Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-Q**

 

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| **x** | **Quarterly  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|-------|---------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended****December 31, 2009**

 

**or**

 
| **o** | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|-------|----------------------------------------------------------------------------------------------------------|

 

**For thetransition period from               to               **

 

**Commission file number: 1-32203**

 

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**ProspectMedical Holdings, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                           | ** ** | **33-0564370**                        |
|------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or  organization)       |       | (I.R.S. Employer  Identification No.) |
|                                                                   |       |                                  |
| **10780  Santa Monica Blvd., Suite 400  Los Angeles, California** |       | **90025**                             |
| (Address of principal  executive offices)                              |       | (Zip Code)                            |

 

**(310) 943-4500**

(Registrant’s telephone number, includingarea code)

 

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 preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateweb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files). Yes o  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one):

 

| Large  accelerated filer o |   | Accelerated filer o          |
|---------------------------------|--------|-----------------------------------|
|                            |   |                              |
| Non-accelerated  filer o   |   | Smaller reporting  company x |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act): Yes o  No x

 

The number of shares of theissuer’s Common Stock, par value $0.01 per share, outstanding as of February 12,2010 was 20,792,520.

 

 

 

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Table of Contents

 

**PROSPECT MEDICAL HOLDINGS, INC.**

 

**Index**

 
| **Part I—Financial Information** |
|--------------------------------------------|
|                                       |   |   |
| Item 1.                               | Financial Statements |   |
|                                       | Condensed Consolidated Balance Sheets as of  December 31, 2009 (unaudited) and September 30, 2009 | 1 |
|                                       | Condensed  Consolidated Statements of Operations for the three-month periods ended  December 31, 2009 and 2008 (unaudited) | 3 |
|                                       | Condensed  Consolidated Statements of Cash Flows for the three-month periods ended  December 31, 2009 and 2008 (unaudited) | 4 |
|                                       | Notes to Condensed Consolidated Financial Statements  (unaudited) | 5 |
| Item 2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 29 |
| Item 3.                               | Quantitative  and Qualitative Disclosures About Market Risk | 51 |
| Item 4.                               | Controls  and Procedures | 51 |
| Part II—Other  Information       |
| Item 1.                               | Legal Proceedings | 53 |
| Item 1A.                              | Risk Factors | 53 |
| Item 2.                               | Unregistered Sales of Equity Securities and Use of  Proceeds | 53 |
| Item 3.                               | Defaults  Upon Senior Securities | 53 |
| Item 4.                               | Submission  of Matters to a Vote of Security Holders | 53 |
| Item 5.                               | Other  information | 53 |
| Item 6.                               | Exhibits | 53 |
| Signatures                                 | 54 |

 

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Table of Contents

 

**PART I—FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(in thousands)**

 
| ** **                                                                                                                                         | ** ** | **December 31,  2009** | ** ** | **September 30,  2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                         |       |                        |       |                         |       |
| **Current assets:**                                                                                                                                |       |                        |       |                         |       |
| Cash and cash equivalents                                                                                                                          |       | $                           | 42,389     |                         | $          | 37,768 |   |
| Restricted cash                                                                                                                                    |       | 1,983                       |       | 1,395                        |       |
| Investments, primarily  restricted certificates of deposit                                                                                         |       | 634                         |       | 665                          |       |
| Patient accounts  receivable, net of allowance for doubtful accounts of $13,090 and $11,715 at  December 31, 2009 and September 30, 2009 |       | 42,344                      |       | 36,806                       |       |
| Government program  receivables                                                                                                                    |       | 2,943                       |       | 4,852                        |       |
| Risk pool receivables                                                                                                                              |       | 120                         |       | —                       |       |
| Other receivables                                                                                                                                  |       | 1,561                       |       | 1,655                        |       |
| Third party settlements                                                                                                                            |       | 379                         |       | 1,575                        |       |
| Notes receivable, current  portion                                                                                                                 |       | 57                          |       | 56                           |       |
| Refundable income taxes,  net                                                                                                                      |       | —                      |       | 1,558                        |       |
| Deferred income taxes, net                                                                                                                         |       | 6,644                       |       | 6,644                        |       |
| Inventories                                                                                                                                        |       | 4,151                       |       | 4,137                        |       |
| Prepaid expenses and other  current assets                                                                                                         |       | 6,784                       |       | 5,380                        |       |
| Total current assets                                                                                                                               |       | 109,989                     |       | 102,491                      |       |
| Property, improvements and  equipment:                                                                                                             |       |                        |       |                         |       |
| Land and land improvements                                                                                                                         |       | 31,028                      |       | 31,028                       |       |
| Buildings                                                                                                                                          |       | 23,920                      |       | 23,665                       |       |
| Leasehold improvements                                                                                                                             |       | 2,032                       |       | 2,029                        |       |
| Equipment                                                                                                                                          |       | 20,930                      |       | 20,255                       |       |
| Furniture and fixtures                                                                                                                             |       | 891                         |       | 913                          |       |
|                                                                                                                                               |       | 78,801                      |       | 77,890                       |       |
| Less accumulated  depreciation and amortization                                                                                                    |       | (14,935                     | )          | (14,166                      | )          |
| Property, improvements and  equipment, net                                                                                                         |       | 63,866                      |       | 63,724                       |       |
| Notes receivable, less  current portion                                                                                                            |       | 343                         |       | 357                          |       |
| Deposits and other assets                                                                                                                          |       | 301                         |       | 694                          |       |
| Deferred financing costs,  net                                                                                                                     |       | 7,785                       |       | 8,205                        |       |
| Goodwill                                                                                                                                           |       | 153,250                     |       | 153,250                      |       |
| Other intangible assets,  net                                                                                                                      |       | 45,325                      |       | 46,425                       |       |
| Total assets                                                                                                                                       |       | $                           | 380,859    |                         | $          | 375,146 |   |

 

The accompanying notes arean integral part of the unaudited condensed consolidated financial statements.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(in thousands, except share amounts)**

 
| ** **                                                                                                                                                                                  | ** ** | **December 31,  2009** | ** ** | **September 30,  2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                              |       |                        |       |                         |       |
| **Current liabilities:**                                                                                                                                                                    |       |                        |       |                         |       |
| Accrued medical claims and  other health care costs payable                                                                                                                                 |       | $                           | 15,784     |                         | $          | 16,824 |   |
| Accounts payable and other  accrued liabilities                                                                                                                                             |       | 34,683                      |       | 31,773                       |       |
| Accrued salaries, wages  and benefits                                                                                                                                                       |       | 22,206                      |       | 24,903                       |       |
| Due to government payer                                                                                                                                                                     |       | 13,834                      |       | 13,834                       |       |
| Income taxes payable, net                                                                                                                                                                   |       | 381                         |       | —                       |       |
| Current portion of capital  leases                                                                                                                                                          |       | 836                         |       | 820                          |       |
| Current portion of long-term  debt                                                                                                                                                          |       | 5,543                       |       | 3,805                        |       |
| Other current liabilities                                                                                                                                                                   |       | 954                         |       | 629                          |       |
| Total current liabilities                                                                                                                                                                   |       | 94,221                      |       | 92,588                       |       |
|                                                                                                                                                                                        |       |                        |       |                         |       |
| Long-term debt, net of  current portion                                                                                                                                                     |       | 172,594                     |       | 172,539                      |       |
| Deferred income taxes                                                                                                                                                                       |       | 29,975                      |       | 29,975                       |       |
| Malpractice reserve                                                                                                                                                                         |       | 2,821                       |       | 2,824                        |       |
| Capital leases, net of  current portion                                                                                                                                                     |       | 956                         |       | 569                          |       |
| Other long-term  liabilities                                                                                                                                                                |       | 166                         |       | 162                          |       |
| Total liabilities                                                                                                                                                                           |       | 300,733                     |       | 298,657                      |       |
| **Commitments, Contingencies and  Subsequent Event**                                                                                                                                        |       |                        |       |                         |       |
| **Shareholders’ equity:**                                                                                                                                                              |       |                        |       |                         |       |
| Prospect Medical  Holdings, Inc.’s shareholders’ equity                                                                                                                      |       |                        |       |                         |       |
| Common stock, $0.01 par  value; 40,000,000 shares authorized; 20,761,944 and 20,619,278 shares issued  and outstanding at December 31, 2009 and September 30, 2009,  respectively |       | 208                         |       | 206                          |       |
| Additional paid-in capital                                                                                                                                                                  |       | 95,669                      |       | 94,498                       |       |
| Accumulated deficit                                                                                                                                                                         |       | (15,444                     | )          | (18,303                      | )          |
| Total Prospect Medical  Holdings, Inc.’s shareholders’ equity                                                                                                                |       | 80,433                      |       | 76,401                       |       |
| Noncontrolling interest                                                                                                                                                                     |       | (307                        | )          | 88                           |       |
| Total shareholders’ equity                                                                                                                                                             |       | 80,126                      |       | 76,489                       |       |
| Total liabilities and shareholders’  equity                                                                                                                                            |       | $                           | 380,859    |                         | $          | 375,146 |   |

 

The accompanying notes arean integral part of the unaudited condensed consolidated financial statements.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

** **

**(in thousands, except per share amounts)**

** **

**(Unaudited)**

 
| ** **                                                                               | ** ** | **Three Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                               | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| Revenues:                                                                                |       |                                      |       |   |   |
| Net hospital services  revenues                                                          |       | $                                         | 69,412     |   | $ | 35,323 |   |
| Medical group revenues                                                                   |       | 46,684                                    |       | 48,131 |   |
| Total revenues                                                                           |       | 116,096                                   |       | 83,454 |   |
| Operating expenses:                                                                      |       |                                      |       |   |   |
| Hospital operating  expenses                                                             |       | 49,668                                    |       | 22,146 |   |
| Medical group cost of  revenues                                                          |       | 36,845                                    |       | 37,612 |   |
| General and administrative                                                               |       | 16,128                                    |       | 12,385 |   |
| Depreciation and  amortization                                                           |       | 2,078                                     |       | 1,766 |   |
| Total operating expenses                                                                 |       | 104,719                                   |       | 73,909 |   |
| Operating income from  unconsolidated joint venture                                      |       | 450                                       |       | 353 |   |
| Operating income                                                                         |       | 11,827                                    |       | 9,898 |   |
| Other (income) expense:                                                                  |       |                                      |       |   |   |
| Investment income                                                                        |       | (29                                       | )          | (48 | ) |
| Interest expense and  amortization of deferred financing costs                           |       | 6,889                                     |       | 6,138 |   |
| Loss in value of interest  rate swap arrangements                                        |       | —                                    |       | 9,668 |   |
| Total other (income)  expense, net                                                       |       | 6,860                                     |       | 15,758 |   |
| Income (loss) before  income taxes                                                       |       | 4,967                                     |       | (5,860 | ) |
| Provision (benefit) for  income taxes                                                    |       | 2,503                                     |       | (2,419 | ) |
| Net income (loss)                                                                        |       | 2,464                                     |       | (3,441 | ) |
| Net income (loss)  attributable to noncontrolling interest                               |       | (395                                      | )          | 4 |   |
| Net income (loss)  attributable to Prospect Medical Holdings, Inc.                  |       | $                                         | 2,859      |   | $ | (3,445 | ) |
|                                                                                     |       |                                      |       |   |   |
| Per share data:                                                                          |       |                                      |       |   |   |
| Net income (loss)  attributable to Prospect Medical Holdings, Inc. per common share |       |                                      |       |   |   |
| Basic                                                                                    |       | $                                         | 0.14       |   | $ | (0.17 | ) |
| Diluted                                                                                  |       | $                                         | 0.13       |   | $ | (0.17 | ) |

 

The accompanying notes arean integral part of the unaudited condensed consolidated financial statements.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(Unaudited)**

 
| ** **                                                                                | ** ** | **Three  Months Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| **Operating activities**                                                                  |       |                                       |       |   |   |
| Net income (loss)                                                                         |       | $                                          | 2,464      |   | $ | (3,441 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                             |       | 2,078                                      |       | 1,766 |   |
| Amortization of deferred financing costs                                                  |       | 459                                        |       | 34 |   |
| Amortization of original issue discount                                                   |       | 419                                        |       | — |   |
| Payment-In-kind interest expense                                                          |       | —                                     |       | 251 |   |
| Loss on interest rate swap arrangements                                                   |       | —                                     |       | 9,668 |   |
| Provision for bad debts                                                                   |       | 6,970                                      |       | 1,493 |   |
| Loss on disposal of assets                                                                |       | (7                                         | )          | — |   |
| Stock based compensation                                                                  |       | 1,173                                      |       | 294 |   |
| Deferred income taxes, net                                                                |       | —                                     |       | (3,845 | ) |
| Amortization of other comprehensive income                                                |       | —                                     |       | 220 |   |
| Changes in assets and liabilities, net of business  combination:                          |       |                                       |       |   |   |
| Risk pool receivables                                                                     |       | (120                                       | )          | 338 |   |
| Patient and other receivables                                                             |       | (9,310                                     | )          | (2,654 | ) |
| Prepaid expenses and other                                                                |       | (1,404                                     | )          | (904 | ) |
| Inventory                                                                                 |       | (14                                        | )          | (76 | ) |
| Refundable income taxes                                                                   |       | 1,558                                      |       | 2,294 |   |
| Deposits and other assets                                                                 |       | 393                                        |       | 84 |   |
| Accrued medical claims and other health care costs  payable                               |       | (1,040                                     | )          | (1,563 | ) |
| Accounts payable and other accrued liabilities                                            |       | 539                                        |       | (2,480 | ) |
| Income taxes payable                                                                      |       | 381                                        |       | — |   |
| Net cash provided by operating activities                                                 |       | 4,539                                      |       | 1,479 |   |
| **Investing activities**                                                                  |       |                                       |       |   |   |
| Purchases of property, improvements and equipment                                         |       | (481                                       | )          | (221 | ) |
| Collections on notes receivable                                                           |       | 13                                         |       | 14 |   |
| Increase in restricted certificates of deposit                                            |       | 31                                         |       | — |   |
| Net cash used in investing activities                                                     |       | (437                                       | )          | (207 | ) |
| **Financing activities**                                                                  |       |                                       |       |   |   |
| Borrowings on line of credit                                                              |       | 26,251                                     |       | — |   |
| Repayments on line of credit                                                              |       | (24,596                                    | )          | — |   |
| Repayments on Class 4 Note                                                           |       | (281                                       | )          | — |   |
| Change in restricted cash                                                                 |       | (588                                       | )          | — |   |
| Repayments of term loan                                                                   |       | —                                     |       | (1,720 | ) |
| Payments on capital leases                                                                |       | (228                                       | )          | (93 | ) |
| Cash paid for deferred financing costs                                                    |       | (39                                        | )          | — |   |
| Net cash provided by (used in) financing activities                                       |       | 519                                        |       | (1,813 | ) |
|                                                                                      |       |                                       |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                      |       | 4,621                                      |       | (541 | ) |
| Cash and cash equivalents at beginning of period                                          |       | 37,768                                     |       | 33,583 |   |
| Cash and cash equivalents at end of period                                                |       | $                                          | 42,389     |   | $ | 33,042 |   |
| **Supplemental cash flow information**                                                    |       |                                       |       |   |   |
| Equipment acquired under capital lease                                                    |       | $                                          | 631        |   | $ | 195 |   |
| Interest paid                                                                             |       | $                                          | 930        |   | $ | 5,719 |   |
| Income taxes paid, net                                                                    |       | $                                          | 920        |   | $ | 1,050 |   |

 

The accompanying notes are anintegral part of the unaudited condensed consolidated financial statements.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31,2009**

 

**(Unaudited)**

 

**1. Business**

 

Prospect Medical Holdings, Inc. (“Prospect” or the “Company”) is aDelaware corporation. Prior to the August 8, 2007 acquisition of AltaHospitals System, LLC (“Alta”), which was previously known as AltaHealthcare System, Inc., the Company was primarily engaged in providingmanagement services to affiliated physician organizations that operate asindependent physician associations (“Medical Groups”) or medical clinics.Following the Alta acquisition and acquisition of a majority stake in BrotmanMedical Center, Inc., a California corporation (“Brotman”) on April 14,2009 (see Note 7), as of December 31, 2009, the Company owns andoperates five community-based hospitals in Southern California, and itsoperations are organized into three primary reportable segments: HospitalServices, Medical Group, and Corporate as discussed below.

 

***Hospital Services Segment***

 

Alta and Brotman (collectively, the “Hospital Services segment”) ownand operate in the aggregate five hospitals in Los Angeles County, allaccredited by the Joint Commission (formerly the Joint Commission onAccreditation of Healthcare Organizations), with a total of approximately 759licensed beds served by 844 on-staff physicians at December 31, 2009. Altaowns (i) Alta Hollywood Hospitals, Inc., a California corporation dbaHollywood Community Hospital and Van Nuys Community Hospital; and (ii) AltaLos Angeles Hospitals, Inc., a California corporation dba Los AngelesCommunity Hospital and Norwalk Community Hospital. On April 14, 2009 (the “AcquisitionDate”), the Company increased its existing approximately 33.1% ownership stakein Brotman, to approximately 71.9% via an investment of approximately$2.5 million in cash, thereby obtaining a controlling interest. Brotman ownsand operates Brotman Medical Center, located in Culver City.

 

The three community hospitals in Hollywood, Los Angeles and Norwalkoffer a comprehensive range of medical and surgical services, including generalacute care hospital services, pediatrics, obstetrics and gynecology, pediatricsub-acute care, general surgery, medical-surgical services, orthopedic surgery,and diagnostic, outpatient, skilled nursing and urgent care services. Thehospital in Van Nuys provides acute inpatient and outpatient psychiatricservices on a voluntary basis. Brotman offers a comprehensive range ofinpatient and outpatient services, including general surgery, orthopedic, spineand neurosurgery, cardiology, diagnostic outpatient, rehabilitation,psychiatric and detox services. In addition, Brotman has an active emergencyroom that plays an integral part in providing emergency services to the WestLos Angeles area.

 

The table below gives a brief overview of the Company’s hospitals andthe locations they serve:

 
| **Name/Location**                                             | ** ** | **Primary Service** | ** ** | **Number of Beds**                  |
|---------------------------------------------------------------|------------|---------------------|------------|-------------------------------------|
| **Hollywood Community Hospital**Hollywood, CA  100% owned     |       | Medical/Surgical    |       | 100  licensed beds/100 staffed beds |
| **Los Angeles Community Hospital**Los Angeles, CA  100% owned |       | Medical/Surgical    |       | 130  licensed beds/121 staffed beds |
| **Norwalk Community Hospital**Norwalk, CA   100% owned        |       | Medical/Surgical    |       | 50  licensed beds/50 staffed beds   |
| **Brotman Medical Center**  Culver City, CA   72% owned       |       | Medical/Surgical    |       | 420  licensed beds/272 staffed beds |
| **Van Nuys Community Hospital**Van Nuys, CA  100% owned       |       | Psychiatric         |       | 59  licensed beds/59 staffed beds   |

 

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Admitting physicians are primarily practitioners in the local area. Thehospitals have payment arrangements with Medicare, Medi-Cal (the Californiaversion of Medicaid) and other third-party payers, including some commercialinsurance carriers, health maintenance organizations (“HMOs”) and preferredprovider organizations (“PPOs”).

 

***Medical Group Segment***

 

The Medical Group segment is a health care management servicesorganization that provides management services to affiliated physicianorganizations that operate as independent physician associations (“Medical Groups”).The 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 Medical Group’s contract with physicians (primary care andspecialist) and other health care providers to provide enrollees with all oftheir medical services. Prospect currently manages the provision of prepaidhealth care services for its affiliated physician organizations in SouthernCalifornia. The network consists of the following physician organizations as ofDecember 31, 2009 (each, an “Affiliate”):

 

Prospect Medical Group, Inc. (“PMG”)

Santa Ana-Tustin Physicians Group, Inc. (“SATPG”)

Prospect Health Source Medical Group, Inc. (“PHS”)

Prospect Professional Care Medical Group (“PPCM”)

Prospect NWOC Medical Group, Inc. (“PNW”)

Starcare Medical Group, Inc. (“PSC”)

APAC Medical Group, Inc. (“APA”) (Inactive)

Nuestra Famila Medical Group, Inc. (“Nuestra”)

AMVI/Prospect Health Network (“AMVI/Prospect”)

Genesis HealthCare of Southern California (“Genesis”)

Pomona Valley Medical Group (“PVMG”)*

Upland Medical Group (“UMG”)*

 

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*              PVMG and UMG are collectively referred to as the “ProMedEntities.”

 

These Affiliates are managed by the following two medical managementcompany subsidiaries that are wholly-owned by Prospect:

 

Prospect Medical Systems, Inc. (“PMS”)

 

ProMed Health Care Administrators, Inc. (“PHCA”)

 

All of the Affiliates are wholly-owned by PMG, with the exception ofNuestra, which is 55% owned by a nominee physician shareholder pursuant to anassignable option agreement described below, and AMVI/Prospect which is a 50/50Joint Venture between AMVI and PMG. PMG is owned by the same nominee physicianshareholder pursuant to a separate assignable option agreement. The results ofall of these entities, with the exception of AMVI/Prospect, are consolidated inthe accompanying unaudited condensed consolidated financial statements.

 

As of December 31, the Medical Group segment manages services tothe following number of enrollees under contracts with various health plans (inthousands):

 
| ** ** | ** ** | **As of December 31** | ** ** |
|------------|------------|----------------------------|------------|
| ** ** | ** ** | **2009**                   | ** ** | **2008** | ** ** |
| Commercial |       | 131.1                      |       | 147.1 |   |
| Medicare   |       | 21.7                       |       | 21.6 |   |
| Medi-Cal   |       | 20.1                       |       | 21.6 |   |
| **Totals** |       | 172.9                      |       | 190.3 |   |

 

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**2. Summary of Significant Accounting Policies**

 

***Basis of Presentation***

 

The accompanying unaudited condensed consolidated financial statementsof the Company have been prepared in conformity with generally acceptedaccounting principles in the United States of America (“U.S. GAAP”) forinterim consolidated financial information and with the instructions for Form 10-Qand Article 10 of Regulation S-X. In accordance with the instructionsand regulations of the Securities and Exchange Commission (“SEC”) for interimreports, certain information and footnote disclosures normally included infinancial statements prepared in conformity with U.S. GAAP for annualreports have been omitted or condensed. All adjustments (consisting of normalrecurring adjustments) and disclosures considered necessary for fairpresentation have been included in the accompanying interim unaudited condensedconsolidated financial statements.

 

The results of operations for the three months ended December 31,2009 are not necessarily indicative of the results to be expected for the fullyear. The information included in this Quarterly Report on Form 10-Qshould be read in conjunction with the audited consolidated financialstatements for the year ended September 30, 2009 and notes theretoincluded in the Company’s Annual Report on Form 10-K filed with the SEC onDecember 21, 2009.

 

As discussed more fullyin Note 11, the Company adopted authoritative guidance issued by the FinancialAccounting Standards Board (“FASB”) that establishes accounting and reportingstandards for a noncontrolling interest in a subsidiary, including theaccounting treatment upon the deconsolidation of a subsidiary. As required bythis guidance, the Company has adjusted the presentation of noncontrollinginterests in the prior period condensed consolidated financial statements sothat they are comparable to those of the fiscal 2010 period.

 

***Principles of Consolidation***

 

The unaudited interim condensed consolidated financial statementsinclude the accounts of the Company and all majority owned subsidiaries andcontrolled entities in accordance with ASC 810-10 (previously Emerging IssuesTask Force (“EITF”) No. 97-2, “*Applicationof FASB Statement No. 94 and APB Opinion No. 16 to Physician PracticeManagement Entities and Certain Other Entities with Contractual ManagementArrangements”* and Financial Accounting Standards Board (“FASB”)Interpretation No. 46, “*Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51*).All adjustments considered necessary for a fair presentation of the results asof the date of, and for the interim periods presented, which consist solely ofnormal recurring 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 fiscal year endingSeptember 30, 2010.

 

***Use of Estimates***

 

The preparation of financial statements in conformity with U.S.Generally Accepted Accounting Principles requires management to make estimatesand assumptions that affect the reported amounts of assets, liabilities,revenues and expenses, and the disclosure of contingent assets and liabilitiesat the dates, and for the periods, that the unaudited condensed consolidatedfinancial statements are prepared. Actual results could materially differ fromthose estimates. Principal areas requiring the use of estimates includethird-party cost report settlements, receivables for medical services,allowances for contractual discounts and uncollectible accounts, accruals formedical claims, impairment of goodwill, long-lived assets and intangibleassets, valuation of interest rate swaps, share-based payments, professionaland general liability claims, reserves for the outcome of litigation, andvaluation allowances for deferred tax assets.

 

***SubsequentEvents***

 

The Company’s condensedconsolidated financial statements  areconsidered issued when filed with the SEC. Accordingly, the Company has evaluated subsequent events up to thefiling date of this Form 10-Q with the SEC (see Note 14).

 

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***RestrictedCash***

 

At December 31, 2009, restricted cash was established at Brotmanpursuant to Brotman’s Amended Plan of Reorganization, consisting of contingencyreserves, totaling $1,750,000 held in escrow for property taxes, maintenanceand emergency room construction required under the JHA loan agreement (seeNote 6). Additionally, $233,000 was held in a restricted account pursuantto workers compensation arrangements.

 

***Restricted Investments***

 

The Company is required to keep restricted deposits by certain HMOs forthe payment of claims. Such restricted deposits are classified as a currentasset in the accompanying unaudited condensed consolidated balance sheet, asthey are restricted for payment of current liabilities.

 

***Dueto Governmental Payer and Third-Party Settlements***

 

Following theacquisition of Brotman, effective April 14, 2009, the Company recorded aliability to the Centers for Medicare and Medicaid Services (“CMS”) arising outof outlier payments received for services provided by Brotman to Medicareeligible inpatients for the last four months of calendar 2005, all of calendar2006, and approximately six weeks of calendar 2007 (ending February 15,2007).

 

While Brotmanreports financial statements on a fiscal year ending September 30,Medicare cost reports are filed on a calendar year basis. Acute care hospitalsreceive Medicare reimbursement payments pursuant to a prospective paymentmethodology based on the diagnosis of the patient, but are entitled to receiveadditional payments, referred to as “outliers” for patients whose treatment isunusually costly. When Brotman acquired the hospital in 2005, CMS provided aratio of cost to charges (the “RCC”) based on the average prevailing marketrate in Southern California. This RCC was an interim estimate provided by CMS,subject to final determination upon filing of the hospital’s cost reports. Uponfiling cost reports, subsequent information called into question whether theinterim RCC provided by CMS was supportable, giving rise to a potential claimfor return of overpayments. Brotman filed its cost reports with CMS for 2005,2006 and 2007, respectively, which have been tentatively reviewed by the fiscalintermediary exclusive of any outlier reconciliation to be conducted directlyby CMS. CMS has not conducted any outlier reconciliations, has not notified thehospital of any pending reconciliation to be conducted and has not determinedthe amount of any liability at this point related to possible overpayments. Asof December 31 and September 30, 2009, an estimated liability of$13,834,000, was included in the accompanying unaudited condensed consolidatedbalance sheet related to this matter. Brotman and Alta have accrued estimatedsettlement net receivables in the amount of $379,000 for filed cost reportingyears and estimates for the three months ended December 31, 2009.  At September 30, 2009,estimated net receivables for cost reports were approximately $1,575,000.

 

***Revenues***

 

Revenues by reportable segment are comprised of the following amounts(in thousands):

 
| ** **                           | ** ** | **Three Months Ended  December 31,** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2009(1)**                               | ** ** | **2008** | ** ** |
| Net Hospital Services                |       |                                      |       |   |   |
| Inpatient                            |       | $                                         | 61,324     |   | $ | 33,240 |   |
| Outpatient                           |       | 7,925                                     |       | 1,722 |   |
| Other                                |       | 163                                       |       | 361 |   |
| Total net Hospital Services revenues |       | $                                         | 69,412     |   | $ | 35,323 |   |
| Medical Group                        |       |                                      |       |   |   |
| Capitation                           |       | $                                         | 46,449     |   | $ | 47,762 |   |
| Management fees                      |       | 153                                       |       | 144 |   |
| Other                                |       | 82                                        |       | 225 |   |
| Total Medical Group revenues         |       | $                                         | 46,684     |   | $ | 48,131 |   |
| Total revenues                       |       | $                                         | 116,096    |   | $ | 83,454 |   |

 

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(1)  Brotmanrevenues have been included in the accompanying unaudited condensedconsolidated financial statements effective April 14, 2009, when theCompany acquired a majority stake in Brotman. Accordingly, the three months ended December 31, 2009 include theoperations of Brotman.

 

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The Company presents segment information externally the same waymanagement uses financial data internally to make operating decisions andassess performance.  The Company’soperations are organized into three reporting segments: (i) HospitalServices, (ii) Medical Group management, and (iii) Corporate (seeNote 8).

 

***Comprehensive Income (Loss)***

 

Comprehensive income (loss) includes net income (loss), net of taxes,and changes in the fair value of interest rate swaps subject to hedgeaccounting that are recorded as other comprehensive income. As of April 1,2008, the swaps ceased to be eligible for hedge accounting under ASC 815. As aresult, all further changes in fair value of the swaps were recorded in theconsolidated statements of operations and the effective portion of the swaps ofapproximately $5.4 million, after tax, that was recorded in othercomprehensive income through March 31, 2008 continued to be amortized tointerest expense, using the effective interest method, over the remaining lifeof the swaps. The remaining unamortized portion of the interest rate swaps wasexpensed in July 2009 in connection with the Company’s termination of suchswaps.

 

The components of comprehensive income (loss) for the periods ended December 31,2009 and 2008 are as follows (in thousands):

 
| ** **                                                     | ** ** | **Three Months********Ended********December 31,** | ** ** | **Three Months********Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                                               | ** ** | **2008**                                         | ** ** |
| Net income (loss)                                              |       | $                                                      | 2,859      |                                             | $          | (3,445 | ) |
| Amortization of fair value of interest rate swaps,  net of tax |       | —                                                 |       | 220                                              |       |
| Comprehensive income (loss)                                    |       | $                                                      | 2,859      |                                             | $          | (3,225 | ) |

 

***Reclassification***

 

Certainprior period amounts have been reclassified to conform to the current periodpresentation with no impact on the unaudited condensed consolidated statementof operations.

 

**3. Equity-Based Compensation Plans**

 

On August 13, 2008, following stockholder approval, the Companyadopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provideflexibility in implementing equity awards, including incentive stock options (“ISO”),non-qualified stock options (“NQSO”), restricted stock grants, stockappreciation rights (“SAR”) and performance based awards to employees,directors and outside consultants, as determined by the Compensation Committeeof the Board of Directors (the “Committee”). In conjunction with the adoptionof the 2008 Plan, effective August 13, 2008, additional equity awardsunder the Company’s 1998 Stock Option Plan (“1998 Plan”) have been discontinuedand new equity awards are now granted under the 2008 Plan. Remaining authorizedshares under the 1998 Plan that were not subject to outstanding awards as of August 13,2008, were canceled on August 13, 2008. The 1998 Plan will remain ineffect as to outstanding equity awards granted under the 1998 Plan prior to August 13,2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved forissuance under the 2008 Plan. As of December 31, 2009, there were 795,250shares available for future grants under the 2008 Plan.

 

Under the terms of the 2008 Plan, the exercise price of an ISO may notbe less than 100% of the fair market value of the Company’s Common Stock on thedate of grant and, if granted to a shareholder owning more than 10% of theCompany’s Common Stock, then not less than 110%. Stock options granted underthe 2008 Plan have a maximum term of 10 years from the grant date, and areexercisable at such time and upon such terms and conditions as determined bythe Committee. Stock options granted to employees generally vest over fouryears, while options granted to certain executives typically vest over a shorterperiod, subject to continued service. In the case of an ISO, the amount of theaggregate fair market value of Common Stock (determined at the time of grant)with respect to which ISO are exercisable for the first time by an employeeduring any calendar year may not exceed $100,000.

 

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The base price, above which any appreciation of a SAR issued under the2008 Plan is measured, will in no event be less than 100% of the fair marketvalue of the Company’s stock on the date of grant of the SAR or, if the SAR isgranted in tandem with a stock option, the exercise price under the associatedoption. The restrictions imposed on shares granted under a restricted stockaward will lapse in accordance with the vesting requirements specified by theCommittee in the award agreement. Such vesting requirements may be based on thecontinued service of the participant with the Company for a specified time, oron the attainment of specified performance goals established by the Committeein its discretion. If the vesting requirements of a restricted stock award arenot satisfied prior to the termination of the participant’s service, theunvested portion of the award will be forfeited and the shares of Common Stocksubject to the unvested portion of the award will be returned to the Company.

 

***Stock Options Activity***

 

The following table summarizes information about our stock options outstandingat December 31, 2009 and activity during the three-month period thenended:

 
| ** **                                          | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (Months)** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------|------------|---------------------------------------------------------------|------------|
| Outstanding as of September 30, 2009           |       | 4,333,335  |       | $                                      | 3.00       |                            |       |                                                          |       |   |
| Granted                                             |       | 420,000    |       | $                                      | 4.47       |                            |       |                                                          |       |   |
| Exercised                                           |       | —     |       | $                                      | —     |                            |       |                                                          |       |   |
| Forfeited                                           |       | (240       | )          | $                                      | 5.20       |                            |       |                                                          |       |   |
| Expired                                             |       | (58,000    | )          | $                                      | 6.45       |                            |       |                                                          |       |   |
| Outstanding as of December 31, 2009            |       | 4,695,095  |       | $                                      | 3.09       |                            | $          | 6,056,622                                                     |       | 44 |   |
| Vested and exercisable as of December 31, 2009 |       | 3,040,911  |       | $                                      | 3.07       |                            | $          | 4,113,651                                                     |       | 42 |   |

 

The aggregate intrinsic value is calculated as the difference betweenthe exercise price of the underlying awards and the quoted price of our commonstock for those awards that have an exercise price currently below the quotedvalue.

 

***Stock-Based Compensation Expense***

 

Under ASC 718, “*Share-Based Payments*,”compensation cost for all share-based payments in exchange for employeeservices (including stock options and restricted stock) is measured at fairvalue on the date of grant, estimated using an option pricing model.

 

Compensation costs for stock-based awards are measured and recognizedin the financial statements, net of estimated forfeitures over the awards’requisite service period. The Company uses the Black-Scholes option pricingmodel and a single option award approach to estimate the fair value of optionsgranted. Estimated forfeitures will be revised in future periods if actualforfeitures differ from the estimates and will impact compensation cost in the periodin which the change in estimate occurs. The determination of fair value usingthe Black-Scholes option-pricing model is affected by the Company’s stock priceas well as assumptions regarding a number of complex and subjective variables,including expected stock price volatility, risk-free interest rate, expecteddividends and projected employee stock option exercise behaviors. Equity-basedcompensation is classified within the same line items as cash compensation paidto employees. Cash retained as a result of excess tax benefits relating toshare-based payments are presented in the statement of cash flows as afinancing cash inflow.

 

The weighted average assumptions used in determining the value ofoptions granted and a summary of the methodology applied to develop eachassumption are as follows:

 
| ** **                                                                             | ** ** | **Three Months Ended  December 31, 2009** | ** **  |
|----------------------------------------------------------------------------------------|------------|------------------------------------------------|-------------|
| Weighted average fair value of option grants                                           |       | $                                              | 1.67        |   |
| Weighted average market price of the Company’s  common stock on the date of grant |       | $                                              | 4.40        |   |
| Weighted average expected life of the options                                          |       | 3.07                                           |  years |
| Risk-free interest rate                                                                |       | 1.38                                           | %           |
| Weighted average expected volatility                                                   |       | 54.49                                          | %           |
| Dividend yield                                                                         |       | 0.00                                           | %           |

 

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Expected Term—The expected term of options granted represents theperiod of time that they are expected to be outstanding. The Company hasadopted the “simplified method” of determining the expected term for “plainvanilla” options, as allowed under Staff Accounting Bulletin (SAB) No. 107.The “simplified method” states that the expected term is equal to the sum ofthe vesting term plus the contract term, divided by two. “Plain vanilla”options are defined as those granted at-the-money, having service time vestingas a condition to exercise, providing that non-vested options are forfeitedupon termination and that there is a limited time to exercise the vestedoptions after termination of service, usually 90 days, and providing theoptions are non-transferable and non-hedgeable. We will continue to gatheradditional information about the exercise behavior of participants and willadjust the expected term of our option awards to reflect the actual exerciseexperience when such historical experience becomes sufficient.

 

Expected Volatility—The Company estimates the volatility of the commonstock at the date of grant based on the average of the historical volatilitiesof a group of peer companies. Since the Company’s shares did not becomepublicly traded until May 2005 and trading volume has been limited,management believes there is currently not enough historical volatility dataavailable to predict the stock’s future volatility. The Company has identifieda group of comparable companies to calculate historical volatility frompublicly available data for sequential periods approximately equal to theexpected terms of the option grants. In selecting comparable companies,management considered several factors including industry, stage of development,size and market capitalization.

 

Risk-Free Interest Rate—The Company bases the risk-free interest rateon the implied yield in effect at the time of option grant on U.S. Treasuryzero-coupon issues with equivalent remaining terms.

 

Dividends—The Company has never paid any cash dividends on its commonstock and does not anticipate paying any cash dividends in the foreseeablefuture.

 

Forfeitures—Share-based compensation is recognized only for thoseawards that are ultimately expected to vest. Compensation expense is recordednet of estimated forfeitures. Those estimates are revised in subsequent periodsif actual forfeitures differ from those estimates. The Company used historicaldata since May 2005 to estimate pre-vesting option forfeitures.

 

During the three monthsended December 31, 2009, an aggregate of 420,000 options were issued underthe 2008 Plan, of which 220,000 were granted to Samuel S. Lee in connectionwith his employment as the Chief Executive Officer of the Company and 200,000were granted to Mike Heather in connection with his employment as ChiefFinancial Officer of the Company. As of December 31, 2009, two-thirds ofthe shares granted to the Chief Executive Officer had vested and one-third ofshares granted to the Chief Financial Officer had vested.

 

Stock-based compensation expense for stock options recognized in thethree months ended December 31, 2009 and 2008 was approximately $520,000and $263,000, respectively. At December 31, 2009, there were 2,990,305unvested options with related compensation expense of approximately $1,139,000which will be recognized ratably over a weighted average remaining vestingperiod of 49 months.

 

***Restricted Stock Award Activities***

 

On August 15, 2008, the Company granted 200,000 shares of restrictedstock to its Chief Financial Officer with a grant date fair value of $2.40 pershare. As of December 31, 2009, all of such shares had fully vested. On December 18,2009, the Company granted an aggregate of 210,000 shares of restricted stock toits Chief Executive Officer and Chief Financial Officer. As of December 31,2009, two-thirds of the shares granted to the Chief Executive Officer hadvested and one-third of the shares granted to the Chief Financial Officer hadvested.  Compensation expense relating torestricted stock of approximately $509,000 was recorded during the three monthsended December 31, 2009.

 

On November 12, 2009, the Companygranted an aggregate of 36,000 shares of restricted stocks to the outsidemembers of the Board of Directors. The expense relating to these shares, whichvested immediately, totaling approximately $144,000, was included in generaland administrative expenses in the accompanying unaudited condensedconsolidated financial statements during the three months ended December 31,2009.

 

**4. Earnings per Share**

 

The Company calculates basic net income (loss) per share by dividingnet income (loss) attributable to common stockholders by the weighted averagenumber of common shares outstanding. Diluted earnings (loss) per share iscomputed by dividing net income (loss) attributable to common stockholders bythe weighted average number of common shares outstanding, after giving effectto potentially dilutive shares computed using the treasury stock method. Suchshares are excluded if determined to be anti-dilutive.

 

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The calculations of basic and diluted net income (loss) per share forthe three months ended December 31, 2009 and 2008 are as follows (inthousands, except share and per-share amounts):

 
| ** **                                                              | ** ** | **Three Months Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                              | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
|                                                                    |       |                                      |       |   |   |
| Net income (loss) attributable to Prospect Medical  Holdings, Inc. |       | $                                         | 2,859      |   | $ | (3,445 | ) |
|                                                                    |       |                                      |       |   |   |
| Weighted average common shares outstanding - basic                      |       | 20,653,524                                |       | 20,508, 444 |   |
| Dilutive effect of stock options and warrants                           |       | 1,174,325                                 |       | — |   |
| Weighted average common shares outstanding -  diluted                   |       | 21,827,849                                |       | 20,508,444 |   |
|                                                                    |       |                                      |       |   |   |
| Basic                                                                   |       | $                                         | 0.14       |   | $ | (0.17 | ) |
| Diluted                                                                 |       | $                                         | 0.13       |   | $ | (0.17 | ) |

 

The Companyexcludes equity instruments from the calculation of diluted earnings per shareif the effect of including such instruments is antidilutive. Accordingly, acertain number of stock options and warrants have been excluded from thecalculation of diluted earnings per share totaling 1,434,537 and 475,774shares, respectively, during the three months ended December 31, 2009.During the three months ended December 31, 2008, the number of stockoptions and warrants excluded from the computation of diluted loss per share asantidilutive were 4,603,137 and 665,973, respectively.

 

**5. Related Party Transactions**

 

Prospect has a controlling financial interest in the affiliatedphysician organizations included in its unaudited interim condensedconsolidated financial statements which are owned by a nominee physicianshareholder designated by the Company. The control is effectuated throughassignable option agreements and management services agreements, which providethe Company a unilateral right to establish or effect a change of the nomineeshareholder for the affiliated physician organizations at will, and without theconsent of the nominee, on an unlimited basis and at nominal cost through theterm of the management agreement. Jacob Y. Terner, M.D. was, through August 8,2008, the sole shareholder, sole director and Chief Executive Officer ofProspect Medical Group, Inc. (“PMG”) and was the Chief Executive Officerof most of PMG’s subsidiary physician organizations. Dr. Terner alsoserved as the sole shareholder and a director and officer of Nuestra FamiliaMedical Group, Inc. (“Nuestra”), an affiliated physician organization. Dr. Terneris a shareholder of the Company, and formerly served as its Chairman and ChiefExecutive Officer through part of fiscal 2008.

 

The Company had an employment agreement with Dr. Terner thatexpired on August 1, 2008 and provided for base compensation (mostrecently $400,000 per year) and further provided that if the Company terminatedDr. Terner’s employment without cause, the Company would pay him $12,500for each month of past service as the Chief Executive Officer, commencing as ofJuly 31, 1996, up to a maximum of $1,237,500. Dr. Terner resigned asthe Chief Executive Officer of the Company effective March 19, 2008 andresigned as the Chairman of the Board of Directors effective May 12, 2008.In consideration of Dr. Terner’s resignation and other promises in hisresignation agreement, the Company agreed to pay to his family trust the sum of$19,361.10 each month during the twelve-month period ending on April 30,2009 and the sum of $42,694.45 each month during the twenty-four month periodending on April 30, 2011, for the total sum of $1,257,000, which amountwas recorded as a general and administrative expense in the third quarter offiscal 2008. In September 2009, the Company ceased making payments to Dr. Ternerfollowing its determination that Dr. Terner was not entitled to receive thepayments. Subsequently, Dr. Terner filed a complaint against the Companyseeking restoration of the payments. The Company and Dr. Terner arecurrently litigating this dispute. Dr. Terner no longer serves as thenominee shareholder of the Company’s affiliated physician organizations.

 

Dr. Arthur Lipper currently serves as the nominee shareholder ofPMG and Nuestra and as the sole director of PMG and its subsidiary physicianorganizations and the Chief Executive Officer, President and Treasurer of allsubsidiary physician organizations, except the ProMed Entities. Dr. Lipperserves as one of two directors of Nuestra, as the sole director of the ProMedEntities, and as a Vice President of Nuestra and the ProMed Entities.

 

On August 1, 2005 and subsequently amended on October 25,2007, Prospect Medical Management, Inc. (now known as Prospect HospitalAdvisory Services, Inc. (“PHAS”)), an affiliate of the Company, enteredinto a consulting services agreement, to provide administrative, financial andmanagement consulting services to Brotman for a monthly fee of $100,000 plusexpenses. The agreement had an initial term of one year and automaticallyrenewed for additional one-year terms unless terminated by either party with90 days written notice. As discussed in Note 7, Brotman, which fileda voluntary petition for bankruptcy protection under Chapter 11 of the 

 

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U.S. Bankruptcy Code on October 25, 2007, emerged from the Chapter 11bankruptcy proceeding on April 14, 2009 (the “Effective Date”). On theEffective Date, the Company increased its approximately 33.1% ownership stakein Brotman, to approximately 71.9% via an incremental investment ofapproximately $2.5 million. For the three months ended December 31,2008, total fees earned under the agreement were approximately $300,000, noneof which was paid and none of which was compromised pursuant to Brotman’sChapter 11 Plan of Reorganization. Beginning April 14, 2009, amountsearned under the agreement have been eliminated in consolidation.

 

EffectiveDecember 15, 2009, the Board of Directors of Brotman authorized certaindesignated officers to enter into an amendment to the consulting servicesagreement, which amendment became effective on February 1, 2010 (“Amendedand Restated Consulting Services Agreement”). Pursuant to the Amended andRestated Consulting Services Agreement, the consulting fees payable by the Companyto PHAS were increased to 4.5% of Brotman’s net operating revenue, retroactiveto April 14, 2009.  The retroactiveeffectiveness of this agreement resulted in $1.2 million in additional consultingfees.  All amounts under this agreementare eliminated upon consolidation.

 

EffectiveDecember 15, 2009, Brotman initiated a Rights Offering (“Rights Offering”),whereby existing shareholders of Brotman could subscribe to purchase up to$5,500,000 of Brotman convertible subordinated promissory notes (theNotes).  The Notes will be due threeyears from the date of issuance, will bear interest at 15% per annum and willbe convertible at the option of the holder into shares of Brotman, at $3.34 pershare.  Prospect exercised its right topurchase its pro rata share of the Notes and, effective January 7, 2010,purchased $3,500,000 of such Notes (see Note 7).

 

PMG, a controlled affiliate of the Company, entered into a risk poolsharing agreement, dated May 1, 2005, with Brotman. Under the agreement,PMG and Brotman agreed to establish a Hospital Control Program (as defined) toserve HMO enrollees and would earn incentive revenue or incur penalties bysharing in the risk for hospitalization based on inpatient services utilized.Risk pools are generally settled in the following year. For the three monthsended December 31, 2008, all incentive revenue earned under the agreementwas compromised pursuant to Brotman’s Chapter 11 Plan of Reorganization.Beginning April 14, 2009, all amounts earned under the agreement areeliminated in consolidation.

 

In connection with the above-described risk-sharing agreement, ProspectMedical Systems, Inc. (“PMS”) and Brotman entered into an AdministrativeServices Agreement, dated October 1, 2005, as amended on October 1,2009, that provides for the administration by PMS of the payment of claimsunder such risk-sharing arrangement, which are eliminated in consolidation.

 

On August 31, 2005, PMG, entered into a joint marketing agreementwith Brotman. The agreement is for an initial term of 20 years, renewablefor successive five-year terms unless terminated by either party with180 days written notice. During the term, Brotman will contractexclusively with PMG with regard to full risk contracting with HMOs for alllines of business, including Medicare, Medicaid and commercial enrollees.Brotman will not merge into, consolidate with, or sell substantially all of itsassets (unless the purchaser or surviving entity expressly assumes thesemanaged care exclusivity arrangements), alter such agreements without theconsent of PMG, and agrees to be bound by the exclusivity provision.

 

**6. Long-Term Debt**

 

Long-term debt consists of the following at December 31, and September 30,2009, respectively (in thousands):

 
| ** **                                 | ** ** | **December 31,********2009** | ** ** | **September 30,********2009** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|
| **Prospect’s debt:**                  |       |                              |       |                               |       |
| Senior secured notes                       |       | $                                 | 160,000    |                               | $          | 160,000 |   |
| Less original issue discount               |       | (11,561                           | )          | (11,980                            | )          |
|                                       |       | 148,439                           |       | 148,020                            |       |
| **Brotman’s debt:**                   |       |                              |       |                               |       |
| Revolving credit facility                  |       | 4,543                             |       | 2,888                              |       |
| Term loan-A (net of discount)              |       | 15,655                            |       | 15,655                             |       |
| Term loan-B                                |       | 6,250                             |       | 6,250                              |       |
| Promissory Note—Creditors’ Trust |       | 3,250                             |       | 3,531                              |       |
|                                       |       | 29,698                            |       | 28,324                             |       |
| Less current maturities                    |       | (5,543                            | )          | (3,805                             | )          |
| Long-term portion                          |       | $                                 | 172,594    |                               | $          | 172,539 |   |

 

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**Prospect’s Debt**

 

***Senior Secured Notes***

 

On July 29, 2009, the Company closed the offering of$160 million in 12.75% senior secured notes due 2014 (the “Notes”) at anissue price of 92.335%. The sale was executed in accordance with Rule 144Aunder the Securities Act of 1933 and Regulation S under the Securities Actof 1933. Concurrent with the issuance of the Notes, the Company entered into athree-year $15 million revolving credit facility which was undrawn at theclosing and is still undrawn, with any future borrowings bearing interest at LondonInterbank Offered Rate (“LIBOR”) plus 7.00%, with a LIBOR floor of 2.00%.

 

The Company used the net proceeds from the sale of the Notes to repayall remaining amounts outstanding under its former $155 million seniorsecured credit facility, plus a prepayment premium of approximately$2.6 million. The Company reflected the prepayment premium, together withthe write-off of approximately $560,000 of deferred financing related to itsformer credit facilities, as interest expense in the fourth quarter of fiscal2009. Capitalized deferred financing costs and original issue discount relatedto the Notes is being amortized over the term of the related debt using theeffective interest method.

 

The terms of the Notes are governed by an indenture among the Company,certain of its subsidiaries and affiliates (as guarantors), and U.S. BankNational Association (as trustee) (the “Indenture”). Interest is payablesemi-annually in arrears on January 15 and July 15, the first paymentof which was made on January 15, 2010. The terms of the revolving seniorsecured credit facility are governed by the Credit Agreement, dated as of July 29,2009, among the Company, Royal Bank of Canada (as administrative agent),Jefferies Finance LLC (as syndication agent) and the lenders party thereto(the “Credit Agreement”).

 

The Notes and the revolving senior secured credit facility are jointlyand severally guaranteed on a senior secured basis by all of the Company’srestricted subsidiaries (as such term is defined in the Indenture) other thanBrotman, Nuestra and certain immaterial subsidiaries. The Notes are securedpari passu with the new revolving credit facility on a first priority basis byliens on substantially all of the Company’s assets and the assets of thesubsidiary guarantors (other than accounts receivable and proceeds therefrom)including all the mortgages on the Company and its subsidiary guarantors’hospital properties (but excluding a pledge of, or mortgage on, the stock,properties or other assets of Brotman, AMVI/Prospect Health Network and certainimmaterial subsidiaries). The lenders under the revolving credit facility havea first priority lien on certain of the accounts receivable of the Company andthe subsidiary guarantors and proceeds therefrom while the holders of the Noteshave a second priority lien on such collateral.

 

The Indenture requires the Company to make an offer to repurchase theNotes at 101% of their principal amount in the event of a change of control ofthe Company and at 100% of the principal amount thereof with certain proceedsof sales of assets. The Indenture also contains certain covenants that, amongother things, limit the Company’s ability, and the ability of its restrictedsubsidiaries to: pay dividends or distributions on capital stock or equityinterests, prepay subordinated indebtedness or make other restricted payments;incur additional debt; make investments; create liens on assets; enter intotransactions with affiliates; engage in other businesses; sell or issue capitalstock of restricted subsidiaries; merge or consolidate with another company;transfer and sell assets; create dividend and other payment restrictionsaffecting subsidiaries; and designate restricted and unrestricted subsidiaries.The Credit Agreement contains a number of customary covenants as well ascovenants requiring the Company to maintain a maximum consolidated leverageratio, minimum fixed charge coverage ratio and a maximum consolidated totalleverage ratio. As of December 31, 2009, the Company was in compliancewith the financial covenants.

 

Pursuant to its definitive Prospectus filed with the SEC on September 26,2009, the Company commenced an offer to exchange (the “Exchange Offer”) up to$160 million of its newly registered 123/4% Senior Secured Notes, Series B, due 2014 (the “Exchange Notes”and together with the Original Notes, the “Notes”) for an equal amount of the Notesissued on July 29, 2009 (the “Original Notes”). The Exchange Notes aresubstantially identical to the Original Notes, except that the offer and saleof the Exchange Notes have been registered under the Securities Act of 1933, asamended, and the Exchange Notes do not bear any legend restricting theirtransfer. The Exchange Offer was extended on November 25, 2009 until December 3,2009, at which time $159 million of the $160 million aggregateprincipal amount of private notes had been tendered and accepted for exchange.The Company filed the required Form S-4 under the Registration RightsAgreement, on September 30, 2009 and went effective on October 23,2009.

 

The Notes will mature on July 15, 2014. Prior to July 15,2012, the Company may redeem up to 35% of the original principal amount of theNotes at a redemption price equal to 112.75% of the principal amount of theNotes redeemed, plus any accrued and unpaid interest, with the proceeds ofcertain equity offerings. From July 15, 2012 until July 15, 2013, theCompany may redeem all, or any portion, of the Notes at a redemption priceequal to 106.375% of the principal amount of the Notes redeemed, plus anyaccrued and unpaid interest. After July 15, 2013, but before the maturitydate of July 15, 2014, the Company may redeem all, or any portion, of theNotes at a redemption price equal to 100% of the principal amount of the Notesredeemed, plus any accrued and unpaid interest.

 

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Effective July 23, 2009, the Company terminated the former masterswap agreement and the swap arrangements thereunder by payment, on July 29,2009, of $11.7 million to the swap counterparty in final settlement of allamounts owed under the swap arrangements. All related amounts included inaccumulated other comprehensive loss, including related deferred income taxes(of approximately $4.2 million) was recorded as interest expense and tothe tax provision, respectively, as of the effective date of the swapterminations.

 

**Brotman’s Debt**

 

The Brotman entity has debt under a Senior Secured Revolving CreditFacility, Secured Term Loans and Unsecured Promissory Note entered into inconjunction with effecting the Plan of Reorganization described in Note 7.The Company has not guaranteed any portion of Brotman’s debt or otherobligations. Given the Company’s majority ownership in Brotman, effective April 14,2009, all Brotman debt is included in the Company’s consolidated financialstatements. The Company has no obligation and has limited ability to fundBrotman’s operations post acquisition. Under the senior secured notes creditagreement, the Company is permitted to make additional investments in Brotmanin an aggregate amount not to exceed $10,000,000, provided that suchinvestments can exceed $10,000,000 if the amounts are funded solely with theproceeds of Equity Interests of the Company (as defined).

 

***Senior Secured Revolving Credit Facility***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman obtained a commitment from Gemino HealthcareFinance, LLC (“Gemino”) for a three-year, $6.0 million, senior creditfacility secured by Brotman’s accounts receivable. The facility expires on theearlier of April 14, 2012 and the Los Angeles Jewish Home for Aging (“JHA”)loan (see below) maturity date and bears interest at LIBOR plus 7% per annum(11.0% at December 31, 2009), given a LIBOR floor of 4%. Interest isincurred based on the greater of $2 million or the actual outstandingprincipal balance. The agreement also includes an unused line fee of 0.5% perannum and a collateral line fee, based on the average outstanding principalbalance, of 0.5% per annum. Loan fees associated with the Gemino loan totalingapproximately $120,000, were capitalized and have been included as deferredfinancing costs in the accompanying unaudited condensed consolidated balancesheet as of December 31, 2009, with the amount being amortized over theterm of the related debt using the effective interest method. The senior creditfacility agreement contains customary covenants for facilities of this type,including restrictions on the payment of dividends, change in ownership and management,asset sales, incurrence of additional indebtedness, sale-leasebacktransactions, and related party transactions. Brotman must also comply with certainfinancial covenants. Prior to a recent amendment discussed below, Brotman wasrequired to comply with a fixed charge coverage ratio of not less than (i) 1.10:1.00for the fiscal quarter ended June 30, 2009, (ii) 1.15:1.00 originallyfor the fiscal quarter ended September 30, 2009; and (iii) 1.20:1.00for each fiscal quarter ending thereafter. As of September 30, 2009,Brotman was not in compliance with the required financial covenants under theGemino credit agreement. Pursuant to an amendment entered into effective December 11,2009, the Gemino credit agreement was amended to provide, among other things, awaiver of the specified events of default and the amendment to the definitionof fixed charge coverage ratio. Under the amended credit agreement, the fixedcharge coverage ratio was amended to require not less than (i) 1.00:1.00for the fiscal quarters ending December 31, 2009 and March 31, 2010; (ii) 1.05:1.00for the fiscal quarters ending June 30, 2010 and September 30, 2010, (iii) 1.10:1.00for the fiscal quarters ending December 31, 2010 and March 31, 2011,and (iv) 1.20:1.00 for the fiscal quarter ending June 30, 2011 andeach fiscal quarter ending thereafter. As of December 31, 2009, Brotmanwas in compliance with the required financial covenants under the amendedcredit agreement.

 

***Secured Credit Facilities Term Loan: A and B***

 

On April 14, 2009, the effective date of the Plan ofReorganization, Brotman consummated the transactions contemplated in the JHAfinancing and the JHA loan documents. Under the terms of the JHA loanagreements, JHA agreed to provide Brotman with up to $22.25 million infinancing, consisting of two term loans: (i) a Term A loan of$16 million (the “Term A Loan”) with a 24-month term and (ii) a TermB loan of up to $6.25 million, with a term of 36 months (the “Term BLoan”). Subject to the notification requirements set forth in the loanagreements, the term of the Term A Loan can be extended up to 36 months.Interest on the Term A Loan is payable at 10% per annum for the first year ofthe loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10%per annum for the term of the loan. The Term A Loan and Term B Loan are securedby certain of Brotman’s personal property, and a mortgage on certain of Brotman’sreal property. The proceeds of the JHA loans were used to repay all existing seniorsecured loans at Brotman as of April 14, 2009. Loan fees associated withthe JHA loans totaling approximately $1,549,000, were capitalized and have beenincluded as deferred financing costs in the accompanying unaudited condensedconsolidated balance sheet as of December 31, 2009, with that amount beingamortized over the term of the related debt using the effective interestmethod.

 

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With respect to the Term A Loan, JHA was granted the right (“Put Right”)to declare the unpaid loan amount, including remaining interest and any otheramounts due and payable under the loan agreements, immediately due and payableat any time after April 14, 2010 and prior to the date which istwenty-four months after the Closing Date, subject to JHA providing writtennotification to Brotman of its exercise of the Put Right at least 180 daysin advance.  Effective February 10,2010, JHA and Brotman entered into an amendment to the Term A Loan, whereby theearliest date on which JHA could provide notice of its exercise of the PutRight was extended from April 14, 2010 to October 14, 2010.  Based on such amendment, as of December 31,2009, the loan has been reflected as noncurrent in the accompanying unauditedcondensed consolidated balance sheet.

 

As part of the JHA financing, Brotman has granted JHA an option topurchase certain Brotman-owned land adjacent to the hospital, where JHA plansto construct a senior living facility, for a purchase price equal to theoutstanding principal balance of the Term A Loan plus any prepaid amounts. Inconnection with JHA’s option right, Brotman is required to deposit$130,000 monthly into a reserve account (up to a maximum of $3,120,000),with such funds specifically earmarked for the construction of a new emergencyroom. Additionally, Brotman is required to deposit $10,000 monthly into areserve account for capital improvements and a Tax and Insurance DepositAccount to be funded monthly, for purposes of Brotman’s annual real estate taxassessments.

 

In accordance with relevant accounting pronouncements, the Term A Loan,which contains a real estate purchase option, is recorded at its present value,with any excess of the proceeds over that amount recorded as an option depositliability account. The present value of the loan is estimated using discountedcash flow analyses based on market rates obtained from independent thirdparties for similar type debt. Based on an estimated market interest rate of10.0%, the present value of the loan was estimated to be approximately$15,667,000 at inception. The difference of $345,000 between the recordedpresent value and the carrying value of the loan has been recorded as adiscount against the loan and is being amortized to interest expense, using theeffective interest rate method, over the term of the loan.

 

***Subordinated Promissory Note***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, tobe held by the Creditor Trust (as defined in the Plan of Reorganization) forthe benefit of holders of allowed Class 4 claims (as defined in the Planof Reorganization) and paid pro rata to holders of allowed Class 4 claims.The Note bears interest at 7.50% per annum and is payable in sixteen equalquarterly installments of principal and accrued interest through February 15,2013. The Note contains a covenant which, so long as amounts remain outstandingunder the Note, restricts Brotman from paying Prospect Medical Holdings, Inc.in cash a consulting fee of more than $100,000 per month, as specified in the Amendedand Restated Consulting Services Agreement (see Note 5).  As such, although the amount of theconsulting fee was increased to 4.5% of Brotman’s net operating revenueeffective April 14, 2009, the amount of such consulting fee actually paidin cash will remain at $100,000 per month until such time as permitted byapplicable agreement or the Creditor Trust Note has been amended or repaid.

 

**7. Acquisitions**

 

**Brotman Medical Center, Inc.**

 

On August 31, 2005, the Company invested $1 million for an approximately33.1% stake in Brotman, a 420-bed licensed and accredited acute care hospital,located in Culver City, California, with the intention of offering jointcontracting to HMOs operating in Brotman’s service area. Brotman incurredsignificant losses before and after the Company’s initial investment and, on October 25,2007 (the “Petition Date”), Brotman filed for bankruptcy protection underChapter 11 of the U.S. Bankruptcy Code. Effective April 22, 2008,Samuel S. Lee (Prospect’s CEO and Chairman of the Board) was appointed as theChairman of the Board of Directors of Brotman. On April 14, 2009 (The “EffectiveDate”), the U.S. Bankruptcy Court confirmed and declared effective the finalChapter 11 Plan of Reorganization (the “Plan of Reorganization”) ofBrotman whereby, among other things, all of Brotman’s outstanding securitieswere canceled and, in exchange for their pro rata share of the New ValueContribution (as defined in the Plan of Reorganization) totaling $3,500,000,holders of Brotman’s existing securities would receive New Common Stock inBrotman in the same percentage as their pro rata share of the New ValueContribution. Pursuant to the terms of the Plan, the Company made additionalcash investments in Brotman, totaling $2,519,000, thereby acquiring anadditional 38.86% ownership interest, which brought its total ownershipinterest to 71.96%.

 

Forfinancial accounting purposes, the additional investment in Brotman wasreferred to as the “Brotman Acquisition” and in accordance with SFAS No. 141,“*Business Combinations*”, thebusiness combination, which was achieved in stages, provides for recognition ofassets at current fair value with respect to the proportion of the Company’sincremental ownership interest in Brotman. Under SFAS No. 141, theaggregate cost of the acquired assets, which includes cash paid of$2.5 million and expenses incurred in connection with the acquisitiontotaling $37,000, were preliminarily allocated to the assets acquired andliabilities assumed. SFAS No. 141 is pre-Codification literature, theprovisions of ASC 805 is not effective for the Company until October 1,2009. The excess of the consideration over the estimated fair value of theassets and liabilities assumed has been allocated to goodwill and identifiable 

 

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intangibleasset. Due to negative net book value of assets acquired, goodwill attributableto the noncontrolling (formerly minority) interest was not recognized. As thenon-controlling interest in Brotman exceeds 20%, the accounting basis in theacquired ownership in Brotman have not been pushed-down to the financialstatements of Brotman and have been reflected in the Parent Company financialstatements. The results of operations of Brotman have been included inconsolidated financial statements since the April 14, 2009 acquisitiondate. Brotman’s operations for the three months ended December 31, 2009reflected a net loss. The Company does not have the intent or ability,including under the terms of its debt agreement, to provide significantfinancial support to Brotman. Prior to October 1, 2009, a pro rata shareof net income attributable to minority interest was not included under minorityinterest in the Company’s consolidated statement of operations, as thecumulative minority share of such income did not exceed their cumulative shareof prior losses absorbed by the Company. Effective October 1, 2009, with theadoption date of new accounting literature (see Note 11), a pro rata share ofnet loss attributable to noncontrolling interest was reported as a component ofequity separate from the Company’s equity in the unaudited condensedconsolidated balance sheet and as net loss attributable to noncontrollinginterest in the unaudited condensed consolidated statement of operations.

 

EffectiveDecember 15, 2009, Brotman initiated a Rights Offering (“Rights Offering”),whereby existing shareholders of Brotman could subscribe to purchase up to$5,500,000 of Brotman convertible subordinated promissory notes (the “BrotmanNotes”). The Rights Offering deadline was originally December 30, 2009,but extended to January 7, 2010. The Brotman Notes will be due three yearsfrom the date of issuance, will bear interest at 15% per annum and will beconvertible at the option of the holder into shares of Brotman, at $3.34 pershare. PHAS planned on exercising its right to purchase its pro rata(approximately 72%) share of the Brotman Notes, as well as any Brotman Notesoffered that were not purchased by other Brotman shareholders. Brotman intendsto use the proceeds from the Brotman Notes to repay approximately$2 million currently due to Prospect, with the balance of the proceedsbeing used to retire certain other obligations of Brotman. A dispute existsbetween Culver Hospital Holdings, L.P. (“Culver”), Brotman’s second largestshareholder, and Prospect, PHAS, and Brotman’s directors regarding obligationsallegedly owed to Culver as a minority shareholder.  In connection withthis dispute, PHAS and Prospect entered into an agreement with Culver underwhich the parties agreed that the Rights Offering will be temporarily suspendedin certain respects as it relates to Culver and PHAS and that PHAS couldpurchase, but not convert, $3,500,000 of the Brotman Notes.  PHAS made such purchase on January 7,2010.

 

The following is an analysis of the preliminary allocation of assetsacquired and liabilities assumed and the preliminary goodwill and identifiableintangible asset amount recognized in connection with the Brotman Acquisition,as of April 14, 2009 (in thousands):

 
| Assets acquired                                              |   | $       | 53,302 |   |
|--------------------------------------------------------------|--------|---------|--------|--------|
| Liabilities assumed                                          |   | (78,119 | )      |
| Net liabilities assumed                                      |   | (24,817 | )      |
| Total purchase consideration                                 |   | (2,556  | )      |
| Purchase consideration in excess of net  liabilities assumed |   | (27,373 | )      |
| Identifiable intangible—trade name                      |   | 3,000   |   |
| Estimated goodwill                                           |   | $       | 24,373 |   |

 

The assets acquired include the relative percentage (38.83%) of thestep up in basis of the assets acquired to estimated fair value amounting to$10,547,000.

 

Goodwill from the Brotman Acquisition is primarily related to newcapacity for future growth, new geographic coverage, additional types ofhospital services and in-place workforce. Through the Brotman Acquisition, theCompany expanded into a new service market in the West Los Angeles, Californiaarea. As a stock purchase, the goodwill acquired in the Brotman Acquisition isnot deductible for income tax purposes. Brotman recorded income related todischarge of debt upon emergence from the Chapter 11 Bankruptcyreorganization.

 

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The following unaudited pro forma financial information for the threemonth period ended December 31, 2008 gives effect to the acquisition ofBrotman as if it had occurred on October 1, 2008. Such unaudited pro formainformation is based on historical financial information with respect to theacquisition and does not include synergies or operational or other changes thatmight have been effected by the Company. Significant proforma adjustmentsinclude increased depreciation related to fixed assets acquired (in thousands).

 
| ** **                                   | ** ** | **Three Months Ended********December 31, 2008** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                           | ** ** |
| Net revenue                                  |       | $                                                    | 111,413    |   |
| Net loss attributable to common stockholders |       | $                                                    | (4,400     | ) |
| Net loss per share:                          |       |                                                 |       |
| Basic                                        |       | $                                                    | (0.21      | ) |
| Diluted                                      |       | $                                                    | (0.21      | ) |

 

Since emergence from bankruptcy, Brotman has continued to incur lossesand experience liquidity issues. Management is currently implementingoperational improvements aimed at returning Brotman to profitability and isevaluating the refinancing of this debt. Prospect has limited ability to fundBrotman’s post acquisition operations (Note 6).

 

Management is currently assessing the Company’s ability to utilize thestate deferred tax assets, mainly comprised of California net operating losscarryforwards, acquired through the Brotman acquisition. This assessment has notyet been finalized.

 

**8. SegmentInformation**

 

ASC 815 provides disclosure guidelines for segments of a company basedon a management approach to defining reporting segments.

 

The Company’s operations are organized into three reporting segments: (i) HospitalServices—which is comprised of Alta and Brotman reporting units, owns andoperates five community-based hospitals—Los Angeles Community Hospital,Hollywood Community Hospital, Norwalk Community Hospital, Van Nuys CommunityHospital and Brotman Medical Center; (ii) Medical Group—which is comprisedof Prospect and ProMed reporting units, provides management services toaffiliated physician organizations that operate as independent physicianassociations; and (iii) Corporate. Corporate represents expenses incurredin Prospect Medical Holdings, Inc. (the “Parent Entity”), which were notallocated to the other reporting segments.

 

The accounting policies of the reporting segments are the same as thosedescribed in the summary of significant accounting policies (see Note 2).The Company evaluates financial performance and allocates resources primarilybased on earnings from continuing operations before interest expense, interestincome, income taxes, depreciation and amortization, as well as income or lossfrom operations before income taxes, excluding infrequent or unusual items.

 

The reporting segments are strategic business units that offerdifferent services within the healthcare industry. Business in each reportingsegment is conducted by one or more direct or indirect wholly-ownedsubsidiaries of the Company and certain affiliated physician organizationscontrolled through assignable option agreements and management servicesagreements.

 

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The following table summarizes certain information for each of thereporting segments regularly provided to and reviewed by the chief operatingdecision maker (in thousands):

 
| ** **                                                     | ** ** | **As of and for the Quarter Ended December 31,  2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital********Services**                                | ** ** | **Medical********Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues  from external customers                              |       | $                                                           | 69,412     |   | $ | 46,762 |   | $ | — |   | $ | — |   | $ | 116,174 |   |
| Intersegment  revenues                                         |       | —                                                      |       | — |   | — |   | (78 | ) | (78 | ) |
| Total  revenues                                                |       | 69,412                                                      |       | 46,762 |   | — |   | (78 | ) | 116,096 |   |
| Operating  income (loss)                                       |       | 12,581                                                      |       | 2,749 |   | (3,503 | ) | — |   | 11,827 |   |
| Investment  income                                             |       | —                                                      |       | (29 | ) | (106 | ) | 106 |   | (29 | ) |
| Interest  expense and amortization of deferred financing costs |       | 1,198                                                       |       | — |   | 5,797 |   | (106 | ) | 6,889 |   |
| Income  (loss) before income taxes                             |       | $                                                           | 11,383     |   | $ | 2,778 |   | $ | (9,194 | ) | $ | — |   | $ | 4,967 |   |
| Identifiable  segment assets                                   |       | $                                                           | 273,382    |   | $ | 96,897 |   | $ | 10,580 |   | $ | — |   | $ | 380,859 |   |
| Segment  capital expenditures, net of dispositions             |       | $                                                           | 427        |   | $ | 48 |   | $ | 6 |   | $ | — |   | $ | 481 |   |
| Segment  goodwill                                              |       | $                                                           | 130,911    |   | $ | 22,339 |   | $ | — |   | $ | — |   | $ | 153,250 |   |

 
| ** **                                                     | ** ** | **As of and for the Quarter Ended December 31,  2008** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital********Services**                                | ** ** | **Medical  Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues  from external customers                              |       | $                                                           | 35,323     |   | $ | 48,131 |   | $ | — |   | $ | — |   | $ | 83,454 |   |
| Intersegment  revenues                                         |       | —                                                      |       | — |   | — |   | — |   | — |   |
| Total  revenues                                                |       | 35,323                                                      |       | 48,131 |   | — |   | — |   | 83,454 |   |
| Operating  income (loss)                                       |       | 9,118                                                       |       | 2,805 |   | (2,025 | ) | — |   | 9,898 |   |
| Investment  income                                             |       | —                                                      |       | (26 | ) | (22 | ) | — |   | (48 | ) |
| Interest  expense and amortization of deferred financing costs |       | 42                                                          |       | — |   | 6,096 |   | — |   | 6,138 |   |
| Loss  on interest rate swap arrangements                       |       | —                                                      |       | — |   | 9,668 |   | — |   | 9,668 |   |
| Income  (loss) before income taxes                             |       | $                                                           | 9,076      |   | $ | 2,831 |   | $ | (17,767 | ) | $ | — |   | $ | (5,860 | ) |
| Identifiable  segment assets                                   |       | $                                                           | 196,561    |   | $ | 159,990 |   | $ | (61,997 | ) | $ | — |   | $ | 294,554 |   |
| Segment  capital expenditures, net of dispositions             |       | $                                                           | 376        |   | $ | 40 |   | $ | — |   | $ | — |   | $ | 416 |   |
| Segment  goodwill                                              |       | $                                                           | 106,539    |   | $ | 22,339 |   | $ | — |   | $ | — |   | $ | 128,878 |   |

 

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(1)           Prospect Medical Holdings, Inc.files consolidated tax returns and allocates costs for shared services andcorporate overhead to each of the reporting segments. With the exception ofBrotman Acquisition, all acquisition-related debt, including those related tothe Medical Group and Hospital Services segment, is recorded at the Parententity level. As such, the Company does not allocate interest expense, and gainor loss on interest rate swaps to each of the reporting segments.

 

(2)           Prospect Medical Group(which serves as a holding company for the other affiliated physicianorganizations) files consolidated tax returns.

 

(3)           Certain prior year amountshave been reclassified to conform to fiscal 2010 presentation.

 

(4)           Brotman amountshave been included after April 14, 2009; as such are not included for thequarter ended December 31, 2008.

 

**9. IncomeTaxes**

 

The Company recorded a tax provision (benefit) ofapproximately $2.5 million and $(2.4) million for the three months ended December 31,2009 and 2008, respectively, with effective tax rates of 50.4% and 41.0%,respectively. The higher effective tax rate in the fiscal 2010 period wasprimarily due to not recognizing the tax benefit from Brotman’s loss forfederal tax purposes.

 

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As part of the Brotman acquisition, management ofthe Company adopted ASC 740-10, accounting for uncertain tax positions, forBrotman and determined that no material unrecognized tax benefits exist as of December 31,2009.  Since its inception in 2005, Brotmanhas generated, and still maintains substantial net operating loss carryfowards whichare open for examination by taxing authorities.

 

**10. FairValue of Financial Investments**

 

Effective April 1, 2009, the Company adopted ASC 825-10(previously issued as FASB Staff Position FAS 107-1 and APB 28-1*, “Disclosures About Fair Value of FinancialInstruments”*). This Statement requires that the fair value offinancial instruments be disclosed in the body or notes of an entity’sfinancial statements in both interim and annual periods. It also requires thedisclosure of methods and assumptions used to estimate fair values. It does notrequire comparative disclosures for periods preceding adoption. The fair valuesof the Company’s current assets and current liabilities approximate theirreported carrying amounts. The carrying values and the fair values ofnon-current financial assets and liabilities, that qualify as financialinstruments under ASC 825-10-50 (previously issued as FAS No. 107, “*Disclosures about Fair Value of Financial Instruments*,”)were as follows (in thousands).

 
| ** **                | ** ** | **At December 31, 2009** | ** ** |
|---------------------------|------------|-------------------------------|------------|
| ** **                | ** ** | **Carrying  Amount**          | ** ** | **Fair Value** | ** ** |
| **Assets:**               |       |                          |       |   |   |
| Long-term note receivable |       | $                             | 343        |   | $ | 324 |   |
| **Liabilities:**          |       |                          |       |   |   |
| Long-term debt            |       | $                             | 172,594    |   | $ | 191,675 |   |

 

The fair value of the notes receivable, which was received as part ofthe consideration for the sale of three medical clinics in April 2004, wasestimated based on expected future payments discounted at risk-adjusted rates.The fair value of the Company’s long-term debt was determined based on quotedmarket prices with respect to Prospect’s Notes and based on expected futurepayments discounted at risk-adjusted rates of 10.0% with respect to Brotman’sdebt.

 

The Company adopted ASC 820-10, (previously issued as SFAS No. 157*“Fair Value Measurements”*) for financial assets and liabilities on October 1,2008 and adopted the provisions for non-financial assets and liabilities on October 1,2009. ASC 820-10 defines fair value, establishes guidelines for measuring fairvalue and expands disclosure about fair value measurements.  It doesnot create or modify any current GAAP requirements to apply fair valueaccounting.  However, it provides a single definition for fair valuethat is to be applied consistently for all prior accounting pronouncements.  Theadoption of this guidance did not have a material impact on the Company’sfinancial position or results of operations.  ASC 820-10 establishes a fair value hierarchythat prioritizes the inputs to valuation techniques used to measure fair value.The three levels of the fair value hierarchy under ASC 820-10 are describedbelow:

 

·      Level 1—Unadjustedquoted prices in active markets that are accessible at the measurement date foridentical, unrestricted assets or liabilities;

 

·      Level 2—Quoted pricesin markets that are not active, or inputs that are observable, either directlyor indirectly, for substantially the full term of the asset or liability; and

 

·      Level 3—Prices orvaluation techniques that require inputs that are both significant to the fairvalue measurement and unobservable (supported by little or no market activity).

 

*Financial Items measured at Fair Value on a Recurring Basis*

 

The following table sets forth the Company’s financial assets andliabilities measured at fair value on a recurring basis and where they are classifiedwithin the hierarchy as of December 31, 2009 (in thousands):

 
| ** **                                            | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|-------------------------------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
| **Restricted Assets:**                                |       |      |       |             |       |             |       |             |       |
| Restricted Investments—money market mutual funds |       | $         | 490        |             | $          | 490              |       | $                | —     |   | $ | — |   |
|                                                       |            |           |            |                  |            |                  |            |                  |            |  |  |  |  |

 

The Company’s investments are classified within Level 1 of thefair value hierarchy because they are valued using quoted market prices. Theinvestment instruments that are valued based on quoted market prices in activemarkets are primarily restricted certificates of deposit.

 

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*NonfinancialItems Measured at Fair Value on a Nonrecurring Basis*

 

Nonfinancialassets such as goodwill and identifiable intangible assets are measured at fairvalue when there is an indicator of impairment and recorded at fair value onlywhen impairment is recognized. No impairment charges of goodwill and intangibleassets were recorded for the three months ended December 31, 2009. SeeNote 7 for additional information about goodwill and intangible assets.

 

**11. Recent Accounting Pronouncements**

 

In December 2007, the FASB issued guidance on ASC 810, “*Noncontrolling Interests in Consolidated FinancialStatements—an Amendment of ARB No. 51*”, previously known asSFAS No. 160. ASC 810 establishes accounting and reporting standards forthe noncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary. Minorityinterests will be re characterized as non controlling interests and will bereported as a component of equity separate from the parent’s equity, andpurchases or sales of equity interests that do not result in a change incontrol will be accounted for as equity transactions. In addition, net incomeattributable to the non controlling interest will be included in consolidatednet income on the face of the income statement and upon a loss of control, theinterest sold, as well as any interest retained, will be recorded at fair valuewith any gain or loss recognized in earnings. This standard is effectivefor fiscal years, and interim periods within those fiscal years, beginning onor after December 15, 2008. It requires retroactive adoption of thepresentation and expanded disclosure requirements for existing noncontrollinginterests. All other requirements of the standard shall be appliedprospectively. The Company adopted this standard effective October 1,2009. The adoptiondid not have a material impact on the Company’s condensed consolidatedfinancial statements.

 

In December 2007,the FASB updated guidance on ASC 805, “*Business Combinations*”,previously known as SFAS No. 141(R). ASC 805 retains the fundamentalrequirements of guidance surrounding business combinations stating that theacquisition method of accounting be used for all business combinations and for anacquirer to be identified for each business combination. ASC 805 defines theacquirer as the entity that obtains control of one or more businesses in thebusiness combination and establishes the acquisition date as the date that theacquirer achieves control. ASC 805 requires an acquirer to recognize the assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree at the acquisition date, measured at their fair values as of thatdate, with limited exceptions specified in the statement. This statementapplies prospectively to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008. The Company adopted the pronouncementeffective October 1, 2009. The adoption did not have a material impact onthe Company’s condensed consolidated financial statements for prior periods;but the pronouncement will impact the accounting for any acquisitionssubsequent to that date.

 

In June 2009,the FASB issued guidance on ASC 810-10, “*Consolidation of VariableInterest Entities, an interpretation of ARB No. 51*”, previouslyknown as FIN No. 46, to revise the approach to determine when a variableinterest entity (“VIE”) should be consolidated. The new consolidation model forVIEs considers whether the Company has the power to direct the activities thatmost significantly impact the VIE’s economic performance and shares in thesignificant risks and rewards of the entity. The guidance on VIE’s requirescompanies to continually reassess VIEs to determine if consolidation isappropriate and provide additional disclosures. The guidance is effective forfiscal years beginning after November 15, 2009. The Company will adopt theguidance for interim and annual reporting periods beginning in the firstquarter of fiscal 2011and is currently assessing the potential impact thisguidance will have on its consolidated financial statements.

 

In June 2008, theFASB issued guidance contained in FASB ASC 260-10, previously known FASB StaffPosition No. EITF 03-6-1. Under the guidance, unvested share-based paymentawards that contain non-forfeitable rights to dividends or dividend equivalentsare participating securities and, therefore, are included in computing earningsper share (“EPS”) pursuant to the two-class method. The two-class methoddetermines earnings per share for each class of common stock and participatingsecurities according to dividends or dividend equivalents and their respectiveparticipation rights in undistributed earnings. The Company adopted theguidance effective October 1, 2009.  The adoption of thisguidance did not impact net income attributable to the Company per common sharefor prior periods and is not expected to have an impact on future periods untilsuch time as the Company declares a regular quarterly dividend.

 

In August 2009, the FASB issued AccountingStandards Update No. 2009-05, “*FairValue Measurements and Disclosures (Topic 820)—MeasuringLiabilities at FairValue,”*which provides guidance on how to measure liabilities atfair value in circumstance in which a quoted price in an active market for theidentical liability is not available. This update is effective for the firstreporting period, including interim periods, beginning after issuance. TheCompany has no liabilities that are governed by this update but will apply itsprovisions in the future as applicable.

 

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**12.Litigation and Contingencies**

 

Many of the Company’s payerand provider contracts are complex in nature and may be subject to differinginterpretations regarding amounts due for the provision of medical services.Such differing interpretations may not come to light until a substantial periodof time has passed following contract implementation. Liabilities for claimsdisputes are recorded when the loss is probable and can be estimated. Anyadjustments to reserves are reflected in current operations.

 

The Company has separate commercial claims-madeinsurance policies for Alta and Brotman. The Alta policy covers malpracticeclaims in excess of $1,000,000 per claim retention, with a $10,000,000 annualaggregate. The General Liability coverage is occurrence coverage with$1,000,000 per occurrence retention.  Thelimit is part of the $10,000,000 annual aggregate.  Brotman has a primary limit of $1,000,000 perclaim and $3,000,000 aggregate for malpractice claims in excess of a $100,000per claim retention. The General Liability coverage is occurrence coverage witha limit of $1,000,000 per occurrence and $3,000,000 aggregate in excess of a$100,000 retention.  There is also a$9,000,000 aggregate Excess policy which is excess of the primary malpracticeand general liability coverage. Total actuarial IBNR reserve balance of approximately$2,821,000 was made for estimated malpractice liability at December 31, 2009.These estimates may change in the future and such changes may be material.

 

Thecollective bargaining agreement entered into between Hollywood Community Hospital, which isone of the hospitals under the consolidated group of Alta Hospitals System, LLC,and Service Employees International Union (“SEIU”),covers a small group of Hollywood Community Hospital’s employees and will expire on May 9, 2011. The collective bargaining agreements entered intobetween Brotman and the California Nurses Association (“CNA”) and Brotman andthe SEIU both expire on February 28, 2010. We currently do notanticipate that any changes in these agreements will have a material adverseeffect on results of our Hospital Services operations in fiscal 2010.

 

The Company is in the process of finalizing certainpost-closing matters related to the 2007 ProMed acquisition, including closingbalance sheet reconciliations, escrow reconciliations and other matters. TheCompany has recorded estimated settlement amounts relating to such matters inthe accompanying unaudited condensed consolidated financial statements.

 

The Company is subject to avariety of claims and suits that arise from time to time in the ordinary courseof its business, acquisition, or other transactions. While management currentlybelieves that resolving all of these matters, individually or in aggregate,will not have a material adverse impact on the Company’s financial position orits results of operations, the litigation and other claims that the Companyfaces are subject to inherent uncertainties and management’s view of thesematters may change in the future. Should an unfavorable final outcome occur,there exists the possibility of a materially adverse impact on the Company’sfinancial position, results of operations and cash flows for the period inwhich the effect becomes probable and reasonably estimable.

 

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**13. Condensed consolidating financial statements ofProspect Medical Holding, Inc. and subsidiaries as of December 31,2009 and September 30, 2009 and for the three months ended December 31,2009**

 

On July 29, 2009, the Company closed the offering of$160 million in 12.75% senior secured notes due 2014 (the “Notes”) at anissue price of 92.335%, and entered into a three-year $15 millionrevolving credit facility which was undrawn at the closing. The Notes and therevolving senior credit facility are jointly and severally guaranteed on asenior secured basis by all of the Company’s restricted subsidiaries (the “Guarantors”),other than Brotman, Nuestra and certain immaterial subsidiaries. The Notes aresecured pari passu with the new revolving credit facility on a first prioritybasis by liens on substantially all of the Company’s assets and assets of thesubsidiary guarantors (other than accounts receivable and proceeds therefrom)including all mortgages on the Company and its subsidiary guarantors’ hospitalproperties (but excluding a pledge of, or mortgage on, the stock, properties orother assets of Brotman, AMVI/Prospect Health Network and certain immaterialsubsidiaries). The lenders under the revolving credit facility have a firstpriority lien on certain of the accounts receivable of the Company and thesubsidiary guarantors and proceeds therefrom, while the holders of the Noteshave a second priority lien on such collateral (see Note 6).

 

The Company conducts all of its business through and derives virtuallyall of its income from its subsidiaries. Therefore, the Company’s ability tomake required payments with respect to its indebtedness (including the Notes)and other obligations depends on the financial results and condition of itssubsidiaries and its ability to receive funds from its subsidiaries.

 

Pursuant to Rule 3-10 of Regulation S-X, the followingsummarized consolidating information is provided for the Company (the “Parent”),the Guarantors, and the Company’s non-Guarantor subsidiaries with respect tothe Notes as of September 30, 2009 and as of and for the three monthsended December 31, 2009.  TheCondensed Consolidating Statements of Operations and Cash Flows for the threemonths ended December 31, 2008 have not been included, as the non-guarantorsubsidiaries for the comparative period were minor. This summarized financialinformation has been prepared from the books and records maintained by theCompany, the Guarantors and the non-Guarantor subsidiaries. The summarizedfinancial information may not necessarily be indicative of the results ofoperations or financial position had the Guarantors or non-Guarantorsubsidiaries operated as independent entities. In addition, intercompanyactivities between subsidiaries and the Parent are presented within operatingactivities on the unaudited condensed consolidating statement of cash flows.

 

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Unaudited Condensed consolidating financial statements for the Companyand its subsidiaries, including the Parent only, the combined GuarantorSubsidiaries and the combined Non-Guarantor Subsidiaries are as follows:

 

**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As of December 31,2009**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                             | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined Non-  Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------|------------|
| **ASSETS**                                                                             |       |                |       |                                  |       |                                       |       |            |       |             |       |
| **Current assets:**                                                                    |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Cash and cash equivalents                                                              |       | $                   | (975       | )                                     | $          | 44,124                                     |       | $               | (760       | )                | $          | — |   | $ | 42,389 |   |
| Restricted cash                                                                        |       | —              |       | —                                |       | 1,983                                      |       | —          |       | 1,983            |       |
| Investments, primarily restricted certificates of  deposit                             |       | —              |       | 634                                   |       | —                                     |       | —          |       | 634              |       |
| Patient accounts receivable, net                                                       |       | —              |       | 21,651                                |       | 20,693                                     |       | —          |       | 42,344           |       |
| Government program receivables                                                         |       | —              |       | 2,943                                 |       | —                                     |       | —          |       | 2,943            |       |
| Risk pool receivables                                                                  |       | —              |       | 120                                   |       | —                                     |       | —          |       | 120              |       |
| Other receivables                                                                      |       | 8                   |       | 1,553                                 |       | —                                     |       | —          |       | 1,561            |       |
| Third-party settlements                                                                |       | —              |       | (63                                   | )          | 442                                        |       | —          |       | 379              |       |
| Notes receivable, current portion                                                      |       | —              |       | 57                                    |       | —                                     |       | —          |       | 57               |       |
| Deferred income taxes, net                                                             |       | 4,323               |       | 2,321                                 |       | —                                     |       | —          |       | 6,644            |       |
| Inventories                                                                            |       | —              |       | 1,548                                 |       | 2,603                                      |       | —          |       | 4,151            |       |
| Prepaid expenses and other current assets                                              |       | 554                 |       | 3,291                                 |       | 2,939                                      |       | —          |       | 6,784            |       |
| Intercompany accounts                                                                  |       | 86,465              |       | (112,012                              | )          | 25,465                                     |       | 82              |       | —           |       |
| **Total current assets**                                                               | ** ** | **90,375**          | ** ** | **(33,833**                           | **)**      | **53,365**                                 | ** ** | **82**          | ** ** | **109,989**      | ** ** |
| **Property, improvements and  equipment:**                                             |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Land and land improvements                                                             |       | —              |       | 27,604                                |       | 3,424                                      |       | —          |       | 31,028           |       |
| Buildings                                                                              |       | —              |       | 22,619                                |       | 1,301                                      |       | —          |       | 23,920           |       |
| Leasehold improvements                                                                 |       | 5                   |       | 2,008                                 |       | 19                                         |       | —          |       | 2,032            |       |
| Equipment                                                                              |       | 137                 |       | 12,997                                |       | 7,796                                      |       | —          |       | 20,930           |       |
| Furniture and fixtures                                                                 |       | 21                  |       | 870                                   |       | —                                     |       | —          |       | 891              |       |
|                                                                                   | ** ** | **163**             | ** ** | **66,098**                            | ** ** | **12,540**                                 | ** ** | **—**      | ** ** | **78,801**       | ** ** |
| Less accumulated depreciation and amortization                                         |       | (143                | )          | (11,126                               | )          | (3,666                                     | )          | —          |       | (14,935          | )          |
| **Total property, improvement and  equipment, net**                                    | ** ** | **20**              | ** ** | **54,972**                            | ** ** | **8,874**                                  | ** ** | **—**      | ** ** | **63,866**       | ** ** |
| Notes receivable, long-term portion                                                    |       | —              |       | 343                                   |       | —                                     |       | —          |       | 343              |       |
| Deposits and other assets                                                              |       | 6                   |       | 278                                   |       | 17                                         |       | —          |       | 301              |       |
| Deferred financing costs, net                                                          |       | 6,644               |       | —                                |       | 1,141                                      |       | —          |       | 7,785            |       |
| Goodwill                                                                               |       | —              |       | 153,250                               |       | —                                     |       | —          |       | 153,250          |       |
| Other intangible assets, net                                                           |       | —              |       | 45,325                                |       | —                                     |       | —          |       | 45,325           |       |
| **Total Assets**                                                                       | ** ** | **$**               | **97,045** | ** **                            | **$**      | **220,335**                                | ** ** | **$**           | **63,397** | ** **       | **$**      | **82** | ** ** | **$** | **380,859** | ** ** |
| **LIABILITIES &  SHAREHOLDERS’ EQUITY**                                  |       |                |       |                                  |       |                                       |       |            |       |             |       |
| **Current liabilities:**                                                               |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Accrued medical claims and other healthcare costs  payable                             |       | $                   | —     |                                  | $          | 15,496                                     |       | $               | 288        |             | $          | — |   | $ | 15,784 |   |
| Accounts payable and other accrued liabilities                                         |       | 11,638              |       | 10,446                                |       | 12,599                                     |       | —          |       | 34,683           |       |
| Accrued salaries, wages and benefits                                                   |       | 2,794               |       | 10,966                                |       | 8,446                                      |       | —          |       | 22,206           |       |
| Due to government payer                                                                |       | —              |       | —                                |       | 13,834                                     |       | —          |       | 13,834           |       |
| Income taxes payable, net                                                              |       | (232                | )          | 670                                   |       | (57                                        | )          | —          |       | 381              |       |
| Current portion of capital leases                                                      |       | —              |       | 439                                   |       | 397                                        |       | —          |       | 836              |       |
| Current portion of long-term debt                                                      |       | —              |       | —                                |       | 5,543                                      |       | —          |       | 5,543            |       |
| Other current liabilities                                                              |       | —              |       | 954                                   |       | —                                     |       | —          |       | 954              |       |
| **Total current liabilities**                                                          | ** ** | **14,200**          | ** ** | **38,971**                            | ** ** | **41,050**                                 | ** ** | **—**      | ** ** | **94,221**       | ** ** |
| Long-term debt, net of current portion                                                 |       | 148,439             |       | —                                |       | 24,155                                     |       | —          |       | 172,594          |       |
| Deferred income taxes                                                                  |       | 8,911               |       | 21,064                                |       | —                                     |       | —          |       | 29,975           |       |
| Malpractice reserve                                                                    |       | —              |       | 881                                   |       | 1,940                                      |       | —          |       | 2,821            |       |
| Capital leases, net of current portion                                                 |       | —              |       | 719                                   |       | 237                                        |       | —          |       | 956              |       |
| Other long-term liabilities                                                            |       | 79                  |       | 87                                    |       | —                                     |       | —          |       | 166              |       |
| **Total liabilities**                                                                  | ** ** | **171,629**         | ** ** | **61,722**                            | ** ** | **67,382**                                 | ** ** | **—**      | ** ** | **300,733**      | ** ** |
| **Shareholders’ equity (deficit):**                                               |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Prospect Medical Holdings, Inc.’s Shareholders’  equity                 |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Common stock                                                                           |       | 208                 |       | (53                                   | )          | (114                                       | )          | 167             |       | 208              |       |
| Additional paid-in-capital                                                             |       | 95,413              |       | 256                                   |       | —                                     |       | —          |       | 95,669           |       |
| Accumulated deficit                                                                    |       | (170,205            | )          | 158,410                               |       | (3,871                                     | )          | 222             |       | (15,444          | )          |
| Total Prospect Medical  Holdings, Inc.’s Shareholders’ equity (deficit) | ** ** | **(74,584**         | **)**      | **158,613**                           | ** ** | **(3,985**                                 | **)**      | **389**         | ** ** | **80,433**       | ** ** |
| Non controlling interest                                                               |       | —              |       | —                                |       | —                                     |       | (307            | )          | (307             | )          |
| **Total Shareholders’ equity  (deficit)**                                         | ** ** | **(74,584**         | **)**      | **158,613**                           | ** ** | **(3,985**                                 | **)**      | **82**          | ** ** | **80,126**       | ** ** |
| **Total liabilities and Shareholders’  equity**                                   | ** ** | **$**               | **97,045** | ** **                            | **$**      | **220,335**                                | ** ** | **$**           | **63,397** | ** **       | **$**      | **82** | ** ** | **$** | **380,859** | ** ** |

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As of September 30,2009**

*(inthousands)*

 
| ** **                                                                             | ** ** | **Parent  Company** | ** **  | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined Non-  Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------|-------------|---------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------|------------|
| **ASSETS**                                                                             |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Current assets:                                                                        |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Cash and cash  equivalents                                                             |       | $                   | (514        | )                                     | $          | 36,995                                     |       | $               | 1,287      |             | $          | — |   | $ | 37,768 |   |
| Restricted cash                                                                        |       | —              |        | —                                |       | 1,395                                      |       | —          |       | 1,395            |       |
| Investments, primarily  restricted certificates of deposit                             |       | —              |        | 665                                   |       | —                                     |       | —          |       | 665              |       |
| Patient accounts  receivable, net                                                      |       | —              |        | 19,543                                |       | 17,263                                     |       | —          |       | 36,806           |       |
| Government program  receivables                                                        |       | —              |        | 4,852                                 |       | —                                     |       | —          |       | 4,852            |       |
| Other receivables                                                                      |       | 8                   |        | 1,647                                 |       | —                                     |       | —          |       | $                | 1,655      |   |
| Third-party settlements                                                                |       | —              |        | 790                                   |       | 785                                        |       | —          |       | 1,575            |       |
| Notes receivable,  current portion                                                     |       | —              |        | 56                                    |       | —                                     |       | —          |       | 56               |       |
| Refundable income taxes,  net                                                          |       | 1,545               |        | 13                                    |       | —                                     |       | —          |       | 1,558            |       |
| Deferred income taxes,  net                                                            |       | 4,323               |        | 2,321                                 |       | —                                     |       | —          |       | 6,644            |       |
| Inventories                                                                            |       | —              |        | 1,477                                 |       | 2,660                                      |       | —          |       | 4,137            |       |
| Prepaid expenses and  other current assets                                             |       | 72                  |        | 2,491                                 |       | 2,817                                      |       | —          |       | 5,380            |       |
| Intercompany accounts                                                                  |       | 90,190              |        | (119,113                              | )          | 28,841                                     |       | 82              |       | —           |       |
| **Total current assets**                                                               | ** ** | **95,624**          | ** **  | **(48,263**                           | **)**      | **55,048**                                 | ** ** | **82**          | ** ** | **102,491**      | ** ** |
| **Property, improvements and  equipment:**                                             |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Land and land  improvements                                                            |       | —              |        | 27,604                                |       | 3,424                                      |       | —          |       | 31,028           |       |
| Buildings                                                                              |       | —              |        | 22,400                                |       | 1,265                                      |       | —          |       | 23,665           |       |
| Leasehold improvements                                                                 |       | 5                   |        | 2,024                                 |       | —                                     |       | —          |       | 2,029            |       |
| Equipment                                                                              |       | 131                 |        | 12,396                                |       | 7,728                                      |       | —          |       | 20,255           |       |
| Furniture and fixtures                                                                 |       | 21                  |        | 892                                   |       | —                                     |       | —          |       | 913              |       |
|                                                                                   | ** ** | **157**             | ** **  | **65,316**                            | ** ** | **12,417**                                 | ** ** | **—**      | ** ** | **77,890**       | ** ** |
| Less accumulated  depreciation and amortization                                        |       | (138                | )           | (10,591                               | )          | (3,437                                     | )          | —          |       | (14,166          | )          |
| **Total property, improvement and  equipment, net**                                    | ** ** | **19**              | ** **  | **54,725**                            | ** ** | **8,980**                                  | ** ** | **—**      | ** ** | **63,724**       | ** ** |
| Notes receivable,  long-term portion                                                   |       | —              |        | 357                                   |       | —                                     |       | —          |       | 357              |       |
| Deposits and other  assets                                                             |       | 6                   |        | 358                                   |       | 330                                        |       | —          |       | 694              |       |
| Deferred financing  costs, net                                                         |       | 6,878               |        | —                                |       | 1,327                                      |       | —          |       | 8,205            |       |
| Deferred income taxes,  net                                                            |       | (643                | )           | 643                                   |       | —                                     |       | —          |       | —           |       |
| Goodwill                                                                               |       | —              |        | 153,250                               |       | —                                     |       | —          |       | 153,250          |       |
| Other intangible assets,  net                                                          |       | —              |        | 46,425                                |       | —                                     |       | —          |       | 46,425           |       |
| **Total Assets**                                                                       | ** ** | **$**               | **101,884** | ** **                            | **$**      | **207,495**                                | ** ** | **$**           | **65,685** | ** **       | **$**      | **82** | ** ** | **$** | **375,146** | ** ** |
| **LIABILITIES &  SHAREHOLDERS’ EQUITY**                                  |       |                |        |                                  |       |                                       |       |            |       |             |       |
| **Current liabilities:**                                                               |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Accrued medical claims  and other healthcare costs payable                             |       | $                   | —      |                                  | $          | 16,613                                     |       | $               | 211        |             | $          | — |   | $ | 16,824 |   |
| Accounts payable and  other accrued liabilities                                        |       | 7,102               |        | 10,548                                |       | 14,123                                     |       | —          |       | 31,773           |       |
| Accrued salaries, wages  and benefits                                                  |       | 4,151               |        | 11,543                                |       | 9,209                                      |       | —          |       | 24,903           |       |
| Due to government payer                                                                |       | —              |        | —                                |       | 13,834                                     |       | —          |       | 13,834           |       |
| Income taxes payable,  net                                                             |       | (1,029              | )           | 1,086                                 |       | (57                                        | )          | —          |       | —           |       |
| Current portion of  capital leases                                                     |       | —              |        | 383                                   |       | 437                                        |       | —          |       | 820              |       |
| Current portion of  long-term debt                                                     |       | —              |        | —                                |       | 3,805                                      |       | —          |       | 3,805            |       |
| Other current  liabilities                                                             |       | 13                  |        | 616                                   |       | —                                     |       | —          |       | 629              |       |
| **Total current liabilities**                                                          | ** ** | **10,237**          | ** **  | **40,789**                            | ** ** | **41,562**                                 | ** ** | **—**      | ** ** | **92,588**       | ** ** |
| Long-term debt, net of  current portion                                                |       | 148,020             |        | —                                |       | 24,519                                     |       | —          |       | 172,539          |       |
| Deferred income taxes                                                                  |       | 8,269               |        | 21,706                                |       | —                                     |       | —          |       | 29,975           |       |
| Malpractice reserve                                                                    |       | —              |        | 914                                   |       | 1,910                                      |       | —          |       | 2,824            |       |
| Capital leases, net of  current portion                                                |       | —              |        | 299                                   |       | 270                                        |       | —          |       | 569              |       |
| Other long-term  liabilities                                                           |       | 78                  |        | 84                                    |       | —                                     |       | —          |       | 162              |       |
| **Total liabilities**                                                                  | ** ** | **166,604**         | ** **  | **63,792**                            | ** ** | **68,261**                                 | ** ** | **—**      | ** ** | **298,657**      | ** ** |
| **Shareholders’ equity (deficit):**                                               |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Prospect Medical Holdings, Inc.’s Shareholders’  equity                 |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Common stock                                                                           |       | 206                 |        | (53                                   | )          | (114                                       | )          | 167             |       | 206              |       |
| Additional paid-in-capital                                                             |       | 94,242              |        | 256                                   |       | —                                     |       | —          |       | 94,498           |       |
| Accumulated deficit                                                                    |       | (159,168            | )           | 143,500                               |       | (2,462                                     | )          | (173            | )          | (18,303          | )          |
| Total Prospect Medical  Holdings, Inc.’s Shareholders’ equity (deficit) |       | (64,720             | )           | 143,703                               |       | (2,576                                     | )          | (6              | )          | 76,401           |       |
| Non controlling interest                                                               |       | —              |        | —                                |       | —                                     |       | 88              |       | 88               |       |
| **Total Shareholders’ equity  (deficit)**                                         | ** ** | **(64,720**         | **)**       | **143,703**                           | ** ** | **(2,576**                                 | **)**      | **(82**         | **)**      | **76,489**       | ** ** |
| **Total liabilities and Shareholders’  equity**                                   | ** ** | **$**               | **101,884** | ** **                            | **$**      | **207,495**                                | ** ** | **$**           | **65,685** | ** **       | **$**      | — | ** ** | **$** | **375,146** | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theThree Months Ended December 31, 2009**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                  | ** ** | **Parent  Company** | ** **  | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined Non-  Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------|-------------|---------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------|------------|
| **Revenues:**                                                               |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Net hospital services revenues                                              |       | $                   | —      |                                  | $          | 40,123                                     |       | $               | 32,264     |             | $          | (2,975 | ) | $ | 69,412 |   |
| Medical group revenues                                                      |       | —              |        | 46,131                                |       | 631                                        |       | (78             | )          | 46,684           |       |
| **Total revenues**                                                          |       | —              | ** **  | **86,254**                            | ** ** | **32,895**                                 | ** ** | **(3,053**      | **)**      | **116,096**      | ** ** |
| Operating expenses:                                                         |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Hospital operating expenses                                                 |       | —              |        | 22,948                                |       | 26,720                                     |       | —          |       | 49,668           |       |
| Medical group cost of revenues                                              |       | —              |        | 36,351                                |       | 494                                        |       | —          |       | 36,845           |       |
| General and administrative                                                  |       | 3,500               |        | 10,008                                |       | 5,673                                      |       | (3,053          | )          | 16,128           |       |
| Depreciation and amortization                                               |       | 4                   |        | 1,837                                 |       | 237                                        |       | —          |       | 2,078            |       |
| **Total operating expenses**                                                | ** ** | **3,504**           | ** **  | **71,144**                            | ** ** | **33,124**                                 | ** ** | **(3,053**      | **)**      | **104,719**      | ** ** |
| Operating income from unconsolidated joint venture                          |       | —              |        | 450                                   |       | —                                     |       | —          |       | 450              |       |
| Operating (loss) income                                                     |       | (3,504              | )           | 15,560                                |       | (229                                       | )          | —          |       | 11,827           |       |
| Other (income) expense:                                                     |       |                |        |                                  |       |                                       |       |            |       |             |       |
| Investment income                                                           |       | (106                | )           | (29                                   | )          | —                                     |       | 106             |       | (29              | )          |
| Interest expense and amortization deferred  financing cost                  |       | 5,797               |        | 17                                    |       | 1,181                                      |       | (106            | )          | 6,889            |       |
| **Total other (income) expense, net**                                       | ** ** | **5,691**           | ** **  | **(12**                               | **)**      | **1,181**                                  | ** ** | **—**      | ** ** | **6,860**        | ** ** |
| Income (loss) before income taxes                                           |       | (9,195              | )           | 15,572                                |       | (1,410                                     | )          | —          |       | 4,967            |       |
| Provision for income taxes                                                  |       | 1,842               |        | 661                                   |       | —                                     |       | —          |       | 2,503            |       |
| Net income (loss)                                                           | ** ** | **(11,037**         | **)**       | **14,911**                            | ** ** | **(1,410**                                 | **)**      | **—**      | ** ** | **2,464**        | ** ** |
| Income (loss) attributable to noncontrolling  interest                      |       | —              |        | —                                |       | —                                     |       | (395            | )          | (395             | )          |
| **Net income (loss) attributable to  Prospect Medical Holdings, Inc.** | ** ** | **$**               | **(11,037** | **)**                                 | **$**      | **14,911**                                 | ** ** | **$**           | **(1,410** | **)**            | **$**      | **395** | ** ** | **$** | **2,859** | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**For theThree Months ended December 31, 2009**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                 | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined Non-  Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------|------------|
| **Net (Loss) Income**                                      |       | $                   | (11,037    | )                                     | $          | 14,911                                     |       | $               | (1,410     | )                | $          | — |   | $ | 2,464 |   |
| **Operating activities:**                                  |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Depreciation and amortization                              |       | 4                   |       | 1,837                                 |       | 237                                        |       | —          |       | 2,078            |       |
| Amortization of deferred financing costs                   |       | 273                 |       | —                                |       | 186                                        |       | —          |       | 459              |       |
| Amortization of original Issue Discount                    |       | 419                 |       | —                                |       | —                                     |       | —          |       | 419              |       |
| Gain on interest rate swaps                                |       | —              |       | —                                |       | —                                     |       | —          |       | —           |       |
| Provision for bad debts                                    |       | —              |       | 2,178                                 |       | 4,792                                      |       | —          |       | 6,970            |       |
| Gain on sale of assets                                     |       | —              |       | (7                                    | )          | —                                     |       | —          |       | (7               | )          |
| Stock-based compensation                                   |       | 1,173               |       | —                                |       | —                                     |       | —          |       | 1,173            |       |
| Intercompany accounts                                      |       | 3,726               |       | (7,101                                | )          | 3,375                                      |       | —          |       | —           |       |
| **Changes in operating activities:**                       |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Risk pool receivables                                      |       | —              |       | (120                                  | )          | —                                     |       | —          |       | (120             | )          |
| Patient and other receivables                              |       | —              |       | (1,431                                | )          | (7,879                                     | )          | —          |       | (9,310           | )          |
| Prepaid expenses and other                                 |       | (483                | )          | (800                                  | )          | (121                                       | )          | —          |       | (1,404           | )          |
| Inventory                                                  |       | —              |       | (70                                   | )          | 56                                         |       | —          |       | (14              | )          |
| Refundable income taxes                                    |       | 1,545               |       | 13                                    |       | —                                     |       | —          |       | 1,558            |       |
| Deposits                                                   |       | —              |       | 81                                    |       | 312                                        |       | —          |       | 393              |       |
| Accrued medical claims and other healthcare costs  payable |       | —              |       | (1,118                                | )          | 78                                         |       | —          |       | (1,040           | )          |
| Accounts payable                                           |       | 3,166               |       | (370                                  | )          | (2,257                                     | )          | —          |       | 539              |       |
| Income taxes payable                                       |       | 798                 |       | (417                                  | )          | —                                     |       | —          |       | 381              |       |
| **Net cash provided by (used in)  operating activities**   | ** ** | **(416**            | **)**      | **7,586**                             | ** ** | **(2,631**                                 | **)**      | —          | ** ** | **4,539**        | ** ** |
| **Investing activities:**                                  |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Purchase of PP&E, net                                  |       | (6                  | )          | (399                                  | )          | (76                                        | )          | —          |       | (481             | )          |
| Decrease on note receivable                                |       | —              |       | 13                                    |       | —                                     |       | —          |       | 13               |       |
| Decrease in restricted certificates of deposit             |       | —              |       | 31                                    |       | —                                     |       | —          |       | 31               |       |
| **Net cash provided by (used in)  investing activities**   | ** ** | **(6**              | **)**      | **(355**                              | **)**      | **(76**                                    | **)**      | —          | ** ** | **(437**         | **)**      |
| **Financing activities**                                   |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Borrowings from long-term debt                             |       | —              |       | —                                |       | —                                     |       | —          |       | —           |       |
| Repayment of capital leases                                |       | —              |       | (102                                  | )          | (126                                       | )          | —          |       | (228             | )          |
| Repayment of long-term debt                                |       | —              |       | —                                |       | —                                     |       | —          |       | —           |       |
| Borrowings on line of credit                               |       | —              |       | —                                |       | 26,251                                     |       | —          |       | 26,251           |       |
| Repayments on line of credit                               |       | —              |       | —                                |       | (24,596                                    | )          | —          |       | (24,596          | )          |
| Repayment of Class 4 Note                             |       | —              |       | —                                |       | (281                                       | )          | —          |       | (281             | )          |
| Cash paid for deferred financing costs                     |       | (39                 | )          | —                                |       | —                                     |       | —          |       | (39              | )          |
| Change in restricted cash                                  |       | —              |       | —                                |       | (588                                       | )          | —          |       | (588             | )          |
| **Net cash provided by (used in)  financing activities**   | ** ** | **(39**             | **)**      | **(102**                              | **)**      | **660**                                    | ** ** | **—**      | ** ** | **519**          | ** ** |
| **Net increase (decrease) in cash  and cash equivalents**  |       | (461                | )          | 7,129                                 |       | (2,047                                     | )          | —          |       | 4,621            |       |
| **Cash and cash equivalents at  9/30/09**                  |       | (514                | )          | 36,995                                |       | 1,287                                      |       | —          |       | 37,768           |       |
| **Cash and cash equivalents at  12/31/09**                 |       | $                   | (975       | )                                     | $          | 44,124                                     |       | $               | (760       | )                | $          | — |   | $ | 42,389 |   |

 

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**14. Subsequent Event**

 

EffectiveDecember 15, 2009, Brotman initiated a Rights Offering (“Rights Offering”),whereby existing shareholders of Brotman could subscribe to purchase up to$5,500,000 of Brotman convertible subordinated promissory notes (the “BrotmanNotes”).  The Brotman Notes will be duethree years from the date of issuance, will bear interest at 15% per annum andwill be convertible at the option of the holder into shares of Brotman, at$3.34 per share.  Prospect exercised itsright to purchase a share of the Notes and, effective January 7, 2010,purchased $3,500,000 of such Notes.

 

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**Item 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**Forward-Looking Statements**

 

The following discussion of our financial condition and results ofoperations should be read in conjunction with the accompanying unauditedinterim condensed consolidated financial statements and the notes to thosestatements appearing elsewhere in this report and the audited consolidatedfinancial statements for the year ended September 30, 2009 appearing inour annual report on Form 10-K and subsequent filings with the Securitiesand Exchange Commission.

 

This discussion contains forward-looking statements that involve risks anduncertainties. These forward-looking statements are often accompanied by wordssuch as “believe,” “should,” “anticipate,” “plan,” “expect,” “potential,” “scheduled,”“estimate,” “intend,” “seek,” “goal,” “may” and similar expressions. Thesestatements include, without limitation, statements about our marketopportunity, our growth strategy, competition, expected activities and futureacquisitions and investments and the adequacy of our available cash resources.Investors are urged to read these statements carefully, and are cautioned thatmatters subject 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 believe that theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, performance, orachievements. Moreover, we do not assume any responsibility for the accuracyand completeness of such statements in the future, and we do not undertake toupdate or revise any forward-looking statements to reflect future events or newinformation.

 

Forward-looking statements involve known and unknown risks anduncertainties that may cause our actual results in future periods to differmaterially from those projected or contemplated in the forward-lookingstatements as a result of, but not limited to, the following factors:

 

·                  Receipt of reimbursementfrom third party providers and collections of accounts receivable fromuninsured patients;

·                  Growth of uninsured andunderinsured patients;

·                  Decreases in the number ofHealth Maintenance Organization (“HMO”) enrollees using our affiliatedindependent physician organizations (“IPA”) networks;

·                  Concentration of revenueswith a limited number of payers and HMOs;

·                  Risk-sharing arrangementsand volume and timing of healthcare claims;

·                  Healthcare costs;

·                  Our ability to maintain requiredworking capital;

·                  Our ability to acquireadvanced diagnostic and surgical equipment and information technology systems;

·                  Our ability to makeacquisitions and integrate the operations of acquired hospitals;

·                  Reliance on key executivemanagement and key physicians;

·                  Labor costs;

·                  Competition;

·                  Government regulation andchanges in the regulatory and healthcare policy environment;

·                  Economic trends generallyand local economic conditions in Southern California;

·                  Medical malpractice claimsand HMO bad-faith liability claims;

·                  Weather conditions, severityof annual flu seasons and other factors;

·                  Recurring losses at Brotmancould have a significant negative impact on our consolidated financial positionand our ability to refinance Brotman debt on favorable terms; and

·                  Certain risks more fullydescribed under the heading “Risk Factors” in our SEC filings.

 

Investors should also refer to our Form 10-K annual report filedwith the Securities and Exchange Commission on December 21, 2009 for adiscussion of risk factors. A copy of the Form 10-K annual report can befound on the internet at *www.prospectmedicalholdings.com*or through the SEC’s electronic data system called EDGAR at *www.sec.gov*. Given these risks anduncertainties, we can give no assurances that results projected in anyforward-looking statements will in fact occur and therefore caution investorsnot to place undue reliance on them.

 

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**Overview**

 

Prior to the acquisition of Alta and Brotman, our organization wasfocused solely on providing medical management systems and services toaffiliated medical organizations, primarily Independent Physician Associations.With the acquisition of Alta and Brotman, we now own and operate five hospitalsin Southern California and our operations are now organized into threereporting segments: Hospital Services, Medical Group and Corporate. TheHospital Services segment includes the results of operations and financialposition of Brotman beginning April 14, 2009.

 

**Hospital Services Segment**

 

The Hospital Servicessegment owns and operates five hospitals in Los Angeles County with a total ofapproximately 759 licensed beds served by 844 on-staff physicians at December 31,2009. Each of the community hospitals in Hollywood, Los Angeles, Norwalk andCulver City offers a comprehensive range of medical and surgical services,including inpatient, outpatient, skilled nursing and urgent care services. Thepsychiatric hospital in Van Nuys provides acute inpatient and outpatientpsychiatric services to patients admitted on a voluntary basis. Admittingphysicians are primarily practitioners in the local area. The hospitals havepayment arrangements with Medicare, Medi-Cal and other third-party payersincluding some commercial insurance carriers, HMOs and Preferred ProviderOrganizations (“PPOs”). The basis for such payments involving inpatient andoutpatient services rendered includes prospectively determined rates perdischarge and cost-reimbursed methodologies. The Alta hospitals are eligible toreceive additional Disproportionate Share Hospital Program (“DSH”) paymentadjustments from Medicare and Medi-Cal based on a prospective payment systemfor hospitals that serve large proportions of low-income patients. The Brotman hospital is eligible to receiveDSH payment adjustments from Medicare and supplemental Distressed Hospital Fund paymentsfrom the California Medical Assistance Commission (“CMAC”).

 

Operating revenue of our Hospital Services segment consists primarilyof payments for services rendered, including estimated retroactive adjustmentsunder reimbursement arrangements with third-party payers. In some cases,reimbursement is based on formulas and reimbursable amounts are not consideredfinal until cost reports are filed and audited or otherwise settled by thevarious programs. We accrue for amounts that we believe will ultimately be dueto or from Medicare and other third-party payers and report such amounts as netpatient revenues in the accompanying unaudited condensed consolidated financialstatements. We closely monitor our historical collection rates, as well aschanges in applicable laws, rules and regulations and contract terms, toassure that provisions are made using the most accurate information available.However, due to the complexities involved in these estimations, actual paymentsfrom payers may be materially different from the amounts we estimate andrecord. A summary of the payment arrangements with major third-party payersfollows:

 

*Medicare: *Medicare is a federalprogram that provides certain hospital and medical insurance benefits topersons aged 65 and over, some disabled persons with end-stage renal disease andcertain other beneficiary categories. Inpatient services rendered to Medicareprogram beneficiaries are paid at prospectively determined rates per discharge,according to a patient classification system based on clinical, diagnostic, andother factors. Outpatient services are paid based on a blend of prospectivelydetermined rates and cost-reimbursed methodologies. We are also reimbursed forvarious disproportionate share and Medicare bad debt components at tentativerates, with final settlement determined after submission of annual Medicarecost reports and audit thereof by the Medicare fiscal intermediary. Normalestimation differences between final settlements and amounts accrued inprevious years are reflected in net patient service revenue in the year offinal settlement.

 

*Medi-Cal: *Medi-Cal is a jointfederal-state funded healthcare benefit program that is administered by thestate of California to provide benefits to qualifying individuals who areunable to afford care. As such, Medi-Cal constitutes the version of the federalMedicaid program that is applicable to California residents. Inpatient servicesrendered to Medi-Cal program beneficiaries are paid at contracted per diemrates. The per diem rates are not subject to retrospective adjustment. Outpatientservices are paid based on prospectively determined rates per procedureprovided.

 

*ManagedCare: *We also receive payment fromcertain commercial insurance carriers, HMOs, and PPOs, though generally do notenter into contracts with these entities. The basis for payment under theseagreements includes our standard charges for services.

 

*Self-Pay: *Our hospitals provideservices to individuals that do not have any form of healthcare coverage. Suchpatients are evaluated, at the time of service or shortly thereafter, for theirability to pay based upon federal and state poverty guidelines, qualificationsfor Medi-Cal, as well as our local hospital’s indigent and charity care policy.

 

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Hospital revenues depend upon inpatient occupancy levels, the medicaland ancillary services and therapy programs ordered by physicians and providedto patients, the volume of outpatient procedures and the charges or negotiatedpayment rates for such services. Charges and reimbursement rates for inpatientroutine services vary depending on the type of services provided(e.g., medical/surgical, intensive care or behavioral health) and thegeographic location of the hospital. Inpatient occupancy levels fluctuate forvarious reasons, many of which are beyond our control. The percentage ofpatient service revenue attributable to outpatient services has generallyincreased in recent years, primarily as a result of advances in medicaltechnology that allow more services to be provided on an outpatient basis, aswell as increased pressure from Medicare, Medi-Cal and private insurers toreduce hospital stays and provide services, where possible, on a less expensiveoutpatient basis. We believe that our experience with respect to our increasedoutpatient levels mirrors the general trend occurring in the healthcareindustry and we are unable to predict the rate of growth and resulting impact onour future revenues.

 

Patients are generally not responsible for any difference betweencustomary hospital charges and amounts reimbursed for such services underMedicare, Medicaid, some private insurance plans, and managed care plans, butare responsible for services not covered by such plans, exclusions, deductiblesor co-insurance features of their coverage. The amount of such exclusions,deductibles and co-insurance has generally been increasing each year.Indications from recent federal and state legislation are that this trend willcontinue. Collection of amounts due from individuals is typically moredifficult than from governmental or business payers and increases in uninsuredand self-pay patients unfavorably impact the collectability of our patientaccounts, thereby increasing our provision for doubtful accounts and charitycare provided.

 

Operating expenses of our Hospital Services segment generally consistof salaries, benefits and other compensation paid to healthcare professionalsthat are employees of our hospitals, medical supplies, consultant andprofessional services, and provision for doubtful accounts.

 

General and administrative expenses of our Hospital Services segmentgenerally consists of salaries, benefits and other compensation for ourhospital administrative employees, insurance, rent, operating supplies, legal,accounting and marketing.

 

**Hospital Services Results of Operations**

 

The following table sets forth the results of operation for ourhospitals and is used in the discussion below for the three-month periods endedDecember 31, 2009 and 2008 (in thousands).

 
| ** **                                      | ** ** | **Three  Months Ended** | ** ** | **%**        | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|--------------|------------|
| ** **                                      | ** ** | **December 31,**   | ** ** | **Increase** | ** ** |
| ** **                                      | ** ** | **2009(5)**             | ** ** | **2008**     | ** ** | **(Decrease)** | ** ** |
| **Net Hospital Services revenues:**             |       |                    |       |         |       |   |   |
| Medicare                                        |       | $                       | 36,729     |         | $          | 16,858 |   | 117.9 | % |
| Medi-Cal                                        |       | 16,733                  |       | 16,114       |       | 3.8 | % |
| Managed care                                    |       | 11,672                  |       | 1,483        |       | 687.1 | % |
| Self pay                                        |       | 4,115                   |       | 507          |       | 711.6 | % |
| Other                                           |       | 163                     |       | 361          |       | (54.8 | )% |
| **Total Hospital Services revenues**            |       | 69,412                  |       | 35,323       |       | 96.5 | % |
| **Hospital operating expenses:**                |       |                    |       |         |       |   |   |
| Salaries, wages and benefits                    |       | 31,915                  |       | 15,894       |       | 100.8 | % |
| Other operating expenses                        |       | 4,212                   |       | 2,185        |       | 92.8 | % |
| Supplies expense                                |       | 5,859                   |       | 2,193        |       | 167.2 | % |
| Provision for doubtful accounts                 |       | 6,971                   |       | 1,493        |       | 366.9 | % |
| Lease and rental expense                        |       | 711                     |       | 381          |       | 86.6 | % |
| **Total Hospital Services operating  expenses** |       | 49,668                  |       | 22,146       |       | 124.3 | % |
| General and administrative expenses             |       | 5,958                   |       | 3,167        |       | 88.1 | % |
| Depreciation and amortization expense           |       | 1,205                   |       | 892          |       | 35.1 | % |
| Total non-medical expenses                      |       | 7,163                   |       | 4,059        |       | 76.5 | % |
| **Operating income**                            |       | $                       | 12,581     |         | $          | 9,118 |   | 38.0 | % |

 

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The following table sets forth selected operating items, expressed as apercentage of total net hospital services revenue:

 
| ** **                                      | ** ** | **Three Months Ended********December 31,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **2009(5)**                                     | ** ** | **2008** | ** ** |
| **Net Hospital Services revenues:**             |       |                                            |       |   |   |
| Medicare                                        |       | 52.9                                            | %          | 47.7 | % |
| Medi-Cal                                        |       | 24.1                                            | %          | 45.6 | % |
| Managed care                                    |       | 16.8                                            | %          | 4.2 | % |
| Self pay                                        |       | 6.0                                             | %          | 1.5 | % |
| Other                                           |       | 0.2                                             | %          | 1.0 | % |
| **Total Hospital Services revenues**            |       | 100.0                                           | %          | 100.0 | % |
| **Hospital Services operating  expenses:**      |       |                                            |       |   |   |
| Salaries, wages and benefits                    |       | 46.0                                            | %          | 45.0 | % |
| Other operating expenses                        |       | 6.1                                             | %          | 6.2 | % |
| Supplies expense                                |       | 8.5                                             | %          | 6.2 | % |
| Provision for doubtful accounts                 |       | 10.0                                            | %          | 4.2 | % |
| Lease and rental expense                        |       | 1.0                                             | %          | 1.1 | % |
| **Total Hospital Services operating  expenses** |       | 71.6                                            | %          | 62.7 | % |
| General and administrative expenses             |       | 8.6                                             | %          | 9.0 | % |
| Depreciation and amortization expense           |       | 1.7                                             | %          | 2.5 | % |
| Total non-medical expenses                      |       | 10.3                                            | %          | 11.5 | % |
| **Operating income**                            |       | 18.1                                            | %          | 25.8 | % |

 

The following table shows certain selected historical operatingstatistics for our hospitals as of and for the three-month periods ended December 31,2009 and 2008:

 
| ** **                                      | ** ** | **Three Months Ended  December 31,** | ** ** | **%********Increase** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2009 (5)**                              | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** |
| Net inpatient revenues (in thousands) (1)       |       | $                                         | 61,324     |                  | $          | 33,240 |   | 84.5 | % |
| Net outpatient revenues (in thousands) (1)      |       | $                                         | 7,925      |                  | $          | 1,722 |   | 360.2 | % |
| Other hospital services revenues (in thousands) |       | $                                         | 163        |                  | $          | 361 |   | (54.8 | )% |
| Number of hospitals at end of period            |       | 5                                         |       | 4                     |       | 25.0 | % |
| Licensed beds at end of the period              |       | 759                                       |       | 339                   |       | 123.9 | % |
| Average licensed beds                           |       | 759                                       |       | 339                   |       | 123.9 | % |
| Average available beds                          |       | 616                                       |       | 330                   |       | 86.7 | % |
| Admissions(2)                                   |       | 5,987                                     |       | 3,585                 |       | 67.0 | % |
| Adjusted patient admissions(3)                  |       | 6,701                                     |       | 3,771                 |       | 77.7 | % |
| Net inpatient revenue per admission             |       | $                                         | 10,243     |                  | $          | 9,272 |   | 10.5 | % |
| Patient days                                    |       | 38,048                                    |       | 23,467                |       | 62.1 | % |
| Adjusted patient days                           |       | 42,768                                    |       | 24,953                |       | 71.4 | % |
| Average length of patients’ stay (days)    |       | 6.4                                       |       | 5.8                   |       | 10.3 | % |
| Net inpatient revenue per patient day           |       | $                                         | 1,612      |                  | $          | 1,415 |   | 13.9 | % |
| Outpatient visits                               |       | 14,156                                    |       | 4,956                 |       | 185.6 | % |
| Net outpatient revenue per visit                |       | $                                         | 559        |                  | $          | 347 |   | 61.1 | % |
| Occupancy rate for licensed beds(4)             |       | 54.5                                      | %          | 75.2                  | %          | (27.5 | )% |
| Occupancy rate for available beds(4)            |       | 67.1                                      | %          | 77.3                  | %          | (13.2 | )% |

 

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(1)                                  Net inpatientrevenues and net outpatient revenues are components of net patient revenues.Net inpatient revenues for the three months ended December 31, 2009 and2008, include self-pay revenues of $1,925,000 and $482,000, respectively. Netoutpatient revenues for the three months ended December 31, 2009 and 2008include self-pay revenues of $2,190,000 and $25,000, respectively.

 

(2)                              Charity careadmissions represent 1.0% and 0.6% of total admissions for the three monthsended December 31, 2009 and 2008, respectively.  Based on the Company’s gross charge rate,revenues foregone under the charity policy, including indigent accounts wereapproximately $1,205,000 and $395,000 for the three months ended December 31,2009 and 2008, respectively.

 

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(3)                                  Adjustedpatient admissions are total admissions adjusted for outpatient volume.Adjusted admissions are computed by multiplying admissions (inpatient volume)by the sum of gross inpatient charges and gross outpatient charges and thendividing the resulting amount by gross inpatient charges.

 

(4)                                  Utilization oflicensed beds represents patient days divided by average licensed beds dividedby number of days in the period. Occupancy rates are affected by many factors, including the populationsize and general economic conditions within particular market service areas,the degrees of variation in medical and surgical products, outpatient use ofhospital services, quality and treatment availability at competing hospitals andseasonality.

 

(5)                                  The threemonths ended December 31, 2009 include Brotman operating results, as theCompany acquired a majority stake in, and began consolidating, Brotman, since April 14,2009.  Accordingly, the comparativeperiod does not include any operating results of Brotman.

 

***Three Months Ended December 31,2009 Compared to Three Months Ended December 31, 2008***

 

*Net Hospital Services Revenues*

 

Net inpatient revenues for the three months ended December 31,2009 were approximately $61,324,000, representing an increase of approximately$28,084,000 or 84.5% from net inpatient revenues for the three months ended December 31,2008, of approximately $33,240,000. The three months ended December 31,2009 include the results of Brotman, which, accounted for $26,626,000 or 94.8%of the increase.

 

Excluding Brotman, same hospital net inpatient revenues increased byapproximately $1,458,000 or 4.4% during fiscal 2010 period as compared tofiscal 2009 period. The increase was due to small increases in both Medicareand Medi-Cal reimbursement rates and increases in total admissions, offset by patientcase mix and small decreases in average length of patients stay.

 

Same-hospital admissions, excluding the effect of Brotman, for the threemonths ended December 31, 2009 increased by approximately 8.7% compared tothe three months ended December 31, 2008 primarily due to net volumeincreases in the primary service lines.

 

Net outpatient revenues for the three months ended December 31,2009 were approximately $7,925,000, representing an increase of approximately $6,203,000or 360.2% from net outpatient revenues for the three months ended December 31,2008, of approximately $1,722,000. The three months ended December 31,2009 include the results of Brotman, which, accounted for $5,551,000 or 89.5%of the increase.

 

Excluding Brotman, same hospital net outpatient revenues increased byapproximately $652,000 or 37.9%.  Theincrease was due primarily to increased outpatient visits, primarilyattributable to H1N1-related cases.

 

*Salaries, Wages and Benefits*

 

Salaries, wages and benefits for the three months ended December 31,2009 were approximately $31,915,000, representing an increase of approximately$16,021,000 or 100.8% from salaries, wages and benefits for the three monthsended December 31, 2008, of approximately $15,894,000. The three monthsended December 31, 2009 include the results of Brotman, which, accountedfor $15,389,000 or 96.8% of the increase.

 

Excluding Brotman, same hospital salaries, wages and benefits expenseas a percentage of net Hospital Services revenues for the three months ended December 31,2009 was 44.5%, compared to 45.0% for the three months ended December 31,2008, with such decrease being primarily due to conversion of certain hospitalpersonnel from contracted to salaried basis, plus productivity gains.

 

Asof December 31, 2009, approximately 5.0% and 79.0%, of the total employeesat our Alta and Brotman hospitals were represented by labor unions,respectively. We believe that labor relations at our hospital facilitiesgenerally have been satisfactory. The collective bargainingagreement entered into between Hollywood CommunityHospital, which is one of the hospitals under the consolidated group of AltaHospitals System, LLC, and Service Employees InternationalUnion (“SEIU”), covers a small group of Hollywood Community Hospital’semployees and will expire on May 9, 2011. The collectivebargaining agreements entered into between Brotman and the California NursesAssociation (“CNA”) and Brotman and the SEIU both expire on February 28, 2010.We currently do not anticipate that any changes in these agreementswill have a material adverse effect on results of our Hospital Servicesoperations in fiscal 2010.

 

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*Other Operating Expenses*

 

Other operating expense for the three months ended December 31,2009 was approximately $4,212,000, representing an increase of $2,028,000 or92.8% from other operating expense for the three months ended December 31,2008, of approximately $2,185,000. The three months ended December 31,2009 include the results of Brotman, which accounted for $2,571,000 or 126.8%of the increase

 

Excluding Brotman, Alta’s same hospital other operating expense as apercentage of Alta’s net Hospital Services revenue for the three months ended December 31,2009 was approximately 4.4%, representing a decrease of 29.0%, compared to 6.2%for the three months ended December 31, 2008. The decrease was dueprimarily to lower costs as a result of the conversion of certain hospitalpersonnel from contracted to salaried basis.

 

*Supplies Expense*

 

Supplies expense for the three months ended December 31, 2009 wasapproximately $5,859,000, representing an increase of approximately $3,666,000or 167.2% from supplies expense for the three months ended December 31,2008, of approximately $2,193,000. The three months ended December 31,2009 include the results of Brotman, which accounted for $3,762,000 or 102.6%of the increase.

 

Excluding Brotman, Alta’s same hospital supplies expense as apercentage of Alta’s net Hospital Services revenue for the three months ended December 31,2009 was 5.6% representing a decrease of 9.1% compared to 6.2% for the threemonths ended December 31, 2008. The decrease was due primarily to theoutsourcing of our sub-acute pharmacy products and improved efficiencies gainedthrough standardization, bulk purchases, contract compliance, and utilization.

 

*Provision for Doubtful Accounts*

 

The provision for doubtful accounts as a percentage of net HospitalServices revenues was 10.0% for the three months ended December 31, 2009compared to 4.2% for three months ended December 31, 2008.  The three months ended December 31, 2009included the results of Brotman, which accounted for 109.2% of the increase.

 

Excluding Brotman, Alta’s hospital provision for doubtful accounts as apercentage of Alta’s net Hospital Services revenue for the three months ended December 31,2009 was approximately 5.9%, compared to 4.2% for the three months ended December 31,2008. The increase was due to an unusually low expense level in the prior yearperiod and certain specific write offs in the current period.

 

*Lease and Rental Expense*

 

Lease and rental expense for the three months ended December 31,2009 was approximately $711,000, representing an increase of approximately $330,000or 86.6% from lease and rental expense for the three months ended December 31,2008, of approximately $381,000. The three months ended December 31, 2009include the results of Brotman, which accounted for $205,000 or 62.3% of theincrease.

 

Excluding Brotman, same hospital lease and rental expense as apercentage of Alta’s net Hospital Services revenue for the three months ended December 31,2009 was approximately 1.4% compared to approximately 1.1% for the three monthsended December 31, 2008. This slight increase was primarily due toadditional rental equipment procured during the fiscal 2010 period.

 

*General and Administrative Expense*

 

General and administrative expense for the three months ended December 31,2009 was approximately $5,958,000, representing an increase of approximately$2,791,000 or 88.1% from general and administrative expense for the threemonths ended December 31, 2008, of approximately $3,167,000. The threemonths ended December 31, 2009 include the results of Brotman, whichaccounted for $2,483,000 or 88.9% of the increase.

 

Excluding Brotman, same hospital general and administrative expense asa percentage of Alta’s net Hospital Services revenue for the three months endedDecember 31, 2009 was 9.4%, compared to 9.0% for the three months ended December 31,2008, with the current year increase was primarily due to increased propertytaxes resulting from reassessment of the property tax base following theacquisition of Alta.

 

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*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended December 31,2009 was approximately $1,205,000, representing an increase of approximately$313,000 or 35.1% from depreciation and amortization expense for the threemonths ended December 31, 2008, of approximately $892,000. The threemonths ended December 31, 2009 include the results of Brotman, whichaccounted for $236,000 or 75.4% of the increase.

 

Excluding Brotman, depreciation and amortization expenses as apercentage of Alta’s net Hospital Services revenues for the three months ended December 31,2009 were approximately 2.6%, compared to 2.5% for the three months ended December 31,2008. The increase was primarily due to depreciation of additional capitalequipment incurred in the fiscal 2010 period. Included in depreciation andamortization expense was amortization of identifiable intangibles ofapproximately $354,000 and $317,000 in the three months ended December 31,2009 and 2008, respectively.

 

*Operating Income*

 

Our Hospital Services segment reported operating income ofapproximately $12,581,000 and $9,118,000 for the three months ended December 31,2009 and 2008, respectively, which increase was the result of the changesdiscussed above. These operating results from the Hospital Services segmentinclude certain corporate expense allocations for insurance, professional fees,and amortization of identifiable intangibles that relate to this segment.

 

**Medical Group Segment**

 

The Medical Group segment provides management services to affiliatedphysician organizations that operate as independent physician associations (“MedicalGroups”). The affiliated physician organizations enter into agreements withHMOs to provide HMO enrollees with a full range of medical services in exchangefor fixed, prepaid monthly fees known as “capitation” payments. The MedicalGroups contract with physicians and other healthcare providers to provide allnecessary medical services.

 

Through our management subsidiaries—Prospect Medical Systems, Inc.(“PMS”), and ProMed Health Care Administrators—we have entered into long-termagreements to 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, human resources services, claims administration, financialreporting services, provider relations, patient eligibility and relatedservices, medical management including utilization management and qualityassurance, data collection, and management information systems.

 

Our management subsidiaries currently provide management services toten affiliated physician organizations, which include PMG, Nuestra FamiliaMedical Group, Inc. (“Nuestra”), eight other affiliated physicianorganizations that PMG owns or controls, and one affiliated physicianorganization (AMVI/Prospect Health Network) that is an unconsolidated jointventure in which PMG owns a 50% interest. PMG, which was our first affiliated physicianorganization, has acquired the ownership interest in all of our otheraffiliated physician organizations, except Nuestra.  Both PMG and Nuestra are owned by ourphysician shareholder nominee, Dr. Arthur Lipper, and controlled throughassignable option agreements and management services agreements (see Note 5 tothe Condensed Consolidated Financial Statements).  While PMG is itself an affiliated physicianorganization that does the same business in its own service area as all of ourother affiliated physician organizations do in theirs, PMG also serves as aholding company for our other affiliated physician organizations, exceptNuestra.

 

The affiliated physician organizations provided medical services to acombined total of approximately 172,900 HMO enrollees at December 31,2009, including approximately 10,300 AMVI/Prospect Health Network enrolleesthat we manage for the economic benefit of an independent third party, and forwhich we earn management fee income.

 

As of December 31, 2009, our affiliated physician organizationshad contracts with approximately 18 HMOs, from which our revenue was primarilyderived. HMOs offer a comprehensive healthcare benefits package in exchange fora capitation amount per enrollee that does not vary through the contract periodregardless of the quantity or cost of medical services required or used. HMOsenroll members by entering into contracts with employer groups or directly withindividuals to provide a broad range of healthcare services for a prepaidcharge, with minimal deductibles or co-payments required of the members. 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 amount per enrollee.

 

Our Medical Group business has developed primarily through theacquisition of Medical Groups by PMG, and is concentrated in Orange County,California, Los Angeles County, California and San Bernardino County,California.

 

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Medical Group revenues consist primarily of amounts received for medicalservices provided by our affiliated physician organizations under capitatedcontracts with HMOs. Capitation revenue under HMO contracts is prepaid monthlyto the affiliates based on the number of covered HMO enrollees. Capitationrevenue may be subsequently adjusted to reflect changes in enrollment as aresult of retroactive terminations or additions. These adjustments havehistorically not had a material effect on capitation revenue. Capitationrevenue is also subject to risk adjustment, whereby capitation with respect toMedicare enrollees is subject to subsequent adjustment for the acuity of theenrollees to whom services were provided. Capitation for the current year ispaid based on data submitted for each Medicare enrollee for preceding periods.Capitation is paid at interim rates during the year and is adjusted insubsequent periods (generally in our fourth fiscal quarter) after the finaldata is compiled. Positive or negative capitation adjustments are made forMedicare enrollees with conditions requiring more or less healthcare servicesthan assumed in the interim payments. Since we do not have the informationnecessary to reliably predict these adjustments, periodic changes in capitationamounts earned as a result of Risk Adjustment are recognized when those changesare communicated to us by the health plans, generally in the fourth quarter ofthe fiscal year to which the adjustments relate. Management fees were primarilycomprised of amounts earned from managing the operations of AMVI, Inc.(our joint venture partner in the AMVI/Prospect Health Network joint venture)related to Medi-Cal members and Medicare members enrolling in CalOPTIMA’sOneCare HMO. OneCare is a Medicare Advantage Special Needs Plan servingdually-eligible members in Orange County who are entitled to both Medicare andare Medi-Cal benefits. Management fee revenue is recognized in the month theservices are delivered.

 

Medical Group revenues also included incentive payments from HMOs under“pay-for-performance” programs for quality medical care based on variouscriteria. These incentives are generally received in the third and fourthquarters of our fiscal year and are recorded when such amounts are known sincewe do not maintain the information necessary to independently and reliablyestimate these amounts.

 

We also potentially earn additional incentive revenue or incurpenalties under HMO contracts by sharing in the risk for hospitalization basedupon inpatient services utilized. These amounts are included in capitationrevenue. As of December 31, 2009, except for one minor contract where wewere contractually obligated for down-side risk, shared risk deficits are notpayable until and unless we generated future risk-sharing surpluses. Risk poolsare generally settled in the following year. Management estimates risk poolincentives based on information received from the HMOs or hospitals with whomthe risk-sharing arrangements were in place, and who typically maintain theinformation and record keeping related to the risk pool arrangements.Differences between actual and estimated settlements are recorded when thefinal outcome is known. Risk pool and pay-for-performance incentives areaffected by many factors, some of which are beyond our control, and may varysignificantly from year to year.

 

We have increased our membership through acquisitions. These increasesthrough acquisition were offset by HMO enrollment declines at our affiliatedphysician organizations, similar to the recent HMO enrollment trends inCalifornia. The following table sets forth the approximate number of members,by category (in thousands):

 
| ** **                 | ** ** | **As of December 31,** | ** ** |
|----------------------------|------------|-----------------------------|------------|
| **Member Category**        | ** ** | **2009**                    | ** ** | **2008** | ** ** | **% Increase  (Decrease)** | ** ** |
| Commercial—owned      |       | 129.5                       |       | 145.7 |   | (11.1 | )% |
| Commercial—managed(l) |       | 1.6                         |       | 1.4 |   | 14.3 | % |
| Senior—owned          |       | 21.5                        |       | 21.5 |   | 0.0 | % |
| Senior—managed(1)     |       | 0.2                         |       | 0.1 |   | 100.0 | % |
| Medi-Cal—owned        |       | 11.6                        |       | 13.9 |   | (16.5 | )% |
| Medi-Cal—managed(1)   |       | 8.5                         |       | 7.7 |   | 10.4 |   |
| Total                      |       | 172.9                       |       | 190.3 |   | (9.1 | )% |

 

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(1)                                  Representmembers of AMVI, Inc., our joint venture partner, which we manage on theirbehalf in exchange for a fee.

 

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The following table details total paid member months, by membercategory, for the three-month periods ended December 31, 2009 and 2008 (inthousands):

 
| ** **                 | ** ** | **Three Months Ended  December 31,** | ** ** | **% Increase** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|---------------------|------------|
| ** **                 | ** ** | **2009**                                  | ** ** | **2008**            | ** ** | **(Decrease)** | ** ** |
| Commercial—owned      |       | 393.5                                     |       | 442.9               |       | (11.2 | )% |
| Commercial—managed(1) |       | 4.8                                       |       | 4.1                 |       | 17.1 | % |
| Senior—owned          |       | 64.7                                      |       | 64.8                |       | (0.2 | )% |
| Senior—managed (1)    |       | 0.6                                       |       | 0.4                 |       | 50.0 | % |
| MediCal—owned         |       | 34.9                                      |       | 41.6                |       | (16.1 | )% |
| MediCal—managed(1)    |       | 25.5                                      |       | 23.3                |       | 9.4 | % |
|                       |       | 524.0                                     |       | 577.1               |       | (9.2 | )% |

 

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(1)                                  Represent membersof AMVI, Inc., our joint venture partner, which we manage on their behalfin exchange for a fee.

 

Our operating expenses include expenses related to the provision ofmedical care services (medical group cost of revenues) and general andadministrative costs. Our results of operations depend on our ability toeffectively manage expenses related to health benefits and accurately predictcosts incurred.

 

Expenses related to medical care services include payments tocontracted primary care physicians and payments to contracted specialists. Ingeneral, primary care physicians are paid on a capitation basis, whilespecialists are paid on either a capitation or a fee-for-service basis.

 

Capitation payments are fixed in advance of periods covered and are notsubject to significant accounting estimates. These payments are expensed in theperiod the providers are obligated to provide services. Fee-for-servicepayments are expensed in the period services are provided to our members.Medical care costs include actual historical claims experience and estimates ofincurred but not reported amounts (“IBNR”). We estimate our IBNR monthly, based on a number of factors, includingprior claims experience. As part of this review, we also consider estimates ofamounts to cover uncertainties related to fluctuations in provider billingpatterns, claims payment patterns, membership and medical cost trends. Theseestimates are adjusted each month as more information becomes available. Inaddition to our own IBNR estimation process, we obtain semi-annualcertifications of our IBNR liability from independent actuaries. We believethat our process for estimating IBNR is adequate and appropriate, but there canbe no assurance that medical care costs will not exceed such estimates. Inaddition to contractual reimbursements to providers, we also make discretionaryincentive payments to physicians, which are in large part based on thepay-for-performance, shared risk revenues and any favorable senior capitationrisk-adjustment payments we receive. Since we record these revenues generallyin the third or fourth quarter of each fiscal year, when the incentives andcapitation adjustments due from the health plans are known, we alsohistorically adjust interim accruals of discretionary physician bonuses in thesame period. Because incentives and risk-adjustment revenues form the basis forthese discretionary bonuses, variability in earnings due to fluctuations inrevenues are mitigated by reductions in bonuses awarded.

 

G&A costs are largely comprised of wage and benefit costs relatedto our employee base and other administrative expenses. G&A functionsinclude claims processing, information systems, provider relations, finance andaccounting services, and legal and regulatory services.

 

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**Medical Group Results of Operations**

 

The following tables summarize our net operating revenue, operatingexpenses and operating income from Medical Group operations and are used in thediscussions below for the three-month periods ended December 31, 2009 and2008 (in thousands).

 
| ** **                                | ** ** | **Three Months Ended  December 31,** | ** ** | **% Increase** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|----------------|------------|
| ** **                                | ** ** | **2009**                                  | ** ** | **2008**       | ** ** | **(Decrease)** | ** ** |
| **Medical Group revenues:**               |       |                                      |       |           |       |   |   |
| Capitation                                |       | $                                         | 46,449     |           | $          | 47,762 |   | (2.7 | )% |
| Management  fees                          |       | 153                                       |       | 144            |       | 6.3 | % |
| Other  revenues                           |       | 82                                        |       | 225            |       | (63.6 | )% |
| **Total Medical Group revenues**          |       | 46,684                                    |       | 48,131         |       | (3.0 | )% |
| **Medical Group cost of revenues:**       |       |                                      |       |           |       |   |   |
| PCP  capitation                           |       | 8,405                                     |       | 8,669          |       | (3.0 | )% |
| Specialist  capitation                    |       | 10,348                                    |       | 11,018         |       | (6.1 | )% |
| Claims  expense                           |       | 17,993                                    |       | 17,693         |       | 1.7 | % |
| Physician  salaries                       |       | 33                                        |       | 778            |       | (95.8 | )% |
| Other  cost of revenues                   |       | 66                                        |       | (546           | )          | (112.1 | )% |
| **Total Medical Group cost of revenues**  |       | 36,845                                    |       | 37,612         |       | (2.0 | )% |
| **Gross margin**                          |       | 9,839                                     |       | 10,519         |       | (6.5 | )% |
| General  and administrative expenses      |       | 6,672                                     |       | 7,196          |       | (7.3 | )% |
| Depreciation  and amortization expense    |       | 868                                       |       | 871            |       | (0.3 | )% |
| Total  other expenses                     |       | 7,540                                     |       | 8,067          |       | (6.5 | )% |
| Income  from unconsolidated joint venture |       | 450                                       |       | 353            |       | 27.5 | % |
| **Operating Income**                      |       | $                                         | 2,749      |           | $          | 2,805 |   | (2.0 | )% |
| **Medical cost ratio**                    |       | 79.3                                      | %          | 78.7           | %          |   |   |

 

The following table sets forth selected operating items, expressed as apercentage of total revenue:

 
| ** **                                | ** ** | **Three Months Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| **Medical Group revenues:**               |       |                                      |       |   |   |
| Capitation  revenue                       |       | 99.5                                      | %          | 99.2 | % |
| Management  fees                          |       | 0.3                                       | %          | 0.3 | % |
| Other  revenues                           |       | 0.2                                       | %          | 0.5 | % |
| **Total Medical Group revenues**          |       | 100.0                                     | %          | 100.0 | % |
| **Medical Group cost of revenues:**       |       |                                      |       |   |   |
| PCP  capitation                           |       | 18.0                                      | %          | 18.0 | % |
| Specialist  capitation                    |       | 22.2                                      | %          | 22.9 | % |
| Claims  expense                           |       | 38.5                                      | %          | 36.8 | % |
| Physician  salaries                       |       | 0.1                                       | %          | 1.5 | % |
| Other  cost of revenues                   |       | 0.1                                       | %          | (1.1 | )% |
| **Total Medical Group cost of revenues**  |       | 78.9                                      | %          | 78.1 | % |
| **Gross margin**                          |       | 21.1                                      | %          | 21.9 | % |
| General  and administrative expenses      |       | 14.3                                      | %          | 15.0 | % |
| Depreciation  and amortization expense    |       | 1.9                                       | %          | 1.8 | % |
| Total  non-medical expenses               |       | 16.2                                      | %          | 16.8 | % |
| Income  from unconsolidated joint venture |       | 1.0                                       | %          | 0.7 | % |
| **Operating Income**                      |       | 5.9                                       | %          | 5.8 | % |

 

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***Three Months Ended December 31, 2009Compared to Three Months Ended December 31, 2008***

 

*Capitation Revenue*

 

Capitation revenue for the three months ended December 31, 2009was approximately $46,449,000, representing a decrease of approximately $1,313,000or 2.7% from capitation revenue for the three months ended December 31,2008, of approximately $47,762,000.

 

The decrease in the fiscal 2010 period was due primarily to a decreasein commercial enrollment as a result of increased unemployment and cancellationof certain unprofitable Medi-Cal contracts, partly offset by rate increases.

* *

*Management Fee Revenue*

 

Management fee revenue for the three months ended December 31,2009 was approximately $153,000, representing an increase of approximately$9,000, or 6.3% from management fee revenue for the three months ended December 31,2008, of approximately $144,000.

 

The increase inmanagement fee revenue during the fiscal 2010 period was primarily dueto an increase in management fee, resulting from an increase in the number ofmembers of AMVICare Health Network, Inc.

 

*Other revenue*

 

Other revenue for the three months ended December 31, 2009 wasapproximately $82,000, representing a decrease of approximately $143,000, or63.6% over other revenue for the three months ended December 31, 2008, ofapproximately $225,000.

 

Amounts represent incentive payments from HMOs under “pay-per-performance”programs for quality medical care based on various criteria. The incentives arerecorded when such amounts are known.

 

The decrease in other revenue during the fiscal 2010 period wasprimarily the result of timing of receipt of pay-for-performance monies and a revisedpharmaceutical reimbursement programs with one of our contracted Health Plans.

 

*PCP Capitation Expense*

 

Primary care physician (“PCP”) capitation expense for the three monthsended December 31, 2009 was approximately $8,405,000, representing adecrease of $264,000, or 3.0% over PCP capitation expense for the three monthsended December 31, 2008, of approximately $8,669,000.

 

The decrease in PCP capitation expense during the fiscal 2010 periodwas primarily due to decreased enrollment, partly offset by market rateadjustments made as part of our effort to attract new physicians and theirmembers.

* *

*Specialist Capitation Expense*

 

Specialist Capitation expense for the three months ended December 31,2010 was approximately $10,348,000, representing a decrease of $670,000, or6.1% from specialist capitation expense for the three months ended December 31,2008, of approximately $11,018,000.

 

The decrease in specialist capitation expense during the fiscal 2010period was due to a combination of decreased enrollment and moving more of certainspecialties to a fee-for-service basis in the current year period, which movewas considered more beneficial to the Company.

* *

*Claims Expense*

 

Claims expense for the three months ended December 31, 2009 wasapproximately $17,993,000, representing an increase of $300,000 or 1.7% overclaims expense for the three months ended December 31, 2008, ofapproximately $17,693,000.  The increasewas due primarily due to moving more of certain specialties to afee-for-service basis in the current fiscal period, which move was consideredmore beneficial to the Company.

 

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*Physician Salaries Expense*

 

Physician salaries expense for the three months ended December 31,2009 was approximately $33,000, representing a decrease of $745,000 or 95.8%over physician salaries expense for the three months ended December 31,2008, of approximately $778,000.

 

The decrease in physician salaries expense was primarily the result ofconverting all on-staff hospitalist physicians from employment to capitationbasis effective during the third quarter of fiscal 2009.

* *

*Other Cost of Revenues*

 

Other cost of revenues for the three months ended December 31,2009 was approximately $66,000 compared to a negative expense of approximately$546,000 for the three months ended December 31, 2008.

 

The change was primarily due to decreased stop-loss insurancerecoveries, caused by the timing of receipts resulting in a contra expense inthe prior year period.

* *

*Gross Margin*

 

Medical care costs as a percentage of medical revenues (the medicalcost ratio, a non-GAAP measure) largely determine our gross margin. Our gross margindecreased slightly to 21.1% for the three months ended December 31, 2009,from 21.9% for the three months ended December 31, 2008.

 

The decrease in our gross margin percentage between the fiscal 2010 and2009 periods was primarily due to the timing of receipts for stop-loss insurancerecoveries, as discussed above.

 

*General and Administrative Expense*

 

General and administrative expenses (“G&A”) were approximately$6,672,000 for the three months ended December 31, 2009, representing 14.3%of total Medical Group revenues, as compared with approximately $7,196,000 or15.0% of total Medical Group revenues, for the fiscal 2009 period.

 

The decrease in G&A expenses during the fiscal 2010 period wasprimarily due to the elimination of a certain personnel, facility and outsideservice costs in connection with the consolidation of certain administrativefunctions among our Medical Groups.

* *

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended December 31,2009 decreased to approximately $868,000 from $871,000 for the same period ofthe prior year, primarily due to retirement of certain capital equipment.

 

*Income from Unconsolidated Joint Venture*

 

The income from unconsolidated joint venture for the three months endedDecember 31, 2009 increased to $450,000 from $353,000 for the same periodof the prior year. The increase was primarily due to write-off of a risk poolreceivable in the fiscal 2009 period.

* *

*Operating Income*

 

Our Medical Group segment reported operating income of approximately$2,749,000 and $2,805,000, for the three months ended December 31, 2009and 2008, respectively, as a result of the changes discussed above. Theoperating results of the Medical Group segment include certain corporateexpense allocations for insurance, professional fees, and amortization ofidentifiable intangibles that relate to this segment.

 

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**Corporate Expenses**

 

Certain expenses incurred at Prospect Medical Holdings, Inc. (the “ParentEntity”) not specifically allocable to the Hospital Services or Medical Groupsegments are recorded in the Corporate segment. These include salaries (includingstock-based compensation), benefits, financing, rent, supplies, legal, SECcompliance, and Sarbanes-Oxley compliance. We do not allocate interest expense,debt extinguishment loss, gain or loss on interest rate swaps and income taxesto the other reporting segments.

 

The following table summarizes our corporate expense for the ParentEntity, and is used in the discussion below for the three-month periods ended December 31,2009 and 2008 (in thousands).

 
| ** **                                                     | ** ** | **Three  Months Ended********December 31,** | ** ** | **%********Increase** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2009**                                         | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** |
| **Corporate Expenses:**                                        |       |                                             |       |                  |       |   |   |
| General and administrative expense                             |       | $                                                | 3,499      |                  | $          | 2,022 |   | 73.0 | % |
| Depreciation and amortization expense                          |       | 4                                                |       | 3                     |       | 33.3 | % |
| **Total Corporate Expenses**                                   |       | 3,503                                            |       | 2,025                 |       | 73.0 | % |
| **Other (Income) Expense:**                                    |       |                                             |       |                  |       |   |   |
| Investment income                                              |       | —                                           |       | (22                   | )          | (100.0 | )% |
| Interest expense and amortization of deferred  financing costs |       | 5,691                                            |       | 6,096                 |       | (6.6 | )% |
| Loss in value of interest rate swap arrangements               |       | —                                           |       | 9,668                 |       | (100.0 | )% |
| **Total Other Expense**                                        |       | 5,691                                            |       | 15,742                |       | (63.8 | )% |
| **Total Corporate Expenses**                                   |       | $                                                | 9,194      |                  | $          | 17,767 |   | (48.3 | )% |

 

The following table sets forth selected operating items, expressed as apercentage of total consolidated revenues:

 
| ** **                                                     | ** ** | **Three Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| **Corporate Expenses:**                                        |       |                                      |       |   |   |
| General and administrative expense                             |       | 3.0                                       | %          | 2.4 | % |
| Depreciation and amortization expense                          |       | 0.0                                       | %          | 0.0 | % |
| **Total Corporate Expenses**                                   |       | 3.0                                       | %          | 2.4 | % |
| **Other (Income) Expense:**                                    |       |                                      |       |   |   |
| Investment income                                              |       | 0.0                                       | %          | 0.0 | % |
| Interest expense and amortization of deferred  financing costs |       | 4.9                                       | %          | 7.3 | % |
| Loss in value of interest rate swap arrangements               |       | 0.0                                       | %          | 11.6 | % |
| **Total Other Expense**                                        |       | 4.9                                       | %          | 18.9 | % |
| **Total Corporate Expenses**                                   |       | 7.9                                       | %          | 21.3 | % |

 

***Three Months Ended December 31,2009 Compared to Three Months Ended December 31, 2008***

 

*General and Administrative Expense*

 

General and administrative (“G&A”) expenses for the three monthsended December 31, 2009 were approximately $3,499,000, representingapproximately 3.0% of total consolidated revenues, compared to approximately$2,022,000 or approximately 2.4% of total consolidated revenues, for the threemonths ended December 31, 2008. The increase in G&A expenses duringthe fiscal 2010 period primarily related to increased stock-based compensationassociated with certain equity grants to management and outside directors.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended December 31,2009 was approximately $4,000, compared to approximately $3,000 for the threemonths ended December 31, 2008, primarily due to depreciation expense ofadditional office equipment incurred in the fiscal 2010 period.

 

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*Investment Income*

 

Investment income for the three months ended December 31, 2009 wasnone, compared to approximately $22,000 for the three months ended December 31,2008.

 

*Interest Expense and Amortization of DeferredFinancing Costs*

 

Interest expense and amortization of deferred financing costs for thethree months ended December 31, 2009 was approximately $5,691,000,compared to approximately $6,096,000 for the three months ended December 31,2008, a decrease of approximately 6.6%.

 

Following our refinance on July 29, 2009, (see Note 6 to theunaudited condensed consolidated financial statements), the effective interestrate on our debt facilities was reduced, resulting in the decrease in quarterlyinterest expense. This decrease was partly offset in that, effective April 14,2009, following the Brotman transaction, we began including interest on allBrotman debt in our consolidated financial statements.

 

*Loss in Value of Interest Rate Swap Arrangements*

 

We had two interest rate swaps in place in connection with our priordebt financing.  These swaps did notqualify for hedge accounting during the fiscal 2009 period and as such, all changesin fair value of those swaps (approximately $9,668,000) were treated as anexpense.

 

Concurrent with the Senior Secured Note transaction on July 29,2009 (see Note 6 to the accompanying unaudited condensed consolidated financialstatements), we terminated the interest rate swap arrangements and expensed allpreviously unamortized swap fluctuation amounts.  Accordingly, there were no interest rateswaps in existence or related expense during the quarter ended December 31,2009.

** **

**Consolidated Results of Operations**

 

***Three months Ended December 31,2009 Compared to Three months Ended December 31, 2008***

 

*Provision for Income Taxes*

 

Income tax provision for the three months ended December 31, 2009was approximately $2,503,000 compared to an income tax benefit of approximately$(2,419,000) in the three months ended December 31, 2008 with the changebeing due to the change in income (loss) before taxes. The effective tax ratewas higher at 50.4% for the three months ended December 31, 2009 comparedto 41.3% for the three months ended December 31, 2008. The highereffective tax rate in the fiscal 2010 period was primarily due to notrecognizing the deferred tax benefit from Brotman’s current period loss, forfederal tax purposes.

 

*Net Loss Attributable to Noncontrolling Interest*

 

Noncontrollinginterests, net of tax decreased to a loss of $395,000 as compared to income of$4,000 for the three months ended December 31, 2009 and 2008,respectively. The decrease was due to consolidation of Brotman in the currentyear period.

 

*Net Income (Loss) Attributable to Prospect MedicalHoldings, Inc.*

 

Net income attributable to Prospect Medical Holdings, Inc.’scommon stockholders for the three months ended December 31, 2009 wasapproximately $2,859,000, or $0.13 per diluted share, as compared to a net lossof approximately $3,445,000, or $0.17 per diluted share, for the three monthsended December 31, 2008, which change was the result of the itemsdiscussed above.

 

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**Liquidity and Capital Resources**

 

Our primary sources of cash have been funds provided by borrowingsunder our credit facilities, by the issuance of equity securities and by cashflow from operations. Prior to the August 8, 2007 acquisition of Alta, ourprimary sources of cash from operations were healthcare capitation revenues,fee-for-service revenues, risk pool payments and pay-for-performance incentivesearned by our affiliated physician organizations. With the acquisition of Alta,and subsequently Brotman, our sources of cash from operations now includepayments for hospital services rendered under reimbursement arrangements withthird-party payers, which include the federal government under the Medicareprogram, the state government under the Medi-Cal program, private insurers,HMOs, PPOs, and self-pay patients.

 

Ourprimary uses of cash include healthcare capitation and claims payments by ouraffiliated physician organizations, administrative expenses, debt service,acquisitions, costs associated with the integration of acquired businesses,information systems and, with the acquisition of Alta and subsequently Brotman,operating, capital improvement and administrative expenses related to ourhospital operations. Our affiliated physician organizations generally receivecapitation revenue in advance of having to make capitation and claims paymentsto their providers. However, our hospitals receive payments for servicesrendered generally 30 to 90 days after the medical care is rendered. Forsome accounts and payer programs, the time lag between service andreimbursement can exceed one year.

 

Our investment strategies are designed to provide safety andpreservation of capital, sufficient liquidity to meet the cash-flow needs, ofour business operations, and attainment of a competitive return. At December 31,2009, we invested our cash in interest bearing money market accounts,interest-bearing certificates of deposit and non interest-bearing checkingaccounts. All of these amounts are classified as current assets and included incash and cash equivalents in our condensed consolidated balance sheets.

 

*Cash Flow from Operations*

 

Net cash provided by operating activities was approximately $4,539,000for the three months ended December 31, 2009 compared to net cash providedby operating activities of approximately $1,479,000 for the three months ended December 31,2008. The increase in net cash provided by operating activities for the threemonths ended December 31, 2009 as compared to the three months ended December 31,2008 was due to various factors, including the following:

 

·                  earnings, excluding non-cash charges andcredits were approximately $13,556,000 in the fiscal 2010 period compared toapproximately $6,440,000 in the fiscal 2009 period;

 

·                  changes in patient, government program andother receivables, a use of approximately $9,310,000 in the fiscal 2010 periodcompared to a use of approximately $2,654,000 in the fiscal 2009 period. Theincrease in the fiscal 2010 period was related to our Hospital Servicessegment, which saw an increase of 67% in patient volume, of which approximately87% was attributable to the Brotman acquisition;

 

·                  changes in prepaid expenses and other, a useof approximately $1,404,000 in the fiscal 2010 period compared to a use ofapproximately $904,000 in the fiscal 2009 period. The increase in the fiscal2010 period was primarily due to the timing of employee health insurancepremium payments in connection with switching health insurance providers;

 

·                  changes in refundable income tax and taxespayable, a source of approximately $1,939,000 in the fiscal 2010 periodcompared to a source of approximately $2,294,000 in the fiscal 2009 period. Thedecrease in the fiscal 2010 period was primarily due to increased tax refundsand use of refundable income tax balances for tax obligations associated withincreased current-year profitability;

 

·                  changes in medical claims and relatedliabilities, a use of approximately $1,040,000 in the fiscal 2010 periodcompared to a use of approximately $1,563,000 in the fiscal 2009 period, withthe decrease in the fiscal 2010 period corresponding to enrollment changes inour Medical Group segment; and

 

·                  changes in accounts payable and other accruedliabilities, a source of approximately $539,000 in the fiscal 2010 periodcompared to a use of approximately $2,480,000 in the fiscal 2009 period. Theincrease in the fiscal 2010 period was primarily due to timing of the paymentof accrued interest as required under our new senior secured Notes.

 

Net cash used in investing activities totaled approximately $437,000for the three months ended December 31, 2009, compared to a use ofapproximately $207,000 for the three months ended December 31, 2008, thelargest component of which was purchases of property, improvements andequipment, a use of approximately $481,000 in the fiscal 2010 period comparedto a use of approximately $221,000 in the fiscal 2009 period.

 

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Net cash provided by financing activities totaled approximately$519,000 for the three months ended December 31, 2009, compared to a useof approximately $1,813,000 for the three months ended December 31, 2008.Net cash provided by financing activities for the three months ended December 31,2009 was comprised primarily of cash provided by borrowings under Brotman’srevolving line of credit for working capital purposes, offset by increaseddeposits into restricted cash of $588,000 as required by Brotman’s JHAfinancing and payments of $228,000 on capital leases. Net cash used infinancing activities for the three months ended December 31, 2008 wascomprised primarily of payments related to our former term debt ofapproximately $1,720,000, payments of $93,000 on capital leases and a paymentof $250,000 on the Brotman Unsecured Creditors Note.

 

At December 31, 2009, we had working capital of approximately$15,768,000 as compared to working capital of approximately $9,903,000 at September 30,2009.

 

At December 31, 2009 and September 30, 2009, cash and cashequivalents and investments totalled approximately $45,006,000 and $39,828,000respectively.

 

*Prospect Note Offering*

 

On July 29,2009, the Company closed the offering of $160 million in 12.75% senior securednotes due 2014 (the “Notes”) at an issue price of 92.335%.  The sale wasexecuted in accordance with Rule 144A under the Securities Act of 1933 andRegulation S under the Securities Act of 1933.  Also, in connection withthe issuance of the Notes, the Company entered into a three-year $15 millionrevolving credit facility, which was undrawn at closing.  The interestrate under the revolving credit facility will be at LIBOR plus an applicablemargin of 7.00%, with a LIBOR floor of 2.00%. The Company used the net proceeds from the sale of the Notes to repayall amounts outstanding under the Former Credit Facility, plus a prepayment premium ofapproximately $2.6 million.

 

*Brotman Financing*

 

As part of Brotman’s emergence from bankruptcy on April 14, 2009,financing was secured from the Los Angeles Jewish Home for the Aging (“JHA”) and Gemino.

 

The JHA financing was comprised of two term debt components, a$16.0 million tranche secured by assets on the west side of the Brotmancampus commonly referred to as “Delmas West” and a $6.25 million trancheon the main hospital pavilion on the east side of the property. The$16.0 million tranche contains an option for JHA to acquire the DelmasWest parcel for a purchase price equal to the outstanding debt within24 months of the effective date of the bankruptcy. If JHA does notexercise its option, Brotman will be required to refinance the$16.0 million tranche on or before April 14, 2011. With respect tothe $16.0 million tranche of the JHA facility, JHA also has the right todeclare the unpaid loan amount, immediately due and payable at any time after April 14,2010 and prior to April 14, 2011, provided that JHA gives 180 days’ writtennotice of exercise. Effective February 10, 2010, JHA and Brotman enteredinto an amendment to the Term A loan, whereby the earliest date on which JHAcould provide notice of its exercise of the Put Right was extended from April 14,2010 to October 14, 2010.  Inaddition, the $6.25 million tranche of the JHA transaction will mature on April 14,2012 and Brotman will need to secure financing to retire this portion of thedebt.

 

The Geminofinancing was comprised of a $6.0 million, senior credit facility secured byaccounts receivable. The facility expires on the earlier of April 14, 2012and the JHA loan (see above) maturity date and bears interest at LIBOR plus 7%per annum, with a LIBOR floor of 4%. Interest is incurred based on the greaterof $2 million or the outstanding principal balance. The agreement also includesan unused line fee of 0.5% per annum and a collateral line fee, based on theaverage outstanding principal balance, of 0.5% per annum. The senior creditfacility agreement contains customary covenants for facilities of this type,including restrictions on the payment of dividends, change inownership/management, asset sales, incurrence of additional indebtedness,sale-leaseback transactions, and related party transactions. Brotman must alsocomply with financial covenants. Prior to a recent amendment discussed below,Brotman was required to comply with a fixed charge coverage ratio of not lessthan (i) 1.10:1.00 for the fiscal quarter ending June 30, 2009, (ii) 1.15:1.00for the fiscal quarter ending September 30, 2009; and (iii) 1.20:1.00for each fiscal quarter ending thereafter. As of September 30, 2009, Brotman was not in compliance with therequired financial covenants under the Gemino credit agreement.  Pursuant to an amendment entered intoeffective December 11, 2009, the Gemino credit agreement was amended toprovide, among other things, a waiver of the specified events of default andthe amendment to the definition of fixed charge coverage ratio.  Under the amended credit agreement, the fixedcharge coverage ratio was amended to require not less than (i) 1.00:1.00for the fiscal quarters ending December 31, 2009 and March 31, 2020; (ii) 1.05:1.00for the fiscal quarters ending June 30, 2010 and September 30, 2010; (iii) 1.10:1.00for the fiscal quarters ending December 31, 2010 and March 31, 2011;and (iv) 1.20:1.00 for the fiscal quarter ending June 30, 2011 andeach fiscal quarter ending thereafter. As of December 31, 2009, Brotman was in compliance with therequired financial covenants under the amended credit agreement.

 

The Class 4 Note, which was executed on April 14, 2009, the EffectiveDate of Brotman’s Plan of Reorganization, for the benefit of the allowed Class4 claims (as defined in the Plan of Reorganization) bears interest at 7.50% perannum and is payable in sixteen equal quarterly installments of principal andaccrued interest through February 15, 2013. The Note contains a covenant which,so long as amounts remain outstanding under the Note, restricts Brotman frompaying Prospect Medical Holdings, Inc. in cash a consulting fee of more than$100,000 per month, as specified in the Amended and Restated ConsultingServices Agreement (see Note 6 to the accompanying unaudited condensedconsolidated financial statements).  Assuch, although the amount of the consulting fee was increased to 4.5% ofBrotman’s net operating revenue effective April 14, 2009, the amount of suchconsulting fee actually paid in cash will remain at $100,000 per month untilsuch time permitted by applicable agreement or the Creditor Trust Note has beenamended or repaid. For the period April 14, 2009 through December 31, 2009,total principal repayments of on the Class 4 Note were approximately $751,000.

 

We anticipate attempting to finance future acquisitions and potentialbusiness expansion with a combination of debt, issuances of equity instrument,and cash flow from operations.

 

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In order to meet our long-term liquidity needs, we may incur, from timeto time, additional bank indebtedness. Banks and traditional commercial lendersdo not generally make loans to companies without substantial tangible networth. Since, by the nature of our business, we accumulate substantial goodwilland intangibles on our balance sheet, it may be difficult for us to obtain thistype of financing in the future. We may issue additional equity and debtsecurities, the availability and terms of which will depend upon market andother conditions. The corporate lending and equity markets have been affectedby the current credit market conditions, resulting in both a reduction in thenumber of transactions as well as the amount of funds raised. Transactions thathave been consummated are completed at lower valuations in the case of equityofferings and at higher interest costs in the case of debt offerings. Ourability to issue any debt or equity instruments in a public or private sale isalso restricted under certain circumstances, pursuant to contractualrestrictions in agreements with our lenders and the indenture governing theNotes (see above). There can be no assurance that additional financing will beavailable upon terms acceptable to us, if at all. The failure to raise thefunds necessary to finance our future cash requirements could adversely affectour ability to pursue our strategy and could adversely affect our futureresults of operations.

 

*Off-Balance Sheet Arrangements*

 

None.

 

**Critical Accounting Policies**

 

The accounting policies described below are considered critical inpreparing our unaudited condensed consolidated financial statements.  Critical accounting policies requiredifficult, subjective or complex judgments, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain. Thejudgments and uncertainties affecting the application of these policies includesignificant estimates and assumptions made by us using information available atthe time the estimates are made. Actual results could differ materially fromthose estimates.

 

***Consolidationof Financial Statements***

 

Under applicable financial reporting requirements, the financialstatements of the affiliated physician organizations with which we havemanagement services agreements are consolidated with our own financialstatements. This consolidation is required under FASB ASC 810-10(previously issued as EITF Issue No. 97-2, “Application of FASB Statement No. 94and APB Opinion No. 16 to Physician Practice Management Entities andCertain Other Entities with Contractual Management Arrangements”) because weare deemed to hold a controlling financial interest in such organizationsthrough a nominee shareholder. We can, through the assignable optionagreements, change the nominee shareholder at will on an unlimited basis andfor nominal cost. There is no limitation on our designation of a nomineeshareholder except that any nominee shareholder must be a licensed physician orotherwise permitted by law to hold shares in a professional medicalcorporation. The operations of our affiliated physician organizations have asignificant impact on our financial statements. The financial statements ofBrotman have been included in our consolidated financial statements since April 14,2009, when we acquired a majority stake in that entity. All inter-companyaccounts and balances have been eliminated in consolidation.

 

***RevenueRecognition***

* *

*Hospital Services Segment*

 

Operating revenue of the Hospital Services segment consists primarilyof net patient service revenue. We report net patient service revenue at theestimated net realizable amounts from patients, third-party payers and othersin the period in which services are rendered. A summary of the paymentarrangements with major third-party payers follows:

* *

*Medicare:*  Medicare is a federal program that providescertain hospital and medical insurance benefits to persons aged 65 and over,some disabled persons and persons with end-stage renal disease. Inpatientservices rendered to Medicare program beneficiaries are paid at prospectivelydetermined rates per discharge, according to a patient classification systembased on clinical, diagnostic, and other factors. Outpatient services are paidbased on a blend of prospectively determined rates and cost-reimbursedmethodologies. We are also reimbursed for various disproportionate share andMedicare bad debt components at tentative rates, with final settlementdetermined after submission of annual Medicare cost reports and audits thereofby the Medicare fiscal intermediary. Normal estimation differences betweenfinal settlements and amounts accrued in previous years are reflected in netpatient service revenue in the year of final settlement.

 

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*Medi-Cal:*  Medi-Cal is a joint federal-state fundedhealthcare benefit program that is administered by the state of California toprovide benefits to qualifying individuals who are unable to afford care.Inpatient services rendered to Medi-Cal program beneficiaries are paid atcontracted per diem rates. The per diem rates are not subject to retrospectiveadjustment. Outpatient services are paid based on prospectively determinedrates per procedure provided.

 

*Managed care:*  We also receive payment from certaincommercial insurance carriers, HMOs and PPOs. The basis for payment is inaccordance with contracted rates or at our standard charges for servicesprovided where no prior contract is in place.

 

*Self-Pay:*  Our hospitals also provide services tocertain individuals that do not have any form of healthcare coverage. Suchpatients are evaluated, at the time of service or shortly thereafter, for theirability to pay based upon federal and state poverty guidelines, qualificationsfor Medi-Cal, as well as our local hospital’s indigent and charity care policy.

 

Timely billing and collection of receivables from third-party payersand patients is critical to our operating performance. We closely monitor ourhistorical collection rates as well as changes in applicable laws, rules andregulations and contract terms, to assure that provisions for contractualallowances are made using the most accurate information available. Our primarycollection risks relate to uninsured patients and the portion of the bill whichis the patient’s responsibility, primarily co-payments and deductibles.Payments for services may also be denied due to issues over patient eligibilityfor medical coverage, our ability to demonstrate medical necessity for servicesrendered and payer authorization for hospitalization. We estimate provisionsfor doubtful accounts based on general factors such as payer mix, the age ofthe receivables and historical collection experience. We routinely reviewaccounts receivable balances in conjunction with these factors and othereconomic conditions which might ultimately affect the collectability of thepatient accounts and make adjustments to allowances for contractual discountsand bad debts as warranted.

 

*Medical Group Segment*

 

Operating revenue of our Medical Groups consists primarily ofcapitation payments for medical services provided by our affiliated physicianorganizations under contracts with HMOs. Capitation revenue under HMO contractsis prepaid monthly to the affiliated physician organizations based on thenumber and type of enrollees assigned to physicians in our affiliated physicianorganizations.

 

Capitation revenue paid by HMOs is recognized in the month in which theaffiliated physician organization is obligated to provide services. Capitationrevenue may be subsequently adjusted to reflect changes in enrollment as aresult of retroactive terminations or additions. Such retroactive terminationsor additions have historically not had a material effect on capitation revenue.

 

Variability in capitation revenue exists under Medicare’s capitationmodel referred to as “Risk Adjustment.” Under the model, capitation withrespect to Medicare enrollees is subject to subsequent adjustment by CMS basedon the acuity of the enrollees to whom services were provided. Capitation forthe current year is paid based on data submitted for each enrollee for previousperiods. Capitation is paid at interim rates during the year and is adjusted insubsequent periods (generally in our fourth fiscal quarter) after the finaldata has been processed by CMS. Positive or negative capitation adjustments aremade for Medicare enrollees with conditions requiring more or less healthcareservices than assumed in the interim payments. Since we cannot reliably predictthese adjustments, periodic changes in capitation amounts earned as a result ofRisk Adjustment are recognized when those changes are communicated from thehealth plans, generally in the fourth quarter of the fiscal year to which theadjustments relate. We recorded approximately $4.3 million and$1.6 million in increased capitation revenue in the fourth quarter offiscal 2009 and 2008, respectively, for risk adjustment factors.

 

We also earn additional incentive revenue or incur penalties under HMOcontracts by sharing in the risk for hospitalization based upon inpatientservices utilized. As of December 31, 2009, except for one contract wherewe are contractually obligated for down-side risk, shared risk deficits are notpayable unless and until we generate future risk-sharing surpluses. Risk poolsare generally settled in the third or fourth quarter of the following year. Dueto the lack of access to timely information necessary to estimate the relatedcosts, shared-risk amounts receivable from the HMOs are recorded when suchamounts are known. We also receive incentives under “pay-for-performance”programs for quality medical care based on various criteria.Pay-for-performance payments are generally recorded in the third and fourthquarters of our fiscal year when such amounts are known, once we are in receiptof information necessary to reliably estimate these amounts. Risk pool andpay-for-performance incentives are affected by many factors, some of which arebeyond our control, and may vary significantly from year to year.

 

Management fee revenue is earned in the month the services have beenperformed.

 

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***AccruedMedical Claims***

 

Our affiliated physician organizations are responsible for the medicalservices their contracted or employed physicians provide to an assigned HMOenrollee. The cost of healthcare services is recognized in the period in whichit is provided and includes an estimate of the cost of services which have beenincurred but not reported. The determination of our claims liability and otherhealthcare costs payable is particularly important to the determination of ourfinancial position and results of operations and requires the application ofsignificant judgment by our management, and as a result, is subject to aninherent degree of uncertainty.

 

Our medical care costs include actual historical claims experience andIBNR. We, together with our independent actuaries, estimate medical claimsliabilities using actuarial methods based upon historical data, adjusted forpayment patterns, cost trends, product mix, utilization of healthcare servicesand other relevant factors. The estimation methods and the resulting reservesare frequently reviewed and updated, and adjustments, if necessary, arereflected in the period they become known. While we believe our estimates areadequate and appropriate, it is possible that future events could require us tomake significant adjustments or revisions to these estimates. In assessing theadequacy of accruals for medical claims liabilities, we consider our historicalexperience, the terms of existing contracts, our knowledge of trends in theindustry, information provided by our customers and information available fromother sources, as appropriate.

 

The most significant estimates involved in determining our claimsliability concern the determination of claims payment completion factors andtrended per member per month cost estimates.

 

We consider historical activity for the current month, plus the prior24 months, in our IBNR calculation. For the fifth month of service priorto the reporting date and earlier, we estimate our outstanding claims liabilitybased upon actual claims paid, adjusted for estimated completion factors.Completion factors seek to measure the cumulative percentage of claims expensethat will have been paid for a given month of service as of a date subsequentto that month of service. Completion factors are based upon historical paymentpatterns. For the four months of service immediately prior to the reportingdate, actual claims paid are not a reliable measure of our ultimate liability,given the delay inherent between the patient/physician encounter and the actualsubmission of a claim for payment. For these months of service we estimate ourclaims liability based upon trended per member per month (“PMPM”) costestimates. These estimates reflect recent trends in payments and expense,utilization patterns, authorized services and other relevant factors.

 

The following tables reflect (i) the change in our estimate ofclaims liability as of December 31, 2009 that would have resulted had wechanged our completion factors for all applicable months of service included inour IBNR calculation (i.e., the preceding 5th through25th months) by the percentages indicated; and (ii) the change in ourestimate of claims liability as of December 31, 2009 that would haveresulted had we changed trended PMPM factors for all applicable months ofservice included in our IBNR calculation (i.e., the preceding1st through 4th months) by the percentages indicated. Changes inestimate of the magnitude indicated in the ranges presented are consideredreasonably likely.

 

| **Increase  (Decrease) in  Estimated Completion Factors** | ** ** | **Increase  (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                | ** ** | **(in  thousands)**                                          | ** ** |
| (3)%                                                      |       | $                                                            | (4,209     | ) |
| (2)%                                                      |       | $                                                            | (2,806     | ) |
| (1)%                                                      |       | $                                                            | (1,403     | ) |
|  1%                                                  |       | $                                                            | 1,403      |   |
|  2%                                                  |       | $                                                            | 2,806      |   |
|  3%                                                  |       | $                                                            | 4,209      |   |

 

| **Increase  (Decrease) in  Trended PMPM Factors** | ** ** | **Increase  (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **(in  thousands)**                                          | ** ** |
| (3)%                                              |       | $                                                            | (789       | ) |
| (2)%                                              |       | $                                                            | (526       | ) |
| (1)%                                              |       | $                                                            | (263       | ) |
| 1%                                                |       | $                                                            | 263        |   |
| 2%                                                |       | $                                                            | 526        |   |
| 3%                                                |       | $                                                            | 789        |   |

 

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The following table shows the components of the change in medicalclaims and benefits payable for the three months ended December 31, 2009and 2008 (in thousands):

 

| ** **                                            | ** ** | **Three  Months Ended  December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| IBNR as of beginning of period                        |       | $                                          | 16,824     |   | $ | 20,480 |   |
| Healthcare claims expense incurred during the  period |       |                                       |       |   |   |
| Related to current year                               |       | 18,922                                     |       | 19,255 |   |
| Related to prior years                                |       | (929                                       | )          | (1,510 | ) |
| Total incurred                                        |       | 17,993                                     |       | 17,745 |   |
| Healthcare claims paid during the period              |       |                                       |       |   |   |
| Related to current year                               |       | (6,646                                     | )          | (4,884 | ) |
| Related to prior years                                |       | (12,387                                    | )          | (14,424 | ) |
| Total paid                                            |       | (19,033                                    | )          | (19,308 | ) |
| IBNR as of end or period                              |       | $                                          | 15,784     |   | $ | 18,917 |   |

 

Through December 31, 2009, the $929,000 change in estimate relatedto IBNR as of September 30, 2009 represented approximately 5.5% of theIBNR balance as of September 30, 2009, approximately 1.3% of fiscal 2009claims expense, and after consideration of tax effect, approximately 38.4% ofnet loss for the year then ended.

 

Through December 31, 2008, the $1,510,000 change in estimate relatedto IBNR as of September 30, 2008 represented approximately 7.4% of theIBNR balance as of September 30, 2008, approximately 1.9% of fiscal 2008claims expense and after consideration of tax effect, approximately 35.9% ofnet income for the year then ended.

 

Past fluctuations in the IBNR estimates might also be a usefulindicator of the potential magnitude of future changes in these estimates.Quarterly IBNR estimates include provisions for adverse development based onhistorical volatility. We maintain similar provisions at fiscal year end.

 

We also regularly evaluate the need to establish premium deficiencyreserves for the probability that anticipated future healthcare costs couldexceed future capitation payments from the HMOs. To date, we have determinedthat no material premium deficiency reserves have been necessary.

 

***Goodwill and Intangible Assets***

 

ASC 805 (previously issued as SFAS No. 141) “*Business Combinations*,” requires all business combinationsafter June 30, 2001 to be accounted for using the purchase method andprohibits the pooling-of-interest method of accounting. ASC 805 also statesthat acquired intangible assets should be separately recognized upon meetingcertain criteria. Such intangible assets include, but are not limited to, tradeand service marks, non-compete agreements, customer lists and licenses. Weadopted the provisions of ASC 805 effective October 1, 2009.

 

ASC 350 (previously issued as SFAS No. 142, “*Goodwill and Other Intangible Assets*,”)requires that goodwill and indefinite life intangible assets not be subject toamortization but be evaluated for impairment on at least an annual basis, ormore frequently if certain indicators are present. Such indicators includeadverse changes in market value and/or stock price, laws and regulations,profitability, cash flows, our ability to maintain enrollment and renew payercontracts on favorable terms. A two-step impairment test is used to identifypotential goodwill impairment and to measure the amount of goodwill impairmentloss to be recognized (if any). The first step consists of estimating the fairvalue of the reporting unit based on recognized valuation techniques, whichinclude a weighted combination of (i) the guideline company method thatutilizes revenue or earnings multiples for comparable publicly-tradedcompanies, and (ii) a discounted cash flow model that utilizes future cashflows, the timing of those cash flows, and a discount rate (or weighted averagecost of capital which considers the cost of equity and cost of debt financingexpected by a representative market participant) representing the time value ofmoney and the inherent risk and uncertainty of the future cash flows. If theestimated fair value of the reporting unit is less than its carrying value, asecond step is performed to compute the amount of the impairment by determiningthe “implied fair value” of the goodwill, which is compared to itscorresponding carrying value.

 

Long-lived assets, including property, improvements and equipment andamortizable intangibles, are evaluated for impairment under ASC 360-10-35,(previously issued as SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*”) wheneverevents or changes in circumstances indicate that the carrying value of suchassets may not be recoverable. We consider assets to be impaired and write themdown to fair value if estimated undiscounted cash flows associated with thoseassets are less than their carrying amounts.

 

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In accordance with ASC 350, we performed our annual goodwill impairmentanalysis for each reporting unit that constitutes a business for which discretefinancial information is produced and reviewed by operating segment managementand provides services that are distinct from the other reporting units. For theHospital Services segment, the reporting unit for the annual goodwillimpairment analysis was determined to be at the segment level. For the MedicalGroup segment, we have determined that ProMed individually and Prospect (whichincludes all the other affiliated physician organizations) each represent areporting unit, based on operational characteristics. The ProMed Entities aregeographically and managerially their own reporting unit.

 

Our impairment test at September 30, 2009 resulted in noimpairment charges.  In addition, no triggeringevents were identified that would cause impairment analysis at December 31,2009.

 

The assessment of impairment indicators, measurement of impairmentloss, selection of appropriate valuation methodology, assumptions and discountfactors, involve significant judgment and requires management to project futureresults which are inherently uncertain.

 

***Recent Accounting Pronouncements***

 

In December 2007, the FASB issued guidance on ASC 810, “*Noncontrolling Interests in Consolidated FinancialStatements—an Amendment of ARB No. 51*”, previously known asSFAS No. 160. ASC 810 establishes accounting and reporting standards forthe noncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary. Minority interests will be re characterized as noncontrollinginterests and will be reported as a component of equity separate from theparent’s equity, and purchases or sales of equity interests that do not resultin a change in control will be accounted for as equity transactions. Inaddition, net income attributable to the noncontrolling interest will beincluded in consolidated net income on the face of the income statement andupon a loss of control, the interest sold, as well as any interest retained,will be recorded at fair value with any gain or loss recognized in earnings.This standard is effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. It requiresretroactive adoption of the presentation and expanded disclosure requirementsfor existing noncontrolling interests. All other requirements of the standardshall be applied prospectively. We adopted this standard effective October 1,2009. The adoption did not have a material impact on our condensed consolidatedfinancial statements.

 

InDecember 2007, the FASB updated guidance on ASC 805, “*BusinessCombinations*”, previously known as SFAS No. 141(R). ASC 805retains the fundamental requirements of guidance surrounding businesscombinations stating that the acquisition method of accounting be used for allbusiness combinations and for an acquirer to be identified for each businesscombination. ASC 805 defines the acquirer as the entity that obtains control ofone or more businesses in the business combination and establishes the acquisitiondate as the date that the acquirer achieves control. ASC 805 requires anacquirer to recognize the assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree at the acquisition date, measured attheir fair values as of that date, with limited exceptions specified in thestatement. This statement applies prospectively to business combinations forwhich the acquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008. We adopted thepronouncement effective October 1, 2009. The adoption did not have amaterial impact on our condensed consolidated financial statements for priorperiods; but the pronouncement will impact the accounting for acquisitionssubsequent to that date.

 

In June 2009,the FASB issued guidance on ASC 810-10, “*Consolidation of VariableInterest Entities, an interpretation of ARB No. 51*”, previouslyknown as FIN No. 46, to revise the approach to determine when a variableinterest entity (“VIE”) should be consolidated. The new consolidation model forVIEs considers whether the Company has the power to direct the activities thatmost significantly impact the VIE’s economic performance and shares in thesignificant risks and rewards of the entity. The guidance on VIE’s requirescompanies to continually reassess VIEs to determine if consolidation isappropriate and provide additional disclosures. The guidance is effective forfiscal years beginning after November 15, 2009. We will adopt the guidancefor interim and annual reporting periods beginning in the first quarter offiscal 2011 and are currently assessing the potential impact this guidance willhave on our consolidated financial statements.

 

InJune 2008, the FASB issued guidance contained in FASB ASC 260-10,previously known FASB Staff Position No. EITF 03-6-1. Under the guidance,unvested share-based payment awards that contain non-forfeitable rights as todividends or dividend equivalents are participating securities and, therefore,are included in computing earnings per share (“EPS”) pursuant to the two-classmethod. The two-class method determines earnings per share for each class ofcommon stock and participating securities according to dividends or dividendequivalents and their respective participation rights in undistributedearnings. We adopted the guidance effective October 1,2009.  The adoption of this guidance did not impact net incomeattributable to our Company per common share for prior periods and is notexpected to have an impact on future periods until such time as we declare aregular quarterly dividend.

 

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InAugust 2009, the FASB issued Accounting Standards Update No. 2009-05,“*Fair Value Measurements and Disclosures (Topic 820)— Measuring Liabilities at Fair Value*,” which provides guidance onhow to measure liabilities at fair value in circumstance in which a quotedprice in an active market for the identical liability is not available.  This update is effective for the firstreporting period, including interim periods, beginning after issuance.  The Company has no liabilities that aregoverned by this update but will apply its provisions in the future asapplicable.

 

***Legal and Other Loss Contingencies***

 

We are subject to contingencies, such as legal proceedings and claimsarising out of our business. In accordance with ASC 450, “*Accounting for Contingencies*,” we recordaccruals for such contingencies when it is probable that a liability will beincurred and the amount of loss can be reasonably estimated. A significantamount of management estimation is required in determining when, or if, anaccrual should be recorded for a contingent matter and the amount of suchaccrual, if any.

 

We are in the process of finalizing certain post-closing mattersrelated to the 2007 ProMed acquisition, including closing balance sheetreconciliations, escrow reconciliations and other matters. We have recorded anestimated settlement amount relating to such matters in the accompanyingunaudited condensed consolidated financial statements.

*** ***

***Acquisitions***

 

Our business has grown through a series of business combinations. Thesebusiness combinations were all accounted for using the purchase method ofaccounting, and accordingly, the operating results of each acquisition havebeen included in our consolidated financial statements since their effectivedate of acquisition. The purchase price for each business combination wasallocated to the assets, including the identifiable intangible assets, andliabilities, based on estimated fair values determined using independentappraisals where appropriate. The excess of purchase price over the nettangible assets acquired was allocated to goodwill and other intangible assets.

 

We have historically funded our acquisition program with debt, the saleof our common stock, and cash flow from operations. The assets that we and ouraffiliated physician organizations have acquired have been largely goodwill andintangible assets. The acquisition of physician organizations consistsprimarily of HMO contracts, physician contracts and the right to manage eachphysician organization through a management services agreement. The physician organizationswe acquire generally do not have significant tangible net equity; therefore,our acquired assets are predominantly goodwill and other intangible assets. Theacquisition of hospital operations consists primarily of trade names,covenants-not-to-compete and property, improvements and equipment.

 

The following table summarizes all business combinations for the threeyears ended December 31, 2009.

 
| **Business Combinations**                                | ** ** | **Effective Date**  | ** ** | **Purchase Price** | ** **  | **Location** |
|----------------------------------------------------------|------------|---------------------|------------|--------------------|-------------|--------------|
| ProMed  Entities                                         |       | June 1, 2007   |       | $                  | 48,392,000  |         | San  Bernardino and Los Angeles Counties |
| Alta                                                     |       | August 8, 2007 |       | $                  | 154,935,000 |         | Los  Angeles County |
| Brotman  (increased investment to a 71.9% interest) |       | April 14, 2009 |       | $                  | 2,556,000   |         | Los  Angeles County |

 

***Divestitures***

 

On August 1, 2008, we completed the sale of all of the outstandingstock of the AV Entities for total cash consideration of $8,000,000. Asrequired by ASC 360-10-35, “*Accounting forthe Impairment or Disposal of Long-Lived Assets*,” the assets andliabilities of the AV Entities and their operations have been presented in ourrecently filed Form 10-K as discontinued operations for all periodspresented. All references to operating results reflect our ongoing operations,excluding the AV Entities, unless otherwise noted.

*** ***

***Inflation***

 

According to U.S. Bureau of Labor Statistics Data, the nationalhealthcare cost inflation rate has exceeded the general inflation rate for thelast four years. We use various strategies to mitigate the negative effects ofhealthcare cost inflation. Specifically, we try to control physician andhospital costs through contracts with independent providers of healthcareservices and close monitoring of cost trends, emphasizing preventive healthcareand appropriate use of specialty and hospital services.

 

While we currently believe our strategies to mitigate healthcare costinflation will continue to be successful, competitive pressures, new healthcareand pharmaceutical product introductions, demands from healthcare providers andcustomers, applicable regulations or other factors may affect our ability tocontrol healthcare costs.

 

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**Item 3.  Quantitative and Qualitative Disclosuresabout Market Risk.**

 

Not applicable

 

**Item 4.  Controls and Procedures.**

 

***Evaluation of Disclosure Controls and Procedures***

 

Wecarried out an evaluation as of December 31, 2009, under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of our disclosure controls and procedures as defined in Rule 13a-15(e) ofthe Securities Exchange Act of 1934. Based upon that evaluation and in light ofthe material weakness in the financial reporting process at Brotman MedicalCenter discussed below, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were ineffective as ofthat date in ensuring that information required to be disclosed in the reportsthat we file with, or submit to, the Securities and Exchange Commission (the “SEC”)under the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andforms. In addition, based on that evaluation, the Chief Executive Officer andChief Financial Officer concluded that our disclosure controls and procedureswere ineffective as of December 31, 2009 in ensuring that informationrequired to be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934 is accumulated and communicated to ourmanagement, including the Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosures.

 

Seebelow for discussion of material weaknesses in internal control over financialreporting at Brotman, which became a majority-owned subsidiary effective April 14,2009.

 

*Summary ofMaterial Weaknesses in Internal Control over Financial Reporting:*

 

As part of our preliminary assessment of internal controls overfinancial reporting, we identified several deficiencies within the financialreporting process of Brotman. We believe the combination of these deficienciescreates an environment where there is a reasonable possibility that a materialmisstatement of Brotman’s financial statements would not be detected in atimely manner. We have assessed a material weakness in the financial reportingprocess of Brotman and its related impact on the corporate consolidatingfinancial reporting process. The deficiencies within the financial reportingprocess are the lack of a formalized month-end close process, limited stafftraining and financial accounting expertise and a lack of department accountingpolicies and procedures.

 

During the financial reporting close for the period ended September 30,2009, Brotman was unable to implement a structured close process which resultedin multiple delays and iterations of their financial statements. Accountreconciliations were not prepared in an accurate or timely manner whichresulted in a significant amount of post-close adjustments. Also, Brotman’saccounting department did not demonstrate a sufficient amount of expertise or trainingto sufficiently complete the steps needed to execute an accurate or timelyclose. Additionally, Brotman’s accounting department did not utilize orimplement policies and procedures to organize or streamline the close process.

 

As a result of these deficiencies, we are in the process ofimplementing significant changes in the Brotman accounting department. We addedadditional resources and personnel with experience in and an understanding ofthe complexities of the business and a financial reporting process. Additionalcontrol processes and oversight procedures have been implemented; however, alonger evaluation period is needed to reasonably validate that such processesand procedures are operating at a level to have fully remediated the material weaknessas of December 31, 2009. At Brotman, we continue to expend significantefforts on financial reporting activities, integration of operations andexpansion of our disclosure controls and procedures.

 

*RemediationSteps to Address Material Weaknesses:*

 

Based on findings of material weaknesses in our internal control overfinancial reporting, we have taken steps to strengthen our internal controlswithin the financial reporting process. We have added to the expertise anddepth of personnel within the Brotman accounting department, including theappointment of a new Chief Financial Officer and Controller, with specific andsignificant expertise in the critical areas identified above. We also addedadditional resources to assist in the review and preparation of significantaccount balance reconciliations as well as the implementation of new policiesand procedures. Also, senior management has increased its scrutiny andoversight of Brotman’s financial statements and has performed significanttop-down financial statement analysis to gain additional assurance as to theaccuracy of Brotman’s financial information. As previously stated, we willcontinue to work on and improve the financial reporting process of Brotman andits impact on the corporate consolidating financial reporting process. Inreview, the principal measures that we are in the process of undertaking toremediate the deficiencies are as follows:

 

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·                  Hired a new Chief FinancialOfficer and Controller and added additional resources to implement a soundfinancial reporting process;

 

·                  Enhanced Brotman’saccounting and finance policies and implemented more robust monitoring controlprocedures and analytics to prevent or detect a misstatement on a timely basis;

 

·                  Developed a financialreporting responsibility matrix, close calendar and checklist for Brotman,whereby all general ledger accounts and financial statement line items arespecifically assigned to a specific member of the accounting department toperform monthly, quarterly and year-end analysis. The analysis will be reviewedby senior members of the accounting department team for accuracy and integrity;

 

·                  Developing a formal monthly,quarterly and annual reporting package, including specific reporting andinformation for identified key risk areas, with formal sign off by thefinancial executive with specific oversight of each area;

 

·                  Documenting formalaccounting policies and procedures with regular compliance reviews of key riskareas to evaluate the designing and effectiveness of controls; and

 

·                  Enhancing the corporatefinancial reporting process oversight of the above mentioned controls andprocesses.

 

***Changes in Internal Control over Financial Reporting***

 

Except as discussed above, regarding Brotman, there have been nochanges in our Internal Control that occurred during the three months ended December 31,2009 that have materially affected, or are reasonably likely to materiallyaffect, our Internal Control.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

We and our affiliated physician organizations are parties to legalactions arising in the ordinary course of business. We believe that liability,if any, under these claims will not have a material adverse effect on ourconsolidated financial position or results of operations.

 

**Item 1A.  Risk Factors.**

 

Not applicable.

 

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

 

None.

 

**Item 3.  Defaults Upon Senior Securities.**

 

None.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

None

 

**Item 5.  Other Information**

 

None

 

**Item 6.  Exhibits.**

 

The followingdocuments are being filed as exhibits to this report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                      |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1*                |       | Employment  Agreement effective June 1, 2007 between Jeereddi Prasad, M.D. and ProMed  Health Care Administrators.                                             |
|                 |       |                                                                                                                                                           |
| 10.2*                |       | Amendment  No. 1 to Promissory Note entered into as of February 10, 2010 by Brotman  Medical Center, Inc. and JHA WEST 16, LLC.                                |
|                 |       |                                                                                                                                                           |
| 10.3*                |       | Amendment  No. 2 to Loan Agreement entered into as of February 10, 2010 by Brotman  Medical Center and JHA WEST 16, LLC.                                       |
|                 |       |                                                                                                                                                           |
| 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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| * | Filed with this  Quarterly Report on Form 10-Q. |
|---|------------------------------------------------------|

 

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                    | PROSPECT  MEDICAL HOLDINGS, INC. |
|-------------------------|---------------------------------------|
|                    | (Registrant)                          |
|                    |                                  |
| February 16,  2010 | **/**s**/**SAMUEL S. LEE              |
| ** **              | **Samuel S. Lee**                     |
| ** **              | **Chief Executive Officer**           |
| ** **              | **(Principal Executive Officer)**     |
| ** **              | ** **                            |
| February 16,  2010 | **/**s**/**MIKE HEATHER               |
| ** **              | **Mike Heather**                      |
| ** **              | **Chief Financial Officer**           |
| ** **              | **(Principal Financial Officer)**     |

 

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