QSII 10Q 6.30.2014


 
 
 
 
 

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 June 30, 2014

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 July 24, 2014 was 60,221,910 shares.



 
 
 
 
 





QUALITY SYSTEMS, INC.

TABLE OF CONTENTS
FORM 10-Q
FOR THE THREE MONTHS ENDED JUNE 30, 2014

 
Item    
Page
 
 
 
 
PART I. FINANCIAL INFORMATION
 
Item 1.
Financial Statements
 
 
Unaudited Consolidated Balance Sheets as of June 30, 2014 and March 31, 2014
 
Unaudited Consolidated Statements of Comprehensive Income for the three months ended June 30, 2014 and 2013
 
Unaudited Consolidated Statements of Cash Flows for the three months ended June 30, 2014 and 2013
 
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 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)
 
June 30, 2014
 
March 31, 2014
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
107,748

 
$
103,145

Restricted cash
2,605

 
4,351

Marketable securities
8,687

 
10,656

Accounts receivable, net
111,842

 
110,181

Inventories
755

 
834

Income taxes receivable
5,999

 
8,366

Deferred income taxes, net
11,757

 
11,690

Other current assets
9,769

 
11,135

Total current assets
259,162

 
260,358

Equipment and improvements, net
22,915

 
22,801

Capitalized software costs, net
38,452

 
39,152

Intangibles, net
31,175

 
33,016

Goodwill
72,804

 
72,804

Other assets
17,273

 
16,927

Total assets
$
441,781

 
$
445,058

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
8,850

 
$
7,888

Deferred revenue
70,692

 
71,077

Accrued compensation and related benefits
13,894

 
15,953

Dividends payable
10,690

 
10,686

Other current liabilities
20,616

 
18,282

Total current liabilities
124,742

 
123,886

Deferred revenue, net of current
2,001

 
2,187

Deferred compensation
5,182

 
4,809

Other noncurrent liabilities
19,316

 
19,086

Total liabilities
151,241

 
149,968

Commitments and contingencies (Note 11)


 


Shareholders’ equity:
 
 
 
Common stock $0.01 par value; authorized 100,000 shares; issued and outstanding 60,222 and 60,206 shares at June 30, 2014 and March 31, 2014, respectively
602

 
602

Additional paid-in capital
195,733

 
194,739

Accumulated other comprehensive loss
(198
)
 
(182
)
Retained earnings
94,403

 
99,931

Total shareholders’ equity
290,540

 
295,090

Total liabilities and shareholders’ equity
$
441,781

 
$
445,058

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 June 30,
 
2014
 
2013
Revenues:
 
 
 
Software and hardware
$
14,743

 
$
15,972

Implementation and training services
6,266

 
6,575

System sales
21,009

 
22,547

Maintenance
40,805

 
38,608

Electronic data interchange services
18,319

 
16,692

Revenue cycle management and related services
16,693

 
16,015

Other services
21,068

 
15,667

Maintenance, EDI, RCM and other services
96,885

 
86,982

Total revenues
117,894

 
109,529

Cost of revenue:
 
 
 
Software and hardware
6,641

 
4,934

Implementation and training services
7,151

 
7,134

Total cost of system sales
13,792

 
12,068

Maintenance
6,914

 
5,302

Electronic data interchange services
11,999

 
10,796

Revenue cycle management and related services
12,706

 
11,401

Other services
10,779

 
8,505

Total cost of maintenance, EDI, RCM and other services
42,398

 
36,004

Total cost of revenue
56,190

 
48,072

Gross profit
61,704

 
61,457

Operating expenses:
 
 
 
Selling, general and administrative
36,730

 
35,096

Research and development costs
16,236

 
5,614

Amortization of acquired intangible assets
983

 
1,194

Total operating expenses
53,949

 
41,904

Income from operations
7,755

 
19,553

Interest income, net
54

 
31

Other income (expense), net
9

 
(254
)
Income before income taxes
7,818

 
19,330

Provision for income taxes
2,655

 
6,385

Net income
$
5,163

 
$
12,945

Other comprehensive income:
 
 
 
Foreign currency translation (net of $0 tax)
(8
)
 
(173
)
Unrealized loss on AFS securities (net of $0 tax)
(8
)
 

Comprehensive income
$
5,147

 
$
12,772

Net income per share:
 
 
 
Basic
$
0.09

 
$
0.22

Diluted
$
0.08

 
$
0.22

Weighted-average shares outstanding:
 
 
 
Basic
60,230

 
59,559

Diluted
60,770

 
59,572

Dividends declared per common share
$
0.175

 
$
0.175







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





QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Three Months Ended June 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net income
$
5,163

 
$
12,945

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
2,136

 
1,897

Amortization of capitalized software costs
3,602

 
2,679

Amortization of other intangibles
1,841

 
1,866

Provision for bad debts
(1,136
)
 
1,805

Provision for inventory obsolescence
9

 

Share-based compensation
790

 
541

Deferred income taxes
16

 
517

Excess tax benefit from share-based compensation

 
(50
)
Change in fair value of contingent consideration
604

 
46

Loss on disposal of equipment and improvements
12

 

Changes in assets and liabilities:
 
 
 
Accounts receivable
3,172

 
7,503

Inventories
70

 
(273
)
Income taxes receivable
2,367

 

Other current assets
3,129

 
4,025

Other assets
(429
)
 
(610
)
Accounts payable
955

 
(4,061
)
Deferred revenue
(571
)
 
(2,416
)
Accrued compensation and related benefits
(2,059
)
 
158

Income taxes payable
(178
)
 
3,823

Other current liabilities
(1,568
)
 
149

Deferred compensation
373

 
141

Other noncurrent liabilities
267

 
842

Net cash provided by operating activities
18,565

 
31,527

Cash flows from investing activities:
 
 
 
Additions to capitalized software costs
(2,902
)
 
(7,300
)
Additions to equipment and improvements
(2,255
)
 
(1,835
)
Proceeds from sales and maturities of marketable securities
1,936

 

Net cash used in investing activities
(3,221
)
 
(9,135
)
Cash flows from financing activities:
 
 
 
Excess tax benefit from share-based compensation

 
50

Proceeds from (payments from) exercise of stock options
(54
)
 
250

Dividends paid
(10,687
)
 
(10,417
)
Payment of contingent consideration related to acquisitions

 
(62
)
Net cash used in financing activities
(10,741
)
 
(10,179
)
Net increase in cash and cash equivalents
4,603

 
12,213

Cash and cash equivalents at beginning of period
103,145

 
105,999

Cash and cash equivalents at end of period
$
107,748

 
$
118,212






QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)
(In thousands)
(Unaudited)
 
Three Months Ended June 30,
 
2014
 
2013
Supplemental disclosures of cash flow information:
 
 
 
Cash paid during the period for income taxes, net of refunds
$
212

 
$
2,032


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 consist of NextGen Healthcare Information Systems, LLC (“NextGen”), NextGen RCM Services, LLC, Opus Healthcare Solutions, LLC, ViaTrack Systems, LLC (“ViaTrack”), Matrix Management Solutions, LLC, QSI Management, LLC, Quality Systems India Healthcare Private Limited (“QSIH”) and Mirth Corporation (“Mirth”) (collectively, the “Company”). All intercompany accounts and transactions have been eliminated.
Basis of Presentation. The accompanying unaudited consolidated financial statements as of June 30, 2014 and for the three months ended June 30, 2014 and 2013 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, 2014. Amounts related to disclosures of March 31, 2014 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.
Revenue Recognition. The Company generates revenue from the sale of licensing rights to its software products directly to end-users and value-added resellers ("VARs"). The Company also generates revenue from sales of hardware and third-party software, implementation and training, electronic data interchange (“EDI”), revenue cycle management ("RCM"), post-contract support (maintenance) and other services, including subscriptions and hosting services, performed for clients who license the Company's 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 the price charged when the same element is sold separately. VSOE calculations are updated and reviewed quarterly or annually depending on the nature of the product or service. The Company generally establishes VSOE for the related undelivered elements based on the bell-shaped curve method. VSOE is established on maintenance for the Company's largest clients 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, 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 that 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 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 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.
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 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. If 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 divided 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, subscriptions, 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.
During the quarter ended June 30, 2014, the Company elected to bypass the optional qualitative step of the goodwill impairment assessment and proceed directly with the quantitative step, under which the Company is required to compare the estimated fair value of each reporting unit with goodwill to its net carrying amount. An impairment loss is recognized when the carrying amount of the reporting unit's net assets exceeds the estimated fair value of the reporting unit. The Company determined the fair value of its reporting units utilizing the average of two valuation methods, consisting of the income approach (based upon estimates of future discounted cash flows for each reporting unit) and a market comparable approach (based upon valuation multiples of companies that operate in similar industries with similar operating characteristics). The cash flows used to determine fair value under the income approach represent Management's best estimates of projected operating results and assumed terminal growth rates that are dependent on a number of significant assumptions based on historical experience, expectations of future performance, and the expected macro-economic environment, which are subject to change given the inherent uncertainty in predicting future results. The Company also considered the Company's stock price and market capitalization as a corroborative step in assessing the reasonableness of the fair values estimated for the reporting units as part of the goodwill impairment assessment. The results of the goodwill impairment assessment established that the fair value for each reporting unit with goodwill significantly exceeded its respective net carrying amount, indicating that no goodwill impairment existed as of the annual test date.
Intangible Assets. Intangible assets consist of customer relationships, trade names and contracts and certain software technology. These intangible assets are recorded at fair value and are stated net of accumulated amortization. The Company currently amortizes the intangible assets over periods ranging from six months to nine years using a method that reflects the pattern in which the economic benefits of the intangible asset are consumed. The Company assesses the recoverability of intangible assets at least annually or whenever adverse events or changes in circumstances indicate that impairment may have occurred. If the future undiscounted cash flows expected to result from the use of the related assets are less than the carrying value of such assets, impairment has been incurred and a loss is recognized to reduce the carrying value of the intangible assets to fair value, which is determined by discounting estimated future cash flows.
Software Development Costs. Development costs, consisting primarily of employee salaries and benefits, incurred in the research and development of new software products and enhancements to existing software products for external use are expensed as incurred until





technological feasibility has been established. After technological feasibility is established, any additional external software development costs are capitalized and amortized on a straight-line basis over the estimated economic life of the related product, which is typically three years. The Company provides support services on the current and prior two versions of its software. Management performs ongoing reviews of the estimated economic life and the recoverability of such capitalized software costs. If a determination is made that capitalized amounts are not recoverable based on the estimated cash flows to be generated from the applicable software, any remaining capitalized amounts are written off.
Share-Based Compensation. The following table shows total share-based compensation expense included in the consolidated statements of comprehensive income (loss) for the three months ended June 30, 2014 and 2013:
 
Three Months Ended June 30,
 
2014
 
2013
Costs and expenses:
 
 
 
Cost of revenue
$
86

 
$
74

Research and development costs
83

 
42

Selling, general and administrative
621

 
425

Total share-based compensation
790

 
541

Income tax benefit
(263
)
 
(168
)
Decrease in net income
$
527

 
$
373


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 May 2014, the FASB, along with the International Accounting Standards Board, issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"), which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition.  ASU 2014-09 provides enhancements to the quality and consistency of how revenue is reported while also improving comparability in the financial statements of companies reporting using International Financial Reporting Standards and GAAP.  The core principle of this updated guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new standard also requires additional disclosure about revenue and provides improved guidance for multiple element arrangements. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Companies are permitted to adopt this new guidance following either a full retrospective or modified retrospective approach.  Early adoption is not permitted. 
ASU 2014-09 is effective for the Company in the first quarter of fiscal 2018.  The Company is currently evaluating the potential impact of implementation of this updated authoritative guidance on its consolidated 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 June 30, 2014 and March 31, 2014:
 
Balance at
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Unobservable Inputs (Level 3)
 
June 30,
2014
 
 
 
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
107,748

 
$
107,748

 
$

 
$

Restricted cash
2,605

 
2,605

 

 

Marketable securities (2)
8,687

 
8,687

 

 

 
$
119,040

 
$
119,040

 
$

 
$

LIABILITIES
 
 
 
 
 
 
 
Contingent consideration related to acquisitions
$
15,517

 
$

 
$

 
$
15,517

 
$
15,517

 
$

 
$

 
$
15,517






 
Balance at
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Unobservable Inputs (Level 3)
 
March 31,
2014
 
 
 
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents (1)
$
103,145

 
$
103,145

 
$

 
$

Restricted cash
4,351

 
4,351

 

 

Marketable securities (2)
10,656

 
10,656

 

 

 
$
118,152

 
$
118,152

 
$

 
$

LIABILITIES
 
 
 
 
 
 
 
Contingent consideration related to acquisitions
$
14,913

 
$

 
$

 
$
14,913

 
$
14,913

 
$

 
$

 
$
14,913

___________________________________
(1) Cash and cash equivalents consists of money market funds.
(2) Marketable securities consist of fixed-income securities, including certificates of deposit and municipal 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. The fair value adjustments are reflected as a component of selling, general and administrative expense. 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 related to the acquisitions of Sphere Health Systems, Inc., IntraNexus, Inc., and Mirth were estimated based on the probability of achieving certain business milestones and/or management’s forecast of expected revenues.
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 three months ended June 30, 2014:
 
 
Total Liabilities
Balance as of April 1, 2014
 
$
14,913

Fair value adjustments
 
604

Balance as of June 30, 2014
 
$
15,517


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 three months ended June 30, 2014, there were no adjustments to fair value of such assets.


3. 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,
2014
 
Acquisitions
 
Impairment
 
June 30,
2014
QSI Dental Division (1)
$
7,289

 
$

 
$

 
$
7,289

NextGen Division
33,225

 

 

 
33,225

RCM Services Division
32,290

 

 

 
32,290

Total goodwill
$
72,804

 
$

 
$

 
$
72,804

(1) QSI Dental Division goodwill is presented on a basis consistent with that of the management reporting structures within QSI.  For the purposes of testing goodwill for impairment annually and as otherwise may be required, however, the QSI Dental Division goodwill is allocated to all business units that derive cash flows from the products associated with the acquired goodwill.  For all periods presented in this report, the allocation resulted in substantially all of such goodwill being ascribed to the NextGen Division.

Approximately 70% of the goodwill balance as of June 30, 2014 is expected to be deductible for income tax purposes over the periods prescribed by the Internal Revenue Code ("IRC").


4. Intangible Assets

The Company’s definite-lived intangible assets, other than capitalized software development costs, are summarized as follows:
 
June 30, 2014
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Gross carrying amount
$
22,050

 
$
3,368

 
$
23,510

 
$
48,928

Accumulated amortization
(12,702
)
 
(1,732
)
 
(3,319
)
 
(17,753
)
Net intangible assets
$
9,348

 
$
1,636

 
$
20,191

 
$
31,175

 
March 31, 2014
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Gross carrying amount
$
22,050

 
$
3,368

 
$
23,510

 
$
48,928

Accumulated amortization
(11,837
)
 
(1,599
)
 
(2,476
)
 
(15,912
)
Net intangible assets
$
10,213

 
$
1,769

 
$
21,034

 
$
33,016


Activity related to the intangible assets for the three months ended June 30, 2014 and 2013 is summarized as follows:
 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Balance as of April 1, 2014
$
10,213

 
$
1,769

 
$
21,034

 
$
33,016

Amortization (1)
(865
)
 
(133
)
 
(843
)
 
(1,841
)
Balance as of June 30, 2014
$
9,348

 
$
1,636

 
$
20,191

 
$
31,175

 
Customer Relationships
 
Trade Name & Contracts
 
Software Technology
 
Total
Balance as of April 1, 2013
$
13,128

 
$
906

 
$
13,516

 
$
27,550

Amortization (1)
(1,054
)
 
(80
)
 
(732
)
 
(1,866
)
Balance as of June 30, 2013
$
12,074

 
$
826

 
$
12,784

 
$
25,684

_______________________________
(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 June 30, 2014:
For the year ended March 31,
 
2015 (remaining nine months)
$
5,286

2016
7,024

2017
6,553

2018
4,301

2019
3,517

2020 and beyond
4,494

Total
$
31,175


Approximately 95% of the acquired intangible assets are expected to be deductible for income tax purposes over the periods prescribed by the IRC.
5. Capitalized Software Costs






The Company’s capitalized software development costs are summarized as follows:
 
June 30,
2014
 
March 31, 2014
Gross carrying amount
$
103,358

 
$
100,455

Accumulated amortization
(64,906
)
 
(61,303
)
Net capitalized software costs
$
38,452

 
$
39,152


Activity related to net capitalized software costs for the three months ended June 30, 2014 and 2013 is summarized as follows:
 
2014
 
2013
Balance as of April 1
$
39,152

 
$
39,781

Capitalized
2,902

 
7,300

Amortization
(3,602
)
 
(2,679
)
Balance as of June 30
$
38,452

 
$
44,402


The following table presents the remaining estimated amortization of capitalized software costs as of June 30, 2014. The estimated amortization is comprised of (i) amortization of released products and (ii) the expected amortization for products that are not yet available for sale based on their estimated economic lives and projected general release dates.
For the year ended March 31,
 
2015 (remaining nine months)
$
11,500

2016
13,800

2017
6,700

2018
2,900

2019
2,700

2020 and beyond
852

Total
$
38,452


6. 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.
 
June 30,
2014
 
March 31,
2014
Accounts receivable, gross
$
127,476

 
$
127,006

Sales return reserve
(10,774
)
 
(10,530
)
Allowance for doubtful accounts
(4,860
)
 
(6,295
)
Accounts receivable, net
$
111,842

 
$
110,181


Inventories are summarized as follows:
 
June 30,
2014
 
March 31,
2014
Computer systems and components
$
755

 
$
834


Equipment and improvements are summarized as follows:





 
June 30,
2014
 
March 31,
2014
Computer equipment
$
38,273

 
$
37,322

Furniture and fixtures
9,571

 
9,395

Leasehold improvements
9,934

 
8,874

 
57,778

 
55,591

Accumulated depreciation and amortization
(34,863
)
 
(32,790
)
Equipment and improvements, net
$
22,915

 
$
22,801


Current and non-current deferred revenue are summarized as follows:
 
June 30,
2014
 
March 31,
2014
Maintenance
$
14,942

 
$
15,482

Implementation services
34,149

 
36,634

Annual license services
11,351

 
11,176

Undelivered software and other (1)
10,250

 
7,785

Deferred revenue
$
70,692

 
$
71,077

Deferred revenue, net of current
$
2,001

 
$
2,187

(1) Includes subscriptions and SaaS deferred revenue.

Accrued compensation and related benefits are summarized as follows:
 
June 30,
2014
 
March 31,
2014
Payroll, bonus and commission
$
3,473

 
$
6,193

Vacation
10,421

 
9,760

Accrued compensation and related benefits
$
13,894

 
$
15,953







Other current and non-current liabilities are summarized as follows:
 
June 30,
2014
 
March 31,
2014
Customer deposits and liabilities
$
3,699

 
$
76

Self insurance reserve
2,675

 
2,090

Care services liabilities
2,605

 
4,351

Accrued EDI expense
1,978

 
1,702

Accrued royalties
1,423

 
1,418

Accrued consulting
1,311

 
1,707

Contingent consideration and other liabilities related to acquisitions
978

 
1,052

Deferred rent
843

 
964

Users group meeting deposits
549

 

Professional services
303

 
170

Accrued travel
251

 
369

Outside commission payable
144

 
255

Other accrued expenses
3,857

 
4,128

Other current liabilities
$
20,616

 
$
18,282

 
 
 
 
Contingent consideration and other liabilities related to acquisitions
$
15,030

 
$
14,736

Deferred rent
3,482

 
3,509

Income tax payable
804

 
841

Other non-current liabilities
$
19,316

 
$
19,086


7. Income Taxes
The provision for income taxes for the three months ended June 30, 2014 and 2013 was approximately $2.7 million and $6.4 million, respectively. The effective tax rates were 34.0% and 33.0% for the three months ended June 30, 2014 and 2013, respectively. The effective rate for the three months ended June 30, 2014 increased as compared to the same prior year period primarily due to the absence of a federal research and development tax credit reflected in the current period, offset by an increased benefit of the foreign rate differential and a decrease in qualified production activities deduction. The federal research and development tax credit statute expired on December 31, 2013 and has not been reenacted as of June 30, 2014.
The deferred tax assets and liabilities have been shown net in the accompanying consolidated balance sheets based on the long-term or short-term nature of the items that give rise to the deferred amount. The Company expects to receive the full benefit of the deferred tax assets recorded with the exception of a specific state tax credit for which the Company has recorded a valuation allowance.
Uncertain tax positions As of June 30, 2014, the Company had recorded a liability of $759 for unrecognized tax benefits related to various federal, state and local income tax matters. If recognized, this amount would reduce the Company’s effective tax rate. The tax liability for the three months ended June 30, 2014 increased from the same prior year period by $24 due to changes in reserves for state and local income tax liabilities and certain tax positions related to acquired companies.
The Company is no longer subject to U.S. federal income tax examinations for tax years before 2013. With few exceptions, the Company is no longer subject to state income tax examinations for tax years before 2009. 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.
 

8. Earnings per Share

The Company provides presentation of “basic” and “diluted” earnings per share (“EPS”). Shares discussed below are in thousands.





 
Three Months Ended June 30,
 
2014
 
2013
Net income
$
5,163

 
$
12,945

Basic net income per share:
 
 
 
Weighted-average shares outstanding — Basic
60,230

 
59,559

Basic net income per common share
$
0.09

 
$
0.22

 
 
 
 
Net income
$
5,163

 
$
12,945

Diluted net income per share:
 
 
 
Weighted-average shares outstanding — Basic
60,230

 
59,559

Effect of potentially dilutive securities
540

 
13

Weighted-average shares outstanding — Diluted
60,770

 
59,572

Diluted net income per common share
$
0.08

 
$
0.22


The computation of diluted net income per share does not include 1,492 and 1,227 options to acquire shares of common stock for the three months ended June 30, 2014 and 2013, respectively, because their inclusion would have an anti-dilutive effect on net income per share.

9. Share-Based Awards
Employee Stock Option and Incentive 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 and directors 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 based on the date of grant, and options under the 1998 Plan expire no later than 10 years from the date of grant. Options granted pursuant to the 1998 Plan became exercisable in accordance with the terms of the agreements pursuant to which they were granted. Upon change of control of the Company, as such term is defined in the 1998 Plan, each outstanding option may be subject to accelerated vesting at the discretion of the Board of Directors if no provision is made for the continuance of the 1998 Plan and the assumption of the options outstanding under the 1998 Plan, or certain other circumstances. The 1998 Plan was terminated on December 31, 2007. As of June 30, 2014, there were 20,000 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 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 and directors of the Company may, at the discretion of the Board of Directors or a duly designated compensation committee, be granted certain share-based awards. In the case of option awards granted under the 2005 Plan, the exercise price of each option is determined based on the date of grant and expire no later than 10 years from the date of grant. Awards granted pursuant to the 2005 Plan are subject to the vesting schedule or performance metrics set forth in the agreements pursuant to which they are granted. Upon a change of control of the Company, as such term is defined in the 2005 Plan, awards under the 2005 Plan will fully vest under certain circumstances. The 2005 Plan expires on May 25, 2015, unless terminated earlier by the Board of Directors. As of June 30, 2014, there were 1,759,551 outstanding options, 53,293 outstanding shares of restricted stock, restricted stock units and performance based restricted stock, and 2,222,739 shares available for future grant under the 2005 Plan.





A summary of stock option transactions during the three months ended June 30, 2014 follows:
 
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
per Share
 
Weighted-
Average
Remaining
Contractual
Life (years)
 
Aggregate
Intrinsic
Value
(in thousands)
Outstanding, April 1, 2014
 
1,370,101

 
$
27.85

 
5.8
 

Granted
 
439,650

 
15.99

 
7.9
 


Exercised
 

 

 
0
 
$

Forfeited/Canceled
 
(30,200
)
 
26.24

 
6.3
 


Outstanding, June 30, 2014
 
1,779,551

 
$
24.94

 
6.1
 
$
26

Vested and expected to vest, June 30, 2014
 
1,678,763

 
$
25.12

 
6.1
 
$
24

Exercisable, June 30, 2014
 
571,981

 
$
30.90

 
4.7
 
$


The Company utilizes the Black-Scholes valuation model for estimating the fair value of share-based compensation with the following assumptions:
 
 
Three Months Ended June 30, 2014
 
Three Months Ended June 30, 2013
Expected life
 
4.8 years
 
4.9 years
Expected volatility
 
36.6%
 
43.7%
Expected dividends
 
4.3%
 
3.9%
Risk-free rate
 
1.7%
 
1.0%
The weighted-average grant date fair value of stock options granted during the three months ended June 30, 2014 and 2013 was $3.50 and $4.87 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 8.4% and 8.1% for employee options for the three months ended June 30, 2014 and 2013, respectively, and 0.0% for director options for the three months ended June 30, 2014 and 2013. Forfeiture rates are adjusted over the requisite service period when actual forfeitures differ, or are expected to differ, from the estimate.
During the three months ended June 30, 2014, a total of 439,650 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 2015 and 2014 is as follows:
Option Grant Date
 
Number of Shares
 
Exercise Price
 
Vesting Terms (1)
 
Expires
June 3, 2014
 
439,650

 
$
15.99

 
Five years
 
June 3, 2022
Fiscal year 2015 option grants
439,650

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
August 15, 2013
 
85,000

 
$
20.85

 
Five years
 
August 15, 2021
July 30, 2013
 
28,000

 
$
22.59

 
Five years
 
July 30, 2021
May 29, 2013
 
356,000

 
$
17.95

 
Five years
 
May 29, 2021
Fiscal year 2014 option grants
 
469,000

 
 
 
 
 
 
__________________________________
(1) Options vest in equal annual installments on each grant anniversary date commencing one year following the date of grant.
Employee and Executive Officer Awards
On May 28, 2014, the Board of Directors awarded options to purchase the Company’s common stock to certain high-performing employees. The options were granted on the first day of the next open trading window under the Company's Insider Trading Policy, issued pursuant to the 2005 Plan, 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 vest in five equal annual installments commencing one year following the date of grant.





On May 27, 2014, the Compensation Committee of the Board of Directors approved the Company's fiscal year 2015 Executive Compensation Program (the "Program") under which the Company's named executive officers are eligible to receive cash bonuses based on meeting certain target increases in revenue and non-GAAP financial targets, as defined in the Program (i.e. non-GAAP earnings per share and a measure of free cash flow) for fiscal year 2015. Under the Program, the named executive officers also received certain equity incentive awards issued under the 2005 Plan. These equity awards included (i) an aggregate of 105,000 options to purchase the Company's common stock, which were granted on the first day of the next open trading window under the Company's Insider Trading Policy, 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 a vesting schedule of five equal annual installments commencing one year following the date of grant; and (ii) a potential award of up to an aggregate of 170,000 restricted performance shares of the Company's common stock vesting over a three year period based on the achievement of target average daily share prices for the ninety calendar day period ending May 31st of each of the subsequent three fiscal years.
Share-based compensation expense associated with the restricted performance shares under the Program is based on the grant date fair value measured at the underlying closing share price on the date of grant using a Monte Carlo-based valuation model. Share-based compensation expense associated with the options under the Company’s equity incentive programs are initially based on the number of options expected to vest after assessing the probability that the performance criteria will be met. Cumulative adjustments are recorded quarterly to reflect subsequent changes in the estimated outcome of performance-related conditions. The Company utilizes the Black-Scholes option valuation model with the assumptions in the table below to calculate the share-based compensation expense related to the options. Share-based compensation expense recorded for these performance-based awards was $104 and $92 for the three months ended June 30, 2014 and 2013, respectively.
 
Three Months Ended June 30, 2014
 
Three Months Ended June 30, 2013
Expected life
4.8 years
 
4.9 years
Expected volatility
36.5%
 
43.5%
Expected dividends
4.3%
 
3.7%
Risk-free rate
1.6%
 
1.4%

Non-vested stock option award activity, including employee stock options and performance-based awards, during the three months ended June 30, 2014 is summarized as follows:
 
 
Non-Vested
Number of
Shares
 
Weighted-
Average
Grant-Date
Fair Value
per Share
Outstanding, April 1, 2014
 
991,560

 
$
7.73

Granted
 
439,650

 
3.50

Vested
 
(193,440
)
 
8.50

Forfeited/Canceled
 
(30,200
)
 
7.66

Outstanding, June 30, 2014
 
1,207,570

 
$
6.07


As of June 30, 2014, $6,308 of total unrecognized compensation costs related to stock options is expected to be recognized over a weighted-average period of 3.8 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 three months ended June 30, 2014 and 2013 was $1,645 and $1,057, respectively.
Director Awards
On May 28, 2014, the Board of Directors approved its 2015 Director Compensation Program, pursuant to which each non-employee director is to be granted 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 $174 and $92 for the three months ended June 30, 2014 and 2013, respectively. Restricted stock activity for the three months ended June 30, 2014 is summarized as follows:
 
 
Number of
Shares
 
Weighted-
Average
Grant-Date
Fair Value
per Share
Outstanding, April 1, 2014
 
64,571

 
$
20.74

Granted
 
788

 
17.14

Vested
 
(12,066
)
 
21.68

Outstanding, June 30, 2014
 
53,293

 
$
21.21


As of June 30, 2014, $713 of total unrecognized compensation costs related to restricted stock is expected to be recognized over a weighted-average period of 1.1 years. This amount does not include the cost of new restricted stock that may be granted in future periods.
 
10. Concentration of Credit Risk
The Company had cash deposits at U.S. banks and financial institutions which exceeded federally insured limits at June 30, 2014. 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.

11. 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.
Hussein Litigation
On October 7, 2013, a complaint was filed against the Company and certain of the Company’s officers and directors in the Superior Court of the State of California for the County of Orange, captioned Ahmed D. Hussein v. Sheldon Razin, Steven Plochocki, Quality Systems, Inc. and Does 1-10, inclusive, No. 30-2013-00679600-CU-NP-CJC, by Ahmed Hussein, a former director and significant shareholder of the Company.  The Company filed a demurrer to the complaint, which the Court granted on April 10, 2014. An amended complaint was filed on April 25, 2014. The amended complaint generally alleges fraud and deceit, constructive fraud, negligent misrepresentation and breach of fiduciary duty in connection with statements made to the Company’s shareholders regarding the Company’s financial condition and projected future performance.  The amended complaint seeks actual damages, exemplary and punitive damages and costs. The Company has filed a demurrer to the amended





complaint and is awaiting a decision from the Court. The Company believes that plaintiff’s claims are without merit and continues to defend against them vigorously.
Federal Securities Class Action
On November 19, 2013, a putative class action complaint was filed on behalf of the shareholders of the Company other than the defendants against the Company and certain of the Company’s officers and directors in the United States District Court for the Central District of California, captioned Deerfield Beach Police Pension Fund, individually and on behalf of all others similarly situated, v. Quality Systems, Inc., Steven T. Plochocki, Paul A. Holt and Sheldon Razin, No. SACV13-01818-CJC-JPRx, by the Deerfield Beach Police Pension Fund, a shareholder of the Company. After the court appointed lead plaintiffs and lead counsel for this action, lead plaintiffs filed an amended complaint on April 7, 2014. The amended complaint, which is substantially similar to the litigation described above under the caption “Hussein Litigation,” generally alleges that statements made to the Company’s shareholders regarding the Company’s financial condition and projected future performance were false and misleading in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and that the individual defendants are liable for such statements because they are controlling persons under Section 20(a) of the Exchange Act. The complaint seeks compensatory damages, court costs and attorneys' fees. The Company filed a motion to dismiss the amended complaint on June 20, 2014. The Company believes that plaintiff’s claims are without merit and intends to defend against them vigorously.
Shareholder Derivative Litigation
On January 24, 2014, a complaint was filed against the Company and certain of the Company’s officers and current and former directors in the United States District Court for the Central District of California, captioned Timothy J. Foss, derivatively on behalf of himself and all others similarly situated, vs. Craig A. Barbarosh, George H. Bristol, James C. Malone, Peter M. Neupert, Morris Panner, D. Russell Pflueger, Steven T. Plochocki, Sheldon Razin, Lance E. Rosenzweig and Quality Systems, Inc., No. SACV14-00110-DOC-JPPx, by Timothy J. Foss, a shareholder of the Company. The complaint arises from the same allegations described above under the captions “Hussein Litigation” and “Federal Securities Class Action” and generally alleges breach of fiduciary duties, abuse of control and gross mismanagement by the Company’s directors, in addition to unjust enrichment and insider selling by individual directors. The complaint seeks compensatory damages, restitution and disgorgement of all profits, court costs, attorneys’ fees and implementation of enhanced corporate governance procedures. The parties have agreed to stay this litigation pending resolution of the Defendants' anticipated motion to dismiss the Federal Securities Class Action. The Company believes that plaintiff’s claims are without merit and intends to defend against them vigorously.


12. Operating Segment Information
The Company has four reportable segments that are evaluated regularly by its chief decision making group (consisting of the Chief Executive Officer, Chief Financial Officer and Chief Operating Officer) in deciding how to allocate resources and in assessing performance. The chief decision making group evaluates performance based upon stand-alone segment operating income. Since assets by segment are not reported to or used by the Company’s chief decision making group to allocate resources, or to assess performance, total assets by segment are not disclosed.
Operating segment data is as follows:
 
 
Three Months Ended June 30,
 
 
2014
 
2013
Revenue:
 
 
 
 
QSI Dental Division
 
$
4,243

 
$
5,151

NextGen Division
 
91,714

 
81,535

Hospital Solutions Division
 
4,176

 
5,467

RCM Services Division
 
17,761

 
17,376

Consolidated revenue
 
$
117,894

 
$
109,529

 
 
 
 
 
Operating income (loss):
 
 
 
 
QSI Dental Division
 
$
935

 
$
1,641

NextGen Division
 
43,965

 
36,629

Hospital Solutions Division
 
(1,125
)
 
(704
)
RCM Services Division
 
1,836

 
3,022

Corporate and unallocated
 
(37,856
)
 
(21,035
)
Consolidated operating income
 
$
7,755

 
$
19,553







Effective April 1, 2014, the Company refined the measurement of its segment data to better reflect an organizational structure whereby certain expenses managed by functional area leadership are no longer classified within the operating segments but rather as a component of Corporate and unallocated. Such classification is consistent with the disaggregated financial information used by the Company's chief decision making group. The amounts classified as Corporate and unallocated have historically consisted primarily of corporate general and administrative costs and other centrally managed overhead costs, including accounting and finance, human resources, and legal costs, as well as non-recurring acquisition costs and the post-acquisition amortization of certain intangible assets. Currently, as a result of the refinement of its segment data, the Company no longer classifies the costs of the marketing and research and development functional areas and the amortization of capitalized software costs within the operating segments. The Company has retroactively reclassified the prior year operating income in the table above to present all segment information on a comparable basis.

The major components of the Corporate and unallocated amounts are summarized in the table below:
 
 
Three Months Ended June 30,
 
 
2014
 
2013
Research and development costs
 
$
16,236

 
$
5,614

Amortization of capitalized software costs
 
4,491

 
2,395

Marketing expense
 
3,229

 
2,167

Other Corporate and overhead costs
 
13,900

 
10,859


 


 


Total Corporate and unallocated
 
37,856

 
21,035



13. Subsequent Events

On July 23, 2014, 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 September 12, 2014 with an expected distribution date on or about October 3, 2014.






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, 2014 (“Annual Report”), as supplemented by additional risk factors, if any, in our interim filings on our Quarterly Reports 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 operations ("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 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, a summary of our acquisition transactions 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 and (iv) the RCM Services Division. We also have 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. Our scalable interoperability and population health offerings help to improve care collaboration, quality and safety. Enabled by our interoperability solutions, data-driven patient population healthcare management decisions assist in creating more desirable operational, clinical, and financial outcomes that substantiate the value of patient-centered and accountable care models.
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 ("ARRA") and the Patient Protection and Affordable Care Act), the mandate requiring individuals to obtain insurance, the individual state responses to the government-requested Medicaid expansion, the creation and operation of insurance exchanges, 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 health information technology 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 like us. Our strategy is to focus on addressing the growing 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 expand our interoperability capabilities enhancing the competitiveness of our software offerings, continue to integrate our ambulatory and hospital products, make our products more intuitive and easy to use, and to enhance 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 adding new clients through maintaining and expanding sales, marketing and product development activities and expanding 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. These investments in our infrastructure will continue while maintaining reasonable expense discipline. We believe that our growing customer base that is using our software on a daily basis is a strategic asset, and we intend to leverage this strategic asset by expanding our product and service offerings towards this customer base.
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, capitalizable software development costs, 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 2014.
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.
Our 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-1980s, we capitalized on the increasing focus on medical cost containment and further expanded our information processing systems to serve the ambulatory market. In the mid-1990s, we made two acquisitions that accelerated our penetration of the ambulatory market and formed the basis for the NextGen Division. In the last few years, we acquired several companies as part of our strategy to enhance our EDI and RCM services capabilities as well as expand into the small and specialty hospital market. More recently, we acquired Mirth Corporation ("Mirth"), which operates under the NextGen Division, and is expected to enhance our current enterprise interoperability initiatives and broaden our accountable and collaborative care, population health, disease management and clinical data exchange offerings. Today, we serve the dental, ambulatory, hospital and RCM services markets through our QSI Dental Division, 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 hospital 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 across all Divisions. 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, including software implementation and customer support functions.
The QSI Dental Division, NextGen Division and Hospital Solutions Division develop and market 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 in a replacement market by leveraging the benefits of our interoperable electronic health records software. With the addition of Mirth, our combined solutions enrich the already strong collaborative, connected care support and set the stage for data synchronization, interoperability growth and expansion of our current accountable and collaborative care, population health, disease management and clinical data exchange offering. These Divisions also develop and market software that automates patient records in physician practices, community health centers 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 financial management and billing software products, which perform administrative functions required for operating small and specialty hospitals as well as clinical offerings such as multi-disciplinary clinical documentation and computerized physician order entry. The RCM Services Division provides technology solutions and outsourcing services to cover the full spectrum of healthcare providers' RCM needs, with a primary focus on outsourced 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. Our employee base in Bangalore has since grown to over 250 employees with a primary focus on software development activities.
We continue to pursue product and service enhancement initiatives within each of our Divisions. The majority of such expenditures are currently targeted to the product lines and client base of the NextGen Division.
The following table reflects our reported segment revenue and segment revenue growth by Division for the three months ended June 30, 2014 and 2013:





 
 
Segment Revenue Breakdown
 
 
Three Months Ended June 30,
 
 
2014
 
2013
QSI Dental Division
 
3.6
%
 
4.7
%
NextGen Division
 
77.8
%
 
74.4
%
Hospital Solutions Division
 
3.5
%
 
5.0
%
RCM Services Division
 
15.1
%
 
15.9
%
Consolidated
 
100.0
%
 
100.0
%
 
 
Segment Revenue Growth (Decline)
 
 
Three Months Ended June 30,
 
 
2014
 
2013
QSI Dental Division
 
(17.6
)%
 
4.0
 %
NextGen Division
 
12.5
 %
 
(5.4
)%
Hospital Solutions Division
 
(23.6
)%
 
(51.9
)%
RCM Services Division
 
2.2
 %
 
10.1
 %
Consolidated
 
7.6
 %
 
(7.4
)%
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 group organizations located throughout the United States. The QSI Dental Division sells additional licenses to its legacy products as existing clients expand their operations, and sells its cloud-based Software as a Service ("SaaS") model practice management and clinical software solutions to new and existing customers. This software solution, QSIDental Web ("QDW"), is marketed primarily to multi-location dental group practices in which the QSI Dental Division has historically been a dominant player. QDW offers a lower cost of ownership as it is a cloud-based solution that requires a customer to have Internet access to run the application. Further, QSI Dental sells its Electronic Dental Chart in conjunction with NextGen PM and EHR ("Electronic Health Record") and is marketed as NextGen® EDR (“Electronic Dental Record”) to Federally Qualified Health Centers (“FQHC”) and other safety net entities further defined below.
The QSI Dental Division participates jointly with the NextGen Division in providing software and services to safety-net clinics like FQHCs 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® EHR, NextGen® EDR, and NextGen® PM provide a unique product in this marketplace — an integrated patient record accessible by both physicians and dentists. On May 3, 2013, NextGen® EDR version 4.3 was ONC-ATCB certified by the Certification Commission for Health Information ("CCHIT®") as a complete EHR and complies with all clinical quality measures for Eligible Providers. The additional software NextGen® EDR version 4.3 relied on to demonstrate compliance was NextGen® EHR version 5.8.
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® PM solution, CPS is re-branded as NextGen® EDR. 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.
On November 14, 2011 we acquired ViaTrack, a developer and provider of information technologies that enhance EDI offerings. This acquisition provides a platform to pursue significant opportunities that exist to leverage ViaTrack's technologies to reduce costs and enhance our EDI offerings to all divisions.
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® EHR, NextGen® PM, NextGen® Dashboard, NextGen® Mobile, and NextGen® NextPen. NextGen® Community Connectivity consists of NextGen® Health Information Exchange (formerly Community Health Solution), NextGen® Patient Portal (NextMD.com), and NextGen® Health Quality Measures. 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.
On September 9, 2013, we acquired Mirth, a global leader in health information technology that helps clients achieve interoperability. Operating results associated with Mirth products and services are included in the NextGen Division. The acquisition of Mirth will enhance our current enterprise interoperability initiatives and broaden our accountable and collaborative care, population health, disease management and clinical data exchange offerings. Mirth offers a wide variety of products and services utilized by both users of Mirth open code technology as well as a large base of domestic and international paying customers. Product offerings available from Mirth include Mirth Connect, Mirth Results, Mirth Match, Mirth Mail, Mirth Appliance, Mirth Care and Mirth Gateway. As a direct result of the Mirth acquisition, we introduced NextGen® Share to our customer base in November 2013. As our first offering that integrates technologies from both NextGen Healthcare and Mirth, NextGen® Share provides the ability to securely and easily share patient charts and other data with other practices using NextGen Internet based software.
Hospital Solutions Division. The Hospital Solutions Division, with its primary location in Austin, Texas, provides integrated clinical, financial and connectivity solutions for rural, community and specialty hospitals. This Hospital Solutions Division also develops and markets an equivalent revenue cycle management and clinical information systems software products for the small and specialty hospital market, which perform the administrative functions required for operating hospitals.
In the last few years, we have acquired companies that were established developers of software and services for the hospital market to operate under the Hospital Solutions Division. On May 1, 2012, we acquired The Poseidon Group, a provider of emergency department software. On July 26, 2011, we acquired CQI Solutions, Inc., a provider of hospital systems for surgery management. On April 29, 2011, we acquired IntraNexus, Inc., a provider of Web-based integrated clinical and hospital information systems. On February 10, 2010, we acquired Opus Healthcare Solutions, LLC, a provider of Web-based clinical solutions to hospital systems and integrated health networks nationwide and on August 12, 2009 we acquired Sphere Health Systems, Inc., a provider of financial information systems to the small hospital inpatient market. These acquisitions are part of our long term strategy to expand in the small and specialty hospital market and to add new clients by taking advantage of cross selling opportunities between the ambulatory and hospital markets.
RCM Services Division. The RCM Services Division, with locations in St. Louis, Missouri, North Canton, Ohio, South Jordan, Utah 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 NextGen® PM 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 information technology solutions and training, implementation and support centered on NextGen technology, to its clients nationwide. The acquisition has enabled 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 7.6% in the three months ended June 30, 2014 as compared to the prior year period. The increase reflects a 11.4% increase in recurring services revenue (i.e. maintenance, EDI, RCM and other services revenues), mitigated by a 6.8% decrease in system sales revenue. The decline in system sales revenue reflects the increasingly saturated markets in which our core software products are sold.
Consolidated gross profit as a percentage of revenue decreased to 52.3% for the three months ended June 30, 2014 compared to 56.1% in the prior year period. The decline is primarily the result of a shift in the mix of revenue towards lower-margin recurring services. For the three months ended June 30, 2014, recurring services revenue comprised 82.2% of consolidated revenue, as compared to 79.4% in the prior year period.
Consolidated operating income decreased 60.3% , or $11.8 million, in the three months ended June 30, 2014 as compared to the prior year period primarily due to a $10.6 million increase in research and development costs as compared to the prior year period resulting from lower capitalization rates of software development costs.
QSI Dental Division
QSI Dental Division revenue decreased 17.6% in the three months ended June 30, 2014. Divisional operating income (excluding Corporate and unallocated amounts) was $0.9 million in the three months ended June 30, 2014, a decrease of 43.0% as compared to the same prior year period. The decrease in operating income was primarily the result of a $0.6 million decrease in system sales revenue. It should be noted that the division's new software solution, QDW, is being sold as a SaaS solution for which revenue is recognized over a longer period of time rather than upfront. Revenue recognized from QDW was not significant in the three months ended June 30, 2014.
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 QDW product.
NextGen Division
NextGen Division revenue increased 12.5% in the three months ended June 30, 2014, as compared to the same prior year period. This variance reflects a 16.4% growth in recurring service revenue, including an increase of 8.6% in maintenance, 10.3% in EDI revenue and 42.9% in other services revenue. The acquisition of Mirth in September 2013 contributed to the growth in other services revenue for the three months ended June 30, 2014. Recurring service revenue increased to $72.5 million and accounted for 79.1% of total NextGen Division revenue for the three months ended June 30, 2014. In the same period a year ago, recurring service revenue of $62.3 million represented 76.5% of total NextGen Division revenue.
NextGen Division operating income (excluding Corporate and unallocated amounts) increased by 20.0% in the three months ended June 30, 2014, as compared to the same prior year period. The increase in operating income is primarily the result of the increase in total revenue and a decline in operating expenses.
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, expanding our software and service offerings supporting pay-for-performance initiatives around accountable care organizations, bringing greater ease of use and intuitiveness to our software products, expanding our interoperability capabilities, integrating our hospital and ambulatory software products and further development and enhancements of our portfolio of specialty focused templates within our EHR software. 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 also intend to continue 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. We believe that our acquisition of Mirth will provide improved capabilities around interoperability and improved competitiveness in our markets, as well as providing new customers and expanded markets for the NextGen Division.
The latest significant versions of our ambulatory software products achieved general release during the third quarter of fiscal 2014. Due to the overall increase in the capitalized software costs balance, we expect that these releases will result in significantly higher rates of amortization relative to previously capitalized software development costs reflected in our recent historical operating results. Amortization of capitalized software costs are reflected as cost of revenue on our Consolidated Statements of Comprehensive Income. Refer to Note 5, “Capitalized Software Costs” of our notes to the consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for an estimate of future amortization of capitalized software costs as of June 30, 2014. We have also noted a trend towards shorter development cycles, which impacts our rate of capitalization of software development costs. Although lower capitalization rates have no impact on our overall cash flows, it results in a higher portion of our software development costs being expensed up front, resulting in increased research and development expenses as compared to prior periods.
The NextGen Division’s growth is attributed to a strong brand name and reputation within the marketplace for healthcare information technology software and services and investments in sales and marketing activities, including new marketing campaigns, Internet advertising investments, 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 decreased 23.6% in the three months ended June 30, 2014. Revenue was negatively impacted by a 43.6% decline in system sales, as well as lower maintenance revenue and higher accruals for anticipated sales credits.
Divisional operating loss (excluding Corporate and unallocated amounts) was $1.1 million for the three months ended June 30, 2014 as compared to a $0.7 million loss for the same prior year period. The decline in operating results is primarily due to the decline of divisional revenue.
The Hospital Solutions Division has incurred losses in the last several quarters and is expected to continue to incur losses for the foreseeable future while we continue to invest in implementation and training, support, and development to support our customer base and maximize customer satisfaction. Our expectations about the future performance of this Division resulted in the full impairment of significant long-term assets of this Division during the three months ended December 31, 2013. Along with recording the impairment charge, we have also ceased capitalization and amortization of software development costs at this Division. For the three months ended June 30, 2013, total capitalized software costs were approximately $0.9 million and total amortization of previously capitalized amounts was approximately $0.4 million.
RCM Services Division
RCM Services Division revenue increased 2.2% in the three months ended June 30, 2014. The RCM Services Division benefited from organic growth achieved through cross selling RCM services to existing NextGen Division clients, as well as new clients added during the three months ended June 30, 2014.





Operating income decreased 39.2% in the three months ended June 30, 2014 as compared to the same prior year period primarily as a result of a decrease in divisional gross profit compared to the prior year period.
The Company believes that a significant opportunity exists to continue cross selling RCM services to existing customers. The portion of existing NextGen customers who are using the RCM Services Division's services is less than 10%. Management is actively pursuing efforts to achieve faster growth from expanded efforts to leverage the existing NextGen Division's sales force towards selling RCM services. We also believe that the increased complexity related to the billing and collections process, expected to go into effect with ICD-10, will create additional opportunities for our RCM Services Division.
Actual and expected customer turnover may impact short term revenue for the division. However, we are encouraged by increased sales activity and a growing sales pipeline of RCM services.
Corporate and unallocated amounts (costs not allocated to the operating segments)
Effective April 1, 2014, we refined the measurement of our segment data to better reflect an organizational structure whereby certain expenses managed by functional area leadership are no longer classified within the operating segments but rather as a component of Corporate and unallocated. Such classification is consistent with the disaggregated financial information used by the chief decision making group. As a result, we no longer classify the amortization of capitalized software costs within the operating segments. The Company has retroactively reclassified the prior year gross margin amounts included in the MD&A to present all segment information on a comparable basis. For additional details, refer to Note 12, “Operating Segment Information,” of our notes to consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
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 June 30,
(Unaudited)
 
2014
 
2013
Revenues:
 
 
 
 
Software and hardware
 
12.5
%
 
14.6
%
Implementation and training services
 
5.3

 
6.0

System sales
 
17.8

 
20.6

Maintenance
 
34.6

 
35.2

Electronic data interchange services
 
15.5

 
15.2

Revenue cycle management and related services
 
14.2

 
14.6

Other services
 
17.9

 
14.3

Maintenance, EDI, RCM and other services
 
82.2

 
79.4

Total revenues
 
100.0

 
100.0

Cost of revenue:
 
 
 
 
Software and hardware
 
5.6

 
4.5

Implementation and training services
 
6.1

 
6.5

Total cost of system sales
 
11.7

 
11.0

Maintenance
 
5.9

 
4.8

Electronic data interchange services
 
10.2

 
9.9

Revenue cycle management and related services
 
10.8

 
10.4

Other services
 
9.1

 
7.8

Total cost of maintenance, EDI, RCM and other services
 
36.0

 
32.9

Total cost of revenue
 
47.7

 
43.9

Gross profit
 
52.3

 
56.1

Operating expenses:
 
 
 
 
Selling, general and administrative
 
31.2

 
32.0

Research and development costs
 
13.8

 
5.1

Amortization of acquired intangible assets
 
0.8

 
1.1

Total operating expenses
 
45.8

 
38.2

Income from operations
 
6.6

 
17.9

Other income (expense), net
 
0.0

 
(0.2)

Income before income taxes
 
6.6

 
17.6

Provision for income taxes
 
2.3

 
5.8

Net income
 
4.3
%
 
11.8
%


Comparison of the Three Months Ended June 30, 2014 and June 30, 2013
Net Income. Our net income for the three months ended June 30, 2014 was $5.2 million, or $0.09 per share on a basic basis and $0.08 per share on a fully diluted basis. In comparison, we earned net income of $12.9 million, or $0.22 per share, on both a basic and fully diluted basis for the three months ended June 30, 2013. The change in net income for the three months ended June 30, 2014 was primarily attributed to the following:
a 6.8% decline in consolidated system sales revenue related to a number of factors, including higher adoption rates by large physician groups resulting in a lower number of new opportunities, the consolidation of physician offices by hospitals and other large enterprises thereby reducing the number of potential opportunities, and an extension of the deadline to adopt stage two meaningful use requirements until calendar 2014.
a $12.0 million, or 28.7%, increase in total operating expenses compared to the prior year period. This increase is primarily due to a 189.2% increase in research and development expenses in the current period primarily due to the lower capitalization rates of software development costs relating to a trend towards shorter development cycles, which impacts our rate of capitalization.
a reduction of $3.7 million in the provision for income taxes, primarily a result of the decline of net income.





Revenue. Revenue for the three months ended June 30, 2014 increased 7.6% to $117.9 million from $109.5 million for the three months ended June 30, 2013. NextGen Division revenue increased 12.5% to $91.7 million compared to $81.5 million in the three months ended June 30, 2013, RCM Services Division revenue increased 2.2% to $17.8 million from $17.4 million, and the Hospital Solutions Division revenue decreased 23.6% during that same period to $4.2 million from $5.5 million. Revenue for the QSI Dental Division decreased 17.6% to $4.2 million from $5.2 million compared to the same prior year period.
System Sales. Revenue earned from our company-wide sales of systems for the three months ended June 30, 2014 decreased 6.8% to $21.0 million from $22.5 million in the same prior year period.
The following table breaks down our reported system sales into software, hardware and third-party software, and implementation and training services components on a consolidated and divisional basis for the three months ended June 30, 2014 and 2013 (in thousands):
 
 
Software
 
Hardware and Third
Party Software
 
Implementation
and Training
Services
 
Total System
Sales
Three Months Ended June 30, 2014
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
159

 
$
247

 
$
186

 
$
592

NextGen Division
 
12,702

 
967

 
5,497

 
19,166

Hospital Solutions Division
 
1,137

 
(567
)
 
583

 
1,153

RCM Services Division
 
98

 

 

 
98

Consolidated
 
$
14,096

 
$
647

 
$
6,266

 
$
21,009

Three Months Ended June 30, 2013
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
551

 
$
391

 
$
277

 
$
1,219

NextGen Division
 
13,496

 
1,398

 
4,297

 
19,191

Hospital Solutions Division
 
(40
)
 
83

 
2,001

 
2,044

RCM Services Division
 
93

 

 

 
93

Consolidated
 
$
14,100

 
$
1,872

 
$
6,575

 
$
22,547

The decrease in system sales was driven primarily by lower sales of software, hardware, and third party software to both new and existing clients for the NextGen Division. NextGen Division software license revenue decreased 5.9% in the three months ended June 30, 2014 versus the same period last year. The NextGen Division’s software revenue accounted for 66.3% of divisional system sales revenue during the three months ended June 30, 2014 compared to 70.3% during the same period a year ago. Software license revenue continues to be an area of primary emphasis for the NextGen Division.
We believe there are other trends which may positively impact future systems sales. Many of our existing large enterprise customers have plans to grow, which will create future revenue opportunities as these customers purchase additional software and services to support their growth plans. We also expect to benefit from the growth of a replacement market driven by an expected consolidation of electronic health records vendors. Finally, we believe many new opportunities will be created by the evolution of healthcare from a pay for services reimbursement model to a pay for performance model around the management of patient populations. Additionally, the Mirth acquisition provided us with new products and services around HIE and interoperability, which we intend to utilize to drive future growth. It is difficult to assess the relative impact as well as the timing of positive and negative trends, however, we believe we are well positioned to support the ever increasing need for healthcare information technology.
During the three months ended June 30, 2014, 5.0% of the NextGen Division’s system sales revenue was represented by hardware and third party software compared to 7.3% during same period a year ago. The number of clients who purchase hardware and third party software and the dollar amount of hardware and third party software revenue fluctuates each quarter depending on the needs of clients. The inclusion of hardware and third party software in the NextGen Division’s sales arrangements is typically at the request of our clients.
Implementation and training revenue related to system sales at the NextGen Division increased 27.9% in the three months ended June 30, 2014 compared to the same prior year period. Implementation and training revenue related to system sales at the Hospital Solutions Division decreased 70.9%, in the three months ended June 30, 2014 as compared to the same prior year period. The amount of implementation and training services revenue is dependent on several factors, including timing of client implementations, the availability of qualified staff and the mix of services being rendered. It should be noted that we have experienced a decline in the level of systems sales in recent quarters which in turn have resulted in a decline in the amount of implementation services sold. We have not had significant reductions in our staffing levels despite the decline in revenue as we believe that the demand for services is going to increase especially as our customers implement the newest release of our core ambulatory software products, which support new ICD-10 billing requirements.
Maintenance, EDI, RCM and Other Services. For the three months ended June 30, 2014, our consolidated revenue from maintenance, EDI, RCM and other services grew 11.4% to $96.9 million from $87.0 million in the same prior year period. The increase is due to an increase across all categories of recurring service revenue.
The following table details maintenance, EDI, RCM and other services revenue by category on a consolidated and divisional basis for the three months ended June 30, 2014 and 2013 (in thousands):





 
 
Maintenance
 
EDI
 
RCM
 
Other
 
Total
Three Months Ended June 30, 2014
 
 
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
1,881

 
$
1,290

 
$

 
$
480

 
$
3,651

NextGen Division
 
36,603

 
16,800

 

 
19,145

 
72,548

Hospital Solutions Division
 
2,182

 
40

 

 
801

 
3,023

RCM Services Division
 
139

 
189

 
16,693

 
642

 
17,663

Consolidated
 
$
40,805

 
$
18,319

 
$
16,693

 
$
21,068

 
$
96,885

Three Months Ended June 30, 2013
 
 
 
 
 
 
 
 
 
 
QSI Dental Division
 
$
2,111

 
$
1,406

 
$

 
$
415

 
$
3,932

NextGen Division
 
33,707

 
15,236

 

 
13,401

 
62,344

Hospital Solutions Division
 
2,582

 
37

 

 
804

 
3,423

RCM Services Division
 
208

 
13

 
16,015

 
1,047

 
17,283

Consolidated
 
$
38,608

 
$
16,692

 
$
16,015

 
$
15,667

 
$
86,982

Total NextGen Division maintenance revenue for the three months ended June 30, 2014 grew 8.6% to $36.6 million from $33.7 million for the same prior year period while NextGen Division EDI revenue grew 10.3% to $16.8 million compared to $15.2 million in the same prior year period. Maintenance revenue for the NextGen Division increased by $2.9 million for the three months ended June 30, 2014 as compared to the same prior year period, primarily as a result of net additional licenses from both new and existing clients and the addition of Mirth maintenance revenue. The NextGen Division’s EDI revenue growth has come from new clients and from further penetration of the division’s existing client base. Other services revenue for the NextGen Division, which consists primarily of third party annual software license renewals, consulting services, SaaS fees, hosting services, and other subscriptions increased 42.9% to $19.1 million in the three months ended June 30, 2014 from $13.4 million in the same prior year period. Other services revenue benefited from a strong increase in consulting revenue to existing NextGen Division customers as well as the addition of Mirth subscription revenue.
QSI Dental Division maintenance, EDI and other services revenue for the three months ended June 30, 2014 and 2013 was $3.7 million and $3.9 million, respectively. For the three months ended June 30, 2014, RCM revenue for the RCM Services Division increased to $16.7 million compared to $16.0 million in the same prior year period. The growth in RCM revenue is primarily attributable to organic growth achieved through cross selling RCM services to existing NextGen Division clients, as well as new clients. For the Hospital Solutions Division, maintenance and other services revenue for the three months ended June 30, 2014 decreased 11.7% as compared to the same prior year period primarily due to a decrease in maintenance revenue primarily due to decreases in the amount of maintenance services provided to existing customers.
We intend to continue to promote maintenance, EDI and RCM services to both new and existing clients.
Cost of Revenue. Cost of revenue for the three months ended June 30, 2014 increased to $56.2 million from $48.1 million in the same prior year period and the cost of revenue as a percentage of revenue increased to 47.7% from 43.9%. The increase in the cost of revenue as a percentage of revenue is primarily due to a change in the mix of revenues toward recurring services revenue, which have historically experienced a lower profit margin than system sales.
The following table details revenue and cost of revenue on a consolidated and divisional basis for the three months ended June 30, 2014 and 2013 (in thousands):





 
 
Three Months Ended June 30,
 
 
2014
 
%
 
2013
 
%
QSI Dental Division
 
 
 
 
 
 
 
 
Revenue
 
$
4,243

 
100.0
 %
 
$
5,151

 
100.0
%
Cost of revenue
 
2,317

 
54.6
 %
 
2,392

 
46.4
%
Gross profit
 
$
1,926

 
45.4
 %
 
$
2,759

 
53.6
%
NextGen Division
 
 
 
 
 
 
 
 
Revenue
 
$
91,714

 
100.0
 %
 
$
81,535

 
100.0
%
Cost of revenue
 
31,881

 
34.8
 %
 
26,856

 
32.9
%
Gross profit
 
$
59,833

 
65.2
 %
 
$
54,679

 
67.1
%
Hospital Solutions Division
 
 
 
 
 
 
 
 
Revenue
 
$
4,176

 
100.0
 %
 
$
5,467

 
100.0
%
Cost of revenue
 
4,306

 
103.1
 %
 
3,875

 
70.9
%
Gross profit (loss)
 
$
(130
)
 
(3.1
)%
 
$
1,592

 
29.1
%
RCM Services Division
 
 
 
 
 
 
 
 
Revenue
 
$
17,761

 
100.0
 %
 
$
17,376

 
100.0
%
Cost of revenue
 
13,195

 
74.3
 %
 
11,883

 
68.4
%
Gross profit
 
$
4,566

 
25.7
 %
 
$
5,493

 
31.6
%
Unallocated cost of revenue
 
$
4,491

 
N/A

 
$
3,066

 
N/A

Consolidated
 
 
 
 
 
 
 
 
Revenue
 
$
117,894

 
100.0
 %
 
$
109,529

 
100.0
%
Cost of revenue
 
56,190

 
47.7
 %
 
48,072

 
43.9
%
Gross profit
 
$
61,704

 
52.3
 %
 
$
61,457

 
56.1
%
Gross profit margins for the NextGen Division, QSI Dental Division and the Hospital Solutions Division decreased for the three months ended June 30, 2014 compared to the same prior year period primarily due to a decrease in total system sales (consisting of software and hardware sales and training and implementation services). Gross profit margin for the RCM Services Division declined compared to the same prior year period primarily due to an increase in cost of revenue at a higher rate than the increase in related revenue.
The following table details the individual components of cost of revenue and gross profit (loss) as a percentage of total revenue on a consolidated and divisional basis for the three months ended June 30, 2014 and 2013:
 
 
Software
 
Hardware and
Third Party
Software
 
Payroll and
Related
Benefits
 
EDI
 
Other
 
Total Cost
of Revenue
 
Gross Profit (Loss)
Three Months Ended June 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
 
QSI Dental Division
 
0.0
 %
 
4.0
%
 
34.1
%
 
9.0
%
 
7.5
%
 
54.6
%
 
45.4
 %
NextGen Division
 
1.4
 %
 
0.8
%
 
11.9
%
 
11.5
%
 
10.6
%
 
34.8
%
 
65.2
 %
Hospital Solutions Division
 
0.0
 %
 
0.5
%
 
81.0
%
 
0.5
%
 
21.1
%
 
103.1
%
 
(3.1
)%
RCM Services Division
 
0.0
 %
 
0.0
%
 
49.6
%
 
1.0
%
 
23.7
%
 
74.3
%
 
25.7
 %
Consolidated