Edgar Filing: QUALITY SYSTEMS INC

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended December 31, 2006

OR

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

Commission file number 0-13801

QUALITY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)


California		95-2888568
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

18191 Von Karman Avenue, Irvine California 92612
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (949) 255-2600

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 twelve 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 ninety days. Yes x No o

Indicate by check mark whether the Registrant is a large accelerated filers, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12B-2 of the Exchange Act. (Check one): Large accelerated filer o Accelerated filer x Non-accelerated filer o

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

Indicate the number of shares outstanding of each of the Registrant’s classes of Common Stock as of the latest practicable date: 26,975,605 shares of Common Stock, $0.01 par value, as of January 9, 2007.

PART I

CONSOLIDATED FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)


	DECEMBER 31, 2006		MARCH 31, 2006

ASSETS

Current assets:
Cash and cash equivalents	$	80,410	$	57,225
Accounts receivable, net		59,015		44,665
Inventories, net		1,311		561
Income tax receivable		1,732		1,195
Net current deferred tax assets		1,341		1,824
Other current assets		3,559		2,912

Total current assets		147,368		108,382

Equipment and improvements, net		4,827		3,739
Capitalized software development costs, net		6,323		5,171
Net deferred tax assets		542		1,157
Goodwill		1,840		1,840
Other		2,399		1,958

Total assets	$	163,299	$	122,247


LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	3,274	$	2,934
Deferred revenue		39,870		34,422
Accrued compensation and related benefits		4,874		5,490
Other current liabilities		6,827		3,812

Total current liabilities		54,845		46,658


Deferred revenue, net of current		676		1,494
Deferred compensation		2,131		1,686

Total liabilities		57,652		49,838


Commitments and contingencies

Shareholders’ equity:
Common stock, $0.01 par value; authorized 50,000 shares; issued and outstanding 26,974 and 26,711 shares at December 31, 2006 and March 31, 2006, respectively		270		267
Additional paid-in capital		61,499		53,675
Retained earnings		43,878		19,151
Deferred compensation		—		(684	)

Total shareholders’ equity		105,647		72,409

Total liabilities and shareholders’ equity	$	163,299	$	122,247

See accompanying condensed notes to consolidated financial statements.

QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)


	THREE MONTHS ENDED				NINE MONTHS ENDED

	DECEMBER 31, 2006		DECEMBER 31, 2005		DECEMBER 31, 2006		DECEMBER 31, 2005


Revenues:
Software, hardware and supplies	$	16,088	$	10,835	$	47,854	$	37,469
Implementation and training services		2,885		2,615		8,687		8,136

System sales		18,973		13,450		56,541		45,605


Maintenance		11,069		7,733		30,107		22,403
Electronic data interchange services (EDI)		4,290		3,310		12,333		9,586
Other services		4,164		2,259		13,048		6,128

Maintenance, EDI and other services		19,523		13,302		55,488		38,117


Total revenue		38,496		26,752		112,029		83,722


Cost of revenue:
Software, hardware and supplies		1,798		1,659		5,210		6,023
Implementation and training services		2,169		1,975		6,285		5,741

Total cost of system sales		3,967		3,634		11,495		11,764


Maintenance		3,058		2,024		8,987		6,517
Electronic data interchange services		3,144		2,216		8,850		6,403
Other services		2,528		1,529		6,655		4,081

Total cost of maintenance and other services		8,730		5,769		24,492		17,001

Total cost of revenue		12,697		9,403		35,987		28,765


Gross profit		25,799		17,349		76,042		54,957


Operating expenses:
Selling, general and administrative		10,593		8,016		30,787		24,968
Research and development costs		2,601		2,208		7,510		5,926

Total operating expenses		13,194		10,224		38,297		30,894


Income from operations		12,605		7,125		37,745		24,063

Interest income		935		594		2,421		1,395


Income before provision for income taxes		13,540		7,719		40,166		25,458
Provision for income taxes		4,819		2,904		15,439		9,774


Net income	$	8,721	$	4,815	$	24,727	$	15,684


Net income per share:
Basic	$	0.32	$	0.18	$	0.92	$	0.60

Diluted	$	0.32	$	0.18	$	0.90	$	0.58


Weighted average shares outstanding:
Basic		26,966		26,490		26,828		26,338

Diluted		27,507		27,372		27,441		27,248

See accompanying condensed notes to consolidated financial statements.

QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)


	NINE MONTHS ENDED

	DECEMBER 31, 2006			DECEMBER 31, 2005

Cash flows from operating activities:
Net income	$	24,727		$	15,684
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		1,382			989
Amortization of capitalized software costs		2,326			1,795
Provision for bad debts		701			1,002
Provision for inventory obsolescence		—			119
Non-cash stock-based compensation		2,666			321
Deferred income taxes, net		1,094			—
Tax benefit from disqualifying dispositions of stock options		2,063			3,535
Excess tax benefit from share based compensation		(2,046	)		—
Changes in assets and liabilities:
Accounts receivable		(15,051	)		(5,501	)
Inventories		(750	)		171
Income tax receivable		(550	)		(299	)
Other current assets		(647	)		(2,564	)
Other assets		(441	)		(226	)
Accounts payable		340			1,087
Deferred revenue		4,630			8,639
Accrued compensation and related benefits		(616	)		863
Other current liabilities		3,015			(632	)
Deferred compensation		445			327

Net cash provided by operating activities		23,288			25,310


Cash flows from investing activities:
Additions to capitalized software costs		(3,478	)		(1,562	)
Additions to equipment and improvements		(2,470	)		(2,341	)

Net cash used in investing activities		(5,948	)		(3,903	)


Cash flows from financing activities:
Dividends paid		—			(14	)
Excess tax benefit from share-based compensation		2,046			—
Proceeds from the exercise of stock options		3,799			2,678

Net cash provided by financing activities		5,845			2,664


Net increase in cash and cash equivalents		23,185			24,071

Cash and cash equivalents at beginning of period		57,225			51,157


Cash and cash equivalents at end of period	$	80,410		$	75,228


Supplemental disclosures of cash flow information:
Cash paid during the period for income taxes, net of refunds	$	12,802		$	8,600

See accompanying condensed notes to consolidated financial statements.

QUALITY SYSTEMS, INC.
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements as of December 31, 2006 and for the three and nine months ended December 31, 2006 and 2005, have been prepared in accordance with the requirements of Form 10-Q and Article 10 of Regulation S-X, and therefore do not include all information and footnotes which would be presented were such financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). These financial statements should be read in conjunction with the audited financial statements presented in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2006. Amounts related to disclosures of March 31, 2006 balances within these interim consolidated financial statements were derived from the aforementioned Form 10-K. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments which are necessary for a fair presentation of the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of results of operations to be expected for the full year.

References to dollar amounts in this financial statement section are in thousands, except share and per share data, unless otherwise specified. Certain prior year amounts have been reclassified to conform with fiscal year 2007 presentation.

2. Stock Split

On January 26, 2006, the Board of Directors declared a 2-for-1 stock split with respect to the Company’s outstanding shares of common stock. The stock split record date was March 3, 2006 and the stock began trading post split on March 27, 2006. References to share and per share data contained in the consolidated financial statements have been retroactively adjusted to reflect the stock split.

3. Summary of Significant Accounting Policies

Principles of consolidation. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant inter-company accounts and transactions have been eliminated.

Revenue recognition. The Company currently recognizes revenue pursuant to Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9 “Modification of SOP 97-2, Software Revenue Recognition” (SOP 98-9). The Company generates revenue from the sale of licensing rights to its software products directly to end-users and value-added resellers (VARs). The Company also generates revenue from sales of hardware and third party software, implementation, training, software customization, Electronic Data Interchange (EDI), post-contract support (maintenance) and other services performed for customers who license its products.

A typical system contract contains multiple elements of the above items. SOP 98-9 requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements. The fair value of an element must be based on vendor specific objective evidence (VSOE). The Company limits its assessment of VSOE for each element to either the price charged when the same element is sold separately (using a rolling average of stand alone transactions) or the price established by management having the relevant authority to do so, for an element not yet sold separately. VSOE calculations are updated and reviewed quarterly or annually.

When evidence of fair value exists for the delivered and undelivered elements of a transaction, then discounts for individual elements are aggregated and the total discount is allocated to the individual elements in proportion to the elements’ fair value relative to the total contract fair value.

When evidence of fair value exists for the undelivered elements only, the residual method, provided for under SOP 98-9, is used. Under the residual method, the Company defers revenue related to the undelivered elements in a system sale based on VSOE of fair value of each of the undelivered elements, and allocates the remainder of the contract price net of all discounts to revenue recognized from the delivered elements. Undelivered elements of a system sale may include, among other things, implementation and training services, hardware and third party software, maintenance, future purchase discounts, or other

services. If VSOE of fair value of any undelivered element does not exist, all revenue is deferred until VSOE of fair value of the undelivered element is established or the element has been delivered.

The Company bills for the entire contract amount upon contract execution. Amounts billed in excess of the amounts contractually due are recorded in accounts receivable as advance billings. Amounts are contractually due when services are performed or in accordance with contractually specified payment dates. Provided the fees are fixed and determinable and collection is considered probable, revenue from licensing rights and sales of hardware and third party software is generally recognized upon shipment and transfer of title. If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized using the residual method. Fees which are considered fixed or determinable at the inception of our arrangements must include the following characteristics:


•	The fee must be negotiated at the outset of an arrangement, and generally be based on the specific volume of products to be delivered without being subject to change based on variable pricing mechanisms such as the number of units copied or distributed or the expected number of users.

•	Payment terms must not be considered extended. If a significant portion of the fee is due more than 12 months after delivery or after the expiration of the license, the fee is presumed not fixed and determinable.

Revenue from implementation and training services is recognized as the corresponding services are performed. Maintenance revenue is recognized ratably over the contractual maintenance period.

Contract accounting is applied where services include significant software modification, development or customization. In such instances, the arrangement fee is accounted for in accordance with Statement of Position No. 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1). Pursuant to SOP 81-1, the Company uses the percentage of completion method provided all of the following conditions exist:


•	contract includes provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement;

•	the customer can be expected to satisfy its obligations under the contract;

•	the Company can be expected to perform its contractual obligations; and

•	reliable estimates of progress towards completion can be made.

The Company measures completion using labor input hours. Costs of providing services, including services accounted for in accordance with SOP 81-1, are expensed as incurred.

If a situation occurs in which a contract is so short term that the financial statements would not vary materially from using the percentage-of-completion method or in which the Company is unable to make reliable estimates of progress of completion of the contract, the completed contract method is utilized.

The Company has historically offered short-term rights of return of less than 20 days in certain sales arrangements. Based on historical experience with similar types of sales transactions bearing these short-term rights of return, no accrual for system sales returns related to short-term rights of return was recorded.

Product returns are estimated in accordance with Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (SFAS 48). The Company also ensures that the other criteria in SFAS 48 have been met prior to recognition of revenue:


•	the price is fixed or determinable;

•	the customer is obligated to pay and there are no contingencies surrounding the obligation or the payment;

•	the customer’s obligation would not change in the event of theft or damage to the product;

•	the customer has economic substance;

•	the amount of returns can be reasonably estimated; and

•	we do not have significant obligations for future performance in order to bring about resale of the product by the customer.

From time to time, the Company offers future purchase discounts on its products and services as part of its sales arrangements. Pursuant to AICPA TPA 5100.50, such discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.

Revenue is divided into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes, maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

Cash and cash equivalents. Cash and cash equivalents generally consist of cash, money market funds and short term U.S. Treasuries with original maturities of less than 90 days. The money market fund in which the Company holds a portion of its cash invests in only investment grade money market instruments from a variety of industries, and therefore bears relatively low market risk. The average maturity of the investments owned by the money market fund is approximately two months.

Allowance for doubtful accounts. The Company provides credit terms typically ranging from thirty days to less than twelve months for most system and maintenance contract sales and generally does not require collateral. The Company performs credit evaluations of its customers and maintains reserves for estimated credit losses. Reserves for potential credit losses are determined by establishing both specific and general reserves. Specific reserves are based on management’s estimate of the probability of collection for certain troubled accounts. General reserves are established based on the Company’s historical experience of bad debt expense and the aging of the Company’s accounts receivable balances net of deferred revenues and specifically reserved accounts. Accounts are written off as uncollectible only after the Company has expended extensive collection efforts.

Included in accounts receivable are amounts related to maintenance and services which were billed, but which had not yet been rendered as of the end of the period. Undelivered maintenance and services are included on the balance sheet in deferred revenue.

Inventories. Inventories consist of hardware for specific customer orders and spare parts, and are valued at lower of cost (first-in, first-out) or market. Management provides a reserve to reduce inventory to its net realizable value.

Equipment and improvements. Equipment and improvements are stated at cost less accumulated depreciation and amortization. Depreciation and amortization of equipment and improvements are provided over the estimated useful lives of the assets, or the related lease terms if shorter, by the straight-line method. Useful lives range as follows:


•	Computers and electronic test equipment	3-5 years

•	Furniture and fixtures	5-7 years

•	Leasehold improvements	lesser of lease term or estimated useful life of asset

Software development costs. Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. After technological feasibility is established, any additional development costs are capitalized in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86). Such capitalized costs are amortized on a straight line basis over the estimated economic life of the related product of three years. The Company provides support services on the current and prior two versions of its software. Management performs an annual review of the estimated economic life and the recoverability of such capitalized software costs. At the time a determination is made that capitalized amounts are not recoverable based on the estimated

cash flows to be generated from the applicable software, any remaining capitalized amounts are written off.

Stock-Based Compensation

On April 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (SFAS 123R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123R supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123R. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123R.

The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of April 1, 2006, the first day of the Company’s fiscal year 2007. The Company’s Consolidated Statement of Income for the three and nine months ended December 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. Share-based compensation expense recognized under SFAS 123R for the three and nine months ended December 31, 2006 was $889 and $2,666, respectively, which consisted of stock-based compensation expense related to employee and director stock options. The $889 and $2,666 includes $107 and $321, respectively, expensed under APB 25 for “in the money” options issued prior to the adoption of SFAS 123R. Excess tax benefits from share based compensation are presented as cash outflows from operating activities and cash inflows from financing activities. The Company has not elected which method to calculate the beginning additional paid-in capital (APIC) pool, which is the amount that would have been in the APIC account if the Company had recognized costs for stock-based compensation using SFAS 123 since 1995, the effective date of SFAS 123. The Company will make an affirmative election on the method during fiscal year 2007.

The impact of adopting SFAS 123R had the following cumulative effects:


(in thousands except per share data)	THREE MONTHS ENDED DECEMBER 31, 2006			NINE MONTHS ENDED DECEMBER 31, 2006

Change in income before income taxes	$	782		$	2,345
Change in net income	$	587		$	1,745
Change in cash flow from operations	$	(477	)	$	(2,046	)
Change in cash flow from financing	$	477		$	2,046
Change in basic earnings per share	$	0.02		$	0.06
Change in diluted earnings per share	$	0.02		$	0.06

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized ratably as expense over the requisite service period in the Company’s Consolidated Statement of Income. Prior to the adoption of SFAS 123R, the Company applied the intrinsic-value-based method of accounting prescribed by APB 25 to account for its fixed-plan stock options. Under this method, compensation expense was recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. As previously allowed under SFAS 123, the Company only adopted the disclosure requirements of SFAS 123, which established a fair-value-based method of accounting for stock-based employee compensation plans. The following is a reconciliation of reported net earnings to adjusted net earnings had the Company recorded compensation expense based on the fair value at the grant date for its stock options under SFAS 123 for the three months and nine months ended December 31, 2005.


	THREE MONTHS ENDED DECEMBER 31, 2005			NINE MONTHS ENDED DECEMBER 31, 2005


Reported net earnings	$	4,815		$	15,684
Add: Option compensation expense, net of tax		66			196
Less: Stock-based compensation expense determined under fair value-based method for all awards		(1,700	)		(2,806	)

Pro forma net earnings	$	3,181		$	13,074

Basic earnings per share:
Reported	$	0.18		$	0.60

Pro forma	$	0.12		$	0.50

Diluted earnings per share:
Reported	$	0.18		$	0.58

Pro forma	$	0.12		$	0.48

In arriving at the stock-based compensation expense reported in the table above, the Company utilized the Black-Scholes valuation model for estimating fair value with the following assumptions: expected life – 48 – 57 months from the date of the grant; stock volatility – 47.7 – 57.0%, risk free interest rate of 3.0 – 3.7% and no dividends during the expected term. For stock options issued subsequent to March 31, 2006, the Company used the simplified method for estimating expected term, which derives a term equal to the midpoint between the vesting period and the contractual term as allowed by SAB 107. Prior to using the simplified method, the Company estimated the expected term of an option. The Company estimates volatility by using the weighted average historical volatility of the Company’s common stock which the Company believes approximates expected volatility. The risk free rate is the implied yield available on the U.S Treasury zero-coupon issues with remaining terms equal to the expected term input to the Black Scholes model. Although the Company announced a one-time $0.75 per share dividend on January 31, 2005, no commitment to any future dividends was made at the time the dividend was announced and no commitment to any future dividends existed at the time when the February 11, 2005 options were granted. The Company had not paid a dividend to its shareholders prior to the one-time dividend announced on January 31, 2005. On January 31, 2006, the Company announced a one-time dividend of $0.875 per share. This dividend was announced subsequent to the options granted in fiscal year 2006 and was not considered in the fair value calculations of such options. Therefore, management believes that using a zero dividend rate in the valuation of the stock options granted during fiscal year 2006 was appropriate. The above pro forma disclosure was not presented for the three and nine month periods ended December 31, 2006 because stock-based compensation has been accounted under SFAS 123R for these periods.

The historical pro forma impact of applying the fair value method prescribed by SFAS 123 may not be representative of the impact that may be expected in the future due to changes resulting from additional grants in future years and changes in assumptions such as volatility, interest rates and expected life used to estimate fair value of the grants in future years.

The following table shows total stock-based employee compensation expense included in the Consolidated Statement of Income for the three and nine month periods ended December 31, 2006.


	THREE MONTHS ENDED DECEMBER 31, 2006			NINE MONTHS ENDED DECEMBER 31, 2006

Costs and expenses:
Cost of revenue	$	123		$	364
Research and development		207			614
Selling, general and administrative		559			1,688

Total stock based compensation for the three and nine months ended	$	889		$	2,666

Amounts capitalized in software development costs	$	(7	)	$	(30	)

Amounts charged against earnings, before income tax benefit	$	882		$	2,636

Amount of related income tax benefit recognized in earnings	$	237		$	681

4. Recent Accounting Pronouncements

In September 2006, the Financial Standards Accounting Board (FASB) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective

beginning in October 2008. The Company is currently evaluating the impact of adopting this standard.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin no. 108 (SAB 108) to clarify consideration of the effects of prior year errors when quantifying misstatements in current year financial statements for the purpose of quantifying materiality. SAB 108 requires issuers to quantify misstatements using both the “rollover” and “iron curtain” approaches and requires an adjustment to the current year financial statements in the event that after the application of either approach and consideration of all relevant quantitative and qualitative factors, a misstatement is determined to be material. SAB 108 is effective for fiscal years beginning after November 15, 2006. The Company does not expect the adoption of SAB 108 will have a material effect on its consolidated financial position, consolidated results of operations, or liquidity.

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (FIN 48) which defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. A tax position that meets the “more-likely-than-not” criterion shall be measured at the largest amount of benefit that is more than 50% likely of being realized upon ultimate settlement. Interpretation No. 48 applies to all tax positions accounted for under SFAS No. 109, “Accounting for Income Taxes.” Interpretation No. 48 is effective for fiscal years beginning after December 15, 2006. Upon adoption, the financial statements will be adjusted to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. Any adjustment will be recorded directly to our beginning retained earnings balance in the period of adoption and reported as a change in accounting principle. The Company is currently analyzing the effects of adopting Interpretation No. 48.

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements” (SFAS 154). SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 did not have a material effect on the Company’s consolidated financial position, consolidated results of operations, or liquidity.

5. Composition of Certain Financial Statement Captions

Accounts receivable include amounts related to maintenance and services which were billed but not yet rendered as of the end of the period. Undelivered maintenance and services are included on the consolidated balance sheet as part of the deferred revenue balance.


	DECEMBER 31, 2006			MARCH 31, 2006


Accounts receivable, excluding undelivered software, maintenance and services	$	36,481		$	29,832
Undelivered software, maintenance and implementation services billed in advance, included in deferred revenue		24,839			17,389

Accounts receivable, gross		61,320			47,221

Reserve for bad debts		(2,305	)		(2,556	)


Accounts receivable, net	$	59,015		$	44,665

Inventories are summarized as follows:


	DECEMBER 31, 2006		MARCH 31, 2006


Computer systems and components, net of reserve for obsolescence of $304, for both periods	$	1,288	$	539
Miscellaneous parts and supplies		23		22


Inventories, net	$	1,311	$	561

Other current liabilities are summarized as follows:


	DECEMBER 31, 2006		MARCH 31, 2006


Customer deposits	$	2,702	$	624
Accrued royalties		681		—
Sales tax payable		664		575
Deferred rent		612		360
Commission payable		536		519
Accrued EDI expenses		—		470
Other accrued expenses		1,632		1,264


Other current liabilities	$	6,827	$	3,812

Accrued compensation and related benefits are summarized as follows:


	DECEMBER 31, 2006		MARCH 31, 2006


Bonus	$	2,743	$	3,714
Vacation		2,131		1,776


Accrued compensation and related benefits	$	4,874	$	5,490

Short and long-term deferred revenue are summarized as follows:


	DECEMBER 31, 2006		MARCH 31, 2006


Maintenance	$	10,209	$	7,838
Implementation services		27,697		23,792
Undelivered software and other		2,640		4,286


Deferred Revenue	$	40,546	$	35,916

6. Intangible Assets – Goodwill

In accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), the Company does not amortize goodwill as the goodwill has been determined to have indefinite useful life. The balance of goodwill is related to the Company’s NextGen Healthcare Information Systems Division (NextGen or Division), which was acquired by virtue of two acquisitions completed in May of 1996 and 1997, respectively. In accordance with SFAS 142, the Company has compared the fair value of the NextGen Division with the carrying amount of assets associated with the Division and determined that none of the goodwill recorded as of June 30, 2006 (the annual assessment date) was impaired. Assessments are performed annually unless there is a triggering event which would require an earlier assessment. The fair value of NextGen was determined using a reasonable estimate of future cash flows of the Division and a risk adjusted discount rate to compute a net present value of future cash flows.

7. Intangible Assets – Capitalized Software Development Costs

The Company had the following amounts related to capitalized software development:


	DECEMBER 31, 2006			MARCH 31, 2006


Gross carrying amount	$	20,062		$	16,584
Accumulated amortization		(13,739	)		(11,413	)


Net capitalized software development	$	6,323		$	5,171


Aggregate amortization expense during the nine and twelve month period ended	$	2,326		$	2,460

Activity related to net capitalized software costs for the nine month period ended December 31, 2006 and 2005 is as follows:


	DECEMBER 31, 2006			DECEMBER 31, 2005

Beginning of the period	$	5,171		$	4,334
Capitalization		3,478			2,341
Amortization		(2,326	)		(1,795	)

End of the period	$	6,323		$	4,880

The following table represents the remaining estimated amortization of intangible assets with determinable lives as of December 31, 2006:


For the year ended March 31,
2007	$	905
2008		2,963
2009		1,854
2010		601

Total	$	6,323


8. Employee Stock Option Plans

In September 1998, the Company’s shareholders approved a stock option plan (the “1998 Plan”) under which 4,000,000 shares of Common Stock were reserved for the issuance of options. The 1998 Plan provides that employees, directors and consultants of the Company, at the discretion of the Board of Directors or a duly designated compensation committee, be granted options to purchase shares of Common Stock. The exercise price of each option granted shall be determined by the Board of Directors at the date of grant and, generally expire no later than ten years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement pursuant to which they were granted. Certain other option grants to directors became exercisable three months from the date of grant. Upon an acquisition of the Company by merger or asset sale, each outstanding option may be subject to accelerated vesting under certain circumstances. The 1998 Plan terminates on December 31, 2007, unless sooner terminated by the Board. At December 31, 2006, 58,300 shares were available for future grant under the 1998 Plan. As of December 31, 2006, there were 1,598,801 outstanding options related to this Plan.

In October 2005, the Company’s shareholders approved a stock option and incentive plan (the “2005 Plan”) under which 2,400,000 shares of Common Stock have been reserved for the issuance of awards, including stock options, incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock, unrestricted stock, restricted stock units, performance shares, performance units (including performance options) and other stock based awards. The 2005 Plan provides that employees, directors and consultants of the Company, at the discretion of the Board of Directors or a duly designated compensation committee, be granted awards to purchase shares of Common Stock. The exercise price of each award granted shall be determined by the Board of Directors at the date of grant and, generally expire no later than ten years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement, pursuant to which they were granted. Upon an acquisition of the Company by merger or asset sale, each outstanding award may be subject to accelerated vesting under certain circumstances. The 2005 Plan terminates on May 25, 2015, unless sooner terminated by the Board. At December 31, 2006, 2,400,000 shares were available for future grant under the 2005 Plan. As of December 31, 2006, there were no outstanding options related to this Plan.

A summary of stock option transactions during the nine months ended December 31, 2006 is as follows:



	Number of Shares			Weighted -Average Exercise Price		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value (in thousands)

Outstanding, April 1, 2006		1,798,372		$	16.78	4.78
Granted		75,000		$	38.36	5.94
Exercised		(274,563	)	$	13.84	3.13	$	6,433
Forfeited/Canceled		(8	)	$	3.25	—

Outstanding, Dec. 31, 2006		1,598,801		$	18.30	4.27	$	30,335

Exercisable, Dec. 31, 2006		423,476		$	19.64	4.29	$	7,464

The Company continues to utilize the Black-Scholes valuation model for estimating the fair value of stock-based compensation after the adoption of SFAS 123R with the following assumptions:


		NINE MONTHS ENDED DECEMBER 31, 2006


Expected life		3.75-4.75 years
Expected volatility		47.7%-48.50%
Expected dividends		2.05%-2.36%
Risk-free rate		4.60%-5.09%

During the nine months ended December 31, 2006, 75,000 options were granted under the 1998 Stock Option Plan. The Company issues new shares to satisfy option exercises. Based on historical experience of option cancellations, the Company has estimated an annualized forfeiture rate of 1.2% for employee options and 0.0% for director options. The weighted average grant date fair value of stock options granted during the first nine months ended December 31, 2006 and 2005 was $14.33 per share and 15.23 per share, respectively.

On September 20, 2006, the Board of Directors granted a total of 35,000 options under the Company’s 1998 Stock Option Plan to non-management Directors pursuant to the Company’s previously announced compensation plan for non-management directors, at an exercise price equal to the market price of the Company’s common stock on the date of grant ($39.81 per share). The options vest in four equal annual installments beginning September 20, 2007 and expire on September 20, 2013.

On August 11, 2006, the Board of Directors granted a total of 40,000 options under the Company’s 1998 Stock Option Plan to selected employees at an exercise price equal to the market price of the Company’s common stock on the date of the grant ($37.09 per share). The options vest in four equal annual installments beginning August 11, 2007 and expire on August 11, 2011.

On July 25, 2006, the Board of Directors approved a performance based equity incentive program for employees to be awarded options to purchase the Company’s common stock based on meeting certain target increases in earnings per share performance and revenue growth during fiscal year 2007. The options shall be issued pursuant to one of the Company’s shareholder approved option plans, have an exercise price equal to the closing price of the Company’s shares on the date of grant, a term of five years, vest in four equal installments commencing one year following the date of grant. The maximum number of options available under the performance based equity incentive program plan is 115,000. Compensation expense of $61 for these options was recorded in the nine months ended December 31, 2006. See also Note 15.

Non-vested stock award activity including awards for the nine month period ended December 31, 2006 is summarized as follows:



	Non-vested Number of Shares			Weighted -Average Grant Date Fair Value per Share

Non-vested, April 1, 2006		1,327,075		$	7.34
Granted		75,000		$	14.33
Vested		(226,750	)	$	5.94
Forfeited/Canceled		—			—

Non-vested, December 31, 2006		1,175,325		$	8.05

As of December 31, 2006, $7,069 of total unrecognized compensation costs related to stock options is expected to be recognized over a weighted average period of 4.26 years. This amount does not include the cost of new options that may be granted in future periods nor any changes in the Company’s forfeiture percentage. The total fair value of shares vested during the nine months ended December 31, 2006 was $1,347.


9. Income Taxes

The provision for income taxes for the nine months ended December 31, 2006 was $15,439 as compared to $9,774 for the year ago period. The effective tax rates for the nine months ended December 31, 2006 and 2005 was 38.4%, respectively. The provision for income taxes for the nine months ended December 31, 2006 differs from the combined statutory rates

primarily due to the impact of federal and state research and development tax credits. The effective rate for the nine month period ended December 31, 2006 also includes a benefit from the Qualified Production Activities Deduction, which was mostly offset by non-deductible option expense related to incentive stock options. The tax provision for the nine months ended December 31, 2005 also included a benefit for research and development credits.


10. Net Income Per Share

The following table reconciles the weighted average shares outstanding for basic and diluted net income per share for the periods indicated. Basic net income per share is based upon the weighted average number of common shares outstanding. Diluted net income per share is based on the assumption that the Company’s outstanding options are included in the calculation of diluted earnings per share, except when their effect would be anti-dilutive. Dilution is computed by applying the treasury stock method. Under this method, options are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.


	THREE MONTHS ENDED DECEMBER 31,				NINE MONTHS ENDED DECEMBER 31,

	2006		2005		2006		2005


Net income	$	8,721	$	4,815	$	24,727	$	15,684
Basic net income per common share:
Weighted average of common shares outstanding		26,966		26,490		26,828		26,338

Basic net income per common share	$	0.32	$	0.18	$	0.92	$	0.60


Net income	$	8,721	$	4,815	$	24,727	$	15,684
Diluted net income per common Share:
Weighted average of common shares outstanding		26,966		26,490		26,828		26,338
Effect of potentially dilutive securities (options)		541		882		613		910

Weighted average of common shares outstanding-diluted		27,507		27,372		27,441		27,248

Diluted net income per common share	$	0.32	$	0.18	$	0.90	$	0.58

The computation of diluted earning per share does not include 92,500 options for the three months and nine months ended December 31, 2006 because their inclusion would have an anti-dilutive effect on earnings per share.


11. Operating Segment Information

The Company has prepared operating segment information in accordance with Statement of Accounting Standards No. 131 “Disclosures About Segments of an Enterprise and Related Information” (SFAS 131) to report components that are evaluated regularly by the Company’s chief operating decision maker, or decision making group in deciding how to allocate resources and in assessing performance.

The Company’s reportable operating segments include its NextGen Healthcare Information Systems Division and the QSI Division.

The disaggregated financial results of the segments reflect allocation of certain functional expense categories consistent with the basis and manner in which Company management internally disaggregates financial information for the purpose of assisting in making internal operating decisions. Certain corporate overhead costs are not allocated to the individual segments by management. The Company evaluates performance based on stand-alone segment revenue and operating income performance. Because the Company does not evaluate performance based on return on assets at the operating segment level, assets are not tracked internally by segment. Therefore, segment asset information is not presented.

Operating segment data for the three and nine month periods ended December 31, 2006 and 2005 is as follows:


	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,

	2006			2005			2006			2005

Revenue:
QSI Division	$	4,267		$	3,867		$	12,129		$	11,718
NextGen Division		34,229			22,885			99,900			72,004

Consolidated revenue	$	38,496		$	26,752		$	112,029		$	83,722


Operating income (loss):
QSI Division	$	1,368		$	951		$	3,526		$	2,971
NextGen Division		13,424			7,904			40,873			26,460
Unallocated corporate expenses		(2,187	)		(1,730	)		(6,654	)		(5,368	)

Consolidated operating income	$	12,605		$	7,125		$	37,745		$	24,063

12. Concentration of Credit Risk

The Company had cash deposits at U.S. banks and financial institutions which exceeded federally insured limits at December 31, 2006. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institutions; however, the Company does not anticipate non-performance by these institutions.

13. Customer Concentration

One customer represented approximately 20.0% of total gross accounts receivable as of December 31, 2006.

14. Guarantees

Software license agreements in both our QSI and NextGen Divisions include a performance guarantee that its software products will substantially operate as described in the applicable program documentation for a period of 365 days after delivery. To date, the Company has not incurred any significant costs associated with these warranties and does not expect to incur significant warranty costs in the future. Therefore, no accrual has been made for potential costs associated with these warranties.

The Company’s standard sales agreements in the NextGen Division contain an indemnification provision pursuant to which it shall indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with any United States patent, any copyright or other intellectual property infringement claim by any third party with respect to its software. The QSI Division arrangements occasionally utilize this type of language as well. As the Company has not incurred any significant costs to defend lawsuits or settle claims related to these indemnification agreements, the Company believes that its estimated exposure on these agreements is currently minimal. Accordingly, the Company has no liabilities recorded for these indemnification obligations.

From time to time, the Company offers future purchase discounts on its products and services as part of its sales arrangements. Discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.

The Company has entered into marketing assistance agreements with existing users of the Company’s products which provide the opportunity for those users to earn commissions if and only if they host specific site visits upon our request for prospective customers which directly result in a purchase of our software by the visiting prospects. Amounts earned by existing users under this program are treated as a selling expense in the period in which commissionable software has been recognized as revenue.

15. Subsequent Events

On January 29, 2007, a committee comprised of all the independent directors of the Board of Directors modified the Company’s previously approved performance based equity incentive program for employees. Under this program, options to purchase the Company’s common stock are awarded based on meeting certain target increases in earnings per share performance and revenue growth during fiscal year 2007. Modifications to the program include an

increase of the maximum number of options available under the program from 115,000 to 290,000. See Note 8.

On January 29, 2007, the Board of Directors approved a one-time cash dividend of $1.00 per share payable on its outstanding shares of common stock. The cash dividend record date is February 13, 2007 and is expected to be distributed to shareholders on or about February 28, 2007.

Also on January 29, 2007, the Board of Directors adopted a policy whereby the Company intends to pay a regular quarterly dividend of twenty-five cents ($0.25) per share on the Company’s outstanding shares of common stock commencing with conclusion of the Company’s first fiscal quarter of 2008 and continuing each fiscal quarter thereafter, subject to further review and approval and establishment of record and distribution dates by the Board of Directors prior to the declaration of each such quarterly dividend.

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

Except for the historical information contained herein, the matters discussed in this quarterly report may include forward-looking statements that involve certain risks and uncertainties. Actual results may differ from those anticipated by us as a result of various factors, both foreseen and unforeseen, including, but not limited to, our ability to continue to develop new products and increase systems sales in markets characterized by rapid technological evolution, consolidation, and competition from larger, better capitalized competitors. Many other economic, competitive, governmental and technological factors could impact our ability to achieve our goals, and interested persons are urged to review any new risks which may be described in “Risk Factors” set forth herein and other risk factors appearing in our most recent filing on Form 10-K, as supplemented by additional risk factors, if any, in our interim filings on Form 10-Q, as well as in our other public disclosures and filings with the Securities and Exchange Commission.

The following discussion should be read in conjunction with, and is qualified in its entirety by, the Consolidated Financial Statements and related notes thereto included elsewhere in this report. Historical results of operations, percentage profit fluctuations and any trends that may be inferred from the discussion below are not necessarily indicative of the operating results for any future period.

Critical Accounting Policies and Estimates. The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate estimates, including but not limited to those related to revenue recognition, uncollectible accounts receivable, intangible assets, software development cost, and income taxes for reasonableness. We base our estimates on historical experience and on various other assumptions that management believes 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. Actual results may differ from these estimates under different assumptions or conditions.

We believe revenue recognition, the allowance for doubtful accounts, capitalized software costs, stock based compensation and income taxes are among the most critical accounting policies and estimates that impact our consolidated financial statements. We believe that our significant accounting policies, as described in Note 3 of our Condensed Notes to Consolidated Financial Statements, “Summary of Significant Accounting Policies”, should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Revenue Recognition. We currently recognize revenue pursuant to SOP 97-2, as amended by SOP 98-9. We generate revenue from the sale of licensing rights to use our software products sold directly to end-users and value-added resellers (VARs). We also generate revenue from sales of hardware and third party software, and implementation, training, EDI, post-contract support (“maintenance”) and other services performed for customers who license our products.

A typical system contract contains multiple elements of the above items. SOP 97-2, as amended, requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements. The fair value of an element must be based on vendor specific objective evidence (VSOE). We limit our assessment of VSOE for each element to either the price charged when the same element is sold separately (using a rolling average of stand alone transactions) or the price established by management having the relevant authority to do so, for an element not yet sold separately. VSOE calculations are updated and reviewed quarterly or annually.

of each of the undelivered elements, and allocates the remainder of the contract price net of all discounts to revenue recognized from the delivered elements. Undelivered elements of a system sale may include implementation and training services, hardware and third party software, maintenance, future purchase discounts, or other services. If VSOE of fair value of any undelivered element does not exist, all revenue is deferred until VSOE of fair value of the undelivered element is established or the element has been delivered.

We bill for the entire contract amount upon contract execution. Amounts billed in excess of the amounts contractually due are recorded in accounts receivable as advance billings. Amounts are contractually due when services are performed or in accordance with contractually specified payment dates. Provided the fees are fixed and determinable and collection is considered probable, revenue from licensing rights and sales of hardware and third party software is generally recognized upon shipment and transfer of title. If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized using the residual method. Fees which are considered fixed or determinable at the inception of our arrangements must include the following characteristics:


§	The fee must be negotiated at the outset of an arrangement, and generally be based on the specific volume of products to be delivered without being subject to change based on variable pricing mechanisms such as the number of units copied or distributed or the expected number of users.

§	Payment terms must not be considered extended. If a significant portion of the fee is due more than 12 months after delivery or after the expiration of the license, the fee is presumed not fixed and determinable.

Revenue from implementation and training services is recognized as the corresponding services are performed. Maintenance revenue is recognized ratably over the contractual maintenance period.

Pursuant to SOP 81-1, the Company uses the percentage of completion method provided all of the following conditions exist:


§	the contract includes provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement;

§	the customer can be expected to satisfy its obligations under the contract;

§	the Company can be expected to perform its contractual obligations; and

§	reliable estimates of progress towards completion can be made.

We measure completion using labor input hours. Costs of providing services, including services accounted for in accordance with SOP 81-1, are expensed as incurred.

If a situation occurs in which a contract is so short term that the financial statements would not vary materially from using the percentage-of-completion method or in which we are unable to make reliable estimates of progress of completion of the contract, the completed contract method is utilized.

The Company has historically offered short-term rights of return of less than 20 days in certain new system sales arrangements. Based on historical experience with similar types of sales transactions bearing these short-term rights of return, no accrual for system sales returns related to short-term rights of return was recorded.

Product returns are estimated in accordance with Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (SFAS 48). We also ensure that the other criteria in SFAS 48 have been met prior to recognition of revenue:


§	the price is fixed or determinable;

§	the customer is obligated to pay and there are no contingencies surrounding the obligation or the payment;

§	the customer’s obligation would not change in the event of theft or damage to the product;


§	the customer has economic substance;

§	the amount of returns can be reasonably estimated; and

§	we do not have significant obligations for future performance in order to bring about resale of the product by the customer.

From time to time, we offer future purchase discounts on our products and implementation services as part of our sales arrangements. Pursuant to AICPA TPA 5100.50, discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires. Significant maintenance discounts are also treated as an additional element of the contract.

Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments to us. We perform credit evaluations of our customers and maintain reserves for estimated credit losses. Reserves for potential credit losses are determined by establishing both specific and general reserves. Specific reserves are based on management’s estimate of the probability of collection for certain troubled accounts. General reserves are established based on our historical experience of bad debt expense and the aging of our accounts receivable balances, net of deferred revenue and specifically reserved accounts. If the financial condition of one or more our customers were to deteriorate resulting in an impairment of their ability to make payments, additional allowances would be required.

Software Development Costs. Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. After technological feasibility is established with the completion of a working model of the enhancement or product, any additional development costs are capitalized in accordance with the Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86). Such capitalized costs are amortized on a straight line basis over the estimated economic life of the related product, which is generally three years. We perform an annual review of the recoverability of such capitalized software costs. At the time a determination is made that capitalized amounts are not recoverable based on the estimated cash flows to be generated from the applicable software, any remaining capitalized amounts would be written off.

Stock Based Compensation. On April 1, 2006, we adopted Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (SFAS 123R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). SFAS 123R requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is expected to vest is recognized as expense over the requisite service period in our Consolidated Statement of Income. We use the simplified method for estimating expected term equal to the midpoint between the vesting period and the contractual term. Prior to using the simplified method, we estimated the expected term of an option. We estimate volatility by using the weighted average historical volatility of our common stock which we believe approximates expected volatility. The risk free rate is the implied yield available on the U.S Treasury zero-coupon issues with remaining terms equal to the expected term. Those inputs are then entered into the Black Scholes model.

Research and Development Tax Credits. Management’s treatment of research and development tax credits represents an estimate that affects the Company’s effective income tax rate for the three and nine months ended December 31, 2005. Research and development credits taken by the Company involve certain assumptions and judgments regarding qualified expenses under the applicable state regulations. In December 2006, the federal research and development tax credit provisions were re-enacted into law, resulting in a benefit for research and development tax credits recorded in the December 2006 quarter. The three month period ended December 31, 2006 includes research and development tax credits for the period from April 2006 to December 2006.

Qualified Production Activities Deduction. Management’s treatment of this deduction represents an estimate that affects the Company’s effective income tax rate for the three and nine months ended December 31, 2006. The deduction taken by the Company involved

certain assumptions and judgments regarding the allocation of indirect expenses as prescribed under Internal Revenue Code Section 199.

Company Overview

Quality Systems Inc., comprised of the QSI Division (QSI Division) and a wholly owned subsidiary, NextGen Healthcare Information Systems, Inc. (NextGen Division) (collectively, the Company, we, our, or us) develops and markets healthcare information systems that automate certain aspects of medical and dental practices, networks of practices such as physician hospital organizations (PHO’s) and management service organizations (MSO’s), ambulatory care centers, community health centers, and medical and dental schools.

The Company, a California corporation formed in 1974, was founded with an early focus on providing information systems to dental group practices. In the mid-1980’s, we capitalized on the increasing focus on medical cost containment and further expanded our information processing systems to serve the medical market. In the mid-1990’s we made two acquisitions that accelerated our penetration of the medical market. These two acquisitions formed the basis for what is today the NextGen Division. Today, we serve the medical and dental markets through our two divisions.

The two divisions operate largely as stand-alone operations with each division maintaining its own distinct product lines, product platforms, development, implementation and support teams, sales staffing, and branding. The two divisions share the resources of the “corporate office” which includes a variety of accounting and other administrative functions. Additionally, there are a small number of clients who are simultaneously utilizing software from each of our two divisions.

The QSI Division, co-located with our Corporate Headquarters in Irvine, California, currently focuses on developing, marketing and supporting software suites sold to dental and certain niche medical practices. In addition, the Division supports a number of medical clients that utilize the Division’s UNIX¹ based medical practice management software product.

The NextGen Division, with headquarters in Horsham, Pennsylvania, and a second significant location in Atlanta, Georgia, focuses principally on developing and marketing products and services for medical practices.

Both divisions develop and market practice management software which is designed to automate and streamline a number of the administrative functions required for operating a medical or dental practice. Examples of practice management software functions include scheduling and billing capabilities. It is important to note that in both the medical and dental environments, practice management software systems have already been implemented by the vast majority of practices. Therefore, we actively compete for the replacement market.

In addition, both divisions develop and market software that automates the patient record. Adoption of this software, commonly referred to as clinical software, is in its relatively early stages. Therefore, we are typically competing to replace paper-based patient record alternatives as opposed to replacing previously purchased systems.

Electronic Data Interchange (EDI)/connectivity products are intended to automate a number of manual, often paper-based or telephony intensive communications between patients and/or providers and/or payors. Two of the more common EDI services are forwarding insurance claims electronically from providers to payors and assisting practices with issuing statements to patients. Most practices utilize at least some of these services from us or one of our competitors. Other EDI/connectivity services are used more sporadically by client practices. We typically compete to displace incumbent vendors for claims and statements accounts, and attempt to increase usage of other elements in our EDI/connectivity product line. In general, EDI services are only sold to those accounts utilizing software from one of our divisions.

The QSI Division’s practice management software suite utilizes a UNIX operating system. Its Clinical Product Suite (CPS) utilizes a Windows NT² operating system and can be fully integrated with the practice management software from each division. CPS incorporates a wide range of clinical tools including, but not limited to, periodontal charting and


¹	UNIX is a registered trademark of the AT&T Corporation.

²	Microsoft Windows, Windows NT, Windows 95, Windows 98, Windows XP, and Windows 2000 are registered trademarks of the Microsoft Corporation.

digital imaging of X-ray and inter-oral camera images as part of the electronic patient record. The Division develops, markets, and manages our EDI/connectivity applications. The QSInet Application Service Provider (ASP/Internet) offering is also developed and marketed by the Division.

Our NextGen Division develops and sells proprietary electronic medical records software and practice management systems under the NextGen^®3 product name. Major product categories of the NextGen suite include Electronic Medical Records (NextGen^emr), Enterprise Practice Management (NextGen^epm), Enterprise Appointment Scheduling (NextGen^eas), NextGen Image Control System (NextGen^ics), Realtime Transaction Server (NextGen^rts), Electronic Data Interchange, System Interfaces, OPTIK, NextGen Edits, NextGen RTF File Monitor, and a Patient-centric Web Portal solution (NextMD⁴.com). NextGen also markets a version of NextGen^emr with reduced capabilities (NextGen Express). NextGen products utilize Microsoft Windows technology and can operate in a client-server environment as well as via private intranet, the Internet, or within an ASP environment.

In May 2006, the NextGen Division announced the launch of a new community network technology product called NextGen^® Community Health Solution (NextGen CHS) and in fiscal year 2006 introduced a new service called Practice Solutions. This service provides billings services to single and group practice practitioners.

We continue to pursue product enhancement initiatives within each division. The majority of such expenditures are currently targeted to the NextGen Division product line and client base.

Inclusive of divisional EDI revenue, the NextGen Division accounted for approximately 88.9% of our revenue for the third quarter of fiscal 2007 compared to 85.5% in the third quarter of fiscal 2006. The QSI Division accounted for 11.1% and 14.5% of revenue in the third quarter of fiscal 2007 and 2006, respectively. The NextGen Division’s year over year revenue grew at 49.6% and 24.7% in the third quarter of fiscal 2007 and 2006, respectively, while the QSI Division’s year over year revenue increased by 10.3% and 3.3% in the third quarter of fiscal 2007 and 2006, respectively.

In addition to the aforementioned software solutions which we offer through our two divisions, each division offers comprehensive hardware and software installation services, maintenance and support services, and system training services.

Results of Operations

Overview of results


§	We have experienced significant growth in our total revenue as a result of growth in our NextGen Division. Consolidated revenue grew 33.8% in the nine months ended December 31, 2006 versus 2005 and 32.0% in the nine months ended December 31, 2005 versus 2004.

§	Consolidated income from operations grew 56.9% in the nine months ended December 31, 2006 versus 2005 and 34.0% in the nine months ended December 31, 2005 versus 2004. This performance was driven principally by the results in our NextGen Division.

§	We have benefited and hope to continue to benefit from the increased demands on healthcare providers for greater efficiency and lower costs, as well as increased adoption rates for electronic medical records and other technology in the healthcare arena.

§	On April 1, 2006, we adopted SFAS 123R which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. Share-based compensation expense recognized under SFAS 123R for the nine months ended December 31, 2006 was $2.7 million, which consisted of stock-based compensation expense related to employee and director stock options. The $2.7 million includes $0.3 million expensed under APB 25 for “in the money” options issued prior to the adoption of SFAS 123R. As of December 31, 2006, $7.1 million of total unrecognized compensation costs related to stock options. These expenses will be allocated between cost of revenue, selling, general and administrative and research and development costs. This amount does not include the cost of new


³	NextGen is a registered trademark of NextGen Healthcare Information Systems, Inc.

⁴	NextMD is a registered trademark of NextGen Healthcare Information Systems, Inc.


	options that may be granted in future periods nor any changes in our forfeiture percentage.

NextGen Division


§	Our NextGen Division has experienced significant growth in revenue and operating income. Divisional revenue grew 38.7% in the nine months ended December 31, 2006 versus 2005 and 39.1% in the nine months ended December 31, 2005 versus 2004 while divisional operating income (excluding unallocated corporate expenses) grew 54.5% in the nine months ended December 31, 2006 versus 2005 and 47.1% in the nine months ended December 31, 2005 versus 2004.

§	During the nine months ended December 31, 2006, we added staffing resources to departments including sales, support, implementation, and software development and intend to continue to do so during the remainder of fiscal year 2007.

§	Our goals include continuing to further enhance our existing products, developing new products for targeted markets, continuing to add new customers, selling additional software and services to existing customers and expanding penetration of connectivity services to new and existing customers.

QSI Division


§	Our QSI Division revenue grew 3.5% in the nine months ended December 31, 2006 versus 2005 and remained relatively consistent in the nine months ended December 31, 2005 versus 2004. The Division experienced an 18.7% increase in operating income (excluding unallocated corporate expenses) in the nine months ended December 31, 2006 versus 2005 as compared to a 13.5% decrease in operating income in the nine months ended December 31, 2005 versus 2004.

§	Our goals for the QSI Division include maximizing profit performance given the constraints represented by a weak purchasing environment in the dental group practice market.

The following table sets forth for the periods indicated the percentage of revenues represented by each item in our Consolidated Statements of Income.


(Unaudited)	THREE MONTHS ENDED DECEMBER 31,				NINE MONTHS ENDED DECEMBER 31,

	2006		2005		2006		2005

Revenues:
Software, hardware and supplies	41.8	%	40.5	%	42.7	%	44.8	%
Implementation and training services	7.5		9.8		7.8		9.7

System sales	49.3		50.3		50.5		54.5

Maintenance	28.8		28.9		26.9		26.8
Electronic data interchange services	11.1		12.4		11.0		11.4
Other services	10.8		8.4		11.6		7.3

Maintenance, EDI and other services	50.7		49.7		49.5		45.5


Total revenue	100.0		100.0		100.0		100.0


Cost of revenue:
Software, hardware and supplies	4.7		6.2		4.7		7.2
Implementation and training services	5.6		7.4		5.6		6.9

Total cost of system sales	10.3		13.6		10.3		14.1

Maintenance	7.9		7.5		8.0		7.8
Electronic data interchange services	8.2		8.3		7.9		7.6
Other services	6.6		5.7		5.9		4.9

Total cost of maintenance, EDI and other services	22.7		21.5		21.8		20.3


Total cost of revenue	33.0		35.1		32.1		34.4


Gross profit	67.0		64.9		67.9		65.6


Selling, general and administrative	27.5		30.0		27.5		29.8
Research and development	6.8		8.2		6.7		7.1


Income from operations	32.7		26.7		33.7		28.7


Interest income	2.4		2.2		2.2		1.7


Income before provision for income taxes	35.2		28.9		35.9		30.4
Provision for income taxes	12.5		10.9		13.8		11.6


Net income	22.7	%	18.0	%	22.1	%	18.7	%*


*	does not add due to rounding

For the Three-Month Periods Ended December 31, 2006 versus 2005

Net Income. The Company’s net income for the three months ended December 31, 2006 was $8.7 million or $0.32 per share on a basic and $0.32 per share on a fully diluted basis. In comparison, we earned $4.8 million or $0.18 per share on a basic and $0.18 per share on a fully diluted basis for the three months ended December 31, 2005. The increase in net income for the three months ended December 31, 2006 was achieved primarily through the following:


§	a 43.9% increase in consolidated revenue;

§	a 49.6% increase in NextGen Division revenue which accounted for 88.9% of consolidated revenue;

§	increase in the consolidated gross profit percentage which increased to 67.0% in the three months ended December 31, 2006 versus 64.9% in the same period last year; and

§	a reduction in the effective tax rate in the quarter ended December 31, 2006 to 35.6% versus 37.6% in the prior year quarter primarily due to a benefit for research and development tax credits recorded in the December, 2006 quarter provision as a result of the re-enactment of research and development tax credit statutes which occurred in December, 2006. The three month period ended December 31, 2006 includes research and development tax credits for the period from April 2006 to December 2006.

Revenue. Revenue for the three months ended December 31, 2006 increased 43.9% to $38.5 million from $26.8 million for the three months ended December 31, 2005. NextGen Division revenue increased 49.6% from approximately $22.9 million to approximately $34.2 million in the period, while QSI Division revenue increased by 10.3% during the period.

We divide revenue into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes, maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

System Sales. Company-wide sales of systems for the three months ended December 31, 2006, increased 41.1% to $19.0 million from $13.5 million in the prior year quarter.

Our increase in revenue from sales of systems was principally the result of a 40.2% increase in category revenue at our NextGen Division. Divisional sales in this category grew from $12.8 million during the quarter ended December 31, 2005 to $17.9 million during the quarter ended December 31, 2006. This increase was driven primarily by higher sales of NextGen^emr and NextGen^epm software to both new and existing clients, as well as delivery of related implementation services. Hardware, third party software and supplies have remained consistent between periods.

The following table breaks down our reported system sales into software, hardware, third party software, supplies, and implementation and training services components by Division:



	Software		Hardware, Third Party Software and Supplies		Implementation and Training Services		Total System Sales

Three months ended December 31, 2006
QSI Division	$	235	$	710	$	119	$	1,064
NextGen Division		14,612		531		2,766		17,909

Consolidated	$	14,847	$	1,241	$	2,885	$	18,973


Three months ended December 31, 2005
QSI Division	$	216	$	391	$	67	$	674
NextGen Division		9,696		532		2,548		12,776

Consolidated	$	9,912	$	923	$	2,615	$	13,450

NextGen Division software revenue increased 50.7% between the three months ended December 31, 2005 and the three months ended December 31, 2006. The Division’s software revenue accounted for 81.6% of divisional system sales revenue during the three months ended December 31, 2006, an increase from 75.9% in the prior year period. Software sales revenue from VAR’s totaled approximately $3.1 million compared to $0.7 million in the prior year period. The increase in VAR revenue was impacted in part by revenue from sales to Siemens Medical Solutions. Software license revenue growth continues to be an area of primary emphasis for the NextGen Division and management was pleased with the Division’s performance in this area.

During the three months ended December 31, 2006, 3.0% of NextGen’s system sales revenue was represented by hardware and third party software compared to 4.2% in the same prior year period. We have noted that results from numerous prior quarters have included a relatively lower amount of hardware and third party software compared to prior periods. However, this decrease was not and is not the result of any change in emphasis on our part. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software revenue fluctuates each quarter depending on the needs of customers. The inclusion of hardware and third party software in the Division’s sales arrangements is typically at the request of the customer and is not a priority focus for us.

Implementation and training revenue related to system sales at the NextGen Division increased 8.6% in the three months ended December 31, 2006 compared to the three months ended December 31, 2005. The amount of implementation and training services revenue in any given quarter is dependent on several factors, including timing of customer implementations, the availability of qualified staff, and the mix of services being rendered. The number of implementation and training staff increased during the three months ended December 31, 2006 versus 2005 in order to accommodate the increased amount of implementation services sold in conjunction with increased software sales. In order to achieve growth in this area, additional staffing increases and additional training facilities are anticipated, though actual future increases in revenue and staff will depend upon the availability of qualified staff, business mix and conditions, and our ability to retain current staff members.

The NextGen Division’s growth has come in part from investments in sales and marketing activities including hiring additional sales representatives, trade show attendance, and advertising expenditures. We have also benefited from winning numerous industry awards for the NextGen Division’s flagship NextGen^emrand NextGen^epm software products in fiscal years 2007 and 2006, as well as in prior years, and the apparent increasing acceptance of electronic medical records technology in the healthcare industry.

For the QSI Division, total system sales increased approximately $0.4 million in the three months ended December 31, 2006 versus December 31, 2005. We do not presently foresee any material changes in the business environment for the Division with respect to the weak purchasing environment in the dental group practice market that has existed for the past several years.

Maintenance, EDI and Other Services. For the three months ended December 31, 2006, Company-wide revenue from maintenance, EDI and other services grew 46.8% to $19.5 million from $13.3 million in the same period in the prior year. The increase in this category resulted from an increase in maintenance, EDI and other services revenue from the NextGen Division’s client base. Total NextGen Division maintenance revenue for the three months ended December 31, 2006 grew 54.7% to $9.3 million from $6.0 million in the same year ago period, while EDI revenue grew 47.0% to $3.2 million compared to $2.2 million during the same prior year period. Other services revenue for the three months ended December 31, 2006 grew to $3.8 million compared from $1.9 million in the year ago period. The increase in Other services was due primarily to purchases of additional training and other services by existing NextGen customers. QSI Division maintenance revenue increased 3.2% in the same period a year ago while QSI divisional EDI revenue decreased by 3.9% between the same period a year ago.

The following table details revenue included in the EDI, maintenance, and other category for the three month periods ended December 31, 2006 and 2005:



	Maintenance		EDI		Other		Total

Three months ended December 31, 2006
QSI Division	$	1,784	$	1,086	$	333	$	3,203
NextGen Division		9,285		3,204		3,831		16,320

Consolidated	$	11,069	$	4,290	$	4,164	$	19,523


Three months ended December 31, 2005
QSI Division	$	1,729	$	1,130	$	334	$	3,193
NextGen Division		6,004		2,180		1,925		10,109

Consolidated	$	7,733	$	3,310	$	2,259	$	13,302

The growth in maintenance revenue for the NextGen Division has come from new customers that have been added each quarter, existing customers who have purchased additional licenses, and our relative success in retaining existing maintenance customers. NextGen’s EDI revenue growth has come from new customers and from further penetration of the Division’s existing customer base. We intend to continue to promote maintenance and EDI services to both new and existing customers.

The following table provides the number of billing sites which were receiving maintenance services as of the last business day of the quarters ended December 31, 2006 and 2005 respectively, as well as the number of billing sites receiving EDI services during the last month of each respective period at each Division of the Company. The table presents summary information only and includes billing entities added and removed for any reason. Note also that a single client may include one or multiple billing sites, and changes in billing protocols for certain clients can cause period to period changes in the number of billing sites.



	NextGen						QSI						Consolidated

	Maintenance			EDI			Maintenance			EDI			Maintenance			EDI


December 31, 2005		783			530			280			190			1,063			720
Billing sites added		178			209			4			16			182			225
Billing sites removed		(30	)		(29	)		(24	)		(26	)		(54	)		(55	)

December 31, 2006		931			710			260			180			1,191			890

Cost of Revenue. Cost of revenue for the three months ended December 31, 2006 increased 35.0% to $12.7 million from $9.4 million in the quarter ended December 31, 2005, while the cost of revenue as a percentage of revenue decreased to 33.0% from 35.1% due to the fact that the rate of growth in cost of revenue grew slower than the aggregate revenue growth rate for the Company.

The decrease in our consolidated cost of revenue as a percentage of revenue between the three months ended December 31, 2006 and the three months ended December 31, 2005 is attributable to the following main factors:


§	a reduction in the level of hardware and third party software expense as well as payroll and related benefits as a percentage of revenue in the NextGen Division; and

§	an increase in the NextGen Division’s share of consolidated revenue from 85.5% in the quarter ended December 31, 2005 to 88.9% in the quarter ended December 31, 2006. The NextGen Division’s gross profit margin has been and continues to be higher than the QSI Division.

The following table details the individual components of cost of revenue and gross profit as a percentage of total revenue for our Company and our two Divisions:



	Hardware, Third Party Software		Payroll and related Benefits		Other		Total Cost of Revenue		Gross Profit

Three months ended December 31, 2006
QSI Division	8.6	%	16.1	%	19.4	%	44.1	%	55.9	%
NextGen Division	2.6		12.7		16.3		31.6		68.4

Consolidated	3.3	%	13.1	%	16.6	%	33.0	%	67.0	%


Three months ended December 31, 2005
QSI Division	10.4	%	19.3	%	20.4	%	50.1	%	49.9	%
NextGen Division	3.1		13.4		16.1		32.6		67.4

Consolidated	4.1	%	14.3	%	16.7	%	35.1	%	64.9	%

During the three months ended December 31, 2006, hardware and third party software constituted a smaller portion of consolidated revenue compared to the same year ago period driven principally by the composition of NextGen Division revenue. We have noted that the last several quarter’s results have included a relatively lower amount of hardware and third party software compared with prior periods. However, this reduction was not the result of any change in emphasis on our part. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software purchased fluctuates each quarter depending on the needs of the customers and is not a priority focus for us.

Our payroll and benefits expense associated with delivering our products and services decreased to 13.1% of consolidated revenue in the three months ended December 31, 2006 compared to 14.3% during the three months ended December 31, 2005. The absolute level of consolidated payroll and benefit expenses grew from $3.8 million in the three months ended December 31, 2005 to $5.0 million in the three months ended December 31, 2006, an increase of 32% or $1.2 million. The increase was due primarily to additions to related headcount, payroll and benefits expense associated with delivering products and services in the NextGen Division where such expenses increased to $4.4 million in the three months ended December 31 2006 from $3.1 million in the three months ended December 31, 2005. Payroll and benefits expense associated with delivering products and services in the QSI Division during the three months ended December 31, 2006 and 2005 remained relatively unchanged at approximately $0.7 million. The adoption of SFAS 123R added approximately $0.1 million in compensation expense to cost of revenue.

We anticipate continued additions to headcount in the NextGen Division in areas related to delivering products and services in future periods but due to the uncertainties in the timing of our sales arrangements, our sales mix, the acquisition and training of qualified personnel, and other issues, we cannot accurately predict if related headcount expense as a percentage of revenue will increase or decrease in the future.

We do not currently intend to make any significant additions to related headcount at the QSI Division.

“Other”, which consists of outside service costs, amortization of software development costs and other costs, decreased slightly to 16.6% of revenue during the three months ended December 31, 2006 from 16.7% of revenue during the three months ended December 31, 2005.

Should the NextGen Division continue to represent an increasing share of our revenue and should the NextGen Division continue to carry higher gross profit than the QSI Division, our consolidated gross profit percentages should increase to more closely match those of the NextGen Division.

As a result of the foregoing events and activities, the gross profit percentage for the Company and both our divisions increased for the three month period ended December 31, 2006 versus the prior year period.

The following table details revenue and cost of revenue on a consolidated and divisional basis for the three month periods ended December 31, 2006 and 2005:



	Three months ended December 31,				Three months ended December 31,

	2006		%		2005		%

QSI Division
Revenue	$	4,267	100.0	%	$	3,867	100.0	%
Cost of revenue		1,880	44.1			1,939	50.1

Gross profit	$	2,387	55.9	%	$	1,928	49.9	%


NextGen Division
Revenue	$	34,229	100.0	%	$	22,885	100.0	%
Cost of revenue		10,817	31.6			7,464	32.6

Gross profit	$	23,412	68.4	%	$	15,421	67.4	%


Consolidated
Revenue	$	38,496	100.0	%	$	26,752	100.0	%
Cost of revenue		12,697	33.0			9,403	35.1

Gross profit	$	25,799	67.0	%	$	17,349	64.9	%

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the three months ended December 31, 2006 increased 32.1% to $10.6 million as compared to $8.0 million for the three months ended December 31, 2005. The increase in these expenses resulted primarily from a $1.7 million in compensation expense in the NextGen Division, a $0.4 million increase in selling related expenses in the NextGen Division and a $0.5 million increase in corporate related expenses. The adoption of SFAS 123R added approximately $0.6 million in compensation expense to selling, general and administrative expenses and is included in the aforementioned amounts. Selling, general and administrative expenses as a percentage of revenue decreased from 30.0% in the three months ended December 31, 2005 to 27.5% in the three months ended December 31, 2006 due in part to the fact that the rate of growth in revenue was greater than the selling, general and administrative expense growth rate for the Company.

We anticipate increased expenditures for trade shows, advertising and the employment of additional sales and administrative staff at the NextGen Division. We also anticipate future increases in corporate expenditures being made in a wide range of areas. While we expect selling, general and administrative expenses to increase on an absolute basis, we cannot accurately predict the impact these additional expenditures will have on selling, general, and administrative expenses as a percentage of revenue.

Research and Development Costs. Research and development costs for the three months ended December 31, 2006 and 2005 were $2.6 million and $2.2 million, respectively. The increases in research and development expenses were due in part to increased investment in the NextGen product line. Additionally, the adoption of SFAS 123R added approximately $0.2 million in compensation expense to research and development costs. Additions to capitalized software costs offset research and development costs. For the three months ended December 31, 2006, $1.3 million was added to capitalized software costs while $0.5 million was capitalized during the three months ended December 31, 2005. Research and development costs as a percentage of revenue decreased to 6.8% from 8.2% during the three months ended December 31, 2006. Research and development expenses are expected to continue at or above current dollar levels.

Interest Income. Interest income for the three months ended December 31, 2006 increased to approximately $0.9 million compared with $0.6 million in the three months ended December 31, 2005. Interest income in the three months ended December 31, 2006 increased primarily due to the effect of an increase in short term interest rates versus the prior year quarter as well as comparatively higher amounts of funds available for investment during the three months ended December 31, 2006.

Our investment policy is determined by our Board of Directors. We currently maintain our cash in very liquid short term assets including money market funds and short term U.S. Treasuries with original maturities of less than 90 days. Our Board of Directors may consider alternate uses for our cash including, but not limited to payment of a special dividend similar to the special dividends paid in March 2006 and 2005, initiation of a regular dividend, initiation of a stock buy-back program, an expansion of our investment policy to include investments with maturities of greater than 90 days, or other items. Additionally, it is possible that we will utilize some or all of our cash to fund an acquisition or other similar business activity. Any or all of these programs could significantly impact our investment income in future periods.

Provision for Income Taxes. The provision for income taxes for the three months ended December 31, 2006 was approximately $4.8 million as compared to approximately $2.9 million for the year ago period. The effective tax rates for the three months ended December 31, 2006 and 2005 were 35.6% and 37.6%, respectively. The provision for income taxes for the three months ended December 31, 2006 differs from the combined statutory rates primarily due to the re-enactment of federal research and development tax credits which occurred in December 2006. The re-enactment was retroactive to the start of our fiscal year, resulting

in a benefit for research and development credits recorded during the quarter ended December 31, 2006. The effective rate for the three months ended December 31, 2006 also includes a benefit from the Qualified Production Activities Deduction, offset by non-deductible option expense related to incentive stock options. The provision for income taxes for the three months ended December 31, 2005 included research and development credits.

For the Nine-Month Periods Ended December 31, 2006 versus 2005

Net Income. The Company’s net income for the nine months ended December 31, 2006 was $24.7 million or $0.92 per share on a basic and $0.90 per share on a fully diluted basis. In comparison, we earned $15.7 million or $0.60 per share on a basic and $0.58 per share on a fully diluted basis in the nine months ended December 31, 2005. The increase in net income for the nine months ended December 31, 2006 was achieved primarily through the following:


•	a 33.8% increase in consolidated revenue;

•	a 38.7% increase in NextGen Division revenue which accounted for 89.2% of consolidated revenue; and

•	increase in the consolidated gross profit percentage which increased to 67.9% in the nine months ended December 31, 2006 versus 65.6% in the same period last year.

Revenue. Revenue for the nine months ended December 31, 2006 increased 33.8% to $112.0 million from $83.7 million for the nine months ended December 31, 2005. NextGen Division revenue increased 38.7% from $72.0 million during the nine month ended December 31, 2005 to $99.9 million during the nine months ended December 31, 2006, while QSI Division revenue increased 3.5% from $11.7 million during the nine months ended December 31, 2005 to $12.1 million during the nine months ended December 31, 2006.

We report revenue in two major categories, “systems sales” and “maintenance, EDI and other services”. Revenue in the systems sales category includes software license fees, hardware, third party software, supplies and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the Maintenance, EDI and other category includes maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

System Sales. Company-wide sales of systems for the nine months ended December 31, 2006 increased 24.0% to $56.5 million from $45.6 million in the same prior year period.

Our increase in revenue from sales of systems was principally the result of a 23.6% increase in category revenue at our NextGen Division whose systems sales grew from $43.9 million to $54.2 million. This increase was driven primarily by higher sales of NextGen^emr and NextGen^epm software to both new and existing clients, as well as delivery of related implementation and training services, partially offset by declines in the sale of hardware, third party software, and supplies.

Category revenue in the QSI Division increased 32.7% to $2.3 million from $1.7 million during the nine months ended December 31, 2006 principally due to sales of hardware, third party software and supplies.

The following table breaks down our reported systems sales into software, hardware and third party software and supplies, and implementation and training services components by Division:



	Software		Hardware, Third Party Software and Supplies		Implementation and Training Services		Total System Sales

Nine months ended December 31, 2006
QSI Division	$	510	$	1,380	$	414	$	2,304
NextGen Division		44,258		1,706		8,273		54,237

Consolidated	$	44,768	$	3,086	$	8,687	$	56,541


Nine months ended December 31, 2005
QSI Division	$	517	$	829	$	389	$	1,735
NextGen Division		33,156		2,967		7,747		43,870

Consolidated	$	33,673	$	3,796	$	8,136	$	45,605

NextGen Division software revenue increased 33.5% between the nine months ended December 31, 2006 and the nine months ended December 31, 2005. The Division’s software revenue accounted for 81.6% of divisional systems sales revenue during the nine months ended December 31, 2006, an increase from 75.6% in the nine months ended December 31, 2005. Sales of additional licenses to existing customers grew significantly during the nine months ended December 31, 2006 compared to the year ago period as a result of an increasing number of customers who are expanding their use of our software in their practices and purchasing additional licenses as well as a successful program conducted with the customer base during the quarter ended September 30, 2006 which generated additional license purchases.

Software sales revenue from VAR’s totaled approximately $9.1 million compared to $3.3 million in the prior year period. The increase in VAR revenue was impacted in part by revenue from sales to Siemens Medical Solutions.

Software license revenue continues to be an area of primary emphasis for the NextGen Division and management was pleased with the Division’s performance in this area.

During the nine months ended December 31, 2006, 3.1% of NextGen’s systems sales revenue was represented by hardware and third party software compared to 6.8% in the same prior year period. We have noted that the last several quarter’s results have included a relatively lower amount of hardware and third party software compared to prior periods. However, this decrease was not the result of any change in emphasis on our part. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software revenue fluctuates each quarter depending on the needs of customers. The inclusion of hardware and third party software in the division’s sales arrangements is typically at the request of the customer and is not a priority focus for us.

Implementation and training revenue at the NextGen Division increased 6.8% from the nine months ended December 31, 2005 compared to the nine months ended December 31, 2006. The growth in implementation and training revenue is the result of increases in the amount of implementation and training services rendered to our customers. The number of implementation and training staff increased during the course of the nine months ended December 31, 2006 versus 2005 in order to accommodate the increased amount of implementation services sold in conjunction with increased software sales. In order to achieve continued increased revenue in this area, additional staffing increases are anticipated, though actual future increases will depend upon the availability of qualified staff, business conditions, and our ability to retain current staff members.

Maintenance, EDI and Other Services. For the nine months ended December 31, 2006, Company-wide revenue from maintenance, EDI and other services grew 45.6% to $55.5 million from $38.1 million during the same period last year. The increase in this category resulted from an increase in maintenance, EDI and other revenue from the NextGen Division’s client base. Total NextGen Division maintenance revenue for the nine months ended December 31, 2006 grew 44.7% to $24.8 million from $17.2 million in the period a year ago, EDI revenue grew 45.7% to $8.9 million compared to $6.1 million during the same period and other services grew to $11.9 million compared to $4.9 million in the year ago period. The increase in other services was due primarily to purchases of additional training and other services by existing NextGen customers. QSI Division maintenance and EDI revenue remained consistent over the year ago period.

The following table details revenue included in Maintenance, EDI and other services for the nine month periods ended December 31, 2006 and 2005:



	Maintenance		EDI		Other		Total

Nine months ended December 31, 2006
QSI Division	$	5,279	$	3,422	$	1,124	$	9,825
NextGen Division		24,828		8,911		11,924		45,663

Consolidated	$	30,107	$	12,333	$	13,048	$	55,488


Nine months ended December 31, 2005
QSI Division	$	5,246	$	3,470	$	1,266	$	9,982
NextGen Division		17,157		6,116		4,862		28,135

Consolidated	$	22,403	$	9,586	$	6,128	$	38,117

The growth in overall maintenance revenue has come from new customers that have been added each quarter, additional software purchases by existing customers, as well as our relative success in retaining existing maintenance customers. NextGen EDI revenue growth has come from new customers and from further penetration of the Division’s existing customer base. We intend to continue to promote maintenance and EDI services to both new and existing customers.

The following table provides the number of billing sites which were receiving maintenance services as of the last business day of the quarters ended December 31, 2006 and 2005 respectively, as well as the number of billing sites receiving EDI services during the last month of each respective period at each division of the Company. The table presents summary information only and includes billing entities added and removed for any reason. Note also that a single client may include one or multiple billing sites, and changes in billing arrangements with certain clients can cause period to period changes in the number of billing sites.



	NextGen						QSI						Consolidated

	Maintenance			EDI			Maintenance			EDI			Maintenance			EDI


December 31, 2005		783			530			280			190			1,063			720
Billing sites added		178			209			4			16			182			225
Billing sites removed		(30	)		(29	)		(24	)		(26	)		(54	)		(55	)

December 31, 2006		931			710			260			180			1,191			890

Cost of Revenue. The cost of revenue for the nine months ended December 31, 2006 increased 25.1% to $36.0 million from $28.8 million, while the cost of revenue as a percentage of net revenue decreased to 32.1% from 34.4% during the same period a year ago.

The decrease in our consolidated cost of revenue as a percentage of revenue between the nine months ended December 31, 2006 and the nine months ended December 31, 2005 is attributable to the following main factors:


§	a reduction in the level of third party hardware and software as a percentage of revenue in the NextGen Division; and

§	an increase in the NextGen Division’s share of consolidated revenue from 86.0% in the nine months ended December 31, 2005 to 89.2% in December 31, 2006. The NextGen Division’s gross profit percentage has been and continues to be higher than that of the QSI Division.

The following table details the individual components of cost of revenue and gross profit as a percentage of total revenue for our Company and our two Divisions:



	Hardware, Third Party Software		Payroll and related Benefits		Other		Total Cost of Revenue		Gross Profit

Nine months ended December 31, 2006
QSI Division	7.6	%	17.6	%	20.8	%	46.0	%	54.0	%
NextGen Division	2.5		12.3		15.6		30.4		69.6

Consolidated	3.0	%	12.9	%	16.2	%	32.1	%	67.9	%


Nine months ended December 31, 2005
QSI Division	9.4	%	18.9	%	20.8	%	49.1	%	50.9	%
NextGen Division	4.9		11.9		15.2		32.0		68.0

Consolidated	5.5	%	12.9	%	16.0	%	34.4	%	65.6	%

During the nine months ended December 31, 2006, the cost of hardware and third party software constituted 3.0% of consolidated revenue compared to 5.5% in the same year ago period. We have noted that the results from numerous prior quarters have included a relatively lower amount of hardware and third party software compared to prior periods. However this year over year reduction was not the result of any change in emphasis on our part. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software purchased fluctuates each quarter depending on the needs of the customers and is not a priority focus for us.

Our payroll and benefits expense associated with delivering our products and services remained consistent at 12.9% of consolidated revenue in the nine months ended December 31, 2006 and in the nine months ended December 31, 2005. The absolute level of consolidated payroll and benefit expenses grew from $10.8 million in the nine months ended December 31, 2005 to $14.4 million in the nine months ended December 31, 2006, an increase of 33%. This increase was due primarily to additions to headcount, payroll and benefits expense associated with delivering products and services in the NextGen Division. These divisional expenses increased to $12.3 million in the nine months ended December 31, 2006 compared to $8.6 million in the nine months ended December 31, 2005, an increase of 43%. The Division’s payroll and benefits expense associated with delivering products and services as a percentage of divisional revenue in the nine months ended December 31, 2006 increased to 12.3% compared to 11.9% in the prior year period. Payroll and benefits expense as a percentage of revenue for the nine month period ended December 31, 2006 at the QSI Division decreased compared to the prior year at 17.6% versus 18.9%, in the prior year period. The adoption of SFAS 123R added approximately $0.4 million in compensation expense to cost of revenue for the nine months ended December 31, 2006.

We anticipate continued additions to headcount in the NextGen Division in areas related to delivering products and services in future periods but due to the uncertainties in the timing of our sales arrangements, our sales mix, the acquisition and training of qualified personnel, and other issues we cannot accurately predict if related headcount expense as a percentage of revenue will increase or decrease in the future.

We do not currently intend to make any significant additions to related headcount at the QSI Division.

“Other,” which consists of outside service costs, amortization of software development costs and other costs, increased to 16.2% of revenue from 16.0% in the year ago period.

Should the NextGen Division continue to represent an increasing share of our revenue and should NextGen continue to show higher gross profit percentages compared to the QSI Division, our gross profit percentages should increase to more closely match those of the NextGen Division.

As a result of the foregoing events and activities, our gross profit percentage for the Company and our two operating Divisions increased for the nine month period ended December 31, 2006 versus the prior year period.

The following table details revenue and cost of revenue on a consolidated and divisional basis for the nine month periods ended December 31, 2006 and 2005:


	Nine months ended December 31,				Nine months ended December 31,

	2006		%		2005		%

QSI Division
Revenue	$	12,129	100.0	%	$	11,718	100.0	%
Cost of revenue		5,580	46.0			5,756	49.1

Gross profit	$	6,549	54.0	%	$	5,962	50.9	%


NextGen Division
Revenue	$	99,900	100.0	%	$	72,004	100.0	%
Cost of revenue		30,407	30.4			23,009	32.0

Gross profit	$	69,493	69.6	%	$	48,995	68.0	%


Consolidated
Revenue	$	112,029	100.0	%	$	83,722	100.0	%
Cost of revenue		35,987	32.1			28,765	34.4

Gross profit	$	76,042	67.9	%	$	54,957	65.6	%

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the nine months ended December 31, 2006 increased 23.3% to $30.8 million as compared to $25.0 million for the nine months ended December 31, 2005. The increase in the amount of such expenses resulted primarily from increases of $4.1 million in salaries, commissions, and related benefits in the NextGen Division, a $0.4 million increase in other selling, general and administrative expenses in the NextGen Division and $1.3 million in increased corporate related expenses. The increase in corporate expenses was primarily composed of salaries and related benefits. The adoption of SFAS 123R added approximately $1.7 million in compensation expense to selling, general and administrative expenses and is included in the aforementioned amounts. Selling, general and administrative expenses as a percentage of revenue decreased from 29.8% in the nine months ended December 31, 2005 to 27.5% in the nine months ended December 31, 2006 due in part to the fact that the rate of growth in revenue was greater than the selling, general and administrative expense growth rate for the Company.

We anticipate increased expenditures for trade shows, advertising and the employment of additional sales and administrative staff at the NextGen Division. We also anticipate future increases in corporate expenditures being made in areas including but not limited to staffing and professional services. While we expect selling, general and administrative expenses to increase on an absolute basis, we cannot accurately predict the impact these additional expenditures will have on selling, general, and administrative expenses as a percentage of revenue.

Research and Development Costs. Research and development costs for the nine months ended December 31, 2006 and 2005 were $7.5 million and $5.9 million, respectively. The increases in research and development expenses were primarily due to increased investment in the NextGen product line. The adoption of SFAS 123R added approximately $0.6 million in compensation expense to research and development costs. Additions to capitalized software costs offset research and development costs. For the nine months ended December 31, 2006, $3.5 million was added to capitalized software costs while $1.6 million was capitalized during the nine months ended December 31, 2005. Research and development costs as a percentage of net revenue decreased to 6.7% from 7.1% due in part, to the fact that the growth in revenue exceeded the increase in research and development spending. Research and development expenses are expected to continue at or above current levels.

Interest Income. Interest income for the nine months ended December 31, 2006 increased 73.6% to $2.4 million compared with $1.4 million in the nine months ended December 31, 2005. Interest income in the nine months ended December 31, 2006 increased primarily due to the effect of an increase in short term interest rates versus the prior year period as well as comparatively higher amounts of funds available for investment during the nine months ended December 31, 2006.

Our investment policy is determined by our Board of Directors. We currently maintain our cash in very liquid short term assets including money market funds and short term U.S. Treasuries with maturities of less than 90 days. Our Board of Directors continues to review alternate uses for our cash including, but not limited to payment of a special dividend, initiation of a regular dividend, initiation of a stock buy back program, an expansion of our investment policy to include investments with maturities of greater than 90 days, or other items. Additionally, it is possible that we will utilize some or all of our cash to fund an acquisition or other similar business activity. Any or all of these programs could significantly impact our investment income in future periods.

Provision for Income Taxes. The provision for income taxes for the nine months ended December 31, 2006 was $15.4 million as compared to $9.8 for the year ago period. The effective tax rates for the nine months ended December 31, 2006 and 2005 was 38.4%, respectively. The provision for income taxes for the nine months ended December 31, 2006 differs from the combined statutory rates primarily due to the impact of federal and state research and development tax credits. The effective rate for the nine month period ended December 31, 2006 also includes a benefit from the Qualified Production Activities Deduction, which was mostly offset by non-deductible option expense related to incentive stock options. The tax provision for the nine months ended December 31, 2005 also included a benefit for research and development credits.

Liquidity and Capital Resources

The following table presents selected financial statistics and information as of and for each of the nine months ended December 31, 2006 and 2005:


	Nine months ended December 31,

	2006		2005


Cash and cash equivalents	$	80,410	$	75,228

Net increase in cash and cash equivalents during the nine month period	$	23,185	$	24,071

Net income during the nine month period	$	24,727	$	15,684

Net cash provided by operations during the nine month period	$	23,288	$	25,310

Number of days of sales outstanding at start of the period		122		119

Number of days of sales outstanding at the end of the period		140		129

Cash provided by operations has historically been our primary source of cash and has primarily been driven by our net income and secondarily by non-cash expenses including depreciation, amortization of capitalized software, provisions for bad debts and inventory obsolescence, net deferred income taxes and stock option expenses.

The following table summarizes our statement of cash flows for the nine month period ended December 31, 2006 and 2005:


	Nine months ended December 31,

	2006			2005


Net income	$	24,727		$	15,684

Non-cash expenses		8,186			7,761

Change in deferred revenue		4,630			8,639

Change in accounts receivable		(15,051	)		(5,501	)

Change in other assets and liabilities		(796	)		(1,273	)


Net cash provided by operating activities	$	23,288		$	25,310

Net Income

As referenced in the above table, net income makes up the majority of our cash generated from operations for the nine month period ended December 31, 2006 and 2005. Our NextGen Division’s contribution to net income has increased each year due to that Division’s operating income increasing more quickly than the Company as a whole.

Non-Cash expenses

Non-cash expenses include depreciation, amortization of capitalized software, provisions for bad debts and inventory obsolescence, net deferred income taxes and stock option expenses. Total non-cash expenses grew by approximately $0.4 million between the nine month periods ended December 31, 2006 and 2005.

Deferred Revenue

Cash from operations benefited from increases in deferred revenue primarily due to an increase in the volume of implementation and maintenance services invoiced by the NextGen Division which had not yet been rendered or recognized as revenue, but for which cash was received. Deferred revenue grew by approximately $4.6 million in the nine month period ending December 31, 2006 versus $8.6 million in the year ago period.

Accounts Receivable

Accounts receivable grew by approximately $15.1 million and $5.5 million in the nine month periods ending December 31, 2006 and 2005, respectively. The increase in accounts receivable in both periods is due to the following factors:


§	NextGen Division revenue grew 38.7% and 39.1% in the nine month periods ended December 31, 2006 and 2005, respectively;

§	The NextGen Division constituted a larger percentage of our receivables at December 31, 2006 compared to March 31, 2006. Turnover of accounts receivable in the NextGen Division is slower than the QSI Division due to the fact that the majority of the QSI Division’s revenue is coming from maintenance and EDI services which typically have shorter payment terms than systems sales related revenue which historically have accounted for a major portion of NextGen Division sales; and

§	We experienced an increase in the volume of undelivered services billed in advance by the NextGen Division which were unpaid as of the end of each period and included in accounts receivable. This resulted in an increase in both deferred revenue and accounts receivable of approximately $7.5 million in the nine month period ended December 31, 2006 and approximately $3.4 million in the nine month period ended December 31, 2005, respectively.

As of December 31, 2006, one customer represented approximately 20.0% of total gross accounts receivable, which customer has longer than average contractual payment terms.

The turnover of accounts receivable measured in terms of days sales outstanding (DSO) increased from 122 days to 140 days during the nine month period ended December 31, 2006 and increased from 119 days to 129 days in the same period in 2005, primarily due to the above mentioned factors.

If amounts included in both accounts receivable and deferred revenue were netted, the Company’s turnover of accounts received expressed as DSO would be 81 days as of December 31, 2006 and 73 days as of December 31, 2005, respectively. Provided turnover of accounts receivable, deferred revenue, and profitability remain consistent with the nine months ended December 31, 2006, we anticipate being able to continue to generate cash from operations during fiscal 2007 primarily from the net income of the Company.

Cash flows from operating activities

Cash and cash equivalents increased by $23.2 million between March 31, 2006 and December 31, 2006 primarily as a result of cash provided by operating activities. Cash and cash equivalents increased approximately $24.1 million during the nine months ended December 31, 2005 compared to the same period in the prior year, also primarily as a result of cash generated by operating activities.

Cash flows from investing activities

Net cash used in investing activities for the nine months ended December 31, 2006 and 2005 was $5.9 million and $3.9 million, respectively. Net cash used in investing activities for the nine months ended December 31, 2006 and 2005 consisted of additions to equipment and improvements and capitalized software.

Cash flows from financing activities

During the nine months ended December 31, 2006, we received proceeds of $3.8 million from the exercise of stock options and recorded a reduction in income tax liability of $2.0 million related to tax deductions received from employee stock option exercises. The benefit was recorded as additional paid in capital.

Cash and cash equivalents

At December 31, 2006, we had cash and cash equivalents of $80.4 million. We intend to expend some of these funds for the development of products complementary to our existing product line as well as new versions of certain of our products. These developments are intended to take advantage of more powerful technologies and to increase the integration of our products. We have no additional significant current capital commitments.

further review and approval and establishment of record and distribution dates by the Board prior to the declaration of each such quarterly dividend.

Management believes that its cash and cash equivalents on hand at December 31, 2006, together with cash flows from operations, if any, will be sufficient to meet its working capital and capital expenditure requirements as well as any dividends paid in the ordinary course of business for the balance of fiscal 2007.

Contractual Obligations

The following table summarizes our significant contractual obligations at December 31, 2006, and the effect that such obligations are expected to have on our liquidity and cash in future periods:



Contractual Obligations	Total		Less than a year		1-3 years		3-5 years		Beyond 5 years


Non-cancelable lease obligations	$	10,222	$	604	$	6,675	$	2,943	$	—

Item 3. Qualitative and Quantitative Disclosures About Market Risk

We have a significant amount of cash and short-term investments with maturities less than three months. This cash portfolio exposes us to interest rate risk as short-term investment rates can be volatile. Given the short-term maturity structure of our investment portfolio, we believe that it is not subject to principal fluctuations and the effective interest rate of our portfolio tracks closely to various short-term money market interest rate benchmarks.

Item 4. Controls and Procedures

The Chief Executive Officer and Chief Financial Officer (our principal executive officer and principal financial officer, respectively) conducted an evaluation of the design and operation of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)). Based on their evaluation of our disclosure controls and procedures, as of December 31, 2006, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures result in the effective recordation, processing, summarization and reporting of information that is required to be disclosed in the reports that we file under the Exchange Act and the rules thereunder.

During the quarter ended December 31, 2006, no significant changes have occurred in our “internal controls over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our financial reporting function. We are performing ongoing evaluations and enhancements to our internal controls system.

PART II

OTHER INFORMATION


Item 1.	Legal Proceedings.

None.

Item 1A.	Risk Factors.

The risk factors described below reflect material changes from risk factors as previously included in our Exchange Act reports. However, additional risks and uncertainties may also impair our business operations including but not limited (i) to those outlined in our prior SEC filings (ii) those we do not currently anticipate, and (iii) those that we currently deem immaterial. If any of these or other risks actually occur, our business, financial condition or results of operations will likely suffer. Any of these or other factors could harm our business and future results of operations and may cause you to lose all or part of your investment.

We face risks related to litigation advanced by a director and shareholder of the Company. In October 2005, a lawsuit was filed against us and nine of our eight directors (those elected by the shareholders, but not nominated by Mr. Ahmed Hussein) by one of our directors, Mr. Ahmed Hussein in connection with our 2005 Annual Shareholder’s Meeting. Thereafter, the California Superior Court issued a ruling in the case against Mr. Hussein and Mr. Hussein filed a notice of appeal with respect to the Court’s decision. In August 2006, the Company and Mr. Hussein entered into a Settlement Agreement which settled the outstanding legal action filed by Mr. Hussein and generally requires the parties to take or refrain from certain actions relating to corporate governance and voting for a period ending on the conclusion of the Company’s 2007 Annual Shareholders’ Meeting. Should Mr. Hussein (i) commence proxy contests and/or legal actions against the Company, its Board and/or its management after the 2007 Annual Shareholders’ Meeting, (ii) claim a breach of the Settlement Agreement provisions and commence legal actions against the Company prior to the 2007 Annual Meeting, or (iii) commence legal actions not addressed and precluded by the Settlement Agreement, the Company’s operating results and share price may be negatively impacted due to the negative publicity, additional expenses incurred, management distraction, and/or other factors. In addition, litigation of this nature may negatively impact our ability to attract and retain qualified board members and management personnel.


Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3.	Defaults Upon Senior Securities.

None.

Item 4.	Submission of Matters to a Vote of Securities Holders.

None.

Item 5.	Other Information.

The Company has received written notification from the Securities and Exchange Commission (“Commission”) stating that the Commission has initiated an investigation of trading activity in the Company’s securities. While making clear that the investigation does not mean the Commission has concluded there has been a violation of law, the Commission seeks Company documents and records concerning the Company’s Chief Financial Officer. The Company intends to cooperate fully with the Commission’s investigation.

Item 6.	Exhibits.

Exhibits:


31.1	Certifications of Chief Executive Officer Required by Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certifications of Chief Financial Officer Required by Rule 13a-14 (a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, we have duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	QUALITY SYSTEMS, INC.

Date:	February 5, 2007	By: /s/ Louis Silverman

		Louis Silverman
		Chief Executive Officer

Date:	February 5, 2007	By: /s/ Paul Holt

		Paul Holt
		Chief Financial Officer; Principal Accounting Officer