SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended. . . . . . . . . . . . . . . . .June 30, 2004

OR

For the transition period from. . . . . . . . . . . to. . . . . . . . . . .

Commission file number. . . . . . . . . . . . . . . . . . . . 0-13591

HEALTHAXIS INC.

5215 N. O’Connor Blvd., 800 Central Tower, Irving, Texas 75039
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code:   (972) 443-5000

Former name, former address and former fiscal year, if changed since last report:   N/A

     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.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 2,768,291 shares of common stock, par value $.10, outstanding as of August 5, 2004.

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Healthaxis Inc.

Table of Contents

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PART I. FINANCIAL INFORMATION

Item 1.     Condensed Consolidated Financial Statements

Healthaxis Inc. and Subsidiaries

(In thousands except share and per share data) (Unaudited)

See notes to consolidated financial statements.

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Healthaxis Inc. and Subsidiaries

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

See notes to consolidated financial statement

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Healthaxis Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Dollars in thousands) (Unaudited)

See notes to consolidated financial statement

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Healthaxis Inc. and Subsidiaries

Note A – Description of business and basis of presentation

Unaudited Financial Information

     The unaudited condensed consolidated financial statements have been prepared by Healthaxis Inc. and its subsidiaries (“Healthaxis” or the “Company”), pursuant to the rules and regulations of the Securities and Exchange Commission and reflect all adjustments consisting of normal recurring entries, which, in the opinion of the Company, are necessary to present fairly the results for the interim periods. The interim financial statements do not include all disclosures provided in fiscal year end financial statements prepared in accordance with accounting principles generally accepted in the United States, although the Company believes that the accompanying disclosures are adequate to make the information presented not misleading. Results of operations for the six-month period ended June 30, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

     These financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

General

     Healthaxis is a technology-enhanced provider of fully integrated solutions and services for health benefit administrators and health insurance claim processors. These solutions, which are comprised of software products and related business process services, are designed to assist health insurance payers and third party administrators (“TPA”) to provide enhanced services to members, employees, employers and providers at lower cost. These services are provided through the application of Healthaxis’ flexible technology, either on a fully integrated or on an Application Service Provider (“ASP”) basis. These technology solutions are complemented by Healthaxis’ Business Process Outsourcing (“BPO”) services, which are offered to the Company’s technology clients and on a stand-alone basis. BPO solutions include mailroom services and the automated capture, imaging, storage and retrieval of electronic claims, attachments, and related correspondence, in addition to rules-based claims pre-adjudication and automated PPO repricing.

     Healthaxis Inc. is a Pennsylvania corporation, which was organized in 1982. Healthaxis’ common stock trades on the NASDAQ SmallCap Market under the symbol “HAXS.” The operations of Healthaxis are conducted through its subsidiary, Healthaxis, Ltd. Unless otherwise indicated, or the context otherwise requires, all references in this document to the “Company,” “Healthaxis,” “we,” “our” or “us” include Healthaxis Inc. and all of its subsidiaries. Healthaxis maintains a website at www.healthaxis.com. The Healthaxis Code of Conduct can be found on the Healthaxis website. Information found on the Healthaxis website is not a part of this report.

Earnings Per Share

     Basic earnings per share is computed on the weighted average number of common shares outstanding, while the dilutive effect of convertible preferred stock, stock options and warrants is excluded. Diluted earnings per share is computed to show the dilutive effect, if any, of convertible preferred stock, stock options and warrants using the treasury stock method based on the average market price of the stock during the respective periods. The effect of including the convertible preferred stock, stock options and warrants, totaling 6,092,598 and 2,031,359 as of June 30, 2004 and 2003 respectively, into the computation of diluted earnings per share would be anti-dilutive. Accordingly, these items have not been included in the computation. Following is a summary of these securities:

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Stock-Based Compensation

     The Company has elected to continue to utilize the accounting method prescribed by APB Opinion No. 25 “Accounting for Stock Issued to Employees” (APB 25), and provide the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”). Although the Company selected an accounting policy which requires only the excess of the market value of its common stock over the exercise price of options granted to be recorded as compensation expense (intrinsic method), pro forma information regarding net loss is required as if the Company had accounted for its employee stock options under the fair value method of SFAS 123. Pro forma net loss applicable to the option granted is not likely to be representative of the effects on reported net loss for future years. The fair value for these options is estimated at the date of grant using a Black-Scholes option pricing model. Stock compensation determined under the intrinsic method is recognized over the vesting period using the straight-line method.

     Had compensation cost for the Company’s stock option grants been determined based on the fair value at the date granted in accordance with the provisions of SFAS 123, the Company’s net loss and net loss per common share would have been increased to the following pro forma amounts:

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Goodwill

     The carrying value of goodwill at June 30, 2004 is $11.3 million. The Company performs its annual impairment review during the fourth quarter of each year or upon the occurrence of any event that indicates potential impairment. It is possible that the carrying amount of goodwill could be effected in the near term because of the impact that the Company’s continued operating losses could have on the estimates used by management to calculate the fair value of the reporting units.

Segments

     The Company has historically presented information regarding its two segments based on the Company’s internal organizational structure and financial reporting. During the first quarter of 2004, the Company re-aligned its operations under a single operating manager and further consolidated its operations. As a result of this change, the Company now produces consolidated information on the operations of the Company (excluding sales, general and administrative), which is regularly reviewed by the executive management committee of the Company in assessing performance and as an aid in making decisions about how resources are allocated. Accordingly, the Company no longer has reportable segments and has discontinued disclosure of segment information for all periods.

Reverse Stock Split

     On August 19, 2003, the Board of Directors authorized a 1-for-10 reverse stock split of the Company’s $.10 par value common stock. All references in the accompanying financial statements to the number of common shares and per-share amounts for prior periods have been restated to reflect the reverse stock split.

Note B – Recently Adopted Accounting Pronouncements

     On May 19, 2004, the FASB issued Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”, (“FSP No. 106-2”). FSP No. 106-2 is effective for the first interim period beginning after June 15, 2004 and provides that an employer shall measure the accumulated plan benefit obligation (“APBO”) and net periodic postretirement benefit cost taking into account any subsidy received under the Act. The Company is evaluating the impact of the Act’s benefits and subsidies on the Company’s accumulated benefit obligation for postretirement benefits. The Company does not expect that the adoption of the Statement will have a material impact on the Company’s financial condition, results of operations or liquidity.

Note C – Post Retirement Benefits

     Healthaxis has an obligation to provide certain post retirement benefits, primarily lifetime health, dental and life insurance coverage, to a group of individuals consisting of three former executives, 17 retired employees, and the Company’s former Chairman. The following table sets forth the components of net postretirement benefit expense for all plans:

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Note D – Repurchase of Securities Held by UICI and Reducing Conversion Price of Series A Convertible Preferred Stock

     On September 30, 2003, the Company purchased all Healthaxis securities held by UICI for $3.9 million. The UICI holdings included 2,585,769 shares of Healthaxis common stock, or 48.3% of the Company’s then outstanding common stock; 1,424 shares of Series A Convertible preferred stock, or 6.1% of the then outstanding preferred stock; and warrants to purchase 22,240 shares of common stock. The repurchased securities were retired. The total purchase price of $3.9 million included $500,000 cash at closing, and a $3.4 million promissory note, which is due over three years and bears interest at 6%. The promissory note is paid through deductions from the monthly invoices for services provided by the Company to certain UICI subsidiaries. The amount of the monthly payment is equal to the greater of one half of the invoice amount for such services or $65,000. A balloon principal payment is due at the maturity of the note if the note has not been paid through the monthly payments. As of June 30, 2004, the balance due under the promissory note is $3.0 million (of which, $617,000 is classified as short-term).

     To gain the required approval of this transaction from the Series A Preferred shareholders, the Company agreed to reduce the per share conversion price of the then remaining preferred shares from $26.25 to $15.50. The repurchase of the preferred shares held by UICI reduced the total liquidation value of the outstanding Series A preferred stock from $23.5 million to $22.1 million. As described under Note H, the terms of the Series A preferred stock were significantly modified on June 30, 2004.

Note E – Significant Customer Concentrations

     For the three months ended June 30, 2004 and 2003, each of four customers represented greater than 10% of revenues, totaling $2.5 million (63%) and $3.0 million (54%), respectively, of the Company’s total revenues. For the six months ended June 30, 2004 and 2003, these four customers accounted for $5.1 million (63%) and $5.9 million (55%), respectively, of the Company’s total revenues At June 30, 2004 and December 31, 2003, one customer accounted for $814,000 (46%) and $965,000 (30%) of the Company’s accounts receivable, respectively.

Note F – Other Liabilities and Contingencies

     Other liabilities include $1.3 million of contingent tax liabilities at June 30, 2004 and December 31, 2003.

Note G – Related Party Transactions

     Historically, Healthaxis conducted a significant amount of business with a major shareholder, UICI. As further described in Note D above, on September 30, 2003, the Company purchased all Healthaxis securities held by UICI for $3.9 million and UICI is no longer considered an affiliate. Notwithstanding, Healthaxis continues to provide certain services to UICI and its subsidiaries pursuant to written agreements.

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     For the three months ended June 30, 2004 and 2003, UICI and its subsidiaries and affiliates accounted for $397,000 (10%) and $487,000 (9%), respectively, of the Company’s revenues. For the six months ended June 30, 2004 and 2003, UICI and its subsidiaries and affiliates accounted for $811,000 (10%) and $942,000 (9%), respectively, of the Company’s revenues. As of June 30, 2004, Healthaxis had accounts receivable due from UICI and its subsidiaries and affiliates totaling $128,000, which represented 6% of the Company’s total accounts receivable.

Note H – Amendment of Preferred Stock

     Previously, the Company’s Series A Convertible preferred stock (“old”)had a stated value of $22.1 million and was convertible into 1,424,258 shares of Healthaxis common stock at a conversion price of $15.50 per share. The terms of the preferred stock provided that cumulative dividends be paid at the rate of 2%, or approximately $442,000 per year, payable semi-annually. In general, the Company could have paid the dividends either in cash or by issuing shares of common stock, although in some circumstances it was required to pay cash dividends. The terms of the preferred stock provided that in some situations the holders of the preferred stock could have forced Healthaxis to buy back their shares. The Company believed that the occurrence of the situations where it could be required to buy back shares of preferred stock was within its control. The preferred stock also contained, among other things, provisions providing the holders a preference in the payment of dividends and also a liquidation preference equal to at least the stated value of the preferred stock plus all accrued but unpaid dividends. The holders of the preferred stock did not have general voting rights, although they did have the right to vote separately as a class in connection with some matters.

     Healthaxis entered into a Preferred Stock Modification Agreement on May 12, 2004. On June 30, 2004, Healthaxis consummated a transaction modifying the terms of its Series A Convertible preferred stock and resulting in the issuance to its preferred shareholders of warrants to purchase shares of the Company’s common stock. Under the terms of the agreements with the preferred shareholders, shares of the preferred stock (“new”) are convertible into an aggregate of 3,850,000 shares of the Company’s common stock. The preferred shareholders also received warrants with a term of five years entitling them to purchase up to 1,000,000 shares of common stock at an exercise price of $5.50 per share (subject to a cashless exercise feature that applies under some circumstances). The shares of common stock into which the shares of preferred stock are convertible and with respect to which the warrants are exercisable, represent approximately 55% of the common stock on a fully diluted basis as of June 30, 2004. Holders of the preferred stock will have no liquidation preference, no voting rights except as required by law, the right to receive a nominal dividend of $0.0001 per share semi-annually (aggregating less than $1,000 per year in total) and otherwise on a pro rata basis to the extent that dividends are paid to holders of common stock, limited anti-dilution rights in the context of stock splits, stock dividends and similar transactions, and no redemption rights.

     The new preferred stock is convertible into shares of common stock at the option of a preferred shareholder at any time and in any amount on or after June 30, 2005, but prior to that date may only be converted if the preferred shareholder desiring to effect the conversion will not hold as a result of the conversion more than 750,000 shares of common stock or if the common stock is trading on a national stock market and has had a closing price of $8.00 or more for 20 out of the 30 trading days immediately preceding the conversion date (in which case, any number of shares may be converted). Notwithstanding the foregoing, in the event of the transfer of shares of preferred stock in accordance with the terms of the agreements with the preferred shareholders, the preferred stock automatically converts into shares of common stock. Healthaxis may compel conversion of the preferred stock or exercise of the warrants granted to the preferred shareholders under some circumstances.

     Under the agreements with the preferred shareholders, Healthaxis agreed that it will not issue any equity securities in a transaction implying a pre-money valuation of Healthaxis of less than $14.5 million or at a per share price of less than $2.15 (these restrictions do not apply to the grant of stock options to Healthaxis employees or

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directors in most circumstances). Further, until June 30, 2005, the preferred shareholders have a right of first refusal to match the terms upon which any third party proposes to purchase from Healthaxis any equity securities having an aggregate purchase price of at least $1.0 million and to match the terms upon which Healthaxis proposes an offering of its common stock.

     Prior to conversion, the new preferred stock will only have the right to vote to the extent it is entitled to do so under applicable law. Under applicable law, the new preferred stock would be entitled to vote separately as a class in certain instances, including in the event of an amendment to Healthaxis’ articles of incorporation, which may occur should Healthaxis decide to engage in some types of mergers or consolidations. To the extent that the new preferred stock is so entitled to vote, prior to June 30, 2005 the preferred shareholders have agreed to vote their shares in favor of such a merger or consolidation if the common shareholders have approved the merger or consolidation and the per share price to be received by the preferred shareholders in the merger or consolidation is at least $3.50 in cash for each share of preferred stock. If the Company pursues a merger or consolidation on or after June 30, 2005, the preferred shareholders have agreed to vote their shares in favor of the merger or consolidation if the common shareholders approve the merger or consolidation and if the per share price to be received by the preferred shareholders in the merger or consolidation for each share of preferred stock is at least equal to what they would have received in the merger or consolidation if they had converted their shares of preferred stock into shares of common stock immediately prior to the merger or consolidation.

     The agreements require Healthaxis to register for resale the shares of common stock issuable upon conversion of the preferred stock or exercise of the warrants, but place certain restrictions on the private sale or transferability of the securities held by the preferred shareholders, and restrict the number of shares of common stock that may be sold in the public markets below a price of $3.50 per share. These stock transfer restrictions lapse on June 30, 2005.

     The Company estimated the fair value of the new preferred stock at June 30, 2004 to be $4.8 million. The estimate assumes a willing buyer and a willing seller in an arms-length negotiation and considers factors such as the price per share of the common stock on the date of closing, the trading restrictions imposed on the new preferred stock through June 30, 2005 and the marketability of the new preferred stock based upon the number of shares of common stock into which the preferred stock is convertible (55% on an fully diluted basis). The Company estimated the fair value of the warrants to be $815,000 using the Black-Scholes pricing model, based upon volatility of the common stock since the announcement of the preferred stock modification transactions. The $261,000 difference between the carrying value of the old preferred stock of $5.9 million and the fair value of the new preferred stock and warrants has been recorded as additional paid in capital and, in accordance with EITF D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock”, is reflected as carrying amount of preferred stock over fair value of consideration in the statement of operations.

     Additionally, while the old preferred stock had a 2% annual dividend payable semi-annually in January and July, the new preferred stock provides for the payment of a nominal semi-annual dividend (aggregating less than $1,000 per year to all preferred shareholders). In the first quarter of 2004, the Company accrued the $110,000 dividend payable in accordance with the terms of the old preferred stock, but this accrual was reversed in the second quarter of 2004 as a result of the completion of the transaction described above. This amount is also netted out of the net loss applicable to common shareholders on the condensed consolidated statement of operations.

     The Company will not recognize any taxable gain or loss as a result of the closing of the preferred stock modification transaction on June 30, 2004. The closing of the transaction may, however, result in the imposition of substantial limitations on the amount of the Company’s net operating losses that may be applied to any future taxable income of the Company.

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Note I – Significant Contract

     The Company had a contract for software licensing, development and systems implementation with the State of Washington Health Care Authority (“HCA”), which began in mid 2002. For the three months ended June 30, 2004 and 2003, HCA accounted for $0 and $576,000 (10.5%), respectively, of the Company’s revenues. For the six months ended June 30, 2004 and 2003, HCA accounted for $0 and $946,000 (9%), respectively, of the Company’s revenues.

     The Company was the prime contractor on the HCA project and utilized the services of a development partner to perform a significant part of the work. A dispute arose under the HCA contract in late 2003, which has now been resolved by the Company and HCA entering into an agreement to terminate the HCA contract. The Company has also simultaneously entered into a cancellation agreement with its development partner canceling and terminating its master software services agreement with the development partner and the work order associated with subcontracted portions of the HCA project.

     Under the terms of the agreement with HCA, the Company paid HCA $300,000 and transferred title to certain project documentation to HCA. The agreement also contains full mutual releases of all parties including HCA, Healthaxis and the development partner, and an express denial of liability or wrongdoing by all parties.

     Under the terms of the agreement between the Company and its development partner, Healthaxis received $208,000, and any rights the development partner may have in the documentation being transferred by Healthaxis to HCA, resulting in a net cash payment by Healthaxis to HCA of $92,000. The agreement also contains full mutual releases between Healthaxis and the development partner, and an express denial of liability or wrongdoing by either party.

     The Company has entered into these agreements solely to avoid the potential time and cost of dispute resolution. The execution and funding of these agreements, which occurred in the second quarter of 2004, resolves all outstanding issues related to the HCA project. The net impact of these transactions is included in general and administrative expense in the accompanying condensed consolidated statement of operations.

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

Forward-Looking Statements

     All statements other than statements of historical fact contained in this report, including statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” concerning the Company’s financial position and liquidity, results of operations, prospects for future growth, and other matters are forward-looking statements. These statements may be identified with words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “could,” “goal,” “target,” “designed,” “on track,” “comfortable with,” “optimistic” and other similar expressions, and constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors, which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include the risks and uncertainties identified in Healthaxis documents filed with, or furnished to, the Securities and Exchange Commission, including without limitation those identified under the caption “Business—Risk Factors” in the Company’s Form 10-K for the year ended December 31, 2003, and under the caption “Proposal I — Approval of Issuance of Common Stock and Related Securities Transactions-Factors Affecting Current Common Shareholders” in the Company’s Proxy Statement dated June 1, 2004. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on forward-looking statements.

Overview

     Healthaxis is a technology-enhanced provider of fully integrated solutions and services for health benefit administrators and health insurance claim processors. These solutions, which are comprised of software products and related business process services, are designed to assist health insurance payers and third party administrators (“TPA”) provide enhanced services to members, employees, employers and providers at lower cost. These services are provided through the application of Healthaxis’ flexible technology, either on a fully integrated or on an Application Service Provider (“ASP”) basis. These technology solutions are complemented by Healthaxis’ Business Process Outsourcing (“BPO”) services, which are offered to the Company’s technology clients and on a stand-alone basis. BPO solutions include the automated capture, imaging, storage and retrieval of electronic claims, attachments, and related correspondence, in addition to rules-based claims pre-adjudication and automated PPO repricing. Healthaxis uses its deep domain expertise in health insurance operations to surround the payment of a health insurance claim, to customize services to meet the specific needs of its customers and to produce value for those customers by tapping unrealized potential in the customers’ operations to achieve the best results.

     Revenue Model. The Company’s revenues consist primarily of software-use license fees, transaction fees and professional services. These revenue sources are described below.

     A significant portion of the Company’s revenue is based on providing application service provider (ASP) services to our insurance, third-party administrator and self-insured plan customers. The ASP service includes a license to use our software, including hosting, maintenance and support, which is typically charged on a per-employee-per-month (PEPM) or per-member-per-month (PMPM) basis. In addition, the Company surrounds these software-use rights with such services as imaging, data capture and retrieval, EDI and print and mail services. These services are typically charged on a transaction fee basis, such as per claim, per image and per document. Due to the long term nature of the software license under the ASP arrangement and because all revenue elements included in the collective services are typically not sold separately, the ASP service revenues are recognized ratably over the term of the agreement and/or as transaction services are provided. With some exceptions, the Company has not historically sold its software for installation on customers’ systems.

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     In preparation for providing services under these multi-year ASP contracts, the Company also usually contracts to perform certain start-up activities directly related to customizing and configuring the licensed software and loading insurance plan data for performance under the contract. The Company defers costs and revenues relating to these start-up activities and recognizes such costs and revenues ratably over the term of the ASP contract.

     Periodically, while an ASP contract is in place, the Company also performs professional services upon request and recognizes the related revenue on a time and materials basis as services are performed. Such professional services are not sold in conjunction with a software license or other revenue elements and therefore are separate from the sale of software licenses.

     The Company uses contract accounting for contracts where significant software modification is performed or where services are performed that are essential to the functionality of the delivered software. Generally, contracts that include significant software modification are accounted for using the percentage of completion method with progress measured based on the cost-to-cost method. If the ultimate achievement of customer billing milestones is not reasonably assured, revenue recognition is discontinued until those payment milestones have been achieved. The assumptions used for recording revenue are adjusted in the period of change to reflect revisions. Contracts with significant customer acceptance provisions are recognized using the completed contract method upon achieving customer acceptance of the completed project. The cumulative impact of any revision in estimates of the percent complete or recognition of losses on loss contracts is generally reflected in the period in which the changes or losses become known. The Company currently has no contracts in progress for which contract accounting is being applied.

     Significant Project Update:

     As previously disclosed, the Company had a contract for software licensing, development and systems implementation with the State of Washington Health Care Authority (“HCA”), which began in mid 2002. The Company was the prime contractor on the HCA project and utilized the services of a development partner to perform a significant part of the work. Also, as previously disclosed, a dispute arose under the HCA contract in late 2003, which has now been resolved by the Company and HCA entering into an agreement to terminate the HCA contract. The Company has also simultaneously entered into a cancellation agreement with its development partner canceling and terminating its master software services agreement with the development partner and the work order associated with subcontracted portions of the HCA project.

     Under the terms of the agreement with HCA, the Company paid HCA $300,000 and transferred title to certain project documentation to HCA. The agreement also contains full mutual releases of all parties including HCA, Healthaxis and the development partner, and an express denial of liability or wrongdoing by all parties.

     Under the terms of the agreement between the Company and its development partner, Healthaxis received $208,000 and any rights the development partner may have in the documentation being transferred by Healthaxis to HCA, resulting in a net cash payment by Healthaxis to HCA of $92,000. The agreement also contains full mutual releases between Healthaxis and the development partner, and an express denial of liability or wrongdoing by either party.

     The Company has entered into these agreements solely to avoid the potential time and cost of dispute resolution. The execution and funding of these agreements, which occurred in the second quarter of 2004, resolves all outstanding issues related to the HCA project. The net impact of these transactions is included in general and administrative expense in the accompanying condensed consolidated statement of operations.

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Goodwill

     The carrying value of goodwill at June 30, 2004 is $11.3 million. The Company performs its annual impairment review during the fourth quarter of each year or upon the occurrence of any event that indicates potential impairment. It is possible that the carrying amount of goodwill could be effected in the near term because of the impact that the Company’s continued operating losses could have on the estimates used by management to calculate the fair value of the reporting units.

Segments

     The Company has historically presented information regarding two segments based on the Company’s internal organizational structure and financial reporting. During the first quarter of 2004, the Company re-aligned its operations under a single operating manager and further consolidated the operations. As a result of this change, the Company now produces consolidated information on the operations (excluding sales, general and administrative), which is regularly reviewed by the executive management committee of the Company in assessing performance and as an aid in making decisions about how resources are allocated. Accordingly, the Company no longer has reportable segments and has discontinued disclosure of segment information for all periods.

Critical Accounting Policies

     Critical accounting policies are those which are most important to the financial statement presentation and that require the most difficult, subjective complex judgments. There have been no changes in the Company’s critical accounting policies as described in the Company’s Form 10-K for the year ended December 31, 2003.

Results of Operations

Three months ended June 30, 2004 compared to three months ended June 30, 2003

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     Revenues were down approximately $1.6 million (29%) in the three months ended June 30, 2004 compared to the same period in 2003. Cessation of work on the State of Washington project, as more fully described under “ – Overview- Significant Project Update” above, accounted for $576,000 of the reduction. Customers in a terminated or in a run-off stage resulted in a reduction in recurring PEPM license fees of $146,000, while other reductions in the number of covered lives administered by our clients was largely offset by increased revenues from new data mining services. Transaction fee revenue decreased $376,000 as a result of the consolidation of print and mailings across certain customers, and as a result of the decreased number of covered lives. Bundling of checks to the same provider of medical services and combining multiple payers into the same envelope for mailing, resulted in decreased print and mailing revenue. This evolution was necessary to remain competitive within the industry. Professional service fees decreased $239,000 as a result of decreased customer dependence upon our technical staff and a decrease in the number of one-time projects, compared to the same period in 2003. Data capture service revenue declined $214,000 as a result of lower claims volume and, in part, to the reduced number of lives covered by certain customers which also use our data capture services.

     Cost of revenues includes all expenses directly associated with the production of revenue, and consists primarily of salaries and related benefits, rent, amortization and depreciation, system expenses such as maintenance and repair, as well as other related consumables. Cost of revenues declined $951,000 (19%) in the three months ended June 30, 2004 compared to the same period in 2003. Cost of revenues was 103% of revenues in 2004 compared to 91% in 2003. Many of the components of cost of revenues are fixed expenses that did not decline proportionately with revenue. Approximately $500,000 of the cost decline was related to termination of the contract labor associated with the State of Washington project, which was underway in 2003. An additional $144,000 of the decline was due to reduced amortization and depreciation expenses resulting from a decline in capital spending for property, plant and equipment over the last three years. The remaining reduction was largely the result of lower costs for salary, benefits, travel and other expenses associated with personnel.

     Sales and marketing expenses consist primarily of employee salaries and related benefits, as well as promotional costs such as direct mailing campaigns, trade shows and media advertising. Company wide sales and marketing expenses increased $58,000 (20%) in the three months ended June 30, 2004 compared to the same quarter of 2003. The increase is primarily due to additional personnel expenses related to sales and marketing management and staff additi