Summary of HEALTHSTREAM INC

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

Special Cautionary Notice Regarding Forward-Looking Statements This Quarterly Report includes various forward-looking statements that are subject to risks and uncertainties. Forward-looking statements include without limitation, statements preceded by, followed by, or that otherwise include the words "believes," "expects," "anticipates," "intends," "estimates" or similar expressions. For those statements, HealthStream, Inc. claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
The following important factors, in addition to those discussed elsewhere in this Quarterly Report and in our Annual Report on Form 10-K, could affect our future financial results and could cause actual results to differ materially from those expressed in forward-looking statements contained in this document:
• our ability to effectively implement our growth strategy, as well as manage growth of our operations and infrastructure;

• fluctuation in quarterly operating results caused by a variety of factors including the timing of sales, revenue recognition, customer renewals, and customer scheduling and acceptance;

• variability and length of our sales cycle;

• our ability to maintain and continue our competitive position against current and potential competitors;

• our ability to obtain proper distribution rights from content partners to support growth in courseware subscriptions;

• our ability to develop enhancements to our existing products and services, achieve widespread acceptance of new features, or keep pace with technological developments;

• loss of a significant customer and concentration of a significant portion of our revenue with a relatively small number of customers;

• our ability to accurately forecast results of operations due to certain revenue components being subject to significant fluctuations and an increase in the percentage of our business subject to renewal;

• our ability to address and resolve in a timely manner any customer concerns with the new version of our HealthStream Learning Center® (HLC) platform;

• our ability to adequately address our customers' needs regarding their use of our products and services;

• our ability to adequately maintain our network infrastructure, computer systems, software and related security;

• our ability to protect our intellectual property;

• the effect of governmental regulation on us, our business partners and our customers, including, without limitation, changes in federal, state and international laws or other regulations regarding education, training and Internet transactions; and

• other risk factors detailed in our Annual Report on Form 10-K for the year ended December 31, 2007, and our other filings with the Securities and Exchange Commission.

Overview
HealthStream's services are focused on the professionals who work within healthcare organizations, and include the delivery of education and training products and services ("HealthStream Learning"), as well as survey and research services ("HealthStream Research"). HealthStream Learning products and services are used by healthcare organizations to meet a broad range of their training and assessment needs, while HealthStream Research products and services provide our customers valuable insight into measuring quality and satisfaction of physicians, patients, employees, and members of the community. Across both our HealthStream Learning and HealthStream Research segments, HealthStream's customers include over 2,400 healthcare organization facilities (predominately acute-care facilities) throughout the United States.
We provide HealthStream Learning products and services to over 1,700 healthcare facilities. The Company's flagship learning product is the HLC, our proprietary, Internet-based learning platform. We deliver educational and training courseware to our customers through the HLC platform. HealthStream Learning products and services are focused on education and training initiatives designed to reach hospital-based healthcare professionals, as well as physicians and medical device and pharmaceutical device industry sales representatives. We offer a variety of online educational and training courseware and also provide traditional seminar and paper-based educational activities. We also deliver Internet-based medical device training within hospitals through our HospitalDirect® platform.

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We provide HealthStream Research products and services to over 1,100 healthcare facilities. These products include quality and satisfaction surveys, data analyses of survey results, and other research-based measurement tools focused on patients, physicians, employees, and members of the community. HealthStream Research services are designed to provide customers thorough analyses that provide insightful recommendations for change; to provide benchmarking capability using our comprehensive databases; and to provide consulting services to identify solutions for our customers based on their survey results. As a certified vendor designated by the Centers for Medicare & Medicaid Services, we offer our customers CAHPS® (Consumer Assessment of Health Plan Survey) Hospital Survey services.
Key financial and operational indicators for the second quarter of 2008 include:
• Revenues of $13.0 million in the second quarter of 2008, up 8% over the second quarter of 2007

• Net income of $739,000 in the second quarter of 2008, up from $425,000 in the second quarter of 2007

• 1,639,000 healthcare professional subscribers fully implemented on our Internet-based learning network at June 30, 2008, up from 1,422,000 at June 30, 2007

• Approximately $1.0 million invested in our stock repurchase plan during the second quarter of 2008

Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("US GAAP"). These accounting principles require us to make certain estimates, judgments and assumptions during the preparation of our financial statements. We believe the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.
The accounting policies and estimates that we believe are the most critical in fully understanding and evaluating our reported financial results include the following:
• Revenue recognition

• Product development costs and related capitalization

• Goodwill, intangibles, and other long-lived assets

• Allowance for doubtful accounts

• Accrual for service interruptions

• Stock based compensation

• Accounting for income taxes

• Nonmonetary exchange of content rights and deferred service credits

In many cases, the accounting treatment of a particular transaction is specifically dictated by US GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting among available alternatives would not produce a materially different result. See Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007 filed with the Securities and Exchange Commission, which contains additional information regarding our accounting policies and other disclosures required by US GAAP. There have been no changes in our critical accounting policies and estimates from those reported in our Annual Report on Form 10-K for the year ended December 31, 2007. Revenues and Expense Components
The following descriptions of the components of revenues and expenses apply to the comparison of results of operations.
Revenues. Revenues for our HealthStream Learning business segment consist of the provision of services through our Internet-based HLC, authoring tools, a variety of courseware subscriptions (add-on courseware), implementation and consulting services, maintenance of 3rd party content, live event development, online training and content development, online sales training courses (RepDirect™), live educational activities for nurses and other professionals conducted within healthcare organizations, continuing education activities at association meetings, and HospitalDirect®. Revenues for our HealthStream Research business segment consist of quality and satisfaction surveys, data analyses of survey results, and other research-based measurement tools focused on physicians, patients, employees, and other members of the community.
Cost of Revenues (excluding depreciation and amortization). Cost of revenues consists primarily of salaries and employee benefits, stock based compensation, employee travel and lodging, materials, outsourced phone survey support, contract labor, hosting costs, and other direct expenses associated with revenues as well as royalties paid by us to content providers based on a percentage of revenues. Personnel costs

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within cost of revenues are associated with individuals that facilitate product delivery, provide services, conduct, process and manage phone and paper-based surveys, handle customer support calls or inquiries, manage the technology infrastructure for our hosted applications, manage content and survey services, coordinate content maintenance services, and provide training or implementation services.
Product Development. Product development expenses consist primarily of salaries and employee benefits, stock based compensation, content acquisition costs before technological feasibility is achieved, costs associated with the development of content and expenditures associated with maintaining, developing and operating our training, delivery and administration platforms. In addition, product development expenses are associated with the development of new software feature enhancements and new products. Personnel costs within product development include our systems team, product managers, and other personnel associated with content and product development and product portfolio management.
Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, commissions and employee benefits, stock based compensation, employee travel and lodging, advertising, trade shows, promotions, and related marketing costs. Annually, we host a national customer conference in Nashville known as "The Summit," the costs of which are included in sales and marketing expenses. Personnel costs within sales and marketing include our sales and marketing team and strategic account management, as well as our account management group. Our account management personnel work to help our customers effectively utilize our products and provide consulting services to identify solutions for our customers based on their use of our products.
Depreciation and Amortization. Depreciation and amortization consist of fixed asset depreciation, amortization of intangibles considered to have definite lives, amortization of content development fees, and amortization of capitalized software feature enhancements.
Other General and Administrative Expenses. Other general and administrative expenses consist primarily of salaries and employee benefits, stock based compensation, employee travel and lodging, facility costs, office expenses, fees for professional services, and other operational expenses. Personnel costs within general and administrative expenses include individuals associated with normal corporate functions (accounting, legal, human resources, administrative, internal information systems, and executive management) as well as personnel who maintain our accreditation status with various organizations.
Other Income/Expense. The primary component of other income is interest income related to interest earned on cash, cash equivalents and investments in marketable securities. The primary component of other expense is interest expense related to a promissory note, capital leases and our revolving credit facility.
Three Months Ended June 30, 2008 Compared to Three Months Ended June 30, 2007 Revenues. Revenues increased approximately $966,000, or 8.0%, to $13.0 million for the three months ended June 30, 2008 from $12.0 million for the three months ended June 30, 2007. Revenues for 2008 consisted of $8.2 million, or 63% of total revenue, for HealthStream Learning and $4.8 million, or 37% of total revenue, for HealthStream Research. In 2007, revenues consisted of $6.5 million, or 54% of total revenue, for HealthStream Learning and $5.5 million, or 46% of total revenue, for HealthStream Research.
HealthStream Learning revenue growth of $1.7 million, or 25.8%, over the prior year quarter included $1.6 million from our Internet-based subscription learning products, which includes revenue increases from the HLC of $900,000 and $666,000 from increased courseware subscriptions and online training services. Revenues from these products collectively increased 30% over the prior year second quarter and approximated $6.8 million for the second quarter of 2008. This revenue growth is a result of both increased HLC subscribers and sales of add-on courseware subscriptions. The remaining revenue growth came from implementation, development, and consulting services which increased $481,000 over the prior year second quarter. These revenue increases were partially offset by a revenue decrease from live events business, study guides and association activities, which collectively declined $328,000 from the prior year second quarter, primarily due to decreasing demand for such services.
HealthStream Research revenue for the second quarter of 2008 decreased approximately $708,000, or 12.8%, when compared to the second quarter of 2007. Revenue mix changes over the prior year included an increase of $232,000 from patient surveys, but was more than offset by revenue declines of $333,000 from employee surveys, $325,000 from community surveys, and $282,000 from physician surveys. These revenue decreases resulted from fewer survey projects being performed and completed during the second quarter of 2008 as compared to the prior year second quarter. This is due in part to a few of our larger customers electing to delay their surveys, and one customer electing not to conduct an interim survey which was conducted in the second quarter of 2007. We expect revenues for the third quarter of 2008 to range between $13.0 and $13.5 million, an increase of approximately 10 to 14 percent over the prior year third quarter. We expect revenues from HealthStream Learning to increase between 13 and 16 percent over the prior year third quarter resulting from growth in our HLC subscriber base and add-on courseware subscriptions. These expected revenue increases are anticipated to be partially offset by continued declines in several of our project-based products such as live events and study guides. We expect revenues from HealthStream Research to increase between seven and 10 percent compared to the prior year third quarter.

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Cost of Revenues (excluding depreciation and amortization). Cost of revenues increased approximately $503,000, or 11.5%, to $4.9 million for the three months ended June 30, 2008 from $4.4 million for the three months ended June 30, 2007. Cost of revenues as a percentage of revenues increased to 37.4% of revenues for the three months ended June 30, 2008 from 36.2% of revenues for the three months ended June 30, 2007. Cost of revenues for HealthStream Learning increased approximately $484,000 to $2.8 million and approximated 33.7% and 34.9% of revenues for the three months ended June 30, 2008 and 2007, respectively. The expense increase was primarily associated with increased royalties paid by us resulting from growth in courseware subscription revenues as well as increased costs to support the revenue growth in implementation, development, and consulting services. These expense increases were partially offset by lower expenses associated with declines in live event, study guides, and association revenues. Cost of revenues for HealthStream Research increased approximately $20,000 to $2.1 million and approximated 43.6% and 37.7% of revenues for the three months ended June 30, 2008 and 2007, respectively. The increase in cost of revenues as a percentage of revenues for HealthStream Research resulted primarily from lower revenues from our higher margin surveys when compared to the prior year quarter.
Gross Margin (excluding depreciation and amortization). Gross margin (which we define as revenues less cost of revenues divided by revenues) declined to 62.6% for the three months ended June 30, 2008 from 63.8% for the three months ended June 30, 2007. This decline is primarily a result of the change in revenue mix and related cost of revenues for HealthStream Research discussed above. Gross margins for HealthStream Learning were 66.3% and 65.1% for the three months ended June 30, 2008 and 2007, respectively. This slight increase is primarily a result of higher subscription based revenues over the prior year quarter. Gross margins for HealthStream Research were 56.4% and 62.3% for the three months ended June 30, 2008 and 2007, respectively. The gross margin decline for HealthStream Research resulted from the change in survey revenue mix and related cost of revenues mentioned above. We expect gross margins for the third quarter of 2008 to be down slightly compared to the prior year third quarter. Product development. Product development expenses increased approximately $230,000, or 20.9%, to $1.3 million for the three months ended June 30, 2008 from $1.1 million for the three months ended June 30, 2007. Product development expenses as a percentage of revenues increased to 10.2% of revenues for the three months ended June 30, 2008 compared to 9.1% of revenues for the three months ended June 30, 2007. The increase in both amount and as a percentage of revenues primarily resulted from increased maintenance and support costs of our HealthStream Learning products, as well as a reclassification of personnel within HealthStream Research to product development from general and administrative expense.
Product development expenses for HealthStream Learning increased approximately $140,000 and approximated 13.3% and 14.5% of revenues for the three months ended June 30, 2008 and 2007, respectively. This expense increase is associated with maintenance and support of our learning platform products. Product development expenses for HealthStream Research increased approximately $117,000 and approximated 5.1% and 2.3% of revenues for the three months ended June 30, 2008 and 2007, respectively. This expense increase relates primarily to a reallocation of personnel from general and administrative expense compared to the prior year quarter. We expect product development expenses for the third quarter of 2008 to increase in amount and as a percentage of revenues over the prior year third quarter consistent with the factors previously discussed. Sales and Marketing. Sales and marketing expenses, including personnel costs, decreased approximately $127,000, or 4.5%, to $2.7 million for the three months ended June 30, 2008 from $2.8 million for the three months ended June 30, 2007. Approximately $421,000 of the decrease is due to the timing of our Annual Summit, which occurred during the second quarter of 2007 and will occur during the third quarter of 2008. The expense decrease was partially offset by incremental personnel and related expenses from both the HealthStream Learning and HealthStream Research sales teams. Sales and marketing expenses approximated 20.7% and 23.4% of revenues for the three months ended June 30, 2008 and 2007, respectively.
Sales and marketing expenses for HealthStream Learning decreased $233,000 and approximated 21.7% and 30.9% of revenues for the three months ended June 30, 2008 and 2007, respectively. This expense decrease primarily resulted from the timing of our Annual Summit, and was partially offset by additional sales personnel and related expenses. Sales and marketing expenses for HealthStream Research increased approximately $80,000, and approximated 17.5% and 13.9% of revenues for the three months ended June 30, 2008 and 2007, respectively. This increase resulted primarily from additional sales personnel and related expenses. We expect sales and marketing expenses for the third quarter of 2008 to increase in amount and as a percentage of revenues over the prior year third quarter. We expect that this expense increase will primarily result from the cost of our Annual Summit and to a lesser extent from new sales personnel hired during late 2007 and early 2008.
Depreciation and Amortization. Depreciation and amortization increased approximately $11,000, and approximated $1.2 million for both the three months ended June 30, 2008 and 2007. Depreciation, which is included in the unallocated corporate function, increased $42,000 resulting from capital expenditures during 2007 and the first half of 2008. Amortization expense decreased $32,000, primarily due to lower amortization of intangible assets. Amortization for HealthStream Learning increased $53,000, and approximated 5.4% and 6.0% of revenues for the three months ended June 30, 2008 and 2007, respectively. This increase is associated with capitalized software feature enhancements associated with our platform products. Amortization for HealthStream Research decreased $85,000 and approximated 5.1% and 6.0% of revenues for the three months ended June 30, 2008 and 2007, respectively. This decrease is primarily associated with lower amortization of

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TJO intangible assets resulting from a reduction in the carrying value of such assets upon completion of the valuation analysis. We expect depreciation and amortization for the third quarter of 2008 be comparable to the prior year third quarter.
Other General and Administrative. Other general and administrative expenses increased approximately $32,000, or 1.5%, and approximated $2.2 million for both the three months ended June 30, 2008 and 2007. Other general and administrative expenses as a percentage of revenues decreased to 16.8% for the three months ended June 30, 2008 from 17.9% for the three months ended June 30, 2007. The percentage decrease is a result of the revenue increases mentioned above. Other general and administrative expenses for HealthStream Learning increased $126,000 compared to the prior year quarter primarily due to increased personnel expenses. Other general and administrative expenses for HealthStream Research decreased approximately $248,000 from the prior year quarter, primarily resulting from combining certain functions at the corporate level, the reallocation of certain personnel to product development, as well as reductions in other expenses. The unallocated corporate portion of other general and administrative expenses increased $155,000 over the prior year quarter resulting from increased recruiting costs, professional fees, and various other corporate expenses. We expect other general and administrative expenses for the third quarter of 2008 to increase in amount, but decrease as a percentage of revenues when compared to the prior year third quarter.
Other Income (Expense). Other income (expense) increased approximately $1,600 or 7.6%, to $23,000 for the three months ended June 30, 2008 from $22,000 for the three months ended June 30, 2007. Interest income increased modestly due to higher invested balances compared to the prior year second quarter, and was partially offset by increased interest expense associated with a promissory note.
Provision for Income Taxes. The Company's income tax provision primarily consists of the alternative minimum tax. Taxable income for 2008 is expected to be substantially offset by the utilization of our net operating loss ("NOL") carryforwards.
Net Income. Net income was approximately $739,000 for the three months ended June 30, 2008, up from $425,000 for the three months ended June 30, 2007. Net income per share during the third quarter of 2008 is expected to range between $0.03 and $0.04 per diluted share.
Six Months Ended June 30, 2008 Compared to Six Months Ended June 30, 2007 Revenues. Revenues increased approximately $4.3 million, or 21.3%, to $24.4 million for the six months ended June 30, 2008 from $20.1 million for the six months ended June 30, 2007. Revenues for 2008 consisted of $15.7 million for HealthStream Learning and $8.8 million for HealthStream Research. In 2007, revenues consisted of $13.0 million for HealthStream Learning and $7.1 million for HealthStream Research. HealthStream Learning experienced growth in revenues from our HLC subscriber base of $1.8 million, increased add-on courseware subscriptions of $1.2 million, and $783,000 from implementation, development, and consulting services. This revenue growth was partially offset by a decline in revenues from live events, study guides, and associations of $1.1 million, primarily due to decreasing demand for these services. HealthStream Research revenue growth resulted primarily from the TJO acquisition, but was partially offset by lower revenues from physician, employee, and community surveys which was due to certain large customers electing to delay projects and in some cases other customers electing not to conduct the same surveys as they had in the prior year.
Cost of Revenues (excluding depreciation and amortization). Cost of revenues increased approximately $2.1 million, or 29.1%, to $9.4 million for the six months ended June 30, 2008 from $7.3 million for the six months ended June 30, 2007. Cost of revenues as a percentage of revenue approximated 38.4% and 36.1% of revenues for the six months ended June 30, 2008 and 2007, respectively. Cost of revenues for HealthStream Learning increased $761,000 and approximated 33.2% and 34.3% of revenues for the six months ended June 30, 2008 and 2007, respectively. This expense increase resulted primarily from increased royalties paid by us associated with the increase in courseware subscription revenues as well as increased personnel and related expenses, but was partially offset by lower costs associated with live events, study guides and association projects. Cost of revenues for HealthStream Research increased $1.4 million and approximated 47.7% and 39.4% of revenues for the six months ended June 30, 2008 and 2007, respectively. The primary expense increases resulted from personnel associated with the TJO acquisition. The decrease as a percentage of revenues resulted primarily from the project mix and related revenues when compared to the prior year.
Gross Margin (excluding depreciation and amortization). Gross margin (which we define as revenues less cost of revenues divided by revenues) was 61.6% and 63.9% for the six months ended June 30, 2008 and 2007, respectively. Gross margins for HealthStream Learning were 66.8% and 65.7% for the six months ended June 30, 2008 and 2007, respectively. This improvement resulted from the change in revenue mix and related cost of revenues discussed above. Gross margins for HealthStream Research were 52.3% and 60.6% for the six months ended June 30, 2008 and 2007, respectively. This decrease resulted from lower revenues from our higher margin surveys.
Product Development. Product development expenses increased approximately $436,000, or 20.0%, to $2.6 million for the six months ended June 30, 2008 from $2.2 million for the six months ended June 30, 2007. Product development expenses as a percentage of revenues was 10.7% and 10.8% of revenues for the six . . .