SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the quarterly period ended MARCH 31, 2003
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from _____________ to _________________
Commission file number 0-22019
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HEALTH GRADES, INC.
- --------------------------------------------------------------------------------
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 62-1623449
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
44 UNION BOULEVARD, SUITE 600, LAKEWOOD, COLORADO 80228
- ------------------------------------------------- -----
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (303) 716-0041
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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. Yes [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
On April 30, 2003, 24,402,316 shares of the Registrant's common stock,
$.001 par value, were outstanding.
Health Grades, Inc. and Subsidiaries
INDEX
PART I. FINANCIAL INFORMATION:
Item 1. Consolidated Balance Sheets
March 31, 2003 and December 31, 2002.............. 3
Consolidated Statements of Operations -
Three Months Ended March 31, 2003 and 2002........ 4
Consolidated Statements of Cash Flows -
Three Months Ended March 31, 2003 and 2002........ 5
Notes to Consolidated Financial
Statements........................................ 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............... 11
Item 3. Quantitative and Qualitative Disclosure About
Market Risk....................................... 15
Item 4. Controls and Procedures ........................... 15
PART II. OTHER INFORMATION:
Item 6. Exhibits and Reports on Form 8-K ................. 16
2
PART I. FINANCIAL INFORMATION
Health Grades, Inc. and Subsidiaries
Consolidated Balance Sheets
MARCH 31 DECEMBER 31
2003 2002
------------ ------------
(UNAUDITED)
ASSETS
Cash and cash equivalents $ 2,616,056 $ 2,947,047
Accounts receivable, net 853,332 675,514
Prepaid expenses and other 302,933 284,898
------------ ------------
Total current assets 3,772,321 3,907,459
Property and equipment, net 105,387 103,911
Goodwill 3,106,181 3,106,181
------------ ------------
Total assets $ 6,983,889 $ 7,117,551
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 65,052 $ 23,332
Accrued payroll, incentive compensation and related expenses 382,412 396,774
Accrued expenses 96,361 114,798
Note payable, current portion 243,485 --
Deferred income 3,370,126 3,251,625
Income taxes payable 76,201 76,723
------------ ------------
Total current liabilities 4,233,637 3,863,252
Note payable, less current portion 256,515 --
------------ ------------
Total liabilities 4,490,152 3,863,252
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 43,965,706 shares issued and outstanding 43,966 43,966
Treasury stock (13,767,580) (13,267,580)
Additional paid-in capital 89,762,836 89,762,836
Retained deficit (73,545,485) (73,284,923)
------------ ------------
Total stockholders' equity 2,493,737 3,254,299
------------ ------------
Total liabilities and stockholders' equity $ 6,983,889 $ 7,117,551
============ ============
See accompanying notes to consolidated financial statements
3
Health Grades, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
THREE MONTHS ENDED
MARCH 31
------------------------------
2003 2002
------------ ------------
Revenue:
Ratings and advisory revenue $ 1,737,741 $ 1,084,955
Physician practice service fees -- 111,831
Other 43 2,021
------------ ------------
1,737,784 1,198,807
Expenses:
Cost of ratings and advisory revenue 440,109 371,237
Cost of physician practice management revenue -- 19,812
------------ ------------
Gross margin 1,297,675 807,758
Operating expenses:
Sales and marketing 642,522 469,199
Product development 327,430 306,803
General and administrative 589,917 538,308
------------ ------------
Loss from operations (262,194) (506,552)
Other:
Gain on sale of assets and other 25 --
Interest income 2,185 4,106
Interest expense (578) --
------------ ------------
Loss before income taxes (260,562) (502,446)
Income tax benefit -- 1,046,296
------------ ------------
Net (loss) income $ (260,562) $ 543,850
============ ============
Net (loss) income per common share (basic and diluted) $ (0.01) $ 0.02
============ ============
Weighted average number of common shares
used in computation (basic and diluted) 33,605,720 35,526,744
============ ============
See accompanying notes to consolidated financial statements.
4
Health Grades, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
THREE MONTHS ENDED MARCH 31
2003 2002
----------- -----------
OPERATING ACTIVITIES
Net (loss) income $ (260,562) $ 543,850
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation 28,407 76,729
Bad debt expense 11,667 --
Gain on disposal of assets (25) --
Change in operating assets and liabilities:
Accounts receivable net (189,485) 260,460
Prepaid expenses and other assets (18,035) (19,858)
Accounts payable and accrued expenses 23,283 (189,288)
Accrued payroll, incentive compensation
and related expenses (14,362) (144,388)
Income taxes payable (522) (1,046,493)
Deferred income 118,501 (64,767)
----------- -----------
Net cash used in operating activities (301,133) (583,755)
INVESTING ACTIVITIES
Purchase of property and equipment (29,883) (6,000)
Sale of property and equipment 25 --
----------- -----------
Net cash used in investing activities (29,858) (6,000)
FINANCING ACTIVITIES
Proceeds form stock purchases -- 21,510
Proceeds from note payable 500,000 --
Purchases of treasury stock (500,000) --
----------- -----------
Net cash provided by financing activities -- 21,510
----------- -----------
Net decrease in cash and cash equivalents (330,991) (568,245)
Cash and cash equivalents at beginning of period 2,947,047 2,295,557
----------- -----------
Cash and cash equivalents at end of period $ 2,616,056 $ 1,727,312
=========== ===========
See accompanying notes to consolidated financial statements.
5
Health Grades, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
March 31, 2003
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited consolidated condensed financial statements of Health
Grades, Inc. and subsidiaries ("HealthGrades") have been prepared in accordance
with generally accepted accounting principles 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 generally accepted
accounting principles 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 three months
ended March 31, 2003 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2003. For further information, refer
to the consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002.
Effective December 31, 2002, we liquidated our Healthcare Ratings, Inc. ("HRI")
and Providerweb.net subsidiaries. This liquidation had no impact on our
financial position or operations. All significant intercompany balances and
transactions for the periods presented prior to December 31, 2002 have been
eliminated in consolidation.
DESCRIPTION OF BUSINESS
HealthGrades provides healthcare ratings, advisory services and other healthcare
information. We grade, or provide the means to assess and compare the quality or
qualifications of, various types of healthcare providers. Our customers include
healthcare providers, employers, health plans, insurance companies and
consumers.
We offer services to hospitals that are either attempting to build a reputation
based upon quality of care or are working to identify areas to improve quality.
For hospitals that have received high ratings, we offer the opportunity to
license our ratings and trademarks and provide assistance in their marketing
programs. For hospitals that have not received high ratings, we offer quality
improvement services.
We also provide basic and expanded profile information on a variety of providers
and facilities. We make this information available to consumers, employers and
health plans to assist them in selecting healthcare providers. The basic profile
information is available free of charge on our website, www.healthgrades.com.
For a fee, we offer healthcare quality reports with respect to certain
healthcare providers. These reports provide more detailed information than is
available free of charge on our website. Report pricing and content varies based
upon the type of provider and whether the user is a consumer or a healthcare
professional (for example medical professional underwriter).
We provide online integrated healthcare quality services for employers, health
plans and other organizations that license access to our database of healthcare
providers.
We have also entered into strategic arrangements with other service providers,
including GeoAccess and J.D. Power & Associates, in an effort to increase our
name recognition and market presence, as well as enhance our service offerings.
In addition to the services noted above, which constitute our ratings and
advisory business, we also provided, through September 2002, limited physician
practice management services to musculoskeletal practices under management
services agreements. As of December 31, 2002, all of these agreements had
expired or had been terminated.
FUTURE EFFECT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Revenue Recognition
At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF) reached a
final consensus regarding EITF issue number 00-21, Revenue Arrangements with
Multiple Deliverables ("EITF 00-21"). The consensus provides that revenue
arrangements with multiple deliverables should be divided into separate units of
accounting if certain criteria are met. The consideration for the arrangement
should be allocated to the separate units of accounting based on their relative
fair values, subject to different reporting guidance if the fair value of all
deliverables are not known or if the fair value is contingent on delivery of
specified items or performance conditions. Applicable revenue recognition
criteria should be considered separately for each separate unit of accounting.
EITF 00-21 is effective for revenue arrangements entered into in fiscal periods
beginning after June 15, 2003.
6
During the quarter ended March 31, 2003, we completed our analysis of EITF
00-21. We examined our QAI - Phase I contracts (which we formerly called Ratings
Quality Analysis or "RQA"), QAI - Phase II contracts (which we formerly called
Quality Assessment and Improvement or "QAI") contracts and Strategic Quality
Initiative ("SQI") contracts to determine if the adoption of EITF 00- 21 would
have any impact on our current revenue recognition policies. As our QAI - Phase
I contracts consist of a single deliverable (as defined by EITF 00-21), a
comprehensive quality analysis, no change is required with respect to our
current policy of recognizing revenue under these arrangements at the point in
time that services are delivered. In addition, as our QAI - Phase II contracts
consist of consulting services provided over the term of the contract, no change
is required with respect to our current policy of recognizing revenue under
these arrangements over the term of the contract on a straight-line basis.
Our SQI contracts contain both an analysis of quality outcomes data as well as a
license to utilize our name and certain ratings information for an annual
period. Based upon our analysis, we concluded that there was not reliable and
verifiable evidence of fair value from which to allocate the consideration
received between the two deliverables. Moreover, we believe the primary
deliverable under these agreements clearly is the license to utilize our name
and certain ratings information for an annual term. In addition, although we
sell the analysis of quality outcomes data separately via our QAI - Phase I
contracts, our QAI - Phase I contracts are sold to clients that have lower
quality ratings (as rated by HealthGrades) and thus should have a more
significant value than the quality analysis imbedded within our SQI contracts.
Furthermore, some of our SQI clients never choose to receive the quality
outcomes analysis included within our SQI contracts. Based upon these factors,
we have concluded that no change is required with respect to our current policy
of recognizing revenue under these arrangements over the term of the contract on
a straight-line basis.
NOTE 2 - STOCK-BASED COMPENSATION
We account for our stock-based compensation arrangements using the intrinsic
value method under the provisions of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB No. 25), and related
interpretations.
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 (loss) income as disclosed below may not be
representative of compensation expense in future years.
The fair value for options awarded were estimated at the date of grant using an
option pricing model with the following assumptions:
Three months ended March 31,
2003 2002
---- ----
Risk-free interest rate 2.18% 2.23%
Dividend yield -- --
Expected life of option 3.0 3.0
Volatility 1.96 1.91
The following table illustrates the effect on net (loss) income and (loss)
income per share if we had applied the fair value recognition provisions of SFAS
123, to our stock-based compensation plan.
Three months ended March 31,
2003 2002
--------- ---------
Net (loss)income as reported $(260,562) $ 543,850
Add: Stock-based employee compensation expense included in
reported net income under APB No. 25
Less: Total stock-based employee compensation expense determined under
fair value based method for awards, net of related tax effects (102,399) (196,456)
--------- ---------
Pro forma net (loss) income $(362,961) $ 347,394
========= =========
(Loss) income per share:
Basic and diluted as reported $ (0.01) $ 0.02
========= =========
Basic and diluted pro forma $ (0.01) $ 0.01
========= =========
7
As of March 31, 2003, we had 55,000 shares underlying options that are currently
exercisable, but were not included in our calculation of weighted average common
shares outstanding as they were antidilutive.
NOTE 3 - STOCK AND WARRANT REPURCHASE AGREEMENT
Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003,
between Chancellor and us, we repurchased from Chancellor 12,004,333 shares of
our common stock and warrants to purchase 1,971,820 shares of our common stock
for a total purchase price of $500,000. Chancellor initially acquired the common
stock and warrants from us in two private transactions in 2000 and 2001.
Immediately prior to the repurchase, Chancellor's ownership of HealthGrades
common stock represented 33% of our outstanding common stock, and Chancellor's
ownership of HealthGrades common stock and warrants represented 36% of our total
outstanding common stock (assuming full exercise of the warrants held by
Chancellor, but assuming no exercise of any other warrants or options).
NOTE 4 - LINE OF CREDIT
Effective March 11, 2003, we executed an amendment to our line of credit
arrangement with Silicon Valley Bank. The terms of the amendment provide for an
extension of the maturity date of the $1,000,000 line of credit arrangement to
February 20, 2004. To date, we have not borrowed any funds under the line of
credit. In addition, the amendment provided for a term loan of $500,000. The
term loan accrues interest at 5.94% and requires us to pay twenty-four equal
installments of principal and interest over the term, beginning on April 1,
2003. We have the ability, at our option, to prepay all, but not less than all,
of the term loan without penalty after August 21, 2003, provided we give Silicon
Valley Bank at least thirty days written notice prior to such repayment.
NOTE 5 - LEGAL PROCEEDINGS
On or about October 10, 2002, Strategic Performance Fund - II ("SPF-II")
commenced an action in the Circuit Court of the 17th Judicial Circuit in and for
Broward County, Florida against us, alleging breach of two leases. These leases
relate to two buildings in which one of our former affiliated practices,
Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center ("Park Place")
leased office space. Park Place ceased the payment of its rental obligations
with respect to the two leases in May 2000, and subsequently filed a petition
for bankruptcy, under Chapter 11 of the Bankruptcy Code, in the United States
Bankruptcy Court, Southern District of Florida, Ft. Lauderdale Division. SPF-II
is seeking damages against HealthGrades in the amount of approximately $4.7
million.
The basis of the allegation against HealthGrades is that while under the
corporate name of Specialty Care Network, Inc., we entered into an Assignment,
Assumption and Release Agreement dated July 8, 1997, under which we assumed the
obligations of Orthopaedic Management Services, Inc., as lessee, under leases
with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The agreement
was executed in connection with our acquisition of most of the non-medical
assets of the Park Place practice. On October 1, 1997, the owner of the leased
properties sold its interests in the leasehold estates to SPF-II, Inc. On June
10, 1999, we sold the assets of the Park Place practice, including the leasehold
interests, back to Park Place and entered into an Absolute Assignment and
Assumption Agreement with Park Place, under which Park Place agreed to indemnify
us in connection with the leasehold obligations. In addition, we entered into an
Indemnification Agreement with Park Place and its individual physician owners,
under which the individual physician owners (severally up to their ownership
interest in the practice) agreed to indemnify us in connection with the
leasehold obligations. SPF-II alleges that, notwithstanding the assignment of
our leasehold interests to Park Place, HealthGrades remains liable for all
lessee obligations under the leases.
We have filed a response to the initial complaint instituted by SPF-II, denying
all liability with respect to the subject leases. In addition, we have filed a
third-party complaint against the individual physician owners seeking
indemnification from each of these individuals under the terms of the
Indemnification Agreement. The physician owners have filed a response to our
complaint denying their liability under the Indemnification Agreement, and
asserting several affirmative defenses, including, among others, our failure to
mitigate damages, lack of consideration, our assertion of a premature claim as
liability and damages have not been established by SPF-II, rejection of the
leases by the bankruptcy court, and, in the case of one physician owner, a claim
that an "agent" of ours (who was, in fact, an employee of Park Place both before
and after our affiliation with the practice) fraudulently induced the purchase
of the Park Place practice's assets from us. The physician owners have also
filed a motion to enjoin further prosecution of the action instituted against
them by HealthGrades and Bank of America, the lender in connection with their
repurchase of the assets of the Park Place practice, pending resolution of the
bankruptcy proceeding.
Earlier this month, we filed a motion to dismiss or for summary judgment that
seeks the entry of judgment in our favor based on the language of the lease
agreements and SPF-II's relationship with Park Place, as lessee.
We intend to contest our obligations under the Assignment, Assumption and
Release Agreement, fully explore SPF-II's obligations to mitigate damages and
vigorously pursue our rights against Park Place and the individual physician
owners.
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.
8
NOTE 6 - SEGMENT DISCLOSURES
For the quarter ended March 31, 2003, substantially all of our revenue and
operating expenses are derived from our ratings and advisory business.
Therefore, for the quarter ended March 31,2003, we had only one reportable
segment.
For the quarter ended March 31, 2002, our reportable segments were Physician
Practice Services ("PPS") and Ratings and Advisory Revenue. PPS derived its
revenue primarily from management services provided to physician practices.
Ratings and Advisory Revenue ("RAR") is derived primarily from marketing
arrangements with hospitals and fees related to the licensing of our content
(including set-up fees).
We used net (loss) income before income taxes for purposes of performance
measurement. The measurement basis for segment assets includes intangible
assets.
Effective December 31, 2002, we liquidated our HRI subsidiary. All operations
that were previously recorded in the HRI subsidiary are now being recorded in
Health Grades, Inc. HRI contained the revenue from our ratings and advisory
business. Expenses of HRI included direct salaries and wages of HRI employees,
disbursements made directly from HRI, and depreciation recorded on HRI assets.
All corporate employees and operating expenses were included in the PPS segment.
We did not perform any expense allocation other than certain telephone and
utilities expense.
AS OF AND FOR THE
THREE MONTHS
ENDED
MARCH 31
2002
------------
RAR
Revenue from external customers $ 1,084,955
Interest income 4,106
Depreciation and amortization expense 36,806
Segment net income before income taxes 46,157
Segment assets 5,493,533
Segment asset expenditures 6,000
PPS
Revenue from external customers $ 111,831
Interest income --
Interest expense --
Depreciation and amortization expense 39,923
Segment net loss before income taxes (548,603)
Segment assets 20,945,541
Segment asset expenditures --
A reconciliation of our segment revenue, segment net loss before income taxes,
segment assets and other significant items to the corresponding amounts in the
consolidated financial statements is as follows:
AS OF AND FOR THE
THREE MONTHS ENDED
MARCH 31
2002
------------
REVENUE
Total for reportable segments $ 1,196,786
Other revenue 2,021
------------
Total consolidated revenue $ 1,198,807
============
LOSS BEFORE INCOME TAXES
Total net loss before tax for
reportable segments $ (502,446)
------------
Loss before income taxes $ (502,446)
============
ASSETS
Total assets for reportable segments $ 26,439,074
Elimination of advance to subsidiaries (10,729,431)
Elimination of investment in subsidiaries (7,795,020)
------------
Consolidated total assets $ 7,914,623
============
9
For each of the periods presented, our primary operations and assets were within
the United States.
NOTE 7 - SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for income taxes amounted to approximately $522 and $-- for the three
months ended March 31, 2003 and 2002, respectively.
For the three months ended March 31, 2002, participants in our 2002 Stock
Purchase Plan (the "Plan") paid $21,510 for shares purchased through payroll
deductions. This amount has been included in cash received from financing
activities in the Company's consolidated statement of cash flows. The Plan
enabled participating employees to purchase shares of our common stock by
electing to have payroll deductions in 2002 of up to 30 percent of their annual
base rate of pay (excluding bonuses, overtime pay, commissions and severance
pay) as in effect on January 1, 2002. The Plan terminated on December 31, 2002.
10
ITEM 2:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Statements in this section, including statements concerning the sufficiency of
available funds, anticipated future revenues and level of commission expense 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, customer turnover and other factors discussed below and in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002,
particularly under "Risk Factors" in Item 1.
Overview
In evaluating our financial results and financial condition, management has
focused principally on the following:
- - Revenue growth - We believe this is the key factor affecting both our
results of operations and our liquidity. During the first quarter of 2003,
our increased revenues reflected our success in adding new hospital
customers to our Strategic Quality Initiative (SQI) and Quality Assessment
and Improvement (QAI) programs and obtaining renewals from hospitals
already enrolled in these programs. Furthermore, because we typically
receive payment in advance for the annual terms of these agreements, the
addition of new customers could significantly affect our liquidity.
Management is focused on increasing revenues in other areas of our
business as well. We believe the principal risk we confront in this regard
is that we may be unable to effect market penetration and growth in these
other areas.
- - Cost control - We have been successful in substantially reducing expenses,
due largely to personnel reductions in 2001. We do not anticipate that
further expense reductions are feasible or advisable, particularly because
we want to be positioned to accommodate increased business if our efforts
to increase revenues are successful. We anticipate that we will add
personnel who provide client consulting and support for our SQI and QAI
programs. Moreover, we believe it is important to provide incentives to
our continuing and new employees. Specifically, we believe it is important
to provide appropriate compensation and incentives to those employees who
contribute to the further growth of our company. Management recognizes,
however, that any increases in expenses to accommodate such growth must be
applied in a disciplined fashion so as to enable us to obtain meaningful
benefits from the standpoint of our operations and cash flows.
- - Liquidity - We believe that current economic conditions and our depressed
market price provides a very challenging environment for external
financing, although we have a maximum of $1,000,000 availability under our
line of credit with a bank. Therefore, we believe that our focus must be
devoted to generating cash flow from operations. During 2002, we benefited
from significantly reduced losses from operations, as well as a $1,000,000
tax refund resulting from tax legislation enacted last year. We
experienced some decrease in our cash position during the first quarter of
2003, principally reflecting our net loss. However, cash used in operating
activities of approximately $301,000 declined from $584,000 used during
the first quarter of 2002. We believe our cash resources are sufficient to
support ongoing operations for the next twelve months, but we confront the
risk that our inability to generate revenues as expected could compel us
to seek additional financing. Moreover, as described in Note 5 to the
consolidated financial statements included in this report, we are engaged
in litigation relating to property leased by a former affiliated practice.
While we do not currently anticipate an outcome that would fundamentally
affect our liquidity, an unanticipated result could be materially harmful
to our financial position.
- - Recent Financing Activities- Effective March 11, 2003, we executed an
amendment to our agreement with a bank as described in Note 4 to our
consolidated financial statements included in this report. The terms of
the amendment provide for an extension of the maturity date of the
$1,000,000 line of credit arrangement to February 20, 2004. To date, we
have not borrowed any funds under the line of credit. In addition, the
amendment provides for a term loan of $500,000. The term loan accrues
interest at 5.94% and requires us to pay twenty-four equal installments of
principal and interest over the term, beginning on April 1, 2003.
Quarterly debt service under the term loan is approximately $67,000. We
have the ability, at our option, to prepay all, but not less than all, of
the term loan without penalty after August 21, 2003, provided we give the
bank at least thirty days written notice prior to such repayment. In
addition, we entered into a Stock and Warrant Repurchase Agreement, dated
March 11, 2003, with Chancellor V, L.P. ("Chancellor"). Under the terms of
the Stock and Warrant Repurchase Agreement, we repurchased from Chancellor
12,004,333 shares of our common stock and warrants to purchase 1,971,820
shares of our common stock for a total purchase price of $500,000.
Chancellor initially acquired the common stock and warrants from us in two
private transactions in 2000 and 2001. Immediately prior to the
repurchase, Chancellor's ownership of HealthGrades common stock
represented 33% of our outstanding common stock, and Chancellor's
ownership of HealthGrades common stock and warrants represented 36% of the
11
our total outstanding common stock (assuming full exercise of the warrants
held by Chancellor, but assuming no exercise of any other warrants or
options).
CRITICAL ACCOUNTING POLICIES
In preparing our financial statements, management is required to make estimates
and assumptions that, among other things, affect the reported amounts of assets,
revenues and expenses. These estimates are most significant in connection with
our critical accounting policies, namely those of our accounting policies that
are most important to the presentation of financial condition and results of
operations and that require the most difficult, subjective, complex judgments.
These judgments often result from the need to make estimates about the effects
of matters that are inherently uncertain. For the first quarter of 2003, we have
identified evaluation of goodwill impairment and revenue recognition as our
critical accounting policies.
Goodwill Impairment
As a result of the adoption of Statement of Financial Accounting Standards No.
142, Goodwill and Other Intangible Assets (SFAS 142), we discontinued the
amortization of goodwill effective January 1, 2002. Statement 142 also requires
companies to perform a transitional test of goodwill for impairment, and we
completed this test during the second quarter of 2002. Based upon the results of
the test, we recorded a charge of approximately $1.1 million in our consolidated
statement of operations for the quarter ended June 30, 2002, as a cumulative
effect of a change in accounting principle. Goodwill in the accompanying
consolidated balance sheets is shown net of the impairment charge described
above as of December 31, 2002 and March 31, 2003.
SFAS 142 describes various potential methodologies for determining fair value,
including market capitalization (if a public company has one reporting unit, as
is the case with HealthGrades), discounted cash flow analysis (present value
technique) and techniques based on multiples of earnings, revenue, EBITDA,
and/or other financial measures. SFAS 142 also states that if a valuation
technique is used that considers multiple sources of information, such as an
average of the quoted market prices of the reporting unit over a specific time
period and the results of a present value technique, the company should apply
that technique consistently period to period (i.e. in the required annual
impairment analysis in subsequent years).
Consistent with the methodology utilized in 2002, for our 2003 annual impairment
test (or sooner, if any indicators of impairment are present), we plan to apply
an approach that provides equal weight to market capitalization (adjusted to
reflect a 30% "control premium") and a probability-weighted average of future
cash flows. As the majority of our outstanding shares are owned by management
and a venture capitalist investor, we believe a premium of 30% is reasonable to
give effect to additional benefits a purchaser would derive from control of
Health Grades, Inc.
As our shares are very thinly traded, we believe that any analysis of
HealthGrades' fair value should include valuation techniques in addition to the
overall market capitalization. We contemplated utilizing cost, market or income
approaches. However, utilization of cost or market approaches was not feasible,
particularly given the fact that HealthGrades does not fall into an easily
identifiable "peer group" of companies from which to compare valuations in the
form of price to earnings ratios, sales of similar companies, etc. Therefore we
determined to utilize an approach using the present value of expected future
cash flows as an additional valuation technique. Due to the inherent uncertainty
involved in projecting cash flows, in particular for a growth company, we
develop a range of possible cash flows and derive a probability-weighted average
of the range of possible amounts to determine the expected cash flow over a
five-year period. Based upon the inherent uncertainty in future cash flows in
particular for a growth company, we feel the utilization of a longer time period
would not be appropriate. As we utilize the expected future cash flow approach
for our present value measurements, the appropriate discount rate to utilize for
application to future cash flow estimates is the risk-free rate of interest over
the time period of the expected cash flows (or five years in our case). This is
due to the fact that in our expected cash flows, we have already built in our
assumptions concerning the uncertainty of cash flows. Therefore, these
assumptions should not be taken into account again in our discount rate.
As required under SFAS 142, we performed our annual test for impairment of our
goodwill during the fourth quarter of 2002. This test resulted in no additional
impairment to our goodwill balance. We will perform the annual impairment test
in the fourth quarter of 2003 and subsequent years or sooner if indicators of
impairment arise at an interim date. Any impairment identified during the annual
impairment tests will be recorded as an operating expense in our consolidated
statement of operations. We expect to continue to utilize the combined market
capitalization and expected cash flow approach described above to perform our
annual impairment analysis and interim tests, if necessary. For the quarter
ended March 31, 2003, as no indicators of impairment were present, no interim
impairment test was performed.
12
Revenue Recognition - Ratings and Advisory Revenue
We currently derive our ratings and advisory revenue principally from annual
fees from hospitals that participate in our Strategic Quality Initiative (SQI)
program. The SQI program provides business development tools to hospitals that
are highly rated on our website. Under our SQI program, we license the
HealthGrades name and our "report card" ratings to hospitals. The license may be
in a single area (for example, Cardiac) or multiple areas (for example, Cardiac,
Neurosciences and Orthopaedics.) We also assist hospitals in promoting their
ratings and measuring the success of their efforts utilizing our team of
in-house healthcare consultants. Another key feature of this program is a
detailed comparison of the data underlying a hospital's rating to local and
national benchmarks.
We recognize revenue related to these arrangements in a straight-line manner
over the term of the agreement. We follow this method because the primary
deliverable under the agreement is the license to utilize our rating over the
contract term. In addition, consulting services are performed as requested by
the client as needed over the term of the agreement. As we typically receive a
non-refundable payment for the contract term upon execution of the agreement, we
record the cash payment as deferred revenue that is then amortized to revenue
over the contract term.
At a November 21, 2002 meeting, the Emerging Issues Task Force (EITF) reached a
final consensus regarding EITF 00-21, Revenue Arrangements with Multiple
Deliverables ("EITF 00-21"). The consensus provides that revenue arrangements
with multiple deliverables should be divided into separate units of accounting
if certain criteria are met. The consideration for the arrangement should be
allocated to the separate units of accounting based on their relative fair
values, subject to different reporting guidance if the fair value of all
deliverables are not known or if the fair value is contingent on delivery of
specified items or performance conditions. Applicable revenue recognition
criteria should be considered separately for each separate unit of accounting.
EITF 00-21 is effective for revenue arrangements entered into in fiscal periods
beginning after June 15, 2003.
During the quarter ended March 31, 2003, we completed our analysis of EITF
00-21. We examined our QAI - Phase I contracts (which we formerly called Ratings
Quality Analysis or "RQA"), QAI - Phase II contracts (which we formerly called
Quality Assessment and Improvement or "QAI") contracts and SQI contracts to
determine if the adoption of EITF 00- 21 would have any impact on our current
revenue recognition policies. As our QAI - Phase I contracts consist of a single
deliverable (as defined by EITF 00-21), a comprehensive quality analysis no
change is required with respect to our current policy of recognizing revenue
under these arrangements at the point in time that the services are delivered.
In addition, as our QAI - Phase II contracts consist of consulting services
provided over the term of the contract, no change is required with respect to
our current policy of recognizing revenue under these arrangements over the term
of the contract on a straight-line basis.
Our SQI contracts contain both an analysis of quality outcomes data as well as a
license to utilize our name and certain ratings information for an annual
period. Based upon our analysis, we concluded that there was not reliable and
verifiable evidence of fair value with which to allocate the consideration
received between the two deliverables. Certainly, the primary deliverable under
these agreements is the license to utilize our name and certain ratings
information for an annual term. In addition, although we do sell the analysis of
quality outcomes data separately via our QAI - Phase I contracts, these
contracts are sold to clients that have lower quality ratings (as rated by
HealthGrades) and thus should have a more significant value than the quality
analysis imbedded within our SQI contracts. Furthermore, some of our SQI clients
never choose to receive the quality outcomes analysis included within our SQI
contracts. Based upon these factors, we have concluded that no change is
required with respect to our current policy of recognizing revenue under these
arrangements over the term of the contract on a straight-line basis.
Were we to recognize revenue for the quality outcomes data analysis in the
period in which the services were delivered, the amount of revenues reported in
any particular period would increase or decrease, depending on the timing of the
provision of these services.
RESULTS OF OPERATIONS
Ratings and advisory revenue. For the three months ended March 31, 2003, ratings
and advisory revenue was approximately $1,738,000, an increase of $653,000 or
60%, over revenue of $1,085,000 for the three months ended March 31, 2002. This
increase is primarily due to the addition of hospital clients under our
strategic quality initiative program. For the first quarter of 2003 and 2002,
approximately 76% of our ratings and advisory revenue was derived from our SQI
services. In addition, approximately 12% of our ratings and advisory revenue was
derived from our QAI services, compared to 10% for the same period in 2002. The
remainder of our revenue for the first quarter of 2003 was derived primarily
from sales of physician reports for consumers and reimbursement of consultant
travel expenses.
Cost of ratings and advisory revenue. For the three months ended March 31, 2003,
cost of ratings and advisory revenue was $440,000, or approximately 25% of
ratings and advisory revenue, compared to $371,000 or approximately 34% for the
same period of 2002. This difference is primarily due to a reduction in costs to
acquire data. During 2002 we renegotiated a data purchase agreement
13
with a vendor that substantially reduced our cost to acquire certain physician
data.
Sales and marketing expenses. Sales and marketing costs include salaries, wages
and commission expenses related to our sales efforts, as well as other direct
sales and marketing costs. For our SQI and QAI agreements, we pay our sales
personnel commissions as we receive payment from our hospital clients. Although
we typically record revenue earned from our SQI and QAI - Phase II agreements
over the term of the agreement (typically one year), we record the commission
expense in the period it is earned, which is typically upon contract execution.
We record the commission expense in this manner, because once a contract is
signed, the salesperson has no remaining obligations to perform in order to earn
the commission.
Sales and marketing costs increased from approximately $469,000, or 43% of
ratings and advisory revenue for the three months ended March 31, 2002, to
approximately $643,000, or 37% of ratings and advisory revenue for the same
period of 2003. The decrease as a percentage of ratings and advisory revenue is
primarily due to our increased renewal 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, as our business expands, the overall
commission cost as a percentage of ratings and advisory revenue should decline.
General and administrative expenses. For the three months ended March 31, 2003,
general and administrative expenses were approximately $590,000, an increase of
approximately $52,000 over general and administrative expenses of approximately
$538,000 for the same period of 2002. This increase is primarily the result of
increased legal fees related to the completion of the Stock and Warrant Purchase
Agreement described above as well as increased litigation costs with respect to
our ongoing dispute with SPF-II, as more fully described in Note 5 to our
consolidated financial statements included in this report.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2003, we had a working capital deficit of approximately $461,000, a
decrease of $505,000 from working capital of approximately $44,000 as of
December 31, 2002. For the first three months of 2003, cash flow used in
operations was approximately $301,000 compared to $584,000 for the same period
of 2002. The decrease in working capital is primarily attributable to our
current obligations under our term loan as well as increased deferred income,
reflecting increased contractual payments that we have already received but will
be recognized as revenue on a straight-line basis over the term of the contract.
Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003,
between Chancellor and us, we repurchased from Chancellor 12,004,333 shares of
our common stock and warrants to purchase 1,971,820 shares of our common stock
for a total purchase price of $500,000. Chancellor initially acquired the common
stock and warrants from us in two private transactions in 2000 and 2001.
Immediately prior to our repurchase, Chancellor's ownership of HealthGrades
common stock represented 33% of our outstanding common stock, and Chancellor's
ownership of HealthGrades common stock and warrants represented 36% of the our
total outstanding common stock (assuming full exercise of the warrants held by
Chancellor, but assuming no exercise of any other warrants or options). As a
result of the transaction, we believe that Chancellor no longer holds any equity
securities in HealthGrades.
We have a line of credit arrangement as amended, (the "Agreement") 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 75% of Eligible Accounts (as defined in the Agreement) plus 50% of
our cash invested with Silicon Valley Bank. As of March 31, 2003, the entire
$1.0 million is available to us. Advances under the Agreement bear interest at
Silicon Valley Bank's prime rate plus .75% 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 February 20, 2004, the end of the
Agreement term. Our ability to request advances under the Agreement is subject
to certain financial and other covenants. As of March 31, 2003, we were in
compliance with these covenants.
Under the Agreement, we also have a term loan of $500,000. The term loan accrues
interest at 5.94% and requires us to pay twenty-four equal installments of
principal and interest over the term, beginning on April 1, 2003. We have the
ability, at our option, to prepay all, but not less than all, of the term loan
without penalty after August 21, 2003, provided we give Silicon Valley Bank at
least thirty days written notice prior to such repayment.
Although we anticipate that we have sufficient funds available to support
ongoing operations for at least the next twelve months, if our revenues fall
short of our expectations or our expenses exceed our expectations, we may need
to raise additional capital through public or private debt or equity financing.
We may not be able to secure sufficient funds on terms acceptable to us. If
equity securities are issued to raise funds, our stockholders' equity may be
diluted. If additional funds are raised through debt financing, we may be
subject to significant restrictions. Furthermore, upon execution of our
strategic quality initiative and quality assessment and improvement agreements,
we typically receive a non-refundable payment for the first year of the contract
term. This payment is recorded as deferred revenue, which is reflected as a
current liability in our consolidated balance sheet. Revenues related to these
agreements are
14
recorded ratably over the term of the agreement. As a result, our operating cash
flow is substantially dependent upon our ability to continue to sign new
agreements. Our current operating plan includes growth in new sales from our
strategic quality initiative and quality assessment and improvement agreements.
For the reasons described above, failure to achieve our new sales plan would
have a material negative impact on our financial position and cash flow.
Moreover, as noted elsewhere in this report, we are engaged in litigation
relating to property leased by a former affiliated practice. While we do not
currently anticipate an outcome that would fundamentally affect our liquidity,
an unanticipated result could be materially harmful to our financial position.
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 March 31, 2003, our investment in this fund amounted to
approximately $2.1 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
three months ended March 31, 2003, interest earned on this balance was
approximately $2,200. Any decrease in interest rates in this investment account
would not have a material impact on our financial position.
ITEM 4. CONTROL PROCEDURES
An evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures, was carried out by us within 90 days prior to the
filing of this Quarterly Report on Form 10-Q, under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer. Based on that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
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 SEC'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. Subsequent to the date of the most
recent evaluation, there were no significant changes in our internal controls or
in other factors that could significantly affect the internal controls,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
15
PART II. OTHER INFORMATION
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).
99.1 Certificate of the Chief Executive Officer of Health Grades, Inc.
pursuant to title 18, Section 1350 of the United States Code.
99.2 Certificate of the Chief Financial Officer of Health Grades, Inc.
pursuant to title 18, Section 1350 of the United States Code.
(b) Reports on Form 8-K.
During the quarter ended March 31, 2003, we filed a report on Form 8-K.
The report, filed on March 18, 2003 and dated March 11, 2003 provided
information responsive to Items 5 in connection with a Stock and Warrant
Repurchase Agreement with Chancellor V, L.P.
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: May 15, 2003 By: /s/ Allen Dodge
------------------------------------
Allen Dodge
Senior Vice President - Finance and
Chief Financial Officer
16
CERTIFICATIONS
I, Kerry R. Hicks, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Health Grades, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: May 15, 2003
---------------------------
/s/ Kerry R. Hicks
- -------------------------------------
Kerry R. Hicks
President and Chief Executive Officer
17
I, Allen Dodge, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Health Grades, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: May 15, 2003
-------------------------------
/s/ Allen Dodge
- -------------------------------------
Allen Dodge
Senior Vice President - Finance and Chief Financial Officer
18
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).
99.1 Certificate of the Chief Executive Officer of Health Grades, Inc.
pursuant to title 18, Section 1350 of the United States Code.
99.2 Certificate of the Chief Financial Officer of Health Grades, Inc.
pursuant to title 18, Section 1350 of the United States Code.
19