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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 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: 6,534,105 shares of Common
Stock, $0.01 par value, as of January 24, 2005 .
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PART I
CONSOLIDATED FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
December 31, March 31,
2004 2004
----------- -----------
ASSETS (UNAUDITED)
Current assets:
Cash and cash equivalents ...................................................... $ 66,432 $ 51,395
Accounts receivable, net ....................................................... 27,929 20,336
Inventories, net ............................................................... 1,405 725
Deferred tax assets ............................................................ 2,979 2,979
Other current assets ........................................................... 1,353 1,437
----------- -----------
Total current assets ................................................. 100,098 76,872
Equipment and improvements, net ...................................................... 2,406 2,012
Capitalized software costs, net ...................................................... 3,961 3,608
Deferred tax assets .................................................................. 1,104 1,104
Goodwill ............................................................................. 1,840 1,840
Other ................................................................................ 1,616 1,242
----------- -----------
Total assets ......................................................... $ 111,025 $ 86,678
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ............................................................... $ 2,269 $ 1,655
Deferred revenue ............................................................... 22,599 16,016
Accrued compensation and related benefits ...................................... 2,304 2,985
Income taxes payable ........................................................... 1,806 273
Other current liabilities ...................................................... 4,478 3,497
----------- -----------
Total current liabilities ............................................ 33,456 24,426
Deferred revenue ..................................................................... 1,103 1,247
----------- -----------
Total liabilities .................................................... 34,559 25,673
----------- -----------
Commitments and contingencies ........................................................ -- --
Shareholders' equity:
Common stock, $0.01 par value; authorized 20,000 shares; issued
and outstanding 6,525 and 6,325 shares at December 31, 2004 and
March 31, 2004, respectively ............................................... 65 63
Additional paid-in capital ..................................................... 43,553 39,735
Retained earnings .............................................................. 34,068 22,750
Deferred compensation .......................................................... (1,220) (1,543)
----------- -----------
Total shareholders' equity ........................................... 76,466 61,005
----------- -----------
Total liabilities and shareholders' equity ........................... $ 111,025 $ 86,678
=========== ===========
See accompanying condensed notes to consolidated financial statements.
1
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
----------------------------- -----------------------------
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenues:
Software, hardware and supplies ............................ $ 9,781 $ 8,068 $ 27,891 $ 24,130
Implementation and training services ....................... 1,889 1,791 6,455 5,229
----------- ----------- ----------- -----------
System sales ................................................. 11,670 9,859 34,346 29,359
Maintenance and other services ............................... 10,418 8,340 29,089 22,788
----------- ----------- ----------- -----------
Total revenue ............................................. 22,088 18,199 63,435 52,147
----------- ----------- ----------- -----------
Cost of revenue:
Software, hardware and supplies ............................ 1,384 1,966 5,428 6,541
Implementation and training services ....................... 1,575 1,427 4,546 3,964
----------- ----------- ----------- -----------
Total cost of system sales ................................... 2,959 3,393 9,974 10,505
Total cost of maintenance and other services ................. 4,556 4,130 13,580 11,120
----------- ----------- ----------- -----------
Total cost of revenue ..................................... 7,515 7,523 23,554 21,625
----------- ----------- ----------- -----------
Gross profit .............................................. 14,573 10,676 39,881 30,522
----------- ----------- ----------- -----------
Operating expenses:
Selling, general and administrative ....................... 6,420 4,902 16,786 14,410
Research and development costs ............................ 1,707 1,628 5,137 4,496
----------- ----------- ----------- -----------
Total operating expenses ................................ 8,127 6,530 21,923 18,906
----------- ----------- ----------- -----------
Income from operations .................................... 6,446 4,146 17,958 11,616
Interest income .............................................. 263 95 553 284
----------- ----------- ----------- -----------
Income before provision for income taxes ..................... 6,709 4,241 18,511 11,900
Provision for income taxes ................................... 2,488 1,630 7,193 4,604
----------- ----------- ----------- -----------
Net income ................................................ $ 4,221 $ 2,611 $ 11,318 $ 7,296
=========== =========== =========== ===========
Net income per share:
Basic ..................................................... $ 0.65 $ 0.42 $ 1.77 $ 1.18
=========== =========== =========== ===========
Diluted ................................................... $ 0.64 $ 0.40 $ 1.72 $ 1.13
=========== =========== =========== ===========
See accompanying condensed notes to consolidated financial statements.
2
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
------------------------------
DECEMBER 31, DECEMBER 31,
2004 2003
------------ ------------
Cash flows from operating activities:
Net income .................................................................. $ 11,318 $ 7,296
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation .............................................................. 724 676
Amortization of capitalized software costs ................................ 1,424 1,113
Provision for bad debts ................................................... 635 370
Non-cash compensation from issuance of options ............................ 323 203
Tax benefit from exercise of stock options ................................ 2,067 --
Changes in assets and liabilities:
Accounts receivable ....................................................... (8,228) (4,354)
Inventories ............................................................... (680) (170)
Other current assets ...................................................... 84 678
Other assets .............................................................. (374) (180)
Accounts payable .......................................................... 614 (411)
Deferred revenue .......................................................... 6,439 4,600
Accrued compensation and related benefits ................................. (681) 467
Income taxes payable ...................................................... 1,533 481
Other current liabilities ................................................. 981 (94)
------------ ------------
Net cash provided by operating activities ............................................... 16,179 10,675
------------ ------------
Cash flows from investing activities:
Additions to equipment and improvements ..................................... (1,118) (788)
Additions to capitalized software costs ..................................... (1,777) (1,955)
------------ ------------
Net cash used in investing activities ................................................... (2,895) (2,743)
------------ ------------
Cash flows from financing activities:
Proceeds from the exercise of stock options ................................. 1,753 973
------------ ------------
Net cash provided by financing activities ............................................... 1,753 973
------------ ------------
Net increase in cash and cash equivalents ............................................... 15,037 8,905
Cash and cash equivalents at beginning of period ........................................ 51,395 36,443
------------ ------------
Cash and cash equivalents at end of period .............................................. $ 66,432 $ 45,348
============ ============
Supplemental disclosures of cash flow information:
Cash paid during the period for income taxes, net of refunds ............ $ 3,741 $ 4,254
============ ============
See accompanying condensed 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 December 31,
2004 and for the three and nine months ended December 31, 2004 and 2003, have
been prepared in accordance with the requirements of Form 10-Q and Article 10 of
Regulation S-X, and therefore do not include all information and footnotes which
would be presented were such financial statements prepared in accordance with
accounting principles generally accepted in the United States. These financial
statements should be read in conjunction with the audited financial statements
presented in the Company's Annual Report on Form 10-K 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.
References to dollar amounts in this financial statement section are in
thousands, except share and per share data, unless otherwise specified. Certain
prior year amounts have been reclassified to conform with fiscal year 2005
presentation.
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 accounts and transactions have been eliminated.
Revenue recognition. The Company currently recognizes revenue pursuant to
Statement of Position No. 97-2, "Software Revenue Recognition" (SOP 97-2), as
amended by Statement of Position No. 98-9 "Modification of SOP 97-2, Software
Revenue Recognition" (SOP 98-9). 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, 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
98-9, 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.
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.
4
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 Statement of Position No. 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1). 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 its products
and services as part of its sales arrangements. Pursuant to AICPA TPA 5100.51,
such 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.
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.
5
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 Statement of Financial
Accounting Standards No. 86, "Accounting for the Costs of Computer Software to
be Sold, Leased or Otherwise Marketed" (SFAS 86). 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 reviews 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 Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB
25), and has adopted the disclosure provisions from the Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure" (SFAS 148) that supercedes Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). SFAS 148 requires pro forma disclosures of net income
and net income per share as if the fair value based method of accounting for
stock-based awards had been applied to employee grants. It also requires
disclosure of option status on a more prominent and frequent basis. Such
disclosure for the three and nine months ended December 31, 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 of Director 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 three and nine
months ended December 31, 2004 and 2003 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
(unaudited):
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
------------------------ ------------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net income, as reported .................. $ 4,221 $ 2,611 $ 11,318 $ 7,296
Deduct: Stock-based employee
compensation expense determined
under the fair value based method,
net of related tax effects ............... 279 64 514 166
--------- --------- --------- ---------
Pro forma net income ..................... $ 3,942 $ 2,547 $ 10,804 $ 7,130
========= ========= ========= =========
Net income per share:
Basic, as reported .................... $ 0.65 $ 0.42 $ 1.77 $ 1.18
========= ========= ========= =========
Basic, pro forma ...................... $ 0.61 $ 0.41 $ 1.69 $ 1.16
========= ========= ========= =========
Diluted, as reported .................. $ 0.64 $ 0.40 $ 1.72 $ 1.13
========= ========= ========= =========
Diluted, pro forma .................... $ 0.59 $ 0.39 $ 1.65 $ 1.10
========= ========= ========= =========
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), these option grants will result in compensation expense
of up to $1,722 (assuming all employees granted options continue their
employment at the Company throughout the entire four year vesting period) to be
amortized evenly over the four year vest period. During the nine month periods
ended December 31, 2004 and 2003, the Company recognized compensation expense of
$323 and $203, respectively, 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
6
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 November 2004, the FASB issued Statement of Financial Accounting Standards
No. 151 "Inventory Costs - an amendment of ARB No. 43, Chapter 4" (SFAS 151) to
clarify the accounting for abnormal amount of idle facility expense, freight,
handling costs and wasted material. This statement requires that those items be
recognized as current period charges. In addition, this statement requires that
allocation of fixed production overhead to the costs of conversion be based on
the normal capacity of the production facilities. SFAS 151 is effective for
inventory costs incurred during fiscal years beginning after June 15, 2005. The
Company does not expect the adoption of SFAS 151 to have material effect on its
financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards
No. 123R, "Share-Based Payment" (SFAS 123R) which is a revision of SFAS 123.
Statement 123R supersedes APB 25 and amends Statement of Financial Accounting
Standards No. 95, "Statement of Cash Flows" (SFAS 95). SFAS 123R requires all
share-based payments to employees, including grants of employee stock options,
to be recognized in the income statement based on their fair values and the pro
forma disclosure alternative is no longer allowable under Statement 123R. The
revised standard is effective for public entities in the first interim or annual
reporting period beginning after June 15, 2005, which for the Company will be
the second quarter of fiscal 2006 beginning July 1, 2005. The adoption of SFAS
123R will result in additional pre-tax compensation expense in fiscal 2006 and
beyond for remaining unvested stock options and any future stock option grants.
4. Composition of Certain Financial Statement Captions
Accounts receivable include 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.
DECEMBER 31, MARCH 31,
2004 2004
------------ -----------
(Unaudited)
Accounts receivable, excluding undelivered maintenance
and services .................................................... $ 14,455 $ 13,131
Undelivered maintenance and services billed in advance,
included in deferred revenue .................................... 15,149 8,498
----------- -----------
Accounts receivable, gross ....................................... 29,604 21,629
Reserve for bad debts ............................................ (1,675) (1,293)
----------- -----------
Accounts receivable, net ......................................... $ 27,929 $ 20,336
=========== ===========
7
Inventories are summarized as follows:
DECEMBER 31, MARCH 31,
2004 2004
------------ -----------
(Unaudited)
Computer systems and components, net of reserve for
obsolescence of $284 and $207, respectively ........................... $ 1,192 $ 478
Replacement parts for certain client systems, net of
accumulated amortization of $693 and $684, respectively ............... 157 221
Miscellaneous parts and supplies ....................................... 56 26
----------- -----------
$ 1,405 $ 725
=========== ===========
Other current liabilities are summarized as follows:
DECEMBER 31, MARCH 31,
2004 2004
------------ -----------
(Unaudited)
Deferred compensation .................................................. $ 1,075 $ 1,013
Sales tax payable ...................................................... 534 442
Accrued EDI expenses ................................................... 421 467
Deferred rent .......................................................... 218 352
Customer deposits ...................................................... 203 397
Other accrued expenses ................................................. 2,027 826
----------- -----------
$ 4,478 $ 3,497
=========== ===========
Short and long-term deferred revenue are summarized as follows:
DECEMBER 31, MARCH 31,
2004 2004
------------ -----------
(Unaudited)
Maintenance ............................................................ $ 5,442 $ 3,794
Implementation services ................................................ 16,298 10,756
Undelivered software and other ......................................... 1,962 2,713
----------- -----------
$ 23,702 $ 17,263
=========== ===========
5. Intangible Assets - Goodwill
In accordance with Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" (SFAS 142), the Company does not amortize
goodwill as the goodwill has been determined to have indefinite useful life. The
balance of goodwill is related to the Company's NextGen Healthcare Information
Systems Division (NextGen or Division), which was acquired by virtue of two
acquisitions completed in May of 1996 and 1997, respectively. In accordance with
SFAS 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 NextGen 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.
6. Intangible Assets - Capitalized Software Development Costs
The Company had the following amounts related to capitalized software
development:
DECEMBER 31, MARCH 31,
2004 2004
------------ -----------
(Unaudited)
Gross carrying amount .................................................. $ 12,387 $ 10,610
Accumulated amortization ............................................... (8,426) (7,002)
----------- -----------
Capitalized software costs, net ........................................ $ 3,961 $ 3,608
=========== ===========
Aggregate amortization expense during the nine month
and twelve month periods ended, respectively ........................... $ 1,424 $ 1,490
=========== ===========
8
Activity related to net capitalized software costs for the nine month period
ended December 31, 2004 is as follows:
Beginning of period ............................................. $ 3,608
Capitalized costs ............................................... 1,777
Amortization expense ............................................ (1,424)
---------
End of the period ............................................... $ 3,961
=========
The following table represents the remaining estimated amortization of
intangible assets with determinable lives as of December 31, 2004:
For the year ended March 31,
2005 ............................................................ $ 330
2006 ............................................................ 1,320
2007 ............................................................ 1,320
2008 ............................................................ 991
---------
Total ........................................................... $ 3,961
=========
7. Income Taxes
The provision for income taxes for the nine month periods ended December 31,
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 research and
development tax credits. As of December 31, 2004, the Company has available a
balance of approximately $575 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 unrecognized research and development
credits account for approximately 50% of the aggregate tax credits accumulated
from April 1, 2001 through December 31, 2004. During the quarter ended December
31, 2004, the provision for income taxes was reduced by $231 for research and
development tax credits from prior periods which had not been recognized
previously, including $49 related to an adjustment of the estimated credit from
the prior fiscal year and $182 from prior year credits which had expired statute
of limitations.
8. 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.
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------------- -----------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
Net income ................................. $ 4,221 $ 2,611 $ 11,318 $ 7,296
Basic net income per common share:
Weighted average of common
shares outstanding ...................... 6,476 6,237 6,400 6,162
Basic net income per common share .......... $ 0.65 $ 0.42 $ 1.77 $ 1.18
=========== =========== =========== ===========
Net income ................................. $ 4,221 $ 2,611 $ 11,318 $ 7,296
Diluted net income per common
Share:
Weighted average of common
shares outstanding ....................... 6,476 6,237 6,400 6,162
Effect of potentially
dilutive securities (options) ............ 165 312 167 314
----------- ----------- ----------- -----------
Weighted average of common
shares outstanding-diluted ............... 6,641 6,549 6,567 6,476
Diluted net income per common
share ..................................... $ 0.64 $ 0.40 $ 1.72 $ 1.13
=========== =========== =========== ===========
9
9. Operating Segment Information
The Company has prepared operating segment information in accordance with
Statement of Accounting Standards No. 131 "Disclosures About Segments of an
Enterprise and Related Information" (SFAS 131) to report components that are
evaluated regularly by the Company's chief operating decision maker, or decision
making group in deciding how to allocate resources and in assessing performance.
The Company's reportable operating segments include its NextGen Healthcare
Information Systems Division and the QSI Division.
The disaggregated financial results of the segments reflect allocation of
certain functional expense categories consistent with the basis and manner in
which Company management internally disaggregates financial information for the
purpose of assisting in making internal operating decisions. Certain corporate
overhead costs are not allocated to the individual segments by management. The
Company evaluates performance based on stand-alone segment revenue and operating
income performance. Because the Company does not evaluate performance based on
return on assets at the operating segment level, assets are not tracked
internally by segment. Therefore, segment asset information is not presented.
Operating segment data for the three and nine month periods ended December 31,
2004 and 2003 is as follows (unaudited):
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------------- -----------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Revenue:
QSI Division ............................ $ 3,742 $ 4,198 $ 11,678 $ 12,452
NextGen Division ........................ 18,346 14,001 51,757 39,695
----------- ----------- ----------- -----------
Consolidated revenue ...................... $ 22,088 $ 18,199 $ 63,435 $ 52,147
=========== =========== =========== ===========
Operating income(loss):
QSI Division ............................ $ 1,037 $ 1,351 $ 3,436 $ 3,701
NextGen Division ........................ 6,727 3,789 17,986 10,995
Unallocated corporate expenses .......... (1,318) (994) (3,464) (3,080)
----------- ----------- ----------- -----------
Consolidated operating income ............. $ 6,446 $ 4,146 $ 17,958 $ 11,616
=========== =========== =========== ===========
10. Concentration of Credit Risk
The Company had cash deposits at U.S. banks and financial institutions which
exceeded federally insured limits at December 31, 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.
11. 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
10
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.
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.
12. Subsequent Events
On January 31, 2005, the Board of Directors declared a one-time cash dividend of
$3.00 per share payable on its outstanding shares of common stock. The cash
dividend record date is February 24, 2005 and is expected to be distributed to
shareholders on or about March 16, 2005.
On February 2, 2005, the Board of Directors declared a 2-for-1 stock split with
respect to its outstanding shares of common stock. The stock split record date
is March 4, 2005. The share and per share data presented and disclosed on the
December 31, 2004 Consolidated Financial Statements and the Condensed Notes to
the Consolidated Financial Statements are not adjusted for the stock split.
11
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
profit 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, goodwill
impairment and research and development tax credits 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
Condensed Notes to 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 SOP 97-2, as
amended by SOP 98-9. 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 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
12
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 Statement of Position No. 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1).
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.
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 December 31, 2004 and 2003, respectively. We adopted 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 as we determined that it had an indefinite life. 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
13
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 and have estimated tax credits for fiscal year 2005. Management has
recorded a cumulative tax benefit which accounts for approximately 50% of the
aggregate tax credits accumulated from April 1, 2001 through December 31, 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 nine month periods ending December 31, 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 January 25, 2005.
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 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 its own distinct product lines, product platforms, development,
implementation and support teams, sales staffing, and branding. The two
Divisions share the resources of the "corporate office" which includes a variety
of accounting and other administrative functions. Additionally, there are a
small number of clients who are simultaneously utilizing software from each of
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.
- ----------
(1) UNIX is a registered trademark of the AT&T Corporation.
14
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 already 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)), 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 83% of our revenue for the third quarter of fiscal 2005 compared
to 77% in the third quarter of fiscal 2004. The QSI Division accounted for 17%
and 23% of revenue in the third quarter of fiscal 2005 and 2004, respectively.
The NextGen Division's year over year revenue grew at 31% and 40% in the third
quarter of fiscal 2005 and 2004, respectively, while the QSI Division's year
over year revenue declined by 11% and 5% in the third quarter of fiscal 2005 and
2004 respectively.
- ----------
(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.
(4) NextMD is a registered trademark of NextGen Healthcare Information
Systems, Inc.
15
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;
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 our 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.
16
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 SOP 97-2, as modified by SOP 98-9,
SAB 101 and 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.
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 an aggregate of approximately 38%
of the outstanding shares of our common stock at December 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 purchase us, 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
17
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 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. 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, 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 a significantly greater degree of subscription pricing 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
increasingly embrace subscription pricing.
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.
18
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 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.
19
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.
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.
20
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 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 our industry, our
dependence on maintaining our relationships with key employees is particularly
significant. We are also dependent on our ability to attract 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;
21
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 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
22
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 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 the price at which
our stock trades. We are in the process of evaluating and documenting our
controls pursuant to Section 404 of the Sarbanes-Oxley Act. In the course of our
evaluation and documentation of our internal controls, we have identified
various deficiencies which we are in the course of remediating. Management does
not believe that any of these identified deficiencies constitute a material
weakness in our internal controls. Our evaluation of our internal controls over
financial reporting is still is process.
Our earnings will be affected beginning quarter ended September 30, 2005 when we
begin recognizing employee stock option expense, pursuant to recently issued
accounting standards. 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. However, beginning quarter ended September 30, 2005 and
beyond, we will begin recognizing employee
23
stock option expense for remaining unvested stock options and any future stock
option grants, resulting in additional pre-tax compensation expense. Option
expensing could have a negative impact upon the price of our stock.
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 forecast and plan future
business activities, and they could cause constrained spending on our products
and services, and/or delay and lengthen sales cycles.
Our future policy concerning the payment of dividends is uncertain. While we
declared a one-time cash dividend in January 2005, we have not historically paid
dividends, cash or otherwise, and there can be no assurance that we will pay
another dividend in the future. Unfulfilled expectation to the contrary could
have a material negative impact upon the price of our stock.
Results of Operations
Overview of results
o We have experienced significant growth in our total revenue as a result of
revenue growth in our NextGen Division. Revenue grew 21.7% on a
consolidated basis in the nine months ended December 31, 2004 versus 2003
and 31.4% in the nine months ended December 31, 2003 versus 2002.
o Consolidated income from operations grew 54.6% in the nine months ended
December 31, 2004 versus 2003 and 44.5% in the nine months ended December
31, 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 30.4% in the nine months ended
December 31, 2004 versus 2003 and 49.9% in the nine months ended December
31, 2003 versus 2002 while divisional operating income (excluding
unallocated corporate expenses) grew 63.6% in the nine months end December
31, 2004 and 69.9% in the nine months ended December 31, 2003.
o During the nine months ended December 31, 2004, we added staffing
resources to departments including sales, support, implementation, and
software development 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, selling additional software and services to existing customers
and expanding penetration of connectivity services to new and existing
customers.
QSI Division
o Our QSI Division experienced a revenue decline of 6.2% in the nine months
ended December 31, 2004 versus 2003 and 4.5% in the nine months ended
December 31, 2003 versus 2002. The Division experienced a 7.2% decrease in
operating income (excluding unallocated corporate expenses) in the nine
months ended December 31, 2004 versus 2003.
o Our goals for the QSI Division include maximizing revenue and profit
performance given the constraints present in this Division's target
market.
24
The following table sets forth for the periods indicated, the percentage of
revenues represented by each item in our Consolidated Statements of Income.
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, December 31,
---------------------------- ----------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(unaudited) (unaudited) (unaudited) (unaudited)
Revenues:
Software, hardware and supplies ................ 44.3% 44.3% 44.0% 46.3%
Implementation and training services ........... 8.5 9.9 10.1 10.0
----------- ----------- ----------- -----------
System sales ..................................... 52.8 54.2 54.1 56.3
Maintenance and other services ................... 47.2 45.8 45.9 43.7
----------- ----------- ----------- -----------
Total revenue ................................. 100.0 100.0 100.0 100.0
----------- ----------- ----------- -----------
Cost of revenue:
Software, hardware and supplies ................ 6.3 10.8 8.6 12.6
Implementation and training services ........... 7.1 7.8 7.1 7.6
----------- ----------- ----------- -----------
Total cost of system sales ....................... 13.4 18.6 15.7 20.2
Total cost of maintenance and other
services ......................................... 20.6 22.7 21.4 21.3
----------- ----------- ----------- -----------
Total cost of revenue ......................... 34.0 41.3 37.1 41.5
----------- ----------- ----------- -----------
Gross profit .................................. 66.0 58.7 62.9 58.5
----------- ----------- ----------- -----------
Selling, general and administrative ........... 29.1 26.9 26.5 27.6
Research and development ...................... 7.7 9.0 8.1 8.6
----------- ----------- ----------- -----------
Income from operations ........................ 29.2 22.8 28.3 22.3
----------- ----------- ----------- -----------
Interest income .................................. 1.2 0.5 0.9 0.5
----------- ----------- ----------- -----------
Income before provision for income
taxes ............................................ 30.4 23.3 29.2 22.8
Provision for income taxes ....................... 11.3 9.0 11.4 8.8
----------- ----------- ----------- -----------
Net income .................................... 19.1% 14.3% 17.8% 14.0%
=========== =========== =========== ===========
For the Three-Month Periods December 31, 2004 versus 2003
Net Income. The Company's net income for the three months ended December 31,
2004 was $4.2 million or $0.65 per share on a basic and $0.64 per share on a
fully diluted basis. In comparison, we earned $2.6 million or $0.42 per share on
a basic and $0.40 per share on a fully diluted basis for the three months ended
December 31, 2003. The increase in net income for the three months ended
December 31, 2004 was achieved primarily through the following:
o a 21.4% increase in consolidated revenue; and
o an increase in the consolidated gross profit margin percentage which
increased to 66.0% in the quarter ended December 31, 2004 versus 58.7% in
the same period last year.
Revenue. Revenue for the three months ended December 31, 2004 increased 21.4% to
$22.1 million from $18.2 million for the three months ended December 31, 2003.
NextGen Division revenue increased 31.0% from approximately $14.0 million to
approximately $18.3 million in the period, while QSI Division revenue declined
by 10.9% during the period from approximately $4.2 million to approximately $3.7
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 the 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.
25
System Sales. Company-wide sales of systems for the three months ended December
31, 2004 increased 18.4% to $11.7 million from $9.9 million in the prior year
quarter.
Our increase in revenue from sales of systems was principally the result of a
21.1% increase in category revenue at our NextGen Division whose sales in this
category grew from $9.3 million during the quarter ended December 31, 2003 to
$11.3 million during the quarter ended December 31, 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 sales of related hardware, third party software,
and supplies.
Systems sales revenue in the QSI Division declined 28.3% to approximately $0.4
million in the quarter ended December 31, 2004 from $0.5 million in the quarter
ended December 31, 2003.
The following table breaks down our reported system sales into software,
hardware, third party software, supplies, and implementation and training
services components by Division:
------------------------------------------------------------------------
Hardware, Third Implementation
Party Software and Training Total
Software and Supplies Services System Sales
------------ ---------------- -------------- ------------
Three months ended
December 31, 2004
QSI Division ................. $ 167 $ 132 $ 89 $ 388
NextGen Division ............. 8,660 822 1,800 11,282
------------ ------------ ------------ ------------
Consolidated ................. $ 8,827 $ 954 $ 1,889 $ 11,670
============ ============ ============ ============
Three months ended
December 31, 2003
QSI Division ................. $ 246 $ 215 $ 80 $ 541
NextGen Division ............. 5,801 1,806 1,711 9,318
------------ ------------ ------------ ------------
Consolidated ................. $ 6,047 $ 2,021 $ 1,791 $ 9,859
============ ============ ============ ============
NextGen Division software revenue increased 49.3% between the three months ended
December 31, 2003 and the three months ended December 31, 2004. The Division's
software revenue accounted for 76.8% of divisional system sales revenue during
the three months ended December 31, 2004, an increase from 62.3% 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 December 31, 2004, 7.3% of NextGen's system sales
revenue was represented by hardware and third party software compared to 19.4%
in the same prior year period. We have noted that the last several quarter's
results have included a relatively lower amount of hardware and third party
software compared to prior periods. However, this decrease was not the result of
any 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 5.2% in
the three months ended December 31, 2004 compared to the three months ended
December 31, 2003. Implementation and training revenue at the NextGen Division
decreased its share of divisional system sales revenue to 16.0% in the three
months ended December 31, 2004 from 18.4% in the three months ended December 31,
2003. The slight growth in implementation and training revenue is the result of
increases in the amount of implementation and training services rendered to our
customers. The amount of implementation and training services revenue and the
corresponding rate of growth compared to a prior period in any given quarter is
dependant on several factors including timing of customer implementations, the
availability of qualified staff, and the mix of services being rendered. The
number of implementation and training staff increased during the three months
ended December 31, 2004 versus 2003 in order to accommodate the increased amount
of
26
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 mix and
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, total system sales decreased 28.3% in the three months
ended December 31, 2004 compared to the three months ended December 31, 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 slight year over year increase in implementation
services was more than offset by decreases in software and hardware/third party
software sales.
Maintenance and Other Services. For the three months ended December 31, 2004,
company-wide revenue from maintenance and other services grew 24.9% to $10.4
million from $8.3 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 December 31, 2004 grew 53.5% to $4.9 million from $3.2
million in the same year ago period, while EDI revenue grew 74.4% to $1.5
million compared to $0.9 million during the same period. QSI Division
maintenance revenue declined 1.0% from $1.9 million in the same period during
the prior year to $1.8 million while QSI divisional EDI revenue declined by
approximately 7.0% from $1.3 million to $1.2 million between the same periods.
The following table details revenue included in the maintenance and other
category for the three month periods ended December 31, 2004 and 2003:
--------------------------------------------------------------------
Maintenance EDI Other Total
----------- ----------- ----------- -----------
Three months ended
December 31, 2004
QSI Division .................... $ 1,845 $ 1,232 $ 277 $ 3,354
NextGen Division ................ 4,852 1,505 707 7,064
----------- ----------- ----------- -----------
Consolidated .................... $ 6,697 $ 2,737 $ 984 $ 10,418
=========== =========== =========== ===========
Three months ended
December 31, 2003
QSI Division .................... $ 1,863 $ 1,325 $ 469 $ 3,657
NextGen Division ................ 3,160 863 660 4,683
----------- ----------- ----------- -----------
Consolidated .................... $ 5,023 $ 2,188 $ 1,129 $ 8,340
=========== =========== =========== ===========
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's EDI revenue growth has come
from new customers and from further penetration of the Division's existing
customer base. 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 sites which were receiving
maintenance services as of the last business day of the quarters ended December
31, 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.
27
------------------------------------------------------------------------------------------
NextGen QSI Consolidated
-------------------------- -------------------------- --------------------------
Maintenance EDI Maintenance EDI Maintenance EDI
----------- ---------- ----------- ---------- ----------- ----------
December 31, 2003 .................. 409 267 240 334 649 601
Billing sites added ................ 99 148 10 4 109 152
Billing sites removed .............. (4) (42) (25) (37) (29) (79)
---------- ---------- ---------- ---------- ---------- ----------
December 31, 2004 .................. 504 373 225 301 729 674
========== ========== ========== ========== ========== ==========
Cost of Revenue. Cost of revenue for the three months ended December 31, 2004
was unchanged at $7.5 million in the quarter ended December 31, 2004 and 2003,
while the cost of revenue as a percentage of net revenue decreased to 34.0% from
41.3%.
The decrease in our consolidated cost of revenue as a percentage of revenue
between the three months ended December 31, 2004 and the three months ended
December 31, 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
76.9% in the quarter ended December 31, 2003 to 83.1% in the quarter ended
December 31, 2004. The NextGen Division's gross profit has been and
continues to be higher than 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 revenue and
gross profit as a percentage of total revenue for our Company and our two
Divisions:
-------------------------------------------------------------- -----------
Hardware, Payroll and
Third Party related Total Cost Gross
Software Benefits Other of Revenue Profit
----------- ----------- ----------- ----------- -----------
Three months ended
December 31, 2004
QSI Division ................. 5.0% 17.8% 25.7% 48.5% 51.5%
NextGen Division ............. 4.5 12.3 14.3 31.1 68.9
----------- ----------- ----------- ----------- -----------
Consolidated ................. 4.6% 13.2% 16.2% 34.0% 66.0%
=========== =========== =========== =========== ===========
Three months ended
December 31, 2003
QSI Division ................. 7.0% 16.0% 26.1% 49.1% 50.9%
NextGen Division ............. 9.9 16.1 13.0 39.0 61.0
----------- ----------- ----------- ----------- -----------
Consolidated ................. 9.3% 16.0% 16.0% 41.3% 58.7%
=========== =========== =========== =========== ===========
During the three months ended December 31, 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. We have noted that the last several quarter's results have included a
relatively lower amount of hardware and third party software compared with prior
periods. However, this reduction was not the result of any 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 decreased to 13.2% of consolidated revenue compared to 16.0% during the
three months ended December 31, 2003. The absolute level of consolidated payroll
and benefit expenses grew from $2.4 million in the three months ended December
31, 2003 to $2.9 million in the three months ended December 31, 2004, an
increase of 21% or $0.5 million. This increase was due primarily to additions to
related headcount, payroll and benefits expense associated
28
with delivering products and services in the NextGen Division where such
expenses increased to $2.2 million in three months ended December 31, 2004 from
$1.7 million in the three months ended December 31, 2003. Payroll and benefits
expense associated with delivering products and services in the QSI Division
during the three months ended December 31, 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.
Other, which consists of outside service costs, amortization of software
development costs and other costs remained fairly consistent on a consolidated
basis between periods.
Should the NextGen Division continue to represent an increasing share of our
revenue and should the NextGen Division continue to carry higher gross profit
than the QSI Division, our consolidated gross profit percentages should increase
to more closely match those of the NextGen Division.
As a result of the foregoing events and activities, gross profit for the Company
and our two operating Divisions increased for the three month period ended
December 31, 2004 versus the prior year period.
The following table details revenue and cost of revenue on a consolidated and
divisional basis for the three month periods ended December 31, 2004 and 2003:
--------------------------------------------------------------------
Three months ended December 31, Three months ended December 31,
------------------------------- -------------------------------
2004 % 2003 %
---------- ---------- ---------- ----------
QSI Division
Revenue ........................ $ 3,742 100.0% $ 4,198 100.0%
Cost of revenue ................ 1,815 48.5 2,060 49.1
---------- ---------- ---------- ----------
Gross profit ................... $ 1,927 51.5 $ 2,138 50.9
========== ========== ========== ==========
NextGen Division
Revenue ........................ $ 18,346 100.0 $ 14,001 100.0
Cost of revenue ................ 5,700 31.1 5,463 39.0
---------- ---------- ---------- ----------
Gross profit ................... $ 12,646 68.9 $ 8,538 61.0
========== ========== ========== ==========
Consolidated
Revenue ........................ $ 22,088 100.0 $ 18,199 100.0
Cost of revenue ................ 7,515 34.0 7,523 41.3
---------- ---------- ---------- ----------
Gross profit ................... $ 14,573 66.0% $ 10,676 58.7%
========== ========== ========== ==========
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the three months ended December 31, 2004 increased
31% to $6.4 million as compared to $4.9 million for the three months ended
December 31, 2003. The increase in the amount of such expenses resulted
primarily from a $0.6 million increase in selling related compensation expenses
in the NextGen Division, a net $0.6 million increase in other selling, general
and administrative expenses in the NextGen Division and a $0.3 million increase
in corporate related expenses. Selling, general and administrative expenses as a
percentage of revenue increased from 26.9% in the three months ended December
31, 2003 to 29.1% in the three months ended December 31, 2004 due to the fact
that the rate of growth in selling, general and administrative expense was more
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
29
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 December 31, 2004 and 2003 were $1.7 million and $1.6 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 7.7% from 9.0%
during the months ended December 31, 2004. Research and development expenses are
expected to continue at or above current levels.
Interest Income. Interest income for the three months ended December 31, 2004
increased 176.8% to approximately $0.02 million compared with $0.01 million in
the three months ended December 31, 2003. Interest income in the three months
ended December 31, 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
December 31, 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 December 31, 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 December 31, 2004 and 2003 were 37.1% and 38.4%,
respectively. The provision for income taxes for the three months ended December
31, 2004 and 2003 differ from the combined statutory rates primarily due to the
impact of varying state income tax rates and the impact of the recognition of
research and development tax credits. The effective rate for the three months
ended December 31, 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. During the quarter ended
December 31, 2004, the provision for income taxes was reduced by $0.2 million
for research and development tax credits from prior periods which had not been
recognized previously. These tax credits are principally from credits in which
the statute of limitations had expired.
For the Nine-Month Periods December 31, 2004 versus 2003
Net Income. The Company's net income for the nine months ended December 31, 2004
was $11.3 million or $1.77 per share on a basic and $1.72 per share on a fully
diluted basis. In comparison, we earned $7.3 million or $1.18 per share on a
basic and $1.13 per share on a fully diluted basis in the nine months ended
December 31, 2003. The increase in net income for the nine months ended December
31, 2004, was achieved primarily through the following:
o a 21.7% increase in consolidated revenue; and
o an increase in the consolidated gross profit margin percentage which
increased to 62.9% in the nine months ended December 31, 2004 versus 58.5%
in the same period last year.
Revenue. Revenue for the nine months ended December 31, 2004 increased 21.7% to
$63.4 million from $52.1 million for the nine months ended December 31, 2004.
NextGen Division revenue increased 30.4% from approximately $39.7 million during
the nine month ended December 31, 2003 to approximately $51.8 million during the
nine month ended December 31, 2004, while QSI Division revenue declined by 6.2%
during the same period from approximately $12.5 million to approximately $11.7
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.
30
System Sales. Company-wide sales of systems for the nine months ended December
31, 2004 increased 17.0% to $34.3 million from $29.4 million in the same prior
year period.
Our increase in revenue from sales of systems was principally the result of a
18.4% increase in category revenue at our NextGen Division whose systems sales
grew from $27.7 million to $32.8 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 declined by 6.6% from $1.6 million in the
nine months ended December 31, 2003 to approximately $1.5 million in the quarter
ended December 31, 2004.
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 Implementation Total
Software and and Training System
Software Supplies Services Sales
----------- ------------ -------------- -----------
Nine months ended
December 31, 2004
QSI Division .................. $ 686 $ 576 $ 246 $ 1,508
NextGen Division .............. 22,821 3,808 6,209 32,838
----------- ----------- ----------- -----------
Consolidated .................. $ 23,507 $ 4,384 $ 6,455 $ 34,346
=========== =========== =========== ===========
Nine months ended
December 31, 2003
QSI Division .................. $ 553 $ 788 $ 274 $ 1,615
NextGen Division .............. 17,423 5,366 4,955 27,744
----------- ----------- ----------- -----------
Consolidated .................. $ 17,976 $ 6,154 $ 5,229 $ 29,359
=========== =========== =========== ===========
NextGen Division software revenue increased 31.0% between the nine months ended
December 31, 2004 and the nine months ended December 31, 2003. The Division's
software revenue accounted for 69.5% of divisional systems sales revenue during
the nine months ending 2004, an increase from 62.8% in the nine months ended
December 31, 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 nine months ended December 31, 2004, 11.6% of NextGen's systems sales
revenue was represented by hardware and third party software compared to 19.3%
in the same prior year period. We have noted that the last several quarter's
results have included a relatively lower amount of hardware and third party
software compared to prior periods. However, this decrease was not the result of
any 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 25.3% from
the nine months ended December 31, 2003 to the nine months ended December 31,
2004. Implementation and training revenue at the NextGen Division increased its
share of category revenue from 17.9% in the nine months ended December 31, 2003
to 18.9% in the nine months ended December 31, 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 nine months
ended December 31, 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.
31
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 systems, decreased 6.6% from the nine months
ended December 31, 2003 to the nine months ended December 31, 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 nine months ended December 31, 2004, Company-wide
revenue from maintenance and other services grew 27.7% to $29.1 million from
$22.8 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 nine months ended December 31, 2004 grew 61.7% to $12.9 million from $7.9
million in the period a year ago, while EDI revenue grew 86.0% to $3.9 million
compared to $2.1 million during the same period. QSI Division maintenance
revenue declined 3.2% from $5.7 million to $5.5 million in the same period while
QSI Divisional EDI revenue declined by approximately 8.0% from $4.0 million to
$3.7 million during such period.
The following table details revenue included in maintenance and other for the
nine month periods ended December 31, 2004 and 2003:
--------------------------------------------------------------------
Maintenance EDI Other Total
----------- ----------- ----------- -----------
Nine months ended
December 31, 2004
QSI Division ................................. $ 5,523 $ 3,687 $ 959 $ 10,169
NextGen Division ............................. 12,852 3,925 2,143 18,920
----------- ----------- ----------- -----------
Consolidated ................................. $ 18,375 $ 7,612 $ 3,102 $ 29,089
=========== =========== =========== ===========
Nine months ended
December 31, 2003
QSI Division ................................. $ 5,704 $ 4,006 $ 1,127 $ 10,837
NextGen Division ............................. 7,949 2,110 1,892 11,951
----------- ----------- ----------- -----------
Consolidated ................................. $ 13,653 $ 6,116 $ 3,019 $ 22,788
=========== =========== =========== ===========
The growth in overall maintenance revenue has come from new customers that have
been added each quarter, additional software purchases by existing customers as
well as our relative success in retaining existing maintenance customers.
NextGen EDI revenue growth has come from new customers and from further
penetration of the Division's existing customer base. NextGen's growth in
maintenance and EDI revenue was at or above our general 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 December
31, 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 Consolidated
---------------------------- ---------------------------- ----------------------------
Maintenance EDI Maintenance EDI Maintenance EDI
----------- ----------- ----------- ----------- ----------- -----------
December 31, 2003 ......... 409 267 240 334 649 601
Billing sites added ....... 99 148 10 4 109 152
Billing sites removed ..... (4) (42) (25) (37) (29) (79)
----------- ----------- ----------- ----------- ----------- -----------
December 31, 2004 ......... 504 373 225 301 729 674
=========== =========== =========== =========== =========== ===========
32
Cost of Revenue. The cost of revenue for the nine months ended December 31, 2004
increased 8.9% to $23.6 million from $21.6 million, while the cost of revenue as
a percentage of net revenue decreased to 37.1% from 41.5% during the same period
a year ago.
The decrease in our consolidated cost of revenue as a percentage of revenue
between the nine months ended December 31, 2004 and the nine months ended
December 31, 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
76.1% in the nine months ended December 31, 2003 to 81.6% in December 31,
2004. The NextGen Division's gross profit percentage has been and
continues to be higher than that 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 revenue and
gross profit as a percentage of total revenue for our Company and our two
Divisions:
--------------------------------------------------------------------------------
Hardware, Payroll and
Third Party related Total Cost Gross
Software Benefits Other of Revenue Profit
----------- ----------- ----------- ----------- -----------
Nine months ended
December 31, 2004
QSI Division ................... 6.9% 17.4% 25.0% 49.3% 50.7%
NextGen Division ............... 6.8 13.1 14.5 34.4 65.6
----------- ----------- ----------- ----------- -----------
Consolidated ................... 6.8% 15.0% 15.3% 37.1% 62.9%
=========== =========== =========== =========== ===========
Nine months ended
December 31, 2003
QSI Division ................... 7.5% 16.7% 26.6% 50.8% 49.2%
NextGen Division ............... 12.2 13.8 12.5 38.5 61.5
----------- ----------- ----------- ----------- -----------
Consolidated ................... 11.1% 14.5% 15.9% 41.5% 58.5%
=========== =========== =========== =========== ===========
During the nine months ended December 31, 2004, the cost of hardware and third
party software constituted 6.8% of consolidated revenue compared to 11.1% in the
same year ago period. We have noted that the last several quarter's results have
included a relatively lower amount of hardware and third party software compared
to prior periods. However this year over year reduction was not the result of
any 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 15.0% of consolidated revenue compared to 14.5% in the
nine months ended December 31, 2003. The absolute level of consolidated payroll
and benefit expenses grew from $7.6 million in the nine months ended December
31, 2003 to $8.8 million in 2004, an increase of 16% or $1.2 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 $6.8 million in the nine months ended
December 31, 2004 compared to $5.5 million in the nine months ended December 31,
2003, an increase of 24%. The Division's payroll and benefits expense associated
with delivering products and services as a percentage of divisional revenue in
the nine months ended December 31, 2004 decreased to 13.1% compared to 13.8% in
the prior year period. Headcount expense as a percentage of revenue for the nine
month period ended December 31, 2004 at the QSI Division increased slightly
compared to the prior year at 17.4% versus 16.7%, 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
33
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.
Other, which consists of outside service costs, amortization of software
development costs and other costs remained fairly consistent on a consolidated
basis between periods.
Should the NextGen Division continue to represent an increasing share of our
revenue and should NextGen continue to show higher gross profit percentages
compared to the QSI Division, our gross profit percentages should increase to
more closely match those of the NextGen Division.
As a result of the foregoing events and activities, our gross profit for the
Company and our two operating Divisions increased for the nine month period
ended December 31, 2004 versus the prior year period.
The following table details revenue and cost of revenue on a consolidated and
divisional basis for the nine month periods ended December 31, 2004 and 2003:
Nine months ended December 31, Nine months ended December 31,
------------------------------ ------------------------------
2004 % 2003 %
---------- ---------- ---------- ----------
QSI Division
Revenue .............. $ 11,678 100.0% $ 12,452 100.0%
Cost of revenue ...... 5,756 49.3 6,323 50.8
---------- ---------- ---------- ----------
Gross profit ......... $ 5,922 50.7 $ 6,129 49.2
========== ========== ========== ==========
NextGen Division
Revenue .............. $ 51,757 100.0 $ 39,695 100.0
Cost of revenue ...... 17,798 34.4 15,302 38.5
---------- ---------- ---------- ----------
Gross profit ......... $ 33,959 65.6 $ 24,393 61.5
========== ========== ========== ==========
Consolidated
Revenue .............. $ 63,435 100.0 $ 52,147 100.0
Cost of revenue ...... 23,554 37.1 21,625 41.5
---------- ---------- ---------- ----------
Gross profit ......... $ 39,881 62.9% $ 30,522 58.5%
========== ========== ========== ==========
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the nine months ended December 31, 2004 increased
16.5% to $16.8 million as compared to $14.4 million for the nine months ended
December 31, 2003. The increase in the amount of such expenses resulted
primarily from increases of $1.3 million in selling related compensation
expenses at the NextGen Division, $0.8 million in other general selling, general
and administrative expenses in the NextGen Division and $0.3 million in
increased corporate related expenses. Selling, general and administrative
expenses as a percentage of revenue declined from 27.6% in the nine months ended
December 31, 2003 to 26.5% in the nine months ended December 31, 2004 due to
revenues growing at a faster rate then selling, general, administrative
expenses.
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 nine
months ended December 31, 2004 and 2003 were $5.1 million and $4.5 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 decreased to 8.1% from 8.6% 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.
Interest Income. Interest income for the nine months ended December 31, 2004
increased 94.7% to approximately $0.6 million compared with $0.3 million in the
nine months ended
34
December 31, 2003. Interest income in the nine months ended December 31, 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 nine months ended December 31, 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 continues to review 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 nine months
ended December 31, 2004 was approximately $7.2 million as compared to
approximately $4.6 million for the year ago period. The effective tax rates for
the nine months ended December 31, 2004 and 2003 were 38.9% and 38.7%,
respectively. The provision for income taxes for the nine months ended December
31, 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. During the nine months ended December 31, 2004, the
provision for income taxes was reduced by approximately $0.3 million for
research and development tax credits from prior periods which had not been
recognized previously including $0.2 million from credits in which the statute
of limitations had expired.
Liquidity and Capital Resources
The following table presents selected financial statistics and information for
each of the nine months ended December 31, 2004 and 2003:
Nine months ended December 31,
------------------------------
2004 2003
- ------------------------------------------------------------------------------------------------
Cash and cash equivalents ................................ $ 66,432 $ 45,348
Net increase in cash and cash equivalents
during the nine month period ............................. $ 15,037 $ 8,905
Net income during the period ............................. $ 11,318 $ 7,296
Net cash provided by operations during the
period ................................................... $ 16,179 $ 10,675
Number of days of sales outstanding at start
of the period ............................................ 99 106
Number of days of sales outstanding at the end
of the period ............................................ 115 108
The Company's principal source of cash was cash provided by operations. The
number of days sales outstanding at the end of the period increased by two days
during the nine month period ended December 31, 2003. The number of days sales
outstanding increased by 16 days during the nine months ended December 31, 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
deferred revenue and accounts receivable. Provided turnover of accounts
receivable, deferred revenue, and profitability remain consistent with the nine
months ended December 31, 2004, we anticipate 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 by $15.0 million between March 31, 2004 and
December 31, 2004 primarily as a result of cash provided by operating
activities. Cash and cash equivalents increased approximately $8.9 million
during the nine months ended December 31, 2003, also primarily as a result of
cash generated by operating activities.
Net cash used in investing activities for the nine months ended December 31,
2004 and 2003 was $2.9 and $2.7 million respectively. Net cash used in investing
activities for the
35
nine months ended December 31, 2004 and 2003 consisted of additions to equipment
and improvements and capitalized software.
During the nine months ended December 31, 2004, we received proceeds of $1.8
million from the exercise of stock options and recorded a reduction in income
tax liability of $2.1 million related to tax deductions received from employee
stock option exercises. The benefit was recorded as additional paid in capital.
At December 31, 2004, we had cash and cash equivalents of $66.4 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 December 31,
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.
Contractual Obligations
The following table summarizes our significant contractual obligations at
December 31, 2004, and the effect that such obligations are expected to have on
our liquidity and cash in future periods:
- -------------------------------- -----------------------------------------------------------------
Less than 1-3 3-5 Beyond
Contractual Obligations Total a year years years 5 years
- -------------------------------- --------- --------- --------- --------- ---------
Non-cancelable lease obligations $ 2,459 $ 334 $ 2,068 $ 56 $ 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 December 31, 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 December
31, 2004 we used both the existing manual process as well as the new software to
perform in a parallel manner the processes
36
described above which related to revenue recognition of our software sales
arrangements with multiple elements. As of December 31, 2004 (i) we had not
developed sufficient controls over our new software in order to rely on the new
automated processes and instead, relied on our existing manual process for the
December 31, 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.
In the course of our evaluation and documentation of our internal controls we
have identified various deficiencies which we are in the course of remediating.
Management does not believe that any identified deficiencies are considered
material to our internal controls. Our evaluation of our internal controls over
financial reporting is still in process.
37
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.
None.
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K
Exhibits:
31.1 Certifications Required by Rule 13a-14 (a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
38
SIGNATURES
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: February 7, 2005 By: /s/ Louis Silverman
-----------------------------------------
Louis Silverman
Chief Executive Officer
Date: February 7, 2005 By: /s/ Paul Holt
-----------------------------------------
Paul Holt
Chief Financial Officer; Principal Accounting
Officer
39