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ALLSCRIPTS HEALTHCARE SOLUTIONS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Business Overview Allscripts is a leading provider of clinical, financial, connectivity and information solutions and related professional services that empower hospitals, physicians and post-acute organizations, such as nursing homes, to deliver world-class outcomes. We deliver innovative solutions that provide healthcare professionals with the information, insights and connectivity required to transform healthcare by improving the quality and efficiency of patient care. We primarily derive our revenue from sales of our proprietary software and related hardware, professional services and IT outsourcing services. These sales also are the basis for our recurring service contracts for software maintenance and certain transaction processing services. Prior to this year, we used three reportable segments: Clinical Solutions, Hospital Solutions, and Health Solutions. In connection with the integration of the Eclipsys operations, in 2012 we realigned certain functions within our business. This realignment included the integration of our sales and services functions in the first quarter of 2012 as well as our solutions research and development team. After the realignment and based on the information used by management for making operating decisions and assessing performance, we identified the following reportable segments: Software Delivery, Services Delivery, Client Support, Pathway Solutions and IT Outsourcing. We believe that the HITECH Act and other provisions provided by the American Recovery and Reinvestment Act (ARRA) will continue to be one of the biggest drivers of healthcare IT adoption in 2012. Management believes that to date the HITECH program has resulted in additional related new orders for all of our Electronic Health Record ("EHR") products. Large physician groups will continue to purchase EHR technology; however, the number of very large practices with over 100 physicians that have not yet acquired such technology is decreasing. Such practices may choose to replace older EHR technology in the future as "meaningful use" regulatory requirements and business realities dictate the need for updates and upgrades, as well as additional features and functionality. We believe small- and medium-sized physician practices (those with three or fewer physicians, and four to 40 physicians, respectively) are increasingly adopting technology driven by a variety of factors, including a desire to maximize federal incentive payments, align with local hospitals, and merge with other practices, as well as other drivers. These offices typically require less time to implement and train than larger offices, so the need to plan implementations well in advance is not as critical as in larger physician organizations. We have also seen an evolution of buying decisions toward an increase in local community-based buying activity whereby individual hospitals, health systems and integrated delivery networks are subsidizing the purchase of EHR licenses or related services for local, affiliated physicians and across their employed physician base as part of an offer to leverage buying power and help those practices take advantage of the HITECH incentives. This activity has also resulted in a pull-through effect where smaller practices affiliated with a community hospital are incited to participate in the incentive program while the subsidizing health system expands connectivity within the local provider community. This pull-through effect has resulted in new orders for Allscripts Professional EHR targeting small- and mid-sized physician practices. Management believes that the focus on new orders driven by the HITECH program and related to EHR and community-based activity will continue to expand as physicians seek to qualify for the HITECH incentives for the first time or upgrade in advance of the start of Stage 2 of the program. The associated challenge we face is to successfully position, sell, implement and support our products to the hospital, health system or integrated delivery network that is subsidizing its affiliated physicians. 25 -------------------------------------------------------------------------------- Table of Contents The vast majority of our acute care and ambulatory customers continue to focus on achieving "meaningful use" under HITECH. As a result, during the remainder of 2012, much of our professional services deployment capacity will be consumed by demand from our customers who wish to upgrade to the most current releases of our EHR products which are certified as meeting "meaningful use" requirements, as well as those requesting implementation of any additional modules required to achieve "meaningful use." Our professional services margins could be impacted as we continue to supplement our staff with third-party resources to help meet the demand. We expect this trend to continue into the near future as customers react to the finalized requirements for "meaningful use" Stage 2. Although we believe that we have taken and continue to take the proper steps to take advantage of the opportunity presented by HITECH, given the effects the law is having on our customers, there can be no assurance that it will continue to result in significant new orders for us in the near term, and if it does, that we will have the capacity to meet the additional market demand in a timely fashion. Allscripts today provides one of the most comprehensive solution offerings for healthcare organizations of every size and setting. By combining physician-office and post-acute care solutions with enterprise solutions for hospitals and health systems, we offer a unified portfolio of clinical, financial, connectivity and information solutions. Given the breadth of our solutions portfolio and customer types, we are uniquely positioned to connect physicians, other care providers and patients across all health care provider settings including hospitals, small or large physician practices, post-acute care facilities, or in a home care setting. We continue to compete for net-new opportunities among community hospitals and health systems that are looking to one information technology vendor to provide a single, end-to-end solution across all points of care. We believe our leading market share in the ambulatory space, in particular, gives us a competitive advantage in this regard as hospitals and health systems increasingly seek to leverage the EHR to build referring relationships with independent physicians across the communities they serve. Additionally, recently enacted public laws reforming the U.S. healthcare system may have an impact on our business. The Patient Protection and Affordable Care Act (H.R. 3590; Public Law 111-148) ("PPACA") and The Health Care and Education and Reconciliation Act of 2010 (H.R. 4872) (the "Reconciliation Act"), which amends the PPACA (collectively the "Health Reform Laws"), were signed into law in March 2010. The Health Reform Laws contain various provisions which may impact the Company and our customers. Some of these provisions (including Accountable Care Organizations and the Comprehensive Primary Care Initiative) may have a positive impact by requiring the expanded use of electronic health records and analytics tools to participate in certain federal programs, for example, while others, such as those mandating reductions in reimbursement for certain types of providers, may have a negative impact by reducing the resources available to purchase our products. Increases in fraud and abuse enforcement and penalties may also adversely affect participants in the healthcare sector, including the Company. Additionally, conversations continue in Congress around the Medicare Sustainable Growth Rate reimbursement model and possible replacement payment methodologies, some of which would further encourage the adoption of health information technology in order to satisfy possible new requirements tying the report of quality measurements to the receipt of payment through Medicare but which also currently raise ambiguity among physician populations and healthcare organizations. Such payment and delivery system reform programs as have been launched related to the Medicare program are also increasingly being rolled out at the state level through Medicaid administrators, as well as through the private sector, presenting additional opportunity for us to provide software and services to our clients who participate. 26 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates There were no material changes to our critical accounting policies and estimates as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011. Third Quarter 2012 Summary Bookings, which reflect the value of executed contracts for our solutions, totaled $162 million for the third quarter which is lower compared with our second quarter bookings of $194 million and the prior year bookings of $267 million. Our current quarter results were impacted by clients who delayed decisions due to speculation about Allscripts' future corporate autonomy, and also by clients who continued to delay purchase decisions as they wait for new product releases. Revenue decreased slightly to $361 million compared with $364 million in the prior year. Increases in maintenance and transaction processing and other revenue categories were offset by decreases in system sales and professional services as we experienced a decline in orders as we continue our efforts to improve product performance and delivery execution. Revenue decreased compared with 2012 second quarter revenue of $370 million. Sequentially we realized an $8 million decrease in system sales and a $5 million decrease in professional services revenue as meaningful use upgrade services decline. These decreases offset an increase in maintenance revenue. We generated operating cash flows of approximately $31 million in the third quarter which compares with $42 million in the prior year. Gross research and development spending increased significantly compared with the prior year. We remain on track for approximately $190 million of gross research and development spending in 2012 and the release of several important upgrades, product enhancements and innovative solutions. In order to better serve our clients and the healthcare market, in October 2012 we publicly announced a plan to standardize our small office electronic health record and practice management systems. As part of this plan, we will converge, over time, our MyWay Electronic Health Record System ("MyWay") and Professional Suite Electronic Health Record System. We plan to upgrade MyWay clients electing to migrate to the converged platform between January 2013 and September 2013, at no additional cost to the MyWay clients. The upgrade will position MyWay clients for Meaningful Use Stage 2 and ICD-10 compliance, and prepare them for the shift to value-based care that focuses on costs, quality and outcomes. MyWay clients not electing to upgrade will continue to have use of the application. As a result of the above decision and the related elimination of future cash flows from sales of the MyWay application, we recorded a non-cash charge to earnings in the quarter ended September 30, 2012 related to the impairment of previously capitalized software development costs for MyWay plus the net carrying value of a perpetual license for certain software code incorporated in MyWay totaling $11 million, on a pre-tax basis. Additional non-recurring period costs will be incurred in future quarters to upgrade the MyWay clients that elect to upgrade. The incremental period costs will be partially offset by cost savings we expect to realize through lower development and support costs. The amount of such costs and anticipated savings are not determinable at this time and will ultimately be based on the number of clients electing to migrate. Also impacting the financial statements for the third quarter is the settlement of an acquired tax position that was included in our liability for uncertain tax benefits prior to the current quarter. Pursuant to an agreement between Misys plc and Allscripts signed in 2010, Misys agreed to indemnify Allscripts against potential contingent tax liabilities for which it could be potentially liable, arising from Allscripts' purchase of Allscripts shares from Misys in 2010. During the three months ended September 30, 2012, we recognized a tax benefit of $16 million related to the settlement of the acquired tax position for an amount less than the carrying value of the uncertain tax liability. Prior to this quarter, our consolidated balance sheet also included a tax indemnification asset related to the uncertain tax liability. Since the settlement amount was less than the carrying value of the indemnification asset, we recorded a write-off of the remaining indemnification asset, which is included in interest income and other (expense), net within the consolidated statement of operations. The resulting charge of $16 million is substantially non-deductible for tax purposes and therefore increases our effective tax rate for the entire year. On November 8, 2012, we confirmed that in light of the ongoing interest expressed in the Company by third parties, we are evaluating strategic alternatives. There can be no assurance that this process will result in any specific transaction. As stated above, our third quarter bookings were impacted by speculation about Allscripts' future corporate autonomy and the timing of new product releases. These factors are expected to also impact future bookings and results of operations. 27 -------------------------------------------------------------------------------- Table of Contents Overview of Consolidated Results Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue: System sales $ 35,220 $ 54,646 (35.5 %) $ 116,176 $ 165,420 (29.8 %) Professional services 62,749 65,275 (3.9 %) 201,615 179,004 12.6 % Maintenance 119,263 113,244 5.3 % 354,295 325,415 8.9 % Transaction processing and other 143,462 130,571 9.9 % 423,276 386,036 9.6 % Total revenue 360,694 363,736 (0.8 %) 1,095,362 1,055,875 3.7 % Cost of revenue: System sales 29,960 39,604 (24.4 %) 96,608 110,420 (12.5 %) Professional services 54,534 56,305 (3.1 %) 173,260 150,367 15.2 % Maintenance 36,564 32,840 11.3 % 108,850 100,963 7.8 % Transaction processing and other 82,600 73,014 13.1 % 246,441 204,507 20.5 % Total cost of revenue 203,658 201,763 0.9 % 625,159 566,257 10.4 % Gross profit 157,036 161,973 (3.0 %) 470,203 489,618 (4.0 %) % of Revenue 43.5 % 44.5 % 42.9 % 46.4 %Selling, general and administrative expenses 90,412 92,152 (1.9 %) 280,020 297,832 (6.0 %) Research and development 37,802 26,032 45.2 % 112,164 72,800 54.1 % Asset impairment charges 11,101 0 NM 11,101 0 NM Amortization of intangible assets 8,537 9,422 (9.4 %) 27,047 28,071 (3.6 %) Income from operations 9,184 34,367 (73.3 %) 39,871 90,915 (56.1 %) Interest expense (3,718 ) (3,746) (0.7 %) (11,930 ) (16,723 ) (28.7 %) Interest income and other (expense), net (15,845 ) 425 NM (15,303 ) 1,184 NM (Loss) income before income taxes (10,379 ) 31,046 (133.4 %) 12,638 75,376 (83.2 %) Benefit (provision) for income taxes 19,754 (11,909 ) (265.9 %) 10,531 (27,750 ) (137.9 %) Effective tax rate 190.3 % 38.4 % (83.3 %) 36.8 % Net income $ 9,375 $ 19,137 (51.0 %) $ 23,169 $ 47,626 (51.4 %) NM - not meaningful 28 -------------------------------------------------------------------------------- Table of Contents Revenue Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue: System sales $ 35,220 $ 54,646 (35.5 %) $ 116,176 $ 165,420 (29.8 %) Professional services 62,749 65,275 (3.9 %) 201,615 179,004 12.6 % Maintenance 119,263 113,244 5.3 % 354,295 325,415 8.9 % Transaction processing and other 143,462 130,571 9.9 % 423,276 386,036 9.6 % Total revenue 360,694 363,736 (0.8 %) 1,095,362 1,055,875 3.7 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Total revenue decreased slightly during the three months ended September 30, 2012 compared with the prior year comparable period as increases in maintenance and transaction processing and other revenue were offset by decreases in system sales and professional services. Maintenance revenue increased primarily due to new system activations and the increase in transaction processing revenue is attributable to the expansion of IT Outsourcing services to our existing clients and growth in our client base. IT Outsourcing contributed $8 million of the increase in transaction processing and other revenue in addition to increases in SaaS and hosting revenues as we expanded our customer base. Offsetting these increases in revenue is a decrease in system sales which consists of a $12 million decrease in software revenue and an $8 million decrease in hardware revenue attributable to a decline in orders as certain clients and prospects delayed purchase decisions due to speculation about Allscripts' future corporate autonomy and others continued to delay purchase decisions as they wait for new product releases. Additionally, we continue to experience a shift in sales to smaller physician practices which typically require less robust hardware solutions. Professional services revenue decreased compared with the prior year as a result of the decline in orders referenced above and a decrease in consulting services. Total revenue increased during the nine months ended September 30, 2012 compared with the prior year as we realized increases in all revenue categories with the exception of system sales. The increase in professional services revenue was driven by increases in implementation and consulting services including the implementation of third-party solutions as compared with the prior year. On a year-to-date basis, orders for professional services have declined compared with the prior year which is reflected in the decline in professional services for the current quarter. Maintenance revenue increased primarily due to new system activations and the increase in transaction processing revenue is attributable to the expansion of IT Outsourcing services to our existing clients and growth in our client base. IT Outsourcing revenues contributed $19 million of the increase in transaction processing and other revenue in addition to increases in SaaS and hosting revenues as we expanded our customer base. Partially offsetting these increases in revenue for the nine months ended September 30, 2012 is a decrease in system sales which consists of a $31 million decrease in software revenue and a $18 million decrease in hardware revenue as we experienced a decline in orders as discussed above. Additionally, we continue to experience a shift in sales to smaller physician practices which typically require less robust hardware solutions. 29 -------------------------------------------------------------------------------- Table of Contents Gross Profit Three Months Ended September 30, Nine Months Ended September 30,(Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Total cost of revenue 203,658 201,763 0.9 % 625,159 566,257 10.4 % Gross profit 157,036 161,973 (3.0 %) 470,203 489,618 (4.0 %) % of Revenue 43.5 % 44.5 % 42.9 % 46.4 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Gross profit decreased during the three months ended September 30, 2012 as we realized a decrease in revenues while costs of revenue increased primarily due to an increase in transaction processing and other costs as we added headcount and made infrastructure improvements in response to increased demand for our SaaS and hosting solutions. This increase and a $3 million increase in the amortization of software development costs were partially offset by decreases in costs of revenue associated with lower system sales and professional services revenue. Gross profit as a percent of revenue declined compared with the prior year due primarily to a higher mix of third-party systems sales which carry lower gross margin, the increases in amortization of software development costs and transaction processing-related costs discussed above, and lower utilization of professional services resources. Gross profit decreased during the nine months ended September 30, 2012 as the increase in total revenue was offset by an increase in costs of revenue compared with the prior year comparable period as we recognized a $9 million increase in the amortization of software development costs and an increase in professional services cost of revenue primarily due to a higher mix of third-party systems sales that are more costly to implement, which offset an increase in professional services revenue. Gross profit was further impacted by an increase in transaction processing and other revenue that was offset by higher costs as we added headcount and made infrastructure improvements in response to increased demand for our SaaS and hosting solutions. Gross profit as a percent of revenue declined compared with the prior year due primarily to a higher mix of third-party systems sales which carry lower gross margin and the increases in amortization of software development costs, professional services costs and transaction processing-related costs. 30-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Expenses Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Selling, general and administrative expenses 90,412 92,152 (1.9 %) 280,020 297,832 (6.0 %) Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Selling, general and administrative expenses during the three months ended September 30, 2012 were flat compared to the prior year. During the nine months ended September 30, 2012, selling, general and administrative expenses decreased compared with the prior year due to a decrease in expenses incurred relating to the Eclipsys Merger and other non-recurring costs and a decrease in people-related expenses. Partially offsetting these decreases is an increase in legal expenses related to general legal matters, including expenses related to addressing legal claims involving the Company. Research and Development Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Research and development $ 37,802 $ 26,032 45.2 % $ 112,164 $ 72,800 54.1 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Research and development expenses increased in the three and nine months ended September 30, 2012 primarily due to an increase in people-related expenses as we increased headcount in order to accelerate development efforts to improve performance and accelerate product integration and innovation. Also contributing to the increase for the three and nine months ended September 30, 2012 is a decrease in the capitalization of software development costs as certain quality and efficiency development efforts were not eligible for capitalization. Asset Impairment Charges Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Asset impairment charges $ 11,101 $ 0 NM $ 11,101 $ 0 NM Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 In October 2012, we publicly announced a plan to standardize our small office electronic health record and practice management systems and converge, over time, our MyWay application with our Professional Suite Electronic Health Record System. As a result of this decision and the related elimination of future cash flows from sales of the MyWay application, we recorded asset impairment charges during the three months ended September 30, 2012 related to the impairment of previously capitalized software development costs for our MyWay Electronic Health Record application plus the net carrying value of a perpetual license for certain software code incorporated in MyWay. Amortization of Intangible Assets Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Amortization of intangible assets $ 8,537 $ 9,422 (9.4 %) $ 27,047 $ 28,071 (3.6 %) Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Amortization of intangible assets recognized during the three and nine months ended September 30, 2012 decreased compared with the prior year comparable periods as certain amortization periods ended and intangible asset amounts were fully amortized. 31 -------------------------------------------------------------------------------- Table of Contents Interest Expense Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Interest expense ($3,718 ) ($3,746 ) (0.7 %) ($11,930 ) ($16,723 ) (28.7 %) Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Interest expense increased during the three months ended September 30, 2012 compared to the prior year due to increased debt outstanding associated with the incremental term loan executed in June 2012. Interest expense for the nine months ended September 30, 2012 is lower compared to the prior year due to lower average debt balances in 2012. Also, interest expense for the nine months ended September 30, 2011 includes the write-off of deferred debt issuance costs totaling $2 million in connection with the execution of an amendment to our credit facility agreement. Interest Income and Other (Expense), Net Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Interest income and other (expense), net ($15,845 ) $425 NM ($15,303 ) $1,184 NM Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Interest income and other (expense), net for the three and nine months ended September 30, 2012 includes a $16 million write-off of a tax indemnification asset due to the settlement of the related acquired tax position indemnified by Misys plc for an amount less than the carrying value of the indemnification asset. Provision for Income Taxes Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Benefit (provision) for income taxes $ 19,754 ($ 11,909 ) (265.9 %) $ 10,531 ($ 27,750 ) (137.9 %) Effective tax rate 190.3 % 38.4 % (83.3 %) 36.8 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 The effective tax rate for the three and nine months ended September 30, 2012 includes a $16 million tax benefit related to the settlement of an acquired tax position for an amount less than the carrying value of the uncertain tax liability. Accordingly, in the current quarter we recognized a tax benefit and decreased our liability for unrecognized tax benefits. The acquired tax position referenced above was indemnified by Misys plc and a related tax indemnification asset was previously included within other assets in our consolidated balance sheet. Since the settlement amount was less than the carrying value of the indemnification asset, we recorded a write-off of the remaining indemnification asset, which is included in interest income and other within the consolidated statement of operations. The resulting charge of $16 million is substantially non-deductible for tax purposes and therefore increases the effective tax rate for the entire year. Excluding the effects of these items, our effective tax rate for the three and nine months ended September 30, 2012 is lower compared to the prior year due to a higher mix of foreign income taxed at lower rates and lower state tax expense. 32 -------------------------------------------------------------------------------- Table of Contents Segment Operations Overview of Segment Results Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue: Software Delivery $ 77,229 $ 95,751 (19.3 %) $ 244,773 $ 283,275 (13.6 %) Services Delivery 62,462 64,080 (2.5 %) 197,669 177,805 11.2 % Client Support 118,315 113,142 4.6 % 353,674 332,009 6.5 % Pathway Solutions 42,796 41,296 3.6 % 130,117 124,301 4.7 % IT Outsourcing 41,261 33,733 22.3 % 119,262 100,855 18.3 % All Other Remote Hosting 17,854 18,151 (1.6 %) 52,790 52,235 1.1 % Unallocated Amounts 777 (2,417 ) (132.1 %) (2,923 ) (14,605 ) (80.0 %) Total All Other 18,631 15,734 18.4 % 49,867 37,630 32.5 % Total revenue $ 360,694 $ 363,736 (0.8 %) $ 1,095,362 $ 1,055,875 3.7 % Income from operations: Software Delivery $ 9,223 $ 19,935 (53.7 %) $ 34,296 $ 62,332 (45.0 %) Services Delivery 8,390 7,088 18.4 % 26,033 24,675 5.5 % Client Support 81,143 78,973 2.7 % 242,828 228,466 6.3 % Pathway Solutions 26,118 25,859 1.0 % 79,719 79,620 0.1 % IT Outsourcing 8,978 6,145 46.1 % 25,298 19,639 28.8 % All Other Remote Hosting 668 652 2.5 % 1,146 3,411 (66.4 %) Unallocated Amounts (125,336 ) (104,285 ) 20.2 % (369,449 ) (327,228 ) 12.9 % Total All Other (124,668 ) (103,633 ) 20.3 % (368,303 ) (323,817 ) 13.7 % Total income from operations $ 9,184 $ 34,367 (73.3 %) $ 39,871 $ 90,915 (56.1 %) 33 -------------------------------------------------------------------------------- Table of Contents Software Delivery Software delivery primarily includes revenue from system solutions, which is comprised of software license fees and hardware revenue, and recurring revenue from SaaS contracts and other subscription-based arrangements, which are included in transaction processing and other, and the related expenses incurred to deliver these solutions to our clients. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue $ 77,229 $ 95,751 (19.3 %) $ 244,773 $ 283,275 (13.6 %) Income from operations $ 9,223 $ 19,935 (53.7 %) $ 34,296 $ 62,332 (45.0 %) Operating margin % 11.9 % 20.8 % 14.0 % 22.0 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Software delivery revenue decreased during the three and nine months ended September 30, 2012 due to a decrease in system sales which consists of a $12 million and $31 million decrease in software revenue, respectively, and an $8 million and $18 million decrease in hardware revenue, respectively, as we experienced a decline in orders as certain clients and prospects delayed purchase decisions due to speculation about Allscripts' future corporate autonomy and others continued to delay purchase decisions as they wait for new product releases. Additionally, we continue to experience a shift in sales to smaller physician practices which typically require less robust hardware solutions. Partially offsetting these decreases was an increase in SaaS and subscription-based revenues during the three and nine months ended September 30, 2012 as we expanded our customer base. Software delivery operating margins declined in the three and nine months ended September 30, 2012 due to a higher mix of third-party systems sales which carry higher costs, an increase in amortization of software development costs and an increase in SaaS operations and infrastructure costs in response to increased demand for our SaaS solutions compared with the same periods in 2011. 34-------------------------------------------------------------------------------- Table of Contents Services Delivery Services delivery derives its revenue through implementation, training and other professional services provided to clients and includes the related expenses incurred to provide these services. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue $ 62,462 $ 64,080 (2.5 %) $ 197,669 $ 177,805 11.2 % Income from operations $ 8,390 $ 7,088 18.4 % $ 26,033 $ 24,675 5.5 % Operating margin % 13.4 % 11.1 % 13.2 % 13.9 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Services delivery revenue decreased during the three months ended September 30, 2012 compared with the prior year as a result of the decline in systems orders and a decrease in consulting services. The increase in services delivery revenue during the nine months ended September 30, 2012 is attributable to increases in implementation and consulting services including the implementation of third-party solutions as compared with the prior year. On a year-to-date basis, orders for professional services have declined compared with the prior year which is reflected in the decline in professional services for the current quarter. Services delivery operating margin increased during the three months ended September 30, 2012 as we decreased people-related costs in response to the decline in orders. Operating margin declined in the nine months ended September 30, 2012 primarily due to the incremental costs incurred to implement a higher mix of third-party systems sales that are more costly to implement. 35 -------------------------------------------------------------------------------- Table of Contents Client Support Client support derives its revenue through software and hardware maintenance contracts and includes the related expenses incurred to provide support to our customers. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue $ 118,315 $ 113,142 4.6 % $ 353,674 $ 332,009 6.5 % Income from operations $ 81,143 $ 78,973 2.7 % $ 242,828 $ 228,466 6.3 % Operating margin % 68.6 % 69.8 % 68.7 % 68.8 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Client support revenue increased during the three and nine months ended September 30, 2012 due to increases in our client base and customer activations compared to the prior year comparable periods. Client support operating margin for the three months ended September 30, 2012 decreased slightly compared with the prior year as people-related and infrastructure expenses increased, and remained flat for the nine months ended September 30, 2012. 36 -------------------------------------------------------------------------------- Table of Contents Pathway Solutions Pathway solutions includes revenue and the related expenses for financial, administrative, and clinical offerings, including medical claims processing and other Revenue Cycle Solutions, ePrescribe and Patient Portal. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue $ 42,796 $ 41,296 3.6 % $ 130,117 $ 124,301 4.7 % Income from operations $ 26,118 $ 25,859 1.0 % $ 79,719 $ 79,620 0.1 % Operating margin % 61.0 % 62.6 % 61.3 % 64.1 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 Pathway solutions revenue increased during the three and nine months ended September 30, 2012 primarily due to an increase in demand for our solutions. Pathway solutions operating margin decreased in the three and nine months ended September 30, 2012 as we incurred increased costs in response to demand for our solutions. 37 -------------------------------------------------------------------------------- Table of Contents IT Outsourcing IT outsourcing includes revenue from our information technology outsourcing solutions and includes the related expenses incurred to deliver these solutions to our clients. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue $ 41,261 $ 33,733 22.3 % $ 119,262 $ 100,855 18.3 % Income from operations $ 8,978 $ 6,145 46.1 % $ 25,298 $ 19,639 28.8 % Operating margin % 21.8 % 18.2 % 21.2 % 19.5 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 IT outsourcing revenue increased during the three and nine months ended September 30, 2012 primarily due to expanded service solutions to existing customers while also expanding our customer base. IT outsourcing operating margin increased during the three and nine months ended September 30, 2012 as increases in revenue were partially offset by increases in headcount-related costs as we responded to the increased demand for our IT outsourcing solutions. 38 -------------------------------------------------------------------------------- Table of Contents All Other Corporate general and administrative expenses are centrally managed and solutions research and development expenses, including amortization of capitalized software development costs, are not attributed to an operating segment. As a result, these expenses are not allocated to our reportable segments because they are not part of the segment profitability results reviewed by management. In determining revenue and income from operations for our segments, we do not include the amortization of acquisition-related deferred revenue adjustments in revenue and we exclude amortization of intangible assets and stock-based compensation expense from the operating expense segment data provided to our chief operating decision maker. Accordingly, these amounts are not included in our reportable segment results and are included in the unallocated amounts within All Other. Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in thousands) 2012 2011 % Change 2012 2011 % Change Revenue: Remote Hosting $ 17,854 $ 18,151 (1.6 %) $ 52,790 $ 52,235 1.1 % Unallocated Amounts 777 (2,417 ) (132.1 %) (2,923 ) (14,605 ) (80.0 %) Total revenue $ 18,631 $ 15,734 18.4 % $ 49,867 $ 37,630 32.5 % Income from operations: Remote Hosting $ 668 $ 652 2.5 % $ 1,146 $ 3,411 (66.4 %) Unallocated Amounts (125,336 ) (104,285 ) 20.2 % (369,449 ) (327,228 ) 12.9 % Total income from operations ($ 124,668 ) ($ 103,633 ) 20.3 % ($ 368,303 ) ($ 323,817 ) 13.7 % Three and Nine Months Ended September 30, 2012 Compared to the Three and Nine Months Ended September 30, 2011 The financial information above includes revenue primarily from our Remote Hosting operating segment and similar amounts of operating expenses related to this segment are included in income from operations for all periods presented. Operating income for the nine months ended September 30, 2012 has decreased compared to the prior year period due to increased infrastructure costs incurred to accommodate software upgrades. Expenses increased during the three and nine months ended September 30, 2012 primarily due to an increase in research and development headcount. Also contributing to the increase are higher legal expenses in connection with general legal matters, including expenses related to addressing claims involving the Company, and a $3 million and $9 million increase, respectively, in amortization of software development costs compared to the prior year. These increases were partially offset by a decrease in expenses incurred relating to the Eclipsys Merger and other non-recurring costs. Additionally, during the three months ended September 30, 2012, we recorded asset impairment charges totaling $11 million that are not attributable to an operating segment. 39-------------------------------------------------------------------------------- Table of Contents Contract Backlog Contract backlog represents the value of bookings and maintenance contracts that have not yet been recognized as revenue. A summary of contract backlog by revenue category is as follows: As of As of As of % Change from September 30, 2012 September 30, December 31, September 30, December 31, September 30,(Dollar amounts in millions) 2012 2011 2011 2011 2011 Contract backlog: System sales $ 111 $ 136 $ 125 (18.4 %) (11.2 %) Professional services 395 393 352 0.5 % 12.2 % Maintenance 860 833 797 3.2 % 7.9 % Transaction processing and other 1,461 1,492 1,496 (2.1 %) (2.3 %) Total contract backlog $ 2,827 $ 2,854 $ 2,770 (0.9 %) 2.1 % Total contract backlog as of September 30, 2012 remained flat compared with December 31, 2011 as an increase in maintenance revenue backlog was offset by decreases in systems sales and transaction processing and other backlog categories. Maintenance revenue backlog increased as a result of new client go-lives as well as maintenance renewals in our installed base. System sales backlog declined as we experienced a decline in orders during the nine months ended September 30, 2012 as we continue our efforts to improve product performance and delivery execution. Total contract backlog increased during the nine months ended September 30, 2012 compared with the prior year comparable period primarily due to an increase in maintenance revenue backlog as a result of new client go-lives as well as maintenance renewals in our installed base. Bookings Bookings reflect the value of executed contracts for software, hardware, services, remote hosting, outsourcing and SaaS. Bookings were as follows: Three Months Ended September 30, Nine Months Ended September 30, (Dollar amounts in millions) 2012 2011 % Change 2012 2011 % Change Bookings $ 162 $ 267 (39.3 %) $ 551 $ 724 (23.9 %) We experienced a decline in bookings during the three and nine months ended September 30, 2012 compared with the prior year comparable periods as certain clients and prospects delayed purchase decisions due to speculation about Allscripts' future corporate autonomy and others continued to delay purchase decisions as they wait for new product releases. 40-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of September 30, 2012 and 2011, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $95 million and $86 million, respectively, and our revolving credit facility described below. The change in our cash balance is reflective of the following: Operating Cash Flow Activities Nine Months Ended September 30, (In thousands) 2012 2011 $ Change Net income $ 23,169 $ 47,626 ($ 24,457 ) Non-cash adjustments to net income 149,283 149,600 (317 ) Cash impact of changes in operating assets and liabilities (7,904 ) (35,901 ) 27,997 Net cash provided by operating activities $ 164,548 $ 161,325 $ 3,223 Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011 Net cash provided by operating activities increased in the nine months ended September 30, 2012 as cash received from customers increased at a faster rate than operating disbursements compared to the same period in 2011. 41-------------------------------------------------------------------------------- Table of Contents Investing Cash Flow Activities Nine Months Ended September 30, (In thousands) 2012 2011 $ Change Capital expenditures ($ 55,481 ) ($ 33,301 ) ($ 22,180 ) Capitalized software (39,340 ) (46,529 ) 7,189 Net (purchases) sales and maturities of marketable securities and other investments 84 (12,857 ) 12,941 Proceeds received from sale of fixed assets 0 20,000 (20,000 ) Change in restricted cash 0 2,225 (2,225 ) Net cash used in investing activities ($ 94,737 ) ($ 70,462 ) ($ 24,275 ) Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011 Net cash used in investing activities increased during the nine months ended September 30, 2012 due to an increase in capital expenditures which was partially offset by a decrease in capitalized software development costs. Also, the prior year includes the acquisition of cost method investments, the release of restricted cash, and proceeds from the sale of certain hosting equipment and infrastructure that did not recur in the current period. The increase in capital expenditures is related to the acquisition of computer equipment and software to improve our information systems infrastructure and to accommodate data management and hosting related to our SaaS and hosting solutions. The capitalization of software development costs decreased as certain quality and efficiency development efforts were not eligible for capitalization. Financing Cash Flow Activities Nine Months Ended September 30, (In thousands) 2012 2011 $ Change Proceeds from issuance of common stock $ 4,042 $ 27,481 ($ 23,439 ) Excess tax benefits from stock-based compensation 609 4,688 (4,079 ) Taxes paid related to net share settlement of equity awards (4,352 ) (2,179 ) (2,173 ) Net payments on debt instruments (233,894 ) (161,570 ) (72,324 ) Credit facility borrowings, net of issuance costs 324,035 47,193 276,842 Repurchase of common stock (225,961 ) (50,051 ) (175,910 ) Net cash used in financing activities ($ 135,521 ) ($ 134,438 ) ($ 1,083 ) Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011 Net cash used in financing activities increased during the nine months ended September 30, 2012 due primarily to the increased level of activity under our stock repurchase program. This increase was partially offset by net borrowings under our credit facility which were used to finance stock repurchases during the current period. Proceeds from stock-based compensation activities were lower compared to the same period in 2011 and excess tax benefits from stock-based compensation declined as the fair value of equity awards vesting during the current period was more aligned with the fair value of the awards on the date of grant. Also, the current period includes an increase in net-share settlements of vested equity awards such that we withheld shares with value equivalent to the employees' minimum statutory obligation for the applicable income and other employment taxes and remitted the cash to the appropriate taxing authorities. 42 -------------------------------------------------------------------------------- Table of Contents Free Cash Flow To supplement our statements of cash flows presented on a GAAP basis, we use a non-GAAP measure of free cash flow which we believe is also useful as one of the bases for evaluating our performance. We believe free cash flow is an important liquidity metric, as it measures the amount of cash generated that is available to repay our current debt obligations, make investments, fund acquisitions, repurchase our common stock and for certain other activities. The presentation of non-GAAP free cash flow is not meant to be considered in isolation and should not be considered a substitute for income from operations, net income, net cash provided by operating activities or any other measure determined in accordance with GAAP. Operating asset and liability balances can fluctuate significantly from period to period and there can be no assurance that free cash flow will not be negatively impacted by material changes in operating assets and liabilities in future periods, since these changes depend upon, among other things, management's timing of payments and cash receipts. In addition to fluctuations resulting from changes in operating assets and liabilities, free cash flow can vary significantly from period to period depending upon, among other things, operating efficiencies, increases or decreases in capital expenditures and capitalized software, and other factors. We calculate free cash flow as follows: Nine Months Ended September 30, (In thousands) 2012 2011 $ Change Net cash provided by operating activities $ 164,548 $ 161,325 $ 3,223 Capital expenditures (55,481 ) (33,301 ) (22,180 ) Capitalized software (39,340 ) (46,529 ) 7,189 Free cash flow $ 69,727 $ 81,495 ($ 11,768 ) Amounts for each element of the table above are as reported in our consolidated statements of cash flows presented in accordance with GAAP. 43-------------------------------------------------------------------------------- Table of Contents Future Capital Requirements On June 11, 2012, we entered into an Incremental Assumption Agreement (the "Agreement") with J. P. Morgan Securities LLC, Mizuho Corporate Bank, LTD., SunTrust Robinson Humphrey, Inc. and other participating lenders to borrow additional amounts under our existing Amended and Restated Credit Agreement (the "Credit Agreement") in the form of a new incremental term loan. Proceeds from the incremental term loan of $150 million were used to partially refinance the $175 million outstanding under our revolving credit facility, which is provided for in the Credit Agreement. We also made a voluntary repayment of the revolver totaling $20 million at the time of the refinancing. The interest rate charged, debt covenants and other terms that apply to the term loan are defined by the terms of the Credit Agreement. The following table summarizes our future payments under the senior secured credit facilities including the incremental term loan as of September 30, 2012: Principal Interest Total (Dollar amounts in thousands) Payments Payments Payments Remaining payments due in 2012 $ 17,616 $ 3,127 $ 20,743 Payments due in 2013 78,770 11,098 89,868 Payments due in 2014 104,698 8,429 113,127 Payments due in 2015 199,395 4,726 204,121 Payments due in 2016 58,603 589 59,192 Thereafter 0 0 0 $ 459,082 $ 27,969 $ 487,051 As of September 30, 2012, $459 million in term loans, $0 million under the revolving credit facility, and $1 million in letters of credit were outstanding under the Credit Agreement. As of September 30, 2012, the interest rate on the senior secured credit facilities was LIBOR plus 2.00%, which totaled 2.22%. Refer to Note 9, "Derivative Financial Instruments," of the Notes to Consolidated Financial Statements in Part I, Item 1 of this report for a discussion of our interest rate swap agreement. There was no default under the Credit Agreement as of September 30, 2012. As of September 30, 2012, we had $249 million available, net of outstanding letters of credit, under our revolving credit facility. There can be no assurance that we will be able to draw on the full available balance of our Credit Agreement if the financial institutions that have extended such credit commitments become unwilling or unable to fund such borrowings. 44-------------------------------------------------------------------------------- Table of Contents On March 31, 2011, we entered into a ten year agreement with Affiliated Computer Services, Inc. ("ACS") to provide services to support our remote hosting services for our Sunrise acute care clients. We will maintain all customer relationships and domain expertise with respect to the hosted applications. The agreement encompasses our payment to ACS for current Allscripts' employees to be retained by ACS from our hosting staff, new remote hosting staff and technology infrastructure, as well as other data center and hosting services, in the amount of approximately $50 million per year. In April 2011, our Board of Directors approved a stock repurchase program under which we may purchase up to $200 million of our common stock over three years expiring on May 9, 2014 or such earlier time that the total dollar amount authorized by these resolutions has been used. In April 2012, our Board of Directors approved the repurchase of an additional $200 million bringing the total repurchase authorization to $400 million. Any share repurchases may be made through open market transactions, block trades, privately negotiated transactions (including accelerated share repurchase transactions) or other means. Any repurchase activity will depend on factors such as our working capital needs, cash requirements for investments, debt repayment obligations, our stock price, and economic and market conditions. Our stock repurchase program may be accelerated, suspended, delayed or discontinued at any time. Refer to "Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities" in Part II, Item 2 of this report for additional information regarding our stock repurchase program. We currently plan to invest over $190 million in research and development efforts during 2012 to improve performance and accelerate product integration and innovation. Our total spending consists of research and development costs directly recorded to expense and also includes capitalized software development costs. To supplement our statement of operations, the table below presents a non-GAAP measure of research and development-related expenditures which we believe is a useful metric for evaluating how we are investing in innovation. Nine Months Ended September 30, (Dollar amounts in thousands) 2012 Research and development costs directly recorded to expense $ 112,164 Capitalized software development costs 39,340 Total non-GAAP R&D-related expense $ 151,504 Total revenue $ 1,095,362 Total expense as a % of total revenue 14 % We believe that our cash, cash equivalents and marketable securities of $95 million as of September 30, 2012, our future cash flows, and our borrowing capacity under our Amended and Restated Credit Agreement, taken together, provide adequate resources to fund ongoing cash requirements for the next twelve months. We cannot provide assurance that our actual cash requirements will not be greater than we expect as of the date of this report. We will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services and technologies, and the purchase of our common stock under our stock repurchase program which might impact our liquidity requirements or cause us to issue additional equity or debt securities. If sources of liquidity are not available or if we cannot generate sufficient cash flow from operations during the next twelve months, we might be required to obtain additional sources of funds through additional operating improvements, capital market transactions, asset sales or financing from third parties, a combination thereof or otherwise. We cannot provide assurance that these additional sources of funds will be available or, if available, would have reasonable terms. Contractual Obligations, Commitments and Off Balance Sheet Arrangements We have various contractual obligations, which are recorded as liabilities in our consolidated financial statements. Other items, such as operating lease contract obligations, are not recognized as liabilities in our consolidated financial statements but are required to be disclosed. During the three months ended September 30, 2012, we settled the acquired tax position related to the Misys share repurchase that occurred in 2010. Accordingly, we decreased our liability for unrecognized tax benefits by approximately $29 million. With the exception of the settlement of an acquired tax position discussed above and additional amounts borrowed under our existing Credit Agreement described above under Future Capital Requirements, there were no material changes, outside of the ordinary course of business, to our contractual obligations and other related matters previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011. Recent Accounting Pronouncements For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 1 of the Notes to Consolidated Financial Statements in Part I, Item 1 of this report. 45 -------------------------------------------------------------------------------- Table of Contents Safe Harbor for Forward-Looking Statements This report contains forward-looking statements within the meaning of the federal securities laws that involve risks and uncertainties. We develop forward-looking statements by combining currently available information with our beliefs and assumptions. These statements relate to future events, including our future performance, and management's expectations, beliefs, intentions, plans or projections relating to the future and some of these statements can be identified by the use of forward-looking terminology such as "believes," "expects," "anticipates," "estimates," "projects," "intends," "seeks," "future," "continue," "contemplate," "would," "will," "may," "should," and the negative or other variations of those terms or comparable terminology or by discussion of strategy, plans, opportunities or intentions. As a result, actual results, performance or achievements may vary materially from those anticipated by the forward-looking statements. Among the factors that could cause actual results, performance or achievements to differ materially from those indicated by such forward-looking statements are: • the risk that we will not achieve the strategic benefits of the August 24, 2010 merger with Eclipsys Corporation (the "Eclipsys Merger"), or that the Allscripts and Eclipsys operations and products will not be integrated successfully; • the possibility that the expected synergies and cost savings of the Eclipsys Merger will not be realized, or will not be realized within the expected time period; • the impact of the realignment of our sales and services organization; • the possibility that our current initiatives focused on product delivery, client experience and financial performance may not be successful; • potential difficulties or delays in achieving platform and product integration and the connection and movement of data among hospitals, physicians, patients and others; • competition within the industries in which we operate, including the risk that existing clients will switch to products of competitors; • failure to achieve interoperability certification pursuant to the Health Information Technology for Economic and Clinical Health Act, with resulting increases in development and other costs for us and possibly putting us at a competitive disadvantage in the marketplace; • the volume and timing of systems sales and installations, the length of sales cycles and the installation process and the possibility that our products will not achieve or sustain market acceptance; • the timing, cost and success or failure of new product and service introductions, development and product upgrade releases; • we may incur costs relating to the standardization of our small office electronic health record and practice management systems that could adversely affect our results of operations; • competitive pressures including product offerings, pricing and promotional activities; • our ability to establish and maintain strategic relationships; • errors or similar problems in our software products or other product quality issues; • the outcome of any legal proceeding that has been or may be instituted against us and others; • compliance obligations under existing laws, regulations and industry initiatives, including increasing enforcement activity in respect of anti-bribery, fraud and abuse and similar laws, and future changes in laws or regulations in the healthcare industry, including possible regulation of our software by the U.S. Food and Drug Administration; • the possibility of product-related liabilities; • our ability to attract and retain qualified personnel; • the implementation and speed of acceptance of the electronic record provisions of the American Recovery and Reinvestment Act of 2009, as well as elements of the Patient Protection and Affordable Care Act (aka health reform) which pertains to healthcare IT adoption; • maintaining our intellectual property rights and litigation involving intellectual property rights; • legislative, regulatory and economic developments; • risks related to third-party suppliers and our ability to obtain, use or successfully integrate third-party licensed technology; • breach of data security by third parties and unauthorized access to patient health information by third parties; • the effects and results of the Company's evaluation of strategic alternatives are uncertain; and • those factors discussed in "Risk Factors" in our periodic filings with the Securities and Exchange Commission (the "SEC"). We make these statements under the protection afforded by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Because forward-looking statements are subject to assumptions and uncertainties, actual results, performance or achievements may differ materially from those expressed or implied by such forward-looking statements. Stockholders are cautioned not to place undue reliance on such statements, which speak only as of the date such statements are made. Except to the extent required by applicable law or regulation, Allscripts undertakes no obligation to revise or update any forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise. 46 -------------------------------------------------------------------------------- Table of Contents |