UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2012.
For the transition period from to .
Commission file number: 000-49796
COMPUTER PROGRAMS AND SYSTEMS, INC.
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
(251) 639-8100
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, 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.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of November 6, 2012, there were 11,077,672 shares of the issuer’s common stock outstanding.
Form 10-Q
(For the three and nine months ended September 30, 2012)
INDEX
PART I. FINANCIAL INFORMATION
Item 1.
Condensed Balance Sheets – September 30, 2012 (Unaudited) and December 31, 2011
Condensed Statements of Income (Unaudited) – Three and Nine Months Ended September 30, 2012 and 2011
Condensed Statements of Comprehensive Income (Unaudited) – Three and Nine Months Ended September 30, 2012 and 2011
Condensed Statement of Stockholders’ Equity (Unaudited) – Nine Months Ended September 30, 2012
Condensed Statements of Cash Flows (Unaudited) – Nine Months Ended September 30, 2012 and 2011
Notes to Condensed Financial Statements (Unaudited)
Item 2.
Item 3.
Item 4.
PART II. OTHER INFORMATION
Item 1A.
Item 5.
Item 6.
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PART I
FINANCIAL INFORMATION
CONDENSED BALANCE SHEETS
Assets
Current assets:
Cash and cash equivalents
Investments
Accounts receivable, net of allowance for doubtful accounts of $1,355,000 and $1,276,000, respectively
Financing receivables, current portion, net
Inventories
Deferred tax assets
Prepaid income taxes
Prepaid expenses and other
Total current assets
Property and equipment
Land
Buildings and improvements
Maintenance equipment
Computer equipment
Leasehold improvements
Office furniture and equipment
Automobiles
Less accumulated depreciation
Property and equipment, net
Financing receivables
Total assets
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Deferred revenue
Accrued vacation
Other accrued liabilities
Total current liabilities
Deferred tax liabilities
Stockholders’ equity:
Common stock, $0.001 par value; 30,000,000 shares authorized; 11,065,380 and 11,063,220 shares issued and outstanding
Additional paid-in capital
Accumulated other comprehensive income
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes.
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CONDENSED STATEMENTS OF INCOME (Unaudited)
Sales revenues:
System sales
Support and maintenance
Business management services
Total sales revenues
Costs of sales:
Total costs of sales
Gross profit
Operating expenses:
Sales and marketing
General and administrative
Total operating expenses
Operating income
Other income:
Interest income
Total other income
Income before taxes
Income taxes
Net income
Net income per share—basic
Net income per share—diluted
Weighted average shares outstanding
Basic
Diluted
Dividends declared per share
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CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
Other comprehensive income(loss), net of tax
Unrealized gain(loss) on investments available for sale, net of tax
Total other comprehensive income(loss), net of tax
Comprehensive income
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CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY (Unaudited)
Balance at December 31, 2011
Unrealized gain on investments held for sale, net of tax
Issuance of restricted stock
Stock-based compensation
Dividends
Income tax benefit from restricted stock dividends
Deficient tax benefit from restricted stock
Balance at September 30, 2012
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CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
Operating Activities
Adjustments to net income:
Provision for bad debt
Deferred taxes
Stock based compensation
Deficient (excess) tax benefit from restricted stock
Depreciation
Changes in operating assets and liabilities:
Accounts receivable
Other liabilities
Net cash provided by operating activities
Investing Activities
Purchases of property and equipment
Purchases of investments
Net cash used in investing activities
Financing Activities
Dividends paid
Excess (deficient) tax benefit from restricted stock
Net cash used in financing activities
(Decrease) increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosure of cash flow information
Cash paid for interest
Cash paid for income taxes, net of refund
Reclassification of inventory to property and equipment
Write-off of fully depreciated assets
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NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of the periods presented. All such adjustments are considered of a normal recurring nature. Quarterly results of operations are not necessarily indicative of annual results.
Certain footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These unaudited condensed financial statements should be read in conjunction with the audited financial statements of Computer Programs and Systems, Inc. (the “Company”) for the year ended December 31, 2011 and the notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
2. REVENUE RECOGNITION
The Company recognizes revenue in accordance with accounting principles generally accepted in the United States of America, principally those required by the Software topic and Revenue Recognition subtopic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (the “Codification”) and those prescribed by the SEC.
The Company’s revenue is generated from three sources:
System Sales—the sale of information systems, which includes software licenses, conversion and installation services, hardware, peripherals, forms and supplies;
Support and Maintenance—the provision of system support services, which includes software application support, hardware maintenance, continuing education, “Software as a Service” (or “SaaS”) products, Internet service provider (“ISP”) products, and information technology management and professional services; and
Business Management Services—the provision of business management services, which includes electronic billing, statement processing, payroll processing, accounts receivable management, contract management and insurance services.
System Sales, Software Application Support, and Hardware Maintenance
The Company enters into contractual obligations to sell hardware, perpetual software licenses, installation and training services, and support and maintenance services. On average, the Company is able to complete a system installation in three to four weeks. The methods employed by the Company to recognize revenue, which are discussed by element below, achieve results materially consistent with the provisions of Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements, due to the relatively short period during which there are multiple undelivered elements, the relatively small amount of non-software related elements in the system sale arrangements, and the limited number of contracts in-process at the end of each reporting period. The Company recognizes revenue on the elements noted above as follows:
Software application support and hardware maintenance – we have established vendor-specific objective evidence (“VSOE”) of the fair value of our software application support and hardware maintenance services by reference to the price our customers are required to pay for the services when sold separately via renewals. Support and maintenance revenue is recognized on a straight-line basis over the term of the maintenance contracts, which is generally three to five years.
Hardware – we recognize revenue for hardware upon shipment. The selling price of hardware is based on management’s best estimate of selling price, which consists of cost plus a targeted margin.
Software licenses and installation and training – the selling price of software licenses and installation and training is based on management’s best estimate of selling price. In determining management’s best estimate of selling price, we consider the following: (1) competitor pricing, (2) supply and demand of installation staff, (3) overall economic conditions, and (4) our pricing practices as it relates to discounts. With the exception of those arrangements with extended payment terms that are not comparable to our historical arrangements (see Note 8), the method of recognizing revenue for the perpetual license of the associated modules included in the arrangement and the related installation and training services over the term the services are performed is on a module by module basis as the respective installation and training for each specific module is completed as this is representative of the pattern of provision of these services.
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SaaS, ISP, and Other Professional IT Services
The Company accounts for SaaS contracts in accordance with the requirements of the Hosting Arrangement section under theSoftware topic and Revenue Recognition subtopic of the Codification. The Codification states that the software elements of SaaS products should not be accounted for as a hosting arrangement “if the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.” Each SaaS contract includes a system purchase and buyout clause, and this clause specifies the total amount of the system buyout. In addition, a clause is included which states that should the system be bought out by the customer, the customer would be required to enter into a general support agreement (for post-contract support services) for the remainder of the original SaaS term. Accordingly, the Company has concluded that SaaS customers do not have the right to take possession of the system without significant penalty (i.e., the purchase price of the system), and thus SaaS revenue of the Company falls within the scope of the Hosting Arrangement section of the Codification. In accordance with SEC regulations, revenue for SaaS arrangements is recognized when the services are performed.
The Company will occasionally provide ISP and other professional IT services. We consider these services to be non-software elements. The selling price of these services is based on third-party evidence of selling price of similar services. Revenue from this element is recognized as the services are performed.
Business Management Services
Business management services consist of electronic billing services, statement processing services, accounts receivable management services, payroll processing, contract management and insurance services. While business management service arrangements are contracts separate from the system sale and support and maintenance contracts, these contracts are sometimes executed within a short time frame of each other. The selling price of these services is based on VSOE of fair value by reference to the rate our customers renew as well as the rate the services are sold to customers when the business management services agreement is not executed within a short time frame. Because the pricing is transaction based (per unit pricing), customers are billed and revenue recognized as services are performed based on transaction levels.
3. OTHER ACCRUED LIABILITIES
Other accrued liabilities are comprised of the following:
Salaries and benefits
Commissions
Self-insurance reserves
Unrecognized tax benefit
Other
4. INVESTMENTS
The Company accounts for investments in accordance with FASB Codification topic, Investments – Debt and Equity Securities. Accordingly, investments are classified as available-for-sale securities and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders’ equity. The Company’s management determines the appropriate classifications of investments in fixed income securities at the time of acquisition and re-evaluates the classifications at each balance sheet date.
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Investments are comprised of the following at September 30, 2012:
Short term investments (cash and accrued income)
Obligations of U.S. Treasury, U.S. government corporations and agencies
Mortgaged-backed securities
Corporate bonds
Shown below are the amortized cost and estimated fair value of securities with fixed maturities at September 30, 2012, by contract maturity date. Actual maturities may differ from contractual maturities because issuers of certain securities retain early call or prepayment rights.
Due in 2012
Due in 2013
Due in 2014
Due in 2015
Due thereafter
Investments were comprised of the following at December 31, 2011:
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position, at September 30, 2012 and December 31, 2011, respectively:
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Our investment portfolio, including those securities in unrealized loss positions at September 30, 2012, is comprised almost entirely of investment-grade corporate and government debt securities. The Company does not intend to sell the investments that are in an unrealized loss position, and it is not likely that the Company will be required to sell any investments before recovery of their amortized cost basis. As a result, the Company has determined that the unrealized losses are deemed to be temporary impairments as of September 30, 2012. The Company believes that the unrealized losses generally are caused by liquidity discounts and increases in risk premiums required by market participants rather than an adverse change in cash flows or a fundamental weakness in the credit quality of the issuer or underlying assets.
5. NET INCOME PER SHARE
The Company presents both basic and diluted earnings per share (“EPS”) amounts. Basic EPS is calculated by dividing net income by the weighted average number of common shares outstanding during the period presented. Diluted EPS amounts are based upon the weighted average number of common and common equivalent shares outstanding during the period presented. There were no dilutive shares outstanding for the three or nine month periods ended September 30, 2012 or September 30, 2011.
6. INCOME TAXES
The Company accounts for income taxes in accordance with FASB’s Codification topic, Income Taxes. Deferred income taxes arise from the temporary differences in the recognition of income and expenses for tax purposes. A valuation allowance is established when the Company believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Deferred tax assets and liabilities are comprised of the following at September 30, 2012 and December 31, 2011:
Deferred tax assets:
Accrued liabilities
Total deferred tax assets
Deferred tax liabilities:
Other comprehensive income
Total deferred tax liabilities
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Significant components of the Company’s income tax provision in the Condensed Statements of Income for the nine months ended September 30 are as follows:
Current provision:
Federal
State
Deferred provision:
Total income tax provision
The difference between income taxes at the U. S. federal statutory income tax rate of 35% and those reported in the Condensed Statements of Income for the nine months ended September 30 is as follows:
Income taxes at U. S. Federal statutory rate
Provision-to-return adjustments
State income tax, net of federal tax effect
Tax credits and other
The provision-to-return adjustments presented above for the nine months ended September 30, 2012 are primarily related to differences between the Domestic Production Activities Deduction reported on the 2011 federal income tax return and amounts previously estimated.
The Company had unrecognized tax benefits of $744,705 related to uncertain tax positions as of September 30, 2012 under the provisions of FASB Codification topic, Income Taxes, which is recorded in other accrued liabilities on the Condensed Balance Sheet. No accrued interest or penalties for such positions is recorded. The federal returns for the tax years 2004, 2005, and 2006 are currently under examination by the Internal Revenue Service, primarily in relation to research credits claimed on those returns by the Company. The federal returns for tax years 2007 through 2011 remain open to examination, and the tax years 2006 through 2011 remain open to other taxing jurisdictions to which the Company is subject.
7. STOCK-BASED COMPENSATION AND EMPLOYEE INCENTIVE PROGRAMS
Stock-based compensation cost is measured at the grant date based on the fair value of the award, and is recognized as an expense over the employee’s or non-employee director’s requisite service period.
The following table shows total stock-based compensation expense for the three and nine months ended September 30, 2012 and 2011, included in the Condensed Statements of Income:
Costs of sales
Operating expenses
Pre-tax stock-based compensation expense
Less: income tax effect
Net stock-based compensation expense
2005 Restricted Stock Plan
On January 27, 2006, the Compensation Committee of the Board of Directors approved the grant of 116,498 shares of restricted stock, effective January 30, 2006, to certain executive officers of the Company under the Company’s 2005 Restricted Stock Plan. The grant date fair value was $42.91 per share. The restricted stock vested in five equal annual installments commencing on the first anniversary date of grant.
On May 17, 2006, the Compensation Committee of the Board of Directors approved the grant of 17,810 shares of restricted stock, effective May 17, 2006, to the then Chief Operating Officer of the Company. The grant date fair value was $42.11 per share. The restricted stock vested in five equal annual installments commencing on January 30, 2007, and each January 30 thereafter.
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On January 23, 2008, the Compensation Committee of the Board of Directors approved the grant of 16,471 shares of restricted stock to the Company’s then Vice President – Finance and Chief Financial Officer. The grant date fair value was $21.25 per share. The restricted stock was scheduled to vest in five equal annual installments commencing on January 30, 2009, and each January 30 thereafter. On June 30, 2010, 9,883 shares of unvested restricted stock were forfeited, cancelled and returned to the authorized and unissued shares of the Company as a result of the termination of employment of this individual on such date.
On April 18, 2011, the Compensation Committee of the Board of Directors approved the grant of a total of 100,346 shares of restricted stock, effective April 18, 2011, to certain executive officers of the Company. Under the terms of the restricted stock award agreements with the executive officers, the shares of restricted stock are scheduled to vest in five equal annual installments commencing on April 18, 2012 and each April 18 thereafter, assuming that the recipient of the award continues to serve as an executive officer of the Company on each applicable vesting date. Compensation expense for this grant will be recognized on a straight-line basis over five years.
2012 Restricted Stock Plan for Non-Employee Directors
On June 18, 2012, the Compensation Committee of the Board of Directors approved the grant of 2,160 shares of restricted stock, effective June 18, 2012, to the five non-employee directors of the Company under the Company’s 2012 Restricted Stock Plan for Non-Employee Directors. The grant date fair value was $55.55 per share. Under the terms of the restricted stock award agreements with the non-employee directors, the shares of restricted stock are scheduled to vest on the third anniversary of the date of grant, assuming that the recipient of the grant continues to serve as a director of the Company on the vesting date. Compensation expense for this grant will be recognized on a straight-line basis over three years.
A summary of activity under the 2005 Restricted Stock Plan and the 2012 Restricted Stock Plan for Non-Employee Directors (the “Plans”) for the nine-month periods ended September 30, 2012 and 2011 is as follows:
Nonvested stock outstanding at beginning of period
Granted
Vested
Nonvested stock outstanding at end of period
As of September 30, 2012, there was $4,432,850 of unrecognized compensation cost related to non-vested restricted stock granted under the Plans.
2012 Incentive Program
On January 23, 2012, the Board of Directors, upon the recommendation of the Compensation Committee, adopted a short-term incentive program for 2012 for certain executive officers of the Company (the “2012 Incentive Program”). Under the 2012 Incentive Program, each executive officer of the Company, other than executive officers earning any commission-based compensation, have a short-term incentive cash bonus opportunity based on the achievement of a specified level of financial performance, specifically the Company’s earnings before interest, income taxes, depreciation or amortization (“EBITDA”) in 2012 (“2012 EBITDA”) compared to the Company’s EBITDA in 2011 (“2011 EBITDA”).
Participants in the 2012 Incentive Program will receive 100% of their target award if the Company’s 2012 EBITDA is 105% of 2011 EBITDA, 75% of the target award if the Company achieves a minimum threshold level of performance (2012 EBITDA reaching 95% of 2011 EBITDA), and a maximum of 150% of the target award for a maximum level of performance (2012 EBITDA equaling or exceeding 130% of 2011 EBITDA). No payments will be made for performance below the specified threshold amount. Payouts between the threshold and maximum will be calculated by the Compensation Committee using the interpolation process described in the 2012 Incentive Program. The Compensation Committee may make adjustments to the terms and conditions of, and the criteria included in, awards under the 2012 Incentive Program in recognition of unusual or nonrecurring events affecting a participant or the Company, or the financial statements of the Company, or in certain other instances specified in the 2012 Incentive Program.
Awards earned under the 2012 Incentive Program will be paid solely in cash. In addition, awards pursuant to the 2012 Incentive Program are subject to recovery or adjustments by the Company in certain circumstances in which the operating results on which payment was based are restated or otherwise adjusted or in the event that a participant’s conduct is not in good faith and materially disrupts, damages, impairs or interferes with the business of the Company.
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8. FINANCING RECEIVABLES
The Company leases its information and patient care systems to certain healthcare providers under sales-type leases expiring in various years through 2017. These receivables typically have terms from two to five years, bear interest at various rates, and are usually collateralized by a security interest in the underlying assets. Since the Company has a history of successfully collecting amounts due under the original payment terms of these extended payment arrangements without making any concessions to its customers, the Company satisfies the requirement for revenue recognition. The Company’s history with these types of extended payment term arrangements supports management’s assertion that revenues are fixed and determinable and probable of collection.
The components of these lease receivables were as follows on September 30, 2012 and December 31, 2011:
Total minimum lease payments receivable
Less allowance for losses
Less unearned income
Lease receivables
Less current portion
Amounts due after one year
Future minimum lease payments to be received subsequent to September 30, 2012 are as follows:
2012
2013
2014
2015
2016
Thereafter
Total minimum lease payments to be received
Net leases receivable
The Company has also sold information and patient care systems to certain healthcare providers under extended payment terms. These receivables, included in the current portion of financing receivables, typically have terms from 3 to 12 months. Total amounts receivable under these arrangements at September 30, 2012 and December 31, 2011 were $1,533,222 and $722,065, respectively.
Credit Quality of Financing Receivables and Allowance for Credit Losses
The following table is a roll-forward of the allowance for financing credit losses for the period ended September 30, 2012 and year ended December 31, 2011:
December 31, 2011
September 30, 2012
The Company’s financing receivables are comprised of a single portfolio segment as the balances are all derived from sales-type leasing arrangements within our target market of community hospitals. The Company evaluates the credit quality of its financing receivables based on a combination of factors, including, but not limited to, customer collection experience, economic conditions, the customer’s financial condition, and known risk characteristics impacting the respective customer base of community hospitals, the most notable of which related to enacted and potential changes in Medicare and Medicaid reimbursement rates as community hospitals typically generate a significant portion of their revenues and related cash flows from beneficiaries of these programs. In addition to specific account identification, the Company utilizes historical collection experience to establish the allowance for credit losses. Financing receivables are written off only after the Company has exhausted all collection efforts. The Company has been successful collecting its financing receivables and considers the credit quality of such arrangements to be good, especially as the underlying assets act as collateral for the receivables.
Customer payments are considered past due if a scheduled payment is not received within contractually agreed upon terms. To facilitate customer collection and credit monitoring efforts, financing receivable amounts are invoiced and reclassified to trade accounts receivable when they become due, with all invoiced amounts placed on nonaccrual status. As a result, all past due amounts related to the
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Company’s financing receivables are included in trade accounts receivable in the accompanying Condensed Balance Sheets. The following is an analysis of the age of financing receivables amounts that have been reclassified to trade accounts receivable and are past due as of September 30, 2012 and December 31, 2011:
From time to time, the Company may agree to alternative payment terms outside of the terms of the original financing receivable agreement due to customer difficulties in achieving the original terms. In general, such alternative payment arrangements do not result in a re-aging of the related receivables. Rather, payments pursuant to any alternative payment arrangements are applied to the already outstanding invoices beginning with the oldest outstanding invoices as the payments are received.
Because amounts are reclassified to trade accounts receivable when they become due, there are no past due amounts included within the financing receivables or the financing receivables, current portion, net amounts in the accompanying Condensed Balance Sheets.
The Company utilizes an aging of trade accounts receivable as the primary credit quality indicator for its financing receivables, which is facilitated by the reclassification of customer payment amounts to trade accounts receivable when they become due. The table below categorizes customer financing receivable balances, none of which are considered past due, based on the age of the oldest payment outstanding that has been reclassified to trade accounts receivable:
Customer balances with amounts reclassified to trade accounts receivable that are:
1 to 90 Days Past Due
91 to 180 Days Past Due
181 + Days Past Due
Total customer balances with past due amounts reclassified to trade accounts receivable
Total customer balances with no past due amounts reclassified to trade accounts receivable
Total financing receivables with contractual maturities of one year or less
Total financing receivables
Extended Meaningful Use Installment Plans
During 2012, the Company has entered into multiple customer license agreements with payment terms requiring the customer to remit to the Company incentive payments (not to exceed the remaining balance of the contract price) received under the American Recovery and Reinvestment Act of 2009 (“ARRA”) for adoption of qualifying electronic health records (“EHRs”), with only nominal payment amounts required until the customer’s receipt of such incentive payments. If no such incentive payments are received by the customer or if such payments are not sufficient to pay the remaining balance under the arrangement, payments continue at contracted nominal amounts until the balance of the contract price is paid full. Because of the significant difference in the underlying economics of these arrangements compared to our historical financing receivables, management has determined that these arrangements are not comparable to historical arrangements. In accordance with the Software topic and Revenue Recognition subtopic of the Codification, the Company recognizes revenue related to these arrangements as the amounts become due. Anticipated future cash flows from these arrangements are excluded from the Company’s financing receivables and deferred revenue in the accompanying condensed balance sheets. Direct, incremental costs in the amount of $861,513, included as a component of prepaid expenses and other in the accompanying condensed balance sheets, have been capitalized as of September 30, 2012 related to these arrangements. There were no such capitalized direct, incremental costs as of September 30, 2011, as these arrangements are new to the Company beginning in the first quarter of 2012.
9. COMMITMENTS AND CONTINGENCIES
From time to time, the Company is involved in routine litigation that arises in the ordinary course of business. Management does not expect this to have a material adverse effect on the Company’s financial statements.
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10. FAIR VALUE
FASB Codification topic, Fair Value Measurements and Disclosures, establishes a framework for measuring fair value and expands financial statement disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. The Codification does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements. The Codification requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or liabilities.
Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
The fair values of the Company’s available-for-sale securities are based on matrix pricing for the periods ended September 30, 2012 and December 31, 2011, which uses observable market based inputs (such as benchmark yields) in addition to quoted prices in active markets to derive fair values. As a result, these inputs are classified as Level 2 within the fair value hierarchy. We generally apply fair value techniques on a non-recurring basis associated with (1) valuing potential impairment loss related to financing receivables accounted for pursuant to Codification topic, Leases, and (2) valuing potential impairment loss related to long-lived assets accounted for pursuant to Codification topic, Property, Plant and Equipment, when events or circumstances indicate a possible impairment.
The following tables summarize the carrying amounts and fair values of certain assets and liabilities at September 30, 2012 and December 31, 2011:
Description
Available-for-sale securities
Short-term investments (cash and accrued income)
Mortgage backed securities
Total available-for-sale securites
Accrued income in the above tables represents earnings due and payable to our investment portfolio at any point in time but not yet received.
The carrying amount of other financial instruments reported in the balance sheet for current assets and current liabilities approximate their fair values because of the short-term nature of these instruments.
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11. RECENT ACCOUNTING PRONOUNCEMENTS
New Accounting Standards Adopted in 2012
Effective January 1, 2012, the Company retrospectively adopted ASU 2011-05, Presentation of Comprehensive Income, as amended by ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. This update requires entities to present comprehensive income either in a single continuous financial statement or in two separate but consecutive statements. Entities no longer have the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The Company’s adoption of this update did not have a material impact on our financial statements and resulted in the accompanying Condensed Statements of Comprehensive Income.
New Accounting Standards Yet to be Adopted
There are no new standards required to be adopted in future periods that will have a material impact on our financial statements.
12. SUBSEQUENT EVENTS
On October 22, 2012, the Company announced a dividend for the third quarter of 2012 in the amount of $0.46 per share, payable on November 23, 2012, to stockholders of record as of the close of business on November 8, 2012.
On October 31, 2012, the Compensation Committee of the Board of Directors approved the grant of 12,292 shares of restricted stock, effective October 31, 2012, to two executive officers of the Company under the Company’s 2005 Restricted Stock Plan. The grant date fair value was $48.81 per share. Under the terms of the restricted stock award agreements with the executive officers, the shares of restricted stock are scheduled to vest in five equal annual installments commencing on October 31, 2013 and each October 31 thereafter, assuming that the recipient of the award continues to serve as an executive officer of the Company on each applicable vesting date. Compensation expense for this grant will be recognized on a straight-line basis over five years.
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You should read the following discussion and analysis of our financial condition and results of operations together with the unaudited financial statements and related notes appearing elsewhere herein.
This discussion and analysis contains forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified generally by the use of forward-looking terminology and words such as “expects,” “anticipates,” “estimates,” “believes,” “predicts,” “intends,” “plans,” “potential,” “may,” “continue,” “should,” “will” and words of comparable meaning. Without limiting the generality of the preceding statement, all statements in this report relating to estimated and projected earnings, margins, costs, expenditures, cash flows, growth rates and future financial results are forward-looking statements. We caution investors that any such forward-looking statements are only predictions and are not guarantees of future performance. Certain risks, uncertainties and other factors may cause actual results to differ materially from those projected in the forward-looking statements. Such factors may include:
overall business and economic conditions affecting the healthcare industry;
potential effects of the federal health care reform legislation enacted in 2010, and implementing regulations, on the businesses of our hospital customers;
funding uncertainties associated with, and potential expenditures required by, the American Recovery and Reinvestment Act of 2009 in connection with the adoption of electronic health records;
saturation of our target market and hospital consolidations;
changes in customer purchasing priorities, capital expenditures and demand for information technology systems;
competition with companies that have greater financial, technical and marketing resources than we have;
failure to develop new technology and products in response to market demands;
fluctuations in quarterly financial performance due to, among other factors, timing of customer installations;
failure of our products to function properly resulting in claims for medical losses;
government regulation of the healthcare and health insurance industries;
government regulation of our products and customers, including changes in healthcare policy affecting Medicare and Medicaid reimbursement rates and qualifying technological standards;
changes in accounting principles generally accepted in the United States of America;
breaches of security and viruses in our systems resulting in customer claims against us and harm to our reputation;
potential intellectual property claims against us;
general economic conditions, including changes in the financial and credit markets that may affect the availability and cost of credit to us or our customers; and
interruptions in our power supply and/or telecommunications capabilities.
Additional information concerning these and other factors which could cause differences between forward-looking statements and future actual results is discussed under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011, as filed with the Securities and Exchange Commission.
Background
CPSI was founded in 1979 and specializes in delivering comprehensive healthcare information systems and related services to community hospitals. Our systems and services are designed to support the primary functional areas of a hospital and to enhance access to necessary financial and clinical information. Our comprehensive system enables healthcare providers to improve clinical, financial and administrative outcomes. Our products and services provide solutions in key areas, including patient management, financial management, patient care and clinical, enterprise and office automation. In addition to servicing small- to medium-sized hospitals, we provide information technology services to other related entities in the healthcare industry, such as nursing homes, home health agencies and physician clinics.
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We sell a fully integrated, enterprise-wide financial and clinical hospital information system comprised of all necessary software, hardware, peripherals, forms and office supplies, together with comprehensive customer service and support. We also offer business management services, including electronic billing submissions, patient statement processing and accounts receivable management, as part of our overall information system solution. We believe that as our customer base grows, the demand for our business management services will also continue to grow, supporting further increases in recurring revenues.
Our system currently is installed and operating in over 650 hospitals in 45 states and the District of Columbia. Our customers consist of community hospitals with 300 or fewer beds, with hospitals having 100 or fewer acute care beds comprising approximately 94% of our customers.
Management Overview
We primarily seek revenue growth through sales of healthcare information technology systems and related services to existing and new customers within our historic target market. Our strategy has produced consistent revenue growth over the long-term, as reflected in five- and ten-year compounded annual growth rates in revenues of approximately 8.4% and 11.3%, respectively, as of the end of our most recently completed fiscal year. Selling new and additional products and services to our existing customer base is an important part of CPSI’s future revenue growth. We believe that as our customer base grows, the demand for additional products and services, including business management services, will also continue to grow, supporting further increases in recurring revenues. We also expect to drive revenue growth from new product development that we may generate from our research and development activities.
In addition to revenue growth, our business model is focused on earnings growth. Once a hospital has installed our system, we continue to provide support and maintenance services to the customer on an ongoing basis. These services are typically provided by the same personnel who perform our system installations but at a reduced cost to us, and therefore at an increased gross margin. We also look to increase margins through cost containment measures where appropriate.
As a result of the recent economic recession and the uncertainty surrounding the economy and credit markets and tightened lending standards, hospitals have experienced reduced availability of third-party credit and an overall reduction in their investment portfolios. In addition, healthcare organizations with a large dependency on Medicare and Medicaid populations, such as community-based hospitals, have been impacted by the challenging financial condition of the federal government and many state governments and government programs. Accordingly, we recognize that prospective hospital customers often do not have the necessary capital to make investments in information technology. Additionally, in response to these challenges, hospitals have become more selective regarding where they invest capital, resulting in a focus on strategic spending that generates a return on their investment. Despite the current economic environment, we believe healthcare information technology is often viewed as more strategic to hospitals than other possible purchases because the technology offers the possibility of a quick return on investment. Information technology also plays an important role in healthcare by improving safety and efficiency and reducing cost. Additionally, we believe most hospitals recognize that they must invest in healthcare information technology to meet current and future regulatory, compliance and government reimbursement requirements.
We have experienced an increase in customers seeking financing arrangements from us over the past four years for system installations as a result of ongoing economic conditions and the uncertainty surrounding the credit markets and tightened lending standards. Historically, we have made financing arrangements available to customers on a case-by-case basis depending upon various aspects of the proposed contract and customer attributes. These financing arrangements include short-term payment plans, longer-term lease financing through us or third-party financing companies, and Software as a Service (“SaaS”) arrangements. We intend to continue to work with prospective customers to provide for financing arrangements to purchase our systems so long as such arrangements do not adversely affect our financial position and liquidity. We believe that meeting the financial needs of community-based hospitals while allowing for the profitable expansion of our footprint in this market will remain both an opportunity and a challenge for us in the foreseeable future.
Despite the current challenging economic conditions generally, including the uncertainty surrounding credit markets and tightened lending standards, we have not experienced a decline in demand for our products and services and our collections of receivables remain consistent with historical trends.
American Recovery and Reinvestment Act of 2009
While the ongoing challenging economic conditions and uncertainty surrounding credit markets and tightened lending standards have impacted and could continue to impact the community hospitals that comprise our target market, we believe that the American Recovery and Reinvestment Act of 2009 (the “ARRA”) has increased and will continue to increase demand for healthcare information technology and will have a positive impact on our business prospects through 2015. The ARRA includes more than $19 billion in funding to aid healthcare organizations in modernizing their operations through the acquisition and widespread use of healthcare information technology. Included in the funding is approximately $17.2 billion in incentives through Medicare and Medicaid reimbursement systems to encourage and assist healthcare providers in adopting and using electronic health records (“EHRs”). These incentive payments began in February 2011 and are expected to last through 2015. If an eligible healthcare provider does not begin to demonstrate meaningful use of EHRs by 2015, then reimbursement under Medicare will begin to be reduced. Our hospital customers began receiving these incentive payments under the ARRA in February 2011. Through November 2, 2012, approximately 240 of our hospital customers had received payments for EHR adoption totaling approximately $224 million.
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We have been focused on ensuring that we take the necessary steps to meet the needs of community hospitals to help them gain access to the incentives made available under the ARRA. Primary among those steps was ensuring that our technology meets the ARRA’s EHR certification requirements. During 2010, both our hospital and medical practice EHR solutions were certified as a complete EHR by CCHIT®. Receiving this certification for both our hospital and ambulatory EHR products ensures that both hospitals and providers using our EHR systems can attain “meaningful use” of EHRs and qualify for ARRA reimbursements. As a result of our obtaining this certification, the ARRA has had and should continue to have a positive impact on our business and the businesses of the community hospitals that comprise our target market.
Health Care Reform
In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, collectively referred to as the “Health Reform Laws.” This sweeping legislation implements changes to the healthcare and health insurance industries over several years through 2015, with the ultimate goal of requiring substantially all U.S. citizens and legal residents to have qualifying health insurance coverage by 2014 and providing the means by which it will be made available to them. We anticipate that the Health Reform Laws will have little direct impact on our internal operation but may have a significant impact on the businesses of our hospital customers. We have not been able to determine at this point whether the impact will be positive, negative or neutral; however, it is likely that the Health Reform Laws will affect hospitals differently depending upon the populations they service. Community hospitals typically service higher uninsured populations than larger urban hospitals and rely more heavily on Medicare and Medicaid for reimbursement. It remains to be seen whether the increase in the insured populations for community hospitals, as well as the increase in Medicare and Medicaid reimbursements under ARRA for hospitals that implement EHR technology, will be enough to offset proposed cuts in Medicare and Medicaid reimbursements contained in the Health Reform Laws.
We believe healthcare initiatives will continue during the foreseeable future. If adopted, some aspects of previously proposed reforms, such as further reductions in Medicare and Medicaid payments, could adversely affect the businesses of our customers and thereby harm our business.
Deficit Reduction
President Obama signed legislation on August 2, 2011, the Budget Control Act of 2011, to increase the U.S. debt ceiling. This legislation imposed significant cuts in federal spending over the next decade, as the special bipartisan Congressional committee appointed under the legislation failed to take any action on deficit reduction. Although Medicaid is specifically exempted from the federal spending cuts mandated by the legislation, it calls for a reduction of up to 2% in federal Medicare spending, all of which will be achieved by reduced reimbursements to health care providers. The reduced reimbursements will take effect starting in January 2013, unless Congress takes specific action to override the spending cuts. As our hospital customers rely heavily on reimbursements from Medicare to fund their operations, the anticipated reduction in reimbursement rates, although capped at 2%, could negatively affect the businesses of our customers and our business.
Results of Operations
In the nine months ended September 30, 2012, we generated revenues of $135.4 million from the sale of our products and services, as compared to $131.3 million in the nine months ended September 30, 2011, an increase of 3.2%. We installed our core financial and patient accounting system in 26 new hospitals in the first nine months of 2012 compared to 16 in the first nine months of 2011. Additionally, our expanding customer base resulted in continued growth in support and maintenance revenues and business management services revenues. We also recognized favorable provision-to-return adjustments of $1.9 million related to our 2011 federal and state income tax returns. Our net income for the nine months ended September 30, 2012 increased 8.1% from the first nine months of 2011, while cash flow from operations decreased 25.8%, primarily as a result of increases in our accounts receivable and financing receivables.
As mentioned above, our operations have been significantly affected by the ARRA. “Meaningful use” of EHR under the ARRA refers to a set of 15 criteria that medical providers must meet in order to prove that they are using their EHR as an effective tool in their practice, plus 10 additional a la carte menu items, of which the medical provider must demonstrate it is using five. In total, each provider must satisfy 20 meaningful use criteria to qualify for stimulus payments under the ARRA during the first stage of the EHR incentive program.
Meaningful use is measured in three stages over five years. Each stage represents a level of adoption of EHR. To qualify for stimulus payments for each stage, the provider is required to report compliance for a consecutive 90-day period during the calendar year. The dollar amount of stimulus payments during stage one of the EHR incentive program is scheduled to begin decreasing in 2013. Due to the deadlines associated with the 90-day compliance requirement, our results have become and will remain uneven during the term of the ARRA program, with system sales activity relating to ARRA likely being higher in the first two quarters of our fiscal year and lower in the last two quarters of our fiscal year. However, based on factors such as those presented below, the recognition of revenue may not be in a pattern consistent with changes in system sales activity.
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At the beginning of 2012, we began including language in certain of our customer license agreements that more evenly matched customers’ anticipated cash inflows under the EHR incentive program with the necessary cash outflows for purchasing our EHR solution (“Extended Meaningful Use Installment Plans”). Under these arrangements, customers are required to remit to us incentive payments (not to exceed the remaining balance) received for adoption of qualifying EHRs, with only nominal payment amounts required until the customer’s receipt of such incentive payments. If no such incentive payments are received by the customer or if such payments are not sufficient to pay the remaining balance under the arrangement, payments continue at contracted nominal amounts until the balance of the contract price is paid in full. Revenue from these arrangements is recognized as the amounts become due. As of September 30, 2012, we have accumulated unrecognized revenue of $9.4 million to be recognized as the amounts become due under these contracts. Of the customers contributing to the $9.4 million in accumulated unrecognized revenue as of September 30, 2012, more than half have attested to stage one of meaningful use as of November 2, 2012, with a vast majority of those customers attesting to stage one having already received related Medicaid incentive payments. Medicare payments, which are typically significantly larger than the related Medicaid payments, are still pending for the majority of these customers. Our experience suggests an average time from successful attestation in stage one to receipt of funds under the EHR incentive program of approximately six weeks. Overall, with respect to these contracts, we typically experience a timeframe of 6 to 12 months from the date of installation to receipt of funds under the EHR incentive program.
The following table sets forth certain items included in our results of operations for the three and nine months ended September 30, 2012 and 2011, expressed as a percentage of our total revenues for these periods (dollar amounts in thousands):
INCOME DATA:
Three Months Ended September 30, 2012 Compared with Three Months Ended September 30, 2011
Revenues. Total revenues for the three months ended September 30, 2012 increased 7.4%, or $3.1 million, compared to the three months ended September 30, 2011. This was largely attributable to an increase in system sales revenues, primarily caused by an increase in new system installations under non-Extended Meaningful Use Installment Plans and a significant increase in previously installed SaaS arrangements that were converted to perpetual licenses at the customers’ request. Additionally, we experienced an increase in support and maintenance revenues and business management services revenues due to a larger customer base and increased applications within that customer base requiring support and maintenance services.
System sales revenues increased by 9.8%, or $1.6 million, for the comparative three-month periods. We installed our core system at eight new hospital clients in the third quarter of 2012 (one of which was under an Extended Meaningful Use Installment Plan) compared to five in the third quarter of 2011 (none of which were under Extended Meaningful Use Installment Plans). Sales to existing customers accounted for 61.3% of our system sales revenues for the third quarter of 2012 compared to 74.9% for the third quarter of 2011. During the third quarter of 2012, the Company continued to install systems under Extended Meaningful Use Installment Plans for which a substantial majority of the consideration will not be received or revenue recognized until the customers successfully achieve meaningful use designation and receive related stage one ARRA incentive payments. The net effect of these arrangements on the Company’s system sales revenues was an increase of approximately $0.5 million, as the revenue recognized for payments due in the third quarter of 2012 exceeded the additional unrecognized revenue accumulated during the third quarter of 2012 to be recognized in future periods as they become due and payable. The Company recognized revenue during the third quarter of 2012 of $0.8 million for previously installed Software as a Service (“SaaS”) arrangements that were converted to perpetual licenses at the customers’ request.
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Support and maintenance revenues increased by 5.7%, or $1.0 million, for the comparative three-month periods. This increase was attributable to an increase in recurring revenues as a result of a larger customer base, an increase in support fees for add-on business sold to existing customers, increases in support rates from contractually agreed upon Consumer Price Index (“CPI”) rate increases and the addition of IT managed services to our suite of service offerings. Support service fees increased by 6.4%, or $1.0 million, for the comparative three-month periods. SaaS, hosting and other fees decreased by 32.9%, or $0.6 million, for the comparative three-month periods. IT managed service fees, which was a new service offering beginning in the third quarter of 2011, were $0.8 million for the three months ended September 30, 2012 compared to $0.2 million for the third quarter of 2011.
Business management services revenues increased by 6.7%, or $0.6 million, for the comparative three-month periods. We experienced this increase in business management services revenues primarily as a result of growth in customer demand for accounts receivable management, private pay and revenue cycle management services. We were providing our full suite of business management services to 42 customers at September 30, 2012, compared to 32 customers at September 30, 2011.
Costs of Sales. Total costs of sales increased by 11.5%, or $2.6 million, for the comparative three-month periods. As a percentage of total revenues, costs of sales increased approximately 200 basis points to 55.7% from 53.7%.
Costs of system sales increased by 6.3%, or $0.7 million, for the comparative three-month periods. The increase in costs of system sales was due to the combined effects of a $0.5 million increase in payroll and related costs due to increased personnel and a $0.5 million increase in travel costs due to the increase in new system installations. These increases were partially offset by a $0.5 million decrease in cost of equipment due largely to a 36% decrease in equipment sales. The third quarter of 2011 saw an unusually high number of equipment sales to existing customers and related cost of equipment due to the Company’s migration to a new operating platform, which required many customers to upgrade existing hardware in order to support the new platform. The gross margin on system sales increased to 34.4% for the three-month period ended September 30, 2012 from 32.2% in the three-month period ended September 30, 2011. Excluding the net effect on revenue resulting from Extended Meaningful Use Installment Plans (which are new to the Company beginning in 2012) and the deferral of the related cost of equipment, the adjusted gross margin on system sales (as hereinafter defined in the “Non-GAAP Financial Measures” section below) increased slightly to 32.3% in the three-month period ended September 30, 2012. The table below summarizes the major components of costs of system sales as a percentage of system sales revenues:
Payroll and related expenses
Travel expenses
Cost of equipment
Excluding the net effect on revenue and cost of equipment resulting from Extended Meaningful Use Installment Plans, payroll and related expenses, travel expense, and adjusted cost of equipment (as hereinafter defined in the “Non-GAAP Financial Measures” section below) would represent 38.1%, 16.8% and 7.2%, respectively, of adjusted system sales (as hereinafter defined in the “Non-GAAP Financial Measures” section below) for the third quarter of 2012. Please see the tables set forth below under the caption “Non-GAAP Financial Measures” for a reconciliation of each of these non-GAAP financial measures to the comparable financial measure determined in accordance with generally accepted accounting principles in the United States (“GAAP”).
Cost of support and maintenance increased 16.0%, or $1.1 million, for the comparative three-month periods, primarily due to an increase in payroll and related costs of 18.8%, or $1.1 million. The increase in payroll and related costs was driven by the addition of personnel to provide IT managed services, which was a new service offering beginning in the third quarter of 2011. The gross margin on support and maintenance revenues decreased to 56.5% for the three-month period ended September 30, 2012 from 60.4% for the three-month period ended September 30, 2011, as our IT managed services offering has yet to achieve the economies of scale that currently benefit the remainder of our support and maintenance services mix.
Our costs associated with business management services increased 16.6%, or $0.8 million, for the comparative three-month periods due primarily to an increase in payroll and related costs. The gross margin on business management services decreased to 39.3% for the three-month period ended September 30, 2012 from 44.5% for the three-month period ended September 30, 2011 due to the disproportionate increase in payroll and related costs versus revenues. Payroll and related expenses increased 29.1%, or $0.8 million, as a result of adding more employees in order to support and develop our growing customer base and increased commissions.
Sales and Marketing Expenses. Sales and marketing expenses decreased 5.6%, or $0.2 million, for the comparative three-month periods. The Company’s commission agreements generally contain escalating commission rates upon an individual meeting certain annual targets. These escalating commission rates were triggered earlier in 2011 than in 2012 due primarily to the $5.8 million, or 24.5%, decrease in system sales revenues in the second quarter of 2012 versus the second quarter of 2011.
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General and Administrative Expenses. General and administrative expenses increased 6.2%, or $0.4 million, for the comparative three-month periods primarily due to a $0.4 million increase in bad debt expense. Bad debt expense for the third quarter of 2011 was significantly lower than historical trends due to successful collections on delinquent customers.
As a percentage of total revenues, sales and marketing expenses, and general and administrative expenses decreased to 22.2% for the three-month period ended September 30, 2012 compared to 23.4% for the three-month period ended September 30, 2011.
As a result of the foregoing factors, income before taxes increased by 4.4%, or $0.4 million, from the three months ended September 30, 2011.
Income Taxes. Our effective income tax rate for the three-month periods ended September 30, 2012 and 2011 was 32.5% and 39.0%, respectively. The significant decrease in our effective income tax rate is primarily due to an increase in the estimated qualified production activities income used in calculating the Domestic Production Activities Deduction (“DPAD”). This increased estimate is based on information obtained in preparing and filing our 2011 federal and state income tax returns, which resulted in $1.8 million of favorable provision-to-return adjustments recorded during the second quarter of 2012, primarily related to differences between the DPAD reported on the 2011 federal income tax return and amounts previously estimated. The federal research and development tax credit expired effective December 31, 2011, and has yet to be extended by Congress. As a result, no tax benefit from these potential tax credits has been recorded for the three months ended September 30, 2012. Aside from the possible extension of federal research and development tax credits, we are unaware of any pending legislation that would affect our current income tax rate for the remainder of 2012.
Net Income. Net income for the three months ended September 30, 2012 increased by 15.6%, or $0.9 million, to $6.9 million, or $0.63 per basic and diluted share, as compared with net income of $6.0 million, or $0.54 per basic and diluted share, for the three months ended September 30, 2011. Net income represented 15.3% of revenue for the three months ended September 30, 2012, as compared to 14.2% of revenue for the three months ended September 30, 2011.
Nine Months Ended September 30, 2012 Compared with Nine Months Ended September 30, 2011
Revenues. Total revenues for the nine months ended September 30, 2012 increased 3.2%, or $4.1 million, compared to the nine months ended September 30, 2011. This was largely attributable to an increase in support and maintenance revenues and business management services revenues due to a larger customer base and increased applications within that customer base requiring support and maintenance services. The increase in support and maintenance revenues and business management services revenues is largely offset by a decrease in system sales revenues as nearly one-third of the installations of core systems at new hospital clients during the nine months ended September 30, 2012 were under Extended Meaningful Use Installment Plans, which are new to the Company beginning in the first quarter of 2012 . This resulted in net unrecognized revenue of $9.4 million being accumulated during the nine months ended September 30, 2012, which will be recognized in future periods as the amounts become due and payable.
System sales revenues decreased by 5.0%, or $2.7 million, for the comparative nine-month periods. We installed our core system at 26 new hospital clients in the first nine months of 2012 (nearly one third of which were under Extended Meaningful Use Installment Plans) compared to 16 in the first nine months of 2011 (none of which were Extended Meaningful Use Installment Plans). Sales to existing customers accounted for 70.8% of our system sales revenues for the first nine months of 2012 compared to 71.8% for the first nine months of 2011. During the first nine months of 2012, the Company installed systems under Extended Meaningful Use Installment Plans for which a substantial majority of the consideration will not be received and revenue recognized until the customers successfully achieve meaningful use designation and receive related ARRA incentive payments, resulting in net unrecognized revenue of $9.4 million accumulated during the nine months ended September 30, 2012 to be recognized in future periods as the amounts become due and payable. The Company recognized revenue during the first nine months of 2012 of $1.8 million for previously installed Software as a Service (“SaaS”) arrangements that were converted to perpetual licenses at the customers’ request.
Support and maintenance revenues increased by 10.4%, or $5.1 million, for the comparative nine-month periods. This increase was attributable to an increase in recurring revenues as a result of a larger customer base, an increase in support fees for add-on business sold to existing customers, increases in support rates from contractually agreed upon Consumer Price Index (“CPI”) rate increases and the addition of IT managed services to our suite of service offerings. Support service fees increased by 9.0%, or $4.0 million, for the comparative nine-month periods. SaaS, hosting and other fees decreased by 22.2%, or $1.2 million, for the comparative nine-month periods. IT managed service fees, which was a new service offering beginning in the third quarter of 2011, were $2.5 million for the nine months ended September 30, 2012 compared to $0.2 million for the nine months ended September 30, 2011.
Business management services revenues increased by 6.5%, or $1.7 million, for the comparative nine-month periods. We experienced this increase in business management services revenues primarily as a result of growth in customer demand for accounts receivable management, revenue cycle management, private pay and claims eligibility services.
Costs of Sales. Total costs of sales increased by 7.8%, or $5.5 million, for the comparative nine-month periods. As a percentage of total revenues, costs of sales increased approximately 240 basis points to 56.1% from 53.7%.
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Costs of system sales decreased by 1.1%, or $0.4 million, for the comparative nine-month periods. The decrease in costs of system sales was due to a $2.4 million decrease in cost of equipment due largely to a 33.7% decrease in equipment sales, coupled with the capitalization of $0.9 million in cost of equipment related to installations for which no revenue has been recognized. During the nine months ended September 30, 2011, we experienced an unusually high number of equipment sales to existing customers and related cost of equipment due to the Company’s migration to a new operating platform, which required many customers to upgrade existing hardware in order to support the new platform. This decrease in cost of equipment in the nine-month period ended September 30, 2012 was partially offset by a $1.6 million increase in travel and related costs due to increased system installations during the nine months ended September 30, 2012. Payroll and related costs increased 3.0% from $18.1 million for the nine months ended September 30, 2011 to $18.6 million for the nine months ended September 30, 2012. The gross margin on system sales decreased to 31.2% for the nine-month period ended September 30, 2012 from 33.9% in the nine-month period ended September 30, 2011, as revenue for nearly one-third of the systems installed during the nine months ended September 30, 2012 will not be recognized until the customers successfully achieve meaningful use designation and receive related ARRA incentive payments. Excluding the effects of the unrecognized revenue noted above and the deferral of the related cost of equipment, the adjusted gross margin on system sales (as hereinafter defined in the “Non-GAAP Financial Measures” section below) increased to 40.2% in the nine-month period ended September 30, 2012. The table below summarizes the major components of costs of system sales as a percentage of system sales revenues:
If the Company had recognized the $9.4 million of unrecognized revenue accumulated during the nine months ended September 30, 2012 from Extended Meaningful Use Installment Plans, payroll and related expenses, travel expense, and adjusted cost of equipment (as hereinafter defined in the “Non-GAAP Financial Measures” section below) would represent 30.1%, 15.7% and 9.1%, respectively, of adjusted system sales (as hereinafter defined in the “Non-GAAP Financial Measures” section below) for the nine months ended September 30, 2012. Please see the tables set forth below under the caption “Non-GAAP Financial Measures” for a reconciliation of each of these non-GAAP financial measures to the comparable financial measure determined in accordance with GAAP.
Cost of support and maintenance increased 16.9%, or $3.3 million, for the comparative nine-month periods, primarily due to an increase in payroll and related costs of 19.0%, or $3.3 million. The increase in payroll and related costs was driven by the addition of personnel to provide IT managed services, which was a new service offering beginning in the third quarter of 2011. The gross margin on support and maintenance revenues decreased to 57.8% for the nine-month period ended September 30, 2012 from 60.2% for the nine-month period ended September 30, 2011, as our IT managed services offering has yet to achieve the economies of scale that currently benefit the remainder of our support and maintenance services mix.
Our costs associated with business management services increased 17.8%, or $2.5 million, for the comparative nine-month periods due primarily to an increase in payroll and related costs. The gross margin on business management services decreased to 40.5% for the nine-month period ended September 30, 2012 from 46.2% for the nine-month period ended September 30, 2011 due to the disproportionate increase in payroll and related costs versus revenues. Payroll and related expenses increased 25.1%, or $2.0 million, as a result of adding more employees in order to support and develop our growing customer base. Similarly, temporary labor expenses increased 10.3%, or $0.2 million.
Sales and Marketing Expenses. Sales and marketing expenses increased 2.8%, or $0.3 million, for the comparative nine-month periods. The increase was attributable to increased spending on industry tradeshows, promotional materials and marketing research.
General and Administrative Expenses. General and administrative expenses increased 1.1%, or $0.2 million, for the comparative nine-month periods. Group health insurance expense increased $0.7 million due to negative claims experience in our self-insurance program. Expenses resulting from our annual national user group conference and various regional or application-specific user group meetings hosted during the first nine months of 2012 increased $0.7 million. Depreciation expense increased $0.5 million as a result of the acquisition of our corporate campus in Mobile, Alabama during December 2011. Retirement plan costs increased $0.4 million, as we changed the employer match component of our defined contribution retirement plan during the first nine months of 2012 such that our matching contributions to participant accounts are more heavily weighted towards the earlier periods in the year. These increases were mostly offset by a $1.3 million decrease in rent expense related to the aforementioned campus acquisition during December 2011 and a $0.9 million decrease in bad debt expense. Bad debt expense for the nine months ended September 30, 2011 was significantly higher than historical trends as several customers declared bankruptcy during the second quarter of 2011 and we increased reserves for specific customers with which we had experienced collection problems.
As a percentage of total revenues, sales and marketing expenses, and general and administrative expenses decreased to 22.5% for the nine-month period ended September 30, 2012 compared to 22.9% for the nine-month period ended September 30, 2011.
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As a result of the foregoing factors, income before taxes decreased by 5.6%, or $1.7 million, from the nine months ended September 30, 2011.
Income Taxes. Our effective income tax rate for the nine-month periods ended September 30, 2012 and 2011 was 29.4% and 38.3%, respectively. The significant decrease in our effective income tax rate is primarily due to favorable provision-to-return adjustments related to our 2011 federal and state income tax returns. These adjustments were primarily related to differences between the DPAD reported on the 2011 federal income tax return and amounts previously estimated. The federal research and development tax credit expired effective December 31, 2011, and has yet to be extended by Congress. As a result, no tax benefit from these potential tax credits has been recorded for the nine months ended September 30, 2012. Aside from the potential extension of federal research and development tax credits, we are unaware of any pending legislation that would affect our current income tax rate for the remainder of 2012.
Net Income. Net income for the nine months ended September 30, 2012 increased by 8.0%, or $1.6 million, to $20.8 million, or $1.88 per basic and diluted share, as compared with net income of $19.3 million, or $1.75 per basic and diluted share, for the nine months ended September 30, 2011. Net income represented 15.4% of revenue for the nine months ended September 30, 2012, as compared to 14.7% of revenue for the nine months ended September 30, 2011.
Liquidity and Capital Resources
As of September 30, 2012, we had cash and cash equivalents of $5.8 million, compared to $11.2 million at September 30, 2011. This decrease in cash and cash equivalents is mostly due to a significant decrease in net cash provided by operating activities, as discussed below. Management believes that cash and investments plus cash generated from our normal operating activities should be adequate to fund our business through the remainder of 2012. Our principal source of liquidity has been cash provided by operating activities. Cash provided by operating activities has been used primarily to fund the growth in our business and return cash to shareholders in the form of dividends. We believe that paying dividends is an effective way of providing an investment return to our stockholders and a beneficial use of our cash. However, the declaration of dividends by CPSI is subject to the discretion of our Board of Directors. Our Board of Directors will continue to take into account such matters as general business conditions, our financial results and such other factors as our Board of Directors may deem relevant.
Net cash provided by operating activities for the nine months ended September 30, 2012 was $18.0 million, compared to $24.2 million for the nine months ended September 30, 2011. The decrease was primarily due to an increase in accounts receivable and financing receivables, coupled with the cash outflows necessary to install systems for which a substantial majority of the consideration will not be received or revenue recognized until the customers successfully achieve meaningful use designation and receive related ARRA incentive payments. During the first nine months of 2012, we have again experienced an increase in requests by customers for payment terms and financing arrangements as a result of the challenging economic environment and limited availability of credit from third parties. Although we will provide capital lease financing arrangements to our customers, we prefer and encourage customers to use a SaaS operating lease arrangement in lieu of capital financing lease arrangements.
Net cash used in investing activities totaled $3.5 million for the nine months ended September 30, 2012, compared to $4.2 million for the nine months ended September 30, 2011. We used cash for the purchase of $2.3 million of property and equipment and for the purchase of investments of $1.1 million during the nine months ended September 30, 2012. We move idle cash to our investment portfolio that we do not anticipate needing within a one-year time frame. We anticipate the need for approximately $0.5 million in capital expenditures during the remainder of 2012, including approximately $0.3 million for the addition of office space in Baldwin County, Alabama.
Net cash used in financing activities totaled $15.3 million for the nine months ended September 30, 2012, compared to $11.8 million for the nine months ended September 30, 2011. During the nine months ended September 30, 2012, we increased our dividend rate 27.8% to $0.46 per share from $0.36 per share.
Our days sales outstanding, which represents the average collection time for accounts receivable, for the nine months ended September 30, 2012 and 2011 were 50 and 49 days, respectively.
We currently do not have a bank line of credit or other credit facility in place. Because we have no debt, we are not subject to contractual restrictions or other influences on our operations, such as payment demands and restrictions on the use of operating funds that are typically associated with debt. If we borrow money in the future, we will likely be subject to operating and financial covenants that could limit our ability to operate as profitably as we have in the past. Defaults under applicable loan agreements could result in the demand by lenders for immediate payment of substantial funds and substantial restrictions on expenditures, among other things. Due to the recent economic recession and ongoing tightened lending standards, additional capital, if needed, may not be available on terms favorable to us, or at all.
Our future capital requirements will depend upon a number of factors, including the rate of growth of our sales, cash collections from our customers and our future investments in fixed assets. We believe that our available cash and cash equivalents, investments and anticipated cash generated from operations will be sufficient to meet our operating requirements for at least the next 12 months.
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Off Balance Sheet Arrangements
As of December 31, 2011, our only off-balance sheet arrangement, as defined by Item 303(a)(4) of SEC Regulation S-K, consisted of our guarantee of certain lease obligations of Solis Healthcare, LP (“Solis Healthcare”) to Winthrop Resources Corporation (“Winthrop”) under a lease agreement. Solis Healthcare purchased a software system from us and then entered into a sale-leaseback transaction with Winthrop in the first quarter of 2008. We provided this guarantee in order to facilitate Solis Healthcare in leasing the new system. During May 2012, all amounts outstanding under the lease were paid in full, resulting in the termination of our obligations under the guarantee.
The Company also has other lease rights and obligations that it accounts for as operating leases that may be reclassified as balance sheet arrangements under accounting pronouncements currently being considered by the FASB.
Critical Accounting Policies
Our Management Discussion and Analysis is based upon our Condensed Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make subjective or complex judgments that may affect the reported financial condition and results of operations. We base our estimates on historical experience and other assumptions that we believe to be reasonable in the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We continually evaluate the information used to make these estimates as our business and the economic environment changes.
In our Annual Report on Form 10-K for the year ended December 31, 2011, we identified our critical accounting polices related to cash and cash equivalents, investments, income taxes, accounts receivable and allowance for doubtful accounts, inventories, property and equipment, deferred revenue, revenue recognition, stock-based compensation, research and development costs, advertising, and shipping and handling costs. There have been no significant changes to these critical accounting policies for the three months ended September 30, 2012.
Non-GAAP Financial Measures
We have included in the discussion under the captions “Three Months Ended September 30, 2012 Compared with Three Months Ended September 30, 2011” and “Nine Months Ended September 30, 2012 Compared with Nine Months Ended September 30, 2011” above financial measures that were not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be made only in conjunction with results presented in accordance with GAAP. Below, we define these non-GAAP financial measures, provide reconciliations of the non-GAAP financial measures to the most directly comparable financial measure calculated in accordance with GAAP, and discuss the reasons that we believe this information is useful to management and may be useful to investors.
We use the non-GAAP financial measures “adjusted gross margin on system sales,” “adjusted cost of equipment,” and “adjusted system sales.” Management believes these non-GAAP financial measures provide our Board of Directors, investors, potential investors, securities analysts and others with useful information to evaluate our performance because they exclude the impact of unrecognized revenue, recognized revenue and related deferral of cost of equipment resulting from our use of Extended Meaningful Use Installment Plans. Extended Meaningful Use Installment Plans are new to the Company in 2012, resulting in the Company not having sufficient experience with comparable arrangements to establish evidence of a standard business practice of historically collecting under the original payment terms of such contracts without making concessions. As a result, the provisions of the Software topic and Revenue Recognition subtopic of the Financial Accounting Standards Board Accounting Standards Codification result in a conclusion that the fee is not fixed or determinable and, as a result, the revenue is to be recognized as the amounts become due. Because the timing of our recognition of revenue under Extended Meaningful Use Installment Plans is not related to any remaining obligation on the part of the Company, the Company and our Board of Directors use these non-GAAP financial measures to evaluate our performance relative to other periods. We believe that the most directly comparable GAAP measures to adjusted gross margin on system sales, adjusted cost of equipment, and adjusted system sales are gross margin on system sales, cost of equipment, and system sales, respectively. Set forth below are reconciliations of adjusted gross margin on system sales, adjusted cost of equipment, and adjusted system sales to the comparable financial measures calculated in accordance with GAAP (dollar amounts in thousands):
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Adjusted Gross Margin on System Sales
Gross margin on system sales
Add: Unrecognized revenue accumulated related to Extended Meaningful Use Installment Plans
Less: Revenue recognized related to Extended Meaningful Use Installment Plans
Less: Deferred cost of equipment related to Extended Meaningful Use Installment Plans
Add: Amortization of deferred cost of equipment related to Extended Meaningful Use Installment Plans
Adjusted gross margin on system sales
Adjusted Cost of Equipment
Add: Deferred cost of equipment related to Extended Meaningful Use Installment Plans
Less: Amortization of deferred cost of equipment related to Extended Meaningful Use Installment Plans
Adjusted cost of equipment
Adjusted System Sales
Adjusted system sales
Our exposure to market risk relates primarily to the potential change in the value of our investment portfolio as a result of fluctuations in interest rates. The primary purpose of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk of loss. As of September 30, 2012, our investment portfolio consisted of a variety of financial instruments, primarily including, but not limited to, money market securities and high quality government and corporate obligations. It is our intent to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We do not hold financial instruments for trading or other speculative purposes. The securities in our investment portfolio are classified as available-for-sale and, consequently, are recorded on our balance sheet at fair market value with their related unrealized gain or loss reflected as a component of accumulated other comprehensive income (loss) in stockholders’ equity.
Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectation due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.
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We believe that the market risk arising from our holdings of these financial instruments is minimal. Due to the conservative allocation of our investment portfolio, we do not believe that an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio. Additionally, since we believe we have the ability to liquidate this portfolio, we do not expect our operating results or cash flows to be materially affected to any significant degree by a sudden change in market interest rates on our investment portfolio. We do not utilize derivative financial instruments to manage our interest rate risks.
The table that follows presents fair values of principal amounts and weighted average interest rates for our investment portfolio as of September 30, 2012.
Cash and Cash Equivalents:
Short-Term Investments: (1)
Accrued income
Money market funds
Obligations of the U.S. Treasury, U.S government corporations and agencies
Corporate debt securities
Total short-term investments
Long-Term Investments: (2)
Total long-term investments
As of September 30, 2012, the Company had no borrowings and, therefore, is not subject to interest rate risks related to debt instruments.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations to the effectiveness of any system of disclosure controls and procedures, no evaluation of disclosure controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been prevented or detected on a timely basis. Even disclosure controls and procedures determined to be effective can only provide reasonable assurance that their objectives are achieved.
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective at the reasonable assurance level.
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Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II
OTHER INFORMATION
From time to time, we are involved in routine litigation that arises in the ordinary course of business. We are not currently involved in any litigation that we believe could reasonably be expected to have a material adverse effect on our business, financial condition or results of operations.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem immaterial also may materially adversely affect our business, financial condition and/or operating results.
Not applicable.
None.
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SIGNATURES
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.
/s/ J. BOYD DOUGLAS
/S/DAVID A. DYE
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Exhibit Index
No.
Exhibit
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