10-Q 1 a69537e10-q.txt FORM 10-Q QUARTER ENDED DECEMBER 31, 2000 1 ================================================================================ U. S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ---------------- -------------------- Commission file number 0-13801 QUALITY SYSTEMS, INC. (Exact name of registrant as specified in its charter) California 95-2888568 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 17822 East 17th Street, Suite 210 Tustin, California 92780 ---------------------------------------- ------------------- (Address of principal executive offices) (Zip Code) Issuer's telephone number, including area code: (714) 731-7171 NOT APPLICABLE (Former name, former address and former fiscal year, if changed, since last year) Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes XX No ---- ---- APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 5,978,816 shares of Common Stock, $.01 par value, as of January 31, 2001 ================================================================================ 2 PART I. CONSOLIDATED FINANCIAL INFORMATION. Item 1. Financial Statements. QUALITY SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (in thousands) ASSETS
December 31, March 31, 2000 2000 ------------ --------- (Unaudited) Current Assets: Cash and cash equivalents $ 15,658 $ 15,926 Short-term investments 254 243 Accounts receivable, net 15,938 13,710 Inventories 899 1,010 Other current assets 2,226 2,496 -------- -------- Total current assets 34,975 33,385 Equipment and Improvements, net 1,919 1,797 Capitalized Software Costs, net 1,814 1,984 Deferred Tax Asset 2,915 3,042 Excess of Cost Over Net Assets of Acquired Business, net 1,857 2,112 Other Assets 1,578 1,816 -------- -------- Total assets $ 45,058 $ 44,136 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Accounts payable $ 1,883 $ 1,246 Deferred service revenue 5,782 5,691 Other current liabilities 4,726 5,116 -------- -------- Total liabilities 12,391 12,053 -------- -------- Commitments and Contingencies Shareholders' Equity: Common stock, $0.01 par value, 20,000 shares authorized, 5,981 and 6,201 shares issued and outstanding, respectively 60 62 Additional paid-in capital 33,734 35,483 Accumulated deficit (1,127) (3,462) -------- -------- Total shareholders' equity 32,667 32,083 -------- -------- Total liabilities and shareholders' equity $ 45,058 $ 44,136 ======== ========
See notes to consolidated financial statements. -2- 3 QUALITY SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (Unaudited) (in thousands, except per share amounts)
Three Months Ended Nine Months Ended December 31, December 31, ------------------ ------------------ 2000 1999 2000 1999 ------- ------- ------- ------- Net Revenues: Sales of computer systems, upgrades and supplies $ 5,230 $ 4,435 $14,419 $15,184 Maintenance and other services 5,103 4,373 14,839 12,435 ------- ------- ------- ------- 10,333 8,808 29,258 27,619 Cost of Products and Services 4,459 4,023 12,854 12,547 ------- ------- ------- ------- Gross Profit 5,874 4,785 16,404 15,072 Selling, General and Administrative Expenses 3,451 3,166 10,060 9,344 Research and Development Costs 1,010 962 2,989 2,819 ------- ------- ------- ------- Income from Operations 1,413 657 3,355 2,909 Investment Income 261 183 758 531 ------- ------- ------- ------- Income before Provision for Income Taxes 1,674 840 4,113 3,440 Provision for Income Taxes 708 365 1,778 1,485 ------- ------- ------- ------- Net Income and Comprehensive Income $ 966 $ 475 $ 2,335 $ 1,955 ======= ======= ======= ======= Net Income per Share, basic $ 0.16 $ 0.08 $ .38 $ 0.31 ======= ======= ======= ======= Net Income per Share, diluted $ 0.16 $ 0.08 $ .37 $ 0.31 ======= ======= ======= =======
See notes to consolidated financial statements. -3- 4 QUALITY SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)
Nine Months Ended December 31, ------------------------- 2000 1999 -------- -------- Cash Flows from Operating Activities: Net income $ 2,335 $ 1,955 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,037 1,990 Loss (gain) on short-term investments (11) 31 Deferred income taxes 406 173 Changes in: Accounts receivable (2,228) (102) Inventories 111 (369) Other current assets (9) (30) Other assets (19) (76) Accounts payable 637 (689) Deferred service revenue 91 646 Income taxes payable and taxes related to equity accounts 146 (769) Other current liabilities (536) 492 -------- -------- Net Cash Provided by Operating Activities 2,960 3,252 -------- -------- Cash Flows from Investing Activities: Net additions to equipment and improvements (643) (298) Additions to capitalized software costs (821) (852) Purchase of short-term investment (50) Proceeds from sale of short-term investment 29 Change in other assets (13) (46) -------- -------- Net Cash Used in Investing Activities (1,477) (1,217) -------- -------- Cash Flows from Financing Activities: Purchases of Common Stock (1,838) (57) Proceeds from exercise of stock options 87 6 -------- -------- Net Cash Used in Financing Activities (1,751) (51) -------- -------- Net Increase (Decrease) in Cash and Cash Equivalents (268) 1,984 Cash and Cash Equivalents, beginning of period 16,180 14,196 -------- -------- Cash and Cash Equivalents, end of period $ 15,658 $ 16,180 ======== ========
See notes to consolidated financial statements. Supplemental Information - During the nine months ended December 31, 2000 and 1999, the Company made income tax payments, net of refunds received, of $1,056 and $2,099, respectively. -4- 5 QUALITY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with the requirements of Form 10-Q and, therefore, do not include all information and footnotes which would be presented were such financial statements prepared in accordance with generally accepted accounting principles, and should be read in conjunction with the audited financial statements presented in the Company's Annual Report for the fiscal year ended March 31, 2000. In the opinion of management, the accompanying financial statements reflect all adjustments which are necessary for a fair presentation of the results of operations for the interim periods presented. The results of operations for such interim periods are not necessarily indicative of results of operations to be expected for the full year. NOTE 2 - STOCK REPURCHASE In February 1997, the Company's Board of Directors authorized the repurchase on the open market of up to 10% of the shares of the Company's outstanding Common Stock, subject to compliance with applicable laws and regulations. This stock authorization has been renewed annually and currently expires on June 7, 2001. The timing and amount of any repurchase is at the discretion of the Company's management. The Company's management could, in the exercise of its judgment, repurchase fewer shares than authorized. During the three months ended December 31, 2000, the Company repurchased 227,400 shares at a cost of $1,802,000. Since the inception of the repurchase authorization through January 28, 2001, 345,800 shares have been repurchased at a cost of $2,494,000. NOTE 3 - INCOME TAXES The provision for income taxes for the three and nine months ended December 31, 2000 and 1999 differ from the expected combined statutory rates primarily due to the impact of non-deductible amortization of certain intangible assets acquired in the May 1996 acquisition of Clinitec International, Inc. and the effect of varying state income tax rates. -5- 6 NOTE 4 - NET INCOME (LOSS) PER SHARE The following table reconciles the weighted average shares outstanding for basic and diluted net income (loss) per share for the periods indicated.
Three Months Ended Nine Months Ended December 31, December 31, ------------------ ------------------ 2000 1999 2000 1999 ------ ------ ------ ------ (in thousands except per share amounts) Net income $ 966 $ 475 $2,335 $1,955 ------ ------ ------ ------ Weighted average number of common shares outstanding 6,119 6,208 6,179 6,213 ------ ------ ------ ------ Basic net income per share $ 0.16 $ 0.08 $ 0.38 $ 0.31 ====== ====== ====== ====== Diluted net income per share: Weighted average number of common shares outstanding 6,119 6,208 6,179 6,213 Weighted average number of common shares equivalents - Weighted average options outstanding 43 10 66 10 ------ ------ ------ ------ Weighted average number of common and common equivalent shares 6,162 6,218 6,245 6,223 ------ ------ ------ ------ Diluted net income per share $ 0.16 $ 0.08 $ 0.37 $ 0.31 ====== ====== ====== ======
NOTE 5 - NEW ACCOUNTING STANDARD In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin #101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 summarizes the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 is effective for the third quarter of fiscal year 2001. In March 2000, the FASB issued Interpretation No. 44 (FIN 44), "Accounting for Certain Transactions involving Stock Compensation." FIN 44 is an interpretation of Accounting Principal Board's Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). Among other matters, FIN 44 clarifies the application of APB 25, the criteria for determining whether a plan qualifies as non-compensatory and the accounting consequences of modifications to the terms of a previously issued stock options or similar awards. The Company adopted the provisions of FIN 44 in the third quarter of 2000. The adoption of FIN 44 did not have a material impact on the Company's financial condition or results of operations. -6- 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q, including discussions of the Company's product development plans and business strategies and market factors influencing the Company's results, are forward-looking statements that involve certain risks and uncertainties. Actual results may differ from those anticipated by the Company as a result of various factors, both foreseen and unforeseen, including, but not limited to, the Company's ability to continue to develop new products and increase systems sales in a market characterized by rapid technological evolution, consolidation, and competition from larger, better capitalized competitors. Many other economic, competitive, governmental and technological factors could impact the Company's ability to achieve its goals and interested persons are urged to review the risks described below, as well as in the Company's other public disclosures and filings with the Securities and Exchange Commission. COMPANY OVERVIEW. Quality Systems, Inc. ("QSI") and its wholly-owned subsidiary, Clinitec International, Inc. ("Clinitec", doing business as Micromed Healthcare Information Systems, Inc ("Micromed"), (collectively, the "Company"), develop and market healthcare information systems which automate medical and dental group practices to entities including, but not limited to, physician hospital organizations ("PHOs"), management service organizations ("MSOs"), community health centers and dental schools. Clinitec markets its Nextgen (Nextgen) and Micromed brand names through its Micromed Healthcare Information Systems division. In response to the growing need for more comprehensive, cost-effective information solutions for physician and dental practices, the Company's systems provide its clients with the ability to redesign patient care and other workflow processes, improve productivity, reduce information processing and administrative costs, and provide multi-site access to patient information. The Company's proprietary software systems include general patient information, electronic medical records, appointment scheduling, billing, insurance claims submission and processing, managed care plan implementation and referral management, treatment outcome studies, treatment planning, drug formularies, dental charting, and letter generation. Several of the Company's proprietary software systems may be operated remotely using thin client connectivity or a standard web browser. In addition to providing fully integrated software information solutions to its clients, the Company offers comprehensive hardware and software installation services, maintenance and support services, system training services, and electronic communications services enhancing the communication between provider offices, patients, and payors. The Company currently has an installed base of more than 600 healthcare information systems serving PHOs, MSOs, group practices, specialty practices, dental schools and other healthcare organizations, each of which consists of from one to 250 physicians or dentists. The Company believes that as healthcare providers are increasingly required to maximize their effiency and improve access to and security of important healthcare data while maintaining the quality of healthcare, the Company will be able to capitalize on its strategy of providing fully integrated information systems and superior client service. -7- 8 QSI is a California Corporation formed in 1974 and was founded with an early focus on providing information systems and services primarily for dental group practices. QSI's initial "turnkey" systems were designed to improve productivity while reducing information processing costs and personnel requirements. In the mid-1980's, QSI capitalized on the opportunity presented by the increasing pressure of cost containment on physicians and healthcare organizations and further expanded its information processing systems into the broader medical market. Today, QSI primarily develops and provides integrated healthcare information systems for both the medical and dental markets. These expandable systems operate on a stand-alone basis or in a networked environment. QSI's wholly owned subsidiary, Cinitec International, Inc. (dba Micromed Healthcare Information Systems, Inc) , develops and sells both proprietary electronic medical records software and practice management systems under the product name of NextGen*. Major product categories of the NextGen suite of applications include Electronic Medical Records (NextGen(emr)), Enterprise Practice Management (NextGen(epm)), Enterprise Appointment Scheduling (NextGen(eas)), Enterprise Master Patient Index (NextGen(epi)), Managed Care, Electronic Data Interchange, System Interfaces, Internet Operability (NextGen web), and a Patient-centric and Provider-centric Web Portal Solution (NextMD). NextGen(emr) allows healthcare providers to create and maintain medical records using a series of user-definable clinical "templates." Data is generally captured using a light pen or a mouse, and entries are then turned into sentences and/or paragraphs to create documentation. NextGen(emr) also supports the scanning and annotation of paper documents, photographs and X-rays, and contains many other advanced features. NextGen(emr) is marketed both in conjunction with the Company's practice management software offerings as well as on a stand-alone basis where NextGen(emr) may interface with other practice management systems. The Company believes that it currently provides a comprehensive information management solution for the medical marketplace. NextGen(epm) has been developed with a client/server architecture; a GUI design utilizing Windows 95, Windows 98, Windows 2000, or Windows NT operating system platforms; and, a platform independent relational database that is ANSI SQL-compliant. NextGen(epm) is designed to provide a flexible, enterprise-wide solution employing a master patient index. ------------ * NextGen is a registered trademark of Clinitec International, Inc. -8- 9 Recognizing the need and benefits to be obtained by using its software in conjunction with the capabilities of the Internet, the Company enhanced its enterprise practice management and electronic medical software packages in fiscal 2000 to enable them to be run via private intranet or the Internet in an application services provider (ASP) environment. Additionally, in April 2000, the Company announced the launch of an Internet-based consumer health portal, NextMD.com. NextMD.com is a vertical portal for the healthcare industry, linking patients with their physicians, insurers, laboratories, and online pharmacies, while providing a centralized source of health-oriented information for both consumers and medical professionals. Patients whose physicians are linked to the portal are able to request appointments, send appointment changes or cancellations, receive test results online, request prescription refills, view and/or pay their statements, and communicate with their physicians, all in a secure, online environment. The Company's NextGen suite of information systems are linked to NextMD.com, integrating a number of these features with physicians' existing systems. RISK FACTORS. COMPETITION. The market for healthcare information systems is intensely competitive and the Company faces significant competition from a number of different sources. The electronic medical records market, in particular, is subject to rapid changes in technology and the Company expects that competition in this portion of the market will increase as new competitors enter the marketplace. In addition, several of the Company's competitors have significantly greater name recognition as well as substantially greater financial, technical, product development and marketing resources than the Company. The industry is highly fragmented and includes numerous competitors, none of which the Company believes dominates the overall market for either group practice management or clinical systems. Furthermore, the Company also competes indirectly and to varying degrees with other major healthcare related companies, information management companies generally, and other software developers which may more directly enter the markets in which the Company competes. There can be no assurance that future competition or new product introductions will not have a material adverse effect on the Company's business, results of operations and financial condition. Competitive pressures and other factors, such as new product introductions by the Company or its competitors, may result in price or market share erosion that could have a material adverse effect on the Company's business, results of operations and financial condition. -9- 10 In addition, the Company believes that once a healthcare provider has chosen a particular healthcare information system vendor, the provider will, for a period of time, be more likely to rely on that vendor for its future information system requirements. Furthermore, if the healthcare industry continues to undergo further consolidation as it has recently experienced, each sale of the Company's systems will assume even greater importance to the Company's business, results of operations and financial condition. The Company's inability to make initial sales of its systems to either newly formed groups and/or healthcare providers that are replacing or substantially modifying their healthcare information systems could have a material adverse effect on the Company's business, results of operations and financial condition. If new systems sales do not materialize, maintenance service revenues can be expected to decrease over time due to the effect of failure to capture new maintenance revenues therefrom in combination with attrition of existing maintenance revenues associated with the Company's current clients whose systems become obsolete or are replaced by competitors' products. FLUCTUATION IN QUARTERLY OPERATING RESULTS. The Company's revenues and operating results have in the past fluctuated, and may in the future fluctuate, from quarter to quarter and period to period, as a result of a number of factors including, without limitation: the size and timing of orders from clients; the length of sales cycles and installation processes; the ability of the Company's clients to obtain financing for the purchase of the Company's products; changes in pricing policies or price reductions by the Company or its competitors; the timing of new product announcements and product introductions by the Company or its competitors; the availability and cost of system components; the financial stability of major clients; market acceptance of new products, applications and product enhancements; the Company's ability to develop, introduce and market new products, applications and product enhancements and to control costs; the Company's success in expanding its sales and marketing programs; deferrals of client orders in anticipation of new products, applications or product enhancements; changes in Company strategy; personnel changes; and general economic factors. The Company's products are generally shipped as orders are received and accordingly, the Company has historically operated with minimal backlog. As a result, sales in any quarter are dependent on orders booked and shipped in that quarter and are not predictable with any degree of certainty. Furthermore, the Company's systems can be relatively large and expensive and individual systems sales can represent a significant portion of the Company's revenues for a quarter such that the loss of even one such sale can have a significant adverse impact on the Company's quarterly profitability. Clients often defer systems purchases until the Company's quarter end, so quarterly results generally cannot be predicted and frequently are not known until the quarter has concluded. The Company's initial contact with a potential customer depends in significant part on the customer's decision to replace, or substantially modify, its existing information system. How and when to implement, replace or substantially modify an information system are major decisions for healthcare providers. Accordingly, the sales cycle for the Company's systems can vary significantly and typically ranges from three to 12 months from initial contact to contract execution/shipment. -10- 11 Because a significant percentage of the Company's expenses are relatively fixed, a variation in the timing of systems sales and installations can cause significant variations in operating results from quarter to quarter. As a result, the Company believes that interim period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Further, the Company's historical operating results are not necessarily indicative of future performance for any particular period. Through March 31, 1998, the Company recognized revenue in accordance with the provisions of the American Institute of Certified Public Accountants ("AICPA") Statement of Position No. 91-1, "Software Revenue Recognition" ("SOP 91-1"). The AICPA has adopted Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2"), that supersedes SOP 91-1 and became effective for the Company on April 1, 1998. There can be no assurance that application and subsequent interpretations of this pronouncement by the Company, its independent auditors or the Securities and Exchange Commission will not further modify the Company's revenue recognition policies, or that such modifications would not have a material adverse effect on the operating results reported in any particular quarter. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin #101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 summarizes the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 is effective for the third quarter of fiscal year 2001. There can be no assurance that the Company will not be required to adopt changes in its licensing or services practices to conform to SOP 97-2, or that such changes, if adopted, would not result in delays or cancellations of potential sales of the Company's products. Due to all of the foregoing factors, it is possible that in some future quarter the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially adversely affected. DEPENDENCE ON PRINCIPAL PRODUCT AND NEW PRODUCT DEVELOPMENT. The Company currently derives substantially all of its net revenues from sales of its healthcare information systems and related services. The Company believes that a primary factor in the market acceptance of its systems has been its ability to meet the needs of users of healthcare information systems. The Company's future financial performance will depend in large part on the Company's ability to continue to meet the increasingly sophisticated needs of its clients through the timely development, successful introduction and implementation of new and enhanced versions of its systems and other complementary products. The Company has historically expended a significant amount of its net revenues on product development and believes that significant continuing product development efforts will be required to sustain the Company's growth. There can be no assurance that the Company will be successful in its product development efforts, that the market will continue to accept the Company's existing or new products, or that products or product enhancements will be developed and implemented in a timely manner, meet the requirements of healthcare providers, or achieve market acceptance. If new products or product enhancements do not achieve market acceptance, the Company's business, results of operations and financial condition could be -11- 12 materially adversely affected. At certain times in the past, the Company has also experienced delays in purchases of its products by clients anticipating the launch of new products by the Company. There can be no assurance that material order deferrals in anticipation of new product introductions will not occur. TECHNOLOGICAL CHANGE. The software market generally is characterized by rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards. The introduction of products incorporating new technologies and the emergence of new industry standards could render the Company's existing products obsolete and unmarketable. There can be no assurance that the Company will be successful in developing and marketing new products that respond to technological changes or evolving industry standards. New product development depends upon significant research and development expenditures which depend ultimately upon sales growth. Any material weakness in revenues or research funding could impair the Company's ability to respond to technological advances in the marketplace and to remain competitive. If the Company is unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, the Company's business, results of operations and financial condition will be materially adversely affected. In response to increasing market demand, the Company is currently developing new generations of certain of its software products designed for the client-server and Internet/intranet environments. There can be no assurance that the Company will successfully develop these new software products or that these products will operate successfully on the principal client-server operating systems, which include UNIX, Microsoft Windows, Windows NT, Windows 95, Windows 98 and Windows 2000, or that any such development, even if successful, will be completed concurrently with or prior to introduction by competitors of products designed for the client-server and Internet/intranet environments. Any such failure or delay could adversely affect the Company's competitive position or could make the Company's current products obsolete. LITIGATION. On April 22, 1997, a purported class action entitled JOHN P. CAVENY v. QUALITY SYSTEMS, INC., ET AL. was filed in the Superior Court of the State of California for the County of Orange, in which Mr. Caveny, on behalf of himself and all others who purchased the Company's Common Stock between June 26, 1995 and July 3, 1996, alleges that the Company, and Sheldon Razin, Robert J. Beck, Gregory S. Flynn, Abe C. LaLande, Donn Neufeld, Irma G. Carmona, John A. Bowers, Graeme H. Frehner, and Gordon L. Setran (all of the foregoing individuals were either officers, directors or both during the period from June 26, 1995 through July 3, 1996), as well as other defendants not affiliated with the Company, violated California Corporations Code Sections 25400 and 25500, California Civil Code Sections 1709 and 1710, and California Business and Professions Code Sections 17200 et. seq., by issuing positive statements about the Company that allegedly were knowingly false, in part, in order to assist the Company and the individual defendants in selling Common Stock at an inflated price in the Company's March 5, 1996 public offering and at other points during the class period. The complaint seeks compensatory and punitive damages in unspecified amounts, disgorgement, declaratory and injunctive relief, and attorneys' fees. -12- 13 The Company and the other named defendants successfully demurred to the plaintiffs' claim under California Civil Code Sections 1709 and 1710, and that claim, which served as the only basis for plaintiffs' request for punitive damages, has been dismissed from both actions. On January 25, 1999, the court denied plaintiffs' motion to certify the class representative and class legal counsel. Plaintiffs appealed that decision as to class legal counsel. On February 25, 2000, the Fourth District Court of Appeals affirmed the order disqualifying the class legal counsel. On May 9, 2000, the Court of Appeals issued its Remittur certifying its decision as final. In May 2000, plaintiffs associated in additional class legal counsel, and moved for approval by the court. Upon defendants' objection, the court on August 17, 2000, denied plaintiffs' motion, and ordered plaintiffs to retain new class counsel. At the end of November 2000, the plaintiffs retained new class counsel who substituted in for plaintiffs' previous class counsel. The Company and the other named defendants did not oppose plaintiffs' motion for approval of the new class counsel. On January 24, 2001, the court granted the motion to certify class legal counsel. Merits-related discovery in the action had been stayed pending the appointment of class counsel and is expected to resume now that class counsel has been approved by the court. The Company and its named officers and directors continue to deny all remaining allegations of wrongdoing made against them in these suits, consider the allegations groundless and without merit, and intend to vigorously defend against these actions. On May 14, 1997, a second purported class action entitled WENDY WOO v. QUALITY SYSTEMS, INC., ET AL. was filed in the same court, essentially repeating the allegations in the Caveny lawsuit and seeking identical relief. This action has for all purposes been consolidated with the Caveny action. On March 23, 1999, a purported class action and derivative complaint entitled IRVING ROSENZWEIG v. SHELDON RAZIN, ET AL. was filed in the Superior Court of the State of California for the County of Orange, in which Mr. Rosenzweig, on behalf of himself and all non-director shareholders, and derivatively on behalf of the Company, alleges that Sheldon Razin, John Bowers, William Bowers, Patrick Cline, Janet Razin and Gordon Setran (all of the foregoing individuals are directors of the Company) breached their fiduciary duties by allegedly entrenching themselves in their positions of control, failing to ensure that third- party offers involving the Company were fully and fairly considered, and/or failing to conduct a reasonable inquiry to assure the maximization of shareholder value. The complaint sought declaratory and injunctive relief, an accounting of monetary damages allegedly suffered by plaintiff and the purported class, and attorneys' fees. Defendants demurred to each of the causes of action alleged in the complaint and the court sustained those demurrers with leave to amend in December 1999. Rather than file an amended complaint, plaintiff filed a motion for attorney's fees. Defendants, in turn, filed a motion to dismiss the action for failure to file an amended pleading within the time limit specified by the court. -13- 14 The parties agreed to a settlement of action and stipulated to a final judgment and order which was entered by the court on May 15, 2000 at which time the action was dismissed. The final judgment and order provided for a dismissal of the action with prejudice, releases given to each of the defendants, and payment of the nominal sum of $100,000 (paid by the Company's Directors and Officers Liability Insurance Company) in full settlement of plaintiff's motion for attorney's fees. The settlement further expressly provided that it did not constitute an admission of any liability of defendants, which defendants continue to vigorously deny. The Company is a party to various other legal proceedings incidental to its business, none of which are considered by the Company to be material. PROPRIETARY TECHNOLOGY. The Company is heavily dependent on the maintenance and protection of its intellectual property and relies largely on license agreements, confidentiality procedures, and employee nondisclosure agreements to protect its intellectual property. The Company's software is not patented and existing copyright laws offer only limited practical protection. There can be no assurance that the legal protections and precautions taken by the Company will be adequate to prevent misappropriation of the Company's technology or that competitors will not independently develop technologies equivalent or superior to the Company's. Further, the laws of some foreign countries do not protect the Company's proprietary rights to as great an extent as do the laws of the United States and are often not enforced as vigorously as those in the United States. The Company does not believe that its operations or products infringe on the intellectual property rights of others. However, there can be no assurance that others will not assert infringement or trade secret claims against the Company with respect to its current or future products or that any such assertion will not require the Company to enter into a license agreement or royalty arrangement with the party asserting the claim. As competing healthcare information systems increase in complexity and overall capabilities and the functionality of these systems further overlaps, providers of such systems may become increasingly subject to infringement claims. Responding to and defending any such claims may distract the attention of Company management and have a material adverse effect on the Company's business, results of operations and financial condition. In addition, claims may be brought against third parties from which the Company purchases software, and such claims could adversely affect the Company's ability to access third party software for its systems. ABILITY TO MANAGE GROWTH. The Company has experienced periods of growth which has placed, and may continue to place, a significant strain on the Company's resources. The Company also anticipates expanding its overall software development, marketing, sales, client management and training capacity. In the event the Company is unable to identify, hire, train and retain qualified individuals in such capacities within a reasonable timeframe, such failure could have a material adverse effect on the Company. In addition, the Company's ability to manage future increases, if any, in the scope of its operations or personnel will depend on significant expansion of its research and -14- 15 development, marketing and sales, management, and administrative and financial capabilities. The failure of the Company's management to effectively manage expansion in its business could have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE UPON KEY PERSONNEL. The Company's future performance also depends in significant part upon the continued service of its key technical and senior management personnel, many of whom have been with the Company for a significant period of time. The Company does not maintain key man life insurance on any of its employees. Because the Company has a relatively small number of employees when compared to other leading companies in the same industry, its dependence on maintaining its employees is particularly significant. The Company is also dependent on its ability to attract and retain high quality personnel, particularly highly skilled software engineers for applications development. The industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that the Company's current employees will continue to work for the Company. Loss of services of key employees could have a material adverse effect on the Company's business, results of operations and financial condition. Furthermore, the Company may need to grant additional stock options to key employees and provide other forms of incentive compensation to attract and retain such key personnel. PRODUCT LIABILITY. Certain of the Company's products provide applications that relate to patient clinical information. Any failure by the Company's products to provide accurate and timely information could result in claims against the Company. In addition, a court or government agency may take the position that the Company's delivery of health information directly, including through licensed physicians, or delivery of information by a third party-site that a consumer accesses through the Company's web sites, exposes the Company to malpractice or other personal injury liability for wrongful delivery of healthcare services or erroneous health information. The Company maintains insurance to protect against claims associated with the use of its products, but there can be no assurance that its insurance coverage would adequately cover any claim asserted against the Company. A successful claim brought against the Company in excess of its insurance coverage could have a material adverse effect on the Company's business, results of operations and financial condition. Even unsuccessful claims could result in the Company's expenditure of funds in litigation and management time and resources. Certain physicians or other healthcare professionals who use the Company's Internet based products will directly enter health information about their patients including information that constitutes a record under applicable law, that the Company will store on the Company's computer systems. Numerous federal and state laws and regulations, the common law, and contractual obligations govern collection, dissemination, use and confidentiality of patient-identifiable health information, including: - State privacy and confidentiality laws; - The Company's contracts with customers and partners; -15- 16 - State laws regulating healthcare professionals, such as physicians, pharmacists and nurse practitioners; - Medicaid laws; - The Heath Insurance Portability and Accountability Act of 1996 and related rules proposed by the Heath Care Financing Administration; and - Health Care Financing Administration standards for Internet transmission of health data. The U.S. Congress has been considering proposed legislation that would establish a new federal standard for protection and use of health information. Any failure by the Company or by the Company's personnel or partners to comply with any of these legal and other requirements would result in material liability. Although the Company has systems in place for safeguarding patient health information from unauthorized disclosure, these systems may not preclude successful claims against the Company for violation of applicable law or other requirements. Other third-party sites or links that consumers access through the Company's web sites also may not maintain systems to safeguard this health information, or may circumvent systems the Company put in place to protect the information from disclosure. In addition, future laws or changes in current laws may necessitate costly adaptations to the Company's systems. There can be no assurance that the Company will not be subject to product liability claims, that such claims will not result in liability in excess of its insurance coverage, that the Company's insurance will cover such claims or that appropriate insurance will continue to be available to the Company in the future at commercially reasonable rates. Such claims could have a material adverse affect on the Company's business, results of operations and financial condition. UNCERTAINTY IN HEALTHCARE INDUSTRY; GOVERNMENT REGULATION. The healthcare industry is subject to changing political, economic and regulatory influences that may affect the procurement processes and operation of healthcare facilities. During the past several years, the healthcare industry has been subject to an increase in governmental regulation of, among other things, reimbursement rates and certain capital expenditures. In the past, various legislators have announced that they intend to examine proposals to reform certain aspects of the U.S. healthcare system including proposals which may increase governmental involvement in healthcare, lower reimbursement rates and otherwise change the operating environment for the Company's clients. Healthcare providers may react to these proposals and the uncertainty surrounding such proposals by curtailing or deferring investments, including those for the Company's systems and related services. Cost-containment measures instituted by healthcare providers as a result of regulatory reform or otherwise could result in greater selectivity in the allocation of capital funds. Such selectivity could have an adverse effect on the Company's ability to sell its systems and related services. The Company cannot predict what impact, if any, such proposals or healthcare reforms might have on its business, results of operations and financial condition. -16- 17 In the year 2001, the Department of Health and Human Services expects to finalize proposed regulations at the federal level authorized under the Health Insurance Portability and Accountability Act of 1996. These proposed regulations will establish new federal standards for privacy of health information. The Company anticipates that these regulations will directly affect the Company's products and services, but the Company cannot accurately predict the impact at this time. Achieving compliance with these regulations could be costly and distract management's attention and other resources from the Company's historical business, and any noncompliance by the Company could result in civil and criminal penalties. In addition, development of related federal and state regulations and policies on confidentiality of health information could negatively affect the Company's business. The Company's software may be subject to regulation by the FDA as a medical device. Such regulation could require the registration of the applicable manufacturing facility and software/hardware products, application of detailed record-keeping and manufacturing standards, and FDA approval or clearance prior to marketing. An approval or clearance could create delays in marketing, and the FDA could require supplemental filings or object to certain of these applications, the result of which could have a material adverse effect on the Company's business, results of operations and financial condition. -17- 18 RESULTS OF OPERATIONS. The following table sets forth for the periods indicated, the percentage of net revenues represented by each item in the Company's consolidated statements of operations. Three Months Nine Months Ended Ended December 31, December 31, ---------------- ---------------- 2000 1999 2000 1999 ------ ------ ------ ------ Net Revenues: Sales of computer systems, upgrades and supplies 50.6% 50.4% 49.3% 55.0% Maintenance and other services 49.4 49.6 50.7 45.0 ------ ------ ------ ------ 100.0 100.0 100.0 100.0 Cost of Products and Services 43.2 45.7 43.9 45.4 ------ ------ ------ ------ Gross Profit 56.8 54.3 56.1 54.6 Selling, General and Administrative Expenses 33.4 35.9 34.4 33.9 Research and Development Costs 9.8 10.9 10.2 10.2 ------ ------ ------ ------ Income from Operations 13.6 7.5 11.5 10.5 Investment Income 2.5 2.0 2.6 1.9 ------ ------ ------ ------ Income before Provision for Income Taxes 16.1 9.5 14.1 12.4 Provision for Income Taxes 6.9 4.1 6.1 5.4 ------ ------ ------ ------ Net Income 9.2% 5.4% 8.0% 7.0% ====== ====== ====== ====== -18- 19 FOR THE THREE-MONTH PERIODS ENDED DECEMBER 31, 2000 AND 1999. The Company's net income for the three months ended December 31, 2000 was $966,000, or $0.16 per share on a basic and diluted basis, as compared to net income of $475,000, or $0.08 per share on a basic and diluted basis, for the three months ended December 31, 1999. Net Revenues. Net revenues increased 17% to $10.3 million for the three months ended December 31, 2000 compared to $8.8 million for the three months ended December 31, 1999. Sales of computer systems, upgrades and supplies increased 18% to $5.2 million from $4.4 million while net revenues from maintenance and other services grew 17% to $5.1 million from $4.4 million during the comparable periods. The increase in net revenues from sales of computer systems, upgrades and supplies was principally the result of an increase in the sales of the Nextgen suite of electronic medical records software and practice management systems, partially offset by a decline in the sale of the Company's character-based healthcare information systems. The increase in maintenance and other services net revenue resulted principally from an increase in revenues from the Company's increased client base from which to generate maintenance together with an increase in revenues generated from the Company's electronic data interchange services. Cost of Products and Services. Cost of products and services for the three months ended December 31, 2000 increased 11% to $4.5 million as compared to $4.0 million for the three months ended December 31, 1999. The increase in the cost of products and services resulted from the impact of increased volume of new systems sales and EDI sales in the December 31, 2000 period. The cost of products and services as a percentage of net revenues declined to 43.2% compared to 45.7% for the three months ended December 31, 1999. The cost of products and services as a percentage of sales declined in part as a result of the increased sales volume being delivered from the existing infrastructure. The effect of increased sales being delivered from the same infrastructure was partially offset from a higher level of low margin hardware content included in new systems sales compared to the year ago quarter. Selling, General and Administrative Expenses. Selling, general and administrative expenses for the three months ended December 31, 2000 increased 9% to $3.5 million as compared to $3.2 million for the three months ended December 31, 1999. The increase in selling, general, and administrative expenses was primarily related to an increase in selling and marketing costs associated with the increase in sales activity in the Micromed Division. Selling, general and administrative expenses as a percentage of net revenues decreased to 33.4% from 35.9% as a result of an improvement in operating leverage with the increase in revenue and the portions of selling, general & administrative expense which are relatively fixed. Research and Development Costs. Research and development costs for the three months ended December 31, 2000 increased 5% to $1,010,000 as compared to $962,000 for the three months ended December 31, 1999. Research and development costs as a percentage of net revenues decreased to 9.8% as compared to 10.9% for the three months ended September 30, 1999. Investments in research and development have remained relatively constant in both periods. The decline in research and development costs as a percentage of revenue was due to the increase in revenue in the three months ended December 31, 2000. -19- 20 Investment Income. Investment income for the three months ended December 31, 2000 was $261,000 while investment income for the December 31, 1999 period was $183,000. The increase in the December 2000 quarter as compared to the December 1999 quarter was principally due to an increase in interest rates earned on the Company's cash balances in the December 2000 quarter compared to the December 1999 quarter. Provision for Income Taxes. The provision for income taxes for the three months ended December 31, 2000 was $708,000 as compared to $365,000 for the three months ended December 31, 1999. The provisions for income taxes for the three months ended December 31, 2000 and 1999 differ from the combined statutory rates primarily due to the impact of non-deductible amortization of certain intangible assets acquired in the May 1996 Clinitec acquisition and the effect of varying state income tax rates. FOR THE NINE-MONTH PERIODS ENDED DECEMBER 31, 2000 AND 1999. The Company's net income for the nine months ended December 31, 2000 was $2.3 million, or $0.38 per share on a basic and $.37 per share on a diluted basis, as compared to a net income of $2.0 million, or 0.31 per share on a basic and diluted basis, for the nine months ended December 31, 1999. Net Revenues. Net revenues for the nine months ended December 31, 2000 increased 5.9% to $29.3 million from $27.6 million for the nine months ended December 31, 1999. Sales of computer systems, upgrades and supplies decreased 5.0% to $14.4 million from $15.2 million, while net revenues from maintenance and other services grew 19% to $14.8 million from $12.4 million during the comparable periods. The decrease in net revenues from sales of computer systems, upgrades and supplies was principally the result of declines in the new sales of the Company's character based software products. The declines experienced in the character based products were partially offset by increases in new Nextgen systems sales. The increase in maintenance and other services revenue resulted principally from an increase in revenues from the Company's increased client base from which to generate maintenance and other services revenue together with an increase in revenues generated from the Company's electronic data interchange services. Cost of Products and Services. Cost of products and services for the nine months ended December 31, 2000 increased 2.5% to $12.9 million from $12.5 million for the nine months ended December 31, 1999 while cost of products and services as a percentage of net revenues decreased to 43.9% from 45.4% during the comparable periods. The increase in the cost of products and services resulted from the impact of increased costs associated with higher revenues generated from the Company's electronic data interchange services partially offset by a decline in new system sales of the Company's character based products. The cost of products and services as a percentage of net revenues decreased primarily as a result of leveraging the growth of maintenance and other services revenue on the Company's existing infrastructure partially offset by the increase in electronic data interchange services revenue which yield a lower margin than other products and services. Selling, General and Administrative Expenses. Selling, general and administrative expenses for the nine months ended December 31, 2000 increased 7.7% to $10.1 million as compared to $9.3 million for the nine months ended December 31, 1999. Selling, general and administrative expenses as a percentage of net revenues increased to 34.4% from 33.9%. The -20- 21 increase in the amount of such expenses resulted from the increased sales and marketing expenses of the Nextgen Suite of software products and administrative infrastructure expenses. The Company has also increased amounts which have been set aside for potential bad debts in the nine months ended December 31, 2000 compared to the nine months ended December 31, 1999. The increase of selling, general and administrative expenses as a percentage of net revenues resulted from the increase in the aforementioned expenses which grew at a faster rate than revenue. Research and Development Costs. Research and development costs for the nine months ended December 31, 2000 increased 6.0% to $3.0 million from $2.8 million for the nine months ended December 31, 1999. Research and development costs as a percentage of net revenues remained unchanged at 10.2%. Investment Income. Investment income for the nine months ended December 31, 2000 and 1999 was $758,000 and $531,000, respectively. The increase was due to an increase in the amount of cash available for investment combined with an increase in interest rates earned on the Company's cash balances in the nine months ended December 31, 2000. Provision for Income Taxes. The provision for income taxes for the nine months ended December 31, 2000 and 1999 was $1.8 million and $1.5 million, respectively. The provisions for income taxes for the nine months ended December 31, 2000 and 1999 differ from the combined statutory rates primarily due to the impact of non-deductible amortization of certain intangible assets acquired in the May 1996 Clinitec acquisition and the effect of varying state income tax rates. LIQUIDITY AND CAPITAL RESOURCES. Cash and cash equivalents decreased $268,000 for the nine months ended December 31, 2000 primarily as a result of cash provided by operating activities, offset by investments in capitalized software, equipment and repurchases of the Company's stock. Cash and cash equivalents increased $2.0 million for the nine months ended December 31, 1999 primarily as a result of cash provided by operating activities. Net cash provided by operating activities for the nine months ended December 31, 2000 was $3.0 million consisting primarily of the Company's $2.3 million in net income adjusted for the principal non-cash operating expenses of depreciation and amortization plus an increase in accounts payable and income tax related accounts offset in part by increases in accounts receivable. Net cash provided by operating activities for the nine months ended December 31, 1999 was $3.3 million consisting primarily of the Company's $2.0 million net income adjusted for the principal non-cash operating expenses of depreciation and amortization plus an increase in deferred service revenue offset in part by increases in accounts payable and income tax related accounts. Net cash used in investing activities for the nine months ended December 31, 2000 was $1.5 million consisting principally of additions to equipment and capitalized software. Net cash used in investing activities for the nine months ended December 31, 1999 was $1.2 million consisting principally of additions to equipment and improvements and capitalized software. -21- 22 Net cash used in financing activities for the nine months ended December 31, 2000 was $1.8 million consisting of the purchase of 227,400 shares of the Company's Common Stock offset in part by the exercise of stock options. Net cash used in financing activities for the nine months ended December 31, 1999 was $51,000 consisting of the purchase of 9,400 shares of the Company's Common Stock offset in part by proceeds from the exercise of stock options. In February 1997, the Company's Board of Directors authorized the repurchase on the open market of up to 10% of the shares of the Company's outstanding Common, subject to compliance with applicable laws and regulations. This stock authorization has been renewed annually and currently expires on June 7, 2001. The timing and amount of any repurchase is at the discretion of the Company's management. The Company's management could, in the exercise of its judgment, repurchase fewer shares than authorized. During the nine months ended December 31, 2000, the Company purchased 232,400 shares at a cost of approximately $1,838,000. At December 31, 2000, the Company had cash and cash equivalents of $15.7 million and short-term investments of $254,000. Except for the Company's intention to expend funds for the development of complementary products to its existing product line and alternative versions of certain of its products for the client-server environment to take advantage of more powerful technologies and to enable a more seamless integration of the Company's products, the Company has no other significant capital commitments and currently anticipates that additions to equipment and improvements for fiscal 2001 will be comparable to fiscal 2000. The Company believes that its cash and cash equivalents and short-term investments on hand at December 31, 2000, together with cash flows from operations, if any, will be sufficient to meet its working capital and capital expenditure requirements for the next year. -22- 23 PART II. OTHER INFORMATION. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits: None. (b) Reports on Form 8-K: None. -23- 24 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. QUALITY SYSTEMS, INC. Date: February 12, 2001 By /s/ Lou Silverman -------------------------------- Lou Silverman President Principal Executive Officer Date: February 12, 2001 By /s/ Paul Holt -------------------------------- Paul Holt Chief Financial Officer; Principal Accounting Officer -24-