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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
Commission file number 0-13801
QUALITY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
California 95-2888568
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
18191 Von Karman Avenue, Irvine, California 92612
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (949) 255-2600
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 twelve months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days. Yes |X| No |_|
Indicate the number of shares outstanding of each of the Registrant's classes of
Common Stock as of the latest practicable date: 6,312,164 shares of Common
Stock, $.01 par value, as of February 9, 2004
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PART I - CONSOLIDATED FINANICAL INFORMATION
Item 1. Financial Statements
QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
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(in thousands, except per share amounts) December 31, March 31,
2003 2003
(unaudited)
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ASSETS
Current assets:
Cash and cash equivalents $ 45,348 $ 36,443
Accounts receivable, net 21,545 17,561
Inventories, net 837 667
Deferred tax assets 2,029 2,029
Other current assets 1,408 2,086
--------------------------
Total current assets 71,167 58,786
Equipment and improvements, net 1,919 1,777
Capitalized software costs, net 3,323 2,511
Deferred tax assets 1,819 1,819
Goodwill 1,840 1,840
Other assets 1,049 869
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Total assets $ 81,117 $ 67,602
==========================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,066 $ 2,477
Deferred revenue 16,299 11,699
Other current liabilities 6,747 5,893
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Total liabilities 25,112 20,069
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Commitments and contingencies
Shareholders' equity:
Common stock, $0.01 par value, 20,000 shares authorized,
6,276 and 6,152 shares issued and outstanding, respectively 63 62
Additional paid-in capital 37,946 35,121
Retained Earnings 19,646 12,350
Deferred Compensation (1,650) --
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Total shareholders' equity 56,005 47,533
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Total liabilities and shareholders' equity $ 81,117 $ 67,602
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See notes to consolidated financial statements.
1
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
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(in thousands, except per share amounts) Three Months Ended Nine Months Ended
December 31, December 31,
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2003 2002 2003 2002
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Net revenues:
Sales of computer systems, upgrades and supplies $ 9,859 $ 7,666 $ 29,359 $ 20,905
Maintenance and other services 8,340 6,734 22,788 18,796
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18,199 14,400 52,147 39,701
Cost of products and services 7,523 6,353 21,625 16,933
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Gross profit 10,676 8,047 30,522 22,768
Selling, general and administrative expenses 4,902 3,918 14,410 11,033
Research and development costs 1,628 1,347 4,496 3,695
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Income from operations 4,146 2,782 11,616 8,040
Investment income 95 109 284 336
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Income before provision for income taxes 4,241 2,891 11,900 8,376
Provision for income taxes 1,630 956 4,604 3,104
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Net income $ 2,611 $ 1,935 $ 7,296 $ 5,272
================================================
Net income per share, basic $ .42 $ 0.32 $ 1.18 $ 0.86
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Net income per share, diluted $ .40 $ 0.30 $ 1.13 $ 0.83
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See notes to consolidated financial statements.
2
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
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(in thousands) Nine Months Ended December 31,
2003 2002
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Cash Flows from Operating Activities:
Net Income $ 7,296 $ 5,272
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 1,789 1,622
Non-cash compensation from stock option grants 203 --
Changes in:
Accounts receivable (3,984) (2,793)
Inventories (170) 141
Other current assets 678 (92)
Other assets (180) 133
Accounts payable (411) (782)
Deferred revenue 4,600 3,584
Other current liabilities 854 2,010
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Net Cash Provided By Operating Activities 10,675 9,095
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Cash Flows From Investing Activities:
Proceeds from the sale of short term investments -- 255
Net additions to equipment and improvements (788) (859)
Additions to capitalized software costs (1,955) (1,045)
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Net Cash Used In Investing Activities (2,743) (1,649)
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Cash Flows from Financing Activities:
Proceeds from exercise of stock options 973 257
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Net Cash Provided by Financing Activities 973 257
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Net Increase in Cash and Cash Equivalents 8,905 7,703
Cash and Cash Equivalents, beginning of period 36,443 25,443
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Cash and Cash Equivalents, end of period $ 45,348 $ 33,146
==========================
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Supplemental Information - During the Nine months ended December 31, 2003 and
2002, the Company made income tax payments, net of refunds received, of
$4,254,000 and $2,411,000 respectively.
See notes to consolidated financial statements.
3
QUALITY SYSTEMS, INC.
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying unaudited consolidated financial statements as of December 31,
2003 and for the three and nine month periods ended December 31, 2003 and 2002,
have been prepared in accordance with the requirements of Form 10-Q and,
therefore, do not include all information and footnotes which would be presented
were such financial statements prepared in accordance with generally accepted
accounting principles. These financial statements should be read in conjunction
with the audited financial statements presented in the Company's Annual Report
for the fiscal year ended March 31, 2003. In the opinion of management, the
accompanying consolidated financial statements reflect all adjustments which are
necessary for a fair presentation of the results of operations and cash flows
for the periods presented. The results of operations for such interim periods
are not necessarily indicative of results of operations to be expected for the
full year.
2. Summary of Significant Accounting Policies
Principles of Consolidation. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiary. All significant
inter-company amounts and transactions have been eliminated.
Basis of Presentation. The accompanying consolidated financial statements have
been prepared in accordance with accounting principals generally accepted in the
United States of America.
Revenue Recognition. The Company recognizes revenue pursuant to Statement of
Position ("SOP") 97-2, "Software Revenue Recognition" ("SOP 97-2") as amended by
SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition". The Company
generates revenues from licensing rights to use its software products directly
to end-users and value-added resellers (VARs). The Company also generates
revenues from sales of hardware and third party software, and implementation,
training and post-contract support ("maintenance") services performed for
customers who license the Company's products. A typical system contract contains
multiple elements of two or more of the above items. SOP 97-2, as amended,
requires revenue earned on software arrangements involving multiple elements to
be allocated to each element based on the relative fair values of those
elements. The fair value of an element must be based on objective evidence that
is specific to the vendor. When evidence of fair value exists for the delivered
and undelivered elements of a transaction, then discounts for individual
elements are aggregated and the total discount is allocated back to the
individual elements in proportion to the elements' fair value to the total
contract fair value.
When evidence of fair value exists for the undelivered elements only, the
residual method, provided for under SOP 98-9, is required to be used. Under the
residual method, the Company defers revenue related to the undelivered elements
in a system sale based on vendor specific objective evidence of each element's
fair value, which is based on the average sales price of those elements when
sold separately, and allocates the remainder of the contract price to revenue
recognized from the delivered elements. Typically, the Company will bill for the
entire contract amount upon contract execution. Amounts billed in excess of the
amounts contractually due are recorded in accounts receivable as advance
billings. Amounts are contractually due when services are performed or in
accordance with contractually specified payment dates.
Provided the fees are fixed and determinable and collection is considered
probable, revenue from licensing rights and sales of hardware and third party
software are generally recognized upon shipment and transfer of title. Revenue
from implementation, training and software customization services is recognized
as the corresponding services are performed. Maintenance revenue is recognized
ratably over the contractual maintenance period.
Certain system sales contracts may contain payment terms based on certain
performance milestones or may include services to provide significant
customization of the software. License and hardware revenues for such contracts
may be recognized using the percentage of completion or completed contract
method, as appropriate.
4
License arrangements with VARs generally do not provide for returns, and
in such cases, license revenues from VARs are generally recognized upon
shipment.
Cash and Cash Equivalents. Cash and cash equivalents generally consist of cash,
money market funds and short term U.S. Treasuries. The Company invests a portion
of its cash in a money market fund which invests in only investment grade money
market instruments from a variety of industries, and therefore bears minimal
risk. The average maturity of the investments owned by the money market fund is
approximately two months.
Accounts Receivable. The Company provides credit terms typically ranging from
thirty days to less than twelve months for most system and maintenance contract
sales and generally does not require collateral. The Company performs ongoing
credit evaluations of its customers and maintains reserves for estimated credit
losses. Reserves for potential credit losses are determined by establishing both
specific and general reserves. Specific reserves are based on management's
estimate of the probability of collection for certain overdue accounts. General
reserves are established based on the Company's historical collection experience
of bad debt expense and the aging of the Company's accounts receivable balances
net of deferred revenues and specifically reserved accounts. Accounts are
written off as uncollectible only after the Company has expended extensive
collection efforts. Included in accounts receivable are amounts related to
maintenance and services which were billed, but which had not yet been rendered
as of the end of the fiscal year. Undelivered maintenance and services are
included on the balance sheet in deferred revenue.
Inventories. Inventories are valued at lower of cost (first-in, first-out) or
market. Certain inventories are maintained for customer support pursuant to
service agreements and are amortized over a five-year period using the
straight-line method.
Equipment and Improvements. Equipment and improvements are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization of
equipment and improvements are provided over the estimated useful lives of the
assets, or the related lease terms if shorter, by the straight-line method.
Useful lives range from three to seven years.
Software Development Costs. Development costs incurred in the research and
development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been
established. After technological feasibility is established, any additional
development costs are capitalized in accordance with the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed." Such costs are amortized on a straight line basis
over the estimated economic life of the related product, generally three years.
The Company performs an annual review of the recoverability of such capitalized
software costs. At the time a determination is made that capitalized amounts are
not recoverable based on the estimated cash flows to be generated from the
applicable software, any remaining capitalized amounts are written off.
Stock-Based Compensation. The Company accounts for stock-based employee
compensation using the intrinsic value method as prescribed by APB Opinion No.
25, Accounting for Stock Issued to Employees, and, effective March 31, 2003, has
adopted SFAS 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure" that supercedes Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation". SFAS 148 requires pro forma disclosures of net
income and net income per share as if the fair value based method of accounting
for stock-based awards had been applied to employee grants. It also requires
disclosure of option status on a more prominent and frequent basis. Such
disclosure for the three and nine month periods ended December 31, 2003 and 2002
is presented immediately below. The Company accounts for stock options and
warrants issued to non-employees based on the fair value method, but has not
elected this treatment for grants to employees and board members. Under the fair
value based method, compensation cost is recorded based on the value of the
award at the grant date and is recognized over the service period.
On October 29, 2003, the Board of Directors granted 3,500 options to Emad
Zikry, a director of the Company, at an exercise price of $7.00 per share, as
director fees solely for his service on the Board of
5
Directors. The options vested immediately and expire on October 20, 2008. This
option grant resulted in compensation expense of approximately $130,000 recorded
in the December, 2003 quarter using the intrinsic value method.
On October 29, 2003, the Board of Directors granted 60,000 options to
employees at an exercise price of $15.46 per share. The options vest in four
equal annual installments beginning October 29, 2004 and expire on October 20,
2008. Based on the closing share price of the Company's stock on October 29,
2003 ($44.16 per share), this option grant will result in compensation expense
of up to $1,722,000 (assuming all employees granted options continue their
employment at the Company throughout the entire four year vesting period) to be
amortized evenly over the next four years. During the quarter ended December 31,
2003, the Company recognized prorata compensation expense of $73,000 related to
these options.
The Company's fair value calculations for options granted in fiscal 2004
were made using the Black-Scholes option pricing model with the following
assumptions: expected life - approximately 48 months from the date of the grant;
stock volatility - 55% , risk free interest rate of 3.0%; and, no dividends
during the expected term. The Company used these assumptions to value the 63,500
options granted on October 29, 2003. No options were granted in fiscal 2003.
The Company's calculations are based on a single option valuation approach
and forfeitures are recognized as they occur. If the computed fair values of
awards had been amortized to expense over the vesting period of the awards, pro
forma net income and net income per share would have been as follows:
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(in thousands except for per share amounts) Quarter Ended Nine Months Ended
December 31, December 31,
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2003 2002 2003 2002
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Net Income $ 2,611 $ 1,935 $ 7,296 $ 5,272
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Proforma Option Compensation Cost (Net of Taxes) 64 80 166 240
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Proforma Net Income $ 2,547 $ 1,855 $ 7,130 $ 5,032
======================================================
Reported Basic Net Income Per Share $ 0.42 $ 0.32 $ 1.18 $ 0.86
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Proforma Net Income Per Share $ 0.41 $ 0.30 $ 1.16 $ 0.82
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Reported Diluted Net Income Per Share $ 0.40 $ 0.30 $ 1.13 $ 0.83
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Proforma Diluted Net Income Per Share $ 0.39 $ 0.29 $ 1.10 $ 0.79
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6
3. Recent Accounting Pronouncements
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"), an interpretation of Accounting Research
Bulletin No. 51. FIN 46 requires that a company consolidate variable interest
entities if that company is subject to a majority of the risk of loss from the
entities' activities or the company receives a majority of the entities'
residual returns. FIN 46 also requires certain disclosure about variable
interest entities in which the company has a significant interest, regardless of
whether consolidation is required. The Company has no interests in variable
interest entities and therefore the adoption of FIN 46 on January 1, 2003, did
not have a material impact on the Company's consolidated financial statements.
In May 2003, the FASB issued Statement No. 150 ("SFAS 150"), "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." This statement establishes standards for how an issuer classifies and
measures in its statement of financial position certain financial instruments
with characteristics of both liabilities and equity. In accordance with the
standard, financial instruments that embody obligations for the issuer are
required to be classified as liabilities. SFAS 150 is effective for all
financial instruments created or modified after May 31, 2003, and otherwise
shall be effective at the beginning of the first interim period beginning after
June 15, 2003. The adoption of SFAS 150 did not have a material effect on the
Company's consolidated financial condition or results of operations because the
Company does not have such financial instruments.
In May 2003, the Emerging Issues Task Force of the Financial Accounting
Standards Board reached a consensus on Issue 00-21, "Revenue Arrangements with
Multiple Deliverables." The consensus sets revenue recognition guidance for
arrangements that have multiple deliverables. The consensus is effective for
arrangements entered into in fiscal periods beginning after June 15, 2003. The
Company adopted the consensus, and the adoption had no material impact on it's
consolidated financial position or results of operations as the Company
continues to account for it's software arrangements with multiple elements under
SOP 97-2, as amended by SOP 98-9.
4. Intangible Assets
In accordance with FASB 142, the Company does not amortize goodwill. The balance
of goodwill is related to the Company's wholly owned subsidiary, NextGen
Healthcare Information Systems Inc. ("NextGen Division"), which was acquired by
virtue of two acquisitions in May of 1996 and 1997, respectively. In accordance
with FASB 142, the Company has compared the fair value of the NextGen Division
with the carrying amount of assets associated with the Division and determined
that none of the goodwill recorded as of June 30, 2003 was impaired. The fair
value of the NextGen Division was determined using a reasonable estimate of
future cash flows of the Division and a risk adjusted discount rate to compute a
net present value of future cash flows.
As of December 31, 2003, the Company had the following amounts related to
intangible assets:
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(in thousands) Gross Carrying Accumulated Net Intangible
Amount Amortization Assets
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Capitalized software development (3 yrs) $ 9,926 $ 6,603 $ 3,323
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Aggregate amortization expense for the nine months ended December 31, 2003 $ 1,091
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7
The unamortized balance of capitalized software development costs as of
December 31, 2003 is estimated to be amortized as follows:
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Estimated Amortization Expense
For the year ended March 31, (in thousands)
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2004 $ 356
2005 $ 1,509
2006 $ 952
2007 $ 506
5. Stock Repurchase Plan
In October 2001, the Company's Board of Directors authorized the repurchase on
the open market of up to 5% of the shares of the Company's outstanding Common
stock, subject to compliance with applicable laws and regulations. There was no
requirement that the Company repurchase such shares. This stock repurchase
authorization expired on September 24, 2003. No shares were repurchased under
the plan.
6. Income Taxes
The provision for income taxes for the three and nine month periods ended
December 31, 2003 and 2002 differ from the expected combined statutory rates
primarily due to the estimated impact of varying state income tax rates, as well
as estimated research and development tax credits.
7. Net Income Per Share
The following table reconciles the weighted average shares outstanding for basic
and diluted net income per share for the periods indicated. Basic net income per
share is based upon the weighted average number of common shares outstanding.
Diluted net income per share is based on the assumption that the Company's
outstanding options are included in the calculation of diluted earnings per
share, except when their effect would be anti-dilutive. Dilution is computed by
applying the treasury stock method. Under this method, options are assumed to be
exercised at the beginning of the period (or at the time of issuance, if later),
and as if funds obtained thereby were used to purchase common stock at the
average market price during the period.
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Three Months Ended Nine Month Ended
(in thousands, except per share amounts) December 31, December 31,
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2003 2002 2003 2002
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Net income $2,611 $1,935 $7,296 $5,272
Basic net income per common share:
Weighted average of common shares outstanding 6,237 6,134 6,162 6,121
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Basic net income per common share $ 0.42 $ 0.32 $ 1.18 $ 0.86
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Diluted net income per share:
Weighted average of common shares outstanding 6,237 6,134 6,162 6,121
Effect of potentially dilutive securities (options) 312 269 314 242
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Weighted average common shares outstanding- diluted 6,549 6,403 6,476 6,363
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Diluted net income per common share $ 0.40 $ 0.30 $ 1.13 $ 0.83
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8
8. Operating Segment Information
The Company has prepared operating segment information in accordance with
Statement of Accounting Standards SFAS No. 131 "Disclosures About Segments of an
Enterprise and Related Information" to report components that are evaluated
regularly by the Company's chief operating decision maker, or decision making
group in deciding how to allocate resources and in assessing performance.
The Company's reportable operating segments include its NextGen Healthcare
Information Systems Division and the QSI Division.
The disaggregated financial results of the segments reflect allocation of
certain functional expense categories consistent with the basis and manner in
which Company management internally disaggregates financial information for the
purpose of assisting in making internal operating decisions. Certain corporate
overhead costs are not allocated to the individual segments by management. The
Company evaluates performance based on stand-alone segment revenue and operating
income performance. Because the Company does not evaluate performance based on
return on assets at the operating segment level, assets are not tracked
internally by segment. Therefore, segment asset information is not presented.
Operating segment data for the three and nine month periods ended December
31, 2003 and 2002 is as follows:
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(in thousands) NextGen
Healthcare
Information Systems Unallocated
QSI Division Division Corporate Expenses Consolidated
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Nine Months Ended
December 31, 2003
Revenue $ 12,452 $ 39,695 $ -- $ 52,147
Operating income (loss) $ 3,701 $ 10,995 $ (3,080) $ 11,616
Nine Months Ended
December 31, 2002
Revenue $ 13,036 $ 26,665 $ -- $ 39,701
Operating income (loss) $ 3,642 6,470 $ (2,072) $ 8,040
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Three Months Ended
December 31, 2003
Revenue $ 4,198 $ 14,001 $ -- $ 18,199
Operating Income (Loss) $ 1,351 $ 3,789 $ (994) $ 4,146
Three Months Ended
December 31, 2002
Revenue $ 4,404 $ 9,996 $ -- $ 14,400
Operating Income (Loss) $ 1,340 $ 2,259 $ (817) $ 2,782
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9
9. Composition of Accounts Receivable
Included in accounts receivable are amounts related to maintenance and services
which were billed but not yet rendered as of the end of the period. Undelivered
maintenance and services are included on the consolidated balance sheet as part
of the deferred revenue balance.
--------------------------
(in thousands) December 31, March 31,
2003 2003
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ACCOUNTS RECEIVABLE: (unaudited)
Accounts receivable, excluding undelivered maintenance and services $ 13,460 $ 12,392
Undelivered maintenance and services billed in advance, included in
deferred revenue 9,214 6,159
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Gross Accounts receivable 22,674 18,551
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Reserve for bad debts (1,129) (990)
-----------------------
Net accounts receivable $ 21,545 $ 17,561
=======================
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10. Concentration of Credit Risk
The Company had cash deposits at U.S. banks and financial institutions
which exceeded federally insured limits at December 31, 2003. The Company is
exposed to credit loss for amounts in excess of insured limits in the event of
non-performance by the institutions; however, the Company does not anticipate
non-performance by these institutions.
11. Commitments and Guarantees
The Company's standard sales agreements entered into in the ordinary
course of business typically contain an indemnification provision pursuant to
which the Company indemnifies, holds harmless, and agrees to reimburse the
indemnified party for losses suffered or incurred by the indemnified party in
connection with any United States patent, or any copyright or other intellectual
property infringement claim by any third party with respect to the Company's
software. The potential amount of future payments the Company could be required
to make under these indemnification provisions is, in some instances, unlimited.
The Company has never incurred costs to defend lawsuits or settle claims related
to these indemnification agreements. As a result, the Company believes that its
estimated exposure on these agreements is currently minimal. Accordingly, the
Company has no liabilities recorded for these indemnifications as of December
31, 2003.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Except for the historical information contained herein, the matters
discussed in this Quarterly Report on Form 10-Q, including discussions of the
Company's product development plans, business strategies and market factors
influencing the Company's results, are forward-looking statements that involve
certain risks and uncertainties. Actual results may differ from those
anticipated by the Company as a result of various factors, both foreseen and
unforeseen, including, but not limited to, the Company's ability to continue to
develop new products and increase systems sales in markets characterized by
rapid technological evolution, consolidation within the Company's target
marketplace and among the Company's competitors, and competition from larger,
better capitalized competitors. Many other economic, competitive, governmental
and technological factors could impact the Company's ability to achieve its
goals. Interested persons are urged to review the risks described below, as well
as in the Company's other public disclosures and filings with the Securities and
Exchange Commission.
Company Overview
Quality Systems Inc., comprised of the QSI Division ("QSI Division") and a
wholly owned subsidiary, NextGen Healthcare Information Systems, Inc. ("NextGen
Division") (collectively, the "Company") develops and markets healthcare
information systems that automate medical and dental practices, networks of
practices such as physician hospital organizations (PHO's) and management
service organizations ("MSO's"), ambulatory care centers, community health
centers, and medical and dental schools.
The Company, a California Corporation formed in 1974, was founded with an
early focus on providing information systems to dental group practices. In the
mid-1980's, the Company capitalized on the increasing focus on medical cost
containment and further expanded its information processing systems to serve the
medical market. In the mid 1990's the Company made two acquisitions that
accelerated its penetration of the medical market. These two acquisitions formed
the basis for what is today the NextGen Division. Today, the Company serves both
the medical and dental markets through its two divisions.
The two divisions operate largely as stand-alone operations with each
division maintaining its own distinct product lines, product platforms,
development, implementation and support teams, sales staffing, and branding. The
two divisions share the resources of the "corporate office" which includes a
variety of accounting and other administrative functions. Additionally, there
are a small number of clients who are simultaneously utilizing software from
each of the Company's two divisions.
The QSI Division, co-located with the Corporate headquarters in Irvine,
California, currently focuses primarily on developing and marketing software to
dental and certain niche medical practices. The division supports a number of
medical clients using medical practice management software developed by the
division.
The NextGen Division, with headquarters in Horsham, Pennsylvania and a
second significant location in Atlanta, Georgia, focuses principally on
developing and marketing its products and services to medical practices.
Both divisions develop and market practice management software which is
designed to automate and streamline a number of the administrative functions
required for operating a medical or dental practice. Examples of practice
management software functions include scheduling and billing capabilities. It is
important to note that in both the medical and dental environments, practice
management software systems have been implemented by the vast majority of
practices. Therefore, the Company actively competes for the replacement market.
In addition, both divisions develop and market software that automates the
patient record and enhances patient-provider interactions. Adoption of this
software, commonly referred to as clinical software, is in its relatively early
stages. Therefore, the Company is typically competing to replace paper-based
patient record alternatives as opposed to replacing previously purchased
systems.
Electronic Data Interchange ("EDI")/connectivity products are intended to
automate a number of manual, often paper-based or telephony intensive
communications between patients and/or providers and/or payors. Two of the more
common EDI services are forwarding insurance claims electronically from
providers to payors and assisting practices with issuing statements to patients.
Most practices utilize
11
at least some of these services from the Company or one of its competitors.
Additional EDI/connectivity services are used more sporadically by client
practices. The Company typically competes to displace incumbent vendors for
claims and statements accounts, and attempts to increase usage of other elements
in its product line.
The QSI Division's practice management software suites utilize a UNIX(1)
operating system. Its Clinical Product Suite (CPS) utilizes a Windows NT(2)
operating system and can be fully integrated with the practice management
software from each division. CPS incorporates a wide range of clinical tools
including, but not limited to, periodontal charting and digital imaging of X-ray
and inter-oral camera images as part of the electronic patient record. The
division develops, markets, and manages the Company's QUIC product suite which
focuses on EDI/connectivity applications. The QSInet Application Service
Provider (ASP/Internet) offering is also developed and marketed by the division.
The Company's NextGen Division develops and sells proprietary electronic
medical records software and practice management systems under the NextGen(R)(3)
product name. Major product categories of the NextGen suite include Electronic
Medical Records (NextGen(emr)), Enterprise Practice Management (NextGen(epm)),
Enterprise Appointment Scheduling (NextGen(eas)), Enterprise Master Patient
Index (NextGen(epi)), NextGen Image Control System (NextGen(ics)), Managed Care,
Electronic Data Interchange, System Interfaces, Internet Operability
(NextGen(web)), a Patient-centric and Provider-centric Web Portal Solution
(NextMD.com(4)), and a handheld product (NextGen(pda)). NextGen products utilize
Microsoft Windows technology and can operate in a client-server environment as
well as via private intranet, the Internet, or in an ASP environment.
The Company continues to pursue product enhancement initiatives within
each division. The majority of such expenditures are currently targeted to the
NextGen Division product line and client base. Recent product enhancements by
the QSI Division include laser generated forms and an electronic signature
capability within the division's CPS product line. While these enhancements are
not projected to materially increase divisional revenues or profits, the
enhancements are designed to maintain and/or increase client satisfaction within
the division's established base of customers.
The NextGen Division recently released NextGen Image Control System
(NextGen(ics)). This module works in conjunction with both NextGen(epm) and
NextGen(emr) to address the high volume scanning needs of clients. Management
does not expect that NextGen(ics) will add materially to the Company's revenues
in the near term, and views this offering as part of the continued build-out of
the division's product line as well as a viable means of addressing an area
where the division had been reliant on third party alternatives.
Inclusive of divisional EDI revenues, the NextGen Division accounts for
approximately 76% of the Company's revenues. The QSI Division accounts for the
balance. The NextGen Division has been growing at annual rates of between 20%
and 37% for the past few years, while the QSI Division's overall revenues have
been relatively stable.
In addition to the aforementioned software solutions offered by the
Company through its two divisions, each division offers comprehensive hardware
and software installation services, maintenance and support services, and system
training services.
- ----------
(1) UNIX is a registered trademark of the AT&T Corporation.
(2) Microsoft Windows, Windows NT, Windows 95, Windows 98, and Windows 2000
are registered trademarks of the Microsoft Corporation.
(3) NextGen is a registered trademark of NextGen Healtcare Information
Systems, Inc
(4) NextMD.com is a trademark of NextGen Healthcare Information Systems, Inc
12
The Company currently has a base of approximately 800 clients, with each
client generally including between one and 500 physicians or dentists.
The Company had 301 employees as of December 31, 2003. This total is
comprised of: NextGen Division 219, QSI Division 66, and Corporate 16. For
comparison, the Company had 254 employees at December 31, 2002. The NextGen
Division accounted for 166, the QSI Division employed 72, and corporate staffing
was 16. Revenue per employee was $242,000 at December 31, 2003, up from $227,000
at the end of the same quarter of the prior year.
Risk Factors
Competition. The markets for healthcare information systems are intensely
competitive, and the Company faces significant competition from a number of
different sources. Several of the Company's competitors have significantly
greater name recognition as well as substantially greater financial, technical,
product development and marketing resources than the Company.
The Company competes in all of its markets with other major healthcare
related companies, information management companies, systems integrators, and
other software developers. Competitive pressures and other factors, such as new
product introductions by the Company or its competitors, may result in price or
market share erosion that could have a material adverse effect on the Company's
business, results of operations and financial condition. Also, there can be no
assurance that the Company's applications will achieve broad market acceptance
or will successfully compete with other competing software products.
The Company's inability to make initial sales of its systems to either
newly formed groups and/or healthcare providers that are replacing or
substantially modifying their healthcare information systems could have a
material adverse effect on the Company's business, results of operations and
financial condition. If new systems sales do not materialize, the Company's near
term and longer term revenues will be negatively affected.
Fluctuation in Quarterly Operating Results. The Company's revenues have
fluctuated in the past, and may fluctuate in the future from quarter to quarter
and period to period, as a result of a number of factors including, without
limitation: the size and timing of orders from clients; the length of sales
cycles and installation processes; the ability of the Company's clients to
obtain financing for the purchase of the Company's products; changes in pricing
policies or price reductions by the Company or its competitors; the timing of
new product announcements and product introductions by the Company or its
competitors; changes in revenue recognition guidelines employed by the Company
and/or established by the Financial Accounting Standards Board or other
rule-making bodies; the availability and cost of system components; the
financial stability of major clients; market acceptance of new products,
applications and product enhancements; the Company's ability to develop,
introduce and market new products, applications and product enhancements; the
Company's success in expanding its sales and marketing programs; deferrals of
client orders in anticipation of new products, applications or product
enhancements; changes in Company strategy; personnel changes; and general
market/economic factors.
The Company's software products are generally shipped as orders are
received and accordingly, the Company has historically operated with a minimal
backlog of license fees. As a result, revenues in any quarter are dependent on
orders booked and shipped in that quarter and are not predictable with any
degree of certainty. Furthermore, the Company's systems can be relatively large
and expensive and individual systems sales can represent a significant portion
of the Company's revenues and profits for a quarter such that the loss or
deferral of even one such sale can have a significant adverse impact on the
Company's quarterly revenue and profitability.
Clients often defer systems purchases until the Company's quarter end, so
quarterly results generally cannot be predicted and frequently are not known
until the quarter has concluded.
The Company's sales are dependent upon clients' initial decision to
replace or substantially modify their existing information system, and
subsequently a decision as to which products and services to purchase. These are
major decisions for healthcare providers, and accordingly, the sales cycle for
the Company's systems can
13
vary significantly and typically ranges from three to twelve months from initial
contact to contract execution/shipment.
Because a significant percentage of the Company's expenses are relatively
fixed, a variation in the timing of systems sales and installations can cause
significant variations in operating results from quarter to quarter. As a
result, the Company believes that interim period-to-period comparisons of its
results of operations are not necessarily meaningful and should not be relied
upon as indications of future performance. Further, the Company's historical
operating results are not necessarily indicative of future performance for any
particular period.
The Company currently recognizes revenue pursuant to Statement of Position
No. 97-2, "Software Revenue Recognition" ("SOP 97-2"), as modified by SOP 98-9
"Modification of SOP 97-2, Software Revenue Recognition, With Respect of Certain
Transactions". Additionally, in December 1999, the Securities and Exchange
Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue
Recognition in Financial Statements" ("SAB 101"). SAB 101 summarizes the staff's
views in applying generally accepted accounting principles to revenue
recognition in financial statements.
There can be no assurance that application and subsequent interpretations
of these pronouncements will not further modify the Company's revenue
recognition policies, or that such modifications would not have a material
adverse effect on the operating results reported in any particular quarter or
year.
Due to all of the foregoing factors, it is possible that the Company's
operating results may be below the expectations of public market analysts and
investors. In such event, the price of the Company's Common Stock would likely
be materially adversely affected.
Stock Price Volatility. The trading price of the Company's common stock
may be volatile. The market for the Company's common stock may experience
significant price and volume fluctuations in response to a number of factors
including actual or anticipated quarterly variations in operating results,
rumors about the Company's performance or software solutions, changes in
expectations of future financial performance or changes in estimates of
securities analysts, governmental regulatory action, health care reform
measures, client relationship developments, changes occurring in the markets in
general and other factors, many of which are beyond the Company's control.
Furthermore, the stock market in general, and the market for software,
health care and high technology companies in particular, have experienced
extreme volatility that often has been unrelated to the operating performance of
particular companies. These broad market and industry fluctuations may adversely
affect the trading price of the Company's common stock, regardless of actual
operating performance.
Dependence on Principal Product and New Product Development. The Company
currently derives substantially all of its net revenues from sales of its
healthcare information systems and related services. The Company believes that a
primary factor in the market acceptance of its systems has been its ability to
meet the needs of users of healthcare information systems. The Company's future
financial performance will depend in large part on the Company's ability to
continue to meet the increasingly sophisticated needs of its clients through the
timely development and successful introduction and implementation of new and
enhanced versions of its systems and other complementary products. The Company
has historically expended a significant percentage of its net revenues on
product development and believes that significant continuing product development
efforts will be required to sustain the Company's growth. Continued investment
in the Company's sales staff and its client implementation and support staff
will also be required to support future growth.
There can be no assurance that the Company will be successful in its
product development efforts, that the market will continue to accept the
Company's existing products, or that new products or product enhancements will
be developed and implemented in a timely manner, meet the requirements of
healthcare providers, or achieve market acceptance. If new products or product
enhancements do not achieve market acceptance, the Company's business, results
of operations and financial condition could be materially adversely affected. At
certain times in the past, the Company has also experienced delays in purchases
of its products by clients anticipating the launch of new products by the
Company. There can be no assurance that material order deferrals in anticipation
of new product introductions will not occur.
14
Subscription Pricing And/Or Application Service Provider, Or ASP,
Delivered Offerings. The Company currently derives substantially all of it's
revenues from traditional software license, maintenance and service fees, as
well as the resale of computer hardware. Today, customers pay an initial license
fee for the use of the Company's products, in addition to a periodic maintenance
fee. If the marketplace demands subscription pricing and/or ASP-delivered
offerings, the Company may be forced to adjust its strategy accordingly, by
offering a higher percentage of the Company's products and services through
these means. Shifting to subscription pricing and/or ASP-delivered offerings
could materially adversely impact the Company's financial condition, cash flows
and quarterly and annual revenues and results of operations, as the Company's
revenues would initially decrease substantially. There can be no assurance that
the marketplace will not embrace subscription pricing and/or ASP-delivered
offerings.
Technological Change. The software market generally is characterized by
rapid technological change, changing customer needs, frequent new product
introductions, and evolving industry standards. The introduction of products
incorporating new technologies and the emergence of new industry standards could
render the Company's existing products obsolete and unmarketable. There can be
no assurance that the Company will be successful in developing and marketing new
products that respond to technological changes or evolving industry standards.
New product development depends upon significant research and development
expenditures which depend ultimately upon sales growth. Any material weakness in
revenues or research funding could impair the Company's ability to respond to
technological advances in the marketplace and to remain competitive. If the
Company is unable, for technological or other reasons, to develop and introduce
new products in a timely manner in response to changing market conditions or
customer requirements, the Company's business, results of operations and
financial condition may be materially adversely affected.
In response to increasing market demand, the Company is currently
developing new generations of certain of its software products. There can be no
assurance that the Company will successfully develop these new software products
or that these products will operate successfully, or that any such development,
even if successful, will be completed concurrently with or prior to introduction
of competing products. Any such failure or delay could adversely affect the
Company's competitive position or could make the Company's current products
obsolete.
Web Site Claims. The Company could be subject to third party claims based
on the nature and content of information supplied on the Company's Web site by
the Company or third parties, including content providers or users. The Company
could also be subject to liability for content that may be accessible through
the Company's Web site or third party Web sites linked from the Company's Web
site or through content and information that may be posted by users in chat
rooms, bulletin boards or on Web sites created by professionals using the
Company's applications. Even if these claims do not result in liability to the
Company, investigating and defending against these claims could be expensive and
time consuming and could divert management's attention away from the Company's
operations.
Claims From Activities of Strategic Partners. The Company relies on third
parties to provide services that impact the Company's business. For example, the
Company uses national clearinghouses in the processing of insurance claims and
the Company outsources some of its hardware maintenance services and the
printing and delivery of patient statements for the Company's customers. The
Company also has relationships with certain third parties where these third
parties serve as sales channels through which the Company generates a portion of
its revenues. Due to these third-party relationships, the Company could be
subject to claims as a result of the activities, products, or services of these
third-party service providers even though the Company was not directly involved
in the circumstances leading to those claims. Even if these claims do not result
in liability to the Company, defending and investigating these claims could be
expensive and time-consuming, divert personnel and other resources from its
business and result in adverse publicity that could harm the Company's business.
Litigation. The Company faces the risks associated with litigation
concerning the operation of its business. The uncertainty associated with
substantial unresolved litigation may have an adverse impact on the Company's
business. In particular, such litigation could impair the Company's
relationships with existing customers and its ability to obtain new customers.
Defending such litigation may result in a diversion of management's time and
attention away from business operations, which could have a material adverse
effect on the Company's business, results of operations and financial condition.
Such litigation may also have the
15
effect of discouraging potential acquirers from bidding for the Company or
reducing the consideration such acquirers would otherwise be willing to pay in
connection with an acquisition.
There can be no assurance that such litigation will not result in
liability in excess of its insurance coverage, that the Company's insurance will
cover such claims or that appropriate insurance will continue to be available to
the Company in the future at commercially reasonable rates.
Proprietary Technology. The Company is heavily dependent on the
maintenance and protection of its intellectual property and relies largely on
license agreements, confidentiality procedures, and employee nondisclosure
agreements to protect its intellectual property. The Company's software is not
patented and existing copyright laws offer only limited practical protection.
There can be no assurance that the legal protections and precautions taken
by the Company will be adequate to prevent misappropriation of the Company's
technology or that competitors will not independently develop technologies
equivalent or superior to the Company's. Further, the laws of some foreign
countries do not protect the Company's proprietary rights to as great an extent
as do the laws of the United States and are often not enforced as vigorously as
those in the United States.
The Company does not believe that its operations or products infringe on
the intellectual property rights of others. However, there can be no assurance
that others will not assert infringement or trade secret claims against the
Company with respect to its current or future products or that any such
assertion will not require the Company to enter into a license agreement or
royalty arrangement or other financial arrangement with the party asserting the
claim. Responding to and defending any such claims may distract the attention of
Company management and have a material adverse effect on the Company's business,
results of operations and financial condition. In addition, claims may be
brought against third parties from which the Company purchases software, and
such claims could adversely affect the Company's ability to access third party
software for its systems.
Dependence on License Rights. The Company depends upon licenses from third
party vendors for some of the technology used in its products. Most of these
licenses can be renewed only by mutual consent and may be terminated if the
Company breaches the terms of the license and fails to cure the breach within a
specified period of time. The Company may not be able to continue using the
technology made available to it under these licenses on commercially reasonable
terms or at all. As a result, the Company may have to discontinue, delay or
reduce product shipments until it can obtain equivalent technology. Most of the
Company's third-party licenses are non-exclusive. The Company's competitors may
obtain the right to use any of the technology covered by these licenses and use
the technology to compete directly with the Company. In addition, if the
Company's vendors choose to discontinue support of the licensed technology in
the future or are unsuccessful in their continued research and development
efforts, the Company may be negatively impacted.
Possible Security Breaches. In the course of its business operations, the
Company compiles and transmits confidential information, including patient
health information, in the Company's processing centers and other facilities. A
breach of security in any of these facilities could damage the Company's
reputation and result in damages being assessed against the Company. In
addition, the other systems with which the Company may interface, such as the
Internet and related systems, may be vulnerable to security breaches, viruses,
programming errors, or similar disruptive problems. The effect of these security
breaches and related issues could reduce demand for the Company's services.
Accordingly, the Company believes that it is critical that these facilities and
infrastructure not only be secure, but also be viewed by the Company's customers
as free from potential breach. Maintaining such standards, protecting against
breaches and curing security flaws, may require the Company to expend
significant capital.
Development and Maintenance of Internet Infrastructure. The Company
delivers Internet-based services and, accordingly, is dependent on the
maintenance of the Internet by third parties. The Internet infrastructure may be
unable to support the demands placed on it and its performance may decrease if
the Internet continues to experience its historic trend of expanding usage. As a
result of damages to portions of its infrastructure, the Internet has
experienced a variety of performance problems which may continue into the
foreseeable future. Such Internet related problems may diminish Internet usage
and availability of the Internet to the Company for transmittal of
Internet-based services by the Company. In addition, difficulties, outages, and
delays by Internet service providers, online service providers and other web
site operators may
16
obstruct or diminish access to the Company's web site by its customers resulting
in a loss of potential or existing users of the Company's services.
Security Breaches and Viruses. The success of the Company's strategy to
offer its EDI services and Internet solutions depends on the confidence of the
Company's customers in its ability to securely transmit confidential
information. The Company's EDI services and Internet solutions rely on
encryption, authentication and other security technology licensed from third
parties to achieve secure transmission of confidential information. The Company
may not be able to stop unauthorized attempts to gain access to or disrupt the
transmission of communications by the Company's customers. Anyone who is able to
circumvent security measures could misappropriate confidential user information
or interrupt the Company's, or the Company's customers', operations. In
addition, the Company's EDI and Internet solutions may be vulnerable to viruses,
physical or electronic break-ins, and similar disruptions. Any failure to
provide secure electronic communication services could result in a lack of trust
by the Company's customers causing them to seek out other vendors, and/or,
damage the Company's reputation in the market making it difficult to obtain new
customers.
Ability to Manage Growth. The Company has in the past experienced periods
of growth which have placed, and may continue to place, a significant strain on
the Company's non-cash resources. The Company also anticipates expanding its
overall software development, marketing, sales, client management and training
capacity. In the event the Company is unable to identify, hire, train and retain
qualified individuals in such capacities within a reasonable timeframe, such
failure could have a material adverse effect on the Company. In addition, the
Company's ability to manage future increases, if any, in the scope of its
operations or personnel will depend on significant expansion of its research and
development, marketing and sales, management, and administrative and financial
capabilities. The failure of the Company's management to effectively manage
expansion in its business could have a material adverse effect on the Company's
business, results of operations and financial condition.
Dependence Upon Key Personnel. The Company's future performance depends in
significant part upon the continued service of its key technical, sales,
marketing and senior management personnel, many of whom have been with the
Company for a significant period of time and may be difficult to replace.
Because the Company has a relatively small number of employees when compared to
other leading companies in the same industry, its dependence on maintaining its
relationship with key employees is particularly significant and the loss of a
few key people can have a relatively major negative impact upon the Company. The
Company is also dependent on its ability to attract and retain high quality
personnel, particularly in the highly competitive areas of sales, management and
applications development.
The industry is characterized by a high level of employee mobility, highly
variable compensation packages, and aggressive recruiting of skilled personnel.
There can be no assurance that the Company's current employees will continue to
work for the Company.
Loss of services of one or more key employees could have a material
adverse effect on the Company's business, results of operations and financial
condition. Generally, within the industry, key personnel are often attracted by
packages that include competitive base remuneration, bonuses and equity (usually
option) plans. Accordingly, the Company believes that it may need to grant
additional stock options to key employees from time to time and provide other
forms of incentive compensation to attract and retain such key personnel.
Failure to provide such types of incentive compensation could jeopardize the
Company's recruitment and retention capabilities and have a material adverse
effect on the Company's business, results of operations and financial condition.
The Company does not maintain key man life insurance on any of its
employees.
Product Liability. Certain of the Company's products provide applications
that relate to patient clinical information. Any failure by the Company's
products to provide accurate and timely information could result in claims
against the Company. In addition, a court or government agency may take the
position that the Company's delivery of health information directly, including
through licensed practitioners, or delivery of information by a third party site
that a consumer accesses through the Company's web sites, exposes the Company to
assertions of malpractice, other personal injury liability, or other liability
for wrongful delivery/handling of healthcare services or erroneous health
information. The Company maintains insurance
17
to protect against claims associated with the use of its products, but there can
be no assurance that its insurance coverage would adequately cover any claim
asserted against the Company. A successful claim brought against the Company in
excess of or outside of its insurance coverage could have a material adverse
effect on the Company's business, results of operations and financial condition.
Even unsuccessful claims could result in the Company's expenditure of funds in
litigation and management time and resources.
Certain healthcare professionals who use the Company's Internet-based
products will directly enter health information about their patients including
information that constitutes a record under applicable law that the Company may
store on the Company's computer systems. Numerous federal and state laws and
regulations, the common law, and contractual obligations, govern collection,
dissemination, use and confidentiality of patient-identifiable health
information, including:
o state and federal privacy and confidentiality laws;
o the Company's contracts with customers and partners;
o state laws regulating healthcare professionals;
o medicaid laws; and
o the Health Insurance Portability and Accountability Act of 1996
("HIPAA") and related rules proposed by the Health Care Financing
Administration; and Health Care Financing Administration standards
for Internet transmission of health data.
The U.S. Congress has finalized the Health Insurance Portability and
Accountability Act of 1996 that established, beginning April, 2003, elements
including, but not limited to, new federal privacy and security standards for
the use and protection of Protected Health Information. Under contractual
arrangement with its customers, any failure by the Company or by its personnel
or partners to comply with applicable requirements may result in a material
liability to the Company.
Although the Company has systems and policies in place for safeguarding
Protected Health Information from unauthorized disclosure, these systems and
policies may not preclude claims against the Company for alleged violations of
applicable requirements. Also, third party sites and/or links that consumers may
access through the Company's web sites may not maintain adequate systems to
safeguard this information, or may circumvent systems and policies the Company
has put in place. In addition, future laws or changes in current laws may
necessitate costly adaptations to the Company's policies, procedures, or
systems.
There can be no assurance that the Company will not be subject to product
liability claims, that such claims will not result in liability in excess of its
insurance coverage, that the Company's insurance will cover such claims or that
appropriate insurance will continue to be available to the Company in the future
at commercially reasonable rates. Such product liability claims could have a
material adverse affect on the Company's business, results of operations and
financial condition.
Effect of Payer and Provider Conduct. Electronic data transmission
services are offered by certain payers to healthcare providers that establish a
direct link between the provider and payer. This process bypasses third party
EDI service providers such as the Company. Accordingly, the Company is unable to
insure that the Company and other independent companies will continue to be used
by healthcare payers and providers to transmit healthcare transactions. A
significant increase in the utilization of direct links between healthcare
providers and payers could have a material adverse effect on the Company's
transaction volume and financial results. In addition, the company cannot
provide assurance that the Company will be able to maintain the Company's
exiting links to payers or develop new connections on terms that are
economically satisfactory to the Company, if at all.
Uncertainty in Healthcare Industry; Government Regulation. The healthcare
industry is subject to changing political, economic and regulatory influences
that may affect the procurement processes and operation of healthcare
facilities. During the past several years, the healthcare industry has been
subject to an increase in governmental regulation of, among other things,
reimbursement rates and certain capital expenditures.
In the past, various legislators have announced that they intend to
examine proposals to reform certain aspects of the U.S. healthcare system
including proposals which may change governmental involvement in healthcare and
reimbursement rates, and otherwise alter the operating environment for the
Company and its clients. Healthcare providers may react to these proposals, and
the uncertainty surrounding such proposals, by
18
curtailing or deferring investments, including those for the Company's systems
and related services. Cost-containment measures instituted by healthcare
providers as a result of regulatory reform or otherwise could result in a
reduction in the allocation of capital funds. Such a reduction could have an
adverse effect on the Company's ability to sell its systems and related
services. On the other hand, changes in the regulatory environment have
increased and may continue to increase the needs of healthcare organizations for
cost-effective data management and thereby enhance the overall market for
healthcare management information systems. The Company cannot predict what
impact, if any, such proposals or healthcare reforms might have on the Company's
business, financial condition and results of operations.
The HIPAA regulation, as adopted by the Department of Health and Human
Services, established, among other things: (i) a national standard for
electronic transactions and code sets to be used in those transactions involving
certain common health care transactions, (ii) privacy regulations to protect the
privacy of plan participants and patients' medical records and (iii) security
regulations designed to establish security controls and measures to protect the
privacy and confidentiality of personal identifiable health information when it
is electronically stored, maintained or transmitted (even if only internally
transmitted within a medical practice.) While the privacy and transaction and
code set standards are currently in effect, the security regulation is expected
to become effective by 2005. As these regulations mature and become better
defined, the Company anticipates that these regulations will continue to
directly affect certain of the Company's products and services, but the Company
cannot fully predict this impact at this time. The Company has taken steps to
modify its products, services and internal practices as necessary to facilitate
its and its client's compliance with the final regulations, but there can be no
assurance that the Company will be able to do so in a timely or complete manner.
Achieving compliance with these regulations could be costly and distract
management's attention and other resources, and any noncompliance by the Company
could result in civil and criminal penalties.
In addition, development of related federal and state regulations and
policies regarding the confidentiality of health information or other matters
could positively or negatively affect the Company's business.
In addition, the Company's software may potentially be subject to
regulation by the U.S. Food and Drug Administration (the "FDA") as a medical
device. Such regulation could require the registration of the applicable
manufacturing facility and software and hardware products; application of
detailed record-keeping and manufacturing standards; and FDA approval or
clearance prior to marketing. An approval or clearance requirement could create
delays in marketing, and the FDA could require supplemental filings or object to
certain of these applications, the result of which could have a material adverse
effect on the Company's business, financial condition and results of operations.
Other E-commerce Regulations. The Company may be subject to additional
federal and state statutes and regulations in connection with offering services
and products via the Internet. On an increasingly frequent basis, federal and
state legislators are proposing laws and regulations that apply to Internet
commerce and communications. Areas being affected by these regulations include
user privacy, pricing, content, taxation, copyright protection, distribution,
and quality of products and services. To the extent that the Company's products
and services are subject to these laws and regulations, the sale of the
Company's products and services could be harmed.
Financial Accounting Matters. Based on the Company's reading and
interpretations of relevant guidance, principles or concepts, issued by, among
other authorities, the American Institute of Certified Public Accountants, the
Financial Accounting Standards Board, and the United States Securities and
Exchange Commission, Management believes its current sales and licensing
contract terms and business arrangements have been properly reported. However,
there continue to be issued interpretations and guidance for applying the
relevant standards to a wide range of sales and licensing contract terms and
business arrangements that are prevalent in the software industry. Future
interpretations or changes by the regulators of existing accounting standards or
changes in the Company's business practices could result in future changes in
the Company's revenue recognition accounting policies and practices that could
have a material adverse effect on the Company's business, financial condition,
cash flows, revenues and results of operations.
19
Results of Operations
The following table sets forth for the periods indicated, the percentage
of net revenues represented by each item in the Company's Consolidated
Statements of Income.
----------------------------------------------
(unaudited) Three Months Ended Nine Months Ended
December 31, December 31,
----------------------------------------------------------------------------------------------------------
2003 2002 2003 2002
----------------------------------------------
Net Revenues:
Sales of computer systems, upgrades and supplies 54.2% 53.2% 56.3% 52.7%
Maintenance and other services 45.8 46.8 43.7 47.3
----------------------------------------------
100.0 100.0 100.0 100.0
Cost of Products and Services 41.3 44.1 41.5 42.7
----------------------------------------------
Gross Profit 58.7 55.9 58.5 57.3
Selling, General and Administrative Expenses 26.9 27.2 27.6 27.8
Research and Development Costs 9.0 9.4 8.6 9.3
----------------------------------------------
Income from Operations 22.8 19.3 22.3 20.3
Investment Income 0.5 0.8 0.5 0.8
----------------------------------------------
Income before Provision for Income Taxes 23.3 20.1 22.8 21.1
Provision for Income Taxes 9.0 6.6 8.8 7.8
----------------------------------------------
Net Income 14.3% 13.5% 14.0% 13.3%
----------------------------------------------------------------------------------------------------------
For the Three-Month Periods Ended December 31, 2003 and 2002
The Company's net income for the three months ended December 31, 2003 was
$ 2,611,000 or $0.42 per share on a basic and $.40 per share on a diluted basis,
as compared to a net income of $1,935,000, or $0.32 per share on a basic and
$0.30 per share on a diluted basis, for the three months ended December 31,
2002.
Net Revenues. Net revenues for the three months ended December 31, 2003
increased 26% to $18.2 million from $14.4 million for the three months ended
December 31, 2002. Net revenue totals were the result of a 40% increase in the
NextGen Division's net revenue from $10 million to $14 million and a 5% decline
in QSI Division net revenue from $4.4 million from $4.2.
Company wide sales of computer systems, upgrades and supplies increased
29% to $9.9 million from $7.7 million in the year ago quarter while net revenues
from maintenance and other services grew 24% to $8.3 million from $6.7 million
during the comparable period last year. Included in computer systems sales are
revenues from the sale of software, hardware, third party software and
implementation services. Included in maintenance and other revenues are revenues
from maintenance, electronic data interchange services, and professional
services, excluding installation.
The increase in net revenues from sales of computer systems, upgrades and
supplies was principally the result of a 33% increase in such revenues at the
NextGen division, which grew from $7.0 million to $9.3 million. This increase
was driven by higher sales of software license and related service revenue.
Category revenues in the QSI Division declined from approximately $0.7 million
to $0.5 million. Software sales in the QSI division included had a relatively
lower amount of hardware resulting in lower revenue compared to the prior year
quarter.
The increase in maintenance and other services revenue resulted
principally from a 56% increase in such revenues generated from the expanded
client base of the NextGen Division. Total maintenance revenue in the NextGen
Division grew 58% to $3.2 million from $2.0 million in the year ago quarter.
Total EDI revenue in the NextGen Division grew to $0.9 million from $0.5 million
in the year ago quarter The QSI Division experienced slight declines in
maintenance revenue (from $2.0 to $1.9 million) and EDI revenue (from $1.4 to
$1.3 million) from the quarter ended December 31, 2002 to the quarter ended
December 31, 2003.
20
Cost of Products and Services. Cost of products and services for the three
months ended December 31, 2003 rose 18% to $7.5 million from $6.4 million in the
prior year quarter. Cost of products and services as a percentage of net
revenues decreased to 41% from 44% for the respective period. The dollar
increase in the cost of products and services was principally the result of
increased labor and other costs associated with increased installation and
customer support activity. The cost of products and services as a percentage of
net revenues decreased in the quarter ended December 31, 2003 compared to the
same period last year, largely as a result of a revenue growing at a faster rate
than labor and overhead costs associated with installation and customer support
services as well as a lower level of hardware and third party software content
included in system sales. The gross margin percentage in the quarter ended
December 31, 2003 was 58.7% versus 55.9% in the prior year. Despite the year
over year increase, the gross margin percentage in the December 31, 2003 quarter
was still within the Company's historical band.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the three months ended December 31, 2003 increased
25% to approximately $4.9 million as compared to $3.9 million for the three
months ended December 31, 2002. Selling, general and administrative expenses as
a percentage of net revenues decreased slightly to 26.9% as compared to 27.2% in
the prior year quarter. The increase in the amount of such expenses resulted
primarily from additions to sales personnel, higher trade show expenses, higher
commission expenses in the NextGen Division of $0.4 million , as well as $0.2
million of higher corporate expenses.
Research and Development Costs. Research and development costs for the
three months ended December 31, 2003 increased by 21% to $1.6 million from $1.3
million in the prior year's quarter. The increase in research and development
costs is attributed primarily to increased investments in the NextGen Division
product suites. Research and development costs as a percentage of net revenues
declined to 8.9% as compared to 9.4% for the quarter ended December 31, 2002.
This percentage decline was driven by the fact that revenues grew faster than
the increase in research and development expense.
Investment Income. Investment income for the three months ended December
31, 2003 decreased by 12.8% from approximately $109,000 to $95,000. Investment
income in the quarter declined due to the lower interest rates earned on the
Company's balances during the quarter versus the year earlier quarter. The
decrease in investment returns were partially offset by higher cash balances.
Provision for Income Taxes. The provision for income taxes for the three
months ended December 31, 2003 was approximately $1.6 million as compared to
approximately $1.0 million for the three months ended December 31, 2002. The
provision for income taxes for the three months ended December 31, 2003 differs
from the combined statutory rates primarily due to the impact of the effect of
varying state income tax rates as well as the impact of estimated research and
development tax credits. The provision for income taxes for the three months
ended December 31, 2002 differs from the combined statutory rates primarily due
to the impact of the effect of varying state income tax rates as well as the
impact of the estimated year to date research and development tax credits
available to the Company.
For the Nine-Month Periods Ended December 31, 2003 and 2002
The Company's net income for the nine months ended December 31, 2003 was
$7.3 million, or $1.18 per share on a basic and $1.13 per share on a diluted
basis, as compared to $5.3 million, or $.86 per share on a basic and $.83 per
share on a diluted basis for the nine months ended December 31, 2002.
Net Revenues Net revenues for the nine months ended December 31, 2003
increased 31% to $52.1 million from $39.7 million for the nine months ended
December 31, 2002. NextGen Division net revenue increased 49% from approximately
$26.7 million to approximately $39.7 million in the period while QSI Division
net revenue declined by 4% during the period from approximately $13 million to
$12.5 million.
Company wide sales of computer systems, upgrades and supplies increased
41% to $29.4 million from $20.9 million while revenues from maintenance and
other services grew 21% to $22.8 million from $18.8 million during the
comparable period.
21
The increase in revenues from sales of computer systems, upgrades and
supplies for the Company was principally the result of a 48% increase in such
revenue at the Company's NextGen Division which grew from $18.8 million to $27.7
million. This increase was driven by higher sales of NextGen(emr) and
NextGen(epm) software as well as related hardware and third party software.
Category revenue in the QSI division declined by 23% from $2.1 million to $1.6
million.
The increase in maintenance and other services revenue for the Company
resulted principally from an increase in maintenance, EDI and other revenues
from the NextGen Division's growing client base. Total maintenance revenue for
the nine months ended December 31, 2003 in the NextGen Division grew 52% to $7.9
million from $5.2 million in the year ago period, while QSI Division maintenance
declined 5% from $6.0 million to $5.7 million in the same comparable period..
Total EDI revenue in the NextGen Division grew 75% to $2.1 million compared to
$1.2 million in the year ago period while QSI Division EDI revenue was unchanged
at approximately $4.0 million in both periods.
Cost of Products and Services. Cost of products and services for the nine
months ended December 31, 2003 increased 28% to $21.6 million from $16.9 million
for the nine months ended December 31, 2002, while cost of products and services
as a percentage of net revenues declined to 41.5% from 42.7% during the
comparable periods. The cost of products and services as a percentage of net
revenues decreased primarily as a result of a revenue growing at a faster rate
than labor and overhead costs associated with installation and customer support
services as well as proportionately lower hardware and third party software
content included in revenues.
Selling, General and Administrative Expenses Selling, general and
administrative expenses for the nine months ended December 31, 2003 increased
31% to $14.4 million as compared to $11.0 million for the nine months ended
December 31, 2002. The increase in the amount of such expenses resulted
primarily from additions to the sales personnel and higher commission expenses
in the NextGen Division of $1.6 million, and $1.0 million in higher corporate
expenses.
Research and Development Costs Research and development costs for the nine
months ended December 31, 2003 and 2002 were $4.5 million and $3.7 million
respectively. The increase in research and development expenses were primarily
due to increased investment in the NextGen product line. Research and
development costs as a percentage of net revenues decreased to 8.6% from 9.3%
due to the fact that revenues increased more quickly than research and
development expense.
Investment Income. Investment income for the nine months ended December
31, 2003 decreased 15% to approximately $284,000 compared with $336,000 in the
nine months ended December 31, 2002. Investment income in the nine months ended
December 31, 2003 declined primarily due to the effect of the drop in short term
interest rates versus the prior year. The decrease in returns were partially
offset by higher cash balances.
Provision for Income Taxes. The provision for income taxes for the nine
months ended December 31, 2003 was approximately $4.6 million as compared to
approximately $3.1 million for the nine months ended December 31, 2002. The
provision for income taxes for the nine months ended December 31, 2003 and 2002
differ from the combined statutory rates primarily due to the impact of varying
state income tax rates and the impact of research and development tax credits.
22
Liquidity and Capital Resources
The following table presents selected financial statistics and information for
each of the nine months ended December 31, 2003 and 2002:
------------------------------
(in thousands) Nine Months Ended December 31,
(unaudited)
------------------------------
2003 2002
----------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 45,348 $ 33,146
----------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents during the period $ 8,905 $ 7,703
----------------------------------------------------------------------------------------------
Net income during the period $ 7,296 $ 5,272
----------------------------------------------------------------------------------------------
Net cash provided by operations during the period $ 10,675 $ 9,095
----------------------------------------------------------------------------------------------
Number of days of sales outstanding at start of period 106 104
----------------------------------------------------------------------------------------------
Number of days of sales outstanding at end of period 108 104
----------------------------------------------------------------------------------------------
The Company's principal source of cash was provided by operations. The
number of days sales outstanding during the period increased by two days
primarily due to an increase in the volume of services sold by the NextGen
Division which had not yet been rendered resulting in an increase in both
accounts receivable and deferred revenue. With the growth of the NextGen
Division as a percentage of consolidated revenues, the overall number of days
sales outstanding has more closely mirrored that of the NextGen Division, which
has historically had a higher days sales outstanding compared to the QSI
Division due to a higher amount of services invoiced in advance and included in
deferred revenue. Provided turnover of accounts receivable, deferred revenue,
and profitability remain consistent with the quarter ended December 31, 2003,
the Company anticipates being able to continue to generate cash from operations
primarily from the net income of the Company.
Cash and cash equivalents increased $8,905,000 between April 1, 2003 and
December 31, 2003 primarily as a result of cash provided by operating
activities. Cash and cash equivalents increased approximately $7,703,000 during
the nine months ended December 31, 2002, also primarily as a result of cash
generated by operating activities. Also, during the nine months ended December
31, 2002, the Company liquidated approximately $255,000 in short-term equity
investments, and moved those funds into cash and cash equivalent accounts.
Net cash used in investing activities for the nine months ended December
31, 2003 and 2002 was $2,743,000 and $1,649,000 respectively. Net cash used in
investing activities for the nine months ended December 31, 2003 consisted of
additions to equipment and improvements and capitalized software. Net cash used
in investing activities for the nine months ended December 31, 2002 consisted of
additions to equipment and improvements and capitalized software and was
partially offset by the proceeds from the sale of short term investments.
Net cash from financing activities is composed entirely of proceeds from
stock option exercises which for the nine periods ended December 31, 2003 and
2002 totaled $973,000 and $257,000 respectively.
At December 31, 2003, the Company had cash and cash equivalents of $45.3
million. The Company intends to expend funds for the development of products
complementary to its existing product line as well as new versions of certain of
its products. The Company has no additional significant current capital
commitments.
Management believes that its cash and cash equivalents on hand at December
31, 2003, together with cash flows from operations, if any, will be sufficient
to meet its working capital and capital expenditure requirements for the balance
of fiscal 2004.
23
Item 3. Qualitative and Quantitative Disclosures About Market Risk
The Company has a significant amount of cash and short-term investments with
maturities less than three months. This cash portfolio exposes the Company to
interest rate risk as short-term investment rates can be volatile. Given the
short-term maturity structure of the Company's investment portfolio, the Company
believes that it is not subject to principal fluctuations and the effective
interest rate of the Company's portfolio tracks closely to various short-term
money market interest rate benchmarks.
Item 4. Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer (our principal
executive officer and principal financial officer, respectively) conducted an
evaluation of the design and operation of the Company's "disclosure controls and
procedures" (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended ("Exchange Act")). Based on that evaluation,
which was conducted within 90 days of the date on which this quarterly report
was filed with the Securities and Exchange Commission, the Chief Executive
Officer and Chief Financial Officer concluded that the disclosure controls and
procedures are effective to ensure that information required to be disclosed by
the Company in the reports filed or submitted by the Company under the Exchange
Act is accumulated, recorded, processed, summarized and reported to management,
including the Company's Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding whether or not disclosure is
required.
During the quarter ended December 31, 2003, there were no changes in our
"internal controls over financial reporting" (as defined in Rule 13a-15(f) under
the Exchange Act) that have materially affected, or are reasonably likely to
materially affect, the Company's internal controls over financial reporting. As
stated in the Company's most recent Form 10-K, the Company received a letter
from it's independent auditors expressing the auditor's opinion as to certain
material weaknesses in the Company's accounting controls and procedures. The
Audit Committee has carefully reviewed such issues and discussed them with the
Company's independent auditors and management. In addition, the Audit Committee
retained a "Big 4" independent auditing firm (the "Review Accountants") to
review the issues raised by the Company's independent auditors and to advise the
Audit Committee with respect to corrective action, if any, that would be
warranted. Following its review, the Review Accountants submitted their report
to the Audit Committee. In response to the report, the Audit Committee and
management are in the process of expanding the Company's accounting department
resources.
24
PART II - OTHER INFORMATION
Item 1. Litigation.
None
Item 2. Changes in Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submissions of Matters to a Vote of Securities Holders.
None
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K.
Exhibits:
31.1 Certifications Required by Rule 13a-14(a) of the Securities Exchange
Act of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
25
Reports on Form 8-K:
On October 30, 2003, the Company filed a Report on Form 8-K with the SEC
concerning the Company's financial performance for the period ended September
30, 2003. A copy of the Company's press release announcing the results and
certain other information was attached to the Report on Form 8-K.
On November 6, 2003, the Company filed a Report on Form 8-K with the SEC
concerning a transcript of the conference call with management covering the
financial performance for the period ended September 30, 2003. A copy of a
transcript of the conference call was attached to the Report on Form 8-K.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
QUALITY SYSTEMS, INC.
Date: February 13, 2004 By: /s/ Louis Silverman
--------------------------------------
Louis Silverman
Chief Executive Officer
Date: February 13, 2004 By: /s/ Paul Holt
--------------------------------------
Paul Holt
Chief Financial Officer; Principal
Accounting Officer
26