**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**Form 10-Q**

 
| ý                               | ** ** | **Quarterly  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|--------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                 |       |                                                                                          |
|                                 |       | **For the quarterly period ended December 31, 2005**                                          |
|                                 |       |                                                                                          |
| **or**                               |
|                                 |       |                                                                                          |
| o                                    | ** ** | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                 |       |                                                                                          |
| **Commission  file number: 1-32203** |
|                                      |            |                                                                                               |  |  |

 

**Prospect Medical Holdings, Inc.**

(Exactname of registrant as specified in its charter)

 
| **Delaware**                                                    | ** ** | **33-0564370**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction ofincorporation  or organization) |       | (I.R.S.  EmployerIdentification  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)

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90days.    Yes ý  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):

 

Largeaccelerated filer  o    Acceleratedfiler  o    Non-acceleratedfiler  ý

 

The number of shares of the issuer’s Common Stock,par value $0.01 per share, outstanding as of February 6, 2006, was 6,878,628

 

 

----

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**Index**

 
|             | **Part I – Financial  Information**                                                                                   |       |
|------------------|----------------------------------------------------------------------------------------------------------------------------|------------|
| **Item 1.**      | **Financial Statements**                                                                                                   |       |
| ** **       | ** **                                                                                                                 |       |
|             | Condensed Consolidated  Balance Sheets as of December 31, 2005 (unaudited) and September 30, 2005                          |       |
|             |                                                                                                                       |       |
|             | Condensed Consolidated  Statements of Income for the three-month periods ended December 31, 2005 and  2004 (unaudited)     |       |
|             |                                                                                                                       |       |
|             | Condensed Consolidated  Statements of Cash Flows for the three-month periods ended December 31, 2005  and 2004 (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 2.**      | **Unregistered Sales of Equity  Securities and Use of Proceeds**                                                           |       |
| ** **       | ** **                                                                                                                 |       |
| **Item 6.** | **Exhibits**                                                                                                               |       |
|             |                                                                                                                       |       |
| **Signatures**   | ** **                                                                                                                 |
|                  |                                                                                                                            |            |  |

 

2

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.    Financial Statements.**

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

** **
| ** **                                                                                                                                                      | ** ** | **December 31,  2005** | ** ** | **September 30  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **(Unaudited)**        | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                      |       |                   |       |                   |       |
| **Current assets**                                                                                                                                              |       |                   |       |                   |       |
| Cash and cash equivalents                                                                                                                                       |       | $                      | 13,418,765 |                   | $          | 16,949,304 |   |
| Investments, primarily restricted certificates of deposit                                                                                                       |       | 1,129,653              |       | 1,100,000              |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Risk pool receivables                                                                                                                                           |       | 3,773                  |       | 57,267                 |       |
| Other receivables, net of allowances of  $874,000 and $802,000  at  December 31, 2005 and  September 30, 2005                                              |       | 993,299                |       | 1,940,536              |       |
| Notes receivable, current portion                                                                                                                               |       | 58,216                 |       | 52,160                 |       |
| Prepaid expenses and other                                                                                                                                      |       | 407,143                |       | 646,932                |       |
| Deferred income taxes, net                                                                                                                                      |       | 1,607,953              |       | 1,904,137              |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Total current assets                                                                                                                                            |       | $                      | 17,618,802 |                   | $          | 22,650,336 |   |
|                                                                                                                                                            |       |                   |       |                   |       |
| Property, improvements and equipment:                                                                                                                           |       |                   |       |                   |       |
| Land                                                                                                                                                            |       | 40,620                 |       | 40,620                 |       |
| Leasehold improvements                                                                                                                                          |       | 804,956                |       | 726,973                |       |
| Equipment                                                                                                                                                       |       | 3,279,244              |       | 3,342,385              |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Furniture and fixtures                                                                                                                                          |       | 557,362                |       | 546,523                |       |
|                                                                                                                                                            |       | 4,682,182              |       | 4,656,501              |       |
| Less accumulated depreciation and amortization                                                                                                                  |       | (3,582,231             | )          | (3,454,282             | )          |
| Property, improvements and equipment, net                                                                                                                       |       | 1,099,951              |       | 1,202,219              |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Notes receivable, long term portion                                                                                                                             |       | 563,711                |       | 572,979                |       |
| Deposits                                                                                                                                                        |       | 500,007                |       | 583,226                |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Goodwill                                                                                                                                                        |       | 38,623,321             |       | 31,404,328             |       |
| Other intangible assets, net                                                                                                                                    |       | 1,993,346              |       | 1,317,614              |       |
| Total assets                                                                                                                                                    |       | $                      | 60,399,138 |                   | $          | 57,730,702 |   |
|                                                                                                                                                            |       |                   |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                   |       |                   |       |                   |       |
| **Current liabilities:**                                                                                                                                        |       |                   |       |                   |       |
| Accrued medical claims and other health care costs payable                                                                                                      |       | $                      | 12,262,202 |                   | $          | 11,532,328 |   |
| Accounts payable and other accrued liabilities                                                                                                                  |       | 6,577,349              |       | 9,799,968              |       |
| Current maturities of long-term debt                                                                                                                            |       | 2,800,000              |       | 2,000,000              |       |
| Total current liabilities                                                                                                                                       |       | 21,639,551             |       | 23,332,296             |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Long-term debt, less current maturities                                                                                                                         |       | 8,800,000              |       | 6,166,667              |       |
| Deferred income taxes                                                                                                                                           |       | 1,000,180              |       | 1,045,696              |       |
| Other long-term liabilities                                                                                                                                     |       | 185,000                |       | 185,000                |       |
| Total liabilities                                                                                                                                               |       | 31,624,731             |       | 30,729,659             |       |
| **Minority interest**                                                                                                                                           |       | 67,003                 |       | 65,405                 |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| **Shareholders’ equity:**                                                                                                                                  |       |                   |       |                   |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Common stock, $0.01 par value; 40,000,000  shares authorized 6,845,362 and 6,640,362 shares issued and outstanding at December  31, 2005 and September 30, 2005 |       | 68,454                 |       | 66,403                 |       |
| Additional paid-in capital                                                                                                                                      |       | 19,040,413             |       | 18,373,487             |       |
| Retained earnings                                                                                                                                               |       | 9,598,537              |       | 8,495,748              |       |
| Total shareholders’ equity                                                                                                                                 |       | 28,707,404             |       | 26,935,638             |       |
|                                                                                                                                                            |       |                   |       |                   |       |
| Total liabilities and shareholders’ equity                                                                                                                 |       | $                      | 60,399,138 |                   | $          | 57,730,702 |   |

 

See accompanying notes.

 

3

----

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited)**

 
| ** **                                         | ** ** | **Three months ended   December 31** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|                                               |       |                                 |       |   |   |
| Revenues                                           |       | $                                    | 33,464,759 |   | $ | 33,280,836 |   |
| Cost of Revenues                                   |       | 24,486,216                           |       | 24,800,612 |   |
|                                               |       |                                 |       |   |   |
| Gross margin                                       |       | 8,978,543                            |       | 8,480,224 |   |
|                                               |       |                                 |       |   |   |
| Operating expenses:                                |       |                                 |       |   |   |
| General and administrative                         |       | 7,131,074                            |       | 6,572,811 |   |
| Depreciation and amortization                      |       | 322,017                              |       | 233,230 |   |
| Total operating expenses                           |       | 7,453,091                            |       | 6,806,041 |   |
|                                               |       |                                 |       |   |   |
| Operating income from unconsolidated joint venture |       | 346,162                              |       | 241,078 |   |
|                                               |       |                                 |       |   |   |
| Operating income                                   |       | 1,871,614                            |       | 1,915,261 |   |
|                                               |       |                                 |       |   |   |
| Other (income) expense:                            |       |                                 |       |   |   |
| Investment income                                  |       | (234,473                             | )          | (77,701 | ) |
|                                               |       |                                 |       |   |   |
| Interest expense                                   |       | 257,517                              |       | 177,722 |   |
| Total other (income) expense, net                  |       | 23,044                               |       | 100,021 |   |
|                                               |       |                                 |       |   |   |
| Income before income taxes                         |       | 1,848,570                            |       | 1,815,240 |   |
| Provision for income taxes                         |       | 744,183                              |       | 728,159 |   |
|                                               |       |                                 |       |   |   |
| Net income before minority interest                |       | 1,104,387                            |       | 1,087,081 |   |
|                                               |       |                                 |       |   |   |
| Minority interest                                  |       | 1,598                                |       | 384 |   |
|                                               |       |                                 |       |   |   |
| Net income                                         |       | $                                    | 1,102,789  |   | $ | 1,086,697 |   |
|                                               |       |                                 |       |   |   |
| Net income per common share:                       |       |                                 |       |   |   |
| Basic                                              |       | $                                    | 0.16       |   | $ | 0.25 |   |
| Diluted                                            |       | $                                    | 0.14       |   | $ | 0.13 |   |
| Weighted average common shares outstanding:        |       |                                 |       |   |   |
| Basic                                              |       | 6,700,579                            |       | 4,344,525 |   |
| Diluted                                            |       | 7,755,789                            |       | 8,682,550 |   |

 

See accompanying notes. 

 

4

----

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                     | ** ** | **Three months ended  December 31** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Operating activities**                                                       |       |                                |       |   |   |
| Net income                                                                     |       | $                                   | 1,102,789  |   | $ | 1,086,697 |   |
| Adjustments to reconcile net income to net cash used in operating  activities: |       |                                |       |   |   |
| Depreciation and amortization                                                  |       | 322,017                             |       | 233,230 |   |
| Provision for bad debts                                                        |       | 72,457                              |       | 17,746 |   |
| Gain on disposal of assets                                                     |       | 151                                 |       | — |   |
| Deferred income taxes, net                                                     |       | 250,668                             |       | 392,145 |   |
| Change in deferred compensation                                                |       | -                                   |       | 29,389 |   |
| Changes in operating assets and  liabilities:                                  |       |                                |       |   |   |
| Risk pool receivables                                                          |       | 53,494                              |       | (150,000 | ) |
| Other receivables                                                              |       | 879,278                             |       | (1,235,499 | ) |
| Prepaid expenses and other                                                     |       | 241,836                             |       | (52,687 | ) |
| Income taxes                                                                   |       | (814,439                            | )          | (612,776 | ) |
| Deposits                                                                       |       | 22,839                              |       |   |   |
| Accrued medical claims and other health  care costs payable                    |       | (267,989                            | )          | 135,224 |   |
| Accounts payable and other accrued  liabilities                                |       | (3,092,319                          | )          | (2,517,144 | ) |
|                                                                           |       |                                |       |   |   |
| Net cash used in operating activities                                          |       | (1,229,218                          | )          | (2,673,675 | ) |
|                                                                           |       |                                |       |   |   |
| **Investing activities**                                                       |       |                                |       |   |   |
| Purchases of property, improvements and equipment                              |       | (33,202                             | )          | (35,937 | ) |
| Proceeds from notes receivable                                                 |       | 3,212                               |       | 108,928 |   |
| Cash paid for acquisitions, net of cash received                               |       | (6,596,080                          | )          | — |   |
| Increase in restricted certificates of deposit                                 |       | (136                                | )          | (138,029 | ) |
| Capitalized expenses related to acquisitions                                   |       | —                              |       | (2,074 | ) |
| Other investing activities                                                     |       | 1,598                               |       | 384 |   |
| Net cash used in investing activities                                          |       | (6,624,608                          | )          | (66,728 | ) |
|                                                                           |       |                                |       |   |   |
| **Financing activities**                                                       |       |                                |       |   |   |
| Borrowings from term loan                                                      |       | 4,000,000                           |       | — |   |
| Repayments on notes payable and capital leases                                 |       | (566,667                            | )          | (508,554 | ) |
| Proceeds (expenses) from issuance of common and preferred stock                |       | 668,977                             |       | (171,737 | ) |
| Tax benefit from options exercised                                             |       | 220,977                             |       | — |   |
| Net cash provided by (used in) financing activities                            |       | 4,323,287                           |       | (680,291 | ) |
|                                                                           |       |                                |       |   |   |
| Net decrease in cash and cash equivalents                                      |       | (3,530,539                          | )          | (3,420,694 | ) |
|                                                                           |       |                                |       |   |   |
| Cash and cash equivalents at beginning of period                               |       | 16,949,304                          |       | 20,330,754 |   |
|                                                                           |       |                                |       |   |   |
| Cash and cash equivalents at end of period                                     |       | $                                   | 13,418,765 |   | $ | 16,910,060 |   |
|                                                                           |       |                                |       |   |   |
| **Supplemental cash flow information**                                         |       |                                |       |   |   |
| Cash paid during the period for:                                               |       |                                |       |   |   |
| Income taxes                                                                   |       | $                                   | 866,000    |   | $ | 2,295,784 |   |
| Interest                                                                       |       | $                                   | 257,517    |   | $ | 177,722 |   |
|                                                                           |       |                                |       |   |   |
| Details of businesses acquired:                                                |       |                                |       |   |   |
| Fair value of assets acquired                                                  |       | $                                   | 9,496,212  |   | $ | — |   |
| Liabilities assumed or created                                                 |       | (1,461,024                          | )          | — |   |
| Less cash acquired                                                             |       | 1,439,108                           |       | — |   |
| Net cash paid for acquisitions                                                 |       | $                                   | 6,596,080  |   | $ | — |   |

 

5

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**PROSPECTMEDICAL HOLDINGS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December31, 2005**

**(Unaudited)**

 

**1. Reporting Entity**

 

Prospect Medical Holdings, Inc.(Prospect or the Company) a Delaware corporation, was incorporated onMay 12, 1993. The Company is a health care management servicesorganization that develops integrated delivery systems, and provides medicalmanagement systems and services to affiliated medical organizations. Theaffiliated 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 interimfinancial statements have been prepared under the assumption that users of theinterim financial data have either read or have access to our auditedconsolidated financial statements for the latest fiscal year ended September30, 2005. Accordingly, certain note disclosures that would substantiallyduplicate the disclosures contained in the September 30, 2005 audited financialstatements have been omitted. These unaudited consolidated interim financialstatements should be read in conjunction with our September 30, 2005 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 (ETIF)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 and for the interim periods presented, which consistsolely of normal recurring adjustments, have been included. All significantinter-company balances and transactions have been eliminated in consolidation.The consolidated results of operations for the current interim period are notnecessarily indicative of the results that may be expected for the entire yearending September 30, 2006.

 

 

Revenues are comprised of the followingamounts:

 

| ** **      | ** ** | **Three Months Ended  December 31,** | ** ** |
|-----------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Capitation      |       | $                                    | 32,618,106 |   | $ | 32,518,763 |   |
| Fee for service |       | 565,750                              |       | 500,281 |   |
| Management fees |       | 275,067                              |       | 212,763 |   |
| Other           |       | 5,836                                |       | 49,029 |   |
| Total revenues  |       | $                                    | 33,464,759 |   | $ | 33,280,836 |   |

 

**3.  Stock Based 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. SFAS 123(R) requirescompensation cost for all share-based payments (including employee stockoptions) to be measured at fair value and eliminates the intrinsic value methodpreviously permitted 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, compensation cost is recognized for all awards granted,modified or settled subsequent to the adoption date, or where the requisiteservice period has not been completed prior to the date of adoption.Compensation cost for awards granted prior to, but not vested as of theadoption date would be based on the same estimated grant-date fair valuepreviously used for pro forma disclosure purposes under SFAS No. 123.Compensation costs for awards granted, modified, or settled after the adoptiondate will be measured and recognized in the financial statements, net of estimatedforfeitures over the awards’ service period, in accordance with SFAS No.123(R). The Company will continue to use the Black-Scholes option pricing modelto estimate the fair value of options granted. The adoption of SFAS No. 123Rdid 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 Company fully vestedall remaining unvested portions of previously issued stock options in September2005. Because none of the stock options whose vesting was accelerated hadexercise prices below the market value of the Company’s stock, no expense wasrecognized upon the acceleration of vesting. Accordingly, no stock basedcompensation expense is reported for the first quarter of fiscal 2006. TheCompany did not make other changes to the terms of the options, which generallyvest prorata over 2 years and expire after 5 years from the date of grant.

 

The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of SFAS No. 123 to employee stockbased compensation for the three month period ended December 31, 2004.

 

| Net income, as reported                                                                                                    |   | $        | 1,086,697 |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|----------|-----------|--------|
| Reconciling items (net of related tax effects):                                                                            |   |     |      |
| Add: Stock-based employee compensation  expense determined under the intrinsic-value based method, included in net  income |   | 29,389   |      |
| Deduct: Stock-based employee compensation  expense determined under the fair-value based method                            |   | (277,943 | )         |
| Net adjustment                                                                                                             |   | (248,554 | )         |
| Pro forma net income                                                                                                       |   | $        | 838,143   |   |
|                                                                                                                       |   |     |      |
| Earnings per share:                                                                                                        |   |     |      |
| Basic—as reported                                                                                                     |   | $        | 0.25      |   |
| Basic—pro forma                                                                                                       |   | $        | 0.19      |   |
| Diluted—as reported                                                                                                   |   | $        | 0.13      |   |
| Diluted—pro forma                                                                                                     |   | $        | 0.10      |   |

 

During the quarter endedDecember 31, 2005, options for 205,000 common shares were exercised for netproceeds of approximately $448,000 and 2,000 options were forfeited. TheCompany realized net tax benefits of $220,977 from these exercises where theprice paid was below the fair value of the common shares on the exercise date.The tax benefits reduced income tax payable and increased additional paid-incapital.

 

The fair value of these options granted during thethree month period endedDecember31, 2004 (prior to the Company becoming a public reporting entity) wasestimated at the date of grant using the Minimum Value option pricing model,with the following weighted average assumptions:

 

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

 

7

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**4. Earnings Per Share**

 

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

 

| ** **                                                               | ** ** | **Three months ended   December 31** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Basic earnings per common share:                                         |       |                                 |       |   |   |
| Numerator — net income                                              |       | $                                    | 1,102,789  |   | $ | 1,086,697 |   |
|                                                                     |       |                                 |       |   |   |
| Denominator — weighted average number of  common shares outstanding |       | 6,700,579                            |       | 4,344,525 |   |
|                                                                     |       |                                 |       |   |   |
| Basic earnings per common share                                          |       | $                                    | 0.16       |   | $ | 0.25 |   |
|                                                                     |       |                                 |       |   |   |
| Diluted earnings per common share:                                       |       |                                 |       |   |   |
| Numerator — net income                                              |       | $                                    | 1,102,789  |   | $ | 1,086,697 |   |
|                                                                     |       |                                 |       |   |   |
| Denominator:                                                             |       |                                 |       |   |   |
| Weighted average number of common shares  outstanding                    |       | 6,700,579                            |       | 4,344,525 |   |
| Dilutive stock options, warrants and  preferred shares                   |       | 1,055,210                            |       | 4,338,025 |   |
|                                                                     |       | 7,755,789                            |       | 8,682,550 |   |
|                                                                     |       |                                 |       |   |   |
| Diluted earnings per common share                                        |       | $                                    | 0.14       |   | $ | 0.13 |   |

 

**5. Related Party Transactions**

 

We have an employment agreement with ourChief Executive Officer, Jacob Y. Terner, which has been extended for athree-year term that ends on August 1, 2008 and provides for compensationof $250,000 per year. The agreement further provides that if we terminateDr. Terner’s employment without cause, we will be required to pay him$12,500 for each month of past service as our Chief Executive Officer,commencing as of July 31, 1996. Effective September 8, 2004, the Company’smaximum contingent obligation under this termination provision was frozen 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 withprevious acquisitions. In the event that PMG is required by the healthmaintenance organizations (HMO’s) or regulatory agencies to maintain a positivetangible net equity and positive working capital, Dr. Terner hadpreviously agreed to personally guarantee the intercompany account receivabledue from Prospect Medical Holdings, Inc. up to a level sufficient to enablePMG to attain positive tangible net equity and working capital.

 

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

 

8

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**6. Long Term Debt**

** **

Long-term debt at December 31 and September30, 2005 consists of the following:

* *

| ** **                                                                | ** ** | **December 31,  2005** | ** ** | **September 30  2005** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| Term loan                                                                 |       | $                      | 11,600,000 |                   | $          | 8,166,667 |   |
| Revolving credit facility, interest at prime rate plus applicable  margin |       | —                 |       | —                 |       |
|                                                                      |       |                   |       |                   |       |
| Less current maturities                                                   |       | (2,800,000             | )          | (2,000,000             | )          |
|                                                                      |       | $                      | 8,800,000  |                   | $          | 6,166,667 |   |

 

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

 

On September 28, 2004, the Company borrowed$10,000,000 on the RFC term loan and paid off its existing term loan andrevolving credit facility with another lender. The Company borrowed $5,000,000on the RFC revolving credit facility on September 29, 2004, which was repaid onOctober 4, 2004 and borrowed $5,000,000 on December 30, 2004 which was repaidon January 3, 2005. No amounts are outstanding under the credit facility atDecember 31, 2005.

 

The RFC revolving credit facility commitment is for three years, withinterest at prime plus 0.5% per annum and an unused line fee of 0.25% perannum. The RFC term loan requires principal payments of $166,667 per monthuntil September 27, 2007, at which time the entire remaining unpaid balance isdue. Interest is payable monthly on the outstanding balance at prime plus 2.0%per annum.. The Company is subject to certain financial covenants under theloan agreement, including a maximum senior debt/EBITDA ratio, minimum fixedcharge coverage ratio, minimum consolidated net worth, minimum liquidity and alimit on capital expenditures. The Company is also restricted, without consent,from using the net proceeds of any sale of equity securities except to pay downindebtedness under the loan agreement.

 

TheCompany exceeded the 1.50 maximum senior debt/EBITDA ratio as of September 30,2004 and December 31, 2004. The actual senior debt/EBITDA ratio as of September30, 2004 and December 31, 2004 was 1.57 and 1.51, respectively. Effective April7, 2005, RFC waived these covenant violations and agreed to exclude certainitems from the covenant computations for a twelve month period, the exclusionof which enabled the Company to meet the minimum fixed charge coverage ratio atDecember 31, 2004. We have been in compliance with all required RFC covenantsfor all subsequent periods.

 

In November 2005, in connection with the acquisition of GenesisHealthcare of Southern California, RFC provided us with an additional term loanof $4,000,000, on terms identical to our existing term loan. This additionalterm loan requires monthly principal payments of $66,667 untilSeptember 27, 2007, at which time the remaining unpaid balance is due.

 

**7. Acquisitions**

 

On November 1,2005, Prospect Medical Group, Inc, acquired the outstanding common stockof Genesis HealthCare of Southern California (Genesis) for $8,000,000 in cash.The purchase price was funded using $4,000,000 of the Company’s existing cashand a $4,000,000 term loan from RFC. Revenues and expenses for this acquisitionhave been included in our consolidated results starting November 1, 2005. Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed, as of the date of acquisition based on the preliminarypurchase price allocation:

 

| Current assets                                                |   | $         | 1,445,653 |   |
|---------------------------------------------------------------|--------|-----------|-----------|--------|
| Goodwill                                                      |   | 7,218,994 |      |
| Identifiable intangibles                                      |   | 800,000   |      |
| Other assets acquired                                         |   | 31,565    |      |
| Total assets                                                  |   | $         | 9,496,212 |   |
| Current liabilities                                           |   | 1,461,024 |      |
| Long-term liabilities                                         |   | —    |      |
| Total liabilities assumed                                     |   | 1,461,024 |      |
| Total purchase price (including $35,188 in transaction costs) |   | $         | 8,035,188 |   |

 

9

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Under the acquisitionagreement, differences between the estimated claims and tax liabilitiesrecorded on the closing date and the ultimate payments will be paid to orreceived from the seller. The agreement also guarantees a minimum amount ofrisk pool incentives for the 2005 calendar year. If actual amounts are less, wewill receive $500,000 from the seller in addition to any other amounts due.This amount will be recorded as a purchase price adjustment 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 limit is reduced ratably over the 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 quarters ended December 31, 2005 and 2004gives effect to the Genesis acquisition as if it had occurred onOctober 1, 2004.  Such unaudited proforma information is based on historical financial information with respect tothe acquisition and does not include operational or other changes that mighthave been effected by the Company.

 

| ** **                 | ** ** | **Quarter ended December 31** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                     | ** ** | **2004** | ** ** |
| ** **                 | ** ** | **(unaudited)**                              | ** ** |
| Net revenue                |       | $                                            | 34,316,687 |   | $ | 35,538,057 |   |
| Net income                 |       | 1,171,697                                    |       | 1,295,724 |   |
| Basic earnings per share   |       | $                                            | 0.17       |   | $ | 0.30 |   |
| Diluted earnings per share |       | $                                            | 0.15       |   | $ | 0.15 |   |

 

**8.  Investment in Brotman Medical Center, Inc.(Hospital)**

 

EffectiveAugust 31, 2005, the Company acquired an approximately 38% stake inBrotman Medical Center, Inc. for $1,000,000. The Company made theinvestment with the intention that it, with the Hospital, would be able tooffer joint contracting to HMOs operating in the area surrounding the Hospital.The Hospital, previously owned by Tenet HealthCare, had been incurringsignificant operating deficits. The new investors in the Hospital, includingProspect, hoped to help turn around the Hospital operations and restoreprofitability.

 

DuringSeptember 2005, the first month of operation under new ownership, theHospital experienced a net loss of approximately $1,000,000, of which Prospect’sportion totaled approximately $400,000. The Hospital has continued to incursignificant losses after September 30, 2005, and, with its limitedcapital, may not ultimately be able to survive.

 

We are not obligated,nor do we have any current intention, to invest any additional monies in theHospital. Based on the Hospital’s current significant operating deficits,uncertain ability to increase revenues and cut costs and limited capital, weconcluded that our remaining investment in Brotman Medical Center was impairedand wrote off our entire investment in the Hospital as of September 30, 2005.

 

10

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

 

**Forward-Looking Statements**

 

The following discussion of our financial conditionand results 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, 2005 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 theforward-looking statements are reasonable, we cannot guarantee futureresults, levels of activity, performance, or achievements. Moreover, we do notassume any responsibility for the accuracy and completeness of such statementsin the future. Subject to applicable law, we do not plan to update any of theforward-looking statements after the date of this report to conform suchstatements to actual results.

 

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

 

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

 

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

 

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

 

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

 

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

 

•                  Our operating results could be adversely affectedif 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.

 

11

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

 

•                  If we do not successfully integrate theoperations of acquired physician organizations into our service network, our costscould increase, our business could be disrupted, and we may not be able torealize 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.

 

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

 

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

 

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

** **

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

 

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

 

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

 

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

 

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

 

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

 

12

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

 

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

 

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

 

Investors should also refer to our Form 10-K annualreport filed with the Securities and Exchange on December 27, 2005 for adiscussion of risk factors. Given these risks and uncertainties, we can give noassurances that any forward-looking statements will in fact occur and thereforecaution investors not to place undue reliance on them.

 

**Overview**

 

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

 

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

 

Through our management subsidiaries —Prospect Medical Systems and  SierraMedical Management  — we have enteredinto long-term agreements to provide management services to each of ouraffiliated physician organizations in exchange for a management fee. Themanagement services we provide include HMO contracting, physician recruiting,credentialing and contracting, utilization management, quality assurance,medical management, human resources services, claims administration, financialservices, provider relations, patient eligibility and other services, medicalmanagement including utilization management and quality assurance, datacollection, and management 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, whichwas 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 184,400 HMO enrollees at December 31, 2005,including the AMVI Prospect Health Network enrollees. We manage approximately177,200 enrollees for our own economic benefit, and 7,200 enrollees for theeconomic benefit of our partner in this joint venture, for which we earn amanagement fee.

 

Currently,our affiliated physicianorganizations have contracts with approximately twelve HMOs, from which ourrevenue is primarily derived. HMOs offer a comprehensive health care benefitspackage in exchange for a capitation fee per enrollee that does not varythrough the contract period regardless of the quantity of medical servicesrequired or used. HMOs enroll members by entering into contracts with employergroups and government payors or directly with individuals to provide a broadrange of health care services for a prepaid charge, with minimal deductibles orco-payments required of the members. All of the contracts between ouraffiliated physician organizations and the HMOs provide for the provision ofmedical services by the affiliated physician organization to the HMO enrolleesin consideration for the prepayment of the fixed monthly capitation fee perenrollee paid by the HMOs.

 

13

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Our consolidated business has grown through the acquisition of IPAs byProspect Medical Group. Our plan is for Prospect Medical Group to continue toacquire additional IPAs. We do not intend to further acquire any individual orsmall medical practices, clinics or medical group practices. We have chosen toconcentrate our growth geographically by limiting our acquisitions to IPAs inOrange County, California and Los Angeles County, California.

 

Operating revenue of the Company consistsprimarily of fees for medical services provided by our affiliated physicianorganizations under capitated contracts with various HMOs or underfee-for-service arrangements. Capitation revenue under HMO contracts is prepaidmonthly to the affiliates based on the number of enrollees electing any one ofthe affiliates as their health care provider. Management fees comprise amountsearned from managing the operations of AMVI, Inc., which is our joint venturepartner in the AMVI/Prospect Health Network joint venture and providinghospital advisory services for the managed care business at Brotman MedicalCenter beginning September 1, 2005.

 

Revenues are comprised of the followingamounts:

 

| ** **      | ** ** | **Three months ended   December 31,** | ** ** | **%****of Increase  (Decrease)** | ** ** |
|-----------------|------------|---------------------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | **2005**                              | ** ** | **2004**                         | ** ** |
| Capitation      |       | $                                     | 32,618,106 |                             | $          | 32,518,763 |   | 0 | % |
| Fee for service |       | 565,750                               |       | 500,281                          |       | 13 | % |
| Management fees |       | 275,067                               |       | 212,763                          |       | 29 | % |
| Other           |       | 5,836                                 |       | 49,029                           |       | (88% | ) |
| Total           |       | $                                     | 33,464,759 |                             | $          | 33,280,836 |   | (1% | ) |

 

Net membership growth has been the primary reasonfor our increasing revenues. We have increased our membership throughacquisitions. These increases through acquisition are offset by HMO enrollmentdeclines at our affiliated physician organizations, which declines areconsistent with, though greater than, general HMO enrollment trends inCalifornia in recent years. The following table sets forth the approximatenumber of members, by category, as of the dates indicated.

 

| **Member  Category**   | ** ** | **As of  December 31,  2005** | ** ** | **As of****December 31****,********2004** | ** ** |
|------------------------|------------|-------------------------------|------------|-------------------------------------------|------------|
| Commercial             |       | 156,700                       |       | 162,500                                   |       |
| Senior                 |       | 13,400                        |       | 14,500                                    |       |
| MediCal – owned   |       | 7,200                         |       | 7,200                                     |       |
| MediCal – managed |       | 7,100                         |       | 7,100                                     |       |
|                   |       |                          |       |                                      |       |
| Total                  |       | 184,400                       |       | 191,300                                   |       |

 

The following table details total paid membermonths, by member category, for the three-month periods ended December 31, 2005and 2004:

 

| ** **        | ** ** | **Three months ended   December 31,** | ** ** | **%****of Increase  (Decrease)** | ** ** |
|-------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| ** **        | ** ** | **2005**                              | ** ** | **2004**                         |
| Commercial        |       | 452,100                               |       | 488,600                          |       | (7 | )% |
| Senior            |       | 39,000                                |       | 44,100                           |       | (12 | )% |
| MediCal - owned   |       | 21,400                                |       | 21,600                           |       | (1 | )% |
| MediCal - managed |       | 22,100                                |       | 22,000                           |       | 0 | % |
|              |       |                                  |       |                             |       |   |   |
| Total             |       | 534,600                               |       | 576,300                          |       | (7 | )% |

 

14

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

 

Expenses related to medical care services includepayments to contracted primary care physicians (PCP), payments to contractedspecialists and the cost of employed physicians at the Company’s medicalclinics. In general, primary care physicians are paid on a capitation basis (afixed amount per member per month regardless of actual utilization of medicalservices), while specialists are paid on either a capitation or afee-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, claimspayment patterns, membership and medical cost trends. These estimates areadjusted monthly as more information becomes available. In addition to our ownIBNR estimation process, we obtain semi-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.

 

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.

 

15

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**Results of Operations**

 

The following table sets forth selectedrevenue categories, cost of revenue categories and other income statement itemsfor the three month periods ended December 31, 2005 and 2004:

 
| ** **                                | ** ** | **Three months ended  December 31,** | ** ** | **%****Increase  (Decrease)** | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **                                | ** ** | **2005**                             | ** ** | **2004**                      |
| Revenues:                                 |       |                                 |       |                          |       |   |   |
| Capitation                                |       | $                                    | 32,618,106 |                          | $          | 32,518,763 |   | 0.3 | % |
| Fee for  service                          |       | 565,750                              |       | 500,281                       |       | 13.1 | % |
| Management  fees                          |       | 275,067                              |       | 212,763                       |       | 29.3 | % |
| Other                                     |       | 5,836                                |       | 49,029                        |       | (88.1 | )% |
|                                      |       |                                 |       |                          |       |   |   |
| Total  revenues                           |       | $                                    | 33,464,759 |                          | $          | 33,280,836 |   | .6 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Cost of  revenues:                        |       |                                 |       |                          |       |   |   |
| PCP  capitation                           |       | 5,904,310                            |       | 6,435,391                     |       | (8.3 | )% |
|                                      |       |                                 |       |                          |       |   |   |
| Specialists  capitation                   |       | 5,404,434                            |       | 5,850,573                     |       | (7.6 | )% |
| Claims  expense                           |       | 12,206,647                           |       | 12,094,408                    |       | 0.9 | % |
| Physician  salaries                       |       | 691,025                              |       | 435,241                       |       | 58.8 | % |
| Other cost  of revenues                   |       | 279,800                              |       | (15,001                       | )          | (1965.2 | )% |
|                                      |       |                                 |       |                          |       |   |   |
| Total cost  of revenues                   |       | 24,486,216                           |       | 24,800,612                    |       | (1.3 | )% |
|                                      |       |                                 |       |                          |       |   |   |
| Gross margin                              |       | 8,978,543                            |       | 8,480,224                     |       | 5.9 | % |
|                                      |       |                                 |       |                          |       |   |   |
| General and  administrative expenses      |       | 7,131,074                            |       | 6,572,811                     |       | 8.5 |  % |
| Depreciation  and amortization expense    |       | 322,017                              |       | 233,230                       |       | 38.1 | % |
| Total  operating expenses                 |       | 7,453,091                            |       | 6,806,041                     |       | 9.5 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Income from  unconsolidated joint venture |       | 346,162                              |       | 241,078                       |       | 43.6 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Operating  income                         |       | 1,871,614                            |       | 1,915,261                     |       | (2.3 | ) % |
|                                      |       |                                 |       |                          |       |   |   |
| Other  (income) expense, net              |       | 23,044                               |       | 100,021                       |       | (77.0 | )% |
|                                      |       |                                 |       |                          |       |   |   |
| Income  before income taxes               |       | 1,848,570                            |       | 1,815,240                     |       | 1.8 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Provision  for income taxes               |       | 744,183                              |       | 728,159                       |       | 2.2 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Minority  interest                        |       | 1,598                                |       | 384                           |       | 316.1 | % |
|                                      |       |                                 |       |                          |       |   |   |
| Net income                                |       | $                                    | 1,102,789  |                          | $          | 1,086,697 |   | 1.5 | % |

 

16

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The following table sets forth selected operatingitems, expressed as a percentage of total revenues:

 
| ** **                                | ** ** | **Three Months   Ended December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Revenues:                                 |       |                                  |       |   |   |
| Capitation                                |       | 97                                    | %          | 98 | % |
| Fee for  service revenue                  |       | 2                                     | %          | 1 | % |
| Management  fees                          |       | 1                                     | %          | 1 | % |
| Other                                     |       | 0                                     | %          | 0 | % |
| Total  revenues                           |       | 100                                   | %          | 100 | % |
|                                      |       |                                  |       |   |   |
| Cost of  revenues:                        |       |                                  |       |   |   |
| PCP  capitation                           |       | 18                                    | %          | 19 | % |
| Specialists  capitation                   |       | 16                                    | %          | 18 | % |
| Claims  expense                           |       | 36                                    | %          | 36 | % |
| Physician  salaries                       |       | 2                                     | %          | 2 | % |
| Other cost  of revenues                   |       | 1                                     | %          | 0 | % |
| Total cost  of revenues                   |       | 73                                    | %          | 75 | % |
|                                      |       |                                  |       |   |   |
| Gross margin                              |       | 27                                    | %          | 25 | % |
|                                      |       |                                  |       |   |   |
| General and  administrative expenses      |       | 21                                    | %          | 20 | % |
| Depreciation  and amortization expense    |       | 1                                     | %          | 1 | % |
| Total  operating expenses                 |       | 22                                    | %          | 21 | % |
|                                      |       |                                  |       |   |   |
| Income from  unconsolidated joint venture |       | 1                                     | %          | 1 | % |
|                                      |       |                                  |       |   |   |
| Operating  income                         |       | 6                                     | %          | 5 | % |
|                                      |       |                                  |       |   |   |
| Other  (income) expense, net              |       | 1                                     | %          | 0 | % |
|                                      |       |                                  |       |   |   |
| Income  before income taxes               |       | 5                                     | %          | 5 | % |
|                                      |       |                                  |       |   |   |
| Provision  for income taxes               |       | 2                                     | %          | 2 | % |
|                                      |       |                                  |       |   |   |
| Minority  interest                        |       | 0                                     | %          | 0 | % |
|                                      |       |                                  |       |   |   |
| Net income                                |       | 3                                     | %          | 3 | % |

 

**Three Months Ended December 31, 2005 Compared to ThreeMonths Ended December 31, 2004**

 

*Capitation Revenue*

 

Capitation revenue for the three months endedDecember 31, 2005 was $32,618,106, representing an increase of $99,343 (0.3%)over capitation revenue for the three months ended December 31, 2004, of$32,518,763.

 

The increase is comprised of three main factors. Weestimate that higher capitation rates on our core business, exclusive ofacquisitions, contributed approximately $2,800,000 in increased capitationrevenue during the 2005 period as compared to

 

17

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the 2004 period. We estimate that enrollmentdeclines reduced capitation revenue by approximately $4,500,000 during the 2005period, as compared to the 2004 period. The acquisition of Genesisincreased capitation revenue by approximately $1,800,000 for the 2005 period.

* *

*Fee for Service Revenue*

 

Fee for service revenue for the three months endedDecember 31, 2005 was $565,750, representing an increase of $65,469 (13.1%)over fee for service revenue for the three months ended December 31, 2004, of$500,281.

 

The increase in fee for service revenue during the2005 quarter was primarily the result of improved facilities at our medicalclinics which had recently completed a major renovation in the 2004 period.

 

*Management Fee Revenue*

 

Management fee revenue for the three months endedDecember 31, 2005 was $275,067, representing an increase of $62,304 (29.3%)over management fee revenue for the three months ended December 31, 2004, of$212,763.

 

The increase in management fee revenue during the2005 quarter was primarily the result of a new management contract with BrotmanMedical Center.

 

*Other Revenue*

 

Other revenue for the three months ended December31, 2005 was $5,836, representing a decrease of $43,193 (88.1%) from otherrevenue for the three months ended December 31, 2004, of $49,029.

 

The decrease in other revenue during the 2005quarter was primarily the result of lower incentives received from ourcontracted Health Plans.

 

*PCP Capitation Expense*

 

Primary Care Physician (“PCP”) capitation expensefor the three months ended December 31, 2005 was $5,904,310, representing adecrease of $531,081 (8.3%) from PCP capitation expense for the three monthsended December 31, 2004, of $6,435,391.

 

This decrease in PCP capitation expense during the2005 period, as compared to the 2004 period resulted primarily from theenrollment declines discussed above.

 

*Specialist Capitation Expense*

 

Specialist capitation expense for the three monthsended December 31, 2005 was $5,404,434, representing a decrease of $446,139(7.6%) from specialist capitation expense for the three months ended December31, 2004, of $5,850,573.

 

This decrease in specialist capitation expenseresulted primarily from the enrollment declines discussed above and a slightincrease in specialist expenses that were paid on a fee-for-service basis asopposed to a capitation basis.

 

*Claims Expense*

 

Claims expense for the three months ended December31, 2005 was $12,206,647, representing an increase of $112,239 (0.9%) overclaims expense for the three months ended December 31, 2004, of $12,094,408.

 

This increase in claims expense resulted primarilyfrom the increase in specialist expenses paid on a fee-for-service basis asopposed to a capitation basis, which was partially offset by enrollmentdeclines.

 

18

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*Physician Salaries Expense*

 

Physician salaries expense for the three monthsended December 31, 2005 was $691,025, representing an increase of $255,784(58.8%) over physician salaries expense for the three months ended December 31,2004, of $435,241.

 

The increase in physician salaries expense duringthe 2005 quarter was primarily the result of higher bonus accruals compared tothe 2004 quarter.

* *

*Other Cost of Revenues*

 

Other cost of revenue for the three months endedDecember 31, 2005 was $279,800, representing an increase of $294,801 (1965.2%)over other cost of revenues for the three months ended December 31, 2004, of($15,001).

 

The increase in other cost of revenues during the2005 quarter was primarily the result of an increase in the level of certainpharmacy and injectibles.  In the 2004quarter there was a stoploss recovery that offset costs in that quarter.

 

*Gross Margin*

 

Medical care costs as a percentage of medicalrevenues (the medical care ratio) largely determines our gross margin. Ourgross margin increased by 1.3%, to 26.8% in the 2005 quarter, from 25.5% in the2004 quarter.

 

The increase in our gross margin percentage betweenthe 2004 and 2005 periods was the result of the decrease in PCP and specialistcapitation as a percent of total revenues by 1.7% and 1.4%, respectively,compared to the same quarter in 2004. This was offset by an increase in the physician compensation of 0.8% andother cost of sales as a percent of sales by 0.9% compared to the same quarterin 2004.

 

*General and Administrative Expenses*

 

General and administrative expenses were $7,131,074for the 2005 quarter, representing 21.3% of total revenues, as compared with$6,572,812, or 19.7% of total revenues, for the 2004 quarter.

 

The increase in general and administrative expenses duringthe 2005 quarter was primarily the result of increased cost of outside servicesrelated to target acquisitions, information technology assistance, and softwarelicensing costs.

 

*Depreciation and Amortization*

 

Depreciation and amortization expense for the threemonths ended December 31, 2005 increased to $322,017 from $233,230 for the sameperiod of the prior year. The increase was primarily due to accelerating,effective April 1, 2005, the rate of amortization of identifiable intangibleassets from prior acquisitions from 90-100 months down to 50-54 months, as wellas depreciation expense associated with increased capital expenditures.Amortization of $44,000 was recorded for Genesis acquisition pendingfinalization of the purchase price allocation.

 

*Other Income (Expense),Net*

 

Other income (expense), net for the three monthsended December 31, 2005 decreased to a net expense of $23,044 from a netexpense of $100,021 for the same period of the prior year. The decrease in netexpense during the 2005 period was primarily due to increased investmentincome, partially offset by additional interest expense on the $4 million RFCterm loan in conjunction with the Genesis acquisition on November 1, 2005.

 

*Provision for Income Taxes*

 

Incometax expense increased approximately 2.2%, or $16,024, to $744,183 for the 2005quarter, from $728,159 in the 2004 quarter. The effective tax rate for the 2005quarter was consistent to the 2004 quarter at 40.3% and 40.1%, respectively.

 

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**Liquidity and Capital Resources**

 

We generate cash from capitation revenue, servicesprovided on a fee-for-service basis at our clinics, management fee revenue andinvestment income. Our primary uses of cash include the payment of expensesrelated to medical care services and G&A expenses. We generally receivecapitation revenue in advance of payment of capitation expenses and claims forrelated health care services.

 

Our investment policies are designed topreserve principal, maintain liquidity for operations and statutoryrequirements and maximize investment return. As of December 31, 2005, weinvested a substantial portion of our cash in a portfolio that included FederalHome Loan bonds with an average maturity of approximately 60 days, overnightand high yield money market funds. All of these amounts are classified ascurrent assets and included in cash and cash equivalents in the accompanyingbalance sheets. We are also required by some of our HMO contracts to set asidecertain amounts in restricted certificates of deposit. These restrictedcertificates of deposit, with an average maturity of approximately 75 days asof December 31, 2005, are included in short-term investments in theaccompanying financial statements as they are available to pay medical claimsupon termination of the HMO contracts.

 

Netcash used by operations was $1,229,218 for the three months ended December 31,2005 and $2,673,675 for the three months ended December 31, 2004. The decreasein net cash used by operations for the three months ended December 31, 2005when compared to the three months ended December 31, 2004 was primarily due tothe following factors:

 
| • | Changes  in risk pool receivable balances, a source of $53,494 in the three months  ended December 31, 2005 compared to a use of $150,000 in the three months  ended December 31, 2004; |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                    |
| • | Collection  of other receivables, a source of $879,278 in the three months ended December  31, 2005 compared to a use of $1,235,499 in the three months ended December  31, 2004;       |
|   |                                                                                                                                                                                    |
| • | Changes  in prepaid expenses and other, a source of $241,836 in the three months ended  December 31, 2005 compared to a use of $52,687 in the three months ended  December 31, 2004;    |

 

Thesewere offset in part by the following:

 
| • | Changes  in medical claims liabilities, which were a use of $267,989 in the three  months ended December 31, 2005 compared to a source of $135,224 in the three  months ended December 31, 2004;             |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                         |
| • | Changes  in accounts payable and other accrued liabilities, a use of $3,092,319 for  the three months ended December 31, 2005 compared to a use of $2,517,144 for  the three months ended December 31, 2004; |

 

Wealso incurred net cash use of $2,301,321 in investing and financing activities:

 
| • | Cash  paid for acquisition, net of cash received, a use of $6,596,080 for the three  months ended December 31, 2005 compared to none the for the three months  ended December 31, 2004; |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |
| • | $4,000,000  from a term loan to finance the Genesis acquisition in the three months ended  December 31, 2005 compared to none in the three months ended December 31,  2004; and         |

 

20

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| • | Issuance  of common stock, a source of  $668,977  in the three months ended December 31, 2005 compared to a use of $171,737 in  the three months ended December 31, 2004. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

AtDecember 31, 2005, we had negative working capital of $4,020,749 as compared tonegative working capital of $681,960 at September 30, 2005. At December 31,2005 and September 30, 2005, cash and cash equivalents were $13,418,765 and$16,949,304 respectively. The reduction in cash and working capital isprimarily due to the $8 million Genesis acquisition, net of $4 million inrelated debt financing.

 

Our subsidiaries are required to maintain minimumcapital prescribed by various HMOs with whom we contract. As of December 31,2005, all of our subsidiaries were in compliance with the minimum capitalrequirements. Barring any change in regulatory requirements, we believe that wewill continue to be in compliance with these requirements at least through theend of fiscal 2006. We also believe that our cash resources and internallygenerated funds will be sufficient to support our operations, regulatoryrequirements and capital expenditures for at least the next 12 months. AtDecember 31, 2005, we had approximately $3.5 million available under the RFCcredit facility for working capital needs.

 

**Contractual Obligations**

 

In our annual report on Form 10-K filed on December27, 2005, we reported on our contractual obligations as of that date. There havebeen no material changes to our contractual obligations since that report.

** **

**Critical Accounting Policies**

 

When we prepare our consolidated financialstatements, we use estimates and assumptions that may affect reported amountsand disclosures. The determination of our liability for medical claims andother health care costs payable is particularly important to the determinationof our financial position and results of operations and requires theapplication of significant judgment by our management and, as a result, issubject to an inherent degree of uncertainty.

 

Our medical care costs include actual historicalclaims experience and estimates for medical care costs incurred but notreported to us (“IBNR”). We, together with our independent actuaries, estimatemedical claims liabilities using actuarial methods based upon historical dataadjusted for payment patterns, cost trends, product mix, utilization of healthcare services and other relevant factors. The estimation methods and theresulting reserves are frequently reviewed and updated, and adjustments, ifnecessary, are reflected in the period known. While we believe our estimatesare adequate, it is possible that future events could require us to makesignificant adjustments or revisions to these estimates. In assessing theadequacy of accruals for medical claims liabilities, we consider our historicalexperience, the terms of existing contracts, our knowledge of trends in theindustry, information provided by our customers and information available fromother sources as appropriate.

 

The most significant estimates involved indetermining our claims liability concern the determination of claims paymentcompletion factors and trended per member per month cost estimates.

 

We consider historical activity for the currentmonth, plus the prior 24 months, in our IBNR calculation. For the months ofservice five months prior to the reporting date and earlier, we estimate ouroutstanding claims liability based upon actual claims paid, adjusted forestimated completion factors. Completion factors seek to measure the cumulativepercentage of claims expense that will have been paid for a given month ofservice as of a date subsequent to that month of service. Completion factorsare based upon historical payment patterns. For the four months of serviceimmediately prior to the reporting date, actual claims paid are not a reliablemeasure of our ultimate liability, given the delay inherent between thepatient/physician encounter and the actual submission of a claim for payment.For these months of service we estimate our claims liability based upon trendedper member per month (“PMPM”) cost estimates. These estimates reflect recenttrends in payments and expense, utilization patterns, authorized services andother relevant factors. The following tables reflect (i) the change in ourestimate of claims liability as of December 31, 2005 that would have resultedhad we changed our completion factors for all applicable months of serviceincluded 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, 2005 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 4thmonths) by the percentages indicated.

 

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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, 2005 estimatedclaims liability (of $12,262,202) and the actual claims incurred run-out, netincome for the three months ended December 31, 2005 would increase or decreaseby approximately $75,000, while diluted net income per share would increase ordecrease by approximately $0.01 per share, net of tax.

 

The following table shows the components of thechange in medical claims and benefits payable for the three months endedDecember 31, 2005:

 

| ** **                                                         | ** ** | **2005**    | ** ** |
|--------------------------------------------------------------------|------------|-------------|------------|
| IBNR as of  beginning of period                                    |       | $           | 11,532,328 |   |
| Health care  claim expenses incurred during the period related to: |       |        |       |
| Current year                                                       |       | 12,520,470  |       |
| Prior years                                                        |       | (313,823    | )          |
| Total  incurred                                                    |       | 12,206,647  |       |
| Health care  claims paid during the period related to:             |       |        |       |
| Current year                                                       |       | (3,679,355  | )          |
| Prior years                                                        |       | (8,795,281  | )          |
| Total paid                                                         |       | (12,474,636 | )          |
|                                                               |       |        |       |
| IBNR  acquired during the period                                   |       | 997,863     |       |
| IBNR as of  end of period                                          |       | $           | 12,262,202 |   |

 

**Inflation**

 

According to U.S. Bureau of Labor Statistics Data,the national health care cost inflation rate has exceeded the general inflationrate for the last four years. We use various strategies to mitigate thenegative effects of health care cost inflation. Specifically, we try to controlmedical and hospital costs through contracts with independent providers ofhealth care services. Through these contracted providers, we emphasizepreventive health care and appropriate use of specialty and hospital services.

 

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While we currently believe our strategies tomitigate health care cost inflation will continue to be successful, competitivepressures, new health care and pharmaceutical product introductions, demandsfrom health care providers and customers, applicable regulations or otherfactors may affect our ability to control health care costs.

 

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

 

**Concentrations of Credit Risk**

 

Financial instruments that potentially subject us toconcentrations of credit risk consist primarily of cash and cash equivalents,receivables, restricted cash and debt.

 

As of December 31, 2005, we had cash and cash equivalentsof $13,418,765. Cash equivalents consist of highly liquid securities withoriginal maturities of up to three months. We invest a substantial portion ofour cash equivalents in Federal Home Loan bonds and overnight, high yield moneymarket funds. We also had $1,129,653 of investments, primarily consisting ofrestricted, interest-bearing certificates of deposit required by various HMOswith whom we do business. These investments are subject to interest rate riskand will decrease in value if market rates increase. All non-restrictedinvestments are maintained at fair market value on the balance sheet. We havethe ability to hold these investments until maturity, and as a result, we wouldnot expect the value of these investments to decline significantly as a resultof a sudden change in market interest rates. Declines in interest rates overtime will reduce our investment income.

 

Our variable rate term loanwith Residential Funding Corporation, with a balance of $11,600,000 at December31, 2005, requires monthly principal payments of $233,334 and monthly interestpayments at prime plus 2% per annum. The fair value of this debt instrument isaffected by changes in market interest rates. As of December 31, 2005, thecarrying value of our term loan approximated its estimated fair value.Considerable judgment is required to develop estimates of fair value.Accordingly, the estimate is not necessarily indicative of the amount we couldrealize in a current market exchange. The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts. For terms relating to our long-term debt, see Note 6 of theNotes to Condensed Consolidated Financial Statements.

 

**Item 4.Controls and Procedures.**

 

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

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Therefore, even thosesystems determined to be effective can provide only reasonable assurance withrespect to financial statement preparation and presentation.

*** ***

***Changes inInternal Controls:***Therewere no changes in the Company’s internal control over financial reportingduring the three months ended December 31, 2005 that have materially affected,or are reasonably likely to materially affect, the Company’s internal controlsover financial reporting.

 

***Sarbanes-Oxley 404Compliance:***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 30,2007, or September 30, 2006 if the Company becomes an accelerated filer as ofMarch 31, 2006.

 

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**PART II — OTHER INFORMATION**

 

**Item 1.Legal Proceedings**

 

We and our affiliatedphysician organizations are parties to legal actions arising in the ordinarycourse of business. We believe that liability, if any, under these claims willnot have a material adverse effect on our consolidated financial position orresults of operations.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

 

Management believes that each of the securities transactions during theperiod covered by this report that is described in the table below was exemptfrom the registration requirements of the Securities Act of 1933, as amended(the “Securities Act”), as referenced in the notes accompanying the table:

 
| **Date** | ** ** | **Title**    | ** ** | **Amount**    | ** ** | **Consideration** | ** ** | **Recipient** | ** **    |
|----------|------------|--------------|------------|---------------|------------|-------------------|------------|---------------|---------------|
| 10/2005  |       | Common Stock |       | 25,000 shares | (1)        | $                 | 31,250     |          | Option holder |   |
|          |            |              |            |               |            |                   |            |               |               |  |

 

(1)                                  Theseshares of common stock were issued upon exercise of outstanding options inreliance on the exemption for non-public offerings provided by Section 4(2) ofthe Securities Act of 1933.

 

**Item 6. Exhibits**

 

The following documents are being filed as exhibitsto this report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                              |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                             |
| 10.1                 |       | Amendment  No. 2, dated as of August 1, 2005, to Employment Agreement, dated as of  August 1, 1999, between Prospect Medical Holdings, Inc. and Jacob Y. Terner,  M.D. |
|                 |       |                                                                                                                                                                   |
| 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.                   |

 

24

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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  10, 2005 | /s/  JACOB Y. TERNER                                                                        |   |
| ** **         | **Jacob Y. Terner, M.D.**                                                                   |
| ** **         | **Chairman of the Board and****Chief Executive  Officer****(Principal  Executive Officer)** |
| ** **         | ** **                                                                                  |
| February  10, 2005 | /s/  MIKE HEATHER                                                                           |   |
| ** **         | **Mike Heather**                                                                            |
| ** **         | **Chief Financial Officer****(Principal  Financial Officer)**                               |

 

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