients of our first annual
Distinguished Hospital Award for Clinical Excellence(TM) (DHA-CE). Hospitals
that were DHA-CE recipients represent the highest-scoring of the nation's
full-service hospitals based on a three-year, risk-adjusted analysis of
procedures and diagnoses in six major clinical specialties. In the fourth
quarter of 2003, we identified the DHA-CE recipients for the 2004 year and began
marketing our services to those hospitals. Sales of both our SQI and DHA-CE
programs during the third and fourth quarter of 2003 contributed to our 2004
revenue growth. Our Distinguished Hospital Award for Patient Safety(TM) (DHA-PS)
was launched during the latter part of the second quarter of 2004. This award is
based on thirteen of the Agency for Healthcare Research and Quality's Patient
Safety Indicators. As part of our 2005 ratings release, which occurred in
October 2004, we added Gastrointestinal services to the eight service lines that
we currently market to hospitals. In addition, we have developed a new Critical
Care service line (which includes procedures and diagnoses such as pulmonary
embolism, sepsis and respiratory failure) which we will begin marketing to
hospitals during the fourth quarter of 2004.

We also experienced meaningful growth from the sales of our quality information
to employers, benefits consulting firms, consumers and others through our
Healthcare Quality Reports and our Quality Ratings Suite (QRS). We have achieved
this growth principally through the utilization of our distribution channels for
our Healthcare Quality Reports such as Hewitt Associates, which provides our
quality information to over 125 Fortune 1000 corporations throughout the United
States and the increased sales of our information to consumers.

In addition to our efforts to generate new sales, a principal objective for us
is to achieve a high rate of retention of our clients. This is particularly true
for our hospital clients, which typically sign agreements for three-year terms,
subject to a cancellation right by either the hospital or us, on each annual
anniversary date. We believe one of the obstacles to maintaining high retention
rates is that clients who signed hospital contracts with us several years ago,
when we were developing our provider services business 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 (subject to the ability
of a client or us to terminate on each anniversary date), we anticipate that all
exclusivity provisions will expire by the end of 2006. While the termination of
exclusivity provisions may serve as a disincentive for some hospitals to renew
agreements with us, we believe we will benefit from the ability to market our
services to hospitals that we were previously precluded from approaching under
exclusivity arrangements. During the nine months ended September 30, 2004, we
retained contracts representing approximately 76% of the annual revenue
associated with all contracts that had first or second year anniversaries during
this period.

We typically receive a non-refundable payment from hospital clients for the
first year of the contract term upon contract execution. If we are unable to
attract new hospital clients and retain a significant portion of our current
clients, our liquidity could be adversely affected.

9

Variable Expense Considerations - During 2003, we added personnel to provide
client consulting and support for our DHA-CE, 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, information technology personnel and, possibly, additional
administrative support personnel as we continue to expand our revenue base. The
addition of personnel, particularly client consultants, will be dependent on the
level and mix of our sales. For example, our QAI programs entail more consulting
services and, therefore, require a higher ratio of consultants than our other
programs. We also continue to look for ways to enhance our existing database of
quality information. We believe the quality of our information is of the utmost
importance and we will continue to pursue ways to enhance both the quantity and
quality of our information. We also have in place a cash incentive program for
2004, the amount of which will be dependent upon company performance. Based on
company performance through the first nine months of 2004, we have recorded an
expense of approximately $518,000 related to the program. Of this amount,
approximately $169,000 was paid out to employees during the third quarter and
the remaining $349,000 is accrued in the accompanying condensed consolidated
balance sheet. 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.

Distribution and Other Collaborative Arrangements - 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 expand upon
distribution channels through relationships with companies such as Hewitt
Associates. We expect to continue to seek 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. In June 2004, we announced an
arrangement with 3M Health Information Systems (3M) under which we will offer,
pursuant to a "Quality Excellence Program", 3M's coding expertise and process
improvement services in conjunction with our clinical quality improvement
services. This program is designed to assist hospitals in assessing and
improving their performance in the quality of care delivered and the accuracy
of the patient data that is publicly available and utilized by employers,
payers, and consumers to identify the best hospitals.

We believe our cash resources are sufficient to support ongoing operations for
the next twelve months. Nevertheless, we confront the risk that our inability to
generate revenues as expected could compel us to seek additional financing,
which may not be available at satisfactory terms.

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 our goodwill impairment analysis. For the nine months ended
September 30, 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

Revenue Overview

Three months ended Three months ended Nine months ended Nine months ended
Product Area September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003
- ------------ ------------------ ------------------- ------------------ ------------------

Marketing services to hospitals
(SQI and DHP products) $ 2,131,578 $ 1,675,224 $ 6,287,540 $ 4,501,979

10

Quality improvement services to
hospitals
(QAI products) 580,330 220,089 1,429,333 639,340

Sales of quality information to
employers, consumers and others
(QRS and Healthcare Quality
Reports) 919,835 309,941 2,520,294 738,889

Consultant reimbursed travel 41,550 44,165 153,863 116,263

Other -- 40,250 -- 40,250
----------- ----------- ----------- -----------
Total $ 3,673,293 $ 2,289,669 $10,391,030 $ 6,036,721
=========== =========== =========== ===========

Ratings and advisory revenue. For the three and nine months ended September 30,
2004, ratings and advisory revenue was approximately $3.7 million and $10.4
million, respectively, compared to ratings and advisory revenue of $2.3 million
and $6.0 million for the three and nine months ended September 30, 2003. For the
third quarter of 2004 and 2003, approximately 58% and 73% of our ratings and
advisory revenue was derived from our marketing services to hospitals. Although
revenue from our marketing services declined as a percentage of total revenue
from 2003 to 2004, revenues from this product area increased by approximately
$456,000 to $2.1 million for the three months ended September 30, 2004.
This increase is principally due to the addition of new clients from 2003 to
2004. We continue to add clients for our eight existing service lines as well as
our Distinguished Hospital Awards for Clinical Excellence and Patient Safety. In
addition, approximately 16% of our ratings and advisory revenue was derived from
the sale of our quality improvement services to hospitals for the third quarter
of 2004 compared to 10% for the same period of 2003. Sales of our quality
information totaled 25% of our ratings and advisory revenue for the three months
ended September 30, 2004 compared to 14% for the same period of 2003. Our
relationship with Hewitt Associates, through whom we provide our quality
information to over 125 of the Fortune 1000 companies was a principal reason for
the increase in sales of our quality information along with growth in our direct
sales of quality reports to consumers via our website.

Cost of ratings and advisory revenue. For the three months and nine months ended
September 30, 2004, cost of ratings and advisory revenue was $651,000 and $1.9
million, respectively, or approximately 18% of ratings and advisory revenue,
compared to $510,000 and $1.4 million, respectively, or approximately 22% and
23% 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 from our marketing services to hospitals and
sales of quality information, and increase sales of these items do not entail a
substantial amount of incremental cost. In addition, one of the significant
components of cost of ratings and advisory revenue is our cost to acquire data,
which has remained relatively fixed for the last year. Moreover, our sales of
our healthcare quality reports do not require any commission costs as these are
sold online directly to consumers. Costs related to our healthcare quality
reports are principally related to payments to internet search engines for
placement on the internet, as well as fees paid to a consultant. These costs are
included in sales and marketing expense in our consolidated statements of
operations.

Sales and marketing costs for the three and nine month periods ended September
30, 2004 increased to approximately $1.3 million and $3.5 million, respectively,
or 35% and 34% of ratings and advisory revenue, from approximately $817,000 and
$2.3 million, or 36% and 38% of ratings and advisory revenue for the three and
nine months ended September 30, 2003. The decrease as a percentage of ratings
and advisory revenue is primarily due to our increased existing base of
business. We pay a lesser percentage of commissions to our sales group upon
renewals of contracts with hospitals than we pay with respect to new contracts.

General and administrative expenses. For the three months ended September 30,
2004, general and administrative expenses were approximately $806,000, an
increase of approximately $150,000 from general and administrative expenses of
approximately $656,000 for the same period of 2003. For the nine months ended
September 30, 2004, general and administrative expenses increased by
approximately $283,000 to $2.3 million compared to the same period of 2003. The
increase in expenses in the three and nine months ended September 30, 2004
compared to the three and nine months ended September 30, 2003 is principally
due to the addition of personnel from 2003.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2004, we had a working capital deficit of approximately
$448,000, a reduction of $1.4 million from our working capital deficit of
approximately $1.8 million as of December 31, 2003. Included in current
liabilities as of September 30, 2004 is $6.3 million in deferred income,
representing contract payments for future services. These amounts will be
reflected in revenue upon provision of

11

the related services. For the first nine months of 2004, cash flow provided by
operations was approximately $1.4 million compared to cash used in operations of
approximately $57,000 for the same period of 2003. Our 2004 profit has
favorably affected the improvement in our working capital deficit as well as our
cash flow from operations.

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 a
maximum borrowing equal to 75% of Eligible Accounts (as defined in the
Agreement) plus 50% of our cash invested with Silicon Valley Bank. As of
September 30, 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. 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 September
30, 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 have determined
that we will be relocating our corporate office upon the expiration of our lease
term. We are currently negotiating a lease on new office space in close
proximity to our current location. We expect that the amount of office space we
will be committing to will be significantly in excess of our current lease to
accommodate our anticipated growth. We expect to incur costs related this move
principally during the first quarter of 2005. These costs will include office
furniture for the new location and moving existing equipment and files from our
current location and other items. We have not yet determined the amount of our
relocation costs. In addition, as we are increasing the amount of space under
lease, we anticipate that our annual lease costs will increase significantly.

Operating lease obligations relate principally to our current office space
lease. In addition to these obligations, we anticipate incurring certain capital
expenditures during the remainder of 2004 primarily to upgrade some of our
information technology hardware and software. We expect that total capital
expenditures in 2004, including planned fourth quarter expenditures, will be
less than $300,000. For the nine months ended September 30, 2004, capital
expenditures totaled approximately $224,000 and related to leasehold
improvements in connection with planned upgrades to our information technology
infrastructure as well as the additional office space in our current location,
as noted above.

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). We record the cash payment as deferred revenue, which is a
current liability on our consolidated balance sheet and then amortized to
revenue over the first year of the term. Subsequent annual 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 agreements. A significant failure to achieve sales targets in the
plan or a significant decline in our renewal rate 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 September 30, 2004, our investment in this fund amounted to
approximately $4.4 million. This amount is included within the cash and cash
equivalent line item of our balance sheet. The fund principally invests in
highly liquid U.S. treasury securities with maturities of 90 days or less. For
the nine months ended September 30, 2004, interest earned on this balance was
$8,289. Any decrease in interest rates in this investment account would not have
a material impact on our financial position.

ITEM 4. CONTROLS AND PROCEDURES

a) Evaluation of Disclosure Controls and Procedures

Management, with the participation of our Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness 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

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under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission's rules and forms. A controls system, no matter how well designed and
operated, cannot provide absolute assurance that the objectives of the controls
system are met, and no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, within a company have
been detected.

b) Change in Internal Control over Financial Reporting

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

PART II. OTHER INFORMATION

ITEM 6. EXHIBITS

Exhibit No. Description
---------- -----------

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

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

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

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

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

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

SIGNATURES

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

HEALTH GRADES, INC.

Date: November 15, 2004 By: /s/ Allen Dodge
-------------------------------------
Allen Dodge
Senior Vice President - Finance and
Chief Financial Officer

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Exhibit Index

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

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

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

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

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

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