Eclipsys 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED June 30, 2008
COMMISSION FILE NUMBER: 000-24539
(Exact name of registrant as specified in its charter)
Three Ravinia Drive
(Address of principal executive offices)
(Telephone number of registrant)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
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 issuers classes of common stock as of the latest practicable date.
ECLIPSYS CORPORATION AND SUBSIDIARIES
For the period ended June 30, 2008
Condensed Consolidated Balance Sheets
(in thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Condensed Consolidated Statements of Operations (Unaudited)
(in thousands, except per share amounts)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Condensed Consolidated Statements of Cash Flows (Unaudited)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE A PREPARATION OF INTERIM FINANCIAL STATEMENTS
In this report, Eclipsys Corporation and its subsidiaries are referred to as we, the Company, or Eclipsys.
The accompanying unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission (SEC) rules that permit reduced disclosure for interim periods. In our opinion, these statements include all adjustments necessary for a fair presentation of the results of the interim periods presented. All adjustments are of a normal recurring nature. The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by United States generally accepted accounting principles (GAAP).
Revenues, expenses, assets, and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be indicative of annual results. For a more complete discussion of our significant accounting policies and other information, you should read this report in conjunction with the consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2007 that was filed with the SEC on February 29, 2008.
The Company manages its business as one reportable segment. Prior period reclassifications were made to expense line items to conform to current period presentation.
NOTE B RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Recently Issued Standards
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 161, Disclosures about Derivative Instruments and Hedging Activities An Amendment of SFAS No. 133 (SFAS 161). SFAS 161 seeks to improve financial reporting for derivative instruments and hedging activities by requiring enhanced disclosures regarding the impact on financial position, financial performance, and cash flows. To achieve this increased transparency, SFAS 161 requires: (1) the disclosure of the fair value of derivative instruments and gains and losses in a tabular format; (2) the disclosure of derivative features that are credit risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is effective for us on January 1, 2009. We currently do not believe this standard will have a material impact on our condensed consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations (SFAS 141R). SFAS 141R continues to require the purchase method of accounting to be applied to all business combinations, but it significantly changes the accounting for certain aspects of business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific acquisition related items including: (1) expensing acquisition related costs as incurred; (2) valuing noncontrolling interests at fair value at the acquisition date; and (3) expensing restructuring costs associated with an acquired business. SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R is to be applied prospectively to business combinations for which the acquisition date is on or after January 1, 2009.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (SFAS 160). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary (minority interest) is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and separate from the parent companys equity. This statement is effective for us on January 1, 2009. We currently do not believe this standard will have a material impact on our condensed consolidated financial statements.
In April 2008, the FASB issued FASB Staff Position (FSP) FAS 142-3, Determination of the Useful Life of Intangible Assets. This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R and other United States generally accepted accounting principles. This FSP shall be effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We currently do not believe that this FSP will have a material impact on our condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities. FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share (EPS) under the two-class method. This FSP shall be effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those years. The share-based payment awards that are granted by the Company contain dividend rights that are forfeitable on unvested shares; therefore, we do not expect this FSP to have a material impact on our calculation of EPS.
Recently Adopted Standards
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, SFAS 159 specifies that unrealized gains and losses for that instrument be reported in earnings at each subsequent reporting date. SFAS 159 was effective for us on January 1, 2008. We did not apply the fair value option to any of our outstanding instruments and, therefore, SFAS 159 did not have an impact on our condensed consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No. 157), which defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods of those fiscal years. We adopted SFAS 157 on January 1, 2008. Our most significant asset that is adjusted to fair value on a recurring basis is our long-term investments.
In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157 which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. Therefore, in accordance with the aforementioned FSP, we have only partially applied FAS 157. Beginning January 1, 2009 we will also apply FAS 157 to all nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis as required by FAS 157. See Note L Fair Value Measurement.
NOTE C EARNINGS PER SHARE
For all periods presented, basic and diluted earnings per common share is presented in accordance with SFAS 128, Earnings per Share, which provides for the accounting principles used in the calculation of earnings per share. Basic earnings per common share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Non-vested restricted stock carries dividend and voting rights and, in accordance with GAAP, is not included in the weighted-average number of common shares outstanding used to compute basic earnings per share. Diluted earnings per common share reflect the potential dilution from assumed conversion of all dilutive securities, such as stock options and unvested restricted stock, using the treasury stock method. When the effect of the outstanding equity securities is anti-dilutive, they are not included in the calculation of diluted earnings per common share. For the three months ended June 30, 2008 and 2007 3,752,462 and 2,562,397 anti-dilutive shares were excluded from the calculation of diluted earnings per common share, respectively. For the six months ended June 30, 2008 and 2007, 3,464,927 and 2,753,537 anti-dilutive shares were excluded from the calculation of diluted earnings per common share, respectively. The earnings amounts used for per-share calculations are the same for both the basic and diluted methods.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The computation of basic and diluted income per common share is as follows (in thousands, except per share data):
NOTE D ACQUISITION OF ENTERPRISE PERFORMANCE SYSTEMS, INC.
On February 25, 2008, the Company acquired all of the outstanding capital stock of Enterprise Performance Systems, Inc. (EPSi), a private company. The aggregate purchase price was $56.1 million ($53.0 million net of cash acquired and transaction costs) and is subject to certain holdback arrangements and working capital adjustments. EPSi is a leading provider of business intelligence solutions, including web-based software and related consulting services that allow clients in the healthcare industry to improve financial performance and operational decision making. We acquired EPSI to strengthen our position in providing clinical, operational and financial performance-improvement solutions that help organizations manage the business of healthcare.
The purchase price has been allocated to the tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill. The fair value assigned to identifiable intangible assets acquired is determined using the income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by management. Purchased intangible assets are amortized on a straight-line basis over the respective useful lives based on an assessed pattern of use. For accounting purposes, the purchase price is $56.1 million which includes $0.7 million of transaction costs and cash acquired. Approximately $0.9 million of the purchase price was allocated to in-process research and development and was charged to our income statement in the first quarter of 2008.
During the second quarter of 2008, as we integrated this acquisition, we adjusted the opening balances of the net assets acquired by $1.6 million, resulting in a reduction of the goodwill balance at June 30, 2008. The resulting allocation of the purchase price is summarized below (in thousands):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the three and six month periods ended June 30, 2008, we recorded amortization expense of $1.1 million and $1.5 million, respectively, related to intangible assets acquired in the EPSi acquisition.
NOTE E ACCOUNTS RECEIVABLE
Accounts receivable, net of an allowance for doubtful accounts, is comprised of the following (in thousands):
NOTE F INVESTMENTS
Investment balances consist of the following (in thousands):
As of June 30, 2008, the Company held approximately $116.6 million par value of investments in auction-rate securities (ARS). Our ARS are comprised of AAA rated pools of student loans. These investments have long-term nominal maturities for which the interest rates are reset through a dutch auction each month. The monthly auctions historically have provided a liquid market for these securities. However, in February 2008, the broker-dealers managing the Companys ARS portfolio experienced failed auctions of certain of these securities where the amount of securities submitted for sale exceeded the amount of purchase orders. Our ARS continued to fail to settle at auctions through the second quarter of 2008. This indicates the estimated fair value of these ARS no longer approximates their par value. Accordingly, at June 30, 2008, the Company has recorded these investments at their estimated fair value of $111.4 million and recorded a temporary loss on these securities of $5.2 million in accumulated other comprehensive income, reflecting the decline in the fair value of these securities. The Company has concluded that no other-than-temporary impairment losses occurred in the six months ended June 30, 2008 because the Company believes that the declines in fair value that occurred during 2008 are due to recent market liquidity conditions.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
We believe these investments continue to be of high credit quality, and we currently plan to hold the ARS until such time as successful auctions occur or the secondary market allows for a sufficient price to recover substantially all of our par value. There can be no assurance this will occur. Accordingly, we have classified these securities as long-term investments in our condensed consolidated balance sheet. The Company will continue to analyze its ARS each reporting period for impairment and it may be required to record an impairment charge in the consolidated statement of operations if the decline in fair value is determined to be other-than-temporary. The fair value of these securities has been estimated by management based on the assumptions that market participants would use in pricing the asset in a current transaction in accordance with SFAS 157 Fair Value Measurements. The estimates of the fair value of the ARS we hold could change significantly based on market conditions.
The Company continues to earn interest on these investments at the contractual rate, and the ARS the Company holds have not been downgraded or placed on credit watch by credit rating agencies. In April 2008, a partial call transaction was closed related to one of our ARS securities, as a result of which we received proceeds of $4.6 million. In May 2008, a call transaction was closed related to another one of our ARS securities, as a result of which we received proceeds of $14.3 million. Each of these two transactions resulted in a recovery of the full par value of the securities. As of June 30, 2008, no calls were outstanding on our ARS.
NOTE G ACQUIRED TECHNOLOGY AND INTANGIBLE ASSETS, INCLUDING GOODWILL
The changes in the carrying amount of goodwill for the six month period ended June 30, 2008 were as follows:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The gross and net amounts for acquired technology, ongoing customer relationships and goodwill consist of the following (in thousands):
The estimated aggregate amortization expense for each of the five succeeding fiscal years is as follows (in thousands):
NOTE H SHORT-TERM FINANCING
On May 9, 2008, the Company entered into a credit agreement with Wachovia Bank, pursuant to which the Company received a senior secured revolving credit facility in the aggregate principal amount of $50.0 million. The Company entered into this arrangement to obtain funds to repay the $45.0 million short-term financing agreement entered into February 15, 2008 which was used to provide funds to close the February 2008 acquisition of EPSi (See Note D Acquisition of Enterprise Performance Systems, Inc.). The Companys obligation under the credit agreement is secured by first priority liens and security interests in substantially all of the assets of the Company and its subsidiaries. The agreement has a one-year term with an interest rate of LIBOR market index rate plus .75%. The Company has borrowed the full $50.0 million available under the facility, with $4.5 million held as cash, net of $45.1 million principal and interest pay down on the short term facility and $0.4 million of transaction costs.
NOTE I STOCK COMPENSATION PLANS
2008 Omnibus Incentive Plan
At our Annual Meeting of Stockholders held June 11, 2008, our stockholders approved the 2008 Omnibus Incentive Plan, or the 2008 Plan. The maximum number of shares of common stock that may be issued under the 2008 Plan (subject to adjustment in the event of stock splits and other similar events) is 5,000,000 shares, less one share of common stock for every share that was subject to a stock option granted after December 31, 2007 under our 2005 Stock Incentive Plan (together with its predecessor incentive plans, collectively, the Prior Plans) and 1.6 shares of common stock for every share that was subject to an award other than options granted after December 31, 2007 under the Prior Plans. Any shares of common stock that are subject to options or stock appreciation rights (SARs), granted under the 2008 Plan shall be counted against this limit as one share of common stock for every share granted, and in the amount of 1.6 shares of common stock for every share that is subject to awards other than options or SARs. Under the 2008 Plan, no further awards will be granted under the Prior Plans. However, if any shares of common stock subject to an award under the 2008 Plan, or after December 31, 2007, any shares of common stock subject to an award under the Prior Plans, are forfeited, expire or are settled for cash, the shares subject to the award may be used again for awards under the 2008 Plan, in the amount of one share of common stock for every share that was subject to options or SARs and in the amount of 1.6 shares of common stock for every share that was subject to awards other than options or SARs.
We expect to satisfy option exercises by issuing the Companys common stock. As of June 30, 2008, there were approximately 4,211,004 shares available for future awards under the 2008 Plan.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
2005 Inducement Grant Stock Incentive Plan
In October 2005, our Board of Directors approved the 2005 Inducement Grant Stock Incentive Plan (the Inducement Grant Plan) for use in making inducement grants of stock options and restricted stock to new employees pursuant to the NASDAQ Marketplace Rules. This Inducement Grant Plan is substantially similar to our 2008 Omnibus Incentive Plan as approved by stockholders, except that eligible recipients are limited to prospective and newly hired employees of the Company, consistent with its purpose as an employment inducement tool.
During the six months ended June 30, 2008, we issued 106,800 stock options and 200,270 shares of restricted stock as inducement grants under the Inducement Grant Plan to founders and employees of EPSi associated with their continued employment with the Company.
Awards granted under the 2008 Plan, the Prior Plans and the Inducement Grant Plan generally have a contractual life of 7 to 10 years and generally vest over a 4 to 5 year period.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Stock Option Awards
Stock option awards granted by the Company entitle recipients to purchase shares of Eclipsys common stock within prescribed periods at a price equal to the fair market value on the date of grant. A summary of stock option transactions is as follows:
As of June 30, 2008, $27.1 million of total unrecognized compensation costs related to stock options is expected to be recognized over a weighted average period of 3.2 years.
The weighted average fair value of outstanding stock options is estimated at the date of grant using a Black-Scholes option pricing model. The following are significant weighted average assumptions used for estimating the fair value of the options granted in the following periods:
We use the simplified method for estimating our expected term equal to the midpoint between the vesting period and the contractual term as allowed by Staff Accounting Bulletin 107, Share-Based Payment.
Staff Accounting Bulletin 110, Year-End Help for Expensing Employee Stock Options, for options granted after December 31, 2007 requires the use of historical data to estimate an expected term unless the company significantly changes the terms of its share-option grants. The grants the Company issued after December 31, 2007 have a contractual term of 7 years, which differs from the contractual term of the historical grants (generally 10 years). Therefore, we do not have sufficient historical data to estimate the expected term for current option issuances. Accordingly, we continue to use the simplified method. Additionally, this reduction in contractual term has lowered our assumption of expected term.
We currently estimate volatility by using the historical volatility of our common stock.
The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term input to the Black-Scholes model.
We estimate forfeitures using a historical forfeiture rate. Our estimate of forfeitures will be adjusted over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from our estimate.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Non-Vested Restricted Stock
Non-vested restricted stock is sometimes granted by the Company. The restrictions lapse on a pro rata basis over a specified period of time, generally four to five years. The grant date fair value per share of non-vested restricted stock, which is the stock price on the grant date, is expensed on a straight-line basis over the period during which the restrictions lapse. The shares represented by restricted stock awards are considered outstanding at the grant date, as the recipients are entitled to dividends and voting rights. A summary of restricted stock award activity for the period is presented below:
As of June 30, 2008, $12.4 million of total unrecognized compensation costs related to non-vested stock awards is expected to be recognized over a weighted average period of 2.7 years.
Stock-Based Compensation Expense
Our stock based compensation expense, as included in each respective expense category, was as follows (in thousands):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE J TOTAL COMPREHENSIVE INCOME
The components of total comprehensive income were as follows (in thousands):
NOTE K RESTRUCTURING
In October 2007, the Company initiated a restructuring plan to relocate its corporate headquarters from Boca Raton, Florida to Atlanta, Georgia. The intent of the restructuring plan was to consolidate more of the Companys operations in one location, reduce overhead costs, and provide a more accessible location for existing and potential clients as well as employees. The charges related to this plan primarily consist of severance-related expenses associated with the termination of impacted employees and include one-time employee-related benefits.
A summary of the restructuring activity related to the relocation of our corporate headquarters is as follows (in thousands):
In January 2006, we effected a restructuring of our operations which included a reduction in headcount of approximately 100 individuals and the reorganization of our Company. In December 2006, we realigned certain management resources and consolidated some facilities to eliminate excess office space. A summary of the restructuring activity related to our 2006 initiatives for the six month period ended June 30, 2008 is as follows (in thousands):
The remaining liability as of June 30, 2008 is expected to be paid out through 2009.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE L FAIR VALUE MEASUREMENT
We measure our financial assets at fair value in accordance with SFAS 157. The fair value framework prescribed in SFAS 157 requires the categorization of assets into three levels based upon the assumptions (inputs) used to determine the estimated fair value of the assets. Level 1 provides the most reliable measure of fair value, whereas Level 3 generally requires significant management judgment. The three levels are defined as follows:
The following table summarizes our financial assets measured at fair value on a recurring basis in accordance with SFAS 157 as of June 30, 2008 (in thousands):
The fair value of our ARS has been estimated by management based on its assumptions of what market participants would use in pricing the asset in a current transaction, or level 3 - unobservable inputs in accordance with SFAS 157, and represents $111.4 million or 68.1% of total assets measured at fair value in accordance with SFAS 157. Management used a model to estimate the fair value of these securities that included certain level 2 inputs as well as assumptions, including a liquidity discount, based on managements judgment, which are highly subjective and therefore considered level 3 inputs in the fair value hierarchy. Accordingly, we categorized $111.4 million of our ARS in the level 3 category; the lowest level of significant valuation input, or level 3, was used to determine the categorization. The estimate of the fair value of the ARS we hold could change significantly based on market conditions. For additional information on our investments, see Note F- Investments.
NOTE M - CONTINGENCIES
In July and August of 2007, four purported stockholder derivative complaints were filed in the United States District Court for the Southern District of Florida against certain current and former directors and officers of Eclipsys and Eclipsys as a nominal defendant, alleging that during the period from at least 1999 until 2006 certain of Eclipsys option grants were backdated and that as a result of this alleged backdating the Companys financial statements were misstated, and stock sales by the named defendants constituted improper insider selling. These complaints were consolidated in November 2007.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On May 27, 2008, the parties to the derivative litigation entered into a stipulation of settlement setting forth the terms of an agreement to settle and resolve all claims. The settlement would involve both payments to and recoveries by Eclipsys, with a net settlement cost to the Company of approximately $0.3 million. The settlement was preliminarily approved by the court on June 11, 2008 and is subject to final approval by the court following notice to stockholders. If the settlement is not approved, additional costs may be incurred.
On May 22, 2008, The McKenna System (TMS) filed a complaint against the Company in the 274th Judicial District Court, Comal County, Texas. The complaint stems from an agreement between the Company and McKenna Health System (McKenna) dated December 29, 2004 pursuant to which McKenna agreed to acquire software and services from the Company. McKenna terminated that agreement on April 18, 2007. The complaint alleges various causes of action essentially amounting to breach of contract for failing to meet contractual obligations related to the software sold and the timeliness of implementation, and intentionally or negligently misleading McKenna. TMS has asserted damages of approximately $7.5 million, and seeks multiple damages under various theories. This case is in the early stages of discovery, and the outcome of this case and its impact on the Companys results of operations depend upon questions of fact and law that are disputed or not clear and cannot be predicted with confidence at this time. The Company intends to contest this matter vigorously, including defending the allegations and pursuing McKennas unfulfilled obligations to Eclipsys.
In addition to the foregoing, the Company and its subsidiaries are from time to time parties to other legal proceedings, lawsuits and other claims incident to their business activities. Such matters may include, among other things, assertions of contract breach or intellectual property infringement, claims for indemnity arising in the course of our business and claims by persons whose employment with us has been terminated. Such matters are subject to many uncertainties, and outcomes are not predictable with assurance. Consequently, management is unable to ascertain the ultimate aggregate amount of monetary liability, amounts which may be covered by insurance or recoverable from third parties, or the financial impact with respect to these other matters as of June 30, 2008. However, based on our knowledge as of June 30, 2008, management believes that the final resolution of such other matters pending at the time of this report, individually and in the aggregate, will not have a material adverse effect upon our consolidated financial position, results of operations or cash flows.
This report contains forward-looking statements that are based on our current expectations, assumptions, estimates and projections about our company and our industry. These statements are not guarantees of future performance and actual outcomes may differ materially from what is expressed or forecasted. When used in this report, the words may, will, should, predict, continue, plans, expects, anticipates, estimates, intends, believe, could, and similar expressions are intended to identify forward-looking statements. These statements may include, but are not limited to, statements concerning our anticipated performance, including revenue, margin, cash flow, balance sheet and profit expectations; development and implementation of our software; duration, size, scope and revenue expectations associated with client contracts; business mix; sales and growth in our client base; market opportunities; industry conditions; and our accounting, including its effects and potential changes in accounting.
Actual results might differ materially from the results projected or implied by the forward-looking statements due to a number of risks and uncertainties, including those described in this report under the heading Risk Factors and in other filings we make from time to time with the U.S. Securities and Exchange Commission. Except as required by law, we assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
Throughout this report we refer to Eclipsys Corporation and its consolidated subsidiaries as Eclipsys, the Company, we, us, and our.
This discussion and analysis should be read in conjunction with our condensed consolidated financial statements, including the notes thereto, which are included elsewhere in this report.
About the Company
Eclipsys is a leading provider of advanced integrated clinical, revenue cycle and access management software, and professional services that help healthcare organizations improve their clinical, financial, operational and client satisfaction outcomes. We develop and license proprietary software and content that is designed for use in connection with many of the key clinical, financial and operational functions that healthcare organizations require. Among other things, our software:
We also provide professional services related to our software. These services include software implementation and maintenance, outsourcing, remote hosting of our software, as well as third-party healthcare information technology applications, technical and user training and consulting.
With the exception of hardware revenues, we classify our revenues in one caption (systems and services) in our statement of operations since the amount of license revenue related to traditional software contracts is less than 10% of total revenues and the remaining revenue types included in this caption relate to bundled subscription arrangements and other services arrangements that have similar attribution patterns for revenue recognition. Our income statement items of revenue are as follows:
We market our software to healthcare providers of many different sizes and specialties, including community hospitals, large multi-entity healthcare systems, academic medical centers, outpatient clinics and physician practices. Most of the top-ranked U.S. hospitals named in U.S. News & World Reports Honor Roll use one or more of our solutions.
We expanded our operations to India in 2006 through an acquisition of a small producer of laboratory software. By June 2008, our India operations, now named Eclipsys (India) Private Limited, have expanded to include two offices and approximately 500 employees. We believe that India provides access to educated professionals to work on software research, development and support, as well as other functions, at an economically effective cost.
In 2007 we exited our networking services business as well as sold our Clinical Practice Model Resource Center (CPMRC) business. These actions resulted in loss of revenue sources that generated an aggregate of approximately $20 million in 2007. We expect to more than offset this loss of revenue with growth in other areas of the business.
Our industry, healthcare information technology, is highly competitive and subject to numerous government regulations and industry standards. Sales of Eclipsys solutions can be affected significantly by many competitive factors, including the features and cost of such solutions as compared to the offerings of our competitors, our marketing effectiveness, and the success of our research and development of new solutions. We anticipate that the healthcare information technology industry will continue to grow and be seen as a way to curb growing healthcare costs while also improving the quality of healthcare.
Consolidated Results of Operations
Key financial and operating data for Eclipsys Corporation and Subsidiaries are as follows (in thousands, except per share amounts):
Total revenues increased by $13.1 million, or 11.0%, for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $24.5 million, or 10.5%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The acquisition of EPSi in February 2008 increased revenues by $3.5 million for the three months ended June 30, 2008 and $4.0 million for the six months ended June 30, 2008.
Systems and Services Revenues
Systems and services revenues increased by $12.0 million, or 10.5%, for the three months ended June 30, 2008, as compared to the three months ended June 30, 2007 and $22.0 million, or 9.8%, for the six months ended June 30, 2008, as compared to the six months ended June 30, 2007. The overall increase for the three months ended June 30, 2008 resulted from increases of $9.1 million in revenues recognized on a ratable basis and $4.6 million in professional services revenues; these increases were partially offset by a decrease of $1.8 million in periodic revenues. The increase for the six months ended June 30, 2008 resulted from an increase of $16.6 million in revenues recognized on a ratable basis, an increase of $2.1 million in periodic revenues related to software licenses and other in-period related activities, and an increase of $3.2 million in professional services revenues.
Revenues Recognized Ratably. Revenues recognized ratably from software, maintenance, outsourcing and remote hosting were $83.5 million for the three months ended June 30, 2008, an increase of $9.1 million, or 12.2%, as compared to the three months ended June 30, 2007 and $164.2 million for the six months ended June 30, 2008, an increase of $16.6 million, or 11.2%, as
compared to the six months ended June 30, 2007. The increase was due to higher sales bookings, related to increases in sales of our software, remote hosting related services, and outsourcing, in previous periods, resulting in growth in our recurring revenue base. Future growth in these revenues depends upon future bookings in excess of previous levels.
Periodic Revenues. Periodic revenues for software related fees, third party software related fees and networking services (only 2007) were $9.1 million for the three months ended June 30, 2008, as compared to $10.8 million for the three months ended June 30, 2007 and $19.3 million for the six months ended June 30, 2008, as compared to $17.2 million for the six months ended June 30, 2007. The table below summarizes the components of periodic revenues (in thousands):
In any period, some software revenues can be considered one time in nature for that period, and we do not recognize these revenues on a ratable basis. These revenues include traditional license fees associated with new contracts signed in the period, including add-on licenses to existing clients and new client transactions, as well as revenues from contract backlog that had not previously been recognized pending contract performance that occurred or was completed during the period, and certain other activities during the period associated with client relationships. In the aggregate, these periodic revenues can contribute significantly to earnings in the period because relatively little in-period costs are associated with such revenues (other than those costs associated with networking services only 2007). We expect these periodic revenues to continue to fluctuate on a quarterly and annual basis as a result of significant variations in the type and magnitude of sales and other contract and client activity in any period, and these variations make it difficult to predict the nature and amount of these periodic revenues. The acquisition of EPSi in February 2008 increased software related fees revenues by $2.8 million for the three months ended June 30, 2008 and $3.0 million for the six months ended June 30, 2008.
During 2007, we exited our networking services business and shifted any residual client network hardware needs to third party hardware providers. The related revenues are included in hardware revenues for the three and six month periods ended June 30, 2008.
Professional Services Revenues. Professional services revenues, which include implementation and consulting related services, were $33.7 million for the three month period ended June 30, 2008, an increase of $4.6 million, or 15.9%, as compared to the three month period ended June 30, 2007 and $61.9 million, for the six month period ended June 30, 2008, an increase of $3.2 million, or 5.4%, as compared to the six month period ended June 30, 2007. The increase in both periods resulted primarily from higher utilization of our professional services team and increased activity associated with implementation of our software following increases in previous period software sales. In addition, the acquisition of EPSi in February 2008 added $0.4 million to our professional services revenues for the three months ended June 30, 2008 and $0.5 million for the six months ended June 30, 2008. These increases were offset by a decrease of $1.2 million and $2.4 million in revenues as a result of the sale of our Clinical Practice Model Resource Center (CPMRC) business in late 2007 for the three and six month periods ended June 30, 2008, respectively.
Hardware revenues increased $1.1 million, or 22.7%, for the three months ended June 30, 2008, as compared to the three month period ended June 30, 2007 and $2.5 million, or 28.8%, for the six months ended June 30, 2008, as compared to the six months ended June 30, 2007. During 2007, we exited our networking services business and shifted any residual client network hardware needs to third party hardware providers resulting in a shift from periodic revenues to hardware revenues. This shift increased hardware revenues by $2.3 million and $4.1 million for the three and six month periods ended June 30, 2008, respectively.
Costs of systems and services - Our costs of systems and services increased $1.8 million, or 2.6%, for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $4.8 million, or 3.7%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The increase in the second quarter reflects:
The $4.8 million increase in cost of systems and services for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007 is due to higher labor related costs of $5.8 million, higher third party software costs of $2.2 million, which were partially offset by lower network costs of $4.4 million for similar reasons for changes in the second quarter discussed above. Higher labor related costs for the six months ended June 30, 2008 included increased headcount, higher wage rates, and higher incentive compensation resulting from continued improved financial performance. The higher labor related costs also included abnormally high employee medical claim expenses in the first quarter of 2008. The increase in the first six months of 2008 also included a $0.5 million increase in bad debt expense related to a reserve for a specific customer in the first quarter of 2008 and $0.4 million increase in rent expense resulting from our headquarter transition from Boca Raton, Florida to Atlanta, Georgia and leasing of additional space to support our growth.
Costs of hardware - Costs of hardware decreased $0.1 million or 3.3% for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 impacted by the timing of hardware activity. Our costs of hardware increased $1.3 million, or 19.5%, for the first six months of 2008 as compared to the first six months of 2007 as a result of exiting our networking services business during 2007 and shifting any residual network hardware activity to third party hardware providers. This shift created additional hardware costs related to increased third party hardware activity.
Sales and marketing - Our sales and marketing expenses increased $4.9 million, or 27.3%, in the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $7.3 million, or 20.2%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The increase in sales and marketing expenses for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 was primarily due to increased labor-related costs of $3.7 million impacted by wage increases, higher stock based compensation, and incremental headcount costs associated with the headquarter transition from Boca Raton to Atlanta. The three months ended June 30, 2008 were also impacted by higher sales commissions supporting sales growth. The remaining increases in sales and marketing expenses for the three month period include slightly higher travel, sales trade shows, and other miscellaneous expenses reflecting continued growth in our business.
The increase in the six months ended June 30, 2008 as compared to the six months ended June 30, 2007 include labor related increases of $5.5 million for similar reasons previously described for the quarter. The remaining increases in sales and marketing expenses for the six month period include slightly higher travel, sales trade shows, higher incremental rent expense in the first quarter of 2008, and other expenses reflecting continued growth in our business.
Research and Development - Our research and development expenses increased $2.0 million, or 14.2%, in the three months ended June 30, 2008, as compared to the three months ended June 30, 2007 and $4.9 million, or 17.3%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. For the three months ended June 30, 2008, research and development expenses increased due to a $1.1 million lower internal labor cost capitalization associated with development work related to SunriseXA 5.0, which we released in December of 2007, and the timing of project work on release 5.5 scheduled for December 2009. We expect these capitalized costs to increase in the second half of 2008. The remaining increase in research and development costs reflects higher salary related costs of $1.0 million due to higher headcount in India.
The $4.9 million increase for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007 reflects lower software capitalization of $2.5 million and higher labor related costs of $2.5 million for reasons similar to the three months ended June 30, 2008, as described above.
Our gross research and development spending, which consists of research and development expenses and capitalized software development costs, increased $0.9 million to $20.0 million in the second quarter of 2008 as compared to $19.1 million in the second quarter of 2007, while the gross spending for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007 increased $2.3 million to $40.0 million. This was due primarily to our continued expansion of research and development activities in India.
In summary, research and development expense for the three and six months ended June 30 was as follows (in thousands):
General and administrative - Our general and administrative expenses increased $0.1 million, or 1.4%, in the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $3.5 million, or 22.8%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The three months ended June 30, 2008 increase included labor related increases of $1.4 million as a result of higher wages and higher headquarter relocation costs, offset by reductions in consulting and legal costs of $1.6 million. The reduction in legal and consulting fees reflects higher costs in the three months ended June 30, 2007 due to the stock based compensation review, while the three months ended June 30, 2008 included $0.7 million in insurance recoveries associated with our derivative lawsuit recorded as a reduction in legal expense.
The $3.5 million increase in our general and administrative expenses for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007 was driven by increased labor related costs of $2.5 million impacted by higher wages and incremental headquarter costs. The six month period increase also included $0.6 million of higher rents, relocation and utilities impacted by the headquarter relocation.
Depreciation and amortization - Depreciation and amortization expense increased $1.4 million, or 33.6%, in the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $1.8 million, or 20.3%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The increase in depreciation and amortization is attributable primarily to amortization related to intangible assets acquired in the EPSi acquisition and to a lesser extent an increased asset base to support our growing operations.
Gain on Sale of Assets
During 2008 we recorded additional gain on sale of assets of $3.5 million resulting from the completion of post-closing milestones associated with the fourth quarter 2007 sale of our CPMRC business.
Interest Income, Net
Net interest income decreased by $0.8 million, or 47.9%, for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $0.2 million, or 5.0%, for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007.
We incurred interest expense of $0.5 million and $0.7 million for the three and six month periods ended June 30, 2008, respectively, on borrowings under the $45 million short-term financing arrangement we entered into in February 2008 and repaid in May 2008, as well as the $50 million short-term financing arrangement we entered into in May 2008.
Interest income decreased $0.3 million, or 19.3%, for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and increased $0.6 million for the six months ended June 30, 2008, or 17.8%, as compared to the six months ended June 30, 2007. Interest rates on ARS increased in the first quarter of 2008 after the dutch auctions failed, February 7, 2007, and penalty rates were applied. These penalty rates remained in effect for various time periods from 28 days to three months depending on the indenture agreements resulting in increased interest income in the period after the failed auctions. As the penalty rates expired, the resulting interest rates were reset consistent with the indenture agreements to maintain the annual interest limit. In some instances, the interest rates were reset at 0%. Interest income will continue to be negatively impacted by lower interest rates in 2008.
Interest income in 2008 is expected to continue to be offset in part by interest obligations on borrowings under short-term financing arrangements, and any long-term financing arrangements we may enter into in the future.
Provision for Income Taxes
Income taxes increased by $1.0 million for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 and $2.7 million for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. The increase in the three month period ended June 30, 2008 as compared to the corresponding period in 2007 is primarily due to EPSi goodwill tax amortization, recorded as a deferred tax liability, for which the valuation allowance may not be reduced; tax in states where no net operating losses exist; and Alternative Minimum Tax liability. The increase in the six months ended June 30, 2008 as compared to the six months ended June 2007 reflects the increases for the second quarter as described above and the result of a charge of approximately $1.8 million recorded as a result of our review of certain state tax positions under the provisions of FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes.
As of June 30, 2008, a valuation allowance of approximately $85.0 million is recorded against the U.S. deferred tax assets that management does not believe are more likely than not to be realized. This determination is based primarily on the Companys recent history of taxable losses, operating losses and uncertainty with respect to its forecasted results. We will continue to assess the requirement for a valuation allowance on a quarterly basis. Should the Company continue to achieve its 2008 forecasted results, we may determine from our valuation allowance assessment that the positive evidence outweighs the negative resulting in the release of all or a portion of the allowance.
The Company is currently analyzing its research and development expenditures for eligibility to qualify for a research and development (R&D) tax credit. The Company plans to complete this analysis later in 2008 and as a result expects to record a deferred tax asset for this potential tax benefit, net of a reduction of a portion of its deferred tax asset for net operating loss carryforwards. The estimated amount of the R&D credit is not determinable at this time.
LIQUIDITY AND CAPITAL RESOURCES
Cash and marketable securities at June 30, 2008 were $61.7 million representing a $129.8 million decrease from December 31, 2007. This decrease primarily reflects the reclassification of $111.4 million of our ARS from marketable securities to non-current assets. The decrease also includes $53.7 million of net cash used for the EPSi acquisition, substantially offset by net proceeds of $50 million from our secured financing described further below. Additional decreases in cash also include payouts under the 2007 incentive plan and capital expenditures, which include investment in our facilities in Pune, India, investments related to the relocation of our corporate headquarters, and investments in computer equipment to support our growing operations. Additionally, our temporary decline in value adjustment related to our ARS reduced the carrying amount of our marketable securities in the six months ended June 30, 2008 by $5.2 million.
During the six month period ended June 30, 2008, operating activities used $6.6 million of cash. Cash flow from operating activities reflected income generated from operations of $35.9 million, after adjusting for non cash items of $27.1 million, which included depreciation and amortization, in-process research and development charge, stock compensation, provision for bad debt, non cash deferred tax provision and gain on sale of assets. This was offset in part by a decrease in net working capital of $29.4 million due primarily to the negative impact of collection activity, changes in accrued compensation expenses driven by payouts under the 2007 incentive plan and increases in prepaid assets negatively impacted by the timing of annual maintenance payments. Our second quarter 2008 collections were impacted by delayed billings in the quarter due to the transition of our billing function to India. We expect to have strong cash collections in the second half of 2008. These negative working capital items were partially offset by increases in accounts payable impacted by the timing of payments in the fourth quarter of 2007 as compared to the first quarter of 2008. Cash flows were also impacted by payments of $1.5 million in connection with our restructuring activities.
Investing activities used $19.7 million of cash which included $53.7 million, net of cash acquired, for our EPSI acquisition, $13.3 million of capital expenditures, and $6.9 million for investment in software, partially offset by net sales of marketable securities of $51.6 million and $2.6 million received on earnouts from previous asset sales. Capital expenditures included investment in our facilities in Pune, India, leasehold improvements in our new corporate headquarters, and investments in computer equipment to support our growing operations.
Financing activities provided cash inflow of $52.4 million, primarily consisting of net proceeds of $49.6 million from our secured financing described further below. We also received $2.4 million from stock option exercises. The amount of cash provided by future stock option exercises is uncertain.
Future Capital Requirements
As of June 30, 2008, our principal source of liquidity is our cash and cash equivalents balances and marketable securities of $61.7 million. We believe that our current cash and cash equivalents and marketable securities combined with our anticipated cash flows from operations will be sufficient to fund our operations for the next twelve months.
The Company held approximately $116.6 million par value of ARS as of June 30, 2008. Our ARS are comprised of certain AAA rated pools of student loans. These investments have historically have been be sold via dutch auctions every 7, 14, 21, 28, or 35 days creating a short-term instrument. In February 2008, the broker-dealers managing the Companys ARS portfolio experienced failed auctions of certain of these securities where the amount of securities submitted for sale exceeded the amount of purchase orders. Our ARS continued to fail to settle at auctions through the second quarter of 2008. This indicates the estimated fair value of these ARS no longer approximates their par value. Accordingly, at June 30, 2008, the Company has recorded these securities as long-term investments at an estimated fair value of $111.4 million and recorded a temporary loss on these securities of $5.2 million in accumulated other comprehensive income, reflecting the decline in the fair value of these securities.
We currently plan to hold the ARS until such time as successful auctions occur or a secondary market develops that provides sufficient liquidity to recover substantially all of our par value. There can be no assurance that this will occur. In April 2008, a partial call transaction was closed related to one of our ARS securities, as a result of which we received proceeds of $4.6 million. In May 2008, a call transaction was closed related to another one of our ARS securities, as a result of which we received proceeds of $14.3 million. Each of these two transactions resulted in a recovery of the full par value of the securities. As of June 30, 2008, no calls were outstanding on our ARS.
Our future cash requirements will depend on a number of factors including, among other things, the timing and level of our new sales volumes, the cost of our development efforts, the success and market acceptance of our future product releases, and other related items. The Company also periodically evaluates business expansion opportunities that fit its strategic plans, such as our February 2008 acquisition of EPSi. If an opportunity requiring significant capital investment were to arise, the Company may seek to finance the opportunity through available cash on hand, existing financings, issuance of additional shares of its stock or additional sources of financing, as circumstances warrant. However, there can be no assurance that adequate liquidity would be available to finance extraordinary business opportunities.
In February 2008 we entered into a secured financing agreement with an investment bank, pursuant to which we received $45.0 million in exchange for a transfer to the bank (as a form of collateral) of ARS with a nominal value of $90.0 million in the aggregate. The Company entered into this arrangement to provide funds to close our February 2008 acquisition of EPSi. On May 9, 2008, we entered into a credit agreement with Wachovia Bank, pursuant to which the Company received a senior secured revolving credit facility in the aggregate principal amount of $50.0 million. We entered into this arrangement to obtain funds to repay the $45.0 million short-term financing agreement. The Companys obligation under the credit agreement is secured by first priority liens and security interests in substantially all of the assets of the Company and its subsidiaries. The agreement has a one-year term with an interest rate of LIBOR market index rate plus .75%. During 2008, we expect to replace this one-year credit agreement with a larger long-term credit agreement to support our future growth strategies.
SFAS 157 Fair Value Measurements
The fair value of our ARS has been estimated by management based on its assumptions of what market participants would use in pricing the asset in a current transaction, or level 3 - unobservable inputs in accordance with SFAS 157 Fair Value Measurements, and represents 68.1% of total assets measured at fair value in accordance with SFAS 157. Management used a model to estimate the fair value of these securities that included certain level 2 inputs as well as assumptions, including a liquidity discount, based on managements judgment, which are highly subjective and therefore considered level 3 inputs in the fair value hierarchy. Accordingly, we categorized $111.4 million of our ARS in the level 3 category; the lowest level of significant valuation input, or level 3, was used to determine the categorization. The estimate of the fair value of the ARS we hold could change significantly based on market conditions. For additional information on our investments, see Note F- Investments.
CRITICAL ACCOUNTING POLICIES
There were no material changes to our critical accounting policies as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007 filed with the SEC on February 29, 2008.
We do not currently use derivative financial instruments or enter into foreign currency hedge transactions. Foreign currency fluctuations through June 30, 2008 have not had a material impact on our financial position or results of operations. We continually monitor our exposure to foreign currency fluctuations and may use derivative financial instruments and hedging transactions in the future if, in our judgment, the circumstances warrant their use.
We have invested primarily in auction-rate securities (ARS). These ARS are debt instruments with long-term nominal maturities that previously could be sold via dutch auctions every 7, 14, 21, 28, or 35 days creating a short-term instrument. In February 2008, broker-dealers holding the Companys ARS portfolio experienced failed auctions of certain ARS where the amount of securities submitted for sale exceeded the amount of related purchase orders. Our ARS continued to fail to settle at auctions through the second quarter of 2008. The Company continues to earn interest on these investments at the contractual rate, and the ARS that the Company holds have not been downgraded or placed on credit watch by credit rating agencies. During the six months ended June 30, 2008, we adjusted the carrying amount of our ARS to estimated fair market value. The adjustment was recorded in other comprehensive income. If uncertainties in the credit and capital markets continue and these markets deteriorate further or the Company experiences any rating downgrades on any investments in its portfolio, the Company may incur further temporary impairments or other-than-temporary impairments, which could negatively affect the Companys financial condition, cash flow and reported earnings.
Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value due to changes in interest rates.
The following table illustrates potential fluctuation in annualized interest income based upon hypothetical values for blended interest rates for hypothetical ARS balances (we currently earn interest on $116.6 million par value of ARS):
We estimate that a one-percentage point decrease in interest rates for our investment securities portfolio as of June 30, 2008 would have resulted in a decrease in interest income of $0.3 million for a three month period or $1.2 million for a 12 month period. This sensitivity analysis contains certain simplifying assumptions, including a constant level and rate of debt securities and an immediate across-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the period, and it does not consider the impact of changes in the portfolio as a result of our business needs or as a response to changes in the market. Therefore, although it gives an indication of our exposure to changes in interest rates, it is not intended to predict future results, and our actual results will likely vary.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) under the Exchange Act as of June 30, 2008. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives of ensuring that information we are required to disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures, and is recorded, processed, summarized and reported, within the time periods specified in the SECs rules and forms. There is no assurance that our disclosure controls and procedures will operate effectively under all circumstances. Based upon the evaluation described above our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2008, our disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control over Financial Reporting
No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter-ended June 30, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
The information set forth under Note M - Contingencies to the unaudited condensed consolidated financial statements of this quarterly report on Form 10-Q is incorporated herein by reference.
Many risks affect our business. These risks include, but are not limited to, those described below, each of which may be relevant to decisions regarding an investment in or ownership of our stock. We have attempted to organize the description of these risks into logical groupings to enhance readability, but many of the risks interrelate or could be grouped or ordered in other ways, so no special significance should be attributed to these groupings or order. Any of these risks could have a significant adverse effect on our reputation, business, financial condition or results of operations.
The risk factors below reflect the following updates to the risk factors set forth in our annual report on Form 10-K for the year ended December 31, 2007: (i) the increasing importance of US federal, state, and foreign government standards and industry trends applicable to our software, including interoperability requirements, in our risk factor titled Changes in standards applicable to our software could require us to incur substantial additional development costs; (ii) the anticipated settlement of the derivative litigation, in our risk factor titled Our past stock option practices and related accounting issues have caused costly derivative litigation and may result in additional litigation, regulatory proceedings and governmental enforcement actions; (iii) ongoing auction failures and temporary loss related to our auction rate securities, in our risk factor titled Funds associated with certain of our investments in auction rate securities may not be liquid or accessible for in excess of 12 months, and our auction rate securities may experience further temporary or other-than-temporary decline in value, which would adversely affect our financial condition, cash flow and reported earnings; and (iv) the termination of our stockholder rights agreement, or poison pill, as part of our ongoing review and improvement of Eclipsys corporate governance, and not in connection with any pending or anticipated transaction, in our risk factor titled Provisions of our charter documents and Delaware law may inhibit potential acquisition bids that a stockholder may believe is desirable, and the market price of our common stock may be lower as a result. In addition, we have added a risk factor titled Our commercial credit facility subjects us to operating restrictions and risks of default, due to our entry into a commercial borrowing arrangement in May 2008.
RISKS RELATING TO DEVELOPMENT AND OPERATION OF OUR SOFTWARE
Our software may not operate properly, which could damage our reputation and impair our sales.
Software development is time consuming, expensive and complex. Unforeseen difficulties can arise. We may encounter technical obstacles, and it is possible that we could discover additional problems that prevent our software from operating properly. If our software contains errors or does not function consistent with software specifications or client expectations, clients could assert liability claims against us and/or attempt to cancel their contracts with us. These risks are generally more significant for newer software, until it has been used for enough time in enough client locations for us to have addressed issues that are discovered through use in disparate circumstances and environments. Due to our development efforts, we generally have significant software that could be considered relatively new and therefore more vulnerable to these risks, including at present our medication management and ambulatory software, among others. It is also possible that future releases of our software, which would typically include additional features, may be delayed or may require additional work to address issues that may be discovered as the software comes into use in our client base. If we fail to deliver software with the features and functionality promised to our clients, we could be subject to significant contractual damages, face serious harm to our reputation and our results of operations could be negatively impacted.
Our software development efforts may be inefficient or ineffective, which could adversely affect our results of operations.
We strive to develop new software, and improve our existing software to add new or enhanced features and functionality. We schedule and prioritize these development efforts according to a variety of factors, including our perceptions of market trends, client requirements, and resource availability. Our software is complex and requires a significant investment of time and resources to develop, test, and introduce into use. Sometimes this takes longer than we expect. Sometimes we encounter unanticipated difficulties that require us to re-direct or scale-back our efforts. Sometimes we change our plans in response to changes in client requirements, market demands, resource availability, regulatory requirements, or other factors. All of this can result in acceleration of some initiatives and delay of others. These factors place significant demands upon our software development organization and require complex planning and decision making. If we make the wrong choices or do not manage our development efforts well, we may fail to produce software that responds appropriately to our clients needs, or we may fail to meet client expectations regarding new or enhanced features and functionality.
Market changes or mistaken development decisions could decrease the demand for our software, which could harm our business and decrease our revenues.
The healthcare information technology market is characterized by rapidly changing technologies, evolving industry standards and new software introductions and enhancements that may render existing software obsolete or less competitive. Our position in the market could erode rapidly due to the development of regulatory or industry standards that our software may not fully meet, or due to changes in the features and functions of competing software, as well as the pricing models for such software. Our future success will depend in part upon our ability to enhance our existing software and services, and to timely develop and introduce competing new software and services with features and pricing that meet changing client and market requirements. As we evolve our offering in an attempt to anticipate and meet market demand, clients and potential clients may find our software and services less appealing. If software development for the healthcare information technology market becomes significantly more expensive due to changes in regulatory requirements or healthcare industry practices, or other factors, we may find ourselves at a disadvantage to larger competitors with more financial resources to devote to development. If we are unable to enhance our existing software or develop new software to meet changing client requirements in a timely manner, demand for our software could suffer.
Our software strategy is dependent on the continued development and support by Microsoft of its .NET Framework and other technologies.
Our software strategy is substantially dependent upon Microsofts .NET Framework and other Microsoft technologies. If Microsoft were to cease actively supporting .NET or other technologies, fail to update and enhance them to keep pace with changing industry standards, encounter technical difficulties in the continuing development of these technologies or make them unavailable to us, we could be required to invest significant resources in re-engineering our software. This could lead to lost or delayed sales, client costs associated with platform changes, unanticipated development expenses and harm to our reputation, and would cause our financial results and business to suffer.
Any failure by us to protect our intellectual property, or any misappropriation of it, could enable our competitors to market software with similar features, which could reduce demand for our software.
We are dependent upon our proprietary information and technology. Our means of protecting our proprietary rights may not be adequate to prevent misappropriation. In addition, the laws of some foreign countries may not enable us to protect our proprietary rights in those jurisdictions. Also, despite the steps we have taken to protect our proprietary rights, it may be possible for unauthorized third parties to copy aspects of our software, reverse engineer our software or otherwise obtain and use information that we regard as proprietary. In some limited instances, clients can access source-code versions of our software, subject to contractual limitations on the permitted use of the source code. Furthermore, it may be possible for our competitors to copy or gain access to our content. Although our license agreements with clients attempt to prevent misuse of the source code or trade secrets, the possession of our source code or trade secrets by third parties increases the ease and likelihood of potential misappropriation of our software. Furthermore, others could independently develop technologies similar or superior to our technology or design around our proprietary rights.
Failure of security features of our software could expose us to significant expense and harm our reputation.
Clients use our systems to store and transmit highly confidential patient health information. Because of the sensitivity of this information, security features of our software are very important. If, notwithstanding our efforts, our software security features do not function properly, or client systems using our software are compromised, we could face claims for contract breach, penalties for violation of applicable laws or regulations, significant costs for remediation and re-engineering to prevent future occurrences, and serious harm to our reputation.
RISKS RELATED TO SALES AND IMPLEMENTATION OF OUR SOFTWARE
The length of our sales and implementation cycles may adversely affect our future operating results.
We have experienced long sales and implementation cycles. How and when to implement, replace, expand or substantially modify an information system, or modify or add business processes, are major decisions for healthcare organizations, our target client market. Furthermore, our software generally requires significant capital expenditures by our clients. The sales cycle for our software ranges from 6 to 18 months or more from initial contact to contract execution. Our implementation cycle has generally ranged from 6 to 36 months from contract execution to completion of implementation. During the sales and implementation cycles, we will expend substantial time, effort and resources preparing contract proposals, negotiating the contract and implementing the software. We may not realize any revenues to offset these expenditures and, if we do, accounting principles may not allow us to recognize the revenues during corresponding periods. Additionally, any decision by our clients to delay purchasing or implementing our software would likely adversely affect our revenues.
We may experience implementation delays that could harm our reputation and violate contractual commitments.
Some of our software is complex and requires a lengthy and expensive implementation process. Each clients situation is different, and unanticipated difficulties and delays may arise as a result of failures by us or the client to meet our respective implementation responsibilities or other factors. Because of the complexity of the implementation process, delays are sometimes difficult to attribute solely to us or the client. Implementation delays could motivate clients to delay payments or attempt to cancel their contracts with us or seek other remedies from us. Any inability or perceived inability to implement our software consistent with a clients schedule could harm our reputation and be a competitive disadvantage for us as we pursue new business. Our ability to improve sales depends upon many factors, including completion of implementation and successful use of our new software releases in live environments for clients who achieve success and are willing to become reference sites for us. Implementation also requires our clients to make a substantial commitment of their own time and resources and to make significant organizational and process changes, and if our clients are unable to fulfill their implementation responsibilities in a timely fashion, our projects may be delayed or become less profitable.
Implementation costs may exceed expectations, which can negatively affect our operating results.
Each clients circumstances may include unforeseen issues that make it more difficult or costly than anticipated to implement our software. We may fail to project, price or manage our implementation services correctly. If we do not have sufficient qualified personnel to fulfill our implementation commitments in a timely fashion, related revenue may be delayed, and if we must supplement our capabilities with third-party consultants, which are generally more expensive, our costs will increase.
Our earnings can vary significantly depending on periodic software revenues.
Periodic software revenues includes traditional license fees associated with new contracts signed in the financial reporting period, add-on licenses to existing clients and new client transactions, as well as revenues from contract backlog that had not previously been recognized pending contract performance that occurred or was completed during the period, and certain other activities during the period associated with existing client relationships. These periodic revenues generally have high margins given that there are relatively little in-period costs associated with such revenues, and we therefore rely upon these revenues as an important element of our earnings in any period. These periodic revenues can fluctuate as a result of significant variations in the type and magnitude of sales and other contract and client activity in any period, and these variations make it difficult to predict the nature and amount of these periodic revenues. If periodic software revenues in any period decline from prior periods or fall short of our expectations, our earnings in that period will be adversely affected.
RISKS RELATED TO OUR INFORMATION TECHNOLOGY (IT) OR TECHNOLOGY SERVICES
Various risks could interrupt clients access to their data residing in our service center, exposing us to significant costs.
We provide remote hosting services that involve running our software and third-party vendors software for clients in our Technology Solutions Center. The ability to access the systems and the data that the Technology Solution Center hosts and supports on demand is critical to our clients. Our operations and facilities are vulnerable to interruption and/or damage from a number of sources, many of which are beyond our control, including, without limitation: (i) power loss and telecommunications failures; (ii) fire, flood, hurricane and other natural disasters; (iii) software and hardware errors, failures or crashes; and (iv) computer viruses, hacking and similar disruptive problems. We attempt to mitigate these risks through various means including redundant infrastructure, disaster recovery plans, separate test systems and change control and system security measures, but our precautions may not protect against all problems. If clients access is interrupted because of problems in the operation of our facilities, we could be exposed to significant claims by clients or their patients, particularly if the access interruption is associated with problems in the timely delivery of medical care. We must maintain disaster recovery and business continuity plans that rely upon third-party providers of related services, and if those vendors fail us at a time that our center is not operating correctly, we could incur a loss of revenue and liability for failure to fulfill our contractual service commitments. Any significant instances of system downtime could negatively affect our reputation and ability to sell our remote hosting services.
Any breach of confidentiality of client or patient data in our possession could expose us to significant expense and harm our reputation.
We must maintain facility and systems security measures to preserve the confidentiality of data belonging to our clients and their patients that resides on computer equipment in our Technology Solution Center or that is otherwise in our possession. Notwithstanding the efforts we undertake to protect data, our measures can be vulnerable to infiltration as well as unintentional lapse, and if confidential information is compromised, we could face claims for contract breach, penalties for violation of applicable laws or regulations, significant costs for remediation and re-engineering to prevent future occurrences, and serious harm to our reputation.
Recruiting challenges and higher than anticipated costs in outsourcing our clients IT operations may adversely affect our profitability.
We provide outsourcing services that involve operating clients IT departments using our employees. At the initiation of these relationships, clients often require us to hire, at substantially the same compensation, the entire IT staff that had been performing the services we take on. In these circumstances, our costs may be higher than we target unless and until we are able to transition the workforce, methods and systems to a more scalable model. Various factors can make this difficult, including geographic dispersion of client facilities and variation in client needs, IT environments, and system configurations. Also, under some circumstances, we may incur unanticipated costs as a successor employer by inheriting obligations of that client. Further, facilities management contracts require us to provide the IT services specified by contract, and in some places it can be difficult to recruit qualified IT personnel. Changes in circumstances or failure to assess the clients environment and scope our services accurately can mean we must hire more staff than we anticipated in order to meet our responsibilities. If we have to increase salaries or relocate personnel, or hire more people than we anticipated, our costs may increase under fixed fee contracts.
Inability to obtain consents needed from third parties could impair our ability to provide remote IT or technology services.
We and our clients need consent from some third-party software providers as a condition to running the providers software in our service center, or to allow our employees who work in client locations under facilities management arrangements to have access to their software. Vendors refusal to give such consents, or insistence upon unreasonable conditions to such consents, could reduce our revenue opportunities and make our IT or technology services less viable for some clients.
RISKS RELATED TO THE HEALTHCARE IT INDUSTRY AND MARKET
We operate in an intensely competitive market that includes companies that have greater financial, technical and marketing resources than we do.
We face intense competition in the marketplace. We are confronted by rapidly changing technology, evolving user needs and the frequent introduction by our competitors of new software. Our principal competitors in our software business include Cerner Corporation, Epic Systems Corporation, Medical Information Technology, Inc., GE Healthcare, McKesson Corporation, and Siemens AG. Other software competitors include providers of practice management, general decision support and database systems, as well as segment-specific applications and healthcare technology consultants. Our services business competes with large consulting firms, as well as independent providers of technology implementation and other services. Our outsourcing business competes with large national providers of technology solutions such as IBM Corporation, Computer Sciences Corp., Perot Systems Corporation, as well as smaller firms. Several of our existing and potential competitors are better established, benefit from greater name recognition and have significantly more financial, technical and marketing resources than we do. Some competitors, particularly those with a more diversified revenue base or that are privately held, may have greater flexibility than we do to compete aggressively on the basis of price. Vigorous and evolving competition could lead to a loss of our market share or pressure on our prices and could make it more difficult to grow our business profitably.
The principal factors that affect competition within our market include software functionality, performance, flexibility and features, use of open industry standards, speed and quality of implementation and client service and support, company reputation, price and total cost of ownership. We anticipate continued consolidation in both the information technology and healthcare industries and large integrated technology companies may become more active in our markets, both through acquisition and internal investment. There is a finite number of hospitals and other healthcare providers in our target market. As costs fall, technology improves, and market factors continue to compel investment by healthcare organizations in software and services like ours, market saturation may change the competitive landscape in favor of larger competitors with greater scale.
Clients that use our legacy software are vulnerable to sales efforts of our competitors.
A significant part of our revenue comes from relatively high-margin legacy software that was installed by our clients many years ago. We attempt to convert these clients to our newer generation software, but such conversions may require significant investments of time and resources by clients. Our competitors also aggressively target these clients. If we are not successful in retaining a large portion of these clients by continuing to support legacy softwarewhich is increasingly expensive to maintainor by converting them to our newer software, our results of operations will be negatively affected.
The healthcare industry faces financial constraints that could adversely affect the demand for our software and services.
The healthcare industry faces significant financial constraints. For example, managed healthcare puts pressure on healthcare organizations to reduce costs, and regulatory changes have reduced Medicare reimbursement to healthcare organizations. In addition, the Fiscal Year 2008 Inpatient Prospective Payment System Final Rule, published by the Centers for Medicare & Medicaid in the U.S., identified several hospital-acquired conditions the treatment for which will no longer be reimbursed by Medicare, starting in October 2008. Our software often involves a significant financial commitment by our clients. Our ability to grow our business is largely dependent on our clients information technology budgets. If healthcare information technology spending declines or increases more slowly than we anticipate, demand for our software could be adversely affected.
Healthcare industry consolidation could put pressure on our software prices, reduce our potential client base and reduce demand for our software.
Many healthcare organizations have consolidated to create larger healthcare enterprises with greater market power. If this consolidation trend continues, it could reduce the size of our target market and give the resulting enterprises greater bargaining power, which may lead to erosion of the prices for our software. In addition, when healthcare organizations combine they often consolidate infrastructure including IT systems, and acquisitions of our clients could erode our revenue base.
Changes in standards applicable to our software could require us to incur substantial additional development costs.
Integration and interoperability of the software and systems provided by various vendors are important issues in the healthcare industry. Market forces, regulatory authorities and industry organizations are causing the emergence of standards for software features and performance that are applicable to us. Healthcare delivery and ultimately the functionality demands of the electronic health record is now expanding to support community health, public health, public policy and population health initiatives. In addition, interoperability and health information exchange features that support emerging and enabling technologies are becoming increasingly important to our clients and require large scale product enhancements and redesign.
For example, the Certification Commission for Healthcare Information Technology, or CCHIT, is developing comprehensive sets of criteria for the functionality, interoperability, and security of healthcare software in the U.S. Achieving CCHIT certification is evolving as a de facto competitive requirement, resulting in increased research and development and administrative expense to conform to these requirements. Similar dynamics are evolving in international markets. CCHIT requirements may diverge from our softwares characteristics and our development direction. We may choose not to apply for CCHIT certification of certain modules of our software or to delay applying for certification. The CCHIT application process requires conformity with 100% of all criteria applicable to each module in order to achieve certification and there is no assurance that we will receive or retain certification for any particular module notwithstanding application. Certification for a software module lasts for two years and must then be re-secured, and certification requirements evolve, so even certifications we receive may be lost. If our software is not consistent with emerging standards our market position and sales could be impaired and we will have to upgrade our software to remain competitive in the market.
US government initiatives and related industry trends are resulting in comprehensive and evolving standards related to interoperability, privacy, and other features that are becoming mandatory for systems purchased by governmental healthcare providers and other providers receiving governmental payments. Various state and foreign governments are also developing similar standards which may be different and even more demanding than CCHIT and U.S. government standards.
Our software does not conform to all of these standards, and conforming to these standards is expected to consume a substantial and increasing portion of our development resources. We expect compliance with these kinds of standards to become increasingly important to clients and therefore to our ability to sell our software. If we make the wrong decisions about compliance with these standards, or are late in conforming our software to these standards, or if despite our efforts our software fails standards compliance testing, our reputation, business, financial condition and results of operations could be adversely affected.
RISKS RELATED TO OUR BUSINESS STRATEGY
Our business strategy includes expansion into markets outside North America, which will require increased expenditures and if our international operations are not successfully implemented, such expansion may cause our operating results and reputation to suffer.
We are working to further expand operations in markets outside North America. There is no assurance that these efforts will be successful. We have limited experience in marketing, selling, implementing and supporting our software abroad. Expansion of our international sales and operations will require a significant amount of attention from our management, establishment of service delivery and support capabilities to handle that business and commensurate financial resources, and will subject us to risks and challenges that we would not face if we conducted our business only in the United States. We may not generate sufficient revenues from international business to cover these expenses.
The risks and challenges associated with operations outside the United States may include: the need to modify our software to satisfy local requirements, including associated expenses and time delays; laws and business practices favoring local competitors; compliance with multiple, conflicting and changing governmental laws and regulations, including healthcare, employment, tax, privacy, healthcare information technology, and data and intellectual property protection laws and regulations; laws regulating exports of technology products from the United States and foreign government restrictions on acquisitions of U.S.-origin products; fluctuations in foreign currency exchange rates; difficulties in setting up foreign operations, including recruiting staff and management; and longer accounts receivable payment cycles and other collection difficulties. One or more of these requirements and risks may preclude us from operating in some markets and may cause our operating results and reputation to suffer.
Foreign sales subject us to numerous stringent U.S. and foreign laws, including the Foreign Corrupt Practices Act, or FCPA, and comparable foreign laws and regulations which prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. and other business entities for the purpose of obtaining or retaining business. As we expand our international operations, there is some risk of unauthorized payments or offers of payments by one of our employees, consultants, sales agents or distributors, which could constitute a violation by Eclipsys of various laws including the FCPA, even though such parties are not always subject to our control. Safeguards we implement to discourage these practices may prove to be less than effective and violations of the FCPA and other laws may result in severe criminal or civil sanctions, or other liabilities or proceedings against us, including class action law suits and enforcement actions from the SEC, Department of Justice and overseas regulators, which could adversely affect our reputation, business, financial condition or results of operations.
RISKS RELATED TO OUR OPERATING RESULTS, ACCOUNTING CONTROLS AND FINANCES
Our past stock option practices and related accounting issues have caused costly derivative litigation and may result in additional litigation, regulatory proceedings and governmental enforcement actions.
As a result of the voluntary review of historical stock option practices we undertook from February to May 2007, we concluded that incorrect measurement dates were used for accounting for certain prior stock option grants. As a result, we recorded additional non-cash stock-based compensation expense, and related tax effects, with regard to certain past stock option grants, and we restated certain previously filed financial statements.
We believe these restatements reflect appropriate judgments in determining the correct measurement dates for our stock option grants, and to date those judgments have not been challenged. However, as with other aspects of our financial statements, the results of our stock option review are subject to regulatory review and there is a risk that we may have to further restate prior period results as a result of such a review.
In July and August of 2007, four purported stockholder derivative complaints were filed in the United States District Court for the Southern District of Florida against certain current and former directors and officers of Eclipsys and Eclipsys as a nominal defendant, alleging that during the period from at least 1999 until 2006 certain of Eclipsys option grants were backdated and that as a result of this alleged backdating our financial statements were misstated, and stock sales by the named defendants constituted improper insider selling. These complaints were consolidated in November 2007. These complaints sought monetary damages, disgorgement, repricing of certain stock options, governance reforms, and other relief. On May 27, 2008, the parties to the derivative litigation entered into a stipulation of settlement setting forth the terms of an agreement to settle and resolve all claims. The settlement was preliminarily approved by the court on June 11, 2008 and is subject to final approval by the court following notice to stockholders. If the settlement is not approved, we will continue to incur significant legal costs associated with the litigation. Dealing with this litigation has required us to incur substantial legal expenses, which affected our financial results for 2007 and the first half of 2008. Derivative litigation also can result in management distraction and adverse publicity and resulting reputational harm, which could impair our sales and marketing efforts.
The option review and conclusions and related litigation may result in additional claims by stockholders or employees, regulatory proceedings, government enforcement actions and related investigations and litigation. Any of these could result in significant expenses, management distraction and potential damages, penalties, other remedies, or adverse findings, which could harm our business, financial condition, results of operations and cash flows.
We have a history of operating losses and we cannot predict future profitability.
We experienced operating losses in the years ended December 31, 2003 through 2006. Although we reported operating income for the year ended December 31, 2007, we may incur losses in the future, and it is not certain that we will sustain or increase our recent profitability.
Our operating results may fluctuate significantly and may cause our stock price to decline.
We have experienced significant variations in revenues and operating results from quarter to quarter. Our operating results may continue to fluctuate due to a number of factors, including:
It is difficult to predict the timing of revenues that we receive from software sales, because the sales cycle can vary depending upon several factors. These include the size and terms of the transaction, the changing business plans of the client, the effectiveness of the clients management, general economic conditions and the regulatory environment. In addition, the timing of our revenue recognition could vary considerably depending upon whether our clients license our software under our subscription model or our traditional licensing arrangements. Because a significant percentage of our expenses are relatively fixed, a variation in the timing of sales and implementations could cause significant variations in operating results from quarter to quarter. We believe that period-to-period comparisons of our historical results of operations are not necessarily meaningful. Investors should not rely on these comparisons as indicators of future performance.
Early termination of client contracts or contract penalties could adversely affect results of operations.
Client contracts can change or terminate early for a variety of reasons. Change of control, financial issues, or other changes in client circumstances may cause us or the client to seek to modify or terminate a contract. Further, either we or the client may generally terminate a contract for material uncured breach by the other. If we breach a contract or fail to perform in accordance with contractual service levels, we may be required to refund money previously paid to us by the client, or to pay penalties or other damages. Even if we have not breached, we may deal with various situations from time to time for the reasons described above which may result in the amendment or termination of a contract. These steps can result in significant current period charges and/or reductions in current or future revenue.
Because in many cases we recognize revenues for our software monthly over the term of a client contract, downturns or upturns in sales will not be fully reflected in our operating results until future periods.
We recognize a significant portion of our revenues from clients monthly over the terms of their agreements, which are typically 5-7 years and can be up to 10 years. As a result, much of the revenue that we report each quarter is attributable to agreements executed during prior quarters. Consequently, a decline in sales, client renewals, or market acceptance of our software in one quarter will not necessarily be reflected in lower revenues in that quarter, and may negatively affect our revenues and profitability in future quarters. In addition, we may be unable to adjust our cost structure to compensate for these reduced revenues. This monthly revenue recognition also makes it more difficult for us to rapidly increase our revenues through additional sales in any period, as a significant portion of revenues from new clients or new sales may be recognized over the applicable agreement term.
Loss of revenue from large clients could have significant negative impact on our results of operations and overall financial condition.
During the fiscal year ended December 31, 2007, approximately 40% of our revenues were attributable to our 20 largest clients. In addition, approximately 38% of our accounts receivable as of December 31, 2007 were attributable to 20 clients. One client represents 10% of our revenues. Loss of revenue from significant clients or failure to collect accounts receivable, whether as a result of client payment default, contract termination, or other factors could have a significant negative impact on our results of operation and overall financial condition.
Impairment of intangible assets could increase our expenses.
A significant portion of our assets consists of intangible assets, including capitalized development costs, goodwill and other intangibles acquired in connection with acquisitions. Current accounting standards require us to evaluate goodwill on an annual basis and other intangibles if certain triggering events occur, and adjust the carrying value of these assets to net realizable value when such testing reveals impairment of the assets. Various factors, including regulatory or competitive changes, could affect the value of our intangible assets. If we are required to write-down the value of our intangible assets due to impairment, our reported expenses will increase, resulting in a corresponding decrease in our reported profit.
Failure to maintain effective internal controls could adversely affect our operating results and the market price of our common stock.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we maintain internal control over financial reporting that meets applicable standards. If we are unable, or are perceived as unable, to produce reliable financial reports due to internal control deficiencies, investors could lose confidence in our reported financial information and operating results, which could result in a negative market reaction.
Funds associated with certain of our investments in auction rate securities may not be liquid or accessible for in excess of 12 months, and our auction rate securities may experience further temporary or other-than-temporary decline in value, which would adversely affect our financial condition, cash flow and reported earnings.
A substantial portion of our short-term investment portfolio is invested in auction rate securities, or ARS. Beginning in February 2008, negative conditions in the credit and capital markets resulted in failed auctions of our ARS because the amount of securities submitted for sale exceeded the amount of related purchase orders. Our ARS continued to fail to settle at auctions through the date of this report. As of June 30, 2008 we recorded a temporary loss on these securities of $5.2 million in accumulated other comprehensive income, reflecting a decline in the estimated fair value of these securities. See Note F Investments for further information. If uncertainties in the credit and capital markets continue, these markets deteriorate further or we experience any rating downgrades on any investments in our portfolio (including on ARS), funds associated with these securities may not be liquid or available to fund current operations for in excess of 12 months, causing us to classify our ARS as noncurrent assets and/or incur further temporary or other-than-temporary impairments in the carrying value of our investments, which could negatively affect our financial condition, cash flow and reported earnings.
Inability to obtain other financing could limit our ability to conduct necessary development activities and make strategic investments.
While we believe at this time that our available cash and cash equivalents and the cash we anticipate generating from operations, will be adequate to meet our foreseeable needs, we could incur significant expenses or shortfalls in anticipated cash generated as a result of unanticipated events in our business or competitive, regulatory, or other changes in our market. As a result, we may in the future need to obtain other financing. If other financing is not available on acceptable terms, or at all, we may not be able to respond adequately to these changes or maintain our business, which could adversely affect our operating results and the market price of our common stock.
Our commercial credit facility subjects us to operating restrictions and risks of default.
On May 9, 2008, we entered into a credit agreement with Wachovia Bank, pursuant to which the Company received a senior secured revolving credit facility in the aggregate principal amount of $50.0 million. This credit agreement is subject to certain financial ratio and collateral covenants. These covenants could restrict our ability to conduct business as we might otherwise deem to be in the Companys best interests, and breach of these covenants could cause the debt to become immediately due and expose us to contractual penalties or damages and liquidation of collateral assets at unfavorable prices.
RISKS OF LIABILITY TO THIRD PARTIES
Our software and content are used to assist clinical decision-making and provide information about patient medical histories and treatment plans. If our software fails to provide accurate and timely information or is associated with faulty clinical decisions or treatment, clients, clinicians or their patients could assert claims against us that could result in substantial cost to us, harm our reputation in the industry and cause demand for our software to decline.
We provide software and content that provides practice guidelines and potential treatment methodologies, and other information and tools for use in clinical decision-making, provides access to patient medical histories and assists in creating patient treatment plans. If our software fails to provide accurate and timely information, or if our content or any other element of our software is associated with faulty clinical decisions or treatment, we could have liability to clients, clinicians or their patients. The assertion of such claims, whether or not valid, and ensuing litigation, regardless of its outcome, could result in substantial cost to us, divert managements attention from operations and decrease market acceptance of our software. We attempt to limit by contract our liability for damages and to require that our clients assume responsibility for medical care and approve all system rules and protocols. Despite these precautions, the allocations of responsibility and limitations of liability set forth in our contracts may not be enforceable, may not be binding upon our clients patients, or may not otherwise protect us from liability for damages. We maintain general liability and errors and omissions insurance coverage, but this coverage may not continue to be available on acceptable terms or may not be available in sufficient amounts to cover one or more large claims against us. In addition, the insurer might disclaim coverage as to any future claim. One or more large claims could exceed our available insurance coverage.
Complex software such as ours may contain errors or failures that are not detected until after the software is introduced or updates and new versions are released. It is challenging for us to envision and test our software for all potential problems because it is difficult to simulate the wide variety of computing environments, medical circumstances or treatment methodologies that our clients may deploy or rely upon. Despite extensive testing by us and clients, from time to time we have discovered defects or errors in our software, and additional defects or errors can be expected to appear in the future. Defects and errors that are not timely detected and remedied could expose us to risk of liability to clients, clinicians and their patients and cause delays in software introductions and shipments, result in increased costs and diversion of development resources, require design modifications or decrease market acceptance or client satisfaction with our software.
Our software and our vendors software that we include in our offering could infringe third-party intellectual property rights, exposing us to costs that could be significant.
Infringement or invalidity claims or claims for indemnification resulting from infringement claims could be asserted or prosecuted against us based upon design or use of software we provide to clients, including software we develop as well as software provided to us by vendors. Regardless of the validity of any claims, defending against these claims could result in significant costs and diversion of our resources, and vendor indemnity might not be available. The assertion of infringement claims could result in injunctions preventing us from distributing our software, or require us to obtain a license to the disputed intellectual property rights, which might not be available on reasonable terms or at all. We might also be required to indemnify our clients at significant expense.
RISKS RELATED TO OUR STRATEGIC RELATIONSHIPS AND INITIATIVES
We depend on licenses from third parties for rights to some of the technology we use, and if we are unable to continue these relationships and maintain our rights to this technology, our business could suffer.
We depend upon licenses for some of the technology used in our software from a number of third-party vendors. Most of these licenses expire within one to five years, 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 software sales until we obtain equivalent technology, which could hurt our business. 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, particularly with regard to Microsoft, we may not be able to modify or adapt our own software.
Our software offering often includes modules provided by third parties, and if these third parties do not meet their commitments, our relationships with our clients could be impaired.
Some of the software modules we offer to clients are provided by third parties. We often rely upon these third parties to produce software that meets our clients needs and to implement and maintain that software. If these third parties fail to fulfill their responsibilities, our relationships with affected clients could be impaired, and we could be responsible to clients for the failures. We might not be able to recover from these third parties for all of the costs we incur as a result of their failures.
If we undertake additional acquisitions, they may be disruptive to our business and could have an adverse effect on our future operations and the market price of our common stock.
An important element of our business strategy has been expansion through acquisitions and while there is no assurance that we will complete any future acquisitions, any acquisitions would involve a number of risks, including the following:
RISKS RELATED TO INDUSTRY REGULATION
Potential regulation by the U.S. Food and Drug Administration of our software and content as medical devices could impose increased costs, delay the introduction of new software and hurt our business.
The U.S. Food and Drug Administration, or FDA, may become increasingly active in regulating computer software or content intended for use in the healthcare setting. The FDA has increasingly focused on the regulation of computer software and computer-assisted products as medical devices under the Food, Drug, and Cosmetic Act, or the FDC Act. If the FDA chooses to regulate any of our software, or third party software that we resell, as medical devices, it could impose extensive requirements upon us, including requiring us to:
If we fail to comply with applicable requirements, the FDA could respond by imposing fines, injunctions or civil penalties, requiring recalls or software corrections, suspending production, refusing to grant pre-market clearance or approval of software, withdrawing clearances and approvals, and initiating criminal prosecution. Any FDA policy governing computer products or content may increase the cost and time to market of new or existing software or may prevent us from marketing our software.
Changes in federal and state regulations relating to patient data could depress the demand for our software and impose significant software redesign costs on us.
Clients use our systems to store and transmit highly confidential patient health information and data. State and federal laws and regulations and their foreign equivalents govern the collection, security, use, transmission and other disclosures of health information. These laws and regulations may change rapidly and may be unclear or difficult to apply.
Federal regulations under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, impose national health data standards on healthcare providers that conduct electronic health transactions, healthcare clearinghouses that convert health data between HIPAA-compliant and non-compliant formats and health plans. Collectively, these groups are known as covered entities. The HIPAA standards prescribe transaction formats and code sets for electronic health transactions; protect individual privacy by limiting the uses and disclosures of individually identifiable health information; and require covered entities to implement administrative, physical and technological safeguards to ensure the confidentiality, integrity, availability and security of individually identifiable health information in electronic form. Though we are not a covered entity, most of our clients are and require that our software and services adhere to HIPAA standards. Any failure or perception of failure of our software or services to meet HIPAA standards could adversely affect demand for our software and services and force us to expend significant capital, research and development and other resources to modify our software or services to address the privacy and security requirements of our clients.
States and foreign jurisdictions in which we or our clients operate have adopted, or may adopt, privacy standards that are similar to or more stringent than the federal HIPAA privacy standards. This may lead to different restrictions for handling individually identifiable health information. As a result, our clients may demand information technology solutions and services that are adaptable to reflect different and changing regulatory requirements which could increase our development costs. In the future, federal, state or foreign governmental or regulatory authorities or industry bodies may impose new data security standards or additional restrictions on the collection, use, transmission and other disclosures of health information. We cannot predict the potential impact that these future rules may have on our business. However, the demand for our software and services may decrease if we are not able to develop and offer software and services that can address the regulatory challenges and compliance obligations facing our clients.
RISKS RELATED TO OUR PERSONNEL AND ORGANIZATION
Our growing operations in India expose us to risks that could have an adverse effect on our results of operations.
We now have a significant workforce employed in India engaged in a broad range of development, support and corporate infrastructure activities that are integral to our business and critical to our profitability. This involves significant challenges that are increased by our lack of prior experience managing operations in India. Further, while there are certain cost advantages to operating in India, significant growth in the technology sector in India has increased competition to attract and retain skilled employees with commensurate increases in compensation costs. We may not be able to hire and retain such personnel at compensation levels consistent with our existing compensation and salary structure. Many of the companies with which we compete for hiring experienced employees have greater resources than we have and may be able to offer more attractive terms of employment. In addition, our operations in India require ongoing capital investments and expose us to foreign currency fluctuations, which may significantly reduce or negate any cost benefit anticipated from such expansion. As a result of these and other factors there can be no assurance that we will successfully integrate our India operations, or that our expansion in India will advance our business strategy and provide a satisfactory return on this investment.
In addition, our reliance on a workforce in India exposes us to disruptions in the business, political and economic environment in that region. Maintenance of a stable political environment is important to our operations, and terrorist attacks and acts of violence or war may directly affect our physical facilities and workforce or contribute to general instability. Our operations in India may also be affected by trade restrictions, such as tariffs or other trade controls, as well as other factors that may adversely affect our business and operating results.
If we fail to attract, motivate and retain highly qualified technical, marketing, sales and management personnel, our ability to execute our business strategy could be impaired.
Our success depends, in significant part, upon the continued services of our key technical, marketing, sales and management personnel, and on our ability to continue to attract, motivate and retain highly qualified employees. Competition for these employees is intense and we maintain at-will employment terms with our employees. In addition, the process of recruiting personnel with the combination of skills and attributes required to execute our business strategy can be difficult, time-consuming and expensive. We believe that our ability to implement our strategic goals depends to a considerable degree on our senior management team. The loss of any member of that team could hurt our business.
RISKS RELATED TO OUR EQUITY STRUCTURE
Provisions of our charter documents and Delaware law may inhibit potential acquisition bids that stockholders may believe are desirable, and the market price of our common stock may be lower as a result.
Our board of directors has the authority to issue up to 4,900,000 shares of preferred stock. The board of directors can fix the price, rights, preferences, privileges and restrictions of the preferred stock without any further vote or action by our stockholders. The issuance of shares of preferred stock may discourage, delay or prevent a merger or acquisition of our company. The issuance of preferred stock may result in the loss of voting control to other stockholders. We have no current plans to issue any shares of preferred stock and we terminated, effective as of May 8, 2008, our stockholder rights agreement, or poison pill, which used preferred stock purchase rights to deter certain takeover efforts. However, we could implement a new poison pill in the future, or make other uses of preferred stock to inhibit a potential acquisition of the company.
Our charter documents contain additional anti-takeover devices, including:
The terms of Class II directors John T. Casey, Steven A. Denning, Jay B. Pieper, and Class III directors Dan L. Crippen, Edward A. Kangas and Craig Macnab continued after the meeting.
See Index to exhibits.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.