**UNITED STATES**

**SECURITIES AND 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 the quarterly period ended June 30,  2005**                                                   |
|       |       |                                                                                                     |
| **or**     |
|       |       |                                                                                                     |
| ** ̈** | ** ** | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |

 

**Commissionfile number: 1-32203**

 

**ProspectMedical Holdings, Inc.**

(Exactname of registrant as specified in its charter)

 

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| **Delaware**                                                       | ** ** | **33-0564370**                        |
|--------------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction ofincorporation  or organization)    |       | (I.R.S.  EmployerIdentification  No.) |
|                                                               |       |                                  |
| **6083  Bristol Parkway, Suite 100  Culver City, California** |       | **90230**                             |
| (Address  of principal executive offices)                          |       | (Zip  Code)                           |

 

**(310) 338-8677**

**(Registrant’stelephone number, including area code)**

 

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

 

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

 

The number of shares of theissuer’s Common Stock, par value $0.01 per share, outstanding as of August 52005, was 6,640,374.

 

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**Index**

 
|             | ** **                                                                                                                            | **Page**   |
|------------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|
|             | **Part I – Financial Information**                                                                                          |       |
| **Item 1.**      | **Financial Statements**                                                                                                              |       |
| ** **       | ** **                                                                                                                            |       |
|             | Condensed  Consolidated Balance Sheets as of June 30, 2005 (unaudited) and  September 30, 2004                              | 3          |
|             |                                                                                                                                  |       |
|             | Condensed Consolidated Statements of Income for the  three-month and nine-month periods ended June 30, 2005 and 2004 (unaudited) | 4          |
|             |                                                                                                                                  |       |
|             | Condensed Consolidated Statements of Cash Flows for  the nine-month periods ended June 30, 2005 and 2004 (unaudited)             | 5          |
|             |                                                                                                                                  |       |
|             | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                     | 6          |
|             |                                                                                                                                  |       |
| **Item  2.**     | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                       | 10         |
| ** **       | ** **                                                                                                                            |       |
| **Item  3.**     | **Quantitative  and Qualitative Disclosures About Market Risk**                                                                       | 23         |
| ** **       | ** **                                                                                                                            |       |
| **Item 4.**      | **Controls  and Procedures**                                                                                                          | 24         |
| ** **       | ** **                                                                                                                            |       |
|             | **Part II – Other Information**                                                                                             |       |
|             | ** **                                                                                                                            |       |
| **Item 1.**      | **Legal  Proceedings**                                                                                                                | 25         |
| ** **       | ** **                                                                                                                            |       |
| **Item  2.**     | **Unregistered  Sales of Equity Securities and Use of Proceeds**                                                                      | 25         |
| ** **       | ** **                                                                                                                            |       |
| **Item  3.**     | **Defaults Upon Senior  Securities**                                                                                                  | **26**     |
| ** **       | ** **                                                                                                                            | ** ** |
| **Item  4.**     | **Submission of Matters to a  Vote of Security Holders**                                                                              | **26**     |
| ** **       | ** **                                                                                                                            | ** ** |
| **Item 5.**      | **Other information**                                                                                                                 | **26**     |
| ** **       | ** **                                                                                                                            | ** ** |
| **Item 6.** | **Exhibits**                                                                                                                          | **27**     |
| ** **       |                                                                                                                                  |
| **Signatures**   | 28                                                                                                                                    |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.   Financial Statements.**

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                | ** ** | **June 30  2005** | ** ** | **September 30  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                | ** ** | **(Unaudited)**        | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                |       |                   |       |                        |       |
| **Current  assets**                                                                                                                                                       |       |                   |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                |       | $                      | 14,600,744 |                        | $          | 20,330,754 |   |
| Investments                                                                                                                                                               |       | 1,162,000              |       | 512,687                     |       |
| Risk pool  receivables                                                                                                                                                    |       | —                 |       | 87,979                      |       |
| Other  receivables, net of allowances of $736,000 and $662,000 at June 30, 2005  and September 30, 2004                                                         |       | 903,574                |       | 1,122,864                   |       |
| Notes  receivable, current portion                                                                                                                                        |       | 51,559                 |       | 281,064                     |       |
| Prepaid  expenses and other                                                                                                                                               |       | 816,584                |       | 607,077                     |       |
| Refundable  income taxes                                                                                                                                                  |       | 888,372                |       | —                      |       |
| Deferred  income taxes, net                                                                                                                                               |       | 1,549,381              |       | 1,605,478                   |       |
| Total  current assets                                                                                                                                                     |       | 19,972,214             |       | 24,547,903                  |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| Property,  improvements and equipment:                                                                                                                                    |       |                   |       |                        |       |
| Land                                                                                                                                                                      |       | 40,620                 |       | 40,620                      |       |
| Leasehold  improvements                                                                                                                                                   |       | 726,973                |       | 714,619                     |       |
| Equipment                                                                                                                                                                 |       | 3,490,471              |       | 3,291,307                   |       |
| Furniture  and fixtures                                                                                                                                                   |       | 517,759                |       | 536,869                     |       |
|                                                                                                                                                                      |       | 4,775,823              |       | 4,583,415                   |       |
| Less  accumulated depreciation and amortization                                                                                                                           |       | (3,447,732             | )          | (2,977,411                  | )          |
| Property,  improvements and equipment, net                                                                                                                                |       | 1,328,091              |       | 1,606,004                   |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| Notes  receivable, long term portion                                                                                                                                      |       | 582,084                |       | 617,545                     |       |
| Prepaid  expenses and other, long term portion                                                                                                                            |       | 1,151,592              |       | 102,958                     |       |
| Goodwill                                                                                                                                                                  |       | 31,369,532             |       | 31,461,303                  |       |
| Other  intangible assets, net                                                                                                                                             |       | 1,459,867              |       | 1,952,291                   |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| Total assets                                                                                                                                                              |       | $                      | 55,863,380 |                        | $          | 60,288,004 |   |
|                                                                                                                                                                      |       |                   |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                            |       |                   |       |                        |       |
| **Current  liabilities:**                                                                                                                                                 |       |                   |       |                        |       |
| Accrued  medical claims and other health care costs payable                                                                                                               |       | $                      | 12,566,103 |                        | $          | 13,323,622 |   |
| Accounts  payable and other accrued liabilities                                                                                                                           |       | 6,533,947              |       | 7,523,808                   |       |
| Current  maturities of long-term debt and capital leases                                                                                                                  |       | 3,000,000              |       | 6,841,887                   |       |
| Total  current liabilities                                                                                                                                                |       | 22,100,050             |       | 27,689,317                  |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| Long-term  debt, less current maturities                                                                                                                                  |       | 6,666,667              |       | 8,166,667                   |       |
| Deferred  income taxes                                                                                                                                                    |       | 997,541                |       | 796,427                     |       |
| Other  long-term liabilities                                                                                                                                              |       | 185,000                |       | 685,000                     |       |
| Total  liabilities                                                                                                                                                        |       | 29,949,258             |       | 37,337,411                  |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| **Minority  interest**                                                                                                                                                    |       | 68,879                 |       | 63,653                      |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| **Shareholders’  equity:**                                                                                                                                           |       |                   |       |                        |       |
| Preferred  stock, $0.01 par value; 5,000,000 shares authorized; 1,918,664 and 2,265,237  shares issued and outstanding at June 30, 2005 and September 30,  2004 |       | 19,187                 |       | 22,652                      |       |
| Common  stock, $0.01 par value; 40,000,000 shares authorized 4,721,710 and 4,344,525  shares issued and outstanding at June 30, 2005 and September 30,  2004    |       | 47,217                 |       | 43,445                      |       |
| Additional  paid-in capital                                                                                                                                               |       | 18,477,129             |       | 18,630,525                  |       |
| Deferred  compensation                                                                                                                                                    |       | (144,703               | )          | (232,871                    | )          |
| Retained  earnings                                                                                                                                                        |       | 7,446,413              |       | 4,423,189                   |       |
| Total shareholders’  equity                                                                                                                                          |       | 25,845,243             |       | 22,886,940                  |       |
|                                                                                                                                                                      |       |                   |       |                        |       |
| Total  liabilities and shareholders’ equity                                                                                                                          |       | $                      | 55,863,380 |                        | $          | 60,288,004 |   |

 

See accompanying notes.

 

3

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited)**

 
| ** **                                                 | ** ** | **Three months ended  June 30** | ** ** | **Nine months ended  June 30** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Revenues                                                   |       | $                                    | 32,392,874 |                                | $          | 35,657,239 |   | $ | 98,004,333 |   | $ | 94,502,109 |   |
| Cost of  Revenues                                          |       | 22,844,535                           |       | 26,453,815                          |       | 71,301,361 |   | 68,693,961 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Gross margin                                               |       | 9,548,339                            |       | 9,203,424                           |       | 26,702,972 |   | 25,808,148 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Operating  expenses:                                       |       |                                 |       |                                |       |   |   |   |   |
| General and  administrative                                |       | 7,551,833                            |       | 6,363,174                           |       | 20,674,911 |   | 18,418,544 |   |
| Depreciation  and amortization                             |       | 308,167                              |       | 202,532                             |       | 805,077 |   | 535,339 |   |
| Total  operating expenses                                  |       | 7,860,000                            |       | 6,565,706                           |       | 21,479,988 |   | 18,953,883 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Operating  income (loss) from unconsolidated joint venture |       | 206,668                              |       | (74,895                             | )          | 304,350 |   | 125,856 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Operating  income                                          |       | 1,895,007                            |       | 2,562,823                           |       | 5,527,334 |   | 6,980,121 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Other  (income) expense:                                   |       |                                 |       |                                |       |   |   |   |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Investment  income                                         |       | (114,422                             | )          | (21,314                             | )          | (291,810 | ) | (45,192 | ) |
| Interest  expense                                          |       | 309,946                              |       | 19,056                              |       | 759,363 |   | 73,930 |   |
| Total other  (income) expense, net                         |       | 195,524                              |       | (2,258                              | )          | 467,553 |   | 28,738 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Income  before income taxes                                |       | 1,699,483                            |       | 2,565,081                           |       | 5,059,781 |   | 6,951,383 |   |
| Provision  for income taxes                                |       | 674,344                              |       | 976,884                             |       | 2,021,153 |   | 2,715,155 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Net income  before minority interest                       |       | 1,025,139                            |       | 1,588,197                           |       | 3,038,628 |   | 4,236,228 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Minority  interest                                         |       | 10,459                               |       | 4,885                               |       | 15,403 |   | 16,625 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Net income                                                 |       | $                                    | 1 014,680  |                                | $          | 1,583,312 |   | $ | 3,023,225 |   | $ | 4,219,603 |   |
|                                                       |       |                                 |       |                                |       |   |   |   |   |
| Net income  per common share:                              |       |                                 |       |                                |       |   |   |   |   |
| Basic                                                      |       | $                                    | 0.22       |                                | $          | 0.36 |   | $ | 0. 67 |   | $ | 0.98 |   |
| Diluted                                                    |       | $                                    | 0.12       |                                | $          | 0.20 |   | $ | 0.35 |   | $ | 0.62 |   |
| Weighted  average shares outstanding:                      |       |                                 |       |                                |       |   |   |   |   |
| Basic                                                      |       | 4,679,997                            |       | 4,344,525                           |       | 4,524,031 |   | 4,314,168 |   |
| Diluted                                                    |       | 8,398,644                            |       | 7,936,752                           |       | 8,614,469 |   | 6,795,379 |   |

 

See accompanying notes. 

 

4

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                                              | ** ** | **Nine months ended  June 30** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Operating  activities**                                                                                               |       |                                |       |   |   |
| Net income                                                                                                              |       | $                                   | 3,023,225  |   | $ | 4,219,603 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities:                           |       |                                |       |   |   |
| Depreciation  and amortization                                                                                          |       | 805,077                             |       | 535,339 |   |
| Provision  for bad debts                                                                                                |       | 75,349                              |       | 196,682 |   |
| Gain on  disposal of assets                                                                                             |       | —                              |       | (5,558 | ) |
| Deferred  income taxes, net                                                                                             |       | 257,211                             |       | (195,360 | ) |
| Change in  deferred compensation                                                                                        |       | 88,168                              |       | 82,161 |   |
| Changes in  operating assets and liabilities, net of assets acquired and liabilities  assumed in purchase transactions: |       |                                |       |   |   |
| Risk pool  receivables                                                                                                  |       | 87,980                              |       | 921,127 |   |
| Other  receivables                                                                                                      |       | 143,941                             |       | 56,988 |   |
| Prepaid  expenses and other                                                                                             |       | (1,258,141                          | )          | (287,728 | ) |
| Income taxes  receivable                                                                                                |       | (888,372                            | )          | — |   |
| Accrued  medical claims and other health care costs payable                                                             |       | (757,519                            | )          | (941,023 | ) |
| Accounts  payable and other accrued liabilities                                                                         |       | (1,489,861                          | )          | 550,184 |   |
|                                                                                                                    |       |                                |       |   |   |
| Net cash  provided by operating activities                                                                              |       | 87,058                              |       | 5,132,415 |   |
|                                                                                                                    |       |                                |       |   |   |
| **Investing  activities**                                                                                               |       |                                |       |   |   |
| Purchases of  property, improvements and equipment                                                                      |       | (192,407                            | )          | (492,843 | ) |
| Cash paid  for acquisitions, net of cash received                                                                       |       | —                              |       | (3,318,171 | ) |
| Collections  on notes receivable                                                                                        |       | 264,965                             |       | 72,658 |   |
| Capitalized  acquisition costs                                                                                          |       | 249,437                             |       | (254,465 | ) |
| Increase in  restricted certificates of deposit                                                                         |       | (649,313                            | )          | (47,246 | ) |
| Proceeds  from sale of medical clinic                                                                                   |       | —                              |       | 300,000 |   |
| Other                                                                                                                   |       | 5,227                               |       | 54,825 |   |
| Net cash  used in investing activities                                                                                  |       | (322,091                            | )          | (3,685,242 | ) |
|                                                                                                                    |       |                                |       |   |   |
| **Financing  activities**                                                                                               |       |                                |       |   |   |
| Repayment of  note payable to shareholder                                                                               |       | —                              |       | (500,000 | ) |
| Net repayments  on line of credit                                                                                       |       | (4,000,000                          | )          | (2,200,000 | ) |
| Repayments  of note payable and capital leases                                                                          |       | (1,341,888                          | )          | (1,016,637 | ) |
| Issuance of  common and preferred stock, net of issuance costs                                                          |       | (153,089                            | )          | 10,643,619 |   |
| Net cash  (used in) provided by financing activities                                                                    |       | (5,494,977                          | )          | 6,926,982 |   |
|                                                                                                                    |       |                                |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                                                                   |       | (5,730,010                          | )          | 8,374,155 |   |
|                                                                                                                    |       |                                |       |   |   |
| Cash and  cash equivalents at beginning of period                                                                       |       | 20,330,754                          |       | 6,516,907 |   |
|                                                                                                                    |       |                                |       |   |   |
| Cash and  cash equivalents at end of period                                                                             |       | $                                   | 14,600,744 |   | $ | 14,891,062 |   |
|                                                                                                                    |       |                                |       |   |   |
| **Supplemental  cash flow information**                                                                                 |       |                                |       |   |   |
| Cash paid  during the period for:                                                                                       |       |                                |       |   |   |
| Income taxes                                                                                                            |       | $                                   | 3,625,286  |   | $ | 2,609,949 |   |
| Interest                                                                                                                |       | $                                   | 759,363    |   | $ | 73,930 |   |
|                                                                                                                    |       |                                |       |   |   |
| Details of  businesses acquired:                                                                                        |       |                                |       |   |   |
| Fair value  of assets acquired                                                                                          |       |                                |       | $ | 19,161,171 |   |
| Liabilities  assumed or created                                                                                         |       |                                |       | (8,661,171 | ) |
| Less cash  acquired                                                                                                     |       |                                |       | (7,181,829 | ) |
| Net cash  paid for acquisitions                                                                                         |       |                                |       | $ | 3,318,171 |   |
|                                                                                                                    |       |                                |       |   |   |
| Common stock  issued in exchange for services rendered                                                                  |       |                                |       | $ | 279,510 |   |

 

5

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**PROSPECTMEDICAL HOLDINGS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**June 30,2005**

**(Unaudited)**

 

**1. Reporting Entity**

 

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

 

**2. Basis of Presentation**

 

The unaudited condensedconsolidated interim financial statements have been prepared under theassumption that users of the interim financial data have either read or haveaccess to our audited consolidated financial statements for the latest fiscalyear ended September 30, 2004. Accordingly, certain note disclosures thatwould substantially duplicate the disclosures contained in the September 30,2004 audited financial statements have been omitted. These unauditedconsolidated interim financial statements should be read in conjunction withour September 30, 2004 audited financial statements.

 

The unaudited condensedconsolidated financial statements include the accounts of the Company and allmajority owned subsidiaries and controlled entities. In the opinion ofmanagement, all adjustments considered necessary for a fair presentation of theresults as of the date and for the interim periods presented, which consistsolely of normal recurring adjustments, have been included. All significantinter-company balances and transactions have been eliminated in consolidation.The consolidated results of operations for the current interim period are notnecessarily indicative of the results that may be expected for the entire yearending September 30, 2005.

 

Certain prior year amounts in theaccompanying condensed consolidated financial statements have been reclassifiedto conform to the 2005 presentation.

 

Revenues are comprised of the following amounts:

 
| ** **       | ** ** | **Three Months Ended June 30,** | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **       | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Capitation       |       | $                                    | 30,577,983 |                                | $          | 34,880,399 |   | $ | 94,507,961 |   | $ | 91,739,714 |   |
| Fee for  service |       | 632,637                              |       | 458,905                             |       | 1,696,242 |   | 2,001,342 |   |
| Management  fees |       | 171,216                              |       | 210,118                             |       | 598,150 |   | 628,576 |   |
| Other            |       | 1,011,038                            |       | 107,817                             |       | 1,201,980 |   | 132,477 |   |
| Total  revenues  |       | $                                    | 32,392,874 |                                | $          | 35,657,239 |   | $ | 98,004,333 |   | $ | 94,502,109 |   |

 

**3. Stock Based Compensation**

 

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

 

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

 

6

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

 

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

 

The Company has adopted the disclosurerequirements under SFAS No. 148. The following table illustrates theeffect on net income and earnings per share as if the Company had applied thefair value recognition provisions for the three and nine month periods ended June 30,2004 and 2005.

 
| ** **                                                                                                                 | ** ** | **Three months ended  June 30** | ** ** | **Nine months ended  June 30** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income,  as reported                                                                                                   |       | $                                    | 1,014,680  |                                | $          | 1,583,312 |   | $ | 3,023,225 |   | $ | 4,219,603 |   |
| Reconciling  items (net of related tax effects):                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Add:  Stock-based employee compensation expense determined under the  intrinsic-value based method, included in net income |       | 29,389                               |       | 45,697                              |       | 88,168 |   | 119,046 |   |
| Deduct:  Stock-based employee compensation expense determined under the fair-value based  method                           |       | (26,971                              | )          | (93,410                             | )          | (331,886 | ) | (187,887 | ) |
| Net  adjustment                                                                                                            |       | 2,418                                |       | (47,713                             | )          | (243,718 | ) | (68,841 | ) |
| Pro forma  net income                                                                                                      |       | $                                    | 1,017,098  |                                | $          | 1,535,599 |   | $ | 2,779,507 |   | $ | 4,150,762 |   |
|                                                                                                                       |       |                                 |       |                                |       |   |   |   |   |
| Earnings per  share:                                                                                                       |       |                                 |       |                                |       |   |   |   |   |
| Basic—as  reported                                                                                                    |       | $                                    | 0.22       |                                | $          | 0.36 |   | $ | 0.67 |   | $ | 0.98 |   |
| Basic—pro  forma                                                                                                      |       | $                                    | 0.22       |                                | $          | 0.35 |   | $ | 0.61 |   | $ | 0.96 |   |
| Diluted—as  reported                                                                                                  |       | $                                    | 0.12       |                                | $          | 0.20 |   | $ | 0.35 |   | $ | 0.62 |   |
| Diluted—pro  forma                                                                                                    |       | $                                    | 0.12       |                                | $          | 0.19 |   | $ | 0.32 |   | $ | 0.61 |   |

 

The fair value of these options, all of whichwere granted prior to the Company becoming a public reporting entity, wasestimated at the date of grant using a Minimum Value option pricing model, withthe following weighted average assumptions:

 
| Expected  market price of the Company’s common stock on the date of grant |   | $3.07 to  $5.05 |   | $ 3.07  to $5.05 |   | $3.07 to  $7.15 |   | $ 3.07 to  $5.05 |   |
|--------------------------------------------------------------------------------|--------|-----------------|--------|-----------------------|--------|-----------------|--------|-----------------------|--------|
| Weighted  average expected life of the options                                 |   | 4 years         |   | 4 to 4.5  years       |   | 4 to 4.5  years |   | 4 years               |   |
| Risk-free  interest rate                                                       |   | 3.00%           |   | 3.00%                 |   | 3.00% to  4.17% |   | 3.00%                 |   |
| Dividend  yield                                                                |   | 0.00%           |   | 0.00%                 |   | 0.00%           |   | 0.00%                 |   |

 

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

 

On October 13, 2004,the Financial Accounting Standards Board concluded that Statement No. 123R,“*Share-Based Payment*,” whichrequires all companies to measure compensation cost for all share-basedpayments (including employee stock options) at fair value, would be effectivefor public companies for annual periods beginning after June 15, 2005.SFAS No. 123R will eliminate our ability to account for share-basedcompensation using the intrinsic value method permitted under Opinion No. 25.We will utilize the modified prospective method, recognizing compensation costfor share-based awards to employees based on their grant-date fair values fromthe beginning of the year in which the recognition provisions are first appliedas if the fair value-based method had been used to account for all employeeawards. Under this transition approach, 

 

7

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compensation cost will be recognized for all awardsgranted, modified or settled after the date of adoption as well as to anyawards that were not fully vested as of that date.   We intend to apply the new rules beginningOctober 1, 2005, as required.

 

**4. Earnings Per Share**

 

The denominators for the computation of basicand diluted earnings per share are calculated as follows:

 
| ** **                                                               | ** ** | **Three months ended  June 30** | ** ** | **Nine months ended  June 30** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic  earnings per common share:                                        |       |                                 |       |                                |       |   |   |   |   |
| Numerator –  net income                                             |       | $                                    | 1,014,680  |                                | $          | 1,583,312 |   | $ | 3,023,225 |   | $ | 4,219,603 |   |
|                                                                     |       |                                 |       |                                |       |   |   |   |   |
| Denominator  – weighted average number of common shares outstanding |       | 4,679,997                            |       | 4,344,525                           |       | 4,524,031 |   | 4,314,168 |   |
|                                                                     |       |                                 |       |                                |       |   |   |   |   |
| Basic  earnings per common share                                         |       | $                                    | 0.22       |                                | $          | 0.36 |   | $ | 0.67 |   | $ | 0.98 |   |
|                                                                     |       |                                 |       |                                |       |   |   |   |   |
| Diluted  earnings per common share:                                      |       |                                 |       |                                |       |   |   |   |   |
| Numerator –  net income                                             |       | $                                    | 1,014,680  |                                | $          | 1,583,312 |   | $ | 3,023,225 |   | $ | 4,219,603 |   |
|                                                                     |       |                                 |       |                                |       |   |   |   |   |
| Denominator:                                                             |       |                                 |       |                                |       |   |   |   |   |
| Weighted  average number of common shares outstanding                    |       | 4,679,997                            |       | 4,344,525                           |       | 4,524,031 |   | 4,314,168 |   |
| Dilutive  stock options, warrants and preferred shares                   |       | 3,718,647                            |       | 3,592,227                           |       | 4,090,438 |   | 2,481,211 |   |
|                                                                     |       | 8,398,644                            |       | 7,936,752                           |       | 8,614,469 |   | 6,795,379 |   |
|                                                                     |       |                                 |       |                                |       |   |   |   |   |
| Diluted  earnings per common share                                       |       | $                                    | 0.12       |                                | $          | 0.20 |   | $ | 0.35 |   | $ | 0.62 |   |

 

**5. Related Party Transactions**

 

The Company has an employment agreement withour Chief Executive Officer, Jacob Y. Terner, which is for a three-year termthat ended on August 1, 2005, and is currently in the process of beingrenewed. The agreement provides for a specified annual compensation and in theevent that the Company terminates Dr. Terner’s employment without cause,the Company will be required to pay him $12,500 for each month of past serviceas the Chief Executive Officer, commencing as of July 31, 1996. Thecontingent termination obligation was capped at $1,237,500, effective September 30,2004. Since the Company has not indicated any intention to terminate Dr. Terner,no such potential liability is accrued as of June 30, 2005.

 

Prospect Medical Group, Inc. (PMG),which is wholly owned by Dr. Terner, and whose accounts are consolidatedin these financial statements under EITF 97-2, maintains an intercompanyaccount with Prospect Medical Holdings, Inc. The intercompany account hashistorically represented a significant receivable for PMG which, because of itsintercompany nature, generally was not includable in the HMOs’ and regulatoryagencies’ determination of tangible net equity (TNE). In the event that PMG wasrequired by the HMOs or regulatory agencies to maintain a positive TNE andpositive working capital, Dr. Terner had agreed to personally guaranteethe intercompany account receivable due from Prospect Medical Holdings, Inc.up to a level sufficient to enable PMG to attain positive TNE and workingcapital.

 

On June 1, 2003, in consideration for Dr. Terner’spersonal guarantee and pledge, the Compensation Committee of the Board ofDirectors granted to Dr. Terner a six-year, non-qualified stock option topurchase 800,000 shares of common stock at $3.00 per share. During its term, Dr. Terner’spersonal guarantee was supported through the pledge of certain of his personalassets. Dr. Terner agreed to maintain his personal guarantee andcollateral in effect until PMG had positive tangible net equity. This personalguarantee arrangement was terminated by the Board of directors effective January 19,2005.

 

8

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**6. Long Term Debt**

 

Long-term debt at June 30, 2005 consistsof the following:

 

| Term loan                                                                 | ** ** | **$**          | **8,666,667** | ** ** |
|---------------------------------------------------------------------------|------------|----------------|---------------|------------|
| Revolving  credit facility, interest at prime rate plus applicable margin | ** ** | **1,000,000**  | ** **    |
| ** **                                                                | ** ** | **9,666,667**  | ** **    |
| Less current  maturities                                                  | ** ** | **(3,000,000** | **)**         |
| ** **                                                                | ** ** | **$**          | **6,666,667** | ** ** |

 

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

 

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

 

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

 

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

 

**Proposed Investment in Brotman Medical Center**

 

In May 2005, we made a $675,000 investmenttoward the purchase of a minority stake in Brotman Medical Center (“Brotman”)from an affiliate of Tenet Healthcare Corporation. The remainder of theownership in Brotman will be held by admitting physicians, other strategicinvestors and the Brotman management team, none of whom will have a controllinginterest in Brotman. The total purchase price for Brotman will be approximately$11 million, substantially all of which will be financed under the termsof a financing commitment currently in place. The financing is non-recourse tous. We made our investment in a newly formed acquisition entity, BrotmanMedical Center, Inc. (“BMCI”). Exclusive of transaction costs, we are notrequired to make any additional investment in the transaction and will not beresponsible for any of the obligations of BMCI or Brotman. The entire amount ofour investment, including expenses, will be funded from our existing cashresources.

 

Brotman Medical Center, founded in 1924, is a 420-bedhospital located at 3828 Delmas Terrace in Culver City, California. Thehospital offers a wide range of inpatient and outpatient acute care services aswell as rehabilitation, psychiatric care and chemical dependency services. Thehospital also operates a 24-hour emergency services center. Brotman is fullyaccredited by the Joint Commission on the Accreditation of HealthcareOrganizations.

 

Closing of the transaction is dependent uponsatisfaction of all conditions required by the asset purchase agreement,obtaining various state and federal regulatory approvals, and finalizing allnecessary investor participation and financing arrangements

 

9

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

 

**Forward-Looking Statements**

 

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

 

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

 

 Forward-looking statements involve known andunknown risks and uncertainties that may cause our actual results in futureperiods to differ materially from those projected or contemplated in theforward-looking statements as a result of, but not limited to, the followingfactors:

 

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

 

•                  Our working capital deficit could adversely affect our ability to satisfyour obligations as they come due.

 

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

 

•                  We may not be able to make any additional significant acquisitionswithout first obtaining additional financing and obtaining the consent of ourcommercial lender.

 

•                  If we are not able to comply with thefinancial covenants and other conditions required by our loan agreement withour commercial lender, our lender could require full repayment of the loan,which would negatively impact our liquidity and preclude us from making furtheracquisitions.

 

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

 

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

 

•                  Our operating results could be adversely affected if our actual healthcare claims exceed our reserves.

 

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

 

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

 

10

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

 

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

 

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

 

•                  If we are unable to identify suitable acquisition candidates or tonegotiate or complete acquisitions on favorable terms, our prospects for growthcould be limited.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

•                  If we were to lose the services of Dr. Terneror other key members of management, we might not be able to replace them in atimely manner with qualified personnel, which could disrupt our business andreduce our profitability and revenue growth.

 

•                  We and our affiliated physician organizations may become subject toclaims of medical malpractice or HMO bad-faith liability claims for which ourinsurance coverage may not be adequate. Such claims could materially increaseour costs and reduce our profitability.

 

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

 

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

 

11

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

 

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

 

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

 

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

 

Investors should also referto our Form 10 registration statement filed with the Securities andExchange on April 7, 2005 for a discussion of risk factors. Given theserisks and uncertainties, we can give no assurances that any forward-lookingstatements will in fact occur and therefore caution investors not to placeundue reliance on them.

 

**Overview**

 

Prospect Medical Holdings, Inc. (we, orthe “company”) is a health care management services organization. We providemanagement services to affiliated physician organizations that operate as independentphysician associations (“IPAs”) or medical clinics.  Our affiliated physician organizations enterinto agreements with health maintenance organizations (“HMOs”) to provideenrollees of the HMOs with a full range of medical services in exchange forfixed, prepaid monthly fees known as “capitation” payments.

 

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

 

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

 

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

 

The twelve affiliated physician organizationsprovide medical services to a combined total of approximately 178,000 HMOenrollees at June 30, 2005, including the AMVI Prospect Health Networkenrollees comprising approximately 5,600 enrollees that we manage for our owneconomic benefit, and 7,300 enrollees that we manage for the economic benefitof our partner in this joint venture, for which we earn management fee income.Currently, our affiliated physician organizations have contracts withapproximately ten HMOs, from which our revenue is primarily derived. HMOs offera comprehensive health care benefits package in exchange for a capitation feeper enrollee that does not vary through the contract period regardless of the quantityof medical services required or used. HMOs enroll members by entering intocontracts with employer groups or directly with individuals to provide a broadrange of health care services for a prepaid charge, with 

 

12

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

 

 Ourconsolidated business has grown through the acquisition of IPAs by ProspectMedical Group. Our plan is for Prospect Medical Group to continue to acquireadditional IPAs. We do not intend to further acquire any individual or smallmedical practices, clinics or medical group practices.

 

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

 

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

 

Revenues arecomprised of the following amounts:

 
| ** **       | ** ** | **Three months ended  June 30,** | ** ** | **%****of  Increase  (Decrease)** | ** ** | **Nine months ended   June 30,** | ** ** | **%****of  Increase  (Decrease)** | ** ** |
|------------------|------------|---------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|
| ** **       | ** ** | **2005**                              | ** ** | **2004**                          | ** ** | ** **                            | **2005**   | ** **                        | **2004**   | ** ** |
| Capitation       |       | $                                     | 30,577,983 |                              | $          | 34,880,399                            |       | (12.3                             | )%         | $ | 94,507,961 |   | $ | 91,739,714 |   | 3.0 | % |
| Fee for  service |       | 632,637                               |       | 458,905                           |       | 37.9                                  | %          | 1,696,242                         |       | 2,001,342 |   | (15.2 | )% |
| Management  fees |       | 171,216                               |       | 210,118                           |       | (18.5                                 | )%         | 598,150                           |       | 628,576 |   | (4.8 | )% |
| Other            |       | 1,011,038                             |       | 107,817                           |       | 837.7                                 | %          | 1,201,980                         |       | 132,477 |   | 807.3 | % |
|             |       |                                  |       |                              |       |                                  |       |                              |       |   |   |   |   |
| Total            |       | $                                     | 32,392,874 |                              | $          | 35,657,239                            |       | (9.2                              | )%         | $ | 98,004,333 |   | $ | 94,502,109 |   | 3.7 | % |

 

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

 

| **Member Category** | ** ** | **As of  June 30,  2005** | ** ** | **As of  June 30,  2004** | ** ** |
|---------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Commercial          |       | 150,100                        |       | 182,500                        |       |
| Senior              |       | 13,100                         |       | 16,100                         |       |
| MediCal -  owned    |       | 7,200                          |       | 7,200                          |       |
| MediCal -  managed  |       | 7,300                          |       | 7,100                          |       |
|                |       |                           |       |                           |       |
| Total               |       | 177,700                        |       | 212,900                        |       |

 

The following table details total paid membermonths, by member category, for the three and nine-month periods ended June 30,2005 and 2004:

 
| ** **         | ** ** | **Three months ended  June 30,** | ** ** | **%****of  Increase  (Decrease)** | ** ** | **Nine months ended  June 30,** | ** ** | **%****of  Increase  (Decrease)** | ** ** |
|--------------------|------------|---------------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|
| ** **         | ** ** | **2005**                              | ** ** | **2004**                          | ** ** | ** **                           | **2005**   | ** **                        | **2004**   | ** ** | ** ** |
| Commercial         |       | 454,000                               |       | 533,000                           |       | (15                                  | )%         | 1,407,000                         |       | 1,468,000 |   | (4 | )% |
| Senior             |       | 43,000                                |       | 49,000                            |       | (12                                  | )%         | 129,000                           |       | 131,000 |   | (2 | )% |
| MediCal -  owned   |       | 21,000                                |       | 21,000                            |       | 0                                    | %          | 64,000                            |       | 61,000 |   | 5 | % |
| MediCal -  managed |       | 22,000                                |       | 22,000                            |       | 0                                    | %          | 67,000                            |       | 65,000 |   | 3 | % |
|               |       |                                  |       |                              |       |                                 |       |                              |       |   |   |   |   |
| Total              |       | 540,000                               |       | 625,000                           |       | (14                                  | )%         | 1,667,000                         |       | 1,725,000 |   | (3 | )% |

 

13

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

 

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

 

Capitation payments arefixed in advance of periods covered and are not subject to significantaccounting estimates. These payments are expensed in the period the providersare obligated to provide services. Fee-for-service payments are expensed in theperiod services are provided to our members. Medical care costs include actualhistorical claims experience and estimates of medical expenses incurred but notreported, or IBNR. Monthly, we estimate our IBNR based on a number of factors, 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 monthly as more information becomes available. Inaddition to our own IBNR estimation process, we obtain twice annualcertifications of our IBNR liability from independent actuaries. We believethat our process for estimating IBNR is adequate, but there can be no assurancethat medical care costs will not exceed such estimates.

 

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

 

**Results of Operations**

 

The followingtable sets forth selected revenue categories, cost of revenue categories andother income statement items for the three and nine month periods ended June 30,2005 and 2004:

 
| ** **                                       | ** ** | **Three months ended  June 30,** | ** ** | **%****Increase  (Decrease)** | ** ** | **Nine months ended  June 30,** | ** ** | **%****Increase  (Decrease)** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **2005**                              | ** ** | **2004**                      | ** ** | ** **                           | **2005**   | ** **                    | **2004**   | ** ** | ** ** |
| Revenues:                                        |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Capitation                                       |       | $                                     | 30,577,983 |                          | $          | 34,880,399                           |       | (12.3                         | )%         | $ | 94,507,961 |   | $ | 91,739,714 |   | 3.0 | % |
| Fee for  service                                 |       | 632,637                               |       | 458,905                       |       | 37.9                                 | %          | 1,696,242                     |       | 2,001,342 |   | (15.2 | )% |
| Management  fees                                 |       | 171,216                               |       | 210,118                       |       | (18.5                                | )%         | 598,150                       |       | 628,576 |   | (4.8 | )% |
| Other                                            |       | 1,011,038                             |       | 107,817                       |       | 837.7                                | %          | 1,201,980                     |       | 132,477 |   | 807.3 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Total  revenues                                  |       | $                                     | 32,392,874 |                          | $          | 35,657,239                           |       | (9.2                          | )%         | $ | 98,004,333 |   | $ | 94,502,109 |   | 3.7 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Cost of  revenues:                               |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| PCP  Capitation                                  |       | 5,654,861                             |       | 7,279,830                     |       | (22.3                                | )%         | 18,044,279                    |       | 18,278,442 |   | (1.3 | )% |
| Specialists  Capitation                          |       | 5,279,637                             |       | 6,568,717                     |       | (19.6                                | )%         | 17,052,359                    |       | 17,282,505 |   | (1.3 | )% |
| Claims  expense                                  |       | 10,710,814                            |       | 11,249,540                    |       | (4.8                                 | )%         | 33,695,075                    |       | 29,301,381 |   | 15.0 | % |
| Physician  salaries                              |       | 926,040                               |       | 1,071,496                     |       | (13.6                                | )%         | 1,998,882                     |       | 3,048,281 |   | (34.4 | )% |
| Other cost  of revenues                          |       | 273,183                               |       | 284,232                       |       | (3.9                                 | )%         | 510,766                       |       | 783,352 |   | (34.8 | )% |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Total cost  of revenues                          |       | 22,844,535                            |       | 26,453,815                    |       | (13.6                                | )%         | 71,301,361                    |       | 68,693,961 |   | 3.8 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Gross margin                                     |       | 9,548,339                             |       | 9,203,424                     |       | 3.7                                  | %          | 26,702,972                    |       | 25,808,148 |   | 3.5 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| General and  administrative expenses             |       | 7,551,833                             |       | 6,363,174                     |       | 18.7                                 | %          | 20,674,911                    |       | 18,418,544 |   | 12.3 | % |
| Depreciation  and amortization expense           |       | 308,167                               |       | 202,532                       |       | 52.2                                 | %          | 805,077                       |       | 535,339 |   | 50.4 | % |
| Total  operating expenses                        |       | 7,860,000                             |       | 6,565,706                     |       | 19.7                                 | %          | 21,479,988                    |       | 18,953,883 |   | 13.3 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Income  (loss) from unconsolidated joint venture |       | 206,668                               |       | (74,895                       | )          | —                               |       | 304,350                       |       | 125,856 |   | 141.8 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Operating  Income                                |       | 1,895,007                             |       | 2,562,823                     |       | (26.1                                | )%         | 5,527,334                     |       | 6,980,121 |   | (20.8 | )% |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Other  (income) expense, net                     |       | 195,524                               |       | (2,258                        | )          | —                               |       | 467,553                       |       | 28,738 |   | 1,526.9 | % |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Income  before income taxes                      |       | 1,699,483                             |       | 2,565,081                     |       | (33.7                                | )%         | 5,059,781                     |       | 6,951,383 |   | (27.2 | )% |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Provision  for income taxes                      |       | 674,344                               |       | 976,884                       |       | (31.0                                | )%         | 2,021,153                     |       | 2,715,155 |   | (25.6 | )% |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Minority  interest                               |       | 10,459                                |       | 4,885                         |       | 114.1                                | %          | 15,403                        |       | 16,625 |   | (7.3 | )% |
|                                             |       |                                  |       |                          |       |                                 |       |                          |       |   |   |   |   |
| Net income                                       |       | $                                     | 1,014,680  |                          | $          | 1,583,312                            |       | (35.9                         | )%         | $ | 3,023,225 |   | $ | 4,219,603 |   | (28.4 | )% |

 

14

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The followingtable sets forth selected operating items, expressed as a percentage of totaloperating revenue:

 
| ** **                                       | ** ** | **Three Months  Ended March 31,** | ** ** | **Nine months  Ended March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2005**                               | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                        |       |                                   |       |                                  |       |   |   |   |   |
| Capitation  revenue                              |       | 94.4                                   | %          | 97.8                                  | %          | 96.5 | % | 97.1 | % |
| Fee for  service revenue                         |       | 2.0                                    | %          | 1.3                                   | %          | 1.7 | % | 2.1 | % |
| Management  fees                                 |       | 0.5                                    | %          | 0.6                                   | %          | 0.6 | % | 0.7 | % |
| Other  revenues                                  |       | 3.1                                    | %          | 0.3                                   | %          | 1.2 | % | 0.1 | % |
| Total  revenues                                  |       | 100.0                                  | %          | 100.0                                 | %          | 100.0 | % | 100.0 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Cost of  revenues:                               |       |                                   |       |                                  |       |   |   |   |   |
| PCP  Capitation                                  |       | 17.5                                   | %          | 20.5                                  | %          | 18.4 | % | 19.4 | % |
| Specialists  Capitation                          |       | 16.3                                   | %          | 18.4                                  | %          | 17.4 | % | 18.3 | % |
| Claims  expense                                  |       | 33.1                                   | %          | 31.5                                  | %          | 34.5 | % | 31.0 | % |
| Physician  salaries                              |       | 2.8                                    | %          | 3.0                                   | %          | 2.0 | % | 3.2 | % |
| Other cost  of revenues                          |       | 0.8                                    | %          | 0.8                                   | %          | 0.5 | % | 0.8 | % |
| Total cost  of revenues                          |       | 70.5                                   | %          | 74.2                                  | %          | 72.8 | % | 72.7 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Gross margin                                     |       | 29.5                                   | %          | 25.8                                  | %          | 27.2 | % | 27.3 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| General and  administrative expenses             |       | 23.3                                   | %          | 17.8                                  | %          | 21.1 | % | 19.5 | % |
| Depreciation  and amortization expense           |       | 1.0                                    | %          | 0.6                                   | %          | 0.8 | % | 0.6 | % |
| Total  operating expenses                        |       | 24.3                                   | %          | 18.4                                  | %          | 21.9 | % | 20.1 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Income  (loss) from unconsolidated joint venture |       | 0.6                                    | %          | (0.2                                  | )%         | 0.3 | % | 0.2 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Operating  income                                |       | 5.8                                    | %          | 7.2                                   | %          | 5.6 | % | 7.4 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Other  (income) expense, net                     |       | 0.7                                    | %          | 0.0                                   | %          | 0.5 | % | 0.0 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Income  before income taxes                      |       | 5.1                                    | %          | 7.2                                   | %          | 5.1 | % | 7.4 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Provision  for income taxes                      |       | 2.1                                    | %          | 2.8                                   | %          | 2.1 | % | 2.9 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Minority  Interest                               |       | 0.0                                    | %          | 0.0                                   | %          | 0.0 | % | 0.0 | % |
|                                             |       |                                   |       |                                  |       |   |   |   |   |
| Net income                                       |       | 3.0                                    | %          | 4.4                                   | %          | 3.0 | % | 4.5 | % |

 

15

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**Three Months Ended June 30, 2005Compared to Three Months Ended June 30, 2004**

 

*Capitation Revenue*

 

Capitation revenue for thethree months ended June 30, 2005 was $30,577,983, representing a decreaseof $4,302,416 (12.3%) over capitation revenue for the three months ended June 30,2004, of $34,880,399.

 

The decrease is comprised oftwo main factors. We estimate that higher capitation rates on our corebusiness, exclusive of acquisitions, contributed approximately $500,000 inincreased capitation revenue during the 2005 period as compared to the 2004period. We estimate that enrollment declines reduced capitation revenue byapproximately $4,800,000 during the 2005 period, as compared to the 2004period.

 

*Fee for service revenue*

 

Fee for servicerevenue for the three months ended June 30, 2005 was $632,637,representing an increase of $173,732 (37.9%) over fee for service revenue forthe three months ended June 30, 2004, of $458,905.

 

The increase in fee forservice revenue during the 2005 quarter was primarily the result of improvedfacilities at our medical clinics which had recently completed a majorrenovation in the 2004 period.

 

*Management fee revenue*

 

Management feerevenue for the three months ended June 30, 2005 was $171,216,representing a decrease of $38,902 (18.5%) over management fee revenuefor the three months ended June 30, 2004, of $210,118.

 

The decrease inmanagement fee revenue during the 2005 quarter was primarily the result of anadjustment to the monthly per member management fee required under a newcontract.

 

*Other revenue*

 

Other revenuefor the three months ended June 30, 2005 was $1,011,038 representing anincrease of $903,221 (837.7%) over other revenue for the three months ended June 30,2004, of $107,817.

 

The increase in otherrevenue during the 2005 quarter was primarily the result of an initialpay-for-performance bonus received from our contracted Health Plans for whichthere was no corresponding amount in the prior quarter.

 

16

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*PCP Capitation Expense*

 

Primary CarePhysician (“PCP”) capitation expense for the three months ended June 30,2005 was $5,654,861, representing a decrease of $1,624,969 (22.3%) overPCP capitation expense for the three months ended June 30, 2004, of$7,279,830.

 

This decrease in PCPcapitation expense during the 2005 period, as compared to the 2004 periodresulted primarily from the enrollment declines discussed above.

 

*Specialist Capitation Expense*

 

Specialist capitationexpense for the three months ended June 30, 2005 was $5,279,637,representing a decrease of $1,289,080 (19.6%) over specialist capitationexpense for the three months ended June 30, 2004, of $6,568,717.

 

This decrease in specialistcapitation expense resulted primarily from the enrollment declines discussedabove and a slight increase in specialist expenses that were paid on afee-for-service basis as opposed to a capitation basis.

 

*Claims Expense*

 

Claims expense for the threemonths ended June 30, 2005 was $10,710,814, representing a decrease of$538,726 (4.8%) over claims expense for the three months ended June 30,2004, of $11,249,540.

 

This decrease in claimsexpense resulted primarily from the enrollment declines discussed above, whichdecrease was partially offset by the increase in specialist expenses paid on a fee-for-service basis asopposed to a capitation basis.

 

*Physician Salaries Expense*

 

Physician salaries expensefor the three months ended June 30, 2005 was $926,040, representing adecrease of $145,456 (13.6%) over physician salaries expense for the threemonths ended June 30, 2004, of $1,071,496.

 

The decrease inphysician salaries expense during the 2005 quarter was primarily the result oflower bonus accruals compared to the 2004 quarter.

 

*Other Cost of Revenue*

 

Other cost of revenue forthe three months ended June 30, 2005 was $273,183, representing a decreaseof $11,049 (3.9%) over other cost of revenue for the three months ended June 30,2004, of $284,232.

 

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

 

*Gross Margin*

 

Medical care costs as apercentage of medical revenues (the medical care ratio) largely determines ourgross margin. Our gross margin increased by 3.7%, to 29.5% in the 2005 quarter,from 25.8% in the 2004 quarter.

 

The increase in our grossmargin percentage between the fiscal 2004 and fiscal 2005 periods was primarilythe result of the increase in pay for performance bonuses that accounted for2.3%.  In addition, PCP and specialistcapitation decreased as a percent of sales by 2.4% and 1.6%, respectivelycompared to the same quarter in 2004. This was offset by an increase in the claims expense of 2.6% as apercent of sales.

 

*General and AdministrativeExpenses*

 

General and administrativeexpenses were $7,551,833 for the 2005 quarter, representing 23.2% of totalrevenues, as compared with $6,363,174, or 17.8% of total revenues, for the 2004quarter.

 

17

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The increasein general and administrative expenses during the 2005 quarter was primarilythe result of increased cost of outside services related totarget acquisitions and information technology assistance, and softwarelicensing costs.

 

*Depreciation and Amortization*

 

Depreciation andamortization expense for the three months ended June 30, 2005 increased to$308,167 from $202,532 for the same period of the prior year. The increase wasprimarily due to accelerating, effective April 1, 2005, the rate ofamortization of identifiable intangible assets acquired in the February 1,2004 acquisitions described above, as well as depreciation expense associatedwith increased capital expenditures.

 

*Other income (expense), net*

 

Other income (expense), netfor the three months ended June 30, 2005 increased to a net expense of$195,525 from net investment income of $2,258 for the same period of the prioryear. The increase in net interest expense during the 2005 period was primarilydue to the $15 million GMAC Residential Funding Corporation credit facilityentered into during September 2004.

 

*Provision for Income Taxes*

 

Income taxexpense decreased approximately 31.0%, or $302,540, to $674,344 for the 2005quarter, from $976,884 in the 2004 quarter. The decrease in income tax expensewas principally due to a 33.7% decrease in pretax income.

 

**Nine months Ended June 30,2005 Compared to Nine months Ended June 30, 2004**

 

*Capitation Revenue*

 

Capitation revenue for thenine months ended June 30, 2005 was $94,507,961, representing an increaseof $2,768,247 (3.02%) over capitation revenue for the nine months ended June 30,2004 of $91,739,714.

 

The increase is comprised ofthree main factors. We estimate that net membership growth from the February 1,2004 acquisitions contributed approximately $9,300,000 in increased capitationrevenue during the 2005 period as compared to the 2004 period. We estimate thathigher capitation rates on our core business, exclusive of acquisitions,contributed approximately $2,400,000 in increased capitation revenue during the2005 period as compared to the 2004 period. We estimate that enrollmentdeclines related to our core business, exclusive of the acquisitions, reducedcapitation revenue by approximately $9,000,000 during the 2005 period, ascompared to the 2004 period.

 

*Fee for service revenue*

 

Fee for service revenue forthe nine months ended June 30, 2005 was $1,696,242 representing a decreaseof $305,101 (15.2%) over fee for service revenue for the nine months ended June 30,2004, of $2,001,342.

 

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

 

*Management fee revenue*

 

Management fee revenue forthe nine months ended June 30, 2005 was $598,150, representing a decreaseof $30,426 (4.8%) over management fee revenue for the nine months ended June 30,2004, of $628,576.

 

The decrease in managementfee revenue for service revenue during the 2005 period was primarily the resultof an adjustment to the monthly per member management fee required under  a new contract.

 

18

----

 

*Other revenue*

 

Other revenue for the ninemonths ended June 30, 2005 was $1,201,980, representing an increase of$1,069,503 (807.3%) over other revenue for the nine months ended June 30,2004, of $132,477.

 

The increase in otherrevenue during the 2005 period was primarily the result of an initial pay forperformance bonuses (additional revenue for meeting certain level of carethresholds) received from our contracted Health Plans for which there was nocorresponding amount in the prior quarter.

 

*PCP Capitation Expense*

 

Primary Care Physician (PCP)Capitation expense for the nine months ended June 30, 2005 was$18,044,279, representing a decrease of $234,163 (1.3%) over PCP capitationexpense for the nine months ended June 30, 2004, of $18,278,442.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $2,200,000 in increased PCP capitation expense during the 2005period, as compared to the 2004 period. This increase was offset by reduced PCPcapitation expense resulting from the enrollment declines discussed above.

 

*Specialist Capitation Expense*

 

SpecialistCapitation expense for the nine months ended June 30, 2005 was$17,052,359, representing a decrease of $230,146 (1.3%) over specialistcapitation expense for the six months ended June 30, 2004, of $17,282,505.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributedapproximately $2,300,000 in increased specialist capitation expense during the2005 period, as compared to the 2004 period. This increase was offset byreduced specialist capitation expense resulting from the enrollment declinesdiscussed above.

 

*Claims Expense*

 

Claims expense for the ninemonths ended June 30, 2005 was $33,695,075, representing an increase of$4,393,694 (15.0%) over claims expense for the nine months ended June 30,2004, of $29,301,381.

 

We estimate that netmembership growth from the February 1, 2004 acquisitions contributed themajority of the increased claims expense during the 2005 period, as compared tothe 2004 period.

 

*Physician Salaries Expense*

 

Physician salaries expensefor the nine months ended June 30, 2005 was $1,998,882, representing adecrease of $1,049,399 (34.4%) over physician salaries expense for the ninemonths ended June 30, 2004, of $3,048,281.

 

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

 

*Other Cost of Revenue*

 

Other cost of revenue forthe nine months ended June 30, 2005 was $510,766, representing a decreaseof $272,585 (34.8%) over other cost of revenue for the nine months ended June 30,2004, of $783,352.

 

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

 

19

----

 

*Gross Margin*

 

Medical care costs as apercentage of medical revenues (the medical care ratio) largely determines ourgross margin. Our gross margin decreased .01%, to 27.2% for the nine monthsended June 30, 2005, from 27.3% for the nine months ended June 30,2004.

 

The most significant factorsin the decrease in our gross margin percentage between the fiscal 2004 andfiscal 2005 periods the result of the increase in pay for performance bonusesthat accounted for 1.0%. Physician salaries expense decreased by 1.2% followingthe sale of the Gateway clinics combined with lower physician bonusaccruals.   In addition, PCP andspecialist capitation decreased as a percent of sales by 0.7% and 0.7%,respectively compared to the same period in 2004.  This was offset by an increase in the claimsexpense of 3.8% as a percent of sales.

 

*General and AdministrativeExpenses*

 

General and administrativeexpenses were $20,647,911 for the 2005 period, representing 21.1% of totalrevenues, as compared with $18,418,544, or 19.5% of total revenues, for the2004 period.

 

The increase in general andadministrative expenses during the 2005 period was primarily the result ofadditional personnel and benefit costs following the January 31, 2004acquisitions. The increase in general and administrative expenses as apercentage of revenues resulted from small comparative increases in outsideservice expense, bad debt expense, software licensing, marketing and rent.

 

*Depreciation and Amortization*

 

Depreciation andamortization expense for the nine months ended June 30, 2005 increased to$805,077 from $535,339 for the same period of the prior year. The increase wasprimarily due to accelerating, effective April 1, 2005, the rate ofamortization of identifiable intangible assets acquired in the February 1,2004 acquisitions described above, as well as additional depreciation expensefor increased capital expenditures.

 

*Other income (expense), net*

 

Other income (expense), netfor the nine months ended June 30, 2005 increased to a net expense of$467,553 from $28,738 for the same period of the prior year. The increase innet interest expense was primarily due to the $15 million GMAC ResidentialFunding Corporation credit facility entered into during September 2004.

 

*Provision for Income Taxes*

 

Income tax expense decreasedapproximately 25.6%, or $694,002, to $2,021,153 for the 2005 period, from$2,715,155 million in the 2004 period. The decrease in income tax expense wasprincipally due to a 27.2% decrease in pretax income.

 

**Liquidity and Capital Resources**

 

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

 

Our investment policies aredesigned to preserve principal, maintain liquidity for operations and statutoryrequirements,   and maximize investmentreturn. As of June 30, 2005, we invested a substantial portion of our cashin a portfolio that included Federal Home Loan bonds with an average maturityof approximately 60 days, overnight and high yield money market funds. All ofthese amounts are classified as current assets and included in cash and cashequivalents in the accompanying balance sheets. We are also required by some ofour HMO contracts to set aside certain amounts in restricted certificates ofdeposit. These restricted certificates of deposit, with an average maturity ofapproximately 75 days as of June 30, 2005, are included in Investments inthe accompanying financial statements.

 

20

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Net cash provided  by operations was $338,569 for the ninemonths ended June 30, 2005 and $5,132,415 for the nine months ended June 30,2004. The decrease in net cash provided by operations for the nine months endedJune 30, 2005 when compared to the nine months ended June 30, 2004was due to the following factors:

 

•                  decreased net income ($1,196,378 lower in2005);

 

•                  increased depreciation and amortization expense($269,738 higher in 2005);

 

•                  changes in net deferred taxes, a source of$257,211 in the nine months ended June 30, 2005 compared to a use of$195,360 in the nine months ended June 30, 2004.

 

•                  changes in accounts receivable balances, asource of $231,921 in the nine months ended June 30, 2005 compared to asource of $978,115 in the nine months ended June 30, 2004;

 

•                  changes in prepaid expenses and other, a use of$1,258,141 in the six months ended June 30, 2005 compared to a use of$287,728 in the six months ended June 30, 2004.

 

•                  changes in income tax receivable, a use of$888,372 for the nine months ended June 30, 2005 compared to a zero forthe nine months ended June 30, 2004;

 

•                  changes in medical claims liabilities, whichwere a use of $757,519 in the nine months ended June 30, 2005 compared toa use of $941,023 in the nine months ended June 30, 2004.

 

•                  changes in accounts payable, a use of$1,489,861 for the nine months ended June 30, 2005 compared to a source of$550,184 for the nine months ended June 30, 2004;

 

These factors were offset in part by the followingfactors:

 

•                  payments on our notes receivable from sale ofthe Gateway clinics, a source of $264,965 for the nine months ended June 30,2005 compared to a source of $72,658 for the nine months ended June 30,2004; and

 

•                  changes in capitalized acquisition costs, asource of $249,437 in the nine months ended June 30, 2005 compared to ause of $254,465 in the nine months ended June 30, 2004.

 

•                  Changes in restricted certificates ofdeposit, a use of $649,313 in the nine months ended June 30, 2005 comparedto a use of $47,246 in the nine months ended June 30, 2004.

 

•                  repayments on our line of credit, a use of$4,000,000 in the nine months ended June 30, 2005 compared to a use of$2,200,000 in the nine months ended June 30, 2004

 

•                  repayments of notes payable and capitalleases, a use of $1,341,888 in the nine months ended June 30, 2005compared to a use of $1,016,637 in the nine months ended June 30, 2004

 

At June 30, 2005, wehad negative working capital of $2,127,836 as compared to negative workingcapital of $3,141,414 at September 30, 2004. At June 30, 2005 and September 30,2004, cash and cash equivalents were $14,600,744 and $20,330,754, respectively.The decrease in cash and cash equivalents resulted primarily from the itemsdiscussed above, the more significant of which include repaying $4,000,000 onour line of credit facility, paying down accounts payable by $1,489,861,repayments of  notes payable and capitalleases of $1,341,888 and an increase in restricted investments of approximately$602,000.

 

Our subsidiaries arerequired to maintain minimum capital prescribed by various HMOs with whom we contract.As of June 30, 2005, all of our subsidiaries were in compliance with theminimum capital requirements. Barring any change in regulatory requirements, webelieve that we will continue to be in compliance with these requirements atleast through the end of fiscal 2006. We also believe that our cash resourcesand internally generated funds will be sufficient to support our operations,regulatory requirements and capital expenditures for at least the next 12months.

 

21

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**Contractual Obligations**

 

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

 

**Critical Accounting Policies**

 

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

 

Our medical care costsinclude actual historical claims experience and estimates for medical carecosts incurred but not reported to us (“IBNR”). We, together with ourindependent actuaries, estimate medical claims liabilities using actuarialmethods based upon historical data adjusted for payment patterns, cost trends,product mix, utilization of health care services and other relevant factors.The estimation methods and the resulting reserves are frequently reviewed andupdated, and adjustments, if necessary, are reflected in the period known.While we believe our estimates are adequate, it is possible that future eventscould require us to make significant adjustments or revisions to theseestimates. In assessing the adequacy of accruals for medical claimsliabilities, we consider our historical experience, the terms of existingcontracts, our knowledge of trends in the industry, information provided by ourcustomers and information available from other sources as appropriate.

 

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

 

We consider historicalactivity for the current month, plus the prior 24 months, in our IBNRcalculation. For the months of service five months prior to the reporting dateand earlier, we estimate our outstanding claims liability based upon actualclaims paid, adjusted for estimated completion factors. Completion factors seekto measure the cumulative percentage of claims expense that will have been paidfor a given month of service as of a date subsequent to that month of service.Completion factors are based upon historical payment patterns. For the fourmonths of service immediately prior to the reporting date, actual claims paidare not a reliable measure of our ultimate liability, given the delay inherentbetween the patient/physician encounter and the actual submission of a claimfor payment. For these months of service we estimate our claims liability basedupon trended per member per month (“PMPM”) cost estimates. These estimatesreflect recent trends in payments and expense, utilization patterns, authorizedservices and other relevant factors. The following tables reflect (i) thechange in our estimate of claims liability as of June 30, 2005 that wouldhave resulted had we changed our completion factors for all applicable monthsof service included in our IBNR calculation (i.e., the preceding 5th  through 25th months) by thepercentages indicated; and (ii) the change in our estimate of claimsliability as of June 30, 2005 that would have resulted had we changedtrended PMPM factors for all applicable months of service included in our IBNRcalculation (i.e., the preceding 1st through 4th months) by the percentages indicated.

 

| **Increase (Decrease) in  Estimated  Completion Factors** | ** ** | **Increase (Decrease) in****Accrued****Medical Claims  Payable** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| (3)%                                                      |       | $                                                                | 3,300,000  |   |
| (2)%                                                      |       | $                                                                | 2,200,000  |   |
| (1)%                                                      |       | $                                                                | 1,100,000  |   |
| 1%                                                        |       | $                                                                | (1,100,000 | ) |
| 2%                                                        |       | $                                                                | (2,200,000 | ) |
| 3%                                                        |       | $                                                                | (3,300,000 | ) |

 

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| **Increase (Decrease) in  Trended PMPM Factors** | ** ** | **Increase (Decrease) in****Accrued****Medical Claims  Payable** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------|------------|
| (3)%                                             |       | $                                                                | (600,000   | ) |
| (2)%                                             |       | $                                                                | (400,000   | ) |
| (1)%                                             |       | $                                                                | (200,000   | ) |
| 1%                                               |       | $                                                                | 200,000    |   |
| 2%                                               |       | $                                                                | 400,000    |   |
| 3%                                               |       | $                                                                | 600,000    |   |

 

Additionally, for each 1%(hypothetical) difference between our June 30, 2005 estimated claimsliability (of $12,566,103) and the actual claims incurred run-out, net incomefor the nine months ended June 30, 2005 would increase or decrease byapproximately $75,000, while diluted net income per share would increase ordecrease by approximately $0.01 per share, net of tax.

 

The following table showsthe components of the change in medical claims and benefits payable for thenine months ended June 30, 2005:

 
| ** **                                                         | ** ** | **2005**    | ** ** |
|--------------------------------------------------------------------|------------|-------------|------------|
| IBNR as of  beginning of period                                    |       | $           | 13,323,622 |   |
| Health care  claim expenses incurred during the period related to: |       |        |       |
| Current year                                                       |       | 34,984,790  |       |
| Prior years                                                        |       | (1,289,715  | )          |
| Total  incurred                                                    |       | 33,695,075  |       |
| Health care  claims paid during the period related to:             |       |        |       |
| Current year                                                       |       | (23,117,828 | )          |
| Prior years                                                        |       | (11,334,766 | )          |
| Total paid                                                         |       | (34,452,594 | )          |
|                                                               |       |        |       |
| IBNR as of  end of period                                          |       | $           | 12,566,103 |   |

 

**Inflation**

 

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

 

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

 

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

 

**Concentrations of Credit Risk**

 

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

 

As of June 30, 2005, wehad cash and cash equivalents of $14,600,744. Cash equivalents consist ofhighly liquid securities with original maturities of up to three months. Weinvest a substantial portion of our cash equivalents in Federal Home Loan bondsand overnight, high yield money market funds. We also had $1,162,000 ofinvestments, primarily consisting of restricted, interest-bearing certificatesof deposit required by various HMOs with whom we do business. These investmentsare subject to interest rate risk and will decrease in value if market ratesincrease. All non-restricted investments are maintained at fair market value onthe balance sheet. We have the ability to hold these investments untilmaturity, and as 

 

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a result, we would not expect the value of theseinvestments to decline significantly as a result of a sudden change in marketinterest rates. Declines in interest rates over time will reduce our investmentincome.

 

Ourterm loan with Residential Funding Corporation, with a balance of $8,666,667 atJune 30, 2005, requires monthly principal payments of $166,667 and monthlyinterest payments at prime plus 2% per annum. The fair value of this debtinstrument is affected by changes in market interest rates. As of June 30,2005, the carrying value of our term loan approximated its estimated fairvalue. Considerable judgment is required to develop estimates of fair value.Accordingly, the estimate is not necessarily indicative of the amount we couldrealize in a current market exchange. The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts. For terms relating to our long-term debt, see Note 6 of theNotes to Condensed Consolidated Financial Statements.

 

**Item 4. Controls and Procedures.**

 

***Evaluation of Disclosure Controls and Procedures:***Our management, with the participation of ourChief Executive Officer and our Chief Financial Officer, has concluded, basedupon its evaluation as of the end of the period covered by this report, thatthe Company’s “disclosure controls and procedures” (as defined in Rules 13(a)-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”))are effective to ensure that information required to be disclosed in thereports that the Company files or submits under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

***Changes in Internal Controls:***There were no changes in the Company’sinternal control over financial reporting during the nine months ended June 30,2005 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal controls over financial reporting.

 

***Sarbanes-Oxley 404 Compliance:***We have begun a detailed assessment of ourinternal controls as called for by the Sarbanes-Oxley Act of 2002. We are stillin the evaluation of design phase. We have supplemented our internal projectteam with the services of an outside specialist. Although we have made thisproject a priority for the Company, there can be no assurances that all controldeficiencies that may be identified and validated will be remediated before therequired due date of September 30, 2006.

 

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**PART II – OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

St. Jude Medical Center Lawsuit

 

In 1998,Prospect Medical Group, Inc. filed a motion to compel arbitration againstSt. Jude Medical Center and PacifiCare of California (PacifiCare), in OrangeCounty Superior Court (Prospect Medical Group, Inc. v. St. Jude MedicalCenter and PacifiCare of California). The action arose due to the failure bySt. Jude Medical Center to provide an accurate accounting of the hospitalincentive pools for the years 1997, 1998 and 1999. The motion to compelarbitration was granted by the Orange County Superior Court.

 

In November 2001,the Arbitrator awarded Prospect $1,200,000, plus interest at 10% per annum fromJanuary 1, 1999 until paid, plus legal fees of approximately $1,000,000.PacifiCare was released from the Prospect claim, and Prospect was ordered topay PacifiCare’s legal fees of approximately $125,000. Included in fiscal 2000net patient service revenue is the $1,200,000 award as this represents therealization of a receivable which existed as of September 30, 2000.

 

In a counterclaim, the Arbitrator awarded St. Jude $275,000, plus interest at 10% per annumfrom January 1, 1999 until paid. These amounts are included in the fiscal2001 financial statements. Net interest receivable and legal fees to bereimbursed have also been recorded.

 

In November 2001,Prospect received a partial payment of $925,000, related to the above amounts.Even though the arbitrator’s award was binding, nonetheless, St. Jude appealedthe arbitrator’s award and in May 2002, the Orange County Superior Courtaffirmed the award to Prospect. On January 31, 2003, the Company receivedapproximately $1,492,000 from St. Jude to settle the amount due, includinginterest, notwithstanding the fact that St. Jude has appealed the judgment. On September 30,2004, the Court ordered supplemental briefs to be filed. The briefs were filedand the matter was resubmitted to the Court on February 4, 2005.

 

The Court of Appeal issuedits decision on May 26, 2005, which upheld the arbitration award, with theexception of the portion of the award in which the Arbitrator had allowedProspect to recover its share of the Arbitrator’s fee from St. Jude. The Courtof Appeal held that the underlying contract required each party to shareequally the Arbitrator’s fee. The case was remanded to the Superior Court forfurther proceedings on this issue. In all other respects, the arbitration awardwas upheld.

 

We are currently engaged insettlement discussions with counsel for the other parties, to determine whetherit will be possible to resolve this issue amicably, and to avoid the need forany further appeals or any litigation proceedings following remand.

 

Pending the final outcome ofthis matter, we have reserved against a portion of the amounts received.Management believes that such reserves are adequate as of June 30, 2005.

 

Other Litigation

 

Prospect isinvolved in various legal proceedings in the ordinary course of business.Management believes that the ultimate resolution of such legal proceedings willnot have a material adverse effect on the financial position and results ofoperations of the Company.

 

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

 

Managementbelieves that each of the securities transactions during the period covered bythis report that is described in the table below was exempt from theregistration requirements of the Securities Act of 1933, as amended (the “SecuritiesAct”), as referenced in the notes accompanying the table:

 

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| **Date**         | ** ** | **Title**    | ** ** | **Amount**     | ** ** | **Consideration**                                  | ** ** | **Recipients**                           | ** ** |
|------------------|------------|--------------|------------|----------------|------------|----------------------------------------------------|------------|------------------------------------------|------------|
|             |       |         |       |           |       |                                               |       |                                     |       |
| 4/2005 to 6/2005 |       | Common Stock |       | 72,579  shares | (1)        | Conversion of Series A Preferred Stock        |       | Holders of Series A Preferred Stock |       |
|             |       |         |       |           |       |                                               |       |                                     |       |
| 6/2005           |       | Common Stock |       | 19,020  shares | (1)        | Cashless exercise (conversion of 40,000  warrants) |       | Comerica Bank                            |       |

 

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(1)                             Theseshares of common stock were issued upon conversion of outstanding securities inreliance on the exemption provided by Section 3(a)(9) of theSecurities Act.

 

**Item 3. Defaults Upon Senior Securities**

 

None.

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

None.

 

**Item 5. Other Information**

 

None.

 

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**Item 6.Exhibits**

 

The following documents arebeing filed as exhibits to this report:

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

 

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**SIGNATURES**

 

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

 
|                 | PROSPECT MEDICAL HOLDINGS, INC.  (Registrant)                                                                         |
|----------------------|-----------------------------------------------------------------------------------------------------------------------|
|                 |                                                                                                                  |
| August 12, 2005 | /s/ JACOB Y. TERNER                                                                                                   |
| ** **           | **Jacob Y. Terner, M.D.****Chairman of the  Board and****Chief Executive  Officer****(Principal  Executive Officer)** |
| ** **           | ** **                                                                                                            |
| August 12, 2005 | /s/ MIKE HEATHER                                                                                                      |
| ** **           | **Mike Heather****Chief Financial  Officer****(Principal  Financial Officer)**                                        |

 

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