**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**Form 10-Q**

 

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**ý****                              ****Quarterly reportpursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For thequarterly period ended March 31, 2005**

 

**or**

 

**o****                              ****Transition report pursuantto Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**Commissionfile number: 1-32203**

 

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**ProspectMedical Holdings, Inc.**

(Exactname of registrant as specified in its charter)

 

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| **Delaware**                                                     | ** ** | **33-0564370**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |
|                                                             |       |                                   |
| **6083  Bristol Parkway, Suite 100  Culver City, California**    |       | **90230**                              |
| (Address  of principal executive offices)                        |       | (Zip  Code)                            |
|                                                             |       |                                   |
| **(310)  338-8677**                                              |
| (Registrant’s  telephone number, including area code)       |

 

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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theSecurities Exchange Act of 1934).    Yes  o    No  ý

 

The number of shares of theissuer’s Common Stock, par value $0.01 per share, outstanding as of May 9, 2005,was 4,677,882.

 

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**Index**

 
| **Part I – Financial Information** |                                                                                                                                    |
|-----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|                                    | ** **                                                                                                                              |   |
| **Item 1.**                             | **Financial Statements**                                                                                                                | 3 |
| ** **                              | ** **                                                                                                                              |   |
|                                    | Condensed Consolidated  Balance Sheets as of March 31, 2005 (unaudited) and September 30,  2004                               | 3 |
|                                    |                                                                                                                                    |   |
|                                    | Condensed  Consolidated Statements of Income for the three-month and six-month periods  ended March 31, 2005, and 2004 (unaudited) | 4 |
|                                    |                                                                                                                                    |   |
|                                    | Condensed  Consolidated Statements of Cash Flows for the six-month periods ended March 31,  2005 and 2004 (unaudited)              | 5 |
|                                    |                                                                                                                                    |   |
|                                    | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                       | 6 |
|                                    |                                                                                                                                    |   |
| **Item  2.**                            | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                         | 10 |
| ** **                              | ** **                                                                                                                              |   |
| **Item  3.**                            | **Quantitative  and Qualitative Disclosures About Market Risk**                                                                         | 23 |
| ** **                              | ** **                                                                                                                              |   |
| **Item 4.**                             | **Controls and  Procedures**                                                                                                            | 23 |
| ** **                              | ** **                                                                                                                              |   |
| **Part II – Other Information**    | ** **                                                                                                                              |
| ** **                              | ** **                                                                                                                              | ** ** |
| **Item 1.**                             | **Legal Proceedings**                                                                                                                   | 25 |
| ** **                              | ** **                                                                                                                              |   |
| **Item  2.**                            | **Unregistered  Sales of Equity Securities and Use of Proceeds**                                                                        | 25 |
| ** **                              | ** **                                                                                                                              |   |
| **Item 3.**                             | **Defaults Upon Senior Securities**                                                                                                     | 26 |
| ** **                              | ** **                                                                                                                              | ** ** |
| **Item  4.**                            | **Submission of Matters to a Vote of Security  Holders**                                                                                | 26 |
| ** **                              | ** **                                                                                                                              | ** ** |
| **Item 5.**                             | **Other information**                                                                                                                   | 26 |
| ** **                              | ** **                                                                                                                              | ** ** |
| **Item 6.**                        | **Exhibits**                                                                                                                            | 27 |
|                                    |                                                                                                                                    |   |
| **Signatures**                          | 28                                                                                                                                      |
|                                         |                                                                                                                                         |  |  |

 

2

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**PART I -FINANCIAL INFORMATION**

 

**Item 1.    FinancialStatements.**

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                | ** ** | **March 31  2005** | ** ** | **September 30  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                |       |                    |       |                        |       |
| **Current  assets**                                                                                                                                                       |       |                    |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                |       | $                       | 11,609,154 |                        | $          | 20,330,754 |   |
| Investments,  primarily restricted certificates of deposit                                                                                                                |       | 1,150,802               |       | 512,687                     |       |
| Risk pool  receivables                                                                                                                                                    |       | 225,588                 |       | 87,979                      |       |
| Other  receivables, net of allowances of $676,000 and $662,000 at March 31,  2005 and September 30, 2004                                                        |       | 1,201,168               |       | 1,122,864                   |       |
| Notes  receivable, current portion                                                                                                                                        |       | 75,445                  |       | 281,064                     |       |
| Prepaid  expenses and other                                                                                                                                               |       | 913,348                 |       | 607,077                     |       |
| Recoverable  income taxes                                                                                                                                                 |       | 1,089,046               |       | 0                           |       |
| Deferred  income taxes, net                                                                                                                                               |       | 1,438,435               |       | 1,605,478                   |       |
| Total current  assets                                                                                                                                                     |       | 17,702,986              |       | 24,547,903                  |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| Property,  improvements and equipment:                                                                                                                                    |       |                    |       |                        |       |
| Land                                                                                                                                                                      |       | 40,620                  |       | 40,620                      |       |
| Leasehold  improvements                                                                                                                                                   |       | 726,973                 |       | 714,619                     |       |
| Equipment                                                                                                                                                                 |       | 3,456,672               |       | 3,291,307                   |       |
| Furniture  and fixtures                                                                                                                                                   |       | 513,593                 |       | 536,869                     |       |
|                                                                                                                                                                      |       | 4,737,858               |       | 4,583,415                   |       |
| Less  accumulated depreciation and amortization                                                                                                                           |       | (3,296,151              | )          | (2,977,411                  | )          |
| Property,  improvements and equipment, net                                                                                                                                |       | 1,441,707               |       | 1,606,004                   |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| Notes  receivable, long term portion                                                                                                                                      |       | 603,112                 |       | 617,545                     |       |
| Prepaid  expenses and other, long term portion                                                                                                                            |       | 476,592                 |       | 102,958                     |       |
| Goodwill                                                                                                                                                                  |       | 31,466,553              |       | 31,461,303                  |       |
| Other  intangible assets, net                                                                                                                                             |       | 1,774,120               |       | 1,952,291                   |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| Total assets                                                                                                                                                              |       | $                       | 53,465,070 |                        | $          | 60,288,004 |   |
|                                                                                                                                                                      |       |                    |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                            |       |                    |       |                        |       |
| **Current  liabilities:**                                                                                                                                                 |       |                    |       |                        |       |
| Accrued  medical claims and other health care costs payable                                                                                                               |       | $                       | 13,254,605 |                        | $          | 13,323,622 |   |
| Accounts  payable and other accrued liabilities                                                                                                                           |       | 5,150,355               |       | 7,523,808                   |       |
| Current  maturities of long-term debt and capital leases                                                                                                                  |       | 2,000,000               |       | 6,841,887                   |       |
| Total  current liabilities                                                                                                                                                |       | 20,404,960              |       | 27,689,317                  |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| Long-term  debt, less current maturities                                                                                                                                  |       | 7,166,667               |       | 8,166,667                   |       |
| Deferred  income taxes                                                                                                                                                    |       | 887,246                 |       | 796,427                     |       |
| Other  long-term liabilities                                                                                                                                              |       | 185,000                 |       | 685,000                     |       |
| Total  liabilities                                                                                                                                                        |       | 28,643,873              |       | 37,337,411                  |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| **Minority  interest**                                                                                                                                                    |       | 68,597                  |       | 63,653                      |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| **Shareholders’  equity:**                                                                                                                                           |       |                    |       |                        |       |
| Preferred  stock, $0.01 par value; 5,000,000 shares authorized; 1,991,246 and 2,265,237 shares  issued and outstanding at March 31, 2005 and September 30, 2004 |       | 19,912                  |       | 22,652                      |       |
| Common  stock, $0.01 par value; 40,000,000 shares authorized 4,630,111 and 4,344,525  shares issued and outstanding at March 31, 2005 and September 30,  2004   |       | 46,301                  |       | 43,445                      |       |
| Additional  paid-in capital                                                                                                                                               |       | 18,428,746              |       | 18,630,525                  |       |
| Deferred  compensation                                                                                                                                                    |       | (174,092                | )          | (232,871                    | )          |
| Retained  earnings                                                                                                                                                        |       | 6,431,733               |       | 4,423,189                   |       |
| Total  shareholders’ equity                                                                                                                                          |       | 24,752,600              |       | 22,886,940                  |       |
|                                                                                                                                                                      |       |                    |       |                        |       |
| Total  liabilities and shareholders’ equity                                                                                                                          |       | $                       | 53,465,070 |                        | $          | 60,288,004 |   |

 

See accompanying notes.

 

3

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME****(Unaudited)**

 
| ** **                                                 | ** ** | **Three months ended  March 31** | ** **    | **Six months ended  March 31** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|---------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                              | ** **    | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Revenues                                                   |       | $                                     | 32,330,622    |                                | $          | 32,987,455 |   | $ | 65,611,458 |   | $ | 58,844,870 |   |
| Cost of  Revenues                                          |       | 23,656,214                            |          | 23,355,803                          |       | 48,456,826 |   | 42,240,146 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Gross margin                                               |       | 8,674,408                             |          | 9,631,652                           |       | 17,154,632 |   | 16,604,724 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Operating  expenses:                                       |       |                                  |          |                                |       |   |   |   |   |
| General and  administrative                                |       | 6,550,266                             |          | 6,891,046                           |       | 13,123,077 |   | 12,055,370 |   |
| Depreciation  and amortization                             |       | 263,680                               |          | 216,681                             |       | 496,910 |   | 332,807 |   |
| Total  operating expenses                                  |       | 6,813,946                             |          | 7,107,727                           |       | 13,619,987 |   | 12,388,177 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Operating  income (loss) from unconsolidated joint venture |       | (143,396                              | )             | 62,939                              |       | 97,682 |   | 200,751 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Operating  income                                          |       | 1,717,066                             |          | 2,586,864                           |       | 3,632,327 |   | 4,417,298 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Other  (income) expense:                                   |       |                                  |          |                                |       |   |   |   |   |
| Investment  income                                         |       | (99,407                               | )             | (6,342                              | )          | (177,388 | ) | (23,876 | ) |
| Interest  expense                                          |       | 271,414                               |          | 21,226                              |       | 449,416 |   | 54,873 |   |
| Total other  (income) expense, net                         |       | 172,007                               |          | 14,884                              |       | 272,028 |   | 30,997 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Income  before income taxes                                |       | 1,545,059                             |          | 2,571,980                           |       | 3,360,299 |   | 4,386,301 |   |
| Provision  for income taxes                                |       | 618,650                               |          | 1,051,323                           |       | 1,346,809 |   | 1,738,271 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Net income  before minority interest                       |       | 926,409                               |          | 1,520,657                           |       | 2,013,490 |   | 2,648,030 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Minority  interest                                         |       | 4,561                                 |          | 6,434                               |       | 4,945 |   | 11,739 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Net income                                                 |       | $                                     |  921,848 |                                | $          |  1,514,223 |   | $ |  2,008,545 |   | $ |  2,636,291 |   |
|                                                       |       |                                  |          |                                |       |   |   |   |   |
| Net income  per common share:                              |       |                                  |          |                                |       |   |   |   |   |
| Basic                                                      |       | $                                     | 0.20          |                                | $          | 0.35 |   | $ | 0.45 |   | $ | 0.61 |   |
| Diluted                                                    |       | $                                     | 0.11          |                                | $          | 0.21 |   | $ | 0.23 |   | $ | 0.42 |   |
| Weighted  average shares outstanding:                      |       |                                  |          |                                |       |   |   |   |   |
| Basic                                                      |       | 4,549,828                             |          | 4,344,525                           |       | 4,446,048 |   | 4,299,073 |   |
| Diluted                                                    |       | 8,757,795                             |          | 7,090,700                           |       | 8,716,551 |   | 6,245,810 |   |

 

See accompanying notes. 

 

4

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)**

 
| ** **                                                                                                              | ** ** | **Six months ended  March 31** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Operating  activities**                                                                                               |       |                                |       |   |   |
| Net income                                                                                                              |       | $                                   | 2,008,545  |   | $ | 2,636,291 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities:                           |       |                                |       |   |   |
| Depreciation  and amortization                                                                                          |       | 496,910                             |       | 332,807 |   |
| Provision  for bad debts                                                                                                |       | 15,555                              |       | 196,894 |   |
| Loss on  disposal of assets                                                                                             |       | —                              |       | 1,159 |   |
| Deferred  income taxes, net                                                                                             |       | 257,862                             |       | 327,608 |   |
| Change in  deferred compensation                                                                                        |       | 58,779                              |       | 73,349 |   |
| Changes in  operating assets and liabilities, net of assets acquired and liabilities  assumed in purchase transactions: |       |                                |       |   |   |
| Risk pool  receivables                                                                                                  |       | (137,608                            | )          | 121,571 |   |
| Other  receivables                                                                                                      |       | (93,859                             | )          | (72,555 | ) |
| Prepaid  expenses and other                                                                                             |       | (679,906                            | )          | 186,588 |   |
| Income taxes  receivable                                                                                                |       | (1,089,046                          | )          |   |   |
| Accrued  medical claims and other health care costs payable                                                             |       | (69,017                             | )          | (246,292 | ) |
| Accounts  payable and other accrued liabilities                                                                         |       | (2,873,452                          | )          | (728,128 | ) |
| Net cash  (used in) provided by operating activities                                                                    |       | (2,105,237                          | )          | 2,456,116 |   |
|                                                                                                                    |       |                                |       |   |   |
| **Investing  activities**                                                                                               |       |                                |       |   |   |
| Purchases of  property, improvements and equipment                                                                      |       | (154,443                            | )          | (365,613 | ) |
| Cash paid  for acquisitions, net of cash received                                                                       |       | —                              |       | (3,318,171 | ) |
| Payments on  notes receivable                                                                                           |       | 220,051                             |       | — |   |
| Capitalized  acquisition costs                                                                                          |       | (5,250                              | )          | (587,360 | ) |
| Increase in  restricted certificates of deposit                                                                         |       | (638,115                            | )          | (47,178 | ) |
| Other                                                                                                                   |       | 4,945                               |       | 52,857 |   |
| Net cash  used in investing activities                                                                                  |       | (572,812                            | )          | (4,265,465 | ) |
|                                                                                                                    |       |                                |       |   |   |
| **Financing  activities**                                                                                               |       |                                |       |   |   |
| Repayment of  note payable to shareholder                                                                               |       | —                              |       | (500,000 | ) |
| Net  repayments on line of credit                                                                                       |       | (5,000,000                          | )          | (2,050,000 | ) |
| Repayments  of note payable and capital leases                                                                          |       | (841,888                            | )          | (666,815 | ) |
| Issuance of  common and preferred stock, net of issuance costs                                                          |       | (201,663                            | )          | 11,004,812 |   |
| Net cash  (used in) provided by financing activities                                                                    |       | (6,043,551                          | )          | 7,787,997 |   |
|                                                                                                                    |       |                                |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                                   |       | (8,721,600                          | )          | 5,978,648 |   |
|                                                                                                                    |       |                                |       |   |   |
| Cash and  cash equivalents at beginning of period                                                                       |       | 20,330,754                          |       | 6,516,907 |   |
|                                                                                                                    |       |                                |       |   |   |
| Cash and cash  equivalents at end of period                                                                             |       | $                                   | 11,609,154 |   | $ | 12,495,555 |   |
|                                                                                                                    |       |                                |       |   |   |
| **Supplemental  cash flow information**                                                                                 |       |                                |       |   |   |
| Cash paid  during the period for:                                                                                       |       |                                |       |   |   |
| Income taxes                                                                                                            |       | $                                   | 3,513,124  |   | $ | 1,398,600 |   |
| Interest                                                                                                                |       | $                                   | 376,846    |   | $ | 67,214 |   |
|                                                                                                                    |       |                                |       |   |   |
| Details of businesses  acquired:                                                                                        |       |                                |       |   |   |
| Fair value  of assets acquired                                                                                          |       |                                |       | $ | 19,161,171 |   |
| Liabilities  assumed or created                                                                                         |       |                                |       | (8,661,171 | ) |
| Less cash  acquired                                                                                                     |       |                                |       | (7,181,829 | ) |
| Net cash  paid for acquisitions                                                                                         |       |                                |       | $ | 3,318,171 |   |
|                                                                                                                    |       |                                |       |   |   |
| Common stock  issued in exchange for services rendered                                                                  |       |                                |       | $ | 279,510 |   |

 

5

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**PROSPECT MEDICAL HOLDINGS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS****March 31, 2005(Unaudited)**

 

**1. Reporting Entity**

 

ProspectMedical Holdings, Inc. (Prospect or the Company) a Delaware corporation,was incorporated on May 12, 1993. The Company is a health care managementservices organization that develops integrated delivery systems, and providesmedical management systems and services to affiliated medical organizations.The affiliated medical organizations employ and/or contract with physicians andprofessional medical corporations, and contract with managed care payors. Prospect  manages the provision of prepaid health careservices for its affiliated medical organizations in Southern California.

 

**2. Basis of Presentation**

 

The unaudited condensed consolidatedinterim financial statements have been prepared under the assumption that usersof the interim financial data have either read or have access to our auditedconsolidated financial statements for the latest fiscal year ended September 30,2004. Accordingly, certain note disclosures that would substantially duplicatethe disclosures contained in the September 30, 2004 audited financialstatements have been omitted. These unaudited consolidated interim financialstatements should be read in conjunction with our September 30, 2004audited financial statements.

 

The unaudited condensed consolidatedfinancial statements include the accounts of the Company and all majority ownedsubsidiaries and controlled entities. In the opinion of management, alladjustments considered necessary for a fair presentation of the results as ofthe date and for the interim periods presented, which consist solely of normalrecurring adjustments, have been included. All significant inter-companybalances and transactions have been eliminated in consolidation. Theconsolidated results of operations for the current interim period are notnecessarily indicative of the results that may be expected for the entire yearending September 30, 2005.

 

Certain prior year amounts in the accompanying condensed consolidatedfinancial statements have been reclassified to conform to the 2005presentation.

 

Revenues are comprised of the following amounts:

 
| ** **       | ** ** | **Three Months Ended March 31** | ** ** | **Six Months Ended March 31** | ** ** |
|------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **       | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Capitation       |       | $                                    | 31,411,215 |                               | $          | 31,744,867 |   | $ | 63,929,977 |   | $ | 56,859,315 |   |
| Fee for  service |       | 563,323                              |       | 1,014,717                          |       | 1,063,604 |   | 1,542,437 |   |
| Management  fees |       | 214,171                              |       | 208,550                            |       | 426,934 |   | 418,458 |   |
| Other            |       | 141,913                              |       | 19,321                             |       | 190,943 |   | 24,660 |   |
| Total  revenues  |       | $                                    | 32,330,622 |                               | $          | 32,987,455 |   | $ | 65,611,458 |   | $ | 58,844,870 |   |

 

**3. Stock Based Compensation**

 

SFAS No. 123, “Accounting for Stock-BasedCompensation,” provides an alternative to Accounting Principles Board (APB)Opinion 25, “Accounting for Stock Issued to Employees.” SFAS No. 123encourages, but does not require, that compensation expense for grants ofstock, stock options and other equity instruments to employees be based on thefair value of such instruments. The statement also allows companies to continueto measure compensation expense using the intrinsic value method prescribed byAPB Opinion No. 25.

 

The Company has elected to follow APB OpinionNo. 25 and related interpretations in accounting for its stock optionsbecause, as discussed below, the alternative fair value accounting provided forunder SFAS No. 123 requires use of option valuation models that were notdeveloped for use in valuing stock options. Under APB No. 25, because theexercise price of the Company’s stock options equals or exceeds the marketprice of the underlying stock on the date of grant, no compensation expense isrecognized, although, in certain circumstances, the current market price hasexceeded the exercise 

 

6

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price, in which case we have recorded stock compensation expense equalto the difference between the market price and the exercise price over thevesting period.

 

In December 2002, SFAS No. 148 “Accountingfor Stock-Based Compensation—Transition and Disclosure,” was issued. SFASNo. 148 amends SFAS No. 123 to provide, among other things,alternative methods of transition to SFAS No. 123’s fair value method ofaccounting for stock-based employee compensation.

 

The Company has adopted the disclosurerequirements under SFAS No. 148. The following table illustrates theeffect on net income and earnings per share as if the Company had applied thefair value recognition provisions for the three and six month periods ended March 31,2004 and 2005.

 
| ** **                                                                                                                 | ** ** | **Three months ended  March 31** | ** ** | **Six months ended  March 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income,  as reported                                                                                                   |       | $                                     | 921,848    |                                | $          | 1,514,223 |   | $ | 2,008,545 |   | $ | 2,636,291 |   |
| Reconciling  items (net of related tax effects):                                                                           |       |                                  |       |                                |       |   |   |   |   |
| Add:  Stock-based employee compensation expense determined under the  intrinsic-value based method, included in net income |       | 29,389                                |       | 36,675                              |       | 58,779 |   | 73,350 |   |
| Deduct:  Stock-based employee compensation expense determined under the fair-value  based method                           |       | (41,496                               | )          | (24,058                             | )          | (319,439 | ) | (94,477 | ) |
| Net  adjustment                                                                                                            |       | (12,107                               | )          | 12,617                              |       | (260,660 | ) | (21,127 | ) |
| Pro forma  net income                                                                                                      |       | $                                     | 909,741    |                                | $          | 1,526,840 |   | $ | 1,747,885 |   | $ | 2,615,164 |   |
|                                                                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Earnings per  share:                                                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Basic—as  reported                                                                                                    |       | $                                     | 0.20       |                                | $          | 0.35 |   | $ | 0.45 |   | $ | 0.61 |   |
| Basic—pro  forma                                                                                                      |       | $                                     | 0.20       |                                | $          | 0.35 |   | $ | 0.39 |   | $ | 0.61 |   |
| Diluted—as  reported                                                                                                  |       | $                                     | 0.11       |                                | $          | 0.21 |   | $ | 0.23 |   | $ | 0.42 |   |
| Diluted—pro  forma                                                                                                    |       | $                                     | 0.10       |                                | $          | 0.22 |   | $ | 0.20 |   | $ | 0.42 |   |

 

The fair value of the options granted in 2004 and 2005 was estimated atthe date of grant using a Minimum Value option pricing model with the followingweighted average assumptions:

 
| Expected  market price of the Company’s common stock on the date of grant |   | $       | 7.15   |    | $      | 3.07           |   | $6.45 to $7.15 |   | $ | 3.07 |   |
|--------------------------------------------------------------------------------|--------|---------|--------|---------|--------|----------------|--------|----------------|--------|---|------|--------|
| Weighted  average expected life of the options                                 |   | 4 years |   | 4 years |   | 4 years        |   | 4 years        |   |
| Risk-free  interest rate                                                       |   | 4.17    | %      | 3.00    | %      | 3.50% to  4.17 | %      | 3.00           | %      |
| Dividend  yield                                                                |   | 0.00    | %      | 0.00    | %      | 0.00           | %      | 0.00           | %      |

 

7

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The denominators for the computation of basic anddiluted earnings per share are calculated as follows:

 
| ** **                                                               | ** ** | **Three months ended  March 31** | ** ** | **Six months ended  March 31** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic  earnings per common share:                                        |       |                                  |       |                                |       |   |   |   |   |
| Numerator –  net income                                             |       | $                                     | 921,848    |                                | $          | 1,514,223 |   | $ | 2,008,545 |   | $ | 2,636,291 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Denominator –  weighted average number of common shares outstanding |       | 4,549,828                             |       | 4,344,525                           |       | 4,446,048 |   | 4,299,073 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Basic  earnings per common share                                         |       | $                                     | 0.20       |                                | $          | 0.35 |   | $ | 0.45 |   | $ | 0.61 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Diluted  earnings per common share:                                      |       |                                  |       |                                |       |   |   |   |   |
| Numerator –  net income                                             |       | $                                     | 921,848    |                                | $          | 1,514,223 |   | $ | 2,008,545 |   | $ | 2,636,291 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Denominator:                                                             |       |                                  |       |                                |       |   |   |   |   |
| Weighted  average number of common shares outstanding                    |       | 4,549,828                             |       | 4,344,525                           |       | 4,446,048 |   | 4,299,073 |   |
| Diluted  stock options, warrants and preferred shares                    |       | 4,207,967                             |       | 2,746,175                           |       | 4,270,503 |   | 1,946,737 |   |
|                                                                     |       | 8,757,795                             |       | 7,090,700                           |       | 8,716,551 |   | 6,245,810 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Diluted  earnings per common share                                       |       | $                                     | 0.11       |                                | $          | 0.21 |   | $ | 0.23 |   | $ | 0.42 |   |

 

The Minimum Value option valuation model wasdeveloped for use in estimating the fair value of traded options that have novesting restrictions and are fully transferable. In addition, option valuationmodels require the input of highly subjective assumptions including theexpected stock price volatility. Because the Company’s stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of its stockoptions.

 

On October 13, 2004,the Financial Accounting Standards Board concluded that Statement No. 123R, “*Share-Based Payment*,” which requires allcompanies to measure compensation cost for all share-based payments (includingemployee stock options) at fair value, would be effective for public companiesfor annual periods beginning after June 15, 2005. SFAS No. 123R willeliminate our ability to account for share-based compensation using theintrinsic value method permitted under Opinion No. 25. We will utilize themodified prospective method, recognizing compensation cost for share-basedawards to employees based on their grant-date fair values from the beginning ofthe year in which the recognition provisions are first applied as if the fairvalue-based method had been used to account for all employee awards. Under thistransition approach, compensation cost will be recognized for all awardsgranted, modified or settled after the date of adoption as well as to anyawards that were not fully vested as of that date. Any adjustments to recognizeshare-based liabilities at fair value from the beginning of the year throughthe date of adoption will be recognized as a cumulative effect of a change inaccounting principle. We intend to apply the new rules beginning October 1,2005, as required.

 

**4. Related Party Transactions**

 

The Company has an employment agreement withour Chief Executive Officer, Jacob Y. Terner, which is for a three-year termending on August 1, 2005. The agreement provides for a specified annualcompensation and in the event that the Company terminates Dr. Terner’semployment without cause, the Company will be required to pay him $12,500 foreach month of past service as the Chief Executive Officer, commencing as of July 31,1996. The contingent termination obligation was capped at $1,237,500, effectiveSeptember 30, 2004. Since the Company has not indicated any intention toterminate Dr. Terner, no such potential liability is accrued as of March 31,2005.

 

Prospect Medical Group, Inc. (PMG),which is wholly owned by Dr. Terner, and whose accounts are consolidatedin these financial statements under EITF 97-2, maintains an intercompanyaccount with Prospect Medical Holdings, Inc. The intercompany account hashistorically represented a significant receivable for PMG which, because of itsintercompany 

 

8

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nature, generally was not includable in the HMOs’ and regulatoryagencies’ determination of tangible net equity (TNE). In the event that PMG wasrequired by the HMOs or regulatory agencies to maintain a positive TNE andpositive working capital, Dr. Terner had agreed to personally guaranteethe intercompany account receivable due from Prospect MedicalHoldings, Inc. up to a level sufficient to enable PMG to attain positive TNEand working capital.

 

On June 1, 2003, in consideration forDr. Terner’s personal guarantee and pledge, the Compensation Committee ofthe Board of Directors granted to Dr. Terner a six-year, non-qualifiedstock option to purchase 800,000 shares of common stock at $3.00 per share.During its term, Dr. Terner’s personal guarantee was supported through thepledge of certain of his personal assets. Dr. Terner agreed to maintainhis personal guarantee and collateral in effect until PMG had positive tangiblenet equity. This personal guarantee arrangement was terminated by the Board ofdirectors effective January 19, 2005.

 

**5. Long Term Debt**

 

Long-term debt at March 31, 2005consists of the following:

 
| Term loan                | ** ** | **$**          | **9,166,667** | ** ** |
|--------------------------|------------|----------------|---------------|------------|
| Less current  maturities | ** ** | **(2,000,000** | **)**         |
| ** **               | ** ** | **$**          | **7,166,667** | ** ** |

 

On September 27, 2004, the Companyentered into a new credit facility with Residential Funding Corporation (RFC),comprised of a $5,000,000 revolving credit facility and a $10,000,000 termloan.

 

On September 28, 2004, the Companyborrowed $10,000,000 on the RFC term loan and paid off its existing term loanand revolving credit facility. The Company borrowed $5,000,000 on the RFCrevolving credit facility on September 29, 2004, which was repaid on October 4,2004.

 

The RFC revolving credit facility commitmentis for three years, with interest at prime plus 0.5% per annum and an unusedline fee of 0.25% per annum. The RFC term loan is amortized over a five-yearperiod with principal payments of $166,667 per month, plus interest payablemonthly on the outstanding balance at prime plus 2.0% per annum. The remainingbalance of the term loan is due and payable in full after 36 months. TheCompany is subject to certain financial covenants under the loan agreement,including a maximum senior debt/EBITDA ratio, minimum fixed charge coverageratio, minimum consolidated net worth, minimum liquidity and a limit on capitalexpenditures. The Company is also restricted, without consent, from using netproceeds of any sale of equity securities except to pay down indebtedness underthe loan agreement.

 

The Company exceeded the 1.50 maximum seniordebt/EBITDA ratio as of September 30, 2004 and December 31, 2004. Theactual senior debt/EBITA ratio as of September 30, 2004 and December 31,2004 was 1.57 and 1.51, respectively. Effective April 7, 2005, RFC haswaived these covenant violations. RFC, in addition, agreed to exclude certainitems from the covenant computations for a twelve month period, the exclusionof which enabled the Company to meet the minimum fixed charge coverage ratio atDecember 31, 2004. The Company was in compliance with all requiredcovenants as of March 31, 2005.

 

9

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

 

**Forward-Looking Statements**

 

The following discussion ofour financial condition and results of operations should be read in conjunctionwith the accompanying unaudited condensed consolidated financial statements andthe notes to those statements appearing elsewhere in this report and theaudited financial statements for the year ended September 30, 2004 appearingin our registration statement on Form 10 filed with the Securities and ExchangeCommission.

 

This discussion containsforward-looking statements that involve risks and uncertainties. Theseforward-looking statements are often accompanied by words such as “believe,” “should,”“anticipate,” “plan,” “expect,” “potential,” “scheduled,” “estimate,” “intend,”“seek,” “goal,” “may” and similar expressions. These statements include,without limitation, statements about our market opportunity, our growthstrategy, competition, expected activities and future acquisitions andinvestments and the adequacy of our available cash resources. Investors areurged to read these statements carefully, and are cautioned that matterssubject to forward-looking statements involve risks and uncertainties,including economic, regulatory, competitive and other factors that may affectour business. These statements are not guarantees of future performance and aresubject to risks, uncertainties and assumptions. Although we believethat the expectations reflected in the forward-looking statements arereasonable, we cannot guarantee future results, levels of activity,performance, or achievements. Moreover, we do not assume any responsibility forthe accuracy and completeness of such statements in the future. Subject toapplicable law, we do not plan to update any of the forward-looking statementsafter the date of this report to conform such statements to actual results.

 

Forward-looking statementsinvolve known and unknown risks and uncertainties that may cause our actualresults in future periods to differ materially from those projected orcontemplated in the forward-looking statements as a result of, but not limitedto, the following factors:

 

•                  Decreases in the number of HMO enrollees usingour provider networks reduce our profitability and inhibit future growth.

 

•                  Our working capital deficit could adverselyaffect our ability to satisfy our obligations as they come due.

 

•                  If the value of our goodwill and intangibleassets with indefinite useful lives becomes impaired, the impaired portion willhave to be written off, which could materially reduce the value of our assetsand reduce our net income for the year in which the write-off occurs.

 

•                  We may not be able to make any additionalsignificant acquisitions without first obtaining additional financing andobtaining the consent of our commercial lender.

 

•                  If we are not able to comply with the financialcovenants and other conditions required by our loan agreement with ourcommercial lender, our lender could require full repayment of the loan, whichwould negatively impact our liquidity and preclude us from making furtheracquisitions.

 

•                  Substantially all of our revenues aregenerated from contracts with a limited number of HMOs, and if our affiliatedphysician organizations were to lose HMO contracts or to renew HMO contracts onless favorable terms, our revenues and profitability could be significantlyreduced.

 

•                  Our profitability may be reduced oreliminated if we are not able to manage health care costs of our affiliatedphysician organizations effectively.

 

•                  Our operating results could be adverselyaffected if our actual health care claims exceed our reserves.

 

•                  We may be exposed to liability or fail toestimate IBNR claims accurately if we cannot process our increased volume ofclaims accurately and timely.

 

•                  Medicare and private third-party payer costcontainment efforts and reductions in reimbursement rates could reduce ourrevenue and our cash flow.

 

10

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•                  Risk-sharing arrangements that our affiliatedphysician organizations have with HMOs and hospitals could result in theircosts exceeding the corresponding revenues, which could reduce or eliminate anyshared risk profitability.

 

•                  If we do not successfully integrate theoperations of acquired physician organizations into our service network, ourcosts could increase, our business could be disrupted, and we may not be ableto realize the anticipated benefits from those acquisitions.

 

•                  When we acquire operations that havehistorically operated at a loss, we may not be able to reverse those losses andoperate those businesses at a profit, which could reduce our earnings.

 

•                  If we are unable to identify suitableacquisition candidates or to negotiate or complete acquisitions on favorableterms, our prospects for growth could be limited.

 

•                  Any acquisitions we complete in the futurecould potentially dilute the equity interests of our current stockholders orcould increase our indebtedness and cost of debt service, thereby reducing ournet income and profitability.

 

•                  We operate in a competitive market; increasedcompetition could adversely affect our revenues.

 

•                  Failure to comply with federal and stateregulations could result in substantial penalties and changes in businessoperations.

 

•                  Future reforms in health care legislation andregulation could reduce our revenues and profitability.

 

•                  Wheneverwe seek to acquire an IPA, an HMO that has a contract with that IPA couldpotentially refuse to consent to the transfer of its contract, and this coulddeter us from completing the acquisition or could deprive us of the enrolleesand revenues associated with that HMO contract if we chose to complete theacquisition without the HMO’s consent.

 

•                  Our profitability could be adversely affectedby any changes that would reduce payments to HMOs under government-sponsoredhealth care programs.

 

•                  Our revenues and profits could be diminishedif we lose the services of key physicians in our affiliated physicianorganizations.

 

•                  Because our business is currently limited tothe Southern California area, any reduction in our revenues and profitabilityfrom a local economic downturn would not be offset by operations in othergeographic areas.

 

•                  We are required to upgrade and modify ourmanagement information systems to accommodate growth in our business andchanges in technology and to satisfy new government regulations. As we seek toimplement these changes, we may experience complications, delays and increasingcosts, which could disrupt our business and reduce our profitability.

 

•                  If we were to lose the services ofDr. Terner or other key members of management, we might not be able toreplace them in a timely manner with qualified personnel, which could disruptour business and reduce our profitability and revenue growth.

 

•                  We and our affiliated physician organizationsmay become subject to claims of medical malpractice or HMO bad-faith liabilityclaims for which our insurance coverage may not be adequate. Such claims couldmaterially increase our costs and reduce our profitability.

 

•                  Fluctuations in our quarterly operatingresults may make it difficult to predict our future results of operations,which could decrease the market value of our common stock.

 

•                  The NASD has conducted an informal inquiryregarding trading in our common stock.

 

11

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•                  If we are not able to develop or sustain anactive trading market for our common stock, it may be difficult forstockholders to dispose of their common stock.

 

•                  Even if an active market develops for ourcommon stock, the market price of our stock is likely to be volatile.

 

•                  If our common stock becomes subject to theSEC’s penny stock rules, our stockholders may find it difficult to sell theirstock.

 

•                  The availability of a substantial number ofshares of our common stock for future sale could cause the market price of ourcommon stock to decrease, even if our business is doing well, thus making itmore difficult for a market in our stock to develop, and could also make itmore difficult for us to raise additional equity capital from investors.

 

Investors should also referto our Form 10 registration statement filed with the Securities and Exchange onApril 7, 2005 for a discussion of risk factors. Given these risks anduncertainties, we can give no assurances that any forward-looking statementswill in fact occur and therefore caution investors not to place undue relianceon them.

 

**Overview**

 

Prospect Medical Holdings, Inc. (we, or the “company”) is a healthcare management services organization. We provide management services toaffiliated physician organizations that operate as independent physicianassociations (“IPAs”) or medical clinics. Our affiliated physician organizations enter into agreements with healthmaintenance organizations (“HMOs”) to provide enrollees of the HMOs with a fullrange of medical services in exchange for fixed, prepaid monthly fees known as “capitation”payments.

 

The IPAs contract with physicians (primarycare and specialist) and other health care providers to provide all of theirmedical services. The medical clinics employ their primary care physicians,which provide the vast majority of their medical services, while contractingwith specialist physicians and other health care providers to provide otherrequired medical services.

 

Through our management subsidiaries –Prospect Medical Systems, Sierra Medical Management and Pinnacle HealthResources (through September, 2004) – we have entered into long-term agreementsto provide management services to each of our affiliated physicianorganizations in exchange for a management fee. The management services weprovide include HMO contracting, physician recruiting, credentialing andcontracting, utilization management, quality assurance, medical management, humanresources services, claims administration, financial services, providerrelations, patient eligibility and other services, medical management includingutilization management and quality assurance, data collection, and managementinformation systems.

 

Our management subsidiaries currently providemanagement services to twelve affiliated physician organizations, which includeProspect Medical Group, ten other affiliated physician organizations thatProspect Medical Group owns or controls, and one affiliated physicianorganization (AMVI/Prospect Health Network) that is an unconsolidated joint venturein which Prospect Medical Group owns a 50% interest.  We have utilized Prospect Medical Group,which was our first affiliated physician organization, to acquire the ownershipinterest in all of our other affiliated physician organizations.  Thus, while Prospect Medical Group is itselfan affiliated physician organization that does the same business in its ownservice area as all of our other affiliated physician organizations do intheirs, Prospect Medical Group also serves as a holding company for our otheraffiliated physician organizations.

 

The twelve affiliated physician organizationsprovide medical services to a combined total of approximately 182,000 HMOenrollees at March 31, 2005, including the AMVI Prospect Health Networkenrollees comprising approximately 5,400 enrollees that we manage for our owneconomic benefit, and 7,300 enrollees that we manage for the economic benefitof our partner in this joint venture, for which we earn management fee income.Currently, our affiliated physician organizations have contracts withapproximately ten HMOs, from which our revenue is primarily derived. HMOs offera comprehensive health care benefits package in exchange for a capitation feeper enrollee that does not vary through the contract period regardless of thequantity of medical services required or used. HMOs enroll members by enteringinto contracts with employer groups or directly with individuals to provide abroad range of health care services for a prepaid charge, with 

 

12

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minimal deductibles or co-payments required of the members. All of thecontracts between our affiliated physician organizations and the HMOs providefor the provision of medical services by the affiliated physician organizationto the HMO enrollees in consideration for the prepayment of the fixed monthlycapitation fee per enrollee paid by the HMOs.

 

Our consolidated business has grown throughthe acquisition of IPAs by Prospect Medical Group. Our plan is for ProspectMedical Group to continue to acquire additional IPAs. We do not intend tofurther acquire any individual or small medical practices, clinics or medicalgroup practices.

 

We have chosento concentrate our growth geographically by limiting our acquisitions to IPAsin Orange County, California and Los Angeles County, California.

 

Operating revenue of the Company consistsprimarily of fees for medical services provided by our affiliated physicianorganizations under capitated contracts with various HMOs or underfee-for-service arrangements. Capitation revenue under HMO contracts is prepaidmonthly to the affiliates based on the number of enrollees electing any one ofthe affiliates as their health care provider. Management fees comprise amountsearned from managing the operations of AMVI, Inc., which is our joint venturepartner in the AMVI/Prospect Health Network joint venture.

 

Revenues arecomprised of the following amounts:

 
| ** **       | ** ** | **Three months ended  March 31,** | ** ** | **%****of  Increase** | ** ** | **Six months ended  March 31,** | ** ** | **%****of  Increase** | ** ** |
|------------------|------------|----------------------------------------|------------|-----------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **       | ** ** | **2005**                               | ** ** | **2004**              | ** ** | **(Decrease)**                       | ** ** | **2005**              | ** ** | **2004** | ** ** | **(Decrease)** | ** ** |
| Capitation       |       | $                                      | 31,411,215 |                  | 31,744,867 |                                 | (1.1       | )%                    | 63,929,977 |   | 56,859,315 |   | 12.4 | % |
| Fee for  service |       | 563,323                                |       | 1,014,717             |       | (44.5                                | )%         | 1,063,604             |       | 1,542,437 |   | (31.0 | )% |
| Management  fees |       | 214,171                                |       | 208,550               |       | 2.7                                  | %          | 426,934               |       | 418,458 |   | 2.0 | % |
| Other            |       | 141,913                                |       | 19,321                |       | 634.5                                |       | 190,943               |       | 24,660 |   | 674.3 | % |
|             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Total            |       | $                                      | 32,330,622 |                  | 32,987,455 |                                 | (2.0       | )%                    | 65,611,458 |   | 58,844,870 |   | 11.5 | % |

 

Net membership growth hasbeen the primary reason for our increasing revenues. We have increased ourmembership through acquisitions. These increases through acquisition are offsetby HMO enrollment declines at our affiliated physician organizations, whichdeclines are consistent with, though greater than, general HMO enrollmenttrends in California in recent years. The following table sets forth theapproximate number of members, by category, as of the dates indicated.

 
| **Member Category** | ** ** | **As of  March 31,  2005** | ** ** | **As of  March 31,  2004** | ** ** |
|---------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Commercial          |       | 154,000                         |       | 181,300                         |       |
| Senior              |       | 13,600                          |       | 17,800                          |       |
| MediCal - owned     |       | 7,100                           |       | 8,400                           |       |
| MediCal -  managed  |       | 7,300                           |       | 7,200                           |       |
|                |       |                            |       |                            |       |
| Total               |       | 182,000                         |       | 214,700                         |       |

 

The following table detailstotal paid member months, by member category, for the three and six-monthperiods ended March 31, 2005 and 2004:

 

13

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| ** **         | ** ** | **Three months ended  March 31,** | ** ** | **%****of  Increase** | ** ** | **Six months ended  March 31,** | ** ** | **%****of  Increase** | ** ** |
|--------------------|------------|----------------------------------------|------------|-----------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **         | ** ** | **2005**                               | ** ** | **2004**              | ** ** | **(Decrease)**                       | ** ** | **2005**              | ** ** | **2004** | ** ** | **(Decrease)** | ** ** |
| Commercial         |       | 465,000                                |       | 515,000               |       | (10                                  | )%         | 953,000               |       | 934,000 |   | 2 | % |
| Senior             |       | 42,000                                 |       | 48,000                |       | (13                                  | )%         | 86,000                |       | 83,000 |   | 4 | % |
| MediCal -  owned   |       | 21,000                                 |       | 20,000                |       | 5                                    | %          | 43,000                |       | 40,000 |   | 8 | % |
| MediCal -  managed |       | 22,000                                 |       | 22,000                |       | 0                                    | %          | 44,000                |       | 43,000 |   | 2 | % |
|               |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Total              |       | 550,000                                |       | 605,000               |       | (9                                   | )%         | 1,126,000             |       | 1,100,000 |   | 2 | % |

 

Our operating expensesinclude expenses related to the provision of medical care services (cost ofrevenues) and  general andadministrative, or G&A, costs. Our results of operations depend on ourability to effectively manage expenses related to health benefits andaccurately predict costs incurred.

 

Expenses related to medicalcare services include payments to contracted primary care physicians, paymentsto contracted specialists and the cost of employed physicians at the Company’smedical clinics. In general, primary care physicians are paid on a capitationbasis (a fixed amount per member per month regardless of actual utilization ofmedical services), while specialists are paid on either a capitation or afee-for-service basis.

 

Capitation payments are fixedin advance of periods covered and are not subject to significant accountingestimates. These payments are expensed in the period the providers areobligated to provide services. Fee-for-service payments are expensed in theperiod services are provided to our members. Medical care costs include actualhistorical claims experience and estimates of medical expenses incurred but notreported, or IBNR. Monthly, we estimate our IBNR based on a number of factors,including prior claims experience. As part of this review, we also considerestimates of amounts to cover uncertainties related to fluctuations in providerbilling patterns, claims payment patterns, membership and medical cost trends.These estimates are adjusted monthly as more information becomes available. Inaddition to our own IBNR estimation process, we obtain twice annualcertifications of our IBNR liability from independent actuaries. We believethat our process for estimating IBNR is adequate, but there can be no assurancethat medical care costs will not exceed such estimates.

 

G&A costs are largelycomprised of wage and benefit costs related to our employee base and otheradministrative expenses. G&A functions include claims processing,information systems, provider relations, finance and accounting services, andlegal and regulatory services.

 

**Results of Operations**

 

The followingtable sets forth selected revenue categories, cost of revenue categories andother income statement items for the three and six month periods ended March 31,2004 and 2005:

 
| ** **                                       | ** ** | **Three months ended  March 31,** | ** ** | **%****of  Increase** | ** ** | **Six months ended  March 31,** | ** ** | **%****of  Increase** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|-----------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**                               | ** ** | **2004**              | ** ** | **(Decrease)**                       | ** ** | **2005**              | ** ** | **2004** | ** ** | **(Decrease)** | ** ** |
| Revenues:                                        |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Capitation                                       |       | $                                      | 31,411,215 |                  | $          | 31,744,867                           |       | (1.1                  | )%         | 63,929,977 |   | 56,859,315 |   | 12.4 | % |
| Fee for  service                                 |       | 563,323                                |       | 1,014,717             |       | (44.5                                | )%         | 1,063,604             |       | 1,542,437 |   | (31.0 | )% |
| Management  fees                                 |       | 214,171                                |       | 208,550               |       | 2.7                                  | %          | 426,934               |       | 418,458 |   | 2.0 | % |
| Other  revenues                                  |       | 141,913                                |       | 19,321                |       | 634.5                                | %          | 190,943               |       | 24,660 |   | 674.3 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Total  revenues                                  |       | $                                      | 32,330,622 |                  | $          | 32,987,455                           |       | (2.0                  | )%         | 65,611,458 |   | 58,844,870 |   | 11.5 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |   |   |
| Cost of  revenues:                               |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| PCP  Capitation                                  |       | 5,954,027                              |       | 6,030,702             |       | (1.3                                 | )%         | 12,389,417            |       | 10,998,612 |   | 12.6 | % |
| Specialists  Capitation                          |       | 5,922,149                              |       | 6,157,694             |       | (3.8                                 | )%         | 11,772,722            |       | 10,713,788 |   | 9.9 | % |
| Claims  expense                                  |       | 10,889,852                             |       | 9,487,203             |       | 14.8                                 | %          | 22,984,261            |       | 18,051,841 |   | 27.3 | % |
| Physician  salaries                              |       | 637,601                                |       | 1,351,535             |       | (52.8                                | )%         | 1,072,842             |       | 1,976,786 |   | (45.7 | )% |
| Other cost  of revenues                          |       | 252,585                                |       | 328,669               |       | (23.1                                | )%         | 237,584               |       | 499,119 |   | (52.4 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Total cost  of revenues                          |       | 23,656,214                             |       | 23,355,803            |       | 1.3                                  | %          | 48,456,826            |       | 42,240,146 |   | 14.7 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Gross margin                                     |       | 8,674,408                              |       | 9,631,652             |       | (9.9                                 | )%         | 17,154,632            |       | 16,604,724 |   | 3.3 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| General and  administrative expenses             |       | 6,550,266                              |       | 6,891,046             |       | (4.9                                 | )%         | 13,123,077            |       | 12,055,370 |   | 8.9 | % |
| Depreciation  and amortization expense           |       | 263,680                                |       | 216,681               |       | 21.7                                 | %          | 496,910               |       | 332,807 |   | 49.3 | % |
| Total  operating expenses                        |       | 6,813,946                              |       | 7,107,727             |       | (4.1                                 | )%         | 13,619,987            |       | 12,388,177 |   | 9.9 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Income  (loss) from unconsolidated joint venture |       | (143,396                               | )          | 62,939                |       | (327.8                               | )%         | 97,682                |       | 200,751 |   | (51.3 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Operating  Income                                |       | 1,717,066                              |       | 2,586,864             |       | (33.6                                | )%         | 3,632,327             |       | 4,417,298 |   | (17.8 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Other  (income) expense, net                     |       | 172,007                                |       | 14,884                |       | 1,055.7                              | %          | 272,028               |       | 30,997 |   | 777.6 | % |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Income  before income taxes                      |       | 1,545,059                              |       | 2,571,980             |       | (39.9                                | )%         | 3,360,299             |       | 4,386,301 |   | (23.4 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Provision  for income taxes                      |       | 618,650                                |       | 1,051,323             |       | (41.2                                | )%         | 1,346,809             |       | 1,738,271 |   | (22.5 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Minority  interest                               |       | 4,561                                  |       | 6,434                 |       | (29.1                                | )%         | 4,945                 |       | 11,739 |   | (57.9 | )% |
|                                             |       |                                   |       |                  |       |                                 |       |                  |       |   |   |   |   |
| Net income                                       |       | $                                      | 921,848    |                  | $          | 1,514,223                            |       | (39.1                 | )%         | 2,008,545 |   | 2,636,291 |   | (23.8 | )% |

 

14

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The following table setsforth selected operating items, expressed as a percentage of total operatingrevenue:

 
| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** | **Six months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2005**                               | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                        |       |                                   |       |                                 |       |   |   |   |   |
| Capitation  revenue                              |       | 97.2                                   | %          | 96.2                                 | %          | 97.4 | % | 96.6 | % |
| Fee for  service revenue                         |       | 1.7                                    | %          | 3.1                                  | %          | 1.6 | % | 2.6 | % |
| Management  fees                                 |       | 0.7                                    | %          | 0.6                                  | %          | 0.7 | % | 0.7 | % |
| Other  revenues                                  |       | 0.4                                    | %          | 0.1                                  | %          | 0.3 | % | 0.1 | % |
| Total revenues                                   |       | 100.0                                  | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Cost of  revenues:                               |       |                                   |       |                                 |       |   |   |   |   |
| PCP  Capitation                                  |       | 18.4                                   | %          | 18.3                                 | %          | 18.9 | % | 18.7 | % |
| Specialists  Capitation                          |       | 18.3                                   | %          | 18.7                                 | %          | 18.0 | % | 18.2 | % |
| Claims  expense                                  |       | 33.7                                   | %          | 28.8                                 | %          | 35.0 | % | 30.7 | % |
| Physician  salaries                              |       | 2.0                                    | %          | 4.1                                  | %          | 1.6 | % | 3.4 | % |
| Other cost  of revenues                          |       | 0.8                                    | %          | 1.0                                  | %          | 0.4 | % | 0.8 | % |
| Total cost  of revenues                          |       | 73.2                                   | %          | 70.8                                 | %          | 73.9 | % | 71.8 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Gross margin                                     |       | 26.8                                   | %          | 29.2                                 | %          | 26.1 | % | 28.2 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| General and  administrative expenses             |       | 20.3                                   | %          | 20.9                                 | %          | 20.0 | % | 20.5 | % |
| Depreciation  and amortization expense           |       | 0.8                                    | %          | 0.6                                  | %          | 0.8 | % | 0.6 | % |
| Total  operating expenses                        |       | 21.1                                   | %          | 21.5                                 | %          | 20.8 | % | 21.1 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Income  (loss) from unconsolidated joint venture |       | (0.4                                   | )%         | 0.2                                  | %          | 0.2 | % | 0.4 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Operating  income                                |       | 5.3                                    | %          | 7.9                                  | %          | 5.5 | % | 7.5 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Other  (income) expense, net                     |       | 0.5                                    | %          | 0.0                                  | %          | 0.4 | % | 0.1 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Income  before income taxes                      |       | 4.8                                    | %          | 7.9                                  | %          | 5.1 | % | 7.4 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Provision  for income taxes                      |       | 1.9                                    | %          | 3.3                                  | %          | 2.0 | % | 2.9 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Minority  Interest                               |       | 0.0                                    | %          | 0.0                                  | %          | 0.0 | % | 0.0 | % |
|                                             |       |                                   |       |                                 |       |   |   |   |   |
| Net income                                       |       | 2.9                                    | %          | 4.6                                  | %          | 3.1 | % | 4.5 | % |

 

15

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**Three Months Ended March 31,2005 Compared to Three Months Ended March 31, 2004**

 

*Capitation Revenue*

 

Capitation revenue for thethree months ended March 31, 2005 was $31,411,215, representing a decreaseof $333,652 (1.1%) over capitation revenue for the three months ended March 31,2004, of $31,744,867.

 

The decrease is comprised ofthree main factors. We estimate that net membership growth from the February 1,2004 acquisitions contributed approximately $1,500,000 in increased capitationrevenue during the 2005 period as compared to the 2004 period. We estimate thathigher capitation rates on our core business, exclusive of acquisitions,contributed approximately $1,400,000 in increased capitation revenue during the2005 period as compared to the 2004 period. We estimate that enrollmentdeclines related to our core business, exclusive of the acquisitions, reducedcapitation revenue by approximately $3,200,000 during the 2005 period, ascompared to the 2004 period.

 

*Fee for service revenue*

 

Fee for service revenue forthe three months ended March 31, 2005 was $563,323, representing adecrease of $451,394 (44.5%) over fee for service revenue for the three monthsended March 31, 2004, of $1,014,717.

 

The decrease in fee forservice revenue during the 2005 quarter was primarily the result of the April 1,2004 sale of the medical clinics acquired in connection with the acquisition ofthe Gateway entities effective February 1, 2004.

 

*Management fee revenue*

 

Management fee revenue forthe three months ended March 31, 2005 was $214,171, representing anincrease of $5,621 (2.7%) over management fee revenue for the three monthsended March 31, 2004, of $208,550.

 

The increase in managementfee revenue for service revenue during the 2005 quarter was primarily theresult of an increase in the number of CalOPTIMA members that we manage.

 

*Other revenue*

 

Other revenue for the threemonths ended March 31, 2005 was $141,913 representing an increase of$122,592 (634.5%) over other revenue for the three months ended March 31,2004, of $19,321.

 

The increase in otherrevenue during the 2005 quarter was primarily the result of a pay forperformance bonus received from one of our contracted Health Plans for whichthere was no corresponding amount in the prior quarter.

 

16

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*PCP Capitation Expense*

 

Primary Care Physician (“PCP”)capitation expense for the three months ended March 31, 2005 was$5,954,027, representing a decrease of $76,676 (1.3%) over PCP capitationexpense for the three months ended March 31, 2004, of $6,030,702.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $900,000 in increased PCP capitation expense during the 2005period, as compared to the 2004 period. This increase was offset by reduced PCPcapitation expense resulting from the enrollment declines discussed above.

 

*Specialist Capitation Expense*

 

Specialist capitationexpense for the three months ended March 31, 2005 was $5,922,149,representing a decrease of $235,545 million (3.8%) over specialist capitationexpense for the three months ended March 31, 2004, of $6,157,694.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $900,000 in increased specialist capitation expense during the2005 period, as compared to the 2004 period. This increase was offset byreduced specialist capitation expense resulting from the enrollment declinesdiscussed above.

 

*Claims Expense*

 

Claims expense for the threemonths ended March 31, 2005 was $10,889,852, representing an increase of$1,402,649 (14.8%) over claims expense for the three months ended March 31,2004, of $9,487,203.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $1,000,000 in increased claims expense during the 2005 period, ascompared to the 2004 period. We estimate that higher claims per member rates onour core business, exclusive of acquisitions, increased claims expense byapproximately $1,500,000 during the 2005 period as compared to the 2004 period.We estimate that enrollment declines related to our core business, exclusive ofthe acquisitions, reduced claims expense by approximately $1,000,000 during the2005 period, as compared to the 2004 period.

 

*Physician Salaries Expense*

 

Physician salaries expensefor the three months ended March 31, 2005 was $637,601, representing a decreaseof $713,934 (52.8%) over physician salaries expense for the three months ended March 31,2004, of $1,351,535.

 

The decrease in physiciansalaries expense during the 2005 quarter was primarily the result of the April 1,2004 sale of the medical clinics which had been acquired in connection with thepurchase of the Gateway entities, effective February 1, 2004.

 

*Other Cost of Revenue*

 

Other cost of revenue forthe three months ended March 31, 2005 was $252,585, representing adecrease of $76,084 (23.1%) over other cost of revenue for the three monthsended March 31, 2004, of $328,669.

 

The decrease in other costof revenue during the 2005 quarter was primarily the result of an increase inthe level of certain pharmacy and injectibles being paid as fee-for-serviceclaims.

 

*Gross Margin*

 

Medical care costs as apercentage of medical revenues (the medical care ratio) largely determines ourgross margin. Our gross margin decreased by 2.4%, to 26.8% in the 2005 quarter,from 29.2% in the 2004 quarter.

 

The decrease in our grossmargin percentage between the fiscal 2004 and fiscal 2005 periods was primarilythe result of an increase of 4.9% in medical claims expense, offset by a 2.1%decrease in physician salaries expense following the sale of the Gateway clinics.

 

17

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*General and AdministrativeExpenses*

 

General and administrativeexpenses were $6,550,266 for the 2005 quarter, representing 20.3% of totalrevenues, as compared with $6,891,046, or 20.9% of total revenues, for the 2004quarter.

 

The decrease in general andadministrative expenses during the 2005 quarter was primarily the result of areduction in front office costs following the sale of the Gateway medicalclinics.

 

*Depreciation and Amortization*

 

Depreciation andamortization expense for the three months ended March 31, 2005 increasedto $263,680 from $216,681 for the same period of the prior year. The increasewas primarily due to the amortization of identifiable intangible assetsacquired in the February 1, 2004 acquisitions described above, as well asdepreciation expense associated with increased capital expenditures.

 

*Other income (expense), net*

 

Other income (expense), netfor the three months ended March 31, 2005 increased to a net expense of$172,007 from $14,884 for the same period of the prior year. The increase innet interest expense during the 2005 period was primarily due to the $15million GMAC Residential Funding Corporation credit facility entered intoduring September 2004.

 

*Provision for Income Taxes*

 

Income tax expense decreasedapproximately 41.2%, or $432,673, to $618,650 for the 2005 quarter, from$1,051,323 in the 2004 quarter. The decrease in income tax expense wasprincipally due to a 39.9% decrease in pretax income. Our effective tax ratedecreased to 40.0% for the 2005 quarter, from 40.9% for the 2004 quarter, dueto minor changes in state taxes and nondeductible items.

 

**Six months Ended March 31,2005 Compared to Six months Ended March 31, 2004**

 

*Capitation Revenue*

 

Capitation revenue for thesix months ended March 31, 2005 was $63,929,977, representing an increaseof $7,070,663 (12.4%) over capitation revenue for the six months ended March 31,2004, of $56,859,315.

 

The increase is comprised ofthree main factors. We estimate that net membership growth from the February 1,2004 acquisitions contributed approximately $11,500,000 in increased capitationrevenue during the 2005 period as compared to the 2004 period. We estimate thathigher capitation rates on our core business, exclusive of acquisitions,contributed approximately $2,600,000 in increased capitation revenue during the2005 period as compared to the 2004 period. We estimate that enrollmentdeclines related to our core business, exclusive of the acquisitions, reducedcapitation revenue by approximately $7,000,000 during the 2005 period, ascompared to the 2004 period.

 

*Fee for service revenue*

 

Fee for service revenue forthe six months ended March 31, 2005 was $1,063,604 representing a decreaseof $478,833 (12.4%) over fee for service revenue for the six months ended March 31,2004, of $1,542,437.

 

The decrease in fee forservice revenue during the 2005 period was primarily the result of the April 1,2004 sale of the medical clinics acquired in connection with the acquisition ofGateway effective February 1, 2004.

 

*Management fee revenue*

 

Management fee revenue forthe six months ended March 31, 2005 was $426,934, representing an increaseof $8,476 (2.0%) over management fee revenue for the six months ended March 31,2004, of $418,455.

 

18

----

 

The increase in managementfee revenue for service revenue during the 2005 period was primarily the resultof an increase in the number of CalOPTIMA members that we manage.

 

*Other revenue*

 

Other revenue for the sixmonths ended March 31, 2005 was $190,943, representing an increase of$166,283 (674.3%) over other revenue for the six months ended March 31,2004, of $24,660.

 

The increase in otherrevenue during the 2005 period was primarily the result of a pay forperformance bonus received from one of our contracted Health Plans for whichthere was no corresponding amount in the prior quarter.

 

*PCP Capitation Expense*

 

Primary Care Physician (PCP)Capitation expense for the six months ended March 31, 2005 was$12,389,417, representing an increase of $1,390,805 (12.6%) over PCP capitationexpense for the six months ended March 31, 2004, of $10,998,612.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $3,200,000 in increased PCP capitation expense during the 2005period, as compared to the 2004 period. This increase was offset by reduced PCPcapitation expense resulting from the enrollment declines discussed above.

 

*Specialist Capitation Expense*

 

Specialist Capitationexpense for the six months ended March 31, 2005 was $11,772,722,representing an increase of $1,058,934 (9.9%) over specialist capitationexpense for the six months ended March 31, 2004, of $10,713,788.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $3,100,000 in increased specialist capitation expense during the2005 period, as compared to the 2004 period. This increase was offset byreduced specialist capitation expense resulting from the enrollment declinesdiscussed above.

 

*Claims Expense*

 

Claims expense for the sixmonths ended March 31, 2005 was $22,984,261, representing an increase of$4,932,420 (27.3%) over claims expense for the six months ended March 31,2004, of $18,051,841.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $4,500,000 in increased claims expense during the 2005 period, ascompared to the 2004 period. We estimate that higher claims per member rates onour core business, exclusive of acquisitions, increased claims expense byapproximately $2,900,000 during the 2005 period as compared to the 2004 period.We estimate that enrollment declines related to our core business, exclusive ofthe acquisitions, reduced claims expense by approximately $2,500,000 during the2005 period, as compared to the 2004 period.

 

*Physician Salaries Expense*

 

Physician salaries expensefor the six months ended March 31, 2005 was $1,072,842, representing adecrease of $903,943 (45.7%) over physician salaries expense for the six monthsended March 31, 2004, of $1,976,786.

 

The decrease in physiciansalaries expense during the 2005 period was primarily the result of the April 1,2004 sale of the medical clinics which had been acquired in connection with thepurchase of the Gateway entities, effective February 1, 2004.

 

19

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*Other Cost of Revenue*

 

Other cost of revenue forthe six months ended March 31, 2005 was $237,584, representing a decreaseof $261,535 (52.4%) over other cost of revenue for the six months ended March 31,2004, of $499,119.

 

The decrease in other costof revenue during the 2005 period was primarily the result of an increase inthe level of certain pharmacy and injectibles being paid as fee-for-serviceclaims.

 

*Gross Margin*

 

Medical care costs as apercentage of medical revenues (the medical care ratio) largely determines ourgross margin. Our gross margin decreased 2.1%, to 26.1% for the six monthsended March 31, 2005, from 28.2% for the six months ended March 31,2004.

 

The most significant factorsin the decrease in our gross margin percentage between the fiscal 2004 andfiscal 2005 periods were an increase of 4.4% in medical claims expense, offsetby a 1.7% decrease in physician salaries expense following the sale of theGateway clinics.

 

*General and AdministrativeExpenses*

 

General and administrativeexpenses were $13,123,077 for the 2005 period, representing 20.0% of totalrevenues, as compared with $12,055,370, or 20.5% of total revenues, for the2004 period.

 

The increase in general andadministrative expenses during the 2005 period was primarily the result ofadditional personnel following the January 31, 2004 acquisitions. Thedecrease in general and administrative expenses as a percentage of revenuesresulted from small comparative decreases in outside service expense, bad debtexpense, supplies and rent, offset by small comparative increases in employeebenefits and miscellaneous expense.

 

*Depreciation and Amortization*

 

Depreciation andamortization expense for the six months ended March 31, 2005 increased to$496,910 from $332,807 for the same period of the prior year. The increase wasprimarily due to the amortization of identifiable intangible assets acquired inthe February 1, 2004 acquisitions described above, as well as additionaldepreciation expense for increased capital expenditures.

 

*Other income (expense), net*

 

Other income (expense), netfor the six months ended March 31, 2005 increased to a net expense of$272,028 from $30,997 for the same period of the prior year. The increase innet interest expense was primarily due to the $15 million GMAC ResidentialFunding Corporation credit facility entered into during September 2004.

 

*Provision for Income Taxes*

 

Income tax expense decreasedapproximately 22.5%, or $391,462, to $1,346,809 for the 2005 period, from$1,738,271 million in the 2004 period. The decrease in income tax expense wasprincipally due to a 23.4% decrease in pretax income. Our effective tax rateincreased to 40.1% for the 2005 period, from 40.0% for the 2004 period, due tominor changes in state taxes and nondeductible items.

 

**Liquidity and Capital Resources**

 

We generate cash fromcapitation revenue, services provided on a fee-for-service basis at ourclinics, management fee revenue and investment income. Our primary uses of cashinclude the payment of expenses related to medical care services and G&Aexpenses. We generally receive capitation revenue in advance of payment ofcapitation expenses and claims for related health care services.

 

20

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Our investment policies aredesigned to preserve principal, maintain liquidity for operations and statutoryrequirements,   and maximize investmentreturn. As of March 31, 2005, we invested a substantial portion of ourcash in a portfolio that included Federal Home Loan bonds with an averagematurity of approximately 60 days, overnight and high yield money market funds.All of these amounts are classified as current assets and included in cash andcash equivalents in the accompanying balance sheets. We are also required bysome of our HMO contracts to set aside certain amounts in restrictedcertificates of deposit. These restricted certificates of deposit, with anaverage maturity of approximately 75 days as of March 31, 2005, areincluded in Investments in the accompanying financial statements.

 

Net cash provided (used) byoperations was $(2,105,237) for the six months ended March 31, 2005 and$2,509,034 for the six months ended March 31, 2004. The decrease in netcash provided by operations for the six months ended March 31, 2005 whencompared to the six months ended March 31, 2004 was due to the followingfactors:

 

•                  decreased net income ($627,746 lower in 2005);

 

•                  increased depreciation and amortization expense($164,103 higher in 2005);

 

•                  changes in accounts receivable balances, ause of $231,467 in the six months ended March 31, 2005 compared to asource of $49,016 in the six months ended March 31, 2005;

 

•                  changesin accounts payable, a use of $2,873,452 for the six months ended March 31,2005 compared to a use of $728,128 for the six months ended March 31,2004;

 

•                  changesin income tax receivable, a use of $1,089,046 for the six months ended March 31,2005 compared to a zero for the six months ended March 31, 2004;

 

•                  changesin medical claims liabilities, which were a use of $69,017 in the six monthsended March 31, 2005 compared to a use of $246,292 in the six months endedMarch 31, 2004.

 

•                  changesin net deferred taxes, a source of $257,862 in the six months ended March 31,2005 compared to a source of $332,608 in the six months ended March 31,2004.

 

•                  changesin prepaid expenses and other, a use of $679,906 in the six months ended March 31,2005 compared to a use of $186,588 in the six months ended March 31, 2004.

 

These factors were offset in part by the followingfactors:

 

•                  paymentson our notes receivable from sale of the Gateway clinics, a source of $220,051for the six months ended March 31, 2005 compared to zero for the sixmonths ended March 31, 2004; and

 

•                  changesin capitalized acquisition costs, a use of $5,250 in the six months ended March 31,2005 compared to a use of $587,360 in the six months ended March 31, 2004.

 

•                  Changesin restricted certificates of deposit, a use of $638,115 in the six monthsended March 31, 2005 compared to a use of $47,178 in the six months ended March 31,2004.

 

•                  repaymentson our line of credit, a use of $5,000,000 in the six months ended March 31,2005 compared to a use of $2,050,000 in the six months ended March 31,2004

 

•                  repaymentsof notes payable and capital leases, a use of $841,888 in the six months ended March 31,2005 compared to a use of 666,815 in the six months ended March 31, 2004

 

At March 31, 2005, wehad negative working capital of $2,701,974 as compared to negative workingcapital of $3,141,414 at September 30, 2004. At March 31, 2005 and September 30,2004, cash and cash equivalents were $11,609,154 and $20,330,754, respectively.The decrease in cash and cash equivalents resulted primarily from the itemsdiscussed above, the more significant of which include repaying $5,000,000 onour line of credit facility, paying down accounts payable by 

 

21

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$2,873,452, repayments of  notespayable and capital leases of $841,888 and an increase in restrictedinvestments of approximately $638,000.

 

Our subsidiaries arerequired to maintain minimum capital prescribed by various HMOs with whom wecontract. As of March 31, 2005, all of our subsidiaries were in compliancewith the minimum capital requirements. Barring any change in regulatoryrequirements, we believe that we will continue to be in compliance with theserequirements at least through 2005. We also believe that our cash resources andinternally generated funds will be sufficient to support our operations,regulatory requirements and capital expenditures for at least the next 12months.

 

**Contractual Obligations**

 

In our registrationstatement on Form 10 filed on April 7, 2005, we reported on ourcontractual obligations as of that date. There have been no material changes toour contractual obligations since that report.

 

**Critical Accounting Policies**

 

When we prepare ourconsolidated financial statements, we use estimates and assumptions that mayaffect reported amounts and disclosures. The determination of our liability formedical claims and other health care costs payable is particularly important tothe determination of our financial position and results of operations andrequires the application of significant judgment by our management and, as aresult, is subject to an inherent degree of uncertainty.

 

Our medical care costsinclude actual historical claims experience and estimates for medical care costsincurred but not reported to us (“IBNR”). We, together with our independentactuaries, estimate medical claims liabilities using actuarial methods basedupon historical data adjusted for payment patterns, cost trends, product mix,utilization of health care services and other relevant factors. The estimationmethods and the resulting reserves are frequently reviewed and updated, andadjustments, if necessary, are reflected in the period known. While we believeour estimates are adequate, it is possible that future events could require usto make significant adjustments or revisions to these estimates. In assessingthe adequacy of accruals for medical claims liabilities, we consider ourhistorical experience, the terms of existing contracts, our knowledge of trendsin the industry, information provided by our customers and informationavailable from other sources as appropriate.

 

The most significantestimates involved in determining our claims liability concern thedetermination of claims payment completion factors and trended per member permonth cost estimates.

 

We consider historicalactivity for the current month, plus the prior 24 months, in our IBNRcalculation. For the months of service five months prior to the reporting dateand earlier, we estimate our outstanding claims liability based upon actualclaims paid, adjusted for estimated completion factors. Completion factors seekto measure the cumulative percentage of claims expense that will have been paidfor a given month of service as of a date subsequent to that month of service.Completion factors are based upon historical payment patterns. For the fourmonths of service immediately prior to the reporting date, actual claims paidare not a reliable measure of our ultimate liability, given the delay inherentbetween the patient/physician encounter and the actual submission of a claimfor payment. For these months of service we estimate our claims liability basedupon trended per member per month cost estimates. These estimates reflectrecent trends in payments and expense, utilization patterns, authorizedservices and other relevant factors. The following table reflects the change inour estimate of claims liability as of March 31, 2005 that would haveresulted had we changed our completion factors for all months of serviceincluded in our IBNR calculation by the percentages indicated. Amounts are inthousands.

 
| **Increase (Decrease) in  Estimated  Completion Factors** | ** ** | **Increase (Decrease) in****Accrued****Medical Claims  Payable** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| (3)%                                                      |       | $                                                                | 3,900,000  |   |
| (2)%                                                      |       | $                                                                | 2,600,000  |   |
| (1)%                                                      |       | $                                                                | 1,300,000  |   |
| 1%                                                        |       | $                                                                | (1,300,000 | ) |
| 2%                                                        |       | $                                                                | (2,600,000 | ) |
| 3%                                                        |       | $                                                                | (3,900,000 | ) |

 

22

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For each 1% (hypothetical)difference between our March 31, 2005 estimated claims liability and theactual claims incurred run-out, net income for the six months ended March 31,2005 would increase or decrease by approximately $135,000, while diluted netincome per share would increase or decrease by approximately $0.01 per share,net of tax.

 

The following table showsthe components of the change in medical claims and benefits payable for the sixmonths ended March 31, 2005:

 
| ** **                                                         | ** ** | **2005**    | ** ** |
|--------------------------------------------------------------------|------------|-------------|------------|
| IBNR as of  beginning of period                                    |       | $           | 13,323,622 |   |
| Health care  claim expenses incurred during the period related to: |       |        |       |
| Current year                                                       |       | 23,963,561  |       |
| Prior years                                                        |       | (979,300    | )          |
| Total  incurred                                                    |       | 22,984,261  |       |
| Health care  claims paid during the period related to:             |       |        |       |
| Current year                                                       |       | (12,601,380 | )          |
| Prior years                                                        |       | (10,451,898 | )          |
| Total paid                                                         |       | (23,053,278 | )          |
|                                                               |       |        |       |
| IBNR as of  end of period                                          |       | $           | 13,254,605 |   |

 

**Inflation**

 

According to U.S. Bureau ofLabor Statistics Data, the national health care cost inflation rate hasexceeded the general inflation rate for the last four years. We use variousstrategies to mitigate the negative effects of health care cost inflation.Specifically, we try to control medical and hospital costs through contractswith independent providers of health care services. Through these contractedproviders, we emphasize preventive health care and appropriate use of specialtyand hospital services.

 

While we currently believeour strategies to mitigate health care cost inflation will continue to besuccessful, competitive pressures, new health care and pharmaceutical productintroductions, demands from health care providers and customers, applicableregulations or other factors may affect our ability to control health carecosts.

 

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk.**

 

**Concentrations of Credit Risk**

 

Financial instruments thatpotentially subject us to concentrations of credit risk consist primarily ofcash and cash equivalents, receivables and restricted cash.

 

As of March 31, 2005,we had cash and cash equivalents of $11,609,154. Cash equivalents consist ofhighly liquid securities with original maturities of up to three months. Weinvest a substantial portion of our cash equivalents in Federal Home Loan bondsand overnight, high yield money market funds. We also had $1,150,802 ofinvestments, primarily consisting of restricted, interest-bearing certificatesof deposit required by various HMOs with whom we do business. These investmentsare subject to interest rate risk and will decrease in value if market ratesincrease. All non-restricted investments are maintained at fair market value onthe balance sheet. We have the ability to hold these investments untilmaturity, and as a result, we would not expect the value of these investmentsto decline significantly as a result of a sudden change in market interestrates. Declines in interest rates over time will reduce our investment income.

 

**Item 4. Controls and Procedures.**

 

***Evaluation of Disclosure Controls and Procedures:***Our management, with the participation of ourChief Executive Officer and our Chief Financial Officer, has concluded, basedupon its evaluation as of the end of the period covered by this report, thatthe Company’s “disclosure controls and procedures” (as defined in Rules13(a)-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”)) are effective to ensure that information required to be disclosed in thereports that the Company files or submits under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

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***Changes in Internal Controls:***There were no changes in the Company’sinternal control over financial reporting during the six months ended March 31,2005 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal controls over financial reporting.

 

***Sarbanes-Oxley 404 Compliance:***We have begun a detailed assessment of ourinternal controls as called for by the Sarbanes-Oxley Act of 2002. We are stillin the evaluation of design phase. We have supplemented our internal projectteam with the services of an outside specialist. Although we have made thisproject a priority for the Company, there can be no assurances that all controldeficiencies that may be identified and validated will be remediated before theend of the Company’s fiscal year.

 

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**PART II –OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

St. Jude Medical Center Lawsuit

 

In 1998, Prospect Medical Group, Inc.filed a motion to compel arbitration against St. Jude Medical Center andPacifiCare of California (PacifiCare), in Orange County Superior Court(Prospect Medical Group, Inc. v. St. Jude Medical Center and PacifiCare ofCalifornia). The action arose due to the failure by St. Jude Medical Center toprovide an accurate accounting of the hospital incentive pools for the years1997, 1998 and 1999. The motion to compel arbitration was granted by the OrangeCounty Superior Court.

 

In November 2001, the Arbitrator awardedProspect $1,200,000, plus interest at 10% per annum from January 1, 1999until paid, plus legal fees of approximately $1,000,000. PacifiCare wasreleased from the Prospect claim, and Prospect was ordered to pay PacifiCare’slegal fees of approximately $125,000. Included in fiscal 2000 net patientservice revenue is the $1,200,000 award as this represents the realization of areceivable which existed as of September 30, 2000.

 

In a counter claim, the Arbitrator awardedSt. Jude $275,000, plus interest at 10% per annum from January 1, 1999until paid. These amounts are included in the fiscal 2001 financial statements.Net interest receivable and legal fees to be reimbursed have also beenrecorded.

 

In November 2001, Prospect received apartial payment of $925,000, related to the above amounts. Even though thearbitrator’s award was binding, nonetheless, St. Jude appealed the arbitrator’saward and in May 2002, the Orange County Superior Court affirmed the awardto Prospect. On January 31, 2003, the Company received approximately$1,492,000 from St. Jude to settle the amount due, including interest,notwithstanding the fact that St. Jude has appealed the judgment. On September 30,2004, the Court ordered supplemental briefs to be filed. The briefs were filedand the matter was resubmitted to the Court on February 4, 2005. Pendingthe final outcome of this matter, the Company has reserved against a portion ofthe amounts received. Management, in consultation with outside counsel,believes that such reserves are adequate as of March 31, 2005.

 

Other Litigation

 

Prospect is involved in various legalproceedings in the ordinary course of business. Management believes that theultimate resolution of such legal proceedings will not have a material adverseeffect on the financial position and results of operations of the Company.

 

**Item 2. Unregistered Sales of Equity Securities andUse of Proceeds**

 

Management believes that each of thesecurities transactions during the period covered by this report that isdescribed in the table below was exempt from the registration requirements ofthe Securities Act of 1933, as amended (the “Securities Act”), as referenced inthe notes accompanying the table:

 
| 3/2005 |   | Options to buy Common Stock |   | 25,000 options(1) |   | Services rendered                      |   | Konnie Krause                       |
|--------|--------|-----------------------------|--------|-------------------|--------|----------------------------------------|--------|-------------------------------------|
| 3/2005 |   | Common Stock                |   | 285,586 shares(2) |   | Conversion of Series A Preferred Stock |   | Holders of Series A Preferred Stock |

 

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(1)                                  Thesesecurities were issued in reliance on the private placement exemption providedby Section 4(2) of the Securities Act on the basis that the number ofinvestors was limited, the investors were accredited or otherwise qualified andhad access to material information about the Company, and restrictions wereplaced on the resale of the securities issued.

 

(2)                                  Theseshares of common stock were issued upon conversion of outstanding shares ofSeries A Preferred Stock in reliance on the exemption provided by Section 3(a)(9)of the Securities Act.

 

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**Item 3.      Defaults Upon SeniorSecurities**

 

None.

 

**Item 4.      Submission ofMatters to a Vote of Security Holders**

 

None.

 

**Item 5.      Other Information**

 

None.

 

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**Item 6. Exhibits**

 

The following documents arebeing filed as exhibits to this report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                     |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                    |
| 31.1                 |       | Certification of Chief Executive Officer pursuant to Rules  13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934, as amended.                        |
|                 |       |                                                                                                                                                          |
| 31.2                 |       | Certification of Chief Financial Officer pursuant to Rules 13a-14(a)/15d-14(a)  under the Securities Exchange Act of 1934, as amended.                        |
|                 |       |                                                                                                                                                          |
| 32.1                 |       | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                 |       |                                                                                                                                                          |
| 32.2                 |       | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|         | PROSPECT MEDICAL HOLDINGS, INC.(Registrant)               |
|--------------|-----------------------------------------------------------|
|         |                                                      |
| May 16, 2005 | /s/ JACOB Y. TERNER                                       |   |
| ** **   | **Jacob Y. Terner, M.D.**                                 |
|         | **Chairman of the Board and****Chief Executive  Officer** |
| ** **   | **(Principal Executive Officer)**                         |
| ** **   | ** **                                                |
| May 16, 2005 | /s/ MIKE HEATHER                                          |   |
| ** **   | **Mike Heather**                                          |
| ** **   | **Chief Financial Officer**                               |
| ** **   | **(Principal Financial Officer)**                         |

 

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