=============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant To Section 13 Or 15(d) Of The Securities Exchange Act Of 1934 FOR THE QUARTERLY PERIOD ENDED June 30, 2002 Or [ ] Transition Report Pursuant To Section 13 Or 15(d) Of The Securities Exchange Act Of 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____ Commission File Number: 0-21031 QUADRAMED CORPORATION (Exact Name of Registrant as Specified in Its Charter) DELAWARE 52-1992861 (State or Other Jurisdiction of (IRS Employer Identification No.) Incorporation or Organization) 12110 SUNSET HILLS ROAD, SUITE 600, RESTON, VIRGINIA 20190 (Address of Principal Executive Offices) (Zip Code) (703) 709-2300 (Registrant's Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 Par Value Per Share 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 __ No X Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Act. Yes __ No X On July 31, 2003, 27,530,815 shares of the Registrant's common stock, $0.01 par value per share, were outstanding. =============================================================================== Explanatory Note Financial statement information and related disclosures included in this filing reflect, where appropriate, changes as a result of the restatement (refer to note 2 to the condensed consolidated financial statements). Statements used in this Form 10-Q containing the words (i) "now", "currently", "present", "to date", and words of similar import, and (ii) "knowledge", and words of similar import, are used to refer to conditions existing on the filing date of this Form 10-Q. We direct you to refer to the other reports we file with the Securities and Exchange Commission ("SEC") from time to time after the date of this report for our more current information, including "Risk Factors that May Impact Future Operating Results". QUADRAMED CORPORATION REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2002 TABLE OF CONTENTS PAGE NUMBER ------ PART I. FINANCIAL INFORMATION Item 1. Financial Statements (unaudited) Interim Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001.................................... 2 Interim Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and 2001............. 3 Interim Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001....................... 4 Notes to Interim Condensed Consolidated Financial Statements.... 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................... 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 34 PART II. OTHER INFORMATION Item 1. Legal Proceedings................................................. 35 Item 2. Submission of Matters to Vote of Securities Holders............... 35 Item 3. Other Matters..................................................... 35 Item 4. Exhibits and Reports on Form 8-K.................................. 36 Signatures................................................................ 37 1 PART I FINANCIAL INFORMATION Item 1. Financial Statements (unaudited) ------ ------------------------------- QUADRAMED CORPORATION INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited) June 30, December 31, ASSETS 2002 2001 (Restated) -------- -------- Current assets Cash and cash equivalents $ 20,940 $ 29,799 Short-term investments 2,380 2,414 Accounts receivable, net of allowance for doubtful accounts of $3,759 and $4,239, respectively 31,536 33,165 Unbilled receivables 4,350 3,825 Notes and other receivables 418 282 Prepaid expenses and other current assets 8,685 7,285 --------- --------- Total current assets 68,309 76,770 --------- --------- Restricted cash 4,459 4,356 Property and equipment, net of accumulated depreciation and amortization of $14,554 and $12,634, respectively 7,323 7,323 Capitalized software development costs, net of accumulated amortization of $6,500 and $6,511, respectively 6,592 6,214 Goodwill 23,413 14,721 Other intangible assets, net of accumulated amortization of $11,869 and $10,784, respectively 10,721 8,634 Other long-term assets 6,850 7,115 --------- --------- Total assets $ 127,667 $ 125,133 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable and accrued expenses $ 1,655 $ 893 Accrued payroll and related 4,583 6,402 Other accrued liabilities 5,049 6,245 Deferred revenue 37,177 30,721 --------- --------- Total current liabilities 48,464 44,261 Convertible subordinated debentures 73,719 73,719 Other long-term liabilities 3,371 2,932 --------- --------- Total liabilities 125,554 120,912 --------- --------- Stockholders' equity Preferred stock, $0.01 par, 5,000 shares authorized, zero shares issued and outstanding -- -- Common stock, $0.01 par, 50,000 shares authorized, 26,944 and 26,493 shares issued and outstanding, respectively 269 265 Additional paid-in-capital 275,528 273,320 Deferred compensation (1,161) (1,085) Accumulated other comprehensive loss (385) (468) Accumulated deficit (272,138) (267,811) --------- --------- Total stockholders' equity 2,113 4,221 --------- --------- Total liabilities and stockholders' equity $ 127,667 $ 125,133 ========= ========= The accompanying notes are an integral part of these interim condensed consolidated financial statements. 2 QUADRAMED CORPORATION INTERIM CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited) Three months ended Six months ended June 30, June 30, ------------------ ------------------ 2002 2001 2002 2001 ---- ---- ---- ---- Revenue Services $ 24,206 $ 25,724 $ 47,352 $ 49,128 Licenses 6,627 8,693 14,820 16,731 -------- -------- -------- -------- Total revenue 30,833 34,417 62,172 65,859 -------- -------- -------- -------- Cost of revenue Cost of services 11,854 13,021 22,957 25,411 Cost of licenses 1,982 2,618 4,116 4,125 -------- -------- -------- -------- Total cost of revenue 13,836 15,639 27,073 29,536 -------- -------- -------- -------- Gross margin 16,997 18,778 35,099 36,323 -------- -------- -------- -------- Operating expenses General and administration 8,261 9,248 17,316 19,662 Sales and marketing 5,379 5,393 10,727 10,667 Research and development 4,015 3,587 7,583 7,309 Amortization, impairment and other operating charges 972 1,556 1,484 3,112 -------- -------- -------- -------- Total operating expenses 18,627 19,784 37,110 40,750 -------- -------- -------- -------- Loss from operations (1,630) (1,006) (2,011) (4,427) -------- -------- -------- -------- Other income (expense) Interest expense (1,063) (1,627) (2,126) (3,285) Interest income 173 1,177 377 1,751 Other income (expense), net (479) 268 (567) 25 Other income (expense) (1,369) (182) (2,316) (1,509) -------- -------- -------- -------- Loss before income taxes and extraordinary item (2,999) (1,188) (4,327) (5,936) Provision for income taxes -- -- -- (81) -------- -------- -------- -------- Loss before extraordinary item (2,999) (1,188) (4,327) (6,017) Gain on redemption of debentures -- 2,402 -- 2,402 -------- -------- -------- -------- Net income (loss) $ (2,999) $ 1,214 $ (4,327) $ (3,615) ======== ======== ======== ======== Income (loss) per share Basic before extraordinary item $ (0.11) $ (0.05) $ (0.16) $ (0.24) Extraordinary item -- 0.09 -- 0.09 -------- -------- -------- -------- Basic after extraordinary item $ (0.11) $ 0.05 $ (0.16) $ (0.14) ======== ======== ======== ======== Diluted before extraordinary item $ (0.11) $ (0.05) $ (0.16) $ (0.24) Extraordinary item -- 0.09 -- 0.09 -------- -------- -------- -------- Diluted after extraordinary item $ (0.11) $ 0.05 $ (0.16) $ (0.14) ======== ======== ======== ======== Weighted average shares outstanding Basic 26,941 25,543 26,390 25,560 ======== ======== ======== ======== Diluted 26,941 25,543 26,390 25,560 ======== ======== ======== ======== The accompanying notes are an integral part of these interim condensed consolidated financial statements. 3 QUADRAMED CORPORATION INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) Six Months Ended June 30, ---------------------------- 2002 2001 -------- -------- Cash provided by operating activities $ 2,872 $ 7,110 -------- -------- Cash flows from investing activities Increase in restricted cash (103) -- Purchase of available-for-sale securities (314) (385) Proceeds from the sale of available-for-sale securities 277 12,622 Acquisitions of businesses (11,930) -- Decrease in restricted cash -- 1,361 Purchase of property and equipment (1,121) (1,714) Proceeds from sale of assets -- 24 Payments for capitalized software development costs (366) (534) -------- -------- Cash (used in) provided by investing activities (13,557) 11,374 -------- -------- Cash flows from financing activities Repayments of debt (38) (3,062) Proceeds from exercise of common stock options 1,864 42 -------- -------- Cash provided by (used in) financing activities 1,826 (3,020) -------- -------- Net (decrease) increase in cash and cash equivalents (8,859) 15,464 Cash and cash equivalents, beginning of period 29,799 27,368 -------- -------- Cash and cash equivalents, end of period $ 20,940 $ 42,832 ======== ======== The accompanying notes are an integral part of these interim condensed consolidated financial statements. 4 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2002 1. NATURE OF OPERATIONS -------------------- QuadraMed Corporation along with all significant business divisions and subsidiaries, (the "Company" or "QuadraMed") is dedicated to improving healthcare delivery by providing innovative healthcare information technology and services. From clinical to patient information management and revenue cycle to health information management, QuadraMed delivers real-world solutions that help healthcare professionals deliver outstanding patient care with optimum efficiency. QuadraMed was reincorporated in Delaware in 1996, having been originally incorporated in California in 1993. QuadraMed is managed in 4 distinct business segments which are as follows: Enterprise Division, Health Information Management Software Division, Health Information Management Services Division and Financial Services Division. 2. BASIS OF PRESENTATION --------------------- Unaudited Interim Results ------------------------- The condensed consolidated financial statements at June 30, 2002 and December 31, 2001 and for the three and six months ended June 30, 2002 and 2001 have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The interim financial information is unaudited, but reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of QuadraMed's condensed consolidated financial position, operating results, and cash flows for the interim periods. The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. These condensed consolidated financial statements have been prepared in accordance with the instructions for a report on Form 10-Q as required by the SEC, and therefore, do not include all information and notes normally provided in annual financial statements. As a result, these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, together with management's discussion and analysis of financial condition and results of operations, contained in QuadraMed's annual report on Form 10-K/A for the fiscal year ended December 31, 2001. The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results for the fiscal year ending December 31, 2002 or any other further periods. Reclassifications ----------------- Adoption of EITF No. 01-14 -------------------------- Certain reclassifications have been made to the 2001 interim condensed consolidated financial statements to conform to the 2002 presentation. Specifically, the June 30, 2001, financial statements have been reclassified to comply with Financial Accounting Standards Board ("FASB") Emerging Issues Task Force ("EITF") No. 01-14, Income Statement Characterization of Reimbursements for 'Out-of-Pocket' Expenses Incurred. As such, QuadraMed has reclassified prior year amounts on a pro-forma basis to include billable out-of-pocket reimbursable expenses in both license and services revenues and cost of licenses and services, respectively. The adoption of EITF No. 01-14 does not impact either income (loss) from operations or net income (loss) but does increase revenue and reduce gross margins as shown in the following tables: 5 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 Three months ended Six months ended June 30, 2001 June 30, 2001 --------------------------- --------------------------- Services Licenses Total Services Licenses Total -------- -------- ----- -------- -------- ----- Revenue Reported revenue $25,724 $ 8,693 $34,417 $49,128 $16,731 $65,859 Less impact of EITF No. 01-14 920 219 1,139 1,934 438 2,372 ------- ------- ------- ------- ------- ------- Pro-forma revenue $24,804 $ 8,474 $33,278 $47,194 $16,293 $63,487 ======= ======= ======= ======= ======= ======= Cost of revenue Reported cost of revenue $13,021 $ 2,618 $15,639 $25,411 $ 4,125 $29,536 Less impact of EITF No. 01-14 920 219 1,139 1,934 438 2,372 ------- ------- ------- ------- ------- ------- Pro-forma cost of revenue $12,101 $ 2,399 $14,500 $23,477 $ 3,687 $27,164 ======= ======= ======= ======= ======= ======= Gross margin percentage Reported gross margin percentage 49.4% 69.9% 54.6% 48.3% 75.3% 55.2% Impact of EITF No. 01-14 1.8 1.8 1.8 2.0 2.1 2.0 ------- ------- ------- ------- ------- ------- Pro-forma gross margin percentage 51.2% 71.7% 56.4% 50.3% 77.4% 57.2% ======= ======= ======= ======= ======= ======= Change in Classification of Certain Service and License Revenues and ---------------------------------------------------------------------- Related Costs ------------- In previously reported periods, the Company's license revenue and associated cost of license revenue included in the Statement of Operations consisted of fees for the licensing of the Company's software products, hardware, maintenance, hosted services, customer training and consulting services. In these Interim Condensed Consolidated Statements of Operations, license revenue and cost of license revenue for both 2002 and 2001 has been reclassified to include only fees and costs, respectively associated with the licensing of the Company's software products. The table below presents the impact of the reclassification of licenses and services for the three and six- month periods ended June 30, 2001 (in thousands): Three months ended Six months ended June 30, June 30, ------------------------- -------------------------- 2001 2001 2001 2001 (Reclassified) (Reclassified) ---- ------------ ---- ------------- Revenue Services $ 11,317 $ 25,724 $ 22,464 $ 49,128 Licenses 23,100 8,693 43,395 16,731 -------- -------- -------- -------- $ 34,417 $ 34,417 $ 65,859 $ 65,859 ======== ======== ======== ======== Cost of revenue Services $ 9,012 $ 13,021 $ 17,696 $ 25,411 Licenses 6,627 2,618 11,840 4,125 -------- -------- -------- -------- $ 15,639 $ 15,639 $ 29,536 $ 29,536 ======== ======== ======== ======== Restatement ----------- In 2002, management of QuadraMed discovered accounting and reporting errors within its Quarterly Report on Form 10-Q as filed for the three months ended March 31, 2002 and its Annual Report on Form 10-K as filed for the years ended December 31, 2001, 2000 and 1999. These errors resulted in management determining that the reports for these years needed to be restated. In June 2003, QuadraMed amended and restated its 2001 Annual Report on Form 10-K/A including the years ended 2001, 2000 and 1999 and all respective quarters. This report is also being filed simultaneously with the restatement of QuadraMed's Quarterly Report on Form 10-Q/A for the three months ended March 31, 2002. 6 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 3. RECENT ACCOUNTING PRONOUNCEMENTS -------------------------------- In June 2001, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 143, Accounting for Asset Retirement Obligations. The statement ------------------------------------------- addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 are required to be applied starting with fiscal years beginning after June 15, 2002. QuadraMed expects that implementation of the new standard will not have a significant impact on its financial condition, results of operations, and cash flows. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements ----------------------------- Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical --------------------------------------------------------------------- Corrections. This statement updates and clarifies existing pronouncements ----------- relating to the classification and reporting of gains and losses from the extinguishment of debt, the treatment of sale-leaseback transactions and also makes technical corrections to existing pronouncements. The provisions of SFAS No. 145 are required to be applied starting with fiscal years beginning after May 15, 2002. QuadraMed anticipates that implementation of this new standard will not have a significant impact on its financial condition, results of operations and cash flows. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs -------------------- Associated with Exit or Disposal Activities, effective for exit or disposal ------------------------------------------- activities initiated after December 31, 2002. Under SFAS 146 a liability for the cost associated with an exit or disposal activity is recognized when the liability is incurred. Under prior guidance, a liability for such costs could be recognized at the date of commitment to an exit plan. SFAS 146 also requires that the liability be measured and recorded at fair value. Accordingly, the adoption of this standard may affect the timing of recognizing future restructuring costs as well as the amounts recognized. QuadraMed will adopt the provisions of SFAS 146 prospectively for all restructuring activities initiated after December 31, 2002. In November 2002, the FASB reached a consensus on EITF No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The guidance -------------------------------------------------------------- in EITF 00-21 is effective for revenue arrangements entered into in fiscal years beginning after June 15, 2003. This issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one earnings process and, if it does, how to divide the arrangement into separate units of accounting consistent with the identified earning processes for revenue recognition purposes. EITF 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The Company is evaluating the effect of this issue on its financial statements. In November 2002, the FASB issued FIN 45, Guarantor's Accounting and -------------------------- Disclosure Requirements for Guarantees, including indirect Guarantees of ------------------------------------------------------------------------ Indebtedness of Others. FIN 45 requires that QuadraMed recognizes the fair ---------------------- 7 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 value for guarantee and indemnification arrangements issued or modified by QuadraMed after December 31, 2002, if these arrangements are within the scope of the interpretation. In addition, QuadraMed must continue to monitor the conditions that are subject to the guarantees and indemnifications, as required under previously existing generally accepted accounting principles, in order to identify if a loss has occurred. If QuadraMed determines it is probable that a loss has occurred then any such estimable loss would be recognized under those guarantees and indemnifications. Some of the software licenses granted by QuadraMed contain provisions that indemnify licensees of QuadraMed's software from damages and costs resulting from claims alleging that QuadraMed's software infringes the intellectual property rights of a third party. QuadraMed has historically received only a limited number of requests for indemnification under these provisions and has not been required to make material payments pursuant to these provisions. Accordingly, QuadraMed has not recorded a liability related to these indemnification provisions. QuadraMed will be required to implement the provisions of FIN 45 as of January 1, 2003 and does not believe that FIN 45 will have a material impact on its financial position, results of operations or cash flows. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, effective for fiscal years ending after December 15, 2002. SFAS 148 amends SFAS 123, to provide alternative methods of transition to the voluntary fair value method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure provisions of SFAS 123 to require that disclosure of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed in tabular format within a Company's summary of significant accounting policies. The disclosure provisions of SFAS 148 are effective for fiscal years ending after December 5, 2002 and have been incorporated into these financial statements and accompanying footnotes. 4. ACQUISITIONS ------------ Acquisitions ------------ Acquisition of Outstanding Shares of Pharmacy Data Systems, Inc. --------------------------------------------------------------- On June 11, 2002, QuadraMed acquired all of the outstanding shares of Pharmacy Data Systems, Inc. ("PDS"), a leader in advanced pharmacy, nursing, and physician information systems, for $10.7 million, assumed liabilities of $1,237,000 and acquisition cash of $262,000. The interim condensed consolidated financial statements include the results of operations of PDS since June 11, 2002. In connection with this acquisition, QuadraMed recorded an in-process research and development charge of $400,000. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands): Assets: Current assets $ 856 Property and equipment 100 Goodwill 7,893 Other intangible assets (including in-process research and development) 3,350 ------- 12,199 Liabilities: Current liabilities (including acquisition costs) 1,499 ------- Net purchase price $10,700 ======= Other intangible assets of $3.4 million included in-process research and development, acquired technology, maintenance and other agreements and trademarks. Capitalized intangible assets are subject to amortization periods of one to five years. PDS is included within the Enterprise Segment of QuadraMed. Acquisition of the Assets of Cascade Health Information Software, Inc. --------------------------------------------------------------------- On May 31, 2002, QuadraMed acquired the assets of Cascade Health Information Software, Inc., ("Cascade") a leading provider of software for the coding and abstracting of patient medical records, which was a subsidiary of 8 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 Transcend Services, Inc. for $935,000, assumed liabilities of $346,000 and acquisition costs of $33,000. The purchase price was allocated $882,000 to goodwill, $222,000 to intangible assets (including maintenance agreements and existing technology), and $210,000 to other tangible net assets. Cascade is included within the HIMS Software Segment of QuadraMed. Pro forma results of operations for these business acquisitions have not been presented because the effects were not material to the consolidated financial statements on either an individual or aggregate basis. Divestitures ------------ Sale of Electronic Remittance Advice Product Line ------------------------------------------------- On March 31, 2001, QuadraMed sold its Electronic Remittance Advice product line. QuadraMed recorded proceeds from the sale of $24,000, and a loss after applicable taxes of $57,000. 5. IMPAIRMENT OF INVESTMENT IN MARKETABLE SECURITIES ------------------------------------------------- In compliance with SFAS No. 115, Accounting for Certain Debt and Equity -------------------------------------- Investments, and internal policy, QuadraMed recorded impairment in December ----------- 2000 of $4.1 million to the VantageMed Corporation ("VantageMed") investment to its then fair market value. In the six-month period ended June 30, 2002, QuadraMed recorded additional impairment charges totaling $341,000. The additional charges result from the continuing decline in VantageMed's stock price, its deteriorating cash position, instability in management, and the non- liquid market for VantageMed shares. As of June 30, 2002, QuadraMed owns 599,425 shares of VantageMed or 7.1% of its outstanding stock, with a fair value of $210,000. 6. GOODWILL AND OTHER INTANGIBLE ASSETS ------------------------------------ In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible ----------------------------- Assets, effective for fiscal years beginning after December 15, 2001. Under ------ SFAS 142, goodwill and intangible assets deemed to have indefinite lives are to be separately disclosed on the balance sheet, and no longer amortized but subject to annual impairment tests. With the adoption of SFAS 142, QuadraMed ceased amortization of goodwill as of January 1, 2002. Prior to this point, goodwill was amortized using the straight-line method over its estimated useful life. SFAS 142 requires that goodwill be tested for impairment at the reporting unit level (i.e., business segments) upon adoption and at least annually thereafter using a two-step impairment analysis. In accordance with SFAS 142, QuadraMed performed the first of the required two-step impairment tests of goodwill and indefinite-lived assets as of January 1, 2002. In performing the first step of this analysis, QuadraMed first assigned its assets and liabilities, including existing goodwill and other intangible assets, to its identified reporting units to determine their carrying value. For this purpose, QuadraMed's reporting units equated to its five business segments then in place. QuadraMed's reporting units equate to its business segments since this is the lowest level of QuadraMed at which operating plans are prepared and operating profitability is measured for assessing management performance. See note 9 for more information regarding QuadraMed's business segments. Based on an analysis by an independent third party appraiser, QuadraMed then estimated the fair value of each reporting unit with significant goodwill utilizing various valuation techniques including the Income Approach and the Market Approach. The Income Approach provides an estimation of the fair value of a reporting unit based on the discounted cash flows derived from the reporting unit's estimated remaining life plus the present value of any residual value. The Market Approach indicates the fair value of a reporting unit based upon a comparison to publicly-traded companies in similar lines of business. Step one of this analysis was then completed by comparing the carrying value of each the-analyzed reporting units to its fair value. This comparison resulted in the fair values of the analyzed reporting units exceeding the carrying values of the net assets. In addition, the independent third party appraiser performed a cursory review of the three unappraised reporting units utilizing the Income Approach to estimate the total market value for QuadraMed Corporation as a whole. The result was an estimated value for the Company that was less than the market capitalization as of January 1, 2002. Accordingly, no indicators of impairment existed. As a result, QuadraMed did not perform step two as described by SFAS 142. 9 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 The following schedule shows the Company's reported net income (loss) for periods prior to the adoption of SFAS No. 142 as adjusted to add back goodwill amortization as if SFAS No. 142 had been adopted during these periods (in thousands, except per share data): Three months ended Six months ended June 30, June 30, ------------------ ------------------ 2002 2001 2002 2001 ---- ---- ---- ---- Net income (loss) $ (2,999) $ 1,214 $ (4,327) $ (3,615) Add back: Goodwill amortization -- 1,556 -- 3,113 -------- -------- -------- -------- Pro-forma net income (loss) $ (2,999) $ 2,770 $ (4,327) $ (502) ======== ======== ======== ======== Basic income (loss) per share Income (loss) per share $ (0.11) $ 0.05 $ (0.16) $ (0.14) Goodwill amortization -- 0.06 -- 0.12 -------- -------- -------- -------- Pro-forma income (loss) per share $ (0.11) $ 0.11 $ (0.16) $ (0.02) ======== ======== ======== ======== Diluted income (loss) per share Income (loss) per share $ (0.11) $ 0.05 $ (0.16) $ (0.14) Goodwill amortization -- 0.06 -- 0.12 -------- -------- -------- -------- Pro-forma income (loss) per share $ (0.11) $ 0.11 $ (0.16) $ (0.02) ======== ======== ======== ======== Except for capitalized software development costs, other intangible assets are amortized on a straight-line basis over a period of five to ten years. Capitalized software development costs are amortized on a straight-line basis generally over a period of five years. These assets are reviewed annually for impairment and written down to net realizable value, if necessary, in accordance with SFAS No. 144, Impairment of Long-Lived Assets. ------------------------------- Amortization of other intangible assets for the three months ended June 30, 2002 and 2001 was $1.0 million and $1.1 million, respectively, and six months ended June 30, 2002 and 2001 was $2.1 million and $2.2 million, respectively. 7. NET INCOME (LOSS) PER SHARE --------------------------- Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the sum of the weighted average number of common shares and common equivalent shares outstanding during the period. Common equivalent shares consist of shares issuable upon the exercise of stock options (using the treasury stock method) and convertible subordinated debentures (using the as- converted method). Common equivalent shares are excluded from the diluted computation only if their effect is anti-dilutive. As QuadraMed recorded a net loss before extraordinary item for each of the three and six months ended June 30, 2002 and 2001, no common equivalent shares are included in the diluted weighted average common shares for those periods. 8. COMPREHENSIVE INCOME (LOSS) -------------------------- The components of comprehensive income (loss) for the three and six months ended June 30, 2002 and 2001 are as follows (in thousands): Three months ended Six months ended June 30, June 30, ------------------ ------------------ 2002 2001 2002 2001 ---- ---- ---- ---- Net income (loss) $ (2,999) $ 1,214 $ (4,327) $ (3,615) Unrealized gain (loss) on available-for-sale securities, net of taxes 29 (22) (19) 1 Amortization of unrecognized pension costs, net of taxes 52 57 103 114 -------- -------- -------- -------- Comprehensive income (loss) $ (2,918) $ 1,249 $ (4,243) $ (3,500) ======== ======== ======== ======== 9. SEGMENT REPORTING ----------------- QuadraMed aligns its operations into four business segments for management reporting purposes. These segments are based on product functionality and shared target markets. This alignment allows management to more accurately measure financial performance by product/division and to establish greater management accountability. QuadraMed's business segments are 10 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 (i) the Enterprise Division, (ii) the Health Information Management Software Division, (iii) the Health Information Management Services Division, and (iv) the Financial Services Division. QuadraMed reports the Enterprise Division, the Health Information Management Software Division, the Health Information Management Services Division, and the Financial Services Division as reportable segments in accordance with SFAS No. 131, Disclosures about Segments of an -------------------------------- Enterprise and Related Information. The accounting policies of the operating ---------------------------------- segments are the same as those described in the summary of significant accounting policies described in the Notes to the Financial Statements contained in QuadraMed's 2001 Restated and Amended Annual Report on Form 10- K/A. The financial results for these operating segments for prior periods have been reclassified on an estimated basis to conform to the current period presentation. Results of operations for these business segments are provided to QuadraMed's Chief Operating Decision Maker (CODM), who is the Chairman of the Board and Chief Executive Officer. Summary financial data by business segment as reported to the CODM is presented below for the three and six months ended June 30, 2002 and 2001 (in thousands): Three months ended June 30, 2002 ------------------------------------------------------------- HIM HIM Financial Consolidated Description Enterprise Software Services Services Other (1) Total ----------------- ---------- -------- -------- -------- --------- ----- Total revenues $15,137 $ 6,627 $ 4,532 $ 3,146 $ 1,391 $ 30,833 Gross margin (2) $ 9,560 $ 3,832 $ 1,166 $ 1,643 $ 796 $ 16,997 Interest income (expense), net $ (326) $ (266) $ (71) $ (43) $ (184) $ (890) Segment assets $41,045 $38,490 $ 9,808 $ 5,986 $32,338 $127,667 Total depreciation and amortization (3) $ 368 $ 840 $ 36 $ 138 $ 959 $ 2,341 -----------------------------(1) All other includes specialty products, non-allocated expenses for bad debt, legal costs, restructuring charges and divested product lines. (2) Gross margin represents segment results before interest, amortization of goodwill, taxes, and corporate overhead allocations. (3) Total depreciation and amortization is comprised of equipment depreciation and capitalized software amortization reflected in gross margin, debt- offering costs as reflected in interest expense, and amortization of other intangibles, excluding capitalized software development costs, which are reflected separately in the above schedule. 11 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 Three months ended June 30, 2001 (4) ------------------------------------------------------------- HIM HIM Financial Consolidated Description Enterprise Software Services Services Other (1) Total ----------------- ---------- -------- -------- -------- --------- ----- Total revenues $ 14,467 $ 7,757 $ 5,211 $ 3,271 $ 3,711 $ 34,417 Gross margin (2) $ 7,985 $ 5,079 $ 1,358 $ 2,013 $ 2,343 $ 18,778 Interest income (expense), net $ (73) $ (112) $ (38) $ (21) $ (206) $ (450) Segment assets $ 26,982 $34,851 $ 11,892 $ 6,721 $ 66,592 $147,038 Total depreciation and amortization (3) $ 472 $ 1,480 $ 280 $ 159 $ 843 $ 3,234(1) All other includes specialty products, non-allocated expenses for bad debt, legal costs, restructuring charges and divested product lines including $1.8 million in revenues for EZ-CAP. (2) Gross margin represents segment results before interest, amortization of goodwill, taxes, and corporate overhead allocations. (3) Total depreciation and amortization is comprised of equipment depreciation and capitalized software amortization reflected in gross margin, debt- offering costs as reflected in interest expenses, and goodwill and amortization of other intangibles, excluding capitalized software developments costs, which are reflected separately in the above schedule. (4) June 30, 2001 results have been adjusted to be consistent with current period reclassification among business segments. Six months ended June 30, 2002 ------------------------------------------------------------- HIM HIM Financial Consolidated Description Enterprise Software Services Services Other (1) Total ----------------- ---------- -------- -------- -------- --------- ----- Total revenues $30,851 $13,840 $ 8,691 $ 6,486 $ 2,304 $ 62,172 Gross margin (2) $19,785 $ 8,665 $ 1,948 $ 3,691 $ 1,010 $ 35,099 Interest income (expense), net $ (547) $ (489) $ (133) $ (81) $ (499) $ (1,749) Segment assets $41,045 $38,490 $ 9,808 $ 5,986 $32,338 $127,667 Total depreciation and amortization (3) $ 676 $ 1,647 $ 69 $ 259 $ 1,841 $ 4,492(1) All other includes specialty products, non-allocated expenses for bad debt, legal costs, restructuring charge and divested product lines. (2) Gross margin represents segment results before interest, amortization of intangibles, taxes, and corporate overhead allocations. (3) Total depreciation and amortization is comprised of equipment depreciation and capitalized software amortization reflected in gross margin, debt- offering costs as reflected in interest expense, and amortization of other intangibles, excluding capitalized software development costs, which are reflected separately in the above schedule. 12 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 Six months ended June 30, 2001 (4) ------------------------------------------------------------- HIM HIM Financial Consolidated Description Enterprise Software Services Services Other (1) Total ----------------- ---------- -------- -------- -------- --------- ----- Total revenues $28,589 $12,621 $10,732 $ 6,272 $ 7,645 $ 65,859 Gross margin (2) $16,162 $ 8,310 $ 3,031 $ 3,937 $ 4,883 $ 36,323 Interest income (expense), net $ (273) $ (364) $ (124) $ (70) $ (703) $ (1,534) Segment assets $26,982 $34,851 $11,892 $ 6,721 $66,592 $147,038 Total depreciation and amortization (3) $ 1,132 $ 2,986 $ 634 $ 343 $ 1,301 $ 6,396(1) All other includes specialty products, non-allocated expenses for bad debt, legal costs, restructuring charge and divested product lines including $4.1 million in revenues of EZ-CAP. (2) Gross margin represents segment results before interest, amortization of intangibles, taxes, and corporate overhead allocations. (3) Total depreciation and amortization is comprised of equipment depreciation and capitalized software amortization reflected in gross margin, debt- offering costs as reflected in interest expense, and goodwill and amortization of other intangibles, excluding capitalized software development costs, which are reflected separately in the above schedule. (4) June 30, 2001 results have been adjusted to be consistent with current period reclassification among business segments. 10. MAJOR CUSTOMERS --------------- For the three and six-month periods ended June 30, 2002 and 2001, no single customer accounted for more than 10% of total revenues however, for the three and six months ended June 30, 2002 and 2001 sales to the U. S. government accounted for 15.5% and 18.8% respectively of HIM Software Division revenues. 11. SUBSEQUENT EVENTS ----------------- In October 2002, a series of securities law class action complaints were filed in the United States District Court, California Northern District, against QuadraMed and certain of its officers and directors. The plaintiffs in these actions allege, among other things, violations of the Securities Exchange Act of 1934 due to issuing a series of allegedly false and misleading statements concerning its business and financial condition between May 11, 2000 and August 11, 2002. The complaints seek unspecified monetary damages and other relief. These matters are at an early stage. No responses to the complaints have yet been filed, and no discovery has taken place. QuadraMed intends to defend itself vigorously against these allegations. On December 31, 2002, the Court entered an order consolidating all related securities class actions against the Company. On December 31, 2002, QuadraMed announced the closing of the sale of its HIM Services Division to Precyse Solutions, LLC. QuadraMed received $14 million in cash (of which $1.5 million is to be held in escrow for 18 months) and a $300,000 promissory note with a two-year term. As a result of the sale, QuadraMed recorded a fourth quarter 2002 after-tax gain of $8.8 million. On February 28, 2003, QuadraMed reported that the SEC has issued a formal non-public order of investigation concerning QuadraMed's accounting and financial reporting practices for the period beginning January 1, 1998. QuadraMed intends to continue to cooperate with the SEC and has complied with the SEC's requests for information. QuadraMed cannot predict when the SEC will conclude its inquiry, or the outcome and impact thereof. On March 4, 2003, QuadraMed's common stock was delisted from the Nasdaq National Market. The delisting constitutes a "Repurchase Event" under the provisions of QuadraMed's Convertible Subordinated Debentures. Upon such an event, the Subordinated Indenture grants to each debenture holder the right, at the holder's option, to require QuadraMed to repurchase all or any of the holder's debentures. On April 16, 2003, QuadraMed announced that it had executed an agreement with certain of its bondholders to refinance its outstanding 5.25% Convertible Subordinated Debentures due 2005 (the "2005 Debt"). On April 17, 2003, under the terms of the refinance agreement, QuadraMed issued $71.0 million of its Senior Secured Notes due 2008 (the "2008 13 QUADRAMED CORPORATION NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) June 30, 2002 Debt"). The proceeds from the issuance of the 2008 Debt were used to repurchase $61.8 million (plus $1.5 million in accrued interest) of the 2005 Debt which became subject to repurchase by QuadraMed as a result of its delisting from the Nasdaq National Market on March 4, 2003. Accordingly, the net proceeds to QuadraMed as a result of the issuance of the 2008 Debt less the costs (including fees) associated with the repurchase of the 2005 Debt was $7.6 million, with $11.9 million of the 2005 Debt remaining outstanding. Additionally, the repurchase right on the 2005 Debt remaining outstanding expired on April 17, 2003. The 2008 Debt bears interest at an initial rate of 10% which will be reduced to 9% upon the relisting of QuadraMed's common stock on the Nasdaq, including Nasdaq SmallCap or U.S. National Market and is secured by certain intellectual property of QuadraMed. As part of the transaction, QuadraMed also issued 11,303,842 detachable warrants with the 2008 Debt. The warrants have a term of five years, have an exercise price of $0.01 per share and are subject to certain anti-dilution provisions including dilution from the issuance of shares in settlement of existing litigation. The 2008 Debt contains certain events of default. These events include: failure to timely repay principal or interest owed on the debentures, default under any other borrowing, and bankruptcy. 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results ------ ----------------------------------------------------------------------- of Operations ------------- Cautionary Statement on Risks Associated With Forward-Looking Statements You should read the following discussion in conjunction with our Interim Condensed Consolidated Financial Statements and related Notes. This Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. The words "believe", "expect", "anticipate", "predict", "intend", "plan", "estimate", "may", "will", "should", "could", and similar expressions and their negatives are intended to identify such statements. Forward-looking statements are not guarantees of future performance and are to be interpreted only as of the date on which they are made. We undertake no obligation to update or revise any forward-looking statement. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described below and elsewhere in this Report, and in other documents we file with the SEC from time to time. Restatement ----------- In 2002, we discovered accounting and reporting errors within our Quarterly Report on Form 10-Q as filed for the three months ended March 31, 2002 and our Annual Report on Form 10-K as filed for the years ended December 31, 2001, 2000 and 1999. These errors resulted in us determining that the reports for these years needed to be restated. In June 2003, we amended and restated our Annual Report on Form 10-K/A including the years ended 2001, 2000 and 1999 and all respective quarters. This report is also being filed simultaneously with the restatement of our Quarterly Report on Form 10-Q/A for the three months ended March 31, 2002. The following table of interim condensed consolidated statement of operations data summarizes the effects of the restatement for the three and six-month periods ended June 30, 2001 (in thousands, except per share amounts): Three months ended Six months ended June 30, 2001 June 30, 2001 ------------------------ ------------------------- (As Reported) (Restated) (As Reported) (Restated) Revenue (1) $ 31,469 $ 34,417 $ 61,401 $ 65,859 Gross margin (1) $ 20,968 $ 18,778 $ 40,659 $ 36,323 Income (loss) from operations $ (300) $ (1,006) $ (2,423) $ (4,427) Loss from continuing operations$ (908) $ -- $ (4,846) $ -- Net income (loss) (1) $ 1,661 $ 1,214 $ (1,271) $ (3,615) Basic net income (loss) per share $ 0.06 $ 0.05 $ (0.05) $ (0.14) Diluted net income (loss) per share $ 0.06 $ 0.05 $ (0.05) $ (0.14) Comprehensive income $ 1,640 $ 1,249 $ (1,345) $ (3,500)(1) Restated revenue for the three and six months ended June 30, 2001 includes $2.2 million and $5.1 million, respectively, in revenue; $1.6 million and $3.7 million, respectively, in gross margin; and, $495,000 and $1.5 million, respectively, in net loss from business assets that were sold and previously reported as discontinued operations. Significant Accounting Policies and Estimates --------------------------------------------- Our significant accounting policies have a considerable impact on Management's Discussion and Analysis. Principles of Consolidation --------------------------- These consolidated financial statements, which include our accounts and all our significant business divisions and subsidiaries, have been prepared in conformity with (i) GAAP; and (ii) the rules and regulations of the SEC. All significant intercompany accounts and transactions between us and our subsidiaries are eliminated in consolidation. Use of Estimates ---------------- Management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities, contingent assets and liabilities, revenues, and expenses. Significant estimates and assumptions have been made regarding revenue recognition, the allowance for doubtful account, investments, capitalized software, income taxes, restructuring, pensions and other benefits, and contingencies and litigation and intangibles, primarily goodwill and customer lists, resulting from our purchase business combinations. We base our 15 estimates, assumptions, and judgments on historical experience and on various other assumptions believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Uncertainties inherent in these estimates include projections of future operating results and the discount rates used to determine the net present values of these future results and useful lives of the acquired assets as well as technological advances. In addition, for our fixed-price contracts, we make significant estimates within percentage-of-completion accounting, including estimating total costs to be incurred as calculated on a labor hour basis. We periodically review and test our estimates, specifically those related to the valuations of intangibles including acquired software, goodwill, customer lists, trademarks and other intangibles, and capitalized software. Actual results may differ materially from these estimates. Revenue Recognition ------------------- Our revenue in the ordinary course of business is principally generated from two sources: (i) licensing arrangements and (ii) services. Our license revenue consists of fees for licenses of our software and hosted services. Cost of license revenue primarily includes product, delivery and royalty costs and facilities costs. Our services revenue consists of maintenance, customer training and consulting services and fees for providing management services such as accounts receivable and payment collection outsourcing, specialized staffing, analytical services and seminars. Cost of services consists primarily of salaries, benefits, and allocated costs related to providing such services, labor costs for engineers performing implementation services and technical support and training personnel. We license our products through our direct sales force. Our license agreements for such products do not provide for a right of return, and historically product returns have not been significant. We recognize revenue on our software products in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition, as amended by SOP 98-9, ---------------------------- Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain ------------------------------------------------------------------------------- Transactions; SOP 81-1, Accounting for Performance of Construction-Type and ------------ --------------------------------------------------- Certain Production-Type Contracts; and Staff Accounting Bulletin ("SAB") 101, --------------------------------- Revenue Recognition in Financial Statements. ------------------------------------------- We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery of the product has occurred; no significant obligations by us with regard to implementation remain; the fee is fixed and determinable; and, collectibility is probable. Delivery is considered to have occurred when title and risk of loss have been transferred to the customer, which generally occurs when media containing the licensed programs is provided to a common carrier. We consider all arrangements with payment terms extending beyond 180 days to be not fixed and determinable, and revenue is recognized as payments become due from the customer. If collectibility is not considered probable, revenue is recognized when the fee is collected. SOP 97-2, as amended, generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. Revenue recognized from multiple- element arrangements is allocated to undelivered elements of the arrangement, such as maintenance, support and professional services, based on the relative fair values of the elements specific to us. Our determination of fair value of each element in multi-element arrangements is based on vendor-specific objective evidence ("VSOE"). We limit its assessment of VSOE for each element to either the price charged when the same element is sold separately or the price established by management, having the relevant authority to do so, for an element not yet sold separately. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. Revenue from hosted applications is recognized ratably over the term of the arrangement. The proportion of revenue recognized upon delivery may vary from quarter to quarter depending upon the relative mix of licensing arrangements and the availability of VSOE of fair value for undelivered elements. 16 Certain of our perpetual and time-based licenses include unspecified additional products and/or payment terms that extend beyond 12 months. We recognize revenue from perpetual and time-based licenses that include unspecified additional software products ratably over the term of the arrangement. Contract accounting is utilized for services revenues from fixed-price contracts and those requiring significant software modification, development or customization. In such instances, the arrangement fee is accounted for in accordance with SOP 81-1, whereby the arrangement fee is recognized, generally using the percentage-of-completion method measured on labor input costs. If increases in projected costs-to-complete are sufficient to create a loss contract, the entire estimated loss is charged to operations in the period the loss first becomes known. The complexity of the estimation process and judgment related to the assumptions, risks and uncertainties inherent with the application of the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in its consolidated financial statements. A number of internal and external factors can affect its estimates, including labor rates, utilization, changes to specification and testing requirements and collectibility of unbilled receivables. Service revenues from software maintenance and support are recognized ratably over the maintenance term, which in most cases is one year. Service revenues from training, consulting and other service elements are recognized as the services are performed. Service revenues from providing management services such as accounts receivable and payment collection outsourcing are recognized in accordance with SAB 101. When all criteria for revenue recognition, as noted above, have been met, revenue is recognized upon invoicing. If collectibility is not considered probable, revenue is recognized when the fee is collected. Accounts Receivable and Allowance for Doubtful Accounts ------------------------------------------------------- Accounts receivable consist primarily of amounts due us from our normal business activities. We maintain an allowance for doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified within our portfolio. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, additional allowances might be required. Intangible Assets ----------------- Goodwill. In June 2001, the FASB issued SFAS No. 142, Goodwill and Other -------- Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under SFAS 142, goodwill and intangible assets deemed to have indefinite lives are to be separately disclosed on the balance sheet, and no longer amortized but subject to annual impairment tests. With the adoption of SFAS 142, we ceased amortization of goodwill as of January 1, 2002. Prior to this point, goodwill was amortized using the straight-line method over its estimated useful life. SFAS 142 requires that goodwill be tested for impairment at the reporting unit level (i.e., business segments) upon adoption and at least annually thereafter using a two-step impairment analysis. In accordance with SFAS 142, we performed the first of the required two-step impairment tests of goodwill and indefinite-lived assets as of January 1, 2002. In performing the first step of this analysis, we first assigned our assets and liabilities, including existing goodwill and other intangible assets, to our identified reporting units to determine their carrying value. For this purpose, our reporting units equated to our five business segments then in place. Our reporting units equate to our business segments since this is the lowest level of QuadraMed at which operating plans are prepared and operating profitability is measured for assessing management performance. See note 9 for more information regarding our business segments. Based on an analysis by an independent third party appraiser, we then estimated the fair value of each reporting unit with significant goodwill utilizing various valuation techniques including the Income Approach and the Market Approach. The Income Approach provides an estimation of the fair value of a reporting unit based on the discounted cash flows derived from the reporting unit's estimated remaining life plus the present value of any residual value. The Market Approach indicates the fair value of a reporting unit based upon a comparison to publicly-traded companies in similar lines of business. Step one of this analysis was then completed by comparing the carrying value of each the-analyzed reporting units to its fair value. This comparison resulted in the fair values of the analyzed reporting units exceeding the carrying values of the net assets. In addition, the independent third party appraiser performed a cursory review of the three unappraised reporting units utilizing the Income Approach to estimate the total market value for QuadraMed Corporation as a whole. The result was an estimated value for the Company that was less than the market capitalization as of January 1, 2002. Accordingly, no indicators of impairment existed. As a result, we did not perform step two as described by SFAS 142. Capitalized Software. Software development costs are capitalized upon the -------------------- establishment of technological feasibility. In accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise ------------------------------------------------------------------------------ Marketed, we establish technological feasibility upon completion of a detailed -------- program design determined on a project-by-project basis, which substantiates that the computer software product can be produced in accordance with its design specifications. Software development costs are capitalized based upon an assessment of their recoverability. This assessment requires considerable judgment by management with respect to various factors, including, but not limited to, anticipated future gross margins, estimated economic lives, and 17 changes in software and hardware technology. Amortization is based on the greater of the ratio that current revenues bear to total and anticipated future revenues for the applicable product, or the straight-line method over the remaining estimated economic life of the product, generally five years, and is charged to cost of licenses. Other Intangible Assets. Other intangible assets primarily relate to ----------------------- acquired software, trademarks and customer lists acquired in our purchase business combinations. On January 1, 2002, we adopted the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which -------------------------------------------------------------- generally requires impairment losses to be recorded on long-lived assets (excluding goodwill) used in operations, such as property, equipment and improvements, and intangible assets, when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of the assets. The provisions of this statement did not have a significant impact on our financial condition or operating results. Recent Accounting Pronouncements -------------------------------- In June 2001, the FASB issued SFAS No. 143, Accounting for Asset -------------------- Retirement Obligations. The statement addresses financial accounting and ---------------------- reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 are required to be applied starting with fiscal years beginning after June 15, 2002. We expect that implementation of the new standard will not have a significant impact on our financial condition, results of operations, and cash flows. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements ----------------------------- Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical --------------------------------------------------------------------- Corrections. This statement updates and clarifies existing pronouncements ----------- relating to the classification and reporting of gains and losses from the extinguishment of debt, the treatment of sale-leaseback transactions and also makes technical corrections to existing pronouncements. The provisions of SFAS No. 145 are required to be applied starting with fiscal years beginning after May 15, 2002. We anticipate that implementation of this new standard will not have a significant impact on our financial condition, results of operations and cash flows. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs -------------------- Associated with Exit or Disposal Activities, effective for exit or disposal ------------------------------------------- activities initiated after December 31, 2002. Under SFAS 146 a liability for the cost associated with an exit or disposal activity is recognized when the liability is incurred. Under prior guidance, a liability for such costs could be recognized at the date of commitment to an exit plan. SFAS 146 also requires that the liability be measured and recorded at fair value. Accordingly, the adoption of this standard may affect the timing of recognizing future restructuring costs as well as the amounts recognized. We will adopt the provisions of SFAS 146 prospectively for all restructuring activities initiated after December 31, 2002. In November 2002, the FASB reached a consensus on Emerging Issues Task Force ("EITF") No. 00-21, Accounting for Revenue Arrangements with Multiple ------------------------------------------------- Deliverables. The guidance in EITF 00-21 is effective for revenue arrangements ------------ entered into in fiscal years beginning after June 15, 2003. This issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one earnings process and, if it does, how to divide the arrangement into separate units of accounting consistent with the identified earning processes for revenue recognition purposes. This issue also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. We are evaluating the effect implementation of this new guidance will have on our financial condition, results of operations and cash flows. In November 2002, the FASB issued FIN 45, Guarantor's Accounting and -------------------------- Disclosure Requirements for Guarantees, including indirect Guarantees of ------------------------------------------------------------------------ Indebtedness of Others. FIN 45 requires that we recognize the fair value for ---------------------- guarantee and indemnification arrangements issued or modified by us after December 31, 2002, if these arrangements are within the scope of the interpretation. In addition, we must continue to monitor the conditions that are subject to the guarantees and indemnifications, as required under previously existing generally accepted accounting principles, in order to identify if a loss has occurred. If we determine it is probable that a loss has occurred then any such estimable loss would be recognized under those guarantees and indemnifications. Some of the software licenses granted by us contain provisions that indemnify licensees of our software from damages and costs resulting from claims alleging that our software infringes the intellectual property rights of a third party. We have historically received only a limited number of requests for indemnification under these provisions and have not been required to make material payments pursuant to these provisions. Accordingly, we have not recorded a liability related to these indemnification provisions. We will be required to implement the provisions of FIN 45 as of January 1, 2003 and do not believe that FIN 45 will have a material impact on our financial position, results of operations or cash flows. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, effective for fiscal years ending after December 15, 2002. SFAS 148 amends SFAS 123, to provide alternative methods of transition to the voluntary fair value method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure provisions of SFAS 123 to require that disclosure of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed in tabular format within a Company's summary of significant 18 accounting policies. We have not yet adopted SFAS 148 and accordingly, the accompanying financial statements reflect the required disclosures of SFAS 123. Acquisitions ------------ In the quarter ended June 30, 2002, we completed two acquisitions, Pharmacy Data Systems, Inc. and Cascade Health Information Software, Inc. PDS is a leader in advanced pharmacy information systems. PDS develops and installs advanced pharmacy, nursing, and physician information systems designed to reduce medication errors, control costs, and improve patient care. PDS will form the core of the newly created Affinity Pharmacy Division. Financial results for PDS are reported as part of the Enterprise Division. We expect the following strategic benefits from the acquisition of PDS: o Provide the Enterprise Division's Affinity product with an integrated pharmacy solution to meet the increasing demand for Computerized Physician Order Entry (CPOE) technology that administers the entire medication management process from ordering through dispensing. o Provide the opportunity to sell Affinity systems to PDS's customers, most of which are not currently our customers. Cascade Software is a leading provider of state-of-the-art software for the coding and abstracting of patient medical records. We will combine the Cascade assets to our growing suite of Healthcare Information Management Software products. We expect that the Cascade acquisition will bring the strategic benefit of providing the opportunity to sell Quantim Health Information Software products to Cascade's customers, most of which are not currently our customers. Results of Operations --------------------- Revenue ------- Services. Service revenue consists of consulting, maintenance, -------- installation, hardware, reimbursable expenses and other service revenue. Services revenue was $24.2 million and $25.7 million for the three months ended June 30, 2002 and 2001, respectively. For the six months ended June 30, 2002, services revenue decreased $1.8 million, or 3.6% to $47.4 million from $49.1 million in the first six months of 2001. Licenses. License revenue consists of license and third-party software -------- sales. License revenue in the three months ended June 30, 2002 was $6.6 million, a decrease of 23.8% from $8.7 million in the corresponding period of 2001. For the six months ended June 30, 2002, license revenue was $14.8 million compared to $16.7 million in the first six months of 2001. 19 Cost of Revenue --------------- Cost of Services. Cost of services consists of salaries and related ---------------- expenses associated with services performed for customer support and consulting services as well as third-party hardware costs. Cost of services for the quarter ended June 30, 2002 of $11.9 million was $1.2 million or 9.0% less than the $13.0 million recorded in the corresponding period of 2001. The gross margin earned on services revenue in the first three months of 2002 was 51.0%, compared to 49.4% in the same period in 2001. For the six months ended June 30, 2002, cost of services decreased 9.6% to $23.0 million from $25.4 million in the same period of 2001. As a percentage of service revenue, the gross margin earned on services was 51.5% in the first six months of 2002 consistent with the 48.3% in the same period of 2001. Cost of Licenses. Cost of licenses consists of third party royalties, ---------------- amortization of capitalized software and documentation and production costs of our software. Cost of licenses in the three months ended June 30, 2002 was $2.0 million, a 70.1% gross margin on licenses, compared to $2.6 million for the same period of 2001, a 69.9% gross margin on licenses. For the six months ended June 30, 2002, cost of licenses decreased by $9,000 to $4.1 million from the same period of 2001. The gross margin on licenses was 72.2% and 75.3% for the six-month periods ended June 30, 2002 and 2001, respectively. Operating Expenses ------------------ General and Administration. General and administration expense consists -------------------------- of compensation and benefit costs for executive, finance, legal, information technology, and administrative personnel. General and administration expense in the three months ended June 30, 2002 was $8.3 million compared to $9.2 million in the same period of 2001. As a percentage of revenue, general and administration expense was 26.8% for the three months ended June 30, 2002 as compared to 26.9% in the same quarter of 2001. For the six months ended June 30, 2002, general and administration expense decreased 11.9% to $17.3 million from $19.7 million in the comparable period in 2001. As a percentage of total revenue, general and administration expense decreased to 27.9% for the six months ended June 30, 2002 from 29.9% in the six months ended June 30, 2001. The decrease in general and administration expense was principally the result of lower salary and related expenses resulting from a lower average staffing level and reduced professional and legal fees. Sales and Marketing. Sales and marketing expense includes costs ------------------- associated with our sales and marketing personnel and product marketing personnel and consists primarily of compensation and benefits, commissions and bonuses, promotional and advertising expenses. Sales and marketing expense in the three months ended June 30, 2002 was $5.4 million very slightly less than in the corresponding period of 2001. As a percentage of revenue, sales and marketing expense was 17.4% for the three months ended June 30, 2002 as compared to 15.7% in the same quarter of 2001. For the six months ended June 30, 2002, sales and marketing expense increased by $60,000 to $10.7 million compared to the first half of 2001. As a percentage of total revenue, sales and marketing expense increased to 17.3% for the six months ended June 30, 2002 from 16.2% in the comparable period in 2001. The small increase for the year to date in sales and marketing was due principally to the increase in the sales force in each segment and higher commissions on the increased sales bookings. Research and Development. Research and development expense includes costs ------------------------ associated with the development of new products, enhancements of existing products for which technological feasibility has not been achieved, and quality assurance activities, and primarily includes compensation and benefits expense. Research and development costs for the three months ended June 30, 2002 was $4.0 million compared to $3.6 million in the same period of 2001. As a percentage of revenue, research and development costs were 13.0% for the three months ended June 30, 2002 compared to 10.4% in the same quarter of 2001. For the six months ended June 30, 2002, research and development costs increased 3.7% to $7.6 million from $7.3 million in the first half of 2001. The level of research and development investments increased in the first six months of 2002 with the funding of development for our Affinity(r) Clinical and Quantim(r) products. During the six months ended June 30, 2002, we capitalized $3.8 million in software development costs on products qualifying for capitalization under the definition of technological feasibility compared to $462,000 in the first six months of 2001. Amortization, Impairments and Other Operating Charges. Amortization, ----------------------------------------------------- impairments and other operating charges decreased to $972,000 in the three months ended June 30, 2002 from $1.6 million in the same period of 2001. For the six months ended June 30, 2002, this category of expenses decreased to $1.5 million from $3.1 million in the first six months of 2001. The decrease in 20 three and six months ended June 30, 2002, is partially related to our January 1, 2002 adoption of SFAS No. 142, Goodwill and Other Intangible Assets, which ------------------------------------ eliminates the amortization of goodwill but requires annual impairment testing. As a result, we no longer amortized goodwill during the three and six months ended June 30, 2002, but continued to amortize other intangible assets. Amortization of goodwill accounted for $1.3 million and $2.7 million in the comparable periods in 2001, respectively. Additionally, we wrote off in-process research and development costs totaling $400,000 in connection with our acquisition of PDS in June 2002. There were no similar charges during First Quarter 2002 or the corresponding periods of 2001. The most significant contributor to other expense during each of the periods presented herein is the continued impairment of our investment in VantageMed Corporation ("VantageMed"). In the three and six-month periods ended June 30, 2002, we recorded additional impairment of VantageMed in the amount of $240,000 and $366,000, respectively, compared with $75,000 in the first six months of 2001. As of June 30, 2002, we own 599,425 shares of VantageMed or 7.0% of its outstanding stock, with a fair value of $210,000. The remainder of other expense for the periods herein is related to individually insignificant amounts of investment gains and losses as well as adjustments associated with certain life insurance policies which are generally accounted for under FASB Technical Bulletin ("FTB") 85-4, Accounting for Life ------------------- Insurance. --------- Other Income (Expense) --------------------- Interest Expense, Net. Interest expense, net of interest income, was --------------------- $890,000 and $450,000 in the three months ended June 30, 2002 and 2001, respectively. For the six months ended June 30, 2002 and 2001, net interest expense was $1.8 million and $1.5 million, respectively. Interest expense is incurred on our Debentures that have a fixed interest rate of 5.25%. Although we redeemed $5.4 million of our Debentures during the three months ended June 30, 2001, the effect of this decrease in interest expense was not fully appreciated as the decline in interest rates earned on our cash and investments from those earned in the comparable periods of 2001 offset interest expense to a lesser degree in 2002. Income Taxes ------------ Provision for Income Taxes. There was no provision for income taxes for -------------------------- the three and six months ended June 30, 2002. This compares with zero and $81,000 for the three and six months ended June 30, 2001, which results primarily from state and alternative minimum tax liabilities on certain of our legal entities. For financial reporting purposes, a 100% valuation allowance has been recorded against our deferred tax assets under SFAS No. 109, Accounting for Income Taxes. Extraordinary Item ------------------ Gain on Redemption of Debentures -------------------------------- During the three months ended June 30, 2001, we repurchased $5.4 million of our subordinated convertible debentures (the "Debentures") on the open market for a total of $3.0 million in cash, resulting in a gain of $2.4 million. Liquidity And Capital Resources ------------------------------- The following section discusses the effects of changes in our balance sheets, cash flows, and commitments on our liquidity and capital resources. Balance Sheet and Cash Flows ---------------------------- Cash and cash equivalents were $20.9 million as of June 30, 2002 and $29.8 million as of December 31, 2001, a decrease of $8.9 million or 29.7% during the 21 period. Cash flows provided by operating activities were $2.9 million for the six months ended June 30, 2002. These amounts primarily resulted from a net loss of $4.3 million for the six months ended June 30, 2002, offset by $3.0 million in non-cash depreciation and amortization charges, $400,000 in write- offs, and a net decrease of $3.8 million in working capital (excluding the change in cash and cash equivalents). Cash outflows for investing activities of $13.6 million primarily reflected the cash outlay of $11.9 million for the purchase of Cascade and PDS and $1.1 million and $366,000 in fixed asset and capitalized software expenditures, respectively. In addition, we issued $1.9 million in common stock as a result of option exercises. We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, specifically the timing of when we recognize revenue, our accounts receivable collections, and the timing of other payments. In addition, cash used in investing activities may fluctuate due to the capitalization of our software development efforts and costs associated with our investments in fixed assets and information technology. For additional discussion, see the Risk Factors section. Commitments ----------- As of June 30, 2002, we had $73.7 million in outstanding 5.25% Convertible Subordinated Debentures due 2005 (the "2005 Debt"), which bear interest at 5.25% per annum. On April 16, 2003, we announced that we had executed an agreement with certain of our bondholders to refinance our 2005 Debt. On April 17, 2003, under the terms of the refinance agreement, we issued $71.0 million of our Senior Secured Notes due 2008 (the "2008 Debt"). The proceeds from the issuance of the 2008 Debt were used to repurchase $61.8 million (plus $1.5 million in accrued interest) of the 2005 Debt which became subject to repurchase by us as a result of our delisting from the Nasdaq National Market on March 4, 2003. Accordingly, the net proceeds to us as a result of the issuance of the 2008 Debt less the costs (including fees) associated with the repurchase of the 2005 Debt was $7.6 million, with $11.9 million of the 2005 Debt remaining outstanding. Additionally, the repurchase right on the 2005 Debt remaining outstanding expired on April 17, 2003. The 2008 Debt bears interest at an initial rate of 10% which will be reduced to 9% upon the relisting of QuadraMed's common stock on the Nasdaq SmallCap or National Market and is secured by certain intellectual property of QuadraMed. However, we may be obligated to redeem the 2005 and 2008 debentures earlier than the maturity dates based upon certain events of default occurring as defined within the debenture agreements. These events include, failure to timely repay principal or interest owed on the debentures, default under any other borrowing, and bankruptcy. In addition, as of June 30, 2002, we had approximately $34.8 million in minimum operating lease commitments that will be repaid through 2011. Finally, we have a Supplemental Executive Retirement Plan ("SERP") that will require total payments from 2008 through 2027 estimated at $7.8 million. We owe annual premiums of $483,000 on the SERP through 2005 to fund our obligations. We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, specifically the timing of when we recognize revenue, our accounts receivable collections and the timing of other payments. In addition, cash used in investing activities may fluctuate due to the capitalization of our software development efforts, which are expected to increase in 2003, and costs associated with our investments in fixed assets and information technology. For additional discussion, see the Risk Factors section. We believe that we will have sufficient liquidity and capital resources to fund our scheduled debt and other obligations through the next twelve months. Business Risks -------------- Factors that have affected our results of operations in the past and are likely to affect our results of operations in the future, include the following: Our Vendors, Suppliers and Customers May React Adversely to the Lack of ----------------------------------------------------------------------- Timely SEC Filings of Our Historical Financial Statements. --------------------------------------------------------- Our future success depends in large part on the support of our vendors and suppliers, who may react adversely to the lack of timely SEC filings of our historical financial statements. The restatement of our historical financial statements has resulted in negative publicity about us, which may cause some of our potential customers to defer purchases of our products. Our vendors and suppliers may re-examine their willingness to do business with us, to develop critical interfaces for us or to supply software and services if they lose confidence in our ability to fulfill our commitments. 22 We Are Currently the Target of Securities Litigation and May Be the Target -------------------------------------------------------------------------- of Further Actions, Which May Be Costly and Time Consuming to Defend. -------------------------------------------------------------------- In October 2002, a series of securities law class action complaints were filed in the United States District Court, California Northern District, against us and certain of our officers and directors. The plaintiffs in these actions allege, among other things, violations of the Securities Exchange Act of 1934 due to issuing a series of allegedly false and misleading statements concerning our business and financial condition between May 11, 2000 and August 11, 2002. The complaints seek unspecified monetary damages and other relief. The ultimate outcome of these matters cannot presently be determined and may require significant commitment of our financial and management resources and time, which may seriously harm our business, financial condition and results of operations. We cannot assure you that any of the allegations discussed above can be resolved without costly and protracted litigation, and the outcome may have a materially adverse impact upon our financial position, results of operations and cash flows. In addition, securities class action litigation has often been brought against a company following a decline in the market price of its securities. The uncertainty of the currently pending investigation and litigation could lead to more volatility in our stock price. We may in the future be the target of securities class action claims similar to those described above. We Are Subject to a Formal SEC Inquiry as a Result of the Restatement of ------------------------------------------------------------------------ Our Financial Statements. ------------------------ Following our August 12, 2002 announcement that it we intended to restate prior period financial statements, the staff of the San Francisco District Office of the SEC requested certain information concerning the anticipated restatement as part of an informal, preliminary inquiry. We provided that information, and expect to provide additional information now that the restatement is completed. We intend to continue to cooperate with the SEC in the event it requests other information. We cannot predict whether such information will be requested, when the SEC will conclude its inquiry, or the outcome or impact thereof. On February 28, 2003, we reported that the SEC had issued a formal non- public order of investigation concerning our accounting and financial reporting practices for the period beginning January 1, 1998. We intend to continue to cooperate with the SEC and comply with the SEC's requests for information. We cannot predict when the SEC will conclude its inquiry, or the outcome and impact thereof. Our Common Stock Has Been Delisted from the Nasdaq Stock Market. --------------------------------------------------------------- We received a notice from the Nasdaq Stock Market that we are required to file Forms 10-Q for the quarters ended June 30, and September 30, 2002 as well as restated financial statements for the years ended December 31, 2001, 2000 and 1999 and the quarter ended March 31, 2002. Our trading symbol as of August 22, 2002 was amended from "QMDC" to "QMDCE", as a result of the delinquent filings. We requested an appeals hearing before a Nasdaq Listing Qualifications Panel (the "Panel"). The Panel notified us on February 6, 2003, that Nasdaq would continue to list our common shares on the Nasdaq Stock Market until February 28, 2003, by which date we must file our Quarterly Report on Form 10-Q for the interim periods ended June 30, 2002 and September 30, 2002 and our amended SEC filings for the years ended December 31, 2001, 2000 and 1999 and the interim period ended March 31, 2002. Further, we were required to file timely all other annual and periodic reports with the SEC and evidence our continued compliance with all requirements for continued listing on the Nasdaq National Market upon the filing of these documents as well as an ability to sustain compliance with those requirements over the long term. We were unable to meet these requirements in a timely manner, and on March 4, 2003, our common stock was delisted from the Nasdaq Stock Market. Although we intend to return to compliance, we can offer no assurances that we will be relisted on the Nasdaq Stock Market. The delisting constitutes a "Repurchase Event" under the provisions of our Convertible Subordinated Debentures. Upon such an event, our Debentures provide the holders with the individual option to redeem the Debentures (see below). 23 Our Debentures Have Been Partially Refinanced with Notes that Are Subject ------------------------------------------------------------------------- to New Terms. ------------ We issued Debentures through a public offering on May 1, 1998 that mature on May 1, 2005 in the principal amount of $115 million (the "2005 Notes"). Our net proceeds from the offering were $110.8 million. The 2005 Notes bear interest at 5.25% per annum and are convertible into common stock at any time prior to the redemption or final maturity, initially at the conversion price of $33.25 per share (resulting in an initial conversion ratio of 30.075 shares per $1,000 principal amount). We are obligated to provide holders of the 2005 Notes with notice of and the holders have the individual option to redeem the 2005 Notes should we, (i) cease to be traded on a U.S. national securities exchange or cease to be approved for trading on a U.S. automated over-the-counter securities market; or (ii) experience defined Changes of Control, including a merger in which we are not the surviving entity or our shareholders do not control 50% of the new entity, the sale of substantially all of our assets, a liquidation, or if there is a substantial change in the board of directors over a two-year period. Additionally, we are obligated to redeem the 2005 Notes upon defined Events of Default, including failure to timely repay principal or interest under the 2005 Notes, default under any other borrowing, and bankruptcy. On March 4, 2003, our common stock was delisted from the Nasdaq Stock Market, and a repurchase event was triggered. On April 17, 2003, QuadraMed Corporation closed the partial refinancing of its 2005 Notes. In conjunction with its repurchase of $61.8 million of its outstanding 2005 Notes pursuant to its offer to repurchase such Notes previously announced on March 19, 2003, the Company issued $71 million of its Senior Secured Notes due 2008 (the "2008 Notes"), together with warrants to purchase 11,303,842 shares of the Company's common stock. Investors in the 2008 Notes included certain holders of 2005 Notes as well as new investors. Additional warrants to purchase 2,047,978 shares of the Company's common stock will be issued to holders of the 2008 Notes if the Company does not file a registration statement within 90 days after receiving a request from the holders on or after the date that is 270 days after April 17, 2003, the date of issuance of the 2008 Notes. The Company also issued warrants to purchase 282,596 shares of the Company's common stock to Philadelphia Brokerage Corporation as consideration in connection with the transaction. The warrants have a term of five years, have an exercise price of $0.01 per share and are subject to certain anti-dilution provisions including dilution from any issuance of shares in settlement of existing litigation. The 2008 Notes bear an initial interest rate of 10%, which interest rate is required to be reduced to 9% upon the listing of the Company's common stock for trading on a U.S. national securities exchange or upon the common stock's relisting on the Nasdaq National Market or the Nasdaq SmallCap Market. The terms of the 2008 Notes provide that interest is initially payable 6% in cash and 4% in additional notes for the first year and payable entirely in cash thereafter. The 2008 Notes are also secured by certain intellectual property of the Company. Provisions in Our Certificate of Incorporation and Bylaws and Delaware Law -------------------------------------------------------------------------- Could Delay or Discourage a Takeover which Could Adversely Affect the Price of ------------------------------------------------------------------------------ Our Common Stock. ---------------- Our board of directors has the authority to issue up to 5 million shares of preferred stock and to determine the price, rights, preferences, privileges, and restrictions, including voting rights, of those shares without any further vote or action by holders of our common stock. If preferred stock is issued, the voting and other rights of the holders of our common stock may be subject to, and may be adversely affected by, the rights of the holders of our preferred stock. The issuance of preferred stock may have the effect of delaying or preventing a change of control of the Company that could have been at a premium price to our stockholders. Certain provisions of our certificate of incorporation and bylaws could discourage potential takeover attempts and make attempts to change management by stockholders difficult. Our board of directors, which is classified into three classes of directors serving staggered, three-year terms, has the authority to impose various procedural and other requirements that could make it more difficult for our stockholders to effect certain corporate actions. In addition, our certificate of incorporation provides that directors may be removed only by the affirmative vote of the holders of two-thirds of the shares of our capital stock entitled to vote. Any vacancy on our board of directors may be filled only by a vote of the majority of directors then in office. Further, our certificate of incorporation provides that the affirmative vote of two-thirds of the shares entitled to vote, voting together as a single class, subject to certain exceptions, is required for certain business combination 24 transactions. These provisions, and certain other provisions of our certificate of incorporation, could have the effect of delaying or preventing (i) a tender offer for our common stock or other changes of control of the Company that could be at a premium price, or (ii) changes in our management. In addition, certain provisions of Delaware law could have the effect of delaying or preventing a change in control of the Company. Section 203 of the Delaware General Corporation Law, for example, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years from the date the person became an interested stockholder unless certain conditions are met. The Trading Price of Our Common Stock Has Been, and Is Expected to ------------------------------------------------------------------ Continue to Be, Volatile. ------------------------ The Nasdaq SmallCap Market on which our common stock was listed, the "Pink Sheets" over-the-counter market, where our stock currently trades, and stock markets in general, have historically experienced extreme price and volume fluctuations that have affected companies unrelated to their individual operating performance. The trading price of our common stock has been and is likely to continue to be volatile due to such factors as: o Variations in quarterly results of operations; o Announcements of new products or acquisitions by our competitors; o Governmental regulatory action; o Resolution of pending or unasserted litigation, including the existing shareholder lawsuits; o Developments or disputes with respect to proprietary rights; and o General trends in our industry and overall market conditions. Movements in prices of equity securities in general may also affect the market price of our common stock. Future Sales of a Substantial Number of Shares of Our Common Stock Could ------------------------------------------------------------------------ Cause the Price of the Stock to Decrease or Fluctuate Substantially. ------------------------------------------------------------------- Our existing stockholders hold a significant number of shares of common stock that may be sold in the future under Rule 144 of the Securities Act or through the exercise of registration rights. Sales of a substantial number of the aforementioned shares in the public markets or the prospect of such sales could adversely affect or cause substantial fluctuations in the market price of our common stock and debt securities and impair our ability to raise additional capital through the sale of our securities. Future Sales of Our Common Stock in the Public Market or Option Exercises ------------------------------------------------------------------------- and Sales Could Lower Our Stock Price. ------------------------------------- A substantial number of the unissued shares of our common stock are subject to stock options and our outstanding 2005 Notes may be converted into shares of common stock. We cannot predict the effect, if any, that future sales of shares of common stock, or the availability of shares of common stock for future sale, will have on the market price of our common stock. Sales of substantial amounts of common stock, including shares issued upon the exercise of stock options or the conversion of our outstanding 2005 Notes, or the perception that such sales could occur, may adversely affect prevailing market prices for our common stock. We Face Product Development Risks Associated with Rapid Technological --------------------------------------------------------------------- Changes. ------- The healthcare software market is highly fragmented and characterized by ongoing technological developments, evolving industry standards, and rapid changes in customer requirements. Our success depends on our ability to timely and effectively: o Offer a broad range of software products; 25 o Enhance existing products and expand product offerings; o Respond promptly to new customer requirements and industry standards; o Remain compatible with popular operating systems and develop products that are compatible with the new or otherwise emerging operating systems; and o Develop new interfaces with competing HIS vendors to fully integrate our Quantim product suite in order to maximize features and functionality of the new products. Our performance depends in large part upon our ability to provide the increasing functionality required by our customers through the timely development and successful introduction of new products and enhancements to our existing suite of products. We may not successfully, or in a timely manner, develop, acquire, integrate, introduce, or market new products or product enhancements. Product enhancements or new products developed by us also may not meet the requirements of hospitals or other healthcare providers and payers or achieve or sustain market acceptance. Our failure to either estimate accurately the resources and related expenses required for a project, or to complete our contractual obligations in a manner consistent with the project plan upon which a contract was based, could have a material adverse effect on our business, financial condition, and results of operations. In addition, our failure to meet a customer's expectations in the performance of our services could damage our reputation and adversely affect our ability to attract new business. Our Inability to Protect Our Intellectual Property Could Lead to ---------------------------------------------------------------- Unauthorized Use of Our Products, which Could Have an Adverse Effect on Our --------------------------------------------------------------------------- Business. -------- We rely on a combination of trade secret, copyright and trademark laws, nondisclosure, non-compete, and other contractual provisions to protect our proprietary rights. In 2001, we filed our first patent application covering our developed technology, the Affinity CPOE software application. Measures taken by us to protect our intellectual property may not be adequate, and our competitors could independently develop products and services that are substantially equivalent or superior to our products and services. Any infringement or misappropriation of our proprietary software and databases could put us at a competitive disadvantage in a highly competitive market and could cause us to lose revenues, incur substantial litigation expense, and divert management's attention from other operations. We depend on licenses from a number of third-party vendors for certain technology used to develop and operate our products. Most of these licenses expire within three to five years. Such licenses can be renewed only by mutual consent and may be terminated if we breach the license terms and fail to cure the breach within a specified time period. If such licenses are terminated, we may not be able to continue using the technology on commercially reasonable terms or at all. As a result, we may have to discontinue, delay or reduce product shipments until equivalent technology is obtained, which could have a material adverse effect on our business, financial condition, and results of operations. Most of our third-party licenses are non-exclusive and competitors may obtain the same or similar technology. In addition, if vendors choose to discontinue support of the licensed technology, we may not be able to modify or adapt our products. Intellectual property litigation is increasingly common in the software industry. The risk of an infringement claim against us may increase over time as the number of competitors in our industry segment grows and the functionality of products overlaps. Third parties could assert infringement claims against us in the future. Regardless of the merits, we could incur substantial litigation expenses in defending any such asserted claim. In the event of an unfavorable ruling on any such claim, a license or similar agreement may not be available to us on reasonable terms, if at all. Infringement may also result in significant monetary liabilities that could have a material adverse effect on our business, financial condition, and results of operations. We may not be successful in the defense of these or similar claims. 26 The Nature of Our Products Makes Us Particularly Vulnerable to Undetected ------------------------------------------------------------------------- Errors or Bugs that Could Reduce Revenues, Market Share or Demand for Our ------------------------------------------------------------------------- Products and Services. --------------------- Products such as those we offer may contain errors or failures, especially when initially introduced or when new versions are released. Although we conduct extensive testing on our products, software errors have been discovered in certain enhancements and products after their introduction. Despite such testing by us and by our current and potential customers, products under development, enhancements, or shipped products may contain errors or performance failures, resulting in, among other things: o Loss of customers and revenue; o Delay in market acceptance; o Diversion of resources; o Damage to our reputation; or o Increased service and warranty costs. Any of these consequences could have a material adverse effect on our business, financial condition, and results of operations. If Our Products Fail to Accurately Assess, Process, or Collect Healthcare ------------------------------------------------------------------------- Claims or Administer Managed Care Contracts, We Could Be Subject to Costly -------------------------------------------------------------------------- Litigation and Be Forced to Make Costly Changes to Our Products. --------------------------------------------------------------- Some of our products and services are used in the payment, collection, coding, and billing of healthcare claims and the administration of managed care contracts. If our employees or products fail to accurately assess, process, or collect these claims, customers could file claims against us. Our insurance coverage may not be adequate to cover such claims. A successful claim that is in excess of, or is not covered by, insurance coverage could adversely affect our business, financial condition, and results of operations. Even a claim without merit could result in significant legal defense costs and could consume management time and resources. In addition, claims could increase our premiums such that appropriate insurance could not be found at commercially reasonable rates. Furthermore, if we were found liable, we may have to significantly alter one or more of our products, possibly resulting in additional unanticipated research and development expenses. We May Be Required to Make Substantial Changes to Our Products if They ---------------------------------------------------------------------- Become Subject to FDA Regulation, which Could Require a Significant Capital --------------------------------------------------------------------------- Investment. ---------- Computer products used or intended for use in the diagnosis, cure, mitigation, treatment, or prevention of disease or other conditions or that affect the structure or function of the body are subject to regulation by the FDA under the Federal Food, Drug and Cosmetic Act. At present, none of our software products are so regulated. In the future, the FDA could determine that some of our products, because of their predictive aspects, are clinical decision tools and subject them to regulation. Compliance with FDA regulations could be burdensome, time consuming, and expensive. Other new laws and regulations affecting healthcare software development and marketing also could be enacted in the future. If so, it is possible that our costs and the length of time for product development and marketing could increase and that other unforeseeable consequences could arise. Governmental Regulation of the Confidentiality of Patient Health ---------------------------------------------------------------- Information Could Result in Our Customers Being Unable to Use Our Products -------------------------------------------------------------------------- Without Significant Modification, which Could Require Us to Expend Substantial ------------------------------------------------------------------------------ Amounts. ------- There is substantial state and federal regulation of the confidentiality of patient health information and the circumstances under which such information may be used by, disclosed to or processed by us as a consequence of our contacts with various health care providers. Although compliance with these laws and regulations is presently the principal responsibility of the hospital, physician, or other healthcare provider, regulations governing 27 patient confidentiality rights are dynamic and rapidly evolving. Changes may be made which require us to change our systems and our methods which could require significant expenditure of capital and decrease future business prospects. Additional federal and state legislation governing the dissemination of individually identifiable information have been proposed and may be adopted, which may also significantly affect our business. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") is a federal law that affects the use, disclosure, transmission and storage of individually identifiable health information. As directed by HIPAA, the United States Department of Health and Human Services ("HHS") must promulgate standards and implementation guidelines for certain electronic health transactions, code sets, data security, unique identification numbers, and privacy of individually identifiable health information. HHS has made several regulatory proposals, which are in various stages of development. First, HHS has published a final regulation governing transaction and code-set standards that had a compliance date of October 16, 2002. If a covered entity (health care providers that transmit certain covered transactions in electronic form, health plans and health care clearinghouses) or its agent file an extension by October 16, 2003, the covered entity would receive an additional year to comply with the HIPAA transaction and code sets requirements. Second, HHS has published a final HIPAA privacy rule which has a compliance date of April 14, 2003. The HIPAA privacy rule is complex and far reaching. Similar to the HIPAA transaction and code sets rule, the HIPAA privacy rule applies to covered entities. Covered entities are required to execute a contract with any business associate that performs certain services on the covered entity's behalf. We may be implicated by the HIPAA privacy rule as a business associate of a covered entity. The HIPAA privacy rule and state healthcare privacy regulations could materially restrict the ability of healthcare providers to disclose individually identifiable health information from patient records using our products and services or could require us to make substantial capital expenditures to be in compliance. Accordingly, the HIPAA Privacy Rule and state privacy laws may significantly impact our product's use in the health care delivery system and therefore, decrease our revenue, increase working capital requirements and decrease future business prospects. Third, HHS published the final HIPAA security rule with a compliance date of April 20, 2005. The HIPAA security rule applies to the use, disclosure, transmission, storage and destruction of electronic protected health information by covered entities. Covered entities must implement stringent security measures to ensure the confidentiality of the electronic protected health information, and to protect against the unauthorized use of the electronic protected health information. Implementing such measures will require us to expend substantial capital due to required product, service, and procedure changes. Government Regulation to Adopt and Implement ICD-10-CM and ICD-10-PCS --------------------------------------------------------------------- Medical Code Set Standards. -------------------------- Prominent HIM organizations are calling on the Department of Health and Human Services (HHS) and the healthcare industry to take action to adopt and implement ICD-10-CM and ICD-10-PCS code sets, rules, and guidelines as a replacement for current ICD-9-CM guidelines used in our software products. Adoption of these new code sets would require us to change our systems and our methods which could require a significant expenditure of R & D capital and decrease future business prospects for our current product line. Government Regulation of the Health Care Delivery System May Affect Health -------------------------------------------------------------------------- Care Providers' Discretionary Spending. -------------------------------------- During the past several years, the healthcare industry has been subject to, among other things, increasing levels of governmental regulation of reimbursement rates and certain capital expenditures. Certain proposals to reform the healthcare system have been and are being considered by Congress. These proposals, if enacted, could change the operating environment for our clients in ways that could have a negative impact on our business, financial condition, and results of operations. We are unable to predict what, if any, changes will occur. 28 Changes in Procurement Practices of Hospitals Have and May Continue to ---------------------------------------------------------------------- Have a Negative Impact on Our Revenues. -------------------------------------- A substantial portion of our revenues has been and is expected to continue to be derived from sales of software products and services to hospitals. Consolidation in the healthcare industry, particularly in the hospital and managed care markets, could decrease the number of existing or potential purchasers of products and services and could adversely affect our business. In addition, the decision to purchase our products often involves a committee approval. Consequently, it is difficult for us to predict the timing or outcome of the buying decisions of our customers or potential customers. In addition, many healthcare providers are consolidating to create IDNs with greater regional market power. These emerging systems could have greater bargaining power, which may lead to decreases in prices for our products, which could adversely affect our business, financial condition, and results of operations. Changes in the Healthcare Financing and Reimbursement System Could ------------------------------------------------------------------ Adversely Affect the Amount of and Manner in which Our Customers Purchase Our ----------------------------------------------------------------------------- Products And Services. --------------------- Changes in current healthcare financing and reimbursement systems could result in unplanned product enhancements, delays, or cancellations of product orders or shipments, or reduce the need for certain systems. We could also have the endorsement of products by hospital associations or other customers revoked. Any of these occurrences could have a material adverse effect on our business. Alternatively, the federal government recently mandated the use of electronic transmissions for large Medicare providers which may positively affect our systems and product. 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 traditional hospital delivery system is evolving as more hospital services are being provided by niche, free standing practices and outpatient providers. The commercial value and appeal of our products may be adversely affected if the current healthcare financing and reimbursement system were to revert to a fee-for-service model. In addition, many of our customers provide services under capitated service agreements, and a reduction in the use of capitation arrangements as a result of regulatory or market changes could have a material adverse effect on our business. During the past several years, the healthcare industry has been subject to increasing levels of governmental regulation of, among other things, reimbursement rates and capital expenditures. Proposals to reform the healthcare system have been and are being considered by the United States Congress. These proposals, if enacted, could change the operating environment of our customers in ways that cannot be predicted. Healthcare organizations may react to these proposals by curtailing or deferring investments, including those for our products and services. In addition, the regulations promulgated under HIPAA could lead healthcare organizations to curtail or defer investments in non-HIPAA related features in the next several years. Our Quarterly Operating Results Are Subject to Fluctuations, which Could ------------------------------------------------------------------------ Adversely Affect Our Financial Results and the Market Price of Our Common ------------------------------------------------------------------------- Stock. ----- Our quarterly operating results have varied significantly in the past and may fluctuate in the future as a result of a variety of factors, many of which are outside our control. Accordingly, quarter-to-quarter comparisons of our operating results may not be indicative of our future performance. Some of the factors causing these fluctuations include: o Variability in demand for products and services; o Introduction of product enhancements and new products by us and our competitors; o Timing and significance of announcements concerning present or prospective strategic alliances; o Discontinuation of, or reduction in, the products and services we offer; o Loss of customers due to consolidation in the healthcare industry; o Delays in product delivery requested by our customers; 29 o Customer budget cycle fluctuation; o Investment in marketing, sales, research and development, and administrative personnel necessary to support anticipated operations; o Costs incurred for marketing and sales promotional activities; o Software defects and other product quality factors; o General economic conditions and their impact on the healthcare industry; o Cooperation from competitors on interfaces and implementation when a customer chooses a QuadraMed software application to use with various vendors; o Delays in implementation due to product readiness, customer induced delays in training or installation, and third party interface development delays; o Final negotiated sales prices of systems; o Federal regulations (i.e., OIG, HIPAA, ICD-10) that can increase demand for new, updated systems; o Federal regulations that directly affect reimbursements received, and therefore the amount of money available for purchasing information systems; o The fines and penalties a healthcare provider or system may incur due to fraudulent billing practices; and o Increases in third party royalty fees associated with embedded products in QuadraMed software applications. Our operating expense levels, which increase with the addition of acquired businesses, are relatively fixed. Accordingly, if future revenues were below expectations, we would experience a disproportionate adverse affect on our net income and financial results. In the event of a revenue shortfall, we will likely be unable to, or may elect not to, reduce spending quickly enough to offset any such shortfall. As a result, it is possible that our future revenues or operating results may fall below the expectations of securities analysts and investors. In such a case, the price of our publicly traded securities may be adversely affected. The Variability and Length of Our Sales Cycle for Our Products May ------------------------------------------------------------------ Exacerbate the Unpredictability and Volatility of Our Operating Results. ----------------------------------------------------------------------- We cannot accurately forecast the timing of customer purchases due to the complex procurement decision processes of most healthcare providers and payers. How and when to implement, replace, expand or substantially modify an information system are major decisions for customers, and such decisions require significant capital expenditures by them. As a result, we typically experience sales cycles that extend over several quarters. In addition, certain products we acquired with Compucare have higher average selling prices and longer sales cycles than many of our other products. As a result, we have only a limited ability to forecast the timing and size of specific sales, making the prediction of quarterly financial performance more difficult. If We Are Unable to Compete Effectively, We Could Experience Price ------------------------------------------------------------------ Reduction, Reduced Gross Margins and Loss of Market Share. --------------------------------------------------------- Competition for our products and services is intense and is expected to increase. Increased competition could result in reductions in our prices, gross margins, and market share and have a material adverse effect on our business, financial condition, and results of operations. We compete with other providers of healthcare information software and services, as well as healthcare consulting firms. Some competitors have formed business alliances with other competitors that may affect our ability to work with some potential customers. In addition, if some of our competitors merge, a stronger competitor may emerge. Some principal competitors include: 30 o In the market for enterprise healthcare information systems in the Enterprise Division: McKesson Corporation, Inc., Shared Medical Systems, Inc., a division of Siemens, MediTech Corporation, Eclipsys Corporation, Cerner, and, IDX Corporation; o In the market for electronic document management products in the Enterprise Division: McKesson Corporation, SoftMed Corporation Inc., FileNet, Lanvision, MedPlus, and, Eclipsys Corporation; o In the market for MPI products and services in the Enterprise Division: Madison Technologies, Inc., McKesson Corporation, Shared Medical Systems, Inc., a division of Siemens, and, Medibase; o In the market for decision support products in the Enterprise Division: Eclipsys Corporation, Healthcare Microsystems, Inc., a division of Health Management Systems Inc., McKesson Corporation, Shared Medical Systems, Inc., a division of Siemens, and, MediQual Systems, Inc., a division of Cardinal Health, Inc.; o In the market for coding, compliance, data, and record management products in the Health Information Management Software Division: 3M Corporation, SoftMed Corporation, Inc., MetaHealth, Eclipsys Corporation, PricewaterhouseCoopers LLP and, HSS, Inc.; o In the Health Information Management Services Division: PricewaterhouseCoopers LLP, Bearing Point and Cap Gemini for compliance products and services and health information management consulting services; and o In the Financial Services Division: Advanced Receivables Strategy, Inc., a division of Perot Systems Corporation, NCO Group, Inc., Outsourcing Solutions, Inc., Health Management Systems, Inc., and Triage Consulting Group. Current and prospective customers also evaluate our products' capabilities against the merits of their existing information systems and expertise. Major software information systems companies, including those specializing in the healthcare industry, that do not presently offer competing products may enter our markets. Many of our competitors and potential competitors have significantly greater financial, technical, product development, marketing and other resources, and market recognition than we have. Many of these competitors also have, or may develop or acquire, substantial installed customer bases in the healthcare industry. As a result of these factors, our competitors may be able to respond more quickly to new or emerging technologies, changes in customer requirements, and changes in the political, economic or regulatory environment in the healthcare industry. These competitors may be in a position to devote greater resources to the development, promotion, and sale of their products than we can. We may not be able to compete successfully against current and future competitors, and such competitive pressures could materially adversely affect our business, financial condition, and operating results. Our Services Face Review and Scrutiny from the Department of Health and ----------------------------------------------------------------------- Human Services, the Department of Justice and Other Law Enforcement Agencies. ---------------------------------------------------------------------------- As a result of rising health care costs, federal and state governments have placed an increased emphasis on detecting and eliminating fraud and abuse in Medicare, Medicaid, and other health care programs. Numerous laws and regulations now exist to prevent fraudulent or abusive billing, to protect patients' privacy rights, and to ensure patients' access to health care. Violation of the laws or regulations governing our operations could result in the imposition of civil or criminal penalties, including temporary or permanent exclusion from participation in government health care programs such as Medicare and Medicaid, the cancellation of our contracts to provide managed care services, and the suspension or revocation of our licenses. We routinely conduct internal audits in our effort to ensure compliance with all applicable laws and regulations. If errors, discrepancies or violations of laws are discovered in the course of these audits or otherwise, we may be required by law to disclose the relevant facts, once known, to the appropriate authorities. 31 We Face Risks Associated with U.S. Government Contracting. --------------------------------------------------------- We have been awarded a U.S. General Services Administration ("GSA") Schedule Contract for Federal Supply Service of commercial information technology. The willingness of government agencies to enter into future contracts depends upon (i) our ability to continue supporting existing products; (ii) maintaining ongoing relationships with third party suppliers of certain elements of our products; and (iii) developing new products with third party suppliers to address new regulatory requirements of government agencies and having these products added to our GSA commercial price list. These contracts are subject to cancellation at the convenience of the contracting government agency. As a commercial vendor, we must file a quarterly sales report with the GSA and remit a 1% "Industrial Funding Fee" based on the sales value of the contract. Reductions or delays in federal funds available for projects we are performing could also have an adverse impact on our government business. Contracts involving time and material fees are also subject to the risks of disallowance of costs upon audit, changes in government procurement policies, required competitive bidding for products not identified on the GSA commercial product price list, and, with respect to contracts involving prime contractors or government-designated subcontractors, the inability of those parties to perform under their contracts. We Have Encountered Significant Challenges Integrating Acquired --------------------------------------------------------------- Businesses, and Future Transactions May Adversely Affect Our Business, --------------------------------------------------------------------- Operations, and Financial Condition. ----------------------------------- From 1993 to 1999, we completed 28 acquisitions encountering significant challenges integrating the acquired businesses into our operations and, in years 2000 and 2002 focused in particular on their integration. Some of the challenges we have encountered, and may encounter with acquisitions in the future, in integrating acquired businesses have included: o Interruption, disruption or delay of our ongoing business; o Distraction of management's attention from other matters; o Additional operational and administrative expenses; o Difficulty managing geographically dispersed operations; o Failure of acquired businesses to achieve expected results, resulting in our failure to realize anticipated benefits; o Write-down or reclassification of acquired assets; o Failure to retain key acquired personnel and difficulty and expense of training those retained; o Increases in stock compensation expense and increased compensation expense resulting from newly hired employees; o Assumption of liabilities and potential for disputes with the sellers of acquired businesses; o Customer dissatisfaction or performance problems related to acquired businesses; o Exposure to the risks of entering markets in which we have no direct prior experience and to risks associated with market acceptance of acquired products and technologies; and o Platform and technical issues related to integrating systems from various acquired companies. All of these factors have had an adverse effect on our business, financial condition, and results of operations in the past, and could have an adverse effect in the future. 32 New Accounting Standards May Make Acquisitions Necessary for Our Growth ----------------------------------------------------------------------- Less Accretive and Less Attractive. ---------------------------------- In June 2001, the FASB issued SFAS No. 141, Business Combinations. The --------------------- statement addresses financial accounting and reporting for business combinations and supersedes APB Opinion No. 16, Business Combinations, and SFAS --------------------- No. 38, Accounting for Pre-acquisition Contingencies of Purchased Enterprises. --------------------------------------------------------------------- From 1993-1999, we completed 28 acquisitions, certain of which were accounted for using the pooling-of-interests methodology, which is no longer acceptable under SFAS 141. Effective June 2001, prospective business combinations are required to be accounted for using purchase accounting. As a result, any amounts paid in excess of fair value of the assets acquired are capitalized and recorded as intangible assets or goodwill whose amortization or impairment may reduce future earnings. Accordingly, future business combinations may be less attractive as our reported generally accepted accounting principles ("GAAP") operating results are likely to be negatively impacted. We May Suffer Losses Due to the Investment Performance of Variable Life ----------------------------------------------------------------------- Insurance Policies That Are Tied to the Performance of Equity Markets That May ------------------------------------------------------------------------------ Lead to Delays in Repayments of Premiums Pursuant to Certain Split-Dollar Life ------------------------------------------------------------------------------ Insurance Agreements or Result in Increased Supplemental Executive Retirement ----------------------------------------------------------------------------- Plan (SERP) Expenses in Future Periods. -------------------------------------- We have an investment interest in three variable life insurance policies. Each of the variable life insurance policies provides for the investment of the cash value portion of policies into various sub-accounts that are similar in nature to mutual funds. Two policies are issued pursuant to split-dollar agreements with the former executives, and trusts established for their benefit make the investment decisions on these policies. The third policy is a corporate-owned policy that we contributed to a grantor or "rabbi" trust established to make contributions to satisfy our obligations under the SERP and two other subsequently terminated benefit plans. We make the investment decisions only on this policy. The performance of the variable life insurance policies for cash value and premium amounts will vary depending on the performance of the selected underlying sub-accounts. Pursuant to FTB 85-4 and FTB 97-14, we report the amounts that could be realized under these variable life insurance contracts as an asset valued as of the balance sheet date and treat the change in cash surrender value during the reported period as an adjustment of premiums paid in determining the expense or income to be recognized. The reduced value of the variable life insurance policies and future adverse changes in the condition of equity markets or poor operating results of underlying policy sub-accounts could result in (i) the delayed repayment of advanced premiums in the case of the split-dollar policies, and/or (ii) increased SERP expenses in future periods. A Significant Amount of Our Assets Are Comprised of Goodwill, Capitalized ------------------------------------------------------------------------- Software, Customer Lists and Other Intangible Items Subject to Impairment and ----------------------------------------------------------------------------- Adjustment That Could Possibly Negatively Impact Our Results of Operations and ------------------------------------------------------------------------------ Stockholders' Equity. -------------------- A significant amount of our assets are comprised of capitalized software and intangible assets, such as the value of the installed customer base, core technology, capitalized software, goodwill, and other identifiable intangible assets acquired through our acquisitions, such as trademarks. Pursuant to SFAS No. 142, we must test goodwill, capitalized software and other intangible assets beyond their economic life for impairment at least annually, and adjust them when impaired to the appropriate net realizable value. We engaged a valuation firm to perform an impairment test on the carrying value of our goodwill and intangibles as of December 31, 2002 and 2001. The valuation firm determined that there was no impairment as of these dates. In addition, our internally-developed software has been capitalized assuming our earnings from these product developments exceeds the costs incurred to develop them. If it is determined that these assets have been impaired and our future operating results will not support the existing carrying value of the capitalized software, we will be required to adjust the carrying value of the capitalized software to net realizable value. We, however, cannot predict that all of our intangible assets will continue to remain unimpaired. Our future operating results and stockholders' equity could possibly decrease with any future impairment and write-down of goodwill, customer lists, or other such intangibles. 33 No Mirror Processing Site for Our Customer Data Processing Facilities --------------------------------------------------------------------- Exists; Our Business, Financial Condition, and Results of Operations Could Be ----------------------------------------------------------------------------- Adversely Affected if These Facilities Were Subject to a Closure from a ----------------------------------------------------------------------- Catastrophic Event or Otherwise. ------------------------------- We currently process substantially all of our customer data at our facilities in Neptune, New Jersey; Irving, Texas; Kansas City, Missouri; and San Rafael, California. Although we back up our data nightly and have safeguards for emergencies, such as power interruption or breakdown in temperature controls, we have no mirror processing site to which processing could be transferred in the case of a catastrophic event at any of these facilities. If a major catastrophic event occurs at these facilities possibly leading to an interruption of data processing, or any other interruption or closure, our business, financial condition, and results of operations could be adversely affected. Item 3. Quantitative and Qualitative Disclosures About Market Risk ------ ---------------------------------------------------------- Interest Rate Risk ------------------ Our exposure to market risk for changes in interest rates primarily relates to our investment portfolio. It is our intent to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We invest in high-quality issuers, including money market funds, corporate debt securities, and debt securities issued by the United States government. We have a policy of investing in securities with maturities of two years or less. We do not invest in derivative financial or foreign investments. The table below presents fair values of principal amounts and weighted average interest rates for our investment portfolio as of June 30, 2002, (in thousands, except average interest rates): Aggregate Weighted Average Fair Value Interest Rate ---------- ------------- Cash and cash equivalents: Cash $ 9,595 Money Market funds 11,345 1.64 % -------- Total cash and cash equivalents $ 20,940 ======== Short-term investments: Corporate debt securities $ 2,380 1.70 % -------- Total short-term investments $ 2,380 ======== Long-term investments: Corporate debt securities $ 542 5.48 % Debt issued by the U.S. government 680 5.39 % -------- Total long-term investments $ 1,222 ======== As our long-term debt consists solely of our Debentures totaling $73.7 million at June 30, 2002, at a fixed interest rate of 5.25% maturing in 2005, we are not exposed to debt related interest rate risk. Performance of Equity Markets ----------------------------- The performance of equity markets can have an effect on our operations, and recent declines in equity markets, if sustained, will have an adverse effect on us related to certain variable life insurance policies in which we have an investment interest. Foreign Currency Risk --------------------- Although we sell our products internationally from time to time, all such transactions are denominated in U.S. Dollars and there is no foreign currency fluctuation risk associated with such sales. 34 PART II. OTHER INFORMATION -------------------------- Item 1. Legal Proceedings ------ ----------------- In October 2002, a series of securities law class action complaints were filed in the United States District Court, California Northern District, against us and certain of our officers and directors. The plaintiffs in these actions allege, among other things, violations of the Securities Exchange Act of 1934 due to issuing a series of allegedly false and misleading statements concerning our business and financial condition between May 11, 2000 and August 11, 2002. The complaints seek unspecified monetary damages and other relief. These matters are at an early stage. No responses to the complaints have yet been filed, and no discovery has taken place. We intend to defend ourselves vigorously against these allegations. On December 31, 2002, the Court entered an order consolidating all related securities class actions against the Company. Following our August 12, 2002 announcement that we intended to restate prior period financial statements, the staff of the San Francisco District Office of the SEC requested certain information and documents relating to this matter as part of an informal, preliminary inquiry. We provided that information, and expect to provide further information now that the restatement is completed. On February 28, 2003, we reported that the SEC had issued a formal non-public order of investigation concerning our accounting and financial reporting practices for the period beginning January 1, 1998. We intend to continue to cooperate with the SEC in the event it requests other information. We cannot predict whether such information will be requested, when the SEC will conclude its inquiry, or the impact or outcome thereof. Item 2. Submission of Matters to a Vote of Security Holders ------ --------------------------------------------------- We held our annual meeting of shareholders on April 29, 2002. The number of shares issued, outstanding, and eligible to vote as of the record date of May 18, 2002 was 27,086,000. At the meeting, 179 proxies representing 21,584,931 shares, or approximately 80% of the eligible shares, were tabulated. Voting was tabulated as follows: Proposal 1. Election of Class III Directors: CLASS III NOMINEES TO HOLD OFFICE UNTIL 2005 FOR WITHHELD ---------- --- -------- Lawrence P. English 20,101,238 1,482,394 Joseph L. Feshbach 21,435,625 148,007 Proposal 2. Approval of our 2002 Employee Stock Purchase Plan and the reservation of 333,450 shares for issuance and its qualification under Section 423 of the Internal Revenue Code of 1986, as amended: FOR AGAINST ABSTAIN NON-VOTE --- ------- ------- -------- 21,466,858 60,903 55,871 0 Proposal 3. Ratification of the appointment of PricewaterhouseCoopers LLP as our independent public accountants for the fiscal year ending December 31, 2002. FOR AGAINST ABSTAIN NON-VOTE --- ------- ------- -------- 21,514,912 62,865 5,855 0 Item 3. Other Matters ------ ------------- Extension of Stock Repurchase Program ------------------------------------- In June 2001, our board of directors approved a stock repurchase program, under which we were authorized to repurchase up to 6,000,000 shares of our common stock over the following twelve-month period ("Repurchase Program"). In 35 July 2002, our board of directors extended the Repurchase Program for an additional twelve months. We intend to buy back our common stock at times when our market value presents opportunities to do so. The Repurchase Program is intended as a means to partially mitigate the dilutive impact of stock options and to provide an alternative investment for our cash. The extent to which we repurchase shares and the timing of such purchases will depend upon market conditions and other corporate considerations. As of June 30, 2002, we had repurchased 200,000 shares of our common stock under the Repurchase Program. The shares were repurchased at an average price of $4.05 and a total purchase price, including acquisition costs, of $821,000, and were recorded as additional paid in capital. Corporate Governance Matters ---------------------------- Creation of Nominating and Corporate Governance Committee --------------------------------------------------------- In July 2002, our board of directors voted to create a Nominating and Corporate Governance Committee ("NCGC"). At the same time, the board of directors elected to the NCGC the following independent directors: Albert E. Greene; F. Scott Gross; E.A. Roskovensky; and Cornelius T. Ryan. In August 2002, the members of the NCGC elected F. Scott Gross to serve as Chairman. Certain Relationships and Related Party Transactions ---------------------------------------------------- On June 21, 2002, Lawrence P. English, our Chairman and Chief Executive Officer, resigned from the Compensation Committee of the Board of Directors of Curative Health Services, Inc. ("Curative"), subsequent to the appointment of Joseph L. Feshbach, one of our directors, as Chief Executive Officer. Prior to this time, Mr. Feshbach served only as Chairman of the Board of Curative. Mr. English was re-elected to the Curative Board for a term of one year at the Curative annual meeting of shareholders on May 30, 2002. Item 4. Exhibits and Reports on Form 8-K ------ -------------------------------- (a) The following documents are filed as a part of this Quarterly Report on Form 10-Q. (i) Financial Statements. The interim condensed consolidated financial statements contained herein. (b) Reports filed on Form 8-K during the period of this Quarterly Report on Form 10-Q: (i) Form 8-K dated April 5, 2002, reporting a change in independent public accountants. (ii) Form 8-K/A dated April 5, 2002, reporting a change in independent public accountants. (iii) Form 8-K dated May 22, 2002, reporting listing on the Nasdaq National Market. (iv) Form 8-K dated June 11, 2002, reporting the acquisition of Pharmacy Data Systems, Inc. (c) Exhibits: The exhibits listed on the accompanying Exhibits Index or incorporated by reference are filed as part of this Quarterly Report on Form 10-Q. 36 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this form to be signed on its behalf by the undersigned, thereunto duly authorized. QUADRAMED CORPORATION Date: August 15, 2003 By: /s/ Lawrence P. English ---------------------------------- Lawrence P. English Chairman of the Board Chief Executive Officer Date: August 15, 2003 By: /s/ Charles J. Stahl ---------------------------------- Charles J. Stahl Chief Financial Officer 37 EXHIBIT INDEX 2.1 Securities Purchase Agreement dated as of May 5, 2000, by and among QuadraMed Corporation, QuadraMed Operating Corporation, Certain Investors and ChartOne, Inc. (6) 2.2 Asset Contribution Agreement dated as of May 3, 2000, by and among QuadraMed Corporation, QuadraMed Operating Corporation and ChartOne, Inc. (6) 2.3 Asset Purchase Agreement, by and among, QuadraMed Corporation, QuadraMed Operating Corporation, OAO Technology Solutions, Inc., and OAO Transaction, LLP, dated as of August 16, 2001. (11) 3.1 Amended and Restated Bylaws of QuadraMed. (1) 3.2 Third Amended and Restated Certificate of Incorporation of QuadraMed. (3) 3.3 Amended and Restated Certificate of Incorporation of QuadraMed amended January 28, 2002. 4.1 Reference is made to Exhibits 3.4 and 3.5. (1) (3) 4.2 Form of Common Stock certificate. (1) 4.11 Form of Warrant to Purchase Common Stock. (1) 4.15 Subordinated Indenture, dated as of May 1, 1998, between QuadraMed and The Bank of New York. (4) 4.16 Officers' Certificate delivered pursuant to Sections 2.3 and 11.5 of the Subordinated Indenture. (2) 4.17 Registration Rights Agreement dated April 27, 1998, by and among QuadraMed and the Initial Purchasers named therein. (2) 4.18 Form of Global Debenture. (2) 4.19 Form of Certificated Debenture. (2) 4.21 Registration Rights Agreement dated December 23, 1998, by and between QuadraMed and the shareholders listed therein. (5) 4.22 Registration Rights Agreement, dated as of March 3, 1999, by and among QuadraMed Corporation and the stockholders of The Compucare Company named therein. (4) 10.1 1996 Stock Incentive Plan of QuadraMed. (1) 10.2 1996 Employee Stock Purchase Plan of QuadraMed. (l) 10.3 Summary Plan Description, QuadraMed Corporation 401(k) Plan. (1) 10.4 Form of Indemnification Agreement between QuadraMed and its directors and executive officers. (1) 10.4 Amendment of Separation Agreement effective as of July 31, 2001 between James D. Durham and QuadraMed. (12) 10.5 1999 Supplemental Stock Option Plan for QuadraMed. (14) 10.5 Amendment of Employment Agreement dated September 20, 2001 between Lawrence P. English and QuadraMed. (13) 10.6 Amendment of Employment Agreement dated September 20, 2001 between Michael H. Lanza and QuadraMed. (13) 10.7 Amendment of Employment Agreement dated September 20, 2001 between Dean Souleles and QuadraMed. (13) 10.8 Amendment of Employment Agreement dated September 20, 2001 between Mark N. Thomas and QuadraMed. (13) 10.9 Amendment of Employment Agreement dated September 20, 2001 between Michael S. Wilstead and QuadraMed. (13) 10.64 Separation Agreement dated June 12, 2000, between James D. Durham and QuadraMed. (7) 10.65 Separation Agreement dated June 12, 2000, between John V. Cracchiolo and QuadraMed. (7) 10.66 Employment Agreement dated June 12, 2000, between Lawrence P. English and QuadraMed. (7) 10.67 Employment Agreement dated May 12, 2000, between Mark Thomas and QuadraMed. (7) 10.67 Employment Agreement dated August 16, 2000, between Dean Souleles and QuadraMed. (9) 10.68 Employment Agreement dated September 18, 2000, between Michael H. Lanza and QuadraMed. (8) 31.1 Certification of the Chairman of the Board and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chairman of the Board and Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002. ---------------------------(1) Incorporated herein by reference from the exhibit with the same number to our Registration Statement on Form SB-2, No. 333-5l80-LA, as filed with the Commission on June 28, 1996, as amended by Amendment No. l, Amendment No. 2 and Amendment No. 3 thereto, as filed with the Commission on July 26, 1996, September 9, 1996, and October 2, 1996, respectively. 38 (2) Incorporated by reference from our Registration Statement on Form S-3, No. 333-55775, as filed with the Commission on June 2, 1998, as amended by Amendment No. 1 thereto, as filed with the Commission on June 17, 1998. (3) Incorporated by reference from the exhibit with the same number to our Quarterly Report on Form 10-Q for the quarter ended June 30, 1998, as filed with the Commission on August 14, 1998, as amended on August 24, 1988. (4) Incorporated herein by reference from our Current Report on Form 8-K/A filed with the Commission on March 22, 1999. (5) Incorporated herein by reference from our Registration Statement on Form S-3, No. 333-80617, as filed with the Commission on June 14, 1999, as amended by Amendment No. l thereto, as filed with the Commission on August 4, 1999. (6) Incorporated herein by reference from exhibit with the same number to our Current Report on Form 8-K filed with the Commission on June 22, 2000. (7) Incorporated herein by reference from the exhibit with the same number to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2000, as filed with the Commission on August 14, 2000. (8) Incorporated herein by reference from the exhibit with the same number to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, as filed with the Commission on November 15, 2000. (9) Incorporated herein by reference from the exhibit with the same number to our Current Report on Form 8-K filed with the Commission on November 6, 2000. (10) Incorporated herein by reference from our annual report on Form 10-K, as filed with the Commission on March 30, 2000, as amended by May 1, 2000. (11) Incorporated herein by reference from our Current Report on Form 8-K, as filed with the Commission on August 21, 2001. (12) Incorporated herein by reference from the exhibit with same number to our Quarterly Report on Form 10-Q as filed with the Commission on August 14, 2001. (13) Incorporated herein by reference from the exhibit with same number to our Quarterly Report on Form 10-Q as filed with the Commission on November 14, 2001. (14) Incorporated herein by reference from our annual report on Form 10-K, as filed with the Commission on March 30, 2000, as amended by May 1, 2000. 39