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EPOCRATES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2010, or fiscal year 2010, included in our Annual Report on Form 10-K for fiscal year 2010, or 2010 Annual Report on Form 10-K. References to "Epocrates" "we", "our" and "us" are to Epocrates, Inc. unless otherwise specified or the context otherwise requires. This Quarterly Report on Form 10-Q contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Terminology such as "believe," "may," "might," "objective," "estimate," "continue," "anticipate," "intend," "should," "plan," "expect," "predict," "potential," or the negative of these terms or other similar expressions is intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified in "Part II -Item 1A. Risk Factors" below, and those discussed in the sections titled "Special Note Regarding Forward-Looking Statements" and "Risk Factors" included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as filed with the SEC on March 31, 2011. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Business overview Epocrates is a leading provider of mobile drug reference tools to healthcare professionals and interactive services to the healthcare industry. Most commonly used on mobile devices at the point of care, our products help healthcare professionals make more informed prescribing decisions, enhance patient safety and improve practice productivity. As of June 30, 2011, our user network consisted of over 1.3 million healthcare professionals, including approximately 328,000, or over 45% of, U.S. physicians. We offer our products on all major U.S. mobile platforms including Apple (iPhone, iPod touch and, with respect to most of our products, iPad), Android, BlackBerry, Palm and Windows Mobile devices. To date, our interactive services clients have included all of the top 20 global pharmaceutical companies by sales and over 350 individual pharmaceutical brands. Our proprietary drug content is the most frequently used mobile reference product by U.S. physicians and provides healthcare professionals with convenient access to information they need at the point of care. Healthcare professionals are able to access information such as dosing, drug/drug interactions, pricing and insurance coverage for thousands of brand, generic and over-the-counter drugs. Physicians trust Epocrates for accurate content and innovative offerings and use our products more than any other mobile drug reference tool. Our strong brand has enabled us to build a large and active network of users, which enhances our ability to market our interactive services. Through our interactive services, we provide the healthcare industry, primarily pharmaceutical companies, access to our user network to deliver targeted information and conduct market research in a cost-effective manner. Our services include DocAlert clinical messages that deliver product news and alerts to healthcare professionals. Our Virtual Representative Services, including drug detailing, sampling, patient literature delivery and the ability to contact drug manufacturers, are designed to supplement and replicate the activities of pharmaceutical sales representatives. We are in the beginning stages of launching several new interactive services products such as SmartSite and Epocrates App Network. A SmartSite is a website that hosts current and relevant promotional content and applications, as developed or provided by a pharmaceutical client. Through the Epocrates App Network we will develop customized medical applications on the iPhone and iPad and distribute them to our user network. We have developed an affordable, easy-to-use electronic health records, or EHR, product that will serve the needs of solo and small group practices and will allow users to qualify for subsidies under the HITECH Act. We believe our experience developing information technology tools used at the point of care by physicians provides us the insight and experience to deliver a product that physicians will find easy to learn and use. In July 2011, we announced the launch of the EHR product. 20 -------------------------------------------------------------------------------- Table of Contents Recent developments In July 2011, we announced the first phase of availability for the Epocrates® EHR mobile and web-based EHR product. In this phase, we introduced the core functionalities that meet the distinct needs of primary care practices with 10 or fewer physicians, which include an intuitive user interface, affordable cost structure, and comprehensive support and service program. Optimized for easy integration into small practice settings, the Epocrates EHR solution is a secure, web-based Software as a Service ("SaaS") system featuring core capabilities, including patient encounter notes, electronic lab integration, ePrescribing, and Epocrates' market-leading drug content. To accommodate the mobile and on-call demands of physicians, we are also offering a native Apple iPhone® app that supports remote patient record look-up and schedule access, as well as ePrescribing capabilities. In April 2011, we launched a new mobile drug sampling service, Epocrates® Mobile Sample Closet. This new service provides pharmaceutical companies the ability to provide custom sample offers to US physicians, who are members of Epocrates' network, via their mobile devices. In addition to drug samples, sponsoring companies may provide physicians with access to patient starter kits, vouchers and educational materials. On February 7, 2011, we closed our initial public offering by issuing 3,574,285 shares of our common stock at $16.00 per share, raising approximately $53.2 million net of underwriters' discounts and commissions. In addition, the underwriters exercised their over-allotment option on an additional 804,000 shares, raising an additional $11.9 million for the company, net of underwriters' discounts and commissions. We raised an aggregate of approximately $62.2 million in proceeds from the IPO net of underwriters' discounts and commissions and other offering costs. From these proceeds, aggregate cumulative dividends to the holders of our Series B preferred stock were paid in full, in the amount of approximately $29.6 million. Financial operations overview We generate revenue by providing healthcare companies with interactive services to communicate with our network of users and through the sale of subscriptions to our premium drug and clinical reference tools to healthcare professionals. For the three months ended June 30, 2011, we recorded total net revenues of $27.9 million, a 10% increase from the three months ended June 30, 2010. For the six months ended June 30, 2011, we recorded total net revenues of $57.0 million, a 15% increase from the six month ended June 30, 2010. The timing of our revenue has been affected by seasonal factors, primarily as a result of the annual budget approval process of many of our customers in the pharmaceutical industry. As a result, our contract bookings and revenue have historically been highest in the fourth quarter of each calendar year. We expect this trend to continue in 2011 and beyond. Also due to the adoption of new revenue recognition guidance in 2009, we are able to recognize revenue in a manner that more closely matches delivery of the contracted services. Prior to the adoption of the new guidance, in cases where we were not able to establish fair value for the undelivered elements in a bundled arrangement, we were required to defer the entire fee and recognize it over the period of delivery of the last undelivered element. Revenue on contracts signed prior to the adoption of the new revenue recognition guidance on January 1, 2009 is deferred until all items in the contracts have been fully delivered. In addition with respect to our pharma revenue, there are two factors which are impacting the timing of revenue growth. Due to the expanding regulatory queues, we are experiencing delays in the launch of DocAlert® messages. For our newer products, the time between contract signing and revenue recognition is taking longer than expected due to the size and complexity of launches. These factors impacted our second quarter revenue and are expected to continue to affect the timing of our net sales for the remainder of the year. As of June 30, 2011, our worldwide user network consisted of over 1.3 million healthcare professionals. Maintaining this large user network of U.S. physicians is important because it will be a key driver of interactive services revenue growth over the long term. The number of users who are U.S. physicians increased approximately 9%, from approximately 300,000 at June 30, 2010 to approximately 328,000 at June 30, 2011. This high growth rate was largely due to rapid iPhone adoption by physicians and to a lesser extent Android adoption by physicians. We expect our network of users to continue to increase, but at a lower rate. The majority of healthcare professionals in our network use our free products. Users who paid for a subscription represented 9% and 11% of total active users as of June 30, 2010 and 2011, respectively. We continue to enhance the clinical functionality of our free services by adding new content and features that are currently only available with our premium products. As part of our strategy to leverage our network of users to generate high margin revenue streams from healthcare industry clients, we plan to devote significant resources to expanding our free product offerings and more actively focus our marketing efforts on increasing awareness and adoption of our free products and services. We expect paid users to continue to represent a decreasing percentage of total active users. As a result, we expect revenues from subscriptions to our premium products to decrease as a percentage of total revenue in the future. 21 -------------------------------------------------------------------------------- Table of Contents To date we have not experienced significant price pressure from competitors other than for our market research services. Competition is high among market research firms, and price has become a major driver in a client's decision about which vendor to use. We have attempted to limit reductions in price because we believe our sizable network of healthcare professionals contributes significantly to a superior result for our clients. This price pressure has caused revenue from market research services to remain essentially flat since 2008. We expect this trend to continue in the future. Currently, our customer base is located almost entirely within the United States. No single customer accounted for more than 10% of the net accounts receivable as of December 31, 2010. There was one customer that accounted for more than 10% net accounts receivable at June 30, 2011. For the three and six months ended June 30, 2010 and 2011, no single customer accounted for more than 10% of net revenue. Our operating expenses, excluding the gain on settlement and change in fair value of contingent consideration, have increased both in absolute dollars and as a percentage of revenue due primarily to a significant investment in our EHR product and other new interactive services products. We expect that research and development and sales and marketing expenses will increase the latter half of 2011 as we continue to enhance our EHR product, develop and release other new interactive service offerings and increase our overall marketing efforts for these new products. In the first half of 2011, there were several one-time charges that resulted in an increase in the general and administrative expenses. We expect that general and administrative expenses will decrease in the latter half of 2011. On an annual fiscal year basis, we have generated positive cash flow from operations since the year ended December 31, 2003. Total cash, cash equivalents and short-term investments increased from $54.7 million at December 31, 2010 to $81.3 million at June 30, 2011. The increase was primarily due to proceeds from our IPO, net of issuance costs and cash generated from operations, partially offset by the payment of $29.6 million of aggregate cumulative dividends to the holders of our Series B preferred stock, increase in capital expenditures in the form of capitalized software development costs and payment of the earn out liability associated with our 2010 acquisition of MedCafe, Inc. Our users pay for one year of our premium subscriptions up front. This amount is deferred and recognized ratably over the term of the subscription. Typically, interactive services clients are billed a portion of the contracted fee upon signing of the contract with the balance billed upon one or more future milestones. The amounts collected are deferred and recognized as services are delivered. Because a significant amount of cash is collected near the beginning of the contract, we have generated strong cash flow from operations relative to revenue recognized. This trend is expected to continue but become less pronounced due to the adoption of new revenue recognition guidance which will result in revenue being recognized in a manner that more closely matches delivery of the contracted services. We invested significant development and marketing resources during fiscal 2010 to develop and deliver new products and we have and expect to continue to invest significant resources in 2011. Specifically, we have recorded $1.3 million and $3.8 million in sales and marketing and research and development expenses, related to the EHR product during the three and six months ended June 30, 2011, respectively. This investment of resources has caused our operating margins to decrease in the six months ended June 30, 2011 as compared to the six months ended June 30, 2010. We expect our EHR product to generate revenue in the latter half of 2011. However, the market for such products is competitive and we have limited experience in that market. Several of our competitors have been participating in this market for many years and have invested significantly more resources in the development of their products than we have. Even if our product meets the requirements of meaningful use as defined by American Recovery and Reinvestment Act of 2009, and is certified as such, we may be too late to the market to compete for the growing number of physicians and others expected to adopt such products in order to qualify for the government incentives beginning in 2011. In addition, numerous other factors, including, but not limited to, development delays, unexpected intellectual property disputes and our inability to compete in the market could hinder customer acceptance of the product. Our revenue estimates for our EHR product may not materialize which could result in an impairment of goodwill related to the EHR reporting unit of up to $1.1 million. In June 2011, we entered into an agreement with the sellers of MedCafe, Inc. to settle the earn out consideration liability for a lump sum payment of $6.4 million. The settlement of the liability resulted in a gain of approximately $6.4 million in the second quarter of 2011. We continue to have approximately $2.1 million of earn-out liability associated with our 2009 acquisition of Caretools, Inc. We carry the contingent consideration at fair value with any changes in fair value of the contingent consideration recorded in operating income. Management estimates the fair value of contingent consideration each quarter based on its most recent financial forecast. To the extent our forecast increases, the fair value of the contingent consideration will increase with the change in fair value recorded to operating expense. Conversely, to the extent our forecast decreases, the fair value of the contingent consideration will decrease with the change in fair value recorded as a reduction in operating expense. With the settlement of the MedCafe, Inc. earn out liability, our future operating results may be subject to a significantly lower level degree of fluctuation. 22 -------------------------------------------------------------------------------- Table of Contents Our operating results will be subject to fluctuations due to variable accounting resulting from re-pricing of certain options. In November 2003, our Board of Directors approved a stock option repricing program. The options repriced were subject to variable accounting, which required that all such vested options repriced be marked to market until such options are cancelled, expire or are exercised. Assuming that none of these outstanding options are exercised, cancelled or expire prior to their expiration date (all such options will expire by December 2013), each $1.00 increase or decrease in the fair market value of our common stock would result in a corresponding increase or decrease in stock based compensation of approximately $0.1 million. We are not a capital intensive business. Most of our expenditures have been related to sales, marketing and product development and we expect this to continue. Critical accounting policies and estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by us may differ materially and adversely from our estimates. Our critical accounting policies are those that affect our historical financial statements materially and involve difficult, subjective or complex judgments by management. Significant estimates and assumptions by management affect revenue recognition, the allowance for doubtful accounts, the carrying value of long-lived assets, the depreciation and amortization period of long-lived assets, the provision for income taxes and related deferred tax accounts, accounting for business combinations, stock based compensation and fair value of contingent consideration. There have been no significant changes in our critical accounting policies during the six months ended June 30, 2011 compared to those previously disclosed in "Critical Accounting Policies and Estimates" in "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2010 Annual Report on Form 10-K. Results from Operations The following table summarizes our results of operations for the three months ended June 30, 2010 compared to the three months ended June 30, 2011 (dollars in thousands). Three Months Ended Increase Increase June 30, (Decrease) (Decrease) 2010 2011 $ % (unaudited) Total revenues, net $ 25,277 $ 27,860 $ 2,583 10.2 % Total cost of revenues 7,736 9,768 2,032 26.3 % Gross profit 17,541 18,092 551 3.1 % Operating expenses: Sales and marketing 7,554 7,600 46 0.6 % Research and development 4,865 5,212 347 7.1 % General and administrative 3,925 5,908 1,983 50.5 % Facilities exit costs - 58 58 * Gain on settlement and change in fair value of contingent consideration (569 ) (6,375 ) (5,806 ) * Total operating expenses 15,775 12,403 (3,372 ) (21.4 )% Income from operations 1,766 5,689 3,923 * Interest income 28 23 (5 ) (17.9 )% Other income (expense), net - 177 177 * Gain on sale-leaseback of building 1,689 - (1,689 ) * Income before income taxes 3,483 5,889 2,406 69.1 % Provision for income taxes (2,721 ) (2,496 ) 225 8.3 % Net income $ 762 $ 3,393 $ 2,631 * --------------------------------------------------------------------------------* Not meaningful 23 -------------------------------------------------------------------------------- Table of Contents The following table summarizes our results of operations for the six months ended June 30, 2010 compared to the six months ended June 30, 2011 (dollars in thousands). Six Months Ended Increase Increase June 30, (Decrease) (Decrease) 2010 2011 $ % (unaudited) Total revenues, net $ 49,613 $ 57,037 $ 7,424 15.0 % Total cost of revenues 14,988 19,158 4,170 27.8 % Gross profit 34,625 37,879 3,254 9.4 % Operating expenses: Sales and marketing 14,392 15,911 1,519 10.6 % Research and development 9,384 11,557 2,173 23.2 % General and administrative 7,950 12,167 4,217 53.0 % Facilities exit costs - 618 618 * Gain on settlement and change in fair value of contingent consideration 645 (6,074 ) (6,719 ) * Total operating expenses 32,371 34,179 1,808 5.6 % Income from operations 2,254 3,700 1,446 64.2 % Interest income 48 51 3 6.3 % Interest expense (214 ) - 214 * Other income (expense), net 2 179 177 * Gain on sale-leaseback of building 1,689 - (1,689 ) * Income before income taxes 3,779 3,930 151 4.0 % Provision for income taxes (2,991 ) (1,663 ) 1,328 44.4 % Net income $ 788 $ 2,267 $ 1,479 * -------------------------------------------------------------------------------- * Not meaningful Historically, we were organized as having one operating segment, Subscriptions and Interactive Services. Beginning in 2010, we reorganized our operations and identified an additional operating segment, EHR. Therefore we currently have two reportable segments, "Subscriptions and Interactive Services" and "EHR". Through June 30, 2011, we have not generated any revenue from our EHR segment as our EHR product was released in July 2011. We do not allocate certain expenses to our segments that benefit both segments, such as stock based compensation, general and administrative expenses and certain marketing and research and development expenses. The following table summarizes our operating results by operating segment for the three months ended June 30, 2010 and 2011 (in thousands): Three Months Ended June 30, 2010 Three Months Ended June 30, 2011 Subscriptions and Electronic Subscriptions and Electronic Interactive Services Health Records Total Interactive Services Health Records TotalNet revenue from external customers $ 25,277 - $ 25,277 27,860 - $ 27,860 Income (loss) from operations 10,642 (1,905 ) 8,737 14,509 (1,339 ) 13,170 Unallocated items: Stock based compensation (1,602 ) (1,523 ) Facilities exit costs - (58 ) Other unallocated corporate costs (5,369 ) (5,900 ) Income from operations, as reported 1,766 5,689 Interest income 28 23 Interest expense - - Other income (expense), net - 177 Gain on sale-leaseback of building 1,689 - Income before income taxes, as reported $ 3,483 $ 5,889 24 -------------------------------------------------------------------------------- Table of Contents The following table summarizes our operating results by operating segment for the six months ended June 30, 2010 and 2011 (in thousands): Six Months Ended June 30, 2010 Six Months Ended June 30, 2011 Subscriptions and Electronic Subscriptions and Electronic Interactive Services Health Records Total Interactive Services Health Records Total Net revenue from external customers $ 49,613 - $ 49,613 $ 57,037 - $ 57,037 Income (loss) from operations 20,185 (4,153 ) 16,032 24,531 (3,650 ) 20,881 Unallocated items: Stock based compensation (3,135 ) (4,330 ) Facilities exit costs - (618 ) Other unallocated corporate costs (10,643 ) (12,233 ) Income from operations, as reported 2,254 3,700 Interest income 48 51 Interest expense (214 ) - Other income (expense), net 2 179 Gain on sale-leaseback of building 1,689 - Income before income taxes, as reported $ 3,779 $ 3,930 Revenues: We generate revenue through the sale of subscriptions to our premium drug and clinical reference tools to healthcare professionals and by providing healthcare companies with interactive services to communicate with our network of users. The following is a breakdown of net revenue from subscriptions and interactive services for the three and six months ended June 30, 2010 and 2011 (dollars in thousands): Three Months Ended Increase Six Months Ended Increase June 30, (Decrease) June 30, (Decrease) 2010 2011 % 2010 2011 % Subscriptions $ 5,796 6,094 5.1 % $ 11,550 12,303 6.5 % Interactive Services 19,481 21,766 11.7 % 38,063 44,734 17.5 % $ 25,277 27,860 10.2 % $ 49,613 57,037 15.0 % The increase in subscription revenue of $0.3 million in the three months ended June 30, 2011 compared to three months ended June 30, 2010 and the increase of $0.8 million in the six months ended June 30, 2011 compared to the six months ended June 30, 2010, was due primarily to an increase in paid subscription revenue as a result of our acquisition of Modality, which we acquired in November 2010. During the first quarter of 2011, we converted several key Modality applications to the Epocrates brand to provide more powerful solutions to physicians. We expect the percentage of users who pay for a subscription to continue to remain flat in 2011. As a result, we expect subscription revenue from our premium products to decrease as a percentage of total revenue in the future. However, we expect that this decrease will be partially offset by the revenue generated from the sale of applications of Modality and revenue from our EHR product, which was launched in July 2011. A key focus of our business during 2011 and beyond is to maintain and deepen our relationship with the user network through the recent introduction of our EHR product. In addition, we intend to devote significant resources to enhancing the clinical functionality of our free offerings and more actively focus our marketing efforts on increasing awareness and adoption of these products and services. The $2.3 million increase in interactive services in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 was driven by $1.0 million increase in DocAlert clinical messaging services and $1.8 million increase in revenue from virtual representative services, which were first launched in the first quarter of 2010. The growth in DocAlert clinical messaging services revenue was driven by a greater volume of messages launched during the three months ended June 30, 2011 compared to the three months ended June 30, 2010. The growth in the virtual representative services revenue was driven by a higher number of launches of our existing products and introduction of new products such as the mobile drug sampling service in 2011. 25 -------------------------------------------------------------------------------- Table of Contents The $6.7 million increase in interactive services in the six months ended June 30, 2011 compared to the six months ended June 30, 2010 was driven by $4.3 million increase in DocAlert clinical messaging services and $3.4 million increase in revenue from virtual representative services, which were first launched in the first quarter of 2010, partially offset by a $1.5 million decrease in revenue from formulary hosting services. The growth in DocAlert clinical messaging services revenue was driven by a greater volume of messages launched during the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The increase was also driven by completion of several large contracts, which were signed prior to the adoption of the new revenue recognition guidance on January 1, 2009, for which revenue was recognized upon completion in the second quarter of 2011. The decline in formulary hosting services revenue was due to more revenue recognized on contracts signed prior to the adoption of the new revenue recognition guidance in the six months ended June 30, 2010 compared to the six months ended June 30, 2011. Revenue on contracts signed prior to the adoption of the new revenue recognition guidance on January 1, 2009 was deferred until all items in the contracts had been fully delivered. There were certain older contracts for which all performance obligations were completed in the six months ended June 30, 2010 and therefore the entire revenue on such contracts was recognized in this period. There was a fewer number of such contracts on which the entire revenue was recognized in the six months ended June 30, 2011. This resulted in lower revenues for the six month ended June 30, 2011 as compared to the six months ended June 30, 2010. The decline was partially offset by a greater number of formularies active in the six months ended June 2011 compared to the same period in the prior year. Historically, our interactive services revenue and particularly our clinical messaging revenues have grown at a much faster rate than subscriptions. We expect this trend to continue as the use of electronic services as a medium to communicate with healthcare providers continues to gain acceptance within the pharmaceutical industry. We continue to provide high value point of care solutions to our large network of physicians as demonstrated by new product offerings and the launch of the new EHR platform. We expect that continued growth in DocAlert messages, new virtual representative services, the Epocrates App network and our SmartSite online resource will complement our core business, strengthen our user network and extend our leadership position in point of care solutions. Cost of revenues. Cost of revenues consists of the costs related to providing services to customers. These costs include salaries and related personnel expenses, stock based compensation, service support costs, payments to participants in market research surveys we conduct for our customers, third party royalties and allocated overhead. Much of the content in our premium drug and reference products is licensed from third parties. Royalty costs consist of fees that we pay to content owners for the use of their intellectual property. Contracts with certain licensors include minimum guaranteed royalty payments, which are payable regardless of ultimate sales. Additional royalties may be due based on sales. We allocate overhead expenses such as rent, occupancy charges and information technology costs to all departments based on headcount. As a result, such expenses are reflected in costs of revenues, as well as in the research and development, sales and marketing and general and administrative expense categories. Depreciation and amortization expense is also allocated to cost of revenues. The following is a breakdown of cost of revenue related to subscriptions and interactive services for the three and six months ended June 30, 2010 and 2011 (dollars in thousands): Three Months Ended Increase Six Months Ended Increase June 30, (Decrease) June 30, (Decrease) 2010 2011 % 2010 2011 % Subscriptions $ 1,574 $ 1,800 14.4 % $ 3,379 $ 3,843 13.7 % Interactive Services 6,162 $ 7,968 29.3 % 11,609 15,315 31.9 % $ 7,736 9,768 26.3 % $ 14,988 19,158 27.8 % Cost of subscription revenue as a percentage of subscription revenue was 27% and 30% for three months ended June 30, 2010 and 2011, respectively. Cost of subscription revenue as a percentage of subscription revenue was 29% and 31% for the six months ended June 30, 2010 and 2011, respectively. This increase was due primarily to an increase in third party royalty costs. The increase in cost of interactive services in the three and six months period ended June 30, 2011 compared to the three and six month period ended June 30, 2010 was due primarily to an increase in the amortization of intangible assets and increased allocated overhead costs. We completed the acquisition of MedCafe, Inc., on February 1, 2010 and Modality, Inc,. on November 12, 2010 and this 26 -------------------------------------------------------------------------------- Table of Contents resulted in a higher amortization reflected in the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010. The intangible assets from the Modality acquisition were amortized beginning the third quarter of 2010 when the underlying assets were available for their intended use. We recorded amortization costs of $15,833 and $1.0 million in the three months ended June 30, 2010 and 2011, respectively, and $24,167 and $2.1 million in the six months ended June 30, 2010 and June 30, 2011, respectively. Cost of interactive services revenue as a percentage of interactive service revenue was 32% and 37% for the three months ended June 30, 2010 and 2011, respectively and 30% and 34% for the six months ended June 30, 2010 and 2011, respectively. We expect that the cost of interactive services revenue will continue to increase. Sales and marketing expense. Sales and marketing expense consists primarily of salaries and related personnel expenses, sales commissions, stock based compensation, trade show expenses, promotional expenses, public relations expenses and allocated overhead. Commissions are expensed upon collection of customer invoices. Sales and marketing expense remained relatively flat for the three months ended June 30, 2011 compared to three months ended June 30, 2010. There was an increase in salary, consulting and other costs to support the release of our EHR product, which was offset by a decline in stock compensation costs as a result of the mark to market for the repriced options. Sales and marketing expense as a percentage of total net revenue for the three months ended June 30, 2010 and 2011 was 30% and 27%, respectively. Sales and marketing expense increased approximately $1.5 million, or 11%, for the six months ended June 30, 2011 compared to six months ended June 30, 2010 due primarily to increased salary, consulting and other costs to support the release of our EHR product. Sales and marketing expense as a percentage of total net revenue for the six months ended June 30, 2010 and 2011 was 29% and 28%, respectively. We expect sales and marketing expense to continue to increase as we continue to develop and launch new interactive service offerings and as we increase our EHR marketing efforts. Research and development expense. Research and development expense consists primarily of salaries and related personnel expenses, stock based compensation, allocated overhead, consultant fees and expenses related to the design, development, testing and enhancements of our services. Research and development expense increased $0.3 million, or 7%, for the three months ended June 30, 2011 compared to the three months ended June 30, 2010. This increase was primarily due to an increase in non-EHR related salary and other personnel costs of $1.2 million for the additional headcount needed to support the development and release of our new products and increased headcount from our recent acquisition of Modality, offset by a reduction in EHR related costs of $0.9 million. The costs relating to our new EHR platform were lower in the three months ended June 30, 2011 compared to the three months ended June 30, 2010 as we started the capitalization of the costs related to our new EHR platform upon reaching technological feasibility in March 2011 with the launch of our Beta version of the EHR platform. Under the generally accepted accounting principles, software development costs are charged to expenses until technological feasibility is established. Costs incurred after technological feasibility is established are capitalized until the product is launched. Accordingly most of the costs incurred on the development of the platform have been capitalized since March 2011, thereby resulting in a reduction in the EHR related research and development costs. Research and development expense as a percentage of total net revenue was 19% for each of the three months ended June 30, 2010 and 2011. Research and development expense increased $2.2 million, or 23%, for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. This increase was primarily due to an increase in non-EHR related salary and other personnel costs of $2.0 million for the additional headcount needed to support the development and release of our new products and increased headcount from our recent acquisition of Modality, offset in part by a reduction in EHR related costs of $0.2 million. Research and development expense as a percentage of total net revenue for the six months ended June 30, 2010 and 2011was 19% and 20%, respectively. We expect research and development expense to increase as we continue to develop new interactive service offerings and enhance our EHR offering based on user feedback, market demands and ongoing development programs. General and administrative expense. General and administrative expense consists primarily of salaries and related personnel expenses, stock based compensation, consulting, audit fees, legal fees, allocated overhead and other general corporate expenses. General and administrative expense increased $2.0 million, or 51%, for the three months ended June 30, 2011 compared to the three months ended June 30, 2010. This increase was primarily due to increased legal and professional fees of $1.0 million and increase in salary and personnel costs of $0.5 million. We incurred significant legal and other professional service fees to support our compliance with the subpoena received in connection with the ongoing SEC investigation, which is described in Part II- Item 1- Legal Proceedings. We incurred higher salary and personnel costs, including stock-based compensation, in the three months ended June 30, 2011, due to the additional headcount needed to support the compliance with the regulatory requirements of being a public company. General and administrative expense as a percentage of total net revenue for the three months ended June 30, 2010 and 2011 was 16% and 22%, respectively. 27 -------------------------------------------------------------------------------- Table of Contents General and administrative expenses increased $4.2 million, or 53%, for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. This increase was primarily due to increased legal and professional fees of $1.3 million, an increase in stock based compensation of $1.2 million and an increase in salary and personnel costs of $0.9 million. We incurred significant legal and other professional service fees to support our compliance with the subpoena received in connection with the ongoing SEC investigation and to support our annual SEC filings. We incurred higher salary and personnel costs, including stock-based compensation, in the six months ended June 30, 2011, due to the additional headcount needed to support the compliance with the regulatory requirements of being a public company. Stock-based compensation expense was also higher in the six months ended June 30, 2011 due to $0.5 million of additional charge recorded in the first quarter of 2011 due to the modification to the terms of the options granted to certain directors. General and administrative expense as a percentage of total net revenue for the six months ended June 30, 2010 and 2011 was 16% and 22%, respectively. We expect general and administrative expense, excluding the one-time costs, to decrease in the remainder of 2011. However, we may incur additional costs in connection with the SEC inquiry and compliance with the subpoena. While the SEC's letter states that, at this time, it has not concluded any violations of securities laws have occurred, we can make no guarantee that legal action will not result from this inquiry. Facilities exit costs. We recorded a charge of approximately $0.1 million and $0.6 million in the three and six months ended June 30, 2011 relating to facilities exit costs. We vacated our East Windsor, New Jersey office in the first quarter of 2011 and relocated our New Jersey operations to Ewing, New Jersey. We had signed a non cancellable lease with the landlord, which does not expire until the end of fiscal 2012 and therefore will be liable to make monthly lease rentals under the contract. The liability recorded at fair value is based on the present value of the remaining lease rentals and is reduced for the estimated sublease rentals that could be reasonably obtained for the property. The additional charge recorded in the three months ended June 30, 2011 related to a revision to the accrual due to a change in the probability of the sublease of a portion of the premises. Gain on settlement and change in fair value of contingent consideration. We acquired certain intangible assets of Caretools, Inc., in June 2009 and of MedCafe Inc., in February 2010. These acquisitions were accounted for as business combinations under GAAP. For the three months ended June 30, 2010 and 2011, we recorded a reduction in the contingent consideration expense of $0.6 million and $6.3 million, respectively. For the six months ended June 30, 2010, we recorded an increase in the contingent consideration expense of $0.6 million compared to a reduction in the contingent consideration expense of $6.1 million. The change in the fair value of the contingent consideration was due in part to changes in discount periods as well as revised estimates of revenue and operating results expected to be generated using the acquired technologies. In April 2011, we paid approximately $0.5 million towards the first installment of the earn out consideration. In June 2011, we entered into an agreement with the sellers of MedCafe, Inc. to settle the earn out consideration liability for a lump sum payment of $6.4 million. The settlement of the liability resulted in a gain of approximately $6.4 million in the second quarter of 2011. As of June 30, 2011, we continue to have approximately $2.1 million of earn-out liability associated with our acquisition of Caretools, Inc. To the extent we are successful in developing and then successfully launching our new products using the acquired companies' technology, we will record additional contingent consideration expense. Conversely, to the extent we are not successful in developing and then successfully launching our new products using the acquired companies' technology, we will record a reduction to contingent consideration expense. Interest income. Interest income was essentially flat for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010. Although average cash and short-term investment balances increased during the three and six months ended June 30, 2011, the continued decline in prevailing interest rates in 2011 compared to 2010 resulted in only a slight increase in interest income. Interest expense. We incurred interest expense of $0 and $0.2 million for the three and six months ended June 30, 2010, respectively, compared to $0 for the three and six months ended June 30, 2011. Interest expense recorded for the six months ended June 30, 2010 related to rent payments on our San Mateo facility which we capitalized. Interest expense decreased during the six months ended June 30, 2011 due to a sale-leaseback of our San Mateo facility. Other income (expense), net. We recorded other income (expense), net of $0 and $2,000 in the three and six months ended June 30, 2010, respectively, compared to $0.2 million in each of the three and six months ended June 30, 2011. In the second quarter of 2011, we received a refund on the property taxes paid in prior years on our San Mateo facility, which has been recorded as other income. 28 -------------------------------------------------------------------------------- Table of Contents Gain on sale-leaseback of building. In April 2007, we began a build-out of existing office space at our San Mateo facility. When we signed the lease, the construction of the space we would lease was unfinished. We concluded that under GAAP, we should be considered the owner of the construction project as we were responsible for any cost overruns to make the building ready for occupancy and were also responsible for paying directly any cost of the project other than normal tenant improvements. Therefore, we have capitalized the fair value of the unfinished portion of the building that we occupy with a corresponding credit to financing liability pursuant to the financing method under GAAP. Subsequent to the completion of construction, we did not qualify for sale-leaseback accounting under GAAP because of a provision in the lease which constituted continuing involvement. In April 2010, we modified the terms of the building lease. The revised provisions under the modified lease agreement allowed us to qualify for sale-leaseback accounting and to begin accounting for the lease as an operating lease. In connection with the sale-leaseback of the building we wrote off the remaining asset value of the building, related accumulated depreciation and the financing liability. As a result of these accounting transactions, we recorded a gain on sale-leaseback of $1.7 million. Since April 2010, the lease has been accounted for as an operating lease. Benefit from (Provision for) for income taxes. For the three months ended June 30, 2010 and 2011 we recorded an income tax provision of $2.7 million and $2.5 million, respectively. For the six months ended June 30, 2010 and 2011, we recorded an income tax provision of $3.0 million and $1.7 million, respectively. At June 30, 2011 our estimate of the annual effective tax rate was approximately 42%. We determine our interim tax benefit from (provision for) income taxes using an estimated annual effective tax rate methodology. Our annual effective tax rate is affected by our forecasted net income, research tax credits, stock compensation expense related to Incentive Stock Options ," or ISO's", and the expected level of other tax benefits. Our annual effective tax rate is difficult to predict because it will be impacted by any disqualifying dispositions of ISO's by our employees. Disqualifying dispositions occur when an employee sells stock that was acquired through the exercise of an ISO within two years of the ISO grant date or one year of the ISO exercise date. Our estimated annual effective tax rate could materially decrease if there are a significant number of disqualifying dispositions of ISO's in the third and fourth quarters of fiscal 2011 upon the expiration of the IPO lock up period. Liquidity and capital resources Cash flow from operating activities has been positive on an annual basis since 2003. Most of our expenditures are for personnel and facilities. As revenues have grown, operating expenses have also increased. Our principal sources of liquidity as of June 30, 2011 consisted of cash, cash equivalents and short term investments of $81.3 million, compared to $54.7 million at December 31, 2010. The increase was primarily due to net proceeds from our IPO, partially offset by the payment of $29.6 million of aggregate cumulative dividends to the holders of our Series B preferred stock, and an increase in capital expenditures in the form of capitalized software development costs and payment of the earn out liability associated with our 2010 acquisition of MedCafe, Inc. We believe that our available cash resources and anticipated future cash flow from operations will provide sufficient cash resources to meet our contractual obligations and our currently anticipated working capital and capital expenditure requirements for at least the next twelve months. Our future liquidity and capital requirements will depend upon numerous factors, including retention of customers at current volume and revenue levels, our existing and new application and service offerings, competing technological and market developments and potential future acquisitions. In addition, our ability to generate cash flow is subject to numerous factors beyond our control, including general economic, regulatory and other matters affecting our customers and us. Operating activities Cash provided by operating activities was $4.6 million for the six months ended June 30, 2011 compared to $7.4 million for the six months ended June 30, 2010. Operating cash flows for the six months ended June 30, 2011 were primarily driven by net income after adjusting for certain non-cash items including stock-based compensation, depreciation and amortization, amortization of intangible assets, change in the fair value of contingent consideration and facilities exit costs, and the impact of changes in operating assets and liabilities. Cash generated from accounts receivable was approximately $1.8 million due to higher collections during the first six months of 2011. The decrease in accounts payable of $1.6 million was mainly due to timing of disbursements. The increase in deferred revenue of $0.7 million in the six months ended June 30, 2011 was driven by higher billings in the six months ended June 30, 2011 on contracts that were signed late in fiscal 2010. Other accrued liabilities decreased $2.6 million due primarily to the payment of the fiscal 2010 employee bonuses in April 2011. 29 -------------------------------------------------------------------------------- Table of Contents Investing activities Cash used in investing activities was $5.9 million for the six months ended June 30, 2011. This was driven primarily by capital expenditures, which includes capitalized internal use software and capitalized software for sale of $6.0 million. Our policy is to invest only in fixed income instruments denominated and payable in U.S. dollars. Our investment policy is as follows: investment in obligations of the U.S. government and its agencies, money market instruments, commercial paper, certificates of deposit, bankers' acceptances, corporate bonds of U.S. companies, municipal securities and asset backed securities are allowed. We do not invest in auction rate securities, futures contracts, or hedging instruments. Securities of a single issuer valued at cost at the time of purchase should not exceed 5% of the market value of the portfolio or $1.0 million, whichever is greater, but securities issued by the U.S. Treasury and U.S. government agencies are specifically exempted from these restrictions. Issue size should normally be greater than $50 million for corporate bonds. No single position in any issue should equal more than 10% of that issue. The final maturity of each security within the portfolio should not exceed 24 months. The following table summarizes our investments in cash, cash equivalents and short-term investments as of December 31, 2010 and June 30, 2011 (in thousands): December 31, June 30, 2010 2011 Cash $ 10,676 $ 36,455 Cash equivalents 25,311 26,465 Short-term investments 18,697 18,375Total cash, cash equivalents and short-term investments $ 54,684 $ 81,295 Unrealized gain (loss) on available-for-sale securities - 1 Financing activities Cash provided by financing activities was $28.2 million in the six months ended June 30, 2011. Cash provided by financing activities in the six months ended June 30, 2011 was due primarily to proceeds from our IPO, net of issuance costs of approximately $64.2 million, partially offset by the payment of $29.6 million of aggregate cumulative dividends to the holders of our Series B preferred stock and payment of $6.9 million to the sellers of MedCafé, Inc. towards the first installment and settlement of the earn out consideration. Contractual obligations The following table summarizes our contractual obligations as of June 30, 2011 and the years in which these obligations are due (in thousands): Remainder of Total 2011 2012 - 2013 2014 - 2015 Other Operating leases(1) 8,371 1,377 5,199 1,795 - Minimum royalty and contract license fees(2) 3,751 2,304 1,447 - - Purchase Obligations and others(3) 1,215 316 899 - - Uncertain tax positions(4) 1,061 - - - 1,061 Fair value of contingent consideration(5) 2,071 - - - 2,071 Total $ 16,469 $ 3,997 $ 7,545 $ 1,795 $ 3,132 --------------------------------------------------------------------------------(1) Relates to our facilities in California, New Jersey and North Carolina. (2) Relates to medical information licensed from third partiesfor use in our subscription services. (3) Relates to a contract with a consulting firm to provide product development and content development work and a reseller partner agreement related to our EHR product. (4) Represents uncertain tax positions for which we could not make a reasonable estimate of the amount or the exact period of related future payments. (5) Represents contingent consideration related to acquisitions. See "Note 5 Acquisitions" for details. 30 -------------------------------------------------------------------------------- Table of Contents This compares to our contractual obligations as of December 31, 2010, of $60.9 million. The primary reason for the decrease is the accrued dividend on Series B mandatorily redeemable convertible preferred stock of $29.3 million existing on December 31, 2010, which was paid in connection with the closing of our initial public offering in February 2011. The second major driver was a reduction of fair value of contingent consideration from $15.0 million to $2.0 million as a result of our settlement of the earn out consideration required to be paid by us in connection with the MedCafe acquisition. See Note 5 to the Unaudited Condensed Consolidated Financial Statements of this quarterly report on Form 10-Q. Off-balance sheet arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. We do not have any outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions, or foreign currency forward contracts. Indemnification Arrangements See Note 8 to the Unaudited Condensed Consolidated Financial Statements of this quarterly report on Form 10-Q. Recent Accounting Pronouncements For a description of accounting changes and recent accounting standards, including the expected dates of adoption and estimated effects, if any, on our unaudited condensed consolidated financial statements, see Note 1 to the Unaudited Condensed Consolidated Financial Statements of this quarterly report on Form 10-Q. Other financial data Three Months Ended Six Months Ended June 30, June 30, 2010 2011 2010 2011 Adjusted EBITDA(1) $ 4,094 $ 4,119 $ 7,844 $ 7,932 Net cash provided by (used in) operating activities 196 (1,757 ) 7,423 4,567 Capital expenditures (1,439 ) (3,317 ) (2,344 ) (6,028 ) -------------------------------------------------------------------------------- (1) Adjusted EBITDA is an unaudited number and represents net income (loss) before interest income, interest expense, other income (expense), net, benefit (provision) for income taxes, depreciation and amortization, building rent recorded as interest expense, stock based compensation and the change in the fair value of contingent consideration. Adjusted EBITDA is not a measure of operating performance or liquidity calculated in accordance with U.S. generally accepted accounting principles, or GAAP, and should be viewed as a supplement to-not a substitute for-our results of operations presented on the basis of GAAP. Adjusted EBITDA does not purport to represent cash flow provided by, or used in, operating activities as defined by GAAP. Our statement of cash flows presents our cash flow activity in accordance with GAAP. Furthermore, adjusted EBITDA is not necessarily comparable to similarly titled measures reported by other companies. We believe adjusted EBITDA is used by and is useful to investors and other users of our financial statements in evaluating our operating performance because it provides them with an additional tool to compare business performance across companies and across periods. We believe that: † EBITDA is widely used by investors to measure a company's operating performance without regard to such items as interest expense, taxes, depreciation and amortization, which can vary substantially from company to company depending upon accounting methods and book value of assets, capital structure and the method by which assets were acquired; and † investors commonly adjust EBITDA information to eliminate the effect of stock based compensation expenses and other charges, which can vary widely from company to company and impair comparability. Our management uses adjusted EBITDA: † as a measure of operating performance to assist in comparing performance from period to period on a consistent basis; † as a measure for planning and forecasting overall expectations and for evaluating actual results against such expectations; † in communications with the board of directors, stockholders, analysts and investors concerning our financial performance; and † as a significant performance measurement included in our bonus plan. 31 -------------------------------------------------------------------------------- Table of Contents The table below sets forth a reconciliation of net income (loss) to adjusted EBITDA (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2010 2011 2010 2011 Net Income $ 762 3,393 $ 788 $ 2,267 Interest income (28 ) (23 ) (48 ) (51 ) Other income (expense), net - (177 ) (2 ) (179 ) Provision for income taxes 2,721 2,496 2,991 1,663 Depreciation and amortization 716 1,032 1,437 2,024 Amortization of purchased intangibles 17 1,029 25 2,059 Stock based compensation 1,602 1,523 3,135 4,330 Gain on settlement and change in fair value of contingent consideration (1) (569 ) (6,375 ) 645 (6,074 ) Gain on sale-leaseback of building (1,689 ) - (1,689 ) - Others (2) 562 1,221 562 1,893 Adjusted EBITDA $ 4,094 $ 4,119 $ 7,844 $ 7,932 -------------------------------------------------------------------------------- (1) Includes $6.4 million gain recorded in the second quarter of 2011 associated with the settlement of the earn out consideration liability with the sellers of MedCafe, Inc., a company we acquired in 2010. (2) Includes legal expenses, facilities costs, refund of property tax and employee severance charges. |