Systems Xcellence Inc. (the “Company”) is a leading provider of healthcare information technology solutions and services to providers, payers and other participants in the pharmaceutical supply chain in North America. The Company’s product offerings include a wide range of pharmacy benefit management services and software products for managing prescription drug programs and for drug prescribing and dispensing. The Company’s solutions are available on a license basis with on-going maintenance and support or on a transaction fee basis using an Application Service Provider (“ASP”) model. The Company’s payer customers include over 70 Managed Care Organizations, Blue Cross Blue Shield organizations, government agencies, employers and intermediaries such as Pharmacy Benefit Managers. The Company’s provider customers include over 1,400 independent, regional chain, institutional, and mail-order pharmacies. The solutions offered by the Company’s services assist both payers and providers in managing the complexity and reducing the cost of their prescription drug programs and dispensing activities.

The Company’s revenue is primarily derived from transaction processing services, software license sales, hardware sales, maintenance, and professional services. Revenue from transaction processing includes ASP and switching services and is recognized as services are provided. Revenue from software licenses and hardware sales is recognized when a license agreement is executed with the customer, the software or hardware product has been delivered, the amount of the fees to be paid by the customer is fixed and determinable, and collection of these fees is deemed probable. Fees are reviewed for arrangements with significant payment due beyond normal trading terms to evaluate whether they are fixed or determinable. If a fee is not fixed or determinable, revenue is recognized as the payments become due from the customer. If collectibility is not considered probable, revenue is recognized when the fee is collected. In cases where collectibility is not deemed probable, revenue is recognized upon receipt of cash, assuming all other criteria have been met. Maintenance and professional services revenues are recognized as the services are performed. Professional services revenue attributed to fixed price arrangements is recognized using the percentage-of-completion method where reasonably dependable estimates of progress toward completion of a contract can be made. For arrangements that are not fixed price arrangements, both the license revenue and professional services revenue are recognized upon delivery of services. For more information on our revenue recognition policies see ‘‘Critical Accounting Policies and Estimates.’’

The Company’s expenses primarily consist of cost of sales, product development costs and selling, general and administrative (“SG&A”) costs. Cost of sales includes costs related to the products and services provided to customers and costs associated with the operation and maintenance of the transaction processing centers. These costs include salaries and related expenses for professional services personnel, transaction processing centers’ personnel, customer support personnel and any hardware or equipment sold to customers. Product development costs consist of staffing expenses in support of the payer and provider products. In general, such costs are not directly related to specific customer products or deliverables, but rather to enhancements and new initiatives. SG&A costs relate to selling expenses, commissions, marketing, network administration and administrative costs, including legal, accounting, investor relations and corporate development costs.

For the three months ended March 31, 2007, the Company’s financial position and growth prospects continued to strengthen in a number of key areas.

During the first three months of 2007, the Company continued to build its customer base with the addition of two new customers, Georgia Department of Community Health and Kroger Corporation. In addition, the Company enjoyed continued growth in its Medicare Part D processing volumes due to growth in the number of new enrollees for the 2007 year.

Recurring revenues remained a cornerstone of the Company’s business model. Growth in revenue from recurring sources has been driven primarily by growth in the Company’s transaction processing business in the form of claims processing and pharmacy benefit administrative services (InformedRx) for its payer customers and switching services for its provider customers. Through the Company’s transaction processing business, where the Company is generally paid on a volume basis, the Company continues to benefit from the growth in pharmaceutical drug use in the United States. The Company believes that aging demographics and increased use of prescription drugs will continue to benefit the transaction processing business. In addition to benefiting from this industry growth, the Company continues to focus on increasing the transaction processing segment of recurring revenue by adding new transaction processing customers to its existing customer base.

For the three months ended March 31, 2007, recurring revenue represented 74% of total revenue as compared to 64% for the same period last year. Recurring revenue increased 44% to $17.9 million for the three months ended March 31, 2007 from $12.4 million for the three months ended March 31, 2006. This increase is due primarily to growth in the transaction processing business (including InformedRx), the claims processing and pharmacy benefit management services for the Company’s payer customers and switching and maintenance services for provider customers.

Transaction processing revenue for the three months ended March 31, 2007 increased $5.1 million, or 58%, as compared to the comparable period in 2006 due to growth in volumes from existing clients as well as the addition of new clients, most notably Georgia Department of Community Health and Kroger Corporation.

Total revenue increased $5.0 million, or 26%, to $24.3 million for the first three months of 2007 from $19.3 million for the same period last year.

Transaction processing revenue (consisting of claims adjudication, benefits processing, and switching revenue) increased $5.1 million, or 58%, due to the addition of new clients as well as growth in volumes from existing clients.

Maintenance revenue (consisting of hardware and software maintenance and certain pharmacy services) increased $0.4 million, or 11%, for the first three months of 2007 primarily due to the increase in system sales compared to the prior year.

Professional services revenue decreased $1.1 million, or 24%, primarily due to a significant number of implementations and custom services being performed in the first quarter of 2006 relating to Medicare Part D processing for many clients.

 

Systems sales revenue (consisting of hardware and software license revenue) increased $0.6 million, or 22%, primarily due to upgrades for existing clients with tiered license upgrade fees, which are linked to the transaction processing volumes and the result of work performed for customers under the Medicare Part D program.

On a percentage basis, recurring revenue accounted for 74% and 64% of consolidated revenue for the first three months of 2007 and 2006, respectively. Recurring revenue consists of transaction processing and maintenance revenue.

Gross profit margin was 62% for the first three months of 2007 compared to 61% for the first three months of 2006. This increase was primarily due to an increase in higher-margin transaction processing revenue and a decrease in lower-margin professional services revenue.

 

Product development costs for the first three months 2007 were $2.9 million, representing 12% of revenue, compared to $2.1 million, or 11% of revenue for the same period last year. The increase is the result of increased utilization of the Company’s employees for development of new products, as opposed to focusing on professional services projects.

SG&A costs for the first three months of 2007 were $5.9 million, or 24% of revenue, compared to $3.9 million, or 20% of revenue, for the first three months of 2006. The increase as a percentage of revenue is due primarily to the expansion of the Company’s operations and increased public reporting costs as a result of the listing of the Company’s shares in the U.S. In addition, higher insurance, consulting, infrastructural and recruiting expenses in support of the Company’s growth contributed to the increase.

SG&A costs for the first three months of 2007 included rental expense for both the Lombard and new Lisle, Illinois facilities as the Company’s lease with the Lombard facility was terminated effective March 31, 2007. Also, the addition of sales and management resources during the latter part of 2006 and early 2007 to address the growing market penetration of the Company contributed to the increase SG&A costs.

Depreciation and amortization expenses increased $0.4 million to $1.3 million for the first three months of 2007 from $0.9 million for the first three months of 2006 due primarily to the purchase of capital assets related to the build-out of the Company’s locations in Scottsdale, Arizona and Lisle, Illinois. In addition, the Company incurred additional expenses related to data center hardware purchases resulting from an increase in data center capacity to support the Company’s higher transaction volume.

In March 2006, the Company entered into a new operating lease for office space in Lisle, Illinois. The lease is effective February 1, 2007 and carries a term of 11 years. The Company gave notice to the lessor of the Company’s office located in Lombard, Illinois, to terminate the lease effective March 31, 2007, which termination was subject to an early termination fee of $0.8 million. The Company received $0.8 million from its new landlord and subsequently paid for the lease termination fee which was expensed in the first quarter of 2006.

The Company accounts for all stock-based payments to employees and non-employees using the fair value based method. Under the fair value based method, compensation cost is measured at fair value on the grant date and recognized over the vesting period. Stock-based compensation expense for the first three months of 2007 decreased to $0.4 million from $0.5 million for the same period last year. This decrease was due to fewer options granted during the first three months of 2007 compared to the first three months of 2006.

Interest income increased to $1.1 million for the first three months of 2007 from $0.5 million for the first three months of 2006 due to additional cash balances available for investment from the Company’s equity offerings in November 2005 and June 2006. Interest expense was $31,000 for the first three months of 2007 and $0.4 million for the same period last year. In July 2006, the Company repaid its long-term debt obligation using proceeds from the equity offering.

The Company reported net income of $3.7 million, or $0.17 per share (fully-diluted), for the first three months of 2007 compared to net income of $5.6 million, or $0.31 per share (fully-diluted), for the same period last year. The $1.9 million decrease in net income was primarily due to an increase in gross profit of $3.3 million, an increase in net interest income of $0.9 million, partially offset by an increase in the following: product development costs ($0.8 million), SG&A costs ($2.0 million), depreciation and amortization ($0.4 million), income taxes ($3.6 million), in addition to a one-time loss on disposal of capital assets of $0.1 million. Net income for the first three months of 2006 included a one-time lease termination charge of $0.8 million.

The increase in revenue was generated primarily from growth in the Company’s transaction processing revenue and consulting, implementation and system sales related to the addition of new clients, and growth in the volume of business from existing clients. The increase in project costs was required to support the Company’s revenue growth. The increase in SG&A costs related primarily to the Company’s increased public reporting costs, insurance, consulting, infrastructural and recruiting fees.

The Company reports its financial results in accordance with generally accepted accounting principles (“GAAP”). The Company’s management also evaluates and makes operating decisions using various other measures. Two such measures are book of business and adjusted EBITDA, which are non-GAAP financial measures. The Company’s management believes that these measures provide useful supplemental information regarding the performance of its business operations.

Book of business is management’s estimate of the total revenue expected to be recognized over future periods generally not exceeding three years based on the existing portfolio of in-place contracts at a point in time. It is composed of two components: (1) revenue expected to be recognized over such period from in-place renewable contracts related to transaction processing and maintenance contracts described as recurring revenues in the above discussion; and (2) revenue expected to be recognized from in-place professional services and systems sales contracts described as non-recurring revenues in the above discussion. The Company’s book of business at any time does not indicate demand for the Company’s products and services and may not reflect actual revenue for any period in the future.

Adjusted EBITDA is a non-GAAP measure that management believes is a useful supplemental measure of operating performance prior to net interest income (expense), income taxes, depreciation, amortization, stock-based compensation, debt service, and certain other one-time charges. Management believes it is useful to exclude depreciation, amortization and net interest income (expense) as these are essentially fixed amounts that cannot be influenced by management in the

short term. In addition, management believes it is useful to exclude stock-based compensation as this is not a cash expense. Lastly, debt service and certain other one-time charges (including lease termination charges and losses on disposals of capital assets) are excluded as these are not recurring items.

Management believes that adjusted EBITDA provides useful supplemental information to management and investors regarding the performance of the Company’s business operations and facilitates comparisons to its historical operating results. Management also uses this information internally for forecasting and budgeting as it believes that the measure is indicative of the Company’s core operating results. Note however, that adjusted EBITDA is a performance measure only, and it does not provide any measure of the Company’s cash flow or liquidity. Non-GAAP financial measures should not be considered as a substitute for measures of financial performance in accordance with GAAP, and investors and potential investors are encouraged to review the reconciliation of adjusted EBITDA.

Adjusted EBITDA does not have a standardized meaning prescribed by GAAP. The Company's method of calculating adjusted EBITDA may differ from the methods used by other companies and, accordingly, it may not be comparable to similarly titled measures used by other companies. Reconciliation of adjusted EBITDA to net income is shown below:

On June 5, 2006, the Company effected a four-to-one share consolidation, unless otherwise stated, all share data contained herein reflects such share consolidation.

As of April 30, 2007, there were 20,612,482 common shares issued and outstanding and 1,881,677 options outstanding, of which 1,251,348 are currently exercisable. There are no warrants or compensation options that are convertible into common stock.

The following table provides summary quarterly results (unaudited) for the eight quarters prior to and including the quarter ended March 31, 2007 (US dollars in thousands except per share data):

Revenue has steadily increased from $12.2 million to $24.3 million between the second quarter of 2005 and the first quarter of 2007. The significant increase in the first quarter of 2006 was primarily due to increased transaction processing related to new customers as well as volume increases and system sales relating to Medicare Part D starting in the first quarter of 2006.

Recurring revenue has increased over the past eight quarters from $8.4 million to $17.9 million as a result of increased transaction processing revenue from the introduction of Medicare Part D prescription benefit coverage in the first quarter of 2006, new payer customers choosing the Company’s outsourced transaction processing offering, as well as the organic growth of existing payer customers.

The recurring revenue percentage from the third and fourth quarters of 2005 were down compared to prior quarters primarily because both quarters had a larger mix of systems sales and professional services related to Medicare Part D recognized during those two quarters. The recurring revenue percentage increased in the first two quarters of 2006 primarily due to higher transaction processing volumes. The recurring revenue percentage increased to 74% for the first quarter of 2007due primarily to the growth in the transaction processing business, the claims processing and pharmacy benefit management services for the Company’s payer customers, and switching and maintenance services for provider customers.

Operating income steadily increased from $1.3 million for the second quarter of 2005 to $3.8 million for the fourth quarter of 2005. Operating income declined for the first and second quarters of 2006 primarily due to the recognition of a one-time lease termination fee of $0.8 million. Operating income steadily increased in the second, third and fourth quarters of 2006 primarily due to increased recurring revenue resulting from increased transaction volumes. Operating income increased from the fourth quarter of 2006 to the first quarter of 2007 primarily due to an increase in recurring revenue.

Net income increased from $1.5 million for the second quarter of 2005 to $5.6 million for the first quarter of 2006. Net income in the first quarter of 2006 was positively impacted by the recognition of $2.5 million of future tax assets (“FTAs”) related to future taxable benefits that were determined by management to “more likely than not” to be realized in the future.

Net income decreased $3.5 million between the first and second quarters of 2006 primarily due to the recognition of the FTAs of $2.5 million in the first quarter of 2006, as well as the Company being fully taxable in the second and third quarters of 2006.

Net income increased $0.5 million between the second and third quarters of 2006 primarily due to an increase in revenue of $2.5 million, offset by increased costs of sales, increased income taxes and $1.0 million in early termination payments related to the repayment of long-term debt and the write-off of the unamortized deferred financing costs.

Net income steadily increased from $2.5 million for the third quarter of 2006 to $3.7 million for the first quarter of 2007 primarily due to increased in revenue, partially offset by increased costs of sales and increased taxes.

As of March 31, 2007, the Company had $77.0 million of cash and cash-equivalents compared to $70.9 million of cash and cash-equivalents at December 31, 2006. The $6.1 million improvement in the Company’s cash position was primarily the result of $9.8 million of cash generated from operating activities, $0.8 million of cash generated from financing activities, which was partially offset by $4.6 million of cash used in investing activities.

During the first three months of 2007, the Company generated $9.8 million of cash through its operations, which primarily consisted of net income of $3.7 million adjusted for $1.4 million in amortization of capital and intangible assets, $0.4 million in stock-based compensation expense, $0.4 million in future tax expense, a $3.9 million dollar increase in working capital, and a $0.1 million net loss on the disposal of capital assets. This is compared to cash generated from operations of $1.8 million in 2006, which primarily consisted of $5.6 million of net income, offset by $0.9 million in amortization of capital and intangible assets, $0.5 million in stock-based compensation expense, a future tax asset decrease of $2.6 million, and a $2.6 million decrease in non-cash working capital.

During the first three months of 2007, the increase in working capital was due primarily to increases in pharmacy benefit claim payments payable of $2.8 million and in pharmacy benefit management rebates payable of $1.3 million. Both amounts represent cash received by the Company that is due to its customers. The increase is due to the timing of the cash receipt by the Company and subsequent payment to its customers.

During the first three months of 2007, the Company generated $0.8 million of cash from financing activities, which primarily consisted of cash received from the exercise of stock options. This is compared to cash used during 2006 of $0.2 million of cash from financing activities, which primarily consisted of the repayment of debt of $0.3 million, partially offset by cash received from the exercise of options.

During the first three months of 2007, the Company used $4.6 million of cash for investing activities, which consisted of capital purchases to support increased ASP activity and the cost of the relocation to new facilities. This is compared to cash used during 2006 of $1.4 million, consisting primarily of capital purchases to support increased ASP activity related to Medicare Part D.

The Company has no off balance sheet arrangements or derivative financial instruments.

The Company has classified its cash and cash equivalents as held-for-trading as the balance represents a medium of exchange. The Company’s amounts receivable are classified as loans and receivables and its amounts payable and accrued liabilities are classified as other liabilities. Due to the immediate or short-term maturity of these financial instruments, their carrying values are estimated to approximate their fair values. As a result, no adjustments to the Company’s consolidated financial statements were made for the period ended March 31, 2007.

At January 1, 2007 and March 31, 2007, the Company has no derivative financial instruments.

The adoption of the standard did not have a material impact on the Company’s consolidated financial statements.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the period. Significant items subject to such estimates and assumptions include revenue recognition, purchase price allocation in connection with acquisitions, the carrying amount of capital assets, intangibles, goodwill, and valuation allowances for receivables and future income taxes. Actual results could differ from those estimates.

The Company's revenue is derived from transaction processing services, systems sales, including software license sales and hardware sales, maintenance, and professional services.

The Company recognizes revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service or product has been provided to the customer; (3) the collection of fees is reasonably assured; (4) the amount of fees to paid by the customer is fixed or determinable; and (5) no uncertainties exist surrounding product acceptance.

Switching services include transaction processing services, and the revenue is recognized as the services are performed.

Typically, software license agreements are multiple element arrangements as they also include professional services, related maintenance, hardware, and/or implementation services fees. Arrangements that include consulting services are evaluated to determine whether those services are considered essential to the functionality of the software.

When services are not considered essential to the functionality of the software, the entire arrangement fee is allocated to each element in the arrangement based on the respective vendor specific objective evidence (“VSOE”) of the fair value of each element. VSOE used in determining the fair value of license revenues is based on the price charged by the Company when the same element is sold in similar volumes to a customer of similar size and nature on a stand-alone basis. VSOE used in determining fair value for installation, integration and training is based on the standard daily rates for the type of services being provided multiplied by the estimated time to complete the task. VSOE used in determining the fair value of maintenance and technical support is based on the annual renewal rates. The revenue allocable to the consulting services is recognized as the services are performed. In instances where VSOE exists for undelivered elements but does not exist for delivered elements of a software arrangement, the Company uses the residual method of allocation of the arrangement fees for revenue recognition purposes.

Goodwill is the residual amount that results when the purchase price of an acquired business exceeds the sum of the amounts allocated to the assets acquired, less liabilities assumed, based on their fair values. Goodwill is allocated as of the date of the business combination to the Company’s reporting units that are expected to benefit from the synergies of the business combination.

Goodwill is not amortized but is tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset might be impaired. The impairment test is carried out in two steps. In the first step, the carrying amount of the reporting unit is compared with its fair value. When the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary. The second step is carried out when the carrying amount of a reporting unit exceeds its fair value, in which case the implied fair value of the reporting unit's goodwill is compared with its carrying amount to measure the amount of the impairment loss, if any. The implied fair value of goodwill is determined in the same manner as the value of goodwill is determined in a business combination using the fair value of the reporting unit as if it was the purchase price. When the carrying amount of reporting unit goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess and is presented as a separate line item in the consolidated statement of operations. The Company completed its goodwill impairment test at December 31, 2006 and 2005 and determined no impairment existed.

Long-lived assets, including capital assets and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. At March 31, 2007, no events or circumstances had occurred that suggested that the carrying amounts of the long-lived asset may not be recoverable.

The Company uses the asset and liability method of accounting for income taxes. Future tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss carryforwards. Future tax assets and liabilities are measured using enacted or substantively enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. The effect on future tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the date of enactment or substantive enactment.

In assessing the realizability of future tax assets, management considers whether it is more likely than not that some portion or all the future tax assets will not be realized. The ultimate realization of future tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible. Management considers projected future taxable income, uncertainties related to the industry in which the Company operates and tax planning strategies in making this assessment.

Additional information regarding the Company’s financial statements and activities, including the Company’s annual information form, are available at www.sedar.com.

 

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