UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

Commission file number: 0-51547

 

 

WEBMD HEALTH CORP.

(Exact name of registrant as specified in its charter)

 

 

 

 

(212) 624-3700

(Registrant’s telephone number including area code)

 

 

 

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes þ     No o

 

Indicate by check mark whether the registrant 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. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

 

Yes o     No þ

 

As of November 5, 2008, the Registrant had 9,602,380 shares of Class A Common Stock (including unvested shares of restricted WebMD Class A Common Stock) and 48,100,000 shares of Class B Common Stock outstanding.

 

 

WEBMD HEALTH CORP.

 

QUARTERLY REPORT ON FORM 10-Q

For the period ended September 30, 2008

 

TABLE OF CONTENTS

 

 

 

WebMD^® , WebMD Health^® , Medscape^® , CME Circle^® , eMedicine^® , MedicineNet^® , theheart.org^® , RxList^® , The Little Blue Book^tm, Subimo^® , Summex^® and Medsite^® are among the trademarks of WebMD Health Corp. or its subsidiaries.

 

This Quarterly Report on Form 10-Q contains both historical and forward-looking statements. All statements other than statements of historical fact are, or may be, forward-looking statements. For example, statements concerning projections, predictions, expectations, estimates or forecasts and statements that describe our objectives, future performance, plans or goals are, or may be, forward-looking statements. These forward-looking statements reflect management’s current expectations concerning future results and events and can generally be identified by the use of expressions such as “may,” “will,” “should,” “could,” “would,” “likely,” “predict,” “potential,” “continue,” “future,” “estimate,” “believe,” “expect,” “anticipate,” “intend,” “plan,” “foresee,” and other similar words or phrases, as well as statements in the future tense.

 

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be different from any future results, performance and achievements expressed or implied by these statements. The following important risks and uncertainties could affect our future results, causing those results to differ materially from those expressed in our forward-looking statements:

 

 

These factors are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors also could have material adverse effects on our future results.

 

The forward-looking statements included in this Quarterly Report on Form 10-Q are made only as of the date of this Quarterly Report. Except as required by law or regulation, we do not undertake any obligation to update any forward-looking statements to reflect subsequent events or circumstances.

PART I
FINANCIAL INFORMATION

 

 

WEBMD HEALTH CORP.

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

 

See accompanying notes.

WEBMD HEALTH CORP.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data, unaudited)

 

 

See accompanying notes.

WEBMD HEALTH CORP.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

 

 

See accompanying notes.

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data, unaudited)

 

 

Background and Basis of Presentation

 

WebMD Health Corp. (the “Company”) is a Delaware corporation that was incorporated on May 3, 2005. The Company completed an initial public offering (“IPO”) of Class A Common Stock on September 28, 2005. The Company’s Class A Common Stock has traded on the Nasdaq National Market under the symbol “WBMD” since September 29, 2005 and now trades on the Nasdaq Global Select Market. Prior to the date of the IPO, the Company was a wholly-owned subsidiary of HLTH Corporation (“HLTH”) and its consolidated financial statements had been derived from the consolidated financial statements and accounting records of HLTH, principally representing the WebMD segment, using the historical results of operations, and historical basis of assets and liabilities of the WebMD related businesses. Since the completion of the IPO, the Company has been a majority-owned subsidiary of HLTH, which currently owns 83.1% of the equity of the Company, after accounting for the impact of shares to be issued pursuant to the purchase agreement for the acquisition of Subimo, LLC. The Company’s Class A Common Stock has one vote per share, while the Company’s Class B Common Stock has five votes per share. As a result, the Company’s Class B Common Stock owned by HLTH represented, as of September 30, 2008, 96.2% of the combined voting power of the Company’s outstanding Common Stock.

 

Transactions between the Company and HLTH have been identified in these notes to the consolidated financial statements as Transactions with HLTH (see Note 4).

 

Interim Financial Statements

 

The unaudited consolidated financial statements of the Company have been prepared by management and reflect all adjustments (consisting of only normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the interim periods presented. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the operating results to be expected for any subsequent period or for the entire year ending December 31, 2008. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted under the Securities and Exchange Commission’s rules and regulations.

 

The unaudited consolidated financial statements and notes included herein should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended December 31, 2007, which are included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

 

Seasonality

 

The timing of the Company’s revenue is affected by seasonal factors. Advertising and sponsorship revenue within the Online Services segment are seasonal, primarily as a result of the annual budget approval process of the advertising and sponsorship clients of the public portals. This portion of the Company’s revenue is usually the lowest in the first quarter of each calendar year, and increases during each consecutive quarter throughout the year. The Company’s private portal licensing revenue is historically highest in the second half of the year as new customers are typically added during this period in conjunction with their annual open enrollment periods for employee benefits. Finally, the annual distribution cycle within the Publishing and Other Services segment results in a significant portion of the Company’s revenue in this segment being recognized in the second and third quarters of each calendar year.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Accounting Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The Company bases its estimates on historical experience, current business factors, and various other assumptions that the Company believes are necessary to consider to form a basis for making judgments about the carrying values of assets and liabilities and disclosure of contingent assets and liabilities. The Company is subject to uncertainties such as the impact of future events, economic and political factors and changes in the Company’s business environment; therefore, actual results could differ from these estimates. Accordingly, the accounting estimates used in the preparation of the Company’s financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as the Company’s operating environment changes. Changes in estimates are made when circumstances warrant. Such changes in estimates and refinements in estimation methodologies are reflected in reported results of operations; if material, the effects of changes in estimates are disclosed in the notes to the consolidated financial statements. Significant estimates and assumptions by management affect: revenue recognition, the allowance for doubtful accounts, the carrying value of prepaid advertising, the carrying value of long-lived assets (including goodwill and intangible assets), the carrying value of investments in auction rate securities, the amortization period of long-lived assets (excluding goodwill), the carrying value, capitalization and amortization of software and Web site development costs, the provision for income taxes and related deferred tax accounts, certain accrued expenses and contingencies, share-based compensation to employees and transactions with HLTH.

 

Net Income (Loss) Per Common Share

 

Basic and diluted net income (loss) per common share are presented in conformity with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” In accordance with SFAS No. 128, basic income (loss) per common share has been computed using the weighted-average number of shares of Common Stock outstanding during the periods presented. Diluted income (loss) per common share has been computed using the weighted-average number of shares of Common Stock outstanding during the periods, increased to give effect to potentially dilutive securities.

 

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Included in basic and diluted shares for the three and nine months ended September 30, 2008 is the impact of shares to be issued pursuant to the purchase agreement for the acquisition of Subimo, LLC. The Company deferred the issuance of 640,930 shares of Class A Common Stock (“Deferred Shares”) until December 2008, subject to acceleration in certain circumstances. A maximum of 246,508 of the Deferred Shares may be used to settle any outstanding claims or warranties the Company may have against the seller. For purposes of calculating basic net income per share, the impact of 394,422 shares representing the non-contingent portion of the Deferred Shares was included. The additional Deferred Shares of 246,508 were considered if their effect was dilutive.

 

The Company has excluded certain outstanding stock options, restricted stock and Deferred Shares from the calculation of diluted income (loss) per common share during the periods in which such securities were anti-dilutive. The total number of shares excluded from the calculation of diluted income (loss) per share was 2,446,553 and 5,602,351 for the three and nine months ended September 30, 2008, respectively, and 1,186,855 and 1,252,553 for the three and nine months ended September 30, 2007, respectively.

 

Recent Accounting Pronouncements

 

On October 10, 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) Financial Accounting Standard (“FAS”) Opinion No. 157-3 (“FSP FAS 157-3”). The FSP clarifies the application of FASB Statement No. 157, “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which financial statements have not been issued. The Company believes that its financial assets are in compliance with FSP FAS 157-3.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

On April 25, 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141 (Revised 2007), “Business Combinations,” and other U.S. GAAP. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Company is currently evaluating the impact, if any, that this FSP will have on the Company’s results of operations, financial position or cash flows.

 

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”), a replacement of SFAS No. 141. SFAS 141R is effective for fiscal years beginning on or after December 15, 2008 and applies to all business combinations. SFAS 141R provides that, upon initially obtaining control, an acquirer shall recognize 100 percent of the fair values of acquired assets, including goodwill, and assumed liabilities, with only limited exceptions, even if the acquirer has not acquired 100 percent of its target. As a consequence, the current step acquisition model will be eliminated. Additionally, SFAS 141R changes current practice, in part, as follows: (1) contingent consideration arrangements will be fair valued at the acquisition date and included on that basis in the purchase price consideration; (2) transaction costs will be expensed as incurred, rather than capitalized as part of the purchase price; (3) pre-acquisition contingencies, such as legal issues, will generally have to be accounted for in purchase accounting at fair value; and (4) in order to accrue for a restructuring plan in purchase accounting, the requirements in SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met at the acquisition date. While there is no expected impact to the Company’s consolidated financial statements on the accounting for acquisitions completed prior to December 31, 2008, the adoption of SFAS 141R on January 1, 2009 could materially change the accounting for business combinations consummated subsequent to that date and for tax matters relating to prior acquisitions settled subsequent to December 31, 2008.

 

 

As of December 31, 2007, the Company entered into an Asset Sale Agreement and completed the sale of certain assets and certain liabilities of its medical reference publications business, including the publications ACP Medicine and ACS Surgery: Principles and Practice. The assets and liabilities sold are referred to below as “ACS/ACP Business.” ACP Medicine and ACS Surgery are official publications of the American College of Physicians and the American College of Surgeons, respectively. As a result of the sale, the historical financial information of the ACS/ACP Business has been reclassified as discontinued operations in the accompanying consolidated financial statements for the prior year period. The Company will receive net cash proceeds of $2,809, consisting of $1,734 received in the quarter ended March 31, 2008 and the remaining $1,075 to be received in the quarter ending December 31, 2008. The Company incurred approximately $800 of professional fees and other expenses associated with the sale of the ACS/ACP Business. During 2007, the Company recognized a gain of $3,571, net of a tax benefit of $177. Summarized operating results for the discontinued operations of the ACS/ACP Business for the three and nine months ended September 30, 2007 were as follows:

 

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

On January 1, 2006, the Company adopted SFAS No. 123, (Revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values. The Company elected to use the modified prospective transition method and as a result prior period results were not restated. Under the modified prospective transition method, awards that were granted or modified on or after January 1, 2006 are measured and accounted for in accordance with SFAS 123R. Unvested stock options and restricted stock awards that were granted prior to January 1, 2006 will continue to be accounted for in accordance with SFAS 123, using the same grant date fair value and same expense attribution method used under SFAS 123, except that all awards are recognized in the results of operations over the remaining vesting periods. The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized for all stock-based compensation beginning January 1, 2006.

 

The Company has various stock-based compensation plans under which directors, officers and other eligible employees receive awards of options to purchase Company Class A Common Stock and HLTH Common Stock and restricted shares of Company Class A Common Stock and HLTH Common Stock. The following sections of this note summarize the activity for each of these plans.

 

HLTH Plans

 

Certain WebMD employees participate in the stock-based compensation plans of HLTH (collectively, the “HLTH Plans”). Under the HLTH Plans certain of the Company’s employees have received grants of options to purchase HLTH Common Stock and restricted HLTH Common Stock. Additionally, all eligible WebMD employees were provided the opportunity to participate in HLTH’s employee stock purchase plan through April 30, 2008. All unvested options to purchase HLTH Common Stock and restricted HLTH Common Stock held by the Company’s employees as of the effective date of the IPO continue to vest under the original terms of those awards. An aggregate of 5,936,018 shares of HLTH Common Stock remained available for grant under the HLTH Plans at September 30, 2008.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Stock Options

 

Generally, options under the HLTH Plans vest and become exercisable ratably over a three to five year period based on their individual grant dates subject to continued employment on the applicable vesting dates. The majority of options granted under the HLTH Plans expire within ten years from the date of grant. Options are granted at prices not less than the fair market value of HLTH’s Common Stock on the date of grant. The following table summarizes activity for the HLTH Plans relating to the Company’s employees during the nine months ended September 30, 2008:

 

 

 

 

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatility is based on implied volatility from traded options of HLTH Common Stock combined with historical volatility of HLTH Common Stock. Prior to January 1, 2006, only historical volatility was considered. The expected term represents the period of time that options are expected to be outstanding following their grant date, and was determined using historical exercise data. The risk-free rate is based on the U.S. Treasury yield curve for periods equal to the expected term of the options on the grant date.

 

Restricted Stock Awards

 

HLTH Restricted Stock consists of shares of HLTH Common Stock which have been awarded to the Company’s employees with restrictions that cause them to be subject to substantial risk of forfeiture and restrict their sale or other transfer by the employee until they vest. Generally, HLTH Restricted Stock awards vest ratably over a three to five year period based on their individual award dates subject to continued employment on the applicable vesting dates. There was no activity of non-vested HLTH Restricted Stock relating to the Company’s employees during the nine months ended September 30, 2008.

 

Proceeds received by HLTH from the exercise of options to purchase HLTH Common Stock were $3,383 and $5,816 during the three and nine months ended September 30, 2008, respectively, and $2,044 and $46,363 during the three and nine months ended September 30, 2007, respectively. The intrinsic value related to the exercise of these stock options, as well as the fair value of shares of HLTH Restricted Stock that vested was $2,523 and $3,424 during the three and nine months ended September 30, 2008, respectively, and $1,213 and $16,415 during the three and nine months ended September 30, 2007, respectively.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

WebMD Plans

 

During September 2005, the Company adopted the 2005 Long-Term Incentive Plan (the “2005 Plan”). In connection with the acquisition of Subimo, LLC in December 2006, the Company adopted the WebMD Health Corp. Long-Term Incentive Plan for Employees of Subimo, LLC (the “Subimo Plan”). The terms of the Subimo Plan are similar to the terms of the 2005 Plan but it has not been approved by the Company’s stockholders. Awards under the Subimo Plan were made on the date of the Company’s acquisition of Subimo, LLC in reliance on the NASDAQ Stock Market exception to shareholder approval for equity grants to new hires. No additional grants will be made under the Subimo Plan. The 2005 Plan and the Subimo Plan are included in all references as the “WebMD Plans.” The maximum number of shares of the Company’s Class A Common Stock that may be subject to options or restricted stock awards under the WebMD Plans is 9,480,574, subject to adjustment in accordance with the terms of the WebMD Plans. The Company had an aggregate of 2,440,150 shares of Class A Common Stock available for grant under the WebMD Plans at September 30, 2008.

 

Stock Options

 

Generally, options under the WebMD Plans vest and become exercisable ratably over a four-year period based on their individual grant dates, subject to continued employment on the applicable vesting dates. The options granted under the WebMD Plans expire within ten years from the date of grant. Options are granted at prices not less than the fair market value of the Company Class A Common Stock on the date of grant. The following table summarizes activity for the WebMD Plans during the nine months ended September 30, 2008:

 

 

 

 

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model considering the assumptions noted in the following table. Prior to August 1, 2007, expected volatility was based on implied volatility from traded options of stock of comparable companies combined with historical stock price volatility of comparable companies. Beginning on August 1, 2007, expected volatility is based on implied volatility from traded options of Company Class A Common Stock combined with historical volatility of Company Class A Common Stock. The expected term represents the period of time that options are expected to be outstanding following their grant date, and was determined using historical

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

exercise data. The risk-free rate is based on the U.S. Treasury yield curve for periods equal to the expected term of the options on the grant date.

 

 

Restricted Stock Awards

 

Company Restricted Stock consists of shares of Company Class A Common Stock which have been awarded to employees with restrictions that cause them to be subject to substantial risk of forfeiture and restrict their sale or other transfer by the employee until they vest. Generally, the Company’s Restricted Stock awards vest ratably over a four year period from their individual award dates subject to continued employment on the applicable vesting dates. The following table summarizes the activity of non-vested Company Restricted Stock during the nine months ended September 30, 2008:

 

 

Proceeds received from the exercise of options to purchase Company Class A Common Stock were $1,061 and $3,453 during the three and nine months ended September 30, 2008, respectively, and $2,767 and $8,490 during the three and nine months ended September 30, 2007, respectively. The intrinsic value related to the exercise of these stock options, as well as the fair value of shares of Company Restricted Stock that vested was $3,299 and $5,769 during the three and nine months ended September 30, 2008, respectively, and $8,203 and $15,291 during the three and nine months ended September 30, 2007, respectively.

 

Employee Stock Purchase Plan

 

HLTH’s Employee Stock Purchase Plan (“ESPP”) allowed eligible employees of the Company the opportunity to purchase shares of HLTH Common Stock through payroll deductions, up to 15% of a participant’s annual compensation with a maximum of 5,000 shares available per participant during each purchase period. The purchase price of the stock was 85% of the fair market value on the last day of each purchase period. There were 31,787 and 22,335 shares of HLTH Common Stock issued to the Company’s employees under HLTH’s ESPP during the nine months ended September 30, 2008 and 2007, respectively. The ESPP was terminated after the purchase period ended April 30, 2008.

 

Other

 

At the time of the IPO and each year on the anniversary of the IPO, the Company issued shares of its Class A Common Stock to each non-employee director with a value equal to the director’s annual board and

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

committee retainers. The Company recorded $85 of stock-based compensation expense during the three months ended September 30, 2008 and 2007 and $255 during the nine months ended September 30, 2008 and 2007 in connection with these issuances.

 

Additionally, the Company recorded $279 of stock-based compensation expense during the three months ended September 30, 2008 and 2007, and $837 and $815 during the nine months ended September 30, 2008 and 2007, respectively, in connection with a stock transferability right for shares required to be issued in connection with the acquisition of Subimo, LLC by the Company.

 

Summary of Stock-Based Compensation Expense

 

The following table summarizes the components and classification of stock-based compensation expense:

 

 

As of September 30, 2008, approximately $163 and $30,561 of unrecognized stock-based compensation expense related to unvested awards (net of estimated forfeitures) is expected to be recognized over a weighted-average period of approximately 0.39 years and 1.50 years, related to the HLTH Plans and the WebMD Plans, respectively.

 

 

Agreements with HLTH

 

In connection with the IPO in September 2005, the Company entered into a number of agreements with HLTH governing the future relationship of the companies, including a Services Agreement, a Tax Sharing Agreement and an Indemnity Agreement. These agreements cover a variety of matters, including responsibility for certain liabilities, including tax liabilities, as well as matters related to HLTH providing the Company with administrative services, such as payroll, accounting, tax, employee benefit plan, employee insurance, intellectual property, legal and information processing services.

 

On February 15, 2006, the Tax Sharing Agreement was amended to provide that HLTH would compensate the Company for any use of the Company’s net operating loss (“NOL”) carryforwards resulting from certain extraordinary transactions, as defined in the Tax Sharing Agreement. On September 14, 2006,

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

HLTH completed the sale of its Emdeon Practice Services business (“EPS”) for approximately $565,000 in cash (“EPS Sale”). On November 16, 2006, HLTH completed the sale of a 52% interest in its Emdeon Business Services business (“EBS”) for approximately $1,200,000 in cash (“2006 EBS Sale”). HLTH recognized a taxable gain on the sale of EPS and EBS and utilized a portion of its federal NOL carryforwards to offset the gain on these transactions. Under the Tax Sharing Agreement between HLTH and the Company, the Company was reimbursed for its NOL carryforwards utilized by HLTH in these transactions at the current federal statutory rate of 35%. During February 2007, HLTH reimbursed the Company $140,000 as an estimate of the payment required pursuant to the Tax Sharing Agreement with respect to the EPS Sale and the 2006 EBS Sale, which amount was subject to adjustment in connection with the filing of the applicable tax returns. During September 2007, HLTH finalized the NOL carryforward attributable to the Company that was utilized as a result of the EPS Sale and the 2006 EBS Sale and reimbursed the Company an additional $9,862. These reimbursements were recorded as capital contributions, which increased additional paid-in-capital at December 31, 2006 and September 30, 2007, respectively.

 

In connection with the termination of the merger between HLTH and the Company on October 19, 2008 HLTH and the Company have agreed to amend the Tax Sharing Agreement so that for tax years beginning after December 31, 2007, HLTH will no longer be required to reimburse the Company for use of NOL carryforwards attributable to the Company that may result from certain extraordinary transactions by HLTH. See Note 11 below for a description of the termination of the proposed HLTH Merger. The Tax Sharing Agreement has not, other than with respect to certain extraordinary transactions by HLTH, required either HLTH or the Company to reimburse the other party for any net tax savings realized by the consolidated group as a result of the group’s utilization of the Company’s or HLTH’s NOL carryforwards during the period of consolidation, and that will continue following the amendment. Accordingly, HLTH will not be required to reimburse the Company for use of NOL carryforwards attributable to the Company in connection with (a) HLTH’s sale in February 2008 of its 48% minority interest in EBS to an affiliate of General Atlantic LLC and investment funds managed by Hellman & Friedman LLC for a sale price of $575,000 in cash or (b) HLTH’s sale in July 2008 of its ViPS segment to an affiliate of General Dynamics Corporation for approximately $225,000 in cash. HLTH expects to recognize taxable gains on these transactions and expects to utilize a portion of the Company’s federal NOL carryforward to offset a portion of the tax liability resulting from these transactions. Based upon information available at the time of this filing, the Company’s current estimate is that the NOL carryforwards that were available as of December 31, 2007 will be reduced by an aggregate of approximately $120,000 as a result of HLTH’s utilization of the Company’s NOL carryforwards to offset HLTH’s taxable gains on these transactions. This estimated amount is based on various assumptions and is subject to material change. The actual amount of the Company’s NOL carryforwards that HLTH will utilize cannot be determined until HLTH completes its 2008 income tax calculations.

 

Charges from the Company to HLTH:

 

Revenue:  The Company sells certain of its products and services to HLTH businesses. These amounts are included in revenue during the three and nine months ended September 30, 2008 and 2007. The Company charges HLTH rates comparable to those charged to third parties for similar products and services.

 

Charges from HLTH to the Company:

 

Corporate Services:  The Company is charged a services fee (the “Services Fee”) for costs related to corporate services provided by HLTH. The services that HLTH provides include certain administrative services, including payroll, accounting, tax planning and compliance, employee benefit plans, legal matters and information processing. In addition, the Company reimburses HLTH for an allocated portion of certain expenses that HLTH incurs for outside services and similar items, including insurance fees, outside personnel, facilities costs, professional fees, software maintenance fees and telecommunications costs. HLTH has agreed to make the services available to the Company for up to 5 years following the IPO. These expense allocations

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

were determined on a basis that HLTH and the Company consider to be a reasonable assessment of the costs of providing these services, exclusive of any profit margin. The basis the Company and HLTH used to determine these expense allocations required management to make certain judgments and assumptions. These cost allocations are reflected in the table below under the caption “Corporate services — shared services allocation.” The Services Fee is reflected in general and administrative expense within the accompanying consolidated statements of operations.

 

Healthcare Expense:  The Company is charged for its employees’ participation in HLTH’s healthcare plans. Healthcare expense is charged based on the number of total employees of the Company and reflects HLTH’s average cost of these benefits per employee. Healthcare expense is reflected in the accompanying consolidated statements of operations in the same expense captions as the related salary costs of those employees.

 

Stock-Based Compensation Expense:  Stock-based compensation expense is related to stock option issuances and restricted stock awards of HLTH Common Stock that have been granted to certain employees of the Company. Stock-based compensation expense is allocated on a specific employee identification basis. The expense is reflected in the accompanying consolidated statements of operations in the same expense captions as the related salary costs of those employees. The allocation of stock-based compensation expense related to HLTH Common Stock is recorded as a capital contribution in additional paid-in capital.

 

The following table summarizes the allocations reflected in the Company’s consolidated financial statements:

 

 

 

America Online, Inc.

 

In May 2001, HLTH entered into an agreement for a strategic alliance with Time Warner, Inc. Under the agreement, the Company was the primary provider of healthcare content, tools and services for use on certain America Online (“AOL”) properties. The agreement ended on May 1, 2007. Under the agreement, the Company and AOL shared certain revenue from advertising, commerce and programming on the health channels of the AOL properties and on a co-branded service created for AOL by the Company. The Company was entitled to share in revenue and was guaranteed a minimum of $12,000 during each contract year from May 1, 2005 through May 1, 2007, when the agreement ended, for its share of advertising revenue. Included in revenue was $2,658 during the nine months ended September 30, 2007, related to sales to third parties of advertising and sponsorship on the AOL health channels, primarily sold through the Company’s sales organization. Also included in revenue for the nine months ended September 30, 2007 was revenue of $1,515, related to the guarantee described above.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Fidelity Human Resources Services Company LLC

 

In 2004, the Company entered into an agreement with Fidelity Human Resources Services Company LLC (“FHRS”) to integrate the Company’s private portals product into the services FHRS provides to its clients. FHRS provides human resources administration and benefits administration services to employers. The Company recorded revenue of $2,272 and $7,062 during the three and nine months ended September 30, 2008, respectively, and $2,441 and $7,693 during the three and nine months ended September 30, 2007, respectively. Included in accounts receivable as of September 30, 2008 was $1,159 related to the FHRS agreement.

 

 

The Company provides health information services to consumers, physicians, healthcare professionals, employers and health plans through the Company’s public and private online portals and health-focused publications. The Company’s two operating segments are:

 

 

The performance of the Company’s business is monitored based on earnings before interest, taxes, depreciation, amortization and other non-cash items. Other non-cash items include non-cash advertising expense and non-cash stock-based compensation expense. Corporate and other overhead functions are allocated to segments on a specifically identifiable basis or other reasonable method of allocation. The Company considers these allocations to be a reasonable reflection of the utilization of costs incurred. The Company does not disaggregate assets for internal management reporting and, therefore, such information is not presented. There are no inter-segment revenue transactions.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Summarized financial information for each of the Company’s operating segments and a reconciliation to income (loss) from continuing operations are presented below:

 

 

 

Effective January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), for assets and liabilities measured at fair value on a recurring basis. SFAS 157 establishes a common definition for fair value to be applied to existing GAAP that require the use of fair value measurements, establishes a framework for measuring fair value and expands disclosure about such fair value measurements. The adoption of SFAS 157 did not have an impact on the Company’s financial position or operating results, but did expand certain disclosures.

 

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Additionally, SFAS 157

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

requires the use of valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized below:

 

 

The Company did not have any Level 1 or Level 2 assets as of September 30, 2008. The Company’s Level 3 financial assets that were measured at fair value as of September 30, 2008 were auction rate securities (“ARS”) of $132,848.

 

The following table reconciles the beginning and ending balances of the Company’s Level 3 assets, which consist of the Company’s ARS holdings:

 

 

The Company holds investments in ARS which have been classified as Level 3 assets as described above. The types of ARS holdings the Company owns are backed by student loans, 97% of which are guaranteed under the Federal Family Education Loan Program (FFELP), and all had credit ratings of AAA or Aaa when purchased. Historically, the fair value of the Company’s ARS holdings approximated par value due to the frequent auction periods, generally every 7 to 28 days, which provided liquidity to these investments. However, since February 2008, virtually all auctions involving these securities have failed. The result of a failed auction is that these ARS holdings will continue to pay interest in accordance with their terms at each respective auction date; however, liquidity of the securities will be limited until there is a successful auction, the issuer redeems the securities, the securities mature or until such time as other markets for these ARS holdings develop. During the three months ended March 31, 2008, the Company concluded that the estimated fair value of the ARS no longer approximated the face value due to the lack of liquidity. The securities have been classified within Level 3 as their valuation requires substantial judgment and estimation of factors that are not currently observable in the market due to the lack of trading in the securities.

 

The Company estimated the fair value of its ARS holdings using an income approach valuation technique. Using this approach, expected future cash flows were calculated over the expected life of each security and were discounted to a single present value using a market required rate of return. Some of the more significant assumptions made in the present value calculations were (i) the estimated weighted average lives for the loan portfolios underlying each individual ARS, which range from 4 to 14 years and (ii) the required rates of return used to discount the estimated future cash flows over the estimated life of each security, which considered both the credit quality for each individual ARS and the market liquidity for these investments. As of March 31, 2008, the Company concluded the fair value of its ARS holdings was $141,044 compared to a face value of $168,450. The impairment in value, or $27,406, was considered to be other-than-temporary and, accordingly, was recorded as an impairment charge within the statement of operations during the three months ended March 31, 2008.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In making the determination that the impairment was other-than-temporary, the Company considered (i) the current market liquidity for ARS, particularly student loan backed ARS, (ii) the long-term maturities of the loan portfolios underlying each ARS owned by the Company which, on a weighted average basis, extend to as many as 14 years and (iii) the ability and intent of the Company to hold its ARS investments until sufficient liquidity returns to the auction rate market to enable the sale of these securities or until the investments mature.

 

During the three and nine months ended September 30, 2008, the Company received $2,000 and $3,700, respectively, associated with the partial redemption of certain of its ARS holdings, which represented 100% of their face value. As a result, as of September 30, 2008, the total face value of the Company’s ARS holdings was $165,500. During the three and nine months ended September 30, 2008, the Company reduced the carrying value of its ARS holdings by $4,107 and $5,490, respectively. The Company assessed these declines in fair market value to be temporary as they resulted from fluctuations in interest rate assumptions and, therefore, recorded these declines as unrealized loss in other comprehensive loss in the accompanying consolidated balance sheet.

 

The Company continues to monitor the market for ARS as well as the individual ARS investments it owns. The Company may be required to record additional losses in future periods if the fair value of its ARS holdings deteriorates further.

 

Credit Facility

 

On May 6, 2008, the Company entered into a non-recourse credit facility (the “Credit Facility”) with Citigroup that is secured by the Company’s ARS holdings (including, in some circumstances, interest payable on the ARS holdings), that will allow the Company to borrow up to 75% of the face amount of the ARS holdings pledged as collateral under the Credit Facility. The Credit Facility is governed by a loan agreement, dated as of May 6, 2008, containing customary representations and warranties of the borrower and certain affirmative covenants and negative covenants relating to the pledged collateral. Under the loan agreement, the borrower and the lender may, in certain circumstances, cause the pledged collateral to be sold, with the proceeds of any such sale required to be applied in full immediately to repayment of amounts borrowed.

 

No borrowings have been made under the Credit Facility to date. The Company can make borrowings under its Credit Facility until May 2009. The interest rate applicable to such borrowings will be one-month LIBOR plus 250 basis points. Any borrowings outstanding under the Credit Facility after March 2009 become demand loans, subject to 60 days notice, with recourse only to the pledged collateral.

 

 

Comprehensive income (loss) is comprised of net income (loss) and other comprehensive loss. Other comprehensive loss includes certain changes in equity that are excluded from net income (loss), such as changes in unrealized losses on available-for-sale marketable securities. The following table presents the components of comprehensive income (loss):

 

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The changes in the carrying amount of goodwill for the year ended December 31, 2007 and the nine months ended September 30, 2008 are as follows:

 

 

Intangible assets subject to amortization consist of the following:

 

 

 

 

Amortization expense was $2,406 and $7,397 during the three and nine months ended September 30, 2008, respectively, and $3,320 and $9,853 during the three and nine months ended September 30, 2007, respectively. Aggregate amortization expense for intangible assets is estimated to be:

 

 

 

In the normal course of business, the Company and its subsidiaries are involved in various claims and legal proceedings. While the ultimate resolution of these matters, including those discussed in Note 12 to the Consolidated Financial Statements included in the Company’s 2007 Annual Report on Form 10-K, has yet to be determined, the Company does not believe that their outcomes will have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

 

WEBMD HEALTH CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

On February 20, 2008, HLTH and the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which HLTH would merge into the Company (the “HLTH Merger”), with the Company continuing as the surviving corporation. The Merger Agreement was amended on May 6, 2008 and September 12, 2008. Pursuant to the terms of a Termination Agreement entered into on October 19, 2008 (the “Termination Agreement”), HLTH and the Company mutually agreed, in light of recent turmoil in financial markets, to terminate the Merger Agreement. The termination was by mutual agreement of the companies and was unanimously approved by the Board of Directors of each of the companies and by a special committee of independent directors of the Company. The Termination Agreement maintains HLTH’s obligation, under the terms of the Merger Agreement, to pay the expenses of the Company incurred in connection with the merger. Under the Termination Agreement, HLTH and the Company also agreed to amend its Tax Sharing Agreement with HLTH. See Note 4 above for a description of the amendment to the Tax Sharing Agreement. The Termination Agreement also provided for HLTH to assign to the Company the Amended and Restated Data License Agreement, dated as of February 8, 2008, among HLTH, EBS Master LLC and certain affiliated companies.

 

 

On September 15, 2008, the Company announced that it had entered into a definitive agreement to acquire QualityHealth.com and its owner, Marketing Technology Solutions Inc. (“MTS”). MTS provides on-line performance-based marketing and media programs directed at pharmaceutical and other healthcare related advertisers. The purchase price for MTS is $50 million in cash, payable at closing, and the Company has agreed to pay up to an additional $25 million in cash if certain performance thresholds are achieved relating to calendar year 2009.

 

This Item 2 contains forward-looking statements with respect to possible events, outcomes or results that are, and are expected to continue to be, subject to risks, uncertainties and contingencies, including those identified in this Item. See “Forward-Looking Statements” on page 3.

 

Overview

 

Management’s discussion and analysis of financial condition and results of operations, or MD&A, is provided as a supplement to the consolidated financial statements and notes thereto included elsewhere in this Quarterly Report and is intended to provide an understanding of our results of operations, financial condition and changes in financial condition. Our MD&A is organized as follows:

 

 

In this MD&A, dollar amounts are in thousands, unless otherwise noted.

 

Introduction

 

Our Company

 

We are a leading provider of health information services to consumers, physicians and other healthcare professionals, employers and health plans. We have organized our business into two operating segments as follows:

 

 

 

Termination of Proposed HLTH Merger

 

On October 19, 2008, pursuant to the terms of a termination agreement (which we refer to as the Termination Agreement), HLTH and WebMD mutually agreed, in light of recent turmoil in financial markets, to terminate the Agreement and Plan of Merger, dated as of February 20, 2008, between HLTH and WebMD, as amended by Amendment No. 1, dated as of May 6, 2008, and Amendment No. 2, dated as of September 12, 2008 (which we refer to as the Merger Agreement). The Merger Agreement resulted from negotiations between HLTH and a Special Committee of the Board of Directors of WebMD during late 2007 and early 2008. The termination of the Merger Agreement was by mutual agreement of the companies and was unanimously approved by the Board of Directors of each of the companies and by a special committee of independent directors of WebMD. The Boards determined that both HLTH, as controlling stockholder of WebMD, and the public stockholders of WebMD would benefit from WebMD continuing as a publicly-traded subsidiary with no long-term debt and approximately $340 million in cash and investments. The Boards concluded that, by terminating the merger, HLTH and WebMD would retain financial flexibility and be in a position to pursue potential acquisition opportunities expected to be available to companies with significant cash resources in a period of financial market uncertainty.

 

The Termination Agreement maintains HLTH’s obligation, under the terms of the Merger Agreement, to pay the expenses of WebMD incurred in connection with the merger. Under the Termination Agreement, HLTH and WebMD have also agreed to amend the Amended and Restated Tax Sharing Agreement, dated as of February 15, 2006, between them (which we refer to as the Tax Sharing Agreement) so that, for tax years beginning after December 31, 2007, HLTH will no longer be required to reimburse WebMD for use of net operating loss (which we refer to as NOL) carryforwards attributable to WebMD that may result from certain extraordinary transactions by HLTH. The Tax Sharing Agreement has not, other than with respect to certain extraordinary transactions by HLTH, required either HLTH or WebMD to reimburse the other party for any net tax savings realized by the consolidated group as a result of the group’s utilization of WebMD’s or HLTH’s NOL carryforwards during the period of consolidation, and that will continue following the amendment. The Termination Agreement also provided for HLTH to assign to WebMD the Amended and Restated Data License Agreement, dated as of February 8, 2008, among HLTH, EBS Master LLC and certain affiliated companies.

Recent or Pending Transactions

 

Pending Acquisition of Marketing Technology Solutions Inc.  On September 15, 2008, we announced that we have entered into a definitive agreement to acquire QualityHealth.com and its owner, Marketing Technology Solutions Inc. (which we refer to as MTS). MTS provides on-line performance-based marketing and media programs directed at pharmaceutical and other healthcare related advertisers. The purchase price for MTS is $50,000 in cash, payable at closing, and we have agreed to pay up to an additional $25,000 in cash if certain performance thresholds are achieved relating to calendar year 2009.

 

Sale of ACP Medicine and ACS Surgery.  As of December 31, 2007, we entered into an Asset Sale Agreement and completed the sale of certain assets and certain liabilities of our medical reference publications business, including the publications ACP Medicine and ACS Surgery: Principles and Practice. The assets and liabilities sold are referred to below as the “ACS/ACP Business.” ACP Medicine and ACS Surgery are official publications of the American College of Physicians and the American College of Surgeons, respectively. We will receive net cash proceeds of $2,809, consisting of $1,734 received in the quarter ended March 31, 2008 and the remaining $1,075 to be received in the quarter ending December 31, 2008. We incurred approximately $800 of professional fees and other expenses associated with the sale of the ACS/ACP Business. In connection with the sale, we recognized a gain of $3,571, net of a tax benefit of $177, as of December 31, 2007. The decision to divest the ACS/ACP Business was made because management determined that it was not a good fit with our core business.

 

Other Significant Developments and Trends

 

Impairment of Auction Rate Securities; Non-Recourse Credit Facility.  We hold investments in auction rate securities (which we refer to as ARS) backed by student loans, 97% of which are guaranteed under the Federal Family Education Loan Program (FFELP), and all had credit ratings of AAA or Aaa when purchased. Historically, the fair value of our ARS investments approximated par value due to the frequent auction periods, generally every 7 to 28 days, which provided liquidity to these investments. However, since February 2008, virtually all auctions involving these securities have failed. The result of a failed auction is that these ARS will continue to pay interest in accordance with their terms at each respective auction date; however, liquidity of the securities will be limited until there is a successful auction, the issuer redeems the securities, the securities mature or until such time as other markets for these ARS investments develop. We concluded that the estimated fair value of the ARS no longer approximated the par value due to the lack of liquidity.

 

As of March 31, 2008, we concluded the fair value of our ARS was $141,044, compared to a face value of $168,450. The impairment in value, or $27,406 was considered to be other-than-temporary, and accordingly, was recorded as an impairment charge within the statement of operations during the three months ended March 31, 2008. During the three and nine months ended September 30, 2008, we received $2,000 and $3,700, respectively, associated with the partial redemption of certain of our ARS holdings which represented 100% of their face value. As a result, as of September 30, 2008, the total face value of our ARS holdings was $165,500, compared to a fair value of $132,848. During the three and nine months ended September 30, 2008, we reduced the carrying value of our ARS holdings by $4,107 and $5,490, respectively. We assessed these declines in fair market value to be temporary as they resulted from fluctuations in interest rate assumptions and, therefore, recorded these declines as an unrealized loss in our stockholders’ equity.

 

In May 2008, we entered into a non-recourse credit facility (which we refer to as the Credit Facility) with Citigroup that is secured by its ARS holdings (including, in some circumstances, interest payable on the ARS holdings), that will allow WebMD to borrow up to 75% of the face amount of the ARS holdings pledged as collateral under the Credit Facility. The Credit Facility is governed by a loan agreement, dated as of May 6, 2008, containing customary representations and warranties of the borrower and certain affirmative covenants and negative covenants relating to the pledged collateral. Under the loan agreement, the borrower and the lender may, in certain circumstances, cause the pledged collateral to be sold, with the proceeds of any such sale required to be applied in full immediately to repayment of amounts borrowed.

 

No borrowings have been made under the Credit Facility to date. Borrowings can be made under this Credit Facility until May 2009. The interest rate applicable to such borrowings will be one-month LIBOR plus

250 basis points. Any borrowings outstanding under the Credit Facility after March 2009 become demand loans, subject to 60 days notice, with recourse only to the pledged collateral.

 

HLTH has also entered into a credit facility with Citigroup, on substantially similar terms and conditions.

 

We continue to monitor the market for ARS as well as the individual ARS investments we own. We may be required to record additional losses in future periods if the fair value of our ARS holdings deteriorates further.

 

Use of the Internet by Consumers and Physicians.  The Internet has emerged as a major communications medium and has already fundamentally changed many sectors of the economy, including the marketing and sales of financial services, travel, and entertainment, among others. The Internet is also changing the healthcare industry and has transformed how consumers and physicians find and utilize healthcare information. As consumers are required to assume greater financial responsibility for rising healthcare costs, the Internet serves as a valuable resource by providing them with immediate access to searchable and dynamic interactive content to check symptoms, assess risks, understand diseases, find providers and evaluate treatment options. The Internet has also become a primary source of information for physicians seeking to improve clinical practice and is growing relative to traditional information sources, such as conferences, meetings and offline journals.

 

Increased Online Marketing and Education Spending for Healthcare Products.  Pharmaceutical, biotechnology and medical device companies spend large amounts each year marketing their products and educating consumers and physicians about them; however, only a small portion of this amount is currently spent on online services. We believe that these companies, which comprise the majority of our advertisers and sponsors, are becoming increasingly aware of the effectiveness of the Internet relative to traditional media in providing health, clinical and product-related information to consumers and physicians, and this increasing awareness will result in increasing demand for our services. However, notwithstanding our general expectation for increased demand, our advertising and sponsorship revenue may vary significantly from quarter to quarter due to a number of factors, many of which are not in our control, and some of which may be difficult to forecast accurately, including the following:

 

 

Other factors that may affect the timing of contracting for specific programs with advertisers and sponsors, or receipt of revenue under such contracts, include: the timing of FDA approval for new products or for new approved uses for existing products; the timing of FDA approval of generic products that compete with existing brand name products; the timing of withdrawals of products from the market; seasonal factors relating to the prevalence of specific health conditions and other seasonal factors that may affect the timing of promotional campaigns for specific products; and the scheduling of conferences for physicians and other healthcare professionals.

 

Changes in Health Plan Design; Health Management Initiatives.  In a healthcare market where a greater share of the responsibility for healthcare costs and decision-making has been increasingly shifting to consumers, use of information technology (including personal health records) to assist consumers in making informed decisions about healthcare has also increased. We believe that through our WebMD Health and Benefits Manager tools, including our personal health record application, we are well positioned to play a role in this consumer-directed healthcare environment, and these services will be a significant driver for the growth of our private portals during the next several years. However, our growth strategy depends, in part, on increasing usage of our private portal services by our employer and health plan clients’ employees and members, respectively. Increasing usage of our services requires us to continue to deliver and improve the

underlying technology and develop new and updated applications, features and services. In addition, we face competition in the area of healthcare decision-support tools and online health management applications and health information services. Many of our competitors have greater financial, technical, product development, marketing and other resources than we do, and may be better known than we are. We also expect that, for clients and potential clients in the industries most seriously affected by recent adverse changes in general economic conditions (including those in the financial services industry), we may experience some reductions in initial contracts, contract expansions and contract renewals for our private portal services.

 

The healthcare industry in the United States and relationships among healthcare payers, providers and consumers are very complicated. In addition, the Internet and the market for online services are relatively new and still evolving. Accordingly, there can be no assurance that the trends identified above will continue or that the expected benefits to our businesses from our responses to those trends will be achieved. In addition, the market for healthcare information services is highly competitive and not only are our existing competitors seeking to benefit from these same trends, but the trends may also attract additional competitors.

 

Seasonality

 

The timing of our revenue is affected by seasonal factors. Advertising and sponsorship revenue within our Online Services segment is seasonal, primarily due to the annual budget approval process of the advertising and sponsorship clients of our public portals. This portion of our revenue is usually the lowest in the first quarter of each calendar year, and increases during each consecutive quarter throughout the year. Our private portal licensing revenue is historically higher in the second half of the year as new customers are typically added during this period in conjunction with their annual open enrollment periods for employee benefits. Finally, the annual distribution cycle within our Publishing and Other Services segment results in a significant portion of our revenue in this segment being recognized in the second and third quarters of each calendar year. The timing of revenue in relation to our expenses, much of which do not vary directly with revenue, has an impact on cost of operations, sales and marketing and general and administrative expenses as a percentage of revenue in each calendar quarter.

 

Critical Accounting Policies and Estimates

 

Our MD&A is based upon our unaudited consolidated financial statements and notes to unaudited consolidated financial statements, which were prepared in conformity with U.S. generally accepted accounting principles. The preparation of the unaudited consolidated financial statements requires us to make estimates and assumptions that affect the amounts reported in the unaudited consolidated financial statements and accompanying notes. We base our estimates on historical experience, current business factors, and various other assumptions that we believe are necessary to consider to form a basis for making judgments about the carrying values of assets and liabilities and disclosure of contingent assets and liabilities. We are subject to uncertainties such as the impact of future events, economic and political factors, and changes in our business environment; therefore, actual results could differ from these estimates. Accordingly, the accounting estimates used in preparation of our financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Changes in estimates are made when circumstances warrant. Such changes in estimates and refinements in estimation methodologies are reflected in reported results of operations; if material, the effects of changes in estimates are disclosed in the notes to our unaudited consolidated financial statements.

 

We evaluate our estimates on an ongoing basis, including those related to revenue recognition, the allowance for doubtful accounts, the carrying value of prepaid advertising, the carrying value of long-lived assets (including goodwill and intangible assets), the carrying value of investments in auction rate securities, the amortization period of long-lived assets (excluding goodwill), the carrying value, capitalization and amortization of software and Web site development costs, the provision for income taxes and related deferred tax accounts, certain accrued expenses and contingencies, share-based compensation to employees and transactions with HLTH.

We believe the following reflects our critical accounting policies and our more significant judgments and estimates used in the preparation of our unaudited consolidated financial statements:

 

 

 

 

 

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model. The assumptions used in this model are expected dividend yield, expected volatility, risk-free interest rate and expected term. The expected volatility for stock options to purchase HLTH Common Stock is based on implied volatility from traded options of HLTH Common Stock combined with historical volatility of HLTH Common Stock. Prior to August 1, 2007, expected volatility for stock options to purchase our Class A Common Stock was based on implied volatility from traded options of stock of comparable companies combined with historical stock price volatility of comparable companies. Beginning on August 1, 2007, expected volatility is based on implied volatility from traded options of our Class A Common Stock combined with historical volatility of our Class A Common Stock.

 

 

Substantially all of our NOL carryforwards are reserved for by a valuation allowance. In determining the need for a valuation allowance, management determined the probability of realizing deferred tax

assets, taking into consideration factors including historical operating results, expectations of future earnings and taxable income. Management will continue to evaluate the need for a valuation allowance and, in the future should management determine that realization of the net deferred tax asset is more likely than not, some or all of the valuation allowance will be reversed, and our effective tax rate may be reduced by such reversal.

 

 

Transactions with HLTH

 

Agreements with HLTH

 

In connection with our IPO in September 2005, we entered into a number of agreements with HLTH governing the future relationship of the companies, including a Services Agreement, a Tax Sharing Agreement and an Indemnity Agreement. These agreements cover a variety of matters, including responsibility for certain liabilities, including tax liabilities, as well as matters related to HLTH providing us with administrative services, such as payroll, accounting, tax, employee benefit plan, employee insurance, intellectual property, legal and information processing services.

 

On February 15, 2006, the Tax Sharing Agreement was amended to provide that HLTH would compensate us for any use of our NOL carryforwards resulting from certain extraordinary transactions, as defined in the Tax Sharing Agreement. On September 14, 2006, HLTH completed the sale of its Emdeon Practice Services business (“EPS”) for approximately $565,000 in cash (“EPS Sale”). On November 16, 2006, HLTH completed the sale of a 52% interest in its Emdeon Business Services business (“EBS”) for approximately $1,200,000 in cash (“2006 EBS Sale”). HLTH recognized a taxable gain on the sale of EPS and EBS and utilized a portion of its federal NOL carryforwards to offset the gain on these transactions. Under the Tax Sharing Agreement between HLTH and us, we were reimbursed for our NOL carryforwards utilized by HLTH in these transactions at the current federal statutory rate of 35%. During February 2007, HLTH reimbursed us $140,000 as an estimate of the payment required pursuant to the Tax Sharing Agreement with respect to the EPS Sale and the 2006 EBS Sale, which was subject to adjustment in connection with the filing of the applicable tax returns. During September 2007, HLTH finalized the NOL carryforward attributable to us that was utilized as a result of the EPS Sale and the 2006 EBS Sale and reimbursed us an additional $9,862. These reimbursements were recorded as capital contributions which increased additional paid-in-capital at December 31, 2006 and September 30, 2007, respectively.

 

In connection with the termination of the merger between HLTH and us on October 19, 2008 we and HLTH have agreed to amend the Tax Sharing Agreement so that for tax years beginning after December 31, 2007, HLTH will no longer be required to reimburse us for use of NOL carryforwards attributable to us that may result from certain extraordinary transactions by HLTH. See “— Introduction — Termination of Proposed HLTH Merger” for a description of the termination of the proposed HLTH Merger. The Tax Sharing Agreement has not, other than with respect to certain extraordinary transactions by HLTH, required either HLTH or us to reimburse the other party for any net tax savings realized by the consolidated group as a result of the group’s utilization of our or HLTH’s NOL carryforwards during the period of consolidation, and that will continue following the amendment. Accordingly, HLTH will not be required to reimburse us for use of NOL carryforwards attributable to us in connection with (a) HLTH’s sale in February 2008 of its 48% minority interest in EBS to an affiliate of General Atlantic LLC and investment funds managed by Hellman & Friedman LLC for a sale price of $575,000 in cash or (b) HLTH’s sale in July 2008 of its ViPS segment to an affiliate of General Dynamics Corporation for approximately $225,000 in cash. HLTH expects to recognize taxable gains on these transactions and expects to utilize a portion of our federal NOL carryforwards to offset a portion of the tax liability resulting from these transactions. Based upon information available as of the time

of this filing, we currently estimate that our NOL carryforwards will be reduced by an aggregate of approximately $120,000 as a result of HLTH’s utilization of our NOL carryforwards to offset its taxable gains on these transactions. This estimated amount is based on various assumptions and is subject to material change. The actual amount of our NOL carryforwards that HLTH will utilize cannot be determined until HLTH completes its 2008 income tax calculations.

 

Charges from the Company to HLTH:

 

Revenue:  We sell certain of our products and services to HLTH businesses. These amounts are included in revenue during the three and nine months ended September 30, 2008. We charge HLTH rates comparable to those charged to third parties for similar products and services.

 

Charges from HLTH to the Company:

 

Corporate Services:  We are charged a services fee (the “Services Fee”) for costs related to corporate services provided to us by HLTH. The services that HLTH provides include certain administrative services, including payroll, accounting, tax planning and compliance, employee benefit plans, legal matters and information processing. In addition, we reimburse HLTH for an allocated portion of certain expenses that HLTH incurs for outside services and similar items, including insurance fees, outside personnel, facilities costs, professional fees, software maintenance fees and telecommunications costs. HLTH has agreed to make the services available to us for up to five years following the IPO. These expense allocations were determined on a basis that we and HLTH consider to be a reasonable assessment of the cost of providing these services, exclusive of any profit margin. The basis we and HLTH used to determine these expense allocations required management to make certain judgments and assumptions. These cost allocations are reflected in the table below under the caption “Corporate services — shared services allocation.” The Services Fee is reflected in general and administrative expense within our consolidated statements of operations.

 

Healthcare Expense:  We are charged for our employees’ participation in HLTH’s healthcare plans. Healthcare expense is charged based on the number of our total employees and reflects HLTH’s average cost of these benefits per employee. Healthcare expense is reflected in the accompanying consolidated statements of operations in the same expense captions as the related salary costs of those employees.

 

Stock-Based Compensation Expense:  Stock-based compensation expense is related to stock option issuances and restricted stock awards of HLTH Common Stock that have been granted to certain of our employees. Stock-based compensation expense is allocated on a specific employee identification basis. The expense is reflected in our consolidated statements of operations in the same expense captions as the related salary costs of those employees. The allocation of stock-based compensation expense related to HLTH Common Stock is recorded as a capital contribution in additional paid-in capital.

 

The following table summarizes the allocations reflected in our consolidated financial statements:

 

Recent Accounting Pronouncements

 

On October 10, 2008, the Financial Accounting Standards Board (or FASB) issued FASB Staff Position (“FSP”) Financial Accounting Standard (“FAS”) Opinion No. 157-3 (“FSP FAS 157-3”). The FSP clarifies the application of FASB Statement No. 157, “Fair Value Measurements”, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which financial statements have not been issued. We believe our financial assets are in compliance with FSP FAS 157-3.

 

On April 25, 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141 (Revised 2007), “Business Combinations,” and other U.S. GAAP. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. We are currently evaluating the impact, if any, that this FSP will have on our results of operations, financial position or cash flows.

 

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”), a replacement of SFAS No. 141. SFAS 141R is effective for fiscal years beginning on or after December 15, 2008 and applies to all business combinations. SFAS 141R provides that, upon initially obtaining control, an acquirer shall recognize 100 percent of the fair values of acquired assets, including goodwill, and assumed liabilities, with only limited exceptions, even if the acquirer has not acquired 100 percent of its target. As a consequence, the current step acquisition model will be eliminated. Additionally, SFAS 141R changes current practice, in part, as follows: (1) contingent consideration arrangements will be fair valued at the acquisition date and included on that basis in the purchase price consideration; (2) transaction costs will be expensed as incurred, rather than capitalized as part of the purchase price; (3) pre-acquisition contingencies, such as legal issues, will generally have to be accounted for in purchase accounting at fair value; and (4) in order to accrue for a restructuring plan in purchase accounting, the requirements in FASB SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met at the acquisition date. While there is no expected impact to our consolidated financial statements on the accounting for acquisitions completed prior to December 31, 2008, the adoption of SFAS 141R on January 1, 2009 could materially change the accounting for business combinations consummated subsequent to that date and for tax matters relating to prior acquisitions settled subsequent to December 31, 2008.

Results of Operations

 

The following table sets forth our consolidated statements of operations data and expresses that data as a percentage of revenue for the periods presented:

 

 

Revenue is derived from our two business segments: Online Services and Publishing and Other Services. Our Online Services segment derives revenue from advertising, sponsorship (including online CME services), e-detailing promotion and physician recruitment services, content syndication and distribution, and licenses of private online portals to employers, healthcare payers and others, along with related services including lifestyle education and personalized telephonic coaching. Our Publishing and Other Services segment derives revenue from sales of, and advertising in, our physician directories, and advertisements in WebMD the Magazine. We sold our ACS/ACP Business as of December 31, 2007 and the revenue and expenses of this business are shown in discontinued operations for the three and nine months ended September 30, 2007.

 

Our customers include pharmaceutical, biotechnology, medical device and consumer products companies, as well as employers and health plans. Our customers also include physicians and other healthcare providers who buy our physician directories.

 

Cost of operations consists of costs related to services and products we provide to customers and costs associated with the operation and maintenance of our public and private portals. These costs relate to editorial and production, Web site operations, non-capitalized Web site development costs, and costs related to the production and distribution of our publications. These costs consist of expenses related to salaries and related expenses, non-cash stock-based compensation, creating and licensing content, telecommunications, leased properties, printing and distribution.

 

Sales and marketing expense consists primarily of advertising, product and brand promotion, salaries and related expenses, and non-cash stock-based compensation. These expenses include items related to salaries and related expenses of account executives, account management and marketing personnel, costs and expenses for marketing programs, and fees for professional marketing and advertising services. Also included in sales and marketing expense are the non-cash advertising expenses discussed below.

 

General and administrative expense consists primarily of salaries, non-cash stock-based compensation and other salary-related expenses of administrative, finance, legal, information technology, human resources and

executive personnel. These expenses include costs of general insurance, costs of accounting and internal control systems to support our operations and a services fee for our portion of certain expenses shared across all segments of HLTH.

 

Our discussions throughout this MD&A reference certain non-cash expenses. The following is a summary of our principal non-cash expenses:

 

 

The following table is a summary of our non-cash expenses included in the respective statements of operations captions.