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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 September 30, 2004
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 by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). 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: 6,451,366 shares of Common
Stock, $.01 par value, as of November 5, 2004.
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PART I - CONSOLIDATED FINANICAL INFORMATION
Item 1. Financial Statements
QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
---------------------------
(in thousands, except per share amounts) September 30, March 31,
2004 2004
(unaudited)
- ---------------------------------------------------------------------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 59,522 $ 51,395
Accounts receivable, net 25,198 20,336
Inventories, net 1,058 725
Deferred tax assets 2,979 2,979
Other current assets 1,595 1,437
-------------------------
Total current assets 90,352 76,872
Equipment and improvements, net 2,302 2,012
Capitalized software costs, net 3,707 3,608
Deferred tax assets 1,104 1,104
Goodwill 1,840 1,840
Other assets 1,282 1,242
-------------------------
Total assets $ 100,587 $ 86,678
=========================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,068 $ 1,655
Deferred revenue 20,933 17,263
Accrued compensation & benefits 2,594 2,985
Income taxes payable 1,363 273
Other current liabilities 4,519 3,497
-------------------------
Total liabilities 31,477 25,673
-------------------------
Commitments and contingencies
Shareholders' equity:
Common stock, $0.01 par value, 20,000 shares authorized,
6,431 and 6,325 shares issued and outstanding, respectively 64 63
Additional paid-in capital 40,527 39,735
Retained Earnings 29,847 22,750
Deferred compensation (1,328) (1,543)
-------------------------
Total shareholders' equity 69,110 61,005
-------------------------
Total liabilities and shareholders' equity $ 100,587 $ 86,678
=========================
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See notes to consolidated financial statements.
1
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
------------------------------------------------------
(in thousands, except per share amounts) Three Months Ended Six Months Ended
September 30, September 30,
- --------------------------------------------------------------------------------------------------------
2004 2003 2004 2003
------------------------------------------------------
Net revenues:
Software, hardware and supplies $ 9,307 $ 8,244 $ 18,110 $ 16,063
Implementation and training services 2,300 1,782 4,566 3,437
------------------------------------------------------
Systems sales 11,607 10,026 22,676 19,500
Maintenance and other services 9,610 7,616 18,671 14,448
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Total revenue 21,217 17,642 41,347 33,948
Cost of revenue:
Software, hardware and supplies 1,692 2,603 4,044 4,575
Implementation and training services 1,579 1,284 2,971 2,538
------------------------------------------------------
Total Cost of system sales 3,271 3,887 7,015 7,113
Cost of maintenance and other services 4,666 3,605 9,023 6,989
------------------------------------------------------
Total cost of revenue 7,937 7,492 16,039 14,102
Gross profit 13,280 10,150 25,309 19,846
Selling, general and administrative expenses 5,414 4,768 10,367 9,508
Research and development costs 1,818 1,502 3,430 2,868
------------------------------------------------------
Income from operations 6,048 3,880 11,512 7,470
Investment income 170 89 290 189
------------------------------------------------------
Income before provision for income taxes 6,218 3,969 11,802 7,659
Provision for income taxes 2,503 1,561 4,705 2,974
------------------------------------------------------
Net income 3,715 $ 2,408 $ 7,097 $ 4,685
======================================================
Net income per share, basic $ 0.58 $ 0.39 $ 1.12 $ 0.76
------------------------------------------------------
Net income per share, diluted $ 0.56 $ 0.37 $ 1.08 $ 0.72
- --------------------------------------------------------------------------------------------------------
See notes to consolidated financial statements.
2
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
------------------------------
(in thousands) Six Months Ended September 30,
2004 2003
- ------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Income $ 7,097 $ 4,685
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 466 432
Amortization of capitalized software costs 932 722
Provision for bad debts 295 172
Non-Cash compensation from stock option grants 215 --
Changes in:
Accounts receivable (5,157) (3,851)
Inventories (333) (317)
Other assets (198) 116
Accounts payable 413 (735)
Deferred revenue 3,670 3,394
Accrued compensation & benefits (391) 106
Income taxes payable 1,090 (28)
Other current liabilities 1,022 929
----------------------------
Net Cash Provided By Operating Activities 9,121 5,625
----------------------------
----------------------------
Cash Flows From Investing
Activities:
Additions to equipment and improvements (756) (452)
Additions to capitalized software costs (1,031) (1,231)
----------------------------
Net Cash Used In Investing Activities (1,787) (1,683)
----------------------------
Cash Flows from Financing Activities:
Proceeds from exercise of stock options 793 188
----------------------------
Net Cash Provided by Financing Activities 793 188
----------------------------
Net Increase in Cash and Cash Equivalents 8,127 4,130
----------------------------
Cash and Cash Equivalents, beginning of period 51,395 $ 36,443
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Cash and Cash Equivalents, end of period $ 59,522 $ 40,573
----------------------------
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Supplemental Information - During the six months ended September 30, 2004 and
2003, the Company made income tax payments, net of refunds received, of
$3,741,000 and $3,014,000 respectively.
See notes to consolidated financial statements.
3
QUALITY SYSTEMS, INC.
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Basis of Presentation
The accompanying unaudited consolidated financial statements as of September 30,
2004 and for the three and six months ended September 30, 2004 and 2003, 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, 2004. 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 principles generally accepted in the
United States of America.
Revenue Recognition. The Company currently 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 revenue from the sale of licensing rights to its software
products directly to end-users and value-added resellers ("VARs"). The Company
also generates revenue from sales of hardware and third party software, and
implementation, training, software customization, Electronic Data Interchange
(EDI), post-contract support ("maintenance") and other services performed for
customers who license its products.
A typical system contract contains multiple elements 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 vendor
specific objective evidence ("VSOE"). The Company limits its assessment of VSOE
for each element to either the price charged when the same element is sold
separately (using a rolling average of stand alone transactions) or the price
established by management having the relevant authority to do so, for an element
not yet sold separately. VSOE calculations are updated and reviewed at the end
of each quarter.
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 to the individual elements in proportion to the
elements' fair value relative 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 used. Under the residual
method, the Company defers revenue related to the undelivered elements in a
system sale based on VSOE of fair value of each of the undelivered elements, and
allocates the remainder of the contract price net of all discounts to revenue
recognized from the delivered elements. Undelivered elements of a system sale
may include implementation and training services, hardware and third party
software, maintenance, future purchase discounts, or other services. If VSOE of
fair value of any undelivered element does not exist, all revenue is deferred
until VSOE of fair value of the undelivered element is established or the
element has been delivered.
4
The Company bills 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 is generally recognized upon shipment and transfer of title. Revenue
from implementation and training services is recognized as the corresponding
services are performed. Maintenance revenue is recognized ratably over the
contractual maintenance period.
Contract accounting is applied where services include significant software
modification, development or customization. In such instances, the arrangement
fee is accounted for in accordance with SOP 81-1 "Accounting for Performance of
Construction-Type and Certain Production-Type Contracts". Pursuant to SOP 81-1,
the Company uses the percentage of completion method provided all of the
following conditions exist:
o contract includes provisions that clearly specify the enforceable
rights regarding goods or services to be provided and received by
the parties, the consideration to be exchanged, and the manner and
terms of settlement;
o the customer can be expected to satisfy its obligations under the
contract;
o the Company can be expected to perform it's contractual obligations;
and
o reliable estimates of progress towards completion can be made.
The Company measures completion using labor input hours. Costs of providing
services, including services accounted for in accordance with SOP 81-1, are
expensed as incurred.
If a situation occurs in which a contract is so short term that the financial
statements would not vary materially from using the percentage-of-completion
method or in which the Company is unable to make reliable estimates of progress
of completion of the contract, the completed contract method is utilized.
From time to time, the Company offers future purchase discounts on our products
and services as part of it's sales arrangements. Discounts which are incremental
to the range of discounts reflected in the pricing of the other elements of the
arrangement, which are incremental to the range of discounts typically given in
comparable transactions, and which are significant, are treated as an additional
element of the contract to be deferred. Amounts deferred related to future
purchase options are not recognized until either the customer exercises the
discount offer or the offer expires.
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 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 troubled accounts. General
reserves are established based on the Company's historical 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.
5
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
period. 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, which is 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 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
quarters ended September 30, 2004 and 2003 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.
The Company's fair value calculations for options granted in the six month
period ended September 30, 2004 were made using the Black-Scholes option pricing
model with the following assumptions: expected life - four years; stock
volatility - 50%, risk free interest rate of 3.0% ; and, no dividends during the
expected term.
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:
6
--------------------------------------------------------
Quarter Ended Six Months Ended
(in thousands except for per share amounts) September 30, September 30,
--------------------------------------------------------
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------------------
Net Income $ 3,715 $ 2,408 $ 7,097 $ 4,685
--------------------------------------------------------
Proforma Option Compensation Cost (Net of Taxes) (156) (51) (235) (102)
--------------------------------------------------------
Proforma Net Income $ 3,559 $ 2,357 $ 6,862 $ 4,583
========================================================
Reported Basic Net Income Per Share $ 0.58 $ 0.39 $ 1.12 $ 0.76
--------------------------------------------------------
Proforma Net Income Per Share $ 0.56 $ 0.38 $ 1.08 $ 0.74
--------------------------------------------------------
Reported Diluted Net Income Per Share $ 0.56 $ 0.37 $ 1.08 $ 0.72
--------------------------------------------------------
Proforma Diluted Net Income Per Share $ 0.54 $ 0.36 $ 1.04 $ 0.71
- ---------------------------------------------------------------------------------------------------------------------------
On October 29, 2003, the Board of Directors granted 60,000 options to
selected 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
29, 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 six month period ended
September 30, 2004, the Company recognized compensation expense of $215,000
related to these options.
On June 10, 2004, the Board of Directors granted 150,000 options to
selected employees at an exercise price equal to the market price of the
Company's common stock on the date of the grant ($46.67 per share). The options
vest in four equal annual installments beginning June 10, 2005 and expire on
June 10, 2009. No compensation expense has been recorded for these options.
On September 3, 2004, the Board of Directors granted 15,000 options to
selected employees at an exercise price equal to the market price of the
Company's common stock on the date of the grant ($47.42 per share). The options
vest in four equal annual installments beginning September 3, 2005 and expire on
September 3, 2009. No compensation expense has been recorded for these options.
On September 21, 2004, the Board of Directors granted 17,500 options to
Directors (2,500 for each Director) at an exercise price equal to the market
price of the Company's common stock on the date of the grant ($51.00 per share).
The options fully vest on March 21, 2005 and expire on September 21, 2009. No
compensation expense has been recorded for these options.
3. Recent Accounting Pronouncements
In December 2003, the SEC issued Staff Accounting Bulletin (SAB) No. 104,
"Revenue Recognition," which supercedes portions of SAB 101. The primary purpose
of SAB 104 is to rescind accounting guidance contained in SAB 101 related to
multiple element revenue arrangements, which was superceded as a result of the
issuance of EITF 00-21. While the wording of SAB 104 changed to reflect the
issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain
largely unchanged by the issuance of SAB 104. The adoption of SAB No. 104 did
not have a material effect on the Company's consolidated results of operations,
financial position or cash flows.
7
In December 2003, the FASB revised SFAS No. 132 --"Employers' Disclosures about
Pensions and Other Postretirement Benefits" . The revisions to SFAS 132 retain
the disclosure requirements contained in the original SFAS No. 132 but require
additional disclosures describing the types of plan assets, investment strategy,
measurement dates, plan obligations, cash flows, and net periodic benefit cost
of defined benefit pension plans and other defined benefit postretirement plans.
The adoption of SFAS No. 132 had no effect on the Company's Consolidated
Financial statement disclosures, as the Company does not provide any defined
benefit plans to its employees.
4. Intangible Assets - Capitalized Software Development Costs
In accordance with FASB 142, the Company does not amortize goodwill. The balance
of goodwill is related to the Company's NextGen Healthcare Information Systems
Division (NextGen), 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, 2004 (the annual assessment date) 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.
The Company had the following amounts related to intangible assets:
----------------------------------------
(in thousands) Six Months Ended Fiscal Year Ended
September 30, 2004 March 31, 2004
(unaudited)
---------------------------------------------------------------------------------------------
Capitalized software development (3 yrs)
----------------------------------------
Gross Carrying Amount $ 11,641 $ 10,610
----------------------------------------
Accumulated Amortization (7,934) (7,002)
----------------------------------------
Net Capitalized Software development $ 3,707 $ 3,608
========================================
Aggregate amortization expense during the
period ended: $ 932 $ 1,490
----------------------------------------
---------------------------------------------------------------------------------------------
Information related to net capitalized software costs for the six month
period ended September 30, 2004 is as follows:
------------------
(in thousands) September 30, 2004
(unaudited)
-------------------------------------------------------------------
Beginning of period $ 3,608
Capitalized 1,031
Amortization (932)
------------------
End of period $ 3,707
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8
The following table represents the remaining estimated amortization of
intangible assets with determinable lives as of September 30, 2004:
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(in thousands) For the year
ended March 31,
-------------------------------------------------------------
2005 $ 1,345
2006 1,571
2007 709
2008 82
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Total $ 3,707
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5. Income Taxes
The provision for income taxes for the six month periods ended September 30,
2004 and 2003 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 for each of the corresponding periods. The
Company has available a balance of approximately $502,000 of research and
development credits which may be recognized as a whole or in part, once the
amount of the credit has been cleared by the tax authorities, or once the
statute of limitations related to the corresponding tax return has expired. The
Company has received refunds covering $417,000 of the available credits as of
September 30, 2004. The unrecognized research and development credits account
for approximately 50% of the aggregate federal tax credits accumulated from
April 1, 1999 through September 30, 2004.
6. 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.
--------------------------------------------------
(in thousands, except per share amounts) Three Months Ended Six Month Ended
September 30, September 30
--------------------------------------------------
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------
Net income $ 3,715 $ 2,408 $ 7,097 $ 4,685
Basic net income per common share:
Weighted average of common shares outstanding 6,390 6,167 6,361 6,162
--------------------------------------------------
Basic net income per common share $ 0.58 $ 0.39 $ 1.12 $ 0.76
--------------------------------------------------
--------------------------------------------------
Diluted net income per share:
Weighted average of common shares outstanding 6,390 6,167 6,361 6,162
Effect of potentially dilutive securities (options) 208 324 219 317
--------------------------------------------------
Weighted average common shares outstanding-diluted 6,598 6,491 6,580 6,479
--------------------------------------------------
Diluted net income per common share $ 0.56 $ 0.37 $ 1.08 $ 0.72
--------------------------------------------------
- -------------------------------------------------------------------------------------------------------------
9
7. 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 six month periods ended September
30, 2004 and 2003 is as follows:
-----------------------------------------------------------------------
NextGen Healthcare Unallocated
Information Systems Corporate
(in thousands) QSI Division Division Expenses Consolidated
- ----------------------------------------------------------------------------------------------------------------
Six Months Ended
September 30, 2004
Revenue $ 7,936 $ 33,411 -- $ 41,347
Operating income (loss) $ 2,399 $ 11,259 $ (2,146) $ 11,512
Six Months Ended
September 30, 2003
Revenue $ 8,254 $ 25,694 -- $ 33,948
Operating income (loss) $ 2,350 $ 7,206 $ (2,086) $ 7,470
- ----------------------------------------------------------------------------------------------------------------
Three Months Ended
September 30, 2004
Revenue $ 3,955 $ 17,262 -- $ 21,217
Operating Income (Loss) $ 1,137 $ 6,064 $ (1,153) $ 6,048
Three Months Ended
September 30, 2003
Revenue $ 4,190 $ 13,452 -- $ 17,642
Operating Income (Loss) $ 1,286 $ 3,847 $ (1,253) $ 3,880
- ----------------------------------------------------------------------------------------------------------------
10
8. 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) September 30, 2004 March 31, 2004
(unaudited)
- ----------------------------------------------------------------------------------------------------------------
Accounts receivable:
Accounts receivable, excluding undelivered maintenance and services $ 14,652 $ 13,131
Undelivered maintenance and services billed in advance, included in
deferred revenue 12,019 8,498
---------------------------------
Gross accounts receivable 26,671 21,629
---------------------------------
Reserve for bad debts (1,473) (1,293)
---------------------------------
Net accounts receivable $ 25,198 $ 20,336
---------------------------------
- ----------------------------------------------------------------------------------------------------------------
9. Concentration of Credit Risk
The Company had cash deposits at U.S. banks and financial institutions
which exceeded federally insured limits at September 30, 2004. 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.
10. Commitments and Guarantees
Software license agreements in both our QSI and NextGen Divisions include
a performance guarantee that our software products will substantially operate as
described in the applicable program documentation for a period of 365 days after
delivery. To date, we have not incurred any significant costs associated with
these warranties and do not expect to incur significant warranty costs in the
future. Therefore, no accrual has been made for potential costs associated with
these warranties.
We have historically offered short-term rights of return of less than 20
days in certain of our sales arrangements. Based on our historical experience
with similar types of sales transactions bearing these short-term rights of
return, we have not recorded any accrual for returns in our financial
statements.
Our standard sales agreements in the NextGen Division contain an
indemnification provision pursuant to which we indemnify, hold harmless, and
agree to reimburse the indemnified party for losses suffered or incurred by the
indemnified party in connection with any United States patent, any copyright or
other intellectual property infringement claim by any third party with respect
to our software. The QSI Division arrangements occasionally utilize this type of
language as well. As we have not incurred any significant costs to defend
lawsuits or settle claims related to these indemnification agreements, we
believe that our estimated exposure on these agreements is currently minimal.
Accordingly, we have no liabilities recorded for these indemnification
obligations.
From time to time, we offer future purchase discounts on our products and
services as part of our sales arrangements. Discounts which are incremental to
the range of discounts reflected in the pricing of the other elements of the
arrangement, which are incremental to the range of discounts typically given in
comparable transactions, and which are significant are treated as an additional
element of the contract to be deferred. Amounts deferred related to future
purchase options are not recognized until either the customer exercises the
discount offer or the offer expires.
11
The Company has entered into marketing assistance agreements with existing
users of the Company's products which provide the opportunity for those users to
earn commissions if and only if they host specific site visits upon our request
for prospective customers which directly result in a purchase of our software by
the visiting prospects. Amounts earned by existing users under this program are
treated as a selling expense in the period in which commissionable software has
been recognized as revenue.
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 may include forward-looking statements that
involve certain risks and uncertainties. Actual results may differ from those
anticipated by us as a result of various factors, both foreseen and unforeseen,
including, but not limited to, our ability to continue to develop new products
and increase systems sales in markets characterized by rapid technological
evolution, consolidation, and competition from larger, better capitalized
competitors. Many other economic, competitive, governmental and technological
factors could impact our ability to achieve our goals, and interested persons
are urged to review the risks described in "Risk Factors" as set forth herein,
as well as in our other public disclosures and filings with the Securities and
Exchange Commission.
The following discussion should be read in conjunction with, and is
qualified in its entirety by, the Consolidated Financial Statements and related
notes thereto included elsewhere in this report. Historical results of
operations, percentage margin fluctuations and any trends that may be inferred
from the discussion below are not necessarily indicative of the operating
results for any future period.
Critical Accounting Policies. The discussion and analysis of our financial
condition and results of operations is based upon our consolidated financial
statements which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenue and expenses, and related
disclosures of contingent assets and liabilities. On an on-going basis, we
evaluate estimates, including those related to revenue recognition,
uncollectible accounts receivable, and intangible assets, for reasonableness. We
base our estimates on historical experience and on various other assumptions
that management believes to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.
We believe revenue recognition, the allowance for doubtful accounts, and
goodwill impairment are among the most critical accounting policies that impact
our consolidated financial statements. We believe that our significant
accounting policies, as described in Note 2 of our Consolidated Financial
Statements, "Summary of Significant Accounting Policies", should be read in
conjunction with Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Revenue Recognition. We currently recognize 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". We
generate revenue from the sale of licensing rights to use our software products
sold directly to end-users and value-added resellers (VARs). We also generate
revenue from sales of hardware and third party software, and implementation,
training, software customization, EDI, post-contract support ("maintenance") and
other services performed for customers who license our products.
A typical system contract contains multiple elements 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 vendor
specific objective evidence ("VSOE"). We limit our assessment of VSOE for each
element to either the price charged when the same element is sold separately
(using a rolling average of stand
12
alone transactions) or the price established by management having the relevant
authority to do so, for an element not yet sold separately. VSOE calculations
are updated and reviewed at the end of each quarter.
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 to the individual elements in proportion to
the elements' fair value relative 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 used. Under the residual
method, the Company defers revenue related to the undelivered elements in a
system sale based on VSOE of fair value of each of the undelivered elements, and
allocates the remainder of the contract price net of all discounts to revenue
recognized from the delivered elements. Undelivered elements of a system sale
may include implementation and training services, hardware and third party
software, maintenance, future purchase discounts, or other services. If VSOE of
fair value of any undelivered element does not exist, all revenue is deferred
until VSOE of fair value of the undelivered element is established or the
element has been delivered.
We 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 is generally recognized upon shipment and transfer of title. Revenue
from implementation and training services is recognized as the corresponding
services are performed. Maintenance revenue is recognized ratably over the
contractual maintenance period.
Contract accounting is applied where services include significant software
modification, development or customization. In such instances, the arrangement
fee is accounted for in accordance with SOP 81-1 "Accounting for Performance of
Construction-Type and Certain Production-Type Contracts".
Pursuant to SOP 81-1, the Company uses the percentage of completion method
provided all of the following conditions exist:
o contract includes provisions that clearly specify the enforceable
rights regarding goods or services to be provided and received by
the parties, the consideration to be exchanged, and the manner and
terms of settlement;
o the customer can be expected to satisfy its obligations under the
contract.;
o the Company can be expected to perform it's contractual obligations;
and
o reliable estimates of progress towards completion can be made.
We measure completion using labor input hours. Costs of providing services,
including services accounted for in accordance with SOP 81-1, are expensed as
incurred.
If a situation occurs in which a contract is so short term that the financial
statements would not vary materially from using the percentage-of-completion
method or in which we are unable to make reliable estimates of progress of
completion of the contract, the completed contract method is utilized.
From time to time, we offer future purchase discounts on our products and
services as part of our sales arrangements. Pursuant to AICPA TPA 5100.51,
discounts which are incremental to the range of discounts reflected in the
pricing of the other elements of the arrangement, which are incremental to the
range of discounts typically given in comparable transactions, and which are
significant, are treated as an additional element of the contract to be
deferred. Amounts deferred related to future purchase options are not recognized
until either the customer exercises the discount offer or the offer expires.
13
Valuation Allowances. We maintain allowances for doubtful accounts for
estimated losses resulting from the inability of our customers to make required
payments. We perform credit evaluations of our customers and maintain 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 troubled
accounts. General reserves are established based on our historical experience of
bad debt expense and the aging of our accounts receivable balances net of
deferred revenue and specifically reserved accounts. If the financial condition
of our customers were to deteriorate resulting in an impairment of their ability
to make payments, additional allowances would be required.
Goodwill Impairment. Our long-lived assets include goodwill of $1.8
million as of September 30, 2004 and 2003, respectively. We adopted SFAS No. 142
"Goodwill and Other Intangible Assets" ("SFAS 142") effective April 1, 2001. The
statement applies to the amortization of goodwill and other intangible assets.
We ceased amortizing amounts related to goodwill beginning April 1, 2001. The
balance of goodwill is related to our NextGen Division. Under SFAS 142, we are
required to perform an annual assessment of the implied fair value of goodwill
and intangible assets with indefinite lives for impairment. We have 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, 2004 (the date of our last annual impairment test) 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.
The process of evaluating goodwill for impairment involves the
determination of the fair value of our business segments. Inherent in such fair
value determinations are certain judgments and estimates, including the
interpretation of current economic indicators and market valuations, and
assumptions about our strategic plans with regard to operations. To the extent
additional information arises or our strategies change, it is possible that our
conclusion regarding goodwill impairment could change and result in a material
effect on our financial position or results of operations.
Research and Development Tax Credits. During the year ended March 31,
2003, we filed amended federal and certain state tax returns for the fiscal
years ended March 31, 1998 through 2001, to take advantage of tax credits
related to our research and development activities. In addition, we claimed
research and development credit on our tax returns for the years ended March 31,
2004, 2003 and 2002. Management has recorded a cumulative tax benefit which
accounts for approximately 50% of the aggregate federal tax credits accumulated
through September 30, 2004 due to the uncertainly concerning the ultimate amount
to be credited. Management's election to not recognize all of the tax credits
claimed represents a significant estimate which affects the effective income tax
rate for the Company in the six month periods ending September 30, 2004 and
2003. Research and development credits taken by the Company involve certain
assumptions and judgments regarding qualification of expenses under the relevant
tax codes. While we have received all of federal refunds claimed on the amended
returns for fiscal years ended March 31, 1998 through 2001, none of the credits
have been audited by the Internal Revenue Service. Credits claimed for state
income tax purposes are in the process of being audited. However, no final
conclusions have been received by us as of November 9, 2004.
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", "we", "our", or "us") develops and
markets healthcare information systems that automate certain aspects of 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, we capitalized on the increasing focus on medical cost containment
and further expanded our information processing systems to serve the medical
market. In the mid 1990's we made two acquisitions that accelerated our
penetration of
14
the medical market. These two acquisitions formed the basis for what is today
the NextGen Division. Today, we serve the medical and dental markets through our
two divisions.
The two divisions operate largely as stand-alone operations with each
division maintaining it's 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 our two Divisions.
The QSI Division, co-located with our Corporate Headquarters in Irvine,
California, currently focuses on developing, marketing and supporting software
suites sold to dental and certain niche medical practices. In addition, the
Division supports a number of medical clients that utilize the Division's
UNIX(1) based medical practice management software product.
The NextGen Division, with headquarters in Horsham, Pennsylvania, and a
second significant location in Atlanta, Georgia, focuses principally on
developing and marketing products and services for 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, we actively compete 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, we are 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 at least some of these services from us or one of our
competitors. Other EDI/connectivity services are used more sporadically by
client practices. We typically compete to displace incumbent vendors for claims
and statements accounts, and attempt to increase usage of other elements in our
EDI/connectivity product line. In general, EDI services are only sold to those
accounts utilizing software from one of our divisions.
The QSI Division's practice management software suite utilizes a UNIX
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 our EDI/connectivity applications. The
QSInet Application Service Provider (ASP/Internet) offering is also developed
and marketed by the Division.
Our 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)),
- ----------
(1) UNIX is a registered trademark of the AT&T Corporation.
(2) Microsoft Windows, Windows NT, Windows 95, Windows 98, Windows XP, and
Windows 2000 are registered trademarks of the Microsoft Corporation.
(3) NextGen is a registered trademark of NextGen Healthcare Information
Systems, Inc.
15
Enterprise Appointment Scheduling (NextGen(eas)), Enterprise Master Patient
Index (NextGen(epi)), NextGen Image Control System (NextGen(ics)), Managed Care
Server (NextGen(mcs)), Electronic Data Interchange, System Interfaces, Internet
Operability (NextGen(web)), a Patient-centric and Provider-centric Web Portal
solution (NextMD(4).com), 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.
We continue 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.
Inclusive of divisional EDI revenue, the NextGen Division accounted for
approximately 81% of our revenue for the second quarter of fiscal 2005 compared
to 76% in the second quarter of fiscal 2004. The QSI Division accounted for 19%
and 24% of revenue in the second quarter of fiscal 2005 and 2004, respectively.
The NextGen Division's year over year revenue grew at 38% and 57% in second
quarter of fiscal 2005 and 2004, respectively, while the QSI Division's year
over year revenue declined by 6% and 5% in the second quarter of fiscal 2005 and
2004 respectively.
In addition to the aforementioned software solutions which we offer
through our two divisions, each division offers comprehensive hardware and
software installation services, maintenance and support services, and system
training services.
Risk Factors
The more prominent risks and uncertainties inherent in our business are
described below. However, additional risks and uncertainties may also impair our
business operations. If any of the following risks actually occur, our business,
financial condition or results of operations will likely suffer. Any of these or
other factors could harm our business and future results of operations and may
cause you to lose all or part of your investment.
We face significant competition. The markets for healthcare information
systems are intensely competitive and we face significant competition from a
number of different sources. Several of our competitors have significantly
greater name recognition as well as substantially greater financial, technical,
product development and marketing resources than we do.
We compete in all of our 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 ourselves or our competitors, may result in price or
market share erosion that could have a material adverse effect on our business,
results of operations and financial condition. Also, there can be no assurance
that our applications will achieve broad market acceptance or will successfully
compete with other available software products.
Our inability to make initial sales of our systems to newly formed groups
and/or healthcare providers that are replacing or substantially modifying their
healthcare information systems could have a material adverse effect on our
business, results of operations and financial condition. If new systems sales do
not materialize, our near term and longer term revenue will be negatively
affected.
Our quarterly operating results have historically fluctuated and may do so
in the future. Our revenue has 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:
o the size and timing of orders from clients;
o the length of sales cycles and installation processes;
o the ability of our clients to obtain financing for the purchase of
our products;
o changes in pricing policies or price reductions by us or our
competitors;
- ----------
(4) NextMD is a registered trademark of NextGen Healthcare Information
Systems, Inc.
16
o the timing of new product announcements and product introductions by
us or our competitors;
o changes in revenue recognition or other accounting guidelines
employed by us and/or established by the Financial Accounting
Standards Board or other rule-making bodies;
o the availability and cost of system components;
o the financial stability of clients;
o market acceptance of new products, applications and product
enhancements;
o our ability to develop, introduce and market new products,
applications and product enhancements;
o our success in expanding our sales and marketing programs;
o deferrals of client orders in anticipation of new products,
applications or product enhancements;
o execution of or changes to Company strategy;
o personnel changes; and
o general market/economic factors.
Our software products are generally shipped as orders are received and
accordingly, we have historically operated with a minimal backlog of license
fees. As a result, revenue in any quarter is dependent on orders booked and
shipped in that quarter and is not predictable with any degree of certainty.
Furthermore, our systems can be relatively large and expensive and individual
systems sales can represent a significant portion of our revenue and profits for
a quarter such that the loss or deferral of even one such sale can have a
significant adverse impact on our quarterly revenue and profitability.
Clients often defer systems purchases until our quarter end, so quarterly
results generally cannot be predicted and frequently are not known until the
quarter has concluded.
Our sales are dependent upon clients' initial decisions to replace or
substantially modify their existing information systems, 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 our
systems can vary significantly and typically ranges from three to twelve months
from initial contact to contract execution/shipment.
Because a significant percentage of our 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, we believe
that interim period-to-period comparisons of our results of operations are not
necessarily meaningful and should not be relied upon as indications of future
performance. Further, our historical operating results are not necessarily
indicative of future performance for any particular period.
We currently recognize 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", Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition
in Financial Statements" ("SAB 101"), and SAB 104, "Revenue Recognition" ("SAB
104"). SAB 101 summarizes the staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. SAB 104
modifies certain guidance provided in SAB 101.
There can be no assurance that application and subsequent interpretations
of these pronouncements will not further modify our 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 our operating
results may be below the expectations of public market analysts and investors.
In such event, the price of our Common Stock would likely be materially
adversely affected.
17
The price of our shares and the trading volume of our shares have been
volatile historically and may continue to be volatile. Volatility may be caused
by a number of factors including but not limited to:
o actual or anticipated quarterly variations in operating results;
o rumors about our performance, software solutions, or merger and
acquisition activity;
o changes in expectations of future financial performance or changes
in estimates of securities analysts;
o governmental regulatory action;
o health care reform measures;
o client relationship developments;
o purchases or sales of company stock;
o changes occurring in the markets in general; and
o other factors, many of which are beyond our control.
Furthermore, the stock market in general, and the market for software,
healthcare and high technology companies in particular, has 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 our common stock, regardless of actual operating
performance.
Two of our directors are significant shareholders which makes it possible
for them to have significant influence over the outcome of all matters submitted
to our shareholders for approval, which influence may be alleged to conflict
with our interests and the interests of our other shareholders. Two of our
directors and principal shareholders beneficially owned approximately 40% of the
outstanding shares of our common stock at March 31, 2004. As such, these
shareholders will have significant influence over the outcome of all matters
submitted to our shareholders for approval, including the election of our
directors and other corporate actions. In addition, such influence by one or
both of these affiliates could have the effect of discouraging others from
attempting to take us over, and/or reducing the market price offered for our
common stock in such an event.
We are dependent on our principal products and our new product
development. We currently derive substantially all of our net revenue from sales
of our healthcare information systems and related services. We believe that a
primary factor in the market acceptance of our systems has been our ability to
meet the needs of users of healthcare information systems. Our future financial
performance will depend in large part on our ability to continue to meet the
increasingly sophisticated needs of our clients through the timely development
and successful introduction and implementation of new and enhanced versions of
our systems and other complementary products. We have historically expended a
significant percentage of our net revenue on product development and believe
that significant continuing product development efforts will be required to
sustain our growth. Continued investment in our sales staff and our client
implementation and support staffs will also be required to support future
growth.
There can be no assurance that we will be successful in our product
development efforts, that the market will continue to accept our 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, our business, results of operations and financial
condition could be materially adversely affected. At certain times in the past,
we have also experienced delays in purchases of our products by clients
anticipating our launch of new products. There can be no assurance that material
order deferrals in anticipation of new product introductions from ourselves or
other entities will not occur.
If the emerging technologies and platforms of Microsoft and others upon
which we build our products do not gain broad market acceptance, or if we fail
to develop and introduce in a timely manner new products and services compatible
with such emerging technologies, we may not be able to
18
compete effectively and our ability to generate revenue will suffer. Our
software products are built and depend upon several underlying and evolving
relational database management system platforms such as those developed by
Microsoft. To date, the standards and technologies upon which we have chosen to
develop our products have proven to have gained industry acceptance. However,
the market for our software products is subject to ongoing rapid technological
developments, quickly evolving industry standards and rapid changes in customer
requirements, and there may be existing or future technologies and platforms
that achieve industry standard status, which are not compatible with our
products.
We face the possibility of subscription pricing and/or application service
provider, ("ASP") delivered offerings. We currently derive substantially all of
our revenue 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 our products, in addition to a periodic maintenance fee. If
the marketplace demands subscription pricing and/or ASP-delivered offerings, we
may be forced to adjust our sales, marketing and pricing strategies accordingly,
by offering a higher percentage of our products and services through these
means. Shifting to subscription pricing and/or ASP-delivered offerings could
materially adversely impact our financial condition, cash flows and quarterly
and annual revenue and results of operations, as our revenue would initially
decrease substantially. There can be no assurance that the marketplace will not
embrace subscription pricing and/or ASP-delivered offerings.
The industry in which we operate is subject to significant 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 our
existing products obsolete and unmarketable. There can be no assurance that we
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 revenue or research
funding could impair our ability to respond to technological advances or
opportunities in the marketplace and to remain competitive. If we are 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, our business, results of operations and financial condition may be
materially adversely affected.
In response to increasing market demand, we are currently developing new
generations of certain of our software products. There can be no assurance that
we 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 our competitive
position or could make our current products obsolete.
We face the possibility of claims based upon our web site. We could be
subject to third party claims based on the nature and content of information
supplied on our Web site by us or third parties, including content providers or
users. We could also be subject to liability for content that may be accessible
through our Web site or third party Web sites linked from our 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 our applications.
Even if these claims do not result in liability to us, investigating and
defending against these claims could be expensive and time consuming and could
divert management's attention away from our operations.
We face the possibility of claims from activities of strategic partners.
We rely on third parties to provide services that impact our business. For
example, we use national clearinghouses in the processing of some insurance
claims and we outsource some of our hardware maintenance services and the
printing and delivery of patient statements for our customers. We also have
relationships with certain third parties where these third parties serve as
sales channels through which we generate a portion of our revenue. Due to these
third-party relationships, we could be subject to claims as a result of the
activities, products, or services of these third-party service providers even
though we were not directly involved in the circumstances leading to those
claims. Even if these claims do not result in liability to us, defending and
investigating these claims could be expensive and time-consuming, divert
personnel and other resources
19
from our business and result in adverse publicity that could harm our business.
We may engage in future acquisitions, which may be expensive and time
consuming and from which we may not realize anticipated benefits. We may acquire
additional businesses, technologies and products if we determine that these
additional businesses, technologies and products are likely to serve our
strategic goals. We currently have no commitments or agreements with respect to
any acquisitions. The specific risks we may encounter in these types of
transactions include but are not limited to the following:
o potentially dilutive issuances of our securities, the incurrence of
debt and contingent liabilities and amortization expenses related to
intangible assets, which could adversely affect our results of
operations and financial conditions;
o difficulty in effectively integrating any acquired technologies or
software products into our current products and technologies;
o difficulty in predicting and responding to issues related to product
transition such as development, distribution and customer support;
o the possible adverse impact of such acquisitions on existing
relationships with third party partners and suppliers of
technologies and services;
o the possibility that staff or customers of the acquired company
might not accept new ownership and may transition to different
technologies or attempt to renegotiate contract terms or
relationships, including maintenance or support agreements;
o the possibility that the due diligence process in any such
acquisition may not completely identify material issues associated
with product quality, product architecture, product development,
intellectual property issues, key personnel issues or legal and
financial contingencies; and
o difficulty in integrating acquired operations due to geographical
distance, and language and cultural differences.
A failure to successfully integrate acquired businesses or technology for
any of these reasons could have a material adverse effect on the Company's
results of operations.
We face the risks and uncertainties that are associated with litigation
against us. We face the risks associated with litigation concerning the
operation of our business. The uncertainty associated with substantial
unresolved litigation may have an adverse impact on our business. In particular,
such litigation could impair our relationships with existing customers and our
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 our business, results of
operations and financial condition. Such litigation may also have the effect of
discouraging potential acquirers from bidding for us 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 our insurance coverage, that our insurance will cover
such claims or that appropriate insurance will continue to be available to us in
the future at commercially reasonable rates.
We rely heavily on our proprietary technology. We are heavily dependent on
the maintenance and protection of our intellectual property and we rely largely
on license agreements, confidentiality procedures, and employee nondisclosure
agreements to protect our intellectual property. Our software is not patented
and existing copyright laws offer only limited practical protection.
There can be no assurance that the legal protections and precautions we
take will be adequate to prevent misappropriation of our technology or that
competitors will not independently develop technologies equivalent or superior
to ours. Further, the laws of some foreign countries do not protect our
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.
20
We do not believe that our 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 us with
respect to our current or future products or that any such assertion will not
require us 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 our business, results of operations and
financial condition. In addition, claims may be brought against third parties
from which we purchase software, and such claims could adversely affect our
ability to access third party software for our systems.
We are dependent on our license rights from third parties. We depend upon
licenses for some of the technology used in our products from third-party
vendors. Most of these licenses can be renewed only by mutual consent and may be
terminated if we breach the terms of the license and fail to cure the breach
within a specified period of time. We may not be able to continue using the
technology made available to us under these licenses on commercially reasonable
terms or at all. As a result, we may have to discontinue, delay or reduce
product shipments until we can obtain equivalent technology. Most of our
third-party licenses are non-exclusive. Our competitors may obtain the right to
use any of the technology covered by these licenses and use the technology to
compete directly with us. In addition, if our vendors choose to discontinue
support of the licensed technology in the future or are unsuccessful in their
continued research and development efforts, we may not be able to modify or
adapt our own products.
We face the possibility of damages resulting from internal and external
security breaches, and viruses. In the course of our business operations, we
compile and transmit confidential information, including patient health
information, in our processing centers and other facilities. A breach of
security in any of these facilities could damage our reputation and result in
damages being assessed against us. In addition, the other systems with which we
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
our services. Accordingly, we believe that it is critical that these facilities
and related infrastructures not only be secure, but also be viewed by our
customers as free from potential breach. Maintaining such standards, protecting
against breaches and curing security flaws, may require us to expend significant
capital. The success of our strategy to offer our EDI services and Internet
solutions depends on the confidence of our customers in our ability to securely
transmit confidential information. Our EDI services and Internet solutions rely
on encryption, authentication and other security technology licensed from third
parties to achieve secure transmission of confidential information. We may not
be able to stop unauthorized attempts to gain access to or disrupt the
transmission of communications by our customers. Anyone who is able to
circumvent our security measures could misappropriate confidential user
information or interrupt us, or our customers', operations. In addition, our 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 our customers causing
them to seek out other vendors, and/or, damage our reputation in the market
making it difficult to obtain new customers.
We are subject to the development and maintenance of the Internet
infrastructure which is not within our control. We deliver Internet-based
services and, accordingly, we are dependent on the maintenance of the Internet
by third parties. The Internet infrastructure may be unable to support the
demands placed on it and our performance may decrease if the Internet continues
to experience it's historic trend of expanding usage. As a result of damage 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 us for transmittal of our Internet-based services. In addition,
difficulties, outages, and delays by Internet service providers, online service
providers and other web site operators may obstruct or diminish access to our
Web site by our customers resulting in a loss of potential or existing users of
our services.
Our failure to manage growth could harm us. We have in the past
experienced periods of growth which have placed, and may continue to place, a
significant strain on our non-cash resources. We also anticipate expanding our
overall software development, marketing, sales, client management and training
capacity. In the event we are unable to identify, hire, train and retain
qualified individuals in such
21
capacities within a reasonable timeframe, such failure could have a material
adverse effect on us. In addition, our ability to manage future increases, if
any, in the scope of our operations or personnel will depend on significant
expansion of our research and development, marketing and sales, management, and
administrative and financial capabilities. The failure of our management to
effectively manage expansion in our business could have a material adverse
effect on our business, results of operations and financial condition.
Our operations are dependent upon our key personnel. If such personnel
were to leave unexpectedly, we may not be able to execute our business plan. Our
future performance depends in significant part upon the continued service of our
key technical and senior management personnel, many of whom have been with us
for a significant period of time. These personnel have acquired specialized
knowledge and skills with respect to our business. We do not maintain key man
life insurance on any of our employees. Because we have a relatively small
number of employees when compared to other leading companies in the same
industry, our dependence on maintaining our relationship with key employees is
particularly significant. We are also dependent on our ability to attract and
retain high quality personnel, particularly in the areas of sales and
applications development.
The industry in which we operate is characterized by a high level of
employee mobility and aggressive recruiting of skilled personnel. There can be
no assurance that our current employees will continue to work for us. Loss of
services of key employees could have a material adverse effect on our business,
results of operations and financial condition. Furthermore, we may need to grant
additional equity incentives to key employees and provide other forms of
incentive compensation to attract and retain such key personnel. Failure to
provide such types of incentive compensation could jeopardize our recruitment
and retention capabilities.
Our products may be subject to product liability legal claims. Certain of
our products provide applications that relate to patient clinical information.
Any failure by our products to provide accurate and timely information could
result in claims against us. In addition, a court or government agency may take
the position that our delivery of health information directly, including through
licensed practitioners, or delivery of information by a third party site that a
consumer accesses through our web sites, exposes us to assertions of
malpractice, other personal injury liability, or other liability for wrongful
delivery/handling of healthcare services or erroneous health information. We
maintain insurance to protect against claims associated with the use of our
products as well as liability limitation language in our end-user license
agreements, but there can be no assurance that our insurance coverage or
contractual language would adequately cover any claim asserted against us. A
successful claim brought against us in excess of or outside of our insurance
coverage could have a material adverse effect on our business, results of
operations and financial condition. Even unsuccessful claims could result in our
expenditure of funds for litigation and management time and resources.
Certain healthcare professionals who use our Internet-based products will
directly enter health information about their patients including information
that constitutes a record under applicable law that we may store on our 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 our contracts with customers and partners;
o state laws regulating healthcare professionals;
o Medicaid laws;
o the Health Insurance Portability and Accountability Act of 1996
("HIPAA") and related rules proposed by the Health Care Financing
Administration; and
o 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 elements including, but not limited
to, new federal privacy and security standards for the use
22
and protection of Protected Health Information. Any failure by us or by our
personnel or partners to comply with applicable requirements may result in a
material liability to us.
Although we have systems and policies in place for safeguarding Protected
Health Information from unauthorized disclosure, these systems and policies may
not preclude claims against us for alleged violations of applicable
requirements. Also, third party sites and/or links that consumers may access
through our web sites may not maintain adequate systems to safeguard this
information, or may circumvent systems and policies we have put in place. In
addition, future laws or changes in current laws may necessitate costly
adaptations to our policies, procedures, or systems.
There can be no assurance that we will not be subject to product liability
claims, that such claims will not result in liability in excess of our insurance
coverage, that our insurance will cover such claims or that appropriate
insurance will continue to be available to us in the future at commercially
reasonable rates. Such product liability claims could have a material adverse
affect on our business, results of operations and financial condition.
We are subject to the effect of payor and provider conduct which we cannot
control. Electronic data transmission services are offered by certain payors to
healthcare providers that establish a direct link between the provider and
payor. This process reduces revenue to third party EDI service providers such as
us. Accordingly, we are unable to insure that we will continue to generate
revenue at or in excess of prior levels for such services. A significant
increase in the utilization of direct links between healthcare providers and
payers could have a material adverse effect on our transaction volume and
financial results. In addition, we cannot provide assurance that we will be able
to maintain our exiting links to payors or develop new connections on terms that
are economically satisfactory to us, if at all.
There is significant uncertainty in the healthcare industry in which we
operate and we are subject to the possibility of changing 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 us and
our clients. Healthcare providers may react to these proposals, and the
uncertainty surrounding such proposals, by curtailing or deferring investments,
including those for our 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 our ability to sell our 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. We cannot predict what impact, if
any, such proposals or healthcare reforms might have on our business, financial
condition and results of operations.
The HIPAA regulations, as adopted by the Department of Health and Human
Services, established, among other things:
o a national standard for electronic transactions and code sets to be
used in those transactions involving certain common health care
transactions;
o privacy regulations to protect the privacy of plan participants and
patients' medical records; and
o 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 will become effective by 2005. As these
regulations mature and become better defined, we anticipate that these
regulations will continue to directly affect certain of our products and
services, but
23
we cannot fully predict the impact at this time. We have taken steps to modify
our products, services and internal practices as necessary to facilitate our and
our client's compliance with the final regulations, but there can be no
assurance that we 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 us 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 our business.
In addition, our 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 our business, financial condition and results of operations.
We may be subject to other e-commerce regulations. We 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 our products and services are subject to these laws and regulations, the
sale of our products and services could be harmed.
We are subject to changes in and interpretations of financial accounting
matters that govern the measurement of our performance. Based on our 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 our 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 our business practices could result in future changes in our revenue
recognition and/or other accounting policies and practices that could have a
material adverse effect on our business, financial condition, cash flows,
revenue and results of operations.
Our per share price may be adversely effected if weaknesses in our
internal controls are identified by ourselves or our independent auditors. Any
weaknesses identified in our internal controls as part of the evaluation being
undertaken by us and our independent public accountants pursuant to Section 404
of the Sarbanes-Oxley Act of 2002 could have an adverse effect on our business
and the price at which our stock trades.
Our earnings may be adversely affected if we change our accounting policy
with respect to employee stock options. Stock options have from time to time
been an important component of the compensation packages for many of our mid-
and senior-level employees. We currently do not deduct the expense of employee
stock option grants from our income. Many companies, however, are considering a
change to their accounting policies to record the value of stock options issued
to employees as an expense and changes in the accounting treatment of stock
options are currently under consideration by the Financial Accounting Standards
Board or other accounting standards-setting bodies. If we were to voluntarily or
involuntarily change our accounting policy with respect to the treatment of
employee stock option grants, our earnings could be materially adversely
affected.
Continuing worldwide political and economic uncertainties may adversely
impact our revenue and profitability. In the last three years, worldwide
economic conditions have experienced a downturn due to numerous factors
including but not limited to concerns about inflation and deflation, decreased
consumer confidence, the lingering effects of international conflicts, and
terrorist and military activities. These conditions make it extremely difficult
for our customers, our vendors and ourselves to accurately
24
forecast and plan future business activities, and they could cause constrained
spending on our products and services, and/or delay and lengthen sales cycles.
Results of Operations
Overview of results
o We have experienced significant growth in revenue as a result of
revenue growth in our NextGen division. Revenue grew 22% on a
consolidated basis in the six months ended September 30, 2004 versus
2003 and 34% in the six months ended September 30, 2003 versus 2002.
o Consolidated Operating Income grew 54% in the six months ended
September 30, 2004 versus 2003 and 42% in the six months ended
September 30, 2003 versus 2002. This performance was driven in large
part by the results in our NextGen Division.
o We have benefited and hope to continue to benefit from the increased
demands on healthcare providers for greater efficiency and lower
costs, as well as increased adoption rates for electronic medical
records and other technology.
NextGen Division
o Our NextGen Division has experienced significant growth in revenue
and operating income. Divisional revenue grew 30% in the six months
ended September 30, 2004 versus 2003 and 57% in the six months ended
September 30, 2003 versus 2002 while divisional operating income
grew 56% in the six months end September 30, 2004 and 72% in the six
months ended September 30, 2003.
o During the six months ended September 30, 2004, we added staffing
resources to departments including sales, support, implementation,
and software development areas and intend to continue to do so
during the remainder of fiscal year 2005.
o Our goals include continuing to further enhance our existing
products, developing new products for targeted markets, continuing
to add new customers, and expanding penetration of connectivity
services to new and existing customers.
QSI Division
o Our QSI division experienced a revenue decline of 5% in the six
months ended September 30, 2004 versus 2003 and 3% in the six months
ended September 30, 2003 versus 2002. The division experienced a 2%
increase in operating income in the six months ended September 30,
2004 and 2003.
o Our goals for the QSI division include maximizing revenue and profit
performance given the constraints present in this division's target
market.
25
The following table sets forth for the periods indicated, the percentage
of net revenues represented by each item in our Consolidated Statements of
Income.
-----------------------------------------
(unaudited) Three Months Ended Six Months Ended
September 30, September 30,
- ----------------------------------------------------------------------------------------------------
2004 2003 2004 2003
-----------------------------------------
Net revenues:
Software, hardware and supplies 43.9 46.7 43.8 47.3
Implementation and training services 10.8 10.1 11.0 10.1
-----------------------------------------
Systems sales 54.7% 56.8% 54.8% 57.4%
Maintenance and other services 45.3 43.2 45.2 42.6
-----------------------------------------
100.0 100.0 100.0 100.0
Cost of revenue:
Software, hardware and supplies 8.0 14.8 9.8 13.5
Implementation and training services 7.4 7.3 7.2 7.5
-----------------------------------------
Total cost of systems sales 15.4 22.1 17.0 21.0
Cost of Maintenance and other services 22.0 20.4 21.8 20.5
-----------------------------------------
Total cost of revenue 37.4 42.5 38.8 41.5
-----------------------------------------
Gross profit 62.6 57.5 61.2 58.5
Selling, General and Administrative Expenses 25.5 27.0 25.1 28.0
Research and Development Costs 8.6 8.5 8.3 8.4
-----------------------------------------
Income from Operations 28.5 22.0 27.8 22.0
Investment Income .8 .5 .7 .6
-----------------------------------------
Income before Provision for Income Taxes 29.3 22.5 28.5 22.6
Provision for Income Taxes 11.8 8.9 11.3 8.8
-----------------------------------------
Net Income 17.5% 13.6% 17.2% 13.8%
- ----------------------------------------------------------------------------------------------------
For the Three-Month Periods September 30, 2004 versus 2003
Net Income. The Company's net income for the three months ended September
30, 2004 was $3,715,000 or $ 0.58 per share on a basic and $ 0.56 per share on a
fully diluted basis. In comparison, we earned $2,408,000 or $0.39 per share on a
basic and $0.37 per share on a fully diluted basis for the three months ended
September 30, 2003. The increase in net income for the three months ended
September 30, 2004 was achieved through the following:
o a 20% increase in consolidated revenue; and
o selling, general and administrative expenses and cost of revenues
which grew at 14% and 6% respectively; slower than the overall
revenue growth rate.
Net Revenue. Net revenue for the three months ended September 30, 2004
increased 20% to $21.2 million from $17.6 million for the three months ended
September 30, 2003. NextGen Division net revenue increased 28% from
approximately $13.5 million to approximately $17.3 million in the period, while
QSI Division net revenue declined by 5% during the period from approximately
$4.2 million to approximately $ 4.0 million.
26
We report revenue in two major categories, "Systems sales" and
"Maintenance and other services". Revenue in the Systems sales category includes
software license fees, hardware, third party software, supplies and
implementation and training services related to purchase of the Company's
software systems. The majority of the revenue in the System sales category is
related to the sale of software. Revenue in the maintenance and other category
includes maintenance, EDI, and other revenue. Maintenance and EDI revenue are
the principal sources of revenue in this category.
Systems Sales. Company-wide sales of systems for the three months ended
September 30, 2004 increased 16% to $11.6 million from $10.0 million in the
prior year quarter.
Our increase in revenue from sales of systems was principally the result
of a 16% increase in category revenue at our NextGen Division whose sales in
this category grew from $9.5 million during the quarter ended September 30, 2003
to $11.0 million during the quarter ended September 30, 2004. This increase was
driven primarily by higher sales of NextGen(emr) and NextGen(epm) software to
both new and existing clients, as well as delivery of related implementation
services offset by declines in related hardware, third party software, and
supplies.
Systems sales revenue in the QSI Division was relatively unchanged at
approximately $0.6 million in each period.
The following table breaks down our reported Systems sales into software,
hardware, third party software, supplies, and implementation and training
services components by division:
------------------------------------------------------------------------
Hardware,
Third Party Implementation
Software & & Training
(In thousands) Software Supplies Services Systems sales
----------------------------------------------------------------------------------------------------------
Three Months Ended
September 30, 2004
----------------------------------------------------------------------------------------------------------
NextGen $7,484 $1,306 $2,200 $10,990
----------------------------------------------------------------------------------------------------------
QSI Division 196 321 100 617
-----------------------------------=======================================================================
Consolidated $7,680 $1,627 $2,300 $11,607
----------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------
Three Months Ended
September 30, 2003
----------------------------------------------------------------------------------------------------------
NextGen $5,756 $2,001 $1,699 $9,456
----------------------------------------------------------------------------------------------------------
QSI Division 117 370 83 570
-----------------------------------=======================================================================
Consolidated $5,873 $2,371 $1,782 $10,026
----------------------------------------------------------------------------------------------------------
NextGen division software revenue increased 30% between the three months
ended September 30, 2003 and the three months ended September 30, 2004. The
Division's software revenue accounted for 68% of divisional category revenue
during the three months ended September 30, 2004, an increase from 61% in the
prior year period. The increase in software's share of systems sales was not the
result of any new trend or change in emphasis on our part relative to software
sales. Software license revenue growth continues to be an area of primary
emphasis for the NextGen Division and management was pleased with the division's
performance in this area.
During the three months ended September 30, 2004, 12% of NextGen's systems
sales revenue was represented by hardware and third party software compared to
21% in the same prior year period. This decrease was not the result of any
identifiable trend or change in emphasis on our part. The number of customers
who purchase hardware and third party software and the dollar amount of hardware
and third party software revenue fluctuates each quarter depending on the needs
of customers. The inclusion of hardware and third party software in the
division's sales arrangements is typically at the request of the customer and is
not a priority focus for us.
27
Implementation and training revenue at the NextGen Division increased 30%
in the three months ended September 30, 2004 compared to the three months ended
September 30, 2003. Implementation and training revenue at the NextGen division
increased its share of category revenue slightly to 20% in the three months
ended September 30, 2004 from 18% in the three months ended September 30, 2003.
The growth in implementation and training revenue is the result of increases in
the amount of implementation and training services rendered to our customers.
The number of implementation and training staff increased during the three
months ended September 30, 2004 versus 2003 in order to accommodate the
increased amount of implementation services sold in conjunction with increased
software sales. In order to achieve continued increased revenue in this area,
additional staffing increases are anticipated, though actual future increases in
revenue and staff will depend upon the availability of qualified staff, business
conditions, and our ability to retain current staff members.
The NextGen Division's growth has come in part from investments in sales
and marketing activities including hiring additional sales representatives,
trade show attendance, and advertising expenditures. We have also benefited from
winning numerous industry awards for the NextGen Division's flagship
NextGen(emr) and NextGen(epm) software products in fiscal years 2004 and 2003,
as well as in prior years, and the apparent increasing acceptance of electronic
medical records technology in the healthcare industry.
For the QSI division, sales of software systems increased 8% in the three
months ended September 30, 2004 compared to the three months ended September 30,
2003. We do not presently foresee any material changes in the business
environment for the Division with respect to the constrained environment that
has been in place for the past several years. The year over year increases in
software sales and implementation services was partially offset by decreases in
hardware/third party software.
Maintenance and Other. For the three months ended September 30, 2004,
company-wide revenue from maintenance and other services grew 26% to $9.6
million from $7.6 million in the same period in the prior year. The increase in
this category resulted from an increase in maintenance and EDI revenue from the
NextGen Division's client base. Total NextGen Division maintenance revenue for
the three months ended September 30, 2004 grew 63% to $4,245,000 from $2,606,000
in the same year ago period, while EDI revenue grew 109% to $1,361,000 compared
to $652,000 during the same period. QSI Division maintenance revenue declined 6%
from $1,902,000 to $1,794,000 in the same period during the prior year while QSI
Divisional EDI revenue declined by approximately 8% from $1,339,000 to
$1,227,000 between the same periods.
The following table details revenue included in the maintenance and other
category for the three month periods ended September 30, 2004 and 2003:
-----------------------------------------------------------------------------
Three Months Ended September 30, Three Months Ended September 30,
(in thousands) 2004 2003
-----------------------------------------------------------------------------
QSI NextGen Consolidated QSI NextGen Consolidated
================================================================================================================
Maintenance $1,794 $4,245 $6,039 $1,902 $2,606 $4,508
- ----------------------------------------------------------------------------------------------------------------
EDI 1,227 1,361 2,588 1,339 652 1,991
- ----------------------------------------------------------------------------------------------------------------
Other 317 666 983 379 738 1,117
================================================================================================================
Total Maintenance & Other $3,338 $6,272 $9,610 $3,620 $3,996 $7,616
- ----------------------------------------------------------------------------------------------------------------
The growth in maintenance revenue for the NextGen Division has come from
new customers that have been added each quarter as well as our relative success
in retaining existing maintenance customers. NextGen EDI revenue growth has come
from new customers, further penetration of the Division's existing customer
base, and an increase in the average EDI revenue per customer . NextGen's growth
in
28
maintenance and EDI revenue was at or above our expectations for the period. We
intend to continue to promote maintenance and EDI services to both new and
existing customers.
The following table provides the number of billing sites which were
receiving maintenance services as of the last business day of the quarters ended
September 30, 2004 and 2003 respectively, as well as the number of billing sites
receiving EDI services during the last month of each respective period at each
division of the Company. The table presents summary information only and
includes billing entities added and removed for any reason. Note also that a
single client may include one or multiple billing sites.
--------------------------------------------------------------------------------------------------------
NextGen QSI Division Consolidated
Period Maintenance EDI Maintenance EDI Maintenance EDI
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
September 30, 2003 404 267 343 253 747 520
--------------------------------------------------------------------------------------------------------
Billing sites added 145 131 5 3 150 134
--------------------------------------------------------------------------------------------------------
Billing sites removed (6) (26) (44) (37) (50) (63)
--------------------------------------------------------------------------------------------------------
September 30, 2004 543 372 304 219 847 591
--------------------------------------------------------------------------------------------------------
Cost of Products and Services. Cost of products and services for the three
months ended September 30, 2004 increased 6% to $7.9 million from $7.5 million
in the quarter ended September 30, 2003 , while the cost of products and
services as a percentage of net revenue decreased to 37.4% from 42.5%.
The decrease in our consolidated cost of revenue as a percentage of
revenue between the three months ended September 30, 2004 and the three months
ended September 30, 2003 is attributable to three main factors:
o a reduction in the level of hardware and third party software
expense as a percentage of revenue in the NextGen Division;
o an increase in the NextGen division's share of consolidated revenue
from 76% in the quarter ended September 30, 2003 to 81% in the
quarter ended September 30, 2004. The NextGen division's gross
margins have been and continue to be higher than those of the QSI
Division; and
o a decrease in the cost of revenue as a percentage of revenue at each
of our divisions causing a corresponding increase in gross profit
margins of both of our divisions.
The following table details the individual components of cost of products and
services and gross profits as a percentage of total revenue for our Company and
our two divisions:
-----------------------------------------------------------------------------
Hardware Outside Services,
& Third Amortization of Software Total
Party Payroll & Development Costs & Cost of Gross
Software Benefits Other Revenue Profit
- -----------------------------------------------------------------------------------------------------------
Three months ended
September 30, 2004
- -----------------------------------------------------------------------------------------------------------
NextGen 5.5% 12.9% 16.1% 34.5% 65.5%
- -----------------------------------------------------------------------------------------------------------
QSI Division 9.3 16.9 24.1 50.3 49.7
- ------------------------------=============================================================================
Consolidated 6.2% 13.7% 17.5% 37.4% 62.6%
- -----------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------
Three months ended
September 30, 2003
- -----------------------------------------------------------------------------------------------------------
NextGen 14.8% 12.5% 12.3% 39.6% 60.4%
- -----------------------------------------------------------------------------------------------------------
QSI Division 7.9 16.5 27.2 51.6 48.4
- ------------------------------=============================================================================
Consolidated 13.2% 13.4% 15.7% 42.5% 57.5%
- -----------------------------------------------------------------------------------------------------------
29
During the three months ended September 30, 2004, hardware and third party
software constituted a smaller portion of consolidated revenue compared to the
same year ago period driven principally by the composition of NextGen Division
revenue. This year over year reduction was not the result of any identifiable
trend or change in emphasis on our part. The number of customers who purchase
hardware and third party software and the dollar amount of hardware and third
party software purchased fluctuates each quarter depending on the needs of the
customers and is not a priority focus for us.
Our payroll and benefits expense associated with delivering our products
and services increased to 13.7% of consolidated revenue compared to 13.4% during
the prior three months ended September 30, 2003. The absolute level of
consolidated payroll and benefit expenses grew from $2.4 million in the three
months ended September 30, 2003 to $2.9 million in the three months ended
September 30, 2004, an increase of 21% or $0.5 million. This increase was due
primarily to additions to related headcount, payroll and benefits expense
associated with delivering products and services in the NextGen Division where
such expenses increased to $2.2 million in three months ended September 30, 2004
from $1.7 million in the three months ended September 30, 2003. Payroll and
benefits expense associated with delivering products and services in the QSI
Division during the three months ended September 30, 2004 and 2003 remained
relatively unchanged at approximately $0.7 million.
We anticipate continued additions to headcount in the NextGen Division in
areas related to delivering products and services in future periods but due to
the uncertainties in the timing of our sales arrangements, our sales mix, the
acquisition and training of qualified personnel, and other issues, we cannot
accurately predict if related headcount expense as a percentage of revenue will
increase or decrease in the future.
We do not currently intend to make any significant additions to related
headcount at the QSI Division.
Should the NextGen division continue to represent an increasing share of
our revenue and should the NextGen division continue to carry higher gross
margins than the QSI division, our consolidated gross margin percentages should
increase to more closely match those of the NextGen division.
As a result of the foregoing events and activities, our gross margins for
the Company and our two operating divisions increased for the three month period
ended September 30, 2004 versus the prior year period.
30
The following table details revenue and cost of products and services on a
consolidated and divisional basis for the three month periods ended September
30, 2004 and 2003:
----------------------------------------------------
(in thousands) Three Months Ended September 30,
----------------------------------------------------
2004 % 2003 %
==========================================================================================
Consolidated
------------------------------------------------------------------------------------------
Net Revenue $21,217 100% $17,642 100%
------------------------------------------------------------------------------------------
Cost of Product & Services 7,937 37.4% 7,492 42.5%
------------------------------------------------------------------------------------------
Gross Margin 13,280 62.6% 10,150 57.5%
==========================================================================================
NextGen Division
------------------------------------------------------------------------------------------
Net Revenue $17,262 100% $13,452 100%
------------------------------------------------------------------------------------------
Cost of Product & Services 5,947 34.5% 5,332 39.6%
------------------------------------------------------------------------------------------
Gross Margin 11,315 65.5% 8,120 60.4%
==========================================================================================
QSI Division
------------------------------------------------------------------------------------------
Net Revenue $ 3,955 100% $ 4,190 100%
------------------------------------------------------------------------------------------
Cost of Product & Services 1,990 50.3% 2,160 51.6%
==========================================================================================
Gross Margin $ 1,965 49.7% $ 2,030 48.4%
------------------------------------------------------------------------------------------
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the three months ended September 30, 2004 increased
13% to $5.4 million as compared to $4.8 million for the three months ended
September 30, 2003. The increase in the amount of such expenses resulted
primarily from a $0.4 million increase in selling related compensation expenses
and a net $0.3 million increase in other selling, general and administrative
expenses in the NextGen Division offset by a $0.1 million decline in corporate
related expenses. Selling, general and administrative expenses as a percentage
of revenue declined from 27.0% in the three months ended September 30, 2003 to
25.5% in the three months ended September 30, 2004 due to the fact that the rate
of growth in selling, general and administrative expense was less than the
aggregate revenue growth rate for the Company.
We anticipate increased expenditures for trade shows, advertising and the
employment of additional sales representatives primarily at the NextGen
Division. We also anticipate future increases in corporate expenditures being
made in the areas of staffing and professional services in areas including but
not limited to the Sarbanes-Oxley Act and related compliance issues. While we
expect selling, general and administrative expenses to increase on an absolute
basis, we cannot accurately predict the impact these additional expenditures
will have on selling, general, and administrative expenses as a percentage of
revenue.
Research and Development Costs. Research and development costs for the
three months ended September 30, 2004 and 2003 were $1.8 million and $1.5
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 revenue increased to 8.6% from 8.5%
during the months ended September 30, 2003. Research and development expenses
are expected to continue at or above current levels.
Investment Income. Investment income for the three months ended September
30, 2004 increased 93% to approximately $170,000 compared with $89,000 in the
three months ended September 30, 2003.
31
Investment income in the three months ended September 30, 2004 increased
primarily due to the effect of an increase in short term interest rates versus
the prior year quarter as well as comparatively higher amounts of funds
available for investment during the three months ended September 30, 2004.
Our investment policy is determined by our Board of Directors. We
currently maintain our cash in very liquid short term assets including money
market funds and short term U.S. Treasuries with maturities of less than 90
days. Our Board of Directors may consider alternate uses for our cash including,
but not limited to payment of a special dividend, initiation of a regular
dividend, initiation of a stock buy-back program, an expansion of our investment
policy to include investments with maturities of greater than 90 days, or other
items. Additionally, it is possible that we will utilize some or all of our cash
to fund an acquisition or other similar business activity. Any or all of these
programs could significantly impact our investment income in future periods.
Provision for Income Taxes. The provision for income taxes for the three
months ended September 30, 2004 was approximately $2.5 million as compared to
approximately $1.6 million for the year ago period. The effective tax rates for
the three months ended September 30, 2004 and 2003 were 40.3% and 39.3%,
respectively. The provision for income taxes for the three months ended
September 30, 2004 and 2003 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. The effective rate for the three months ended
September 30, 2004 increased from the prior year primarily due to a relatively
smaller impact of research and development tax credits as well as slightly
higher effective federal income tax rates.
For the Six-Month Periods September 30, 2004 versus 2003
Net Income. The Company's net income for the six months ended September
30, 2004 was $7,097,000 or $ 1.12 per share on a basic and $ 1.08 per share on a
fully diluted basis. In comparison, we earned $4,685,000 or $0.76 per share on a
basic and $0.72 per share on a fully diluted basis in the six months ended
September 30, 2003. The increase in net income for the six months ended
September 30, 2004, was achieved through the following:
o a 22% increase in consolidated revenue; and
o selling, general and administrative and costs of revenues which grew
at 9% and 14% respectively; slower than the overall revenue growth
rate.
Net Revenue. Net revenue for the six months ended September 30, 2004
increased 22% to $41.3 million from $33.9 million for the six months ended
September 30, 2003. NextGen Division net revenue increased 30% from
approximately $25.7 million during the quarter ended September 30, 2003 to
approximately $33.4 million during the quarter ended September 30, 2004, while
QSI Division net revenue declined by 4% during the same period from
approximately $8.3 million to approximately $7.9 million.
We report revenue in two major categories, "Systems sales" and
"Maintenance and other services". Revenue in the systems sales category includes
software license fees, hardware, third party software, supplies and
implementation and training services related to purchase of the Company's
software systems. The majority of the revenue in the System sales category is
related to the sale of software. Revenue in the maintenance and other category
includes maintenance, EDI, and other revenue. Maintenance and EDI revenue are
the principal sources of revenue in this category.
Systems Sales. Company-wide sales of systems for the six months ended
September 30, 2004 increased 16% to $22.7 million from $19.5 million in the
prior year period
Our increase in revenue from sales of systems for the Company was
principally the result of a 17% increase in category revenue at our NextGen
Division whose systems sales grew from $18.4 million to $21.6 million. This
increase was driven primarily by higher sales of NextGen(emr) and NextGen(epm)
software to both new and existing clients, as well as delivery of related
implementation and training services, partially offset by declines in the sale
of hardware, third party software, and supplies.
Category revenue in the QSI Division was unchanged at approximately $1.1
million in each period.
32
The following table breaks down our reported systems sales into software,
hardware and third party software and supplies, and implementation and training
services components by division:
----------------------------------------------------------------------
Hardware, third
party software & Implementation &
(in thousands) Software supplies training services Systems Sales
------------------------------------------------------------------------------------------------
Six Months Ended
September 2004
------------------------------------------------------------------------------------------------
NextGen $14,220 $2,925 $4,409 $21,554
------------------------------------------------------------------------------------------------
QSI Division 519 446 157 1,122
----------------------------====================================================================
Consolidated $14,739 $3,371 $4,566 $22,676
------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
Six Months Ended
September 2003
------------------------------------------------------------------------------------------------
NextGen $11,623 $3,560 $3,244 $18,427
------------------------------------------------------------------------------------------------
QSI Division 306 574 193 1,073
----------------------------====================================================================
Consolidated $11,929 $4,134 $3,437 $19,500
------------------------------------------------------------------------------------------------
NextGen Division software revenue increased 22% between the six months ended
September 30, 2004 and the six months ended September, 2003. The Division's
software revenue accounted for 66% of divisional systems sales revenue during
the six months ending 2004, an increase from 63% in the six months ended
September 30, 2003. This increase was not the result of any new trend or change
in emphasis on our part relative to software sales. Software license revenue
continues to be an area of primary emphasis for the NextGen Division and
management was pleased with the division's performance in this area.
During the six months ended September 30, 2004, 14% of NextGen's systems sales
revenue was represented by hardware and third party software compared to 19% in
the same prior year period. This decrease was not the result of any new trend or
change in emphasis on our part. The number of customers who purchase hardware
and third party software and the dollar amount of hardware and third party
software revenue fluctuates each quarter depending on the needs of customers.
The inclusion of hardware and third party software in the division's sales
arrangements is typically at the request of the customer and is not a priority
focus for us.
Implementation and training revenue at the NextGen Division increased 36% from
the six months ended September 30, 2003 to the six months ended September, 2004.
Implementtion and training revenue at the NextGen Division increased its share
of category revenue from 18% in the six months ended September 30, 2003 to 20%
in the six months ended September 30, 2004. The growth in implementation and
training revenue is the result of increases in the amount of implementation and
training services rendered to our customers. The number of implementation and
training staff increased during the course of the six months ended September 30,
2004 versus 2003 in order to accommodate the increased amount of implementation
services sold in conjunction with increased software sales. In order to achieve
continued increased revenue in this area, additional staffing increases are
anticipated, though actual future increases will depend upon the availability of
qualified staff, business conditions, and our ability to retain current staff
members.
The NextGen Division's growth has come in part from investments in sales and
marketing activities including hiring additional sales representatives, trade
show attendance, and advertising expenditures. We have also benefited from
winning numerous industry awards for the NextGen Division's flagship
NextGen(emr) and NextGen(epm) software products in fiscal years 2004 and 2003 as
well as in prior years, and the apparent increasing acceptance of electronic
medical records technology in the healthcare industry.
33
For the QSI Division, sales of systems increased 4% from the six months ended
September 30, 2003 to the six months ended September 30, 2004. Increased
software revenue in the division was offset by decreases in hardware, third
party software, and implementation and training services. We do not presently
foresee any material changes in the business environment for the division from
that which we have experienced in recent quarters.
Maintenance and Other. For the six months ended September 30, 2004,
company-wide revenue from maintenance and other services grew 29% to $ 18.7
million from $14.4 million during the same period last year. The increase in
this category resulted principally from an increase in maintenance and EDI
revenue from the NextGen Division's client base. Total NextGen Division
maintenance revenue for the six months ended September 30, 2004 grew 67% to
$8,000,000 from $4,789,000 in the year ago period, while EDI revenue grew 94% to
$2,421,000 compared to $1,248,000 during the same period. QSI Division
maintenance revenue declined 4% from $3,841,000 to $3,678,000 in the same period
while QSI Divisional EDI revenue declined by approximately 8% from $2,682,000 to
$2,455,000 during such period.
The following table details revenue included in maintenance and other for
the six month periods ended September 30, 2004 and 2003:
-------------------------------------------------------------------------------------
(in thousands) Six Months Ended September 30, 2004 Six Months Ended September 30, 2003
-------------------------------------------------------------------------------------
QSI NextGen Consolidated QSI NextGen Consolidated
====================================================================================================================
Maintenance $ 3,678 $ 8,000 $ 11,678 $ 3,841 $ 4,789 $ 8,630
- --------------------------------------------------------------------------------------------------------------------
EDI 2,455 2,421 4,876 2,682 1,248 3,930
- --------------------------------------------------------------------------------------------------------------------
Other 681 1,436 2,117 657 1,231 1,888
- --------------------------------------------------------------------------------------------------------------------
Total Maintenance & Other $ 6,814 $ 11,857 $ 18,671 $ 7,180 $ 7,268 $ 14,448
- --------------------------------------------------------------------------------------------------------------------
The growth in overall maintenance revenue has come from new customers that
have been added each quarter as well as our relative success in retaining
existing maintenance customers. NextGen EDI revenue growth has come from new
customers, further penetration of the Division's existing customer base, and an
increase in the average EDI revenue per customer. NextGen's growth in
maintenance and EDI revenue was at or above our expectations for the period. We
intend to continue to promote maintenance and EDI services to both new and
existing customers.
The following table provides the number of billing site who were receiving
maintenance services as of the last business day of the quarters ended September
30, 2004 and 2003 respectively, as well as the number of billing sites receiving
EDI services during the last month of each respective period at each division of
the Company. The table presents summary information only and includes billing
entities added and removed for any reason. Note that a single client may include
one or multiple billing sites.
--------------------------------------------------------------------------------------------------------
NextGen QSI Division Consolidated
Period Maintenance EDI Maintenance EDI Maintenance EDI
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
September 30, 2003 404 267 343 253 747 520
--------------------------------------------------------------------------------------------------------
Billing sites added 145 131 5 3 150 134
--------------------------------------------------------------------------------------------------------
Billing sites removed (6) (26) (44) (37) (50) (63)
--------------------------------------------------------------------------------------------------------
September 30, 2004 543 372 304 219 847 591
--------------------------------------------------------------------------------------------------------
34
Cost of Products and Services. The Cost of products and services for the
six months ended September 30, 2004 increased 14% to $ 16.0 million from $14.1,
while the cost of products and services as a percentage of net revenue decreased
to 39% from 42% during the same period a year ago.
The decrease in our consolidated cost of revenue as a percentage of revenue
between the six months ended September 30, 2004 and the six months ended
September 30, 2003 is attributable to three main factors:
o a reduction in the level of third party hardware and software as a
percentage of revenue in the NextGen Division;
o an increase in the NextGen Division's share of consolidated revenue
from 76% in the six months ended September 30, 2003 to 81% in
September 30, 2004. The NextGen Division's gross margins have been
and continue to be higher than those of the QSI Division; and
o a decrease in the cost of revenue as a percentage of revenue at each
of our divisions causing a corresponding increase in gross profit
margins at both of our divisions.
The following table details the individual components of cost of products
and services and gross profits as a percentage of total revenue for our Company
and our two divisions:
- -------------------------------------------------------------------------------------------------------------
Hardware & Outside Services,
Third Party Payroll & Amortization of Software Total Cost Gross
Software Benefits Development Costs & Other of revenue Profit
- -------------------------------------------------------------------------------------------------------------
Six months ended
September 30, 2004
- -------------------------------------------------------------------------------------------------------------
NextGen 7.5% 13.6% 15.1% 36.2% 63.8%
- -------------------------------------------------------------------------------------------------------------
QSI Division 8.1 17.2 24.4 47.7 50.3
- -----------------------------================================================================================
Consolidated 8.0% 14.3% 16.5% 38.8% 61.2%
- -------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------
Six months ended
September 30, 2003
- -------------------------------------------------------------------------------------------------------------
NextGen 13.4% 12.6% 12.2% 38.2% 61.8%
- -------------------------------------------------------------------------------------------------------------
QSI Division 8.1 17.1 26.5 51.7 48.3
- -----------------------------================================================================================
Consolidated 12.1% 13.7% 15.8% 41.6% 58.4%
- -------------------------------------------------------------------------------------------------------------
During the six months ended September 30, 2004, the cost of hardware and
third party software constituted 8.0% of consolidated revenue compared to 12.1%
in the same year ago period. This year over year reduction was not the result of
any identifiable trend or change in emphasis on our part. The number of
customers who purchase hardware and third party software and the dollar amount
of hardware and third party software purchased fluctuates each quarter depending
on the needs of the customers and is not a priority focus for us.
Our payroll and benefits expense associated with delivering our products
and services increased to 14.3% of consolidated revenue compared to 13.7% in the
six months ended September 30, 2003. The absolute level of consolidated payroll
and benefit expenses grew from $4.6 million in the six months ended September
30, 2003 to $5.9 million in 2004, an increase of 28% or $1.3 million. This
increase was due primarily to additions to headcount, payroll and benefits
expense associated with delivering products and services in the NextGen
Division. These expenses increased to $4.5 million in the six months ended
35
September 30, 2004 compared to $3.2 million in the six months ended September
30, 2003, an increase of 41%. The Division's payroll and benefits expense
associated with delivering products and services as a percentage of divisional
revenue in the six months ended September 30, 2004 increased to 13.6% compared
to 12.6% in the prior year period. Headcount expense as a percentage of revenue
for the six month period ended September 30, 2004 at the QSI Division remained
relatively unchanged compared to the prior year at 17.2% versus 17.1%, in the
prior year period.
We anticipate continued additions to headcount in the NextGen Division in
areas related to delivering products and services in future periods but due to
the uncertainties in the timing of our sales arrangements, our sales mix, the
acquisition and training of qualified personnel, and other issues we cannot
accurately predict if related headcount expense as a percentage of revenue will
increase or decrease in the future.
We do not currently intend to make any significant additions to related
headcount at the QSI Division.
Should the NextGen division continue to represent an increasing share of
our revenue and NextGen continue to show higher margins compared to the QSI
division, our gross margin percentages should increase to more closely match
those of the NextGen division.
As a result of the foregoing events and activities, our gross margins for
the Company and our two operating divisions increased for the six month period
ended September 30, 2004 versus the prior year period.
The following table details revenue and cost of products and services on a
consolidated and divisional basis for the six month periods ended September 30,
2004 and 2003:
----------------------------------------------
(in thousands) Six Months Ended September 30,
----------------------------------------------
2004 % 2003 %
====================================================================================================
Consolidated
----------------------------------------------------------------------------------------------------
Net Revenue $41,347 100% $33,948 100%
----------------------------------------------------------------------------------------------------
Cost of Product & Services 16,038 38.8% 14,102 41.6%
----------------------------------------------------------------------------------------------------
Gross Margin 25,309 61.2% 19,846 58.4%
====================================================================================================
NextGen Division
----------------------------------------------------------------------------------------------------
Net Revenue $33,411 100% $25,694 100%
----------------------------------------------------------------------------------------------------
Cost of Product & Services 12,098 36.2% 9,839 38.2%
----------------------------------------------------------------------------------------------------
Gross Margin 21,313 63.8% 15,855 61.8%
====================================================================================================
QSI Division
----------------------------------------------------------------------------------------------------
Net Revenue $ 7,936 100% $ 8,254 100%
----------------------------------------------------------------------------------------------------
Cost of Product & Services 3,940 49.7% 4,263 51.7%
====================================================================================================
Gross Margin $ 3,996 50.3% $ 3,991 48.3%
----------------------------------------------------------------------------------------------------
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the six months ended September 30, 2004 increased 9%
to $10.4 million as compared to $9.5 million for the
36
six months ended September 30, 2003. The increase in the amount of such expenses
resulted primarily from increases of $1.0 million in selling related
compensation expenses in the NextGen Division. Selling, general and
administrative expenses as a percentage of revenue declined from 28.0% in the
six months ended September 30, 2003 to 25.1% in the six months ended September
30, 2004 due to minimal growth in consolidated non-corporate selling, general
and administrative expenses compared to the prior year, as well as revenues
growing at a faster rate then selling, general, administrative expenses at the
NextGen Division.
We anticipate increased expenditures for trade shows, advertising and the
employment of additional sales representatives primarily at the NextGen Division
We also anticipate continued increases in corporate expenditures being made in
the areas of staffing and professional services in areas including but not
limited to Sarbanes-Oxley Act and related compliance issues. While we expect
selling, general and administrative expenses to increase, we cannot accurately
predict the impact these additional expenditures will have on selling, general,
and administrative expenses as a percentage of revenue.
Research and Development Costs. Research and development costs for the six
months ended September 30, 2004 and 2003 were $3.4 million and $2.9 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 revenue decreased to 8.3% from 8.4% due
in part, to the fact that revenue growth exceeded the increase in research and
development spending. Research and development expenses are expected to continue
at or above current levels.
Investment Income. Investment income for the six months ended September
30, 2004 increased 53% to approximately $290,000 compared with $189,000 in the
six months ended September 30, 2003. Investment income in the six months ended
September 30, 2004 increased primarily due to the effect of an increase in short
term interest rates versus the prior year period as well as comparatively higher
amounts of funds available for investment during the six months ended September
30, 2004.
Our investment policy is determined by our Board of Directors. We
currently maintain our cash in very liquid short term assets including money
market funds and short term U.S. Treasuries with maturities of less than 90
days. Our Board of Directors may consider alternate uses for our cash including,
but not limited to payment of a special dividend, initiation of a regular
dividend, initiation of a stock buy back program, an expansion of our investment
policy to include investments with maturities of greater than 90 days, or other
items. Additionally, it is possible that we will utilize some or all of our cash
to fund an acquisition or other similar business activity. Any or all of these
programs could significantly impact our investment income in future periods.
Provision for Income Taxes. The provision for income taxes for the six
months ended September 30, 2004 was approximately $4.7 million as compared to
approximately $3.0 million for the year ago period. The effective tax rates for
the six months ended September 30, 2004 and 2003 were 39.9% and 38.8%,
respectively. The provision for income taxes for the six months ended September
30, 2004 and 2003 differ from the combined statutory rates primarily due to the
impact of varying state income tax rates and the impact of research and
development tax credits. The effective rate for the six months ended September
30, 2004 increased from the prior year primarily due to a relatively smaller
impact of research and development tax credits as well as slightly higher
effective federal income tax rates.
37
Liquidity and Capital Resources
The following table presents selected financial statistics and information
for each of the six months ended September 30, 2004 and 2003:
------------------------------
($ in thousands) Six Months Ended September 30,
(unaudited) 2004 2003
----------------------------------------------------------------------------------------------------
Cash and cash equivalents $59,522 $40,573
----------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents during the six
month period $ 8,127 $ 4,130
----------------------------------------------------------------------------------------------------
Net income during the period $ 7,097 $ 4,685
----------------------------------------------------------------------------------------------------
Net cash provided by operations during the period $ 9,121 $ 5,625
----------------------------------------------------------------------------------------------------
Number of days of sales outstanding at start of period 99 106
----------------------------------------------------------------------------------------------------
Number of days of sales outstanding at end of period 108 110
----------------------------------------------------------------------------------------------------
The Company's principal source of cash was cash provided by operations.
The number of days sales outstanding at the end of the period decreased by two
days compared to September 30, 2003. The number of days sales outstanding
increased by nine days during the six months ended September 30, 2004 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. Provided turnover of accounts receivable, deferred
revenue, and profitability remain consistent with the six months ended September
30, 2004, the Company anticipates being able to continue to generate cash from
operations during fiscal 2005 primarily from the net income of the Company.
Cash and cash equivalents increased $8.1 million between March 31, 2004
and September 30, 2004 primarily as a result of cash provided by operating
activities. Cash and cash equivalents increased approximately $4.1 million
during the six months ended September 30, 2003, also primarily as a result of
cash generated by operating activities.
Net cash used in investing activities for the six months ended September
30, 2004 and 2003 was $1.8 and $1.7 million respectively. Net cash used in
investing activities for the three months ended September 30, 2004 and 2003
consisted of additions to equipment and improvements and capitalized software.
At September 30, 2004, we had cash and cash equivalents of $59.5 million.
We intend to expend some of these funds for the development of products
complementary to our existing product line as well as new versions of certain of
our products. These developments are intended to take advantage of more powerful
technologies and to increase the integration of our products. We have no
additional significant current capital commitments.
Management believes that its cash and cash equivalents on hand at
September 30, 2004, 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 2005.
38
The following table summarizes our significant contractual obligations at
September 30, 2004, and the effect that such obligations are expected to have on
our liquidity and cash in future periods:
- ----------------------------------------------------------------------------------------------------------
Less than a Beyond 5
Contractual Obligations Total year 1-3 years 3-5 years years
- ----------------------------------------------------------------------------------------------------------
Non-cancelable lease obligations 2,741 1.157 1,391 393 0
- ----------------------------------------------------------------------------------------------------------
Item 3. Qualitative and Quantitative Disclosures About Market Risk
We have a significant amount of cash and short-term investments with
maturities less than three months. This cash portfolio exposes us to interest
rate risk as short-term investment rates can be volatile. Given the short-term
maturity structure of our investment portfolio, we believe that it is not
subject to principal fluctuations and the effective interest rate of our
portfolio tracks closely to various short-term money market interest rate
benchmarks.
Item 4. 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 our "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
use in the reports filed or submitted by us under the Exchange Act is
accumulated, recorded, processed, summarized and reported to management,
including our Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding whether or not disclosure is
required.
During the quarter ended September 30, 2004, the following changes have
occurred 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, our financial reporting function. We
have continued a process of implementing new software which will automate
certain processes surrounding the recognition and the deferral of revenue
related to our software sales arrangements with multiple elements. These
processes include computing the amount of deferred revenue related to
undelivered elements at the time a new sales arrangement is recorded and then
subsequently recognizing the applicable portion of revenue as the elements are
delivered to customers or are earned. These processes have historically been,
and are currently being performed manually. During the quarter ended September
30, 2004 we used both the existing manual process as well as the new software to
perform in a parallel manner the processes described above which related to
revenue recognition of our software sales arrangements with multiple elements.
As of September 30, 2004 (i) we had not developed sufficient controls over our
new software in order to rely on the new automated processes and instead, relied
our existing manual process for the September 30, 2004 quarter financial
statements, and (ii) we had also not completed our evaluation over our internal
controls related to this new software. We have hired a third party accounting
firm to assist in the process of evaluating and documenting our internal
controls structure in preparation for our reporting requirements under Section
404 of the Sarbanes-Oxley Act.
39
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
None
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submissions of Matters to a Vote of Securities Holders.
On September 21, 2004, the Company held its Annual Meeting of
Shareholders. At the meeting, the shareholders elected as directors Sheldon
Razin (with 5,645,610 affirmative votes and 155,634 votes withheld), Ahmed
Hussein (with 6,300,001 affirmative votes and 237,189 votes withheld),Maurice
DeWald (with 5,645,610 affirmative votes and 155,959 votes withheld), William
Botts (with 5,645,610 affirmative votes and 155,634 votes withheld), Vincent
Love (with 5,645,610 affirmative votes and 156,034 votes withheld), Jonathan
Javitt (with 5,645,610 affirmative votes and 155,678 votes withheld), and Steve
Plochocki (with 5,645,609 affirmative votes and 155,959 votes withheld)
The shareholders also ratified the appointment of Grant Thornton LLP as the
independent public accountants for the Company for the fiscal year ending March
31, 2005 (with 5,059,979 affirmative votes, 12,087 against, and 4,218
abstaining.)
Item 5. Other Information.
None.
Item 6. Exhibits
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
Pursuant to the requirements of the Securities Exchange Act of 1934, we have
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
QUALITY SYSTEMS, INC.
Date: November 9, 2004 By: /s/ Louis Silverman
---------------------------------
Louis Silverman
Chief Executive Officer
Date: November 9, 2004 By: /s/ Paul Holt
---------------------------------
Paul Holt
Chief Financial Officer;
Principal Accounting Officer
40