Health Grades (HGRD) 10-Q 2005 Q2 Quarterly report

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 ended                    JUNE 30, 2005                    

OR

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 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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

     On July 31, 2005, 27,421,806 shares of the Registrant’s common stock, $.001 par value, were outstanding.

Health Grades, Inc.

INDEX

PART I. FINANCIAL INFORMATION:
Item 1.	Condensed Balance Sheets
	June 30, 2005 and December 31, 2004	3
	Condensed Statements of Income -
	Three and Six Months Ended June 30, 2005 and 2004	4
	Condensed Statements of Cash Flows -
	Six Months Ended June 30, 2005 and 2004	5
	Notes to Condensed Financial
	Statements	6
Item 2.	Management's Discussion and Analysis of Financial
	Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About
	Market Risk	14
Item 4.	Controls and Procedures	14
PART II. OTHER INFORMATION:
Item 1.	Legal Proceedings	14
Item 4.	Submission of Matters to a Vote of Security Holders	14
Item 6.	Exhibits and Reports on Form 8-K	15
1996 Equity Compensation Plan
Certification of CEO Required by Rule 15d-14(a)
Certification of CFO Required by Rule 15d-14(a)
Certification of CEO Required by Rule 15d-14(b)
Certification of CFO Required by Rule 15d-14(b)

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PART I. FINANCIAL INFORMATION
Health Grades, Inc.

Condensed Balance Sheets

(Unaudited)

	JUNE 30,			DECEMBER 31,
	2005			2004
ASSETS
Cash and cash equivalents	$	8,035,071		$	6,153,862
Accounts receivable, net		2,567,407			3,034,375
Prepaid expenses and other		468,369			253,839
Deferred income taxes		1,593,416			—
Total current assets		12,664,263			9,442,076
Property and equipment, net		1,116,663			382,870
Intangible assets, net		209,093			—
Goodwill		3,106,181			3,106,181
Deferred income taxes		16,324			—
Total assets	$	17,112,524		$	12,931,127
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable	$	309,781		$	44,035
Accrued payroll, incentive compensation and related expenses		879,089			1,178,581
Accrued expenses		243,467			322,777
Current portion of capital lease obligations		1,271			—
Current portion of deferred rent		45,974			—
Deferred income		8,125,606			7,729,195
Income taxes payable		—			71,298
Total current liabilities		9,605,188			9,345,886
Long-term portion of capital lease obligations		5,919			—
Long-term portion of deferred rent		349,767			—
Total liabilities		9,960,874			9,345,886
Commitments and contingencies
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, and 46,985,114 and 44,880,176 shares issued in 2005 and 2004, respectively		46,985			44,880
Additional paid-in capital		91,196,344			90,094,408
Accumulated deficit		(70,324,099	)		(72,786,467	)
Treasury stock, 19,563,390 shares		(13,767,580	)		(13,767,580	)
Total stockholders’ equity		7,151,650			3,585,241
Total liabilities and stockholders’ equity	$	17,112,524		$	12,931,127

See accompanying notes to condensed financial statements

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Health Grades, Inc.

Condensed Statements of Income

(Unaudited)

	THREE MONTHS ENDED					SIX MONTHS ENDED
	JUNE 30,					JUNE 30,
	2005			2004		2005			2004
Revenue:
Ratings and advisory revenue	$	4,868,748		$	3,500,314	$	9,568,675		$	6,717,737
Other		387			867		6,939			1,117
		4,869,135			3,501,181		9,575,614			6,718,854
Expenses:
Cost of ratings and advisory revenue		795,997			548,103		1,522,757			1,210,306
Gross margin		4,073,138			2,953,078		8,052,857			5,508,548
Operating expenses:
Sales and marketing		1,270,813			1,152,999		2,615,756			2,244,449
Product development		734,664			445,232		1,517,958			910,682
General and administrative		1,246,867			731,214		2,563,872			1,534,423
Income from operations		820,794			623,633		1,355,271			818,994
Other:
Gain on sale of assets and other		1,405			—		1,405			—
Interest income		34,316			3,233		54,748			5,083
Interest expense		(73	)		—		(73	)		—
Income before income taxes		856,442			626,866		1,411,351			824,077
Income tax benefit		1,051,017			—		1,051,017			—
Net income	$	1,907,459		$	626,866	$	2,462,368		$	824,077
Net income per common share (basic)	$	0.07		$	0.03	$	0.09		$	0.03
Weighted average number of common shares used in computation (basic)		26,889,435			25,030,159		26,437,470			24,932,969
Net income per common share (diluted)	$	0.05		$	0.02	$	0.07		$	0.03
Weighted average number of common shares used in computation (diluted)		34,955,601			33,023,883		34,703,918			32,545,662

See accompanying notes to condensed financial statements.

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Health Grades, Inc.

Condensed Statements of Cash Flows

(Unaudited)

	SIX MONTHS ENDED JUNE 30,
	2005			2004
OPERATING ACTIVITIES
Net income	$	2,462,368		$	824,077
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		167,577			63,272
Bad debt expense		20,000			—
Deferred income tax benefit		(983,369	)		—
Gain on disposal of assets		4,481			—
Non-cash compensation expense related to non-employee stock options		—			142,500
Change in operating assets and liabilities:
Accounts receivable, net		446,968			598,200
Prepaid expenses and other assets		(214,530	)		4,033
Accounts payable and accrued expenses		186,436			(37,602	)
Accrued payroll, incentive compensation and related expenses		(299,492	)		(250,214	)
Income taxes payable		(71,298	)		(1,100	)
Current portion of capital lease obligations		(344	)		—
Current portion of deferred rent		3,690			—
Deferred income		396,411			(393,223	)
Deferred rent		392,051			—
Net cash provided by operating activities		2,510,949			949,943
INVESTING ACTIVITIES
Purchase of property and equipment		(916,360	)		(150,759	)
Acquisition of intangible assets		(200,000	)		—
Sale of property and equipment		8,950			—
Net cash used in investing activities		(1,107,410	)		(150,759	)
FINANCING ACTIVITIES
Exercise of common stock options		477,670			53,854
Net cash provided by financing activities		477,670			53,854
Net increase in cash and cash equivalents		1,881,209			853,038
Cash and cash equivalents at beginning of period		6,153,862			3,559,125
Cash and cash equivalents at end of period	$	8,035,071		$	4,412,163

See accompanying notes to condensed financial statements.

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Health Grades, Inc.

Notes to Condensed Financial Statements (Unaudited)

June 30, 2005

NOTE 1 — BASIS OF PRESENTATION

The accompanying unaudited condensed financial statements of Health Grades, Inc. have been prepared in accordance with accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America 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 six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004.

NOTE 2 — STOCK-BASED COMPENSATION

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R),Share-Based Payment(SFAS 123(R)). SFAS No. 123(R) requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, and allowed under the original provisions of SFAS No. 123,Accounting for Stock-Based Compensation. SFAS 123(R) requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. In April 2005, the Securities and Exchange Commission delayed the effective date of SFAS 123(R), which is now effective for public companies for annual, rather than interim, periods that begin after June 15, 2005.

We account for our stock-based compensation arrangements using the intrinsic value method under the provisions of APB No. 25 and related interpretations. Under SFAS 123(R), we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123(R). We are evaluating the requirements of SFAS 123(R) and anticipate that we will adopt the prospective transition method. Although we have not yet determined the fair value model to be used for valuing share-based payments, if we continued the utilization of the Black-Scholes option valuation model we would record additional compensation expense related to our adoption of SFAS 123(R) with respect to the stock options that are outstanding as of June 30, 2005 of slightly less than $600,000 for the year ended December 31, 2006. Depending upon the option valuation model we ultimately determine to utilize and the amount of any share-based payments granted during the remainder of 2005 and during 2006, this amount may not be indicative of the actual expense we incur during 2006.

Pro forma information regarding net income and earnings per share is required by Statement of Financial Accounting Standards No. 123,Accounting for Stock Based Compensation(SFAS 123) and has been determined as if we had accounted for our employee stock options under the fair value method of that accounting pronouncement. The Black-Scholes option valuation model was utilized for the purpose of this disclosure. The Black-Scholes model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options’ vesting period. Because compensation expense associated with an award is recognized over the vesting period, the impact on pro forma net income (loss) as disclosed below may not be representative of compensation expense in future years.

For the six months ended June 30, 2005, the fair value of options awarded during this period were estimated using the Black Scholes model with the following assumptions: a risk-free interest rate over the life of the options of between 3.67% to 3.96%; no dividend yield; and expected three year lives of the options. The volatility factors utilized ranged from 1.50 to 1.58.

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For the six months ended June 30, 2004, the fair value of options awarded during this period were estimated using the Black Scholes model with the following assumptions: a risk-free interest rate over the life of the options of between 2.44% to 3.16%; no dividend yield; and expected three year lives of the options. The volatility factors utilized ranged from 1.76 to 1.78.

	Three months ended June 30,						Six months ended June 30,
	2005			2004			2005			2004
Net income as reported	$	1,907,459		$	626,866		$	2,462,368		$	824,077
Add: Stock-based compensation expense included in reported net income under APB No. 25		—			—			—			—
Less: Total stock-based compensation expense determined under fair value based method for awards, net of related tax effects		(134,703	)		(31,290	)		(237,705	)		(65,403	)
Pro forma net income	$	1,772,756		$	595,576		$	2,224,663		$	758,674
Income per share:
Basic as reported	$	0.07		$	0.03		$	0.09		$	0.03
Diluted as reported	$	0.05		$	0.02		$	0.07		$	0.03
Basic pro forma	$	0.07		$	0.02		$	0.08		$	0.03
Diluted pro forma	$	0.05		$	0.02		$	0.06		$	0.02

The following table sets forth the computation of basic and diluted earnings per share for the three and six months ended June 30, 2005 and 2004.

	Three months ended June 30,				Six months ended June 30,
	2005		2004		2005		2004
Numerator for both basic and diluted earnings per share:
Net income	$	1,907,459	$	626,866	$	2,462,368	$	824,077
Denominator:
Denominator for basic net income per common share—weighted average shares		26,889,435		25,030,159		26,437,470		24,932,969
Effect of dilutive securities:
Stock options and warrants		8,066,166		7,993,724		8,266,448		7,612,693
Denominator for diluted net income per common share—adjusted weighted average shares and assumed conversion		34,955,601		33,023,883		34,703,918		32,545,662
Net income per common share (basic)	$	0.07	$	0.03	$	0.09	$	0.03
Net income per common share (diluted)	$	0.05	$	0.02	$	0.07	$	0.03

During the six months ended June 30, 2005, the number of our common shares issued increased by approximately 1.7 million shares due to the exercise of stock options. We received approximately $467,000 in cash from this exercise of stock options, which represents the exercise price of the options. As of June 30, 2005, we have outstanding options to purchase approximately 8.2 million shares of our common stock, the majority of which have exercise prices of less than $2.00 per share. Therefore, we anticipate that additional options will be exercised.

NOTE 3 — LINE OF CREDIT

On May 13, 2002, we completed a line of credit arrangement (the “Agreement”) with Silicon Valley Bank. Through subsequent amendments, we extended the term of the Agreement to February 13, 2006. Under the terms of the Agreement, we were entitled to request advances not to exceed an aggregate amount of $1.0 million over the term of the Agreement, subject to a limit of 75% of Eligible Accounts (as defined in the Agreement) plus 50% of our cash invested with Silicon Valley Bank. To date we have not borrowed any funds under the Agreement.

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Advances under the Agreement bear interest at Silicon Valley Bank’s prime rate plus 0.5% and are secured by substantially all of our assets. Interest is due monthly on advances outstanding and the principal balance of any advances taken by us are due at the end of the Agreement term. Our ability to request advances under the Agreement is subject to certain financial and other covenants. As of June 30, 2005, we had no advances outstanding and we were in compliance with the covenants. In connection with a lease we executed for our new headquarters in Golden, Colorado, in December 2004, 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 subject to the letter of credit reduces the amount we can request as an advance under the Agreement. Therefore, as of June 30, 2005, $500,000 of our line of credit was available to us.

NOTE 4 — PROPERTY AND EQUIPMENT, NET

At June 30, 2005, property and equipment, net includes approximately $130,000 capitalized in connection with software we have developed for a web-hosting application. We evaluated the costs to be capitalized in accordance with the provisions of Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Useand EITF 00-3,Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware. Based upon these pronouncements, we capitalized costs related to the application development of the web-hosting software and will continue to capitalize additional application development costs until such time that the software is ready for its intended use after all substantial testing is completed, which is anticipated to occur in August 2005. When this software is ready for its intended use, we will begin amortizing these costs on a straight-line basis over the estimated useful life of the software.

NOTE 5 — INCOME TAXES

The provision for income taxes is made pursuant to the liability method as prescribed in Statement of Financial Accounting Standards No. 109,Accounting for Income Taxes. This method requires recognition of deferred income taxes based on temporary differences between the financial reporting and income tax bases of assets and liabilities, using currently enacted income tax rates and regulations.

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities at June 30, 2005 and December 31, 2004 are as follows:

	June 30, 2005		December 31, 2004
Deferred tax assets:
Accrued liabilities	$	40,131	$	49,741
Allowance for doubtful accounts		13,390		6,247
Intangible assets, net		7,946		—
Deferred rent		150,381		—
Net operating loss carryforwards		1,716,169		1,574,402
		1,928,017		1,630,390
Valuation allowance for deferred tax assets		—		(1,500,550	)
Gross deferred tax asset		1,928,017		129,840
Deferred tax liabilities:
Prepaid expenses		176,274		104,075
Property and equipment, net		142,003		25,765
Gross deferred tax liability		318,277		129,840
Net deferred tax asset	$	1,609,740	$	—

During the six month period ended June 30, 2005, the valuation allowance for deferred tax assets was reduced by $1,500,550. The valuation allowance at December 31, 2004 resulted from uncertainty regarding our ability to realize the benefits of the related deferred tax assets. In accordance with Statement of Financial Accounting Standards No. 109,Accounting for Income Taxes, we assessed the continuing need for the valuation allowance and concluded that, consistent with criteria we established in 2004, the valuation allowance was no longer required.

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The income tax (benefit) expense for the six months ended June 30, 2005 and 2004, respectively, is summarized as follows:

	June 30, 2005			June 30, 2004
Current:
Federal	$	—		$	—
State		(67,648	)		—
		(67,648	)		—
Deferred:
Federal		(863,553	)		—
State		(119,816	)		—
		(983,369	)		—
Total	$	(1,051,017	)	$	—

The total income tax (benefit) expense differs from amounts currently payable because certain revenues and expenses are reported in the statement of operations in periods that differ from those in which they are subject to taxation. The principal differences relate to different methods of calculating depreciation and deferred rent for financial statement and income tax purposes, currently deductible book prepaid amounts and currently non-deductible book accruals and reserves.

The deferred income tax benefit summarized above does not include a tax benefit of $626,371 related to certain employee stock option transactions. In accordance with Financial Accounting Standards No. 109,Accounting for Income Taxes, this tax benefit has been recorded as an increase to stockholder’s equity in the accompanying condensed balance sheet. In addition, this tax benefit has been recorded as a cash flow from operations in the accompanying condensed statement of cash flows.

As of June 30, 2005, we have approximately $4,500,000 in net operating loss carryforwards which may be used to offset future taxable income. These loss carryforwards expire from 2019 through 2025. Certain changes in our stock ownership during 2001 resulted in an ownership change pursuant to the tax laws and, due to this change, approximately $800,000 of our net operating loss carryforwards are subject to restrictions on the timing of their use. The remaining $3,700,000 of net operating loss carryforwards are not subject to any use limitations.

NOTE 6 — DEFERRED RENT

As of June 30, 2005, we had approximately $395,741 recorded as deferred rent in our accompanying condensed balance sheet. Deferred rent relates principally to cash payments we received from the landlord of our new office facility as reimbursement for tenant improvements we made. In addition, deferred rent includes approximately two and a half months of construction period rent from the period beginning on the date upon which we accepted delivery of the premises and when we actually moved into the facility. Deferred rent will be amortized as a reduction to rent expense over the sixty-three month term of our lease.

NOTE 7 — LEGAL PROCEEDINGS

In 2004, we provided indemnification to our Chief Executive Officer, Kerry R. Hicks, for legal fees totaling approximately $272,000 relating to litigation involving Mr. Hicks. We provided additional indemnification of approximately $266,000 during the six months ended June 30, 2005. The litigation 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 a minority interest in an internet healthcare rating business that has become our current healthcare provider rating and advisory services business. We were the majority owner of the business, but had agreed with the holder of the minority interest 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 were compelled to convert 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 their 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 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 federal court in Tennessee 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.

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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 court for abuse of process, defamation and intentional infliction of emotional distress. The 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 after consideration of the other pending claims. An arbitration hearing was held in February 2005 on the other claims submitted by the parties.

In April 2005, the arbitrator announced his determination. 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 federal court in Tennessee. The arbitrator determined that the bank had no liability.

Mr. Hicks has not been paid the arbitration award. The collection agency sought reconsideration of the ruling by the arbitrator, who denied the request. Mr. Hicks has filed a motion with the federal district court to confirm the award. The collection agency has opposed confirmation and has sought to vacate the award. The court has set a hearing date in November 2005 to consider these matters. In addition, the arbitrator has not ruled on, among other things, the claims that the arbitrator stayed prior to the February 2005 hearing. Discovery has been scheduled and an arbitration hearing on these remaining matters has been set for December 2005.

Our 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. Although we expect to indemnify Mr. Hicks for additional legal expenses incurred in 2005, we do not expect these expenses to be material in relation to our total operating expenses in 2005.

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

NOTE 8 — COMMON STOCK AND WARRANTS

During the six months ended June 30, 2005, warrants to purchase 1,783,170 shares of our common stock were converted into 321,573 shares of our common stock, in accordance with a net exercise provision of the warrants. In addition, warrants to purchase 41,580 shares of our common stock were exercised at a price of $0.26 per share.

As of June 30, 2005 we had the following warrants outstanding to purchase our common stock:

Entity or Individual Holding Warrants	Number of Warrants		Warrant Price		Expiration Date of Warrants
Essex Woodlands Health Ventures		145,530	$	0.15		10/9/2007
		207,900	$	0.26		4/16/2007

NOTE 9 — SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for income taxes amounted to approximately $3,650 and $1,100 for the six months ended June 30, 2005 and 2004, respectively.

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ITEM 2:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Statements in this section, including but not limited to statements concerning the sufficiency of available funds, anticipated future revenues, overall commission cost as a percentage of rating and advisory revenue, general and administrative expenses, future option exercises, capital expenditures, impact of interest rates in our investment account and materiality of legal expenses to our operations are “forward looking statements.” Actual events or results may differ materially from those discussed in forward looking statements as a result of various factors, including failure to achieve revenue increases, unanticipated expenditures, client turnover, inability to identify suitable businesses with which to enter into product or distribution arrangements and other factors discussed below and in our Annual Report on Form 10-K for the year ended December 31, 2004, particularly under “Risk Factors” in Item 1.

Introductory Commentary

In evaluating our financial results and financial condition, management has focused principally on the following:

•	Revenue Growth and Client Retention — We believe these are key factors affecting both our results of operations and our liquidity. During the first six months of 2005, our increased revenues as compared to the same period of 2004 reflected our success in several product areas. We continued adding new hospital customers to our Distinguished Hospital (DHP), Strategic Quality Initiative (SQI) and Quality Assessment and Improvement (QAI) programs. In addition, we continued to increase sales through the distribution of our quality information in our Quality Ratings Suite and Healthcare Quality Reports for Consumers.
	As our base of hospital clients grows, one of our principal objectives will be to achieve a high rate of retention of these clients. We believe one of the obstacles to maintaining high retention rates is that clients who signed contracts with us several years ago, when we were developing our provider services and charging significantly lower fees than we do today, may be unwilling to accept our current pricing structure. In addition, prior to January 2004, for clients that signed SQI contracts with us, we agreed not to sign similar agreements with a specified number of hospitals in close proximity to the client hospital. Beginning in January 2004, we no longer offer this type of exclusivity under our hospital contracts. For hospitals that signed agreements with us during 2003 and prior years, we will continue to honor the exclusivity provisions in their contracts solely for the remaining term of the agreement. As our agreements are typically three years (subject to a cancellation right by either the client or us, on each annual anniversary date), we anticipate that all exclusivity provisions will expire by the end of 2006. For the six months ended June 30, 2005, we retained, or signed new agreements with, approximately 67% of the hospitals whose contracts had first or second year anniversary dates. We have limited experience with respect to assessing retention rates of hospital whose contracts expire at the end of the three year term. In general, our retention rates for expiring contracts is lower than our retention rate with respect to contracts that have a cancellation option on the first or second anniversary dates.
	We typically receive a non-refundable payment for the first year of the contract term (which as noted above is typically three years, subject to a cancellation right 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 liquidity could be adversely affected.
•	Income Taxes — As of June 30, 2005, we had a net deferred tax asset of approximately $1.6 million recorded in our condensed balance sheet. During the six month period ended June 30, 2005, the valuation allowance for deferred tax assets was reduced by $1.5 million. The valuation allowance at December 31, 2004 resulted from uncertainty regarding our ability to realize the benefits of the related deferred tax assets. In accordance with Statement of Financial Accounting Standards No. 109,Accounting for Income Taxes, we assessed the continuing need for the valuation allowance and concluded that, consistent with criteria we established in 2004, the valuation allowance was no longer required. As a result, net income for the six months ended June 30, 2005 includes an income tax benefit of $1.1 million. The benefit consists principally of the elimination of the valuation allowance for deferred tax assets of $1.5 million, offset by a provision for income taxes of $0.4 million. We anticipate that we will incur income tax expense at a rate of between 37-39% for the remainder of 2005.

RESULTS OF OPERATIONS

Revenue Overview

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	Three months		Three months		Six months		Six months
Product Area	ended		ended		ended		ended
	June 30, 2005		June 30, 2004		June 30, 2005		June 30, 2004
Marketing services to hospitals (SQI and DHP products)	$	2,950,377	$	2,079,080	$	5,695,160	$	4,155,962
Quality improvement services to hospitals (QAI products)		645,116		455,862		1,202,304		849,003
Sales of quality information to employers, consumers and others (QRS and Healthcare Quality Reports)		1,217,892		914,558		2,550,890		1,600,459
Consultant reimbursed travel		55,363		50,814		120,321		112,313
Total	$	4,868,748	$	3,500,314	$	9,568,675	$	6,717,737

Ratings and advisory revenue. For the three and six months ended June 30, 2005, ratings and advisory revenue was approximately $4.9 million and $9.6 million, respectively, compared to ratings and advisory revenue of $3.5 million and $6.7 million for the three and six months ended June 30, 2004. These increases are due to the addition of hospital clients under our DHP and SQI programs as well as increased sales of our Healthcare Quality Reports for Consumers and QRS products. For the three months ended June 30, 2005 compared to the three months ended June 30, 2004, sales to hospitals accounted for approximately $1,065,000 or 78% of our increased revenue while our sales of quality information accounted for approximately $303,000 or 22% of the increase. For the second quarter of 2005 and 2004, approximately 61% and 59% of our ratings and advisory revenue was derived from our marketing services to hospitals. In addition, approximately 13% of our ratings and advisory revenue was derived from the sale of our QAI services for the second quarter of 2005 and 2004. Sales of our quality information totaled 25% of our ratings and advisory revenue for the three months ended June 30, 2005 compared to 26% for the same period of 2004.

Cost of ratings and advisory revenue. For the three months and six months ended June 30, 2005, cost of ratings and advisory revenue was $796,000 and $1.5 million, respectively, or approximately 16% of ratings and advisory revenue, compared to $548,000 and $1.2 million, respectively, or approximately 16% and 18% for the same periods of 2004.

Sales and marketing costs for the three and six month periods ended June 30, 2005 were approximately $1.3 million and $2.6 million, respectively, or 26% and 27% of ratings and advisory revenue Sales and marketing costs constituted from approximately $1.2 million and $2.2 million, or 33% of ratings and advisory revenue for the three and six months ended June 30, 2004. The decrease in sales and marketing costs as a percentage of ratings and advisory revenue is primarily due to our increased existing base of business. Since we pay a lesser percentage of commissions to our sales group upon renewals of contracts than we pay with respect to new contracts, the overall commission cost as a percentage of ratings and advisory revenue should decline as our business expands.

Product development costs increased from approximately $445,000 for the three months ended June 30, 2004 to approximately $735,000 for the same period of 2005. This increase is principally due to additional personnel hired to support our product development efforts including both the improvement of existing products as well as the development of new product offerings. In addition, we continue to invest in the improvement of our physician data. The physician data we maintain relates to over 600,000 physicians. This data does not identify physicians by a unique physician identifier (such as a social security number for an individual). Therefore, in order to properly match the various data points that we maintain to the appropriate physician, we must conduct a robust matching process. We continue to acquire new physician data and refine our matching process to improve the accuracy of our data.

General and administrative expenses. For the three months ended June 30, 2005, general and administrative expenses increased to approximately $1.2 million, from approximately $731,000 for the same period of 2004. For the six months ended June 30, 2005, general and administrative expenses increased by approximately $1.0 million to $2.5 million compared to the same period of 2004. The increased expenses over the prior year principally resulted from our move into our new headquarters which provides approximately double the amount of square footage as our previous location, costs related to our ongoing efforts to comply with the internal control provisions of Sarbanes-Oxley and the indemnification expense described in note 7 to the condensed financial statements included in this report. As we anticipated, general and administrative expenses for the second quarter of 2005 remained relatively consistent with general and administrative expenses for the first quarter of 2005.

Income tax benefit. Net income for the six months ended June 30, 2005 includes an income tax benefit of $1.1 million. The benefit for the six months ended June 30, 2005 consists principally of the elimination of a valuation allowance for deferred tax assets of $1.5

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million, offset by a provision for income taxes for the six months ended June 30, 2005 of $0.4 million. The previously recorded valuation allowance resulted from the uncertainty regarding the ability of the Company to realize the benefits of the related deferred tax asset. Based upon the criteria set forth in our Annual Report on Form 10-K, management determined that complete elimination of the valuation allowance was appropriate in the second quarter of 2005. We anticipate that we will incur income tax expense at a rate of between 37-39% for the remainder of 2005. See also note 5 to the condensed financial statements included in this report for further discussion of our income taxes.

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2005, we had working capital of approximately $3.1 million, an increase of $3.0 million from working capital of approximately $96,000 as of December 31, 2004. Included in current liabilities as of June 30, 2005 is $8.1 million in deferred income, representing principally contract payments for future marketing and quality improvement services to hospitals. These amounts will be reflected in revenue upon provision of the related services. For the quarter ended June 30, 2005, cash flow provided by operations was approximately $2.5 million compared to cash provided by operations of approximately $1.0 million for the same period of 2004. In addition to the positive effect of our net income, cash provided by operations for the six months ended June 30, 2005 reflects a tax benefit of approximately $626,000 related to certain employee stock option transactions.

During the six months ended June 30, 2005, the number of our common shares issued increased by approximately 1.7 million shares due to the exercise of stock options. We received approximately $467,000 in cash from this exercise of stock options, which represents the exercise price of the options. As of June 30, 2005, we have outstanding options to purchase approximately 8.2 million shares of our common stock, the majority of which have exercise prices of less than $2.00 per share. Therefore, we anticipate that additional options will be exercised.

We have a line of credit arrangement with Silicon Valley Bank. Under the terms of the Agreement, we may request advances not to exceed an aggregate amount of $1.0 million over the term of the Agreement, subject to a maximum borrowing equal to 75% of Eligible Accounts (as defined in the Agreement) plus 50% of our cash invested with Silicon Valley Bank. Our ability to request advances is also limited by any outstanding letters of credit. In connection with a lease we executed on our new headquarters in Golden, Colorado, in December 2004, we executed a standby letter of credit with Silicon Valley Bank for $500,000 in January 2005. Therefore, subsequent to the issuance of the standby letter of credit in January 2005, approximately $500,000 was available to us. Advances under the Agreement bear interest at Silicon Valley Bank’s prime rate plus .5% and are secured by substantially all of our assets. Interest is due monthly on advances outstanding, and the principal balance of any advances taken by us are due on February 13, 2006. Our ability to request advances under the Agreement is subject to certain financial and other covenants. As of June 30, 2005, we were in compliance with these covenants.

In February 2004, we added approximately 2,900 square feet of office space to our existing lease of 12,200 square feet relating to our former headquarters. Total annual lease costs for our full-service lease on the 15,100 square feet were approximately $270,000. This lease expired in February 2005. In December 2004, we executed a lease agreement on an office building at a new location in Golden, Colorado for approximately 28,700 square feet. Our lease began in February 2005. The term of the lease is 63 months.

During the six months ended June 30, 2005, we incurred approximately $916,000 in capital expenditures. The majority of these expenditures related to leasehold improvements, furniture for our new office space, server equipment and computers for new employees. In addition, we paid $200,000 to acquire certain intangible assets (survey tools as well as a survey builder application) from the Foundation for Accountability, a not-for-profit organization. These tools are intended to enable consumers to compare their healthcare experience to evidenced-based guidelines for specific conditions. In addition to the capital expenditures related to our new facility, we anticipate incurring certain capital expenditures during 2005 primarily to upgrade some of our information technology hardware and software.

We anticipate that we have sufficient funds available to support ongoing operations at their current level. As noted above, upon execution of our SQI, DHP 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 by either the client or us on each annual anniversary date) upon contract execution. We record the cash payment as deferred revenue, which is a current liability on our consolidated balance sheet that is then amortized to revenue 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, as well as 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.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We have certain investments in a treasury obligation fund maintained by Silicon Valley Bank. As of June 30, 2005, our investment in this fund amounted to approximately $2.2 million. This amount is included within the cash and cash equivalent line item of our balance sheet and consists of investments in highly liquid U.S. treasury securities with maturities of 90 days or less. For the six months ended June 30, 2005, interest earned on this balance was $54,748. Any decrease in interest rates in this investment account would not have a material impact on our financial position.

ITEM 4. CONTROL PROCEDURES

a) Evaluation of Disclosure Controls and Procedures

Management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. A controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

b) Change in Internal Control over Financial Reporting

No change in our internal control over financial reporting occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

Reference is made to the disclosure in Note 7 of the Notes to Condensed Financial Statements contained in this report, which is incorporated herein by reference.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On June 22, 2005, we held our annual meeting of stockholders. At the meeting, the stockholders voted on the election of five members of the Board of Directors.

     The voting results are set forth below.

NAME OF NOMINEE	FOR		WITHHELD
Kerry R. Hicks		23,790,873		1,071,933
Peter H. Cheesbrough		24,763,013		99,793
Leslie S. Matthews		24,791,513		71,293
John J. Quattrone		24,789,413		73,393
J. D. Kleinke		23,793,874		1,068,932
Mark Pacala		24,765,113		97,693

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) 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 and Restated Bylaws, as amended (Incorporated by reference to Exhibit 3.2 to our Annual Report on Form 10-K for the year ended December 31, 2001).
10.1	1996 Equity Compensation Plan.
31.1	Certificate of the Chief Executive Officer of Health Grades, Inc. required by Rule 15d-14(a).
31.2	Certificate of the Chief Financial Officer of Health Grades, Inc. required by Rule 15d-14(a).
32.1	Certificate of the Chief Executive Officer of Health Grades, Inc. required by Rule 15d-14(b).
32.2	Certificate of the Chief Financial Officer of Health Grades, Inc. required by Rule 15d-14(b).

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SIGNATURES

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

	HEALTH GRADES, INC.
Date: August 15, 2005	By:	/s/ Allen Dodge
		Allen Dodge
		Senior Vice President - Finance and Chief Financial Officer

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EXHIBIT INDEX

Exhibit Number	Description
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 and Restated Bylaws, as amended (Incorporated by reference to Exhibit 3.2 to our Annual Report on Form 10-K for the year ended December 31, 2001).
10.1	1996 Equity Compensation Plan.
31.1	Certificate of the Chief Executive Officer of Health Grades, Inc. required by Rule 15d-14(a).
31.2	Certificate of the Chief Financial Officer of Health Grades, Inc. required by Rule 15d-14(a).
32.1	Certificate of the Chief Executive Officer of Health Grades, Inc. required by Rule 15d-14(b).
32.2	Certificate of the Chief Financial Officer of Health Grades, Inc. required by Rule 15d-14(b).