MEDE Medecision (MM)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x         QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

OR

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934

For the transition period from                   to                

Commission File Number 001-33191

MEDecision, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code: (610) 540-0202

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filed, 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 x

As of August 11, 2008, 16,361,869 shares of the registrant’s common stock, no par value per share, were outstanding.

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PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements

MEDECISION, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements.

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MEDECISION, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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MEDECISION, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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MEDECISION, INC.

Notes to Consolidated Financial Statements

(in thousands, except share and per share data)

(unaudited)

(1)        Basis of Presentation

The accompanying unaudited interim financial statements as of and for the three and six months ended June 30, 2008 and 2007 of MEDecision, Inc. and its wholly-owned subsidiaries (collectively the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading.

It is suggested that these interim financial statements be read in conjunction with the financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K.

In the opinion of management, the accompanying unaudited financial statements reflect all adjustments, which include all normal recurring adjustments, necessary to present fairly the Company’s interim financial information. The interim financial information presented is not necessarily indicative of the results to be expected for the entire year ending December 31, 2008.

(2)                        Merger Agreement

O n June 17, 2008, the Company, Health Care Service Corporation, a Mutual Legal Reserve Company, an Illinois corporation (“HCSC”), and Mercury Acquisition Corp., a Pennsylvania corporation and a wholly-owned subsidiary of HCSC (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which Merger Sub will merge with and into the Company and the Company will become a wholly-owned subsidiary of HCSC (the “Merger”). The following description of the Merger Agreement does not purport to be a complete description and is qualified in its entirety by reference to the full text of the Merger Agreement, which was filed with the Securities and Exchange Commission (“SEC”) as Exhibit 2.1 to a Current Report on Form 8-K on June 18, 2008.

If the Merger is completed, each outstanding share of the Company’s common stock will be converted into the right to receive $7.00 in cash (the “Merger Consideration”), without interest and less any required withholding taxes. Except for (i) options to purchase an aggregate of 176,975 shares of the Company’s common stock, which will terminate upon consummation of the merger without any further payment rights, and (ii) options to purchase an aggregate of 60,000 shares of the Company’s common stock held by one of its key management employees, which will be converted into a post-closing payment right, upon the effective time of the merger each option to purchase the Company’s common stock outstanding immediately prior to the effective time of the merger will be cancelled, and the holder of each such option will be entitled to receive, in full settlement and cancellation of such option, a cash payment equal to the product of the number of shares subject to such option multiplied by the excess, if any, of (a) $7.00 less (b) the exercise price per share of such option, without interest and less any required withholding tax.

The Company intends to hold a special shareholders meeting on August 14, 2008 for the purpose of voting on the adoption of the Merger Agreement and the approval of the Merger.

The completion of the Merger is subject to various customary conditions, including, among others, (i) the receipt of the required Company shareholder approval; (ii) the absence of a Company Material Adverse Effect (as defined in the Merger Agreement) since December 31, 2007; and (iii) the Company having Adjusted Net Cash (as defined in the Merger Agreement) of at least the specified amounts set forth in the Merger Agreement.

In connection with the execution of the Merger Agreement, HCSC and certain holders of the Company’s common stock have each entered into voting agreements (collectively, the “Voting Agreements”). Pursuant to the Voting Agreements, these shareholders have agreed to vote their shares of the Company’s common stock in favor of adopting the Merger Agreement and approval of the Merger. These holders beneficially own in the aggregate approximately 45% of the Company’s common stock. The Voting Agreements will terminate: (i) upon the adoption of the Merger Agreement by the Company’s shareholders; (ii) upon the termination of the Merger Agreement in accordance with its terms; or (iii) at any time upon notice by HCSC to the signatory shareholders of the Voting Agreements.

The foregoing description of the Voting Agreements is qualified in its entirety by reference to the full text of the Voting Agreements, which were filed with the SEC as Exhibits 99.1 through 99.7 to a Current Report on Form 8-K on June 18, 2008.

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(3)                        Recently Issued Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands the disclosure requirements about fair value measurements. In February 2008, the FASB issued Staff Position No. SFAS 157-2 (“FSP 157-2”) that deferred the effective date of applying the provisions of SFAS 157 to the fair value measurement of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. Effective January 1, 2008, the Company adopted, on a prospective basis, SFAS 157 for financial assets and financial liabilities. The adoption did not have a material impact on the Company’s consolidated financial statements. The Company has assessed the impact of SFAS 157 for nonfinancial assets and nonfinancial liabilities and the adoption will not have a material impact on the Company’s consolidated financials statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115” (“SFAS 159”). Under SFAS 159, entities will be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the fair value option). By electing the fair value measurement attribute for certain assets and liabilities, entities will be able to mitigate potential “mismatches” that arise under the current mixed measurement attribute model. Entities will also be able to offset changes in the fair values of a derivative instrument and its related hedged item by selecting the fair value option for the hedged item. SFAS 159 became effective for fiscal years beginning after November 15, 2007. Effective January 1, 2008, the Company adopted, on a prospective basis, SFAS 159. Upon adoption, the Company did not elect the fair value option for any items within the scope of SFAS 159 and therefore, the adoption of SFAS 159 did not have a material impact on the Company’s consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”), was issued. SFAS 161 amends and expands the disclosure requirements for derivative instruments and hedging activities under SFAS No. 133. “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). SFAS 161 will require a more detailed discussion of how an entity uses derivative instruments and hedging activities and how such derivative instruments and related hedged items affect the entity’s financial position, financial performance and cash flows. Among other things, the expanded disclosures will also require presentation of the fair values of derivative instruments and their gains and losses in tabular format and enhanced liquidity disclosures, including discussion of credit-risk-related derivative features. SFAS will become effective January 1, 2009. At this time, the Company does not believe the adoption of this statement will not have any impact on its consolidated financial statements.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), was issued. SFAS 162 identifies a consistent framework, or hierarchy, for selecting accounting principles used in the preparation of financial statements presented in conformity with generally accepted accounting principles of nongovernmental entities. SFAS 162 will be effective 60 days after the Securities and Exchange Commission approves the Public Company Accounting Oversight Board’s amendments to Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” The Company is currently evaluating the effect that the adoption of this statement will have on its consolidated financial statements.

(4)        Stock-Based Compensation

The Company accounts for share based payments in accordance with SFAS No. 123R, Share Based Payment. Effective January 1, 2006, the Company adopted the calculated value recognition provisions of SFAS No. 123R utilizing the prospective-transition method, as permitted by SFAS No. 123R.

During the three and six months ended June 30, 2008, ten-year options to purchase 264,300 shares of common stock, at a weighted average exercise price of $2.28, were granted to employees and directors. During the three and six months ended June 30, 2007, ten-year options to purchase 277,500 and 377,150 shares, respectively, of common stock, at a weighted average exercise price of $5.33 and $5.74, respectively, were granted to employees and directors. For the three months ended June 30, 2008 and 2007, the Company recognized stock compensation expense of $54 ($0.00 per share) and $311 ($0.02 per share), respectively, of which $77 and $99, respectively, pertained to the intrinsic value of options issued below fair market value in 2005 and 2004. For the six months ended June 30, 2008 and 2007, the Company recognized stock compensation expense of $377 ($0.02 per share) and $523 ($0.03 per share), respectively, of which $150 and $197, respectively, pertained to the intrinsic value of options issued below fair market value in 2005 and 2004.

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The Company used a Black-Scholes model to determine the fair value of options issued in 2008 and 2007. The weighted average calculated value of options at date of grant and the assumptions utilized to determine such values are indicated in the following table:

The Company determined its volatility factor through an analysis of peer companies in terms of market capitalization and total assets. The Company cannot compute expected volatility of its stock due to its lack of historical stock prices. The Company uses historical data to estimate option exercise and employee termination behavior within the valuation model. Separate groups of employees and non-employees that have similar historical exercise behavior are considered separately for valuation purposes. The Company calculated the expected term by analyzing for each group cumulative share exercise and expiration data and post-vesting employment termination behavior as of the grant date. The weighted average life as of each grant date was then calculated and used in determining the fair value at each grant date. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected dividend yield is zero based on the Company’s historical experience.

As of June 30, 2008, there was $1,438 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under existing stock option plans, which will be recognized over the weighted average period of 2.1 years. At June 30, 2008, there were 1,093,747 shares available for grant under the Company’s 2006 Equity Incentive Plan.

Stock option activity for the six months ended June 30, 2008 is as follows:

The total intrinsic value of options exercised during the three months ended June 30, 2008 and 2007 was $13 and $434, respectively. The total intrinsic value of options exercised during the six months ended June 30, 2008 and 2007 was $110 and $2,359, respectively. During the three months ended June 30, 2008 and 2007, the Company received $23 and $74, respectively, in cash payments related to option exercises. During the three months ended June 30, 2008, the Company withheld and subsequently canceled 103 and 80 shares, respectively, of common stock to satisfy stock option exercise consideration and tax obligations. During the six months ended June 30, 2008 and 2007, the Company received $71 and $334, respectively, in cash payments related to option exercises. During the six months ended June 30, 2008, the Company withheld and subsequently canceled 1,214 and 1,585 shares, respectively, of common stock to satisfy stock option exercise consideration and tax obligations.

(5)        Loss Per Share

Basic loss per share is calculated by dividing net loss by the weighted average numbers of shares outstanding. The Company had a net loss available to common shareholders for the three and six months ended June 30, 2008 and 2007. As a result, the common stock equivalents of stock options, warrants and convertible securities issued and outstanding at those dates were not included in the computation of diluted loss per share for the periods then ended as they were anti-dilutive.

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Net loss per share is computed as follows:

For the three months ended June 30, 2008 and 2007, weighted average shares of common stock issuable in connection with stock options and warrants of 1,117,860 and 737,238 shares, respectively, were not included in the diluted loss per share calculation because doing so would have been anti-dilutive. For the six months ended June 30, 2008 and 2007, weighted average shares of common stock issuable in connection with stock options and warrants of 1,180,357 and 659,838 shares, respectively, were not included in the diluted loss per share calculation because doing so would have been anti-dilutive.

(6)        Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes , under the asset-and-liability method. Deferred 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 and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Any change in the enacted tax rate and its effect on deferred assets and liabilities is recognized in the period that includes the enactment date. A valuation allowance is recorded against deferred tax assets if it is more likely than not that such assets will not be realized.

The Company adopted the Financial Accounting Standard Board’s Interpretation No. 48, Accounting for Income Tax Uncertainties (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. As of December 31, 2007, the Company had $19,050 of unrecognized tax benefits which, if recognized, would favorably impact the Company’s effective tax rate. The Company does not anticipate that total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of the statute of limitations within the next 12 months. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in provision for income taxes in the consolidated statements of operations. As of June 30, 2008, the Company has no accrued interest or penalties related to uncertain tax positions. Tax years beginning in 2003 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used.

(7)        Leases

The Company is obligated under capital leases covering office furniture and computer hardware and software that expire at various dates through October 2012. At June 30, 2008 and December 31, 2007, the gross amount of property and equipment and related accumulated amortization recorded under capital leases was as follows:

Amortization of assets held under capital leases is included with depreciation and amortization expense in the accompanying statements of operations.

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The Company leases office space, equipment, and a vehicle under various cancelable and non-cancelable operating lease agreements that expire on various dates through August 2016. The Company’s operating lease for office space allows the Company to terminate the lease after seven years, provided twelve months’ written notice is provided. Upon such termination, the Company must pay a penalty of $1,800, reduced by $30 each month subsequent to the 84 ^th month of the lease. The penalty reductions would not begin until September 2011. For the three months ended June 30, 2008 and 2007, rental expense for operating leases was approximately $532 and $541, respectively. For the six months ended June 30, 2008 and 2007, rental expense for operating leases was approximately $1,066 and $1,097, respectively.

Future minimum lease payments under non-cancelable operating leases and future minimum capital lease payments as of June 30, 2008 are:

(8)        Warrants

In connection with various financing activities, the Company issued warrants to purchase its common stock. There was no warrant activity for the three and six months ended June 30, 2008. During the year ended December 31, 2007, warrants for 259,558 shares were exercised in net shares settlement transactions, in which a net of 147,756 shares of common stock were issued.

As of June 30, 2008, warrants to purchase the Company’s common stock were outstanding as follows:

(9)        Industry and Geographic Segment Information

The Company operates in one segment and derived all of its revenue from the healthcare industry in the three and six month periods ended June 30, 2008 and 2007. All of the Company’s revenue in those periods was derived from United States customers and all of its assets during these periods were in the United States.

(10)     Commitments and Contingencies

On January 1, 2008, an employment agreement previously entered into with an officer of the Company automatically renewed for an additional term of one year at an annual base salary of $315 in addition to other discretionary cash and stock option bonuses. Under this agreement, unless either party gives notice to the other at least sixty days prior to the expiration, the agreement is renewed automatically for succeeding terms of one year each. Scheduled future payments under this agreement as of June 30, 2008 are $158. On February 19, 2008, the Company entered into an employment agreement with another officer of the Company. The agreement includes an annual base salary of $225 and other discretionary cash and stock option bonuses.

On April 7, 2008, the Company entered into an employment agreement with an employee of the Company. The agreement includes an annual base salary of $230 and other discretionary cash and stock option bonuses. On April 21, 2008, the Company entered into an employment agreement with an employee of the Company. The agreement includes an annual base salary of $330 and other discretionary cash and stock option bonuses. As of June 30, 2008, all employment agreements provide for additional payments upon employee separation with the aggregate amount of all such payments equal to approximately $848.

On April 9, 2008, the Company accepted the resignation of one of its employees. Based on the employee’s employment agreement, the Company is obligated to make separation payments through January 15, 2009 totaling approximately $188. As of June 30, 2008, the Company made payments of approximately $54.

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On April 21, 2008, the Company announced that it entered into a Consulting Agreement (the “Consulting Agreement”) with Timothy W. Wallace to serve as the Company’s Interim President and Chief Operating Officer. On July 18, 2008, the Company accepted the resignation of its Interim President and Chief Operating Officer and the Consulting Agreement dated April 21, 2008 with him was terminated. Under the terms of his Consulting Agreement, Mr. Wallace received a payment of $7 for each week that he served as Interim President and Chief Operating Officer. The Company also agreed to continue to pay Mr. Wallace for his service as a member of the Company’s Board of Directors, except for service on any committees of the Board of Directors. Due to the nature of the consulting responsibilities contemplated, the Consulting Agreement prohibited Mr. Wallace from accepting engagements that interfered with the performance of his duties as Interim President and Chief Operating Officer of the Company. The Consulting Agreement was terminable, upon thirty days’ notice, by either party. Mr. Wallace has agreed to certain restrictive covenants, including confidentiality and non-competition and non-solicitation provisions during his engagement with the Company and for a period of twelve months thereafter. For the three and six months ended June 30, 2008, the Company recorded $72 of expense relating to this Consulting Agreement.

The Company is party to a contract to purchase third-party licenses from a software vendor. The agreement expired on December 31, 2005; however, the agreement automatically renews on an annual basis, unless terminated by either party. Expense incurred under this agreement during the three months ended June 30, 2008 and 2007 was $130 and $127, respectively, and is included in cost of subscription, maintenance and transaction fees revenue in the accompanying financial statements. Expense incurred under this agreement during the six months ended June 30, 2008 and 2007 was $261 and $254, respectively, and is included in cost of subscription, maintenance and transaction fees revenue in the accompanying financial statements. On February 14, 2008, we entered into an amendment for an additional term of three years. Scheduled future payments under this amendment are $0.3 million in 2008, $0.5 million in 2009, and $0.6 million in 2010. The Company made payments of $0.2 million during the six months ended June 30, 2008.

In addition, the Company is party to another contract to purchase a third-party license from a software vendor. The agreement expires on December 31, 2012. Expense incurred under this agreement during the three and six months ended June 30, 2008 was $17 and $35, respectively. These costs are included in cost of subscription, maintenance and transaction fees revenue in the accompanying financial statements. For the three months ended June 30, 2008, we made payments of $0.1 million under this agreement. For the six months ended June 30, 2008, we made payments of $0.2 million under this agreement. Scheduled future minimum payments as of June 30, 2008 under this agreement are $0.2 million in 2008.

The Company’s contracts with its customers provide that customers are responsible for payment of sales and use taxes on the Company’s licensing and maintenance fees, and where applicable, professional services. Prior to 2006, the Company did not collect sales taxes. Since January 1, 2006, the Company began to collect and remit sales taxes from its customers. In the event that a customer has not paid use tax where and when due, or is otherwise unable to pay, the Company may have a contingent liability for unpaid taxes, interest and penalties. A liability of $145 and $150 has been accrued at June 30, 2008 and December 31, 2007, respectively, against such contingencies.

If the Merger Agreement is terminated under certain circumstances, the Company may be required to pay a termination fee of $6.0 million to HCSC. In addition, under certain circumstances, the Company will be required to pay a termination fee of $1.0 million to HCSC as reimbursement for expenses incurred by HCSC in connection with the negotiation, preparation, execution, and performance of the Merger Agreement and related documentation.

The Company, in the normal course of business, may be party to various claims. Management believes that the ultimate resolution of any such claims would not have a material impact on the Company’s financial position or operating results.

(11)     Concentration of Credit Risk

Revenue from the Company’s top three customers for the three months ended June 30, 2008 was 55%. Revenue from the Company’s top two customers for the three months ended June 30, 2007 was 42%. Revenue from the Company’s top three customers for the six months ended June 30, 2008 was 48%. Revenue from the Company’s top two customers for the six months ended June 30, 2007 was 38%.

Trade receivables related to three customers was 41% of total net accounts receivable as of June 30, 2008. Trade receivables related to four customers was 61% of total net accounts receivable as of December 31, 2007.

(12)     Subsequent Events

On July 18, 2008, the Company accepted the resignation of its Interim President and Chief Operating Officer and the Consulting Agreement dated April 21, 2008 with him was terminated.

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

This Quarterly Report on Form 10-Q, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties, including, without limitation, statements about the expected timing, completion and effects of the proposed merger between us and HCSC. Such statements are based on current expectations of future events that involve a number of risks and uncertainties that may cause the actual events to differ materially from those discussed herein. In addition, such forward-looking statements are necessarily dependent upon assumptions, estimates and dates that may be incorrect or imprecise and involve known and unknown risks and other factors. Accordingly, any forward-looking statements included herein do not purport to be predictions of future events or circumstances and may not be realized. Forward-looking statements can be identified by, among other things, the use of forward-looking terminology such as “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,” “pro forma,” “potential,” “anticipates,” “predicts,” “plans,” “estimates,” or “intends,” or the negative of any thereof, or other variations thereon or comparable terminology, or by discussions of strategy or intentions. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Forward-looking statements should be considered in light of various important factors, including those set forth under the caption “Risk Factors” in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2007 filed with the Securities and Exchange Commission. All forward-looking statements, and reasons why results may differ, that are included in this report are made as of the date of this report, and except as required by law, we disclaim any obligations to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein or reasons why results might differ to reflect future events or developments. References herein to “MEDecision,” “we,” “our,” and “us” collectively refer to MEDecision, Inc., a Pennsylvania corporation, and all of its subsidiaries.

Overview

We are a leading provider of collaborative health care management solutions, including integrated software, services and clinical content to health care payers. Our solutions provide a logical way to manage members and member populations and improve health outcomes.

Before we simplified our product offerings in December 2007, our Collaborative Health Care Management suite consisted of four related product modules—(i) Data Gathering and Analytics; (ii) Clinical Rules and Processes; (iii) Advanced Medical Management; and (iv) Collaborative Data Exchange. We currently have combined our Case Management, Disease Management, Utilization Management functions and supporting applications (which were primarily features and functions incorporated into the previous Data Gathering and Analytics, Clinical Rules and Processes, and Advanced Medical Management module) into Alineo ^TM and our collaborative health information exchange services (previously certain features and functions of Collaborative Data Exchange) into Nexalign ^TM .

Our collaborative health care management solutions include—(i) Alineo, a platform addressing case management, disease management and utilization management within a payer organization; and (ii) Nexalign, a collaborative health information exchange service. The Alineo solution provides a simplified and smart process for analyzing, applying, and automating payer-driven best practices. It provides intuitive predictive modeling tools to identify patients who can immediately benefit from case and disease management programs, delivers turnkey clinical knowledge and pathways based on embedded clinical content and allows payers to automatically and intelligently administer and evaluate member and population-wide health care programs including approvals, referrals, and extensions. The Nexalign solution provides a simplified and smart way for health care payers, patients, physicians, and other health care providers to securely access and exchange health information to foster better clinical decisions. It is designed around Clinical Summaries, clinically validated payer-based electronic health records.

Since 1999, we have focused on broadening our solutions to respond to the evolving needs of our customers. In 1999, we began offering a Data Gathering and Analytics module; in 2001, we began offering a Collaborative Data Exchange module; in 2003, we began offering OptiCareCert; in 2004, we began offering OptiCarePath; in 2005, we began offering our customers the ability to electronically transmit Clinical Summaries via our Collaborative Data Exchange module; and, in December 2007, we reengineered and simplified our product offering into two solutions: Alineo, focusing on the information and workflow requirements inside a payer’s organization, and Nexalign, focusing on the exchange of clinical information from multiple sources to the point of care.

We operate in a relatively small market, where we have 57 of approximately 350 potential customers. This presents our management with the challenge of expanding our revenue within a limited potential customer base, and the attendant risk of our inability to grow revenue if we are unable to do so. Our strategy is to develop new customers, sell additional solutions to existing customers, and introduce new products such as Alineo and Nexalign. However, not every potential customer is in the market for software at all times. Because of the cost, time and effort involved in implementing a software solution like the products we sell, once a potential customer chooses a solution from a competitor over the collaborative health care management solutions that we offer, these potential customers may not be in the market to buy a complete software solution for a number of years, although there may be opportunities to provide them with specific modules to address particular needs that they may have.

We license our solutions primarily to large regional health care insurance companies. As of June 30, 2008, our customers included approximately 57 regional and national managed care organizations, including the largest organizations in more than 29 regional markets. Our revenue has increased at a compound annual growth rate of 21.5% since 2003, to $44.8 million for the year ended December 31, 2007. Our overall increase in revenue is attributable to increased emphasis by our customers on active management of their total insured population and the expansion of our solutions to meet their evolving needs.

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In the past, our non-recurring revenue, which primarily consists of term license fees for our software products and professional service fees associated with implementation of these software products, has constituted a significant portion of our revenue. This non-recurring revenue is generally paid in lump sums, thereby decreasing the predictability of our revenue. As a result of these risks and challenges, we have focused, and anticipate that we will continue to focus, on the growth of our business, expanding existing customer relationships, developing innovative new solutions, expanding our customer base within our market and continuing to build recurring and predictable revenue through new products like our Clinical Summaries.

Prior to 2006, we experienced our fastest growth in term licenses and professional services revenue, thereby increasing those items as a percentage of our revenue. Consequently we realized a decreasing percentage of subscription, maintenance and transaction fee revenue even though that revenue grew as well. In the future, we anticipate the market will have an increased focus on Electronic Health Records and what we refer to as our Clinical Summaries. For these solutions, our customers pay an annual subscription fee and pay a transaction fee each time they utilize the solution. In addition, once adopted by a customer, there are less sales and administrative efforts required to increase the transaction volume with a customer as compared to the efforts required to sell a new term license for one of our other solutions. We anticipate that the growth of this portion of our business will continue to outpace our traditional software licenses and, as a result, subscription and transaction revenue will become a larger portion of our overall revenue. We anticipate that this strategy will continue to lead to more recurring and predictable overall revenue. In addition, given the lower administrative and sales costs associated with this revenue, we anticipate that this will increase our margins, especially as transaction volume with a given customer increases.

We evaluate and monitor our business based on our results from operations, including our percentage of revenue growth, our revenue by category, operating expenses as a percent of total revenue and our overall financial position. In doing so, we monitor margins for our existing business and evaluate the potential margin contributions for each type of revenue that we generate. We operate in one reportable segment.

Merger Agreement

O n June 17, 2008, we, Health Care Service Corporation, a Mutual Legal Reserve Company, an Illinois corporation (“HCSC”), and Mercury Acquisition Corp., a Pennsylvania corporation and a wholly-owned subsidiary of HCSC (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which Merger Sub will merge with and into us and we will become a wholly-owned subsidiary of HCSC (the “Merger”).

If the Merger is completed, each outstanding share of our common stock will be converted into the right to receive $7.00 in cash (the “Merger Consideration”), without interest and less any required withholding taxes. Except for (i) options to purchase an aggregate of 176,975 shares of our common stock, which will terminate upon consummation of the merger without any further payment rights, and (ii) options to purchase an aggregate of 60,000 shares of our common stock held by one of our key management employees, which will be converted into a post-closing payment right, upon the effective time of the merger each option to purchase our common stock outstanding immediately prior to the effective time of the merger will be cancelled, and the holder of each such option will be entitled to receive, in full settlement and cancellation of such option, a cash payment equal to the product of the number of shares subject to such option multiplied by the excess, if any, of (a) $7.00 less (b) the exercise price per share of such option, without interest and less any required withholding tax.

We intend to hold a special shareholders meeting on August 14, 2008 for the purpose of voting on the adoption of the Merger Agreement and the approval of the Merger.

The completion of the Merger is subject to various customary conditions, including, among others, (i) the receipt of the required approval by our shareholders; (ii) the absence of a Company Material Adverse Effect (as defined in the Merger Agreement) since December 31, 2007; and (iii) our having Adjusted Net Cash (as defined in the Merger Agreement) of at least the specified amounts set forth in the Merger Agreement.

In connection with the execution of the Merger Agreement, HCSC and certain holders of our common stock have each entered into voting agreements (collectively, the “Voting Agreements”). Pursuant to the Voting Agreements, these shareholders have agreed to vote their shares of our common stock in favor of adopting the Merger Agreement and approval of the Merger. These holders beneficially own in the aggregate approximately 45% of our common stock. The Voting Agreements will terminate: (i) upon the adoption of the Merger Agreement by our shareholders; (ii) upon the termination of the Merger Agreement in accordance with its terms; or (iii) at any time upon notice by HCSC to the signatory shareholders of the Voting Agreements.

Sources of Revenue

We derive revenue from the following sources: (i) subscription, maintenance and transaction fees; (ii) term license fees for our solutions; and (iii) fees for discrete professional services. These revenue streams are derived from the licensing of our collaborative health care management solutions that include—(i) Alineo, a platform addressing case management, disease management, and utilization management within a payer organization; and (ii) Nexalign, a collaborative health information exchange service. Alineo is a collaborative health care management platform that addresses case, disease, and utilization management within the walls of the payer and consists of: Alineo Care Management Analytics, that enables a payer to process, summarize, and evaluate information from both internal and external sources; Alineo Clinical Intelligence, that identifies specific condition treatment opportunities as well as health and wellness interventions; Alineo Clinical Summaries, that are clinically validated payer-based health records compiled from claims and care management data files and created for our customer’s members; Alineo Clinical Programs, that consists of clinical pathways for case and disease management that automatically populate

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questionnaires, goal templates, and other correspondence to members and providers; Alineo Clinical Criteria, that allows our customers to determine the medical appropriateness of a requested health care service or treatment; Alineo Automated Approvals, that support the use of customer defined business rules to automatically evaluate care requests to determine medical appropriateness and whether the request should be approved or pended for further review by our customer’s medical staff; Alineo Reporting, that is a standard set of report templates; Alineo Correspondence , that supports documentation management and letter generation; and Workflow Management, that allows care management staff to automatically and intelligently administer, manage and evaluate both individual and population-wide health care programs. Our Nexalign solution is a collaborative health care information exchange service that provides a way for payers, patients, physicians, and other health care providers to securely access and exchange health information to foster better clinical decisions. Nexalign is designed around Clinical Summaries, which are payer-based electronic health records that have been clinically validated.

Subscription, Maintenance and Transaction Fees

Our customers pay annual subscription fees to license clinical pathways for case and disease management through Alineo Clinical Programs, to process data through our service bureau and access reports using Alineo Care Management Analytics and Alineo Clinical Intelligence and to transmit clinical data and decisions through our Nexalign solution. Customers also pay a fee for each transaction transmitted over our network. We recognize these subscription fees ratably over the term of the subscription agreement and include this in subscription, maintenance and transaction fee revenue in our consolidated statements of operations. We also offer our customers a hosted solution and receive monthly fees for those services. We recognize hosting revenue ratably over the term of the related agreement, which is typically five years in duration. Hosting revenue is included in subscription, maintenance and transaction fee revenue on our consolidated statements of operations.

Our customers pay an annual maintenance and support fee equal to approximately 22% of the Workflow Management and Alineo Automated Approvals initial license fees, which entitles our customers to unspecified software updates and upgrades and basic product support. For Alineo Clinical Programs contracted for under a term license model, our customers pay approximately 35% of the initial license fee for unspecified software updates and upgrades, including content updates, and basic product support. We recognize maintenance and support fees ratably over the term of the maintenance and support agreement.

Our customers pay transaction fees for each member eligibility verification, for clinical adjudication of treatment requests and for access to on-demand member health information, including Clinical Summaries. We recognize transaction fees at the time of the transaction.

Term Licenses

Our customers pay a term license fee to utilize Workflow Management and Alineo Automated Approvals and Clinical Rules and Processes modules, typically for five years. We recognize revenue for term license fees upon delivery of the software assuming all other revenue recognition criteria have been met.

Professional Services

In conjunction with our solutions, we provide services to assist our customers in the installation and implementation of the software and the integration of our solutions with their other systems. We sell these services on either a fixed price or a time-and-materials basis and recognize revenue when the services are performed. Services revenue also includes reimbursable billable travel, lodging and other out-of-pocket expenses incurred as part of delivering services to our customers.

Each of our license models provides us with a recurring revenue stream. Historically, a substantial portion of our clients have renewed their licenses each year. The combination of recurring revenue and high renewal rates provide us with substantial annual revenue predictability. Although in general our revenue is consistent throughout the year, sales of certain modules that have an initial term license can cause revenue volatility from quarter to quarter. The sales cycle for our Alineo solution is typically eight months or longer. As a result, it is difficult for us to predict the quarter in which a particular sale may occur. In addition, in a small portion of our sales, the license fee is material relative to our total revenue during the quarter. Accordingly, our revenue may vary significantly from quarter to quarter depending on the quarter during which a large sale occurs.

Strategy for Growth

Our strategy for revenue growth is to (1) increase recurring and transaction-based revenue streams as a percentage of total revenue, primarily through Patient Clinical Summary transactions; (2) expand our customer base into additional managed care organizations in the United States that could benefit from our entire Collaborative Care Management suite or its related product modules; (3) expand relationships with our existing customers; and (4) develop the next generation of our Collaborative Care Management suite.

Historically, we derived most of our revenue from our Advanced Medical Management module, for which our customers purchase five-year term licenses and which we recognize as revenue at the time we enter into the contract. In 1999, we began licensing modules that provide transaction or annual recurring revenue that are recorded ratably over the contract term. In 2005, we began to deliver a Patient Clinical Summary, and continue to do so today for 13 managed care organizations. We intend to emphasize modules with transaction oriented and annual recurring revenue, as these streams provide us with greater revenue visibility and higher gross margins and operating margins. We have developed a scalable network infrastructure to deliver a high volume of transactions (such as authorizations, referrals and Patient Clinical

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Summaries) to providers and patients. An increase in transaction volume will require some additional technology infrastructure, but we believe the cost of network expansion will be substantially lower than the increase in revenue. In addition, we expect some investment initially in sales and marketing to educate and assist in the initial deployment of transaction-based modules, but less, as a percentage of revenue, than the increase in revenue.

Prior to 2003, we licensed our software modules separately to payer organizations. Beginning in 2003, we began marketing and licensing our modules as an integrated solution, providing the payer an ability to license the entire Collaborative Care Management suite, or certain components initially, based upon the payer’s business needs at that time. We believe there are at least 300 additional managed care organizations in the United States, plus a substantial number of self-insured companies and Medicare and Medicaid organizations that could benefit from licensing and deploying our entire Collaborative Care Management suite, or selected modules. We license our solutions to new customers through our direct sales force, and our marketing initiatives generally have included conferences, trade shows, healthcare industry events and direct mail campaigns. We will continue to invest in additional sales personnel and marketing programs to increase awareness of our integrated solution, but not at the same rate of our revenue growth.

Through our customer sales operation, we have expanded our penetration within our customer base by including more members and by increasing the number of modules licensed by our customers. We intend to develop additional cross-selling programs to aid our customer relationship staff to continue to increase the number of modules utilized by our customers in the provision of care to their membership. The largest cross-selling opportunity is based on the adoption of the Patient Clinical Summary transactions, which benefit the payer, patient and provider. As the Company continues to license the Patient Clinical Summary, we will be required to increase marketing expenditures related to the adoption of the Patient Clinical Summary by providers. The increase in marketing expenditures is not determinable at this time.

Trends in Sales of our Solutions

Our strategy for revenue growth is to (1) increase recurring and transaction-based revenue streams as a percentage of total revenue, primarily through Clinical Summary transactions; (2) expand our customer base into additional managed care organizations in the United States that could benefit from our entire collaborative health care management solutions, including Alineo and Nexalign; (3) expand relationships with our existing customers; and (4) develop the next generation of our solutions.

Historically, we derived most of our revenue from our Advanced Medical Management module, for which our customers purchase five-year term licenses and which we recognize as revenue at the time we enter into the contract. In 1999, we began licensing modules that provide transaction or annual recurring revenue that are recorded ratably over the contract term. In 2005, we began delivering a Clinical Summary for eight managed care organizations. We intend to emphasize Nexalign and components of Alineo that are transaction oriented and annual recurring revenue, as these streams provide us with greater revenue visibility and higher gross margins and operating margins. We have developed a scalable network infrastructure to deliver a high volume of transactions (such as authorizations, referrals and Clinical Summaries) to providers and patients. An increase in transaction volume will require some additional technology infrastructure, but we believe the cost of network expansion will be substantially lower than the increase in revenue. In addition, we expect some investment initially in sales and marketing to educate and assist in the initial deployment of transaction-based modules, but less, as a percentage of revenue, than the increase in revenue.

Prior to 2003, we licensed our software module separately to payer organizations. Beginning in 2003, we began marketing and licensing our modules as an integrated solution, providing the payer an ability to license the entire Collaborative Care Management suite, or certain components initially, based upon the payer’s business needs at that time. In December 2007, we reengineered and simplified our product offering into two solutions: Alineo, focusing on the information and workflow requirements inside a payer’s organization, and Nexalign, focusing on the exchange of clinical information from multiple sources to the point of care. We intend to market and license Alineo and Nexalign as an integrated Collaborative Health Care Management Solution. In addition we intend to allow new customers to license components based upon their business needs at the time of licensing and to allow existing customers to increase their utilization of integrated solutions as their business needs changes. We believe there are at least 350 additional managed care organizations in the United States, self-insured companies and Medicare and Medicaid organizations that could benefit from licensing and deploying our entire collaborative health care management solutions, or selected modules-within Alineo and Nexalign. We license our solutions to new customers through our direct sales force, and our marketing initiatives generally have included conferences, trade shows, health care industry events and direct mail campaigns. We will continue to invest in additional sales personnel and marketing programs to increase awareness of our integrated solution, but not at the same rate of our revenue growth.

Through our customer sales operation, we have expanded our penetration within our customer base by including more members and by increasing the number of modules licensed by our customers. We intend to develop additional cross-selling programs to aid our customer relationship staff to continue to increase the number of modules utilized by our customers in the provision of care to their membership. The large cross-selling opportunity is based on the adoption of the Clinical Summary transactions, which benefit the payer, patient and provider. This adoption will require some investment in marketing, but we expect it to be less than the direct sales costs associated with the sales of our historical software solutions.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and consolidated results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based upon historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates.

We believe that our critical accounting policies affect our more significant estimates and judgments used in the preparation of our consolidated financial statements. Our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 contains a discussion of these critical accounting policies. There have been no significant changes in our critical accounting policies since December 31, 2007. See also Note 3 to our unaudited consolidated financial statements for the three and six months ending June 30, 2008 as set forth herein.

Significant Customer Contracts

Three of our customers, Blue Cross Blue Shield of Florida (“Florida”), HCSC, and Blue Cross Blue Shield of Minnesota (“Minnesota”) accounted for approximately 21%, 20%, and 14%, respectively, of our revenue for the three months ended June 30, 2008. Two of our customers, HCSC and Horizon Blue Cross Blue Shield (“Horizon”) accounted for approximately 32% and 10%, respectively, of our revenue for the three months ended June 30, 2007. For the six months ended June 30, 2008, HCSC, Minnesota, and Florida accounted for approximately 23%, 13%, and 12%, respectively, of our revenue. For the six months ended June 30, 2007, HCSC and Horizon accounted for approximately 28% and 10%, respectively, of our revenue. Each of these contracts contains a term license component and an annual subscription and maintenance fee component. As is the case generally with all of our term license arrangements, a significant amount of the revenue of the contract is recognized in the initial year of the contract, with the remaining year revenue composed predominantly of annual subscription and maintenance fees and professional services relating primarily to implementation. As a result, while these contracts represent a material portion of our revenue for the three and six months ended June 30, 2008, we can not determine at this time whether these contracts will represent a material portion of our revenue in the future.

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Consolidated Results of Operations

Comparison of Three and Six Months Ended June 30, 2008 and 2007

The following table sets forth key components of our results of operations for the periods indicated as a percentage of total revenue:

Revenue

Consolidated revenue increased $4.5 million, or 46% percent, to $14.2 million for the three months ended June 30, 2008 compared to $9.7 million for the three months ended June 30, 2007. The increase is attributable to an increase in subscription, maintenance and transaction fees and term licenses revenue. Consolidated revenue increased $5.5 million, or 28% percent, to $25.0 million for the six months ended June 30, 2008 compared to $19.5 million for the six months ended June 30, 2007. The increase is attributable to an increase in subscription, maintenance and transaction fees, term licenses, and in professional services revenue.

Revenue by source is as follows:

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During the three months ended June 30, 2008, we entered into contracts with two new customers. These two new customers licensed our Alineo product suite and represent aggregate term licenses revenue of $2.5 million. In addition, we entered into a new contract with an existing customer who had already licensed our Advanced Medical Management module and was renewing their existing license agreement. During the three months ended June 30, 2007, we entered into contracts with two new customers. These customers licensed our Collaborative Care Management suite including the Patient Clinical Summary and represented aggregate term licenses revenue of $3.2 million. We recognized $3.1 million of term licenses revenue in fourth quarter of 2007.

During the six months ended June 30, 2008, we entered into contracts with two new customers. These two new customers licensed our Alineo product suite and represent aggregate term licenses revenue of $2.5 million. In addition, we entered into five new contracts with existing customers who had already licensed our Advanced Medical Management module and were adding an additional module or renewing their existing license agreement. We entered into a total of eight contracts during the six months ended June 30, 2007. In addition to the two contracts with new customers, we executed six contracts with existing customers that had already licensed our Advanced Medical Management module and were adding an additional module or renewing their existing license agreement.

Subscription, maintenance, and transaction fees

The increase in subscription, maintenance and transaction fees revenue for the three months ended June 30, 2008 compared to the same period in 2007 was a result of maintenance and support revenue from contracts consummated in the periods subsequent to June 30, 2007, annual CPI inflators of approximately 4% included in our maintenance and support contracts, and an increase in authorization and referral transaction revenues.

The increase in subscription, maintenance and transaction fees revenue for the six months ended June 30, 2008 compared to the same period in 2007 was a result of maintenance and support revenue from contracts consummated in the periods subsequent to June 30, 2007, annual CPI inflators of approximately 4% included in our maintenance and support contracts, and an increase in authorization and referral transaction revenues.

Term licenses

The increase in term licenses revenue is primarily due to the two contracts with new customers consummated and recorded during the three months ended June 30, 2008 compared to the same period in 2007. A significant portion of the term licenses revenue related to a contract consummated during the three months ended June 30, 2007 was not recognized until fourth quarter of 2007.

The increase in term licenses revenue is primarily due to the two contracts with new customers consummated and recorded during the six months ended June 30, 2008 compared to the same period in 2007. A significant portion of the term licenses revenue related to a contract consummated during the six months ended June 30, 2007 was not recognized until fourth quarter of 2007.

Professional services

Professional services revenue remained constant for the three months ended June 30, 2008 compared to the same period in 2007.

Professional services revenue increased for the six months ended June 30, 2008 compared to the same period in 2007 due to new contracts signed since June 2007 resulting in increased implementation revenue.

Cost of revenue

Cost of revenue increased 19% to $5.3 million for the three months ended June 30, 2008 from $4.5 million for the three months ended June 30, 2007. Cost of revenue increased 19% to $10.6 million for the six months ended June 30, 2008 from $8.9 million for the six months ended June 30, 2007.

Cost of revenue for each revenue source is as follows: