-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, AFbKS7Ikzer6ClRIjAZ3rsZvFQhzIuotSJE6EptTxuHkp+2RA0bJePWH/SOMErLb PmtJGJOXz59TZn8acaPviA== 0000950123-99-000351.txt : 19990126 0000950123-99-000351.hdr.sgml : 19990126 ACCESSION NUMBER: 0000950123-99-000351 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981031 FILED AS OF DATE: 19990125 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HEALTH MANAGEMENT SYSTEMS INC CENTRAL INDEX KEY: 0000861179 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROCESSING & DATA PREPARATION [7374] IRS NUMBER: 132770433 STATE OF INCORPORATION: NY FISCAL YEAR END: 1031 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-20946 FILM NUMBER: 99511992 BUSINESS ADDRESS: STREET 1: 401 PARK AVE SOUTH CITY: NEW YORK STATE: NY ZIP: 10016 BUSINESS PHONE: 2126854545 MAIL ADDRESS: STREET 1: 401 PARK AVENUE SOUTH CITY: NEW YORK STATE: NY ZIP: 10016 10-K 1 HEALTH MANAGEMENT SYSTEMS, INC. 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED OCTOBER 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 0-20946 HEALTH MANAGEMENT SYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) NEW YORK 13-2770433 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER) INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 401 PARK AVENUE SOUTH 10016 NEW YORK, NEW YORK (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (212) 685-4545 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) -------------------------------- SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED ------------------- ------------------- NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK (Title of Class) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- The aggregate market value of the registrant's common stock held by non-affiliates as of January 11, 1999 was $127,027,607 based on the closing price on the Nasdaq National Market System on that day. Number of shares outstanding of the registrant's common stock, $.01 par value, on January 11, 1999 was 17,316,671. DOCUMENTS INCORPORATED BY REFERENCE:
DOCUMENT WHERE INCORPORATED -------- ------------------ PROXY STATEMENT FOR THE ANNUAL MEETING PART III TO BE HELD ON MARCH 9, 1999
2 TABLE OF CONTENTS
Page Contents Number - -------- ------ Cover Page ........................................................................ i PART I Item 1. Business .............................................................. 1 Item 2. Properties ............................................................ 10 Item 3. Legal Proceedings ..................................................... 11 Item 4. Submission of Matters to a Vote of Security Holders ................... 12 PART II Item 5. Market for Registrant's Common Equity and Related Shareholder Matters.. 12 Item 6. Selected Financial Data ............................................... 12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................. 13 Item 7A. Quantitative and Qualitative Disclosures About Market Risks ........... 13 Item 8. Financial Statements and Supplementary Data ........................... 13 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .................................................. 13 PART III Item 10. Directors and Executive Officers of the Registrant .................... 13 Item 11. Executive Compensation ................................................ 13 Item 12. Security Ownership of Certain Beneficial Owners and Management ........ 13 Item 13. Certain Relationships and Related Transactions ........................ 13 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ...... 13 Signatures ..................................................................... 14 Exhibit Index .................................................................. 15
ii 3 PART I SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS EXCEPT FOR THE HISTORICAL FINANCIAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS ANNUAL REPORT ON FORM 10-K MAY BE CONSIDERED "FORWARD-LOOKING" STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. SUCH STATEMENTS INCLUDE DECLARATIONS REGARDING THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF THE COMPANY AND ITS MANAGEMENT. PROSPECTIVE INVESTORS ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES AND THAT ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. AMONG THE IMPORTANT FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS INCLUDE THOSE RISKS IDENTIFIED IN "ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - CERTAIN FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS" AND OTHER RISKS IDENTIFIED FROM TIME TO TIME IN THE COMPANY'S REPORTS AND REGISTRATION STATEMENTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. ITEM 1. BUSINESS OVERVIEW Health Management Systems, Inc. (the "Company" or "HMSY") furnishes proprietary information management and data processing products and services to healthcare providers and payors, including government health service agencies. These services address the various types of data generated by the interaction of the participants in the healthcare delivery process: the providers of care, the third-party payors, and the patients. Through its product and service offerings, the Company acts as an outsourcer of information management functions addressing the operational, administrative, financial, and clinical data that result from the rendering of healthcare services to patients. The Company's product and service offerings benefit its clients by enhancing revenue (achieved through improved reimbursability, profitability, and/or collectability), accelerating cash flow, reducing operating and administrative costs (by supplying advanced information analytics), and improving decision-making capabilities (via the provision of useful information). Healthcare providers receive payment for services from patients, third-party payors, or a combination thereof. Third-party payors include commercial insurance companies, governments or their fiscal agents and intermediaries, health maintenance organizations, preferred provider organizations, third-party administrators for self-insured companies, and managed care companies. Although patients generally retain primary responsibility for payment for all healthcare services, third-party payors bear the preponderance of the responsibility for many charges for care. Obtaining reimbursement from third-party payors has become increasingly difficult because of frequent changes in reimbursement formulae and contractual requirements for pre-admission certification and utilization review, and administrative procedures instituted by third-party payors in an effort to control costs. To be successful in obtaining payment from third-party payors, hospitals and other healthcare providers require regulatory knowledge and technical skills to manage complex data collection, integration, analysis, and accounts receivable management functions. To ensure that program costs are not greater than necessary, third-party payors require knowledge and skills analogous to those required by providers. Using the operational, financial, administrative, and clinical data generated as part of the healthcare delivery process, the Company applies proprietary software and other analytical tools to transform data into valuable information that clients use to (i) minimize operating and administrative costs while improving profitability, (ii) measure the quality of care, and (iii) optimize the outcome of the transfer payment processes linking payors, providers, and patients. Customers of the Company utilize the Company's products and services to improve their decision-making and operating capabilities and to achieve improved operational, administrative, financial, and clinical performance. The Company believes its customers benefit from the Company's unique understanding of the healthcare delivery and associated transfer payment processes, from the perspective of both providers and payors. 1 4 Company History A healthcare information systems and services enterprise, the Company is organized into two divisions: Transfer Payment Services ("Transfer Payment Division") and Software Systems and Services ("Software Division"). The Transfer Payment Division comprises two business units: Provider Transfer Payment Services ("Provider Transfer Payment Unit") and Payor Transfer Payment Services ("Payor Transfer Payment Unit"). The Company's Software Division also comprises two business units: Decision Support Systems ("DSS Unit") and Managed Care Information Systems ("MCIS Unit"). Within the Transfer Payment Division, the Provider Transfer Payment Unit has delivered Retroactive Claims Reprocessing ("RCR")(sm) services since 1974 and began to deliver Comprehensive Account Management Services ("CAMS")(sm) in 1986 and Electronic Data Interchange ("EDI") services with the acquisition in 1990 of Quality Medi-Cal Adjudication Incorporated ("QMA"). QMA provides electronic billing and automated denial reprocessing services. In 1997 the Company acquired a computerized medical record-based processing system for managed care public health and ambulatory care facilities as part of its purchase of substantially all the assets of Global Health Systems, Inc. and GHS Management Services, Inc. (collectively "Global"). In 1997 the Company formed a Business Office Outsourcing business unit and in 1998 consolidated this Business Office Outsourcing unit with the remainder of its Provider Transfer Payment Unit. The Payor Transfer Payment Unit began delivery of Third Party Liability Recovery ("TPLR")(sm) services in 1985 and augmented its product line in 1996 with the acquisition of CDR Associates, Inc. ("CDR"). CDR is a provider of hospital-based claim audits to payors, principally Blue Cross and Blue Shield organizations. The Company's Software Division was referred to in the aggregate as MCIS in 1997; in 1998, MCIS refers to one of the Software Division's two business units, while the DSS Unit refers to the other. The Company entered the software business in 1995 as a consequence of its merger with Health Care microsystems, Inc. ("HCm"). HCm furnishes microcomputer-based distributed decision support systems and services to providers of care and bearers of financial risk in the healthcare industry and today comprises the DSS Unit of the Company. In 1996 the DSS Unit acquired Quality Standards in Medicine, Inc. ("QSM") and integrated QSM's clinical information systems with HCm's decision support offerings. In 1997 the Company, which had owned a 43% equity interest in Health Information Systems Corporation ("HISCo"), acquired from Welsh, Carson, Anderson & Stowe ("WCAS") and various of its affiliates, independent investors, and from certain of the Company's executive officers and directors, the remaining 57% of HISCo's equity. At the time of acquisition, HISCo merged with its sole operating subsidiary, Health Systems Architects, Inc., and was renamed HSA Managed Care Systems, Inc ("HSA"). Today, this entity comprises the MCIS Unit and furnishes automated business and information solutions, including software and services, to bearers of financial risk in the healthcare industry. The HCm, CDR, and QSM mergers were accounted for using the pooling of interest method, while the QMA, HISCo, and Global acquisitions were accounted for using the purchase method. HEALTHCARE REFORM AND REGULATORY MATTERS The healthcare reimbursement process continues to change. Federal, state, and local governments, as well as other third-party payors, have initiated policies to reduce the rate of increase in healthcare expenditures. Many of these policy initiatives have contributed to the complex and time-consuming nature of obtaining healthcare reimbursement for medical services. Changes occurring in the healthcare industry, most notably the evolution of healthcare towards the present managed care model characterized by the formation of large integrated delivery systems and capitated reimbursement, have created an increasingly complex reimbursement environment that impacts both providers and payors. This environment is made even more complex as the historical distinction between providers and payors becomes less clear. The consolidation of healthcare into integrated delivery systems has broken down traditional organizational barriers that once supported a clear delineation between the manner in which providers and payors utilized operational, financial, administrative, and clinical information. Today, emphasis is placed on improving the level of provider and payor accountability for both the delivery and the utilization of healthcare services. Providers 2 5 must ensure that they are properly reimbursed by third-party payors for healthcare services rendered in accordance with pre-established contracts. Likewise, payors must ensure that they are making payments for only those services for which they are responsible and in the dollar amounts specified by these pre-established contracts. Although the Company cannot predict the nature of future healthcare reforms that will be adopted by federal, state, and local governments, the Company believes that the shifting of traditional insurance risk to providers of care, the consolidation of providers, and the resulting additional information management requirements placed on providers and payors should increase the demand for the Company's offerings. Moreover, the Company believes that providers, payors, and patients--both separately and together--will benefit from the Company's integration of cost and other financial and clinical data, enabling identification and management by all participants (providers, payors, and patients) of the outcomes (benefits and costs) achieved. The Company observes the intensification of interest in ensuring compliance by providers and payors with the statutory, regulatory, and contractual requirements of managed care. The Company believes that the intensifying concern regarding compliance has increased its costs, as the Company seeks to ensure its own compliance and that of its customers. At the same time, the Company believes that the increased focus on compliance creates a potential market for its products and services. The Company's services also are subject to regulations pertaining to billing services, which primarily involve recordkeeping requirements and other provisions designed to prevent fraud. The Company believes that it operates in a manner consistent with such regulations, the enforcement of which is increasingly more stringent. The Medicare program is administered by the Health Care Financing Administration ("HCFA"), an agency of the United States Department of Health and Human Services. HCFA currently contracts with numerous intermediaries and fiscal agents to process regional claims for reimbursement. Although HCFA has established the regulatory framework for Medicare claims administration, Medicare intermediaries have the authority to develop independent procedures for administering the claims reimbursement process. The Medicaid program is subject to regulation by HCFA, but is administered by state governments. State governments provide for Medicaid claims reimbursement either through the establishment of state-owned and operated processing centers or through contractual arrangements with third-party fiscal agents who own and operate their own processing centers. The requirements and procedures for reimbursement implemented by Medicaid differ from state to state. Similar to the claims administration processes of Medicare and Medicaid, many national health insurance companies and self-insured employers administer reimbursement of claims through local or regional offices. Consequently, because guidelines for the reimbursement of claims are generally established by third-party payors at local or regional levels, hospital and other provider reimbursement managers must remain current with the local procedures and requirements of third-party payors. The ownership and operation of hospitals is subject to comprehensive federal and state regulation, which affects hospital reimbursement. Since adoption, the Medicare and Medicaid programs have undergone significant and frequent changes, and it is realistic to expect additional changes in the future. Specifically, the Balanced Budget Act of 1997 ("BBA"), which is expected to cut Medicare and Medicare-funded Medicaid spending by more than $115 billion over the next four years, could reduce Medicare payments received by hospitals by as much as 10% to 15%. While the BBA could have an adverse effect on the operations of hospitals and other providers of healthcare, and consequently reduce the amount of the Company's revenue, the Company believes that healthcare organizations can use the Company's products and services to reduce costs while maintaining or improving the quality of care (thereby compensating in part or whole losses in revenue due to the BBA). In addition, the Social Security Act imposes certain requirements on the Company with regard to confidentiality and disclosure of Medicare and Medicaid provider and beneficiary data. Specifically, the Company is prohibited from disclosing information that is obtained by or from the Department of Health and Human Services except as otherwise provided by regulations or other federal law. Generally, the Company is required to maintain standards of confidentiality that are comparable to those of an agency administering the Medicare or Medicaid program when the Company uses data obtained from such programs. 3 6 Finally, the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") requires the Secretary of Health and Human Services to adopt national standards for certain types of electronic health information transactions and the data elements used in such transactions and to adopt standards to ensure the integrity and confidentiality of health information. All providers, payors, and clearinghouses will be mandated to use HIPAA standards when electronically exchanging health data covered by HIPAA. Any material restriction on the ability of healthcare providers and payors to obtain or disseminate health information could adversely affect the Company's business, financial condition, and results of operations. The Company believes that the rapidity of consolidation within the healthcare industry will continue to create opportunities for the Company in its role as data consolidator. Yet the rapidity of change suggests that some of the consolidation may have been overdone and may be undone over the next several years, as providers downsize and integrated delivery networks ("IDN's") begin to unbundle. The Company believes these dynamics constitute both a risk to its existing business relationship with Columbia/HCA Healthcare Corporation ("Columbia"), the Company's largest client, and an opportunity for new business in the future. PRINCIPAL PRODUCTS AND SERVICES The Company is organized into two divisions: the Transfer Payment Division and the Software Division. The Transfer Payment Division comprises two business units: the Provider Transfer Payment Unit and the Payor Transfer Payment Unit. The Company's Software Division also comprises two business units: the DSS Unit and the MCIS Unit. Provider Transfer Payment Unit The Provider Transfer Payment Unit within the Transfer Payment Division has delivered RCR services since 1974 and began to deliver CAMS in 1986 and EDI services with the acquisition in 1990 of QMA. In 1997 the Company acquired a computerized medical record-based processing system for managed care public health and ambulatory care facilities as a consequence of its purchase of Global. In 1997 the Company formed a Business Office Outsourcing business unit and in 1998 consolidated this Business Office Outsourcing unit with the remainder of its Provider Transfer Payment Unit. The Company's Provider Transfer Payment Unit offerings are performed on retroactive, concurrent, and prospective bases. The Company's first product, RCR, entails the retroactive recovery of third-party payments due provider healthcare organizations, including large public and voluntary hospitals. RCR services are used by a hospital (most commonly for its emergency room and outpatient clinics) to realize third-party revenue from patient accounts after the hospital has expended its own best efforts at billing and collection, but before the accounts are referred to a collection agency. The Company's specialized data aggregation, data purification, data editing, and electronic claim preparation and transmission routines are designed to facilitate the reimbursement of accounts that remain unpaid because necessary billing information was missing or because third-party coverage was not known. RCR services have evolved from a strictly background process to a process frequently concurrent and integrated with clients' internal processes, entailing onsite support, designed to generate the maximum results through targeted review, analysis, and opportunity identification. RCR services require the hospital to provide the Company with copies of existing data files, demand minimal hospital staff support, and generally involve no patient contact. Through the application of the Company's proprietary technology, the Company's RCR services produce for its hospital clients incremental revenue, which otherwise would remain uncollected. Since 1974, RCR services have generated in excess of $1.3 billion for hospitals from Medicaid, Medicare, and commercial insurors nationwide. Over the last three fiscal years, such services have generated over $360 million in incremental reimbursements. Using database-driven methodologies developed in connection with RCR, the Provider Transfer Payment Unit is able to provide a range of additional retroactive recovery services to healthcare providers. The Unit offers Cost Report recovery services, including Medicare Bad Debt Recovery, in which the Company assists providers in isolating coinsurance and deductible amounts that qualify for Bad Debt reimbursement, and Disproportionate Share services, in which the Company identifies and recalculates improperly classified claims that are eligible for Federal 4 7 Financial Participation. The Unit supports clients' substantiation of future claims for Medicare Bad Debt by establishing appropriate processes. The Provider Transfer Payment Unit furnishes Accounts Receivable Conversion Services, in which the Company liquidates aged accounts from an outgoing patient accounting system before a new patient accounting system is installed. In addition, the Company performs Supplemental Security Income ("SSI") identification and recovery services in order to generate reimbursement from Medicaid for services rendered to recipients approved for SSI upon conclusion of the lengthy SSI application review process. As a result of the technology and expertise developed in providing RCR services, the Company is able to provide custom institutionalized data processing, computer software, and operations support services to hospitals, public health clinics, outpatient treatment facilities, and companies that serve the healthcare industry. In contrast to RCR services, which retrospectively reprocess patient accounts receivable data, CAMS delivered to healthcare providers provides concurrent third-party claim identification, editing, preparation, and electronic claims submission. The Company integrates data derived from the hospital's disparate data collection systems and manages the electronic interfaces between the hospital and the transfer payment agencies upon which the hospital is dependent for reimbursement. CAMS is designed to provide an integrated and comprehensive solution to a hospital's accounts receivable liquidation requirements by combining (i) an intimate familiarity with the principal in-house shared data collection and patient accounting systems found in large urban hospitals with (ii) expertise in the management and liquidation of accounts receivable, thereby offering a hospital a unique opportunity to improve the effectiveness of its accounts receivable management program (enhance revenue and accelerate cash flow) while decreasing its administrative costs. Through its RCR and CAMS offerings, the Company has developed the capability to submit healthcare claims data and to receive remittance data electronically from a diverse array of third-party payors. In addition, the Company provides electronic billing and follow-up services for claims submitted by providers to Medi-Cal (the California Medicaid program). The Company also provides stand-alone EDI services to clients in Illinois, New York, and Pennsylvania. The Company's strategy includes the continued development of EDI services as an integral component of its Business Office Outsourcing offering. Using its EDI capability and medical record-based processing system acquired from Global, the Provider Transfer Payment Unit is also able to provide products and services on a concurrent basis as part of its Business Office Outsourcing offering. The Company created this offering in 1997 to provide a lower-cost alternative to its CAMS offering for hospitals, physician groups, faculty practices, public and private clinic systems, and other healthcare organizations. As part of its Business Office Outsourcing offering, the Company integrates its software, staff, and processes to enable providers, including those bearing financial risk, to manage their data and transfer payment processes. Components of the Company's Business Office Outsourcing offering include pre-treatment patient registration and admission; treatment authorization; claim preparation and billing; account follow-up; and reporting. For providers at financial risk, the Company's Business Office Outsourcing offering includes membership services, claims administration, provider services, risk administration, and management information. The Company's fees are tailored to the particular configuration of service furnished to the client, with the preponderance of the Company's remuneration based upon contingent fee arrangements, which range from single digit fees for full outsourcing to fees of 25% or more for more selective revenue enhancement engagements. The Company recognizes revenue at the time the work on a particular bill submission, claim, recovery, or cost report has been completed and accepted by the client for purposes of initiating the revenue recovery process. Payor Transfer Payment Unit The Payor Transfer Payment Unit began delivery of TPLR services in 1985 and augmented its product line in 1996 with the acquisition of CDR, a provider of hospital-based claim audits to payors, principally Blue Cross and Blue Shield organizations. In 1985, the Company began to offer TPLR services principally to state Medicaid agencies, as a means of identifying third parties with prior liability for Medicaid claims. As part of its TPLR offering, the Company provides hospital-based claims audits on behalf of payors, for the purpose of recovering credit balances and duplicate 5 8 payments. The Company provides services to state Medicaid agencies as well as to Medicaid HMO's and to Blue Cross/Blue Shield organizations and commercial insurers (including managed care payors). The Payor Transfer Payment Unit applies its proprietary information management and coordination of benefits methodologies used in TPLR to examine paid claims datasets in order to identify duplicate payments, overpayments, compliance-related erroneous payments, and other inappropriate payments on behalf of payor organizations. TPLR contracts generally have one to three year terms and provide for contingent fees that typically range from 8% to 10% or more of the amounts recovered for the client. The Company recognizes revenue at the time the work on a particular recovery or disallowance has been submitted to the client or its third-party payors or intermediaries and accepted by the client for purposes of initiating the recovery process. Since 1985, TPLR services (exclusive of those offered by CDR) have generated in excess of $677 million, of which $382 million has been generated in the last three years. DSS UNIT The Company entered the software business in 1995 as a consequence of its merger with HCm. HCm furnishes microcomputer-based distributed decision support systems and services to providers of care and bearers of financial risk in the healthcare industry and comprises the DSS Unit of the Company. In 1996 the DSS Unit acquired QSM and integrated QSM's clinical information systems with HCm's decision support offerings. The DSS Unit provides clients with prospective, concurrent, and retroactive decision support applications and services, including a concurrent managed care contract profiler and payment calculator system and data warehouse services for a substantial number of Columbia facilities. As a consequence, proper calculation of anticipated contractual allowances are now provided as an integrated component of the managed care reimbursement process for a substantial number of Columbia facilities. On a retroactive basis, the DSS Unit performs underpayment recovery services in conjunction with its decision support applications to assist healthcare providers in the recovery of underpayments due from managed care payors; the Company is paid on a contingent fee basis for these underpayment recovery services. In addition, the DSS Unit provides Columbia with prospective DSS applications for reimbursement management. The growth of managed care and the consolidation of healthcare institutions is significantly increasing the complexity of the industry and the associated demand for decision support systems. In the managed care environment, the Company believes decision support to be the linchpin for integrating, analyzing, and understanding key operational, financial, administrative, and clinical data obtained from institutions' transaction-based healthcare information systems. As such, decision support systems and services are increasingly being relied upon to guide the management practices of providers (in areas ranging from managed care contracting and clinical pathways development to physician profiling) to ensure the success and financial and operational viability of their organizations. The current clients for the DSS Unit include more than 500 hospitals and IDN's located primarily in the United States. These hospitals range in size from 50 to more than 1,000 beds, and include many of the most progressive and complex health systems in the Country, as well as some of the largest multi-site hospital chains, managed care organizations, and long-term care institutions. In development with several major healthcare organizations for the past three years, the Company's suite of DSS products and services, called Alliance for Decision Support(TM) ("Alliance"; formerly called HCm Alliance(TM) for Managed Care), was released to the market in June 1998. Alliance enables healthcare providers to perform clinical, cost, and contract management from the perspective of the provider, payor, and/or third-party administrator. Employing advanced systems integration, data validation, and distribution methods, Alliance supports evolving data warehousing and information systems initiatives. Alliance was built with an open system architecture, running on a variety of platforms that support client server processing and world wide web applications. In addition to purchasing the Company's software, customers have the option of partnering with the Company or outsourcing part or all of the operation of the Alliance system to the Company. The Company continues to integrate clinical quality measures within Alliance. 6 9 In partnering relationships, the Company dedicates considerable resources to providing a wide variety of related consulting applications, including managed care strategic consulting, data acquisition, development and training, contract management and compliance, clinical performance measurement, and managed care reporting. Through Alliance for Financial Management(TM) ("FM"; formerly called HCm Alliance(TM) for Financial Modeling), the DSS Unit offers hospitals and long-term care organizations an enterprise-wide financial analysis and modeling application, with capabilities including productivity analysis, budgeting and forecasting, long-range planning and analysis, and provider resource management. FM incorporates multi-dimensional, on-line analytical processing technology, integrated with electronic mail applications and standard spreadsheet tools to support communications and analysis. The DSS Unit also provides FM-related application consulting services, focusing on analysis and development of cost accounting, contract management, budgeting, business lines, and treatment patterns. MCIS Unit In 1997 the Company, which had owned a 43% equity interest in HISCo, acquired from WCAS and various of its affiliates, independent investors, and from certain of the Company's executive officers and directors, the remaining 57% of HISCo's equity. At the time of acquisition, HISCo merged with its operating subsidiary, Health Systems Architects, Inc., and was renamed HSA Managed Care Systems, Inc. Today, this entity comprises the MCIS Unit and furnishes automated business and information solutions, including software and services, to bearers of financial risk in the healthcare industry. The MCIS Unit provides large-scale transaction processing systems and services to large and medium-sized commercial payors and managed care plans, including some large Blue Cross/Blue Shield organizations, as well as to newly formed managed care organizations. Through the implementation of development partnerships with large payor organizations, the MCIS Unit has begun to provide its products and services on an outsourcing basis. In fiscal year 1998, the Company executed an agreement pursuant to which it will complete a full-scale rollout in fiscal year 1999 of its pilot Service Bureau engagement on a per member/per month basis. Both public and private entities are rapidly embracing managed care health plans as a means of providing and managing healthcare services. With this increased demand, the number of existing payors, the number of start-up entities, and the number of IDN's seeking to offer managed care products has greatly increased. To support their businesses, these payors require systems to: manage patient membership, provider contracts, and networks; process and adjudicate claims; manage risk; and perform medical management. The four principal offerings of the MCIS Unit are Health Enterprise Systems ("HES"); ProAlliance(TM) (formerly called Provider Information Management System); CapAlliance(TM) (formerly called The Capitation Facility); and Service Bureau. HES is a risk management solution for payors seeking a strategy to manage their own health plans and market their own products, providing data processing for plans offering a full spectrum of products, from traditional indemnity coverage through complete managed care programs. Comprised of modular systems, HES automates four major areas of healthcare administration: membership and billing; provider administration; capitation; and benefits and claims. ProAlliance(TM) is a data repository enabling proactive management based on integrated information such as credentialing, accreditation, and pricing arrangements. CapAlliance(TM), the Company's stand-alone capitation offering, manages the payment to providers of pre-negotiated per capita amounts. Through its Service Bureau offering, the Company provides its managed care functionality, including hardware and software, in an outsourcing mode. In fiscal year 1998, in conjunction with development partners and on its own, the Company migrated various of its MCIS offerings to an open system architecture, running on platforms that support client server and world wide web applications. The Company's MCIS offerings are sold on a stand-alone basis, or can be integrated into existing systems, the latter option enabling payors to preserve their investments in information technology. The Company believes that these offerings dramatically reduce the cost of processing claims through auto-adjudication. 7 10 CUSTOMERS The Company's client base includes hospitals, IDN's, multi-hospital systems, large commercial payors, Blue Cross/Blue Shield organizations, and state Medicaid agencies. The Company also has a limited number of clients in the United Kingdom. Among the Company's domestic clients are the nation's three largest public health systems. The Company works with selected development partners in the research, development, and testing of its software products and services. MARKET TRENDS/OPPORTUNITIES The demands of managing the delivery of patient care with ever increasing qualitative and quantitative rigor will continue to drive the need for increased amounts of operational, financial, administrative, and clinical information. The Company believes that it possesses the data content, analytic tools, technology, and process management skills required to respond to the current and anticipated needs of provider and payor clients for tools and services to manage this evolving complexity. Cost pressures continue to drive horizontal and vertical integration of providers and payors alike. Consolidation among healthcare organizations is creating larger healthcare delivery systems with greater regional market power. This phenomenon is creating a new market for the Company's products, with fewer but larger client prospects. Despite some recent analyses suggesting that the rapidity of this change may be undone over the next several years, as providers are downsized and IDN's begin to unbundle, the Company believes that it has the opportunity to leverage its products and services across larger enterprises, making the Company's products and services more cost effective for clients. As well, the shifting of financial risk from payors to providers creates the opportunity for the Company to provide its MCIS offerings to providers as well as payors. A certain portion of the accounts receivable against which the Company's traditional receivables management services were focused has been capitated and is no longer subject to recovery through the primary RCR offering. Capitation and other forms of managed care reimbursement, however, have created an opportunity for the Company to augment its RCR offering with underpayment recovery services, enabling providers to ensure proper reimbursement under capitated and other managed care contracts. In addition, providers' commercial insurance portfolios are becoming more problematic. Providers are increasingly seeking assistance from vendors to optimize recovery of commercial insurance claims, which are frequently rejected erroneously as managed care claims. In addition, the Company expects that there will be a growing trend toward outsourcing by healthcare provider organizations in the future. 8 11 COMPETITION Although the Company's products and services involve various proprietary aspects, its business is highly competitive and competition has been consolidating rapidly. While the Company believes that no one company competes with all aspects of its business, several companies, some of which may be larger and have greater financial resources than the Company, compete with the Company in providing one or more of the Company's offerings. The Company also encounters competition from companies attempting to expand the scope of their products and services within or into the healthcare information management services industry. PROVIDER TRANSFER PAYMENT UNIT The Company's Provider Transfer Payment Unit competes with systems integration companies (such as Electronic Data Systems Corporation ["EDS"]), hospital computer systems vendors (such as HBOC & Company ["HBOC"], which has announced its intent to be acquired by McKesson Corporation, and Shared Medical Systems Corporation ["SMS"]), EDI companies (such as National Data Corporation ["NDC"], MedE America Corporation ("MedE"), and QuadraMed Corporation ["QMDC"]), and national public accounting firms. The Company competes on the basis of its proprietary systems, existing relationships, long-standing reputation in the provider market segment, and pricing. The Company's EDI offerings compete with numerous entities, including MedE, NDC, and QMDC. PAYOR TRANSFER PAYMENT UNIT The Company's Payor Transfer Payment Unit targets federal and state healthcare agencies and large commercial payors, and competes primarily with national public accounting firms (especially Deloitte & Touche LLP and its frequent business partner Public Consulting Group). The Company competes on the basis of its proprietary systems, historically high recovery rates, and pricing. DSS UNIT The Company's DSS Unit competes with products provided by Transition Systems, Inc. (recently acquired by Eclipsys Corporation), HBOC, and QMDC. Companies that offer financial management products, including Hyperion Software and PeopleSoft, Inc., are also competitors. The Company competes on the basis of its proprietary software and management consulting services. MCIS UNIT The Company's MCIS Unit competes against many companies, including Health Systems Design Corporation and ERISCO, Inc. ("ERISCO"), as well as with in-house systems development groups. The Company sells its products to large provider organizations, and views IDN's as a potential market for its existing products and services. In the provider market, competition comes from large hospital computer systems vendors, such as HBOC and SMS, which also offer managed care information systems as part of their solutions. In the traditional indemnity health insurance market, the Company's MCIS offerings compete with claims adjudication and provider management products from ERISCO, Synertech, a subsidiary of Highmark, Inc., Resource Information Management Systems, Inc., and Rothenberg Health Systems, Inc., which was acquired by QMDC. As the Company enters the IDN market, it will compete with HBOC's Amisys Division and SMS. CSC Healthcare, a subsidiary of Computer Sciences Corporation, has also been investing in and may emerge as a strong competitor in the IDN information systems market. The Company's MCIS offerings compete on the basis of its proprietary software, healthcare software development expertise, and large-scale project management capabilities. 9 12 SIGNIFICANT CONTRACTS The Company's largest client is Columbia, a customer of the DSS Unit. This client accounted for 10%, 12%, and 8% of the Company's total revenue in fiscal years 1998, 1997, and 1996, respectively. The Company provides its services to Columbia primarily principally pursuant to a series of 12-month work order agreements. There is no assurance that any of these agreements will be renewed. The Company's second largest client is a group of healthcare facilities under the governance of Los Angeles County, for which the Company provides a full range of provider business office outsourcing products and services, including managed care services. During fiscal years 1998, 1997, and 1996, this group accounted for 9%, 12%, and 12%, respectively, of the Company's total revenue. The Company's ten largest clients accounted for approximately 50% of the Company's revenue in fiscal year 1998. Including the Company's contract with the County of Los Angeles, six of the Company's ten largest contracts expire in fiscal year 1999. The Company provides its services pursuant to agreements subject to competitive re-procurement. There is no assurance that any of these agreements will be renewed and, if renewed, that the fee rates will be equal to those currently in effect. NEW PRODUCTS AND SERVICES The Company's strategy is to continue to strengthen its position as a leading provider of decision support software and services, managed care information systems and services, and transfer payment products and services for both providers and payors. In addition, the Company will continue to leverage its existing software and services to enhance its outsourcing offerings. Key components of the Company's strategy include: (i) increasing levels of investment in product research and development, (ii) enhancing its outsourcing capabilities, (iii) investing in its data warehousing infrastructure, (iv) leveraging existing relationships with large clients through provision of additional Company products and services, and (v) expanding the Company's strategic development partnerships with provider and payor organizations for all aspects of its business. MERGERS AND ACQUISITIONS The Company may acquire companies that supply healthcare providers and payors with information management software, systems, or services if the offerings of such companies would benefit from access to the Company's technology, software applications, or client base. The Company believes that such acquisition opportunities exist due, in part, to competitive pressures on local service businesses that lack adequate capital, technical, and management resources. The Company also believes that consolidation will continue to occur within the healthcare information services industry. EMPLOYEES As of October 31, 1998, the Company had 860 employees: 420 in the Software Division and 440 in the Transfer Payment Division. No employees are covered by a collective bargaining agreement or are represented by a labor union. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Specific financial information with respect to the Company's industry segments is provided in Note 13, Business Segment Information, of Notes to Consolidated Financial Statements, on page F-31 on this Form 10-K. ITEM 2. PROPERTIES The Company's New York City offices consist of approximately 146,000 square feet. In addition, the Company leases approximately 142,000 square feet of office space in approximately 22 locations throughout the United States. Information regarding the Company's leases is included in Note 14, Commitments, of Notes to Consolidated Financial Statements, on page F-32 of this Form 10-K. 10 13 The Company operates IBM CMOS processors, associated peripheral devices from Hitachi Data Systems and EMC Corporation, communications devices, a large number of microcomputers, and extensive local and wide area networks. These technologies facilitate both product development and production processes. The Company's data processing operations afford both batch processing and national on-line network capabilities and are controlled by multiple levels of physical and software security. Each of the Company's critical systems is backed up on a nightly basis. Copies of the Company's operating systems, key applications software, and critical client data are maintained offsite to ensure continuity of business. The Company does not rely on unique hardware or software systems and its purchase and maintenance agreements with vendors provide for back-up support in case of computer systems failure. ITEM 3. LEGAL PROCEEDINGS In April and May 1997, five purported class action lawsuits were commenced in the United States District Court for the Southern District of New York against the Company and certain of its present and former officers and directors alleging violations of the Securities Exchange Act of 1934 in connection with certain allegedly false and misleading statements. These lawsuits, which sought damages in an unspecified amount, were consolidated into a single proceeding captioned In re Health Management Systems, Inc., Securities Litigation (97 CIV-1965 (HB) and a Consolidated Amended Complaint was filed. Defendants made a motion to dismiss the Consolidated Amended Complaint, which was submitted to the Court on December 18, 1997 following oral argument. On May 27, 1998, the Consolidated Amended Complaint was dismissed by the Court for failure to state a claim under the federal securities laws, with leave for the plaintiffs to replead. On July 17, 1998, a Second Consolidated Amended Complaint was filed in the United States District Court of the Southern District of New York, which reiterates plaintiffs' allegations in their prior Complaint. On September 11, 1998, the Company and the other defendants filed a motion to dismiss the second Complaint. The motion was fully briefed in late November 1998, at which time the motion was submitted to the Court. The Company intends to continue its vigorous defense of this lawsuit. On June 1, 1998, MedE America Corp. commenced a lawsuit against the Company and others in the United States District Court for the Southern District of New York. In its complaint, plaintiff alleges copyright infringement and other violations of its rights relating to the Company's development and sale of certain computer software, known as the Universal Billing Platform, which was recently developed for the Company by certain former employees of plaintiff, who are also defendants in the action, acting as independent contractors. Plaintiff, among other relief, seeks (i) to restrain the Company from continuing to market and sell the alleged infringing software, and (ii) monetary damages in excess of $10,000,000. Over a period in excess of nine months prior to the filing of the complaint, the parties engaged in an extensive exchange of communications, as a result of which the Company concluded, after investigation, that plaintiff's claims were without merit. On July 22, 1998, the Company answered the complaint, denying the material allegations of the complaint. Discovery has commenced, and the Company intends to vigorously contest plaintiff's claims. Pursuant to the Rules of the Court, this matter has been referred to a court-appointed mediator, who in the context of non-binding mediation and independent of the court proceeding, will attempt to assist in settling the matter or narrowing the issues between the parties. Absent a settlement of this matter through mediation, the Company intends to continue its vigorous defense of this lawsuit. On June 28, 1998, eight holders of promissory notes (the "Notes") of HHL Financial Services, Inc. ("HHL") commenced a lawsuit against the Company and others in the Supreme Court of the State of New York, County of Nassau, alleging various breaches of fiduciary duty on the part of the defendants against HHL. The complaint alleges that as a result of these breaches of duty, HHL was caused to make substantial unjustified payments to the Company, which ultimately led to defaults on the Notes and to HHL filing for Chapter 11 bankruptcy protection. On June 30, 1998, the same Note holders commenced a virtually identical action (the "Adversary Proceeding") in the United States Bankruptcy Court for the District of Delaware, where HHL's Chapter 11 proceeding is pending. The Adversary Proceeding alleges the same wrongdoing as the New York State Court proceeding and seeks the same damages, i.e., $2,300,000 (the unpaid amount of the Notes) plus interest. Plaintiffs have moved in the Bankruptcy Court to have the Court abstain from hearing the Adversary Proceeding in deference to the New York State Court action. The Company has opposed plaintiffs' motion for abstention and on September 15, 1998, filed a motion in the Bankruptcy Court to dismiss the Adversary Proceeding. This motion was fully 11 14 briefed in mid-December 1998, at which time the motions were submitted to the Court. The Company intends to continue its vigorous defense of this lawsuit. The Company is a party to several other legal proceedings. In the opinion of the Company's management, none of these other proceedings is expected to have a material adverse effect on the Company's financial position, results of operations, or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Company's common stock is included in the Nasdaq-AMEX National Market System (symbol: HMSY). As of the close of business on January 19, 1999, there were approximately 10,000 holders of the Company's common stock, including the individual participants in security position listings. The Company has not paid any cash dividends on its common stock and does not anticipate paying cash dividends in the foreseeable future. The Company's current intention is to retain earnings to support the future growth of its business. The Company's credit agreement with its bank contains limitations on the Company's ability to pay cash dividends. The table below summarizes the high and low closing prices per share for the Company's common stock for the fiscal year periods indicated, as reported on the Nasdaq-AMEX National Market System.
First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- 1998: Market Price: High $ 7.63 13.38 13.12 9.25 Low 5.25 7.25 7.75 3.94 1997: Market Price: High $27.75 12.37 7.50 10.00 Low 13.00 4.75 4.50 5.63 1996: Market Price: High $26.83 31.75 37.00 31.75 Low 21.33 24.50 25.50 22.25
ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is found on page F-13 of this report. 12 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by Item 7 is found on pages F-1 to F-12 of this report. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is found on pages F-16 to F-37 of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 will be included in the Company's Proxy Statement for the 1999 Annual Meeting of Shareholders (the "Proxy Statement"), which will be mailed within 120 days after the close of the Company's fiscal year ended October 31, 1998, and is hereby incorporated herein by reference to such Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 will be included in the Proxy Statement, which will be mailed within 120 days after the close of the Company's fiscal year ended October 31, 1998, and is hereby incorporated herein by reference to such Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 will be included in the Proxy Statement, which will be mailed within 120 days after the close of the Company's fiscal year ended October 31, 1998, and is hereby incorporated herein by reference to such Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 will be included in the Proxy Statement, which will be mailed within 120 days after the close of the Company's fiscal year ended October 31, 1998, and is hereby incorporated herein by reference to such Proxy Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. Financial Statements - See Index to Consolidated Financial Statements on page F-14. B. Schedule Schedule II - Valuation and Qualifying Accounts C. Reports on Form 8-K None D. Exhibits - See Exhibit Index 13 16 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. HEALTH MANAGEMENT SYSTEMS, INC. ------------------------------ (REGISTRANT) BY: /S/ PAUL J. KERZ ------------------------------ Paul J. Kerz President and Chief Executive Officer DATE: January 11, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signatures Title Date - ---------- ----- ---- /S/ PAUL J. KERZ Chairman, President, January 11, 1999 - ------------------------- Chief Executive Officer, Paul J. Kerz Chief Financial Officer, and Director /S/ ROBERT V. NAGELHOUT Executive Vice President, January 11, 1999 - ------------------------- Chief Operating Officer, and Robert V. Nagelhout Director /S/ DONALD J. STAFFA Senior Vice President and January 11, 1999 - ------------------------ Director Donald J. Staffa /S/ RANDOLPH G. BROWN Director January 11, 1999 - ------------------------ Randolph G. Brown /S/ WILLIAM W. NEAL Director January 11, 1999 - ------------------------- William W. Neal /S/ GALEN D. POWERS Director January 11, 1999 - ------------------------- Galen D. Powers /S/ ELLEN A. RUDNICK Director January 11, 1999 - ------------------------- Ellen A Rudnick /S/ RICHARD H. STOWE Director January 11, 1999 - ------------------------- Richard H. Stowe
14 17 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 2.1 Agreement and Plan of Merger dated as of January 18, 1995 among Health Management Systems, Inc., HCm Acquisition Corp., and all the shareholders of Health Care microsystems, Inc., as amended (Incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the year ended October 31, 1994 and to Exhibit 10.2 to the Company's Registration Statement on Form S-3, file no. 33-91518) 2.2 Agreement and Plan of Merger, dated as of April 29, 1996 among Health Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc., and all the shareholders of CDR Associates, Inc. (Incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 29, 1996) 2.2(i) First Amendment to Agreement and Plan of Merger, dated as of April 29, 1996, among Health Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc., and all the shareholders of CDR Associates, Inc. (Incorporated by reference to Exhibit 2.2(i) to the Company's Annual Report on Form 10-K for the year ended October 31, 1996 [the 1996 Form 10-K].) 2.3 Agreement and Plan of Merger, dated as of September 3, 1996, by and among Health Management Systems, Inc., QSM Acquisition Corporation and Quality Standards in Medicine, Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Registration Statement on Form S-4, File No. 333-13513 [the S-4]) 2.3(i) Amendment to Agreement and Plan of Merger, dated as of November 20, 1996, by and among Health Management Systems, Inc., QSM Acquisition Corporation, and Quality Standards in Medicine, Inc. (Incorporated by reference to Exhibit 10.1 to Post-Effective Amendment No. 1 to the S-4) 2.4 Agreement and Plan of Merger, dated as of March 18, 1997, by and among Health Management Systems, Inc., HISCo Acquisition Corp., Health Information Systems Corporation and HSA Managed Care Systems, Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997 [the April 1997 Form 10-Q]) 2.5 Asset Purchase Agreement, dated as of March 10, 1997, by and among GHS, Inc., Global Health Systems, Inc. GHS Management Services, Inc., Health Management Systems, Inc. and Global Health Acquisition Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1997 [the July 1997 Form 10-Q].) 2.5(i) Assignment and Assumption Agreement, dated as of July 15, 1997, between Global Health Acquisition Corp. and HSA Managed Care Systems, Inc. (Incorporated by reference to Exhibit 2.2 to the July 1997 Form 10-Q.) 3.1 Amended and Restated Certificate of Incorporation of Health Management Systems, Inc. (Incorporated by reference to Exhibit 3.1 to Amendment No. 1 [Amendment No. 1] to the Company's Registration Statement on Form S-1, File No. 33-4644 [the Registration Statement] and Exhibit 3(i) to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996 [the January 1996 Form 10-Q])
15 18 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 3.2 By-Laws of Health Management Systems, Inc. (Incorporated by reference to Exhibit 3.2 to Amendment No. 1) 10.1 Financial Management Services Agreement, dated August 1, 1989, between Health Management Systems, Inc. and the County of Los Angeles (Incorporated by reference to Exhibit 10.2 to the Registration Statement) 10.2(i) Master Software License Agreement, dated June 29, 1992, by and between Health Care microsystems, Inc. and Healthtrust, Inc. - The Hospital Company. 10.2(ii) Amendment, dated as of September 1, 1995, to Master Software License, dated June 29, 1992, by and between Health Care microsystems, Inc. and Columbia/HCA. (Incorporated by reference to Exhibit 10.2(ii) to the 1997 Form 10-K) 10.3(i) Health Management Systems, Inc. Stock Option and Restricted Stock Purchase Plan, as amended (Incorporated by reference to Exhibit 10.3 to the Registration Statement, to Exhibit 10.3 to Amendment No. 2 [Amendment No. 2] to the Registration Statement, Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1994 [the January 1994 Form 10-Q] and Exhibit to the January 1996 Form 10-Q.) 10.3(ii) Amendment No. 6, dated as of December 2, 1997, to the Health Management Systems, Inc., Stock Option and Restricted Stock Purchase Plan. (Incorporated by reference to Exhibit 10.3(iii) to the 1997 Form 10K) 10.3(iii) Health Management Systems, Inc. Employee Stock Purchase Plan, as amended (Incorporated by reference to Exhibit 10.2 to the January 1994 Form 10-Q and to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1995 [the January 1995 Form 10-Q]) 10.3(iv) Health Management Systems, Inc. 1995 Non-Employee Director Stock Option Plan (Incorporated by reference to Exhibit 10.2 to the January 1995 Form 10-Q) 10.3(v) Health Management Systems, Inc. Profit Sharing Plan (Incorporated by reference to Exhibit 10.3(iv) to the Company's Annual Report on Form 10-K for the year ended October 31, 1995 [the 1995 Form 10-K]) 10.3(vi) Health Management Systems, Inc. Profit Sharing Plan, as amended (Incorporated by reference to Exhibit 10.3(vi) to the 1995 Form 10-K) 10.4(i) Credit Agreement and Guaranty Among Health Management Systems, Inc., as Borrower, Accelerated Claims Processing, Inc., Quality Medi-Cal Adjudication, Incorporated, Health Care microsystems, Inc., and CDR Associates, Inc., as Guarantors, and The Chase Manhattan Bank, as Bank (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1996 [the July 1996 Form 10-Q]) 10.4(ii) First Amendment to Credit Agreement and Guaranty and Waiver (Incorporated by reference to Exhibit 10.1(i) to the July 1996 Form 10-Q)
16 19 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 10.4(iii) Guaranty Agreement, dated as of April 16, 1997, between Health Management Systems, Inc. and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the April 1997 Form 10-Q) 10.4(iv) Second Amendment to Credit Agreement and Guaranty, dated as of April 16, 1997, among Health Management Systems, Inc., Accelerated Claims Processing, Inc., Quality Medical Adjudication, Incorporated, Health Care microsystems, Inc., CDR Associates, Inc., and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form 10-Q) 10.4(v) Third Amendment to Credit Agreement and Guaranty, dated as of June 30, 1997, among Health Management Systems, Inc., Accelerated Claims Processing, Inc., Quality Medical Adjudication, Incorporated, Health Care Microsystems, Inc., CDR Associate, Inc., HSA Managed Care Systems, Inc., Quality Standards in Medicine, Inc. and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form 10-Q) 10.5(i) Leases, dated February 1, 1980, September 24, 1981, September 24, 1982, and January 6, 1986, as amended, between 401 Park Avenue South Associates and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.13 to the Registration Statement and to Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1994) 10.5(ii) Lease, dated as of March 15, 1996, by and between 387 PAS Enterprises, as Landlord, and Health Management Systems, Inc., as Tenant (Incorporated by reference to Exhibit 10.2 to the July 1996 Form 10-Q) 10.6 Lease, dated September 1996, by and between Pacific Corporate Towers LLC, Health Management Systems, Inc., and Health Care microsystems, Inc. (Incorporated by reference to Exhibit 10.13 to the 1996 Form 10-K) 10.7 Services Agreement, dated as of October 31, 1995, between Health Information Systems Corporation and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.19(iv) to the 1995 Form 10-K) 10.8 Agreement and Release of Claims dated as of October 29, 1996, by and among HHL Financial Services, Inc., Health Management Systems, Inc., and the First National Bank of Chicago (Incorporated by reference to Exhibit 10.12 to the 1996 Form 10-K) 10.9 Security Agreement, dated as of April 16, 1997, by and between Robert V. Nagelhout and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.3 to the April 1997 Form 10-Q) 10.10 Promissory note, dated as of April 16, 1997, by and between Robert V. Nagelhout and The Chase Manhattan Bank. (Incorporated by reference to Exhibit 10.4 to the April 1997 Form 10-Q) 10.11 Consulting Service Agreement, dated as of May 1, 1997, by and between Improved Funding Techniques, Inc. and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.2 to the July 1997 Form 10-Q)
17 20 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 10.12 Employment Agreement, as of May 1, 1997, by and between Joseph H. Czajkowski and CDR Associates, Inc., a wholly-owned subsidiary of Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.3 to the July 1997 Form 10-Q) 10.13 Employment Agreement, as of May 1, 1997, by and between Jeffrey R. Donnelly and CDR Associates, Inc., a wholly-owned subsidiary of Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.4 to the July 1997 Form 10-Q) 10.14 Sublease Agreement, dated December 23, 1997, between Health Management Systems, Inc. and Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1998 [the January 1998 Form 10-Q]) 10.15 Consent to Sublease, dated December 23, 1997, by 387 P.A.S. Enterprises to the subletting by Health Management Systems, Inc. to Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.2 to the January 1998 Form 10-Q) *10.16 Promissory note, dated as of October 15, 1998, in the principal amount of $500,000 between Paul J. Kerz and HSA Managed Care Systems, Inc. *10.17 Promissory note, dated as of October 15, 1998, in the principal amount of $250,000 between Paul J. Kerz and HSA Managed Care Systems, Inc. *10.18 Security Agreement, dated as of October 15, 1998, between Paul J. Kerz and HSA Managed Care Systems, Inc. *11.0 Computation of Earnings per Share *21.1 List of subsidiaries of Health Management Systems, Inc. *23.1 Consent of KPMG LLP, independent certified public accountants 24.2 Consent of Ernst & Young LLP, independent certified public accountant. (Incorporated by reference to Exhibit 24.2 to the 1996 Form 10-K) 24.3 Report of independent certified public accountants on the financial statements of Health Information Systems Corporation as of and for the period ended October 31, 1996 (Incorporated by reference to Exhibit 24.3 to the 1996 Form 10-K) *27.1 Financial Data Schedule, which is submitted electronically to the Securities and Exchange Commission for informational purposes only
* Filed herewith 18 21 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION This Annual Report on Form 10-K contains forward-looking statements which involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in "Risk Factors" beginning on page F-7. OVERVIEW A healthcare information systems and services enterprise, the Company is organized into two divisions: Transfer Payment Division and Software Division. The Transfer Payment Division comprises two business units: Provider Transfer Payment Unit and Payor Transfer Payment Unit. The Company's Software Division also comprises two business units: DSS Unit and MCIS Unit. Within the Transfer Payment Division, the Provider Transfer Payment Unit has delivered RCR services since 1974 and began to deliver CAMS in 1986 and EDI services with the acquisition in 1990 of QMA. QMA provides electronic billing and automated denial reprocessing services. In 1997 the Company acquired a computerized medical record-based processing system for managed care public health and ambulatory care facilities as part of its purchase of substantially all the Global assets. In 1997 the Company formed a Business Office Outsourcing unit and in 1998 consolidated this Business Office Outsourcing unit with the remainder of its Provider Transfer Payment Unit. The Payor Transfer Payment Unit began delivery of TPLR services in 1985 and augmented its product line in 1996 with the acquisition of CDR. CDR is a provider of hospital-based claim audits to payors, principally Blue Cross and Blue Shield organizations. The Company's Software Division was referred to in the aggregate as MCIS in 1997; in 1998, the MCIS Unit refers to one of the Software Division's two business units, while the DSS Unit refers to the other. The Company entered the software business in 1995 as a consequence of its merger with HCm. HCm furnishes microcomputer-based distributed decision support systems and services to providers of care in the healthcare industry and today comprises the DSS Unit of the Company. In 1996 the DSS Unit acquired QSM and integrated QSM's clinical information systems with HCm's decision support offerings. In 1997 the Company, which had owned a 43% equity interest in HISCo, acquired from WCAS and various of its affiliates, independent investors, and from certain of the Company's executive officers and directors, the remaining 57% of HISCo's equity. At the time of acquisition, HISCo merged with its sole operating subsidiary, Health Systems Architects, Inc., and was renamed HSA Managed Care Systems, Inc.("HSA"). Today, this entity comprises the MCIS Unit and furnishes automated business and information solutions, including software and services, to bearers of financial risk in the healthcare industry. The HCm, CDR, and QSM mergers were accounted for using the pooling of interest method, while the QMA, HISCo, and Global acquisitions were accounted for using the purchase method. F-1 22 RESULTS OF OPERATIONS The table below summarizes the Company's results of operations and the percentage of total revenue of selected line items for the last three fiscal years.
Years Ended October 31, 1998 1997(a) 1996 ($ In Thousands) - --------------------------------------------------------------------------------------------------------------------------------- Amount % Amount % Amount % ------------------------- ------------------------- ------------------------- Revenue: Transfer Payment Division Provider $ 34,987 33% $ 39,007 44% $ 55,410 55% Payor 22,251 21% 16,849 19% 26,406 26% --------- --------- --------- --------- --------- --------- 57,238 54% 55,856 62% 81,816 81% Software Division Provider (DSS) 25,499 24% 24,873 28% 19,510 19% Payor (MCIS) 22,515 21% 8,788 9% 0 0% --------- --------- --------- --------- --------- --------- 48,014 46% 33,661 38% 19,510 19% - --------------------------------------------------------------------------------------------------------------------------------- 105,252 100% 89,517 100% 101,326 100% Cost of services: Compensation 59,288 56% 52,361 58% 49,370 49% Data processing 8,771 9% 7,593 9% 10,282 10% Occupancy 9,663 9% 10,383 12% 8,001 8% Other 17,906 17% 18,018 20% 20,220 20% - --------------------------------------------------------------------------------------------------------------------------------- 95,628 91% 88,355 99% 87,873 87% Operating margin before amortization of intangibles 9,624 9% 1,162 1% 13,453 13% Amortization of intangibles 1,964 2% 1,331 1% 204 0% - --------------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 7,660 7% (169) (0)% 13,249 13% Net interest and net other income 1,700 2% 2,755 3% 987 1% Gain (loss) on investment 597 1% (9) (0)% (927) (1)% Merger related costs 0 0% (537) (1)% (494) (0)% Equity in (loss) earnings of affiliate 0 0% (310) (0)% 50 0% - --------------------------------------------------------------------------------------------------------------------------------- Income before income taxes 9,957 9% 1,730 2% 12,865 13% Income tax (expense) benefit (3,869) (4)% 351 0% (5,574) (6)% - --------------------------------------------------------------------------------------------------------------------------------- Net income $ 6,088 6% $ 2,081 2% $ 7,291 7% - ---------------------------------------------------------------------------------------------------------------------------------
(a) The fiscal year 1997 operating results have been reclassified to include Global in the Transfer Payment Division. F-2 23 YEARS ENDED OCTOBER 31, 1998 AND 1997 Consolidated revenue for the fiscal year ended October 31, 1998 was $105,252,000, an increase of $15,735,000 or 18% from prior year revenue of $89,517,000. Revenue from the Transfer Payment Division was $57,238,000, an increase of $1,382,000 or 2% from the prior year. Revenue from the Software Division was $48,014,000, an increase of $14,353,000 or 43% over the prior year; this increase is primarily attributable to the inclusion of the MCIS Unit results for the entirety of the fiscal year in 1998 but for only two-thirds of the year (March 18 through October 31) in 1997. Cost of services for the fiscal year ended October 31, 1998 was $95,628,000, an increase of $7,273,000 or 8% from the prior year, which included only partial year costs for the MCIS Unit in fiscal year 1997 and partial year costs for the Global acquisition consummated by the Company in July 1997 and reported as part of the Provider Transfer Payment Unit in fiscal year 1998. In summary, increased costs in the Software Division of $11,045,000 (of which $8,962,000 are attributable to the MCIS Unit) were offset by diminished costs of approximately $3,772,000 in the Transfer Payment Division. Compensation expense for the fiscal year ended October 31, 1998 was $59,288,000 or 62% of total cost of services, an increase of $6,927,000 or 13% over the prior year, when compensation cost was 59% of total cost of services. Increased compensation expense was attributable in large part to the addition of full year compensation costs for the MCIS Unit and the full year effect of the Global acquisition, offset by lower compensation expense in the Transfer Payment Division due to reduction in average headcount and decreased deferred compensation benefits. Headcount, the principal driver of compensation expense, for the entire Company increased by 48 or 6% from 812 at the end of October 1997 to 860 at the end of October 1998. Headcount for the DSS Unit decreased from 248 at the end of 1997 to 229 at the end of 1998, while headcount for the MCIS Unit increased from 142 to 191; thus, headcount for the Software Division increased by 30, from 390 to 420. Headcount for the Transfer Payment Division increased by 18, from 422 to 440. Data processing expense for the fiscal year ended October 31, 1998 was $8,771,000, an increase of $1,178,000 or 16% from the prior year. The increase is due primarily to full year costs of operations in fiscal year 1998 associated with acquisitions completed during the course of fiscal year 1997. Occupancy expense for the fiscal year ended October 31, 1998 was $9,663,000, a decrease of $720,000 or 7% from the prior year. The decrease is attributable to the subletting of two floors at the Company's New York City offices, offset by increases associated with acquisitions completed during the course of fiscal year 1997. Other operating expense for the fiscal year ended October 31, 1998 was $17,906,000, a decrease of $112,000 or 1% from the prior year. This decrease was attributable to cost reductions in the Transfer Payment Division, offset in part by full year costs in fiscal year 1998 for acquisitions completed during the course of fiscal year 1997. Operating margin before amortization of intangible assets for the fiscal year ended October 31, 1998 was $9,624,000, an increase of $8,462,000 or 728% from the $1,162,000 realized in fiscal year 1997. The Company's operating margin rate before amortization of intangible assets was 9.1%, compared to 1.3% in the prior year. Amortization of intangible assets for the fiscal year ended October 31, 1998 was $1,964,000, an increase of $633,000 from the prior year. This increase was attributable to a full year of amortization of intangibles for both the Global and HSA acquisitions. Net interest and other income for the fiscal year ended October 31, 1998 was $2,297,000, an increase of $398,000 over the prior year. Fiscal year 1998 other income included $597,000 in capital gains compared to a loss of $9,000 in the prior year. The prior year also included $877,000 in interest expense reversal resulting from a favorable Internal Revenue Service audit resolution, merger expense of $537,000 and equity losses in F-3 24 HISCo of $310,000, none of which events occurred in fiscal year 1998. Finally, fiscal year 1998 interest income declined by $178,000 from the prior year due to lower interest rates and lower cash balances. The Company's income tax expense for the fiscal year ended October 31, 1998 was $3,869,000, resulting in an effective tax rate of approximately 38.9%. This compared to an income tax benefit of $351,000 for fiscal year 1997. The fiscal year 1998 tax rate of 38.9% is lower than the Company's normal rate of slightly under 42% and is attributable to available capital losses carried forward which sheltered the entirety of a $593,000 long term capital gain, both for tax and financial statement purposes. The effective tax rate for fiscal year 1998 exclusive of the benefit of the tax-sheltered capital gain was 41.3%, compared to an equivalent effective tax rate of 42.9% in fiscal year 1997. The tax benefit in fiscal year 1997 was primarily due to a reversal of $1,093,000 in accrued taxes arising from the favorable resolution of an Internal Revenue Service audit. Net income for the fiscal year ended October 31, 1998 was $6,088,000, an increase of $4,007,000 or 193% from the prior year. Diluted earnings per share were $0.34 in fiscal year 1998, compared to $0.12 in fiscal year 1997. Included in the fiscal year 1998 earnings per share are $0.03 resulting from $593,000 in fully sheltered long-term capital gains; included in fiscal year 1997 earnings per share were $0.06 attributable to non-recurring events, which were a $310,000 loss in earnings due to the Company's [then] equity interest in HISCo, $537,000 in merger related costs, offset by a one-time benefit from the reversal of a $877,000 reserve for interest expense and $1,093,000 in accrued taxes resulting from a favorable resolution of an Internal Revenue Service audit concluded fiscal year 1997. Earnings per share without the one-time and unusual events increased from $0.06 in Fiscal Year 1997 to $0.31 in fiscal year 1998, an increase of $0.25 per share. YEARS ENDED OCTOBER 31, 1997 AND 1996 Consolidated revenue for the fiscal year ended October 31, 1997 was $89,517,000, a decrease of $11,809,000 or 12% from the prior year. Consolidated revenue during fiscal year 1996 gave effect to a charge during the third quarter occasioned by the default of HHL Financial Services, Inc. ("HHL") on its obligations under a data processing agreement with the Company. Before the HHL revenue reversal of $2,180,000 in the third quarter of fiscal year 1996, consolidated revenue decreased $13,989,000 or 14%. Revenue from the Transfer Payment Division was $55,855,000, a decrease of $25,960,000 or 32% from the prior year. Before the HHL revenue reversal, Transfer Payment Division revenue decreased $23,780,000 or 29% from the prior year due to the non-recurrence in 1997 of one-time projects in 1996, a contract hiatus with a major client, lower billing volumes and fee rates, and contract expirations. Revenue by division during fiscal year 1997 has been reclassified to transfer Global revenue from the Software Division to the Transfer Payment Division. Revenue from the Software Division during the fiscal year ended October 31, 1997 was $33,661,000, an increase of $14,151,000 or 73% from the prior year period. Revenue from DSS services was $24,873,000, an increase of $5,363,000 or 28% over the prior year due to the continued growth of software consulting fees and maintenance contract revenue. Revenue from MCIS for fiscal year 1997 was $8,788,000. There was no comparable prior year revenue for MCIS because HSA was acquired during fiscal year 1997 in a transaction accounted for under the purchase method. Cost of services for the fiscal year ended October 31, 1997 was $88,355,000, an increase of $482,000 or less than 1% from the prior year. Prior to the effect of the one-time HHL charge of $6,704,000 in the third quarter of 1996, comprised of $1,362,000 of compensation costs, $2,199,000 of data processing costs, and $3,143,000 of other operating costs (including $2,881,000 of bad debt expense related to HHL receivables and $262,000 of net other operating expenses), cost of services increased $7,186,000 or 9% over the prior year. This increase was due primarily to the added cost of services resulting from the HSA and Global acquisitions, which added costs of services by $9,249,000, and increased operating costs of DSS services of $3,228,000, which increases were offset by certain cost reductions in the Transfer Payment Division. Compensation expense for the fiscal year ended October 31, 1997 was $52,361,000 or 59% of total cost of services, an increase of $2,991,000 or 6% from the prior year. Compensation expense in 1997 compared F-4 25 to 1996 prior to the HHL one-time charge of $1,362,000 in the third quarter of 1996 increased $4,353,000 or 9%. The increased compensation expense was primarily attributable to operating costs resulting from the HSA and Global acquisitions, which increased compensation expense by $6,395,000, and increased compensation cost from DSS services of $2,642,000. Included in compensation expense in 1997 was severance cost of $568,000 in connection with two reductions in force in the Transfer Payment Division. These cost increases were partially offset by lower compensation expenses, including bonus and profit sharing expenses, in the Transfer Payment Division. Data processing expense for the fiscal year ended October 31, 1997 was $7,593,000, a decrease of $2,689,000 or 26% from the prior year. Prior to the effect of the HHL one-time charge in the third quarter of 1996 of $2,199,000, data processing expense decreased $490,000 or 6%. The decrease in cost was due to certain cost reductions and lower Transfer Payment Division revenue, which more than offset the $1,087,000 increase in operating costs from the HSA and Global acquisitions. Occupancy expense for the fiscal year ended October 31, 1997 was $10,383,000, an increase of $2,382,000 or 30% over the prior year. This increase was primarily due to the expansion of the Company's facilities, including additional floors at the Company's New York City offices, and $813,000 in additional operating expense from the HSA and Global acquisitions. Other operating expense for the fiscal year ended October 31, 1997 was $18,018,000, a decrease of $2,202,000 or 11% from the prior year. Prior to the effect of the HHL one-time charge of $3,143,000 in the third quarter of 1996, other operating expenses increased $941,000 or 6%. The increase was due to an additional $954,000 in other operating expenses attributable to HSA and Global. Operating margin before amortization of intangible assets for the fiscal year ended October 31, 1997 was $1,162,000, a decrease of $12,291,000 or 91% from the prior year. The Company's operating margin rate before amortization of intangible assets was 1.3%, compared to 13.3% in the prior year. Prior to the effect of the HHL one-time charge and revenue reversal in 1996, operating margin before amortization decreased $21,175,000 or 95%. Amortization of intangible assets for the fiscal year ended October 31, 1997 was $1,331,000, an increase of $1,127,000 from the prior year. The increase resulted primarily from the amortization of software and goodwill acquired in the HSA and Global acquisitions. Net interest and net other income for the fiscal year ended October 31, 1997 was $2,746,000, an increase of $1,759,000. The increase was partially due to a reversal of $877,000 in accrued interest expense resulting from a favorable resolution of an Internal Revenue Service audit during fiscal year 1997. In addition, the Company wrote off its investment in HHL of $927,000 in 1996 as part of the one-time charge. Merger related costs of $537,000 were incurred in the fiscal year ended October 31, 1997 related to the Company's merger with QSM in November 1996. Merger related costs of $494,000 were incurred in the fiscal year end October 31, 1996 related to the Company's merger with CDR in April 1996. The Company recognized a loss of $310,000 through March 18, 1997 (the date on which the Company acquired the remaining 57% of HISCo's equity which it did not already own) from its equity investment in HISCo, compared to earnings of $50,000 in the prior year. The Company's income tax benefit for the fiscal year ended October 31, 1997 was $351,000. The tax benefit was primarily due to a reversal of $1,093,000 in accrued taxes arising from the favorable Internal Revenue Service audit resolution in 1997. Exclusive of the Internal Revenue Service audit resolution, the effective tax rate was 42.9%. This compares to income tax expense of $5,574,000 and an effective tax rate of 43.3% for fiscal year 1996. Net income for the fiscal year ended October 31, 1997 was $2,081,000, a decrease of $5,210,000 or 71% from the prior year. Earnings per share were $0.12 in 1997 compared to $0.39 in 1996. Earnings per share excluding all one-time events were $0.06 in 1997 compared to $0.72 in 1996. F-5 26 LIQUIDITY AND CAPITAL RESOURCES At October 31, 1998, the Company had $56,709,000 in net working capital, an increase of $2,910,000 or 5% from the level at October 31, 1997. The Company's principal sources of liquidity at October 31, 1998 consisted of cash, cash equivalents, and short-term investments aggregating $28,402,000, net accounts receivable of $54,993,000, and an available balance of $30,000,000 under its bank line of credit. On June 11, 1998, an officer and director of the Company repaid a loan guaranteed by the Company to the bank and the available balance under the Company's line of credit with the bank increased by $1,600,000 from $28,400,000 to $30,000,000. See Note 16(c) of the Notes to Consolidated Financial Statements. Accounts receivable at October 31, 1998 reflected an increase of $15,474,000 or 39% from the October 31, 1997 balance. The increase in accounts receivable results primarily from revenue increases in the Payor Transfer Payment Unit and its elongated receivables liquidation cycle. The Company's bank line of credit expires on July 15, 1999. Although the Company intends to secure a new line of credit at that time, there can be no assurance that the Company will be able to do so on terms which are acceptable to it. On May 28, 1997, the Board of Directors authorized the Company to repurchase such number of shares of its common stock that have an aggregate purchase price not in excess of $10,000,000. The Company is authorized to repurchase these shares from time to time on the open market or in negotiated transactions at prices deemed appropriate by the Company. Repurchased shares are deposited in the Company's treasury and used for general corporate purposes. In the fourth quarter of fiscal year 1998, the Company repurchased 185,000 shares of common stock at an average price of $6.97 per share, for an aggregate purchase price of $1,290,000. In fiscal year 1998, the Company repurchased a total of 734,500 shares of common stock at an average price of $8.01 per share, for an aggregate purchase price of $5,887,000. Since the inception of the repurchase program in June 1997, the Company has repurchased in the open market 1,049,000 shares of common stock at an average price of $7.39 per share, for an aggregate purchase price of $7,750,000. INFLATION The Company's business is labor intensive. Wages and other employee-related expenses increase during periods of inflation and when shortages in the skilled labor market occur. Although the moderate inflation rates of the past several years have not imposed significant problems for the Company, the Company implemented selective wage increases in fiscal year 1998 to assure retention of qualified personnel in key areas of its operations. RISK FACTORS This Annual Report on Form 10-K and other statements issued or made from time to time by the Company or its representatives contain statements which may constitute "forward-looking statements" within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. Those statements include statements regarding the intent, belief or current expectations of the Company and members of its management, as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are set forth in the safe harbor compliance statement for forward-looking statements set forth below. The Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time. F-6 27 PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 SAFE HARBOR COMPLIANCE STATEMENT FOR FORWARD-LOOKING STATEMENTS In passing the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), Congress encouraged public companies to make "forward-looking statements" by creating a safe harbor to protect companies from securities law liability in connection with forward-looking statements. The Company intends to qualify both its written and oral forward-looking statements for protection under the Reform Act and any other similar safe harbor provisions. "Forward-looking statements" are defined by the Reform Act. Generally, forward-looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected. Due to those uncertainties and risks, prospective investors are urged not to place undue reliance on written or oral forward-looking statements of the Company. The Company undertakes no obligation to update or revise this safe harbor compliance statement for forward-looking statements to reflect future developments. In addition, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time. The Company provides the following risk factor disclosure in connection with its continuing effort to qualify its written and oral forward-looking statements for the safe harbor protection of the Reform Act and any other similar safe harbor provisions. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include the following: VARIABILITY OF OPERATING RESULTS; LENGTH OF SALES CYCLES; TERMINABILITY OF CUSTOMER CONTRACTS. The Company's revenue and operating results may vary significantly from quarter to quarter as a result of a number of factors, including the number and timing of systems sales; the termination of, or a reduction in, offerings of the Company's products and services; the loss of customers due to consolidation in the healthcare industry; the length of the sales cycles and delays in the implementation process; and general economic conditions. The Company experiences sales cycles of three to eighteen months. As a result, the Company's results of operations are subject to significant fluctuations and its results of operations for any particular quarter or fiscal year may not be indicative of results of operations for future periods. A significant portion of the Company's operating expenses are fixed, and planned expenditures are based primarily on sales forecasts. Any inability of the Company to reduce spending or to compensate for any failure to meet sales forecasts or receive anticipated revenues could magnify the adverse impact of such events on the Company's operating results. Further, the commencement of one or more major implementations could generate a large increase in revenue and net income for any given quarter or fiscal year, which increase may prove anomalous when compared to changes in revenues and net income in other periods, and which may not provide a valid basis for future projections. The Company's ability to complete implementation of its systems and recognize revenue is dependent on certain factors outside the control of the Company, including its customers' ability to allocate internal resources to the implementation process and, with respect to certain customers, the need to obtain necessary approvals upon completion of work but prior to customer acceptance. In addition, many of the Company's agreements with its customers may be terminated under certain circumstances upon 30 to 90 days notice. The termination of customer agreements could have a material adverse effect on the Company's business, financial condition and results of operations. F-7 28 NEW PRODUCT DEVELOPMENT AND SYSTEM ENHANCEMENT The Company's future performance will depend in large part upon the Company's ability to provide the increasing functionality required by its customers through the timely development and successful introduction of new products and enhancements to its existing suite of products. The Company has historically devoted significant resources to product enhancements and research and development and believes that significant continuing development efforts will be required to adapt to changing marketplace requirements, to sustain its operations and integrate the products and technologies of acquired businesses. There can be no assurance that the Company will successfully or in a timely manner develop, acquire, integrate, introduce and market new product enhancements or products, or that product enhancements or new products developed by the Company will meet the requirements of hospitals or other healthcare providers and payors and achieve or sustain market acceptance. LIMITED PROPRIETARY RIGHTS; RISK OF INFRINGEMENT The Company's success is dependent to a significant extent on its ability to maintain the proprietary and confidential aspects of its data processing and computer software technology. The Company relies on a combination of trade secrets, copyright and trademark laws, nondisclosure and other contractual provisions to protect its proprietary rights. There can be no assurance that the measures taken by the Company to protect its intellectual property will be adequate or that the Company's competitors will not independently develop products and services that are substantially equivalent or superior to those of the Company. Substantial litigation regarding intellectual property rights exists in the software industry, and the Company expects that software products may be increasingly subject to third-party infringement claims as the number of competitors in the Company's industry segment grows and the functionality of products overlaps. Although the Company believes that its products do not infringe upon the proprietary rights of third parties, a lawsuit alleging copyright infringement has been filed against the Company, and there can be no assurance that other third parties will not assert infringement claims against the Company in the future or that a license or similar agreement will be available on reasonable terms in the event of an unfavorable ruling on any such claim. In addition, any claim may require the Company to incur substantial litigation expenses or subject the Company to significant liabilities and could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be successful in its defense of any such claims. See "Item 3, Legal Proceedings" for additional information regarding the copyright infringement claim pending against the Company. RISK OF PRODUCT DEFECTS; FAILURE TO MEET PERFORMANCE CRITERIA Products and services such as those offered by the Company at times contain errors or failures, especially when initially introduced or when new versions are released or processes implemented. Although the Company conducts extensive testing, software errors have been discovered in certain enhancements and products and services after their introduction. There can be no assurance that, despite testing by the Company and by current and potential customers, errors or performance failures will not occur in these products and services under development or in other enhancements or products after commencement of commercial shipments or implementations, resulting in loss of revenue and customers, delay in market acceptance, diversion of development resources, damage to the Company's reputation or increased service and warranty costs, any of which could have a material adverse effect upon the Company's business, financial condition and results of operations. F-8 29 ACQUISITIONS AND EXPANSION The Company's strategy includes the expansion of its business through selective acquisitions. In pursuing such acquisitions, the Company competes with other prospective acquirors, some of which may have greater financial resources than the Company. There can be no assurance that suitable acquisition opportunities will be identified or that acquisitions can be consummated or integrated successfully into the Company's operations. In addition, future acquisitions by the Company could result in potentially dilutive issuances of equity securities, the incurrence of debt and contingent liabilities and amortization expenses related to goodwill and other tangible assets, any of which could materially adversely affect the Company's operating results and financial position. Growth through acquisition entails certain risks in that acquired operations could be subject to unanticipated business uncertainties or legal liabilities. The Company seeks to minimize these risks through investigation and evaluation of the operations proposed to be acquired and through transaction structure and indemnification. The various risks associated with the acquisitions and operational integration of future acquisitions and the subsequent performance of such acquired operations may adversely affect the Company's results of operations. The ability of the Company to acquire additional operations may depend upon its ability to obtain appropriate financing and personnel. COMPETITION The business of providing information management and data processing products and services to hospitals and other healthcare providers and to government health service agencies and other healthcare payors is highly competitive. The Company's competitors vary in the size, scope and breadth of the products and services they offer. There can be no assurance that competitors will not develop or offer products with superior functionality, or that other features of competitive products will not be preferred by the Company's customers. Several of the Company's competitors have significantly greater financial, technical, product development and marketing resources than the Company. In the future, additional competitors could enter the market, including providers of information systems to other segments of the healthcare industry, and compete with the Company. A substantial amount of the Company's sales are derived from competitive procurement processes managed directly by sophisticated clients or consultants that require specific, highly detailed presentations from several qualified vendors. There can be no assurance that future competition will not have a material adverse effect on the Company's business, financial condition and results of operations. HEALTHCARE PAYMENT COMPLEXITY The complexity of the healthcare transfer payment process, and the experience of the Company in offering services that improve the ability of its customers to recover incremental revenue through that process, have been contributing factors to the success of the Company's service offerings. Complexities of the healthcare transfer payment process include multiple payors, the coordination and utilization of clinical, operational, financial and/or administrative review instituted by third-party payors in an effort to control costs and manage care. If the payment processes associated with the healthcare industry are simplified, the need for services such as those offered by the Company could be reduced, and there could be a resulting adverse effect on the Company's business, results of operations or financial condition. F-9 30 HEALTHCARE REGULATION AND REFORM The healthcare industry in the United States is subject to changing political, economic and regulatory influences that may affect the procurement practices and operations of healthcare organizations. The Company's products are designed to function within the structure of the healthcare financing and reimbursement system currently being used in the United States. During the past several years, the healthcare industry has been subject to increasing levels of governmental regulation of, among other things, reimbursement rates and certain capital expenditures. From time to time, certain proposals to reform the healthcare system have been considered by Congress. These proposals, if enacted, may increase government involvement in healthcare, lower reimbursement rates and otherwise change the operating environment for the Company's clients. Healthcare organizations may react to these proposals and the uncertainty surrounding such proposals by curtailing or deferring investments, including those for the Company's products and services. The Company cannot predict with any certainty what impact, if any, such proposals or healthcare reforms might have on its results of operations, financial condition or business. DEPENDENCE UPON KEY PERSONNEL As the Company's success depends upon the continued contributions of its senior management, the loss of services of certain of the Company's executive officers could have an adverse effect on the Company's business. Accordingly, although the Company does not have long term service agreements with most of its executive officers, the Company does have confidentiality, non-compete and non-solicitation agreements with most of its management and certain other key employees. In general, such agreements (i) require the employee to protect the confidential and proprietary information of the Company and (ii) preclude the employee from soliciting other employees of the Company or competing with the Company for periods of up to three years following termination of employment. In addition, the Company believes that its continued success also will depend in large part on its ability to attract and retain highly-skilled management, technology, marketing, and sales personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel as necessary. Furthermore, the Company's ability to manage change and growth successfully will require the Company to continue to improve its management expertise as well as its financial systems and controls. Additions of new personnel, and departures of existing skilled employees, can be disruptive and could have a material adverse effect on the Company's business, financial condition and results of operations. POSSIBLE VOLATILITY OF STOCK PRICES The market price of the Company's common stock has been subject in the past and could be subject in the future to significant fluctuations in response to variations in the Company's quarterly operating results and other factors, such as announcements of technological innovations or new products by the Company or by the Company's competitors, adoption of new or amended government regulations, challenges to or changes in patent or other proprietary rights, and developments in the Company's relationships with its customers. In addition, the stock market has in recent years experienced and continues to experience significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Broad market fluctuations, as well as fluctuating economic conditions generally, may adversely affect the market price of the Company's common stock. F-10 31 CERTAIN ANTI-TAKEOVER PROVISIONS The Company's certificate of incorporation, as amended, authorizes the issuance of up to 5,000,000 shares of "blank check" preferred stock with such designations, rights and preferences as may be determined by the Company's Board of Directors. Accordingly, the Company's Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights which could adversely affect the voting power or other rights of holders of the Company's common stock. In the event of issuance, preferred stock could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change in control of the Company. Although the Company has no present intention to issue any shares of preferred stock, there can be no assurance that the Company will not do so in the future. In addition, the Company's by-laws provide for a classified Board of Directors, which provision could also have the effect of discouraging a change of control of the Company. LITIGATION The Company is a party to various proceedings as described under Item 3, "Legal Proceedings," of this Report, which description is incorporated herein by reference. Although the Company believes that it has meritorious defenses to the claims of liability or for damages in the actions against the Company, there can be no assurance that an outcome favorable to the Company will be reached in any of these litigations or that additional lawsuits will not be filed against the Company. Further, there can be no assurance that these lawsuits will not have a disruptive effect upon the operations of the business, that the defense of the lawsuits will not consume the time and attention of the senior management of the Company, or that the resolution of the lawsuits will not have a material adverse effect upon the Company, including without limitation, the Company's results of operations, financial position and cash flow. The Company is a party to several other legal proceedings. In the opinion of the Company's management, none of these other proceedings is expected to have a material adverse effect on the Company's financial position, results of operations, or liquidity. YEAR 2000 In common with many other companies, the "Year 2000 ("Y2K") computer issue" creates risks for the Company. To address these Y2K issues, the Company formulated a plan and began work at the end of 1997. The plan has assessment and remediation proceeding in tandem with completion and testing of critical systems by mid-1999. The Company has put in place a working committee and continues to track to plan and original costs estimates. Activities included in this plan are intended to encompass all major categories of systems in use by the Company, including product development, operations, sales, finance, and human resources. Interactions with major suppliers of products and services have been identified and the Company is working to ensure uninterrupted delivery of those products and services. Contingency plans for all potential single points of disruption have been or are being developed. It is expected that assessment and remediation will be completed by mid-1999, and contingency planning activities will be completed by the autumn of 1999. The Company is working closely with, and has developed and delivered correspondence to, all of its clients potentially affected by the Y2K problem as to the status of the Company's plans. The Company continues to work with its clients to ensure a smooth transition to the next millennium. The Company also responded to the passage of the Y2K Information and Disclosure Act ("Y2K Act") enacted on October 19, 1998. The purpose of the Y2K Act is to encourage and promote disclosure regarding Y2K issues and to provide limitations for claims on tort liability. The Company has designed and tested the most current versions of its products for Y2K Compliance. A significant number of the Company's customers are running product versions that are not Y2K compliant. While the Company has been encouraging such customers to migrate to current versions, it is possible that the Company may experience increased expenses in addressing migration issues and may lose customers. Moreover, the revenue stream and financial stability of existing customers may be adversely impacted by Y2K problems, which could F-11 32 cause fluctuations in the Company's revenue. In addition, there can be no assurances that the Company's current products do not contain undetected errors or defects associated with Y2K date functions that may result in the material costs to the Company. Moreover, the assessment of whether a complete system will operate correctly depends on the hardware capability of the system and software design and integration, and for most end-users this will include hardware and software provided by companies other than the Company. Except as specifically provided for in the limited warranty accompanying the current versions of its products, the Company does not believe it is legally responsible for costs incurred by customers related to ensuring their Y2K capability. Nevertheless, the Company is incurring various costs to provide customer support and customer satisfaction services regarding Y2K issues, and it is anticipated that these expenditures will continue through 1999 and thereafter. The costs incurred to date related to these programs are estimated at less than $1,000,000. The Company currently expects that the total cost of these programs, including both incremental spending and redeployed resources, will not exceed $2,000,000. The total cost estimate does not include potential costs related to any customer or other claims or the cost of internal software and hardware replaced in the normal course of business. In some instances, the installation schedule of new software and hardware in the normal course of business is being accelerated to afford a timely solution to Y2K capability issues. The total cost estimate is based on the current assessment of relevant projects and is subject to change as the projects progress. The expenses incurred by the Company to identify and address the Y2K matters discussed above, or the expenses or liabilities to which the Company may become subject as a result of such matters, could have a material adverse effect on the Company's business, financial condition and results of operation. In addition, there can be no assurance that the failure to ensure Y2K capability by a supplier or another third party would not have a material adverse effect on the Company. F-12 33 SELECTED CONSOLIDATED FINANCIAL DATA
Years Ended October 31, 1998 1997 (a) 1996 (b) 1995 (b) 1994 (b) ($ In Thousands, Except Per Common Share Data) - -------------------------------------------------------------------------------------------------------------------------------- STATEMENT OF OPERATIONS DATA: Revenue $ 105,252 89,517 101,326 90,495 73,940 Cost of services 95,628 88,355 87,873 73,035 61,094 - -------------------------------------------------------------------------------------------------------------------------------- Operating margin before amortization of 9,624 1,162 13,453 17,460 12,846 intangibles Amortization of intangibles (c) 1,964 1,331 204 243 190 - -------------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 7,660 (169) 13,249 17,217 12,656 Net interest and net other income 1,700 2,746 987 942 464 Gain (loss) on investment 597 0 (927) 0 0 Merger related costs 0 (537)(d) (494)(e) (1,045)(f) (59)(f) Equity in (loss) earnings of affiliate (g) 0 (310) 50 0 0 - -------------------------------------------------------------------------------------------------------------------------------- Income before income taxes 9,957 1,730 12,865 17,114 13,061 Income tax (expense) benefit (3,869) 351 (5,574) (8,152) (6,353) - -------------------------------------------------------------------------------------------------------------------------------- Net income 6,088 2,081 7,291 8,962 6,708 - -------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE DATA: Diluted net income attributable to common $ 0.34 $ 0.12 $ 0.39 $ 0.51 $ 0.40 shareholders Weighted average common shares and common share equivalents 17,833 17,979 18,494 17,579 16,674 - -------------------------------------------------------------------------------------------------------------------------------- SELECTED OPERATING DATA: Operating margin as a percentage of revenue 9% 1% 13% 19% 17% Operating income (loss) as a percentage of revenue 7% (0)% 13% 19% 17% - --------------------------------------------------------------------------------------------------------------------------------
October 31, -------------------------------------------------------------------- 1998 1997 1996 1995 1994 - -------------------------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA: Cash and short-term investments $ 28,402 39,080 39,521 30,112 27,827 Working capital 56,709 53,799 54,753 41,413 35,732 Total assets 117,802 109,694 109,643 88,101 70,689 Common shareholders' equity 83,269 79,806 74,612 58,203 46,662 - --------------------------------------------------------------------------------------------------------------------------------
NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA (a) Includes the revenue and costs associated with the Company's HSA and Global acquisitions. See Notes 2(a) and 2(b) of Notes to Consolidated Financial Statements. (b) Financial data for the years 1994 through 1996 has been restated to reflect the merger with QSM in 1997. See Note 2(c) of Notes to Consolidated Financial Statements. (c) Intangible assets were principally recorded in connection with the Company's 1989 recapitalization, its acquisition of QMA in 1990, and its HSA and Global acquisitions in 1997. See Notes 1(e) and 6 of Notes to Consolidated Financial Statements. (d) Includes costs associated with the Company's merger with QSM. See Note 2(c) of Notes to Consolidated Financial Statements. (e) Includes costs associated with the Company's merger with CDR. See Note 2(d) of Notes to Consolidated Financial Statements. (f) Includes costs associated with the Company's merger with HCm. (g) In March 1997, the Company acquired the remaining outstanding shares of HISCo not already owned by the Company. The acquisition was accounted for using the purchase method. See Note 2(b) of Notes to Consolidated Financial Statements. F-13 34 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE CONSOLIDATED FINANCIAL STATEMENTS NUMBER - --------------------------------- ------ Report of Independent Certified Public Accountants F-15 Consolidated Statements of Operations for the Years Ended October 31, 1998, 1997, and 1996 F-16 Consolidated Balance Sheets as of October 31, 1998 and 1997 F-17 Consolidated Statements of Shareholders' Equity for the Years Ended October 31, 1998, 1997, and 1996 F-18 Consolidated Statements of Cash Flows for the Years Ended October 31, 1998, 1997, and 1996 F-19 Notes to Consolidated Financial Statements F-20 FINANCIAL STATEMENT SCHEDULE: Schedule II - Valuation and Qualifying Accounts F-37
F-14 35 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors and Shareholders Health Management Systems, Inc.: We have audited the accompanying consolidated financial statements of Health Management Systems, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Health Management Systems, Inc. and subsidiaries as of October 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended October 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. New York, New York November 24, 1998 F-15 36 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS ($ In Thousands, Except Per Share Amounts)
Years ended October 31, ------------------------------- 1998 1997 1996 ---- ---- ---- Revenue: Trade $105,252 $89,186 $ 95,719 Affiliates 0 331 5,607 -------- ------- -------- 105,252 89,517 101,326 Cost of services: Compensation 59,288 52,361 49,370 Data processing 8,771 7,593 10,282 Occupancy 9,663 10,383 8,001 Other 17,906 18,018 20,220 -------- ------- -------- 95,628 88,355 87,873 -------- ------- -------- Operating margin before amortization of intangibles 9,624 1,162 13,453 Amortization of intangibles 1,964 1,331 204 -------- ------- -------- Operating income (loss) 7,660 (169) 13,249 Other income (expense): Net interest and net other income 1,700 2,755 987 Gain (loss) on investment 597 (9) (927) Merger related costs 0 (537) (494) Equity in (loss) earnings of affiliate 0 (310) 50 -------- ------- -------- 2,297 1,899 (384) Income before income taxes 9,957 1,730 12,865 Income tax (expense) benefit (3,869) 351 (5,574) -------- ------- -------- Net income $ 6,088 $ 2,081 $ 7,291 ======== ======= ======== Earnings per share data: Basic: Basic earnings per share $ 0.35 $ 0.12 $ 0.42 ======== ======= ======== Weighted average common shares outstanding 17,366 17,611 17,166 ======== ======= ======== Diluted: Diluted earnings per share $ 0.34 $ 0.12 $ 0.39 ======== ======= ======== Weighted average common shares and common share equivalents 17,833 17,979 18,494 ======== ======= ========
See accompanying notes to consolidated financial statements. F-16 37 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ($ In Thousands, Except Per Share Amounts)
October 31, October 31, 1998 1997 ----------- ----------- ASSETS Current assets: Cash and cash equivalents $ 13,883 $ 20,694 Short-term investments 14,519 18,386 Accounts receivable, billed, net 28,792 22,593 Accounts receivable, unbilled, net 26,201 16,926 Income tax receivable 2,340 510 Other current assets 4,021 2,874 ----------- ----------- Total current assets 89,756 81,983 Property and equipment, net 6,687 7,988 Goodwill, net 11,742 12,316 Capitalized software costs, net 4,203 2,020 Deferred income taxes 3,303 2,721 Other assets 2,111 2,666 ----------- ----------- Total assets $ 117,802 $ 109,694 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable and accrued expenses $ 15,864 $ 16,153 Deferred revenue 5,876 5,122 Deferred income taxes 11,307 6,909 ----------- ----------- Total current liabilities 33,047 28,184 Other liabilities 1,486 1,704 ----------- ----------- Total liabilities 34,533 29,888 Shareholders' equity: Preferred stock - $.01 par value; 5,000,000 shares authorized; none issued and outstanding 0 0 Common stock - $.01 par value; 45,000,000 shares authorized; 18,332,367 shares issued and 17,283,367 shares outstanding at October 31, 1998; 17,773,653 shares issued and 17,459,153 shares outstanding at October 31, 1997 183 178 Capital in excess of par value 71,134 67,304 Retained earnings 19,595 13,506 Unrealized appreciation on short-term investments 107 681 ----------- ----------- 91,019 81,669 Less treasury stock, at cost 1,049,000 shares at October 31, 1998 and 314,500 shares at October 31, 1997 (7,750) (1,863) ----------- ----------- Total shareholders' equity 83,269 79,806 Total liabilities and shareholders' equity $ 117,802 $ 109,694 =========== =========== See accompanying notes to consolidated financial statements.
F-17 38 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY ($ In Thousands)
Unrealized Common Stock Appreciation -------------------- Capital In (Loss) Total Par Excess Of Retained on Short-term Treasury Shareholders' Shares Value Par Value Earnings Investments Stock Equity ------ ----- ---------- -------- ----------- ----- ------ Balance at October 31, 1995 16,562,912 $165 53,439 4,135 464 0 58,203 Net income 0 0 0 7,290 0 0 7,290 Stock option activity 794,994 8 5,629 0 0 0 5,637 Employee stock purchase plan activity 163,085 2 2,330 0 0 0 2,332 Disqualifying dispositions 0 0 1,143 0 0 0 1,143 Appreciation on short-term investments 0 0 0 0 7 0 7 ---------- ---- ------ ------ ---- ------ ------ Balance at October 31, 1996 17,520,991 $175 62,541 11,425 471 0 74,612 Net income 0 0 0 2,081 0 0 2,081 Stock option activity 69,480 1 333 0 0 0 334 Employee stock purchase plan activity 95,332 1 708 0 0 0 709 Stock issued to retire QSM debt 87,850 1 1,434 0 0 0 1,435 Stock issued to non-employees 0 0 98 0 0 0 98 Disqualifying dispositions 0 0 2,190 0 0 0 2,190 Treasury stock acquisition (314,500) 0 0 0 0 (1,863) (1,863) Appreciation on short-term investments 0 0 0 0 210 0 210 ---------- ---- ------ ------ ---- ------ ------ Balance at October 31, 1997 17,459,153 $178 67,304 13,506 681 (1,863) 79,806 Net income 0 0 0 6,088 0 0 6,088 Stock option activity 440,316 4 2,713 0 0 0 2,717 Employee stock purchase plan activity 118,398 0 515 0 0 0 515 Treasury stock acquisition (734,500) 1 0 0 0 (5,887) (5,886) Disqualifying dispositions 0 0 602 0 0 0 602 Depreciation on short-term investments 0 0 0 0 (574) 0 (574) ---------- ---- ------ ------ ---- ------ ------ Balance at October 31, 1998 17,283,367 $183 71,134 19,595 107 (7,750) 83,269 ========== ==== ====== ====== ==== ====== ======
See accompanying notes to consolidated financial statements. F-18 39 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS ($ In Thousands)
Years ended October 31, ------------------------------------ 1998 1997 1996 -------- -------- -------- Operating activities: Net income $ 6,088 $ 2,081 $ 7,291 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Loss on investment 0 0 927 Depreciation and amortization 3,520 3,811 3,117 Amortization of intangibles 1,964 1,331 204 Provision for doubtful accounts 838 538 4,485 Loss on disposal of assets 0 17 0 Deferred tax expense (benefit) 4,022 (1,635) (424) Equity in loss (earnings) of affiliate 0 310 (50) Stock options issued to non-employees 0 98 0 Changes in assets and liabilities: (Increase) decrease in accounts receivable (15,474) 5,008 (15,188) (Increase) decrease in other current assets (2,977) 4,137 (793) Increase (decrease) in accounts payable and accrued expenses (289) (2,910) 3,196 Increase (decrease) in amounts payable to affiliates 0 (747) 902 Increase (decrease) in deferred revenue 754 (575) 881 Increase (decrease) in other assets and liabilities, net (1,497) (1,531) 2,187 Net cash (used in) provided by operating activities -------- -------- -------- (3,051) 9,933 6,735 -------- -------- -------- Investing activities: Capital asset expenditures (1,263) (2,462) (4,456) Acquisition of assets of subsidiaries of GHS, Inc. 0 (2,146) 0 Software capitalization (3,138) (1,498) (1,151) Investment in affiliates 0 0 (28) Acquisition of remainder of Health Information Systems Corporation, net of cash acquired 0 (3,689) 0 Net proceeds (purchases) in short-term investments 3,295 (964) 2,106 -------- -------- -------- Net cash used in investing activities (1,106) (10,759) (3,529) -------- -------- -------- Financing activities: Proceeds from issuance of common stock 515 709 2,332 Proceeds from exercise of stock options 2,717 334 5,637 Common stock repurchases (5,886) (1,863) 0 Proceeds from notes payable 0 0 340 -------- -------- -------- Net cash (used in) provided by financing activities (2,654) (820) 8,309 -------- -------- -------- Net (decrease) increase in cash and cash equivalents (6,811) (1,646) 11,515 Cash and cash equivalents at beginning of period 20,694 22,340 10,825 -------- -------- -------- Cash and cash equivalents at end of period $ 13,883 $ 20,694 $ 22,340 ======== ======== ========
See accompanying notes to consolidated financial statements. F-19 40 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Founded in 1974, Health Management Systems, Inc. (the "Company") provides information management software, systems and services to healthcare providers and payors. (a) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Cash and Cash Equivalents For purposes of financial reporting, the Company considers all highly liquid investments purchased with an original maturity of three months or less (including money market instruments of $6,231,000 and $6,283,000 at October 31, 1998 and 1997, respectively) to be cash equivalents. (c) Short-Term Investments Short-term investments are recorded at fair value. Included in short-term investments are investments classified as available for sale and carried at fair value. Debt securities that the Company does not have the intent and ability to hold to maturity are classified either as "available for sale" or as "trading" and are carried at fair value. Unrealized gains and losses on securities classified as available for sale are carried as a separate component of shareholders' equity. Unrealized gains and losses on securities classified as trading are reported in earnings. Management determines the appropriate classification of its investments in debt and equity securities at the time of purchase and reevaluates such determination at each balance sheet date. At October 31, 1998 and 1997, the Company recorded cumulative unrealized appreciation of $107,000 and $681,000, respectively, on these short-term investments. (d) Depreciation and Amortization of Property and Equipment Property and equipment are recorded at cost. Depreciation is provided over the estimated useful lives of the property and equipment utilizing the straight-line method. Amortization of leasehold improvements is provided over the estimated useful lives of the assets or the terms of the leases, whichever is shorter, utilizing the straight-line method. The estimated useful lives are as follows: Equipment 3-5 years Leasehold improvements 5-8 years Furniture and fixtures 5-7 years (e) Intangible Assets Intangible assets have been recorded primarily as a result of the recapitalization of the Company in 1989, the acquisition of Quality Medi-Cal Adjudication, Incorporated ("QMA") in 1990, the acquisition of the remaining shares of Health Information Systems Corporation ("HISCo") in March 1997, and the acquisition of the assets of Global Health Systems, Inc. and GHS Management Services, Inc. (collectively "Global"), subsidiaries of GHS, Inc., in July 1997. Intangible assets consist of software, customer lists, and goodwill, which are being amortized on a straight-line basis over three years, three years and between ten and forty years, respectively. F-20 41 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (f) Software Development Costs The Company capitalizes software development costs (related to software developed for resale) incurred subsequent to the establishment of technological feasibility of the product, including costs incurred to develop upgrades subsequent to the commercial release of the product. Amortization of software development costs is determined on a product-by-product basis to be the greater of the amount computed on a straight-line basis over the expected economic life of the product, generally estimated to be 36-48 months, or using the ratio of current gross revenue to total current and anticipated future gross revenue, whichever is greater. Software development costs are stated at original cost of $6,893,000 and $3,755,000 less accumulated amortization of $2,690,000 and $1,735,000 at October 31, 1998 and 1997, respectively. Amortization expense for the years ended October 31, 1998, 1997, and 1996 was $956,000, $992,000, and $543,000, respectively. (g) Revenue Recognition The Company generally recognizes revenue for financial reporting purposes when billings are submitted to clients or their third-party payors or intermediaries as a consequence of services performed by the Company for a client. Accounts receivable, unbilled, net, represents amounts recognized for services rendered but not yet invoiced and is based on the Company's estimate of the fees that will be invoiced upon receipt of remittance data. Accounts receivable, billed, net, represents amounts invoiced to clients. Several client contracts contain periodic fee limitations that the Company believes will be exceeded in the normal course of business. As a result, the fees allowable under these contracts are recognized on a straight-line basis over the fee limitation period as services are performed, and amounts billed in excess of revenue recognized are deferred. Other contracts have sliding fee scales for which revenue is fairly predictable. For these, the Company recognizes revenue, at the estimated effective fee rate, ratably over the client's contract year. Finally, certain contracts are subject to fixed-fee arrangements covering specified periods, which the Company realizes on a straight-line basis over the corresponding periods. The Company recognizes revenue from consulting services as the services are provided. Revenue from software products sold to customers under license agreements is deferred and recognized as revenue upon software installation and satisfaction of significant Company obligations, if any, and collection of the resulting receivable is reasonably assured. Revenue from ongoing maintenance agreements is deferred and recognized as revenue on a straight-line basis over the periods of the respective maintenance agreements. (h) Income Taxes Income taxes are accounted for under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. (i) New Accounting Pronouncements On June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general purpose financial statements. SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. The Company will adopt SFAS No. 130 for the fiscal year ended October 31, 1999. F-21 42 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of An Enterprise and Related Information." SFAS No. 131 established standards for reporting information about operating segments in annual financial statements and in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. In general, such information must be reported for externally in the same manner used for internal management purposes. SFAS No. 131 is effective for financial statements issued for periods beginning after December 15, 1997. In the initial year of adoption, comparative information for earlier years must be restated. The Company will adopt SFAS No. 131 for fiscal year ended October 31, 1999. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2 "Software Revenue Recognition" ("SOP 97-2"). SOP 97-2 is effective for transactions entered into in fiscal years beginning after December 15, 1997. The Company does not believe the adoption of the provisions of SOP 97-2 will have an impact on the revenue recognition of software products. (j) Net Income Per Common Share In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("FSAS 128"). The Company adopted SFAS 128 during the quarter ended January 31, 1998, and earnings per share amounts for all periods presented in the accompanying consolidated statement of operations are calculated and presented in accordance with SFAS 128. The statement specifies new standards for the computation and presentation of earnings per share, requiring the presentation of both "basic" and "diluted" earnings per share. Basic earnings per share is based on the net income for the relevant period divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share is based on the net income for the relevant period divided by the weighted average number of common shares and common stock equivalents outstanding during the period. The Company had weighted average common shares and common stock equivalents outstanding during fiscal years 1998, 1997, and 1996 of 17,366,000, 17,611,000 and 17,166,000 and of 467,000, 368,000, and 1,328,000, respectively. The Company's common stock equivalents consist principally of stock options. As of October 31, 1998, the Company had 1,802,102 potentially dilutive common shares outstanding that could have an effect on future calculations of fully diluted earnings per share. (k) Use of Estimates The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reported period. The actual results could differ from those estimates. (l) Reclassifications Certain reclassifications were made to prior year amounts to conform to the 1998 presentation. (m) Fair Value of Financial Instruments The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties. With the exception of short-term investments (see Note 1(c)), the carrying amounts of the Company's financial instruments included in the accompanying consolidated balance sheets approximate estimated fair value as of October 31, 1998 and 1997. (n) Stock-Based Compensation The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related F-22 43 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On October 31, 1997, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation", which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro-forma net income and pro-forma earnings per share disclosures for employee stock option grants made in fiscal 1996 and future years as if the fair-value based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro-forma disclosure provisions of SFAS No. 123. (o) Accounting for the Impairment of Long-Lived Assets The Company reviews its long-lived assets, certain identifiable intangibles, and goodwill for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. 2. BUSINESS COMBINATIONS (a) Acquisition of the Assets of Global Health Systems Inc. and GHS Management Services, Inc. In July 1997, the Company acquired substantially all the assets of Global for $2,146,000. Global provides computerized record-based processing systems and services for managed care, public health and ambulatory care facilities. The acquisition was accounted for using the purchase method and accordingly the results of operations for Global from the date of acquisition through October 31, 1998 are included in the accompanying consolidated financial statements. The $1,701,000 excess of the purchase price over the fair market value of the identifiable assets acquired was recorded as goodwill and is being amortized over a period not to exceed 20 years. (b) Acquisition of Health Information Systems Corporation In March 1997, the Company, which owned 43% of the equity of Health Information Systems Corporation ("HISCo"), acquired the remaining 57% of HISCo's equity for $3,689,000, net of cash acquired from Welsh, Carson, Anderson & Stowe ("WCAS"), a limited partnership affiliated with WCAS, other affiliates of WCAS, independent investors, and certain of the Company's executive officers and directors. HISCo has been renamed HSA Managed Care Systems, Inc.("HSA") HSA provides automated business and information solutions, including software and services, to the bearers of risk in the healthcare industry. At the end of fiscal year 1997, HSA became the MCIS segment of the Company's Software Systems and Services Division ("Software Division"). The acquisition was accounted for using the purchase method and accordingly the results of operations of HSA from the date of acquisition through October 31, 1998 are included in the accompanying consolidated financial statements. The $2,309,000 excess of the purchase price over the fair market value of the identifiable net assets acquired was recorded as goodwill and is being amortized over a period not to exceed 20 years. The following unaudited pro forma financial information presents the combined results of operations of the Company and HSA as if the acquisition had occurred as of the beginning of fiscal years 1997 and 1996, after giving effect to certain adjustments. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company and HSA constituted a single entity during such periods. F-23 44 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Year ended October 31, 1997 1996 - ----------------------------------------------------------------------------- Revenue $ 94,582,000 116,892,000 Net Income $ 1,671,000 7,358,000 - ----------------------------------------------------------------------------- Earnings per share $ 0.09 0.40 - -----------------------------------------------------------------------------
(c) Merger with Quality Standards in Medicine, Inc. In November 1996, the Company completed the acquisition of Quality Standards in Medicine, Inc. ("QSM"), a Boston-based company providing clinical quality management systems, for 260,000 shares of the Company's common stock. This transaction was accounted for using the pooling of interests method. Accordingly, the accompanying consolidated financial statements have been retroactively restated through 1994 for periods presented to include the financial position, results of operations, and cash flows of QSM. Founded in 1986, QSM provides hospitals with sophisticated systems and consulting services to help define and measure the quality of care. QSM has clients located primarily in 13 states and the District of Columbia. Operationally, QSM has been combined with the Company's Health Care microsystems, Inc. ("HCm") subsidiary, providing Decision Support Software ("DSS") as part of the Company's Software Division. (d) Merger with CDR Associates, Inc. In April 1996, the Company acquired all the outstanding capital stock of CDR Associates, Inc. ("CDR") in exchange for 460,000 shares of the Company's stock in a merger transaction which was accounted for using the pooling of interests method. Accordingly, the accompanying consolidated financial statements have been retroactively restated for all periods presented to include the financial position, results of operations, and cash flows of CDR. The CDR product makes up part of the Company's Third Party Liability Recovery ("TPLR") Services in the Company's Transfer Payment Services Division ("Transfer Payment Division"). 3. ACCOUNTS RECEIVABLE BILLED, NET AND UNBILLED, NET Accounts receivable billed, net and unbilled, net as of October 31, 1998 and 1997 were $28,792,000 and $26,201,000, and $22,593,000, and $16,926,000, respectively. Accounts receivable are reflected net of an allowance for doubtful accounts of $1,853,000 and $1,428,000 at October 31, 1998 and 1997, respectively. 4. FEES HELD IN ESCROW The Company is obligated to maintain a portion of fees received from two clients in escrow accounts. The Company's obligation to maintain such fees in escrow terminates at either: (a) the earlier of six years from the dates of service associated with fees generated and settlement of the client's Medicaid and/or Medicare audits for each applicable year, and/or (b) termination of the contract. Due to the 1994 renewal of one client contract that eliminated future escrow requirements and the Company's fulfillment of its maximum escrow deposit for the second client, the Company completed its obligation to make escrow deposits as of October 31, 1994. As of October 31, 1998 and 1997, fees held in escrow were $457,000 and $772,000, respectively. 5. PROPERTY AND EQUIPMENT Property and equipment as of October 31, 1998 and 1997 consisted of the following:
1998 1997 - ---------------------------------------------------------------------------------------------- Equipment $15,411,000 14,697,000 Leasehold improvements 6,035,000 5,728,000 Furniture and fixtures 5,119,000 4,877,000 - ---------------------------------------------------------------------------------------------- 26,565,000 25,302,000 Less accumulated depreciation and amortization (19,878,000) (17,314,000) - ---------------------------------------------------------------------------------------------- $6,687,000 7,988,000 - ----------------------------------------------------------------------------------------------
F-24 45 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Depreciation and amortization expense related to property and equipment charged to operations for the years ended October 31, 1998, 1997, and 1996 was $2,592,000, $2,819,000, and $2,574,000, respectively. 6. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill and other intangible assets as of October 31, 1998 and 1997 consisted of the following:
1998 1997 - ------------------------------------------------------------------------------ Goodwill 14,298,000 14,298,000 Less accumulated amortization (2,556,000) (1,982,000) - ------------------------------------------------------------------------------ 11,742,000 12,316,000 - ------------------------------------------------------------------------------ Other intangible assets 7,036,000 7,036,000 Less accumulated amortization (6,325,000) (4,935,000) - ------------------------------------------------------------------------------ 711,000 2,101,000 - ------------------------------------------------------------------------------
Amortization expense related to intangible assets charged to operations for the years ended October 31, 1998, 1997, and 1996, was $1,964,000, $1,331,000, and $204,000, respectively. 7. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses as of October 31, 1998 and 1997 consisted of the following:
1998 1997 - --------------------------------------------------------------------------- Accrued compensation $ 5,802,000 4,633,000 Accrued direct project costs 1,763,000 3,282,000 Accrued HHL one-time charges 519,000 719,000 Accounts payable and other accrued expenses 7,719,000 7,519,000 - --------------------------------------------------------------------------- $ 15,803,000 16,153,000 - ---------------------------------------------------------------------------
8. CREDIT FACILITY On June 30, 1997, the Company amended its unsecured revolving credit facility with a major money center financial institution in order to remain in compliance with one of the financial covenants of the credit agreement. The credit facility has a term of three years, carries an unused commitment fee of 20 basis points, and bears interest at the institution's prime lending rate, or LIBOR plus 5/8%, at the Company's option. The revolving credit facility contains, among other things, restrictions on additional borrowings, capital expenditures, leases, sales of assets, and payments of dividends. The revolving credit facility also contains covenants that require the Company to maintain minimum tangible consolidated shareholders' equity and limit debt-to-equity and debt-to-asset relationships as defined in the agreement. The Company's plans to repurchase up to $10,000,000 in common stock would have brought the Company below the minimum consolidated tangible net worth test in fiscal year 1998. The amended credit agreement reduced the credit facility to $30,000,000 and lowered the minimum consolidated tangible net worth test for fiscal years 1998 and 1999. The Company had an available balance under this credit facility of $30,000,000 at October 31, 1998 and $28,400,000 at October 31, 1997. See Note 16(c) - Related Party Transactions. The Company's bank line of credit expires on July 15, 1999. Although the Company intends to obtain a new line of credit at that time, there can be no assurance that the Company will be able to do so on terms which are acceptable to it. Cash interest payments including bank charges attributable to the aforementioned credit facility for the years ended October 31, 1998, 1997, and 1996 were $59,000, $0, and $68,000, respectively. F-25 46 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INCOME TAXES Income tax benefit (expense) for the years ended October 31, 1998, 1997, and 1996 was comprised of the following:
1998 1997 1996 - -------------------------------------------------------------------------------------------------- Current tax (expense) benefit: Federal $ 577,000 (716,000) (4,264,000) State and local (423,000) (568,000) (1,734,000) - -------------------------------------------------------------------------------------------------- 154,000 (1,284,000) (5,998,000) - -------------------------------------------------------------------------------------------------- Deferred tax (expense) benefit: Federal (3,505,000) 1,136,000 448,000 State and local (518,000) 499,000 (24,000) - -------------------------------------------------------------------------------------------------- (4,022,000) 1,635,000 424,000 - -------------------------------------------------------------------------------------------------- Income tax (expense) benefit, net $ (3,869,000) 351,000 (5,574,000) - --------------------------------------------------------------------------------------------------
F-26 47 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation of the income tax benefit (expense) to the federal statutory rate of 34% follows:
1998 1997 1996 - ---------------------------------------------------------------------------------------------------------------------------------- Income tax (expense) benefit: Computed at federal statutory rate $(3,386,000) (34.0)% (588,000) (34.0)% (4,374,000) (34.0)% State and local tax expense, net of federal (621,000) (6.2)% (46,000) (2.7)% (1,160,000) (9.0)% benefit Amortization of goodwill (83,000) (0.8)% (70,000) (4.0)% (55,000) (0.4)% Merger related costs 0 0.0% (183,000) (10.6)% (157,000) (1.2)% Equity loss in affiliate 0 0.0% (88,000) (5.1)% 0 0.0% Municipal interest 181,000 1.8% 258,000 14.9% 233,000 1.8% IRS audit resolution 0 0.0% 1,093,000 63.2% 0 0.0% Amortization of software (104,000) (1.0)% (24,000) (1.4)% 0 0.0% Tax contingency 261,000 2.6% 0 0.0% 0 0.0% Other, net (117,000) (1.3)% (1,000) 0.0% (61,000) (0.6)% - ---------------------------------------------------------------------------------------------------------------------------------- Total income tax (expense) benefit $(3,869,000) (38.9)% 351,000 20.3% (5,574,000) (43.4)% ==================================================================================================================================
Deferred income taxes are recognized for the future tax consequences of temporary differences between the financial statement and tax bases of assets and liabilities. The types of temporary differences that give rise to the deferred tax liability, and the effect on the deferred income tax benefit (expense) of changes in those temporary differences, are as follows:
1998 1997 1996 - ------------------------------------------------------------------------------------------------------------- Accounts receivable $ (3,466,000) 3,298,000 (3,294,000) Fees held in escrow 141,000 188,000 108,000 Depreciable and amortizable assets (314,000) 12,000 397,000 Allowance for doubtful accounts 132,000 (206,000) 653,000 Unbilled costs (12,000) 259,000 (156,000) Accounts payable and other accrued expenses (124,000) (1,273,000) (170,000) Deferred revenue (157,000) (196,000) 275,000 Deferred rent (55,000) 14,000 237,000 Contract termination contingency 0 1,093,000 479,000 HHL one-time charges 0 (1,434,000) 2,070,000 Other (167,000) (120,000) (175,000) - ------------------------------------------------------------------------------------------------------------- Deferred income tax (expense) benefit $ (4,022,000) 1,635,000 424,000 =============================================================================================================
F-27 48 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The tax effect of temporary differences that give rise to a significant portion of the deferred tax assets and deferred tax liabilities at October 31, 1998 and 1997 were as follows:
1998 1997 - -------------------------------------------------------------------------------------------------------------- Deferred tax assets: Accounts receivable/deferred items $ 343,000 $ 1,061,000 Property and equipment 3,354,000 2,838,000 HHL one-time charges 335,000 689,000 Allowance for doubtful accounts 705,000 573,000 Accounts payable and accrued expenses 170,000 367,000 Net operating loss carryforward 1,396,000 1,396,000 Other 637,000 692,000 - -------------------------------------------------------------------------------------------------------------- Total deferred tax assets before valuation 6,940,000 7,616,000 Less: Valuation allowances (1,396,000) (1,396,000) - -------------------------------------------------------------------------------------------------------------- Total deferred tax assets after valuation $ 5,544,000 $ 6,220,000 ============================================================================================================== Deferred tax liabilities: Accounts receivable/deferred items $ 10,200,000 $ 7,436,000 Property and equipment 1,722,000 892,000 Other 1,626,000 2,080,000 - -------------------------------------------------------------------------------------------------------------- Total deferred tax liabilities $ 13,548,000 $10,408,000 ============================================================================================================== Net current deferred tax liabilities $(11,307,000) $(6,909,000) Net noncurrent deferred tax assets 3,303,000 2,721,000 - -------------------------------------------------------------------------------------------------------------- Total net deferred tax liabilities $ (8,004,000) $(4,188,000) ==============================================================================================================
The valuation allowances for the fiscal years ended October 31, 1998, 1997, and 1996 were $1,396,000, $1,396,000 and $0, respectively. At October 31, 1998, the Company had a net operating loss carryforward for federal income tax purposes of $3,988,000, which is available to offset future federal taxable income of the Company's QSM subsidiary through 2012. The Company's management believes that the utilization of such net operating loss carryforward is in doubt. Cash payments attributable to income taxes for the years ended October 31, 1998, 1997, and 1996 were $2,412,000, $1,263,000, and $5,896,000, respectively. The Company has had significant disqualifying disposition transactions during the three years ended October 31, 1998. Disqualifying dispositions are non-cash transactions and are excluded from the statements of cash flows. The tax benefit derived from disqualifying dispositions increased shareholders' equity by $602,000, $2,190,000, and $1,143,000 during the fiscal years ended October 31, 1998, 1997, and 1996. 10. EQUITY On May 28, 1997, the Board of Directors authorized the Company to repurchase such number of shares of its common stock that have an aggregate purchase price not in excess of $10,000,000. The Company is authorized to repurchase these shares from time to time on the open market or in negotiated transactions at prices deemed appropriate by the Company. Repurchased shares are deposited in the Company's treasury and used for general corporate purposes. In the fourth quarter of fiscal year 1998, the Company repurchased 185,000 shares of common stock at an average price of $6.97 per share, using $1,290,000. In fiscal year 1998, the Company repurchased a total of 734,500 shares of common stock at an average price of $8.01 per share, for an aggregate purchase price of $5,887,000. Since the inception of the repurchase program in June 1997, the Company has repurchased in the open F-28 49 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS market 1,049,000 shares of common stock at an average price of $7.39 per share having an aggregate purchase price of $7,750,000. The Company's certificate of incorporation, as amended, authorizes the issuance of up to 5,000,000 shares of "blank check" preferred stock with such designations, rights and preferences as may be determined by the Company's Board of Directors. 11. PROFIT SHARING AND 401(k) PLAN The Company had a discretionary defined contribution profit sharing plan in which a substantial number of its employees participated. For the years ended October 31, 1998, 1997, and 1996, profit sharing expense was $0, $197,000, and $944,000 respectively. Effective January 1, 1992, the Company amended its profit sharing plan to include a 401(k) plan, which permits an employee to contribute a portion of the employee's compensation, subject to certain limitations. At its discretion, the Company may make annual contributions to the 401(k) plan for the benefit of participating employees. For the years ended October 31, 1998, 1997, and 1996, 401(k) plan expense was $959,000, $804,000, and $611,000, respectively. Effective October 31, 1997, the Company terminated its profit sharing plan, including the 401(k) plan. A replacement, but identical, 401(k) plan was established as of November 1, 1997. Having obtained approval by the Internal Revenue Service, an initial distribution of the assets of the terminated profit sharing plan was completed on December 18, 1998, with the balance to be distributed in March 1999. 12. STOCK-BASED COMPENSATION PLANS At October 31, 1998, the Company had three stock-based compensation plans, which are described below. The Company has adopted the disclosure-only provisions of SFAS 123 and applies APB Opinion No. 25 and related Interpretations in accounting for its plans. Accordingly, no employee compensation costs have been recognized for its stock purchase plan and stock option plans. Had compensation costs for the Company's three stock-based compensation plans been determined consistent with fair value method prescribed by SFAS 123, the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below:
1998 1997 1996 - --------------------------------------------------------------------------------------------------------------- Net income As reported $ 6,088 $ 2,081 $ 7,291 Pro forma 2,189 837 6,630 Net income per diluted share As reported 0.34 0.12 0.39 Pro forma 0.12 0.05 0.36 - ---------------------------------------------------------------------------------------------------------------
The effect noted above by applying the disclosure-only provisions of SFAS 123 may not be representative of the pro forma effect in future years. The fair value of the stock options granted in 1998, 1997, and 1996 is estimated at the grant date using the Black-Scholes option-pricing model with the following assumptions: dividend yield of 0% (the Company does not pay dividends); expected volatility of 48.9%, 51.4%, and 51.4%; a risk-free interest rate of 5.7%, 5.8%, and 5.8%; and expected lives of 4.91, 4.90, and 4.90 years, respectively. F-29 50 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Effective May 31, 1989, the Company adopted the Health Management Systems, Inc. Stock Option and Restricted Stock Purchase Plan (the "Plan") under which: (a) options can be granted to purchase shares of the Company's common stock at an exercise price equal to (incentive stock options) or less than (non-qualified stock options) the estimated fair market value of the Company's common stock, or (b) rights can be granted in the form of an award to purchase shares of the Company's common stock at a price equal to, more than, or less than the estimated fair market value of the Company's common stock. Subsequent amendments to the Plan, which have been approved by shareholders, have increased the number of shares available to be issued under the Plan to 6,750,000 shares. The Plan expires in May 1999. The stock options become exercisable and expire at various dates through November 2008. As of October 31, 1998, no stock appreciation rights or stock purchase awards had been granted. Effective November 13, 1998, the Company awarded 1,655,850 stock options. Of the total options, 1,418,500 options are subject to a performance based accelerated vesting schedule. These options are to vest 100 percent on October 31, 2003, subject to accelerated vesting of all or a portion of the total options upon realization of certain annual performance measures. All options whose vesting has not otherwise been accelerated pursuant to the foregoing will vest on October 31, 2003, subject only to the continued employment by the Company of the optionee. The Company's 1995 Non-Employee Director Stock Option Plan (the "NEDP") was adopted by the Board of Directors on November 30, 1994, which action was subsequently approved by shareholders at the Annual Meeting of Shareholders held on March 7, 1995. Under the NEDP, directors of the Company who are not employees of the Company or its subsidiaries are granted options to purchase 1,500 shares of common stock of the Company during the fourth fiscal quarter of each year commencing with fiscal year 1995. Options for the purchase of up to 112,500 shares of common stock may be granted under the NEDP and the Company will reserve the same number of shares for issuance. The options available for grant are automatically increased to the extent any granted options expire or terminate unexercised. Presented below is a summary of the stock option plans for the years ended October 31, 1998, 1997, and 1996:
1998 1997 1996 - ---------------------------------------------------------------------------------------------------------------- Weighted Weighted Weighted average exercise average exercise average exercise Shares price Shares price Shares price - ---------------------------------------------------------------------------------------------------------------- Options outstanding at 1,926,870 $ 7.82 1,962,752 $12.47 2,778,584 $ 10.51 beginning of year Granted 541,504 6.57 1,573,294 9.09 135,828 27.63 Exercised (440,316) 6.17 (69,424) 3.90 (794,688) 7.10 Cancelled (225,956) 10.61 (1,539,752) 15.22 (156,972) 17.48 - ---------------------------------------------------------------------------------------------------------------- Options outstanding at end of year 1,802,102 $ 7.50 1,926,870 $ 7.82 1,962,752 $ 12.47 ================================================================================================================ Weighted average grant-date fair value of options granted (Black-Scholes) $ 3.17 $ 4.63 $ 13.28 - ----------------------------------------------------------------------------------------------------------------
F-30 51 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes information for stock options outstanding at October 31, 1998:
Weighted Weighted Range of Number average Weighted average exercise outstanding remaining average Number exercise prices as of 10/31/98 contractual life exercise price exercisable price - ----------------------------------------------------------------------------------------------------------------- $0.43 - 4.04 59,659 2.63 $ 2.05 59,659 $ 2.05 5.88 - 6.03 683,467 8.59 5.88 401,971 5.88 6.32 - 7.00 596,152 7.65 6.48 286,202 6.63 8.16 - 10.06 311,970 5.96 9.30 271,970 9.26 15.31 - 23.00 150,570 7.20 17.18 136,011 17.31 70.51 - 70.51 284 7.18 70.51 116 70.51 - ------------------------------------------------------------------------------------------------------------------ $ 0.43 - 70.51 1,802,102 7.51 $ 7.50 1,155,929 $ 8.02 - ------------------------------------------------------------------------------------------------------------------
On May 28, 1997, the Board of Directors authorized a stock option exchange program for employee participants in the Plan. Eligible employees who held stock options ("Old Options") with exercise prices in excess of $10.00 per share were able to exchange them for stock options ("New Options") exercisable for a lesser number of shares with an exercise price of $5.88 per share, the average price of the Company's common stock on the Nasdaq-Amex National Market System on June 2, 1997 ("Grant Date"). Approximately 1,600,000 Old Options were eligible to be exchanged for 900,000 New Options. At the end of the exchange program, 1,288,000 Old Options were exchanged for 609,000 New Options. The New Options received in the exchange entailed a new vesting schedule where one quarter vested immediately on the Grant Date, with an additional quarter vesting on each of November 1, 1998, 1999, and 2000, respectively. To the extent that the fair market value of the Company's common stock exceeded $12.50 on each day for ten consecutive trading days, the vesting of all New Options not otherwise vested would become accelerated and 100% fully vested. On March 30, 1998, these New Options became fully vested as a consequence of the fair market value of the Company's common stock having exceeded $12.50 for the requisite ten consecutive trading day period. On May 28, 1993, the Board of Directors adopted the Health Management Systems, Inc. Employee Stock Purchase Plan (the "ESPP"), which was subsequently approved by shareholders at the Annual Meeting of Shareholders held on February 28, 1994. The Company has reserved for issuance up to 1,125,000 shares of common stock pursuant to the ESPP, which is intended to qualify as an "employee stock purchase plan" within the meaning of Section 423 of the Internal Revenue Code of 1986. The ESPP provides that all full-time employees of the Company and its subsidiaries may elect to participate in the ESPP without regard to length of service if their customary employment is a minimum of 20 hours per week. For the years ended October 31, 1998, 1997, and 1996, the Company had sold 118,531, 95,332, and 163,426 shares, respectively, of common stock pursuant to the ESPP for aggregate consideration of $516,000, $709,000, and $2,332,000, respectively, which activity is reflected in the accompanying consolidated financial statements. The weighted-average fair value of those purchase rights granted in 1998, 1997 and 1996, respectively, based on the Black-Scholes model was $3.52, $10.68, and $7.77 respectively. 13. BUSINESS SEGMENT INFORMATION A healthcare information systems and services enterprise, the Company is organized into two divisions: Transfer Payment Division and Software Division. The Transfer Payment Division comprises two business units: Provider Transfer Payment Services and Payor Transfer Payment Services. The Company's Software Division also comprises two units: DSS Unit and MCIS Unit. F-31 52 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Transfer Software Payment Division Division Consolidated - ----------------------------------------------------------------------------------------------- 1998 Revenue $ 57,238,000 48,014,000 105,252,000 Operating income 955,000 6,705,000 7,660,000 Total assets 89,176,000 28,626,000 117,802,000 Depreciation and amortization 2,365,000 3,119,000 5,484,000 Capital expenditures 999,000 830,000 1,829,000 - ----------------------------------------------------------------------------------------------- 1997 Revenue $ 55,856,000 33,661,000 89,517,000 Operating (loss) income (4,008,000) 3,839,000 (169,000) Total assets 82,061,000 27,633,000 109,694,000 Depreciation and amortization 2,651,000 2,491,000 5,142,000 Capital expenditures 970,000 2,990,000 3,960,000 - ----------------------------------------------------------------------------------------------- 1996 Revenue $ 81,816,000 19,510,000 101,326,000 Operating income 10,752,000 2,497,000 13,249,000 Total assets 97,133,000 12,510,000 109,643,000 Depreciation and amortization 2,585,000 736,000 3,321,000 Capital expenditures 4,072,000 1,535,000 5,607,000 - -----------------------------------------------------------------------------------------------
14. COMMITMENTS The Company leases office space and equipment under operating leases which expire at various dates through 2006. The lease agreements provide for rent escalations. Total rent expense for the years ended October 31, 1998, 1997, and 1996, including escalations, was $7,552,000, $7,634,000, and $6,313,000, respectively. Minimum annual lease payments for each of the next five years ending October 31 and thereafter are as follows:
Year PAYMENTS --------------------------------------------- 1999 $ 5,481,000 2000 4,015,000 2001 3,820,000 2002 3,628,000 2003 2,794,000 Thereafter 1,953,000 --------------------------------------------- Total $ 21,691,000 =============================================
F-32 53 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. SIGNIFICANT CONTRACTS The Company's largest client is Columbia, a customer of the DSS Unit. This client accounted for 10%, 12%, and 8% of the Company's total revenue in 1998, 1997, and 1996, respectively. The Company provides its services to Columbia primarily pursuant to a series of 12-month work order agreements, each expiring at different times. There is no assurance that any of these agreements will be renewed. The Company's second largest client is a group of healthcare facilities under the governance of the County of Los Angeles, for which the Company provides a full range of provider business office outsourcing products and services, including managed care services. During the fiscal years ended October 31, 1998, 1997, and 1996, this group accounted for 9%, 12%, and 12%, respectively, of the Company's total revenue. The Company's ten largest clients accounted for approximately 50% of the Company's revenue in fiscal year 1998. Including the Company's contract with the County of Los Angeles, six of the Company's ten largest contracts expire in fiscal year 1999. The Company provides its services pursuant to agreements which are subject to competitive reprocurement. There is no assurance that any of these agreements will be renewed, and if renewed, that the fee rates will be equal to those now in effect. 16. RELATED PARTY TRANSACTIONS (a) HHL Financial Services, Inc. Effective January 31, 1992, the Company entered into a management and data processing services agreement ("Management Agreement") with HHL Financial Services, Inc. ("HHL"). Under the Management Agreement, the Company provided HHL with executive management, data processing, and technical support services through June 30, 1996, subject to certain termination and renewal provisions. Effective July 1, 1993, the Management Agreement was amended ("Outsourcing Amendment") to include the Company's provision of comprehensive data processing and information management services to HHL. The five-year term of the Outsourcing Amendment called for fixed annual fees that range from $6,700,000 to $9,500,000, subject to upward adjustment in the event of material changes in the scope of service and/or growth in HHL revenue in excess of 7% annually. On August 21, 1996, the Company announced a one-time charge and revenue reversal pertaining to its relationship with HHL, which was in default of the Outsourcing Amendment. The Company's one-time charge related to (i) the full reservation of prior period accounts receivable of $2,881,000, (ii) accrual of net costs to be incurred in excess of anticipated revenue relating to the Company's continued contractual obligation with HHL of $3,823,000, and (iii) the write-off of its investment in HHL of $927,000, resulting in a total one-time charge of $7,631,000. Additionally, revenue of $2,180,000 earned and initially recorded in the third quarter was reversed. The result of the total write-off and revenue reversal recognized in the third quarter of $9,811,000 translated to an after-tax impact of $5,563,000, or $0.30 per share. On October 29, 1996, the Company entered into an agreement with HHL and HHL's primary financial creditor providing for mutual general releases and the cessation of all claims. The Company also settled its liabilities due to HHL of $1,950,000 for a payment of $870,000 resulting in the reversal of $1,080,000 in liabilities as an offset to other operating expenses. In addition, the Company agreed to provide, for a period of up to 18 months, a reduced level of service to HHL in exchange for payment in advance. During this 18 month period, HHL has the right to lower the level of service requested and therefore lower the amount paid in advance. Also, HHL has the right to cancel the service completely on 30 days prior written notice. As of October 31, 1996, the Company had incurred and offset $165,000 in net expenses for its contractual obligations with HHL. During 1997, the Company had incurred and offset $2,739,000 in net expenses for its contractual obligations with HHL. The remaining accrual of $519,000 at October 31, 1998, is scheduled to be offset over the next four years against a contractual obligation of the Company to a third party. F-33 54 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS During the years ended October 31, 1998, 1997, and 1996, the Company received approximately $0, $1,849,000, and $5,446,000 in fees from HHL related to these agreements and in connection with jointly executed client projects. During the same periods, HHL charged the Company expenses for services totaling $0, $250,000, and $1,557,000, respectively, in connection with work done on jointly executed client projects. (b) HISCo The Company and HISCo entered into an agreement, dated as of October 31, 1995 (the "HISCo Agreement"), pursuant to which the Company was to provide HISCo with certain services ("Basic Services"), including executive, acquisition support, and corporate support services. For these Basic Services, the Company was entitled to receive a fee, payable monthly, calculated at the Company's then current standard hourly rates established for internal allocations plus 20%. The term of the HISCo Agreement was to continue until the later of (i) June 30, 2000 or (ii) the expiration of any outstanding work order related to additional services. The Company believes that the terms of the HISCo Agreement were fair and reasonable and were no less favorable to the Company than those that could have been obtained with respect to comparable engagements with independent third parties. In fiscal years 1997 and 1996, the Company received approximately $331,000 and $161,000 in fees from HISCo for services provided pursuant to the HISCo Agreement. In fiscal years 1997 and 1996, HISCo received $0 and $569,000 in fees for software development services provided to the Company pursuant to the HISCo agreement. These software development fees were expensed by the Company. In March 1997, the Company, which owned 43% of HISCo's equity, acquired the remaining 57% of HISCo's equity for $3,689,000, net of cash acquired. In connection with this acquisition, the HISCo agreement was terminated and HISCo merged with its sole operating subsidiary, Health Systems Architects, Inc. and was renamed HSA Managed Care Systems, Inc. HSA provides automated business and information solutions, including software and services, to the bearers of risk in the healthcare industry. The acquisition was accounted for using the purchase method and accordingly the results of operations of HSA from the date of acquisition through October 31, 1998 are included in the accompanying financial statements. The $2,309,000 excess of the purchase price over fair market value of the identifiable net assets acquired was recorded as goodwill and is being amortized over a period of 20 years. In connection with the sale of their respective equity interests in HISCo to the Company, certain of the Company's current and former officers and directors derived gross proceeds as follows: Paul J. Kerz, $101,000; Laurence B. Simon, $62,000; Donald J. Staffa, $31,000; Russell L. Carson, $79,000; and Richard H. Stowe, $30,000. The Company's total revenue from related parties was $0, $331,000, and $5,607,000 in fiscal years 1998, 1997, and 1996, respectively. (c) Robert V. Nagelhout In April 1997, the Company guaranteed a loan by The Chase Manhattan Bank (the "Bank") in the original principal amount of $1,600,000 to Robert V. Nagelhout, the Chief Operating Officer and a director of the Company. Mr. Nagelhout granted the Company a security interest in 500,000 shares of the Company's common stock as collateral for its guarantee. On June 11, 1998, Mr. Nagelhout repaid the loan in its entirety, the Bank released the Company's guaranty, and the available balance under the Company's line of credit with the Bank was restored by $1,600,000 to $30,000,000. (d) Paul J. Kerz During October 1998, the Company's HSA subsidiary, a Delaware corporation, made two loans to Paul J. Kerz, an officer and director of HSA, who is also the Company's Chairman and Chief Executive Officer. One loan, in the principal amount of $500,000, is secured by a pledge of 162,666 shares of the Company's common stock owned by Mr. Kerz, while the other loan, in the principal amount of $250,000, is unsecured. Both loans bear interest at the rate of 5.3125% per annum, payable semi-annually commencing April 30, 1999, and are due as to F-34 55 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS principal and all then accrued but unpaid interest on October 31, 2000. The loans were unanimously approved by the Board of Directors of HSA and the Company as the sole stockholder of HSA, following the recommendation of the Compensation Committee of the Company's Board of Directors that the loans were in the best interest of HSA and the Company, and the unanimous approval of the loans by the independent members of the Company's Board of Directors. 17. QUARTERLY FINANCIAL DATA (UNAUDITED) The table below summarizes the Company's unaudited quarterly operating results for its last three fiscal years.
First Second Third Fourth ($ In Thousands, Except Earnings Per Common Share) Quarter Quarter Quarter Quarter - ----------------------------------------------------------------------------------------------------------------------- 1998: Revenue $25,037 25,636 26,736 27,843 Cost of services 23,504 23,523 24,267 24,334 - ----------------------------------------------------------------------------------------------------------------------- Operating margin before amortization of intangibles 1,533 2,113 2,469 3,509 Operating income 1,010 1,609 1,960 3,081 Net income 879 1,185 1,388 2,636 Basic earnings per common share 0.05 0.07 0.08 0.15 Diluted earnings per common share $ 0.05 0.07 0.08 0.15 - ----------------------------------------------------------------------------------------------------------------------- 1997: Revenue $22,272 20,108 22,103 25,034 Cost of services 18,945 22,319 23,063 24,028 - ----------------------------------------------------------------------------------------------------------------------- Operating margin (loss) before amortization of intangibles 3,327 (2,211) (960) 1,006 Operating income (loss) 3,281 (2,450) (1,472) 472 Net income (loss) 1,803 281 (603) 600 Basic earnings per common share 0.10 0.02 (0.03) 0.03 Diluted earnings per common share $ 0.10 0.02 (0.03) 0.03 - ----------------------------------------------------------------------------------------------------------------------- 1996: Revenue $25,619 25,707 25,935 24,065 Cost of services 19,920 20,238 28,555 19,160 - ----------------------------------------------------------------------------------------------------------------------- Operating margin (loss) before amortization of intangibles 5,699 5,469 (2,620) 4,905 Operating income (loss) 5,644 5,414 (2,671) 4,862 Net income (loss) 3,610 3,102 (2,097) 2,676 Basic earnings per common share 0.22 0.18 (0.12) 0.15 Diluted earnings per common share $ 0.20 0.17 (0.12) 0.14 - -----------------------------------------------------------------------------------------------------------------------
F-35 56 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. Legal In April and May 1997, five purported class action lawsuits were commenced in the United States District Court for the Southern District of New York against the Company and certain of its present and former officers and directors alleging violations of the Securities Exchange Act of 1934 in connection with certain allegedly false and misleading statements. These lawsuits, which sought damages in an unspecified amount, were consolidated into a single proceeding captioned In re Health Management Systems, Inc., Securities Litigation (97 CIV-1965 (HB) and a Consolidated Amended Complaint was filed. Defendants made a motion to dismiss the Consolidated Amended Complaint, which was submitted to the Court on December 18, 1997 following oral argument. On May 27, 1998, the Consolidated Amended Complaint was dismissed by the Court for failure to state a claim under the federal securities laws, with leave for the plaintiffs to replead. On July 17, 1998, a Second Consolidated Amended Complaint was filed in the United States District Court of the Southern District of New York, which reiterates plaintiffs' allegations in their prior Complaint. On September 11, 1998, the Company and the other defendants filed a motion to dismiss the second Complaint. The motion was fully briefed in late November 1998, at which time the motion was submitted to the Court. The Company intends to continue its vigorous defense of this lawsuit. On June 1, 1998, MedE America Corp. commenced a lawsuit against the Company and others in the United States District Court for the Southern District of New York. In its complaint, plaintiff alleges copyright infringement and other violations of its rights relating to the Company's development and sale of certain computer software, known as the Universal Billing Platform, which was recently developed for the Company by certain former employees of plaintiff, who are also defendants in the action, acting as independent contractors. Plaintiff, among other relief, seeks (i) to restrain the Company from continuing to market and sell the alleged infringing software, and (ii) monetary damages in excess of $10,000,000. Over a period of in excess of nine months prior to the filing of the complaint, the parties engaged in an extensive exchange of communications, as a result of which the Company concluded, after investigation, that plaintiff's claims were without merit. On July 22, 1998, the Company answered the complaint, denying the material allegations of the complaint. Discovery has commenced, and the Company intends to vigorously contest plaintiff's claims. Pursuant to the Rules of the Court, this matter has been referred to a court-appointed mediator, who in the context of non-binding mediation and independent of the Court proceeding, will attempt to assist in settling the matter or narrowing the issues between the parties. Absent a settlement of this matter through mediation, the Company intends to continue its vigorous defense of this lawsuit. On June 28, 1998, eight holders of promissory notes (the "Notes") of HHL commenced a lawsuit against the Company and others in the Supreme Court of the State of New York, County of Nassau, alleging various breaches of fiduciary duty on the part of the defendants against HHL. The complaint alleges that as a result of these breaches of duty, HHL was caused to make substantial unjustified payments to the Company which, ultimately, led to defaults on the Notes and to HHL's filing for Chapter 11 bankruptcy protection. On June 30, 1998, the same Note holders commenced a virtually identical action (the "Adversary Proceeding") in the United States Bankruptcy Court for the District of Delaware, where HHL's Chapter 11 proceeding is pending. The Adversary Proceeding alleges the same wrongdoing as the New York State Court proceeding and seeks the same damages, i.e., $2,300,000 (the unpaid amount of the Notes) plus interest. Plaintiffs have moved in the Bankruptcy Court to have the Court abstain from hearing the Adversary Proceeding in deference to the New York State Court action. The Company has opposed plaintiffs' motion for abstention and on September 15, 1998, filed a motion in the Bankruptcy Court to dismiss the Adversary Proceeding. This motion was briefed by mid-December 1998, at which time the motions will be submitted to the Court. The Company intends to continue its vigorous defense of this lawsuit. The Company is a party to several other legal proceedings. In the opinion of the Company's management, none of these other proceedings is expected to have a material adverse effect on the Company's financial position, results of operations or liquidity. F-36 57 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS Allowance for doubtful accounts: Balance, October 31, 1995 $ 296,000 Provision 4,485,000 Recoveries -- Charge-offs (3,099,000) ----------- Balance, October 31, 1996 1,682,000 Provision 538,000 Recoveries -- Charge-offs (792,000) ----------- Balance, October 31, 1997 1,428,000 Provision 838,000 Recoveries -- Charge-offs (413,000) ----------- BALANCE, OCTOBER 31, 1998 $ 1,853,000 ===========
F-37 58 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 2.1 Agreement and Plan of Merger dated as of January 18, 1995 among Health Management Systems, Inc., HCm Acquisition Corp., and all the shareholders of Health Care microsystems, Inc., as amended (Incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the year ended October 31, 1994 and to Exhibit 10.2 to the Company's Registration Statement on Form S-3, file no. 33-91518) 2.2 Agreement and Plan of Merger, dated as of April 29, 1996 among Health Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc., and all the shareholders of CDR Associates, Inc. (Incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 29, 1996) 2.2(i) First Amendment to Agreement and Plan of Merger, dated as of April 29, 1996, among Health Management Systems, Inc., CDR Acquisition Corp., CDR Associates, Inc., and all the shareholders of CDR Associates, Inc. (Incorporated by reference to Exhibit 2.2(i) to the Company's Annual Report on Form 10-K for the year ended October 31, 1996 [the 1996 Form 10-K].) 2.3 Agreement and Plan of Merger, dated as of September 3, 1996, by and among Health Management Systems, Inc., QSM Acquisition Corporation and Quality Standards in Medicine, Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Registration Statement on Form S-4, File No. 333-13513 [the S-4]) 2.3(i) Amendment to Agreement and Plan of Merger, dated as of November 20, 1996, by and among Health Management Systems, Inc., QSM Acquisition Corporation, and Quality Standards in Medicine, Inc. (Incorporated by reference to Exhibit 10.1 to Post-Effective Amendment No. 1 to the S-4) 2.4 Agreement and Plan of Merger, dated as of March 18, 1997, by and among Health Management Systems, Inc., HISCo Acquisition Corp., Health Information Systems Corporation and HSA Managed Care Systems, Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997 [the April 1997 Form 10-Q]) 2.5 Asset Purchase Agreement, dated as of March 10, 1997, by and among GHS, Inc., Global Health Systems, Inc. GHS Management Services, Inc., Health Management Systems, Inc. and Global Health Acquisition Inc. (Incorporated by reference to Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1997 [the July 1997 Form 10-Q].) 2.5(i) Assignment and Assumption Agreement, dated as of July 15, 1997, between Global Health Acquisition Corp. and HSA Managed Care Systems, Inc. (Incorporated by reference to Exhibit 2.2 to the July 1997 Form 10-Q.) 3.1 Amended and Restated Certificate of Incorporation of Health Management Systems, Inc. (Incorporated by reference to Exhibit 3.1 to Amendment No. 1 [Amendment No. 1] to the Company's Registration Statement on Form S-1, File No. 33-4644 [the Registration Statement] and Exhibit 3(i) to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996 [the January 1996 Form 10-Q])
59 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 3.2 By-Laws of Health Management Systems, Inc. (Incorporated by reference to Exhibit 3.2 to Amendment No. 1) 10.1 Financial Management Services Agreement, dated August 1, 1989, between Health Management Systems, Inc. and the County of Los Angeles (Incorporated by reference to Exhibit 10.2 to the Registration Statement) 10.2(i) Master Software License Agreement, dated June 29, 1992, by and between Health Care microsystems, Inc. and Healthtrust, Inc. - The Hospital Company. 10.2(ii) Amendment, dated as of September 1, 1995, to Master Software License, dated June 29, 1992, by and between Health Care microsystems, Inc. and Columbia/HCA. (Incorporated by reference to Exhibit 10.2(ii) to the 1997 Form 10-K) 10.3(i) Health Management Systems, Inc. Stock Option and Restricted Stock Purchase Plan, as amended (Incorporated by reference to Exhibit 10.3 to the Registration Statement, to Exhibit 10.3 to Amendment No. 2 [Amendment No. 2] to the Registration Statement, Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1994 [the January 1994 Form 10-Q] and Exhibit to the January 1996 Form 10-Q.) 10.3(ii) Amendment No. 6, dated as of December 2, 1997, to the Health Management Systems, Inc., Stock Option and Restricted Stock Purchase Plan. (Incorporated by reference to Exhibit 10.3(iii) to the 1997 Form 10K) 10.3(iii) Health Management Systems, Inc. Employee Stock Purchase Plan, as amended (Incorporated by reference to Exhibit 10.2 to the January 1994 Form 10-Q and to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1995 [the January 1995 Form 10-Q]) 10.3(iv) Health Management Systems, Inc. 1995 Non-Employee Director Stock Option Plan (Incorporated by reference to Exhibit 10.2 to the January 1995 Form 10-Q) 10.3(v) Health Management Systems, Inc. Profit Sharing Plan (Incorporated by reference to Exhibit 10.3(iv) to the Company's Annual Report on Form 10-K for the year ended October 31, 1995 [the 1995 Form 10-K]) 10.3(vi) Health Management Systems, Inc. Profit Sharing Plan, as amended (Incorporated by reference to Exhibit 10.3(vi) to the 1995 Form 10-K) 10.4(i) Credit Agreement and Guaranty Among Health Management Systems, Inc., as Borrower, Accelerated Claims Processing, Inc., Quality Medi-Cal Adjudication, Incorporated, Health Care microsystems, Inc., and CDR Associates, Inc., as Guarantors, and The Chase Manhattan Bank, as Bank (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1996 [the July 1996 Form 10-Q]) 10.4(ii) First Amendment to Credit Agreement and Guaranty and Waiver (Incorporated by reference to Exhibit 10.1(i) to the July 1996 Form 10-Q)
60 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 10.4(iii) Guaranty Agreement, dated as of April 16, 1997, between Health Management Systems, Inc. and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the April 1997 Form 10-Q) 10.4(iv) Second Amendment to Credit Agreement and Guaranty, dated as of April 16, 1997, among Health Management Systems, Inc., Accelerated Claims Processing, Inc., Quality Medical Adjudication, Incorporated, Health Care microsystems, Inc., CDR Associates, Inc., and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form 10-Q) 10.4(v) Third Amendment to Credit Agreement and Guaranty, dated as of June 30, 1997, among Health Management Systems, Inc., Accelerated Claims Processing, Inc., Quality Medical Adjudication, Incorporated, Health Care Microsystems, Inc., CDR Associate, Inc., HSA Managed Care Systems, Inc., Quality Standards in Medicine, Inc. and The Chase Manhattan Bank (Incorporated by reference to Exhibit 10.1 to the July 1997 Form 10-Q) 10.5(i) Leases, dated February 1, 1980, September 24, 1981, September 24, 1982, and January 6, 1986, as amended, between 401 Park Avenue South Associates and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.13 to the Registration Statement and to Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1994) 10.5(ii) Lease, dated as of March 15, 1996, by and between 387 PAS Enterprises, as Landlord, and Health Management Systems, Inc., as Tenant (Incorporated by reference to Exhibit 10.2 to the July 1996 Form 10-Q) 10.6 Lease, dated September 1996, by and between Pacific Corporate Towers LLC, Health Management Systems, Inc., and Health Care microsystems, Inc. (Incorporated by reference to Exhibit 10.13 to the 1996 Form 10-K) 10.7 Services Agreement, dated as of October 31, 1995, between Health Information Systems Corporation and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.19(iv) to the 1995 Form 10-K) 10.8 Agreement and Release of Claims dated as of October 29, 1996, by and among HHL Financial Services, Inc., Health Management Systems, Inc., and the First National Bank of Chicago (Incorporated by reference to Exhibit 10.12 to the 1996 Form 10-K) 10.9 Security Agreement, dated as of April 16, 1997, by and between Robert V. Nagelhout and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.3 to the April 1997 Form 10-Q) 10.10 Promissory note, dated as of April 16, 1997, by and between Robert V. Nagelhout and The Chase Manhattan Bank. (Incorporated by reference to Exhibit 10.4 to the April 1997 Form 10-Q) 10.11 Consulting Service Agreement, dated as of May 1, 1997, by and between Improved Funding Techniques, Inc. and Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.2 to the July 1997 Form 10-Q)
61 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT INDEX
EXHIBIT NUMBER - ------ 10.12 Employment Agreement, as of May 1, 1997, by and between Joseph H. Czajkowski and CDR Associates, Inc., a wholly-owned subsidiary of Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.3 to the July 1997 Form 10-Q) 10.13 Employment Agreement, as of May 1, 1997, by and between Jeffrey R. Donnelly and CDR Associates, Inc., a wholly-owned subsidiary of Health Management Systems, Inc. (Incorporated by reference to Exhibit 10.4 to the July 1997 Form 10-Q) 10.14 Sublease Agreement, dated December 23, 1997, between Health Management Systems, Inc. and Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.1 to the company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1998 [the January 1998 Form 10-Q]) 10.15 Consent to Sublease, dated December 23, 1997, by 387 P.A.S. Enterprises to the subletting by Health Management Systems, Inc. to Shandwick USA, Inc. (Incorporated by reference to Exhibit 10.2 to the January 1998 Form 10-Q) *10.16 Promissory note, dated as of October 15, 1998, in the principal amount of $500,000 between Paul J. Kerz and HSA Managed Care Systems, Inc. *10.17 Promissory note, dated as of October 15, 1998, in the principal amount of $250,000 between Paul J. Kerz and HSA Managed Care Systems, Inc. *10.18 Security Agreement, dated as of October 15, 1998, between Paul J. Kerz and HSA Managed Care Systems, Inc. *11.0 Computation of Earnings per Share *21.1 List of subsidiaries of Health Management Systems, Inc. *23.1 Consent of KPMG LLP, independent certified public accountants 24.2 Consent of Ernst & Young LLP, independent certified public accountant. (Incorporated by reference to Exhibit 24.2 to the 1996 Form 10-K) 24.3 Report of independent certified public accountants on the financial statements of Health Information Systems Corporation as of and for the period ended October 31, 1996 (Incorporated by reference to Exhibit 24.3 to the 1996 Form 10-K) *27.1 Financial Data Schedule, which is submitted electronically to the Securities and Exchange Commission for informational purposes only
* Filed herewith EX-10.16 2 PROMISSORY NOTE 1 Exhibit 10.16 PROMISSORY NOTE (SECURED LOAN) Date of Note: October __, 1998 Amount of Note: $500,000 Borrower: Paul J. Kerz Interest Rate: 5.53125% per annum 1. Borrower's Promise to Pay. In return for a loan (the "Loan") that I have received, I promise to pay, in one lump sum payment on the maturity date (defined below), U.S. $500,000 (this amount is hereinafter called the "principal"), plus interest, to the order of the Lender. The "Lender" is HSA MANAGED CARE SYSTEMS, INC. The Lender or anyone who takes this Note by transfer and who is entitled to receive payments under this Note is called the "Note Holder". 2. Interest. Interest will be charged on the principal until the full amount of the principal has been paid. I will pay interest at a yearly rate as described above. The interest rate required by this Section 2 is the rate I will pay both before and after any default described in Section 6(b) of this Note. 3. Payments. Time and Place of Payments. I will pay interest semi-annually by making payments on the last day of April and October of each year. I will make my first semi-annual payment of interest on April 30, 1999. I will continue to make these payments every six months until I have paid all of the principal and interest and any other charges described below that I may owe under this Note. My semi-annual payments will be applied to interest before principal. I will pay all of the unpaid principal of the Loan along with any accrued and unpaid interest related thereto on October 31, 2000 (the "Maturity Date"). 4. Borrower's Right to Prepay. I have the right to make payments of principal at any time before they are due. 2 Any such payment of principal is hereinafter called a "prepayment". When I make a prepayment, I will notify the Note Holder in writing of such prepayment. I may make a full prepayment or partial prepayment without paying any prepayment charge. The Note Holder will use all of my prepayments to reduce the amount of principal that I owe under this Note. If I make a partial prepayment, there will be no changes in the due date of my semi-annual payments unless the Note Holder agrees in writing to those changes. Any amounts of the Loan prepaid may not be reborrowed. 5. Loan Charges. If a law, which applies to this Loan and which sets maximum loan charges, is finally interpreted so that the interest or other loan charges collected or to be collected in connection with this Loan exceed the permitted limits, then: (i) any such loan charge shall be reduced by the amount necessary to reduce the charge to the permitted limit; and (ii) any sums already collected from me which exceeded permitted limits will be refunded to me. The Note Holder may choose to make this refund by reducing the principal I owe under this Note or by making a direct payment to me. If a refund reduces principal, the reduction will be treated as a partial prepayment. 6. Borrower's Failure to Pay as Required. (a) Late Charge for Overdue Payments. Any amount of principal or interest which is not paid when due, whether at stated maturity, by acceleration, or otherwise, shall bear interest from the date when due until said principal or interest amount is paid in full, payable on demand, at the prime commercial lending rate announced from time to time by Chase Bank at its principal office in New York City. (b) Default. If I do not pay the full amount of each semi-annual payment on the date it is due, I will be in default. (c) Notice of Default. If I am in default, the Note Holder may send me a written notice telling me that if I do not pay the overdue amount, the Note Holder may require me to pay immediately the full amount of principal which has not been paid and all the interest that I owe on that amount. That date must be at least fifteen (15) days after the date on which the notice is delivered or mailed to me. (d) No Waiver By Note Holder. Even if, at a time when I am in default, the Note Holder does not require me to pay 3 immediately in full as described above, the Note Holder will still have the right to do so if I am in default at a later time. (e) Payment of Note Holder's Costs and Expenses. If the Note Holder has required me to pay immediately in full as described above, the Note Holder will have the right to be paid back by me for all of its costs and expenses in enforcing this Note to the extent not prohibited by applicable law. Those expenses include reasonable attorneys' fees. 7. Giving of Notices. Unless applicable law requires a different method, any notice that must be given to me under this Note will be given by delivering it or by mailing it by first class mail to me at 126 East 65th Street, New York, New York 10021, or at a different address if I give the Note Holder a notice of my different address. Any notice that must be given to the Note Holder under this Note will be given by delivering it or mailing it by first class mail to the Note Holder at: HSA Managed Care Systems, Inc., c/o Health Care microsystems, Inc., 200 N. Sepulveda Boulevard, El Segundo, California 90245, Attention: Thomas J. Kazamek, or at a different address if I am given a notice of that different address. 8. Waivers. I and any other person who has obligations under this Note waive the rights of presentment and notice of dishonor. "Presentment" means the right to require the Note Holder to demand payment of amounts due. "Notice of dishonor" means the right to require the Note Holder to give notice to other persons that amounts due have not been paid. 9. Secured Note. In addition to the protections given to the Note Holder under this Note, the Security Agreement which I have entered into with the Lender dated as of today's date (the "Security Agreement") protects the Note Holder from possible losses which might result if I do not keep the promises which I make in this Note. 10. Events of Default. Notwithstanding anything to the contrary provided herein, the occurrence of any one or more of the following shall be an "Event of Default" hereunder and upon the occurrence of an Event of Default, any and all principal and interest due hereunder shall be immediately due and payable: 4 (a) if I shall fail to pay when due and payable any obligations owing under this Note or another note of even date herewith (the "Unsecured Loan Note") I executed in favor of the Lender in connection with an unsecured loan made to me by the Lender (the "Unsecured Loan"); (b) if I cease to be actively involved in the management of the Lender or its parent company, Health Management Systems, Inc. ("HMS"); (c) if the Security Agreement ceases to be in full force and effect; (d) if an Event of Default has occurred under the Unsecured Loan; (e) if I shall file a petition in bankruptcy or for an arrangement or for reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, or if, by decree of a court of competent jurisdiction, I shall be adjudicated a bankrupt, or be declared insolvent, or shall make an assignment for the benefit of creditors, or shall admit in writing my inability to pay my debts generally as they become due, or shall consent to the appointment of a receiver or receivers of all or any part of my property; (f) if any of my creditors shall file a petition in bankruptcy against me or for my reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, and if such petition shall not be discharged or dismissed within sixty (60) days after the date on which such petition was filed; (g) if I shall fail to observe or perform any covenant, condition or agreement in this Note, the Security Agreement or in any other document that I shall have executed or delivered in connection with this Loan; or (h) if any representation or warranty made by me in this Note, the Security Agreement or in any other document that I shall have executed or delivered in connection with this Loan shall prove to have been incorrect in any material respect on or as of the date made. IN WITNESS WHEREOF, I have executed and delivered this Note on the day and year first above written. 5 PAUL J. KERZ EX-10.17 3 PROMISSORY NOTE 1 Exhibit 10.17 PROMISSORY NOTE (UNSECURED NOTE) Date of Note: October __, 1998 Amount of Note: $250,000 Borrower: Paul J. Kerz Interest Rate: 5.53125% per annum 1. Borrower's Promise to Pay. In return for a loan (the "Loan") that I have received, I promise to pay, in one lump sum payment on the maturity date (defined below), U.S. $250,000 (this amount is hereinafter called the "principal"), plus interest, to the order of the Lender. The "Lender" is HSA MANAGED CARE SYSTEMS, INC. The Lender or anyone who takes this Note by transfer and who is entitled to receive payments under this Note is called the "Note Holder". 2. Interest. Interest will be charged on the principal until the full amount of the principal has been paid. I will pay interest at a yearly rate as described above. The interest rate required by this Section 2 is the rate I will pay both before and after any default described in Section 6(b) of this Note. 3. Payments. Time and Place of Payments. I will pay interest semi-annually by making payments on the last day of April and October of each year. I will make my first semi-annual payment of interest on April 30, 1999. I will continue to make these payments every six months until I have paid all of the principal and interest and any other charges described below that I may owe under this Note. My semi-annual payments will be applied to interest before principal. I will pay all of the unpaid principal of the Loan along with any accrued and unpaid interest related thereto on October 31, 2000 (the "Maturity Date"). 4. Borrower's Right to Prepay. I have the right to make payments of principal at any time before they are due. 2 Any such payment of principal is hereinafter called a "prepayment". When I make a prepayment, I will notify the Note Holder in writing of such prepayment. I may make a full prepayment or partial prepayment without paying any prepayment charge. The Note Holder will use all of my prepayments to reduce the amount of principal that I owe under this Note. If I make a partial prepayment, there will be no changes in the due date of my semi-annual payments unless the Note Holder agrees in writing to those changes. Any amounts of the Loan prepaid may not be reborrowed. 5. Loan Charges. If a law, which applies to this Loan and which sets maximum loan charges, is finally interpreted so that the interest or other loan charges collected or to be collected in connection with this Loan exceed the permitted limits, then: (i) any such loan charge shall be reduced by the amount necessary to reduce the charge to the permitted limit; and (ii) any sums already collected from me which exceeded permitted limits will be refunded to me. The Note Holder may choose to make this refund by reducing the principal I owe under this Note or by making a direct payment to me. If a refund reduces principal, the reduction will be treated as a partial prepayment. 6. Borrower's Failure to Pay as Required. (a) Late Charge for Overdue Payments. Any amount of principal or interest which is not paid when due, whether at stated maturity, by acceleration, or otherwise, shall bear interest from the date when due until said principal or interest amount is paid in full, payable on demand, at the prime commercial lending rate announced from time to time by Chase Bank at its principal office in New York City. (b) Default. If I do not pay the full amount of each semi-annual payment on the date it is due, I will be in default. (c) Notice of Default. If I am in default, the Note Holder may send me a written notice telling me that if I do not pay the overdue amount, the Note Holder may require me to pay immediately the full amount of principal which has not been paid and all the interest that I owe on that amount. That date must be at least fifteen (15) days after the date on which the notice is delivered or mailed to me. (d) No Waiver By Note Holder. Even if, at a time when I am in default, the Note Holder does not require me to pay 3 immediately in full as described above, the Note Holder will still have the right to do so if I am in default at a later time. (e) Payment of Note Holder's Costs and Expenses. If the Note Holder has required me to pay immediately in full as described above, the Note Holder will have the right to be paid back by me for all of its costs and expenses in enforcing this Note to the extent not prohibited by applicable law. Those expenses include reasonable attorneys' fees. 7. Giving of Notices. Unless applicable law requires a different method, any notice that must be given to me under this Note will be given by delivering it or by mailing it by first class mail to me at 126 East 65th Street, New York, New York 10021, or at a different address if I give the Note Holder a notice of my different address. Any notice that must be given to the Note Holder under this Note will be given by delivering it or mailing it by first class mail to the Note Holder at: HSA Managed Care Systems, Inc., c/o Health Care microsystems, Inc., 200 N. Sepulveda Boulevard, El Segundo, California 90245, Attention: Thomas J. Kazamek, or at a different address if I am given a notice of that different address. 8. Waivers. I and any other person who has obligations under this Note waive the rights of presentment and notice of dishonor. "Presentment" means the right to require the Note Holder to demand payment of amounts due. "Notice of dishonor" means the right to require the Note Holder to give notice to other persons that amounts due have not been paid. 9. Events of Default. Notwithstanding anything to the contrary provided herein, the occurrence of any one or more of the following shall be an "Event of Default" hereunder and upon the occurrence of an Event of Default, any and all principal and interest due hereunder shall be immediately due and payable: (a) if I shall fail to pay when due and payable any obligations owing under this Note or another note of even date herewith (the "Secured Loan Note") I executed in favor of Lender in connection with a secured loan made to me by the Lender (the "Secured Loan"); 4 (b) if I cease to be actively involved in the management of the Lender or its parent company, Health Management Systems, Inc.; (c) if an Event of Default has occurred under the Secured Loan; (d) if I shall file a petition in bankruptcy or for an arrangement or for reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, or if, by decree of a court of competent jurisdiction, I shall be adjudicated a bankrupt, or be declared insolvent, or shall make an assignment for the benefit of creditors, or shall admit in writing my inability to pay my debts generally as they become due, or shall consent to the appointment of a receiver or receivers of all or any part of my property; (e) if any of my creditors shall file a petition in bankruptcy against me or for my reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, and if such petition shall not be discharged or dismissed within sixty (60) days after the date on which such petition was filed; (f) if I shall fail to observe or perform any covenant, condition or agreement in this Note or in any other document that I shall have executed or delivered in connection with this Loan; or (g) if any representation or warranty made by me in this Note or in any other document that I shall have executed or delivered in connection with this Loan shall prove to have been incorrect in any material respect on or as of the date made. IN WITNESS WHEREOF, I have executed and delivered this Note on the day and year first above written. PAUL J. KERZ EX-10.18 4 SECURITY AGREEMENT 1 Exhibit 10.18 SECURITY AGREEMENT THIS SECURITY AGREEMENT (the "Security Agreement") made as of the ____ day of October, 1998 by and between PAUL J. KERZ (the "Debtor") and HSA MANAGED CARE SYSTEMS, INC. (the "Secured Party"). WITNESSETH: WHEREAS, the Secured Party has agreed to provide a secured loan (the "Secured Loan") to the Debtor in the amount of $500,000, which is to be evidenced by a promissory note from Debtor to the Secured Party (the "Secured Note") which the Debtor has agreed to pay together with any costs or expenses which arise pursuant to the Secured Note (collectively, the "Secured Loan Obligations"); and WHEREAS, it is a condition precedent to the obligation of the Secured Party to provide the Secured Loan that all of the Debtor's Secured Loan Obligations to the Secured Party be secured by the collateral described herein; NOW, THEREFORE, to induce the Secured Party to make the Secured Loan, and in consideration thereof and for other good and valuable consideration, the receipt and sufficiency of which being hereby acknowledged, the parties hereto agree as follows: 1. Security Interest. The Debtor hereby grants, bargains, sells, assigns, transfers and pledges to the Secured Party, its successors and assigns, a first security interest (the "Security Interest") in and to 162,666 shares of the common stock, $.01 par value, of Health Management Systems, Inc. (the "Parent"), together with any and all proceeds thereof (the "Collateral"). 2. Obligations. This Security Agreement and the Security Interest shall secure repayment of the Secured Loan Obligations to the Secured Party. 3. Financing Statements and Other Action. The Debtor will do all lawful acts which the Secured Party deems necessary or desirable to protect the Security Interest or otherwise to carry out the provisions of this Security Agreement, including, but not limited to, the execution of Uniform Commercial Code (the "Code") financing, continuation, amendment and termination statements and similar instruments, the execution of such additional documents as may be necessary to effectuate the purposes of this Security Agreement. The Debtor irrevocably appoints the 2 Secured Party as its attorney-in-fact (such power of attorney being coupled with an interest) during the term of this Security Agreement to do all acts which it may be required to do under this Security Agreement. 4. Representations and Warranties. The Debtor hereby represents and warrants to the Secured Party as follows: (a) The Debtor is the sole owner of the Collateral. The Security Interest created herein in the Collateral does not require the approval of any other party. (b) Except for the Security Interest created by this Security Agreement, the Collateral is free and clear of all security interests, liens and encumbrances. (c) The Debtor has the full power and authority to enter into this Agreement and to pledge the Collateral. Entering into this Agreement does not violate any material provision of any contract, license or agreement to which the Debtor is a party. 5. Encumbrances. The Debtor warrants that it has good and marketable title to the Collateral purportedly owned by it and that there are no sums owed or claims, liens, security interests or other encumbrances against the Collateral. The Debtor will notify the Secured Party of any lien, security interest or other encumbrance adverse to the Secured Party, and will not create, incur, assume, or suffer to exist any lien, security interest or other encumbrances against the Collateral. 6. Default. In the case of the happening of any of the following events (hereinafter called "Events of Default"): (a) if the Debtor shall fail to pay when due and payable any obligations owing under the Secured Note or other note of even date herewith (the "Unsecured Loan Note") executed by Debtor in favor of the Secured Party in connection with an unsecured loan (the "Unsecured Loan") made by Secured Party to the Debtor; (b) if the Debtor ceases to be actively involved in the management of the Secured Party or the Parent; (c) if the Debtor shall file a petition in bankruptcy or for an arrangement or for reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, or if, by decree of a court of competent 3 jurisdiction, the Debtor shall be adjudicated a bankrupt, or be declared insolvent, or shall make an assignment for the benefit of creditors, or shall admit in writing its inability to pay its debts generally as they become due, or shall consent to the appointment of a receiver or receivers of all or any part of its property; (d) if any of the Debtor's creditors shall file a petition in bankruptcy against it or for its reorganization pursuant to the Federal Bankruptcy Act or any similar law, federal or state, and if such petition shall not be discharged or dismissed within sixty (60) days after the date on which such petition was filed; (e) if the Debtor shall fail to observe or perform any covenant, condition or agreement in the Secured Note, the Unsecured Note, this Security Agreement or in any other document that the Debtor shall have executed or delivered in connection with the Secured Loan or the Unsecured Loan; or (f) if any representation or warranty made by the Secured Party in the Secured Note, the Unsecured Note, this Security Agreement or in any other document that the Debtor shall have executed or delivered in connection with the Secured Loan or the Unsecured Loan shall prove to have been incorrect in any material respect on or as of the date made; thereafter the Secured Party may declare all Secured Loan Obligations secured hereby, and any other Obligations of the Debtor to the Secured Party, immediately due and payable and shall have the remedies with respect to the Collateral of a secured party under the Code. The Secured Party will give the Debtor reasonable notice of the time and place of any public sale of the Collateral or of the time after which any private sale or any other intended disposition thereof is to be made. The requirements of reasonable notice shall be met if such notice is delivered in the manner described in Section 9 of this Agreement, to the address of the Debtor shown in such Section at least ten (10) days before the time of the sale or disposition. Expenses of retaking, holding, preparing for sale, selling or the like shall include the Secured Party's attorney's fees and legal expenses. 6. Waivers. To the extent permitted by law, the Secured Party may release, supersede, exchange or modify any Collateral which it may from time to time hold. 7. Termination. This Security Agreement and the Security Interest shall terminate when all Secured Loan 4 Obligations have been paid and discharged in full by the Debtor and the Secured Party, upon such termination, shall deliver to the Debtor appropriate Code termination statements with respect to the Collateral so released from the Security Interest, for filing with each filing office with which Code financing statements have been filed by the Secured Party with respect to the Collateral, and shall release the Collateral to the Debtor. 8. Modification. This Security Agreement may not be modified or amended without the prior written consent of each of the parties hereto. 9. Notices. Except as otherwise provided in this Security Agreement, all notices and other communications hereunder shall be deemed to have been sufficiently given when sent by certified mail, return receipt requested, or by fax, provided the sender shall have received such return receipt or a confirmation of receipt in the case of a fax, such notices or communications to be addressed as follows: If to the Secured Party: HSA Managed Care Systems, Inc. c/o Health Care microsystems, Inc. 200 N. Sepulveda Boulevard El Segundo, California 90245 If to the Debtor: Paul J. Kerz 126 East 65th Street New York, New York 10021 or at such other address or fax number, as the case may be, as the party to whom such notice or demand is directed may have designated in writing to the other party hereto by notice as provided in this Section 9, except that notices of change of address shall be effective when actually received by the addressee. Each of the parties hereto shall have the right to rely on as an original any notice given hereunder by fax as aforesaid. 10. Rights; Merger. No course of dealing between the Debtor and the Secured Party, nor any delay in exercising, on the part of the Secured Party, any right, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, power or 5 privilege. The rights and remedies hereunder are cumulative and are in addition to, and not exclusive of, any rights or remedies provided by law or in equity, including, without limitation, the rights and remedies of a secured party under the Code. It is understood and agreed that all understandings and agreements heretofore had between the parties, if any, with respect to the subject matter hereof are merged into this Security Agreement and this Security Agreement represents the full and complete agreement of the parties with respect to the subject matter hereof. 11. Governing Law, Binding Effect, Etc. This Security Agreement and the rights and obligations of the parties hereunder shall be construed in accordance with and governed by the laws of the State of New York. This Security Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. 12. Statute Of Limitations. To the full extent permitted by law, the Debtor waives the right to plead any statute of limitations as a defense to any indebtedness or obligation secured hereunder. 13. Survival of Provisions. All representations, warranties and covenants of the Debtor contained herein shall survive the execution and delivery of this Security Agreement and shall terminate only upon the termination of this Security Agreement and the Security Interest created hereby in accordance with the provisions of Section 7. 14. Counterparts. This Security Agreement may be executed in two or more counterparts, each of which shall be deemed to be an original, but all of which taken together shall constitute one and the same instrument. 15. Severability. The invalidity or unenforceability of any provision hereof shall in no way affect the validity or enforceability of any other provision hereof. 6 IN WITNESS WHEREOF, the parties hereto have executed this Security Agreement as of the day and year first above written. HSA MANAGED CARE SYSTEMS, INC. By:__________________________________ Name: Title: __________________________________ PAUL J. KERZ EX-11.0 5 COMPUTATION OF EARNINGS PER SHARE 1 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT 11 - COMPUTATION OF EARNINGS PER SHARE (In Thousands, Except Per Share Amounts)
Years Ended October 31, 1998 1997 1996 ------- ------ ------ Diluted earnings per share: Earnings data: Net income $ 6,088 2,081 7,291 ======= ====== ====== Weighted average shares outstanding Average shares of common stock outstanding 17,366 17,611 17,166 Net effect of dilutive stock options - based on the treasury stock method using average market price 467 368 1,328 ------- ------ ------ Weighted average shares outstanding 17,833 17,979 18,494 ======= ====== ====== Diluted earnings per common share: Net income $ 0.34 0.12 0.39 ======= ====== ======
EX-21.1 6 LIST OF SUBSIDIARIES 1 HEALTH MANAGEMENT SYSTEMS, INC. AND SUBSIDIARIES EXHIBIT 21.1 - LIST OF SUBSIDIARIES OF HEALTH MANAGEMENT SYSTEMS, INC.
SUBSIDIARY STATE OF ---------- -------- INCORPORATION ------------- Accelerated Claims Processing, Inc. Delaware 401 Park Avenue South New York, NY 10016 Quality Medi-Cal Adjudication, California Incorporated 10381 Old Placerville Road Sacramento, CA 95827 Health Care microsystems, Inc. California 200 North Sepulveda Boulevard El Segundo, CA 90245 CDR Associates, Inc. Maryland 9642 Deereco Road Timonium, MD 21093 Quality Standards in Medicine, Inc. Delaware 95 Sawyer Road, 3 University Park Waltham, MA 02453 HSA Managed Care Systems, Inc. Delaware 234 Spring Lake Drive Itasca, IL 60143
EX-23.1 7 CONSENT OF KPMG LLP 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors Health Management Systems, Inc.: We consent to incorporation by reference in the registration form S-3 (File No. 33-91518) and forms S-8 (File Nos. 33-65560, 33-76638, 33-76770, 33-95326 and 33-33706) of Health Management Systems, Inc. of our report dated November 24, 1998, relating to the consolidated balance sheets of Health Management Systems, Inc. and subsidiaries as of October 31, 1997 and 1998, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended October 31, 1998 and related schedule, which report appears in the October 31, 1998 Annual Report on Form 10-K of Health Management Systems, Inc. /s/ KPMG LLP New York, New York January 25, 1999 EX-27.1 8 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial statement information extracted from Consolidated Balance Sheets at October 31, 1998 and 1997 and the Statement of Operations for the years ended October 31, 1998, 1997, and 1996 and is qualified in its entirety by reference to such financial statements. 0000861179 HEALTH MANAGEMENT SYSTEMS, INC. 1,000 U.S. DOLLARS YEAR YEAR YEAR OCT-31-1998 OCT-31-1997 OCT-31-1996 NOV-01-1997 NOV-01-1996 NOV-10-1995 OCT-31-1998 OCT-31-1997 OCT-31-1996 1 1 1 13,883 20,694 22,340 14,519 18,386 17,181 56,845 40,947 44,412 (1,853) (1,428) (1,682) 0 0 0 89,756 81,983 86,955 26,565 25,302 22,070 (19,878) (17,314) (14,247) 117,802 109,694 109,643 33,047 28,184 32,204 0 0 0 0 0 0 0 0 0 183 178 175 83,086 79,628 74,437 117,802 109,694 109,643 105,252 89,517 101,326 105,252 89,517 101,326 0 0 0 95,628 88,355 87,873 2,297 1,899 (384) 0 538 4,485 (102) 0 (569) 9,957 1,730 12,865 3,869 (351) 5,574 7,660 (169) 13,249 0 0 0 0 0 0 0 0 0 6,088 2,081 7,291 0.35 0.12 0.42 0.34 0.12 0.39
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