QSII 10Q 12.31.2012


 
 
 
 
 

UNITED STATES
SECURITIES and EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q


þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2012

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 001-12537

QUALITY SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

California
(State or other jurisdiction of incorporation or organization)

18111 Von Karman Avenue, Suite 700, Irvine, California
(Address of principal executive offices)
95-2888568
(IRS Employer Identification No.)

92612
(Zip Code)
 
(949) 255-2600
(Registrant’s telephone number, including area code)

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 þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer þ
Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)
Small reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of outstanding shares of the Registrant’s common stock as of January 28, 2013 was 59,534,835 shares.



 
 
 
 
 





QUALITY SYSTEMS, INC.

TABLE OF CONTENTS
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2012

 
Item    
Page
 
 
 
 
PART I. FINANCIAL INFORMATION
 
Item 1.
Financial Statements (Unaudited)
 
 
Consolidated Balance Sheets as of December 31, 2012 and March 31, 2012
 
Consolidated Statements of Comprehensive Income for the three and nine months ended December 31, 2012 and 2011
 
Consolidated Statements of Cash Flows for the nine months ended December 31, 2012 and 2011
 
Notes to Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risks
Item 4.
Controls and Procedures
 
PART II. OTHER INFORMATION
 
Item 1.
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.
Defaults Upon Senior Securities
Item 4.
Mine and Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
 
Signatures








PART I. FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)
 
December 31, 2012
 
March 31, 2012
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
101,702

 
$
134,444

Restricted cash
5,155

 
1,962

Marketable securities
4,987

 
4,987

Accounts receivable, net
151,495

 
145,756

Inventories
3,912

 
3,715

Income taxes receivable
1,864

 
2,628

Deferred income taxes, net
10,127

 
10,127

Other current assets
7,276

 
9,090

Total current assets
286,518

 
312,709

Equipment and improvements, net
20,930

 
17,841

Capitalized software costs, net
32,881

 
19,994

Intangibles, net
29,415

 
23,259

Goodwill
63,161

 
60,776

Other assets
7,315

 
5,773

Total assets
$
440,220

 
$
440,352

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
6,563

 
$
4,532

Deferred revenue
63,001

 
83,108

Accrued compensation and related benefits
8,595

 
11,870

Dividends payable

 
10,354

Other current liabilities
27,750

 
19,568

Total current liabilities
105,909

 
129,432

Deferred revenue, net of current
1,307

 
1,293

Deferred income taxes, net
4,096

 
5,351

Deferred compensation
3,454

 
3,497

Other noncurrent liabilities
4,368

 
5,602

Total liabilities
119,134

 
145,175

Commitments and contingencies (Note 12)


 


Shareholders’ equity:
 
 
 
Common stock $0.01 par value; authorized 100,000 shares; issued and outstanding 59,535 and 59,180 shares at December 31, 2012 and March 31, 2012, respectively
595

 
592

Additional paid-in capital
179,306

 
169,033

Accumulated other comprehensive loss
(45
)
 
(45
)
Retained earnings
141,230

 
125,597

Total shareholders’ equity
321,086

 
295,177

Total liabilities and shareholders’ equity
$
440,220

 
$
440,352

The accompanying notes are an integral part of these consolidated financial statements.





QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands, except per share data)
(Unaudited)
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
Software and hardware
$
21,899

 
$
35,074

 
$
71,463

 
$
95,845

Implementation and training services
7,266

 
6,555

 
27,847

 
18,121

System sales
29,165

 
41,629

 
99,310

 
113,966

Maintenance
39,463

 
36,245

 
116,746

 
102,961

Electronic data interchange services
15,209

 
12,101

 
44,056

 
36,178

Revenue cycle management and related services
15,015

 
11,147

 
43,902

 
34,170

Other services
15,658

 
11,643

 
44,920

 
33,566

Maintenance, EDI, RCM and other services
85,345

 
71,136

 
249,624

 
206,875

Total revenues
114,510

 
112,765

 
348,934

 
320,841

Cost of revenue:
 
 
 
 
 
 
 
Software and hardware
4,660

 
4,622

 
16,055

 
13,423

Implementation and training services
7,221

 
5,994

 
23,873

 
15,119

Total cost of system sales
11,881

 
10,616

 
39,928

 
28,542

Maintenance
5,259

 
4,412

 
14,811

 
12,260

Electronic data interchange services
9,852

 
7,890

 
28,251

 
23,816

Revenue cycle management and related services
10,918

 
8,405

 
32,344

 
25,687

Other services
8,686

 
7,011

 
26,021

 
18,977

Total cost of maintenance, EDI, RCM and other services
34,715

 
27,718

 
101,427

 
80,740

Total cost of revenue
46,596

 
38,334

 
141,355

 
109,282

Gross profit
67,914

 
74,431

 
207,579

 
211,559

Operating expenses:
 
 
 
 
 
 
 
Selling, general and administrative
35,532

 
33,096

 
110,045

 
94,651

Research and development costs
7,786

 
8,277

 
22,634

 
22,462

Amortization of acquired intangible assets
1,212

 
543

 
3,665

 
1,545

Total operating expenses
44,530

 
41,916

 
136,344

 
118,658

Income from operations
23,384

 
32,515

 
71,235

 
92,901

Interest income (expense), net
13

 
55

 
(14
)
 
212

Other expense
(122
)
 
(218
)
 
(115
)
 
(400
)
Income before provision for income taxes
23,275

 
32,352

 
71,106

 
92,713

Provision for income taxes
7,649

 
11,247

 
24,292

 
32,129

Net income
$
15,626

 
$
21,105

 
$
46,814

 
$
60,584

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation (net of $0 tax)
10

 
(9
)
 

 
(7
)
Unrealized loss on AFS securities (net of $0 tax)

 
(12
)
 

 
(35
)
Comprehensive income
$
15,636

 
$
21,084

 
$
46,814

 
$
60,542

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.26

 
$
0.36

 
$
0.79

 
$
1.03

Diluted
$
0.26

 
$
0.36

 
$
0.79

 
$
1.03

Weighted-average shares outstanding:
 
 
 
 
 
 
 
Basic
59,400

 
58,847

 
59,343

 
58,623

Diluted
59,405

 
59,128

 
59,411

 
58,943

Dividends declared per common share
$
0.175

 
$
0.175

 
$
0.525

 
$
0.525







The accompanying notes are an integral part of these consolidated financial statements.





QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended December 31,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net income
$
46,814

 
$
60,584

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
5,075

 
3,853

Amortization of capitalized software costs
7,261

 
5,994

Amortization of other intangibles
5,694

 
3,175

Provision for bad debts
4,324

 
3,839

Share-based compensation
1,966

 
2,465

Deferred income tax benefit
(1,255
)
 

Excess tax benefit from share-based compensation
49

 
(2,457
)
Change in fair value of contingent consideration
998

 

Loss on disposal of equipment and improvements

 
71

Changes in assets and liabilities, net of amounts acquired:
 
 
 
Accounts receivable
(8,665
)
 
(22,312
)
Inventories
(197
)
 
(1,261
)
Income taxes receivable
715

 
(5,053
)
Other current assets
(878
)
 
1,972

Other assets
(1,543
)
 
303

Accounts payable
1,285

 
1,367

Deferred revenue
(20,111
)
 
13,336

Accrued compensation and related benefits
(3,275
)
 
749

Income taxes payable

 
(1,073
)
Other current liabilities
10,596

 
(7,574
)
Deferred compensation
(43
)
 
637

Other non-current liabilities
(3,965
)
 
3,127

Net cash provided by operating activities
44,845

 
61,742

Cash flows from investing activities:
 
 
 
Additions to capitalized software costs
(20,148
)
 
(9,577
)
Additions to equipment and improvements
(7,159
)
 
(7,372
)
Proceeds for disposal of equipment and improvements

 
11

Cash acquired from purchase of ViaTrack

 
10

Purchase of ViaTrack

 
(5,710
)
Cash acquired from purchase of CQI

 
222

Purchase of CQI

 
(2,737
)
Purchase of IntraNexus

 
(3,279
)
Purchase of Poseidon
(2,033
)
 

Purchase of Matrix
(5,073
)
 

Net cash used in investing activities
(34,413
)
 
(28,432
)
Cash flows from financing activities:
 
 
 
Excess tax benefit from share-based compensation
(49
)
 
2,457

Proceeds from exercise of stock options
763

 
7,346

Dividends paid
(41,535
)
 
(30,684
)
Payment of contingent consideration related to acquisitions
(2,353
)
 

Net cash used in financing activities
(43,174
)
 
(20,881
)
Net (decrease) increase in cash and cash equivalents
(32,742
)
 
12,429

Cash and cash equivalents at beginning of period
134,444

 
116,617

Cash and cash equivalents at end of period
$
101,702

 
$
129,046






QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)
(In thousands)
(Unaudited)
 
Nine Months Ended December 31,
 
2012
 
2011
Supplemental disclosures of cash flow information:
 
 
 
Cash paid during the period for income taxes, net of refunds
$
24,691

 
$
38,254

Non-cash investing and financing activities:
 
 
 
Unrealized gain (loss) on marketable securities, net of tax
$

 
$
(34
)
Common stock issued at fair value for ViaTrack earnout settlement
$
3,001

 
$

Common stock issued at fair value for Opus earnout settlement
$

 
$
11,888

Effective May 1, 2012, the Company acquired Poseidon in a transaction summarized as follows:
 
 
 
Fair value of assets acquired
$
2,551

 
 
Cash paid
(2,033
)
 
 
Purchase price holdback
(500
)
 
 
Liabilities assumed
$
18

 
 
Effective April 16, 2012, the Company acquired Matrix in a transaction summarized as follows:
 
 
 
Fair value of assets acquired
$
14,587

 
 
Cash paid
(5,073
)
 
 
Common stock issued at fair value
(3,953
)
 
 
Purchase price holdback
(853
)
 
 
Fair value of contingent consideration
(2,862
)
 
 
Fair value of non-compete agreement (liability)
(1,100
)
 
 
Liabilities assumed
$
746

 
 
Effective November 14, 2011, the Company acquired ViaTrack in a transaction summarized as follows:
 
 
 
Fair value of net assets acquired
 
 
$
11,048

Cash paid
 
 
(5,710
)
Common stock issued at fair value
 
 
(1,068
)
Purchase price holdback
 
 
(1,187
)
Fair value of contingent consideration
 
 
(2,958
)
Liabilities assumed
 
 
$
125

Effective July 26, 2011, the Company acquired CQI in a transaction summarized as follows:
 
 
 
Fair value of assets acquired
 
 
$
11,417

Cash paid
 
 
(2,737
)
Common stock issued at fair value
 
 
(2,864
)
Purchase price holdback
 
 
(600
)
Fair value of contingent consideration
 
 
(2,346
)
Liabilities assumed
 
 
$
2,870

Effective April 29, 2011, the Company acquired IntraNexus in a transaction summarized as follows:
 
 
 
Fair value of assets acquired
 
 
$
4,524

Cash paid
 
 
(3,279
)
Purchase price holdback
 
 
(125
)
Fair value of contingent consideration
 
 
(800
)
Liabilities assumed
 
 
$
320


The accompanying notes are an integral part of these consolidated financial statements.






QUALITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except shares and per share data)
(Unaudited)
1. Summary of Significant Accounting Policies

Principles of Consolidation. The consolidated financial statements include the accounts of Quality Systems, Inc. and its wholly-owned subsidiaries, which consists of NextGen Healthcare Information Systems, LLC (“NextGen”), NextGen RCM Services, LLC, Opus Healthcare Solutions, LLC (“Opus”), ViaTrack Systems, LLC (“ViaTrack”), Matrix Management Solutions, LLC ("Matrix"), QSI Management, LLC and Quality Systems India Healthcare Private Limited (“QSIH”) (collectively, the “Company”). All intercompany accounts and transactions have been eliminated.

Basis of Presentation. The accompanying unaudited consolidated financial statements as of December 31, 2012 and for the three and nine months ended December 31, 2012 and 2011 have been prepared in accordance with the requirements of Form 10-Q and Article 10 of the Securities and Exchange Commission Regulation S-X and therefore do not include all information and notes which would be presented were such consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These consolidated financial statements should be read in conjunction with the audited consolidated financial statements presented in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2012. Amounts related to disclosures of March 31, 2012 balances within these interim consolidated financial statements were derived from the aforementioned Form 10-K. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments which are necessary for a fair presentation of the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of results of operations to be expected for the full year.
  
References to amounts in the consolidated financial statement sections are in thousands, except shares and per share data, unless otherwise specified.
  
On July 27, 2011, the Company’s Board of Directors approved a two-for-one stock split (the “stock split”) of the Company’s outstanding shares of common stock. Shareholders of record at the close of business on October 6, 2011 received one additional share for every outstanding share held on the record date. The additional shares were distributed on October 26, 2011. All share and per share data provided herein gives effect to this stock split, applied retroactively.
Revenue Recognition. The Company generates revenue from the sale of licensing rights to its software products directly to end-users and value-added resellers, or VARs. The Company also generates revenue from sales of hardware and third-party software, implementation, training, electronic data interchange (“EDI”), post-contract support (maintenance) and other services, including revenue cycle management (“RCM”), performed for clients who license its products.
A typical system contract contains multiple elements of the above items. Revenue earned on software arrangements involving multiple elements is allocated to each element based on the relative fair values of those elements. The fair value of an element is based on vendor-specific objective evidence (“VSOE”). The Company limits 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. VSOE calculations are updated and reviewed quarterly or annually depending on the nature of the product or service. The Company has established VSOE for the related undelivered elements based on the bell-shaped curve method. Maintenance VSOE for the Company's largest clients is based on stated renewal rates only if the rate is determined to be substantive and falls within the Company's customary pricing practices.
When evidence of fair value exists for the delivered and undelivered elements of a transaction, then discounts for individual elements are aggregated and the total discount is allocated to the individual elements in proportion to the elements' fair value relative to the total contract fair value.
When evidence of fair value exists for the undelivered elements only, the residual method is used. Under the residual method, the Company defers revenue related to the undelivered elements in a system sale based on VSOE of fair value of each of the undelivered elements and allocates the remainder of the contract price net of all discounts to revenue recognized from the delivered elements. If VSOE of fair value of any undelivered element does not exist, all revenue is deferred until VSOE of fair value of the undelivered element is established or the element has been delivered.
Provided the fees are fixed or determinable and collection is considered probable, revenue from licensing rights and sales of hardware and third-party software is generally recognized upon physical or electronic shipment and transfer of title. In certain transactions where collection risk is high, the revenue is deferred until collection occurs or becomes probable. If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized using the residual method. Fees which are considered fixed or determinable at the inception of the Company's arrangements must include the following characteristics:
The fee must be negotiated at the outset of an arrangement and generally be based on the specific volume of products to be delivered without being subject to change based on variable pricing mechanisms such as the number of units copied or distributed or the expected number of users.





Payment terms must not be considered extended. If a significant portion of the fee is due more than 12 months after delivery or after the expiration of the license, the fee is presumed not fixed or determinable.
Revenue from implementation and training services is recognized as the corresponding services are performed. Maintenance revenue is recognized ratably over the contractual maintenance period.
Contract accounting is applied where services include significant software modification, development or customization.
The Company ensures that the following criteria have been met prior to recognition of revenue:
the price is fixed or determinable;
the customer is obligated to pay and there are no contingencies surrounding the obligation or the payment;
the customer's obligation would not change in the event of theft or damage to the product;
the customer has economic substance;
the amount of returns can be reasonably estimated; and
the Company does not have significant obligations for future performance in order to bring about resale of the product by the customer.
The Company has historically offered short-term rights of return in certain sales arrangements. When the Company is able to estimate returns for these types of arrangements, revenue is recognized, net of an allowance for returns, and these arrangements are recorded in the consolidated financial statements. If the Company is unable to estimate returns for these types of arrangements, revenue is not recognized in the consolidated financial statements until the rights of return expire, provided also, that all other criteria for revenue recognition have been met.
Revenue related to sales arrangements that include hosting or the right to use software stored on the Company's hardware is recognized in accordance to the same revenue recognition criteria discussed above only if the customer has the contractual right to take possession of the software without incurring a significant penalty and it is feasible for the customer to either host the software themselves or through another third-party. Otherwise, the arrangement is accounted for as a service contract in which the entire arrangement is deferred and recognized over the period that the hosting services are being performed.
From time to time, the Company offers future purchase discounts on its products and services as part of its sales arrangements. Such discounts that are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, that are incremental to the range of discounts typically given in comparable transactions, and that are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.
RCM service revenue is derived from services fees, which include amounts charged for ongoing billing and other related services, and are generally billed to the customer as a percentage of total collections. The Company does not recognize revenue for services fees until these collections are made, as the services fees are not fixed or determinable until such time.
Revenue is reported into two categories, “system sales” and “maintenance, EDI, RCM and other services.” Revenue in the system sales category includes software license fees, third-party hardware and software and implementation and training services related to purchase of the Company's software systems. Revenue in the maintenance, EDI, RCM and other services category includes maintenance, EDI, RCM services, consulting services, annual third-party license fees, hosting services, Software as a Service ("SaaS") fees and other services revenue.

Goodwill. The Company tests goodwill for impairment annually during its first fiscal quarter, referred to as the annual test date. The Company will also test for impairment between annual test dates if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Impairment testing for goodwill is performed at a reporting-unit level, which is defined as an operating segment or one level below an operating segment (referred to as a component). A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. An impairment loss would generally be recognized when the carrying amount of the reporting unit's net assets exceeds the estimated fair value of the reporting unit.
During the quarter ended December 31, 2012, certain events and circumstances indicated the possibility that the carrying amount of goodwill could potentially be impaired. See Note 4.





Share-Based Compensation. The following table shows total share-based compensation expense included in the consolidated statements of comprehensive income for the three and nine months ended December 31, 2012 and 2011:
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
2012
 
2011
 
2012
 
2011
Costs and expenses:
 
 
 
 
 
 
 
Cost of revenue
$
51

 
$
71

 
$
200

 
$
190

Research and development costs
76

 
56

 
209

 
133

Selling, general and administrative
456

 
677

 
1,557

 
2,142

Total share-based compensation
583

 
804

 
1,966

 
2,465

Income tax benefit
(174
)
 
(298
)
 
(621
)
 
(916
)
Decrease in net income
$
409

 
$
506

 
$
1,345

 
$
1,549


Recent Accounting Standards. New accounting pronouncements implemented by the Company during the current year or requiring implementation in future periods are discussed below or in the notes, where applicable.
In the first quarter of fiscal 2013, the Company adopted new accounting guidance intended to simplify goodwill impairment testing. Under the revised guidance, entities testing goodwill for impairment have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test would be required. Under the revised guidance, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period. The revised guidance does not change how goodwill is calculated or assigned to reporting units, nor does it revise the requirement to test goodwill annually for impairment. In addition, the revised guidance does not amend the requirement to test goodwill for impairment between annual tests if events or circumstances warrant; however, it does revise the examples of events and circumstances that an entity should consider. The adoption did not have a material impact on the Company's financial position, results of operations or cash flows and is discussed further within this footnote.
In the first quarter of fiscal 2013, the Company adopted guidance regarding the presentation of comprehensive income. The new standard requires the presentation of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The adoption of this guidance did not have a material impact on the Company's financial statements.
In the first quarter of fiscal 2013, the Company adopted additional guidance on fair value measurements intended to clarify the application of the existing guidance and disclosure requirements, as well as change certain fair value measurement principles and require additional disclosures surrounding these fair value measurements. The adoption of this guidance did not have a material impact on the Company's financial statements.

2. Fair Value Measurements

The following tables set forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis at December 31, 2012 and March 31, 2012:
 
Balance at
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Unobservable Inputs (Level 3)
 
December 31,
2012
 
 
 
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
101,702

 
$
101,702

 
$

 
$

Restricted cash
5,155

 
5,155

 

 

Marketable securities (2)
4,987

 
4,987

 

 

 
$
111,844

 
$
111,844

 
$

 
$

LIABILITIES
 
 
 
 
 
 
 
Contingent consideration related to acquisitions
$
5,062

 
$

 
$

 
$
5,062

 
$
5,062

 
$

 
$

 
$
5,062






 
Balance at
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Unobservable Inputs (Level 3)
 
March 31,
2012
 
 
 
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
134,444

 
$
134,444

 
$

 
$

Restricted cash
1,962

 
1,962

 

 

Marketable securities (2)
4,987

 
4,987

 

 

 
$
141,393

 
$
141,393

 
$

 
$

LIABILITIES
 
 
 
 
 
 
 
Contingent consideration related to acquisitions
$
6,556

 
$

 
$

 
$
6,556

 
$
6,556

 
$

 
$

 
$
6,556

___________________________________
(1) Cash equivalents consists of money market funds.
(2) Marketable securities consist of fixed-income securities.

The Company’s contingent consideration liability is accounted for at fair value on a recurring basis and is adjusted to fair value when the carrying value differs from fair value. Key assumptions include discount rates and probability-adjusted achievement of revenue and strategic targets that are not observable in the market. The categorization of the framework used to measure fair value of the contingent consideration liability is considered Level 3 due to the subjective nature of the unobservable inputs used. The fair values of the contingent consideration liability for Sphere Health Systems, Inc. ("Sphere"), IntraNexus, Inc. ("IntraNexus"), CQI Solutions, Inc. ("CQI"), ViaTrack, and Matrix were estimated based on the probability of achieving certain business milestones and management’s forecast of expected revenues. See Note 3.

The following table presents activity in the Company’s financial assets and liabilities measured at fair value using significant unobservable inputs (Level 3), as of and for the nine months ended December 31, 2012:
 
 
Total Liabilities
Balance as of April 1, 2012
 
$
6,556

Acquisitions (Note 3)
 
2,862

Earnout payments (1)
 
(5,354
)
Fair value adjustments
 
998

Balance as of December 31, 2012
 
$
5,062

_______________________
(1) Earnout payments comprised of $2,353 in cash and $3,001 in common stock

Non-Recurring Fair Value Measurements

The Company has certain assets, including goodwill and other intangible assets, which are measured at fair value on a non-recurring basis and are adjusted to fair value only if an impairment charge is recognized. The categorization of the framework used to measure fair value of the assets is considered Level 3 due to the subjective nature of the unobservable inputs used. During the nine months ended December 31, 2012, there were no adjustments to fair value of such assets, except for the intangible assets acquired from Matrix and The Poseidon Group, Inc. ("Poseidon") as discussed further below.

3. Business Combinations

On May 1, 2012, the Company acquired Poseidon, a leading provider of hospital emergency department documentation and web-based electronic medical record solutions. The Poseidon purchase price totaled $2,533. Poseidon operates under the Hospital Solutions Division.

On April 16, 2012, the Company acquired Matrix, a provider of revenue cycle management services, healthcare IT solutions and training, implementation and support centered around the NextGen Division's suite of practice management software and electronic health record solutions. The Matrix purchase price totaled $13,841. The purchase price included contingent consideration payable over an 18-month period with a fair value of $2,862, which shall not exceed $4,000. The goodwill associated with this acquisition is deductible for tax purposes. Matrix operates under the RCM Services Division.

The Company accounted for the Matrix and Poseidon acquisitions as purchase business combinations. The purchase price for each was allocated to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the applicable acquisition date. The fair value of the assets acquired and liabilities assumed represent management’s estimate of fair value. The estimated fair value of the





acquired tangible and intangible assets and liabilities assumed were determined using multiple valuation approaches depending on the type of tangible or intangible asset acquired, including but not limited to the income approach, the excess earnings method and the relief from royalty method approach.

The total purchase price for the Matrix and Poseidon acquisitions during the nine months ended December 31, 2012 are summarized as follows:
 
Matrix
 
Poseidon
Cash paid
$
5,073

 
$
2,033

Purchase price holdback
853

 
500

Common stock issued at fair value
3,953

 

Contingent consideration
2,862

 

Future payments for non-compete agreement
1,100

 

Total purchase price
$
13,841

 
$
2,533


The following table summarizes the final purchase price allocations for the Matrix and Poseidon acquisitions:
 
Matrix
 
Poseidon
Fair value of the net tangible assets acquired and liabilities assumed:
 
 
 
Current assets (including accounts receivable of $1,287 and $111 for Matrix and Poseidon, respectively)
1,755

 
143

Equipment and improvements and other long-term assets
966

 
39

Accounts payable and accrued liabilities
(746
)
 

Deferred revenues

 
(18
)
Total net tangible assets acquired and liabilities assumed
1,975

 
164

Fair value of identifiable intangible assets acquired:
 
 
 
Trade Name
150

 

Customer relationships
8,650

 
800

Software technology

 
1,150

Non-compete agreement
1,100

 

Goodwill
1,966

 
419

Total identifiable intangible assets acquired
11,866

 
2,369

Total purchase price
$
13,841

 
$
2,533

The pro forma effects of the Matrix and Poseidon acquisitions would not have been material to the Company’s results of operations and are therefore not presented.






4. Goodwill

The Company does not amortize goodwill as it has been determined to have an indefinite useful life.

Goodwill by division consists of the following:
 
March 31,
2012
 
Acquisitions
 
December 31, 2012
QSI Dental Division
 
 
 
 
 
ViaTrack Systems, LLC
$
7,289

 
$

 
$
7,289

Total QSI Dental Division goodwill
7,289

 

 
7,289

NextGen Division
 
 
 
 
 
NextGen Healthcare Information Systems, LLC
1,840

 

 
1,840

Total NextGen Division goodwill
1,840

 

 
1,840

Hospital Solutions Division
 
 
 
 
 
The Poseidon Group, Inc.

 
419

 
419

CQI Solutions, Inc.
4,863

 

 
4,863

IntraNexus, Inc.
1,903

 

 
1,903

Opus Healthcare Solutions, Inc.
13,537

 

 
13,537

Sphere Health Systems, Inc.
1,020

 

 
1,020

Total Hospital Solutions Division goodwill
21,323

 
419

 
21,742

RCM Services Division
 
 
 
 
 
Matrix Management Solutions, LLC

 
1,966

 
1,966

Practice Management Partners, Inc.
19,485

 

 
19,485

Healthcare Strategic Initiatives
10,839

 

 
10,839

Total RCM Services Division goodwill
30,324

 
1,966

 
32,290

Total goodwill
$
60,776

 
$
2,385

 
$
63,161


During the quarter ended December 31, 2012, certain events and circumstances indicated the possibility that the carrying amount of goodwill of the Hospital Solutions Division (“Hospital reporting unit”) could potentially be impaired. The primary factor giving rise to this consideration was the recent operating performance of the Hospital reporting unit which reported a net loss from operations for both the quarters ended September 30, 2012 and December 31, 2012. Prior to these periods, the Hospital reporting unit had consistently generated income from operations. In the quarter ended September 30, 2012, the Hospital reporting unit began experiencing a decline in operating performance attributable to the aggregation of several factors, including: a) higher costs related to the expansion of implementation and support infrastructure; b) increased investment in selling, general, and administrative costs; c) a reduction in maintenance revenue; d) comparatively lower system sales revenues, and e) higher levels of sales credits. As of September 30, 2012, the circumstances that gave rise to the operating loss for the quarter then ended did not appear to be long-term in nature. However, prior to the end of the quarter ended December 31, 2012, the Company anticipated that the Hospital reporting unit would incur a sequential operating loss. Such expectation indicated that the goodwill of the Hospital reporting unit could potentially be impaired.
Based upon the above, the Company performed an assessment of the fair value of all of its reporting units, which concluded that all reporting units have a fair value in excess of 100% of their respective carrying amounts, with the exception of the Hospital reporting unit, which had an excess of fair value over its carrying amount of approximately 30%. Total goodwill in this division as of December 31, 2012 is $21.7 million. As a result, the Company concluded that no goodwill impairment existed in any of its reporting units as of December 31, 2012. The Company will continue to monitor the operating performance of its reporting units in future periods, however, for evidence of additional indicators of potential impairment.

The assessment of fair value of all of our reporting units during the quarter ended December 31, 2012 was based upon discounted cash flow analysis and a market approach, in which the valuation of comparable business enterprises is considered. The total of the values ascribed to the components of our business was also evaluated in light of our market capitalization, as of the valuation date.

Key assumptions affecting the results of the discounted cash flow analysis include our future revenues and operating margins. For the Hospital Solutions Division, revenue-related assumptions include sustained growth in revenues from future systems sales and improvements in operating efficiency, over time. We believe that sustained growth in our system sales will be achievable if we are able to effectively execute our growth strategies, including the expanded use of the NextGen Division sales force to cross sell hospital products to both new and existing NextGen Division customers. We also believe that we will be able to generate operational improvements and efficiencies in our implementation of new customers and that there continues to be meaningful opportunity in the Hospital Solutions Division market. Though we have confidence in our assumptions and





the future performance of the Hospital Solutions Division, if the Hospital Solutions Division fails to achieve sustained revenue growth and improved operating margins, the fair value of the reporting unit could be negatively impacted, resulting in an impairment of goodwill and/or other intangible assets.


5. Intangible Assets

In connection with the Poseidon acquisition, the Company recorded $1,950 of intangible assets related to customer relationships and software technology. The Company is amortizing the customer relationships over five years and the software technology over five years.

In connection with the Matrix acquisition, the Company recorded $9,900 of intangible assets related to a trade name, customer relationships and non-compete agreements. The Company is amortizing the trade name over six months, the customer relationships over five years and the non-compete agreements over four years.

The Company’s definite-lived intangible assets, other than capitalized software development costs, are summarized as follows:
 
December 31, 2012
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Gross carrying amount
$
23,156

 
$
2,018

 
$
20,509

 
$
45,683

Accumulated amortization
(8,976
)
 
(1,030
)
 
(6,262
)
 
(16,268
)
Net intangible assets
$
14,180

 
$
988

 
$
14,247

 
$
29,415

 
March 31, 2012
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Gross carrying amount
$
13,706

 
$
768

 
$
19,359

 
$
33,833

Accumulated amortization
(5,901
)
 
(606
)
 
(4,067
)
 
(10,574
)
Net intangible assets
$
7,805

 
$
162

 
$
15,292

 
$
23,259


Activity related to the intangible assets for the nine months ended December 31, 2012 and 2011 is summarized as follows:
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Balance as of April 1, 2012
$
7,805

 
$
162

 
$
15,292

 
$
23,259

Acquisition
9,450

 
1,250

 
1,150

 
11,850

Amortization (1)
(3,075
)
 
(424
)
 
(2,195
)
 
(5,694
)
Balance as of December 31, 2012
$
14,180

 
$
988

 
$
14,247

 
$
29,415

 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Balance as of April 1, 2011
$
6,327

 
$
208

 
$
10,355

 
$
16,890

Acquisition
3,500

 
130

 
7,240

 
10,870

Amortization (1)
(1,420
)
 
(125
)
 
(1,630
)
 
(3,175
)
Balance as of December 31, 2011
$
8,407

 
$
213

 
$
15,965

 
$
24,585

_____________________________
(1) Amortization of the customer relationships and the trade name & contracts intangible assets is included in operating expenses and amortization of the software technology intangible assets is included in cost of revenue for software and hardware.






The following table represents the remaining estimated amortization of definite-lived intangible assets as of December 31, 2012:

For the year ended March 31,
 
2013 (remaining three months)
$
1,864

2014
7,391

2015
6,335

2016
5,998

2017 and beyond
7,827

Total
$
29,415


6. Capitalized Software Costs

The Company’s capitalized software development costs are summarized as follows:
 
December 31,
2012
 
March 31, 2012
Gross carrying amount
$
85,369

 
$
65,221

Accumulated amortization
(52,488
)
 
(45,227
)
Net capitalized software costs
$
32,881

 
$
19,994


Activity related to net capitalized software costs for the nine months ended December 31, 2012 and 2011 is summarized as follows:
 
2012
 
2011
Balance as of April 1
$
19,994

 
$
15,150

Capitalized
20,148

 
9,577

Amortization
(7,261
)
 
(5,994
)
Balance as of December 31
$
32,881

 
$
18,733


The following table represents the remaining estimated amortization of capitalized software costs as of December 31, 2012:
For the year ended March 31,
 
2013 (remaining three months)
$
2,841

2014
13,387

2015
9,931

2016
5,547

2017 and beyond
1,175

Total
$
32,881


7. Composition of Certain Financial Statement Captions

Accounts receivable include amounts related to maintenance and services that were billed but not yet rendered at each period end. Undelivered maintenance and services are included as a component of the deferred revenue balance on the accompanying consolidated balance sheets.
 
December 31,
2012
 
March 31,
2012
Accounts receivable, gross
$
160,745

 
$
154,237

Allowance for doubtful accounts
(9,250
)
 
(8,481
)
Accounts receivable, net
$
151,495

 
$
145,756







Inventories are summarized as follows:
 
December 31,
2012
 
March 31,
2012
Computer systems and components
$
3,912

 
$
3,709

Miscellaneous parts

 
6

Inventories
$
3,912

 
$
3,715


Equipment and improvements are summarized as follows:
 
December 31,
2012
 
March 31,
2012
Computer equipment
$
29,936

 
$
24,936

Furniture and fixtures
7,445

 
6,358

Leasehold improvements
6,983

 
4,906

 
44,364

 
36,200

Accumulated depreciation and amortization
(23,434
)
 
(18,359
)
Equipment and improvements, net
$
20,930

 
$
17,841


Current and non-current deferred revenue are summarized as follows:
 
December 31,
2012
 
March 31,
2012
Maintenance
$
12,543

 
$
12,742

Implementation services
38,110

 
55,235

Annual license services
8,854

 
11,730

Undelivered software and other
3,494

 
3,401

Deferred revenue
$
63,001

 
$
83,108

Deferred revenue, net of current
$
1,307

 
$
1,293


Accrued compensation and related benefits are summarized as follows:
 
December 31,
2012
 
March 31,
2012
Payroll, bonus and commission
$
746

 
$
4,890

Vacation
7,849

 
6,980

Accrued compensation and related benefits
$
8,595

 
$
11,870







Other current and non-current liabilities are summarized as follows:
 
December 31,
2012
 
March 31,
2012
Contingent consideration and other liabilities related to acquisitions
$
7,640

 
$
5,482

Care services liabilities
5,155

 
1,962

Accrued Consulting and Outside Services
2,928

 
880

Users Group Meeting (UGM) deposits
2,106

 

Accrued royalties
1,635

 
1,974

Accrued EDI expense
1,250

 
2,588

Self insurance reserve
942

 
934

Sales tax payable
765

 
527

Deferred rent
728

 
610

Outside commission payable
498

 
520

Accrued travel
415

 
509

Customer deposits
136

 
1,297

Other accrued expenses
3,552

 
2,285

Other current liabilities
$
27,750

 
$
19,568

 
 
 
 
Deferred rent
$
2,510

 
$
2,476

Contingent consideration and other liabilities related to acquisitions
1,720

 
2,989

Other liabilities
138

 
137

Other non-current liabilities
$
4,368

 
$
5,602


8. Income Tax

The provision for income taxes for the three months ended December 31, 2012 and 2011 was approximately $7.6 million and $11.2 million, respectively. The effective tax rates were 32.9% and 34.8% for the three months ended December 31, 2012 and 2011, respectively. The effective tax rate decreased as compared to the prior year period as a result of increased benefit of discrete items, principally as the result of the lower level of taxable income in the current period. In addition, the effective tax rate reflects a reduction in the Company's composite state effective tax rate for the three months ended December 31, 2012, largely offset by the absence of a research and development tax credit in such period, due to the expiration of the applicable federal statute on December 31, 2011.

The provision for income taxes for the nine months ended December 31, 2012 and 2011 was approximately $24.3 million and $32.1 million, respectively. The effective tax rates were 34.2% and 34.7% for the nine months ended December 31, 2012 and 2011, respectively. The effective tax rate decreased slightly due to a reduction in the Company's composite state effective tax rate, largely offset by the absence of a research and development tax benefit in the current year, as described above.

Uncertain tax positions
As of December 31, 2012, the Company had recorded a liability of $563 for unrecognized tax benefits related to various federal and state income tax matters. If recognized, this amount would reduce the Company’s effective tax rate. The tax liability decreased from the prior year period by $174 due to changes in contingent liability reserves and certain tax positions related to acquired companies.

The Company's income tax returns filed for tax years 2010 through 2012 and 2008 through 2012 are subject to examination by the federal and state taxing authorities, respectively. The Company is not currently under examination by the Internal Revenue Service. The Company is under routine examination by six state income tax authorities. The Company does not anticipate that total unrecognized tax benefits will significantly change due to the settlement of audits or the expiration of statute of limitations within the next twelve months.
 






9. Earnings per Share

The Company provides dual presentation of “basic” and “diluted” earnings per share (“EPS”). Shares discussed below are in thousands.
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
2012
 
2011
 
2012
 
2011
Net income
$
15,626

 
$
21,105

 
$
46,814

 
$
60,584

Basic net income per share:
 
 
 
 
 
 
 
Weighted-average shares outstanding — Basic
59,400

 
58,847

 
59,343

 
58,623

Basic net income per common share
$
0.26

 
$
0.36

 
$
0.79

 
$
1.03

 
 
 
 
 
 
 
 
Net income
$
15,626

 
$
21,105

 
$
46,814

 
$
60,584

Diluted net income per share:
 
 
 
 
 
 
 
Weighted-average shares outstanding — Basic
59,400

 
58,847

 
59,343

 
58,623

Effect of potentially dilutive securities
5

 
281

 
68

 
320

Weighted-average shares outstanding — Diluted
59,405

 
59,128

 
59,411

 
58,943

Diluted net income per common share
$
0.26

 
$
0.36

 
$
0.79

 
$
1.03


The computation of diluted net income per share does not include 1,250 and 1,027 options to acquire shares of common stock for the three and nine months ended December 31, 2012, respectively, because their inclusion would have an anti-dilutive effect on net income per share.

The computation of diluted net income per share does not include 364 and 346 options to acquire shares of common stock for the three and nine months ended December 31, 2011, respectively, because their inclusion would have an anti-dilutive effect on net income per share.

10. Share-Based Awards

All share and per share data provided within this footnote is adjusted for the effect of the stock split, as discussed in Note 1.

Employee Stock Option Plans
In September 1998, the Company’s shareholders approved a stock option plan (the “1998 Plan”) under which 8,000,000 shares of common stock were reserved for the issuance of options. The 1998 Plan provides that employees, directors and consultants of the Company may, at the discretion of the Board of Directors or a duly designated compensation committee, be granted options to purchase shares of common stock. The exercise price of each option granted was determined by the Board of Directors at the date of grant, and options under the 1998 Plan expire no later than 10 years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement pursuant to which they were granted. Certain option grants to directors became exercisable three months from the date of grant. Upon an acquisition of the Company by merger or asset sale, each outstanding option may be subject to accelerated vesting under certain circumstances. The 1998 Plan terminated on December 31, 2007. As of December 31, 2012, there were 40,000 outstanding options related to the 1998 Plan.

In October 2005, the Company’s shareholders approved a stock option and incentive plan (the “2005 Plan”) under which 4,800,000 shares of common stock were reserved for the issuance of awards, including stock options, incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock, unrestricted stock, restricted stock units, performance shares, performance units (including performance options) and other share-based awards. The 2005 Plan provides that employees, directors and consultants of the Company may, at the discretion of the Board of Directors or a duly designated compensation committee, be granted awards to acquire shares of common stock. The exercise price of each option award shall be determined by the Board of Directors at the date of grant in accordance with the terms of the 2005 Plan, and under the 2005 Plan awards expire no later than 10 years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement pursuant to which they were granted. Upon an acquisition of the Company by merger or asset sale, each outstanding option may be subject to accelerated vesting under certain circumstances. The 2005 Plan terminates on May 25, 2015, unless terminated earlier by the Board of Directors. As of December 31, 2012, there were 1,226,711 outstanding options and 2,915,963 shares available for future grant related to the 2005 Plan.






A summary of stock option transactions during the nine months ended December 31, 2012 follows:
 
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
per Share
 
Weighted-
Average
Remaining
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
(in thousands)
Outstanding, April 1, 2012
 
988,337

 
$
32.09

 
5.4

 

Granted
 
516,500

 
28.65

 
7.4

 
 
Exercised
 
(45,366
)
 
16.83

 
0.5

 
$
24

Forfeited/Canceled
 
(192,760
)
 
32.61

 
5.9

 
 
Outstanding, December 31, 2012
 
1,266,711

 
$
31.18

 
5.7

 
$
21

Vested and expected to vest, December 31, 2012
 
1,212,844

 
$
31.11

 
5.7

 
$
21

Exercisable, December 31, 2012
 
362,636

 
$
27.30

 
3.4

 
$
21


The Company utilizes the Black-Scholes valuation model for estimating the fair value of share-based compensation with the following assumptions:
 
 
Nine Months Ended December 31, 2012
 
Nine Months Ended December 31, 2011
Expected life
 
 5.0 years
 
 4.3 years
Expected volatility
 
41.3% - 45.1%
 
41.2%
Expected dividends
 
2.4% - 4.0%
 
1.6%
Risk-free rate
 
0.7% - 0.8%
 
1.8%

The weighted average grant date fair value of stock options granted during the nine months ended December 31, 2012 and 2011 was $8.37 and $13.32 per share, respectively.

The Company issues new shares to satisfy option exercises. Based on historical experience of option cancellations, the Company has estimated an annualized forfeiture rate of 6.2% and 3.9% for employee options for the nine months ended December 31, 2012 and 2011, respectively, and 0.0% for director options for the nine months ended December 31, 2012 and 2011. Forfeiture rates are adjusted over the requisite service period when actual forfeitures differ, or are expected to differ, from the estimate.

During the nine months ended December 31, 2012, a total of 516,500 options to purchase shares of common stock were granted under the 2005 Plan at an exercise price equal to the market price of the Company’s common stock on the date of grant. A summary of stock options granted under the 2005 Plan during fiscal years 2013 and 2012 is as follows:
 
 
Number of
 
 
 
Vesting
 
 
Option Grant Date
 
Shares
 
Exercise Price
 
Terms (1)
 
Expires
November 5, 2012
 
5,000

 
$
17.68

 
Five years
 
November 5, 2020
September 25, 2012
 
20,000

 
$
18.42

 
Five years
 
September 25, 2020
May 24, 2012
 
346,000

 
$
29.17

 
Five years
 
May 24, 2020
May 24, 2012
 
30,000

 
$
29.17

 
Four years
 
May 24, 2020
May 23, 2012
 
115,500

 
$
29.45

 
Five years
 
May 23, 2020
Fiscal year 2013 option grants
 
516,500

 
 
 
 
 
 
May 31, 2011
 
459,400

 
$
43.04

 
Five years
 
May 31, 2019
Fiscal year 2012 option grants
 
459,400

 
 
 
 
 
 
__________________________________
(1) Options vest in equal annual installments on each grant anniversary date commencing one year following the date of grant.

Performance-Based Awards






On May 24, 2012, the Board of Directors approved its fiscal year 2013 equity incentive program for certain employees to be awarded options to purchase the Company’s common stock. The maximum number of options available under the equity incentive program plan is 600,000, of which 220,000 are reserved for the Company’s named executive officers and 380,000 for non-executive employees of the Company. Under the program, executives are eligible to receive cash bonuses and options based on meeting certain target increases in EPS performance and revenue and operating income growth during fiscal year 2013. Under the program, the non-executive employees are eligible to receive options based on satisfying certain management established criteria and recommendations of senior management. The options shall be issued pursuant to one of the Company’s shareholder approved option plans, have an exercise price equal to the closing price of the Company’s shares on the date of grant, a term of eight years and vesting in five equal annual installments commencing one year following the date of grant.

Compensation expense associated with the performance based awards under the Company’s equity incentive plans are initially based on the number of options expected to vest after assessing the probability that certain performance criteria will be met. Cumulative adjustments are recorded quarterly to reflect subsequent changes in the estimated outcome of performance-related conditions. The Company utilized the Black-Scholes option valuation model and recorded stock compensation expense related to the performance based awards of approximately $419 during the nine months ended December 31, 2011. Stock compensation expense related to the performance based awards was not significant for the nine months ended December 31, 2012. See the assumptions used below.
 
Nine Months Ended December 31, 2012
 
Nine Months Ended December 31, 2011
Expected life
 5.0 years
 
 4.3 years
Expected volatility
41.7% - 45.0%
 
41.2% - 42.2%
Expected dividends
2.5% - 4.0%
 
1.4% - 1.9%
Risk-free rate
0.6% - 0.7%
 
0.8% - 1.8%

Non-vested stock option award activity, including employee stock options and performance-based awards, during the nine months ended December 31, 2012 is summarized as follows:
 
 
Non-Vested
Number of
Shares
 
Weighted-
Average
Grant-Date
Fair Value
per Share
Outstanding, April 1, 2012
 
778,319

 
$
10.76

Granted
 
516,500

 
8.37

Vested
 
(197,984
)
 
8.29

Forfeited/Canceled
 
(192,760
)
 
10.45

Outstanding, December 31, 2012
 
904,075

 
$
10.01


As of December 31, 2012, $6,662 of total unrecognized compensation costs related to stock options is expected to be recognized over a weighted-average period of 3.7 years. This amount does not include the cost of new options that may be granted in future periods or any changes in the Company’s forfeiture percentage. The total fair value of options vested during the nine months ended December 31, 2012 and 2011 was $1,641 and $1,767, respectively.

Restricted Stock
On May 24, 2012, the Board of Directors approved its 2013 Director Compensation Program, whereby each non-employee director is to be awarded shares of restricted stock upon election or re-election to the Board of Directors. The shares of restricted stock are awarded under the 2005 Plan. Such shares of restricted stock vest in two equal, annual installments on the first and second anniversaries of the grant date and are nontransferable for one year following vesting. The weighted-average grant date fair value for the restricted stock was estimated using the market price of the common stock on the date of grant. The fair value of the restricted stock is amortized on a straight-line basis over the vesting period.






The Company recorded compensation expense related to restricted stock of approximately $450 and $394 for the nine months ended December 31, 2012 and 2011, respectively. Restricted stock activity for the nine months ended December 31, 2012 follows:
 
 
Number of
Shares
 
Weighted-
Average
Grant-Date
Fair Value
per Share
Outstanding, April 1, 2012
 
30,001

 
$
36.32

Granted
 
20,939

 
19.13

Vested
 
(17,667
)
 
31.95

Outstanding, December 31, 2012
 
33,273

 
$
26.79


As of December 31, 2012, $680 of total unrecognized compensation costs related to restricted stock is expected to be recognized over a weighted-average period of 1.9 years. This amount does not include the cost of new restricted stock that may be granted in future periods.
 
11. Concentration of Credit Risk

The Company had cash deposits at U.S. banks and financial institutions which exceeded federally insured limits at December 31, 2012. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institutions; however, the Company does not anticipate non-performance by these institutions.

12. Commitments, Guarantees and Contingencies

Commitments and Guarantees
The Company's software license agreements include a performance guarantee that the Company's software products will substantially operate as described in the applicable program documentation for a period of 365 days after delivery. To date, the Company has not incurred any significant costs associated with its performance guarantee or other related warranties and does not expect to incur significant warranty costs in the future. Therefore, no accrual has been made for potential costs associated with these warranties. Certain arrangements also include performance guarantees related to response time, availability for operational use, and other performance-related guarantees. Certain arrangements also include penalties in the form of maintenance credits should the performance of the software fail to meet the performance guarantees. To date, the Company has not incurred any significant costs associated with these warranties and does not expect to incur significant warranty costs in the future. Therefore, no accrual has been made for potential costs associated with these warranties.
The Company has historically offered short-term rights of return in certain sales arrangements. If the Company is able to estimate returns for these types of arrangements and all other criteria for revenue recognition have been met, revenue is recognized and these arrangements are recorded in the consolidated financial statements. If the Company is unable to estimate returns for these types of arrangements, revenue is not recognized in the consolidated financial statements until the rights of return expire, provided also, that all other criteria of revenue recognition have been met.
Certain standard sales agreements contain a money back guarantee providing for a performance guarantee that is already part of the software license agreement as well as training and support. The money back guarantee also warrants that the software will remain robust and flexible to allow participation in the federal health incentive programs. The specific elements of the performance guarantee pertain to aspects of the software, which the Company has already tested and confirmed to consistently meet using the Company's existing software without any modifications or enhancements. To date, the Company has not incurred any costs associated with this guarantee and does not expect to incur significant costs in the future. Therefore, no accrual has been made for potential costs associated with this guarantee.
The Company's standard sales agreements contain an indemnification provision pursuant to which it shall indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with any United States patent, any copyright or other intellectual property infringement claim by any third-party with respect to its software. As the Company has not incurred any significant costs to defend lawsuits or settle claims related to these indemnification agreements, the Company believes that its estimated exposure on these agreements is currently minimal. Accordingly, the Company has no liabilities recorded for these indemnification obligations.
The Company has entered into marketing assistance agreements with existing users of the Company's products which provide the opportunity for those users to earn commissions if they host specific site visits upon the Company's request for prospective clients that directly result in a purchase of the Company's software by the visiting prospects. Amounts earned by existing users under this program are treated as a selling expense in the period when earned.






13. Operating Segment Information

The Company has four reportable segments that are evaluated regularly by its chief decision making group in deciding how to allocate resources and in assessing performance.

Operating segment data is as follows:
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2012
 
2011
 
2012
 
2011
Revenue:
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
5,088

 
$
4,863

 
$
14,886

 
$
14,469

NextGen Division
 
85,757

 
85,900

 
259,277

 
243,015

Hospital Solutions Division
 
7,365

 
9,928

 
26,903

 
25,671

RCM Services Division
 
16,300

 
12,074

 
47,868

 
37,686

Consolidated revenue
 
$
114,510

 
$
112,765

 
$
348,934

 
$
320,841

 
 
 
 
 
 
 
 
 
Operating income:
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
1,265

 
$
620

 
$
2,413

 
$
2,518

NextGen Division
 
30,906

 
35,240

 
93,643

 
98,875

Hospital Solutions Division
 
(1,334
)
 
3,406

 
(152
)
 
8,919

RCM Services Division
 
2,090

 
1,238

 
5,732

 
4,377

Unallocated corporate expense (1)
 
(9,543
)
 
(7,989
)
 
(30,401
)
 
(21,788
)
Consolidated operating income
 
$
23,384

 
$
32,515

 
$
71,235

 
$
92,901

_________________________________
(1) Unallocated corporate expense includes eliminations relating to QSIH revenues and related expenses included in the results of operating segments. For the nine months ended December 31, 2012 and 2011, eliminations were not significant.

Management evaluates performance based upon stand-alone segment operating income. Because the Company does not evaluate performance based upon return on assets at the operating segment level, assets are not tracked internally by segment. Therefore, segment asset information is not presented.

14. Subsequent Events

On January 23, 2013, the Board of Directors approved a quarterly cash dividend of $0.175 per share on the Company’s outstanding shares of common stock, payable to shareholders of record as of March 15, 2013 with an expected distribution date on or about April 5, 2013.
In January 2013, Congress enacted a tax law to extend the Federal research and development tax credit ("R&D Credit") retroactive to January 1, 2012 and through December 31, 2013.  As a result of the timing of this legislative change, the Company was not entitled to recognize any portion of the expected tax benefit relating to the 2012 R&D Credit for the nine months ended December 31, 2012. The full expected fiscal year benefit of this credit will be recognized in the provision for income taxes in the quarter ended March 31, 2013.






Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q and certain information incorporated herein by reference contain forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements included or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements that are purely historical, are forward-looking statements. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate,” “will,” “should,” “would,” “could,” “may,” and similar expressions also identify forward-looking statements. These forward-looking statements include, without limitation, discussions of our product development plans, business strategies, future operations, financial condition and prospects, developments in and the impacts of government regulation and legislation, including, without limitation, The American Recovery and Reinvestment Act ("ARRA") and The Patient Protection and Affordable Care Act, and market factors influencing our results. Our expectations, beliefs, objectives, intentions and strategies regarding our future results are not guarantees of future performance and are subject to risks and uncertainties, both foreseen and unforeseen, that could cause actual results to differ materially from results contemplated in our forward-looking statements. These risks and uncertainties include, but are not limited to, our ability to continue to develop new products and increase systems sales in markets characterized by rapid technological evolution, consolidation, and competition from larger, better-capitalized competitors. Many other economic, competitive, governmental and technological factors could affect our ability to achieve our goals, and interested persons are urged to review any risks that may be described in “Item 1A. Risk Factors” as set forth herein and other risk factors appearing in our most recent Annual Report on Form 10-K for the fiscal year ended March 31, 2012 (“Annual Report”), as supplemented by additional risk factors, if any, in our interim filings on our Quarterly Report on Form 10-Q, as well as in our other public disclosures and filings with the Securities and Exchange Commission ("SEC"). Because of these risk factors, as well as other variables affecting our financial condition and results of operations, past financial performance may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods. We assume no obligation to update any forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of the filing of this Quarterly Report on Form 10-Q.

This management's discussion and analysis of financial condition and results of operation, or MD&A, is provided as a supplement to the consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q in order to enhance your understanding of our results of operations and financial condition and should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. Historical results of operations, percentage margin fluctuations and any trends that may be inferred from the discussion below are not necessarily indicative of the operating results for any future period.

Our MD&A is organized as follows:
Management Overview. This section provides a general description of our Company and operating segments, a discussion as to how we derive our revenue, background information on certain trends and developments affecting our Company, a summary of our acquisition transactions and a discussion on management’s strategy for driving revenue growth.
Critical Accounting Policies and Estimates. This section discusses those accounting policies that are considered important to the evaluation and reporting of our financial condition and results of operations, and whose application requires us to exercise subjective or complex judgments in making estimates and assumptions. In addition, all of our significant accounting policies, including our critical accounting policies, are summarized in Note 1, “Summary of Significant Accounting Policies,” of our notes to consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
Company Overview.  This section provides a more detailed description of our Company, its operating segments, and the products and services we offer.
Overview of Results of Operations and Results of Operations by Operating Divisions. These sections provide our analysis and outlook for the significant line items on our consolidated statements of income, as well as other information that we deem meaningful to understand our results of operations on both a consolidated basis and an operating division basis.
Liquidity and Capital Resources.  This section provides an analysis of our liquidity and cash flows.
New Accounting Pronouncements. This section provides a summary of the most recent authoritative accounting standards and guidance that have either been recently adopted by our Company or may be adopted in the future.








Management Overview

Quality Systems, Inc. and its wholly-owned subsidiaries operate as four business divisions (each, a "Division") which are comprised of: (i) the QSI Dental Division, (ii) the NextGen Division, (iii) the Hospital Solutions Division (formerly Inpatient Solutions) and (iv) the RCM Services Division (formerly Practice Solutions). In fiscal year 2011, we opened a captive entity in India called Quality Systems India Healthcare Private Limited (“QSIH”). We primarily derive revenue by developing and marketing healthcare information systems that automate certain aspects of medical and dental practices, networks of practices such as physician hospital organizations (“PHOs”) and management service organizations (“MSOs”), ambulatory care centers, community health centers and medical and dental schools along with comprehensive systems implementation, maintenance and support and add on complementary services such as revenue cycle management (“RCM”) and electronic data interchange (“EDI”). Our systems and services provide our clients with the ability to redesign patient care and other workflow processes while improving productivity through the facilitation of managed access to patient information. Utilizing our proprietary software in combination with third-party hardware and software solutions, our products enable the integration of a variety of administrative and clinical information operations.

The turbulence in the worldwide economy has impacted almost all industries. While healthcare is not immune to economic cycles, we believe it is more heavily influenced by US-based regulatory and national health projects than by the economic cycles of our economy. The impact of the current economic conditions on our existing and prospective clients has been mixed. While we continue to see organizations that are doing fairly well operationally, some organizations, especially those with a large dependency on Medicaid populations, have been impacted by the challenging financial conditions faced by many state governments. Various factors have had, and are anticipated to continue to have, a meaningful impact on the U.S. healthcare industry, including the Obama Administration's broad healthcare reform efforts (particularly the HITECH portion of the American Recovery and Reinvestment Act and the Patient Protection and Affordable Care Act), the individual state responses to the government-requested Medicaid expansion to address new insureds, and the increasing focus of private businesses on moving their employee health benefit offerings to a more wellness-based health platform.

We have benefited and hope to continue to benefit from the increased demands on healthcare providers for greater efficiency and lower costs, financial incentives from the ARRA to physicians who adopt electronic health records, as well as increased adoption rates for electronic health records and other technology in the healthcare arena. We also believe that healthcare reform and the movement towards pay for performance/quality initiatives will also stimulate demand for robust electronic health record solutions as well as new HIT solutions from bundled billing capabilities to patient engagement and population health management.

While we expect to benefit from the increasing demands for greater efficiency as well as government support for increased adoption of electronic health records, the market for physician based electronic health records software is becoming increasingly saturated while physician group practices are rapidly being consolidated by hospital, insurance payers and other entities. Hospital software providers are leveraging their position with their hospital customers to gain market share with hospital owned physician practices. Insurance providers and large physician groups are also consolidating physician offices creating additional opportunity for ambulatory software providers such as NextGen. Our strategy is to focus addressing upcoming needs of accountable care organizations around interoperability, patient engagements, population health, and data analytics. We believe that our core strength lies in the central role our software products and services play in the delivery of healthcare by the primary physician in an ambulatory setting. We intend to remain at the forefront of upcoming new regulatory requirements including ICD-10 and meaningful use requirements for stimulus payments. We believe that the expanded requirements for continued eligibility for incentive payments under meaningful use rules will result in an expanded replacement market for electronic health records software. We intend to continue the development and enhancement of our software solutions to support healthcare reform and the transition from fee for service to pay for performance/quality initiatives such as accountable care organizations. Key elements of our future software development will be to continue to integrate our ambulatory and inpatient products, making our products more intuitive and easy to use, and enhancing our ability to deliver our software over the cloud with the latest technology.

We also want to continue investments in our infrastructure including but not limited to product development, sales, marketing, implementation and support, to continue efforts to make infrastructure investments within an overall context of maintaining reasonable expense discipline, to add new clients through maintaining and expanding sales, marketing and product development activities and to expand our relationship with existing clients through delivery of add-on and complementary products and services while continuing our gold-standard commitment of service in support of our client satisfaction programs. We believe that our growing customer base that is using our software on a daily basis is a strategic asset, and we intend to expand our product and service offerings towards this customer base in order to leverage this strategic asset.

Critical Accounting Policies and Estimates

The discussion and analysis of our consolidated financial statements and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate estimates (including but not limited to those related to revenue recognition, uncollectible accounts receivable, software development cost, intangible assets and self-insurance accruals) for reasonableness. We base our estimates on historical experience and on various other assumptions that management believes 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 may not be readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.






We describe our significant accounting policies in Note 2, “Summary of Significant Accounting Policies,” of our Notes to Consolidated Financial Statements included in our Annual Report. We discuss our critical accounting policies and estimates in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report. There have been no material changes in our significant accounting policies or critical accounting policies and estimates since the end of fiscal year 2012.
 
As described in Note 1 “Summary of Significant Accounting Policies” of our Notes to Consolidated Financial Statements included in this report, we determined during the quarter ended December 31, 2012 that certain events and circumstances indicated the possibility that the carrying amount of goodwill of the Hospital Solutions Division ("Hospital reporting unit") could potentially be impaired.

The primary factor giving rise to this consideration is the recent operating performance of the Hospital reporting unit which reported a net loss from operations for both the quarters ended September 30, 2012 and December 31, 2012. Prior to these periods, the Hospital reporting unit had consistently generated income from operations. In the quarter ended September 30, 2012, the Hospital reporting unit began experiencing a decline in operating performance attributable to the aggregation of several factors, including: a) higher costs related to the expansion of implementation and support infrastructure; b) increased investment in selling, general, and administrative costs; and c) a reduction in maintenance revenue; d) comparatively lower systems sales revenues; and e) higher levels of sales credits. As of September 30, 2012, the circumstances that gave rise to the operating loss for the quarter then ended did not appear to be long-term in nature. However, prior to the end of the quarter ended December 31, 2012, the Company anticipated that the Hospital reporting unit would incur a sequential operating loss. Such expectation indicated that goodwill of the Hospital reporting unit could potentially be impaired.

Based upon the above, we performed an assessment of the fair value of all of our reporting units, which concluded that all reporting units have a fair value in excess of 100% of their respective carrying amounts, with the exception of the Hospital reporting unit, which had an excess of fair value over its carrying amount of approximately 30%. Total goodwill in this division as of December 31, 2012 is $21.7 million. As a result, we concluded that no goodwill impairment existed in any of our reporting units as of December 31, 2012. We will continue to monitor the operating performance of our reporting units in future periods, however, for evidence of additional indicators of potential impairment.

The assessment of fair value of all of our reporting units during the quarter ended December 31, 2012 was based upon discounted cash flow analysis and a market approach, in which the valuation of comparable business enterprises is considered. The total of the values ascribed to the components of our business was also evaluated in light of our market capitalization, as of the valuation date.

Key assumptions affecting the results of the discounted cash flow analysis include our future revenues and operating margins. For the Hospital Solutions Division, revenue-related assumptions include sustained growth in revenues from future systems sales and improvements in operating efficiency, over time. We believe that sustained growth in our system sales will be achievable if we are able to effectively execute our growth strategies, including the expanded use of the NextGen Division sales force to cross sell hospital products to both new and existing NextGen Division customers. We also believe that we will be able to generate operational improvements and efficiencies in our implementation of new customers and that there continues to be meaningful opportunity in the Hospital Solutions Division market. Though we have confidence in our assumptions and the future performance of the Hospital Solutions Division, if the Hospital Solutions Division fails to achieve sustained revenue growth and improved operating margins, the fair value of the reporting unit could be negatively impacted, resulting in an impairment of goodwill and/or other intangible assets.

Company Overview

Quality Systems, Inc. was incorporated in California in 1974. Our principal offices are located at 18111 Von Karman Ave., Suite 700, Irvine, California, 92612. We operate on a fiscal year ending on March 31.

The Company was founded with an early focus on providing information systems to dental group practices. This focus area would later become the QSI Dental Division. In the mid-1980's, we capitalized on the increasing focus on medical cost containment and further expanded our information processing systems to serve the medical market. In the mid-1990's, we made two acquisitions that accelerated our penetration of the medical market and formed the basis for the NextGen Division. Today, we serve the dental markets through our QSI Dental Division, physician practice, inpatient and RCM services through NextGen Division, Hospital Solutions Division and RCM Services Division.

The Divisions have historically operated as stand-alone operations, with each Division maintaining its own distinct product lines, product platforms, development, implementation and support teams and branding. However, there are a growing number of customers who are simultaneously utilizing software or services from more than one of our Divisions. In an effort to encourage this cross selling of our products and services between Divisions, we are in the process of further integrating our ambulatory and inpatient products to provide a more robust and comprehensive platform to offer our customers. The Divisions also share the resources of our “corporate office,” which includes a variety of accounting and other administrative functions.

In September, 2012, we announced certain organizational changes to achieve greater efficiency and integration in our operations as well as to enhance our ability to cross sell products and services to our customers. The changes consolidated Sales, Marketing, Information Technology, and Software Development responsibilities into separate Company-wide roles. We also announced the hiring of a Chief Operating Officer, reporting





directly to the Chief Executive Officer responsible for the operations of the Company. We are continuing to evaluate the organizational structure of the Company with the objective to achieve greater synergies and further integration of our products and services.

The QSI Dental Division, NextGen Division, and Hospital Solutions Division develop and market practice management software that is designed to automate and streamline a number of the administrative functions required for operating a medical, dental, or hospital practice, such as patient scheduling and billing. It is important to note that since in both the medical and dental environments, practice management software systems have already been implemented by the vast majority of practices, we actively compete for the replacement market. These Division's also develop and market software that automates patient records in physician practices, community health centers (CHC's) and hospital settings. In this patient records area of our business, we are typically competing to replace paper-based patient record alternatives as opposed to replacing previously purchased systems. The Hospital Solutions Division develops and markets an equivalent practice management software product, which performs administrative functions required for operating a small hospital as well as physician documentation and computerized physician order entry (CPOE) charting. The RCM Services Division provides technology solutions and consulting services to cover the full spectrum of healthcare providers' RCM needs, with a primary focus on billing and collection services.

In January 2011, QSIH was formed in Bangalore, India to function as our India-based captive to offshore technology application development and business processing services.

We continue to pursue product and service enhancement initiatives within each of our Divisions. The majority of such expenditures are currently targeted to the NextGen and Hospital Solutions Division product lines and client bases.

The following table reflects our reported segment revenue and segment revenue growth by Division for the three and nine months ended December 31, 2012 and 2011:
 
 
Segment Revenue Breakdown
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2012
 
2011
 
2012
 
2011
QSI Dental Division
 
4.4
%
 
4.3
%
 
4.3
%
 
4.5
%
NextGen Division
 
75.0
%
 
76.2
%
 
74.3
%
 
75.8
%
Hospital Solutions Division
 
6.4
%
 
8.8
%
 
7.7
%
 
8.0
%
RCM Services Division
 
14.2
%
 
10.7
%
 
13.7
%
 
11.7
%
Consolidated
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%


 
 
Segment Revenue Growth
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2012
 
2011
 
2012
 
2011
QSI Dental Division
 
4.6
 %
 
12.5
 %
 
2.9
%
 
1.0
%
NextGen Division
 
(0.2
)%
 
24.0
 %
 
6.7
%
 
26.0
%
Hospital Solutions Division
 
(25.8
)%
 
71.6
 %
 
4.8
%
 
101.2
%
RCM Services Division
 
35.0
 %
 
(3.4
)%
 
27.0
%
 
3.8
%
Consolidated
 
1.5
 %
 
22.7
 %
 
8.8
%
 
25.2
%

QSI Dental Division. The QSI Dental Division, co-located with our corporate headquarters in Irvine, California, focuses on developing, marketing and supporting software suites sold to dental organizations located throughout the United States. In addition, the QSI Dental Division supports a growing number of dental organizations using its Software as a Service (“SaaS”) model-based financial and clinical software, as well as a number of medical clients that use the QSI Dental Division's UNIX®-based legacy medical practice management software product. This SaaS software, formerly called NextDDS™, has undergone a name change and is now “QSIDental™ Web”. The name change was undertaken to give the product stronger identification in the marketplace as a web-based solution.

In July 2009, we licensed source code that allows us to deliver hosted, Web-based SaaS model practice management and clinical software solutions to the dental industry. This software solution, QSIDental Web, is being marketed primarily to the multi-location dental group practice market in which the QSI Dental Division has historically been a dominant player. QSIDental Web moves the QSI Dental Division to the forefront of the emergence of Internet-based applications and cloud computing and represents a significant growth opportunity for the Division to sell to both its existing client base and new clients.
 





The QSI Dental Division participates jointly with the NextGen Division in providing software and services to safety-net clinics like Federally Qualified Health Centers (“FQHC”) and other “safety net” health centers, including Public Health Centers, Community Health Centers, Free Clinics, as well as Rural and Tribal Health Centers. FQHCs are community-based organizations and are funded by the federal government, which provide medical and dental services to underprivileged and underserved communities. The Patient Protection and Affordable Care Act, which was signed into law in March 2010, reserved $11 billion over a multi-year period for FQHCs, creating unprecedented opportunities for FQHCs growth and the formation of new FQHCs. When combined and used in tandem, NextGen Ambulatory EHR, NextGen Electronic Dental Record and NextGen Practice Management provides a unique product in this marketplace - an integrated patient record accessible by both physicians and dentists.
 
The QSI Dental Division's legacy practice management software suite uses a UNIX® operating system. It's Clinical Product Suite (“CPS”) can be fully integrated with the client server-based practice management software offered from each of our Divisions. When integrated and delivered with the NextGen Healthcare practice management solution, CPS is re-branded as NextGen EDR (Electronic Dental Record). CPS/EDR incorporates a wide range of clinical tools including, but not limited to, periodontal charting and digital imaging of X-ray and inter-oral camera images as part of the electronic patient record. The QSI Dental Division also develops, markets, and provides EDI services to dental practices, including electronic submission of claims to insurance providers as well as automated patient statements.

NextGen Division. The NextGen Division, with headquarters in Horsham, Pennsylvania and a significant location in Atlanta, Georgia, provides integrated clinical, financial and connectivity solutions for ambulatory and dental provider organizations. The NextGen Division's major product categories include the NextGen Ambulatory product suite and NextGen Community Connectivity.

The NextGen Ambulatory product suite streamlines patient care with standardized, real-time clinical and administrative workflows within a physician’s practice, and major product categories include NextGen Electronic Health Records (“NextGenehr”), NextGen Practice Management (“NextGenpm”), NextGen Dashboard, NextGen Mobile and NextGen NextPen. NextGen Community Connectivity consists of NextGen Health Information Exchange (“NextGen HIE,” formerly Community Health Solution), NextGen Patient Portal (“NextMD.com”), and NextGen Health Quality Measures (“NextGen HQM”). The NextGen Division also offers hosting services, NextGuard – Data Protection services, and consulting services, such as strategic governance models and operational transformation, technical consulting such as data conversions or interface development. The NextGen Division products utilize Microsoft Windows technology and can operate in a client-server environment as well as via private intranet, the Internet, or in an ASP environment. The NextGen Division also provides EDI services, which include electronic submission of claims to insurance providers as well as automated patient statements.

Hospital Solutions Division. The Hospital Solutions Division, with its primary location in Austin, Texas, provides integrated clinical, financial and connectivity solutions for rural and community hospitals. This Hospital Solutions Division also develops and markets an equivalent practice management software product for the small hospital market, which performs the administrative functions required for operating a small hospital.

In the last few years, we have continued to acquire companies that were established developers of software and services for the inpatient market to operate under the Hospital Solutions Division. On May 1, 2012, we acquired The Poseidon Group, Inc. ("Poseidon"), a provider of emergency department software. On July 26, 2011, we acquired CQI Solutions, Inc. ("CQI"), a provider of hospital systems for surgery management. On April 29, 2011, we acquired IntraNexus, Inc. ("IntraNexus"), a provider of Web-based integrated clinical and hospital information systems. On February 10, 2010, we acquired Opus Healthcare Solutions, LLC ("Opus"), a provider of Web-based clinical solutions to hospital systems and integrated health networks nationwide. On August 12, 2009, we acquired Sphere Health Systems, Inc. ("Sphere"), a provider of financial information systems to the small hospital inpatient market. These acquisitions are part of our strategy to continue to expand in the small hospital market and to add new clients by taking advantage of cross selling opportunities between the ambulatory and inpatient markets.
 
RCM Services Division. The RCM Services Division, with locations in St. Louis, Missouri and Hunt Valley, Maryland, provides technology solutions and consulting services to cover the full spectrum of healthcare providers' RCM needs, from patient access through claims denials, with a primary focus on billing and collection services. The RCM Services Division combines a Web-delivered SaaS model and the NextGenpm software platform to execute its service offerings. Execution of the plan to transition our client base onto the NextGen platform is being implemented. On April 15, 2012, we acquired Matrix Management Solutions, LLC (“Matrix”). Since 1998, North Canton, Ohio-based Matrix, a value-added reseller for NextGen Healthcare, has provided RCM services, healthcare IT solutions and training, implementation and support centered on NextGen® technology, to its clients nationwide. The acquisition will enable our RCM Services Division to expand its footprint among private and hospital-based physicians and groups by leveraging Matrix's RCM expertise.
 
Overview of Our Results
Consolidated revenue increased 8.8% in the nine months ended December 31, 2012 as compared to the prior year period. Revenue was positively impacted by growth in all of our service revenue categories, which in total grew 20.7%. The increase in consolidated revenue however was largely offset by a decline in system sales revenue which declined by 12.9%.
Consolidated gross profit decreased to 59.5% for the nine months ended December 31, 2012 compared to 65.9% in the prior year period. The decline was attributable to a 32.8% decrease in software and hardware gross profit, partially offset by increases of 32.3%, 27.8% and 36.2%, respectively, in implementation, EDI and RCM services gross profit.





Consolidated operating income decreased 23.3% in the nine months ended December 31, 2012 as compared to the prior year period primarily due to the following factors: (a) a change in the mix of revenue towards lower margin service revenue, (b) higher selling, general and administrative expenses, which was primarily a result of increased headcount and selling-related expenses at the NextGen Division and (c) higher corporate-related expenses.

QSI Dental Division
QSI Dental Division revenue increased 2.9% in the nine months ended December 31, 2012 and divisional operating income (excluding unallocated corporate expenses) decreased 4.1% as compared to the same prior year period. The decline in operating income is the result of a decrease in system sales and higher selling, general and administrative expenses in the current period. It should be noted that the QSI Dental Division's new software solution (“QSIDental™ Web”) is being sold as a SaaS solution which spreads revenue over a longer period of time rather than being recognized upfront. Revenue recognized from QSIDental Web was not significant in the nine months ended December 31, 2012.
The QSI Dental Division is well-positioned to sell to the FQHCs market and intends to continue leveraging the NextGen Division's sales force to sell its dental electronic medical records software to practices that provide both medical and dental services, such as FQHCs, which are receiving grants as part of the ARRA.
Our goal for the QSI Dental Division is to maximize profit performance given the constraints represented by a relatively weak purchasing environment in the dental group practice market while taking advantage of opportunities with the new QSIDental™ Web product.

NextGen Division
NextGen Division revenue increased 6.7% in the nine months ended December 31, 2012 and divisional operating income (excluding unallocated corporate expenses) decreased 5.3% as compared to the same prior year period. NextGen revenue was positively impacted by growth in service revenue which grew by 20.0%, largely offset by a decline in system sales revenue which declined by 13.8%.
Recurring revenue, which consists primarily of maintenance and EDI revenue, increased 16.4% to $138.4 million and accounted for 53.4% of total NextGen Division revenue for the nine months ended December 31, 2012. In the same period a year ago, recurring revenue of $118.9 million represented 48.9% of total NextGen Division revenue.
During the nine months ended December 31, 2012, we added staffing resources in anticipation of growth from the ARRA and the future of healthcare reform and accountable care organizations. Our goals include taking maximum advantage of benefits related to the ARRA and continuing to further enhance our existing products, including continued efforts to maintain our status as a qualified vendor under the ARRA, integrating our inpatient and ambulatory software products, further development and enhancements of our portfolio of specialty focused templates within our EHR software, developing new products for targeted markets, continuing to add new clients, selling additional software and services to existing clients, expanding penetration of connectivity and other services to new and existing clients, and capitalizing on growth and cross selling opportunities within the RCM Services Division and the Hospital Solutions Division.
The NextGen Division's growth is attributed to a strong brand name and reputation within a growing marketplace for electronic health records and investments in sales and marketing activities, including new marketing campaigns, trade show attendance and other expanded advertising and marketing expenditures. We have also recently expanded our relationship with certain value added resellers with significant resources both domestically and internationally.

Hospital Solutions Division
Hospital Solutions Division revenue increased 4.8% in the nine months ended December 31, 2012. Revenue was negatively impacted by lower system sales as well as slightly lower maintenance revenue and higher levels of sales credits. The decline in revenue was partially offset by higher implementation revenue compared to the prior period.
Divisional operating income (excluding unallocated corporate expenses) decreased to a loss of $0.2 million for the nine months ended December 31, 2012 as compared to income of $8.9 million for the same prior year period. Operating income was negatively impacted by increases in implementation costs related to expanding infrastructure to support a growing customer base, lower software revenue and a $3.0 million increase in selling, general and administrative expenses during the period.
Our acquisition of Poseidon in May 2012 did not significantly impact the Hospital Solutions Division results for the period.
The Hospital Solutions Division has benefited from being able to offer both financial and CCHIT® certified clinical software, which has been packaged together. The Hospital Solutions Division has also benefited from cross sell opportunities with existing NextGen Division customers, including hospitals that are owned or affiliated with physician offices.
We intend to continue to invest in implementation and training, support, and development to support our growing customer base, however improved operating results for the division will require effective execution by the division including effectively expanding implementation and support capabilities and successful cross selling of Hospital Solutions to new and existing customers.






RCM Services Division
RCM Services Division revenue increased 27.0% in the nine months ended December 31, 2012. Divisional operating income (excluding unallocated corporate expenses) increased 30.9% to $5.7 million in the nine months ended December 31, 2012 as compared to $4.4 million for the same prior year period. Our acquisition of Matrix in April 2012 added approximately $9.2 million in revenue for the current period.
The RCM Services Division benefited from organic growth achieved through cross selling RCM services to existing NextGen Division clients and well as new clients added during the nine months ended December 31, 2012. The division also benefited from the cross sale of software and services to its existing customers. Systems sales to existing RCM Services customers are credited to the division.
The Company believes that a significant opportunity exists to cross sell revenue cycle management services to existing NextGen Division customers. The portion of existing NextGen Division customers who are using the RCM Services Division's RCM services is less than 15%. There is also a significant opportunity to expand the RCM Services Division's services into the Hospital Solution and Dental Division's customers as well. Management is actively pursuing efforts to achieve faster growth from expanded efforts to leverage the existing NextGen Division's sales force towards selling revenue cycle management services.
Actual and expected customer turnover may result in a near term decline in revenues for the Division. However, we are encouraged by increased sales activity and a growing sales pipeline of RCM services.
Operating income as a percentage of revenue increased to approximately 12.0% of revenue in the nine months ended December 31, 2012 versus 11.6% of revenue in the same prior year period primarily as a result of a significant increase in the RCM Services Division's revenue compared to the prior year period, partially offset by higher selling, general and administrative expenses during the current period.

The following table sets forth, for the periods indicated, the percentage of net revenue represented by each item in our consolidated statements of income (certain percentages below may not sum due to rounding):






 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
(Unaudited)
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
 
Software and hardware
 
19.1