GENERAL

A.D.A.M. provides high-quality health information services and benefits technology solutions to healthcare organizations, benefit brokers, employers, consumers, and educational institutions. Our portfolio of products helps consumers better understand their health and wellness, manage their personal benefits and health account finances, while helping organizations reduce the costs of healthcare and benefits administration. We also provide software applications for the education market that are designed to teach students gross anatomy and human physiology.

Our health information products include a rich library of interactive health content and interactive applications that can be used by a broad range of healthcare consumers-from those with low health literacy to those who play an active and ongoing role in their personal health management. Our health information can be used for learning about general health concerns, specific diseases, medical conditions and treatments, surgical procedures, drug information, specialty health subjects such as women's health and children's health, nutrition, alternative medicine and more. Our health applications, such as our Health Risk Assessments, allow consumers to learn more about their health by providing them with relevant feedback regarding their health condition to help in making better decisions.

Our Benergy™ communications system ("Benergy") is used to communicate to employees about employer provided benefits, assist employees in the selection and enrollment process, and then promote and facilitate the use of their benefit programs. Benergy provides employees a self-service access and enables employees to better understand their benefit choices and make informed decisions about selection of their health insurance and other employer sponsored benefit plans.

Our broker agency management system includes a product suite called Advisor Tools. Within the Advisor Tool suite, we have several products brokers use to help them manage their business and communicate with their employer clients. One of the principal products within the Advisor Tool suite is AgencyWare, a client relationship management system specific to brokerage firms. AgencyWare assists brokers in quoting and selling insurance, managing commissions, tracking client interactions and other critical functions central to their business. Another application, Client Community, is a communications tool that facilitates communications between the broker and the human resources/benefits professional. Currently, Client Community is deployed to approximately 40,000 employers and prospective clients.

Critical Accounting Policies and Estimates

Discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the amounts reported in the consolidated financial statements and the accompanying notes. On an on-going basis, we evaluate our estimates, including those related to product returns, product and content development expenses, bad debts, intangible assets, income taxes and contingencies. We base our estimates on experience and on various assumptions that are believed 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 the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

• Revenue Recognition

We derive revenues from the following sources: (1) electronically delivered content, which includes content license and postcontract customer support (PCS) revenue, (2) hosted content, which includes content license, hosting and PCS revenue, (3) professional services and (4) product sales. We recognize revenue when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and
(4) collectability is reasonably assured. When a contract includes multiple elements, such as content and services, the entire fee is allocated to each respective element based on vendor specific objective evidence of fair value, and recognized when the revenue criteria for each element is met.

Electronically delivered content, which includes content license and PCS revenue, is recognized in accordance with Statement of Position No. 97-2, "Software Revenue Recognition," with the entire amount recognized ratably over the term of the license agreement.

Hosted content, which includes content license, hosting and PCS revenue, is recognized using GAAP principles for service revenue recognition as per Emerging Issues Task Force (EITF) Issue No. 00-3. The entire amount of revenue is recognized ratably over the term of the license agreement, which matches the service that is being provided.

Professional service revenues are generally recognized upon completion and acceptance of the service by the customer. For revenue arrangements in which we sell through a reseller, we recognize revenue only after an agreement has been finalized between the customer and our authorized reseller and the content has been delivered to the customer by the reseller.

Product sales revenues are generally recognized at the time title passes to customers, distributors or resellers.

• Sales Returns Allowances and Allowance for Doubtful Accounts

Significant management judgments and estimates must be made in connection with establishing the sales returns and other allowances in any accounting period. Management must make estimates of potential future product returns related to current period product revenue. We evaluate the adequacy of allowances for returns primarily based upon our evaluation of historical and expected sales experience and by channel of distribution. The judgments and estimates of management may have a material effect on the amount and timing of our revenue for any given period. The allowance for returns in prior years has not been significant.

Similarly, management must make estimates of the uncollectability of accounts receivable. Management specifically analyzes accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

• Capitalized Software Product and Content Development Costs

We capitalize software product and content development costs in accordance with Financial Accounting Standards Board ("FASB") Statement No. 86 ("FAS 86"), "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed." This statement specifies that costs incurred internally in creating a computer software product shall be charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of all planning, designing, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements. We cease capitalization of internally developed software when the product is made available for general release to customers and thereafter any maintenance and customer support is charged to expense when related revenue is recognized or when those costs are incurred. We amortize such capitalized costs as cost of revenues on a product-by-product basis using the greater of the ratio of current product revenue to the total of current and anticipated product revenue or on a straight line basis over the estimated life of the software, which we have determined to generally be two years. We continually evaluate the recoverability of capitalized costs and if the successes of new product releases are less than we anticipate then a write-down of capitalized costs may be made which could adversely affect our results in the reporting period in which the write-down occurs.

We also capitalize internal software development costs in accordance with the American Institute of Certified Public Accountants' Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This statement specifies that computer software development costs for computer software intended for internal use occurs in three stages: (1) the preliminary project stage, where costs are expensed as incurred, (2) the application development stage, where costs are capitalized, and (3) the post-implementation or operation stage, where again costs are expensed as incurred. We cease capitalization of developed software for internal use when the software is ready for its intended use and placed in service. We amortize such capitalized costs as cost of revenues on a product-by-product basis using the straight-line method over a period of three years. We continually evaluate the usability of the products that make up our capitalized costs and if certain circumstances arise such as the introduction of new technology in the marketplace that management intends to use in place of the capitalized project, then a write-down of capitalized costs may be made which could adversely affect our results in the reporting period in which the write-down occurs.

• Goodwill and Intangible Assets

In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," we evaluate goodwill and intangible assets for impairment on an annual basis. Additionally, goodwill is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce

the fair value of an asset below its carrying value. These events or circumstances would include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business or other factors. The carrying value of goodwill is evaluated in relation to the operating performance and estimated future discounted cash flows of the entity.

• Income Taxes

As part of the process of preparing our consolidated financial statements we are required to estimate our taxes in each of the jurisdictions in which we operate. This process involves management estimating the actual tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and U.S. GAAP purposes. These differences result in deferred tax assets and liabilities, which are included within our accompanying consolidated balance sheet. We must then assess the likelihood that deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance.

• Stock-based Compensation

We account for stock-based compensation in accordance with SFAS No. 123(R). Under the fair value recognition provisions of this statement, stock-based compensation cost is estimated at the grant date based on the award's fair value as calculated by the Black-Scholes Method option-pricing model and is recognized as expense over the requisite service period. The Black-Scholes Method requires various highly judgmental assumptions including volatility, forfeiture rates and expected option life. If any of the assumptions used in the option pricing model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

RESULTS OF OPERATIONS

Comparison of the Three and Nine Months Ended September 30, 2008 with the Three and Nine Months Ended September 30, 2007

Revenues (numbers in table in thousands)



                                      Three Months Ended                                Nine Months Ended
                                        September 30,           $           %             September 30,          $          %
                                       2008         2007      Change      Change         2008        2007     Change      Change
A.D.A.M., Inc. Consolidated
Licensing                           $    6,270    $  5,822   $    448        7.7 %    $   19,028   $ 17,380   $ 1,648        9.5 %
Product                                    368         390        (22 )     (5.6 )%          925      1,312      (387 )    (29.5 )%
Professional services and other            501         464         37        8.0 %         1,498      1,553       (55 )     (3.5 )%

Total Net Revenues                  $    7,139    $  6,676   $    463        6.9 %    $   21,451   $ 20,245   $ 1,206        6.0 %

Total net revenues increased 6.9%, or $463,000 to $7,139,000, for the three months ended September 30, 2008 over the three months ended September 30, 2007 compared to the total net revenues increase of 6.0%, or $1,206,000 to $21,451,000, for the nine months ended September 30, 2008 over the nine months ended September 30, 2007. For the periods shown above, over 85% of those revenues came from the licensing of our health information services and benefits technology solutions.

Licensing revenues are recognized on a monthly basis, either based on usage, expiration of monthly minimums, or on a straight-line basis over the life of the contract. Therefore fluctuation in licensing revenue is due to new contracts, customer usage levels or contract terminations. We annualize each contract's committed value and use changes to that value, from new sales or terminations, to calculate a net client retention rate.

Our increase in licensing revenue is a result of new customer contracts and solid client retention from our health information products. We derive those revenues primarily from healthcare organizations and healthcare information technology companies. The increase in new customer contracts is a result of the increased staffing in sales and marketing personnel, product enhancements, and an increase in the demand for online consumer-focused health information.

Revenues from product sales decreased by 29.5%, or $387,000, to $925,000 for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007. Our product revenues consist primarily of CD-based product sales to the educational market. Revenues were lower in this area due to a market shift from CD-based products to online solutions. We are planning to invest in new product development of online solutions to meet the current market requirements.

Professional services and other revenue are derived from products such as custom implementation services, flexible spending account services, direct to consumer products, and sales of nonrecurring products such as books, publications, and medical images.