================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
Commission file number 0-13801
QUALITY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
California 95-2888568
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
18191 Von Karman Avenue, Irvine California 92612
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (949) 255-2600
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding twelve months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days. Yes |X| No |_|
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |X| No |_|
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |_| No |X|
Indicate the number of shares outstanding of each of the Registrant's classes of
Common Stock as of the latest practicable date: 13,201,628 shares of Common
Stock, $0.01 par value, as of November 1, 2005.
================================================================================
PART I
CONSOLIDATED FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
ASSETS (UNAUDITED)
Current assets:
Cash and cash equivalents ............................................ $ 63,126 $ 51,157
Accounts receivable, net ............................................. 40,733 33,362
Inventories, net ..................................................... 547 960
Income tax receivable ................................................ 177 15
Net current deferred tax assets ...................................... 1,796 1,796
Other current assets ................................................. 1,975 1,677
--------- ---------
Total current assets ....................................... 108,354 88,967
Equipment and improvements, net ............................................. 3,113 2,697
Capitalized software costs, net ............................................. 4,823 4,334
Goodwill .................................................................... 1,840 1,840
Other ....................................................................... 1,715 1,604
--------- ---------
Total assets ............................................... $ 119,845 $ 99,442
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ..................................................... $ 3,450 $ 2,284
Deferred revenue ..................................................... 28,627 24,115
Accrued compensation and related benefits ............................ 3,874 3,436
Other current liabilities ............................................ 4,759 4,021
--------- ---------
Total current liabilities .................................. 40,710 33,856
Deferred revenue, net of current ............................................ 1,447 1,362
Net deferred tax liabilities ................................................ 291 291
Deferred compensation ....................................................... 1,457 1,202
--------- ---------
Total liabilities .......................................... 43,905 36,711
--------- ---------
Commitments and contingencies ............................................... -- --
Shareholders' equity:
Common stock, $0.01 par value; authorized 20,000 shares; issued and
outstanding 13,186 and 13,111 shares at September 30, 2005 and
March 31, 2005, respectively ..................................... 131 131
Additional paid-in capital ........................................... 46,639 44,499
Retained earnings .................................................... 30,068 19,213
Deferred compensation ................................................ (898) (1,112)
--------- ---------
Total shareholders' equity ................................. 75,940 62,731
--------- ---------
Total liabilities and shareholders' equity ................. $ 119,845 $ 99,442
========= =========
See accompanying condensed notes to consolidated financial statements.
1
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
---------------------------- ----------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2005 2004 2005 2004
------------- ------------- ------------- -------------
Revenues:
Software, hardware and supplies ......... $13,661 $ 9,307 $26,634 $18,110
Implementation and training services .... 3,031 2,300 5,521 4,566
------- ------- ------- -------
System sales ............................. 16,692 11,607 32,155 22,676
------- ------- ------- -------
Maintenance and other services .......... 9,676 7,022 18,539 13,796
Electronic data interchange services .... 3,174 2,588 6,276 4,875
------- ------- ------- -------
Maintenance, EDI and other services ...... 12,850 9,610 24,815 18,671
------- ------- ------- -------
Total revenue ......................... 29,542 21,217 56,970 41,347
------- ------- ------- -------
Cost of revenue:
Software, hardware and supplies ......... 1,907 1,692 4,364 4,044
Implementation and training services .... 1,942 1,579 3,766 2,971
------- ------- ------- -------
Total cost of system sales ............... 3,849 3,271 8,130 7,015
------- ------- ------- -------
Maintenance and other services .......... 3,637 2,956 7,045 5,902
Electronic data interchange services .... 2,125 1,710 4,187 3,121
------- ------- ------- -------
Total cost of maintenance and other
services ................................. 5,762 4,666 11,232 9,023
------- ------- ------- -------
Total cost of revenue ................. 9,611 7,937 19,362 16,038
------- ------- ------- -------
Gross profit .......................... 19,931 13,280 37,608 25,309
------- ------- ------- -------
Operating expenses:
Selling, general and administrative ... 8,920 5,414 16,952 10,367
Research and development costs ........ 1,977 1,818 3,718 3,430
------- ------- ------- -------
Total operating expenses ............ 10,897 7,232 20,670 13,797
------- ------- ------- -------
Income from operations ................ 9,034 6,048 16,938 11,512
Interest income .......................... 460 170 801 290
------- ------- ------- -------
Income before provision for income
taxes .................................... 9,494 6,218 17,739 11,802
Provision for income taxes ............... 3,700 2,503 6,870 4,705
------- ------- ------- -------
Net income ............................ $ 5,794 $ 3,715 $10,869 $ 7,097
======= ======= ======= =======
Net income per share:
Basic ................................... $ 0.44 $ 0.29 $ 0.83 $ 0.56
======= ======= ======= =======
Diluted ................................. $ 0.43 $ 0.28 $ 0.80 $ 0.54
======= ======= ======= =======
Weighted average shares outstanding:
Basic .................................... 13,149 12,780 13,131 12,722
======= ======= ======= =======
Diluted .................................. 13,564 13,196 13,529 13,160
======= ======= ======= =======
See accompanying condensed notes to consolidated financial statements.
2
QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
------------------------------
SEPTEMBER 30, SEPTEMBER 30,
2005 2004
------------- -------------
Cash flows from operating activities:
Net income ....................................................... $ 10,869 $ 7,097
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation ................................................... 649 466
Amortization of capitalized software costs ..................... 1,160 932
Provision for bad debts ........................................ 724 295
Provision for inventory obsolescence ........................... 118 103
Non-cash compensation from issuance of options ................. 215 215
Tax benefit from exercise of stock options ..................... 1,015 244
Changes in assets and liabilities:
Accounts receivable ............................................ (8,095) (5,157)
Inventories .................................................... 294 (436)
Other current assets ........................................... (298) (158)
Income tax receivable .......................................... (162) --
Other assets ................................................... (111) (40)
Accounts payable ............................................... 1,166 413
Deferred revenue ............................................... 4,597 3,670
Accrued compensation and related benefits ...................... 438 (391)
Income taxes payable ........................................... -- 846
Other current liabilities ...................................... 738 1,008
Deferred compensation .......................................... 255 14
-------- --------
Net cash provided by operating activities ..................................... 13,572 9,121
-------- --------
Cash flows from investing activities:
Additions to equipment and improvements .......................... (1,065) (756)
Additions to capitalized software costs .......................... (1,649) (1,031)
-------- --------
Net cash used in investing activities ......................................... (2,714) (1,787)
-------- --------
Cash flows from financing activities:
Dividends paid ................................................... (14) --
Proceeds from the exercise of stock options ...................... 1,125 793
-------- --------
Net cash provided by financing activities ..................................... 1,111 793
-------- --------
Net increase in cash and cash equivalents ..................................... 11,969 8,127
Cash and cash equivalents at beginning of period .............................. 51,157 51,395
-------- --------
Cash and cash equivalents at end of period .................................... $ 63,126 $ 59,522
======== ========
Supplemental disclosures of cash flow information:
Cash paid during the period for income taxes, net of refunds ... $ 6,542 $ 3,741
======== ========
See accompanying condensed notes to consolidated financial statements.
3
QUALITY SYSTEMS, INC.
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Basis of Presentation
The accompanying unaudited consolidated financial statements as of September 30,
2005 and for the three and six months ended September 30, 2005 and 2004, have
been prepared in accordance with the requirements of Form 10-Q and Article 10 of
Regulation S-X, and therefore do not include all information and footnotes which
would be presented were such financial statements prepared in accordance with
accounting principles generally accepted in the United States. These financial
statements should be read in conjunction with the audited financial statements
presented in the Company's Annual Report on Form 10-K for the fiscal year ended
March 31, 2005. In the opinion of management, the accompanying consolidated
financial statements reflect all adjustments which are necessary for a fair
presentation of the results of operations and cash flows for the periods
presented. The results of operations for such interim periods are not
necessarily indicative of results of operations to be expected for the full
year.
References to dollar amounts in this financial statement section are in
thousands, except share and per share data, unless otherwise specified. Certain
prior year amounts have been reclassified to conform with fiscal year 2006
presentation.
2. Stock Split
On February 2, 2005, the Board of Directors declared a 2-for-1 stock split with
respect to the Company's outstanding shares of common stock. The stock split
record date was March 4, 2005 and the stock began trading post split on March
28, 2005. References to share and per share data contained in the consolidated
financial statements have been retrospectively adjusted to reflect the stock
split for all periods presented.
3. Summary of Significant Accounting Policies
Principles of consolidation. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiary. All significant
inter-company accounts and transactions have been eliminated.
Revenue recognition. The Company currently recognizes revenue pursuant to
Statement of Position No. 97-2, "Software Revenue Recognition" (SOP 97-2), as
amended by Statement of Position No. 98-9 "Modification of SOP 97-2, Software
Revenue Recognition" (SOP 98-9). The Company generates revenue from the sale of
licensing rights to its software products directly to end-users and value-added
resellers (VARs). The Company also generates revenue from sales of hardware and
third party software, implementation, training, software customization,
Electronic Data Interchange (EDI), post-contract support (maintenance) and other
services performed for customers who license its products.
A typical system contract contains multiple elements of the above items. SOP
98-9 requires revenue earned on software arrangements involving multiple
elements to be allocated to each element based on the relative fair values of
those elements. The fair value of an element must be based on vendor specific
objective evidence (VSOE). The Company limits its assessment of VSOE for each
element to either the price charged when the same element is sold separately
(using a rolling average of stand alone transactions) or the price established
by management having the relevant authority to do so, for an element not yet
sold separately. VSOE calculations are updated and reviewed at the end of each
quarter.
When evidence of fair value exists for the delivered and undelivered elements of
a transaction, then discounts for individual elements are aggregated and the
total discount is allocated to the individual elements in proportion to the
elements' fair value relative to the total contract fair value.
When evidence of fair value exists for the undelivered elements only, the
residual method, provided for under SOP 98-9, is used. Under the residual
method, the Company defers revenue related to the undelivered elements in a
system sale based on VSOE of fair value of each of the undelivered elements, and
allocates the remainder of the contract price net of all discounts to revenue
recognized from the delivered elements. Undelivered elements of a system sale
may include implementation and training services, hardware and third party
software, maintenance, future purchase discounts, or other services. If VSOE of
4
fair value of any undelivered element does not exist, all revenue is deferred
until VSOE of fair value of the undelivered element is established or the
element has been delivered.
The Company bills for the entire contract amount upon contract execution.
Amounts billed in excess of the amounts contractually due are recorded in
accounts receivable as advance billings. Amounts are contractually due when
services are performed or in accordance with contractually specified payment
dates.
Provided the fees are fixed and determinable and collection is considered
probable, revenue from licensing rights and sales of hardware and third party
software is generally recognized upon shipment and transfer of title. Revenue
from implementation and training services is recognized as the corresponding
services are performed. Maintenance revenue is recognized ratably over the
contractual maintenance period.
Contract accounting is applied where services include significant software
modification, development or customization. In such instances, the arrangement
fee is accounted for in accordance with Statement of Position No. 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1). Pursuant to SOP 81-1, the Company uses the percentage of
completion method provided all of the following conditions exist:
o contract includes provisions that clearly specify the enforceable rights
regarding goods or services to be provided and received by the parties,
the consideration to be exchanged, and the manner and terms of settlement;
o the customer can be expected to satisfy its obligations under the
contract;
o the Company can be expected to perform its contractual obligations; and
o reliable estimates of progress towards completion can be made.
The Company measures completion using labor input hours. Costs of providing
services, including services accounted for in accordance with SOP 81-1, are
expensed as incurred.
If a situation occurs in which a contract is so short term that the financial
statements would not vary materially from using the percentage-of-completion
method or in which the Company is unable to make reliable estimates of progress
of completion of the contract, the completed contract method is utilized.
From time to time, the Company offers future purchase discounts on its products
and services as part of its sales arrangements. Pursuant to AICPA TPA 5100.51,
such discounts which are incremental to the range of discounts reflected in the
pricing of the other elements of the arrangement, which are incremental to the
range of discounts typically given in comparable transactions, and which are
significant, are treated as an additional element of the contract to be
deferred. Amounts deferred related to future purchase options are not recognized
until either the customer exercises the discount offer or the offer expires.
Cash and cash equivalents. Cash and cash equivalents generally consist of cash,
money market funds and short term U.S. Treasuries. The Company invests a portion
of its cash in a money market fund which invests in only investment grade money
market instruments from a variety of industries, and therefore bears minimal
risk. The average maturity of the investments owned by the money market fund is
approximately two months.
Accounts receivable. The Company provides credit terms typically ranging from
thirty days to less than twelve months for most system and maintenance contract
sales and generally does not require collateral. The Company performs credit
evaluations of its customers and maintains reserves for estimated credit losses.
Reserves for potential credit losses are determined by establishing both
specific and general reserves. Specific reserves are based on management's
estimate of the probability of collection for certain troubled accounts. General
reserves are established based on the Company's historical experience of bad
debt expense and the aging of the Company's accounts receivable balances net of
deferred revenues and specifically reserved accounts. Accounts are written off
as uncollectible only after the Company has expended extensive collection
efforts.
Included in accounts receivable are amounts related to maintenance and services
which were billed, but which had not yet been rendered as of the end of the
period. Undelivered maintenance and services are included on the balance sheet
in deferred revenue.
5
Inventories. Inventories consist of hardware for specific customer orders and
spare parts, and are valued at lower of cost (first-in, first-out) or market.
Management provides a reserve to reduce inventory to its net realizable value.
Equipment and improvements. Equipment and improvements are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization of
equipment and improvements are provided over the estimated useful lives of the
assets, or the related lease terms if shorter, by the straight-line method.
Useful lives range as follows:
Computers and electronic test equipment 3-5 years
Furniture and fixtures 5-7 years
Vehicles 7 years
Leasehold improvements lesser of lease term or estimated useful life of asset
Software development costs. Development costs incurred in the research and
development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been
established. After technological feasibility is established, any additional
development costs are capitalized in accordance with Statement of Financial
Accounting Standards No. 86, "Accounting for the Costs of Computer Software to
be Sold, Leased or Otherwise Marketed" (SFAS 86). Such costs are amortized on a
straight line basis over the estimated economic life of the related product,
which is generally three years. The Company reviews the recoverability of such
capitalized software costs. At the time a determination is made that capitalized
amounts are not recoverable based on the estimated cash flows to be generated
from the applicable software, any remaining capitalized amounts are written off.
Stock-based compensation. The Company accounts for stock-based employee
compensation using the intrinsic value method as prescribed by Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB
25), and has adopted the disclosure provisions from the Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure" (SFAS 148) that supercedes Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). SFAS 148 requires pro forma disclosures of net income
and net income per share as if the fair value based method of accounting for
stock-based awards had been applied to employee grants. It also requires
disclosure of option status on a more prominent and frequent basis. Such
disclosure for the three and six months ended September 30, 2005 and 2004 is
presented below.
The Company accounts for stock options and warrants issued to non-employees
based on the fair value method, but has not elected this treatment for grants to
employees and Board of Director members. Under the fair value based method,
compensation cost is recorded based on the value of the award at the grant date
and is recognized over the service period.
On August 8, 2005, the Board of Directors granted 9,500 options under the
Company's 1998 Stock Option Plan to selected employees at an exercise price
equal to the market price of the Company's common stock on the date of the grant
($64.89 per share). The options vest in four equal annual installments beginning
August 8, 2006 and expire on August 8, 2012. No compensation expense has been
recorded for these options. The Company's fair value calculations for options
granted on August 8, 2005 were made using the Black-Scholes option pricing model
with the following assumptions: expected life - approximately 57 months; stock
volatility - 47.7%, risk free interest rate of 3.7%; and no dividends during the
expected term. Although the Company paid a one-time dividend in fiscal year
2005, as the Company had not paid a dividend to its shareholders prior to the
one-time dividend in fiscal year 2005 and has no commitment to any future
dividends, management believes that using a zero dividend rate in the valuation
of the stock options granted on August 8, 2005 is appropriate.
The Company's calculations are based on a single option valuation approach and
forfeitures are recognized as they occur. If the computed fair values of awards
had been amortized to expense over the vesting period of the awards, pro forma
net income and net income per share would have been as follows (unaudited):
6
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2005 2004 2005 2004
--------------------- ---------------------
Net income, as reported ............. $ 5,794 $ 3,715 $ 10,869 $ 7,097
Add: Option expense, net of tax ..... 65 64 130 129
Deduct: Stock-based employee
compensation expense determined
under the fair value based method,
net of related tax effects .......... (504) (220) (1,106) (364)
-------- -------- -------- --------
Pro forma net income ................ $ 5,355 $ 3,559 $ 9,893 $ 6,862
======== ======== ======== ========
Net income per share:
Basic, as reported ............... $ 0.44 $ 0.29 $ 0.83 $ 0.56
======== ======== ======== ========
Basic, pro forma ................. $ 0.41 $ 0.28 $ 0.75 $ 0.54
======== ======== ======== ========
Diluted, as reported ............. $ 0.43 $ 0.28 $ 0.80 $ 0.54
======== ======== ======== ========
Diluted, pro forma ............... $ 0.39 $ 0.27 $ 0.73 $ 0.52
======== ======== ======== ========
4. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standard Board (FASB) issued
Statement of Financial Accounting Standards No. 123R, "Share-Based Payment"
(SFAS 123R) which is a revision of SFAS 123. Statement 123R supersedes APB 25
and amends Statement of Financial Accounting Standards No. 95, "Statement of
Cash Flows" (SFAS 95). SFAS 123R requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income
statement based on their fair values and the pro forma disclosure alternative is
no longer allowable under SFAS 123R. Subsequently, in April 2005, the Securities
and Exchange Commission (SEC) extended the effective date for required
implementation of SFAS 123R as described above to the first annual reporting
period beginning after June 15, 2005, which for the Company will commence April
1, 2006. The Company has not completed the process of evaluating the impact that
will result from adopting SFAS 123R and is therefore unable to disclose the
impact that adoption will have on the Company's financial position and results
of operations.
In May 2005, the FASB issued Statement of Financial Accounting Standards No.
154, "Accounting Changes and Error Corrections, a replacement of APB Opinion No.
20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in
Interim Financial Statements" (SFAS 154). SFAS 154 provides guidance on the
accounting for and reporting of accounting changes and error corrections. It
establishes, unless impracticable, retrospective application as the required
method for reporting a change in accounting principle in the absence of explicit
transition requirements specific to the newly adopted accounting principle. SFAS
154 is effective for accounting changes and corrections of errors made in fiscal
years beginning after December 15, 2005. The Company does not expect that
adoption of SFAS 154 will have a material effect on its consolidated financial
position, consolidated results of operations, or liquidity.
5. Composition of Certain Financial Statement Captions
Accounts receivable include amounts related to maintenance and services which
were billed but not yet rendered as of the end of the period. Undelivered
maintenance and services are included on the consolidated balance sheet as part
of the deferred revenue balance.
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
(Unaudited)
Accounts receivable, excluding undelivered maintenance
and services ............................................. $ 25,173 $ 22,162
Undelivered maintenance and services billed in advance,
included in deferred revenue ............................. 17,714 13,037
-------- --------
Accounts receivable, gross ................................ 42,887 35,199
Reserve for bad debts ..................................... (2,154) (1,837)
-------- --------
Accounts receivable, net .................................. $ 40,733 $ 33,362
======== ========
7
Inventories are summarized as follows:
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
(Unaudited)
Computer systems and components, net of reserve for
obsolescence of $266 and $146, respectively .................. $ 525 $ 891
Miscellaneous parts and supplies .............................. 22 69
------- -------
$ 547 $ 960
======= =======
Other current liabilities are summarized as follows:
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
(Unaudited)
Other deposits ................................................ $ 997 $ --
Customer deposits ............................................. 927 527
Sales tax payable ............................................. 802 833
Commission payable ............................................ 533 625
Professional services ......................................... 345 417
Payroll tax payable ........................................... 308 --
Deferred rent ................................................. 291 198
Accrued EDI expenses .......................................... -- 419
Other accrued expenses ........................................ 556 1,002
------- -------
$ 4,759 $ 4,021
======= =======
Short and long-term deferred revenue are summarized as follows:
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
(Unaudited)
Maintenance ................................................... $ 5,899 $ 4,639
Implementation services ....................................... 20,024 17,471
Undelivered software and other ................................ 4,151 3,367
------- -------
$30,074 $25,477
======= =======
6. Intangible Assets - Goodwill
In accordance with Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" (SFAS 142), the Company does not amortize
goodwill as the goodwill has been determined to have indefinite useful life. The
balance of goodwill is related to the Company's NextGen Healthcare Information
Systems Division (NextGen or Division), which was acquired by virtue of two
acquisitions completed in May of 1996 and 1997, respectively. In accordance with
SFAS 142, the Company has compared the fair value of the NextGen Division with
the carrying amount of assets associated with the Division and determined that
none of the goodwill recorded as of June 30, 2005 (the annual assessment date)
was impaired. The fair value of NextGen was determined using a reasonable
estimate of future cash flows of the Division and a risk adjusted discount rate
to compute a net present value of future cash flows.
7. Intangible Assets - Capitalized Software Development Costs
The Company had the following amounts related to capitalized software
development:
SEPTEMBER 30, MARCH 31,
2005 2005
------------- ---------
(Unaudited)
Gross carrying amount .............................. $ 14,936 $ 13,287
Accumulated amortization ........................... (10,113) (8,953)
-------- --------
Capitalized software costs, net .................... $ 4,823 $ 4,334
======== ========
Aggregate amortization expense during the six and
twelve month periods ended, respectively ............. $ 1,160 $ 1,952
======== ========
8
Activity related to net capitalized software costs for the six month period
ended September 30, 2005 is as follows:
Beginning of period ................................................ $ 4,334
Capitalized costs .................................................. 1,649
Amortization expense ............................................... (1,160)
-------
End of the period .................................................. $ 4,823
=======
The following table represents the remaining estimated amortization of
intangible assets with determinable lives as of September 30, 2005:
For the year ended March 31,
2006 ................................................................. $1,242
2007 ................................................................. 2,124
2008 ................................................................. 1,254
2009 ................................................................. 203
------
Total ................................................................ $4,823
======
8. Income Taxes
The provision for income taxes for the six months ended September 30, 2005 was
$6,870 as compared to $4,705 for the year ago period. The effective tax rates
for the six months ended September 30, 2005 and 2004 were 38.7% and 39.9%,
respectively. The provision for income taxes for the six months ended September
30, 2005 differs from the combined statutory rates primarily due to the impact
of varying state income tax rates, research and development tax credits and the
domestic manufacturer's deduction. The effective rate for the six months ended
September 30, 2005 decreased from the prior year primarily due to the relatively
larger impact of research and development tax credits and the domestic
manufacturer's production activities deduction under the Jobs Creation Act of
2004, which is effective for the fiscal year ending March 31, 2006. The
provision for income taxes for the six months ended September 30, 2004 differs
from the combined statutory rates primarily due to the impact of varying state
income tax rates and research and development tax credits.
9. Net Income Per Share
The following table reconciles the weighted average shares outstanding for basic
and diluted net income per share for the periods indicated. Basic net income per
share is based upon the weighted average number of common shares outstanding.
Diluted net income per share is based on the assumption that the Company's
outstanding options are included in the calculation of diluted earnings per
share, except when their effect would be anti-dilutive. Dilution is computed by
applying the treasury stock method. Under this method, options are assumed to be
exercised at the beginning of the period (or at the time of issuance, if later),
and as if funds obtained thereby were used to purchase common stock at the
average market price during the period (unaudited).
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
------------------ ------------------
2005 2004 2005 2004
------- ------- ------- -------
Net income ......................... $ 5,794 $ 3,715 $10,869 $ 7,097
Basic net income per common share:
Weighted average of common
shares outstanding .............. 13,149 12,780 13,131 12,722
------- ------- ------- -------
Basic net income per common share .. $ 0.44 $ 0.29 $ 0.83 $ 0.56
======= ======= ======= =======
Net income ......................... $ 5,794 $ 3,715 $10,869 $ 7,097
Diluted net income per common
Share:
Weighted average of common
shares outstanding ............... 13,149 12,780 13,131 12,722
Effect of potentially
dilutive securities (options) .... 415 416 398 438
------- ------- ------- -------
Weighted average of common
shares outstanding-diluted ....... 13,564 13,196 13,529 13,160
------- ------- ------- -------
Diluted net income per common
share ............................. $ 0.43 $ 0.28 $ 0.80 $ 0.54
======= ======= ======= =======
9
10. Operating Segment Information
The Company has prepared operating segment information in accordance with
Statement of Accounting Standards No. 131 "Disclosures About Segments of an
Enterprise and Related Information" (SFAS 131) to report components that are
evaluated regularly by the Company's chief operating decision maker, or decision
making group in deciding how to allocate resources and in assessing performance.
The Company's reportable operating segments include its NextGen Healthcare
Information Systems Division and the QSI Division.
The disaggregated financial results of the segments reflect allocation of
certain functional expense categories consistent with the basis and manner in
which Company management internally disaggregates financial information for the
purpose of assisting in making internal operating decisions. Certain corporate
overhead costs are not allocated to the individual segments by management. The
Company evaluates performance based on stand-alone segment revenue and operating
income performance. Because the Company does not evaluate performance based on
return on assets at the operating segment level, assets are not tracked
internally by segment. Therefore, segment asset information is not presented.
Operating segment data for the three and six month periods ended September 30,
2005 and 2004 is as follows (unaudited):
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
Revenue:
QSI Division .................... $ 4,018 $ 3,955 $ 7,851 $ 7,936
NextGen Division ................ 25,524 17,262 49,119 33,411
-------- -------- -------- --------
Consolidated revenue .............. $ 29,542 $ 21,217 $ 56,970 $ 41,347
======== ======== ======== ========
Operating income(loss):
QSI Division .................... $ 1,303 $ 1,137 $ 2,020 $ 2,399
NextGen Division ................ 9,853 6,064 18,556 11,259
Unallocated corporate expenses .. (2,122) (1,153) (3,638) (2,146)
-------- -------- -------- --------
Consolidated operating income ..... $ 9,034 $ 6,048 $ 16,938 $ 11,512
======== ======== ======== ========
11. Concentration of Credit Risk
The Company had cash deposits at U.S. banks and financial institutions which
exceeded federally insured limits at September 30, 2005. The Company is exposed
to credit loss for amounts in excess of insured limits in the event of
non-performance by the institutions; however, the Company does not anticipate
non-performance by these institutions.
12. Commitments and Guarantees
Software license agreements in both our QSI and NextGen divisions include a
performance guarantee that its software products will substantially operate as
described in the applicable program documentation for a period of 365 days after
delivery. To date, the Company has not incurred any significant costs associated
with these warranties and do not expect to incur significant warranty costs in
the future. Therefore, no accrual has been made for potential costs associated
with these warranties.
The Company has historically offered short-term rights of return of less than 20
days in certain of its sales arrangements. Based on its historical experience
with similar types of sales transactions bearing these short-term rights of
return, the Company has not recorded any accrual for returns in its financial
statements.
The Company's standard sales agreements in the NextGen division contain an
indemnification provision pursuant to which it shall indemnify, hold harmless,
and agree to reimburse the indemnified party for losses suffered or incurred by
the indemnified party in connection with any United States patent, any copyright
or other intellectual property infringement claim by any third party with
respect to its software. The QSI division arrangements occasionally utilize this
type of language as well. As the Company has not incurred any significant costs
to defend lawsuits or settle claims related to these indemnification
10
agreements, the Company believes that its estimated exposure on these agreements
is currently minimal. Accordingly, the Company has no liabilities recorded for
these indemnification obligations.
From time to time, the Company offers future purchase discounts on its products
and services as part of irs sales arrangements. Discounts which are incremental
to the range of discounts reflected in the pricing of the other elements of the
arrangement, which are incremental to the range of discounts typically given in
comparable transactions, and which are significant are treated as an additional
element of the contract to be deferred. Amounts deferred related to future
purchase options are not recognized until either the customer exercises the
discount offer or the offer expires.
The Company has entered into marketing assistance agreements with existing users
of the Company's products which provide the opportunity for those users to earn
commissions if and only if they host specific site visits upon our request for
prospective customers which directly result in a purchase of our software by the
visiting prospects. Amounts earned by existing users under this program are
treated as a selling expense in the period in which commissionable software has
been recognized as revenue.
13. Subsequent Events
Stock options grant. On October 5, 2005, the Board of Directors granted a total
of 62,000 stock options under the Company's 1998 Stock Option Plan to
non-management Directors pursuant to the Company's previously announced
compensation plan for non-management directors, at an exercise price equal to
the market price of the Company's common stock on the date of the grant ($68.13
per share). The options fully vest on January 5, 2006 and expire on October 5,
2012. No compensation expense has been recorded for these options.
Amendment to Articles of Incorporation. On October 6, 2005, the Company filed
with the California Secretary of State an amendment to the Company's Articles of
Incorporation to increase the level of its authorized shares of common stock
from 20,000,000 shares to 50,000,000 shares. The amendment was approved
previously by the Company's shareholders and the Board.
Litigation. After the close of business on October 26, 2005, the Company learned
that a lawsuit has been filed against the Company and six of its eight directors
by Ahmed Hussein, a director and significant shareholder of the Company. The
complaint names the Company and individual directors, Patrick Cline, Maurice
DeWald, Vincent Love, Steven Plochocki, Sheldon Razin and Louis Silverman.
Director Ibrahim Fawzy was not named as a defendant.
Filed in the Superior Court for Orange County, California, the complaint alleges
that in connection with the Company's 2005 Annual Shareholders' Meeting, the
certified results from the independent inspector of election included certain
proxies that should not have been included in the final vote tabulation. The
independent inspector of election has certified the election of the Company's
eight directors (as previously announced) after hearing Mr. Hussein's claim
concerning this matter. Specifically, Mr. Hussein seeks (i) a determination that
the election of directors at the Annual Meeting is invalid, (ii) a determination
that the votes of the disputed shares were improper and in violation of
applicable regulations, (iii) an order requiring that the election of directors
at the Annual Meeting be retabulated without including the disputed shares in
the count, (iv) an order requiring the election of directors with the
retabulated votes in a manner so as to provide Mr. Hussein with the greatest
number of directors possible, and (v) costs.
The Company believes that Mr. Hussein's claims lack merit and that the results
certified by the independent inspector of elections are conclusive of this
matter. The Company intends to defend itself vigorously.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Except for the historical information contained herein, the matters discussed in
this quarterly report may include forward-looking statements that involve
certain risks and uncertainties. Actual results may differ from those
anticipated by us as a result of various factors, both foreseen and unforeseen,
including, but not limited to, our ability to continue to develop new products
and increase systems sales in markets characterized by rapid technological
evolution, consolidation, and competition from larger, better capitalized
competitors. Many other economic, competitive, governmental and technological
factors could impact our ability to achieve our goals, and interested persons
are urged to review the risks described in "Risk Factors" as set forth herein,
as well as in our other public disclosures and filings with the Securities and
Exchange Commission.
The following discussion should be read in conjunction with, and is qualified in
its entirety by, the Consolidated Financial Statements and related notes thereto
included elsewhere in this report. Historical results of operations, percentage
profit fluctuations and any trends that may be inferred from the discussion
below are not necessarily indicative of the operating results for any future
period.
Critical Accounting Policies. The discussion and analysis of our financial
condition and results of operations is based upon our consolidated financial
statements which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenue and expenses, and related
disclosures of contingent assets and liabilities. On an on-going basis, we
evaluate estimates, including but not limited to those related to revenue
recognition, uncollectible accounts receivable, intangible assets and software
development cost for reasonableness. We base our estimates on historical
experience and on various other assumptions that management believes to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
We believe revenue recognition, the allowance for doubtful accounts, goodwill
impairment and software development costs are among the most critical accounting
policies that impact our consolidated financial statements. We believe that our
significant accounting policies, as described in Note 3 of our Condensed Notes
to Consolidated Financial Statements, "Summary of Significant Accounting
Policies", should be read in conjunction with Management's Discussion and
Analysis of Financial Condition and Results of Operations.
Revenue Recognition. We currently recognize revenue pursuant to SOP 97-2, as
amended by SOP 98-9. We generate revenue from the sale of licensing rights to
use our software products sold directly to end-users and value-added resellers
(VARs). We also generate revenue from sales of hardware and third party
software, and implementation, training, software customization, EDI,
post-contract support ("maintenance") and other services performed for customers
who license our products.
A typical system contract contains multiple elements of the above items. SOP
97-2, as amended, requires revenue earned on software arrangements involving
multiple elements to be allocated to each element based on the relative fair
values of those elements. The fair value of an element must be based on vendor
specific objective evidence (VSOE). We limit our assessment of VSOE for each
element to either the price charged when the same element is sold separately
(using a rolling average of stand alone transactions) or the price established
by management having the relevant authority to do so, for an element not yet
sold separately. VSOE calculations are updated and reviewed at the end of each
quarter.
When evidence of fair value exists for the delivered and undelivered elements of
a transaction, then discounts for individual elements are aggregated and the
total discount is allocated to the individual elements in proportion to the
elements' fair value relative to the total contract fair value.
When evidence of fair value exists for the undelivered elements only, the
residual method, provided for under SOP 98-9, is used. Under the residual
method, the Company defers revenue related to the undelivered elements in a
system sale based on VSOE of fair value of each of the undelivered elements, and
allocates the remainder of the contract price net
12
of all discounts to revenue recognized from the delivered elements. Undelivered
elements of a system sale may include implementation and training services,
hardware and third party software, maintenance, future purchase discounts, or
other services. If VSOE of fair value of any undelivered element does not exist,
all revenue is deferred until VSOE of fair value of the undelivered element is
established or the element has been delivered.
We bill for the entire contract amount upon contract execution. Amounts billed
in excess of the amounts contractually due are recorded in accounts receivable
as advance billings. Amounts are contractually due when services are performed
or in accordance with contractually specified payment dates.
Provided the fees are fixed and determinable and collection is considered
probable, revenue from licensing rights and sales of hardware and third party
software is generally recognized upon shipment and transfer of title. Revenue
from implementation and training services is recognized as the corresponding
services are performed. Maintenance revenue is recognized ratably over the
contractual maintenance period.
Contract accounting is applied where services include significant software
modification, development or customization. In such instances, the arrangement
fee is accounted for in accordance with Statement of Position No. 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" (SOP 81-1).
Pursuant to SOP 81-1, the Company uses the percentage of completion method
provided all of the following conditions exist:
o contract includes provisions that clearly specify the enforceable rights
regarding goods or services to be provided and received by the parties,
the consideration to be exchanged, and the manner and terms of settlement;
o the customer can be expected to satisfy its obligations under the
contract;
o the Company can be expected to perform it's contractual obligations; and
o reliable estimates of progress towards completion can be made.
We measure completion using labor input hours. Costs of providing services,
including services accounted for in accordance with SOP 81-1, are expensed as
incurred.
If a situation occurs in which a contract is so short term that the financial
statements would not vary materially from using the percentage-of-completion
method or in which we are unable to make reliable estimates of progress of
completion of the contract, the completed contract method is utilized.
From time to time, we offer future purchase discounts on our products and
services as part of our sales arrangements. Pursuant to AICPA TPA 5100.51,
discounts which are incremental to the range of discounts reflected in the
pricing of the other elements of the arrangement, which are incremental to the
range of discounts typically given in comparable transactions, and which are
significant, are treated as an additional element of the contract to be
deferred. Amounts deferred related to future purchase options are not recognized
until either the customer exercises the discount offer or the offer expires.
Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts
for estimated losses resulting from the inability of our customers to make
required payments. We perform credit evaluations of our customers and maintain
reserves for estimated credit losses. Reserves for potential credit losses are
determined by establishing both specific and general reserves. Specific reserves
are based on management's estimate of the probability of collection for certain
troubled accounts. General reserves are established based on our historical
experience of bad debt expense and the aging of our accounts receivable balances
net of deferred revenue and specifically reserved accounts. If the financial
condition of our customers were to deteriorate resulting in an impairment of
their ability to make payments, additional allowances would be required.
Goodwill Impairment. Our long-lived assets include goodwill of $1.8 million as
of September 30, 2005 and 2004, respectively. We adopted SFAS 142 effective
April 1, 2001. The statement applies to the amortization of goodwill and other
intangible assets. We ceased amortizing amounts related to goodwill beginning
April 1, 2001 as we determined that it had an indefinite life. The balance of
goodwill is related to our NextGen Division. Under SFAS 142, we are required to
perform an annual assessment of the implied fair value of goodwill and
intangible assets with indefinite lives for impairment. We have compared the
fair value of the NextGen Division with the carrying amount of assets associated
with the Division and determined that none of the goodwill recorded as of June
13
30, 2005 (the date of our last annual impairment test) was impaired. The fair
value of the NextGen Division was determined using a reasonable estimate of
future cash flows of the Division and a risk adjusted discount rate to compute a
net present value of future cash flows.
The process of evaluating goodwill for impairment involves the determination of
the fair value of our business segments. Inherent in such fair value
determinations are certain judgments and estimates, including the interpretation
of current economic indicators and market valuations, and assumptions about our
strategic plans with regard to operations. To the extent additional information
arises or our strategies change, it is possible that our conclusion regarding
goodwill impairment could change, which could have a material negative effect on
our financial position or results of operations.
Software Development Costs. Development costs incurred in the research and
development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been
established. After technological feasibility is established with the completion
of a working model of the enhancement or product, any additional development
costs are capitalized in accordance with the Statement of Financial Accounting
Standards No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed" (SFAS 86). Such capitalized costs are amortized on
a straight line basis over the estimated economic life of the related product,
of three years. We perform an annual review of the recoverability of such
capitalized software costs. At the time a determination is made that capitalized
amounts are not recoverable based on the estimated cash flows to be generated
from the applicable software, any remaining capitalized amounts are written off.
Company Overview
Quality Systems Inc., comprised of the QSI Division (QSI Division) and a wholly
owned subsidiary, NextGen Healthcare Information Systems, Inc. (NextGen
Division) (collectively, the Company, we, our, or us) develops and markets
healthcare information systems that automate certain aspects of medical and
dental practices, networks of practices such as physician hospital organizations
(PHO's) and management service organizations (MSO's), ambulatory care centers,
community health centers, and medical and dental schools.
The Company, a California corporation formed in 1974, was founded with an early
focus on providing information systems to dental group practices. In the
mid-1980's, we capitalized on the increasing focus on medical cost containment
and further expanded our information processing systems to serve the medical
market. In the mid 1990's we made two acquisitions that accelerated our
penetration of the medical market. These two acquisitions formed the basis for
what is today the NextGen Division. Today, we serve the medical and dental
markets through our two divisions.
The two Divisions operate largely as stand-alone operations with each Division
maintaining its own distinct product lines, product platforms, development,
implementation and support teams, sales staffing, and branding. The two
Divisions share the resources of the "corporate office" which includes a variety
of accounting and other administrative functions. Additionally, there are a
small number of clients who are simultaneously utilizing software from each of
our two Divisions.
The QSI Division, co-located with our Corporate Headquarters in Irvine,
California, currently focuses on developing, marketing and supporting software
suites sold to dental and certain niche medical practices. In addition, the
Division supports a number of medical clients that utilize the Division's
UNIX(1) based medical practice management software product.
The NextGen Division, with headquarters in Horsham, Pennsylvania, and a second
significant location in Atlanta, Georgia, focuses principally on developing and
marketing products and services for medical practices.
Both Divisions develop and market practice management software which is designed
to automate and streamline a number of the administrative functions required for
operating a medical or dental practice. Examples of practice management software
functions include
- ----------
(1) UNIX is a registered trademark of the AT&T Corporation.
14
scheduling and billing capabilities. It is important to note that in both the
medical and dental environments, practice management software systems have
already been implemented by the vast majority of practices. Therefore, we
actively compete for the replacement market.
In addition, both Divisions develop and market software that automates the
patient record and enhances patient-provider interactions. Adoption of this
software, commonly referred to as clinical software, is in its relatively early
stages. Therefore, we are typically competing to replace paper-based patient
record alternatives as opposed to replacing previously purchased systems.
Electronic Data Interchange (EDI)/connectivity products are intended to automate
a number of manual, often paper-based or telephony intensive communications
between patients and/or providers and/or payors. Two of the more common EDI
services are forwarding insurance claims electronically from providers to payors
and assisting practices with issuing statements to patients. Most practices
utilize at least some of these services from us or one of our competitors. Other
EDI/connectivity services are used more sporadically by client practices. We
typically compete to displace incumbent vendors for claims and statements
accounts, and attempt to increase usage of other elements in our
EDI/connectivity product line. In general, EDI services are only sold to those
accounts utilizing software from one of our Divisions.
The QSI Division's practice management software suite utilizes a UNIX operating
system. Its Clinical Product Suite (CPS) utilizes a Windows NT(2) operating
system and can be fully integrated with the practice management software from
each Division. CPS incorporates a wide range of clinical tools including, but
not limited to, periodontal charting and digital imaging of X-ray and inter-oral
camera images as part of the electronic patient record. The Division develops,
markets, and manages our EDI/connectivity applications. The QSInet Application
Service Provider (ASP/Internet) offering is also developed and marketed by the
Division.
Our NextGen Division develops and sells proprietary electronic medical records
software and practice management systems under the NextGen(R)(3) product name.
Major product categories of the NextGen suite include Electronic Medical Records
(NextGen(emr)), Enterprise Practice Management (NextGen(epm)), Enterprise
Appointment Scheduling (NextGen(eas)), Enterprise Master Patient Index
(NextGen(epi)), NextGen Image Control System (NextGen(ics)), Realtime
Transaction Server Server (NextGen(rts)), Electronic Data Interchange, System
Interfaces, a Patient-centric Web Portal solution (NextMD(4).com), and a
handheld product (NextGen(pda)). NextGen also markets a version of NextGen(emr)
with reduced capabilities (NextGen Express). NextGen products utilize Microsoft
Windows technology and can operate in a client-server environment as well as via
private intranet, the Internet, or within an ASP environment.
We continue to pursue product enhancement initiatives within each Division. The
majority of such expenditures are currently targeted to the NextGen Division
product line and client base.
Inclusive of divisional EDI revenue, the NextGen Division accounted for
approximately 86.4% of our revenue for the second quarter of fiscal 2006
compared to 81.4% in the second quarter of fiscal 2005. The QSI Division
accounted for 13.6% and 18.6% of revenue in the second quarter of fiscal 2006
and 2005, respectively. The NextGen Division's year over year revenue grew at
47.9% and 28.3% in the second quarter of fiscal 2006 and 2005, respectively,
while the QSI Division's year over year revenue increased by 1.6% and declined
by 5.6% in the second quarter of fiscal 2006 and 2005, respectively.
In addition to the aforementioned software solutions which we offer through our
two divisions, each division offers comprehensive hardware and software
installation services, maintenance and support services, and system training
services.
- ----------
(2) Microsoft Windows, Windows NT, Windows 95, Windows 98, Windows XP, and
Windows 2000 are registered trademarks of the Microsoft Corporation.
(3) NextGen is a registered trademark of NextGen Healthcare Information
Systems, Inc.
(4) NextMD is a registered trademark of NextGen Healthcare Information
Systems, Inc.
15
Risk Factors
The more prominent risks and uncertainties inherent in our business are
described below. However, additional risks and uncertainties may also impair our
business operations. If any of these or other risks actually occur, our
business, financial condition or results of operations will likely suffer. Any
of these or other factors could harm our business and future results of
operations and may cause you to lose all or part of your investment.
We face significant competition. The markets for healthcare information systems
are intensely competitive and we face significant competition from a number of
different sources. Several of our competitors have significantly greater name
recognition as well as substantially greater financial, technical, product
development and marketing resources than we do.
We compete in all of our markets with other major healthcare related companies,
information management companies, systems integrators, and other software
developers. Competitive pressures and other factors, such as new product
introductions by ourselves or our competitors, may result in price or market
share erosion that could have a material adverse effect on our business, results
of operations and financial condition. Also, there can be no assurance that our
applications will achieve broad market acceptance or will successfully compete
with other available software products.
Our inability to make initial sales of our systems to newly formed groups and/or
healthcare providers that are replacing or substantially modifying their
healthcare information systems could have a material adverse effect on our
business, results of operations and financial condition. If new systems sales do
not materialize, our near term and longer term revenue will be negatively
affected.
Our quarterly operating results have historically fluctuated and may do so in
the future. Our revenue may fluctuate in the future from quarter to quarter and
period to period, as a result of a number of factors including, without
limitation:
o the size and timing of orders from clients;
o the specific mix of software, hardware, and services in client orders;
o the length of sales cycles and installation processes;
o the ability of our clients to obtain financing for the purchase of our
products;
o changes in pricing policies or price reductions by us or our competitors;
o the timing of new product announcements and product introductions by us or
our competitors;
o changes in revenue recognition or other accounting guidelines employed by
us and/or established by the Financial Accounting Standards Board or other
rule-making bodies;
o the availability and cost of system components;
o the financial stability of clients;
o market acceptance of new products, applications and product enhancements;
o our ability to develop, introduce and market new products, applications
and product enhancements;
o our success in expanding our sales and marketing programs;
o deferrals of client orders in anticipation of new products, applications,
product enhancements, or public/private sector initiatives;
o execution of or changes to our strategy;
o personnel changes; and
o general market/economic factors.
Our software products are generally shipped as orders are received and
accordingly, we have historically operated with a minimal backlog of license
fees. As a result, revenue in any quarter is dependent on orders booked and
shipped in that quarter and is not predictable with any degree of certainty.
Furthermore, our systems can be relatively large and expensive and individual
systems sales can represent a significant portion of our revenue and profits for
a quarter such that the loss or deferral of even one such sale can have a
significant adverse impact on our quarterly revenue and profitability.
Clients often defer systems purchases until our quarter end, so quarterly
results generally cannot be predicted and frequently are not known until the
quarter has concluded.
Our sales are dependent upon clients' initial decisions to replace or
substantially modify their existing information systems, and subsequently a
decision as to which products and services to purchase. These are major
decisions for healthcare providers, and accordingly,
16
the sales cycle for our systems can vary significantly and typically ranges from
six to twenty four months from initial contact to contract execution/shipment.
Because a significant percentage of our expenses are relatively fixed, a
variation in the timing of systems sales, implementations, and installations can
cause significant variations in operating results from quarter to quarter. As a
result, we believe that interim period-to-period comparisons of our results of
operations are not necessarily meaningful and should not be relied upon as
indications of future performance. Further, our historical operating results are
not necessarily indicative of future performance for any particular period.
We currently recognize revenue pursuant to SOP 97-2, as modified by SOP 98-9 and
SAB 104. SAB 104 summarizes the staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements.
There can be no assurance that application and subsequent interpretations of
these pronouncements will not further modify our revenue recognition policies,
or that such modifications would not have a material adverse effect on the
operating results reported in any particular quarter or year.
Due to all of the foregoing factors, it is possible that our operating results
may be below the expectations of public market analysts and investors. In such
event, the price of our common stock would likely be materially adversely
affected.
The price of our shares and the trading volume of our shares have been volatile
historically and may continue to be volatile. Volatility may be caused by a
number of factors including but not limited to:
o actual or anticipated quarterly variations in operating results;
o rumors about our performance, software solutions, or merger and
acquisition activity;
o changes in expectations of future financial performance or changes in
estimates of securities analysts;
o governmental regulatory action;
o health care reform measures;
o client relationship developments;
o purchases or sales of company stock;
o changes occurring in the markets in general; and
o other factors, many of which are beyond our control.
Furthermore, the stock market in general, and the market for software,
healthcare and high technology companies in particular, has experienced extreme
volatility that often has been unrelated to the operating performance of
particular companies. These broad market and industry fluctuations may adversely
affect the trading price of our common stock, regardless of actual operating
performance.
Two of our directors are significant shareholders, which makes it possible for
them to have significant influence over the outcome of all matters submitted to
our shareholders for approval and which influence may be alleged to conflict
with our interests and the interests of our other shareholders. Two of our
directors and principal shareholders beneficially owned an aggregate of
approximately 38% of the outstanding shares of our common stock at September 30,
2005. The Company's Bylaws permit its shareholders to cumulate their votes, the
effect of which is to provide shareholders with sufficiently large
concentrations of Company shares the opportunity to assure themselves one or
more seats on the Company's Board. The amounts required to assure a Board
position can vary based upon the number of shares outstanding, the number of
shares voting, the number of directors to be elected, the number of "broker
non-votes", and the number of shares held by the shareholder exercising
cumulative voting rights. In the event that cumulative voting is invoked, it is
likely that the two of our directors holding an aggregate of approximately 38%
of the outstanding shares of our common stock at September 30, 2005 will each
have sufficient votes to assure themselves of one or more seats on our Board.
With or without cumulative voting, these shareholders will have significant
influence over the outcome of all matters submitted to our shareholders for
approval, including the election of our directors and other corporate actions.
In addition, such influence by one or both of these affiliates could have the
effect of discouraging others from attempting to purchase us, take us over,
and/or reducing the market price offered for our common stock in such an event.
17
Certain matters presented to shareholders for approval at the Company's 2005
Annual Shareholders' Meeting held on September 21, 2005 were contested by Ahmed
Hussein, one of the aforementioned directors and principal shareholders. In
particular, Mr. Hussein (i) opposed shareholder approval of our 2005 Stock
Option and Incentive Plan and (ii) sought to elect three of his director
nominees. Upon certification of the election, the 2005 Stock Option and
Incentive Plan was adopted by the shareholders and two of Mr. Hussein's nominees
were elected to the Board. After the close of business on October 26, 2005, we
learned that a lawsuit has been filed against us and six of our eight directors
(those elected by the shareholders, but not nominated by Mr. Hussein). The
complaint alleges that in connection with our 2005 Annual Shareholders' Meeting,
the certified results from the independent inspector of election included
certain proxies that should not have been included in the final vote tabulation.
The independent inspector of election has certified the election of the eight
directors presently serving on the Board after hearing Mr. Hussein's claim
concerning this matter. Mr. Hussein continues to pursue his claim in California
State Superior Court. As result of such litigation, the Company's operating
results and share price may be negatively impacted due to the negative
publicity, additional expenses incurred, management distraction, and/or other
factors.
We are dependent on our principal products and our new product development. We
currently derive substantially all of our net revenue from sales of our
healthcare information systems and related services. We believe that a primary
factor in the market acceptance of our systems has been our ability to meet the
needs of users of healthcare information systems. Our future financial
performance will depend in large part on our ability to continue to meet the
increasingly sophisticated needs of our clients through the timely development
and successful introduction and implementation of new and enhanced versions of
our systems and other complementary products. We have historically expended a
significant percentage of our net revenue on product development and believe
that significant continuing product development efforts will be required to
sustain our growth. Continued investment in our sales staff and our client
implementation and support staffs will also be required to support future
growth.
There can be no assurance that we will be successful in our product development
efforts, that the market will continue to accept our existing products, or that
new products or product enhancements will be developed and implemented in a
timely manner, meet the requirements of healthcare providers, or achieve market
acceptance. If new products or product enhancements do not achieve market
acceptance, our business, results of operations and financial condition could be
materially adversely affected. At certain times in the past, we have also
experienced delays in purchases of our products by clients anticipating our
launch of new products. There can be no assurance that material order deferrals
in anticipation of new product introductions from ourselves or other entities
will not occur.
If the emerging technologies and platforms of Microsoft and others upon which we
build our products do not gain broad market acceptance, or if we fail to develop
and introduce in a timely manner new products and services compatible with such
emerging technologies, we may not be able to compete effectively and our ability
to generate revenue will suffer. Our software products are built and depend upon
several underlying and evolving relational database management system platforms
such as those developed by Microsoft. To date, the standards and technologies
upon which we have chosen to develop our products have proven to have gained
industry acceptance. However, the market for our software products is subject to
ongoing rapid technological developments, quickly evolving industry standards
and rapid changes in customer requirements, and there may be existing or future
technologies and platforms that achieve industry standard status, which are not
compatible with our products.
We face the possibility of subscription pricing. We currently derive
substantially all of our revenue from traditional software license, maintenance
and service fees, as well as the resale of computer hardware. Today, customers
pay an initial license fee for the use of our products, in addition to a
periodic maintenance fee. If the marketplace demands subscription pricing, we
may be forced to adjust our sales, marketing and pricing strategies accordingly,
by offering a higher percentage of our products and services through these
means. Shifting to a significantly greater degree of subscription pricing could
materially adversely impact our financial condition, cash flows and quarterly
and annual revenue and results of operations, as our revenue would initially
decrease substantially. There can be no assurance that the marketplace will not
increasingly embrace subscription pricing.
The industry in which we operate is subject to significant technological change.
The software market generally is characterized by rapid technological change,
changing
18
customer needs, frequent new product introductions, and evolving industry
standards. The introduction of products incorporating new technologies and the
emergence of new industry standards could render our existing products obsolete
and unmarketable. There can be no assurance that we will be successful in
developing and marketing new products that respond to technological changes or
evolving industry standards. New product development depends upon significant
research and development expenditures which depend ultimately upon sales growth.
Any material weakness in revenue or research funding could impair our ability to
respond to technological advances or opportunities in the marketplace and to
remain competitive. If we are unable, for technological or other reasons, to
develop and introduce new products in a timely manner in response to changing
market conditions or customer requirements, our business, results of operations
and financial condition may be materially adversely affected.
In response to increasing market demand, we are currently developing new
generations of certain of our software products. There can be no assurance that
we will successfully develop these new software products or that these products
will operate successfully, or that any such development, even if successful,
will be completed concurrently with or prior to introduction of competing
products. Any such failure or delay could adversely affect our competitive
position or could make our current products obsolete.
We face the possibility of claims based upon our Web site. We could be subject
to third party claims based on the nature and content of information supplied on
our Web site by us or third parties, including content providers or users. We
could also be subject to liability for content that may be accessible through
our Web site or third party Web sites linked from our Web site or through
content and information that may be posted by users in chat rooms, bulletin
boards or on Web sites created by professionals using our applications. Even if
these claims do not result in liability to us, investigating and defending
against these claims could be expensive and time consuming and could divert
management's attention away from our operations.
We face the possibility of claims from activities of strategic partners. We rely
on third parties to provide services that impact our business. For example, we
use national clearinghouses in the processing of some insurance claims and we
outsource some of our hardware maintenance services and the printing and
delivery of patient statements for our customers. We also have relationships
with certain third parties where these third parties serve as sales channels
through which we generate a portion of our revenue. Due to these third-party
relationships, we could be subject to claims as a result of the activities,
products, or services of these third-party service providers even though we were
not directly involved in the circumstances leading to those claims. Even if
these claims do not result in liability to us, defending and investigating these
claims could be expensive and time-consuming, divert personnel and other
resources from our business and result in adverse publicity that could harm our
business.
We may engage in future acquisitions, which may be expensive and time consuming
and from which we may not realize anticipated benefits. We may acquire
additional businesses, technologies and products if we determine that these
additional businesses, technologies and products are likely to serve our
strategic goals. We currently have no commitments or agreements with respect to
any acquisitions. The specific risks we may encounter in these types of
transactions include but are not limited to the following:
o potentially dilutive issuances of our securities, the incurrence of debt
and contingent liabilities and amortization expenses related to intangible
assets, which could adversely affect our results of operations and
financial conditions;
o use of cash as acquisition currency may adversely impact interest or
investment income, thereby potentially negatively affecting our earnings
and /or earnings per share;
o difficulty in effectively integrating any acquired technologies or
software products into our current products and technologies;
o difficulty in predicting and responding to issues related to product
transition such as development, distribution and customer support;
o the possible adverse impact of such acquisitions on existing relationships
with third party partners and suppliers of technologies and services;
o the possibility that staff or customers of the acquired company might not
accept new ownership and may transition to different technologies or
attempt to renegotiate contract terms or relationships, including
maintenance or support agreements;
o the possibility that the due diligence process in any such acquisition may
not completely identify material issues associated with product quality,
product architecture, product development, intellectual property issues,
key personnel issues
19
or legal and financial contingencies, including any deficiencies in
internal controls and procedures and the costs associated with remedying
such deficiencies;
o difficulty in integrating acquired operations due to geographical
distance, and language and cultural differences; and
o The possibility that acquired assets become impaired, requiring the
Company to take a charge to earnings which could be significant.
A failure to successfully integrate acquired businesses or technology for any of
these reasons could have a material adverse effect on the Company's results of
operations.
We face the risks and uncertainties that are associated with litigation against
us. We face the risks associated with litigation concerning the operation of our
business. The uncertainty associated with substantial unresolved litigation may
have an adverse impact on our business. In particular, such litigation could
impair our relationships with existing customers and our ability to obtain new
customers. Defending such litigation may result in a diversion of management's
time and attention away from business operations, which could have a material
adverse effect on our business, results of operations and financial condition.
Such litigation may also have the effect of discouraging potential acquirers
from bidding for us or reducing the consideration such acquirers would otherwise
be willing to pay in connection with an acquisition.
There can be no assurance that such litigation will not result in liability in
excess of our insurance coverage, that our insurance will cover such claims or
that appropriate insurance will continue to be available to us in the future at
commercially reasonable rates.
We rely heavily on our proprietary technology. We are heavily dependent on the
maintenance and protection of our intellectual property and we rely largely on
license agreements, confidentiality procedures, and employee nondisclosure
agreements to protect our intellectual property. Our software is not patented
and existing copyright laws offer only limited practical protection.
There can be no assurance that the legal protections and precautions we take
will be adequate to prevent misappropriation of our technology or that
competitors will not independently develop technologies equivalent or superior
to ours. Further, the laws of some foreign countries do not protect our
proprietary rights to as great an extent as do the laws of the United States and
are often not enforced as vigorously as those in the United States.
We do not believe that our operations or products infringe on the intellectual
property rights of others. However, there can be no assurance that others will
not assert infringement or trade secret claims against us with respect to our
current or future products or that any such assertion will not require us to
enter into a license agreement or royalty arrangement or other financial
arrangement with the party asserting the claim. Responding to and defending any
such claims may distract the attention of Company management and have a material
adverse effect on our business, results of operations and financial condition.
In addition, claims may be brought against third parties from which we purchase
software, and such claims could adversely affect our ability to access third
party software for our systems.
We are dependent on our license rights from third parties. We depend upon
licenses for some of the technology used in our products from third-party
vendors. Most of these licenses can be renewed only by mutual consent and may be
terminated if we breach the terms of the license and fail to cure the breach
within a specified period of time. We may not be able to continue using the
technology made available to us under these licenses on commercially reasonable
terms or at all. As a result, we may have to discontinue, delay or reduce
product shipments until we can obtain equivalent technology. Most of our
third-party licenses are non-exclusive. Our competitors may obtain the right to
use any of the technology covered by these licenses and use the technology to
compete directly with us. In addition, if our vendors choose to discontinue
support of the licensed technology in the future or are unsuccessful in their
continued research and development efforts, we may not be able to modify or
adapt our own products.
We face the possibility of damages resulting from internal and external security
breaches, and viruses. In the course of our business operations, we compile and
transmit confidential information, including patient health information, in our
processing centers and other facilities. A breach of security in any of these
facilities could damage our reputation and result in damages being assessed
against us. In addition, the other
20
systems with which we may interface, such as the Internet and related systems
may be vulnerable to security breaches, viruses, programming errors, or similar
disruptive problems. The effect of these security breaches and related issues
could disrupt our ability to perform certain key business functions and could
potentially reduce demand for our services. Accordingly, we have expended
significant resources toward establishing and enhancing the security of our
related infrastructures, although no assurance can be given that they will be
entirely free from potential breach. Maintaining and enhancing our
infrastructure security may require us to expend significant capital in the
future.
The success of our strategy to offer our EDI services and Internet solutions
depends on the confidence of our customers in our ability to securely transmit
confidential information. Our EDI services and Internet solutions rely on
encryption, authentication and other security technology licensed from third
parties to achieve secure transmission of confidential information. We may not
be able to stop unauthorized attempts to gain access to or disrupt the
transmission of communications by our customers. Anyone who is able to
circumvent our security measures could misappropriate confidential user
information or interrupt our, or our customers' operations. In addition, our EDI
and Internet solutions may be vulnerable to viruses, physical or electronic
break-ins, and similar disruptions.
Any failure to provide secure infrastructure and/or electronic communication
services could result in a lack of trust by our customers causing them to seek
out other vendors, and/or, damage our reputation in the market making it
difficult to obtain new customers.
We are subject to the development and maintenance of the Internet infrastructure
which is not within our control. We deliver Internet-based services and,
accordingly, we are dependent on the maintenance of the Internet by third
parties. The Internet infrastructure may be unable to support the demands placed
on it and our performance may decrease if the Internet continues to experience
it's historic trend of expanding usage. As a result of damage to portions of its
infrastructure, the Internet has experienced a variety of performance problems
which may continue into the foreseeable future. Such Internet related problems
may diminish Internet usage and availability of the Internet to us for
transmittal of our Internet-based services. In addition, difficulties, outages,
and delays by Internet service providers, online service providers and other web
site operators may obstruct or diminish access to our Web site by our customers
resulting in a loss of potential or existing users of our services.
Our failure to manage growth could harm us. We have in the past experienced
periods of growth which have placed, and may continue to place, a significant
strain on our non-cash resources. We also anticipate expanding our overall
software development, marketing, sales, client management and training capacity.
In the event we are unable to identify, hire, train and retain qualified
individuals in such capacities within a reasonable timeframe, such failure could
have a material adverse effect on us. In addition, our ability to manage future
increases, if any, in the scope of our operations or personnel will depend on
significant expansion of our research and development, marketing and sales,
management, and administrative and financial capabilities. The failure of our
management to effectively manage expansion in our business could have a material
adverse effect on our business, results of operations and financial condition.
Our operations are dependent upon our key personnel. If such personnel were to
leave unexpectedly, we may not be able to execute our business plan. Our future
performance depends in significant part upon the continued service of our key
technical and senior management personnel, many of whom have been with us for a
significant period of time. These personnel have acquired specialized knowledge
and skills with respect to our business. We maintain key man life insurance on
only one of our employees. Because we have a relatively small number of
employees when compared to other leading companies in our industry, our
dependence on maintaining our relationships with key employees is particularly
significant. We are also dependent on our ability to attract high quality
personnel, particularly in the areas of sales and applications development.
The industry in which we operate is characterized by a high level of employee
mobility and aggressive recruiting of skilled personnel. There can be no
assurance that our current employees will continue to work for us. Loss of
services of key employees could have a material adverse effect on our business,
results of operations and financial condition. Furthermore, we may need to grant
additional equity incentives to key employees and provide other forms of
incentive compensation to attract and retain such key personnel. Failure to
provide such types of incentive compensation could jeopardize our recruitment
and retention capabilities.
21
Our products may be subject to product liability legal claims. Certain of our
products provide applications that relate to patient clinical information. Any
failure by our products to provide accurate and timely information could result
in claims against us. In addition, a court or government agency may take the
position that our delivery of health information directly, including through
licensed practitioners, or delivery of information by a third party site that a
consumer accesses through our Web sites, exposes us to assertions of
malpractice, other personal injury liability, or other liability for wrongful
delivery/handling of healthcare services or erroneous health information. We
maintain insurance to protect against claims associated with the use of our
products as well as liability limitation language in our end-user license
agreements, but there can be no assurance that our insurance coverage or
contractual language would adequately cover any claim asserted against us. A
successful claim brought against us in excess of or outside of our insurance
coverage could have a material adverse effect on our business, results of
operations and financial condition. Even unsuccessful claims could result in our
expenditure of funds for litigation and management time and resources.
Certain healthcare professionals who use our Internet-based products will
directly enter health information about their patients including information
that constitutes a record under applicable law that we may store on our computer
systems. Numerous federal and state laws and regulations, the common law, and
contractual obligations, govern collection, dissemination, use and
confidentiality of patient-identifiable health information, including:
o state and federal privacy and confidentiality laws;
o our contracts with customers and partners;
o state laws regulating healthcare professionals;
o Medicaid laws;
o the Health Insurance Portability and Accountability Act of 1996 (HIPAA)
and related rules proposed by the Health Care Financing Administration;
and
o Health Care Financing Administration standards for Internet transmission
of health data.
The Health Insurance Portability and Accountability Act of 1996 establishes
elements including, but not limited to, federal privacy and security standards
for the use and protection of Protected Health Information. Any failure by us or
by our personnel or partners to comply with applicable requirements may result
in a material liability to us.
Although we have systems and policies in place for safeguarding Protected Health
Information from unauthorized disclosure, these systems and policies may not
preclude claims against us for alleged violations of applicable requirements.
Also, third party sites and/or links that consumers may access through our web
sites may not maintain adequate systems to safeguard this information, or may
circumvent systems and policies we have put in place. In addition, future laws
or changes in current laws may necessitate costly adaptations to our policies,
procedures, or systems.
There can be no assurance that we will not be subject to product liability
claims, that such claims will not result in liability in excess of our insurance
coverage, that our insurance will cover such claims or that appropriate
insurance will continue to be available to us in the future at commercially
reasonable rates. Such product liability claims could have a material adverse
affect on our business, results of operations and financial condition.
We are subject to the effect of payor and provider conduct which we cannot
control. We offer certain electronic claims submission products and services as
part of our product line. While we have implemented certain product features
designed to maximize the accuracy and completeness of claims submissions, these
features may not be sufficient to prevent inaccurate claims data from being
submitted to payors. Should inaccurate claims data be submitted to payors, we
may be subject to liability claims.
Electronic data transmission services are offered by certain payors to
healthcare providers that establish a direct link between the provider and
payor. This process reduces revenue to third party EDI service providers such as
us. Accordingly, we are unable to insure that we will continue to generate
revenue at or in excess of prior levels for such services. A significant
increase in the utilization of direct links between healthcare providers and
payers could have a material adverse effect on our transaction volume and
financial results. In addition, we cannot provide assurance that we will be
22
able to maintain our exiting links to payors or develop new connections on terms
that are economically satisfactory to us, if at all.
There is significant uncertainty in the healthcare industry in which we operate
and we are subject to the possibility of changing government regulation. The
healthcare industry is subject to changing political, economic and regulatory
influences that may affect the procurement processes and operation of healthcare
facilities. During the past several years, the healthcare industry has been
subject to an increase in governmental regulation of, among other things,
reimbursement rates and certain capital expenditures.
In the past, various legislators have announced that they intend to examine
proposals to reform certain aspects of the U.S. healthcare system including
proposals which may change governmental involvement in healthcare and
reimbursement rates, and otherwise alter the operating environment for us and
our clients. Healthcare providers may react to these proposals, and the
uncertainty surrounding such proposals, by curtailing or deferring investments,
including those for our systems and related services. Cost-containment measures
instituted by healthcare providers as a result of regulatory reform or otherwise
could result in a reduction in the allocation of capital funds. Such a reduction
could have an adverse effect on our ability to sell our systems and related
services. On the other hand, changes in the regulatory environment have
increased and may continue to increase the needs of healthcare organizations for
cost-effective data management and thereby enhance the overall market for
healthcare management information systems. We cannot predict what impact, if
any, such proposals or healthcare reforms might have on our business, financial
condition and results of operations.
The HIPAA regulations, as adopted by the Department of Health and Human
Services, established, among other things:
o a national standard for electronic transactions and code sets to be used
in those transactions involving certain common health care transactions;
o privacy regulations to protect the privacy of plan participants and
patients' medical records; and
o security regulations designed to establish security controls and measures
to protect the privacy and confidentiality of personal identifiable health
information when it is electronically stored, maintained or transmitted
(even if only internally transmitted within a medical practice).
As these regulations mature and become better defined, we anticipate that these
regulations will continue to directly affect certain of our products and
services, but we cannot fully predict the impact at this time. We have taken
steps to modify our products, services and internal practices as necessary to
facilitate our and our client's compliance with the final regulations, but there
can be no assurance that we will be able to do so in a timely or complete
manner. Achieving compliance with these regulations could be costly and distract
management's attention and divert other Company resources, and any noncompliance
by us could result in civil and criminal penalties.
In addition, development of related federal and state regulations and policies
regarding the confidentiality of health information or other matters may or may
not supercede HIPAA and have the potential to positively or negatively affect
our business.
In addition, our software may potentially be subject to regulation by the U.S.
Food and Drug Administration (FDA) as a medical device. Such regulation could
require the registration of the applicable manufacturing facility and software
and hardware products, application of detailed record-keeping and manufacturing
standards, and FDA approval or clearance prior to marketing. An approval or
clearance requirement could create delays in marketing, and the FDA could
require supplemental filings or object to certain of these applications, the
result of which could have a material adverse effect on our business, financial
condition and results of operations.
We may be subject to other e-commerce regulations. We may be subject to
additional federal and state statutes and regulations in connection with
offering services and products via the Internet. On an increasingly frequent
basis, federal and state legislators are proposing laws and regulations that
apply to Internet commerce and communications. Areas being affected by these
regulations include user privacy, pricing, content, taxation, copyright
protection, distribution, and quality of products and services. To the extent
that our products and services are subject to these laws and regulations, the
sale of our products and services could be harmed.
23
We are subject to changes in and interpretations of financial accounting matters
that govern the measurement of our performance. Based on our reading and
interpretations of relevant guidance, principles or concepts issued by, among
other authorities, the American Institute of Certified Public Accountants, the
Financial Accounting Standards Board, and the United States Securities and
Exchange Commission, Management believes our current sales and licensing
contract terms and business arrangements have been properly reported. However,
there continue to be issued interpretations and guidance for applying the
relevant standards to a wide range of sales and licensing contract terms and
business arrangements that are prevalent in the software industry. Future
interpretations or changes by the regulators of existing accounting standards or
changes in our business practices could result in future changes in our revenue
recognition and/or other accounting policies and practices that could have a
material adverse effect on our business, financial condition, cash flows,
revenue and results of operations.
Our per share price may be adversely effected if weaknesses in our internal
controls are identified by ourselves or our independent auditors. Any weaknesses
identified in our internal controls as part of the ongoing evaluation being
undertaken by us and our independent public accountants pursuant to Section 404
of the Sarbanes-Oxley Act of 2002 could have an adverse effect on the price at
which our stock trades. In the process of evaluating and documenting our
controls pursuant to Section 404 of the Sarbanes-Oxley Act, we have identified
various deficiencies which were remediated. Management does not believe that any
of these identified deficiencies constitute a material weakness in our internal
controls.
No evaluation process can provide complete assurance that our internal controls
will detect and correct all failures within the Company to disclose material
information otherwise required to be reported. The effectiveness of our controls
and procedures could also be limited by simple errors or faulty judgments. In
addition, if we continue to expand, either organic growth or through
acquisitions (or both), the challenges involved in implementing appropriate
controls will increase and may require that we evolve some or all of our
internal control processes.
It is also possible that the overall scope of Section 404 of the Sarbanes-Oxley
Act of 2002 may be revised in the future, thereby causing our auditors and
ourselves to review, revise or reevaluate our internal control processes which
may result in the expenditure of additional human and financial resources.
Our earnings will be affected beginning fiscal year 2007 when we begin
recognizing employee stock option expense, pursuant to recently issued
accounting standards. Stock options have from time to time been an important
component of the compensation packages for many of our mid- and senior-level
employees. We currently do not deduct the expense of employee stock option
grants from our income. However, beginning with the quarter ended June 30, 2006
and beyond, we will begin recognizing employee stock option expense for
remaining unvested stock options and any future stock option grants, resulting
in additional pre-tax compensation expense. Option expensing could have a
negative impact upon the price of our stock.
Continuing worldwide political and economic uncertainties may adversely impact
our revenue and profitability. From time to time during the last four years,
worldwide economic conditions have experienced a downturn due to numerous
factors including but not limited to concerns about inflation and deflation,
decreased consumer confidence, the lingering effects of international conflicts,
energy costs and terrorist and military activities. These conditions make it
extremely difficult for our customers, our vendors and ourselves to accurately
forecast and plan future business activities, and they could cause constrained
spending on our products and services, and/or delay and lengthen sales cycles.
Our future policy concerning the payment of dividends is uncertain. While we
paid a one-time cash dividend in March 2005, we have not historically paid
dividends, cash or otherwise, and there can be no assurance that we will pay
another dividend in the future. Unfulfilled expectation to the contrary could
have a material negative impact upon the price of our stock.
Results of Operations
Overview of results
o We have experienced significant growth in our total revenue as a result of
revenue growth in our NextGen Division. Revenue grew 37.8% on a
consolidated basis in the six
24
months ended September 30, 2005 versus 2004 and 21.8% in the six months
ended September 30, 2004 versus 2003.
o Consolidated income from operations grew 47.1% in the six months ended
September 30, 2005 versus 2004 and 54.1% in the six months ended September
30, 2004 versus 2003. This performance was driven principally by the
results in our NextGen Division.
o We have benefited and hope to continue to benefit from the increased
demands on healthcare providers for greater efficiency and lower costs, as
well as increased adoption rates for electronic medical records and other
technology.
NextGen Division
o Our NextGen Division has experienced significant growth in revenue and
operating income. Divisional revenue grew 47.0% in the six months ended
September 30, 2005 versus 2004 and 30.0% in the six months ended September
30, 2004 versus 2003 while divisional operating income (excluding
unallocated corporate expenses) grew 64.8% in the six months end September
30, 2005 versus 2004 and 56.2% in the six months ended September 30, 2004
versus 2003.
o During the six months ended September 30, 2005, we added staffing
resources to departments including sales, support, implementation, and
software development and intend to continue to do so during the remainder
of fiscal year 2006.
o Our goals include continuing to further enhance our existing products,
developing new products for targeted markets, continuing to add new
customers, selling additional software and services to existing customers
and expanding penetration of connectivity services to new and existing
customers.
QSI Division
o Our QSI Division experienced a revenue decline of 1.1% in the six months
ended September 30, 2005 versus 2004 and 3.9% in the six months ended
September 30, 2004 versus 2003. The Division experienced a 15.8% decrease
in operating income (excluding unallocated corporate expenses) in the six
months ended September 30, 2005 versus 2004.
o Our goals for the QSI Division include maximizing revenue and profit
performance given the constraints present in this Division's target
market.
The following table sets forth for the periods indicated, the percentage of
revenues represented by each item in our Consolidated Statements of Income.
THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
(unaudited) (unaudited) (unaudited) (unaudited)
Revenues:
Software, hardware and supplies ........ 46.2% 43.9% 46.8% 43.8%
Implementation and training services ... 10.3 10.8 9.7 11.0
----- ----- ----- -----
System sales .............................. 56.5 54.7 56.5 54.8
Maintenance and other services ......... 32.8 33.1 32.5 33.4
Electronic data interchange services ... 10.7 12.2 11.0 11.8
----- ----- ----- -----
Maintenance, EDI and other services ....... 43.5 45.3 43.5 45.2
----- ----- ----- -----
Total revenue ........................ 100.0 100.0 100.0 100.0
----- ----- ----- -----
Cost of revenue:
Software, hardware and supplies ........ 6.4 8.0 7.7 9.8
Implementation and training services ... 6.6 7.4 6.6 7.2
----- ----- ----- -----
Total cost of system sales ................ 13.0 15.4 14.3 17.0
Maintenance and other services ......... 12.3 13.9 12.4 14.3
Electronic data interchange services ... 7.2 8.1 7.3 7.5
----- ----- ----- -----
Total cost of maintenance, EDI and
other services ............................ 19.5 22.0 19.7 21.8
----- ----- ----- -----
Total cost of revenue .................. 32.5 37.4 34.0 38.8
----- ----- ----- -----
Gross profit ........................... 67.5 62.6 66.0 61.2
----- ----- ----- -----
Selling, general and administrative .... 30.2 25.5 29.8 25.1
Research and development ............... 6.7 8.6 6.5 8.3
----- ----- ----- -----
Income from operations ................. 30.6 28.5 29.7 27.8
----- ----- ----- -----
Interest income ........................... 1.6 0.8 1.4 0.7
----- ----- ----- -----
Income before provision for income
taxes ..................................... 32.1 29.3 31.1 28.5
Provision for income taxes ................ 12.5 11.8 12.0 11.3
----- ----- ----- -----
Net income ............................. 19.6% 17.5% 19.1% 17.2%
===== ===== ===== =====
25
For the Three-Month Periods September 30, 2005 versus 2004
Net Income. The Company's net income for the three months ended September 30,
2005 was $5.8 million or $0.44 per share on a basic and $0.43 per share on a
fully diluted basis. In comparison, we earned $3.7 million or $0.29 per share on
a basic and $0.28 per share on a fully diluted basis for the three months ended
September 30, 2004. The increase in net income for the three months ended
September 30, 2005 was achieved primarily through the following:
o a 39.2% increase in consolidated revenue;
o a 47.9% increase in NextGen Division revenue which accounted for 86.4% of
consolidated revenue; and
o an increase in the consolidated gross profit percentage which increased to
67.5% in the quarter ended September 30, 2005 versus 62.6% in the same
period last year.
Revenue. Revenue for the three months ended September 30, 2005 increased 39.2%
to $29.5 million from $21.2 million for the three months ended September 30,
2004. NextGen Division revenue increased 47.9% from approximately $17.3 million
to approximately $25.5 million in the period, while QSI Division revenue
increased by 1.6% during the period.
We report revenue in two major categories, "Systems sales" and "Maintenance and
other services". Revenue in the systems sales category includes software license
fees, hardware, third party software, supplies and implementation and training
services related to the purchase of the Company's software systems. The majority
of the revenue in the system sales category is related to the sale of software.
Revenue in the Maintenance and other category includes maintenance, EDI, and
other revenue. Maintenance and EDI revenue are the principal sources of revenue
in this category.
System Sales. Company-wide sales of systems for the three months ended September
30, 2005, increased 43.8% to $16.7 million from $11.6 million in the prior year
quarter.
Our increase in revenue from sales of systems was principally the result of a
46.7% increase in category revenue at our NextGen Division whose sales in this
category grew from $11.0 million during the quarter ended September 30, 2004 to
$16.1 million during the quarter ended September 30, 2005. This increase was
driven primarily by higher sales of NextGen(emr) and NextGen(epm) software to
both new and existing clients, as well as delivery of related implementation
services, offset by declines in sales of related hardware, third party software,
and supplies.
The following table breaks down our reported system sales into software,
hardware, third party software, supplies, and implementation and training
services components by Division:
-------------------------------------------------------
Hardware,
Third Party Implementation
Software and and Training Total
Software Supplies Services System Sales
-------- ------------ -------------- ------------
Three months ended
September 30, 2005
QSI Division ........... $ 250 $ 124 $ 196 $ 570
NextGen Division ....... 12,274 1,013 2,835 16,122
------- ------- ------- -------
Consolidated ........... $12,524 $ 1,137 $ 3,031 $16,692
======= ======= ======= =======
------- ------- -------
Three months ended
September 30, 2004
QSI Division ........... $ 196 $ 321 $ 100 $ 617
NextGen Division ....... 7,484 1,306 2,200 10,990
------- ------- ------- -------
Consolidated ........... $ 7,680 $ 1,627 $ 2,300 $11,607
======= ======= ======= =======
26
NextGen Division software revenue increased 64.0% between the three months ended
September 30, 2004 and the three months ended September 30, 2005. The Division's
software revenue accounted for 76.1% of divisional system sales revenue during
the three months ended September 30, 2005, an increase from 68.1% in the prior
year period. Sales of additional licenses to existing customers grew to $2.2
million during the three months ended September 30, 2005 compared to $1.3
million in the year ago period. The increase in software's share of systems
sales was not the result of any new trend or change in emphasis on our part
relative to software sales. Software license revenue growth continues to be an
area of primary emphasis for the NextGen Division and management was pleased
with the Division's performance in this area.
During the three months ended September 30, 2005, 6.3% of NextGen's system sales
revenue was represented by hardware and third party software compared to 11.9%
in the same prior year period. We have noted that the last several quarter's
results have included a relatively lower amount of hardware and third party
software compared to prior periods. However, this decrease was not the result of
any change in emphasis on our part. The number of customers who purchase
hardware and third party software and the dollar amount of hardware and third
party software revenue fluctuates each quarter depending on the needs of
customers. The inclusion of hardware and third party software in the Division's
sales arrangements is typically at the request of the customer and is not a
priority focus for us.
Implementation and training revenue at the NextGen Division increased 28.9% in
the three months ended September 30, 2005 compared to the three months ended
September 30, 2004. Implementation and training revenue at the NextGen Division
decreased its share of divisional system sales revenue to 17.6% in the three
months ended September 30, 2005 from 20.0% in the three months ended September
30, 2004. The growth in implementation and training revenue is the result of
increases in the amount of implementation and training services rendered to our
customers. The amount of implementation and training services revenue and the
corresponding rate of growth compared to a prior period in any given quarter is
dependant on several factors including timing of customer implementations, the
availability of qualified staff, and the mix of services being rendered. The
number of implementation and training staff increased during the three months
ended September 30, 2005 versus 2004 in order to accommodate the increased
amount of implementation services sold in conjunction with increased software
sales. In order to achieve continued increased revenue in this area, additional
staffing increases are anticipated, though actual future increases in revenue
and staff will depend upon the availability of qualified staff, business mix and
conditions, and our ability to retain current staff members.
The NextGen Division's growth has come in part from investments in sales and
marketing activities including hiring additional sales representatives, trade
show attendance, and advertising expenditures. We have also benefited from
winning numerous industry awards for the NextGen Division's flagship
NextGen(emr) and NextGen(epm) software products in fiscal years 2005 and 2004,
as well as in prior years, and the apparent increasing acceptance of electronic
medical records technology in the healthcare industry.
For the QSI Division, total system sales decreased 7.6% in the three months
ended September 30, 2005 compared to the three months ended September 30, 2004.
We do not presently foresee any material changes in the business environment for
the Division with respect to the constrained environment that has been in place
for the past several years.
Maintenance and Other Services. For the three months ended September 30, 2005,
Company-wide revenue from maintenance and other services grew 33.7% to $12.9
million from $9.6 million in the same period in the prior year. The increase in
this category resulted from an increase in maintenance and EDI revenue from the
NextGen Division's client base offsetting slight decreases in the QSI Division's
revenue in these areas. Total NextGen Division maintenance revenue for the three
months ended September 30, 2005 grew 32.2% to $5.6 million from $4.2 million in
the same year ago period, while EDI revenue grew 48.1% to $2.0 million compared
to $1.4 million during the same prior year period. QSI Division
27
maintenance revenue declined 2.6% in the same period while QSI divisional EDI
revenue declined by 5.6% between the same periods.
The following table details revenue included in the Maintenance and other
category for the three month periods ended September 30, 2005 and 2004:
------------------------------------------
Maintenance EDI Other Total
----------- ------- ------- -------
Three months ended
September 30, 2005
QSI Division ....................... $ 1,748 $ 1,158 $ 542 $ 3,448
NextGen Division ................... 5,612 2,016 1,774 9,402
------- ------- ------- -------
Consolidated ....................... $ 7,360 $ 3,174 $ 2,316 $12,850
======= ======= ======= =======
Three months ended
September 30, 2004
QSI Division ....................... $ 1,794 $ 1,227 $ 317 $ 3,338
NextGen Division ................... 4,245 1,361 666 6,272
------- ------- ------- -------
Consolidated ....................... $ 6,039 $ 2,588 $ 983 $ 9,610
======= ======= ======= =======
The growth in maintenance revenue for the NextGen Division has come from new
customers that have been added each quarter as well as our relative success in
retaining existing maintenance customers. NextGen's EDI revenue growth has come
from new customers and from further penetration of the Division's existing
customer base. We intend to continue to promote maintenance and EDI services to
both new and existing customers.
The following table provides the number of billing sites which were receiving
maintenance services as of the last business day of the quarters ended September
30, 2005 and 2004 respectively, as well as the number of billing sites receiving
EDI services during the last month of each respective period at each Division of
the Company. The table presents summary information only and includes billing
entities added and removed for any reason. Note also that a single client may
include one or multiple billing sites, and changes in billing protocols for
certain clients can cause period to period changes in the number of billing
sites.
-------------------------------------------------------------------
NextGen QSI Consolidated
------------------- ------------------- -------------------
Maintenance EDI Maintenance EDI Maintenance EDI
-------------------------------------------------------------------
September 30,
2004 ........... 465 372 304 219 769 591
Billing sites
added .......... 248 184 5 20 253 204
Billing sites
removed ........ (6) (79) (29) (40) (35) (119)
---- ---- ---- ---- ---- ----
September 30,
2005 ........... 707 477 280 199 987 676
==== ==== ==== ==== ==== ====
Cost of Revenue. Cost of revenue for the three months ended September 30, 2005
increased 21.1% to $9.6 million in the quarter ended September 30, 2005 from
$7.9 million in the quarter ended September 30, 2004, while the cost of revenue
as a percentage of net revenue decreased to 32.5% from 37.4%.
The decrease in our consolidated cost of revenue as a percentage of revenue
between the three months ended September 30, 2005 and the three months ended
September 30, 2004 is attributable to three main factors:
o a reduction in the level of hardware and third party software expense as a
percentage of revenue in the NextGen Division and the QSI Division;
o a reduction in the level of employee compensation expense included in cost
of sales as a percentage of revenue in the NextGen Division;
o an increase in the NextGen Division's share of consolidated revenue from
81.4% in the quarter ended September 30, 2004 to 86.4% in the quarter
ended September 30, 2005. The NextGen Division's gross profit has been and
continues to be higher than the QSI Division; and
o a decrease in the cost of revenue as a percentage of revenue at each of
our Divisions causing a corresponding increase in gross profit margins of
both of our Divisions.
28
The following table details the individual components of cost of revenue and
gross profit as a percentage of total revenue for our Company and our two
Divisions:
--------------------------------------------
Hardware, Payroll
Third and Total
Party related Cost of Gross
Software Benefits Other Revenue Profit
--------- -------- ----- ------- ------
Three months ended
September 30, 2005
QSI Division ........ 4.5% 18.3% 21.2% 44.0% 56.0%
NextGen Division .... 5.0 11.2 14.5 30.7 69.3
---- ---- ---- ---- ----
Consolidated ........ 4.9% 12.2% 15.4% 32.5% 67.5%
==== ==== ==== ==== ====
Three months ended
September 30, 2004
QSI Division ........ 9.3% 16.9% 24.1% 50.3% 49.7%
NextGen Division .... 5.5 12.9 16.1 34.5 65.5
---- ---- ---- ---- ----
Consolidated ........ 6.2% 13.7% 17.5% 37.4% 62.6%
==== ==== ==== ==== ====
During the three months ended September 30, 2005, hardware and third party
software constituted a smaller portion of consolidated revenue compared to the
same year ago period driven principally by the composition of NextGen Division
revenue. We have noted that the last several quarter's results have included a
relatively lower amount of hardware and third party software compared with prior
periods. However, this reduction was not the result of any change in emphasis on
our part. The number of customers who purchase hardware and third party software
and the dollar amount of hardware and third party software purchased fluctuates
each quarter depending on the needs of the customers and is not a priority focus
for us.
Our payroll and benefits expense associated with delivering our products and
services decreased to 12.2% of consolidated revenue in the three months ended
September 30, 2005 compared to 13.7% during the three months ended September 30,
2004. The absolute level of consolidated payroll and benefit expenses grew from
$2.9 million in the three months ended September 30, 2004 to $3.6 million in the
three months ended September 30, 2005, an increase of 24% or $0.7 million. This
increase was due primarily to additions to related headcount, payroll and
benefits expense associated with delivering products and services in the NextGen
Division where such expenses increased to $2.9 million in three months ended
September 30, 2005 from $2.2 million in the three months ended September 30,
2004. Payroll and benefits expense associated with delivering products and
services in the QSI Division during the three months ended September 30, 2005
and 2004 remained relatively unchanged at approximately $0.7 million.
We anticipate continued additions to headcount in the NextGen Division in areas
related to delivering products and services in future periods but due to the
uncertainties in the timing of our sales arrangements, our sales mix, the
acquisition and training of qualified personnel, and other issues, we cannot
accurately predict if related headcount expense as a percentage of revenue will
increase or decrease in the future.
We do not currently intend to make any significant additions to related
headcount at the QSI Division.
"Other," which consists of outside service costs, amortization of software
development costs and other costs, declined on a consolidated basis to 15.4% of
revenue during the three months ended September 30, 2005 compared to 17.5% a
year ago.
Should the NextGen Division continue to represent an increasing share of our
revenue and should the NextGen Division continue to carry higher gross profit
than the QSI Division, our consolidated gross profit percentages should increase
to more closely match those of the NextGen Division.
As a result of the foregoing events and activities, gross profit percentage for
the Company and our two operating Divisions increased for the three month period
ended September 30, 2005 versus the prior year period.
29
The following table details revenue and cost of revenue on a consolidated and
divisional basis for the three month periods ended September 30, 2005 and 2004:
--------------------------------------------------
Three months Three months
ended September 30, ended September 30,
--------------------- ---------------------
2005 % 2004 %
------- ------- ------- -------
QSI Division
Revenue ............. $ 4,018 100.0% $ 3,955 100.0%
Cost of revenue ..... 1,769 44.0 1,990 50.3
------- ------- ------- -------
Gross profit ........ $ 2,249 56.0 $ 1,965 49.7
======= ======= ======= =======
NextGen Division
Revenue ............. $25,524 100.0 $17,262 100.0
Cost of revenue ..... 7,842 30.7 5,947 34.5
------- ------- ------- -------
Gross profit ........ $17,682 69.3 $11,315 65.5
======= ======= ======= =======
Consolidated
Revenue ............. $29,542 100.0 $21,217 100.0
Cost of revenue ..... 9,611 32.5 7,937 37.4
------- ------- ------- -------
Gross profit ........ $19,931 67.5% $13,280 62.6%
======= ======= ======= =======
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the three months ended September 30, 2005 increased
64.8% to $8.9 million as compared to $5.4 million for the three months ended
September 30, 2004. The increase in the amount of such expenses resulted
primarily from a $0.8 million increase in commissions expenses in the NextGen
Division, a $0.8 million increase in salaries and wages in the NextGen Division,
a net $0.9 million increase in other selling, general and administrative
expenses in the NextGen Division and a $1.0 million increase in corporate
related expenses. Approximately half of the increase in year over year corporate
related expense was related to expenses associated with the contested proxy
election which occurred in conjunction with the 2005 Annual Shareholders'
Meeting. Selling, general and administrative expenses as a percentage of revenue
increased from 25.5% in the three months ended September 30, 2004 to 30.2% in
the three months ended September 30, 2005 due to the fact that the rate of
growth in selling, general and administrative expense was more than the
aggregate revenue growth rate for the Company.
We anticipate increased expenditures for trade shows, advertising and the
employment of additional sales and administrative staff at the NextGen Division.
We also anticipate future increases in corporate expenditures being made in a
wide range of areas. While we expect selling, general and administrative
expenses to increase on an absolute basis, we cannot accurately predict the
impact these additional expenditures will have on selling, general, and
administrative expenses as a percentage of revenue.
Research and Development Costs. Research and development costs for the three
months ended September 30, 2005 and 2004 were $2.0 million and $1.8 million,
respectively. The increases in research and development expenses were primarily
due to increased investment in the NextGen product line. Research and
development costs as a percentage of net revenue decreased to 6.7% from 8.6%
during the months ended September 30, 2005. Research and development expenses
are expected to continue at or above current dollar levels.
Interest Income. Interest income for the three months ended September 30, 2005
increased 171% to approximately $0.5 million compared with $0.2 million in the
three months ended September 30, 2004. Interest income in the three months ended
September 30, 2005 increased primarily due to the effect of an increase in short
term interest rates versus the prior year quarter as well as comparatively
higher amounts of funds available for investment during the three months ended
September 30, 2005.
Our investment policy is determined by our Board of Directors. We currently
maintain our cash in very liquid short term assets including money market funds
and short term U.S. Treasuries with maturities of less than 90 days. Our Board
of Directors may consider alternate uses for our cash including, but not limited
to payment of a special dividend, initiation of a regular dividend, initiation
of a stock buy-back program, an expansion of our investment policy to include
investments with maturities of greater than 90 days, or other items.
Additionally, it is possible that we will utilize some or all of our cash to
fund an acquisition or other similar business activity. Any or all of these
programs could significantly impact our investment income in future periods.
30
Provision for Income Taxes. The provision for income taxes for the three months
ended September 30, 2005 was approximately $3.7 million as compared to
approximately $2.5 million for the year ago period. The effective tax rates for
the three months ended September 30, 2005 and 2004 were 39.0% and 40.3%,
respectively. The provision for income taxes for the three months ended
September 30, 2005 differs from the combined statutory rates primarily due to
the impact of varying state income tax rates, the research and development tax
credits, and the newly-created domestic manufacturer's deduction under Internal
Revenue Code Section 199. The effective rate for the three months ended
September 30, 2005 decreased from the prior year primarily due to the relatively
larger impact of research and development tax credits and the domestic
manufacturer's deduction which became effective at the start of fiscal year
2006. The provision for income taxes for the three months ended September 30,
2004 differs from the combined statutory rates primarily due to the impact of
varying state income tax rates and research and development tax credits.
For the Six-Month Periods September 30, 2005 versus 2004
Net Income. The Company's net income for the six months ended September 30, 2005
was $10.9 million or $0.83 per share on a basic and $0.80 per share on a fully
diluted basis. In comparison, we earned $7.0 million or $0.56 per share on a
basic and $0.54 per share on a fully diluted basis in the six months ended
September 30, 2004. The increase in net income for the six months ended
September 30, 2005, was achieved primarily through the following:
o a 37.8% increase in consolidated revenue;
o a 47.0% increase in NextGen Division revenue which accounted for 86.2% of
consolidated revenue; and
o increase in the consolidated gross profit percentage which increased to
66.0% in the six months ended September 30, 2005 versus 61.2% in the same
period last year.
Revenue. Revenue for the six months ended September 30, 2005 increased 37.8% to
$57.0 million from $41.3 million for the six months ended September 30, 2004.
NextGen Division revenue increased 47.0% from $33.4 million during the six month
ended September 30, 2004 to $49.1 million during the six month ended September
30, 2005, while QSI Division revenue declined by 1.1% during the same period.
We report revenue in two major categories, "Systems sales" and "Maintenance and
other services". Revenue in the systems sales category includes software license
fees, hardware, third party software, supplies and implementation and training
services related to purchase of the Company's software systems. The majority of
the revenue in the system sales category is related to the sale of software.
Revenue in the Maintenance and other category includes maintenance, EDI, and
other revenue. Maintenance and EDI revenue are the principal sources of revenue
in this category.
System Sales. Company-wide sales of systems for the six months ended September
30, 2005 increased 41.8% to $32.2 million from $22.7 million in the same prior
year period.
Our increase in revenue from sales of systems was principally the result of a
44.3% increase in category revenue at our NextGen Division whose systems sales
grew from $21.6 million to $31.1 million. This increase was driven primarily by
higher sales of NextGen(emr) and NextGen(epm) software to both new and existing
clients, as well as delivery of related implementation and training services,
partially offset by declines in the sale of hardware, third party software, and
supplies.
Category revenue in the QSI Division declined by 5.4% between the six months
ended September 30, 2004 and the six months ended September 30, 2005.
The following table breaks down our reported systems sales into software,
hardware and third party software and supplies, and implementation and training
services components by Division:
Hardware,
Third Party Implementation Total
Software and and Training System
Software Supplies Services Sales
-------- ------------ -------------- -------
Six months ended
September 30, 2005
QSI Division ......... $ 301 $ 438 $ 322 $ 1,061
NextGen Division ..... 23,460 2,435 5,199 31,094
------- ------- ------- -------
Consolidated ......... $23,761 $ 2,873 $ 5,521 $32,155
======= ======= ======= =======
Six months ended
September 30, 2004
QSI Division ......... $ 519 $ 446 $ 157 $ 1,122
NextGen Division ..... 14,220 2,925 4,409 21,554
------- ------- ------- -------
Consolidated ......... $14,739 $ 3,371 $ 4,566 $22,676
======= ======= ======= =======
31
NextGen Division software revenue increased 65.0% between the six months ended
September 30, 2005 and the six months ended September 30, 2004. The Division's
software revenue accounted for 75.4% of divisional systems sales revenue during
the six months ending September 30, 2005, an increase from 66.0% in the six
months ended September 30, 2004. Sales of additional licenses to existing
customers grew to $3.5 million during the six months ended September 30, 2005
compared to $2.1 million in the year ago period. This increase was not the
result of any new trend or change in emphasis on our part relative to software
sales. Software license revenue continues to be an area of primary emphasis for
the NextGen division and management was pleased with the Division's performance
in this area.
During the six months ended September 30, 2005, 7.8% of NextGen's systems sales
revenue was represented by hardware and third party software compared to 13.6%
in the same prior year period. We have noted that the last several quarter's
results have included a relatively lower amount of hardware and third party
software compared to prior periods. However, this decrease was not the result of
any change in emphasis on our part. The number of customers who purchase
hardware and third party software and the dollar amount of hardware and third
party software revenue fluctuates each quarter depending on the needs of
customers. The inclusion of hardware and third party software in the division's
sales arrangements is typically at the request of the customer and is not a
priority focus for us.
Implementation and training revenue at the NextGen Division increased 17.9% from
the six months ended September 30, 2004 compared to the six months ended
September 30, 2005. Implementation and training revenue at the NextGen Division
decreased its share of category revenue from 20.5% in the six months ended
September 30, 2004 to 16.7% in the six months ended September 30, 2005. The
growth in implementation and training revenue is the result of increases in the
amount of implementation and training services rendered to our customers. The
number of implementation and training staff increased during the course of the
six months ended September 30, 2005 versus 2004 in order to accommodate the
increased amount of implementation services sold in conjunction with increased
software sales. In order to achieve continued increased revenue in this area,
additional staffing increases are anticipated, though actual future increases
will depend upon the availability of qualified staff, business conditions, and
our ability to retain current staff members.
The NextGen Division's growth has come in part from investments in sales and
marketing activities including hiring additional sales representatives, trade
show attendance, and advertising expenditures. We have also benefited from
winning numerous industry awards for the NextGen Division's flagship
NextGen(emr) and NextGen(epm) software products in fiscal years 2005 and 2004,
as well as in prior years, and the apparent increasing acceptance of electronic
medical records technology in the healthcare industry.
Maintenance and Other Services. For the six months ended September 30, 2005,
Company-wide revenue from maintenance and other services grew 32.9% to $24.8
million from $18.7 million during the same period last year. The increase in
this category resulted principally from an increase in maintenance and EDI
revenue from the NextGen Division's client base. Total NextGen Division
maintenance revenue for the six months ended September 30, 2005 grew 39.4% to
$11.2 million from $8.0 million in the period a year ago, while EDI revenue grew
62.6% to $3.9 million compared to $2.4 million during the same period. QSI
Division maintenance revenue declined 4.4% from $3.7 million to $3.5 million in
the same period while QSI Divisional EDI revenue declined by 4.7% from $2.5
million to $2.3 million during such period.
The following table details revenue included in Maintenance and other for the
six month periods ended September 30, 2005 and 2004:
---------------------------------------------
Maintenance EDI Other Total
----------- ------- ------- -------
Six months ended
September 30, 2005
QSI Division ................... $ 3,517 $ 2,340 $ 933 $ 6,790
NextGen Division ............... 11,153 3,936 2,936 18,025
------- ------- ------- -------
Consolidated ................... $14,670 $ 6,276 $ 3,869 $24,815
======= ======= ======= =======
Six months ended
September 30, 2004
QSI Division ................... $ 3,678 $ 2,455 $ 681 $ 6,814
NextGen Division ............... 8,000 2,421 1,436 11,857
------- ------- ------- -------
Consolidated ................... $11,678 $ 4,876 $ 2,117 $18,671
======= ======= ======= =======
32
The growth in overall maintenance revenue has come from new customers that have
been added each quarter, additional software purchases by existing customers, as
well as our relative success in retaining existing maintenance customers.
NextGen EDI revenue growth has come from new customers and from further
penetration of the Division's existing customer base. We intend to continue to
promote maintenance and EDI services to both new and existing customers.
The following table provides the number of billing sites which were receiving
maintenance services as of the last business day of the quarters ended September
30, 2005 and 2004 respectively, as well as the number of billing sites receiving
EDI services during the last month of each respective period at each division of
the Company. The table presents summary information only and includes billing
entities added and removed for any reason. Note also that a single client may
include one or multiple billing sites, and changes in billing arrangements with
certain clients can cause period to period changes in the number of billing
sites.
-------------------------------------------------------------
NextGen QSI Consolidated
------------------ ------------------ ------------------
Maintenance EDI Maintenance EDI Maintenance EDI
-------------------------------------------------------------
September 30,
2004 ............ 465 372 304 219 769 591
Billing sites
added ........... 248 184 5 20 253 204
Billing sites
removed ......... (6) (79) (29) (40) (35) (119)
---- ---- ---- ---- ---- ----
September 30,
2005 ............ 707 477 280 199 987 676
==== ==== ==== ==== ==== ====
Cost of Revenue. The cost of revenue for the six months ended September 30, 2005
increased 20.7% to $19.4 million from $16.0 million, while the cost of revenue
as a percentage of net revenue decreased to 34.0% from 38.8% during the same
period a year ago.
The decrease in our consolidated cost of revenue as a percentage of revenue
between the six months ended September 30, 2005 and the six months ended
September 30, 2004 is attributable to three main factors:
o a reduction in the level of third party hardware and software as a
percentage of revenue in the NextGen Division;
o a reduction in the level of employee compensation expense included in cost
of sales as a percentage of revenue in the NextGen Division;
o an increase in the NextGen Division's share of consolidated revenue from
80.8% in the six months ended September 30, 2004 to 86.2% in September 30,
2005. The NextGen Division's gross profit percentage has been and
continues to be higher than that of the QSI Division; and
o a decrease in the cost of revenue as a percentage of revenue at each of
our Divisions causing a corresponding increase in gross profit margins at
both of our Divisions.
The following table details the individual components of cost of revenue and
gross profit as a percentage of total revenue for our Company and our two
Divisions:
-------------------------------------------- ------
Hardware, Payroll
Third and Total
Party related Cost of Gross
Software Benefits Other Revenue Profit
--------- -------- ----- ------- ------
Six months ended
September 30, 2005
QSI Division ........ 8.8% 18.7% 21.1% 48.6% 51.4%
NextGen Division .... 5.7 11.2 14.7 31.6 68.4
---- ---- ---- ---- ----
Consolidated ........ 6.2% 12.2% 15.6% 34.0% 66.0%
==== ==== ==== ==== ====
Six months ended
September 30, 2004
QSI Division ........ 8.1% 17.2% 24.4% 49.7% 50.3%
NextGen Division .... 7.5 13.6 15.1 36.2 63.8
---- ---- ---- ---- ----
Consolidated ........ 8.0% 14.3% 16.5% 38.8% 61.2%
==== ==== ==== ==== ====
33
During the six months ended September 30, 2005, the cost of hardware and third
party software constituted 6.2% of consolidated revenue compared to 8.0% in the
same year ago period. We have noted that the last several quarter's results have
included a relatively lower amount of hardware and third party software compared
to prior periods. However this year over year reduction was not the result of
any change in emphasis on our part. The number of customers who purchase
hardware and third party software and the dollar amount of hardware and third
party software purchased fluctuates each quarter depending on the needs of the
customers and is not a priority focus for us.
Our payroll and benefits expense associated with delivering our products and
services decreased to 12.2% of consolidated revenue in the six months ended
September 30, 2005 compared to 14.3% in the six months ended September 30, 2004.
The absolute level of consolidated payroll and benefit expenses grew from $5.9
million in the six months ended September 30, 2004 to $7.0 million in September
30, 2005, an increase of 18.6%. This increase was due primarily to additions to
headcount, payroll and benefits expense associated with delivering products and
services in the NextGen Division. These divisional expenses increased to $5.5
million in the six months ended September 30, 2005 compared to $4.5 million in
the six months ended September 30, 2004, an increase of 22.2%. The Division's
payroll and benefits expense associated with delivering products and services as
a percentage of divisional revenue in the six months ended September 30, 2005
decreased to 11.2% compared to 13.6% in the prior year period. Headcount expense
as a percentage of revenue for the six month period ended September 30, 2005 at
the QSI Division increased compared to the prior year at 18.7% versus 17.2%, in
the prior year period.
We anticipate continued additions to headcount in the NextGen Division in areas
related to delivering products and services in future periods but due to the
uncertainties in the timing of our sales arrangements, our sales mix, the
acquisition and training of qualified personnel, and other issues we cannot
accurately predict if related headcount expense as a percentage of revenue will
increase or decrease in the future.
We do not currently intend to make any significant additions to related
headcount at the QSI Division.
"Other," which consists of outside service costs, amortization of software
development costs and other costs, declined slightly to 15.6% of revenue from
16.5% in the year ago period.
Should the NextGen Division continue to represent an increasing share of our
revenue and should NextGen continue to show higher gross profit percentages
compared to the QSI Division, our gross profit percentages should increase to
more closely match those of the NextGen Division.
As a result of the foregoing events and activities, our gross profit percentage
for the Company and our two operating Divisions increased for the six month
period ended September 30, 2005 versus the prior year period.
The following table details revenue and cost of revenue on a consolidated and
divisional basis for the six month periods ended September 30, 2005 and 2004:
Six months Six months
ended September 30, ended September 30,
------------------- -------------------
2005 % 2004 %
------- ------- ------- -------
QSI Division
Revenue ...................... $ 7,851 100.0% $ 7,936 100.0%
Cost of revenue .............. 3,817 48.6 3,940 49.7
------- ------- ------- -------
Gross profit ................. 4,034 51.4 3,996 50.3
======= ======= ======= =======
NextGen Division
Revenue ...................... 49,119 100.0 33,411 100.0
Cost of revenue .............. 15,545 31.6 12,098 36.2
------- ------- ------- -------
Gross profit ................. 33,574 68.4 21,313 63.8
======= ======= ======= =======
Consolidated
Revenue ...................... 56,970 100.0 41,347 100.0
Cost of revenue .............. 19,362 34.0 16,038 38.8
------- ------- ------- -------
Gross profit ................. $37,608 66.0% $25,309 61.2%
======= ======= ======= =======
34
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the six months ended September 30, 2005 increased
63.5% to $17.0 million as compared to $10.4 million for the six months ended
September 30, 2004. The increase in the amount of such expenses resulted
primarily from increases of $1.5 million in salaries and related benefits in the
NextGen division, $1.3 million in commission expenses in the NextGen Division,
$1.8 million in other general selling, general and administrative expenses in
the NextGen Division and $2.0 million in increased corporate related expenses.
Approximately $0.6 million of the increase in year over year corporate related
expenses was salaries and related benefits and $0.5 million was related to
expenses associated with the contested proxy election which occurred in
conjunction with the 2005 Annual Shareholders' Meeting. Selling, general and
administrative expenses as a percentage of revenue increased from 25.1% in the
six months ended September 30, 2004 to 29.8% in the six months ended September
30, 2005 due to selling, general, administrative expenses growing at a faster
rate then revenue.
We anticipate increased expenditures for trade shows, advertising and the
employment of additional sales and administrative staff at the NextGen Division.
We also anticipate future increases in corporate expenditures being made in
areas including but not limited to staffing and professional services. While we
expect selling, general and administrative expenses to increase on an absolute
basis, we cannot accurately predict the impact these additional expenditures
will have on selling, general, and administrative expenses as a percentage of
revenue.
Research and Development Costs. Research and development costs for the six
months ended September 30, 2005 and 2004 were $3.7 million and $3.4 million,
respectively. The increases in research and development expenses were primarily
due to increased investment in the NextGen product line. Research and
development costs as a percentage of net revenue decreased to 6.5% from 8.3% due
in part, to the fact that revenue growth exceeded the increase in research and
development spending. Research and development expenses are expected to continue
at or above current levels.
Interest Income. Interest income for the six months ended September 30, 2005
increased 176.2% to $0.8 million compared with $0.3 million in the six months
ended September 30, 2004. Interest income in the six months ended September 30,
2005 increased primarily due to the effect of an increase in short term interest
rates versus the prior year period as well as comparatively higher amounts of
funds available for investment during the six months ended September 30, 2005.
Our investment policy is determined by our Board of Directors. We currently
maintain our cash in very liquid short term assets including money market funds
and short term U.S. Treasuries with maturities of less than 90 days. Our Board
of Directors continues to review alternate uses for our cash including, but not
limited to payment of a special dividend, initiation of a regular dividend,
initiation of a stock buy back program, an expansion of our investment policy to
include investments with maturities of greater than 90 days, or other items.
Additionally, it is possible that we will utilize some or all of our cash to
fund an acquisition or other similar business activity. Any or all of these
programs could significantly impact our investment income in future periods.
Provision for Income Taxes. The provision for income taxes for the six months
ended September 30, 2005 was approximately $6.9 million as compared to
approximately $4.7 million for the year ago period. The effective tax rates for
the six months ended September 30, 2005 and 2004 were 38.7% and 39.9%,
respectively. The provision for income taxes for the six months ended September
30, 2005 differs from the combined statutory rates primarily due to the impact
of varying state income tax rates, research and development tax credits and the
newly-created domestic manufacturer's deduction under Internal Revenue Code
Section 199. The effective rate for the six months ended September 30, 2005
decreased from the prior year primarily due to the relatively larger impact of
research and development tax credits and the domestic manufacturer's deduction,
which is effective for the fiscal year ending March 31, 2006. The provision for
income taxes for the six months ended September 30, 2004 differs from the
combined statutory rates primarily due to the impact of varying state income tax
rates and research and development tax credits.
35
Liquidity and Capital Resources
The following table presents selected financial statistics and information for
each of the six months ended September 30, 2005 and 2004:
Six months ended
September 30,
-------------------
2005 2004
- --------------------------------------------------------------------------------
Cash and cash equivalents .............................. $63,126 $59,522
Net increase in cash and cash equivalents
during the six month period ............................ $11,969 $ 8,127
Net income during the period ........................... $10,869 $ 7,097
Net cash provided by operations during the
period ................................................. $13,572 $ 9,121
Number of days of sales outstanding at start of
the period ............................................. 119 99
Number of days of sales outstanding at the end
of the period .......................................... 126 108
The Company's principal source of cash was cash provided by operations. The
number of days sales outstanding at the end of the period increased by 7 days
during the six month period ended September 30, 2005 compared to the prior year
period. Such increase was primarily due to an increase in the volume of services
sold by the NextGen Division which had not yet been rendered, resulting in an
increase in both deferred revenue and accounts receivable. If amounts included
in both accounts receivable and deferred revenue were netted out, the Company's
turnover of accounts received expressed as days sales outstanding would be 71
days as of September 30, 2005 and 72 days as of March 31, 2005. Provided
turnover of accounts receivable, deferred revenue, and profitability remain
consistent with the six months ended September 30, 2005, we anticipate being
able to continue to generate cash from operations during fiscal 2006 primarily
from the net income of the Company.
Cash and cash equivalents increased by $12.0 million between March 31, 2005 and
September 30, 2005 primarily as a result of cash provided by operating
activities. Cash and cash equivalents increased approximately $8.1 million
during the six months ended September 30, 2004, also primarily as a result of
cash generated by operating activities.
Net cash used in investing activities for the six months ended September 30,
2005 and 2004 was $2.7 million and $1.8 million respectively. Net cash used in
investing activities for the six months ended September 30, 2005 and 2004
consisted of additions to equipment and improvements and capitalized software.
During the six months ended September 30, 2005, we received proceeds of $1.1
million from the exercise of stock options and recorded a reduction in income
tax liability of $1.0 million related to tax deductions received from employee
stock option exercises. The benefit was recorded as additional paid in capital.
At September 30, 2005, we had cash and cash equivalents of $63.1 million. We
intend to expend some of these funds for the development of products
complementary to our existing product line as well as new versions of certain of
our products. These developments are intended to take advantage of more powerful
technologies and to increase the integration of our products. We have no
additional significant current capital commitments.
Management believes that its cash and cash equivalents on hand at September 30,
2005, together with cash flows from operations, if any, will be sufficient to
meet its working capital and capital expenditure requirements in the ordinary
course of business for the balance of fiscal 2006.
36
Contractual Obligations
The following table summarizes our significant contractual obligations at
September 30, 2005, and the effect that such obligations are expected to have on
our liquidity and cash in future periods:
- -------------------------------- --------------------------------------------------
Less
than a 1-3 3-5 Beyond
Contractual Obligations Total year years years 5 years
- -------------------------------- ------ ------ ------ ------ -------
Non-cancelable lease obligations $4,774 $ 769 $2,472 $1,467 $ 66
====== ====== ====== ====== ======
Item 3. Qualitative and Quantitative Disclosures About Market Risk
We have a significant amount of cash and short-term investments with maturities
less than three months. This cash portfolio exposes us to interest rate risk as
short-term investment rates can be volatile. Given the short-term maturity
structure of our investment portfolio, we believe that it is not subject to
principal fluctuations and the effective interest rate of our portfolio tracks
closely to various short-term money market interest rate benchmarks.
Item 4. Controls and Procedures
The Chief Executive Officer and Chief Financial Officer (our principal executive
officer and principal financial officer, respectively) conducted an evaluation
of the design and operation of our "disclosure controls and procedures" (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended ("Exchange Act")). Based on that evaluation, which was
conducted within 90 days of the date on which this quarterly report was filed
with the Securities and Exchange Commission, the Chief Executive Officer and
Chief Financial Officer concluded that the disclosure controls and procedures
are effective to ensure that information required to be disclosed by use in the
reports filed or submitted by us under the Exchange Act is accumulated,
recorded, processed, summarized and reported to management, including our Chief
Executive Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding whether or not disclosure is required.
During the quarter ended September 30, 2005, no significant changes have
occurred in our "internal controls over financial reporting" (as defined in Rule
13a-15(f) under the Exchange Act) that have materially affected, or are
reasonably likely to materially affect, our financial reporting function.
However, we are performing ongoing evaluations of our internal processes in
order to find opportunities to further enhance our internal controls system.
37
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
After the close of business on October 26, 2005, the Company learned that a
lawsuit has been filed against the Company and six of its eight directors by
Ahmed Hussein, a director and significant shareholder of the Company. The
complaint names the Company and individual directors, Patrick Cline, Maurice
DeWald, Vincent Love, Steven Plochocki, Sheldon Razin and Louis Silverman.
Director Ibrahim Fawzy was not named as a defendant.
Filed in the Superior Court for Orange County, California, the complaint alleges
that in connection with the Company's 2005 Annual Shareholders' Meeting, the
certified results from the independent inspector of election included certain
proxies that should not have been included in the final vote tabulation. The
independent inspector of election has certified the election of the Company's
eight directors (as previously announced) after hearing Mr. Hussein's claim
concerning this matter. Specifically, Mr. Hussein seeks (i) a determination that
the election of directors at the Annual Meeting is invalid, (ii) a determination
that the votes of the disputed shares were improper and in violation of
applicable regulations, (iii) an order requiring that the election of directors
at the Annual Meeting be retabulated without including the disputed shares in
the count, (iv) an order requiring the election of directors with the
retabulated votes in a manner so as to provide Mr. Hussein with the greatest
number of directors possible, and (v) costs.
The Company believes that Mr. Hussein's claims lack merit and that the results
certified by the independent inspector of elections are conclusive of this
matter. The Company intends to defend itself vigorously.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Securities Holders.
Information concerning the Company's 2005 Annual Meeting of Shareholders held on
September 21, 2005 is contained in Form 8-K filed with the Securities and
Exchange Commission on October 11, 2005.
Item 5. Other Information.
None.
Item 6. Exhibits.
Exhibits:
31.1 Certifications Required by Rule 13a-14 (a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
38
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, we have
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
QUALITY SYSTEMS, INC.
Date: November 4, 2005 By: /s/ Louis Silverman
------------------------------------
Louis Silverman
Chief Executive Officer
Date: November 4, 2005 By: /s/ Paul Holt
------------------------------------
Paul Holt
Chief Financial Officer; Principal
Accounting Officer
39