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PART II
ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW We were incorporated in Delaware in May 1997. Since completing our initial public offering in October 1999, we have completed the following acquisitions, all of which were accounted for using the purchase method of accounting:
On October 2, 2000, we acquired all of the issued and outstanding capital stock of Erisco from IMS Health Incorporated and Erisco became our wholly owned subsidiary. The purchase price of approximately $228.7 million consisted of 12,142,857 shares of common stock with a value of $15.89 per share, assumed liabilities of $30.0 million, which includes $14.2 million of deferred tax liability resulting from the differences between the book and tax bases of the intangible assets arising as a result of the acquisition, and acquisition costs of approximately $5.8 million. At the time of the transaction, Erisco's balance sheet included $32.0 million of cash. Pursuant to the merger agreement and related stockholders agreement, IMS Health has appointed one member to our Board of Directors. On December 1, 2000, we acquired all of the issued and outstanding capital stock of RIMS and RIMS became our wholly owned subsidiary. The purchase price of approximately $99.3 million consisted of 2,588,427 shares of common stock with a value of $21.20 per share, $3.0 million in cash, assumed liabilities of $35.7 million, which includes $16.6 million of deferred tax liability resulting from the differences between the book and tax bases of the intangible assets arising as a result of the acquisition, and acquisition costs of approximately $1.0 million. In addition, we assumed employee stock options to purchase approximately 300,000 shares of our common stock and agreed to issue up to 94,354 shares of restricted common stock to certain employees, of which 82,553 shares have been issued to date. Our revenue is classified into two categories: (i) recurring or multi-year contractually-based revenue and (ii) revenue generated from non-recurring agreements. Recurring revenue from application services is subscription-based and billed monthly over a contract term of typically three to seven years. The amount billed monthly is based on units of volume, such as numbers of physicians, members or desktops covered by each contract. Recurring software maintenance revenue is typically based on one-year renewable contracts. Recurring revenue is recognized ratably over the term of the contract. Non-recurring revenue from consulting services is billed principally on either a time and materials or a fixed fee basis and is recognized as the services are performed. Non-recurring revenue from software license sales is typically recognized when revenue recognition criteria have been satisfied. Cash received in excess of revenue recognized is recorded as deferred revenue. Cost of revenue are those costs related to the products and services we provide to our customers and costs associated with the operation and maintenance of our customer connectivity centers. These costs include salaries and related expenses for consulting personnel, customer connectivity centers personnel, customer support personnel, application software license fees, amortization of capitalized software development costs, telecommunications costs and maintenance costs. Research and development expenses are salaries and related expenses associated with the development of software applications prior to establishment of technological feasibility and services and include compensation paid to engineering personnel and fees to outside contractors and consultants. Costs incurred internally in the development of our software products are expensed as incurred as research and development expenses until technological feasibility has been established, at which time any future production costs are properly capitalized and amortized to cost of revenue based on current and future revenue over the remaining estimated economic life of the product. Selling, general and administrative expenses consist primarily of salaries and related expenses for sales, account management, marketing, administrative, finance, legal, human resources and executive personnel, commissions, expenses for marketing programs and trade shows and fees for professional services. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2000 COMPARED TO THE YEAR ENDED DECEMBER 31, 1999. REVENUE. Total revenue in 2000 increased $56.2 million, or 171%, to $89.1 million from $32.9 million in 1999. Of this increase, $14.6 million was generated by the acquisitions of HME, Erisco and RIMS and $21.1 million reflected the impact of a full year of operations of Finserv and Novalis, which we acquired in late 1999. The remaining increase of $20.5 million primarily represented growth in both our recurring and non-recurring ASP solutions revenue. Recurring revenue in 2000 increased $42.4 million, or 218%, to $61.8 million from $19.4 million in 1999. Of this increase, $9.1 million was generated by our acquisitions in 2000 and $17.7 million reflected the impact of a full year of operations of Finserv and Novalis. The remaining increase of $15.6 million primarily represented growth in our ASP solutions. Non-recurring revenue in 2000 increased $13.8 million, or 102%, to $27.2 million from $13.5 million in 1999. Of this increase, $5.5 million was generated by our acquisitions in 2000, and $3.5 million reflected the impact of a full year of operations of Finserv and Novalis. The remaining increase of $4.8 million reflected increases in ASP solutions revenue relating to consulting services provided by our transformation services group. COST OF REVENUE. Cost of revenue in 2000 increased $47.6 million, or 174%, to $75.0 million from $27.4 million in 1999. Of this increase, $9.9 million represented incremental costs associated with our acquisitions in 2000 and $19.7 million reflected the impact of a full year of operations of Finserv and Novalis. The remaining increase of $18.0 million was primarily due to the costs incurred to support the overall expansion of our ASP solutions. As a percentage of total revenue, cost of revenue approximated 84% in 2000 and 83% in 1999. Cost of recurring revenue in 2000 increased $37.6 million, or 217%, to $54.9 million from $17.4 million in 1999. Of this increase, $5.1 million represented incremental costs associated with our acquisitions in 2000 and $17.0 million reflected the impact of a full year of operations of Finserv and Novalis. The remaining increase of $15.5 million was due to additional expenses for personnel and facilities to support our growing ASP solutions, as well as increased network operation costs, software license fees, and other costs required to support our increased consulting revenue related to our ASP solutions. As a percentage of recurring revenue, cost of recurring revenue approximated 89% in 2000 and 89% in 1999. Cost of non-recurring revenue in 2000 increased $10.1 million, or 100%, to $20.1 million from $10.0 million in 1999. Of this increase, $4.8 million represented incremental costs associated with our acquisitions in 2000 and $2.7 million reflected the impact of a full year of operations for Finserv and Novalis. The remaining increase of $2.6 million resulted mainly from the increase in staffing levels and the use of outside services necessary to support the increasing demand for our consulting revenue related to our ASP solutions. As a percentage of non-recurring revenue, cost of non-recurring revenue approximated 74% in 2000 and 75% in 1999. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased $6.1 million, or 254%, to $8.5 million from $2.4 million in 1999. Of this increase, $3.1 million represented incremental research and development costs associated with our acquisitions in 2000 and $2.3 million reflects the impact of a full year of operations of Finserv and Novalis. The remaining increase of approximately $700,000 was primarily due to an increase in costs related to the design and development of our applications and services, primarily HealthWeb. As a percentage of total revenue, research and development expenses approximated 10% in 2000 and 7% in 1999. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses in 2000 increased $24.7 million, or 265%, to $34.1 million from $9.4 million in 1999. Of this increase, $4.6 million represented incremental costs associated with our acquisitions in 2000 and $3.9 million reflected the impact of a full year of operations of Finserv and Novalis. The remaining increase of $16.2 million was due primarily to growing our sales force and expanding our market presence while introducing new products and integrated solutions to the market, including growing the management and support functions during the year. As a percentage of total revenue, selling, general and administrative expenses approximated 38% in 2000 and 28% in 1999. AMORTIZATION OF INTANGIBLES. Amortization of intangibles in 2000 increased $17.8 million, or 2,278% to $18.6 million from $783,000 in 1999. Of this increase, $13.9 million represented incremental costs associated with our acquisitions in 2000, and $4.3 million of the increase reflects the impact of a full year of amortization expense related to our 1999 acquisitions of Finserv and Novalis. The remaining decrease of $367,000 was due primarily to the write off of certain intangibles. WRITE OFF OF ACQUIRED IN-PROCESS TECHNOLOGY. Write off of acquired in-process technology was $1.4 million in both 2000 and 1999. Our acquisitions of Creative Business Solutions, Inc. and HealthWeb Systems Ltd. in February 1999 and Novalis in November 1999 resulted in an excess of purchase price over the fair market value of the net assets acquired of $15.7 million. Of this amount, $1.4 million was allocated to acquired in-process technology and was written off in 1999. Our acquisitions of HME, Erisco and RIMS in 2000 resulted in an excess of purchase price over the fair market value of the net assets acquired of $281.2 million. Of this amount, $1.4 million related to HME and RIMS was allocated to acquired in-process technology and was written off in 2000. INTEREST INCOME. Interest income in 2000 increased $867,000, or 165%, to $1.4 million from $527,000 in 1999. The increase was due to the increase in cash available for investing for the entire year from proceeds received from our initial public offering and the $32.0 million cash received from IMS when we acquired Erisco. INTEREST EXPENSE. Interest expense in 2000 increased $627,000, or 245%, to $883,000 from $256,000 in 1999. The increase was primarily due to borrowings under our line of credit and term note in 2000, as well as additional borrowings on new capital lease agreements during the year. BENEFIT OF INCOME TAXES. Benefit of income taxes in 2000 increased $5.6 million to $5.8 million from $213,000 in 1999. The benefit was primarily generated from the net reduction of deferred tax liabilities, primarily resulting from the amortization of intangible assets relating to the RIMS and Erisco acquisitions. YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998. REVENUE. Total revenue in 1999 increased $21.5 million, or 188%, to $32.9 million from $11.4 million in 1998. Of this increase, $5.4 million was generated by our acquisitions of Creative Business Solutions, Inc. and HealthWeb Systems, Ltd. in February 1999 and Novalis in November 1999. The remaining increase of $16.1 million represented growth in both our recurring and non-recurring ASP solutions revenue. Recurring revenue in 1999 increased $14.1 million, or 267%, to $19.4 million from $5.3 million in 1998. Of this increase, $1.2 million was generated by our acquisitions in 1999. The remaining increase of $12.9 million primarily represented the overall increase in demand for our ASP solutions. Non-recurring revenue in 1999 increased $7.4 million, or 120%, to $13.5 million from $6.1 million in 1998. Of this increase, $4.2 million was generated by our acquisitions in 1999. The remaining increase of $3.1 million represented increases in ASP solutions revenue relating to consulting provided by our transformation services group. COST OF REVENUE. Cost of revenue in 1999 increased $19.9 million, or 266%, to $27.4 million from $7.5 million in 1998. Of this increase, $5.0 million represented incremental costs associated with our acquisitions in 1999. The remaining increase of $14.9 million was primarily due to the costs incurred to support the overall expansion of our ASP solutions business. As a percentage of total revenue, cost of revenue approximated 83% in 1999 and 65% in 1998. Cost of recurring revenue in 1999 increased $13.4 million, or 336%, to $17.4 million from $4.0 million in 1998. Of this increase, $1.7 million represented incremental costs associated with our acquisitions in 1999. The remaining increase of $11.7 million represented the incremental expenses for personnel and facilities costs incurred to support our growing ASP solutions business. Incremental infrastructure costs were also required in 1999 to support our transition from our former data center to our new customer connectivity center in Englewood, Colorado. As a percentage of recurring revenue, cost of recurring revenue approximated 89% in 1999 and 75% in 1998. Cost of non-recurring revenue in 1999 increased $6.5 million, or 187%, to $10.0 million from $3.5 million in 1998. Of this increase, $3.3 million represented incremental costs associated with our acquisitions in 1999. The remaining increase of $3.2 million resulted mainly from the increase in staffing levels and the use of outside services necessary to support the increasing demand for our consulting revenue related to our ASP solutions in 1999. As a percentage of non-recurring revenue, cost of non-recurring revenue approximated 74% in 1999 and 57% in 1998. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased $1.3 million, or 121%, to $2.4 million from $1.1 million in 1998. Of this increase, approximately $200,000 represented incremental research and development costs associated with our acquisitions in 1999. The remaining increase of $1.1 million was primarily due to the development of our HealthWeb platform and its related applications. Expenses relating to system enhancements from which we derive revenue are not classified as research and development and are included in cost of revenue. As a percentage of total revenue, research and development expenses approximated 7% in 1999 and 9% in 1998. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses in 1999 increased $6.5 million, or 224%, to $9.4 million from $2.9 million in 1998. Of this increase, $2.0 million represented incremental costs associated with our acquisitions in 1999. The remaining increase of $4.5 million was due primarily to expansion of the sales force, staff growth in management and administrative support areas, and expansion of related office space. As a percentage of total revenue, selling, general and administrative expenses approximated 28% in 1999 and 25% in 1998. AMORTIZATION OF INTANGIBLES. Amortization of intangibles in 1999 increased $783,000 from zero in 1998. This increase reflects the impact of a full year of amortization expense related to our 1999 acquisitions. WRITE OFF OF ACQUIRED IN-PROCESS TECHNOLOGY. Our acquisitions of Creative Business Solutions and HealthWeb Systems in February 1999 resulted in an excess of purchase price over the fair market value of the assets purchased and liabilities assumed of $2.5 million. Of this amount, $484,000 was allocated to acquired in-process technology, based upon an independent appraisal, and was written-off in 1999. In addition, our acquisition of Novalis in November 1999 resulted in an excess purchase price over the fair market value of the assets purchased and liabilities assumed of $13.2 million. Of this amount, $923,000 was allocated to acquired in-process technology, based on an independent appraisal, and was written off in 1999. INTEREST INCOME. Interest income in 1999 increased $317,000, or 151%, to $527,000 from $210,000 in 1998. The increase was due to the incremental cash invested in 1999 resulting from $4.5 million in gross proceeds we raised in April 1999, and the full year impact of our investing approximately $6.0 million in gross proceeds we raised in April 1998. The increase is also a result of the investment of the net proceeds of $36.0 million raised during our initial public offering in October 1999. INTEREST EXPENSE. Interest expense in 1999 increased $204,000, or 392%, to $256,000 from $52,000 in 1998. The increase is due to interest paid on notes payable issued in February 1999 in connection with our purchase of HealthWeb Systems and Creative Business Solutions, notes payable in connection with our purchase of software applications licenses, and capital lease obligations for the purchase of computer and other office equipment. PROVISION FOR (BENEFIT OF) INCOME TAXES. Provision for income tax in 1999 decreased $295,000 to a tax benefit of $213,000 from a tax expense of $82,000 in 1998. The benefit was primarily generated from the pre-tax loss, partially offset by the recording of a valuation allowance on the deferred tax assets. SELECTED QUARTERLY RESULTS OF OPERATIONS The following table sets forth certain unaudited consolidated statements of operations data for the eight quarters ended December 31, 2000. This data has been derived from unaudited consolidated financial statements that, in the opinion of our management, include all adjustments consisting only of normal recurring adjustments that we consider necessary for a fair presentation of the information when read in conjunction with our audited consolidated financial statements and the attached notes included herein. The operating results for any quarter are not necessarily indicative of the results for any future period.
The figures stated above give effect to the reclassification of deferred stock compensation from selling, general and administrative to cost of revenue and research and development. The figures also give effect to the reclassification of amortization of goodwill and acquired intangibles from selling, general and administrative expense to its own line item. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have financed our operations primarily through a combination of cash from operations, private financings, an initial public offering of our common stock and cash obtained from our acquisition of Erisco. As of December 31, 2000, we had approximately $28.4 million of cash, cash equivalents and short-term investments, including $1.5 million in restricted cash. In October 1999, we completed our initial public offering of 4,480,000 shares of common stock, including 630,000 shares in connection with the exercise of underwriters' over-allotment option, at a price of $9.00 per share, that raised approximately $36.0 million, net of underwriting discounts, commissions and other offering costs. In addition, in connection with the offering, 350,000 shares of common stock were sold by a selling stockholder at $9.00 per share, for which we received no proceeds. Upon the closing of the offering, all of our mandatorily redeemable convertible preferred stock converted into approximately 6,276,000 shares of common stock. Cash used in operating activities in 2000 was $12.6 million. Cash used during this period was primarily attributable to net losses of $42.3 million, which was offset in part by depreciation and amortization, provision for doubtful accounts, amortization of deferred stock compensation, write off of in-process technology and other changes in operating assets and liability accounts. These losses were principally related to increased research and development expenses and sales, general and administrative expenses. In addition, the losses were generated by the expansion of our infrastructure to support growing demand of our recurring line of business. The cash provided by investing activities of $14.8 million in 2000 was primarily the result of $32.0 million cash received in connection with the acquisition of Erisco and net sales of $4.2 million in short-term and long-term equity investments. This increase was partially offset by our purchase of $7.3 million in property and equipment and software licenses and $7.3 million of payments related to our acquisitions of HME, Erisco and RIMS. The cash provided by financing activities of $2.8 million in 2000 was primarily the result of $15.4 million of proceeds from our line of credit and notes payable, $1.9 million of proceeds from our equipment line of credit, and $1.1 million of proceeds from the issuance of common stock related to employee exercise of stock options and employee purchases of common stock. The increase in cash from these proceeds was reduced by payments we made on the line of credit as well as principal payments on notes payable and capital lease obligations of $15.6 million. In the third quarter of 2000, we entered into a revolving credit facility with a maximum principal amount of $15.0 million which was amended in the fourth quarter to include Erisco and RIMS as additional borrowers. The revolving credit facility is collateralized by all of our receivables and expires in September 2002. Borrowings under the revolving credit facility are limited to and shall not exceed 80% of qualified accounts as defined in the loan documents. Interest on the revolving credit facility is prime rate plus 1.5%. Interest is payable monthly in arrears on the first business day of the month. The revolving credit facility contains certain covenants, including minimum tangible net worth as defined, the generation of specified monthly net earnings before interest, depreciation and amortization, and minimum cash balances. As of December 31, 2000, we had outstanding borrowings on the revolving credit facility of $11.4 million. In December 1999, we entered into a lease line of credit with a financial institution. This lease line of credit was specifically established to finance computer equipment purchases. The lease line of credit had a limit of $2.0 million and expired as scheduled in December 2000. Borrowings under the lease line of credit at December 31, 2000 totaled approximately $1.5 million, and are secured by the assets under lease. In accordance with the terms of the lease line of credit, the outstanding balance is being repaid in monthly installments of principal and interest through June 2003. In March 1999, we entered into a revolving line of credit agreement with a financial institution. In October 1999, we entered into a subsequent agreement which increased the amount available under the line of credit. The line of credit has a total capacity of $3.0 million and expires in December 2001. Borrowings under the line of credit bear interest at prime plus 0.50% and are collateralized by compensating cash balances on deposit. Interest is payable monthly as it accrues. The line of credit agreement contains covenants that we must adhere to during the term of the agreement including restrictions on the payment of dividends. As of December 31, 2000, there were no outstanding borrowings on the line of credit. We have outstanding seven standby letters of credit in the aggregate amount of $1.5 million which serve as security deposits for our capital leases.We are required to maintain a cash balance equal to the outstanding letters of credit, which is classified as restricted cash on the balance sheet. Based on the our current operating plan, we believe existing cash, cash equivalents and short-term investments balances, cash forecasted by management to be generated by operations and borrowings from existing credit facilities will be sufficient to meet our working capital and capital requirements for at least the next twelve months. However, if events or circumstances occur such that the we do not meet our operating plan as expected, we may be required to seek additional capital and/or to reduce certain discretionary spending, which could have a material adverse effect on our ability to achieve our intended business objectives. We may seek additional financing, which may include debt and/or equity financing or funding through third party agreements. There can be no assurance that any additional financing will be available on acceptable terms, if at all. Any equity financing may result in dilution to existing stockholders and any debt financing may include restrictive covenants. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities". SFAS 133 as amended by SFAS 137 and 138 establishes methods of accounting and reporting for derivative instruments and hedging activities and is effective for all quarters for all years beginning after June 15, 2000. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The implementation of SFAS 133 will not have a material impact on our financial statements.
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