FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 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: 0-30859 CARESCIENCE, INC. ------------------------------------------------------ (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) PENNSYLVANIA 23-2703715 --------------------------------- ------------------- (STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 3600 MARKET STREET PHILADELPHIA, PA 19104 ------------------------------------------------------ (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (215) 387-9401 ------------------------------------------------------ (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) ------------------------------------------------------ (FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares of the registrant's Common Stock outstanding, as of November 9, 2001 was 13,280,016. Page 1 CARESCIENCE INC. FORM 10-Q SEPTEMBER 30, 2001 INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets--December 31, 2000 and September 30, 2001 (unaudited).................................................................2 Consolidated Statements of Operations--Three and Nine Months Ended September 30, 2000 and September 30, 2001 (unaudited).......................3 Consolidated Statements of Cash Flows--Nine Months Ended September 30, 2000 and September 30, 2001 (unaudited).....................................4 Notes to Consolidated Financial Statements....................................5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...................................................7 Item 3. Quantitative and Qualitative Disclosures About Market Risk...........13 PART II. OTHER INFORMATION Item 1. Legal Proceedings....................................................13 Item 2. Changes in Securities and Use of Proceeds............................13 Item 5. Other Information....................................................14 Item 6. Exhibits and Reports on Form 8-K.....................................14 Signatures...................................................................15 Page 2 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements CARESCIENCE, INC. CONSOLIDATED BALANCE SHEETS (UNAUDITED) DECEMBER 31, SEPTEMBER 30, 2000 2001 ------------ ------------ ASSETS Current assets: Cash and cash equivalents ..................................... $ 26,702,096 $ 16,440,841 Short-term investments ........................................ 3,001,770 6,041,900 Interest receivable ........................................... 174,034 54,360 Accounts receivable, net of allowance for doubtful accounts of $48,794 and $63,854, respectively ............... 865,075 1,329,618 Prepaid expenses and other .................................... 240,345 737,856 ------------ ------------ Total current assets ............................................. 30,983,320 24,604,575 ------------ ------------ Property and equipment: Computer equipment ............................................ 4,611,573 4,943,869 Office equipment .............................................. 482,385 488,760 Furniture and fixtures ........................................ 397,629 397,629 ------------ ------------ 5,491,587 5,830,258 Less--Accumulated depreciation and amortization ............... (2,562,342) (3,625,986) ------------ ------------ Net property and equipment .................................. 2,929,245 2,204,272 ------------ ------------ Goodwill and other intangibles, net ............................. -- 1,328,647 ------------ ------------ Total assets .............................................. $ 33,912,565 $ 28,137,494 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current portion of capital lease obligations and note payable ............................................ $ 250,685 $ 375,821 Accounts payable .............................................. 1,090,613 252,859 Accrued expenses .............................................. 1,141,662 1,065,641 Deferred revenues ............................................. 3,035,511 4,250,869 ------------ ------------ Total current liabilities ................................... 5,518,471 5,945,190 ------------ ------------ Capital lease obligations ........................................ 428,602 247,445 ------------ ------------ Shareholders' equity: Common stock, no par value, 16,000,000 shares authorized, 14,206,851 and 14,720,016 shares issued and 12,766,851 and 13,280,016 outstanding ................................................. 59,612,380 60,256,012 Additional paid-in capital .................................... 5,590,620 5,356,977 Deferred compensation ......................................... (4,010,828) (2,829,789) Accumulated other comprehensive income ........................ 1,770 41,900 Accumulated deficit ........................................... (32,328,450) (39,560,241) Subscription receivables ...................................... -- (420,000) Treasury stock, at cost, 1,440,000 shares ..................... (900,000) (900,000) ------------ ------------ Total shareholders' equity .................................. 27,965,492 21,944,859 ------------ ------------ Total liabilities and shareholders' equity ................ $ 33,912,565 $ 28,137,494 ============ ============ The accompanying notes are an integral part of these statements. Page 3 CARESCIENCE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) FOR THE THREE MONTHS FOR THE NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ----------------------------- ----------------------------- 2000 2001 2000 2001 ------------ ------------ ------------ ------------ Revenues ................................. $ 2,207,402 $ 3,508,661 $ 5,758,384 $ 9,001,043 Cost of revenues (excludes stock-based compensation of $171,088 and $512,278 for the three and nine months ended September 30, 2000, respectively, and $163,209 and $489,831 for three and nine months ended September 30, 2001, respectively) .......................... 1,275,550 1,614,151 3,450,016 4,483,923 ------------ ------------ ------------ ------------ Gross profit ........................... 931,852 1,894,510 2,308,368 4,517,120 ------------ ------------ ------------ ------------ Operating expenses: Research and development (excludes stock-based compensation of $23,922 and $70,779 for the three and nine months ended September 30, 2000, respectively, and $9,772 and $29,316 for three and nine months ended September 30, 2001, respectively) .... 1,329,069 840,567 2,734,740 3,168,116 Selling, general and administrative (excludes stock-based compensation of $146,742 and $439,387 for the three and nine months ended September 30, 2000, respectively, and $142,707 and $428,249 for three and nine months ended September 30, 2001, respectively) ........................ 2,192,210 2,420,400 5,533,485 8,456,836 Stock-based compensation ............... 341,752 315,688 1,022,444 947,396 ------------ ------------ ------------ ------------ Total operating expenses ............. 3,863,031 3,576,655 9,290,669 12,572,348 ------------ ------------ ------------ ------------ Operating loss ....................... (2,931,179) (1,682,145) (6,982,301) (8,055,228) Interest income .......................... (561,695) (247,675) (627,982) (889,652) Interest expense ......................... 23,839 23,497 68,302 66,215 ------------ ------------ ------------ ------------ Net loss ................................. (2,393,323) (1,457,967) (6,422,621) (7,231,791) Accretion of redemption premium on preferred stock ........................ -- -- 253,731 -- Preference distribution on preferred stock .................................. -- -- 5,716,784 -- ------------ ------------ ------------ ------------ Net loss applicable to common shareholders ........................... $ (2,393,323) $ (1,457,967) $(12,393,136) $ (7,231,791) ============ ============ ============ ============ Net loss per common share: Basic and diluted ...................... $ (0.19) $ (0.11) $ (1.88) $ (0.55) Weighted average shares outstanding: Basic and diluted ...................... 12,756,851 13,277,384 6,602,066 13,108,855 The accompanying notes are an integral part of these statements. Page 4 CARESCIENCE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- 2000 2001 ------------ ------------ Cash flows from operating activities: Net loss ............................... $ (6,422,621) $ (7,231,791) Adjustments to reconcile net loss to net cash used inoperating activities-- Depreciation and amortization ........ 577,132 1,034,710 Loss on disposal ..................... -- 158,000 Provision for bad debts .............. 12,000 14,475 Stock-based compensation ............. 1,022,444 947,396 Changes in assets and liabilities-- (Increase) decrease in-- Interest receivable .............. (395,084) 119,559 Accounts receivable .............. (53,634) (270,076) Prepaid expenses and other ....... (150,277) (495,571) Increase (decrease) in-- Accounts payable and accrued expenses ....................... 953,952 (1,057,447) Deferred revenues ................ 82,923 805,068 ------------ ------------ Net cash used in operating activities ..................... (4,373,165) (5,975,677) ------------ ------------ Cash flows used in investing activities: Proceeds from the redemption of short-term investments ............... -- 5,000,115 Purchases of short-term investments .... (20,500,129) (8,000,000) Purchase of acquisition, net ........... -- (882,367) Purchases of property and equipment, net .................................. (1,761,450) (302,155) ------------ ------------ Net cash used in investing activities ..................... (22,261,579) (4,184,407) Cash flows provided by (used in) financing activities: Proceeds from note payable ............. -- 237,751 Payments on capital lease obligations and note payable ...................... (278,040) (343,805) Cost related to the issuance of Common stock ......................... (1,285,047) -- Payments of dividends of Series C, D, & E Preferred Stock .................. (1,516,785) -- Redemption of Series F Preferred Stock . (4,935,367) -- Proceeds from the issuance of common stock and exercise of common stock options ........................ 44,640,000 4,883 ------------ ------------ Net cash provided by (used in) financing activities ....... 36,624,761 (101,171) ------------ ------------ Net increase (decrease) in cash and cash equivalents ............................ 9,990,017 (10,261,255) Cash and cash equivalents, beginning of period .................... 3,381,600 26,702,096 ------------ ------------ Cash and cash equivalents, end of period .......................... $ 13,371,617 $ 16,440,841 ============ ============ The accompanying notes are an integral part of these statements. Page 5 CARESCIENCE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated balance sheet as of September 30, 2001, the statements of operations for the three and nine months ended September 30, 2000 and 2001 and the statements of cash flows for the nine months ended September 30, 2000 and 2001 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting of normal and recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows at September 30, 2001 and for all periods presented have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these financial statements be read in conjunction with the financial statements and notes thereto included in the Annual Report on Form 10-K as filed with the Securities and Exchange Commission. The results of operations for the three and nine months ended September 30, 2001 are not necessarily indicative of the operating results for the full year. Principles of Consolidation The accompanying consolidated financial statements include the accounts of CareScience, Inc. and its subsidiary. All significant intercompany transactions and balances have been eliminated. New Accounting Prounouncements In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations". SFAS No. 141 eliminates the use of the pooling-of-interests method of accounting for business combinations and establishes the purchase method of accounting as the only acceptable method on all business combinations initiated after June 30, 2001. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets." This statement modifies existing generally accepted accounting principles related to the amortization and impairment of goodwill and other intangible assets. Upon adoption of the new standard, goodwill, including goodwill associated with equity method investments, will no longer be amortized. For the nine months ended September 30, 2001, goodwill amortization was $129,070. In addition, goodwill, other than goodwill associated with equity method investments, must be assessed at least annually for impairment using a fair-value based approach. The provisions of this statement are required to be adopted as of the beginning of the first fiscal year after December 15, 2001. Impairment losses that arise due to the initial application of this statement are to be reported as a cumulative effect of change in accounting principle. The Company has not completed an analysis of the impact of implementing the provisions of this statement. Cash and Cash Equivalents and Short-term Investments The Company invests excess cash in highly liquid investment-grade marketable securities including corporate commercial paper and U.S. government agency bonds. For financial reporting purposes, the Company considers all highly liquid investment instruments purchased with an original maturity of three months or less to be cash equivalents. All investment instruments with maturities greater than three months are available for use in current operations and accordingly are classified as current assets. Page 6 All investments are considered available-for-sale and accordingly, unrealized gains and losses are included in a separate component of shareholders' equity. As of September 30, 2001 cash and cash equivalents and short-term investments at cost and fair market value consisted of the following: SEPTEMBER 30, 2001 ----------------------------------------- GROSS FAIR ORIGINAL UNREALIZED MARKET COST GAINS VALUE ----------- ----------- ----------- Cash and cash equivalents $16,440,841 $ -- $16,440,841 Short-term investments 6,000,000 41,900 6,041,900 ----------- ----------- ----------- $22,440,841 $ 41,900 $22,482,741 =========== =========== =========== At September 30, 2001, short-term investments consisted of a $2 million debt instrument maturing July 25, 2002 and two $2 million debt instruments each maturing August 28, 2002. Supplemental Cash Flow Information The Company paid interest of $68,302 and $66,215 for the nine months ended September 30, 2000 and 2001, respectively. The Company financed $252,401 and $0 of property and equipment purchases with capital leases for the nine months ended September 30, 2000 and 2001, respectively. Major Customers The Company's operations are conducted in one business segment and sales are primarily made to health care payors and providers. The Company had one customer for each of the nine month periods ended September 30, 2000 and 2001, which accounted for 20% and 13% of total revenues, respectively. The Company also had two customers for each of the three month periods ended September 30, 2000 and 2001, which accounted for 31% and 22% of total revenues, respectively. The Company had two customers at September 30, 2001, which accounted for 31% of total accounts receivable. (2) NET LOSS PER SHARE Net loss per share is calculated utilizing the principles of SFAS No. 128, "Earnings per Share" ("SFAS No. 128"). Basic Earnings per Share ("EPS") excludes potentially dilutive securities and is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is computed assuming the conversion or exercise of all dilutive securities such as preferred stock, options and warrants. Under SFAS No. 128, the Company's granting of certain stock options, warrants and convertible preferred stock resulted in potential dilution of basic EPS. The number of incremental shares from the assumed exercise of stock options and warrants is calculated applying the treasury stock method. Stock options, warrants and Preferred stock convertible into common shares were excluded from the calculations as they were anti-dilutive due to the net loss. (3) COMMITMENTS AND CONTINGENCIES CareScience and certain of its officers are defendants in several purported shareholder class action lawsuits described below for alleged violations of federal securities laws. Although we cannot predict the ultimate outcome of the case or estimate the range of any potential loss that may be Page 7 incurred in the litigation, we believe the lawsuits are frivolous and without merit, strenuously deny all allegations of wrongdoing asserted by plaintiffs, and believe we have meritorious defenses to plaintiffs' claims. We intend to vigorously defend the lawsuits. CareScience and certain of its officers are defendants in a purported class action litigation pending in the United States District Court for the Eastern District of Pennsylvania. These actions are the result of several complaints filed with the Court beginning on October 17, 2001. We are currently seeking to consolidate these actions. These complaints purport to bring claims on behalf of all persons who allegedly purchased our common stock between June 29, 2000 and November 1, 2000, for alleged violations of the federal securities laws, including Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by issuing a materially false and misleading Prospectus and Registration Statement with respect to the initial public offering of our common stock. Specifically, the complaints allege, among other things, that our Prospectus and Registration Statement misrepresented and omitted to disclose material facts concerning two of our prospective products. The actions seek compensatory and other damages, and costs and expenses associated with litigation. (4) SHAREHOLDERS'EQUITY Subscriptions Receivable On June 15, 2001 the Company issued 259,259 shares of its Common stock to seven of its officers and three of its directors in a private sale at a price of $1.62 per share which is equal to the closing price of its Common stock on the Nasdaq National Market on that date. Concurrent with this sale, full recourse notes bearing interest at a rate of 4.11% compounded semi-annually, were issued to these officers and directors. The total amount of such notes issued was $420,000. Equity Compensation Plans The Company's 1995 Equity Compensation Plan (the "Plan") permits the granting of incentive stock options, nonqualified stock options, stock appreciation rights and restricted stock. The Company has authorized the issuance of up to 2,565,038 shares of Common stock to satisfy grants under the Plan. At September 30, 2001, there were 480,786 shares reserved under the Plan available for grant. A committee of the Board of Directors (the "Committee") administers the Plan and determines the terms of the grants. In December 1998, the Company adopted the 1998 Time Accelerated Restricted Stock Option Plan (the "Accelerated Plan"). The Accelerated Plan provides for the granting of non-qualified stock options to officers, senior management and employee directors of the Company. The aggregate number of shares of Common stock the Company may issue under the Accelerated Plan is 483,594 shares. At September 30, 2001 there were no shares reserved under the Accelerated Plan available for grant. The Company accounts for all plans under APB Opinion No. 25, under which compensation expense is recognized based on the amount by which the fair value of the underlying common stock exceeds the exercise price of the stock options on the measurement date. For financial reporting purposes, the Company has determined that the deemed fair market value on the measurement date for certain stock options was in excess of the exercise price. This amount has been recorded as deferred compensation and is being amortized over the vesting period of the applicable options, which range between four and seven years. The Company recorded deferred compensation of $120,683 and $0 during the year ended December 31, 2000 and the nine months ended September 30, 2001, respectively and reversed $154,902 and $233,643 of deferred compensation in connection with forfeited common stock options during the year ended December 31, 2000 and the nine months ended September 30, 2001, respectively. The Company recognized $341,752 and $1,022,444 of compensation expense related to options for the three and nine months ended September 30, 2000, respectively and $315,688 and $947,396 of compensation expense related to options for the three and nine months ended September 30, 2001, respectively. Page 8 The following table summarizes the option activity for both plans: OPTIONS OUTSTANDING ------------------------------------------------------ SHARES WEIGHTED AVAILABLE NUMBER EXERCISE AVERAGE FOR OF PRICE AGGREGATE EXERCISE GRANT SHARES PER SHARE PRICE PRICE ---------- --------- ----------- ---------- ---------- Balance, December 31, 1997............. 362,800 251,200 $0.25- 1.25 $ 271,200 $1.08 Authorized........................... 1,134,632 -- -- -- -- Granted.............................. (472,635) 472,635 1.25- 2.60 895,227 1.89 Forfeited/Canceled................... 12,800 (12,800) 0.25- 1.25 (10,800) .84 ---------- --------- ----------- ---------- Balance, December 31, 1998............. 1,037,597 711,035 0.25- 2.60 1,155,627 1.63 Authorized........................... -- -- -- -- -- Granted.............................. (1,108,150) 1,108,150 1.25- 2.59 2,814,164 2.54 Forfeited/Canceled................... 216,413 (216,413) 0.25- 2.59 (291,017) 1.34 ---------- --------- ----------- ---------- Balance, December 31, 1999............. 145,860 1,602,772 0.25- 2.60 3,678,774 2.30 Authorized........................... 800,000 -- -- -- -- Granted.............................. (817,663) 817,663 0.78-12.00 6,782,592 8.30 Forfeited/Canceled................... 573,298 (573,298) 1.25-12.00 (4,926,524) 8.59 Excercised........................... -- (10,000) 0.25 2,500 0.25 ---------- --------- ----------- ---------- Balance, December 31, 2000............. 701,495 1,837,137 0.25-12.00 5,537,342 3.01 Authorized (unaudited)............... 500,000 -- -- -- -- Granted (unaudited).................. (880,036) 880,036 0.38- 2.81 1,563,002 1.78 Forfeited/canceled (unaudited)....... 159,327 (159,327) 0.78- 6.63 (442,536) 2.78 Excercised (unaudited)............... -- (3,906) 1.25 (4,883) 1.25 ---------- --------- ----------- ---------- Balance, September 30, 2001(unaudited) 480,786 2,553,940 $0.25-12.00 $6,652,925 2.60 ========== ========= =========== ========== ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This report includes a number of forward-looking statements that reflect our current views with respect to future events and financial performance. We use words such as anticipates, believes, expects, future, and intends, and similar expressions to identify forward-looking statements. For these statements we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. There are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements, including: - the difficulty in evaluating our business because we operate in a new industry and our operating history is limited; - we have a history of losses and expect our losses to continue; - the proprietary technology we own or license may be subjected to infringement claims or disagreements with the licensor which could be costly to resolve; - we depend on exclusive licenses with the University of Pennsylvania and California Health Care Foundation for important parts of our technology, and the loss of either of these licenses would impair our ability to develop our business; - we could be liable for information retrieved from our Web sites and incur significant costs from resulting claims; - we may experience system failures which could interrupt our service and damage our customer relationships; - the health care industry may not accept our solutions or buy our products which would adversely affect our financial results; Page 9 - because our revenues are dependent on a limited number of product lines, the failure of any one of these product lines would significantly decrease our revenues; - termination of one or more of our significant contracts would cause a significant decline in our revenue; - failure to manage our growth would adversely affect our operations; - we face intense competition and may be unable to compete successfully which would adversely affect our financial results; - the loss of any of our key personnel could adversely affect our operations; - our failure to develop strategic relationships could adversely affect our ability to develop new products; - our failure to use new technologies effectively or to adapt emerging industry standards would adversely affect our ability to compete; - our failure to adapt our technology to our customers' needs or to handle high levels of customer activity would adversely affect our ability to increase revenue; - failure of our service providers could interrupt our business and damage our customer relationships; - we may need to obtain additional capital and failure to do so may limit our growth; - health information is subject to potential government regulation and legal uncertainties and changes may require us to alter our business; - changes in the health care industry could adversely affect our operations; - our business will suffer if commercial users do not accept Internet solutions; - our industry is evolving and we may not adapt successfully. Overview CareScience, Inc. is a provider of online care management services. Our mission is to transform the quality and efficiency of care delivery by providing innovative clinical information technology to the health care industry. We market our services to hospitals, health systems and pharmaceutical and biotechnology manufacturers, and support more than 150 customers in 40 states and in Europe. We work with health care providers to manage clinical processes surrounding the point of care so that fundamental reductions in errors and operating cost can be achieved. Our online service offerings collect, share, store and analyze clinical data generated by more than 100 widely used health information systems. Our services allow customers to apply this data to the management of care, including quality monitoring, practice improvement, credentialing, profiling, error tracking, case management and clinical guidelines. We provide consulting services to healthcare providers that support strategic planning and clinical operations, with a special emphasis on mentoring physicians and other clinical leaders in operational and executive roles. For the pharmaceutical and biotechnology industry, we provide tools and services that shorten the drug development cycle and improve development yield. Our offerings include a suite of Internet-based data analysis and workflow management tools, consulting services, customized research and strategic development support. These tools and services are aimed at the specialized drug development needs of pharmaceutical industry clinicians, product managers, market strategists, health economists and outcomes researchers. We have pioneered and commercialized numerous clinical information technologies. We have developed one of the nation's first online quality measurement and management tools, one of the first clinically based outcome risk assessment algorithms, one of the first health care application service providers, and, most recently, the first peer-to-peer clinical data sharing technology. We have developed these tools in collaboration with leading public organizations, including the Wharton School of Business at the University of Pennsylvania, the National Library of Medicine, Los Alamos National Laboratory and The California HealthCare Foundation. Page 10 CareScience was incorporated in 1992 with the purpose of commercializing intellectual property that was developed at the University of Pennsylvania School of Medicine and The Wharton School of Business. In 1993, we exclusively licensed the intellectual property underlying our core technology in a 30-year agreement with the University of Pennsylvania. In 1996, we launched our first Internet-based commercial offering based on this proprietary technology under our Care Management System-TM- (formerly called CaduCIS) service line. In 1999, we launched our Care Data Exchange-TM-, and Technology Assessment Tools-TM-, as well as our Lifecycle Decision System-TM- service line, which is aimed at the pharmaceutical and biotechnology industries. To date, we have signed more than 50 contracts covering more than 150 hospitals, health systems and pharmaceutical companies. We generate revenues from subscriptions to our Internet-based proprietary technology applications and hosting of customer data, as well as from training, implementation and consulting services. We sell our services individually or as an integrated suite of services. Our contracts are fixed price based on estimates of certain variables, such as the number of a hospital's patient admissions or outpatient visits. Our subscription and development agreements typically cover an initial three-to five-year period with provisions for automatic renewals. We recognize training and implementation fees, as well as subscriptions and related hosting revenues, on a pro-rata basis over the life of the contract. We recognize consulting fees on a percentage-of-completion basis or as the program or service is delivered. Our contracts generally provide for payment in advance of services rendered. Therefore, we record these payments as deferred revenues and recognize these payments when earned in accordance with our revenue recognition policy. Our deferred revenue balances were $3.0 million and $4.3 million at December 31, 2000 and September 30, 2001, respectively. We have incurred substantial research and development costs since inception and have also invested in our corporate infrastructure to support our long-term growth strategy. We expect that our operating expenses will continue to exceed our gross profit, and as a result, we expect to continue to incur quarterly net losses for the foreseeable future. On June 28, 2000 we completed an initial public offering of 4,000,000 shares of Common stock at a price of $12.00 per share. We received aggregate net cash proceeds of approximately $43.2 million from the initial public offering on July 5, 2000. RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000 REVENUES Total revenues increased 59% to $3.5 million for the three months ended September 30, 2001 from $2.2 million for the three months ended September 30, 2000. The increase was primarily related to revenues generated for services provided under newly signed customer contracts. Unrecognized revenues related to customer contracts as of September 30, 2001 totaled $18.0 million. COST OF REVENUES Cost of revenues include customer product and service-related costs including personnel and facility costs, depreciation and maintenance. Cost of revenues for the three months ended September 30, 2001 was $1.6 million (excluding stock-based compensation of $163,000), an increase of $339,000 or 27%, compared to $1.3 million (excluding stock-based compensation of $171,000) for the three months ended September 30, 2000. The increase was primarily a result of additional costs necessary to service new customers. GROSS PROFIT Our gross profit margin increased from 42% for the three months ended September 30, 2000, to 54% for the three months ended September 30, 2001. The increase in gross profit margin is primarily due to increased revenues spread over a partially fixed cost base. Page 11 RESEARCH AND DEVELOPMENT Research and development costs include technology and product development costs. Research and development costs for the three months ended September 30, 2001 were $841,000 (excluding stock-based compensation of $10,000), a decrease of $489,000 or approximately 37%, compared to $1.3 million (excluding stock-based compensation of $24,000) for the three months ended September 30, 2000. This decrease is primarily due to the allocation of resources to the other areas as well as a reduction of emphasis on the development of new products. As a percentage of revenue, research and development costs were 24% for the three months ended September 30, 2001 as compared to 60% for the three months ended September 30, 2000. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses include costs associated with our sales, marketing, finance, human resource and administrative functions. Selling, general and administrative expenses for the three months ended September 30, 2001 were $2.4 million (excluding stock-based compensation of $143,000), an increase of $228,000, or 10% compared to $2.2 million (excluding stock-based compensation of $147,000) for the three months ended September 30, 2000. The increase was primarily related to hiring of additional sales and management personnel and marketing expenditures to increase and support customer growth. As a percentage of revenues, selling, general, and administrative expenses were 69% for the three months periods ended September 30, 2001 as compared to 99% for the three months ended September 30, 2000. STOCK-BASED COMPENSATION We granted certain stock options to our officers and employees with exercise prices deemed to be below the fair market value of the underlying stock. The remaining cumulative difference between the fair value of the underlying stock at the date the options were granted and the exercise price of the granted options was $2.8 million at September 30, 2001. We expect to amortize this amount over the four to seven year vesting periods of the granted options. Accordingly, our results from operations will include stock-based compensation expense at least through 2006. We recognized $342,000 and $316,000 of this expense during the three months ended September 30, 2000 and 2001, respectively. INTEREST INCOME AND EXPENSE Net interest income for the three months ended September 30, 2001 was $224,000, a decrease of $314,000 compared to $538,000 for the three months ended September 30, 2000. The decrease is primarily due to lower investable cash balances as funds from the initial public offering have been used to fund operations. NINE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000 REVENUES Total revenues increased 56% to $9.0 million for the nine months ended September 30, 2001 from $5.8 million for the nine months ended September 30, 2000. The increase was primarily related to revenues generated for services provided under newly signed customer contracts. COST OF REVENUES Cost of revenues include customer product and service-related costs including personnel and facility costs, depreciation and maintenance. Cost of revenues for the nine months ended September 30, 2001 was $4.5 million (excluding stock-based compensation of $490,000), an increase of $1.0 million Page 12 or 30%, compared to $3.5 million (excluding stock-based compensation of $512,000) for the nine months ended September 30, 2000. The increase was primarily a result of additional costs necessary to service new customers. GROSS PROFIT Our gross profit margin increased from 40% for the nine months ended September 30, 2000, to 50% for the nine months ended September 30, 2001. The increase in gross profit margin is primarily due to increased revenues spread over a partially fixed cost base. RESEARCH AND DEVELOPMENT Research and development costs include technology and product development costs. Research and development costs for the nine months ended September 30, 2001 were $3.2 million (excluding stock-based compensation of $29,000), an increase of $433,000 or approximately 16%, compared to $2.7 million (excluding stock-based compensation of $71,000) for the nine months ended September 30, 2000. This increase is primarily due to expenditures made related to new product development. As a percentage of revenue, research and development costs were 35% of revenue for the nine months ended September 30, 2001 as compared to 47% for the nine months ended September 30, 2000. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses include costs associated with our sales, marketing, finance, human resource and administrative functions. Selling, general and administrative expenses for the nine months ended September 30, 2001 were $8.5 million (excluding stock-based compensation of $428,000); an increase of $2.9 million, or 53% compared to $5.5 million (excluding stock based compensation of $439,000) for the nine months ended September 30, 2000. The increase was primarily related to hiring of additional sales and management personnel and marketing expenditures to increase and support customer growth. As a percentage of revenues, selling, general, and administrative expenses were 94% for the nine months ended September 30, 2001 as compared to 96% for the nine months ended September 30, 2000. STOCK-BASED COMPENSATION We granted certain stock options to our officers and employees with exercise prices deemed to be below the fair market value of the underlying stock. The remaining cumulative difference between the fair value of the underlying stock at the date the options were granted and the exercise price of the granted options was $2.8 million at September 30, 2001. We expect to amortize this amount over the four to seven year vesting periods of the granted options. Accordingly, our results from operations will include stock-based compensation expense at least through 2006. We recognized $1.0 million and $947,000 of this expense during the nine months ended September 30, 2000 and September 30, 2001, respectively. INTEREST INCOME AND EXPENSE Net interest income for the nine months ended September 30, 2001 was $823,000, an increase of $263,000 compared to $560,000 for the nine months ended September 30, 2000. The increase is primarily due to higher investable cash balances as a result of the initial public offering. LIQUIDITY AND CAPITAL RESOURCES - SEPTEMBER 30, 2001 Since inception, we have financed our operations and funded our capital expenditures through the private sale of equity securities, supplemented by debt and equipment leases. As of September 30, 2001, we had $22.5 million in cash and short term investments and working capital of $18.7 million. Net cash used in operating activities was $6.0 million for the nine months ended September 30, 2001 and $4.4 million for the nine months ended September 30, 2000. For those periods, net cash used in operating activities was primarily to fund losses from operations partially offset by changes in current assets and liabilities. Page 13 Net cash used in investing activities was $4.2 million for the nine months ended September 30, 2001 and consisted of purchases of short-term investments (net of proceeds), funding of an acquisition and purchases of property and equipment. For the nine months ended September 30, 2000 net cash used in investing activities was $22.3 million and consisted of purchases of short-term investments and property and equipment. Net cash used in financing activities was $101,000 for the nine months ended September 30, 2001. Financing activities for this period consisted primarily of payments on capital lease obligations and proceeds from issuance of a note payable. Net cash provided by financing activities was $36.6 million for the nine months ended September 30, 2000 and consisted primarily of the proceeds of the initial public offering net of the payment of dividends and redemption of preferred stock. As we execute our strategy, we expect significant increases in our operating expenses to fund development of current and new divisions and product lines. Presently, we anticipate that our existing capital resources will meet our operating and investing needs through the end of 2002. After that time, additional funding may not be available on acceptable terms or at all. If we require additional capital resources to grow our business, execute our operating plans or acquire complementary businesses at any time in the future, we may seek to sell additional equity or debt securities or secure additional lines of credit, which may result in ownership dilution to our shareholders. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Most of our cash equivalents and capital lease obligations are at fixed interest rates and therefore the fair market value of these instruments is affected by changes in market interest rates. As of September 30, 2001 all of our cash equivalents matured within 90 days and we had the ability to immediately liquidate our investments. Therefore, we believe that we are exposed to immaterial levels of market risk. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS CareScience and certain of its officers are defendants in several purported shareholder class action lawsuits described below for alleged violations of federal securities laws. Although we cannot predict the ultimate outcome of the case or estimate the range of any potential loss that may be incurred in the litigation, we believe the lawsuits are frivolous and without merit, strenuously deny all allegations of wrongdoing asserted by plaintiffs, and believe we have meritorious defenses to plaintiffs' claims. We intend to vigorously defend the lawsuits. CareScience and certain of its officers are defendants in a purported class action litigation pending in the United States District Court for the Eastern District of Pennsylvania. These actions are the result of several complaints filed with the Court beginning on October 17, 2001. We are currently seeking to consolidate these actions. These complaints purport to bring claims on behalf of all persons who allegedly purchased our common stock between June 29, 2000 and November 1, 2000, for alleged violations of the federal securities laws, including Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by issuing a materially false and misleading Prospectus and Registration Statement with respect to the initial public offering of our common stock. Specifically, the complaints allege, among other things, that our Prospectus and Registration Statement misrepresented and omitted to disclose material facts concerning two of our prospective products. The actions seek compensatory and other damages, and costs and expenses associated with litigation. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS USE OF PROCEEDS On June 28, 2000 the Securities and Exchange Commission declared effective our Registration Statement on Form S-1 (File number 333-32376), relating to the initial public offering of our Common Page 14 Stock, no par value per share. The net offering proceeds to us after total expenses were $43.2 million. As of September 30, 2001, we have used approximately $21.3 million of the net proceeds from our initial public offering of which approximately $11.4 million was used for working capital and other general corporate purposes, approximately $6.5 million was used for dividends on and the redemption of preferred stock, approximately $2.3 million was used for the purchase of property plant and equipment and $1.1 million was used for the acquisition of Strategic Outcomes Services, Inc. None of the net proceeds from the offering were used to pay, directly or indirectly, directors, officers, persons owning ten percent or more of the Company's equity securities, or affiliates of the Company. ITEM 5. OTHER INFORMATION On October 30, 2001, our board of directors approved the amendment and restatement of the Company's Amended and Restated 1995 Equity Compensation Plan in order to amend the change of control provisions of that plan. The amendment and restatement of the plan became effective upon approval by our board of directors. The amended and restated plan is attached as an exhibit to this Form 10-Q and is incorporated by reference herein. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See Exhibit Index. (b) Reports on Form 8-K None Page 15 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CARESCIENCE, INC. Date: November 9, 2001 By: /s/ RONALD A. PAULUS ---------------------------- Ronald A. Paulus, President Date: November 9, 2001 By: /s/ STEVEN BELL ---------------------------- Steven Bell, Chief Financial Officer and Treasurer Page 16 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION ----------- ----------- 10.1 Amended and Restated 1995 Equity Compensation Plan