HealthStream - 10-Q quarterly report FY

 

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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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of August 10, 2005, 21,550,069 shares of the registrant’s common stock were outstanding.

See accompanying notes to the condensed consolidated financial statements.

See accompanying notes to the condensed consolidated financial statements.

See accompanying notes to the condensed consolidated financial statements.

See accompanying notes to the condensed consolidated financial statements.

See accompanying notes to the condensed consolidated financial statements.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, condensed consolidated financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. All significant intercompany transactions have been eliminated in consolidation. Operating results for the three and six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

The balance sheet at December 31, 2004 is consistent with the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for a complete set of financial statements. For further information, refer to the consolidated financial statements and footnotes thereto for the year ended December 31, 2004 (included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission).

The statement of cash flows for the six months ended June 30, 2004 has been revised to reflect the reclassification of investments in marketable securities for auction rate securities held by the Company on June 30, 2004. We previously classified investments in auction rate securities as cash equivalents due to the short-term nature of their relative auction dates. We modified the statement of cash flows for the six months ended June 30, 2004 to include additional gross sales of $7.5 million and purchases of $9.9 million related to our investments in marketable securities.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payments.” Statement 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments, including stock options. In April 2005, the Securities and Exchange Commission amended the effective date of the Statement to begin with the first interim or annual reporting period of the first fiscal year beginning on or after December 15, 2005. The Company intends to adopt Statement 123(R) in the first quarter of 2006, and to implement it on a prospective basis. We are currently assessing the impact the Statement will have on our consolidated results of operations.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,” which amends APB Opinion No. 29. The guidance in APB 29, “Accounting for Nonmonetary Transactions,” is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The amendment made by Statement 153 eliminates the exception for exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. The provisions of the statement are effective for exchanges taking place in fiscal periods beginning after June 15, 2005. We do not believe the adoption of this Statement will have a material effect on our consolidated financial position or results of operations.

On March 28, 2005, the Company acquired all of the stock of Data Management & Research, Inc. (DMR) for approximately $10.7 million, consisting of $9.1 million in cash and 479,234 shares of our common stock. Of the common stock portion, 319,489 shares are being held in an escrow account for eighteen months from the acquisition date, subject to any claims for indemnification pursuant to the stock purchase agreement. The Company also incurred direct, incremental expenses associated with the acquisition of approximately $0.4 million. DMR provides healthcare organizations a wide range of quality and satisfaction surveys, data analyses of survey results, and other research-based measurement tools. The allocation of purchase price is preliminary and may be subject to change as a result of changes in estimates related to the acquired business. The preliminary purchase price allocation is disclosed on the statement of cash flows. The Company is currently determining the composition and valuation of indefinite and finite lived intangible assets, therefore amounts recorded for goodwill and intangible assets at June 30, 2005 are subject to change.

The results of operations for DMR have been included in the Company’s statement of operations, effective March 29, 2005.

The following unaudited pro forma results of operations give effect to the operations of DMR as if the acquisition had occurred as of January 1, 2005 and 2004. These unaudited pro forma results of operations include certain adjustments arising from the acquisition such as owner compensation and amortization expense. The pro forma results of operations do not purport to represent what the Company’s results of operations would have been had such transactions in fact occurred at the beginning of the period presented or to project the Company’s results of operations in any future period.

We account for our stock-based compensation plans under the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. APB 25 does not utilize the fair value method, as prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123) . However, we have disclosed the fair value recognition requirements of SFAS No. 123 and the additional disclosure requirements as specified in SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” which amended SFAS No. 123.

If the alternative method of accounting for stock incentive plans prescribed by SFAS No. 123 had been followed, our net income (loss) and net income (loss) per share would have been as follows:

Basic net income (loss) per share is computed by dividing the net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares, composed of incremental common shares issuable upon the exercise of stock options and warrants, and escrowed or restricted shares, are included in diluted net income (loss) per share only to the extent these shares are dilutive. The total number of common equivalent shares excluded from the calculations of diluted net loss per share, due to their anti-dilutive effect, was approximately 1,400,000 and 3,100,000 for the three months ended June 30, 2005 and 2004, respectively, and approximately 1,400,000 and 3,250,000 for the six months ended June 30, 2005 and 2004, respectively.

The following table sets forth the computation of basic and diluted net income (loss) per share for three and six months ended June 30, 2005 and 2004:

We have two reportable segments, services provided to healthcare organizations and professionals (HCO) and services provided to pharmaceutical and medical device companies (PMD). On March 28, 2005, we acquired DMR, a company focused on offering healthcare organizations a wide range of quality and satisfaction surveys, data analyses of survey results, and other research-based measurement tools. Accordingly, DMR is included in our HCO business segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in our Annual Report on Form 10-K for the year ended December 31, 2004. We believe the accounting policies related to DMR are consistent with our accounting policies. We manage and operate our business segments based on the markets they serve and the products and services provided to those markets.

The following is our business segment information as of and for the three and six months ended June 30, 2005 and 2004. We measure segment performance based on operating income (loss) before income taxes and prior to the allocation of corporate overhead expenses, interest income, interest expense, and depreciation.

We account for goodwill under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” We test goodwill for impairment using a discounted cash flow model. The technique used to determine the fair value of our reporting units is sensitive to estimates and assumptions associated with cash flow from operations and its growth, discount rates, and reporting unit terminal values. If these estimates or their related assumptions change in the future, we may be required to record impairment charges, which could adversely impact our operating results for the period in which such a determination is made. We perform our annual impairment evaluation of goodwill during the fourth quarter of each year and as changes in facts and circumstances indicate impairment exists.

On March 28, 2005, we acquired DMR. We are in the process of performing the purchase price allocation and related evaluation of indefinite and finite lived intangible assets, thus the amount of goodwill recorded at June 30, 2005 related to the acquisition of DMR is preliminary. During the three months ended June 30, 2005, certain adjustments to goodwill were made as a result of changes in the purchase price allocation for DMR. There were no changes in the carrying amount of goodwill during the six months ended June 30, 2004.

All identifiable intangible assets have been evaluated in accordance with SFAS No. 142 and are considered to have finite useful lives. We are in the process of performing the purchase price allocation and related evaluation of indefinite and finite lived intangible assets associated with the acquisition of DMR, thus the balances recorded at June 30, 2005 are preliminary. Intangible assets with finite lives are being amortized over their estimated useful lives, ranging from one to five years. Amortization of intangible assets was $224,072 and $311,942 for the three and six months ended June 30, 2005, respectively, and $83,239 and $177,585 for the three and six months ended June 30, 2004, respectively.

Identifiable intangible assets are comprised of the following:

Estimated amortization expense for the periods and years ending December 31, is as follows:

Taxable income for the year is expected to be reduced by available net operating loss carryforwards. Therefore, no income tax provision has been recorded in the Company’s statement of operations for the three or six months ended June 30, 2005.

Commercial support liabilities represent grant funds received from entities supporting educational activities, such as live events, in which we are the accredited provider of the continuing educational activity. The funds are unrestricted, and are primarily used to pay for expenses associated with conducting the educational activities. The grants will be used to pay for live event expenses during 2005 and 2006.

We are subject to various legal proceedings and claims that may arise in the ordinary course of business. In the opinion of management, the ultimate liability with respect to those proceedings and claims will not materially affect our financial position or results of operations.

This Quarterly Report includes various forward-looking statements that are subject to risks and uncertainties. Forward-looking statements include without limitation, statements preceded by, followed by, or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “estimates” or similar expressions. For those statements, HealthStream, Inc. claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

The following important factors, in addition to those discussed elsewhere in this Quarterly Report, could affect our future financial results and could cause actual results to differ materially from those expressed in forward-looking statements contained in this document:

HealthStream was incorporated in 1990 and began marketing its Internet-based solutions in March 1999. The Company focuses on being a provider of training solutions for entities in the healthcare industry. Revenues from our healthcare organizations business unit (HCO) are derived from the following categories: provision of services through our Internet-based learning products, courseware subscriptions, workforce development tools and services, maintenance and support of installed learning management products and a variety of other online products. On March 28, 2005, we acquired Data Management & Research, Inc. (DMR), which provides healthcare organizations a wide range of quality and satisfaction surveys, analyses of survey results, and other research-based services. Accordingly, DMR is included in our HCO business segment. Revenues from our pharmaceutical and medical device company business unit (PMD) are derived from live event development, content development, Web cast events, and other educational and training services, including HospitalDirect.

Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). These accounting principles require us to make certain estimates, judgments and assumptions during the preparation of our financial statements. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.

The accounting policies and estimates that we believe are the most critical in fully understanding and evaluating our reported financial results include the following:

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result. See Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission, which contains additional information regarding our accounting policies and other disclosures required by GAAP. There have been no changes in our critical accounting policies and estimates from those reported in our Annual Report on Form 10-K for the year ended December 31, 2004.

On March 28, 2005, the Company acquired all of the stock of DMR for approximately $10.7 million, consisting of $9.1 million in cash and 479,234 shares of our common stock. Of the common stock portion, 319,489 shares were deposited in an escrow account to be held for eighteen months from the acquisition date, subject to any claims for indemnification pursuant to the stock purchase agreement. DMR provides healthcare organizations a wide range of quality and satisfaction surveys, data analyses of survey results, and other research-based measurement tools.

The following descriptions of the components of revenues and expenses apply to the comparison of results of operations.

Revenues. Revenues for our HCO business unit currently consist of the provision of services through our Internet-based HealthStream Learning Center (HLC), authoring tools, maintenance and support services for our installed learning management products, maintenance of content, competency tools, courseware subscriptions (add-on courseware), as well as revenues from survey-related services. Revenues for our PMD business unit consist of live event development, online training and content development, online sales training courses, HospitalDirect, live educational activities for nurses and technicians conducted within healthcare organizations, and continuing education activities at association meetings.

Cost of Revenues. Cost of revenues consists primarily of salaries and employee benefits, employee travel and lodging, materials, contract labor, hosting costs, and other direct expenses associated with revenues as well as royalties paid by us to content providers based on a percentage of revenues. Personnel costs within cost of revenues are associated with individuals that provide services, handle customer support calls or inquiries, manage our web sites, content delivery and survey services, coordinate content maintenance services, and provide training or implementation services.

Product Development. Product development expenses consist primarily of salaries and employee benefits, content acquisition costs before technological feasibility is achieved, costs associated with the development of content and expenditures associated with maintaining, developing and operating our training delivery and administration platforms. In addition, product development expenses are associated with the development of feature enhancements and new products to the extent that such enhancements don’t expand the anticipated revenues associated with the base product or further extend the life of such product. In accordance with our policy, we capitalize the cost of features and content developed by third parties where the life expectancy is greater than one year and the anticipated cash flows from such content are expected to exceed their respective costs. Personnel costs within product development include our systems team, product managers, and other personnel associated with content and product development.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, commissions and employee benefits, employee travel and lodging, advertising, promotions, and related marketing costs. Annually, we host a national users’ group in Nashville known as The Summit. Personnel costs within sales and marketing include our sales and marketing team as well as our account management group.

Our account management personnel are involved with the contract renewal process for existing hospital customers, as well as working to ensure our products and services are fully utilized by our customers.

Depreciation and Amortization. Depreciation and amortization consist of fixed asset depreciation, amortization of intangibles considered to have finite lives, amortization of content or license fees, software feature enhancements, and prepaid compensation.

Other General and Administrative Expenses. Other general and administrative expenses consist primarily of salaries and employee benefits, employee travel and lodging, facility costs, office expenses, fees for professional services, and other operational expenses. Personnel costs within general and administrative expenses include individuals associated with normal corporate functions (accounting, legal, human resources, administrative and executive management) as well as accreditation professionals.

Other Income/Expense. The primary component of other income is interest income related to interest earned on cash, cash equivalents and investments in marketable securities. The primary component of other expense is interest expense related to capital leases and other obligations.

During the three months ended June 30, 2005, revenues increased $2.1 million, or 45.1%, to $6.8 million from $4.7 million for the three months ended June 30, 2004. Revenue increases of $1.2 million resulted from the acquisition of DMR, while revenues from our flagship product, the HealthStream Learning Center^TM, increased $590,000, or 25% over the prior year quarter. Growth in add-on courseware revenues also contributed $270,000 of the increase, while revenues from maintenance fees associated with our HCO installed learning management products declined over the prior year quarter by $100,000. Our fully implemented subscriber base was approximately 1,113,000 at June 30, 2005. Revenues from our PMD unit experienced moderate increases over the prior year quarter, while the mix of revenues changed. Revenues from live events and online content subscriptions increased, but were partially offset by declines in content development and other training services.

Gross margins (which we define as revenues less cost of revenues divided by revenues) for the second quarter 2005 increased to 63.9% as compared to 62.7% for the second quarter 2004 primarily as a result of increased revenues from DMR and the HealthStream Learning Center^TM. We achieved net income of $23,000 in the second quarter of 2005, compared to a net loss of $529,000 in the second quarter of 2004. This improvement is primarily related to the increase in revenues and related gross margins. Marketing expenses increased over the prior year quarter, primarily associated with our annual Summit, which occurred during April 2005. This event was split between the first and second quarters of 2004. We also experienced increases in product development, sales, depreciation, amortization, and other general and administrative expenses as a result of the DMR acquisition. Net income (loss) per share improved to break-even for the three months ended June 30, 2005 from a loss of $(0.03) per share for the three months ended June 30, 2004.

Revenues. Revenues increased approximately $2.1 million, or 45.1%, to $6.8 million for the three months ended June 30, 2005 from $4.7 million for the three months ended June 30, 2004. Revenues for 2005 consisted of $5.3 million for HCO and $1.5 million for PMD. In 2004, revenues consisted of $3.2 million for HCO and $1.5 million for PMD. The increase in HCO revenues related primarily to revenues from the acquisition of DMR of $1.2 million, revenue growth of $590,000 from our Internet-based HLC subscriber base, and $270,000 from growth in add-on courseware revenues. Our subscriber base increased approximately 29%, to approximately 1,113,000 fully implemented subscribers at June 30, 2005 from approximately 864,000 fully implemented subscribers at June 30, 2004. These HCO revenue increases were partially offset by an anticipated decline in revenues from maintenance and support fees associated with our installed learning management products of approximately $100,000. This decline is consistent with our strategy to transition these customers to our Internet-based learning platform. Revenues from our Internet-based subscription products represented approximately 59% of revenues for the three months ended June 30, 2005 compared to 65% of revenues for the three months ended June 30, 2004. This percentage decrease resulted from the addition of DMR’s revenues, which are not included within our Internet-based product offering. PMD revenues increased slightly over the prior year quarter. Live event and online training revenues increased modestly, but were partially offset by a decline in content development and other training services.

We expect continued revenue growth during the third quarter for HCO, compared to both the third quarter 2004 and second quarter 2005, primarily associated with our Internet-based subscription products and survey revenues from the DMR acquisition. Revenues associated with DMR are seasonal, with the first and fourth quarters being the strongest. During the third quarter, we expect the percentage of total revenues from our Internet-based subscription products to remain comparable to the second quarter. As we continue to focus on transitioning the customers using our installed learning management products to our Internet-based learning platform, we expect revenues from our installed products to continue to decline during the remainder of 2005. We expect third quarter revenues for PMD to experience modest increases from the levels experienced in the second quarter, and we expect the mix of revenues for PMD to remain comparable to the second quarter.

Cost of Revenues. Cost of revenues increased approximately $708,000, or 40.5%, to $2.5 million for the three months ended June 30, 2005 from $1.8 million for the three months ended June 30, 2004. Cost of revenues as a percentage of revenues decreased to 36.1% of revenues for the three months ended June 30, 2005 from 37.3% of revenues for the three months ended June 30, 2004. The overall increase in cost of revenues resulted primarily from additional costs associated with DMR, increases in personnel expenses and increased royalties paid by us associated with the increase in add-on courseware revenues.

Cost of revenues for HCO increased approximately $800,000 and approximated 27.2% and 19.6% of revenues for the three months ended June 30, 2005 and 2004, respectively. Cost of revenues for HCO increased due to additional costs associated with DMR, increases in personnel expenses and contract labor associated with content maintenance, as well as an increase in the percentage royalties paid by us to content partners. Cost of revenues for PMD declined $100,000 as compared to the prior year quarter and approximated 56.8% and 67.0% of revenues for the three months ended June 30, 2005 and 2004, respectively. Cost of revenues for PMD decreased as a result of lower personnel expenses and lower direct costs associated with the declines in content development revenues. We expect quarter-to-quarter fluctuations in cost of revenues for PMD due to the seasonality in live event and association activities and the variability related to our content development services.

Gross Margin. Gross margin (which we define as revenues less cost of revenues divided by revenues) improved to approximately 63.9% for the three months ended June 30, 2005 from 62.7% for the three months ended June 30, 2004. The improvement is a result of the change in revenue mix and related cost of revenues discussed above. Gross margins for HCO were 72.8% and 80.4% for the three months ended June 30, 2005 and 2004, respectively. Gross margins for PMD were 43.2% and 33.0% for the three months ended June 30, 2005 and 2004, respectively.

Product development. Product development expenses increased approximately $109,000, or 17.2%, to $743,000 for the three months ended June 30, 2005 from $634,000 for the three months ended June 30, 2004. This increase resulted from personnel expenses associated with DMR. Product development expenses as a percentage of revenues decreased to 10.9% of revenues for the three months ended June 30, 2005 from 13.5% for the three months ended June 30, 2004. The percentage decrease is a result of the increases in revenues.

Product development expenses for HCO increased approximately $100,000 as compared to the prior year quarter and approximated 11.1% and 15.0% of revenues for the three months ended June 30, 2005 and 2004, respectively. The increase for HCO is a result of DMR personnel expenses. Product development expenses for PMD decreased slightly as compared to the prior year period and approximated 6.2% and 7.9% of revenues for the three months ended June 30, 2005 and 2004, respectively. The unallocated corporate portion of our product development expenses was comparable between periods.

Sales and Marketing. Sales and marketing expenses, including personnel costs, increased approximately $397,000, or 32.9%, to $1.6 million for the three months ended June 30, 2005 from $1.2 million for the three months ended June 30, 2004. Sales and marketing expenses approximated 23.5% and 25.7% of revenues for the three months ended June 30, 2005 and 2004, respectively. Sales and marketing expenses for HCO increased approximately $276,000 and approximated 22.4% and 28.1% of revenues for the three months ended June 30, 2005 and 2004, respectively. HCO experienced increases in marketing expenses, sales personnel expenses, and expenses associated with DMR. Our annual Summit, which was held during the second quarter of 2005, contributed $150,000 of the HCO increase. This increase is a result of the event being split between the first and second quarters in 2004 and an increase in customer attendance at the event. Sales and marketing expenses for PMD increased approximately $110,000, and approximated 22.4% and 16.0% of revenues for the three months ended June 30, 2005 and 2004, respectively. The increase for PMD is associated with increased sales personnel, commissions and marketing expenses.

Depreciation and Amortization. Depreciation and amortization increased approximately $256,000, or 50.7%, to $760,000 for the three months ended June 30, 2005 from $504,000 for the three months ended June 30, 2004. The increase is associated with depreciation of property and equipment and amortization of DMR intangible assets, content and feature enhancements.

Other General and Administrative. Other general and administrative expenses increased approximately $116,000, or 9.9%, to $1.3 million for the three months ended June 30, 2005 from $1.2 million for the three months ended June 30, 2004. The increase is associated with DMR personnel and office expenses. Other general and administrative expenses as a percentage of revenues decreased to 18.9% for the three months ended June 30, 2005 from 25.0% for the three months ended June 30, 2004. The percentage decrease is a result of the increases in revenues.

Other Income/Expense. Other income/expense increased approximately $23,000, or 51.3%, to $68,000 for the three months ended June 30, 2005 from $45,000 for the three months ended June 30, 2004. The increase resulted from an increase in interest income on investments in marketable securities.

Net Income (Loss). Net income was $23,000 for the three months ended June 30, 2005 compared to a net loss of $529,000 for the three months ended June 30, 2004. This improvement is a result of the factors mentioned above.

Revenues. Revenues increased approximately $2.9 million, or 30.1%, to $12.5 million for the six months ended June 30, 2005 from $9.6 million for the six months ended June 30, 2004. Revenues for 2005 consisted of $9.2 million for HCO and $3.3 million for PMD. In 2004, revenues consisted of $6.4 million for HCO and $3.2 million for PMD. The increase in HCO revenues related primarily to growth in revenues from our Internet-based HLC subscriber base of $1.2 million, $1.2 million from the DMR acquisition, $430,000 from growth in add-on courseware revenues, and $195,000 from content maintenance services. These HCO revenue increases were partially offset by an anticipated decline in revenues from maintenance and support fees associated with our installed learning management products of $286,000. PMD revenues increased $100,000 over the prior year, although we experienced a change in revenue mix. Revenues from online training content increased $180,000, and live event revenues were comparable between periods. This increase was partially offset by a decline in content development services. On a pro forma basis, taking into consideration the effect of the DMR acquisition as if the acquisition occurred on January 1, 2004, pro forma revenues for the six months ended June 30, 2005 would have been $13.9 million compared to $11.8 million for the six months ended June 30, 2004.

Cost of Revenues. Cost of revenues increased approximately $854,000, or 23.5%, to $4.5 million for the six months ended June 30, 2005 from $3.6 million for the six months ended June 30, 2004. Cost of revenues as a percentage of revenues decreased to 36.0% of revenues for the six months ended June 30, 2005 from 37.9% of revenues for the six months ended June 30, 2004. The increase in cost of revenues resulted from the incremental expenses associated with DMR, increases in personnel expenses and royalties paid by us, and was partially offset by declines in contract labor and materials associated with declines in content development revenues.

Cost of revenues for HCO increased approximately $1.1 million and approximated 25.7% and 19.9% of revenues for the six months ended June 30, 2005 and 2004, respectively. Cost of revenues increases for HCO resulted from the additional expenses associated with DMR, increased personnel expenses and contract labor associated with content maintenance, as well as an increase in the percentage royalties paid by us to content partners. Cost of revenues for PMD declined $255,000 as compared to the prior year period and approximated 55.8% and 65.6% of revenues for the six months ended June 30, 2005 and 2004, respectively. Cost of revenues for PMD decreased as a result of lower personnel expenses and lower direct costs associated with the declines in content development revenues. We expect quarter-to-quarter fluctuations in cost of revenues for PMD due to the seasonality in live event and association activities and the variability related to our content development services.

Gross Margin. Gross margin (which we define as revenues less cost of revenues divided by revenues) improved to approximately 64.0% for the six months ended June 30, 2005 from 62.1% for the six months ended June 30, 2004. The improvement is a result of the change in revenue mix and related cost of revenues discussed above. Gross margins for HCO were 74.3% and 80.1% for the six months ended June 30, 2005 and 2004, respectively. Gross margins for PMD were 44.2% and 34.4% for the six months ended June 30, 2005 and 2004, respectively.

Product development. Product development expenses increased approximately $99,000, or 7.7%, to $1.4 million for the six months ended June 30, 2005 from $1.3 million for the six months ended June 30, 2004. This increase is primarily related to additional personnel expenses associated with the DMR acquisition. Product development expenses as a percentage of revenues decreased to 11.0% of revenues for the six months ended June 30, 2005 from 13.3% for the six months ended June 30, 2004. The decrease is a result of the increases in revenues.

Product development expenses for HCO increased approximately $44,000 as compared to the prior year period and approximated 11.5% and 15.8% of revenues for the six months ended June 30, 2005 and 2004, respectively. Product development expenses for PMD were comparable between periods and approximated 6.1% and 6.3% of revenues for the six months ended June 30, 2005 and 2004, respectively. The unallocated corporate portion of our product development expenses increased approximately $56,000.

Sales and Marketing. Sales and marketing expenses, including personnel costs, increased approximately $430,000, or 18.2%, to $2.8 million for the six months ended June 30, 2005 from $2.4 million for the six months ended June 30, 2004. Sales and marketing expenses approximated 22.4% and 24.6% of revenues for the six months ended June 30, 2005 and 2004, respectively. Sales and marketing expenses for HCO increased approximately $273,000 and approximated 21.6% and 26.8% of revenues for the six months ended June 30, 2005 and 2004, respectively. HCO increases were a result of the DMR acquisition, increased spending associated with The Summit, and to a lesser extent, increased commissions. Sales and marketing expenses for PMD increased approximately $149,000 and approximated 20.4% and 16.3% of revenues for the six months ended June 30, 2005 and 2004, respectively. The increase is associated with increased personnel expenses and commissions.

Depreciation and Amortization. Depreciation and amortization increased approximately $386,000, or 38.9%, to $1.4 million for the six months ended June 30, 2005 from $1.0 million for the six months ended June 30, 2004. The increase is associated with depreciation of property and equipment and amortization of DMR intangible assets, content and feature enhancements.

Other General and Administrative. Other general and administrative expenses increased approximately $77,000, or 3.3%, and approximated $2.4 million for the six months ended June 30, 2005 and 2004. Other general and administrative expenses as a percentage of revenues decreased to 19.6% for the six months ended June 30, 2005 from 24.6% for the six months ended June 30, 2004. The percentage decrease is a result of the increases in revenues.

Other Income/Expense. Other income/expense increased approximately $72,000, or 75.9%, to $166,000 for the six months ended June 30, 2005 from $94,000 for the six months ended June 30, 2004. The increase resulted from an increase in interest income on investments in marketable securities.

Net Income (Loss). Net income was $167,000 for the six months ended June 30, 2005 compared to a net loss of $948,000 for the six months ended June 30, 2004. This improvement is a result of the factors mentioned above. On a pro forma basis, as if the DMR acquisition occurred on January 1, 2004, pro forma net income would have been $641,000 for the six months ended June 30, 2005 compared to a pro forma net loss of $481,000 for the six months ended June 30, 2004.

Since our inception, we have financed our operations largely through proceeds from our initial public offering, private placements of equity securities, loans from related parties and, to an increasing extent, from revenues generated from the sale of our products and services.

Net cash provided by operating activities was approximately $1.2 million during the six months ended June 30, 2005 compared to $72,000 during the six months ended June 30, 2004. The improvement over the prior year was primarily related to the improvement from a net loss in 2004 of $948,000 to net income of $167,000 in 2005, receipts from commercial support grants and a decline in accounts receivable (net of acquired balances from DMR). These cash increases were partially offset by the purchases of content and other prepaid assets and declines in accounts payable and accrued liabilities. Days sales outstanding, or the number of days it takes to collect accounts receivable, increased compared to the prior year, approximating 58 days for the six months ended June 30, 2005 compared to 48 days for the six months ended June 30, 2004. The increase in days sales outstanding is a result of slower collections during the second quarter of 2005 resulting primarily from certain larger customers having payment terms greater than our standard payment term. The Company calculates days sales outstanding by dividing the accounts receivable balance (excluding unbilled and other receivables) by average daily revenues for the period. During the six months ended June 30, 2004, the primary sources of cash resulted from improved net loss and receipts of commercial support grants, offset by cash utilized to fund operations and purchase content and other prepaid assets.

Net cash used in investing activities was approximately $358,000 during the six months ended June 30, 2005 compared to approximately $50,000 during the six months ended June 30, 2004. The primary uses of cash during the six months ended June 30, 2005 related to cash paid in connection with the acquisition of DMR of $9.4 million, $1.0 million in purchases of investments in marketable securities and $521,000 of property and equipment acquisitions. These uses of cash were offset by $10.5 million of proceeds from the sale and maturity of investments in marketable securities. Property and equipment acquisitions related to hardware and software to support the growth of our product infrastructure, primarily our Internet-based learning platform. During the six months ended June 30, 2004, we received proceeds of $13.0 million from the maturity of investments in marketable securities and $233,000 in proceeds from collection of a note receivable — related party, offset by $12.5 million in purchases of investments in marketable securities and $782,000 in property and equipment acquisitions.

Cash provided by financing activities was approximately $609,000 for the six months ended June 30, 2005 compared to $175,000 during the six months ended June 30, 2004. Cash provided by financing activities during 2005 consisted of proceeds from the exercise of stock options of $479,000 and $159,000 associated with the issuance of common stock to our Employee Stock Purchase Plan, and was partially offset by payments under capital lease obligations. Cash provided by financing activities during the six months ended June 30, 2004 consisted of proceeds from the exercise of stock options of $128,000 and $77,000 associated with the issuance of common stock to our Employee Stock Purchase Plan, and was partially offset by payments under capital lease obligations.

As of June 30, 2005, our primary source of liquidity was $8.4 million of cash and cash equivalents, restricted cash, investments in marketable securities, and interest receivable. We have no bank credit facility or other indebtedness other than capital lease obligations. As of July 31, 2005, we had cash and cash equivalents, restricted cash, investments in marketable securities, and interest receivable of approximately $8.7 million. The increase in our liquidity is a result of strong cash collections during July 2005.

We believe that our existing cash and cash equivalents, restricted cash, and related interest receivable will be sufficient to meet anticipated cash needs for working capital, new product development and capital expenditures for at least the next 12 months. Failure to generate sufficient cash flow from operations or raise additional capital when required during or following that period in sufficient amounts and on terms acceptable to us could harm our business, financial condition and results of operations. Our growth strategy may also include acquiring companies that complement our products and services. We anticipate that these acquisitions, if any, will be effected through a combination of stock and cash consideration. The issuance of stock would have a dilutive effect and could adversely affect our stock price.

We expect that content and capital expenditures will range between $2.0 and $2.5 million for the remainder of 2005.

Our strategic alliances have typically provided for payments to content and distribution partners and development partners based on revenues, and we expect to continue similar arrangements in the future. We have capital lease obligations and operating lease commitments for our operating facilities in Nashville, TN, Franklin, TN, and Denver, CO, and a closed facility in Dallas, TX. We entered into capital lease arrangements during the three months ended June 30, 2005 that include future payments of approximately $223,000 over three years.

We are exposed to market risk from changes in interest rates. We do not have any commodity price risk. As of June 30, 2005, we had no outstanding indebtedness other than approximately $338,000 of capital lease obligations. Accordingly, we are not exposed to significant market risk. We are exposed to market risk with respect to the cash and cash equivalents and marketable securities in which we invest. At July 31, 2005, we had approximately $8.7 million of cash and cash equivalents, restricted cash, investments in marketable securities, and accrued interest that was invested in a combination of short term investments. Current investment rates of return approximate 2-3%. Assuming a 2.5% rate of return on $8.7 million of investments, a hypothetical 10% decrease in interest rates would decrease interest income and decrease net income on an annualized basis by approximately $22,000.

We manage our investment risk by investing in corporate debt securities, foreign corporate debt and secured corporate debt securities with minimum acceptable credit ratings. For certificates of deposit and corporate obligations, ratings must be A2/A or better; A1/P1 or better for commercial paper; A2/A or better for taxable or tax advantaged auction rate securities and AAA or better for tax free auction rate securities. We also require that all securities must mature within 24 months from the original settlement date, the average portfolio shall not exceed 18 months, and the greater of 10% or $5.0 million shall mature within 90 days. Further, our investment policy also limits concentration exposure and other potential risk areas.

The above market risk discussion and the estimated amounts presented are forward-looking statements of market risk assuming the occurrence of certain adverse market conditions. Actual results in the future may differ materially from those projected as a result of actual developments in the market.

HealthStream’s chief executive officer and principal financial officer have reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this quarterly report. Based on that evaluation, the chief executive officer and principal financial officer have concluded that HealthStream’s disclosure controls and procedures effectively and timely provide them with material information relating to HealthStream required to be disclosed in the reports it files or submits under the Exchange Act.

There was no change in HealthStream’s internal control over financial reporting that occurred during the period covered by this quarterly report that has materially affected, or that is reasonably likely to materially affect, HealthStream’s internal control over financial reporting.

On May 26, 2005, the Company held its Annual Meeting of Shareholders. At the Annual Meeting, the shareholders of the Company elected the following persons as Class II directors to serve until the Annual Meeting of Shareholders in 2008 and until such time as their respective successors are duly elected and qualified, with the number of votes cast for, or withheld as set forth opposite their names.

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.