**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**Form 10-Q**

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**x**                              Quarterlyreport pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

**Forthe quarterly period ended December 31, 2006**

**or**

** ̈**                                 Transitionreport pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

**Commissionfile number: 1-32203**

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**Prospect Medical Holdings, Inc.**

(Exactname of registrant as specified in its charter)

| **Delaware**                              |   | **33-0564370**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
| incorporation or  organization)           |   | Identification  No.) |
|                                      |   |                 |
| **400  Corporate Pointe, Suite 525**      |   | ** **           |
| **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 mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    Yes x      No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):

Large accelerated filer o    Accelerated filer o    Non-acceleratedfiler x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act):

Yes o   No  x

The number ofshares of the issuer’s Common Stock, par value $0.01 per share, outstanding asof February 7, 2007 was 7,697,217.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

**Index**
| **Part I –  Financial Information** |
|------------------------------------------|
|                                     |   |   |   |   |
| **Item 1.**                              |   | Financial Statements |   |   |
| ** **                               |   |   |   |   |
|                                     |   | Condensed Consolidated  Balance Sheets as of December 31, 2006 (unaudited) and September 30, 2006 |   |   |
|                                     |   |   |   |   |
|                                     |   | Condensed  Consolidated Statements of Income for the three-month periods ended December  31, 2006 and 2005 (unaudited) |   |   |
|                                     |   |   |   |   |
|                                     |   | Condensed  Consolidated Statements of Cash Flows for the three-month periods ended  December 31, 2006 and 2005 (unaudited) |   |   |
|                                     |   |   |   |   |
|                                     |   | Notes to  Condensed Consolidated Financial Statements (unaudited) |   |   |
|                                     |   |   |   |   |
| **Item 2.**                              | ** ** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 3.**                              | ** ** | **Quantitative  and Qualitative Disclosures About Market Risk** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 4.**                              | ** ** | **Controls and  Procedures** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Part II - Other  Information**         |
|                                     | ** ** | ** ** |   |   |
| **Item 1.**                              | ** ** | **Legal Proceedings** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 1A.**                             | ** ** | **Risk Factors** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 2.**                              | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 3.**                              | ** ** | **Defaults Upon  Senior Securities** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 4.**                              | ** ** | **Submission of  Matters to a Vote of Security Holders** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 5.**                              | ** ** | **Other information** |   |   |
| ** **                               | ** ** | ** ** |   |   |
| **Item 6.**                         | ** ** | **Exhibits** |   |   |
| ** **                               |   |   |   |   |
| **Signatures**                           |   |   |   |   |

 

2

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**PART I - FINANCIAL INFORMATION**

**Item1.    Financial Statements.**

**PROSPECT MEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                       | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                       | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Current assets**                                                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                       |       | $                           | 13,385,906 |                         | $          | 16,623,407 |   |
| Investments, primarily  restricted certificates of deposit                                                                                                                                                       |       | 836,244                     |       | 836,244                      |       |
| Risk pool receivables                                                                                                                                                                                            |       | 2,324,424                   |       | 1,418,973                    |       |
| Other receivables, net  of allowances of $493,000 and $509,000 at December 31, 2006 and September 30, 2006                                                                                                       |       | 1,555,158                   |       | 1,916,883                    |       |
| Notes receivable,  current portion                                                                                                                                                                               |       | 176,265                     |       | 176,265                      |       |
| Prepaid expenses and  other                                                                                                                                                                                      |       | 552,064                     |       | 645,466                      |       |
| Refundable income taxes                                                                                                                                                                                          |       | 2,963,253                   |       | 2,493,035                    |       |
| Deferred income taxes,  net                                                                                                                                                                                      |       | 188,912                     |       | 657,678                      |       |
| Total current  assets                                                                                                                                                                                            |       | 21,982,226                  |       | 24,767,951                   |       |
|                                                                                                                                                                                                             |       |                        |       |                         |       |
| Property, improvements  and equipment:                                                                                                                                                                           |       |                        |       |                         |       |
| Land                                                                                                                                                                                                             |       | 40,620                      |       | 40,620                       |       |
| Leasehold  improvements                                                                                                                                                                                          |       | 977,816                     |       | 984,934                      |       |
| Equipment                                                                                                                                                                                                        |       | 3,711,669                   |       | 3,478,435                    |       |
| Furniture and  fixtures                                                                                                                                                                                          |       | 793,831                     |       | 782,087                      |       |
|                                                                                                                                                                                                             |       | 5,523,936                   |       | 5,286,076                    |       |
| Less accumulated  depreciation and amortization                                                                                                                                                                  |       | (4,145,062                  | )          | (3,999,863                   | )          |
| Property, improvements  and equipment, net                                                                                                                                                                       |       | 1,378,874                   |       | 1,286,213                    |       |
|                                                                                                                                                                                                             |       |                        |       |                         |       |
| Notes receivable, long  term portion                                                                                                                                                                             |       | 404,474                     |       | 413,577                      |       |
| Deposits                                                                                                                                                                                                         |       | 709,432                     |       | 613,087                      |       |
| Goodwill                                                                                                                                                                                                         |       | 37,902,958                  |       | 37,838,169                   |       |
| Other intangible  assets, net                                                                                                                                                                                    |       | 1,491,855                   |       | 1,738,475                    |       |
| Total assets                                                                                                                                                                                                     |       | $                           | 63,869,819 |                         | $          | 66,657,472 |   |
| ** **                                                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                   | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                         | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Accrued medical claims  and other health care costs payable                                                                                                                                                      |       | $                           | 12,300,000 |                         | $          | 11,400,000 |   |
| Accounts payable and  other accrued liabilities                                                                                                                                                                  |       | 6,400,596                   |       | 8,191,849                    |       |
| Current maturities of  long-term debt                                                                                                                                                                            |       | 2,800,000                   |       | 5,300,000                    |       |
| Total current  liabilities                                                                                                                                                                                       |       | 21,500,596                  |       | 24,891,849                   |       |
| Long-term debt, less  current maturities                                                                                                                                                                         |       | 6,000,000                   |       | 6,700,000                    |       |
| Deferred income taxes                                                                                                                                                                                            |       | 1,195,156                   |       | 1,145,573                    |       |
| Other long-term  liabilities                                                                                                                                                                                     |       | 231,368                     |       | 34,712                       |       |
| Total  liabilities                                                                                                                                                                                               |       | 28,927,120                  |       | 32,772,134                   |       |
| **Minority interest**                                                                                                                                                                                            |       | 71,994                      |       | 81,881                       |       |
| ** **                                                                                                                                                                                                       |       |                        |       |                         |       |
| **Shareholders’  equity:**                                                                                                                                                                                  | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Common stock, $0.01 par  value; 40,000,000 shares authorized 7,515,537 (including 40,197 shares held  in treasury) and 7,186,977 shares  issued and outstanding at December 31, 2006 and September 30, 2006 | ** ** | 74,753                      | ** ** | 71,869                       | ** ** |
| Additional paid-in  capital                                                                                                                                                                                      |       | 21,076,492                  |       | 20,345,805                   |       |
| Retained earnings                                                                                                                                                                                                |       | 13,719,460                  |       | 13,385,783                   |       |
| Total  shareholders’ equity                                                                                                                                                                                 |       | 34,870,705                  |       | 33,803,457                   |       |
| Total liabilities and  shareholders’ equity                                                                                                                                                                 |       | $                           | 63,869,819 |                         | $          | 66,657,472 |   |

See accompanying notes.

3

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited)**
| ** **                                          | ** ** | **Three Months Ended  December 31** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
|                                                |       |                                               |       |   |   |
| Revenues                                            |       | $                                                  | 34,827,997 |   | $ | 33,464,759 |   |
| Cost of revenues                                    |       | 26,036,026                                         |       | 24,486,216 |   |
|                                                |       |                                               |       |   |   |
| Gross margin                                        |       | 8,791,971                                          |       | 8,978,543 |   |
|                                                |       |                                               |       |   |   |
| Non-medical expenses:                               |       |                                               |       |   |   |
| General and administrative                          |       | 8,077,069                                          |       | 7,131,074 |   |
| Depreciation and amortization                       |       | 391,819                                            |       | 322,017 |   |
| Total non-medical  expenses                         |       | 8,468,888                                          |       | 7,453,091 |   |
|                                                |       |                                               |       |   |   |
| Operating income  from unconsolidated joint venture |       | 263,942                                            |       | 346,162 |   |
|                                                |       |                                               |       |   |   |
| Operating income                                    |       | 587,025                                            |       | 1,871,614 |   |
| ** **                                          | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Other (income)  expense:                            |       |                                               |       |   |   |
| Investment income                                   |       | (241,532                                           | )          | (234,473 | ) |
| Interest expense                                    |       | 266,980                                            |       | 257,517 |   |
| Total other expense,  net                           |       | 25,448                                             |       | 23,044 |   |
|                                                |       |                                               |       |   |   |
| Income before  income taxes                         |       | 561,577                                            |       | 1,848,570 |   |
| Provision for  income taxes                         |       | 225,352                                            |       | 744,183 |   |
|                                                |       |                                               |       |   |   |
| Net income  before minority interest                |       | 336,225                                            |       | 1,104,387 |   |
|                                                |       |                                               |       |   |   |
| Minority  interest                                  |       | 2,548                                              |       | 1,598 |   |
|                                                |       |                                               |       |   |   |
| Net income                                          |       | $                                                  | 333,677    |   | $ | 1,102,789 |   |
|                                                |       |                                               |       |   |   |
| Net income per  common share:                       |       |                                               |       |   |   |
| Basic                                               |       | $                                                  | 0.05       |   | $ | 0.16 |   |
| Diluted                                             |       | $                                                  | 0.04       |   | $ | 0.14 |   |
| Weighted average  shares outstanding:               |       |                                               |       |   |   |
| Basic                                               |       | 7,272,887                                          |       | 6,700,579 |   |
| Diluted                                             |       | 8,420,476                                          |       | 7,755,789 |   |

 

See accompanying notes.

4

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**
| ** **                                                                     | ** ** | **Three Months Ended  December 31** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| **Operating  activities**                                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Net income                                                                     |       | $                                                  | 333,677    |   | $ | 1,102,789 |   |
| Adjustments to reconcile net income to net cash used  in operating activities: |       |                                               |       |   |   |
| Depreciation and amortization                                                  |       | 391,819                                            |       | 322,017 |   |
| Provision for bad debts                                                        |       | (16,843                                            | )          | 72,457 |   |
| Loss on disposal of assets                                                     |       | —                                             |       | 151 |   |
| Deferred income taxes, net                                                     |       | 518,349                                            |       | 250,668 |   |
| Changes in operating assets and liabilities:                                   |       |                                               |       |   |   |
| Risk pool receivables                                                          |       | (905,450                                           | )          | 53,494 |   |
| Other receivables                                                              |       | 378,569                                            |       | 879,278 |   |
| Prepaid expenses and other                                                     |       | 119,497                                            |       | 241,836 |   |
| Recoverable income taxes                                                       |       | (292,996                                           | )          | (372,485 | ) |
| Excess tax benefits from options exercised                                     |       | (177,221                                           | )          | (220,977 | ) |
| Deposits and other assets                                                      |       | (122,440                                           | )          | 22,839 |   |
| Accrued medical claims and other health care costs  payable                    |       | 900,000                                            |       | (267,989 | ) |
| Accounts payable and other accrued liabilities                                 |       | (1,594,598                                         | )          | (3,092,319 | ) |
| Net cash used in operating activities                                          |       | (467,637                                           | )          | (1,008,241 | ) |
|                                                                           |       |                                               |       |   |   |
| **Investing  activities**                                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Purchases of property, improvements and equipment                              |       | (237,861                                           | )          | (33,202 | ) |
| Proceeds from note receivable                                                  |       | 9,103                                              |       | 3,212 |   |
| Cash paid for acquisitions, net of cash received                               |       | —                                             |       | (6,560,892 | ) |
| Increase in restricted certificates of deposit                                 |       | —                                             |       | (136 | ) |
| Capitalized expenses related to acquisitions                                   |       | (64,790                                            | )          | (35,188 | ) |
| Other investing activities                                                     |       | (9,887                                             | )          | 1,598 |   |
| Net cash used in investing activities                                          |       | (303,435                                           | )          | (6,624,608 | ) |
|                                                                           |       |                                               |       |   |   |
| **Financing  activities**                                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Borrowings from Term Loan                                                      |       | —                                             |       | 4,000,000 |   |
| Borrowings on line of credit                                                   |       | —                                             |       | — |   |
| Repayments on credit line                                                      |       | (2,500,000                                         | )          | — |   |
| Reduction of note payable                                                      |       | (700,000                                           | )          | (566,667 | ) |
| Proceeds from issuance of common stock                                         |       | 556,350                                            |       | 448,000 |   |
| Excess tax benefit from options exercised                                 |       | 177,221                                            |       | 220,977 |   |
| Net cash (used in) provided by financing activities                            |       | (2,466,429                                         | )          | 4,102,310 |   |
|                                                                           |       |                                               |       |   |   |
| Net decrease in cash and cash equivalents                                      |       | (3,237,501                                         | )          | (3,530,539 | ) |
| Cash and cash equivalents at beginning of period                               |       | 16,623,407                                         |       | 16,949,304 |   |
| Cash and cash equivalents at end of period                                     |       | $                                                  | 13,385,906 |   | $ | 13,418,765 |   |
| ** **                                                                     | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information**                                        | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid during the period for:                                               |       |                                               |       |   |   |
| Income taxes                                                                   |       | $                                                  | —     |   | $ | 866,000 |   |
| Interest                                                                       |       | $                                                  | 266,980    |   | $ | 257,517 |   |
|                                                                           |       |                                               |       |   |   |
| Details of  businesses acquired:                                               |       |                                               |       |   |   |
| Fair value of assets acquired                                                  |       |                                               |       | $ | 9,329,556 |   |
| Liabilities assumed or created                                                 |       |                                               |       | (1,329,556 | ) |
| Less cash acquired                                                             |       |                                               |       | 1,439,108 |   |
| Net cash paid for acquisitions                                                 |       |                                               |       | $ | 6,560,892 |   |

 

5

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**PROSPECT MEDICAL HOLDINGS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**December31, 2006****(Unaudited)**

**1. Reporting Entity**

Prospect MedicalHoldings, Inc. (Prospect or the Company), a Delaware corporation, wasincorporated 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 condensed consolidated interim financialstatements have been prepared under the assumption that users of the interimfinancial data have either read or have access to our audited consolidatedfinancial statements for the latest fiscal year ended September 30, 2006.Accordingly, certain note disclosures that would substantially duplicate thedisclosures contained in the September 30, 2006 audited financial statementshave been omitted. These unaudited condensed consolidated interim financialstatements should be read in conjunction with our September 30, 2006 auditedfinancial statements.

The unaudited condensed consolidated financialstatements include the accounts of the Company and all majority ownedsubsidiaries and controlled entities under Emerging Issues Task Force (EITF)No. 97-2, “*Application of FASB Statement No. 94 and APBOpinion No. 16 to Physician Practice Management Entities and Certain OtherEntities with Contractual Management Arrangements.”* In the opinionof management, all adjustments considered necessary for a fair presentation ofthe results as of the date of, and for the interim periods presented, whichconsist solely of normal recurring adjustments, have been included. Allsignificant inter-company balances and transactions have been eliminated inconsolidation. The consolidated results of operations for the current interimperiod are not necessarily indicative of the results that may be expected forthe entire year ending September 30, 2007.

Revenuesare comprised of the following amounts:

|                 | ** ** | **Three months ended  December 31,** | ** ** |
|-----------------|------------|-----------------------------------------------------|------------|
| ** **      | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **% of  Increase  (Decrease)** | ** ** |
| Capitation      |       | $                                                   | 34,092,290 |   | $ | 32,618,106 |   | 5 | % |
| Fee for service |       | 382,880                                             |       | 565,750 |   | (32 | )% |
| Management fees |       | 264,067                                             |       | 275,067 |   | (4 | )% |
| Other           |       | 88,760                                              |       | 5,836 |   | NM |   |
| Total           |       | $                                                   | 34,827,997 |   | $ | 33,464,759 |   | 4 | % |

Certain prior year amounts have been reclassified toconform to current period presentation

**3.  StockBased Compensation**

The Company has stockoption agreements with certain directors, officers and employees. On October 1,2005, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 123(R), “*Share-Based Payment*,”by applying the modified prospective method and the supplemental implementationguidance in Staff Accounting Bulletin (SAB) No. 107. SFAS No.123(R) requires compensation cost for all share-based payments inexchange for employee services (including employee stock options) to bemeasured at fair value and eliminates the intrinsic value method previouslypermitted under Accounting Principles Board (APB) Opinion 25, “*Accounting for Stock Issued to Employees*” and SFAS No. 123 “*Accounting for Stock-Based Compensation*.” Under APB No. 25,compensation costs were recognized only to the extent the market price of theunderlying stock exceeded the exercise price on the date of grant. Since theCompany generally issues shared-based awards at or above the market price ofthe underlying stock, these equity awards have not historically resulted incompensation expense.

6

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Under the modifiedprospective method, prior periods are not restated to reflect the impact ofSFAS No. 123(R).  Compensation cost isrecognized for all awards granted, modified or settled subsequent to theadoption date, or where the requisite service period has not been completedprior to the date of adoption. Compensation cost for awards granted prior to,but not vested as of the adoption date would be based on the same estimatedgrant-date fair value previously used for pro forma disclosure purposes underSFAS No. 123. Compensation costs for awards granted, modified, or settled afterthe adoption date are measured and recognized in the financial statements basedon their grant date fair value, net of estimated forfeitures over the awards’service period, in accordance with SFAS No. 123(R). The Company will continueto use the Black-Scholes option pricing model and a single option awardapproach to estimate the fair value of options granted. The adoption of SFASNo. 123R did not result in adjustments that are required to be reported as thecumulative effect of a change in accounting principle. Equity-basedcompensation, if any, is classified within the same line items as cashcompensation paid to employees. Cash retained as a result of excess taxbenefits relating to share-based payments are presented in the statement ofcash flows as a financing cash inflow. Previously, the cash retained fromexcess tax benefits was presented in operating cash flows.

The adoption of SFAS No.123(R) did not have a significant effect on the Company’s financial positionand results of operations since the Company fully vested all remaining unvestedportions of previously issued stock options in September 2005 and madeinsignificant grants thereafter, as discussed below. Because none of the stockoptions whose vesting was accelerated had exercise prices below the marketvalue of the Company’s stock, no expense was recognized upon the accelerationof vesting. The Company did not make other changes to the terms of the options,which generally vest pro-rata over 2 years (the requisite service period) andexpire after 5 years from the date of grant.

Option Activity for the three months ended December31, 2006 is summarized below:

|                                                 | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (Months)** | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-------------------------------------|------------|---------------------------------------------------------------|------------|
| Outstanding as  of September 30, 2006           |       | 2,812,247  |       | 4.15                                   |       |                                |       |                                                          |       |
| Granted                                         |       |       |       |                                   |       |                                |       |                                                          |       |
| Exercised                                       |       | (400,700   | )          | 3.05                                   |       |                                |       |                                                          |       |
| Forfeited                                       |       | (24,434    | )          | 5.62                                   |       |                                |       |                                                          |       |
| Outstanding as  of December 31, 2006            |       | 2,387,113  |       | 4.32                                   |       | $                                   | 4,484,570  |                                                          | 29         |   |
| Vested and Exercisable  as of December 31, 2006 |       | 2,387,113  |       | 4.32                                   |       | $                                   | 4,484,570  |                                                          | 29         |   |

 

The aggregate intrinsicvalue is calculated as the difference between the exercise price of the underlyingawards and the quoted price of our common stock for those awards that have anexercise price currently below the quoted value.

During the three monthsended December 31, 2006 and 2005, the company did not grant any options.  During the three months ended December 31,2006, options for 400,700 common shares were exercised for net proceeds ofapproximately $556,350 and 24,434 options were forfeited. The aggregateintrinsic value of the options exercised was $1,156,000. During the threemonths ended December 31, 2005, options for 205,000 common shares wereexercised for net proceeds of $448,000 and 2,000 options were forfeited. Theaggregate intrinsic value of the options exercised was $562,000. The Companyrealized net tax benefits of $177,221 and $220,977 from the 2006 and 2005exercises where the price paid was below the fair value of the common shares onthe exercise date. The tax benefits reduced income tax payable and increasedadditional paid-in capital. At December 31, 2006 and 2005, there are nounvested awards and no unrecognized stock-based compensation costs.

The fair value of theoptions granted prior to the Company becoming a public reporting entity in May2005 was estimated at the date of grant using the Minimum Value option model.Under SFAS No. 123 non-public companies were permitted to use the minimum-valuemethod to estimate compensation costs for pro-forma disclosure purposes, whicheffectively allowed those

7

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companies to valueemployee stock options using an assumed volatility of zero. The minimum valuemethod is not an acceptable approach under SFAS No. 123(R) and theminimum-value disclosures for the 2005 periods are no longer provided.   The fair value of the options granted afterthe Company became a public reporting entity was estimated at the date of thegrant using the Black-Scholes option pricing model.

Thefollowing table is a summary of options outstanding under all of the Company’soption plans as of December 31, 2006:

| Range of Exercise Prices | ** ** | **Number  Outstandng  and  Exercisable** | ** ** | **Weighted  Average  Remaining  Contractual  Terms  (Months)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------|------------|
| $3.00                                   |       | 1,017,450                                |       | 21                                                             |       | 3.00                                   |       |
| $4.86 - $5.00                           |       | 1,078,497                                |       | 35                                                             |       | 4.98                                   |       |
| $6.45-$7.15                             |       | 291,166                                  |       | 36                                                             |       | 6.48                                   |       |
| $3.00 - $7.15                           |       | 2,387,113                                |       | 29                                                             |       | 4.32                                   |       |

 

**4.  EarningsPer Share**

The denominators for thecomputation of basic and diluted earnings per share are calculated as follows:

|                                                                          | ** ** | **For the three month period  ended December 31** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                                                        | ** ** | **2005** | ** ** |
| Basic earnings per common share:                                         |       |                                                                            |       |   |   |
| Numerator – net income                                              |       | $                                                                               | 333,677    |   | $ | 1,102,789 |   |
|                                                                     |       |                                                                            |       |   |   |
| Denominator – weighted average number of common shares  outstanding |       | 7,272,887                                                                       |       | 6,700,579 |   |
|                                                                     |       |                                                                            |       |   |   |
| Basic earnings  per common share                                         |       | $                                                                               | 0.05       |   | $ | 0.16 |   |
|                                                                     |       |                                                                            |       |   |   |
| Diluted earnings per common share:                                       |       |                                                                            |       |   |   |
| Numerator – net income                                              |       | $                                                                               | 333,677    |   | $ | 1,102,789 |   |
|                                                                     |       |                                                                            |       |   |   |
| Denominator:                                                             |       |                                                                            |       |   |   |
| Weighted average  number of common shares outstanding                    |       | 7,272,887                                                                       |       | 6,700,579 |   |
| Dilutive stock options and warrants                                      |       | 1,147,589                                                                       |       | 1,055,210 |   |
|                                                                     |       | 8,420,476                                                                       |       | 7,755,789 |   |
|                                                                     |       |                                                                            |       |   |   |
| Diluted earnings per  common share                                       |       | $                                                                               | 0.04       |   | $ | 0.14 |   |

 

**5.  Related Party Transactions**

We have an employmentagreement with our Chief Executive Officer, Jacob Y. Terner that runs throughAugust 1, 2008 and provides for compensation of $250,000 per year. Theagreement further provides that if we terminate Dr. Terner’s employmentwithout cause, we will be required to pay him $12,500 for each month of pastservice as our Chief Executive Officer, commencing as of July 31, 1996. TheCompany’s maximum contingent obligation under this termination provision wasfrozen at $1,237,500.

Prospect MedicalGroup, Inc. (PMG), which is wholly owned by Dr. Terner, and whoseaccounts are consolidated in these financial statements under EITF 97-2,maintains an intercompany account receivable due from Prospect MedicalHoldings, Inc. The intercompany receivable was created in connection withintercompany transactions, including those related to previous acquisitions. Inthe event that PMG is required by the health maintenance organizations (HMO’s)or regulatory agencies to maintain a positive tangible net equity and positiveworking capital, Dr. Terner had previously agreed to personally guaranteethe intercompany account receivable due from Prospect MedicalHoldings, Inc. up to a level sufficient to enable PMG to attain positivetangible net equity and working capital.

8

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On June 1, 2003, inconsideration for Dr. Terner’s personal guarantee and pledge, theCompensation Committee of the Board of Directors granted to Dr. Terner asix-year, non-qualified stock option to purchase 800,000 shares of common stockat $3.00 per share. During its term, Dr. Terner’s personal guarantee wassupported through the pledge of certain of his personal assets. Dr. Terneragreed to maintain his personal guarantee and collateral in effect until PMGhad positive tangible net equity. This personal guarantee arrangement wasterminated by the Board of Directors effective January 19, 2005.

**6.  Long Term Debt**

Long-term debt atDecember 31, 2006 and September 30, 2006, respectively, consists of thefollowing:

|                                                                           | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Term loan                                                                 |       | $                           | 8,800,000  |                         | $          | 9,500,000 |   |
| Revolving credit  facility, interest at prime rate plus applicable margin |       | —                      |       | 2,500,000                    |       |
|                                                                      |       | 8,800,000                   |       | 12,000,000                   |       |
| Less current  maturities                                                  |       | (2,800,000                  | )          | (5,300,000                   | )          |
|                                                                      |       | $                           | 6,000,000  |                         | $          | 6,700,000 |   |

 

On September 27, 2004,the Company entered into a senior secured credit facility with ResidentialFunding Corporation (RFC), comprised of a $5,000,000 revolving credit facilityand a $10,000,000 term loan.

On September 28, 2004,the Company borrowed $10,000,000 on the RFC term loan and paid off its existingterm loan and revolving credit facility with another lender. The Companyborrows from the revolving credit facility, and repays the amounts, from timeto time. No amounts are outstanding under the revolving the credit facility atDecember 31, 2006.

The RFC revolving creditfacility commitment is for three years, with interest at prime plus 0.5% perannum (8.75% at September 30, 2006 and December 31, 2006) and an unused linefee of 0.25% per annum. The Company may borrow, make repayments, and re-borrowunder the revolving credit facility until January 31, 2008. The RFC term loanis amortized over a five-year period with principal payments of $166,667 permonth, plus interest payable monthly on the outstanding balance at prime plus2.0% per annum (10.25% at September 30, 2006 and December 31, 2006). Theremaining balance of the term loan is due and payable in full on January 31,2008. The Company is subject to certain financial covenants under the loanagreement, including a maximum senior debt/EBITDA ratio, minimum fixed chargecoverage ratio, minimum consolidated net worth, minimum liquidity and a limiton capital expenditures. The Company is also restricted, without consent, fromusing the net proceeds of any sale of equity securities except to pay downindebtedness under the loan agreement.

The Company was incompliance with all of the loan covenants at December 31, 2005. At September30, 2006, the Company reported a fixed charge coverage ratio of 1.12 comparedto the minimum required ratio of 1.25. In December 2006, the Company and RFC amended the credit agreementeffective September 30, 2006 to reduce the ratio to 1.00 for the test periodsended September 30, 2006 through December 30, 2006.  The minimum ratio for test periods thereafterwill remain 1.25.  The Company was incompliance with the reduced ratio at December 31, 2006, and believes that itwill be able to comply with the adjusted minimum ratio through December 31,2007.  As a result, scheduled paymentsdue after twelve months have been classified as non-current at December 31,2006.

In November 2005, inconnection with the acquisition of Genesis Healthcare of Southern California,RFC provided us with additional term loan debt financing of $4,000,000, onterms similar to our existing term loan. This additional term loan requiresmonthly principal payments of $66,667 until September 27, 2007, at whichtime the remaining unpaid balance is due.

In September 2006, RFCextended the maturity and expiration date of the term loan and revolving creditfacility to January 31, 2008.

9

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**7.  Acquisition**

On November 1, 2005Prospect Medical Group, Inc., acquired the outstanding stock of GenesisHealthCare of Southern California for $8,000,000 in cash. The purchase pricewas funded using $4,000,000 of the Company’s existing cash and a $4,000,000term loan from RFC. Revenues and expenses for this acquisition have beenincluded in our consolidated results starting November 1, 2005. The Companyused an outside valuation firm to determine the fair value of the assets andliabilities acquired. The following table summarizes the estimated fair valuesof the assets acquired and liabilities assumed, as of the date of acquisition:

| Current assets             |   | $         | 1,520,539 |   |
|----------------------------|--------|-----------|-----------|--------|
| Goodwill                   |   | 6,398,652 |      |
| Identifiable  intangibles  |   | 1,378,800 |      |
| Other assets  acquired     |   | 31,565    |      |
| Total assets               |   | $         | 9,329,556 |   |
| Current  liabilities       |   | 1,329,556 |      |
| Long-term  liabilities     |   | —    |      |
| Total  liabilities assumed |   | 1,329,556 |      |
| Net assets acquired        |   | $         | 8,000,000 |   |

 

Intangiblesinclude tradename of $194,800, a covenant not-to-compete of $199,200 and$984,800 for customer relations, which are being amortized on a straightlinebasis over 18 months to four years. The Company made a Section 338 election,and expects $7,777,452 of total goodwill and intangibles to be deductible fortax purposes.

Under theacquisition agreement, differences between the estimated claims and taxliabilities recorded on the closing date and the ultimate payment amounts willbe paid to or received from the seller. The agreement also guarantees certainminimum risk pool incentives for the 2005 calendar year. To the extent actualamounts are less than the guaranteed amounts, we will be entitled to receivemonies up to $500,000 from the seller, in addition to any other amounts due.These amounts will be recorded as purchase price adjustments if and whenreceived. The seller also provides customary indemnification of up to $1.5million for eligible non-medical and non-tax claims submitted within a two yearperiod. The indemnification amount is reduced ratably over 24 months. Inconjunction with the acquisition, we have entered into an employment agreementwith the sole selling shareholder of Genesis and 2 of its employees.

The following unauditedpro forma information for the three months ended December 31, 2005 gives effectto the Genesis acquisition as if it had occurred on October 1, 2005.  Such unaudited pro forma information is basedon historical financial information with respect to the acquisition and doesnot include operational or other changes that might have been effected by theCompany.

|                             | ** ** | **Three months ended  December 31** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                           | ** ** |
| Net revenue                 |       | $                                                  | 34,354,212 |   |
| Net income                  |       | 1,139,758                                          |       |
| Basic earnings  per share   |       | $                                                  | 0.07       |   |
| Diluted earnings per  share |       | $                                                  | 0.15       |   |

 

**Use ofEstimates**

The preparation of financialstatements in conformity with U.S. generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses, and the disclosure ofcontingent assets and liabilities at the date and for the periods that thefinancial statements are prepared. Actual results could differ from thoseestimates. Principal areas requiring the use of estimates include settlementsunder the risks/savings sharing programs, medical receivables, determination ofallowances for uncollectible accounts, medical claims and accruals, impairmentof long-lived and intangible assets, professional and general liability claims,reserves for potential absorption of claims unpaid by insolvent providers, reservesfor the outcome of litigation and valuation allowances for deferred tax assets.

During the quarter endedDecember 31, 2006, we recorded favorable changes in estimated shared riskrevenues of $300,000 for the fiscal 2006 period. We also recorded approximately$900,000 in additional expense related to adverse development of fiscal 2006claims.

10

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**8.  New Accounting Pronouncements**

In May 2005, theFinancial Accounting Standards Board (FASB) issued Statement No. 154 (SFASNo. 154), *Accounting Changes and ErrorCorrections*, which replaced APB Opinion No. 20, *Accounting Changes*, and SFAS No. 3, *Reporting Changes in Interim Financial Statements*.SFAS No. 154 requires retrospective application to prior periods’financial statements of voluntary changes in accounting principles and changesrequired by a new accounting standard when the standard does not includespecific transition provisions. Previous guidance required most voluntarychanges in accounting principle to be recognized by including in net income ofthe period in which the change was made the cumulative effect of changing tothe new accounting principle. SFAS No. 154 carries forward existingguidance regarding the reporting of the correction of an error and a change inaccounting estimate. SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. Adoption of SFAS No. 154 as of October 1, 2006 did not have amaterial effect on our consolidated financial position or results ofoperations.

In July 2006, the FASBissued Final Interpretation No. (FIN) 48, *Accountingfor Uncertainty in Income Taxes*, an interpretation of SFASNo. 109 *Accounting for Income Taxes*. FIN48 clarifies the accounting for income taxes by prescribing the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. In addition, FIN 48 excludesincome taxes from the scope of SFAS No. 5, *Accounting for Contingencies*. FIN 48 is effective for fiscalyears beginning after December 15, 2006. Differences between the amountsrecognized in the consolidated balance sheets prior to the adoption of FIN 48and the amounts reported after adoption are accounted for as acumulative-effect adjustment to the beginning balance of retained earnings.Adoption of FIN 48 as of October 1, 2007 is not expected to have a materialeffect on our consolidated financial position or results of operations.

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements.” This Statementdefines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements. This Statement applies under other accountingpronouncements that require or permit fair value measurements, the Board havingpreviously concluded in those accounting pronouncements that fair value is therelevant measurement attribute. Accordingly, this Statement does not requireany new fair value measurements. This Statement is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. The Company is currently evaluatingthe impact of the provisions of SFAS No. 157.

In September 2006,the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin(“SAB”) No. 108 regarding the process of quantifying financial statementmisstatements. SAB No. 108 states that registrants should use both abalance sheet approach and an income statement approach when quantifying andevaluating materiality of a misstatement. The interpretations in SABNo. 108 contain guidance on correcting errors under the dual approach aswell as provide transition guidance for correcting errors. This interpretation doesnot change the requirements within SFAS No. 154 for the correction of anerror in financial statements. SAB No. 108 is effective for annualfinancial statements covering the first fiscal year ending afterNovember 15, 2006. The Company adopted this interpretation on October 1,2006.

Other recent accountingpronouncements issued by the FASB (including its Emerging Issues Task Force),the AICPA, and the SEC did not, or are not believed by management to, have amaterial impact on our present or future consolidated financial statements.

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

**Forward-Looking Statements**

The following discussion of our financial condition andresults of operations should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and the notes to thosestatements appearing elsewhere in this report and the audited financialstatements for the year ended September 30, 2006 appearing in our annual reporton Form 10-K filed with the Securities and Exchange Commission.

This discussion contains forward-looking statementsthat involve risks and uncertainties. These forward-looking statements areoften accompanied by words such as “believe,” “should,” “anticipate,” “plan,” “expect,”“potential,” “scheduled,” “estimate,” “intend,” “seek,” “goal,” “may” andsimilar expressions. These statements include, without limitation, statementsabout our market opportunity, our growth strategy, competition, expectedactivities and future acquisitions and investments and the adequacy of ouravailable cash resources. Investors are urged to read these statementscarefully, and are cautioned that matters subject to forward-looking statementsinvolve risks and uncertainties, including economic, regulatory, competitiveand other factors that may affect our business. These statements are notguarantees of future performance and are subject to risks, uncertainties andassumptions. Although we believe that the expectations reflected in the forward-lookingstatements are reasonable, we cannot guarantee future results, levels ofactivity, performance, or achievements. Moreover, we do not assume anyresponsibility for the accuracy and completeness of such statements in thefuture. Subject to applicable law, we do not plan to update any of the forward-lookingstatements after the date of this report to conform such statements to actualresults.

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

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

·                  Our historical working capital deficit couldadversely affect our ability to satisfy our obligations as they come due.

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

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

·                  If we are not able to comply with 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 adverselyaffected if our actual health care claims exceed our reserves.

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

·                  Medicare and private third-party payercost containment efforts and reductions in reimbursement rates could reduce ourrevenue and our cash flow.

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

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

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

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

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

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

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

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

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

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

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

·                  The National Association of SecuritiesDealers (NASD) has conducted an informal inquiry regarding trading in ourcommon stock. Both the inquiry and our response occurred in February 2004.Wehave not received any subsequent communication from NASD on the matter.

·                  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.

Investors should also refer to our Form 10-K annualreport filed with the Securities and Exchange Commission on December 28, 2006for a discussion of risk factors. Given these risks and uncertainties, we cangive no assurances that any forward-looking statements will in fact occur andtherefore caution investors not to place undue reliance on them.

**Overview**

Prospect Medical Holdings, Inc. (we, or the “Company”)is a health care management services organization. We provide managementservices 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 (primary care andspecialist) and other health care providers to provide all of their medicalservices. The medical clinics employ their primary care physicians, whichprovide the vast majority of their medical services, while contracting withspecialist physicians and other health care providers to provide other requiredmedical services.

13

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Through our management subsidiaries – Prospect MedicalSystems and Sierra Medical Management — we have entered into long-termagreements to provide management services to each of our affiliated physicianorganizations in exchange for a management fee. The management services weprovide include HMO contracting, physician recruiting, credentialing andcontracting, human resources services, claims administration, financial services,provider relations, patient eligibility and other services, medical managementincluding utilization management and quality assurance, data collection, andmanagement information systems.

Our management subsidiaries currently providemanagement services to thirteen affiliated physician organizations, whichinclude Prospect Medical Group, eleven other affiliated physician organizationsthat Prospect 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 otheraffiliated physician organizations.

Thethirteen affiliated physician organizations provide medical services to acombined total of approximately 171,000 HMO enrollees at  December 31, 2006, including approximately7,200 AMVI Prospect Health Network enrollees that we manage for the economicbenefit of our partner in this joint venture, and for which we earn managementfee income.

Currently, our affiliated physician organizations havecontracts with approximately twelve HMOs, from which our revenue is primarilyderived. HMOs offer a comprehensive health care benefits package in exchangefor a capitation fee per enrollee that does not vary through the contractperiod regardless of the quantity of medical services required or used. HMOsenroll members by entering into contracts with employer groups or directly withindividuals to provide a broad range of health care services for a prepaidcharge, with minimal deductibles or co-payments required of the members. All ofthe contracts between our affiliated physician organizations and the HMOsprovide for the provision of medical services by the affiliated physicianorganization to the HMO enrollees in consideration for the prepayment of thefixed monthly capitation fee per enrollee.

Our consolidated business has grown through theacquisition of IPAs by Prospect Medical Group. Our plan is for Prospect MedicalGroup to continue to acquire additional IPAs. We do not intend to furtheracquire any individual or small medical practices, clinics or medical grouppractices.

We have chosen to concentrate our growthgeographically by limiting our acquisitions to IPAs in Orange County,California and Los Angeles County, California.

Operating revenue consists primarily of fees for medicalservices provided by our affiliated physician organizations under capitatedcontracts with various HMOs or under fee-for-service arrangements. Capitationrevenue under HMO contracts is prepaid monthly to the affiliates based on thenumber of enrollees electing any one of the affiliates as their health careprovider. Capitation revenue may be subsequently adjusted to reflect changes inenrollment as a result of retroactive terminations or additions. Theseadjustments have not had a material effect on capitation revenue. Capitationrevenue is also subject to risk adjustments. Beginning in calendar 2004,Medicare began a four year phase-in of a revised capitation model referred toas “Risk Adjustment.” Under the new model, capitation with respect to Medicareenrollees is subject to subsequent adjustment for the acuity of the enrolleesto whom services were provided. Capitation for the current year is paid basedon data submitted for each enrollee for the preceding year. Capitation is paidat interim rates during the year and is adjusted in subsequent periods(generally in the fourth quarter) after the final data is compiled. Positive ornegative capitation adjustments are made for seniors with conditions requiringmore or less healthcare services than assumed in the interim payments. Since wedo not currently have the ability to reliably predict these adjustments,periodic changes in capitation amounts earned as a result of Risk Adjustmentare recognized when those changes are communicated from the health plans,generally in the fourth quarter of the fiscal year to which the adjustmentsrelate. Management fees primarily comprise amounts earned from managing theoperations of AMVI, Inc., which is our joint venture partner in theAMVI/Prospect Health Network joint venture. Management services havehistorically related only to MediCal members. However, starting in fiscal 2006,this was expanded to also include management services related to Medicaremembers enrolling in CalOPTIMA’s OneCare HMO, as well as management servicesprovided to Brotman Medical Center, an equity investee in which we hold a 38%interest. OneCare is a Medicare Advantage Special Needs Plan launched in August2005 by CalOPTIMA to serve dually-eligible members in Orange County who areentitled to Medicare benefits and are also MediCal eligible. Management feerevenue is earned in the month the services are delivered. Other revenuesinclude incentive payments from HMOs under “pay-for-performance” programs forquality medical care based on various criteria. These incentives are generallyreceived in the third and fourth quarters of our fiscal year and are recordedwhen such amounts are known since we do not have the information to reliablyestimate these amounts. Risk pool and pay-for-performance incentives areaffected by many factors, some of which are beyond the Company’s control, andmay vary significantly from year to year.

We also earn additional incentive revenue or incurpenalties under HMO contracts by sharing in the risk for hospitalization basedupon inpatient services utilized. These amounts are included in capitationrevenue. Except for two contracts where we are contractually obligated fordown-side risk, shared risk deficits are not payable until and unless we generatefuture risk sharing surpluses. Risk pools are generally settled in thefollowing year. Management estimates risk pool incentives based on estimatedhospital utilization and associated costs compared to budget and, if available,interim risk-pool settlements reported by health plans. These estimates areinherently uncertain and could differ significantly from actual results.Differences between actual and estimated settlements are recorded when thefinal outcome is known.

Revenues are comprised of the following amounts:
|                 | ** ** | **Three Months Ended  December 31,** | ** ** |
|-----------------|------------|-----------------------------------------------------|------------|
| ** **      | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Capitation      |       | 34,092,290                                          |       | $ | 32,618,106 |   |
| Fee for service |       | 382,880                                             |       | 565,750 |   |
| Management fees |       | 264,067                                             |       | 275,067 |   |
| Other           |       | 88,760                                              |       | 5,836 |   |
| Total           |       | $                                                   | 34,827,997 |   | $ | 33,464,759 |   |
|                 |            |                                                     |            |  |  |  |  |

 

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We have increased our membership through acquisitions.These increases through acquisition are offset by HMO enrollment declines atour affiliated physician organizations, similar to the general HMO enrollmenttrends in California in recent years. The following table sets forth theapproximate number of members, by category.
|                          | ** ** | **As of  December 31** | ** ** |
|--------------------------|------------|-----------------------------|------------|
| **Member Category** | ** ** | **2006**                    | ** ** | **2005** | ** ** | **% of  Increase  (Decrease)** | ** ** |
| Commercial               |       | 133,400                     |       | 156,700 |   | (15 | )% |
| Senior – owned      |       | 13,900                      |       | 13,300 |   | 5 | % |
| Senior – managed    |       | 200                         |       | 100 |   | 100 | % |
| MediCal – owned     |       | 16,500                      |       | 7,200 |   | 129 | % |
| MediCal –  managed  |       | 7,000                       |       | 7,100 |   | (1 | )% |
| Total                    |       | 171,000                     |       | 184,400 |   | (7 | )% |

 

The following table details total paid member months,by member category, for the three-month periods ended December 31, 2006 and2005:
|                         | ** ** | **Three months ended** | ** ** | ** **          | ** ** |
|-------------------------|------------|----------------------------------|------------|---------------------|------------|
| ** **              | ** ** | **December 31**             | ** ** | **% Increase** | ** ** |
| ** **              | ** ** | **2006**                         | ** ** | **2005**            | ** ** | **(Decrease)** | ** ** |
| Commercial              |       | 406,300                          |       | 452,100             |       | (10 | )% |
| Senior – owned     |       | 42,100                           |       | 38,800              |       | 9 | % |
| Senior – managed   |       | 500                              |       | 200                 |       | 100 | % |
| MediCal – owned    |       | 44,000                           |       | 21,400              |       | 106 | % |
| MediCal –  managed |       | 21,200                           |       | 22,100              |       | (4 | )% |
|                    |       |                             |       |                |       |   |   |
| Total                   |       | 514,100                          |       | 534,600             |       | (4 | )% |

 

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Our operating expenses include expenses related to theprovision of medical care services (cost of revenues) and  general and administrative, or G&A,costs. Our results of operations depend on our ability to effectively manageexpenses related to health benefits and accurately predict costs incurred.

Expenses related to medical care services include paymentsto contracted primary care physicians, payments to contracted specialists andthe cost of employed physicians at the Company’s medical clinics. In general,primary care physicians are paid on a capitation basis, while specialists arepaid on either a capitation or a fee-for-service basis.

Capitation payments are fixed in advance of periodscovered and are not subject to significant accounting estimates. These paymentsare expensed in the period the providers are obligated to provide services.Fee-for-service payments are expensed in the period services are provided toour members. Medical care costs include actual historical claims experience andestimates of medical expenses incurred but not reported, or IBNR. Monthly, weestimate our IBNR based on a number of factors, including prior claimsexperience. As part of this review, we also consider estimates of amounts tocover uncertainties related to fluctuations in provider billing patterns,claims payment patterns, membership and medical cost trends. These estimatesare adjusted monthly as more information becomes available. In addition to ourown IBNR estimation process, we obtain twice annual certifications of our IBNRliability from independent actuaries. We believe that our process forestimating IBNR is adequate, but there can be no assurance that medical carecosts will not exceed such estimates. In addition to contractual reimbursementsto providers, we also make discretionary incentive payments to physicians,which are in large part based on the pay-for-performance and shared riskrevenues and favorable senior capitation risk adjustment payments. Since theCompany records these revenues generally in the third or fourth quarter of eachfiscal year when the incentives and capitation adjustments due from the healthplans are known, the Company also records the discretionary physician bonusesin the same period. Since incentives and risk adjustment revenues form thebasis for these discretionary bonuses, variability in earnings due tofluctuations in revenues are mitigated by reductions in bonuses awarded.

G&A costs are largely comprised of wage andbenefit costs related to our employee base and other administrative expenses.G&A functions include claims processing, information systems, providerrelations, finance and accounting services, and legal and regulatory services.

16

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**Results of Operations**

The following table sets forth selected revenuecategories, cost of revenue categories and other income statement items for thethree month periods ended December 31, 2006 and 2005
| ** **                                | ** ** | **Three months ended  December 31** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | ** **                                         | ** ** | ** ** | ** ** | **% Increase** | ** ** |
| ** **                                | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| **Revenues:**                             | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capitation revenue                        |       | $                                                  | 34,092,290 |   | $ | 32,618,106 |   | 4.5 | % |
| Fee for service revenue                   |       | 382,880                                            |       | 565,750 |   | (32.3 | )% |
| Management fees                           |       | 264,067                                            |       | 275,067 |   | (4.0 | )% |
| Other operating revenue                   |       | 88,760                                             |       | 5,836 |   | NM |   |
| **Total revenues**                        |       | 34,827,997                                         |       | 33,464,759 |   | 4.1 | % |
| ** **                                | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cost of  revenues:**                    | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| PCP capitation                            |       | 5,876,598                                          |       | 5,904,310 |   | (0.5 | )% |
| Specialists capitation                    |       | 5,281,084                                          |       | 5,404,434 |   | (2.3 | )% |
| Claims expense                            |       | 13,970,127                                         |       | 12,206,647 |   | 14.4 | % |
| Physician salaries                        |       | 628,452                                            |       | 691,025 |   | (9.1 | )% |
| Other cost of revenues                    |       | 279,765                                            |       | 279,800 |   | 0.0 | % |
| Total cost of revenues                    |       | 26,036,026                                         |       | 24,486,216 |   | (6.3 | )% |
|                                      |       |                                               |       |   |   |   |   |
| **Gross  margin**                         |       | 8,791,971                                          |       | 8,978,543 |   | (2.1 | )% |
|                                      |       |                                               |       |   |   |   |   |
| General and administrative expenses       |       | 8,077,069                                          |       | 7,131,074 |   | 13.3 | % |
| Depreciation and amortization expense     |       | 391,819                                            |       | 322,017 |   | 21.7 | % |
| Total non-medical expenses                |       | 8,468,888                                          |       | 7,453,091 |   | 13.6 | % |
|                                      |       |                                               |       |   |   |   |   |
| Income from  unconsolidated joint venture |       | 263,942                                            |       | 346,162 |   | (23.8 | )% |
| Operating Income                          |       | 587,025                                            |       | 1,871,614 |   | (68.6 | )% |
| Other expense, net                        |       | 25,448                                             |       | 23,044 |   | 10.4 | % |
| Income before income taxes                |       | 561,577                                            |       | 1,848,570 |   | (69.6 | )% |
| Provision for income taxes                |       | 225,352                                            |       | 744,183 |   | (69.7 | )% |
| Minority interest                         |       | 2,548                                              |       | 1,598 |   | 59.4 | % |
| Net income                                |       | $                                                  | 333,677    |   | $ | 1,102,789 |   | (69.7 | )% |

 

17

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The followingtable sets forth selected operating items, expressed as a percentage of totalrevenue:
| ** **                               | ** ** | **Three months ended   December 31** | ** ** |
|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| **Revenues:**                            |       |                                                     |       |   |   |
| Capitation revenue                       |       | 97.89                                                    | %          | 97.47 | % |
| Fee for service revenue                  |       | 1.10                                                     | %          | 1.69 | % |
| Management fees                          |       | 0.76                                                     | %          | 0.82 | % |
| Other operating revenue                  |       | 0.25                                                     | %          | 0.02 | % |
| **Total  revenues**                      |       | 100.00                                                   | %          | 100.00 | % |
| ** **                               | ** ** | ** **                                               | ** ** | ** ** | ** ** |
| **Cost of  revenues:**                   | ** ** | ** **                                               | ** ** | ** ** | ** ** |
| PCP capitation                           |       | 16.87                                                    | %          | 17.64 | % |
| Specialists capitation                   |       | 15.6                                                     | %          | 16.15 | % |
| Claims expense                           |       | 40.11                                                    | %          | 36.48 | % |
| Physician salaries                       |       | 1.81                                                     | %          | 2.06 | % |
| Other cost of revenues                   |       | 0.81                                                     | %          | 0.84 | % |
| Total cost of revenues                   |       | 74.76                                                    | %          | 73.17 | % |
|                                     |       |                                                     |       |   |   |
| **Gross margin**                         |       | 25.24                                                    | %          | 26.83 | % |
|                                     |       |                                                     |       |   |   |
| General and administrative expenses      |       | 23.19                                                    | %          | 21.31 | % |
| Depreciation and amortization expense    |       | 1.13                                                     | %          | 0.96 | % |
| Total non-medical expenses               |       | 24.32                                                    | %          | 22.27 | % |
|                                     |       |                                                     |       |   |   |
| Income from unconsolidated joint venture |       | 0.76                                                     | %          | 1.03 | % |
|                                     |       |                                                     |       |   |   |
| Operating income                         |       | 1.68                                                     | %          | 5.59 | % |
|                                     |       |                                                     |       |   |   |
| Other expense, net                       |       | 0.07                                                     | %          | 0.07 | % |
|                                     |       |                                                     |       |   |   |
| Income before income taxes               |       | 1.61                                                     | %          | 5.52 | % |
|                                     |       |                                                     |       |   |   |
| Provision for income taxes               |       | 0.65                                                     | %          | 2.22 | % |
|                                     |       |                                                     |       |   |   |
| Minority interest                        |       | 0.00                                                     | %          | 0.00 | % |
|                                     |       |                                                     |       |   |   |
| Net income                               |       | 0.96                                                     | %          | 3.30 | % |

 

**ThreeMonths Ended December 31, 2006 Compared to Three Months Ended December 31, 2005**

*CapitationRevenue*

Capitation revenue for the three months ended December31, 2006 was $34,092,290 representing an increase of 4.5% over capitationrevenue for the three months ended December 31, 2005, of $32,618,106

The increase is comprised of three main factors. Weestimate that higher capitation rates on our core business, exclusive ofacquisitions, contributed approximately $1,700,000 in increased capitationrevenue during the 2006 period as compared to the 2005 period. We estimate thatenrollment declines reduced capitation revenue by approximately $3,000,000during the 2006 period, as compared to the 2005 period. The November 2005acquisition of Genesis HealthCare of Southern California (Genesis) increasedcapitation revenue by approximately $1,300,000 for the 2006 period as comparedto the 2005 period. Additionally, we recorded approximately $1,200,000 in sharedrisk revenues in the 2006 quarter and minimal amounts in the 2005 period. Ofthe $1,200,000, $300,000 represents favorable changes in estimate from theprior year.

*Feefor service revenue*

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Feefor service revenue for the three months ended December 31, 2006 was $382,880,representing a decrease of $160,456 (32.3%) from fee for service revenue forthe three months ended December 31, 2005, of $565,750.

The decrease infee for service revenue during the 2006 period was primarily due tofluctuations in patient visits at our owned clinics.

*Managementfee revenue*

Managementfee revenue for the three months ended December 31, 2006 was $264,067,representing a decrease of  4% overmanagement fee revenue for the three months ended December 31, 2005, of$275,067.

Thedecrease in management fee revenue during the 2006 quarter was primarily theresult of  an amendment to the BrotmanMedical Center advisory contract which reduced our management involvment andthe related fee.

*Otherrevenue*

Otherrevenue for the three months ended December 31, 2006 was $88,760 representingan increase of $82,924  from otherrevenue for the three months ended December 31, 2005, of $5,836.

Amountsrepresent incentive payments from HMOs under “pay-per-performance” programs forquality medical care based on various criteria. The incentives  are recorded when such amounts are known.

Theincrease in other revenue during the 2006 quarter was primarily the result oftiming of the incentives received from our contracted Health Plans.

*PCPCapitation Expense*

PrimaryCare Physician (“PCP”) capitation expense for the three months ended December31, 2006 was $5,876,598, representing a decrease of $27,712 (0.5%) from PCPcapitation expense for the three months ended December 31, 2005, of $5,904,310.

Weestimate that net membership growth from the November 1, 2005 acquisition ofGenesis contributed approximately $200,000 in increased PCP capitation expenseduring the 2006 period, as compared to the 2005 period. We estimate that highercapitation rates on our core business, exclusive of acquisitions, increased PCPcapitation expense by approximately $300,000 during the 2006 period as comparedto the 2005 period. We estimate that enrollment declines related to our corebusiness, exclusive of the acquisition, reduced PCP capitation expense byapproximately $500,000 during the 2006 period, as compared to the 2005 period.

*SpecialistCapitation Expense*

Specialistcapitation expense for the three months ended December 31, 2006 was $5,281,084representing a decrease of $123,350 (2.3%) from specialist capitation expensefor the three months ended December 31, 2005, of $5,404,434.

Weestimate that net membership growth from the November 1, 2005 acquisition ofGenesis contributed approximately $130,000 in increased specialist capitationexpense during the 2006 period, as compared to the 2005 period. We estimatethat higher capitation rates on our core business, exclusive of theacquisition, increased specialist capitation expense by approximately $230,000during the 2006 period as compared to the 2005 period. We estimate thatenrollment declines related to our core business, exclusive of the acquisitions,reduced specialist capitation expense by approximately $480,000 during the 2006period, as compared to the 2005 period.

*ClaimsExpense*

Claimsexpense for the three months ended December 31, 2006 was $13,970,127,representing an increase of $1,763,480 (14.4%) over claims expense for thethree months ended December 31, 2005, of $12,206,647.

Weestimate that net membership growth from acquisitions contributed approximately$700,000 in increased claims expense during the 2006 period, as compared to the2005 period. We estimate that higher claims per member rates on our corebusiness, exclusive of acquisitions, increased claims expense by approximately$2,000,000 during the 2006 period as compared to the 2005 period. Thisestimated $2,000,000 increase includes approximately $900,000 related to priorperiods. We estimate that enrollment declines related to our core business,exclusive of the acquisition, reduced claims expense by approximately$1,000,000 during the 2006 period, as compared to the 2005 period.

*PhysicianSalaries Expense*

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Physiciansalaries expense for the three months ended December 31, 2006 was $628,452,representing a decrease of $62,573 (9.1%) from physician salaries expense forthe three months ended December 31, 2005, of $691,025.

Thedecrease in physician salaries expense during the 2006 quarter was primarilythe result of lower bonus accruals compared to the 2005 quarter. Physiciansalaries expense includes discretionary performance bonuses awarded annually toproviders. These bonuses are generally recorded in the same periods we recordpay-for-performance incentives, Medicare risk adjustment payments and sharedrisk incentives from the health plans, as a portion of these incentives formthe basis of the discretionary awards to our providers.

*OtherCost of Revenue*

Other cost of revenues for the three months endedDecember 31, 2006 was $279,765, representing a decrease of $34 (0.0%) fromother cost of revenue for the three months ended December 31, 2005, of$279,800.

Thedecrease in other cost of revenues during the 2006 quarter was primarily theresult of a decrease in the level of certain pharmacy and injectibles costsoffset by an increase in the cost of professional liability insurance.

*GrossMargin*

Medicalcare costs as a percentage of total revenues (the medical care ratio) largelydetermines our gross margin. Our gross margin decreased  by 1.6%, to 25.2% in the 2006 quarter, from26.8% in the 2005 quarter.

Thedecrease in our gross margin percentage between the 2005 and 2006 periods wasprimarily the result of a $900,000 adverse claims development relating to thefiscal 2006 period and increasing claims cost per member per month.

*Generaland Administrative Expenses*

Generaland administrative expenses were $8,077,069 for the 2006 quarter, representing 23.2%of total revenues, as compared with $7,131,074 or 21.3% of total revenues, forthe 2005 quarter.

Theincrease in general and administrative expenses during the 2006 quarter wasprimarily related to an increase in personnel and personnel related costs. Thisis due to the addition and upgrading of several key positions as well asstaffing for management of the Genesis operation which was brought in house inOctober, 2006.

*Depreciationand Amortization*

Depreciationand amortization expense for the three months ended December 31, 2006 increasedto $391,819 from $322,017 for the same period of the prior year. The increasewas primarily due to amortization of the identifiable intangible related to theacquision of Genesis.

*Incomefrom Unconsolidated Joint Venture*

Theincome from unconsolidated joint venture for the three months ended December31, 2006 decreased to $263,942 from $346,162 for the same period of the prioryear. The decrease resulted from a decrease in the MediCal related risk pools,offset by the fiscal year 2006 participation in the OneCare program effectiveJanuary 1, 2006, whereby some of the Medicare beneficiaries joiningCalOPTIMA’s OneCare program were assigned to AMVI/Prospect Medical Group.

*OtherExpense, Net*

Otherexpense, net for the three months ended December 31, 2006 increased to $25,448from $23,044 for the same period of the prior year. The increase in netinterest expense during the 2006 period was primarily due to additionalinterest expense on the $4 million GMAC Residential Funding Corporation creditfacility entered into on November 1, 2005 to finance the Genesis acquisition,partially offset by increased interest income earned in the 2006 period.

*Provisionfor Income Taxes*

Incometax expense decreased approximately 69.7%, or $518,831, to $225,352 for the2006 quarter, from $744,183 in the 2005 quarter. The effective tax rate wascomparable at 40.3% in the three months ended December 31, 2005 compared to40.1% in the three months ended December 31, 2006.

20

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**Liquidity and Capital Resources**

Wegenerate cash from capitation revenue, healthcare services provided on afee-for-service basis at our clinics, management fee revenue and investmentincome. Our primary uses of cash include the payment of expenses related tomedical care services and G&A expenses. We generally receive capitationrevenue in advance of payment of capitation expenses and claims for relatedhealth care services.

Ourinvestment policies are designed to preserve principal, maintain liquidity foroperations and statutory requirements, and maximize investment return. As ofDecember 31, 2006 we invested a substantial portion of our cash in a portfoliothat included Federal Home Loan bonds with an average maturity of approximately60 days, and overnight and high yield money market funds. All of these amountsare classified as current assets and included in cash and cash equivalents inthe accompanying balance sheets. We are also required by some of our HMOcontracts to set aside certain amounts in restricted certificates of deposit tosecure our ability to pay medical claims. These restricted certificates ofdeposit, with an average maturity of approximately 90 days as of December 31,2006, are included in current investments in the accompanying financialstatements as they are restricted for payment of current liabilities.

Netcash used in operations was $467,637 for the three months ended December 31,2006 and $1,008,241 for the three months ended December 31, 2005. The decreasein net cash used by operations for the three months ended December 31, 2006when compared to the three months ended December 31, 2005 was due to thefollowing factors:

·                  Decreasednet income ($769,112 lower in  2006) dueto the factors discussed above;

·                  Changesin risk pool and other receivables, a use of $526,881 in the three months endedDecember 31, 2006 compared to a source of $932,772 in the three months endedDecember 31, 2005. The 2005 period included greater collections on otherreceivables than the 2006 period, while the 2006 period saw an increase of $905,450in the recorded risk pool receivable;

·                  Changesin medical claims liabilities, a source of $900,000 in the three months endedDecember 31, 2006 compared to a use of $267,989 in the three months endedDecember 31, 2005. The increased source in the 2006 period was primarily due toan increase in the estimated claims liability;

·                  Changesin accounts payable and other accrued liabilities,  a use of $1,594,598 in the three months endedDecember 31, 2006 compared to a use of $3,092,319 in the three months endedDecember 31, 2005. The lower use during the 2006 period is primarily the resultof lower physician bonus payments in 2006.

Netcash used in investing activities was $303,434 for the three months endedDecember 31, 2006 and $6,624,608 for the three months ended December 31, 2005.The increased net cash used in investing activities during the 2005 period wasdue to the cash paid for acquisition, of $6,560,892, for the November 2005Genesis acquisition. $4,000,000 of the purchase price was financed throughborrowings. Investing activities also included purchases of fixed assets, a useof $237,861 in the three months ended December 31, 2006 compared to a use of$33,202 in the three months ended December 31, 2005.

Netcash used in financing activities was $2,466,429 for the three months endedDecember 31, 2006 and cash provided by financing activities was $4,102,310 forthe three months ended December 31, 2005. The increase in net cash provided byfinancing activities was due to the following factors:

·                  Proceedsfrom the term loan, a source of $4,000,000 in the three months ended December31, 2005, to finance the November 2005 Genesis acquisition, compared to $2,500,000in  repayments on our line of credit,during the three months ended December 31, 2006;.

21

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·                  $556,350in proceeds from common stock issuances during the three months ended December31, 2006, compared to $448,000 in the three months ended December 31, 2005,representing stock option exercise activity in the respective periods;.

At December 31,2006, we had positive working capital of $481,630 as compared to negativeworking capital of $123,898 at September 30, 2006.

AtDecember 31, 2006 and September 30, 2006, cash and cash equivalents were$13,385,906 and $16,623,407 respectively.

Oursubsidiaries are required to maintain minimum capital prescribed by variousHMOs with whom we contract. As of December 31, 2006, all of our subsidiarieswere in compliance with the minimum capital requirements. Barring any change inregulatory requirements, we believe that we will continue to be in compliancewith these requirements at least through the end of fiscal 2007. We alsobelieve that our cash resources and internally generated funds will besufficient to support our operations, regulatory requirements and capitalexpenditures for at least the next 12 months.

We expect torefinance existing debt upon its maturity, January 31, 2008.

**Contractual Obligations**

Inour annual report on Form 10-K filed on December 28, 2006, we reported on ourcontractual obligations as of that date. There have been no material changes toour contractual obligations since that report.

**Critical Accounting Policies**

Whenwe prepare our consolidated financial statements, we use estimates andassumptions that may affect reported amounts and disclosures. The determinationof our liability for medical claims and other health care costs payable isparticularly important to the determination of our financial position andresults of operations and requires the application of significant judgment byour management and, as a result, is subject to an inherent degree ofuncertainty.

Ourmedical care costs include actual historical claims experience and estimatesfor medical care costs incurred but not reported to us (“IBNR”). We, togetherwith our independent actuaries, estimate medical claims liabilities usingactuarial methods based upon historical data adjusted for payment patterns,cost trends, product mix, utilization of health care services and otherrelevant factors. The estimation methods and the resulting reserves arefrequently reviewed and updated, and adjustments, if necessary, are reflectedin the period known. While we believe our estimates are adequate, it ispossible that future events could require us to make significant adjustments orrevisions to these estimates. In assessing the adequacy of accruals for medicalclaims liabilities, we consider our historical experience, the terms ofexisting contracts, our knowledge of trends in the industry, informationprovided by our customers and information available from other sources asappropriate.

Themost significant estimates involved in determining our claims liability concernthe determination of claims payment completion factors and trended per memberper month cost estimates.

Weconsider historical activity for the current month, plus the prior 24 months,in our IBNR calculation. For the months of service five months prior to thereporting date and earlier, we estimate our outstanding claims liability basedupon actual claims paid, adjusted for estimated completion factors. Completionfactors seek to measure the cumulative percentage of claims expense that willhave been paid for a given month of service as of a date subsequent to thatmonth of service. Completion factors are based upon historical paymentpatterns. For the four months of service immediately prior to the reportingdate, actual claims paid are not a reliable measure of our ultimate liability,given the delay inherent between the patient/physician encounter and the actualsubmission of a claim for payment. For these months of service we estimate ourclaims liability based upon trended per member per month (“PMPM”) costestimates. These estimates reflect recent trends in payments and expense,utilization patterns, authorized services and other relevant factors. Thefollowing tables reflect (i) the change in our estimate of claims liability asof December 31, 2006 that would have resulted had we changed our completionfactors for all applicable months of 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 claims liabilityas of December 31, 2006 that would have resulted had we changed trended PMPMfactors for all applicable months of service included in our IBNR calculation(i.e., the preceding 1st through 4th months) by the percentages indicated.

22

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| Increase (Decrease) in   Estimated   Completion Factors | ** ** | **Increase (Decrease) in  Accrued Medical Claims  Payable** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| (3)%                                                                             |       | $                                                                               | 3,400,000  |   |
| (2)%                                                                             |       | $                                                                               | 2,300,000  |   |
| (1)%                                                                             |       | $                                                                               | 1,100,000  |   |
| 1%                                                                               |       | $                                                                               | (1,100,000 | ) |
| 2%                                                                               |       | $                                                                               | (2,300,000 | ) |
| 3%                                                                               |       | $                                                                               | (3,400,000 | ) |

 
| 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 December 31, 2006 estimatedclaims liability (of $12,300,000) and the actual claims incurred run-out, netincome for the three months ended December 31, 2006 would increase or decreaseby approximately $74,000, or approximately $0.01 per diluted share.

Thefollowing table shows the components of the change in medical claims andbenefits payable for the three months ended December 31, 2006: 
|                                                         | ** ** | **2006**    | ** ** |
|---------------------------------------------------------|------------|-------------|------------|
| IBNR as of  beginning of period                         |       | $           | 11,400,000 |   |
| Health care  claim expenses incurred during the period: |       |        |       |
| Related to current period                               |       | 13,057,127  |       |
| Related to prior periods                                |       | 913,000     |       |
| Total incurred                                          |       | 13,970,127  |       |
| Health care  claims paid during the period:             |       |        |       |
| Related to current period                               |       | (4,309,460  | )          |
| Related to prior periods                                |       | (8,760,667  | )          |
| Total paid                                              |       | (13,070,127 | )          |
|                                                    |       |        |       |
| IBNR as of end of  period                               |       | $           | 12,300,000 |   |

 

**Inflation**

Accordingto U.S. Bureau of Labor Statistics Data, the national health care costinflation rate has exceeded the general inflation rate for the last four years.We use various strategies to mitigate the negative effects of health care costinflation. Specifically, we try to control medical and hospital costs throughcontracts with independent providers of health care services. Through thesecontracted providers, we emphasize preventive health care and appropriate useof specialty and hospital services.

Whilewe currently believe our strategies to mitigate health care cost inflation willcontinue to be successful, competitive pressures, new health care andpharmaceutical product introductions, demands from health care providers andcustomers, applicable regulations or other factors may affect our ability tocontrol health care costs.

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**Item 3.Quantitative and Qualitative Disclosures About Market Risk.**

**Concentrations of Credit Risk**

Financialinstruments that potentially subject us to concentrations of credit riskconsist primarily of cash and cash equivalents, receivables, restricted cashand debt.

Asof December 31, 2006, we had cash and cash equivalents of $13,385,906. Cashequivalents consist of highly liquid securities with original maturities of upto three months. We invest a substantial portion of our cash equivalents in highyield money market funds. We also had $836,244 of investments, primarilyconsisting of restricted, interest-bearing certificates of deposit required byvarious HMOs with whom we do business. These investments are subject tointerest rate risk and will decrease in value if market rates increase. Allnon-restricted investments are maintained at fair market value on the balancesheet. We have the ability to hold these investments until maturity, and as aresult, we would not expect the value of these investments to declinesignificantly as a result of a sudden change in market interest rates. Declinesin interest rates over time will reduce our investment income. Concentration ofcredit risk related to receivables is generally limited to amounts due fromlarge HMO’s.

Ourterm loan with Residential Funding Corporation (RFC), with a balance of$8,800,000 at December 31, 2006, requires monthly principal payments of$233,333 and monthly interest payments at prime plus 2% per annum. The fairvalue of this debt instrument is affected by changes in market interest rates.As of December 31, 2006, the carrying value of our term loan approximated itsestimated fair value. Considerable judgment is required to develop estimates offair value. Accordingly, the estimate is not necessarily indicative of theamount we could realize in a current market exchange. The use of differentmarket assumptions and/or estimation methodologies may have a material effecton the estimated fair value amounts. For terms relating to our long-term debt,see Note 6 of the Notes to Condensed Consolidated Financial Statements.

**Item 4.Controls and Procedures.**

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

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Therefore, even those systems determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation.

***Changes in Internal Controls:***Therewere no changes in the Company’s internal control over financial reportingduring the three months ended December 31, 2006 that have materially affected,or are reasonably likely to materially affect, the Company’s internal controlsover financial reporting.

***Sarbanes-Oxley 404 Compliance:***Wehave begun a detailed assessment of our internal controls as called for by theSarbanes-Oxley Act of 2002. We are still in the evaluation of design phase. Wehave supplemented our internal project team with the services of an outsidespecialist. Although we have made this project a priority for the Company,there can be no assurances that all control deficiencies that may be identifiedand validated will be remediated before the required due date of September 30,2008.

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**PART II –OTHER INFORMATION**

**Item 1.    Legal Proceedings.**

We and our affiliated physician organizations areparties to legal actions arising in the ordinary course of business. We believethat liability, if any, under these claims will not have a material adverseeffect on our consolidated financial position or results of operations.

**Item 1A.  Risk Factors.**

None.

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

None.

**Item 3.    DefaultsUpon Senior Securities.**

None.

**Item 4.    Submissionof Matters to a Vote of Security Holders.**

None.

**Item 5.    OtherInformation.**

None.

**Item 6.    Exhibits.**

The following documentsare being filed as exhibits to this report:
| Exhibit No. | ** ** | **Title**                                                                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Amended and Restated Certificate of Incorporation of  Prospect Medical Holdings, Inc.(1)                                                             |
|             |       |                                                                                                                                                 |
| 3.2              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical Holdings, Inc.(1)                                 |
|             |       |                                                                                                                                                 |
| 3.3              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical Holdings, Inc.(1)                                 |
|             |       |                                                                                                                                                 |
| 3.4              |       | Certificate of Designation of Series A Convertible  Preferred Stock of Prospect Medical Holdings, Inc.(1)                                            |
|             |       |                                                                                                                                                 |
| 3.5              |       | Amended and Restated Bylaws of Prospect Medical  Holdings, Inc.(1)                                                                                   |
|             |       |                                                                                                                                                 |
| 3.6              |       | First Amendment to Amended and Restated Bylaws of  Prospect Medical Holdings, Inc.(1)                                                                |
|             |       |                                                                                                                                                 |
| 4.1              |       | Specimen Common Stock Certificate(1)                                                                                                                 |
|             |       |                                                                                                                                                 |
| 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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(1)           Previously filed as an exhibit to ourForm 10 registration statement on May 27, 2004, and incorporated herein byreference.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                   | PROSPECT MEDICAL HOLDINGS, INC.                                                                              |
|-------------------|--------------------------------------------------------------------------------------------------------------|
|              | (Registrant)                                                                                                 |
|              |                                                                                                         |
| February 14, 2007 | /s/ JACOB Y. TERNER                                                                                          |
|              | **Jacob Y. Terner, M.D.  Chairman of the Board and  Chief Executive Officer  (Principal Executive Officer)** |
|              | ** **                                                                                                   |
| February 14, 2007 | /s/ MIKE HEATHER                                                                                             |
|              | **Mike Heather  Chief Financial Officer  (Principal Financial Officer)**                                     |

 

26

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Exhibit Index
| Exhibit No. | ** ** | **Title**                                                                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                 |
| 3.1              |       | Amended and Restated Certificate of Incorporation of  Prospect Medical Holdings, Inc.(1)                                                             |
|             |       |                                                                                                                                                 |
| 3.2              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical Holdings, Inc.(1)                                 |
|             |       |                                                                                                                                                 |
| 3.3              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical Holdings, Inc.(1)                                 |
|             |       |                                                                                                                                                 |
| 3.4              |       | Certificate of Designation of Series A Convertible  Preferred Stock of Prospect Medical Holdings, Inc.(1)                                            |
|             |       |                                                                                                                                                 |
| 3.5              |       | Amended and Restated Bylaws of Prospect Medical  Holdings, Inc.(1)                                                                                   |
|             |       |                                                                                                                                                 |
| 3.6              |       | First Amendment to Amended and Restated Bylaws of  Prospect Medical Holdings, Inc.(1)                                                                |
|             |       |                                                                                                                                                 |
| 4.1              |       | Specimen Common Stock Certificate(1)                                                                                                                 |
|             |       |                                                                                                                                                 |
| 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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(1)Previously filed as an exhibit to our Form 10 registration statement on May 27,2004, and incorporated herein by reference.

27

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