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

Overview

We provide point-of-care medication management and physician decision support solutions that focus on addressing the needs of physicians, managed care payers and plans, and pharmaceutical manufacturers.

From our inception in 1986 through 1996, we focused almost exclusively on the sale of prepackaged medications to physicians, in particular those with a high percentage of fee-for-service patients. The advent of managed prescription benefit programs required providers to obtain reimbursement for medications dispensed from managed care organizations rather than directly from their patients. This new reimbursement methodology made it more difficult for our physician customers to dispense medications to their patient base.

In 1997, under the direction of our new executive management team, we focused our efforts on the information aspects of medication management, including the development of technology tools necessary for electronic prescribing, routing of prescription information and submission of medication claims for managed care reimbursement. In January 1998, we introduced the first version of our TouchWorks software that fully incorporated these features. At the same time, we redirected our sales and marketing efforts away from our traditional fee-for-service customer base to physicians who have a large percentage of managed care patients. We recognized that there is a larger market opportunity among physicians whose patients are covered by managed care plans because the portion of prescriptions covered by managed care plans is increasing relative to the portion of fee-for-service prescriptions. Further, we believe that our technology can give us a competitive advantage where more patients' prescriptions are covered b y managed care plans because our products streamline the process by which physicians, managed care organizations and patients interact. In addition, we believe that the managed care market provides us with the opportunity to realize higher margins on our software products.

We believe that managed care prescription programs will continue to cover an increasing percentage of patients in the foreseeable future. This trend will have the effect of reducing the dispensing opportunities of our traditional dispensing customers because of their inability to submit claims electronically for reimbursement by managed care payers. This reduction in dispensing opportunities will reduce the revenue that we have historically recognized from these customers. Additionally, managed care programs impose reduced reimbursement rates for the medications dispensed to their plan participants, thus providing us with a dollar margin per prescription dispensed that is lower than we have historically experienced. Because TouchWorks enables physicians to submit claims electronically for reimbursement by managed care payers, a large portion of the medications dispensed by our TouchWorks customers is dispensed to managed care patients. Accordingly, we expect that this portion of our business will provide margins with respect to the sale of prepackaged medications that are lower than we have historically experienced. In addition, we expect that seasonal variances in demand for our products and services will continue. Historically, all other factors aside, our sales of prepackaged medications have been highest in the fall and winter months.

In addition to medication management, there are other aspects of the physician's daily work flow that we address through technology-focused solutions. We have enhanced and intend to continue to enhance our current offerings by integrating new products and services. In May 2000, we acquired MasterChart, Inc., a software developer providing dictation, integration and patient record technology, and Medifor, Inc., a provider of electronic patient education. In addition, on January 8, 2001, we acquired Channelhealth Incorporated, a software developer providing modular software for physicians to access medical information and manage clinical workflow. Our TouchWorks software now provides a full electronic medical record for physicians practicing in an ambulatory environment.

In July 2001, we announced and began implementation of a restructuring plan to realign our organization; prioritize our initiatives around high-growth areas of our business; focus on profitability; reduce operating expenses; improve efficiencies in light of the aforementioned acquisitions; and focus sales and service efforts on larger physician practices, academic medical centers, and integrated delivery networks. The restructuring plan includes workforce and overhead reduction, and the termination of certain strategic agreements and unprofitable customer contracts. As a result of the restructuring plan, we recorded restructuring and other charges of $4,370,000 and $4,266,000, respectively, during the third quarter of 2001, of which $6,435,000 was classified as operating expenses and $2,201,000 was classified as cost of revenue. In addition, certain events and changes in circumstances caused us to conduct a review of the carrying value of our goodwill and purchased intangible assets. These events inc lude the restructuring plan, the business climate, which has generated valuation declines of enterprises in our industry, and the failure of certain assets to generate the cash flows that were projected at the time of acquisition. As a result of this review, we recorded an asset impairment charge of $354,984,000 during 2001.

We currently operate in three reportable business segments: prepackaged medications; software and related services; and information services. Software and related services include revenue from software licenses, computer hardware, and related services. Information services include physician education and information products.

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The following table illustrates the quarterly revenue trend for the three reportable segments for the quarters ended (unaudited in thousands):

Critical Accounting Policy

Software Capitalization

In accordance with Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed," we capitalize certain computer software development costs upon the establishment of technological feasibility. Technological feasibility is established upon completion of all planning, designing, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements, which is generally evidenced by a detailed program design. Capitalization of costs occurs from this point until the product is available for general release to our customers.

At each balance sheet date, we compare the carrying value of each capitalized software product to its estimated net realizable value, which is determined by estimating future gross revenues from that product reduced by the estimated future costs of completing and disposing of that product, including the costs of performing maintenance and customer support required to satisfy our responsibility set forth at the time of sale.

We amortize capitalized software costs for product available for general release based upon the greater of the ratios that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product, or the straight-line method over the estimated useful life of the product.

Significant management judgment and estimates are utilized in the assessment of when technological feasibility is established, as well as in the ongoing assessment of the recoverability of capitalized costs. If we determine in the future that the carrying value of the capitalized software is not realizable, a write-down of the carrying value of the capitalized software to its estimated net realizable value would be required. Factors that affect our assessment of net realizable value include: the estimated useful life of the product; the level of revenues which are expected to be generated in the future; the level of costs which are expected to be incurred in completion, sale, and support of the product; and identification of any high risk development issues which may render a product, for which costs have been capitalized, unsaleable.

Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001

Prepackaged Medications

Prepackaged medication revenue decreased by 1.9%, or $239,000, from $12,719,000 in the second quarter of 2001 to $12,480,000 in the second quarter of 2002. The decrease reflects a decrease in the volume of prepackaged medications sold resulting from the termination of unprofitable customer arrangements, offset by an increase in the average selling prices of medications sold, due primarily to general price inflation.

Cost of revenue for prepackaged medications for the three months ended June 30, 2002 decreased by 2.9%, or $303,000, from $10,405,000 in 2001 to $10,102,000 in 2002. The decrease was due to decreased volume of sales of prepackaged medications and more favorable buying arrangements with suppliers.

Operating expenses for prepackaged medications for the three months ended June 30, 2002 decreased by 15.6%, or $337,000, from $2,157,000 in 2001 to $1,820,000 in 2002. The decrease was primarily due to lower intangible amortization expense resulting from an intangible asset impairment charge taken during 2001, and the elimination of the requirement to amortize goodwill pursuant to SFAS No. 142, "Goodwill and Other Intangible Assets."

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Software and Related Services

Software and related service revenue for the three months ended June 30, 2002 decreased by 6.7%, or $361,000, from $5,379,000 in 2001 to $5,018,000 in 2002. The decrease reflects lower revenue derived from our software sales to smaller physician practices as a result of a decision we made in 2001 to focus sales and service efforts on larger physician practices, as well as our exit from unprofitable customer arrangements.

Cost of revenue for software and related services decreased by 28.2%, or $1,637,000, from $5,812,000 in the second quarter of 2001 to $4,175,000 in the second quarter of 2002. The decrease was primarily due to lower amortization expense of acquired software and lower depreciation expense due to the decision to exit unprofitable customer contracts, offset by increased cost of implementation, training, and support.

Operating expenses for software and related services for the three months ended June 30, 2002 decreased by 77.7%, or $23,501,000, from $30,254,000 in 2001 to $6,753,000 in 2002. The decrease was primarily due to lower intangible amortization expense resulting from an intangible asset impairment charge taken during 2001, and the elimination of the requirement to amortize goodwill pursuant to SFAS No. 142. In addition, operating expenses were lower as a result of workforce reductions that were aimed at improving efficiencies in light of acquisitions made during 2001 and 2000, the decision to focus sales and service efforts on larger physician practices, and the subsidization of marketing expenses by our strategic partners. Also, during the second quarter of 2002, we capitalized $638,000 of software development costs pursuant to SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed."

Information Services

Information services revenue increased by 141.5%, or $1,521,000, from $1,075,000 in the second quarter of 2001 to $2,596,000 in 2002. The increase in information services revenue reflects an increase in the number of interactive physician education programs sold and completed.

Cost of revenue for information services for the three months ended June 30, 2002 increased 30.1%, or $196,000, from $651,000 in 2001 to $847,000 in 2002. The increase was due to a higher number of physician education sessions completed.

Operating expenses for information services for the three months ended June 30, 2002 decreased by 18.3%, or $255,000, from $1,393,000 in 2001 to $1,138,000 in 2002. The decrease was primarily due to lower intangible amortization expense as the related intangible asset was fully amortized during 2001.

Interest Income and Income Taxes

Interest income for the three months ended June 30, 2002 was $727,000 as compared to $1,335,000 for the prior year period. The decrease related to a lower average cash and marketable securities balance and a decrease in the average interest rates earned on our investments as compared to the prior year period.

We recorded a benefit for income taxes during the three months ended June 30, 2001 of $2,249,000 from the scheduled reversal of deferred tax liabilities related to the amortization of non-goodwill intangible assets. No other provision or tax benefit for income taxes was recorded in either period because we currently anticipate that annual income taxes payable will be minimal or zero, and we have provided a valuation allowance for our net deferred tax assets.

Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001

Prepackaged Medications

Prepackaged medication revenue decreased by 1.3%, or $323,000, from $25,282,000 in the first six months of 2001 to $24,959,000 in the first six months of 2002. The decrease reflects a decrease in the volume of prepackaged medications sold resulting from the termination of unprofitable customer arrangements, offset by an increase in the average selling prices of medications sold, due primarily to general price inflation.

Cost of revenue for prepackaged medications for the six months ended June 30, 2002 decreased by 1.9%, or $388,000, from $20,718,000 in 2001 to $20,330,000 in 2002. The decrease was due to decreased volume of sales of prepackaged medications and more favorable buying arrangements with suppliers.

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Operating expenses for prepackaged medications for the six months ended June 30, 2002 decreased by 17.8%, or $775,000, from $4,352,000 in 2001 to $3,577,000 in 2002. The decrease was primarily due to lower intangible amortization expense resulting from an intangible asset impairment charge taken during 2001, and the elimination of the requirement to amortize goodwill pursuant to SFAS No. 142.

Software and Related Services

Software and related service revenue for the six months ended June 30, 2002 increased by 8.7%, or $756,000, from $8,701,000 in 2001 to $9,457,000 in 2002. The increase reflects an increase in sales of our integrated content and clinical workflow products, offset by lower revenue derived from our software sales to smaller physician practices as a result of a decision we made in 2001 to focus sales and service efforts on larger physician practices, as well as our exit from unprofitable customer arrangements.

Cost of revenue for software and related services decreased by 24.1%, or $2,564,000, from $10,643,000 in the first six months of 2001 to $8,079,000 in the first six months of 2002. The decrease was primarily due to lower amortization expense of acquired software and lower depreciation expense due to the decision to exit unprofitable customer contracts, offset by increased cost of implementation, training, and support.

Operating expenses for software and related services for the six months ended June 30, 2002 decreased by 76.6%, or $47,723,000, from $62,263,000 in 2001 to $14,540,000 in 2002. The decrease was primarily due to lower intangible amortization expense resulting from an intangible asset impairment charge taken during 2001, and the elimination of the requirement to amortize goodwill pursuant to SFAS No. 142. In addition, operating expenses were lower as a result of workforce reductions that were aimed at improving efficiencies in light of acquisitions made during 2001 and 2000, the decision to focus sales and service efforts on larger physician practices, and the subsidization of marketing expenses by our strategic partners. Also, during the first six months of 2002, we capitalized $744,000 of software development costs pursuant to SFAS No. 86. During the six months ended June 30, 2001, we recorded a write-off of acquired in-process research and development of $3,000,000 related to an acquisition.

Information Services

Information services revenue increased by 148.8%, or $2,662,000, from $1,789,000 in the first six months of 2001 to $4,451,000 in 2002. The increase in information services revenue reflects an increase in the number of interactive physician education sessions sold and completed.

Cost of revenue for information services for the six months ended June 30, 2002 increased 52.1%, or $571,000, from $1,095,000 in 2001 to $1,666,000 in 2002. The increase was due to the higher number of physician education sessions completed.

Operating expenses for information services for the six months ended June 30, 2002 decreased by 25.2%, or $727,000, from $2,884,000 in 2001 to $2,157,000 in 2002. The decrease was primarily due to lower intangible amortization expense as the related intangible asset was fully amortized during 2001.

Interest Income and Income Taxes

Interest income for the six months ended June 30, 2002 was $1,473,000 as compared to $3,114,000 for the prior year period. The decrease related to a lower average cash and marketable securities balance and a decrease in the average interest rates earned on our investments as compared to the prior year period.

We recorded a benefit for income taxes during the six months ended June 30, 2001 of $4,348,000 from the scheduled reversal of deferred tax liabilities related to the amortization of non-goodwill intangible assets. No other provision or tax benefit for income taxes was recorded in either period because we currently anticipate that annual income taxes payable will be minimal or zero, and we have provided a valuation allowance for our net deferred tax assets.

Liquidity and Capital Resources

At June 30, 2002, our principal sources of liquidity consisted of $21,144,000 of cash and cash equivalents and $46,585,000 of marketable securities. At June 30, 2002, we had working capital of $48,773,000 and an accumulated deficit of $548,292,000.

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Net cash used in operating activities was $10,651,000 for the six months ended June 30, 2002. Cash used in operating activities resulted primarily from a loss from operations of $9,986,000, partially offset by depreciation and amortization of $3,088,000. Accounts receivable increased by $3,683,000 in the six months ended June 30, 2002, primarily due to growth in revenue. Inventories decreased by $1,884,000 during the six months ended June 30, 2002 due to the sale of advance purchases of certain medications where shortages were expected. Accrued restructuring and other charges decreased by $1,183,000 during the six months ended June 30, 2002 primarily due to cash payments made for employee severance arrangements.

Net cash used in investing activities was $4,235,000 for the six months ended June 30, 2002. Cash used in investing activities resulted primarily from net purchases of marketable securities of $2,419,000. In addition, capital expenditures were $1,072,000 for the six months ended June 30, 2002 as a result of capital outlays to support the future growth of our business. We also capitalized software development costs of $744,000 during the six months ended June 30, 2002. Currently, we have no material commitments for capital expenditures, although we anticipate ongoing capital expenditures in the ordinary course of business.

Net cash provided by financing activities was $1,906,000 for the six months ended June 30, 2002, primarily as a result of the sale of common stock to a strategic partner.

The following table summarizes our contractual obligations at June 30, 2002, and the effect such obligations are expected to have on our liquidity and cash in future periods (in thousands):

We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet the anticipated cash needs of our current business for at least the next twelve months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. We will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services and technologies, which might impact our liquidity requirements or cause us to issue additional equity or debt securities. There can be no assurance that financing will be available in the amounts or on terms acceptable to us, if at all.

Safe Harbor For Forward-Looking Statements

This report, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Notes to Consolidated Financial Statements," and statements we or our representatives make may contain forward-looking statements that involve risks and uncertainties. We develop forward-looking statements by combining currently available information with our beliefs and assumptions. These statements often contain words like believe, expect, anticipate, intend, contemplate, seek, plan, estimate or similar expressions. Forward-looking statements do not guarantee future performance. Recognize these statements for what they are and do not rely upon them as facts.

Forward-looking statements involve risks, uncertainties and assumptions, including, but not limited to, those discussed in this report. We make these statements under the protection afforded them by Section 21E of the Securities Exchange Act of 1934. Because we cannot predict all of the risks and uncertainties that may affect us, or control the ones we do predict, our actual results may be materially different from the results we express in our forward-looking statements. Unless otherwise required by applicable securities laws, we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

For a more complete discussion of the risks, uncertainties and assumptions that may affect us, see our Annual Report on Form 10-K for the fiscal year ended December 31, 2001.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of June 30, 2002, we did not own any derivative instruments but we were exposed to market risks, primarily changes in U.S. interest rates. As of June 30, 2002, we had cash, cash equivalents and marketable securities in financial instruments of $67,729,000. Maturities range from less than one month to approximately 18 years. Declines in interest rates over time will reduce our interest income from our investments. Based upon our balance of cash, cash equivalents and marketable securities as of June 30, 2002, a decrease in interest rates of 1.0% would cause a corresponding decrease in our annual interest income of approximately $677,000.

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PART II. OTHER INFORMATION

ITEM 4. Submission of Matters to a Vote of Security Holders

At Allscripts' Annual Meeting of Stockholders held on May 2, 2002, the stockholders (1) elected M. Fazle Husain, Richard E. Tarrant, and Glen E. Tullman as directors of the Company to hold office until the 2005 annual meeting of stockholders (subject to the election and qualification of their successors or their earlier death, resignation or removal); and (2) approved the amendment of the Company's Amended and Restated 1993 Stock Incentive Plan to increase the number of shares that may be issued under the plan by 1,000,000 shares. The votes were as follows:

ITEM 6. Exhibits and Reports on Form 8-K

(A) Exhibits -- See Index to Exhibits.

(B) Reports on Form 8-K -- None.

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SIGNATURES

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

                                                                         ALLSCRIPTS HEALTHCARE SOLUTIONS, INC.
  (Registrant)

                        By:      /s/ David B. Mullen
                                      David B. Mullen
                                              Chief Financial Officer
                                              (Duly Authorized Officer and
                                               Principal Financial Officer)

Date: August 13, 2002

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INDEX TO EXHIBITS

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