Health Grades 10Q 2009 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)


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

For the quarterly period endedSeptember 30, 2009


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to

Commission file number0-22019

HEALTH GRADES, INC.

(Exact Name of Registrant as Specified in Its Charter)


DELAWARE		62-1623449

(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

500 GOLDEN RIDGE ROAD, SUITE 100, GOLDEN, COLORADO		80401

(Address of Principal Executive Offices)		(Zip Code)

Registrant’s Telephone Number, Including Area Code(303) 716-0041

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yesþ Noo

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yeso Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large Accelerated Filero	Accelerated Filerþ	Non-Accelerated Filero	Smaller reporting companyo
		(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yeso Noþ

On November 1, 2009, 29,784,391 shares of the Registrant’s common stock, $.001 par value, were outstanding.

Health Grades, Inc.

INDEX


PART I. FINANCIAL INFORMATION:

Item 1. Condensed Consolidated Balance Sheets — September 30, 2009 (unaudited) and December 31, 2008			3

Condensed Consolidated Statements of Income — Three and Nine Months Ended September 30, 2009 and 2008 (unaudited)			4

Condensed Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2009 and 2008 (unaudited)			5

Notes to Condensed Consolidated Financial Statements (unaudited)			6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			15

Item 3. Quantitative and Qualitative Disclosures About Market Risk			21

Item 4. Controls and Procedures			21

PART II. OTHER INFORMATION:

Item 1. Legal Proceedings			21

Item 1A. Risk Factors			21

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			22

Item 6. Exhibits			22

EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Health Grades, Inc.

Condensed Consolidated Balance Sheets


	SEPTEMBER 30,			DECEMBER 31,
	2009			2008
	(Unaudited)
ASSETS
Cash and cash equivalents	$	14,151,624		$	11,327,741
Accounts receivable, net		9,053,237			9,563,163
Prepaid income taxes		—			12,603
Prepaid expenses and other		1,422,271			1,087,914

Total current assets		24,627,132			21,991,421

Property and equipment, net		3,065,143			2,451,210
Intangible assets, net		698,613			854,613
Goodwill		9,712,110			9,104,060
Deferred income taxes		820,447			683,866

Total assets	$	38,923,445		$	35,085,170


LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable	$	170,021		$	224,252
Accrued payroll, incentive compensation and related expenses		3,288,466			3,352,294
Accrued expenses		1,312,187			629,359
Current portion of capital lease obligations		984			1,898
Current portion of deferred rent		243,380			—
Deferred revenue		15,650,948			19,713,079
Income taxes payable		195,581			—
Deferred income taxes		265,900			130,493

Total current liabilities		21,127,467			24,051,375

Long-term portion of capital lease obligations		—			984
Long-term portion of deferred rent		102,508			309,131

Total liabilities		21,229,975			24,361,490

Commitments and contingencies

Stockholders’ equity:
Health Grades, Inc. stockholders’ equity
Preferred stock, $0.001 par value, 2,000,000 shares authorized, no shares issued or outstanding		—			—
Common stock, $0.001 par value, 100,000,000 shares authorized, 54,033,901 and 52,744,438 shares issued as of September 30, 2009 and December 31, 2008, respectively		54,033			52,743
Additional paid-in capital		100,075,991			98,242,403
Accumulated deficit		(48,844,434	)		(54,026,164	)
Treasury stock, 24,269,647 and 23,982,694 shares as of September 30, 2009 and December 31, 2008, respectively		(33,678,100	)		(33,545,302	)

Total Health Grades, Inc. equity		17,607,490			10,723,680
Noncontrolling interest		85,980			—

Total stockholders’ equity		17,693,470			10,723,680

Total liabilities and stockholders’ equity	$	38,923,445		$	35,085,170

See accompanying notes to condensed consolidated financial statements.

Health Grades, Inc.

Condensed Consolidated Statements of Income

(Unaudited)


	THREE MONTHS ENDED						NINE MONTHS ENDED
	SEPTEMBER 30,						SEPTEMBER 30,
	2009			2008			2009			2008

Revenue:
Ratings and advisory revenue	$	13,302,333		$	10,023,373		$	38,162,227		$	28,444,560
Other		11,712			6,684			22,737			18,789

Total revenue		13,314,045			10,030,057			38,184,964			28,463,349

Expenses:
Cost of ratings and advisory revenue		1,773,750			1,604,983			5,503,809			4,723,125

Gross margin		11,540,295			8,425,074			32,681,155			23,740,224

Operating expenses:
Sales and marketing		3,240,474			2,677,158			9,612,211			7,435,584
Product development		2,214,636			1,889,339			6,611,269			5,291,336
General and administrative		3,209,594			1,894,964			8,405,207			5,874,077

Income from operations		2,875,591			1,963,613			8,052,468			5,139,227

Other:
Interest income		2,841			94,428			16,518			422,829
Interest expense		(31	)		(90	)		(643	)		(206	)
Equity earnings of investment		—			—			34,000			—

Income before income taxes		2,878,401			2,057,951			8,102,343			5,561,850
Income taxes		1,109,762			789,065			3,100,700			2,112,452

Net income		1,768,639			1,268,886			5,001,643			3,449,398
Net loss attributable to noncontrolling interest		45,420			53,069			180,087			237,226

Net income attributable to Health Grades, Inc.	$	1,814,059		$	1,321,955		$	5,181,730		$	3,686,624


Net income per common share (basic)	$	0.07		$	0.05	*	$	0.19		$	0.13	*


Weighted average number of common shares used in computation (basic)		27,782,227			28,185,206	*		27,524,240			28,518,894	*


Net income per common share (diluted)	$	0.06		$	0.04	*	$	0.17		$	0.11	*


Weighted average number of common shares used in computation (diluted)		31,431,346			32,635,913	*		31,063,009			33,115,972	*


*		Reflects the retroactive presentation of recognizing unvested share-based compensation awards that contain nonforfeitable rights to dividends in the computation of basic earnings per share. See “Recently Adopted Accounting Pronouncements” in Note 1 for additional information.

See accompanying notes to condensed consolidated financial statements.

Health Grades, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)


	NINE MONTHS ENDED SEPTEMBER 30,
	2009			2008
OPERATING ACTIVITIES
Net income	$	5,181,730		$	3,686,624
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,263,828			879,499
Bad debt expense		86,246			—
Loss on disposal of assets		402			—
Non-cash equity compensation expense		1,407,789			327,518
Tax benefit from stock option exercise		(176,606	)		(125,977	)
Deferred income taxes		(1,174	)		41,322
Noncontrolling interest		(180,087	)		(237,226	)
Change in operating assets and liabilities, net of acquisitions:
Accounts receivable		423,680			(1,552,316	)
Prepaid expenses and other assets		(338,680	)		(16,751	)
Accounts payable		(54,231	)		(145,770	)
Accrued payroll, incentive compensation and related expenses		(63,828	)		494,208
Accrued expenses		51,976			378,477
Income taxes payable		385,798			229,409
Deferred revenue		(4,062,131	)		(436,340	)
Deferred rent		41,080			(22,447	)

Net cash provided by operating activities		3,965,792			3,500,230

INVESTING ACTIVITIES
Purchase of property and equipment		(1,598,631	)		(1,149,578	)
Business acquisition costs		(730	)		—

Net cash used in investing activities		(1,599,361	)		(1,149,578	)

FINANCING ACTIVITIES
Payments under capital lease obligations		(1,898	)		(1,706	)
Excess tax benefits from stock-based payment arrangements		176,606			125,977
Exercise of common stock options		415,542			384,089
Purchase of treasury stock		(132,798	)		(9,826,115	)

Net cash provided by (used in) financing activities		457,452			(9,317,755	)

Net increase (decrease) in cash and cash equivalents		2,823,883			(6,967,103	)
Cash and cash equivalents at beginning of period		11,327,741			23,369,368

Cash and cash equivalents at end of period	$	14,151,624		$	16,402,265

See accompanying notes to condensed consolidated financial statements.

Health Grades, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2009

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Health Grades, Inc. have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results of the interim periods reported herein. Operating results for the nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008.

Certain prior year balances have been reclassified in order to conform to current year presentation as a result of presenting the noncontrolling interest within equity on the Condensed Consolidated Balance Sheets and after income before taxes on the Condensed Consolidated Statements of Income.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of Health Grades, Inc. and our controlled subsidiary, Healthcare Credit Solutions LLC (collectively, the “Company”, “we”, “us” or “our”). All significant intercompany accounts have been eliminated in consolidation.

Recently Adopted Accounting Pronouncements

In May 2009, the Financial Accounting Standards Board (“FASB”) issued guidance that sets forth the period after the balance sheet date during which management of a reporting entity shall evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity shall recognize events or transactions that occurred after the balance sheet date in its financial statements and the disclosures that an entity shall make about the events or transactions that occurred after the balance sheet date. This guidance became effective for us on June 30, 2009. The adoption of the guidance did not have a material impact on our financial position, cash flows or results of operations.

In June 2008, FASB issued guidance which concludes that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and must be included in the computation of basic earnings per share using the two-class method. We retrospectively adopted this guidance on January 1, 2009. The adoption of this guidance decreased our previously reported basic and diluted earnings per share for the nine months ended September 30, 2008 by $0.01 and had no effect on the previously reported basic or diluted earnings per share for the three months ended September 30, 2008.

In April 2008, the FASB issued guidance that amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets. The intent of this guidance is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset under other GAAP measures. This guidance became effective for us on January 1, 2009. The adoption of this guidance did not have a material impact on our financial position, cash flows or results of operations.

In December 2007, the FASB issued guidance that establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. This guidance also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. This guidance became effective for us on January 1, 2009. The adoption of this guidance did not have a material impact on our financial position, cash flows or results of operations.

In April 2009, the FASB issued guidance that amends and clarifies accounting provisions related to business combinations to address application issues raised by preparers, auditors and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. This guidance became effective for us on January 1, 2009. The adoption of this guidance did not have a material impact on our financial position, cash flows or results of operations.

In December 2007, the FASB issued guidance that establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. This guidance also establishes disclosure requirements that clearly identify and distinguish between the interest of the parent and the interests of the noncontrolling owners. We adopted this guidance on January 1, 2009 via retrospective application of the presentation and disclosure requirements. The noncontrolling interest recorded in our Condensed Consolidated Balance Sheets relates to a third party’s interest in our majority owned subsidiary, Healthcare Credit Solutions LLC. At December 31, 2008, the noncontrolling interest balance of $0 that was previously recorded as a minority interest in the mezzanine section of the Condensed Consolidated Balance Sheets has been reclassified to noncontrolling interest in the equity section of the Condensed Consolidated Balance Sheets. Noncontrolling interest for the three and nine months ended September 30, 2008 in the amount of $53,069 and $237,226, respectively, on the Condensed Consolidated Statements of Income was originally presented before income tax expense. The retrospective presentation of this guidance requires the noncontrolling interest to be presented after income tax expense, and we have presented noncontrolling interest net of income tax expense for the three and nine months ended September 30, 2008. There was no impact on net income attributable to Health Grades, Inc. or the net income used in computing earnings per share.

In May 2008, the FASB issued guidance that identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with GAAP for nongovernmental entities. This guidance was issued to include the GAAP hierarchy in the accounting literature established by the FASB. This guidance became effective for us on January 1, 2009. The adoption of this guidance did not have a material impact on our financial position, cash flows or results of operations.

Recently Issued Accounting Pronouncements Not Yet Adopted

In October 2009, the FASB issued guidance on revenue arrangements with multiple deliverables stating that when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. This guidance will be effective for us January 1, 2011. We do not expect the application of this guidance will have a material impact on our financial position, cash flows or operating results.

In June 2009, the FASB issued guidance that significantly changes the criteria for determining whether the consolidation of a variable interest entity is required. This guidance also addresses the effect of changes required by other guidance,and concerns regarding the application of certain provisions related to accounting for variable interest entities, including concerns that the accounting and disclosures under the guidance does not always provide timely and useful information about an entity’s involvement in a variable interest entity. This guidance will be effective for us January 1, 2010. We do not expect the application of this guidance will have a material impact on our financial position, cash flows or operating results.

NOTE 2 – INTERNALLY DEVELOPED SOFTWARE

In accordance with guidance related to internally developed software, we capitalize certain costs associated with the implementation of software developed for internal use and costs incurred during the application development stage (such as software configuration and interfaces, coding, installation to hardware and testing) for certain applications we build. Costs capitalized consist of employee salaries and benefits, consulting fees and other costs allocated to the implementation project. We capitalize application development costs until the projects are substantially complete and ready for their intended use (after all substantial testing is completed). We capitalized approximately $871,000 and $582,000 of software development costs incurred during the nine months ended September 30, 2009 and 2008, respectively, related to certain applications developed for internal use. As the applications become ready for their intended use and are placed into service, we begin to amortize the costs over their useful life, which we expect to be three years. Amortization expense related to internally developed software for the three and nine months ended September 30, 2009 was approximately $115,000 and $407,000, respectively, and approximately $109,000 and $259,000 for the three and nine months ended September 30, 2008, respectively.

NOTE 3 – LINE OF CREDIT AND LETTER OF CREDIT

Line of Credit

On April 13, 2009, we entered into a Loan and Security Agreement with Silicon Valley Bank for a revolving line of credit of up to $5.0 million maturing on April 13, 2011. We may borrow, repay and re-borrow under the line of credit facility at any time. The amount that we are able to borrow under the line of credit will vary based on the availability amount, as defined in the agreement. The line of credit facility bears interest at the greater of 5% or the bank’s prime rate plus 0.5%. The bank’s prime rate was 4% at September 30, 2009. The line of credit is collateralized by substantially all of our assets and requires us to comply with customary affirmative and negative covenants principally relating to the use and disposition of assets, satisfaction of a quick ratio test, and minimum operating income. In addition, the Loan and Security Agreement contains customary events of default. Upon occurrence of an uncured event of default, among other things, the bank may declare that all amounts owed under the line of credit are immediately due and payable. As of September 30, 2009, we were in compliance with all covenants.

As of September 30, 2009, we had $0 outstanding on the line of credit.

Letter of Credit

In connection with a lease we executed in December 2004 for our headquarters in Golden, Colorado, we executed a $500,000 standby letter of credit with Silicon Valley Bank in January 2005 to secure our obligations under the lease. The amount of the standby letter of credit, as required by the lease, was decreased to $45,000 on February 15, 2009.

As of September 30, 2009, the available amount of the standby letter of credit was $45,000. The amount drawn under the standby letter of credit is $0 and is secured by the cash and cash equivalents we maintain with Silicon Valley Bank.

NOTE 4 – LEGAL PROCEEDINGS

Indemnification of our Chief Executive Officer and Derivative Complaint

For the nine months ended September 30, 2009, we provided indemnification to our Chief Executive Officer, Kerry R. Hicks, for legal fees totaling approximately $836,000. The legal proceedings arose from loans that Mr. Hicks and three other executive officers provided to us in December 1999 in the amount of $3,350,000 (including $2,000,000 individually loaned by Mr. Hicks). These loans enabled us to purchase in December 1999 a minority interest in an internet healthcare rating business that has become our current healthcare provider rating and advisory services business. This purchase was critical to our business because we had agreed with the minority interest holder that if we failed to purchase the holder’s interest by December 31, 1999, we would relinquish control and majority ownership to the holder. In March 2000, the executive officers converted our obligations to them (including the $2,000,000 owed to Mr. Hicks) into our equity securities in order to induce several private investors to invest an aggregate of $14,800,000 in our equity securities.

The executive officers personally borrowed money from our principal lending bank in order to fund the December 1999 loans to us. In early 2001, the bank claimed that Mr. Hicks was obligated to pay amounts owed to the bank by a former executive officer who was unable to fully repay his loan; Mr. Hicks denied this obligation. In October 2002, the bank sold the note to an affiliate of a collection agency (the collection agency and the affiliate are collectively referred to as the “collection agency”). Although the bank informed the collection agency in July 2003 of the bank’s conclusion that Mr. Hicks was not obligated under the former executive’s promissory note issued to the bank, the collection agency commenced litigation in September 2003 in Tennessee federal district court to collect the remaining balance of approximately $350,000 on the note and named Mr. Hicks as a defendant. On motion by Mr. Hicks, the court action was stayed, and Mr. Hicks commenced an arbitration proceeding against the collection agency in October 2003, seeking an order that he had no liability under the note and asserting claims for damages. The bank was added as a party in March 2004.

The bank repurchased the note from the collection agency in December 2003 and resold the note to another third party in February 2004, so that Mr. Hicks’ obligation to repay the note was no longer at issue. The remaining claims included, among others, claims by the bank against Mr. Hicks for costs and expenses of collection of the loan, claims by the collection agency against Mr. Hicks for abuse of process and tortious interference with the relationship between the bank and the collection agency, and claims by Mr. Hicks against the bank for breach of fiduciary duty and fraud, and against the collection agency for abuse of process and defamation. Mr. Hicks also commenced litigation in Colorado state court against the other parties, as well as two individuals affiliated with the collection agency (together with the collection agency, the “collection agency parties”), based on similar claims. That case was removed to federal court by the defendants. Mr. Hicks later filed an amended complaint against the collection agency parties in federal district court for abuse of process, defamation and intentional infliction of emotional distress. The federal district court determined that Mr. Hicks’ claims should be submitted to the arbitration proceeding, but in January 2005, the arbitrator stayed Mr. Hicks’ federal court claims and the collection agency’s claims against Mr. Hicks for abuse of process and tortious interference until the other pending claims were considered. An arbitration hearing was held in February 2005 on the other claims submitted by the parties.

In April 2005, the arbitrator ruled that the collection agency was liable to Mr. Hicks in the amount of $400,000 for emotional distress and other maladies as well as attorneys’ fees in the amount of $15,587 with interest as a result of the collection agency’s abuse of process in initiating the action in Tennessee federal district court. The arbitrator determined that the bank had no liability.

The collection agency sought reconsideration of the ruling by the arbitrator, who denied the request. Mr. Hicks filed a motion with the federal district court to confirm the arbitration award, and the court confirmed the award in October 2005. The collection agency appealed the federal district court’s confirmation of the arbitration award entered in favor of Mr. Hicks. In February 2007, the 10th Circuit Court of Appeals affirmed the district court’s confirmation of the April 2005 award entered in favor of Mr. Hicks. This award has not been paid to Mr. Hicks.

The hearing on the remaining matters in the arbitration was held in February and March 2006. The arbitrator who heard these claims died unexpectedly a few days after the arbitration hearing concluded. A new arbitrator was appointed, and the remaining matters were again heard by the new arbitrator in October 2006. Final briefings on the remaining matters in the arbitration were concluded in April 2007. In May 2007, the arbitrator entered an award in favor of Mr. Hicks in connection with his claims of defamation and outrageous conduct. For these claims, the arbitrator awarded Mr. Hicks compensatory damages from the collection agency parties totaling $950,000. The arbitrator also awarded Mr. Hicks punitive damages totaling $950,000 against Daniel C. Cadle, Buckeye Retirement Co., LLC, Ltd and The Cadle Company and $10,000 against William Shaulis, Buckeye Retirement Co., LLC, Ltd. and The Cadle Company. Additionally, the arbitrator awarded Mr. Hicks prejudgment interest in the approximate amount of $300,000. With respect to the collection agency parties’ claims against Mr. Hicks, the arbitrator ruled in favor of Mr. Hicks. The arbitrator ruled against Mr. Hicks with respect to his abuse of process claim. In July 2008, the U.S. District Court confirmed the arbitrator’s May 2007 order and subsequent final award in favor of Mr. Hicks, with the exception of the award of prejudgment interest. This award has not been paid to Mr. Hicks. We do not know what other actions the collection agency parties may take, when Mr. Hicks will be paid the awards, or when we may receive reimbursement for any or all of the indemnification expenses we have incurred and continue to incur in these matters.

On July 10, 2007, a U.S. District Court Judge entered an order precluding Daniel C. Cadle, one of the collection agency parties, from engaging in 13 acts that the arbitrator found to be outrageous. On July 20, 2007, a County Court Judge in Jefferson County, Colorado, entered a Permanent Civil Protection Order against Daniel C. Cadle. The Protection Order requires that Mr. Cadle stay at least 250 yards from Mr. Hicks, his residences and our headquarters. On July 26, 2007, Mr. Cadle appealed the Civil Protection Order entered by the County Court Judge in Jefferson County, Colorado, to the State District Court. On January 15, 2008, the State District Court affirmed the Civil Protection Order entered by the County Court. On December 2, 2008, the Colorado Supreme Court denied Mr. Cadle’s request for further review. Thus, the Permanent Civil Protection Order remains in effect.

In July 2007, Mr. Hicks filed a motion for leave to file a second amended complaint and to refer claims to arbitration in which he alleged that certain of the collection agency parties, after the October 2006 arbitration hearing, continued to engage in conduct substantially similar to that upon which the arbitrator entered his compensatory and punitive damages order in May 2007. The collection agency parties opposed the relief sought by Mr. Hicks. On October 17, 2007, the court granted Mr. Hicks’ motion for leave to file a second amended complaint. A supplemental complaint asserting claims for defamation and outrageous conduct against certain of the collection agency parties was filed on October 29, 2007, in accordance with the court’s order. Those claims have been referred to arbitration. The claims Mr. Hicks asserts in the arbitration are for defamation and outrageous conduct against the collection agency parties. Mr. Hicks has filed motions to attempt to narrow the issues to be heard based upon the findings made by the arbitrator in his May 2007 ruling. The collection agency parties have raised claims against Mr. Hicks for abuse of process, “frivolous and spurious lawsuit” and “attorneys’ fees.” Mr. Hicks filed a motion to dismiss the counterclaims. All counterclaims have been dismissed voluntarily or by order of the Arbitrator, except the Buckeye Respondents’ counterclaim for abuse of process. The hearing on these claims commenced on August 10, 2009 for one week. Additional hearing days were added and the evidence should conclude on or before December 3, 2009.

On October 7, 2008, the U.S. District Court entered judgment in favor of Mr. Hicks on both arbitration awards and certified the judgment as immediately appealable. The District Court reversed the Arbitrator’s award of prejudgment interest. On October 14, 2008, the Clerk of Courts entered judgment as follows: in favor of Mr. Hicks and against The Cadle Company, Buckeye Retirement Co., LLC. Ltd., jointly and severally, in the amount of $415,587; against The Cadle Company, Buckeye Retirement Co., LLC. Ltd., and Daniel C. Cadle, jointly and severally, for compensatory and punitive damages in the amount of $1.7 million; and against The Cadle Company, Buckeye Retirement Co., LLC. Ltd., and William E. Shaulis, jointly and severally, for compensatory and punitive damages in the amount of $210,000; with post judgment interest accruing at the legal rate of 1.59%. The collection agency parties have appealed the judgment to the 10th Circuit Court of Appeals and Mr. Hicks has appealed the denial of his award of prejudgment interest.

On February 11, 2009, the U.S. District Court in Colorado permitted registration of the judgment in the Northern District of Ohio, where Mr. Hicks believes there are assets of the collection agency parties. Mr. Hicks retained counsel in Ohio to collect on the judgment. On February 27, 2009, the collection agency parties posted a cash supersedeas bond in an amount exceeding $2.3 million with the U.S. District Court in Colorado. If Mr. Hicks prevails in the appeal, he may collect the amounts due him from the bond.

Our Board of Directors initially agreed to indemnify Mr. Hicks in December 2004. The determination to indemnify Mr. Hicks was based on, among other things, the fact that the dispute related to Mr. Hicks’ efforts and personal financial commitment to provide funds to us in December 1999, without which we likely would not have remained viable. Mr. Hicks has advised us that he intends to reimburse us for all indemnification expenses we have incurred and continue to incur from the proceeds of any final awards paid to him, net of any income taxes payable by him resulting from the awards.

By a letter to our Board of Directors dated February 13, 2006, Daniel C. Cadle made allegations directed at us, Mr. Hicks, the attorneys representing Mr. Hicks in the arbitration and the late arbitrator. The principal allegations appear to be that we, Mr. Hicks, and the attorneys conspired to enter into an illegal arrangement with an account officer of the bank whose loan was the initial subject of the arbitration, without the bank’s knowledge, that enabled us to indirectly obtain funds from the bank and, in conspiracy with the late arbitrator, prevented the collection agency parties from reporting the alleged conduct to government authorities. Mr. Cadle threatened suit if he was not paid $10.3 million. We believe these allegations are absurd and completely without merit. To our knowledge, neither Mr. Cadle nor any of the other collection agency parties has sought to assert any such “claims” against us in the arbitration. We will vigorously contest any such litigation that may be brought against us by the collection agency parties.

In addition, in September and October 2006, our Board of Directors and our counsel received communications from counsel to Daniel C. Cadle demanding a review of the indemnification payments made by us on Mr. Hicks’ behalf and raising certain other issues. In December 2006, Daniel C. Cadle filed a putative shareholder derivative complaint in the U.S. District Court for the District of Colorado against several of our current and former members of our Board of Directors, Mr. Hicks and our Chief Financial Officer (collectively, the “defendants”). Mr. Cadle alleged, among other items, that the defendants wasted and continued to waste corporate assets and opportunities by permitting the indemnification described above, that Mr. Hicks converted assets properly belonging to us and our stockholders to his own use and benefit by accepting the indemnification payments and that the defendants violated Colorado and Delaware state and federal law by concealing material information or making materially misleading statements in our quarterly and annual financial reports regarding these matters. Mr. Cadle sought a recovery to our company of the attorneys fees paid to indemnify Mr. Hicks, participatory damages to himself personally as well as any attorneys’ fees he incurred in this matter. Mr. Cadle also sought injunctive relief to prevent us from continuing to indemnify Mr. Hicks. In April 2007, the defendants filed a motion to dismiss the shareholder derivative complaint. The defendants’ motion to dismiss the shareholder derivative complaint was granted by the U.S. District Court in June 2007, and the plaintiff appealed the dismissal of the complaint to the 10th Circuit Court of Appeals. In April 2008, the 10th Circuit Court of Appeals affirmed the dismissal of the shareholder derivative complaint. In June 2008, the U.S. District Court denied our motion for attorneys’ fees in this case.

Gotham/Primarius Complaint

In March 2007, Gotham Holdings, LP, Primarius Partners LP, Primarius Offshore Partners LTD., Primarius Focus LP and Primarius China Fund LP (collectively, the “Plaintiffs”) commenced an action in the United States District Court, Southern District of New York against us, MDB Capital Group (“MDB”) and Essex Woodlands Health Ventures (“Essex”). The case relates to sales made by Essex in December 2005 and February 2006 of approximately 9.1 million shares of our common stock to a number of investors, including the Plaintiffs. These sales occurred under a registration statement that we initially filed with the Securities and Exchange Commission (the “SEC”) in May 2005. Essex engaged a broker, MDB, in connection with the sales. We did not receive any proceeds from these sales.

The Plaintiffs allege claims under Section 10(b) of the Exchange Act and Rule 10b-5, Section 12 of the Securities Act, fraud with respect to alleged material misrepresentations and/or omissions of material fact and negligent misrepresentation in connection with the Plaintiffs’ purchase of our common stock. As they relate to us, the claims arise out of our SEC filings and presentations made by Company management at the request of Essex, to Plaintiffs (or parties allegedly related to the Plaintiffs) in December 2005 and February 2006. Specifically, the claims relate to alleged misrepresentations by Company management regarding the likelihood that an agreement we had with Hewitt Associates would move to full implementation.

In July 2007, we filed a motion to dismiss the Gotham/Primarius complaint. The Plaintiffs responded by filing a first amended complaint in August 2007. In the first amended complaint, the Plaintiffs asserted the same four claims against us that they had made in the original complaint, and three new entities were added as plaintiffs (Willow Creek Capital Partners, LP, Willow Creek Capital Partners II, LP, and Willow Creek Offshore, Ltd.). We filed a motion to dismiss the first amended complaint in September 2007. In October 2007, the court granted our motion to dismiss the first amended complaint, with leave given to the Plaintiffs to file a second amended complaint.

In October 2007, the Plaintiffs filed a second amended complaint against us, which contained allegations that were substantially similar to those pled in the first amended complaint. We filed a motion to dismiss the second amended complaint in December 2007.

The court conducted oral argument on the motion to dismiss the second amended complaint in January 2008, at which time it denied our motion to dismiss the common law fraud and Section 10(b) claims, but deferred a decision on the Section 12 and negligent misrepresentation claims. In February 2008, the court issued an opinion dismissing the Section 12 claim, but maintaining the negligent misrepresentation claim because dismissal at that time was premature. We will have an opportunity to renew our argument once the court has decided which state’s law applies.

In December 2008, Plaintiffs moved to file a third amended complaint. Following argument on the motion, the court granted the Plaintiffs leave to file an amended complaint. Plaintiffs filed the third amended complaint on February 17, 2009. The third amended complaint adds Kerry Hicks, our Chief Executive Officer, as a defendant and asserts claims against him for violation of Section 20(a) of the Exchange Act and for fraud. Aside from the addition of Mr. Hicks as defendant, the substantive allegations of the third amended complaint are the same as the second amended complaint. Discovery in the matter is ongoing. Documents have been exchanged, but no depositions have yet taken place.

We are subject to other legal proceedings and claims that arise in the ordinary course of our business. In the opinion of management, these other actions are unlikely to materially affect our financial position.

NOTE 5 – COMMON STOCK

Equity Compensation Plan

A summary of stock option activity for the nine months ended September 30, 2009 is as follows:


						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
				Exercise		Contractual		Intrinsic
	Options			Price		Term (in years)		Value
Outstanding at December 31, 2008		4,576,405		$	0.41
Granted		—			—
Exercised		(548,663	)		0.76
Forfeited		—			—
Expired		(6,667	)		4.08

Outstanding at September 30, 2009		4,021,075		$	0.36		2.41	$	18,462,151


Vested or expected to vest at September 30, 2009		4,021,075		$	0.36		2.41	$	18,462,151


Exercisable at September 30, 2009		4,007,325		$	0.35		2.39	$	18,457,476

A summary of the status of nonvested restricted stock activity for the nine months ended September 30, 2009 is as follows:


	Number of			Weighted Average
	Restricted Stock			Grant-Date Fair
	Awards			Value Per Share

Nonvested at December 31, 2008		1,725,360		$	4.15
Granted		740,800			3.42
Vested		(139,344	)		5.20
Forfeited		(253,828	)		3.83

Nonvested at September 30, 2009		2,072,988		$	3.86

Expected to vest at September 30, 2009		1,141,649		$	3.74

Stock-Based Compensation Expense

The impact on our results of operations of recording stock-based compensation expense are as follows for the three and nine months ended September 30:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008		2009		2008
Cost of ratings and advisory revenue	$	65,561	$	27,883	$	120,199	$	67,576
Sales and marketing		323,003		106,323		543,422		79,779
Product development		31,788		26,317		89,088		70,231
General and administrative		477,480		86,389		655,080		109,932

Total stock-based compensation expense	$	897,832	$	246,912	$	1,407,789	$	327,518

Stock-based compensation expense for the three and nine months ended September 30, 2009 includes $589,492 related to restricted stock previously granted to members of our executive management team. The shares vest upon the achievement of performance metrics based upon certain annual revenue and operating income targets. As of September 30, 2009, we concluded that a performance target related to annual revenue was probable of achievement. We expect to recognize an additional $293,877 of expense related to this performance target over the next fifteen months. There was no expense related to performance vesting for the three or nine months ended September 30, 2008.

NOTE 6 – EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per share for the three and nine months ended September 30:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008⁽¹⁾		2009		2008⁽¹⁾
Numerator for both basic and diluted earnings per share:
Net income	$	1,814,059	$	1,321,955	$	5,181,730	$	3,686,624

Denominator:
Denominator for basic net income per common share—weighted average shares		27,782,227		28,185,206		27,524,240		28,518,894
Effect of dilutive securities:
Stock options and restricted stock awards		3,649,119		4,450,707		3,538,769		4,597,078

Denominator for diluted net income per common share—adjusted weighted average shares		31,431,346		32,635,913		31,063,009		33,115,972


Net income per common share (basic)	$	0.07	$	0.05	$	0.19	$	0.13

Net income per common share (diluted)	$	0.06	$	0.04	$	0.17	$	0.11


⁽¹⁾		Presentation and certain computational changes have been made in connection with the adoption of guidance requiring unvested share-based compensation awards that contain nonforfeitable rights to dividends when computing earnings per share. The impact of this retrospective application was to reduce basic and diluted earnings per share for the nine months ended September 30, 2008 by $0.01. See “Recently Adopted Accounting Pronouncements” in Note 1.

For the three and nine months ended September 30, 2009, the number of our issued and outstanding shares of common stock increased by 39,429 and 548,663 shares, respectively, due to the exercise of stock options. For the three and nine months ended September 30, 2009, we received approximately $0.1 million and $0.4, million, respectively, in payment of the exercise price of the options. We record restricted stock awards (“RSAs”) as common stock issued and outstanding upon grant of the awards. During the restriction period, a grantee of an RSA may not sell, assign, transfer, pledge or otherwise dispose of the award, but has the right to vote such shares. Some RSA holders have the right to receive any dividends or other distributions paid on such shares. For the three and nine months ended September 30, 2009, our common shares issued and outstanding increased by 384,300 and 740,800 shares due to grants of RSAs, respectively. During the three and nine months ended September 30, 2008, the number of our issued and outstanding shares of common stock increased by 32,656 and 249,034 shares, respectively, due to the exercise of stock options. For the three and nine months ended September 30, 2008, we received approximately $20,000 and $0.4 million, respectively, in payment of the exercise price of the options. For the three and nine months ended September 30, 2008, the number of our common shares issued and outstanding increased by 250,700 and 283,150, respectively, shares due to grants of RSAs.

NOTE 7 — NONCONTROLLING INTEREST

The following schedule shows the effect of changes in Health Grades, Inc.’s ownership interest in our subsidiary, Healthcare Credit Solutions, LLC, on Health Grades, Inc.’s equity for the nine months ended September 30:


	2009			2008

Net income attributable to Health Grades, Inc.	$	5,181,730		$	3,686,624
Decrease in Health Grades, Inc. additional paid-in capital for purchase of 12.9% of Healthcare Credit Solutions LLC		(266,067	)		—


Change from net income attributable to Health Grades, Inc. and transfers to noncontrolling interest	$	4,915,663		$	3,686,624

NOTE 8 — BUSINESS ACQUISITION

In October 2008, we completed the acquisition of certain operating assets of Adviware Pty Ltd. (“Adviware”), a provider of medical and health information for consumers and health professionals via the websiteswww.WrongDiagnosis.com andwww.CureResearch.com. This transaction was accounted for as a business combination. The purchase price was approximately $6.7 million, paid in cash, including direct transaction costs of approximately $0.5 million.

We are obligated to pay to Adviware contingent cash consideration of up to $1.2 million in each of 2009 and 2010 based on certain future levels of page views and revenue targets. As these contingent payments are based on the achievement of performance targets, actual payments may be substantially lower. Future payments will be recorded as goodwill when earned. As of September 30, 2009, contingent consideration of approximately $0.6 million has been earned. As such, this amount has been accrued and recorded as an increase to goodwill.

The results of operations from the Adviware acquisition have been included in the condensed consolidated financial statements as of the acquisition date, October 13, 2008. Supplemental information on an unaudited pro forma basis, as if the Adviware acquisition had been consummated at the beginning of each of the periods presented, is as follows:


	Three Months		Nine Months
	Ended		Ended
	September 30,		September 30,
	2008		2008
Revenue	$	10,510,683	$	29,635,588
Net income attributable to Health Grades, Inc.	$	1,431,959	$	3,844,011
Net income per share — diluted	$	0.04	$	0.12

The unaudited pro forma supplemental information is based on estimates and assumptions, which we believe are reasonable; it is not necessarily indicative of our consolidated financial position or results of income in future periods or the results that actually would have been realized had we been a combined company during the periods presented. The unaudited pro forma supplemental information includes incremental asset amortization and other charges as a result of the acquisition, net of related tax effects.

NOTE 9 – INCOME TAXES

On January 1, 2007, we adopted the provisions of accounting guidance related to income taxes where tax benefits are recognized only for tax positions that are more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than fifty percent likely to be realized upon ultimate settlement. Unrecognized tax benefits are tax benefits claimed in tax returns that do not meet these recognition and measurement standards.

Upon adoption, and as of September 30, 2009, we had no unrecognized tax benefits – that is, the tax effect of differences between tax return positions and the benefits recognized in our financial statements. We are subject to income taxes in the U.S. and various states. Tax consequences within each jurisdiction are subject to the applicable tax laws and regulations of the specific jurisdiction and often require significant judgment to apply. With few exceptions, we are no longer subject to U.S. federal, state or local income tax examinations by tax authorities for any years before 2002. Our policy is to classify any interest incurred on tax deficiencies as interest expense and income tax penalties as part of income tax expense.

NOTE 10 – SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for income taxes amounted to $2,724,366 and $1,841,785 for the nine months ended September 30, 2009 and 2008, respectively. Cash paid for interest expense amounted to $643 and $90 for the nine months ended September 30, 2009 and 2008, respectively.

Non-cash financing and investing are as follows for the nine months ended September 30:


	2009		2008
Property and equipment included in accrued expenses	$	23,532	$	50,479
Data acquired with stock warrants		100,000		—
Accrued contingent consideration in business combination		607,320		—
Purchase of additional ownership interest in subsidiary		266,067		—
Property and equipment acquired with capital lease		—		1,628

NOTE 11 – RELATED PARTY TRANSACTIONS

On March 17, 2009, Mats Wahlström was named a director of the Company. Mr. Wahlström is co-CEO of Fresenius Medical Care North America (“FMCNA”) and President and CEO of Fresenius Medical Services. We provide services to FMCNA pursuant to an Internet Agreement (the “Agreement”), which became effective June 1, 2008. Under the Agreement, FMCNA sponsors the physician-quality reports of all of its practicing nephrologists found onwww.healthgrades.com, and pays the Company approximately $1.9 million annually. For the three and nine months ended September 30, 2009, we recognized approximately $0.5 million and $1.5 million, respectively, of revenue in connection with the Agreement.

NOTE 12 – SUBSEQUENT EVENTS

We evaluated our September 30, 2009 financial statements for subsequent events through November 9, 2009, the date the financial statements were available to be issued. We are not aware of any subsequent events which would require recognition or disclosure in the financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Statements in this report, including but not limited to statements concerning sufficiency of available funds, contingent consideration payable and exercises of stock options are “forward looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially from those discussed in forward looking statements as a result of various factors, including non-renewal or cancellation of contracts, changes in tax laws or regulations, failure to achieve anticipated revenue increases, unanticipated developments in litigation or arbitration, decline in our stock price, material changes in our balances of cash, cash equivalents and short-term investments and other factors discussed below and as referenced under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2008 (the “Form 10-K”). Furthermore, such forward looking statements speak only as of the date on which such statements are made. We undertake no obligation to update any forward looking statements to reflect events or circumstances after the date of such statements.

OVERVIEW

In evaluating our financial results and financial condition, management has focused principally on revenue growth and client retention, which we believe are key factors affecting both our results of operations and our cash flow from operations. Our increased revenue for the nine months ended September 30, 2009 as compared to the nine months ended September 30, 2008 reflected our success in several Provider Services and Internet Business Group product areas. For our Provider Services business group, we continued adding new hospital clients to our Strategic Quality Partnership (��SQP”), Strategic Quality Initiative (“SQI”), Quality Assessment (“QA”) and Quality Assessment and Improvement (“QAI”) programs and improved our retention rate for existing clients. For our Internet Business Group, we have experienced significant growth as a result of increased traffic to our websites, which includewww.healthgrades.com andwww.WrongDiagnosis.com. The increase in traffic has lead to increased revenue from internet advertising and our quality reports and associated subscription services for physicians and hospitals.

Provider Services

In the current economic environment, both our hospital clients and prospects are facing significant financial challenges. In a recent study published by a leading hospital association, 55% of all hospitals are experiencing a moderate to severe decrease in inpatient admissions and 59% are experiencing a moderate to severe decrease in elective procedures. The challenges hospitals are facing affects us through a lengthening of the sales cycle and through hospitals that would typically purchase our products are choosing not to do so for budgetary reasons. However, we are beginning to see acceleration in sales with the launch of our new fall annual hospital ratings. We also continue to add to our sales team and improve our leadership in this area.

As our base of hospital clients grows, one of our principal objectives is to achieve a high rate of retention of these clients. An obstacle to maintaining high retention rates for our SQP and SQI clients is that clients may have lost their high quality ratings on any given contract anniversary date. In addition, for our contracts with hospitals that have also been awarded an overall hospital designation, such as our Distinguished Hospital Award for Clinical Excellence™, we have found that in many cases the hospitals terminate their contracts with us if they lose the overall hospital designation. For example, hospitals that contract with us for the SQP program typically have been awarded our Distinguished Hospital Award for Clinical Excellence. In addition, the contracts give hospitals the ability to utilize any additional marketing messages they have for our individual service lines. However, if a hospital does not achieve the Distinguished Hospital Award for Clinical Excellence each year of its agreement, it may not place as much value on the individual service line messages and, therefore, may terminate its agreement with us. We have continued to enhance the services provided in our agreements as well as add service line awards that are designed to increase our ability to retain these clients.

We typically receive a non-refundable payment for the first year of the contract term, which is typically three years, subject to a cancellation right that may be exercised by either the client or us on each annual anniversary date, upon contract execution. Because we typically receive payment in advance for each year of the term of these agreements, if we cannot continue to attract new hospital clients and retain a significant portion of our current clients, our cash flow from operations could be adversely affected.

For the nine months ended September 30, 2009, we retained or signed new contracts representing approximately 80% of the annual contract value of hospitals whose contracts had first or second year anniversary dates, compared to 78% for the nine months ended September 30, 2008. This increase in contracts retained is primarily a result of our efforts to ensure that our clients view us as strategic partners. For contracts that expired at the end of their three-year term, our retention rate is lower, especially with respect to our QAI clients, than our retention rate for contracts at their first or second anniversary dates, when hospitals may exercise their cancellation option. Some of our QAI clients view a three-year term as the culmination of their improvement efforts rather than a starting point. The increase in our contract prices over the last several years also has caused some hospitals to decline renewal. Because we give our clients a fixed annual contract price during the three-year term, our price points for renewals may have increased significantly by the expiration of the contract.

Internet Business Group

Revenue from our Internet Business Group includes internet advertising and sponsorship, quality report sales and our Connecting Point and Focal Point offerings. Our Connecting Point program is designed to increase the efficiency and profitability of participating sponsoring entities and physicians through marketing and patient education. Our Focal Point program allows marketers to reach targeted patient populations through exclusive sponsorship packages, which gives brand access to chosen patients. Revenue from our Internet Business Group is dependent upon the traffic and perception of our websites. We continue to add staff with expert knowledge in Search Engine Optimization (“SEO”) and internet advertising. Our efforts have led us to successfully monetize this increased traffic. With approximately 17 million total unique visitors per month, the combined traffic from our principal web properties,www.healthgrades.com andwww.WrongDiagnosis.com, currently ranks us eighth on overall healthcare properties by ComScore, a global leader in measuring the digital world and the preferred source of digital marketing intelligence. In addition to our SEO efforts and licensing our data to other web publishers, the addition ofwww.WrongDiagnosis.com has contributed significantly to our growth.

We earn revenue from sales of advertisements on our websites through impression-based advertising (fees earned from the number of times an advertisement appears in pages viewed by users of our website) and activity based advertising (fees earned when our users click on an advertisement or text link to visit the websites of our merchant partners). Advertisements are served via direct placement, agency or ad network relationships. We have been gaining traction in the medical device and pharmaceutical industries and have begun running direct advertising campaigns, which have premium market pricing.

RESULTS OF OPERATIONS

Revenue Overview


	Three months		Three months		Nine months		Nine months
	ended		ended		ended		ended
	September 30,		September 30,		September 30,		September 30,
Product Area	2009		2008		2009		2008

Provider Services	$	7,778,065	$	7,371,214	$	23,541,665	$	21,440,269

Internet Business Group		4,957,029		2,116,348		12,896,673		5,534,571

Strategic Health Solutions		567,239		535,811		1,723,889		1,469,720

Total	$	13,302,333	$	10,023,373	$	38,162,227	$	28,444,560

We provide revenue information with respect to three business areas: Provider Services, Internet Business Group and Strategic Health Solutions. Our Provider Services revenue includes sales of marketing products (SQI and SQP) and quality improvement products (QA and QAI), as well as revenue from our consultant-reimbursed travel. Our Internet Business Group revenue includes internet and sponsorship revenue, the sale of our quality reports to consumers and revenue from our Connecting Point (formerly known as Internet Patient Acquisition™) and Focal Point offerings. Our Strategic Health Solutions revenue includes sales of our quality information through our HealthGrades Health Management Suite to employers, benefit consulting firms, payers and others, as well as revenue derived from our majority interest subsidiary, Healthcare Credit Solutions LLC.

Ratings and advisory revenue.Ratings and advisory revenue for the three months ended September 30, 2009 increased $3.3 million, or 33%, to $13.3 million from $10.0 million over the three months ended September 30, 2008. For the nine months ended September 30, 2009, ratings and advisory revenue increased $9.8 million, or 34%, to $38.2 million from $28.4 million over the nine months ended September 30, 2008. The revenue growth was principally driven by an increase in our Provider Services and Internet Business Group products, as discussed below.

Provider Services

For the three months ended September 30, 2009, Provider Services revenue was $7.8 million, an increase of $0.4 million, or 6%, over the three months ended September 30, 2008. For the nine months ended September 30, 2009, Provider Services revenue was $23.5 million, an increase of $2.1 million, or 10%, over the nine months ended September 30, 2008. This increase reflects increased revenue from both our marketing and quality-improvement products. For the nine months ended September 30, 2009 and 2008, 34% and 33%, respectively, of all new sales in Provider Services were to existing clients. For the nine months ended September 30, 2009 and 2008, we retained or signed new contracts representing approximately 80% and 78%, respectively, of the annual contract value of hospitals whose contracts had first or second year anniversary dates.

Internet Business Group

For the three months ended September 30, 2009, Internet Business Group revenue was $5.0 million, an increase of $2.8 million, or 134%, over the three months ended September 30, 2008. For the nine months ended September 30, 2009, Internet Business Group revenue was $12.9 million, an increase of $7.4 million, or 133%, over the nine months ended September 30, 2008. This increase in revenue is a result of growth from all products in the Internet Business Group. For the three and nine months ended September 30, 2009, our internet advertising and sponsorship revenue included $1.3 million and $3.2 million, respectively, fromwww.WrongDiagnosis.com, the website acquired from Adviware in October 2008. In addition, for the nine months ended September 30, 2009, revenue from Connecting Point included approximately $1.5 million related to our agreement with Fresenius Medical Care North America, signed in June 2008. Revenue from quality reports to consumers also increased $1.8 million over the nine months ended September 30, 2008, due to sales of our Watchdog subscription services.

Strategic Health Solutions

For the three months ended September 30, 2009, Strategic Health Solutions revenue was $0.6 million, unchanged from the three months ended September 30, 2008. For the nine months ended September 30, 2009, Strategic Health Solutions revenue was $1.7 million, an increase of $0.2 million, or 17%, over the nine months ended September 30, 2008.

Cost of ratings and advisory revenue.For the three and nine months ended September 30, 2009, cost of ratings and advisory revenue was $1.8 million and $5.5 million, or 13% and 14% of ratings and advisory revenue, compared to $1.6 million and $4.7 million, or 16% and 17% of ratings and advisory revenue, for the three and nine months ended September 30, 2008, respectively. The decrease in cost of ratings and advisory revenue as a percentage of ratings and advisory revenue is due in part to the cost to acquire data remaining relatively flat. In addition, sales consultant costs have been relatively consistent while ratings and advisory revenue has increased. The decrease in cost of ratings and advisory revenue as a percentage of ratings and advisory revenue also is a result of the change in revenue mix due to the growth in Internet Business Group revenue, which has a higher gross margin.

Sales and marketing costs.Sales and marketing costs for the three and nine months ended September 30, 2009 were $3.2 million and $9.6 million, or 24% and 25%, respectively, of ratings and advisory revenue. Sales and marketing costs were $2.7 million and $7.4 million, or 27% and 26% of ratings and advisory revenue, for the three and nine months ended September 30, 2008, respectively. The increase in sales and marketing costs in the three and nine months ended September 30, 2009 over the same periods in 2008 is mainly due to an increase in expenses in stock-based compensation, sales personnel, associated travel expenses and investments we have made in our sponsorship and advertising business. In addition, sales and marketing expenses increased to promote internet advertising on our websites atwww.WrongDiagnosis.com andwww.CureResearch.com, which we acquired in October 2008.

Product development costs. Product development costs for the three and nine months ended September 30, 2009 were $2.2 million and $6.6 million, or 17% of ratings and advisory revenue. Product development costs were $1.9 million and $5.3 million, or 19% of ratings and advisory revenue, for the three and nine months ended September 30, 2008, respectively. This increase is principally due to additional personnel hired to support product development efforts, including both the improvement of existing products and the development of new product offerings. In particular, we added personnel to focus on advertising initiatives, as well as several projects that are in process with our search engine partners. We also continue to invest in initiatives to both improve our existing data, as well as bring new and actionable data to consumers. In addition, we continue to invest in the improvement of physician data. The physician data that we maintain relates to nearly 800,000 physicians. We continue to acquire new physician data and refine our data-matching process to improve both the impact and the accuracy of this information.

General and administrative expenses.General and administrative expenses for the three and nine months ended September 30, 2009 were $3.2 million and $8.4 million, or 24% and 22% of ratings and advisory revenue, respectively. General and administrative expenses were $1.9 million and $5.9 million, or 19% and 21% of ratings and advisory revenue, for the three and nine months ended September 30, 2008, respectively. This increase is principally due to stock-based compensation expense, personnel hired and additional leased office space to support our growth.

Operating income. Operating income for the three months ended September 30, 2009 was $2.9 million, a $0.9 million increase, or 46%, over the three months ended September 30, 2008. Operating income for the nine months ended September 30, 2009 was $8.1 million, a $3.0 million increase, or 57%, over the nine months ended September 30, 2008.

Income taxes.Income taxes increased to $1.1 million and $3.1 million for the three and nine months ended September 30, 2009, respectively, from $0.8 million and $2.1 million for the three and nine months ended September 30, 2008, respectively. For the three months ended September 30, 2009 and 2008, our effective income tax rate was approximately 39% and 38%, respectively. For the nine months ended September 30, 2009 and 2008, our effective income tax rate was approximately 38%.

Noncontrolling interest. Noncontrolling interest, which represents HealthCo, LLC’s share of the operating loss of Healthcare Credit Solutions LLC, was $45,000 and $180,000 for the three and nine months ended September 30, 2009, respectively, compared to $53,000 and $237,000 for the three and nine months ended September 30, 2008, respectively.

Net income attributable to Health Grades, Inc.As a result of the foregoing, net income attributable to Health Grades, Inc. was $1.8 million and $5.2 million, or $0.06 and $0.17 per diluted share for the three and nine months ended September 30, 2009, respectively, compared to $1.3 million and $3.7 million, or $0.04 and $0.11 per diluted share, for the three and nine months ended September 30, 2008, respectively.

Recently Adopted Accounting Pronouncements

Recently Issued Accounting Pronouncements Not Yet Adopted

There were no other new accounting pronouncements issued during the nine months ended September 30, 2009 that had a material impact or are anticipated to have a material impact on our financial position, cash flows or operating results.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2009, we had $14.2 million in cash and cash equivalents, a 25% increase from the balance of $11.3 million at December 31, 2008. The increase is due to $4.0 million of cash provided by operations, which was partially offset by $1.6 million used for purchases of property and equipment during the nine months ended September 30, 2009.

As of September 30, 2009, we had working capital of $3.5 million, an increase of $5.6 million from a working capital deficit of $2.1 million as of December 31, 2008. Included in current liabilities as of September 30, 2009 is $15.7 million in deferred revenue, which principally represents contract payments for future marketing and quality improvement services to hospitals. These amounts will be reflected in revenue upon provision of the related services.

On April 13, 2009, we entered into a Loan and Security Agreement with Silicon Valley Bank for a revolving line of credit of up to $5.0 million maturing on April 13, 2011. We may borrow, repay and re-borrow under the revolving line of credit at any time. The amount that we are able to borrow under the line of credit will vary based on the availability amount, as defined in the Loan and Security Agreement. The line of credit facility bears interest at the greater of 5% or the bank’s prime rate plus 0.5%. The bank’s prime rate was 4% at November 9, 2009. The line of credit is collateralized by substantially all of our assets and requires us to comply with customary affirmative and negative covenants principally relating to the use and disposition of assets, satisfaction of a quick ratio test, and minimum operating income. In addition, the Loan and Security Agreement contains customary events of default. Upon occurrence of an uncured event of default, among other things, the bank may declare that all amounts owed under the line of credit are immediately due and payable. We were in compliance with all such covenants as of September 30, 2009. As of September 30, 2009, we had $0 outstanding on the line of credit and we were in compliance with all such covenants.

We also have available a standby letter of credit with Silicon Valley Bank in the amount of $45,000, which was provided in January 2005 in connection with our entry into a lease for our office in Golden, Colorado. As of November 9, 2009, the amount drawn under the standby letter of credit is $0 and is secured by the cash and cash equivalents we maintain with Silicon Valley Bank. We currently have no other credit arrangements.

For the nine months ended September 30, 2009, cash provided by operations was $4.0 million compared to cash provided by operations of $3.5 million for the nine months ended September 30, 2008, an increase of $0.5 million. Net cash flow used in investing activities was $1.6 million for the nine months ended September 30, 2009, compared to $1.1 million for the nine months ended September 30, 2008, an increase of cash used of $0.5 million. During the nine months ended September 30, 2009 and 2008, we incurred $1.6 million and $1.1 million, respectively, in capital expenditures. The majority of these expenditures were principally for the purchase and development of computer hardware and software. For the nine months ended September 30, 2009, net cash flow provided by financing activities was $0.5 million. For the nine months ended September 30, 2008, net cash flow used in financing activities was $9.3 million.

Included in cash flow used in financing activities for the nine months ended September 30, 2008 was $9.8 million in purchases of treasury stock that were primarily made under our stock repurchase program. We did not repurchase any shares of our common stock under our stock repurchase program during the nine months ended September 30, 2009. Since June 22, 2006 and through September 30, 2009, under a stock repurchase program approved by our board of directors, we have repurchased 4,242,202 shares of our common stock for an aggregate purchase price of $19,572,461, which includes commissions and fees of $169,936. As of September 30, 2009, we have 757,798 shares available for repurchase under the stock repurchase program.

During the nine months ended September 30, 2009, the number of issued and outstanding shares of our common stock increased by 548,663 shares due to the exercise of stock options by our employees. We received approximately $416,000 in cash from the exercise of these stock options. As of September 30, 2009, there are outstanding options to purchase approximately 4.0 million shares of our common stock, at a weighted average exercise price of $0.35 per share. Therefore, we anticipate that additional options will be exercised. We also record restricted stock awards (“RSAs”) as common stock issued and outstanding upon grant of the award. During the restriction period, a grantee of an RSA may not sell, assign, transfer, pledge or otherwise dispose of the award, but has the right to vote these shares. Some RSA holders have the right to receive dividends or other distributions paid on the shares underlying the RSAs. For the nine months ended September 30, 2009, the issued and outstanding shares of our common stock increased by 740,800 shares due to grants of RSAs.

Stock-based compensation expense for the three and nine months ended September 30, 2009 include $589,492 related to restricted stock previously granted to members of our executive management team. The shares vest upon the achievement of performance metrics based upon certain annual revenue and operating income targets. As of September 30, 2009, we concluded that a performance target related to annual revenue was probable of achievement. We expect to recognize an additional $293,877 of expense related to this performance target over the next fifteen months. There was no expense related to performance vesting for the three or nine months ended September 30, 2008.

As of November 9, 2009, we anticipate that our total 2009 capital expenditures will be approximately $2.1 million. For the nine months ended September 30, 2009, we have incurred $1.7 million of capital expenditures. We expect to fund all capital expenditures through current operations.

We are obligated to pay contingent consideration with respect to the acquisition of the websiteswww.WrongDiagnosis.com andwww.CureResearch.com of up to $1.2 million in each of 2009 and 2010 based on levels of page views and revenue targets. As these contingent payments are based on the achievement of performance targets, actual payments may be substantially lower. Future payments will be recorded as goodwill when paid. The maximum payment for page views in 2009 is approximately $0.6 million, and the maximum payment for revenue is approximately $0.6 million. As of November 9, 2009, Tier IV of the revenue target representing 50% of the contingent consideration obligation, or approximately $0.6 million, was achieved. Our anticipated payment amount is subject to change based upon actual results for the year ending December 31, 2009.

We anticipate that we have sufficient funds available to support ongoing operations at their current level. As noted above, upon execution of our SQI, SQP and QAI agreements, we typically receive a non-refundable payment for the first year of the contract term (which is typically three years, subject to a cancellation right that may be exercised by either the client or us on each annual anniversary date, with certain exceptions). We record the cash payment as deferred revenue, which is a current liability on our balance sheet that is then amortized to revenue on a straight-line basis over the first year of the term. Annual renewal payments, which are made in advance of the year to which the payment relates, are treated in the same manner during each of the following two years. As a result, our operating cash flow is substantially dependent upon our ability to continue to sign new agreements, and to continue to maintain a high rate of client retention. Our current operating plan includes growth in new sales from these agreements. A significant failure to achieve sales targets in the plan would have a material negative impact on our financial position and cash flow.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal, maintain liquidity and achieve an acceptable rate of return. We seek to achieve these objectives through an investment policy that establishes guidelines of eligible types of securities and credit requirements for each investment.

Changes in prevailing interest rates will cause the market value of our investments to fluctuate. To minimize this risk, we maintain cash in an overnight investment account that includes short-term U.S. government obligations with maturities not exceeding three months and investments in a short-term investment account that includes U.S. government and government agency debt securities with original maturities not exceeding three months. As of September 30, 2009, our total investment in these accounts amounted to $11.4 million. This amount is included in the cash and cash equivalents on the Condensed Consolidated Balance Sheets. For the nine months ended September 30, 2009, interest earned on these accounts was $17,000.

As of November 9, 2009, we had no borrowings outstanding under our revolving line of credit. We do not believe we are exposed to material direct risks associated with changes in interest rates other than with our cash and cash equivalents and short-term investments.

We have not utilized derivative financial instruments in our investment portfolio.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of September 30, 2009.

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Indemnification of our Chief Executive Officer and Derivative Complaint

Reference is made to the disclosure in our Form 10-K for the year ended December 31, 2008 under Item 3, “Legal Proceedings,” relating to the indemnification of our Chief Executive Officer and the derivative action brought by Daniel C. Cadle in December 2006. See also the disclosure in Note 4 of the notes to the condensed consolidated financial statements contained in this report.

Gotham/Primarius Complaint

Reference is made to the disclosure in our Form 10-K for the year ended December 31, 2008 under Item 3, “Legal Proceedings,” relating to the Gotham/Primarius litigation. See also the disclosure in Note 4 of the notes to the condensed consolidated financial statements contained in this report.

ITEM 1A. RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, financial condition, results of operations, cash flows, and trading price of our common stock. Please refer to our Form 10-K for the year ended December 31, 2008 for information concerning risks and uncertainties that could negatively impact us.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Repurchases of Equity Securities

On June 22, 2006, our Board of Directors authorized the repurchase of up to 3,000,000 shares of our common stock under a stock repurchase program that does not have an expiration date and may be limited or terminated at any time without prior notice. On March 19, 2008, our Board of Directors approved an increase of an additional 500,000 shares to be repurchased under the current repurchase program. On July 22, 2008, our Board of Directors increased the stock repurchase authorization from 3,500,000 shares to 5,000,000 shares. Under the repurchase program, purchases may be made at management’s discretion from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing. During the nine months ended September 30, 2009, we did not repurchase any shares of our common stock under the stock repurchase program. From the inception of the repurchase program through September 30, 2009, we have repurchased 4,242,202 shares of our common stock recorded as treasury stock at an average purchase price per share of $4.61, for an aggregate cost of $19,572,461, which includes commissions and fees of $169,936.

The following chart provides information regarding common stock purchases by us for the nine months ended September 30, 2009.

Issuer Purchases of Equity Securities

Total

Number of

Maximum

Number of

Purchased

Shares That

as Part of

May Yet Be

Total

Publicly

Purchased

Number of

Average

Announced

Under the

Price Paid

Plans or

Period

Purchased⁽¹⁾

per Share

Programs

July 1, 2009 through July 31, 2009

29,833

4.12

—

757,798

August 1, 2009 through August 31, 2009

292

4.78

—

757,798

September 1, 2009 through September 30, 2009

301

4.21

—

757,798

Total

30,426

4.13

—

757,798


⁽¹⁾		Shares purchased represent the portion of employee payroll taxes associated with vested restricted stock awards.

ITEM 6. EXHIBITS

Exhibits –


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

	3.2			Amended Bylaws (Incorporated by reference to Exhibit 3.2 to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2004).

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

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

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

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

SIGNATURES

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


	HEALTH GRADES, INC.
Date: November 9, 2009	By:	/s/ Allen Dodge
		Allen Dodge
		Executive Vice President / CFO

EXHIBIT INDEX


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

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

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

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

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. sophomore Good

Health Grades (HGRD) Inactive 10-Q2009 Q3 Quarterly report

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