Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**Form 10-Q**

 

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

 

**For the quarterly period ended****June 30,2009**

 

**or**

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

 

**For the transition period from                to                 **

 

**Commissionfile number: 1-32203**

 

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**Prospect Medical Holdings, Inc.**

(Exact name of registrant asspecified in its charter)

 

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

 

**(310) 943-4500**(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer,”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

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

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act): Yes o  No x

 

The number of shares of the issuer’s Common Stock, par value $0.01 pershare, outstanding as of August 12, 2009 was 20,575,111.

 

 

 

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Table ofContents

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**Index**

 
| **Part I—Financial Information** |
|--------------------------------------------|
|                                       |   |   |
| Item 1.                               | Financial Statements |   |
|                                       | Condensed Consolidated Balance Sheets as of  June 30, 2009 and September 30, 2008 (unaudited) | 1 |
|                                       | Condensed Consolidated Statements of Operations for  the three-month and nine-month periods ended June 30, 2009 and 2008  (unaudited) | 3 |
|                                       | Condensed Consolidated Statements of Cash Flows for  the nine-month periods ended June 30, 2009 and 2008 (unaudited) | 4 |
|                                       | Notes to Condensed Consolidated Financial Statements  (unaudited) | 5 |
| Item 2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 27 |
| Item 3.                               | Quantitative  and Qualitative Disclosures About Market Risk | 56 |
| Item 4T.                              | Controls and  Procedures | 56 |
| Part II—Other Information        |
| Item 1.                               | Legal Proceedings | 58 |
| Item 1A.                              | Risk Factors | 58 |
| Item 2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds | 58 |
| Item 3.                               | Defaults  Upon Senior Securities | 58 |
| Item 4.                               | Submission  of Matters to a Vote of Security Holders | 59 |
| Item 5.                               | Other information | 59 |
| Item 6.                               | Exhibits | 59 |
| Signatures                                 | 61 |

 

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Table ofContents

 

**PART I—FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(inthousands)**

 

**(Unaudited)**

 
| ** **                                                                                                                                    | ** ** | **June 30,  2009** | ** ** | **September 30,  2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                    |       |                    |       |                         |       |
| **Current  assets:**                                                                                                                          |       |                    |       |                         |       |
| Cash and cash equivalents                                                                                                                     |       | $                       | 31,587     |                         | $          | 33,583 |   |
| Restricted cash                                                                                                                               |       | 1,745                   |       | —                       |       |
| Investments, primarily restricted certificates of  deposit                                                                                    |       | 665                     |       | 637                          |       |
| Patient accounts receivable, net of allowance for  doubtful accounts of $11,509 and $3,891 at June 30, 2009 and  September 30, 2008 |       | 39,307                  |       | 18,314                       |       |
| Government program receivables                                                                                                                |       | 3,606                   |       | 4,365                        |       |
| Risk pool receivables                                                                                                                         |       | 194                     |       | 338                          |       |
| Other receivables                                                                                                                             |       | 1,222                   |       | 2,598                        |       |
| Third party settlements                                                                                                                       |       | 2,990                   |       | 217                          |       |
| Notes receivable, current portion                                                                                                             |       | 62                      |       | 224                          |       |
| Refundable income taxes, net                                                                                                                  |       | —                  |       | 2,654                        |       |
| Deferred income taxes, net                                                                                                                    |       | 5,788                   |       | 5,788                        |       |
| Inventories                                                                                                                                   |       | 4,185                   |       | 1,460                        |       |
| Prepaid expenses and other current assets                                                                                                     |       | 4,479                   |       | 2,776                        |       |
| Total current assets                                                                                                                          |       | 95,830                  |       | 72,954                       |       |
| Property, improvements and equipment:                                                                                                         |       |                    |       |                         |       |
| Land and land improvements                                                                                                                    |       | 31,028                  |       | 18,452                       |       |
| Buildings                                                                                                                                     |       | 27,047                  |       | 22,233                       |       |
| Leasehold improvements                                                                                                                        |       | 2,028                   |       | 1,505                        |       |
| Equipment                                                                                                                                     |       | 20,140                  |       | 10,628                       |       |
| Furniture and fixtures                                                                                                                        |       | 913                     |       | 912                          |       |
|                                                                                                                                          |       | 81,156                  |       | 53,730                       |       |
| Less accumulated depreciation and amortization                                                                                                |       | (13,219                 | )          | (7,911                       | )          |
| Property, improvements and equipment, net                                                                                                     |       | 67,937                  |       | 45,819                       |       |
| Notes receivable, less current portion                                                                                                        |       | 371                     |       | 238                          |       |
| Deposits and other assets                                                                                                                     |       | 391                     |       | 778                          |       |
| Deferred financing costs, net                                                                                                                 |       | 3,045                   |       | 662                          |       |
| Goodwill                                                                                                                                      |       | 150,046                 |       | 128,877                      |       |
| Other intangible assets, net                                                                                                                  |       | 44,553                  |       | 47,740                       |       |
| Total assets                                                                                                                                  |       | $                       | 362,174    |                         | $          | 297,068 |   |

 

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

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 

**(inthousands, except share amounts)**

 

**(Unaudited)**

 
| ** **                                                                                                                                                                             | ** ** | **June 30,  2009** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                         |       |                    |       |                         |       |
| **Current  liabilities:**                                                                                                                                                              |       |                    |       |                         |       |
| Accrued medical claims and other health care costs  payable                                                                                                                            |       | $                       | 17,863     |                         | $          | 20,480 |   |
| Accounts payable and other accrued liabilities                                                                                                                                         |       | 28,548                  |       | 16,296                       |       |
| Accrued salaries, wages and benefits                                                                                                                                                   |       | 22,745                  |       | 11,257                       |       |
| Due to government payer                                                                                                                                                                |       | 13,834                  |       | —                       |       |
| Income taxes payable, net                                                                                                                                                              |       | 64                      |       | —                       |       |
| Payable to Creditors’ Trust                                                                                                                                                       |       | 1,000                   |       | —                       |       |
| Current portion of capital leases                                                                                                                                                      |       | 1,137                   |       | 341                          |       |
| Current portion of long-term debt                                                                                                                                                      |       | 900                     |       | 12,100                       |       |
| Interest rate swap liability – current (see Note  7)                                                                                                                              |       | 11,032                  |       | —                       |       |
| Other current liabilities                                                                                                                                                              |       | 693                     |       | 107                          |       |
| Total current liabilities                                                                                                                                                              |       | 97,816                  |       | 60,581                       |       |
|                                                                                                                                                                                   |       |                    |       |                         |       |
| Long-term debt, net of current portion                                                                                                                                                 |       | 160,399                 |       | 131,921                      |       |
| Deferred income taxes                                                                                                                                                                  |       | 26,522                  |       | 24,433                       |       |
| Malpractice reserve                                                                                                                                                                    |       | 2,706                   |       | 786                          |       |
| Capital leases, net of current portion                                                                                                                                                 |       | 542                     |       | 442                          |       |
| Interest rate swap liability – non-current                                                                                                                                        |       | —                  |       | 6,013                        |       |
| Total liabilities                                                                                                                                                                      |       | 287,985                 |       | 224,176                      |       |
| Minority interest                                                                                                                                                                      |       | 86                      |       | 81                           |       |
| **Commitments, Contingencies and  Subsequent Event**                                                                                                                                   |       |                    |       |                         |       |
| **Shareholders’ equity:**                                                                                                                                                         |       |                    |       |                         |       |
| Common stock, $0.01 par value; 40,000,000 shares  authorized; 20,575,111 and 20,508,444 shares issued and outstanding at  June 30, 2009 and September 30, 2008, respectively |       | 206                     |       | 204                          |       |
| Additional paid-in capital                                                                                                                                                             |       | 94,172                  |       | 93,407                       |       |
| Accumulated other comprehensive loss                                                                                                                                                   |       | (4,258                  | )          | (4,917                       | )          |
| Accumulated deficit                                                                                                                                                                    |       | (16,017                 | )          | (15,883                      | )          |
| Total shareholders’ equity                                                                                                                                                        |       | 74,103                  |       | 72,811                       |       |
| Total liabilities and shareholders’ equity                                                                                                                                        |       | $                       | 362,174    |                         | $          | 297,068 |   |

 

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

 

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**PROSPECT MEDICALHOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 

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

 

**(Unaudited)**

 
| ** **                                                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **2009**                              | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Revenues:                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Net hospital services revenues                                            |       | $                                     | 66,470     |                                 | $          | 31,413 |   | $ | 139,701 |   | $ | 91,096 |   |
| Managed care revenues                                                     |       | 47,848                                |       | 49,448                               |       | 144,138 |   | 150,697 |   |
| Total revenues                                                            |       | 114,318                               |       | 80,861                               |       | 283,839 |   | 241,793 |   |
| Operating expenses:                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Hospital services operating expenses                                      |       | 51,278                                |       | 20,764                               |       | 96,281 |   | 59,732 |   |
| Managed care cost of revenues                                             |       | 36,968                                |       | 38,973                               |       | 111,535 |   | 120,448 |   |
| General and administrative                                                |       | 17,740                                |       | 16,122                               |       | 43,505 |   | 43,057 |   |
| Depreciation and amortization                                             |       | 2,162                                 |       | 1,903                                |       | 5,751 |   | 5,712 |   |
| Total operating expenses                                                  |       | 108,148                               |       | 77,762                               |       | 257,072 |   | 228,949 |   |
| Operating income from unconsolidated joint venture                        |       | 535                                   |       | 955                                  |       | 1,482 |   | 2,124 |   |
| Operating income                                                          |       | 6,705                                 |       | 4,054                                |       | 28,249 |   | 14,968 |   |
| Other (income) expense:                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Investment income                                                         |       | (33                                   | )          | (81                                  | )          | (101 | ) | (523 | ) |
| Interest expense and amortization of deferred  financing costs            |       | 8,682                                 |       | 6,562                                |       | 21,396 |   | 16,055 |   |
| (Gain) loss in value of interest rate swap  arrangements                  |       | (3,694                                | )          | (4,948                               | )          | 5,019 |   | (4,072 | ) |
| Loss on debt extinguishment                                               |       | —                                |       | 8,309                                |       | — |   | 8,309 |   |
| Total other (income) expense, net                                         |       | 4,954                                 |       | 9,842                                |       | 26,313 |   | 19,769 |   |
| Income (loss) from continuing operations before  income taxes             |       | 1,751                                 |       | (5,788                               | )          | 1,936 |   | (4,801 | ) |
| Provision (benefit) for income taxes                                      |       | 1,989                                 |       | (2,083                               | )          | 2,065 |   | (1,728 | ) |
| Loss from continuing operations before minority  interest                 |       | (237                                  | )          | (3,705                               | )          | (129 | ) | (3,073 | ) |
| Minority interest                                                         |       | 1                                     |       | 3                                    |       | 5 |   | 12 |   |
| (Loss) from continuing operations                                         |       | (238                                  | )          | (3,708                               | )          | (134 | ) | (3,085 | ) |
| Income (loss) from discontinued operations, net of  tax (see Note 4) |       | —                                |       | 188                                  |       | — |   | (203 | ) |
| Net loss before preferred dividend                                        |       | (238                                  | )          | (3,520                               | )          | (134 | ) | (3,288 | ) |
| Dividends to preferred stockholders                                       |       | —                                |       | (1,932                               | )          | — |   | (5,797 | ) |
| Net loss attributable to common stockholders                              |       | $                                     | (238       | )                                    | $          | (5,452 | ) | $ | (134 | ) | $ | (9,085 | ) |
|                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Per share data:                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Net loss per share attributable to common  stockholders:                  |       |                                  |       |                                 |       |   |   |   |   |
| Basic:                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                     |       | $                                     | (0.01      | )                                    | $          | (0.48 | ) | $ | (0.01 | ) | $ | (0.75 | ) |
| Discontinued operations                                                   |       | $                                     | —     |                                 | $          | 0.02 |   | $ | — |   | $ | (0.02 | ) |
| Net loss attributable to common stockholders                              |       | $                                     | (0.01      | )                                    | $          | (0.46 | ) | $ | (0.01 | ) | $ | (0.77 | ) |

 

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

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Nine Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                       | ** ** | **2009**                             | ** ** | **2008** | ** ** |
| **Operating activities**                                                         |       |                                 |       |   |   |
| Net loss                                                                         |       | $                                    | (134       | ) | $ | (3,288 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                    |       | 5,751                                |       | 5,712 |   |
| Amortization of deferred financing costs                                         |       | 259                                  |       | 479 |   |
| Loss on debt extinguishment                                                      |       | —                               |       | 8,308 |   |
| Payment-In-kind interest expense                                                 |       | 277                                  |       | 454 |   |
| Loss (Gain) on interest rate swap arrangements                                   |       | 5,019                                |       | (4,072 | ) |
| Provision for bad debts                                                          |       | 12,283                               |       | 2,998 |   |
| Loss on disposal of assets                                                       |       | 34                                   |       | 65 |   |
| Stock based compensation                                                         |       | 766                                  |       | 87 |   |
| Deferred income taxes, net                                                       |       | (1,628                               | )          | (4,898 | ) |
| Loss on discontinued operations                                                  |       | —                               |       | 287 |   |
| Amortization of other comprehensive income                                       |       |                                 | 659        |   |   | — |   |
| Changes in assets and liabilities, net of business  combination:                 |       |                                 |       |   |   |
| Risk pool receivables                                                            |       | 144                                  |       | (171 | ) |
| Patient and other receivables                                                    |       | (9,160                               | )          | (2,582 | ) |
| Prepaid expenses and other                                                       |       | 431                                  |       | (655 | ) |
| Inventory                                                                        |       | 133                                  |       | (258 | ) |
| Refundable income taxes                                                          |       | 2,654                                |       | 3,248 |   |
| Excess tax benefits from options exercised                                       |       | —                               |       | — |   |
| Deposits and other assets                                                        |       | 142                                  |       | (22 | ) |
| Accrued medical claims and other health care costs  payable                      |       | (2,617                               | )          | (771 | ) |
| Accounts payable and other accrued liabilities                                   |       | (3,009                               | )          | 805 |   |
| Net cash used in operating activities from  discontinued operations              |       | —                               |       | (8 | ) |
| Net cash provided by operating activities                                        |       | 12,004                               |       | 5,718 |   |
| **Investing activities**                                                         |       |                                 |       |   |   |
| Purchases of property, improvements and equipment                                |       | (764                                 | )          | (1,532 | ) |
| Collections on notes receivable                                                  |       | 29                                   |       | 25 |   |
| Cash paid for acquisitions, net of cash received                                 |       | (2,310                               | )          | — |   |
| Decrease in restricted certificates of deposit                                   |       | (28                                  | )          | (36 | ) |
| Capitalized expenses related to acquisitions                                     |       | (37                                  | )          | (102 | ) |
| Other investing activities                                                       |       | 5                                    |       | 12 |   |
| Net cash used in investing activities from discontinued  operations              |       | —                               |       | (3 | ) |
| Net cash used in investing activities                                            |       | (3,105                               | )          | (1,636 | ) |
| **Financing activities**                                                         |       |                                 |       |   |   |
| Borrowings on line of credit                                                     |       | —                               |       | 4,000 |   |
| Repayments on line of credit                                                     |       | (1,671                               | )          | — |   |
| Change in restricted cash                                                        |       | 1,047                                |       | — |   |
| Repayments of term loan                                                          |       | (8,904                               | )          | (3,750 | ) |
| Payments on capital leases                                                       |       | (395                                 | )          | (126 | ) |
| Cash paid for deferred financing costs                                           |       | (972                                 | )          | (327 | ) |
| Cash paid to lenders for loan modifications                                      |       | —                               |       | (757 | ) |
| Proceeds from exercises of stock options and  warrants                           |       | —                               |       | 1,200 |   |
| Net cash provided by financing activities                                        |       | (10,895                              | )          | 240 |   |
|                                                                             |       |                                 |       |   |   |
| Net increase in cash and cash equivalents                                        |       | (1,996                               | )          | 4,322 |   |
| Cash and cash equivalents at beginning of period                                 |       | 33,583                               |       | 22,095 |   |
| Cash and cash equivalents at end of period                                       |       | $                                    | 31,587     |   | $ | 26,417 |   |
| **Supplemental cash flow  information**                                          |       |                                 |       |   |   |
| Non-cash investing and financing activities:                                     |       |                                 |       |   |   |
| Dividend on preferred shares                                                     |       | $                                    | —     |   | $ | 5,797 |   |
| Deferred income taxes related to change in  interest rate swap liability         |       | $                                    | 530        |   | $ | 3,304 |   |
| Write off of deferred financing costs                                            |       | $                                    | —     |   | $ | 6,038 |   |
| Paid-in-kind interest added to principal                                         |       | $                                    | 252        |   | $ | 1,967 |   |
| **Details of businesses acquired:**                                              |       |                                 |       |   |   |
| Fair value of assets acquired                                                    |       | $                                    | 7,502      |   | $ | — |   |
| Liabilities assumed or accrued for                                               |       | (4,983                               | )          | — |   |
| Total net assets acquired                                                        |       | 2,519                                |       | — |   |
| Less: cash acquired                                                              |       | (209                                 | )          | — |   |
| Net cash paid for acquisitions                                                   |       | $                                    | 2,310      |   | $ | — |   |

 

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

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**June 30,2009**

 

**(Unaudited)**

 

**1. Business**

 

Prospect Medical Holdings, Inc. (“Prospect” or the “Company”) is aDelaware corporation. Prior to the August 8, 2007 acquisition of AltaHospitals System, LLC (“Alta”), which was previously known as AltaHealthcare System, Inc., the Company was primarily engaged in providingmanagement services to affiliated physician organizations that operate asindependent physician associations (“IPAs”) or medical clinics. Inclusive ofthe acquisition of a majority stake in Brotman Medical Center, Inc., aCalifornia corporation (“Brotman”) on April 14, 2009 (see Note 8), as of June 30,2009, the Company owns and operates five community-based hospitals in SouthernCalifornia, and its operations are organized into three primary reportablesegments: Hospital Services, IPA, and Corporate as discussed below.

 

***Liquidity and Recent OperatingResults***

 

As discussed in Note 7, prior to the July 29, 2009refinancing, the Company was subject to certain financial and administrativecovenants, cross default provisions and other conditions required by the loanagreements with its prior lenders. While the Company met all debt servicerequirements timely, it did not comply with certain financial andadministrative covenants as of September 30, 2007, December 31, 2007and March 31, 2008. On May 15, 2008, the credit agreements wereformally modified to waive past defaults, amend certain covenant provisionsprospectively and make changes to the interest rates and payment terms. Thesechanges resulted in a substantial modification to the credit facilities, whichwas accounted for as an extinguishment of the existing debt during the quarterended June 30, 2008, with the modified debt recorded as new debt.

 

The Company met all of the May 15, 2008 amended financial covenantprovisions for all subsequent reporting periods. However, on March 19,2009, the Company received notices from its lenders asserting that the Companywas in default of a requirement to sell certain assets by a specified date; andon April 17, 2009, the Company received notices from its lenders assertingthat the Company’s April 14, 2009 increase in ownership of Brotman (seeNote 8) violated certain provisions of the amended credit agreements.Effective with the first asserted default, the lenders began assessing interestat default rates on all loans. The Company contested both asserted events ofdefault. On June 30, 2009, the Company entered into loan amendmentswhereby, among other things, the lenders waived all alleged events of default,and stopped assessing default interest rates. In connection with these amendments,the Company also entered into an amendment and waiver related to its swapagreements which provide that the alleged events of default under the existingcredit facility would not trigger an event of default under the swapagreements. The amendments required the Company to refinance all debt no laterthan October 31, 2009.

 

On July 29,2009, the Company issued $160.0 million in the aggregate principal amountof 12.75% senior secured notes due 2014 (the “Notes”) with net proceeds, afteroriginal issue discount and expenses, of $141.4 million, which amount wasused to repay all amounts outstanding under prior debt and, together with theCompany’s existing cash, terminate the interest rate swap agreements. Based on such refinancing, all amountsowing under the prior borrowing arrangements were reclassified as long-term inthe June 30, 2009 unaudited condensed consolidated balance sheet. Giventhe Company’s subsequent termination and repayment, the interest rate swapliabilities continued to be classified as current at June 30, 2009.

 

Following the Company’s acquisition of a majority stake in Brotmaneffective April 14, 2009, all Brotman debt has been included in theCompany’s condensed consolidated financial statements. However, the Company hasno obligation and only limited ability to fund Brotman’s operations postacquisition. 

 

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***Hospital Services Segment***

 

Alta, which was acquired on August 8, 2007, owns (i) AltaHollywood Hospitals, Inc., a California corporation dba HollywoodCommunity Hospital and Van Nuys Community Hospital; and (ii) Alta LosAngeles Hospitals, Inc., a California corporation dba Los Angeles CommunityHospital and Norwalk Community Hospital. On April 14, 2009 (the “AcquisitionDate”), the Company increased its approximately 33.1% ownership stake inBrotman, to approximately 71.9% via an incremental investment of approximately$2.5 million, all of which was paid as of June 30, 2009. As of June 30,2009, Alta and Brotman (collectively, the “Hospital Services segment”) owns andoperates five hospitals in the greater Los Angeles area, with a combined 759licensed beds, served by 787 on-staff physicians. The hospitals in Hollywood,Los Angeles, Norwalk and Culver City offer a comprehensive range of medical andsurgical services, including inpatient, outpatient, skilled nursing and urgentcare services. The hospital in Van Nuys provides acute inpatient and outpatientpsychiatric services to patients who are admitted on a voluntary basis.Admitting physicians are primarily practitioners in the local area. Thehospitals have payment arrangements with Medicare, Medi-Cal (the Californiaversion of Medicaid) and other third-party payers, including some commercialinsurance carriers, health maintenance organizations (“HMOs”) and preferredprovider organizations (“PPOs”).

 

***IPA Segment***

 

The IPA segment is comprised of two management services organizations,Prospect Medical Systems, Inc. and ProMed Health Care Administrators, thatprovide management services to affiliated physician organizations that operateas IPAs. The affiliated physician organizations enter into agreements with HMOsto provide enrollees of the HMOs with a full range of medical services inexchange for fixed, prepaid monthly fees known as “capitation” payments. TheIPAs contract with physicians (primary care and specialist) and other healthcare providers to provide all necessary medical services.

 

**2. Summary of Significant Accounting Policies**

 

***Basis of Presentation***

 

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

 

The results of operations for the three months and nine months ended June 30,2009 are not necessarily indicative of the results to be expected for the fullyear. The information included in this Quarterly Report on Form 10-Qshould be read in conjunction with the audited consolidated financialstatements for the year ended September 30, 2008 and notes theretoincluded in the Company’s Annual Report on Form 10-K filed with the SEC onDecember 29, 2008 and Form 8-K filed with the SEC on July 8,2009 and, relating to the Brotman transaction, as included in Form 8-K/Afiled with the SEC on July 8, 2009.

 

***Principles of Consolidation***

 

The unaudited interim condensed consolidated financial statementsinclude the accounts of the Company and all majority owned subsidiaries andcontrolled entities under Emerging Issues Task Force (“EITF”) No. 97-2, “*Application of FASB Statement No. 94 and APBOpinion No. 16 to Physician Practice Management Entities and Certain OtherEntities with Contractual Management Arrangements”* and FinancialAccounting Standards Board (“FASB”) Interpretation No. 46, “*Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51*” (“FIN 46”). All adjustmentsconsidered necessary for a fair presentation of the results as of the date of,and for the interim periods presented, which consist solely of normal recurringadjustments, have been included. Effective April 14, 2009, the results ofoperations and financial position of Brotman have been included in theaccompanying unaudited interim condensed consolidated financial statements. Allsignificant inter-company balances and transactions have been eliminated inconsolidation.

 

***RestrictedCash***

 

Restricted cash is established at Brotman pursuant to Brotman’s AmendedPlan of Reorganization, consisting of contingency reserves, totaling $525,000held in escrow in satisfaction of a certain pre-emergence bankruptcy creditor ofBrotman; property tax, maintenance and an emergency room construction reservesset aside in connection with Brotman’s JHA loan agreements (see Note 7); andthe Class 4 cash, in the amount of $987,000 that was received in June 2009in satisfaction of the discharge of Class 4 claims (see below). Additionally,$233,000 was held in restricted account pursuant to workers compensationarrangements at June 30, 2009.

 

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***Payableto Creditors’ Trust***

 

On April 14, 2009(the “Effective Date”), pursuant to the confirmation of Brotman’s Plan, inexchange for their new equity stakes in Brotman, the Company and certainholders of pre-reorganized Brotman’s securities committed to contribute cashtotaling approximately $3.5 million ($2.5 million as of the Effective Date and$1 million within six months of the Effective Date), which amount was to beused solely for the satisfaction of holders of Class 4 claims. As of June 30,2009, the remaining approximately $1 million of Class 4 cash that wasreceived in June 2009 was recorded in the accompanying unaudited condensedconsolidated balance sheet as payable to Creditors’ Trust.

 

***Dueto governmental payers and third party settlements***

 

Following theacquisition of Brotman, effective April 14, 2009, the Company recorded aliability to the Centers for Medicare and Medicaid Services (“CMS”) arising outof payments for services provided by Brotman to Medicare eligible inpatientsfor the last four months of calendar 2005, all of calendar 2006, andapproximately six weeks of calendar 2007 (ending February 15, 2007).

 

While Brotmanreports financial statements on a fiscal year ending September 30,Medicare cost reports are filed on a calendar year basis. Acute care hospitalsreceive Medicare reimbursement payments pursuant to a prospective paymentmethodology based on diagnosis of the patient, but are entitled to receiveadditional payments, referred to as “outliers” for patients whose treatment isunusually costly. When Brotman acquired the hospital in 2005, CMS provided aratio of cost to charges (the “RCC”) based on the average prevailing marketrate in Southern California. This RCC was an interim estimate provided by CMS,subject to final determination upon filing of the hospital’s cost reports. Uponfiling cost reports, subsequent information called into question whether theinterim RCC provided by CMS was supportable, giving rise to a potential claimfor return of overpayments. Brotman filed its cost reports with CMS for 2005,2006 and 2007, respectively, which have been tentatively reviewed by the fiscalintermediary exclusive of any outlier reconciliation to be conducted directlyby CMS. CMS has not conducted any outlier reconciliations, has not notified thehospital of any pending reconciliation to be conducted and has not determined theamount of any liability at this point related to possible overpayments. As of June 30,2009, an estimated liability of $13,834,000 was included in the accompanyingunaudited condensed consolidated balance sheet related to this matter. Brotmanand Alta have accrued estimated settlement net receivables in the amount of$2,990,000 for as filed cost reporting years and estimates for the nine monthsended June 30, 2009.

 

***Government program receivables***

 

Brotman receives supplemental payments from theCalifornia Medical Assistance Commission (“CMAC”). The contract between CMACand Brotman was entered into on September 1, 2005 (“Agreement”).  That Agreement has an “evergreen” provisionthat requires at least 120 days notice for either side to provide the otherwith termination notice.  On June 10,2009, Brotman entered into an Amendment of this Agreement which extends theearliest termination notice date to July 1, 2010.  Thus, the earliest possible termination ofthis Agreement could be November 1, 2010. At June 30, 2009, the Company had accrued CMAC Distressed Hospital Fundsin the amount of $2,000,000, which amount was included as receivable in theaccompanying unaudited condensed consolidated balance sheet. In addition to theaforementioned  receivable the Companyaccrued an additional $1,606,000 in Disproportionate Share Revenue (DSH) underthe Medi-Cal DSHProgram.

 

***Reclassifications***

 

Certain prioramounts have been reclassified to conform to current period presentation. Thesereclassifications primarily relate to the discontinued operations treatment ofthe AV Entities, following their sale on August 1, 2008.

 

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***Discontinued Operations***

 

As discussed in Note 4, effective August 1, 2008, the Companysold all of the issued and outstanding stock of Sierra Medical Management (“SMM”),Sierra Primary Care Medical Group, Antelope Valley Medical Associates, Inc.and Pegasus Medical Group, Inc., (collectively, the “AV Entities”) to athird party. As required under U.S. GAAP, the assets and liabilities of the AVEntities and their operations have been presented in the condensed consolidatedfinancial statements as discontinued operations for all periods presented. Allreferences to operating results reflect the ongoing operations of the Company,excluding the AV Entities, unless otherwise noted.

 

***Revenues***

 

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

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2009(2)**                           | ** ** | **2008(1)**                          | ** ** | **2009(2)** | ** ** | **2008(1)** | ** ** |
| Net Hospital Services                |       |                                  |       |                                 |       |   |   |   |   |
| Inpatient                            |       | $                                     | 59,039     |                                 | $          | 29,664 |   | $ | 127,839 |   | $ | 84,914 |   |
| Outpatient                           |       | 6,651                                 |       | 1,377                                |       | 10,315 |   | 4,959 |   |
| Other                                |       | 780                                   |       | 372                                  |       | 1,547 |   | 1,223 |   |
| Total net hospital services revenues |       | $                                     | 66,470     |                                 | $          | 31,413 |   | $ | 139,701 |   | $ | 91,096 |   |
| IPA (Managed Care)                   |       |                                  |       |                                 |       |   |   |   |   |
| Capitation                           |       | $                                     | 47,369     |                                 | $          | 49,057 |   | $ | 143,005 |   | $ | 149,832 |   |
| Management fees                      |       | 149                                   |       | 150                                  |       | 437 |   | 404 |   |
| Other                                |       | 330                                   |       | 241                                  |       | 696 |   | 461 |   |
| Total managed care revenues          |       | $                                     | 47,848     |                                 | $          | 49,448 |   | $ | 144,138 |   | $ | 150,697 |   |
| Total revenues                       |       | $                                     | 114,318    |                                 | $          | 80,861 |   | $ | 283,839 |   | $ | 241,793 |   |

 

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(1)          The above amounts for theIPA segment exclude revenue related to the AV Entities, given theirclassification as discontinued operations in the accompanying unauditedcondensed consolidated financial statements.

 

(2)          Brotman revenues have beenincluded in the accompanying unaudited condensed consolidated financialstatements effective April 14, 2009, when the Company acquired a majoritystake in that entity.

 

The Company presents segment information externally the same waymanagement uses financial data internally to make operating decisions andassess performance. Following the acquisition of Alta in August 2007, theCompany’s operations are organized into three reporting segments: (i) HospitalServices, (ii) IPA (Managed Care), and (iii) Corporate (seeNote 9). Corporate represents expenses incurred in Prospect MedicalHoldings, Inc., which were not allocated to the IPA or Hospital Servicessegments.

 

***Comprehensive Income (Loss)***

 

Comprehensive income (loss) includes net income (loss) and changes inthe fair value of interest rate swaps subject to hedge accounting that wererecorded as other comprehensive income. As of April 1, 2008, the swapsceased to be eligible for hedge accounting under SFAS No. 133, “*Accounting For Derivatives And Hedging Activities*”(“SFAS No. 133”). As a result, all subsequent changes in the fair value ofthe swaps were recorded in the condensed consolidated statements of operationsand the effective portion of the swaps of approximately $5.4 million,after tax, that was recorded in other comprehensive income through June 30,2008 was being amortized to interest expense, using the effective interestmethod, over the remaining life of the interest rate swaps.  (See Note 15 for subsequent termination ofinterest rate swap arrangements, effective July 23, 2009.)

 

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The components of comprehensive income (loss) for the periods ended June 30,2009 and 2008 are as follows (in thousands):

 
| ** **                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                              | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net loss including discontinued operations                     |       | $                                     | (388       | )                                    | $          | (3,519 | ) | $ | (284 | ) | $ | (3,288 | ) |
| Change in fair value of interest rate swaps, net  of tax       |       | —                                |       | 163                                  |       | — |   | (4,990 | ) |
| Amortization of fair value of interest rate swaps,  net of tax |       | 220                                   |       | —                               |       | 660 |   | — |   |
| Comprehensive income (loss)                                    |       | $                                     | (168       | )                                    | $          | (3,356 | ) | $ | 376 |   | $ | (8,278 | ) |

 

**3. Equity-Based Compensation Plans**

 

On August 13, 2008, following stockholder approval, the Companyadopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provideflexibility in implementing equity awards, including incentive stock options (“ISO”),non-qualified stock options (“NQSO”), restricted stock grants, stockappreciation rights (“SAR”) and performance based awards to employees,directors and outside consultants, as determined by the Compensation Committeeof the Board of Directors (the “Committee”). In conjunction with the adoptionof the 2008 Plan, effective August 13, 2008, additional equity awardsunder the Company’s 1998 Stock Option Plan (“1998 Plan”) have been discontinuedand new equity awards are now granted under the 2008 Plan. Remaining authorizedshares under the 1998 Plan that were not subject to outstanding awards as of August 13,2008, were canceled on August 13, 2008. The 1998 Plan will remain ineffect as to outstanding equity awards granted under the 1998 Plan prior to August 13,2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved forissuance under the 2008 Plan. As of June 30, 2009, there were 1,746,250shares available for future grants under the 2008 Plan.

 

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

 

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

 

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***Stock Options Activities***

 

The following table summarizes information about our stock optionsoutstanding at June 30, 2009 and activity during the nine-month periodthen ended:

 
| ** **                                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (Months)** | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------|------------|---------------------------------------------------------------|------------|
| Outstanding as of September 30, 2008       |       | 5,087,637  |       | $                                      | 3.17       |                            |       |                                                          |       |   |
| Granted                                         |       | 207,500    |       | $                                      | 1.86       |                            |       |                                                          |       |   |
| Exercised                                       |       | —     |       | $                                      | —     |                            | $          | —                                                        |       |   |   |
| Forfeited                                       |       | (1,141,249 | )          | $                                      | 4.12       |                            |       |                                                          |       |   |
| Outstanding as of June 30, 2009            |       | 4,153,888  |       | $                                      | 2.84       |                            | $          | 4,755,581                                                     |       | 44 |   |
| Vested and exercisable as of June 30, 2009 |       | 2,464,969  |       | $                                      | 3.17       |                            | $          | 2,401,653                                                     |       | 39 |   |

 

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

 

***Stock-Based Compensation Expense***

 

Under SFAS No. 123(R), “*Share-BasedPayments*,” compensation cost for all share-based payments inexchange for employee services (including stock options and restricted stock)is measured at fair value on the date of grant, estimated using an optionpricing model.

 

Compensation costs for stock-based awards are measured and recognizedin the financial statements, net of estimated forfeitures over the awards’requisite service period. The Company uses the Black-Scholes option pricingmodel and a single option award approach to estimate the fair value of optionsgranted. Estimated forfeitures will be revised in future periods if actualforfeitures differ from the estimates and will impact compensation cost in theperiod in which the change in estimate occurs. The determination of fair valueusing the Black-Scholes option-pricing model is affected by the Company’s stockprice as well as assumptions regarding a number of complex and subjectivevariables, including expected stock price volatility, risk-free interest rate,expected dividends and projected employee stock option exercise behaviors.Equity-based compensation 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.

 

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

 
| ** **                                                                             | ** ** | **Nine Months Ended  June 30, 2009** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Weighted average fair value of option grants                                           |       | $                                         | 0.67       |   |
| Weighted average market price of the Company’s  common stock on the date of grant |       | $                                         | 1.84       |   |
| Weighted average expected life of the options                                          |       | 3.5 years                                 |       |
| Weighted average risk-free interest rate                                               |       | 1.31                                      | %          |
| Weighted average expected volatility                                                   |       | 48.8                                      | %          |
| Dividend yield                                                                         |       | 0.00                                      | %          |

 

Expected Term—The expected term of options granted represents theperiod of time that they are expected to be outstanding. The Company hasadopted the “simplified method” of determining the expected term for “plainvanilla” options, as allowed under Staff Accounting Bulletin (SAB) No. 107.The “simplified method” states that the expected term is equal to the sum of thevesting term plus the contract term, divided by two. “Plain vanilla” optionsare defined as those granted at-the-money, having service time vesting as acondition to exercise, providing that non-vested options are forfeited upontermination and that there is a limited time to exercise the vested optionsafter termination of service, usually 90 days, and providing the optionsare non-transferable and non-hedgeable. We will continue to gather additionalinformation about the exercise behavior of participants and will adjust theexpected term of our option awards to reflect the actual exercise experiencewhen such historical experience becomes sufficient.

 

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

 

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

 

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

 

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

 

Stock-based compensation expense for stock options recognized in thenine months ended June 30, 2009 and 2008 was approximately $665,000 and$86,645, respectively. At June 30, 2009, there were 1,688,919 unvestedoptions with related compensation expense of approximately $683,000, which willbe recognized ratably over a weighted average remaining vesting period of52 months.

 

***Restricted Stock Award Activities***

 

On August 15, 2008, the Company granted 200,000 shares ofrestricted stock with a grant date fair value of $2.40. As of June 30,2009, there were no unvested shares of restricted stock outstanding.Compensation expense relating to restricted stock of approximately $113,000 wasrecorded during the nine months ended June 30, 2009.

 

**4. Discontinued Operations**

 

On August 1, 2008, the Company sold all of the outstanding stockof Sierra Medical Management, Inc. (“SMM”), a management subsidiary, andall of the outstanding stock of Sierra Primary Care Medical Group, AntelopeValley Medical Associates, Inc. and Pegasus Medical Group, Inc.,(collectively with SMM, the “AV Entities”). As part of the sale, the Companyentered into a non-competition agreement in the Antelope Valley region of LosAngeles County for the benefit of the buyer.

 

Total consideration paid by the buyer was $8,000,000, of which$2,000,000 was paid into an escrow account to fund certain AV Entities’liabilities and approximately $815,000 was paid directly to AV Entities’vendors, employees and physicians. Of the remaining amount totaling approximately$5,185,000, $4,219,000 was paid directly to the Company’s lenders, andapproximately $966,000 was retained by the Company for transaction expenses andthe required balance sheet reconciliation items.

 

The Company recorded a gain of approximately $7.1 million inconnection with this transaction in the fourth quarter of fiscal 2008. The saledocuments contain certain post-closing purchase price adjustment provisions forworking capital and claims liabilities which require a final determination by August 10,2010. Once the sale price has been finalized and the net gain on thetransaction determined, any adjustment to the gain will be recorded indiscontinued operations.

 

The AV Entities have been classified as discontinued operations for allperiods presented. As discontinued operations, revenues and expenses of the AVEntities have been aggregated and stated separately from the respectivecaptions of continuing operations in the unaudited interim condensedconsolidated statements of operations. Expenses include direct costs of thebusiness that will be eliminated from future operations as a result of thesale. The Company also allocated interest expense associated with the portionof debt required to be repaid for the nine months ended June 30, 2008 todiscontinued operations in accordance with EITF Issue 87-24, “*Allocation of Interest to Discontinued Operations.*”

 

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The results of operations of the AV Entities reported as discontinuedoperations are summarized as follows (in thousands):

 
| ** **                                                     | ** ** | **Three Months Ended  June 30, 2008** | ** ** | **Nine Months Ended  June 30, 2008** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| Managed care revenues                                          |       | $                                          | 4,595      |                                      | $          | 13,267 |   |
| Operating expenses:                                            |       |                                       |       |                                      |       |
| Managed care cost of revenues                                  |       | 2,441                                      |       | 8,185                                     |       |
| General and administrative                                     |       | 1,709                                      |       | 5,024                                     |       |
| Depreciation and amortization                                  |       | 7                                          |       | 44                                        |       |
| Total operating expenses                                       |       | 4,157                                      |       | 13,253                                    |       |
| Operating income                                               |       | 438                                        |       | 13                                        |       |
| Other expense                                                  |       | (115                                       | )          | (300                                      | )          |
| Income (loss) before income taxes                              |       | 323                                        |       | (287                                      | )          |
| Income tax (provision) benefit                                 |       | (135                                       | )          | 84                                        |       |
| Income (loss) from discontinued operations, net of  income tax |       | $                                          | 188        |                                      | $          | (203 | ) |

 

**5. Earnings per Share**

 

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

 

The calculations of basic and diluted net income (loss) per share forthe three months and nine months ended June 30, 2009 and 2008 are asfollows (in thousands, except per share amounts):

 
| ** **                                                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                              | ** ** | **2009**                              | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Basic:**                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                   |       | $                                     | (238       | )                                    | $          | (3,708 | ) | $ | (134 | ) | $ | (3,085 | ) |
| Dividends to preferred stockholders                                     |       | —                                |       | (1,932                               | )          | — |   | (5,797 | ) |
|                                                                    |       | (238                                  | )          | (5,640                               | )          | (134 | ) | (8,882 | ) |
| Discontinued operations                                                 |       | —                                |       | 188                                  |       | — |   | (203 | ) |
| Net loss attributable to common stockholders                            |       | $                                     | (238       | )                                    | $          | (5,452 | ) | $ | (134 | ) | $ | (9,085 | ) |
|                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average number of common shares  outstanding                   |       | 20,520                                |       | 11,783                               |       | 20,512 |   | 11,759 |   |
| Basic net income (loss) per share attributable to  common stockholders: |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                   |       | $                                     | (0.01      | )                                    | $          | (0.48 | ) | $ | (0.01 | ) | $ | (0.75 | ) |
| Discontinued operations                                                 |       | $                                     | —     |                                 | $          | 0.02 |   | $ | — |   | $ | (0.02 | ) |
|                                                                    |       | $                                     | (0.01      | )                                    | $          | (0.46 | ) | $ | (0.01 | ) | $ | (0.77 | ) |

 

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Due to net losses, all potentiallydilutive securities were excluded from the calculation of diluted loss pershare attributable to common stockholders during the three and nine monthsended June 30, 2009 and 2008, as their effect would be anti-dilutive. Thenumber of stock options and warrants excluded from the computation of dilutedearnings per share duringthe three and nine months ended June 30, 2009 were 4,819,851 and4,819,851, and during the three and nine months ended June 30,2008 were 1,785,000, and 1,017,000, respectively. 1,672,880 Series Bpreferred shares were also excluded from diluted earnings per share during thethree months and nine months ended June 30, 2008, since their conversionwas contingent upon stockholder approval and would have been anti-dilutive.

 

Following stockholder approval on August 13, 2008, the holders ofall of the outstanding shares of Series B Preferred Stock elected toconvert their preferred shares into Common Stock. The former holders alsoceased to have any right to receive dividends on the preferred shares. All suchdividends terminated and ceased to accrue, and all previously accrued dividendsthrough August 13, 2008 were forgiven and the liability was recorded toadditional paid-in capital. Accordingly, an adjustment to additional paid-in-capitalin the amount of $7,881,890 was recorded as of that date.

 

Thefollowing pro forma basic and diluted earnings per share assume the conversionof preferred shares into common stock at a ratio of 1:5 at the beginning of thefiscal 2008 year (in thousands, except per share amounts):

 
| ** **                                                                            | ** ** | **Three Months Ended  June 30, 2008** | ** ** | **Nine Months Ended  June 30, 2008** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| Basic and  Diluted:                                                                   |       |                                       |       |                                      |       |
| Net  loss attributable to common stockholders—historical                         |       |                                       |       |                                      |       |
| Continuing  operations                                                                |       | $                                          | (5,640     | )                                         | $          | (8,882 | ) |
| Add:  Dividend to preferred stockholders                                              |       | 1,932                                      |       | 5,797                                     |       |
| Net  continuing loss attributable to common stockholders                              |       | (3,708                                     | )          | (3,085                                    | )          |
| Discontinued  operations                                                              |       | 188                                        |       | (203                                      | )          |
| Net  loss attributable to common stockholders—proforma                           |       | $                                          | (3,520     | )                                         | $          | (3,288 | ) |
| Weighted  average number of common shares outstanding—historical                 |       | 11,783                                     |       | 11,759                                    |       |
| Add  number of preferred shares converted to common shares                            |       | 8,364                                      |       | 8,364                                     |       |
| Weighted  average number of common shares outstanding—pro forma                  |       | 20,147                                     |       | 20,123                                    |       |
| Basic  net income (loss) per share attributable to common stockholders—pro forma |       |                                       |       |                                      |       |
| Continuing  operations                                                                |       | $                                          | (0.19      | )                                         | $          | (0.15 | ) |
| Discontinued  operations                                                              |       | $                                          | 0.01       |                                      | $          | (0.01 | ) |
|                                                                                  |       | $                                          | (0.18      | )                                         | $          | (0.16 | ) |

 

**6. Related Party Transactions**

 

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

 

The Company had an employment agreement with Dr. Terner thatexpired on August 1, 2008 and provided for base compensation (mostrecently $400,000 per year) and further provided that if the Company terminatedDr. Terner’s employment without cause, the Company would be required topay him $12,500 for each month of past service as the Chief Executive Officer,commencing as of July 31, 1996, up to a maximum of $1,237,500. Dr. Ternerresigned as the Chief Executive Officer of the Company effective March 19,2008 and resigned as the chairman of the board of directors effective May 12,2008. In consideration of Dr. Terner’s resignation and other provisions inhis resignation agreement, the Company agreed to pay to his family trust thesum of $19,361 each month during the twelve-month period ending on April 30,2009 and the sum of $42,694 each month during the twenty-four month periodending on April 30, 2011, for the total sum of $1,257,000, which amountwas recorded as a general and administrative expense in fiscal 2008.

 

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Dr. Arthur Lipper currently serves as the nominee shareholder ofPMG and Nuestra and as the sole director of PMG and its subsidiary physicianorganizations and the Chief Executive Officer, President and Treasurer of alllegacy subsidiary physician organizations (i.e., not including the ProMedEntities).  Dr. Lipper serves as oneof two directors of Nuestra, as the sole director of the ProMed Entities, andas a Vice President of Nuestra and the ProMed Entities.

 

Through the ProMed Acquisition (see Note 8), the Company acquiredthe lease of an office facility which is jointly owned by a former officer ofthe ProMed Entities. The total lease payments during the nine months ended June 30,2009 and 2008 under that lease were approximately $362,000 and $350,000,respectively.

 

On August 1, 2005 and subsequently amended on October 25,2007, Prospect Medical Management, Inc. (now known as Prospect HospitalAdvisory Services, Inc.), an affiliate of the Company, had entered into aconsulting services agreement, to provide administrative, financial andmanagement consulting services to Brotman for a monthly fee of $100,000 plusexpenses. The agreement had an initial term of one year and automaticallyrenewed for additional one-year terms unless terminated by either party with 90days written notice. As discussed in Note 8, Brotman, which filed a voluntarypetition for bankruptcy protection under Chapter 11 of the U. S. BankruptcyCode on October 25, 2007, emerged from the Chapter 11 bankruptcyproceeding on April 14, 2009 (the “Effective Date”).  On the Effective Date, the Company increasedits approximately 33.1% ownership stake in Brotman, to approximately 71.9% viaan incremental investment of approximately $2.5 million. For the three and ninemonths ended June 30, 2008, total fees earned under the consultingservices agreement were approximately $300,000 and $820,000, of which $300,000and $620,000 were paid, respectively, and none of which were compromised,pursuant to Brotman’s Chapter 11 Plan of Reorganization. For the period October 1,2008 through April 13, 2009, total fees earned under the agreement wereapproximately $650,000, of which $50,000 was paid, and none of which wascompromised pursuant to Brotman’s Chapter 11 Plan of Reorganization.  Beginning April 14, 2009, amounts earnedunder the agreement have been eliminated in consolidation.

 

PMG, a controlled affiliate of the Company (see description ofassignable option agreements and management services agreements above) hadentered into a risk pool sharing agreement, dated May 1, 2005, withBrotman. Under the agreement, PMG and Brotman agreed to establish a HospitalControl Program (as defined) to serve HMO enrollees and would earn incentiverevenue or incur penalties by sharing in the risk for hospitalization based oninpatient services utilized. Risk pools are generally settled in the followingyear. For the three and nine months ended June 30, 2008, all incentiverevenue earned under the agreement was compromised pursuant to Brotman’sChapter 11 Plan of Reorganization. For the period October 1, 2008 through April 13,2009, no incentive revenue was earned under the agreement.  Beginning April 14, 2009, all amountsearned under the agreement have been eliminated in consolidation.

 

In connection with theabove-described risk-sharing agreement, Prospect Medical Systems, Inc. (“PMS”)and Brotman entered into an Administrative Services Agreement, dated October 1,2005, that provides for the administration by PMS of the payment of claimsunder such risk-sharing arrangement.

 

On August 31, 2005,PMG, entered into a joint marketing agreement with Brotman. The agreement isfor an initial term of 20 years, renewable for successive five-year termsunless terminated by either party with 180 days written notice.  During the term, Brotman will contractexclusively with PMG with regard to full risk contracting with HMOs for alllines of business, including Medicare, Medicaid and commercial enrollees.  Brotman will not merge into, consolidatewith, or sell substantially all assets (unless the purchaser or survivingentity expressly assumes these managed care exclusivity arrangements), altersuch agreements without the consent of PMG, and agrees to be bound by theexclusivity provision.

 

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**7. Debt**

 

Debt at June 30, 2009 and September 30, 2008, respectively,consists of the following (in thousands):

 
| ** **                             | ** ** | **June 30,  2009** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **(unaudited)**         | ** ** | ** **                   | ** ** |
| Prospect’s debt:                  |       |                    |       |                         |       |
| Term loan — first-lien            |       | $                       | 76,789     |                         | $          | 85,443 |   |
| Term loan — second-lien           |       | 51,754                  |       | 51,478                       |       |
| Revolving credit facility              |       | 7,100                   |       | 7,100                        |       |
| Brotman’s debt:                   |       |                    |       |                         |       |
| Term loan-A                            |       | 15,656                  |       | —                       |       |
| Term loan-B                            |       | 6,250                   |       | —                       |       |
| Promissory Note – Creditors Trust |       | 3,750                   |       | —                       |       |
|                                   |       | 161,299                 |       | 144,021                      |       |
| Less current maturities                |       | (900                    | )          | (12,100                      | )          |
| Long-term portion                      |       | $                       | 160,399    |                         | $          | 131,921 |   |

 

**Prospect’sDebt**

 

***Senior Secured Credit Facilities***

 

On August 8, 2007, the Company entered into a $155,000,000syndicated senior secured credit facility, comprised of a $95,000,000seven-year first-lien term loan at LIBOR plus 400 basis points, with quarterlyprincipal payments of $1,250,000 and an annual principal payment of 50% ofexcess cash flow, as defined in the loan agreement; a $50,000,000 seven andone-half year second-lien term loan at LIBOR plus 825 basis points, with allprincipal due at maturity and a revolving credit facility of $10,000,000bearing interest at prime plus a margin that ranged from 275 to 300 basispoints based on the consolidated leverage ratio. The Company capitalizedapproximately $6.9 million in deferred financing costs on the$155 million credit facility in August 2007, which was beingamortized over the term of the related debt using the effective interestmethod.

 

The Company was subject to certain financial and administrativecovenants, cross default provisions and other conditions required by the loanagreements, including a maximum senior debt/EBITDA (earnings before interest,taxes, depreciation and amortization) ratio, and a minimum fixed-chargecoverage ratio, and a minimum EBITDA level, based on consolidated trailingtwelve-month operating results. Substantially all of the Company’s assets werepledged to secure the credit facilities.

 

***Default and Debt Modification***

 

The Company exceeded the maximum senior debt/EBITDA ratio of 3.75 as ofSeptember 30, 2007, December 31, 2007 and March 31, 2008, failedto meet the minimum fixed charge coverage ratio of 1.25 as of and for thetrailing twelve-month periods ended December 31, 2007 and March 31,2008, and did not comply with certain administrative covenants.

 

The Company and its lenders entered into various forbearanceagreements, whereby the lenders assessed default interest and permanentlyincreased the applicable margins on the first and second-lien term loans to 750and 1,175 basis points, respectively, and the range of applicable margins onthe revolving line of credit from 500 to 750 basis points effective April 10,2008. The modified agreements also stipulated that the LIBOR rate would not beless than 3.5% for the term of the credit facilities. Additionally, theavailable line of credit under the revolving credit facility was permanentlyreduced from $10,000,000 to $7,250,000. The Company also agreed to pay certainfees and expenses to the lenders and their advisors.

 

On May 15, 2008, the Company and its lenders entered intoagreements to waive past covenant violations and amended the financial covenantprovisions prospectively, starting in April 2008, to modify the requiredratios and to increase the frequency of compliance reporting from quarterly tomonthly for a specified period. Effective May 15, 2008, the maximum seniordebt/EBITDA ratios were increased to levels ranging from 3.90 to 7.15 for futuremonthly reporting periods from April 30, 2008 through June 30, 2009and were increased to levels ranging from 3.30 to 3.75 beginning with the September 30,2009 quarterly reporting period, through maturity of the term loan. The minimumfixed charge coverage ratios were reduced to levels ranging from 0.475 to 0.925for monthly reporting periods from April 30, 2008 through June 30,2009 and were reduced to levels ranging from 0.85 to 0.90 beginning with the September 30,2009 quarterly reporting period, through maturity of the term loan. The Companywas also required to meet a new minimum EBITDA requirement for monthlyreporting periods from April 30, 2008 through June 30, 2009 and theremaining quarterly reporting periods through maturity of the term loan.

 

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In connection with obtaining forbearance and waivers, during the secondand third quarters of fiscal 2008, the Company paid $450,000 in fees to Bank ofAmerica, N.A., which was included in general and administrative expenses and$1,525,000 in forbearance fees to the lenders, which was included in interestexpense. In addition, the Company incurred $860,000 in legal and consultingfees paid to the lenders’ advisors in connection with the forbearanceactivities, which was included in general and administrative expenses. Pursuantto the amended senior credit facility agreement, the Company was also requiredto pay an amendment fee of $758,000 in cash and to add 1% to the principalbalance of the first and second-lien debt and the revolving line of credit,totaling $1,514,000. The amendment fees were expensed as loss on debtextinguishment in the third quarter of 2008. The Company also began to incur anadditional 4% payment-in-kind (“PIK”) interest expense on the second-lien debt,which was accrued and added to the principal balance on a monthly basis. The 4%could be reduced on a quarterly basis by 0.50% for each 0.25% reduction in theCompany’s consolidated leverage ratio. Effective January 2009, the Company’sconsolidated leverage ratio had been sufficiently reduced to end this PIKinterest accrual.

 

In the third quarter of fiscal 2008, the Company accounted for themodifications of its first and second-lien term debt in accordance with EITFIssue 96-19, “*Debtor’s Accounting for aModification or Exchange of Debt Instruments*,” and the modificationof its revolving credit facility in accordance with EITF Issue 98-14, “*Debtor’s Accounting for Changes in Line-of-Credit orRevolving Debt Arrangements*.” Pursuant to EITF Issue 96-19 and EITFIssue 98-14, the Company accounted for these modifications as debtextinguishments, given that the terms of the debt had changed substantially, asdefined. A substantial modification occurs when the discounted future cashflows have changed by more than 10% before and after the modification in thecase of the term loans; and if the product of the remaining term and themaximum available credit (i.e. the borrowing capacity) of the new revolverhas decreased in relation to the existing line of credit. As a result of theincreased interest and principal payments (including PIK interest) under theterm loans, and reduction in the maximum borrowing limit for the revolver, theCompany determined that these modifications should be accounted for as anextinguishment of the existing credit facilities effective April 10, 2008.The modified facilities were recorded as new debt instruments at fair value,which equaled their face value.

 

In connection with the modifications of the first and second-lien termdebt and the revolving line of credit, considered as an early extinguishment ofdebt, the Company wrote off the remaining unamortized discount and debtissuance costs of $6,036,000, and expensed as debt extinguishment loss $758,000in amendment fees paid to lenders and $1,514,000 of PIK interest added to thenew debt, resulting in a total charge of $8,308,000 in connection with thisdebt extinguishment. Additionally, the Company capitalized $327,000 of deferredfinancing costs related to the new credit agreements, which was being amortizedover their remaining terms.

 

The Company was in compliance with the amended financial covenantprovisions for the April 2008 through March 2009 monthlyreporting periods. While the Company continued to meet all debt servicerequirements on a timely basis, on March 19, 2009, the Company receivedwritten notices from its lenders asserting that the Company was in default of arequirement to sell certain assets by a specified date. Additionally, on April 17,2009, the Company received notices from its lenders asserting that the Company’sApril 14, 2009 increase in ownership of Brotman violated certainprovisions of the amended credit agreements. Effective with the first asserteddefault, the lenders began assessing interest at default rates on all loans.The Company contested the asserted events of default. On June 30, 2009,the Company entered into amendments to its loan agreements, whereby, amongother things, the lenders agreed to waive all alleged events of default andstop assessing default interest rates. In connection with these amendments, theCompany also entered into an amendment and waiver related to its swapagreements which provided that the alleged events of default under the ExistingCredit Facility would not trigger an event of default under the swapagreements. The amendments required the Company to refinance all existing debtno later than October 31, 2009.

 

On July 29, 2009, the Company closed the offering of $160 millionin 12.75% senior secured notes due 2014 (the “Notes”) at an issue price of92.335%.  Concurrent with the issuance of the Notes, the Company enteredinto a three-year $15 million revolving credit facility, which was undrawn atclose, with any future borrowings bearing interest at LIBOR plus 7.00%, with aLIBOR floor of 2.00%.  The Company used the net proceeds fromthe sale of the Notes to repay all remaining amounts outstanding under the $155million senior secured credit facility, plus a prepayment premium ofapproximately $2.6 million (see Note 15). In accordance with Statement of Financial Accounting Standards No. 6,“*Classification of Short-Term Obligations Expectedto be Refinanced*,” all debt amounts outstanding at June 30,2009 that were refinanced by the Notes have been classified as long-term in theaccompanying unaudited condensed consolidated balance sheet.

 

***Interest Rate Swaps***

 

As set forth below, on July 29, 2009, the Company terminated theinterest rate swap arrangements that were previously required by the creditfacilities entered into during fiscal 2007. In connection with those facilities, the Company entered into a$48 million interest rate swap, to effectively convert the variableinterest rate (the LIBOR component) of $48 million of borrowings to a fixedrate of 5.3%, and a $97.8 million interest rate swap agreement to effectivelyconvert the variable interest rate (the LIBOR component) of $97.8 million ofborrowings to a fixed rate of 5.05%. The notional amounts of these interestrate swaps were scheduled to decline as the principal balances owing under theterm loans declined. Under these swaps, the Company was required to makemonthly fixed-rate payments to the swap counterparties calculated on thenotional amount of the swaps and the interest rates for the swaps, while theswap counterparties were obligated to make certain monthly floating ratepayments to the Company referencing the 

 

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samenotional amounts. These interest rate swaps effectively fixed the LIBORcomponent of the weighted average annual interest rate payable on the termloans to 5.13%.

 

The interest rate swap agreements contained cross-default provisionswhereby, in the event the Company was in default under its credit agreements,the Company was also deemed to be in default under the swap agreements.

 

The interest rate swap agreements were designated as cash flow hedgesof expected interest payments on the term loans with the effective date of the$48 million swap being December 31, 2007 and the effective date of the$97.8 million swap being September 6, 2007. Prior to the hedge effectivedates, all mark-to-market adjustments in the value of the swaps were charged toexpense. After the hedge effective date, the effective portions of the fairvalue gains or losses on these cash flow hedges were recorded as a component ofother comprehensive income, net of tax, to be subsequently reclassified intoearnings when the forecasted transaction affects earnings. Effective April 1,2008, in anticipation of changes to the loan agreements that would impactrecording of interest rate swaps, the Company elected to discontinue hedgeaccounting. Changes in the fair value of the interest rate swaps after March 31,2008 are recorded as other income or expense. Total net gain (loss) on theinterest rate swaps included in earnings for the nine months ended June 30,2009 and 2008 were approximately $5,018,000 and $(4,072,000), respectively. Theeffective portion of the swaps of approximately $5,400,000 after tax, that wasrecorded in other comprehensive income through March 31, 2008 wascontinued to be amortized as expense over the remaining life of the swaps.Approximately $1,097,000 was amortized to expense for the nine months ended June 30,2009.

 

On July 29,2009, the Company paid Bank of America, N.A. $11.7 million in final settlementof all amounts owed under the swap arrangements (see Note 15).  Given the asserted credit agreement defaultand subsequent pay-off and termination, the interest rate swap liability hasbeen classified as a current liability at June 30, 2009.

 

**Brotman’s Debt**

 

The Brotman entityhas debt under a Senior Secured Revolving Credit Facility, Secured Term Loansand Unsecured Promissory Note entered into in conjunction with effecting thePlan of Reorganization described in Note 8. The Company has not guaranteed any portion ofBrotman’s debt or other obligations; however, given the Company’s majorityownership in Brotman effective April 14, 2009, all Brotman debt isincluded in the Company’s unaudited consolidated financial statements. However, theCompany has no obligation and has limited ability to fund Brotman’s operationspost acquisition. 

 

***Senior Secured Revolving CreditFacility***

 

On April 14, 2009, theEffective Date of the Plan of Reorganization, Brotman obtained a commitmentfrom Gemino Healthcare Finance, LLC (“Gemino”) for a three-year, $6.0 million,senior credit facility secured by Brotman’s accounts receivable. The facilityexpires on the earlier of April 14, 2012 and the Los Angeles Jewish Homefor the Aging (“JHA”) loan (see below) maturity date and bears interest atLibor plus 7% per annum (11.0% at June 30, 2009) with a LIBOR floor of 11%.Interest is incurred based on the greater of $2 million or the outstandingprincipal balance. The agreement also includes an unused line fee of 0.5% perannum and a collateralline fee, based on the average outstanding principal balance, of 0.5% perannum.Loan feesassociated with the Gemino loan totaling approximately $120,000, werecapitalized and have been included as deferred financing costs in theaccompanying unaudited condensed consolidated balance sheet as of June 30,2009, and the amount is being amortized over the term of the related debt usingthe effective interest method. The senior credit facilityagreement contains customary covenants for facilities of this type includingrestrictions on the payment of dividends, change in ownership and management,asset sales, incurrence of additional indebtedness, sale-leasebacktransactions, and related party transactions. In addition, Brotman must alsocomply with financial covenants, including a fixed charge coverage ratio of notless than (i) 1.10:1.00 for the fiscal quarter ending June 30, 2009, (ii) 1.15:1.00for the fiscal quarter ending September 30, 2009; and (iii) 1.20:1.00for each fiscal quarter ending thereafter. As of June 30, 2009, Brotman didnot have borrowings outstanding under the Gemino financing and was not incompliance with the required financial covenants. As of June 30, 2009,Gemino has collected $243,000 in excess of amount due under the revolvingcredit facility, which is reflected as other receivables on the unauditedcondensed consolidated balance sheet.

 

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

 

On April 14, 2009, theeffective date of the Plan of Reorganization, Brotman consummated thetransactions contemplated in the JHA financing and the JHA loan documents.Under the terms of the JHA loan agreements, JHA agreed to provide Brotman withup to $23 million in financing, consisting of two term loans: (i) a Term Aloan of $16 million (the “Term A Loan”) with a 24-month term and (ii) aTerm B loan of up to $7 million, with a term of 36 months (the “Term B Loan”).Subject to thenotification requirements set forth in the loan agreements, the term of the TermA Loan can be extended up to 36 months. Interest on the Term A Loanis payable at 10% per annum for the first year of the loan, and 7.5%thereafter. Interest on the Term B Loan is payable at 10% per annum for theterm of the loan. The Term A Loan and Term B Loan is secured by certain of Brotman’spersonal property, and a mortgage on certain Brotman’s real property. Theproceeds of the JHA loans were used to repay all existing senior secured loansat Brotman as of April 14, 2009. Loan fees associated with the JHA loans totalingapproximately $1,549,000, were capitalized and have been included as deferredfinancing costs in the accompanying unaudited condensed consolidated balancesheet as of June 30, 2009, and the amount is being amortized over the termof the related debt using the effective interest method.

 

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With respect to the Term A loan, JHA was granted the right (“Put Right”)to declare the unpaid loan amount, including remaining interest and any otheramounts due and payable under the loan agreements, immediately due and payableat any time following the first twelve months of the Closing Date and prior tothe date which is twenty-four months after the Closing Date, subject to JHAproviding written notification to Brotman of its exercise of the Put Right atleast 180 days in advance. JHA may not however provide notification of itsexercise of the Put Right prior to the first anniversary of the April 14,2009 closing date.

 

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

 

In accordance withrelevant accounting pronouncements, the Term A Loan, which contains a realestate purchase option, is recorded at its present value, with any excess ofthe proceeds over that amount to be recorded as an option deposit liabilityaccount. The present value of the loan is estimated using discounted cash flowanalyses based on market rates obtained from independent third parties forsimilar type debt. Based on an estimated market interest rate of 10.0%, thepresent value of the loan was estimated to be approximately $15,667,000 atinception. The difference of $345,000 between the recorded present value andthe carrying value of the loan has been recorded as a discount against the loanand is amortized, using the effective interest rate method, to interestexpense, over the term of the loan.

 

***Subordinated Promissory Note***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, to be held bythe Creditor Trust (as defined in the Plan of Reorganization) for the benefitof holders of allowed Class 4 claims (as defined in the Plan ofReorgnization) and paid pro rata to holders of allowed Class 4 claims. TheNote bears interest at 7.50% per annum and is payable in sixteen equalquarterly installments of principle and accrued interest through February 15,2013. The Notecontains a covenant which, so long as amounts remain outstanding under theNote, restricts Brotman from paying Prospect Medical Holdings, Inc. aconsulting fee of more than $100,000 per month, as specified in the consultingservices agreement (see Note 6).

 

In addition to thesubordinated promissory note pursuant to the confirmation of the Plan ofReorganization, Brotman owes approximately $1.0 million to the Creditors Trustat June 30, 2009. In exchange for their new equity stakes in Brotman, theCompany and certain holders of pre-reorganized Brotman’s securities committedto contribute cash totaling $3,500,000 ($2,500,000 as of the Effective Date and$1,000,000 within six months of the Effective Date), which amount was to beused solely to satisfy holders of Class 4 claims. As of June 30,2009, the remaining approximately $1,000,000 of Class 4 cash that wasreceived in June 2009.

 

**8. Acquisitions**

 

***ProMed Health Services Company***

 

On June 1, 2007, the Company and Prospect Medical Group, Inc.(“PMG”), one of its affiliated physician organizations, acquired ProMed HealthServices Company and its subsidiary, ProMed Health Care Administrators (“PHCA”)(collectively “ProMed Health Care Administrators”), and two affiliated IPAs:Pomona Valley Medical Group, Inc. dba ProMed Health Network (“PomonaValley Medical Group”), and Upland Medical Group, a Professional MedicalCorporation (“Upland Medical Group” and together with Pomona ValleyMedical  Group, the “ProMed Entities”).PHCA manages the medical care of HMO enrollees served by Pomona Valley MedicalGroup and Upland Medical Group. Total purchase consideration of $48,000,000included $41,040,000 of cash and 1,543,237 shares of Prospect Medical Holdings, Inc.common stock valued at $6,960,000, or $4.51 per share. The transaction isreferred to as the “ProMed Acquisition.”

 

The ProMed Acquisition, and $392,000 in related transaction costs, wasfinanced by $48,000,000 in borrowings (less $896,000 in debt issuance costs)and $2,379,000 from cash reserves. The debt proceeds and cash reserves wereused to fund the cash consideration of $41,040,000 and to repay all existingdebt of Prospect Medical Holdings, Inc. ($7,842,000 plus $209,000 ofprepayment penalties). The $48,000,000 in borrowings used to finance theacquisition of the ProMed Entities was refinanced in August 2007, usingproceeds from the $155,000,000 credit facility entered into in connection withthe Alta transaction, described below. The purchase agreements provide forcertain post-closing working capital, medical claims reserve and otheradjustments, which the Company is currently negotiating. During fiscal 2008,the Company recorded a post-closing working capital adjustment of approximately$560,000 as a reduction in goodwill.

 

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***Alta Hospitals System, LLC***

 

On August 8, 2007, the Company acquired all of the outstandingcommon shares of Alta Hospitals System, LLC (“Alta”), which was formerlyknown as Alta Healthcare System, Inc. Alta is a for-profit hospital management company that, through twosubsidiary corporations, owns and operates four community-based hospitals—VanNuys Community Hospital, Hollywood Community Hospital, Los Angeles CommunityHospital and Norwalk Community Hospital. These hospitals provide acomprehensive range of medical, surgical and psychiatric services and have acombined 339 licensed beds served by 315 on-staff physicians. Total purchaseconsideration, including transaction costs, was approximately $154,935,000,comprised of repayment of approximately $41,500,000 of Alta’s existing debt,payment of approximately $51,300,000 in cash to the former Alta shareholders,issuance of 1,887,136 shares of Prospect common stock, issuance of 1,672,880shares of Prospect convertible preferred stock valued, for purposes of thetransaction, at $61,030,000, and payment of transaction costs of approximately$1.2 million. Each share of preferred stock was convertible into fivecommon shares upon stockholder approval (which occurred on August 13,2008). Prior to conversion, each share of preferred stock accrued dividends at18% per year, compounding annually. Such dividends (amounting to $7,881,890)were canceled upon conversion to common shares on August 13, 2008, and therelated liability reclassified to additional paid in capital. For purposes ofdetermining the number of shares to be issued in connection with thetransaction, Prospect common stock was valued at $5.00 per share and Prospectpreferred stock was valued at $25.00 per share. However, for purposes ofrecording the transaction, (i) the value per share of common stock wasestimated at $5.58, based on the average of the stock’s closing prices beforeand after the acquisition announcement date of July 25, 2007, and (ii) thevalue per share of preferred stock was estimated at $30.19, based on theclosing stock price of a common share on the acquisition date, plus a premiumfor the preference features of the stock. As such, total recorded purchaseconsideration, exclusive of transaction costs, was approximately $153,772,000.

 

The Alta Acquisition, the extinguishment of Alta’s existing debt andthe refinancing of the ProMed Acquisition debt described above were financed bya $155,000,000 senior secured credit facility, comprised of $145,000,000 interm loans and a $10,000,000 revolver, of which $3,000,000 was drawn at closing(see Note 7 for discussion of debt). Net proceeds of $141.1 million(net of issuance discount and financing costs of $6.9 million) were usedto repay Alta’s existing borrowings of $41.5 million, refinance$47.0 million in outstanding ProMed Acquisition debt, pay the cash portionof the purchase price of $51.3 million and fund approximately$1.2 million in transaction costs. As set forth in Note 7, the new senior secured facility was repaid andterminated on July 29, 2009.

 

***Brotman Medical Center, Inc.***

 

On August 31, 2005,the Company invested $1 million for an approximately 33.1% stake in Brotman.Brotman is a 420 bed licensed and accredited acute care hospital, located inCulver City, California. The Company made the investment with the intentionthat it, with Brotman, would be able to offer joint contracting to HMOsoperating in Brotman’s service area. Brotman incurred significant losses beforeand after the Company’s initial investment and, on October 25, 2007(the “PetitionDate”), Brotman filed for bankruptcy protection under Chapter 11 of the U.S.Bankruptcy Code, at which point, the initial investment was considered fullyimpaired.  On the Petition Date, theCompany entered into an amendment to its existing consulting services agreementwith Brotman, providing for an increased level of service and responsibility(see Note 6).  Additionally, effective April 22,2008, Samuel S. Lee (Prospect’s CEO and Chairman of the Board) was appointed asthe Chairman of the Board of Directors of Brotman.  On April 14, 2009 (The “Effective Date”),the U.S. Bankruptcy Court confirmed and declared effective the final Chapter 11Plan of Reorganization (the “Plan”) of Brotman whereby, among other things, allof Brotman’s outstanding securities were canceled and, in exchange for theirpro rata share of the New Value Contribution (as defined in the Plan) totaling$3,500,000, holders of Brotman’s securities would receive New Common Stock inBrotman in the same percentage as their pro rata share of the New Value Contribution.Pursuant to the terms of the Plan, the Company made a $1,814,000 investment inBrotman on January 13, 2009 and $705,000 on June 30, 2009, totaling$2,519,000 while the minority shareholders made a total cash investment of$981,000 . Based on such contributions, Prospect acquired an additional 38.86%ownership interest in Brotman, effective April 14, 2009, which brought itstotal interest to 71.96%.

 

For financial accounting purposes, the additional investment in Brotman was referred to as the “Brotman Acquisition” and in accordance with Statement of Financial Accounting Standards No. 141, “*Business Combinations*” (“SFAS No. 141”), the business combination, which was achieved in stages, provides for recognition of assets at current fair value with respect to the proportion of the Company’s incremental ownership interest in Brotman. Under SFAS No. 141, the aggregate cost of the acquired assets, which includes cash paid of $2.5 million and expenses incurred in connection with the acquisition totaling $37,000, were preliminarily allocated to the assets acquired and liabilities assumed. The excess of the consideration over the estimated fair value of the assets and liabilities assumed has been allocated to goodwill. Due to negative net book value of assets acquired, goodwill attributable to the minority interest is not recognized. The purchase price allocation will be adjusted upon completion of the final valuation studies and may differ materially from the information presented herein. The results of operations and financial position of Brotman have been included in the unaudited condensed consolidated financial statements since the April 14, 2009 acquisition date.  Brotman’s operations for the period from April 14, 2009 to June 30, 2009 reflected a net loss of $2,760,000. The Company does not have the intent or ability, including under the terms of its debt agreement, to provide significant financial support to Brotman. A pro rata (approximately 28%) share of net income attributable to Brotman will be included under Minority Interest in the Company’s statement of operations, once 

 

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the cumulative minority share of such income exceeds their cumulative share of prior losses absorbed by the Company, as its majority interest holder; this would be through the implementation of new relevant accounting literature (see Note 13).

 

Thefollowing is an analysis of the preliminary goodwill amount recognized inconnection with the Brotman Acquisition based on the April 14, 2009balance sheet of Brotman (in thousands):

 
| Total  purchase consideration                                      |   | $       | 2,556   |   |
|--------------------------------------------------------------------|--------|---------|---------|--------|
| Add:  net negative book value acquired                             |   | (14,896 | )       |
| Add:  estimated tax effect from step-up of acquired assets         |   | 3,717   |    |
| Acquisition  cost in excess of revised net book value acquired     |   | 21,169  |    |
| Estimated  identifiable intangible assets                          |   | —  |    |
| Estimated  goodwill                                                |   | $       | 21,169  |   |
|                                                               |   |    |    |
| Reconciliation  of net book value acquired at April 14, 2009: |   |    |    |
| Negative  net book value at April 14, 2009                    |   | $       | (29,132 | )      |
| Estimated  fair value of Brotman                                   |   | 7,502   |    |
| Excess  of estimated fair value over the net book value            |   | 36,634  |    |
| Additional  ownership interest acquired                            |   | 38.86   | %       |
| Estimated  step-up in basis of net assets acquired                 |   | $       | 14,236  |   |

 

Goodwillfrom the Brotman Acquisition is primarily related to new capacity for futuregrowth, new geographic coverage, management team and in-place workforce.Through the Brotman Acquisition, the Company expanded into a new service marketin the West Los Angeles, California area. As a stock purchase, the goodwillacquired in the Brotman Acquisition is not deductible for income tax purposes.  Brotman recorded incomerelated to discharge of debt upon emergence from the Chapter 11 Bankruptcyreorganization.  Under Internal Revenue Code 108 (“IRC 108”), an insolventtaxpayer can exclude from its taxable income computation, the income related todischarge of debt to the extent of the insolvency amount.  Brotman’s taxprovision reflects that the entire amount of debt discharge income is qualifiedfor the exclusion under IRC 108.  Also, under current tax law, a taxpayeris required to reduce its tax attribute to the extent of the excluded debtdischarge income, and this attribute reduction occurs on the first day of thetax year after the debt discharge occurs.  In addition, a taxpayer isallowed an election to use an alternative tax reduction orderingrules.  As of June 30, 2009, management has not concluded onthe attribute reduction ordering, however, tax attribute reduction maycreate additional deferred tax liabilities for which the tax impact will berecognized through purchase accounting.

 

The following unaudited pro forma financial information for thethree-month and nine-month periods ended June 30, 2009 and 2008 giveseffect to the acquisition of Brotman as if it had occurred on October 1,2007. Such unaudited pro forma information is based on historical financialinformation with respect to the acquisition and does not include synergies,operational or other changes that might have been effected by the Company.Significant proforma adjustments include increased depreciation related tofixed assets acquired.

 
| ** **                                     | ** ** | **Three  Months Ended**                       | ** ** | **Nine  Months Ended** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **June 30**                              | ** ** | **June 30**       | ** ** |
| ** **                                     | ** ** | **2009**                                      | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **(in  thousands, except per-share amounts)** | ** ** |
| ** **                                     | ** ** | ** **                                    | ** ** |
| Net revenue                                    |       | $                                             | 149,563    |                   | $          | 101,728 |   | $ | 345,225 |   | $ | 316,278 |   |
| Net loss from continuing operations            |       | $                                             | (4,111     | )                      | $          | (7,465 | ) | $ | (2,752 | ) | $ | (8,009 | ) |
| Net loss per share—continuing operations: |       |                                          |       |                   |       |   |   |   |   |
| Basic                                          |       | $                                             | (0.20      | )                      | $          | (0.78 | ) | $ | (0.13 | ) | $ | (1.19 | ) |
| Diluted                                        |       | $                                             | (0.20      | )                      | $          | (0.78 | ) | $ | (0.13 | ) | $ | (1.19 | ) |

 

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**9. Segment Information**

 

The Company’s operations are organized into three reporting segments: (i) IPA—whichis comprised of the Prospect and ProMed reporting units, provides managementservices to affiliated physician organizations that operate as independentphysician associations (“IPAs”); (ii) Hospital Services—which owns andoperates five hospitals—Los Angeles Community Hospital, Hollywood CommunityHospital, Norwalk Community Hospital, Van Nuys Community Hospital and BrotmanMedical Center; and (iii) Corporate - which represents expenses incurredat Prospect Medical Holdings, Inc. (the “Parent Entity”), that were notallocated to the IPA and Hospital Services segments.

 

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

 

The reporting segments are strategic business units that offerdifferent services within the healthcare industry. Business in each reportingsegment is conducted by one or more direct or indirect wholly-ownedsubsidiaries of the Company and certain affiliated physician organizationscontrolled through assignable option agreements and management servicesagreements described in Note 6 above.

 

The following tables summarize certain information for each of thereporting segments regularly provided to and reviewed by the chief operatingdecision (thousands):

 
| ** **                                                     | ** ** | **As of and for the Three Months Ended June 30,  2009** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                       | ** ** | **IPA** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                            | 66,470     |   | $ | 47,848 |   | $ | — |   | $ | — |   | $ | 114,318 |   |
| Intersegment revenues                                          |       | —                                                       |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 66,470                                                       |       | 47,848 |   | — |   | — |   | 114,318 |   |
| Operating income (loss)                                        |       | 7,327                                                        |       | 3,240 |   | (3,861 | ) | — |   | 6,705 |   |
| Investment (income)                                            |       | —                                                       |       | (20 | ) | (13 | ) | — |   | (33 | ) |
| Interest expense and amortization of deferred  financing costs |       | 1,106                                                        |       | — |   | 7,576 |   | — |   | 8,682 |   |
| Gain on interest rate swap arrangements                        |       | —                                                       |       | — |   | (3,694 | ) | — |   | (3,694 | ) |
| Income (loss) from continuing operations before  income taxes  |       | $                                                            | 6,221      |   | $ | 3,260 |   | $ | (7,730 | ) | $ | — |   | $ | 1,751 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                            | 289,326    |   | $ | 160,346 |   | $ | (87,498 | ) | $ | — |   | $ | 362,174 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                            | 187        |   | $ | 50 |   | $ | — |   | $ | — |   | $ | 237 |   |
| Segment goodwill                                               |       | $                                                            | 127,708    |   | $ | 22,338 |   | $ | — |   | $ | — |   | $ | 150,046 |   |

 
| ** **                                                     | ** ** | **As of and for the Three Months Ended June 30,  2008** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                       | ** ** | **IPA** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                            | 31,413     |   | $ | 49,448 |   | $ | — |   | $ | — |   | $ | 80,861 |   |
| Intersegment revenues                                          |       | —                                                       |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 31,413                                                       |       | 49,448 |   | — |   | — |   | 80,861 |   |
| Operating income (loss)                                        |       | 6,410                                                        |       | 3,288 |   | (5,644 | ) | — |   | 4,054 |   |
| Investment (income)                                            |       | —                                                       |       | (64 | ) | (17 | ) | — |   | (81 | ) |
| Interest expense and amortization of deferred  financing costs |       | 40                                                           |       | — |   | 6,522 |   | — |   | 6,562 |   |
| Gain on interest rate swap arrangements                        |       | —                                                       |       | — |   | (4,948 | ) | — |   | (4,948 | ) |
| Loss on debt extinguishment                                    |       | —                                                       |       | — |   | 8,309 |   | — |   | 8,309 |   |
| Income (loss) from continuing operations before  income taxes  |       | $                                                            | 6,370      |   | $ | 3,352 |   | $ | (15,510 | ) | $ | — |   | $ | (5,788 | ) |
| Identifiable segment assets (liabilities)                      |       | $                                                            | 180,888    |   | $ | 148,193 |   | $ | (48,549 | ) | $ | — |   | $ | 280,532 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                            | 370        |   | $ | (45 | ) | $ | — |   | $ | — |   | $ | 325 |   |
| Segment goodwill                                               |       | $                                                            | 106,494    |   | $ | 22,761 |   | $ | — |   | $ | — |   | $ | 129,255 |   |

 

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| ** **                                                     | ** ** | **As  of and for the Nine Months Ended June 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                      | ** ** | **IPA  Management** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                           | 139,701    |   | $ | 144,138 |   | $ | — |   | $ | — |   | $ | 283,839 |   |
| Intersegment revenues                                          |       | —                                                      |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 139,701                                                     |       | 144,138 |   | — |   | — |   | 283,839 |   |
| Operating income (loss)                                        |       | 27,509                                                      |       | 9,480 |   | (8,740 | ) | — |   | 28,249 |   |
| Investment (income)                                            |       | —                                                      |       | (51 | ) | (50 | ) | — |   | (101 | ) |
| Interest expense and amortization of deferred  financing costs |       | 1,198                                                       |       | — |   | 20,197 |   | — |   | 21,396 |   |
| Loss on interest rate swap arrangements                        |       | —                                                      |       | — |   | 5,019 |   | — |   | 5,019 |   |
| Income (loss) from continuing operations before  income taxes  |       | $                                                           | 26,311     |   | $ | 9,531 |   | $ | (33,906 | ) | $ | — |   | $ | 1,936 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                           | 289,326    |   | $ | 160,346 |   | $ | (87,498 | ) | $ | — |   | $ | 362,174 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                           | 562        |   | $ | 114 |   | $ | — |   | $ | — |   | $ | 676 |   |
| Segment goodwill                                               |       | $                                                           | 127,708    |   | $ | 22,338 |   | $ | — |   | $ | — |   | $ | 150,046 |   |

 
| ** **                                                     | ** ** | **As of and for the Nine Months Ended June 30,  2008** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                      | ** ** | **IPA  Management** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                           | 91,096     |   | $ | 150,697 |   | $ | — |   | $ | — |   | $ | 241,793 |   |
| Intersegment revenues                                          |       | —                                                      |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 91,096                                                      |       | 150,697 |   | — |   | — |   | 241,793 |   |
| Operating income (loss)                                        |       | 19,524                                                      |       | 7,499 |   | (12,055 | ) | — |   | 14,968 |   |
| Investment (income)                                            |       | —                                                      |       | (204 | ) | (319 | ) | — |   | (523 | ) |
| Interest expense and amortization of deferred  financing costs |       | 120                                                         |       | — |   | 15,935 |   | — |   | 16,055 |   |
| Gain on interest rate swap arrangements                        |       | —                                                      |       | — |   | (4,072 | ) | — |   | (4,072 | ) |
| Loss on debt extinguishment                                    |       | —                                                      |       | — |   | 8,309 |   | — |   | 8,309 |   |
| Income (loss) from continuing operations before  income taxes  |       | $                                                           | 19,404     |   | $ | 7,703 |   | $ | (31,908 | ) | $ | — |   | $ | (4,801 | ) |
| Identifiable segment assets (liabilities)                      |       | $                                                           | 180,888    |   | $ | 148,193 |   | $ | (48,549 | ) | $ | — |   | $ | 280,532 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                           | 1,220      |   | $ | 176 |   | $ | 17 |   | $ | — |   | $ | 1,413 |   |
| Segment goodwill                                               |       | $                                                           | 106,494    |   | $ | 22,761 |   | $ | — |   | $ | — |   | $ | 129,255 |   |

 

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| (1)    |   | Prospect  Medical Holdings, Inc. files a consolidated tax return and  allocates costs for shared services and corporate overhead to each of the  reporting segments. All acquisition-related debt, including debt related to  the IPA and Hospital Services segment, is recorded at the Parent entity  level. As such, the Company does not allocate interest expense, and gain or  loss on interest rate swaps to the IPA and Hospital Services segments. |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (2)    |   | Prospect  Medical Group, Inc. (which serves as a holding company for our affiliated  physician organizations and is itself an affiliated physician organization)  files a separate consolidated tax return.                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (3)    |   | During  the three months and nine months ended June 30, 2008, the Company  incurred approximately $45,000 and $1,383,000 in costs related to the  restatement of Alta’s pre-acquisition financial statements, preparation of  SEC filings and the related special investigation by the Company’s audit  committee, which was completed in March 2008. These expenses are  included in general and administrative expenses of the Company.        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (4)    |   | Certain  prior year amounts have been reclassified to conform to the fiscal 2009  period presentation.                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (5)    |   | Hospital  Services segment includes the operations of Brotman since April 14, 2009  (see Note 8).                                                                                                                                                                                                                                                                                                                                                               |

 

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**10. Income Taxes**

 

The Company recorded a taxprovision of approximately $1,989,000 and $2,065,000 for the three months andnine months ended June 30, 2009, with an effective tax rate of 114% and 107%,respectively, and a tax benefit of approximately $2,083,000 and $1,728,000 forthe three months and nine months ended June 30, 2008, each of which was aneffective tax rate of 36%. The higher effective tax rates in the fiscal 2009period was primarily due to not recognizing the deferred tax benefit fromBrotman’s loss, for which realization does not meet the more likely than notstandard per SFAS No. 109. Full valuation allowance in accordance with SFAS No.109 was recorded against net deferred tax assets at Brotman at June 30, 2009.

 

Additionally, the effectivetax rate in 2009 differs from the statutory rate of 34% due to the fact thatBrotman files a separate return for federal and state purposes. For federalincome tax purposes, the privilege of filing a consolidated return is extendedto an affiliated group of corporations under IRC Sections 1501 and1504(b).  This consolidation privilege is limited to the affiliated groupwith 80% or higher direct ownership.   As Prospects’ ownership inBrotman Medical Center Inc does not meet this 80% ownership threshold, Prospectand Brotman may not file consolidated return for federal income taxpurposes.  Brotman has historically been operating in losses and is notanticipated to turn profitable in foreseeable future.  Therefore,management determined that income tax benefits for Brotman losses cannot berecognized due to the insufficient evidence that the losses can be realized asof June 30, 2009.  

 

California requires membersof a commonly controlled group that conducts a unitary business to computetheir California income on a combined basis. Under California law, thedetermination of whether two or more commonly controlled corporations areunitary depends on the facts in each case.  As of June 30, 2009,management has not determined if the unitary relationship exists betweenBrotman and Prospect, and therefore provisioned for its state income taxesunder an assumption that Brotman will file separate company return and will notbe included in Prospect’s combined California income tax returns. Management plans to reevaluate if the California combined unitary reporting isrequired for Brotman.  If the determination is made that Brotman operationis considered unitary with Prospect, the Company’s state tax provision maychange significantly and it may have a material impact to financial statements.

 

Aspart of the Brotman acquisition, management of the Company adopted FIN 48, accountingfor uncertain tax positions, for Brotman and determined that no materialunrecognized tax benefits exist as of June 30, 2009.  Brotman generated, and still maintains,carryfowards of a substantial amount of net operating losses since itsinception in 2005 which are open for the taxing authority’s examination. 

 

**11. Use of Estimates**

 

The preparation of unaudited consolidated financial statements inconformity with accounting principles generally accepted in the U.S. requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses, and the disclosure of contingentassets and liabilities at the dates, and for the periods, that the financialstatements are prepared. Actual results could materially differ from thoseestimates. Principal areas requiring the use of estimates include third-partycost report settlements, risk-sharing programs, patient and medical relatedreceivables, determination of allowances for contractual discounts and uncollectibleaccounts, medical claims and accruals, impairment of goodwill, long-lived andintangible assets, valuation of interest rate swaps, share-based payments,professional and general liability claims, reserves for the outcome oflitigation, liabilities for uncertain income tax positions and valuationallowances for deferred tax assets.

 

During the nine months ended June 30, 2009 and 2008, the Companyrecorded approximately $1,347,000 and $2,101,000 in favorable changes inestimates during the respective periods related to medical claims developmentfrom the prior periods.

 

**12. Fair Value of Financial Investments**

 

EffectiveApril 1, 2009, the Company adopted FASBStaff Position FAS 107-1 and APB 28-1*, “DisclosuresAbout Fair Value of Financial Instruments”*(“FSP 107-1” and “APB28-1”)*.* This Statementrequires that the fair value of financial instruments be disclosed in the bodyor notes of an entity’s financial statements in both interim and annualperiods. It also requires the disclosure of methods and assumptions used toestimate fair values. It does not require comparative disclosures for periodspreceding adoption. The fair values of the Company’s current assets andcurrent liabilities approximate their reported carrying amounts. The carryingvalues and the fair values of non-current financial assets and liabilities,that qualify as financial instruments per FAS No. 107, “*Disclosures about Fair Value of Financial Instruments*,” wereas follows (in thousands).

 
| ** **                | ** ** | **At June 30, 2009** | ** ** |
|---------------------------|------------|---------------------------|------------|
| ** **                | ** ** | **Carrying Amount**       | ** ** | **Fair Value** | ** ** |
| **Assets:**               |       |                      |       |   |   |
| Long-term note receivable |       | $                         | 371        |   | $ | 320 |   |
| **Liabilities:**          |       |                      |       |   |   |
| Long-term debt            |       | $                         | 160,399    |   | $ | 94,558 |   |

 

The fair value ofthe notes receivable, which was received as part of the consideration for thesale of the Company’s three medical clinics in April 2004, was estimatedbased on expected future payments discounted at risk-adjusted rates. The fairvalue of the Company’s long-term debt was estimated based on expectedfuture payments discounted at risk-adjusted rates.

 

Effective October 1, 2008, the Company adopted SFAS No. 157*, “Fair ValueMeasurement’s”* (“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurementsfor all financial assets and liabilities measured at fair value on a recurringbasis. In 

 

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February 2008,the FASB staff issued Staff Position No. 157-2 “*Effective Date of FASB Statement No. 157,*” (“FSPSFAS 157-2”). FSP SFAS 157-2 delayed the effective date ofFAS 157 for nonfinancial assets and nonfinancial liabilities, except foritems that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually). In accordance with theprovisions of FSP SFAS 157-2, the Company has elected to deferimplementation of SFAS 157 until October 1, 2009 as it relates to itsnon-financial assets and non-financial liabilities that are not permitted orrequired to be measured at fair value on a recurring basis. Management iscurrently evaluating the impact, if any, SFAS No. 157 will have on thosenon-financial assets and liabilities.

 

The FASB also issued FASB Staff Position No. 157-3, *Determining the Fair Value of a Financial Asset whenthe Market for that Asset is not Active*, (“FSP 157-3”) in October 2008.FSP 157-3 clarifies the application of SFAS 157 in an inactive market andprovides an example to illustrate key considerations in determining the fairvalue of a financial asset when the market for that financial asset is notactive. FSP 157-3 is effective immediately and was adopted by the Company as ofOctober 1, 2008. The impact of adopting FSP 157-3 was not material to theCompany’s consolidated financial statements.

 

SFAS No. 157 establishes a fair value hierarchy that prioritizesthe inputs to valuation techniques used to measure fair value. The hierarchygives the highest priority to unadjusted quoted prices in active markets foridentical assets or liabilities (Level 1 measurements) and the lowestpriority to unobservable inputs (Level 3 measurements). The three levelsof the fair value hierarchy under SFAS No. 157 are described below:

 

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

 

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

 

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

 

The following table sets forth the Company’s financial assets andliabilities measured at fair value on a recurring basis and where they areclassified within the hierarchy as of June 30, 2009 (in thousands):

 
| ** **                   | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
| **Assets:**                  |       |      |       |             |       |             |       |             |       |
| Investments                  |       | $         | 665        |             | $          | 665              |       | $                | —     |   | $ | — |   |
| **Liabilities:**             |       |      |       |             |       |             |       |             |       |
| Interest rate swap liability |       | $         | 11,032     |             | $          | —           |       | $                | 11,032     |   | $ | — |   |

 

A financial asset or liability is categorized within the hierarchybased upon the lowest level of input that is significant to the fair valuemeasurement. Following is a description of the valuation methodologies used bythe Company as well as the general classification of such instruments pursuantto the hierarchy.

 

*Investments*

 

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

 

*Interest Rate Derivative Liabilities*

 

As of June 30, 2009, the Company has two interest rate swapagreements in place for an initial notional amount of $48 million and$97.8 million, respectively. These instruments effectively cause a portionof the Company’s floating rate debt to become fixed rate debt and are held witha major financial institution. A mark-to-market valuation that takes intoconsideration anticipated cash flows from the transaction using quoted marketprices, other economic data and assumptions, and pricing indications used byother market participants is used to value the swaps. Given the degree ofvarying assumptions used to value the swaps, they are deemed to be Level 2instruments.

 

**13. Recent Accounting Pronouncements**

 

In December 2007, the FASB issued SFAS No. 160, *“Noncontrolling Interests in Consolidated FinancialStatements—an Amendment of ARB No. 51”* (“SFAS No. 160”).SFAS No. 160 establishes accounting and reporting standards for thenoncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary. It clarifies that a non-controlling minority interest in asubsidiary is an ownership interest in the consolidated entity that should bereported as equity in the accompanying Consolidated Financial Statementsseparate from the parent company’s equity. Net income (loss) attributable tothe non-controlling interest will be included 

 

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inconsolidated net income on the face of the income statement. SFAS No. 160is effective for fiscal years, and interim periods within those fiscal years,beginning on or after December 15, 2008. SFAS No. 160 requiresretroactive adoption of the presentation and expanded disclosure requirementsfor existing minority interests. All other requirements of SFAS No. 160shall be applied prospectively. The Company will adopt SFAS No. 160 on October 1,2009 and is currently evaluating the potential impact of the adoption of SFAS No. 160on its consolidated financial statements.

 

In May 2009,the FASB issuedStatement of Accounting Standards No. 165, “*SubsequentEvent*s”(“SFAS No. 165”), which establishes general standards ofaccounting and disclosure for events that occur after the balance sheet datebut before financial statements are issued. This standard will be effective forreporting periods ending after June 15, 2009. The adoption of SFAS No. 165does not impact the Company’s financial position or results of operations, asits requirements are disclosure-only in nature. The unaudited consolidatedfinancial statements were available to be issued on August 19, 2009 andthe Company evaluated subsequent events known to management through such date(see Note 15).

 

**14. Litigation and Contingencies**

 

Many of the Company’s payer and provider contracts are complex innature and may be subject to differing interpretations regarding amounts duefor the provision of medical services. Such differing interpretations may notcome to light until a substantial period of time has passed following contractimplementation. Liabilities for claims disputes are recorded when the loss isprobable and can be estimated. Any adjustments to reserves are reflected incurrent operations.

 

TheCompany has commercial claims-made insurance policies for Alta and Brotmanseparately. The policies cover for malpractice claims in excess of $1,000,000per claim with a $3,000,000 annual aggregate. The General Liability coverage isoccurrence coverage with no per occurrence retention and no annual aggregatefor Alta, and with $1,000,000 per occurrence retention and $3,000,000 annualaggregate for Brotman.Total actuarial IBNR estimate of approximately $2,706,000 was made forestimated malpractice liability through June 30, 2009. These estimates maychange in the future and such changes may be material.

 

The Company is inthe process of finalizing certain post-closing matters related to the 2007ProMed acquisition, including closing balance sheet reconciliations, escrowreconciliations and other matters. The Company has recorded settlement amounts relatingsuch matters in the accompanying unaudited condensed consolidated financialstatements.

 

The Company is subject to a variety of claims and suits that arise fromtime to time in the ordinary course of its business, acquisition, or othertransactions. While management currently believes that resolving all of thesematters, individually or in aggregate, will not have a material adverse impacton the Company’s financial position or its results of operations, thelitigation and other claims that the Company faces are subject to inherentuncertainties and management’s view of these matters may change in the future.Should an unfavorable final outcome occur, there exists the possibility of amaterially adverse impact on the Company’s financial position, results ofoperations and cash flows for the period in which the effect becomes probableand reasonably estimable.

 

**15. Subsequent Event**

 

On July 29, 2009, the Company closed the offeringof $160 million in 12.75% senior secured notes due 2014 (the “Notes”) at anissue price of 92.335%.  The sale was executed in accordance with Rule 144Aunder the Securities Act of 1933 and Regulation S under the Securities Act of1933.  Concurrent with the issuance of the Notes, the Company entered intoa three-year $15 million revolving credit facility which was undrawn at theclosing, with any future borrowings bearing interest at LIBOR plus 7.00%, witha LIBOR floor of 2.00%.  The Company usedthe net proceeds from the sale of the Notes to repay all remaining amountsoutstanding under its $155 million senior secured credit facility, plus aprepayment premium of approximately $2.6 million. The Company will reflect therepayment premium, together with the write-off of approximately $560,000 ofdeferred financing related to its former credit facilities, as interestexpense. Capitalized deferred financing costs and original issue discount willbe amortized over the term of the related debt using the effective interestmethod.

 

EffectiveJuly 23, 2009, the Company terminated the master swap agreement and theswap arrangements thereunder by payment, on July 29, 2009, of $11.7million to the swap counterparty in final settlement of all amounts owed underthe swap arrangements. All related amounts included in accumulated othercomprehensive loss of approximately $4.2 million and related deferred incometaxes will be recorded as interest expense and to the tax provision, respectively,as of the effective date of the swap terminations.

 

Theterms of the Notes are governed by an indenture, among the Company, certain ofits subsidiaries and affiliates (as guarantors) and U.S. Bank NationalAssociation (as trustee) (the “Indenture”).  Interest is payable semi-annuallyin arrears on January 15 and July 15, commencing on January 15,2010.  The terms of the revolving senior secured credit facility aregoverned by the Credit Agreement, dated as of July 29, 2009, among theCompany, Royal Bank of Canada (as administrative agent), Jefferies Finance LLC(as syndication agent) and the lenders party thereto (the “Credit Agreement”).

 

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TheNotes and the revolving senior secured credit facility are jointly andseverally guaranteed on a senior secured basis by all of the Company’srestricted subsidiaries (as such term is defined in the Indenture) other thanBrotman, Nuestra Familia Medical Group, Inc. and certain immaterialsubsidiaries.  The Notes are secured pari passu with the new revolvingcredit facility on a first priority basis by liens on substantially all of theCompany’s assets and the assets of the subsidiary guarantors (other thanaccounts receivable and proceeds therefrom) including all the mortgages on theCompany and its subsidiary guarantors’ hospital properties (but excluding apledge of, or mortgage on, the stock, properties or other assets of Brotman,AMVI/Prospect Health Network and certain immaterial subsidiaries).  Thelenders under the revolving credit facility have a first priority lien oncertain of the accounts receivable of the Company and the subsidiary guarantorsand proceeds therefrom while the holders of the Notes have a second prioritylien on such collateral.

 

TheIndenture requires the Company to make an offer to repurchase the Notes at 101%of their principal amount in the event of a change of control of the Companyand at 100% of the principal amount thereof with certain proceeds of sales ofassets.  The Indenture also contains certain covenants that, among otherthings, limit the Company’s ability, and the ability of its restrictedsubsidiaries to: pay dividends or distributions on capital stock or equityinterests, prepay subordinated indebtedness or make other restricted payments;incur additional debt; make investments; create liens on assets; enter intotransactions with affiliates; engage in other businesses; sell or issue capitalstock of restricted subsidiaries; merge or consolidate with another company;transfer and sell assets; create dividend and other payment restrictionsaffecting subsidiaries; and designate restricted and unrestrictedsubsidiaries.  The Credit Agreement contains a number of customarycovenants as well as covenants requiring the Company to maintain a maximumconsolidated leverage ratio, minimum fixed charge coverage ratio and a maximumconsolidated total leverage ratio.

 

Inconnection with the issuance of the Notes, the Company also entered into aregistration rights agreement (the “Registration Rights Agreement”) thatrequires the Company to: (a) use its reasonable best efforts to consummatean exchange offer within 270 days after the issuance of the Notes, whereby theCompany will file a registration statement with the U.S. Securities andExchange Commission and offer to exchange the Notes and the related guaranteesfor publicly tradable notes and guarantees having substantially identicalterms; and (b) file a shelf registration statement for the resale of theNotes and use its reasonable best efforts to cause the shelf registrationstatement to be declared effective if the Company cannot effect an exchangeoffer within such 270-day period.  If the Company does not comply with itsobligations under the Registration Rights Agreement, the interest rate on theNotes will increase by 0.25% per annum for the following 90 day period and anadditional 0.25% per annum with respect to each subsequent 90 day period, up toa maximum increase of 1.00% per annum.  However, the interest rate willreturn to 12.75% as soon as the Company complies with the registrationrequirements.

 

TheNotes will mature on July 15, 2014.  Prior to July 15, 2012, theCompany may redeem up to 35% of the original principal amount of the Notes at aredemption price equal to 112.75% of the principal amount of the Notesredeemed, plus any accrued and unpaid interest, with the proceeds of certainequity offerings.  From July 15, 2012 until July 15, 2013, theCompany may redeem all, or any portion, of the Notes****at a redemption price equal to 106.375% of the principalamount of the Notes redeemed, plus any accrued and unpaid interest.  AfterJuly 15, 2013, but before the maturity date of July 15, 2014, theCompany may redeem all, or any portion, of the Notes at a redemption priceequal to 100% of the principal amount of the Notes redeemed, plus any accruedand unpaid interest.

 

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

 

**Forward-Looking Statements**

 

The following discussion of our financial condition and results ofoperations should be read in conjunction with the accompanying unauditedinterim condensed consolidated financial statements and the notes to thosestatements appearing elsewhere in this report and the audited consolidated financialstatements for the year ended September 30, 2008 appearing in our annualreport on Form 10-K and subsequent filings with the Securities andExchange Commission.

 

This discussion contains forward-looking statements that involve risksand uncertainties. These forward-looking statements are often accompanied bywords such as “believe,” “should,” “anticipate,” “plan,” “expect,” “potential,”“scheduled,” “estimate,” “intend,” “seek,” “goal,” “may” and similarexpressions. These statements include, without limitation, statements about ourmarket opportunity, our growth strategy, competition, expected activities andfuture acquisitions and investments and the adequacy of our available cashresources. Investors are urged to read these statements carefully, and arecautioned that matters subject to forward-looking statements involve risks anduncertainties, including economic, regulatory, competitive and other factorsthat may affect our business. These statements are not guarantees of futureperformance and are subject to risks, uncertainties and assumptions. Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, levels of activity,performance, or achievements. Moreover, we do not assume any responsibility forthe accuracy and completeness of such statements in the future, and we do notundertake to update or revise any forward-looking statements to reflect futureevents or new information.

 

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

 

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

 

·                  Growth of uninsured andunderinsured patients;

 

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

 

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

 

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

 

·                  Healthcare costs;

 

·                  Our ability to maintainrequired working capital;

 

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

 

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

 

·                  Reliance on key executivemanagement and key physicians;

 

·                  Labor costs;

 

·                  Competition;

 

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

 

·                  Economic trends generallyand local economic conditions in Southern California;

 

·                  Medical malpractice claimsand HMO bad-faith liability claims;

 

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

 

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

 

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

 

Investors should also refer to our Form 10-K annual report filedwith the Securities and Exchange Commission on December 29, 2008 for adiscussion of risk factors and Form 8-K filed on July 8, 2009. A copyof the Form 10-K annual report and Form 8-K filed on July 8,2009 can be found on the internet at *www.prospectmedicalholdings.com*or through the SEC’s electronic data system called EDGAR at *www.sec.gov*. Given these risks anduncertainties, we can give no assurances that results projected in any forward-lookingstatements will in fact occur and therefore caution investors not to placeundue reliance on them.

 

**Overview**

 

Prior to the acquisition of Alta and Brotman, we were primarily ahealthcare management services organization that provided medical managementsystems and services to affiliated medical organizations, primarily IndependentPhysician Associations. With the acquisition of Alta and Brotman, we now ownand operate five hospitals in Southern California and our operations are noworganized into three reporting segments: Hospital Services, IPA and Corporate.The Hospital Services segment includes the results of operations and financialposition of Brotman beginning April 14, 2009.

 

**Hospital Services Segment**

 

The Hospital Servicessegment owns and operates five hospitals in Los Angeles County with a total ofapproximately 759 licensed beds served by 787 on-staff physicians at June 30,2009. Each of the community hospitals in Hollywood, Los Angeles, Norwalk andCulver City offers a comprehensive range of medical and surgical services,including inpatient, outpatient, skilled nursing and urgent care services. Thepsychiatric hospital in Van Nuys provides acute inpatient and outpatientpsychiatric services to patients admitted on a voluntary basis. Admittingphysicians are primarily practitioners in the local area. The hospitals havepayment arrangements with Medicare, Medi-Cal and other third-party payersincluding some commercial insurance carriers, HMOs and Preferred ProviderOrganizations (“PPOs”). The basis for such payments involving inpatient andoutpatient services rendered includes prospectively determined rates perdischarge and cost-reimbursed methodologies. The Alta hospitals are eligible toreceive additional Disproportionate Share Hospital Program (“DSH”) paymentadjustments from Medicare and Medi-Cal based on a prospective payment systemfor hospitals that serve large proportions of low-income patients. The Brotman hospital is eligible to receiveDSH payment adjustments from Medicare and supplemental Distressed Hospital Fund paymentsfrom the California Medical Assistance Commission (“CMAC”).

 

Operating revenue of our Hospital Services segment consists primarilyof payments for services rendered, including estimated retroactive adjustmentsunder reimbursement arrangements with third-party payers. In some cases,reimbursement is based on formulas and reimbursable amounts are not consideredfinal until cost reports are filed and audited or otherwise settled by thevarious programs. We accrue for amounts that we believe will ultimately be dueto or from Medicare and other third-party payers and report such amounts as netpatient revenues in the accompanying financial statements. We closely monitorour historical collection rates, as well as changes in applicable laws, rules andregulations and contract terms, to assure that provisions are made using themost accurate information available. However, due to the complexities involvedin these estimations, actual payments from payers may be materially differentfrom the amounts we estimate and record. A summary of the payment arrangementswith major third-party payers follows:

 

*Medicare: *Medicare is a federalprogram that provides certain hospital and medical insurance benefits topersons aged 65 and over, some disabled persons with end-stage renal diseaseand certain other beneficiary categories. Inpatient services rendered toMedicare program beneficiaries are paid at prospectively determined rates perdischarge, according to a patient classification system based on clinical,diagnostic, and other factors. Outpatient services are paid based on a blend ofprospectively determined rates and cost-reimbursed methodologies. We are alsoreimbursed for various disproportionate share and Medicare bad debt componentsat tentative rates, with final settlement determined after submission of annualMedicare cost reports and audit thereof by the Medicare fiscal intermediary.Normal estimation differences between final settlements and amounts accrued inprevious years are reflected in net patient service revenue in the year offinal settlement.

 

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

 

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

 

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

 

Hospital revenues depend upon inpatient occupancy levels, the medicaland ancillary services and therapy programs ordered by physicians and providedto patients, the volume of outpatient procedures and the charges or negotiatedpayment rates for such services. Charges and reimbursement rates for inpatientroutine services vary depending on the type of services provided (e.g., medical/surgical,intensive care or behavioral health) and the geographic location of thehospital. Inpatient occupancy levels fluctuate for various reasons, many ofwhich are beyond our control. The percentage of patient service revenue attributableto outpatient services has generally increased in recent years, primarily as aresult of advances in medical technology that allow more services to beprovided on an outpatient basis, as well as increased pressure from Medicare,Medi-Cal and private insurers to reduce hospital stays and provide services,where possible, on a less expensive outpatient basis. We believe that ourexperience with respect to our increased outpatient levels mirrors the generaltrend occurring in the healthcare industry and we are unable to predict therate of growth and resulting impact on our future revenues.

 

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

 

Operating expenses of our Hospital Services segment generally consistof salaries, benefits and other compensation paid to physicians and healthcareprofessionals that are employees of our hospitals; medical supplies; consultantand professional services; and provision for doubtful accounts.

 

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

 

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**Hospital Services Results of Operations**

 

Thefollowing table sets forth the results of operation for our hospitals and isused in the discussion below for the three-month and the nine-month periodsended June 30, 2009 and 2008 (in thousands).

 
|                                            |       | **Three  Months Ended** |       | **%**        |       | **Nine  Months Ended** |       | **%**        |       |
|-------------------------------------------------|------------|-------------------------|------------|--------------|------------|------------------------|------------|--------------|------------|
| ** **                                      | ** ** | **June 30,**       | ** ** | **Increase** | ** ** | **June 30,**      | ** ** | **Increase** | ** ** |
| ** **                                      | ** ** | **2009**                | ** ** | **2008**     | ** ** | **(Decrease)**         | ** ** | **2009**     | ** ** | **2008** | ** ** | **(Decrease)** | ** ** |
| **Net Hospital Services revenues:**             |       |                    |       |         |       |                   |       |         |       |   |   |   |   |
| Medicare                                        |       | $                       | 30,734     |         | $          | 16,182                 |       | 89.9         | %          | $ | 65,493 |   | $ | 48,352 |   | 35.5 | % |
| Medi-Cal                                        |       | 22,766                  |       | 12,785       |       | 78.1                   | %          | 56,344       |       | 36,852 |   | 52.9 | % |
| Managed care                                    |       | 8,383                   |       | 1,546        |       | 442.3                  | %          | 11,377       |       | 3,203 |   | 255.3 | % |
| Self pay                                        |       | 3,808                   |       | 529          |       | 619.8                  | %          | 4,940        |       | 1,467 |   | 236.7 | % |
| Other                                           |       | 780                     |       | 371          |       | 110.2                  | %          | 1,547        |       | 1,223 |   | 26.5 | % |
| **Total Hospital Services revenues**            |       | 66,470                  |       | 31,413       |       | 111.6                  | %          | 139,701      |       | 91,096 |   | 53.4 | % |
| **Hospital operating expenses:**                |       |                    |       |         |       |                   |       |         |       |   |   |   |   |
| Salaries, wages and benefits                    |       | 29,461                  |       | 15,263       |       | 93.0                   | %          | 61,278       |       | 44,205 |   | 38.6 | % |
| Other operating expenses                        |       | 6,280                   |       | 1,939        |       | 223.9                  | %          | 10,715       |       | 5,474 |   | 95.7 | % |
| Supplies expense                                |       | 6,360                   |       | 2,306        |       | 175.8                  | %          | 10,738       |       | 6,483 |   | 65.6 | % |
| Provision for doubtful accounts                 |       | 8,577                   |       | 948          |       | 804.7                  | %          | 12,286       |       | 2,809 |   | 337.4 | % |
| Lease and rental expense                        |       | 599                     |       | 308          |       | 94.5                   | %          | 1,264        |       | 761 |   | 66.1 | % |
| **Total Hospital Services operating  expenses** |       | 51,278                  |       | 20,764       |       | 147.0                  | %          | 96,281       |       | 59,732 |   | 61.2 | % |
| General and administrative expenses             |       | 6,597                   |       | 3,219        |       | 104.9                  | %          | 12,813       |       | 8,755 |   | 46.4 | % |
| Depreciation and amortization expense           |       | 1,270                   |       | 1,020        |       | 24.5                   | %          | 3,097        |       | 3,085 |   | 0.4 | % |
| Total non-medical expenses                      |       | 7,866                   |       | 4,239        |       | 85.6                   | %          | 15,911       |       | 11,840 |   | 34.4 | % |
| **Operating income**                            |       | $                       | 7,327      |         | $          | 6,410                  |       | 14.3         | %          | $ | 27,509 |   | $ | 19,524 |   | 40.9 | % |

 

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

 
| ** **                                      | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------|------------|
| ** **                                      | ** ** | **2009**                                    | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Net Hospital Services revenues:**             |       |                                        |       |                                 |       |   |   |   |   |
| Medicare                                        |       | 46.2                                        | %          | 51.5                                 | %          | 46.9 | % | 53.1 | % |
| Medi-Cal                                        |       | 34.2                                        | %          | 40.7                                 | %          | 40.3 | % | 40.5 | % |
| Managed care                                    |       | 12.6                                        | %          | 4.9                                  | %          | 8.1 | % | 3.5 | % |
| Self pay                                        |       | 5.7                                         | %          | 1.7                                  | %          | 3.5 | % | 1.6 | % |
| Other                                           |       | 1.3                                         | %          | 1.2                                  | %          | 1.2 | % | 1.3 | % |
| **Total Hospital Services revenues**            |       | 100.0                                       | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
| **Hospital Services operating  expenses:**      |       |                                        |       |                                 |       |   |   |   |   |
| Salaries, wages and benefits                    |       | 44.3                                        | %          | 48.6                                 | %          | 43.9 | % | 48.5 | % |
| Other operating expenses                        |       | 9.4                                         | %          | 6.2                                  | %          | 7.7 | % | 6.0 | % |
| Supplies expense                                |       | 9.6                                         | %          | 7.3                                  | %          | 7.7 | % | 7.1 | % |
| Provision for doubtful accounts                 |       | 12.9                                        | %          | 3.0                                  | %          | 8.8 | % | 3.1 | % |
| Lease and rental expense                        |       | 0.9                                         | %          | 1.0                                  | %          | 0.9 | % | 0.8 | % |
| **Total Hospital Services operating  expenses** |       | 77.1                                        | %          | 66.1                                 | %          | 69.0 | % | 65.5 | % |
| General and administrative expenses             |       | 9.9                                         | %          | 10.2                                 | %          | 9.2 | % | 9.6 | % |
| Depreciation and amortization expense           |       | 1.9                                         | %          | 3.2                                  | %          | 2.2 | % | 3.4 | % |
| Total non-medical expenses                      |       | 11.8                                        | %          | 13.5                                 | %          | 11.4 | % | 13.0 | % |
| **Operating income**                            |       | 11.1                                        | %          | 20.5                                 | %          | 19.6 | % | 21.5 | % |

 

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Thefollowing table shows certain selected historical operating statistics for ourhospitals for the three-month and the nine-month periods ended June 30,2009 and 2008:

 
| ** **                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                      | ** ** | **2009 (5)**                          | ** ** | **2008**                             | ** ** | **2009 (5)** | ** ** | **2008** | ** ** |
| Net inpatient revenues (in thousands) (1)       |       | $                                     | 59,039     |                                 | $          | 29,664 |   | $ | 127,839 |   | $ | 84,914 |   |
| Net outpatient revenues (in thousands) (1)      |       | $                                     | 6,651      |                                 | $          | 1,377 |   | $ | 10,315 |   | $ | 4,959 |   |
| Other hospital services revenues (in thousands) |       | $                                     | 780        |                                 | $          | 371 |   | $ | 1,547 |   | $ | 1,223 |   |
| Number of hospitals at end of period            |       | 5                                     |       | 4                                    |       | 5 |   | 4 |   |
| Licensed beds at end of the period              |       | 759                                   |       | 339                                  |       | 759 |   | 339 |   |
| Average licensed beds                           |       | 759                                   |       | 339                                  |       | 759 |   | 339 |   |
| Average available beds                          |       | 616                                   |       | 331                                  |       | 616 |   | 331 |   |
| Admissions(2)                                   |       | 5,451                                 |       | 3,560                                |       | 12,675 |   | 10,616 |   |
| Adjusted patient admissions(3)                  |       | 6,056                                 |       | 3,752                                |       | 13,655 |   | 11,295 |   |
| Net inpatient revenue per admission             |       | $                                     | 10,831     |                                 | $          | 8,332 |   | $ | 10,086 |   | $ | 7,999 |   |
| Patient days                                    |       | 36,800                                |       | 22,127                               |       | 84,329 |   | 63,747 |   |
| Adjusted patient days                           |       | 40,072                                |       | 22,901                               |       | 90,625 |   | 67,683 |   |
| Average length of patients’ stay (days)    |       | 6.3                                   |       | 5.6                                  |       | 4.5 |   | 5.5 |   |
| Net inpatient revenue per patient day           |       | $                                     | 1,604      |                                 | $          | 1,341 |   | $ | 1,516 |   | $ | 1,332 |   |
| Outpatient visits                               |       | 10,930                                |       | 5,000                                |       | 21,109 |   | 15,253 |   |
| Net outpatient revenue per visit                |       | $                                     | 609        |                                 | $          | 275 |   | $ | 489 |   | $ | 325 |   |
| Occupancy rate for licensed beds(4)             |       | 52.7                                  | %          | 71.7                                 | %          | 40.7 | % | 68.6 | % |
| Occupancy rate for available beds(4)            |       | 64.9                                  | %          | 73.5                                 | %          | 50.2 | % | 70.3 | % |

 

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(1)                                  Net inpatientrevenues and net outpatient revenues are components of net patient revenues.Net inpatient revenues for the three and the nine months ended June 30,2009 and 2008, include self-pay revenues of $3,309,000, $4,306,000, $508,000and $1,387,000, respectively. Net outpatient revenues for the three and thenine months ended June 30, 2009 and 2008 include self-pay revenues of $100,000,$581,000, $634,000, $24,000  and $81,000,respectively.

 

(2)                              Charity careadmissions represent 0.6%, 0.6%, 0.6% and 0.4% of total admissions for thethree and the nine months ended June 30, 2009 and 2008, respectively.

 

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

 

(4)                                  Utilization oflicensed beds represents patient days divided by average licensed beds dividedby number of days in the period.  Occupancyrates are affected by many factors, including the population size and generaleconomic conditions within particular market service areas, the degrees ofvariation in medical and surgical products, outpatient use of hospitalservices, quality and treatment availability at competing hospitals andseasonality.

 

(5)                                  The aboveamounts include Brotman operating results since April 14, 2009, when theCompany acquired a majority stake in Brotman.

 

***Three Months Ended June 30,2009 Compared to Three Months Ended June 30, 2008***

 

*Net Hospital Services Revenues*

 

Net inpatient revenues for the three months ended June 30, 2009were approximately $59,039,000, representing an increase of approximately$29,375,000 or 99.0% from net inpatient revenues for the three months ended June 30,2008, of approximately $29,664,000. Brotman, which results were included since April 14,2009, accounted for $24,652,000 or 83.9% of the increase.

 

Excluding Brotman, same hospital net inpatient revenues increased byapproximately $4,723,000 or 15.9% during fiscal 2009 period as compared to fiscal 2008 period. The increase was due toincreases in both Medicare and Medi-Cal reimbursement rates of approximately7.0% and increases in total admissions.

 

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Same-hospital admissions, excluding the effect of Brotman, for thethree months ended June 30, 2009 increased by approximately 3.8% comparedto the three months ended June 30, 2008 primarily due to net volumeincreases in many of the service lines emphasized by our targeted growthinitiative.

 

Net outpatient revenues for the three months ended June 30, 2009were approximately $6,651,000, representing an increase of approximately $5,274,000or 383.0% from net outpatient revenues for the three months ended June 30,2008, of approximately $1,377,000. Brotman, which results were included since April 14,2009, accounted for $4,823,000 or 91.4% of the increase.

 

Excluding Brotman, same hospital net outpatient revenues increased byapproximately $452,000 or 32.8%.  Theincrease was due to increases in outpatient visits and higher reimbursementrates.

 

*Salaries, Wages and Benefits*

 

Salaries, wages and benefits for the three months ended June 30,2009 were approximately $29,461,000, representing an increase of approximately$14,198,000 or 93.0% from salaries, wages and benefits for the three monthsended June 30, 2008, of approximately $15,263,000. Brotman, which resultswere included since April 14, 2009, accounted for $13,065,000 or 92.0% ofthe increase.

 

Excluding Brotman, same hospital salaries, wages and benefits expenseas a percentage of Alta’s net Hospital Services revenues for the three monthsended June 30, 2009 was 44.8%, representing a decrease of 7.7% compared to48.6% for the three months ended June 30, 2008. Same hospital salaries,wages and benefits per adjusted patient day for the three months ended June 30,2009 was approximately $659 representing a decrease of 1.1% compared to $666for the three months ended June 30, 2008. The decrease is primarily due toproductivity gained through efficiencies, partially offset by merit increasesfor our employees.

 

Asof June 30, 2009, approximately 4.5% and 79%, of the total employees atour Alta and Brotman hospitals were represented by labor unions, respectively.Labor relations at our hospital facilities generally have been satisfactory. The collectivebargaining agreement entered into between Hollywood CommunityHospital, which is one of the hospitals under the consolidated group of AltaHospitals System, LLC, and Service Employees InternationalUnion (“SEIU”), covers a small group of Hollywood Community Hospital’semployees and will expire on May 9, 2011. The collectivebargaining agreements entered into between Brotman and the California NursesAssociation (“CNA”), and Brotman and the SEIU both expire on February 28,2010. We do not anticipate that any changes in these agreements will have amaterial adverse effect on results of our Hospital Services operations infiscal 2009.

 

*Other Operating Expenses*

 

Other operating expense for the three months ended June 30, 2009was approximately $6,280,000, representing an increase of $4,341,000 or 223.9%from other operating expense for the three months ended June 30, 2008, ofapproximately $1,939,000. Brotman, which results were included since April 14,2009, accounted for $4,317,000 or 99.5% of the increase.

 

Excluding Brotman, Alta’s same hospital other operating expense as apercentage of Alta’s net Hospital Services revenue for the three months ended June 30,2009 was approximately 5.4%, representing a decrease of 13.1%, compared to 7.3%for the three months ended June 30, 2008. Same hospital other operatingexpenses per adjusted patient day decreased approximately 6.8% to $79 in thethree months ended June 30, 2009 compared to $85 for the same period infiscal 2008. The decrease was due primarily to a change in estimate relating toa certain vendor in the fiscal 2008 period.

 

*Supplies Expense*

 

Supplies expense for the three months ended June 30, 2009 wasapproximately $6,360,000, representing an increase of approximately $4,054,000or 175.8% from supplies expense for the three months ended June 30, 2008,of approximately $2,306,000. Brotman, which results were included since April 14,2009, accounted for $4,097,000 or 101.0% of the increase.

 

Excluding Brotman, Alta’s same hospital supplies expense as apercentage of Alta’s net Hospital Services revenue for the three months ended June 30,2009 was 6.2% representing a decrease of 15.7% compared to 7.3% for the threemonths ended June 30, 2008. Same hospital supplies expense per adjustedpatient day for the three months ended June 30, 2009 was approximately $91,representing a decrease of 9.7%, compared to approximately $101 for the threemonths ended June 30, 2008. This decrease in supplies expense per adjustedpatient day reflects improved efficiencies gained through continued focus onsupply management. We strive to control supplies expense through productstandardization, bulk purchases, contract compliance, improved utilization andoperational improvements.

 

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*Provision for Doubtful Accounts*

 

The provision for doubtful accounts as a percentage of net HospitalServices revenues was 12.9% for the three months ended June 30, 2009compared to 3.0% for three months ended June 30, 2008. Brotman, whichresults were included since April 14, 2009, accounted for 83.67% of theincrease.

 

Excluding Brotman, Alta’s hospital provision for doubtful accounts as apercentage of Alta’s net Hospital Services revenue for the three months ended June 30,2009 was approximately 6.0%, representing an increase of 100%, compared to 3.0%for the three months ended June 30, 2008. The increase was due to anunusually low percentage in the prior year period, associated with refinementsin the Company’s bad debt write off and contractual allowance recording.

 

*Lease and Rental Expense*

 

Lease and rental expense for the three months ended June 30, 2009was approximately $599,000, representing an increase of approximately $291,000or 94.5% from lease and rental expense for the three months ended June 30,2008, of approximately $308,000. Brotman, which results were included since April 14,2009, accounted for $177,000 or 60.7% of the increase.

 

Excluding Brotman, same hospital lease and rental expense as apercentage of Alta’s net Hospital Services revenue for the three months ended June 30,2009 remained unchanged at approximately 1.0% compared to the three monthsended June 30, 2008. Included in lease and rental expenses were operatinglease arrangements for our administrative offices with terms expiring atvarious dates through 2015. The office space is shared with Prospect.

 

*General and Administrative Expense*

 

General and administrative expense for the three months ended June 30,2009 was approximately $6,597,000, representing an increase of approximately$3,378,000 or 104.9% from general and administrative expense for the threemonths ended June 30, 2008, of approximately $3,219,000. Brotman, whichresults were included since April 14, 2009, accounted for $3,333,000 or98.7% of the increase.

 

Excluding Brotman, same hospital general and administrative expense asa percentage of Alta’s net Hospital Services revenue for the three months endedJune 30, 2009 was 8.9%, representing a decrease of approximately 12.4%,compared to 10.2% for the three months ended June 30, 2008. Included ingeneral and administrative, or “G&A”, expenses were consulting and outsideservices, supplies, insurance, utilities, taxes and licenses, and maintenancewhich accounted for approximately 95.3% of the total expenses in the threemonths ended June 30, 2009, as compared to 91.7% for the three monthsended June 30, 2008.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended June 30,2009 was approximately $1,270,000, representing an increase of approximately$250,000 or 24.5% from depreciation and amortization expense for the threemonths ended June 30, 2008, of approximately $1,020,000. Brotman, whichresults were included since April 14, 2009, accounted for $263,000 or 105.2%of the increase.

 

Excluding Brotman, depreciation and amortization expenses as apercentage of Alta’s net Hospital Services revenues for the three months ended June 30,2009 were approximately 2.9%, representing a decrease of 19.7%, compared to3.2% for the three months ended June 30, 2008. Included in depreciationand amortization expense was amortization of identifiable intangibles ofapproximately $317,000 and $317,000 in the three months ended June 30,2009 and 2008, respectively. During the three months ended June 30, 2009and 2008, total capital expenditures incurred of approximately $129,000 and$370,000, respectively, were within our budgeted expectations.

 

*Operating Income*

 

Our Hospital Services segment reported operating income ofapproximately $7,327,000 and $6,410,000 for the three months ended June 30,2009 and 2008, respectively, which increase was the result of the changesdiscussed above. The pre-tax operating results from the Hospital Servicessegment include certain corporate expense allocations for insurance,professional fees, and amortization of identifiable intangibles.

 

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***Nine Months Ended June 30, 2009Compared to Nine Months Ended June 30, 2008***

 

*Net Hospital Services Revenues*

 

Net inpatient revenues for the nine months ended June 30, 2009were approximately $127,839,000, representing an increase of approximately $42,925,000or 50.6% from net inpatient revenues for the nine months ended June 30,2008, of approximately $84,914,000. Brotman, which results were included since April 14,2009, accounted for $24,652,000 or 57.4% of the increase.

 

Excluding Brotman, same hospital net inpatient revenues increased byapproximately $18,273,000 or 21.5% during fiscal 2009 period as compared tofiscal 2008 period. The increase was due to increases in both Medicare andMedi-Cal reimbursement rates of approximately 7.0%, and increases in totaladmissions.

 

Same-hospital admissions, excluding the effect of Brotman, for the ninemonths ended June 30, 2009 increased by 2.8% compared to the nine monthsended June 30, 2008 primarily due to net volume increases in many of theservice lines emphasized by our targeted growth initiative.

 

Net outpatient revenues for the nine months ended June 30, 2009were approximately $10,315,000, representing an increase of approximately$5,356,000 or 108.0% from net outpatient revenues for the nine months ended June 30,2008, of approximately $4,959,000. Brotman, which results were included since April 14,2009, accounted for $4,823,000 or 90.0% of the increase.

 

Excluding Brotman, same hospital net outpatient revenues increased byapproximately $533,000 or 10.7%.  Theincrease was due to increases in outpatient visits and higher reimbursementrates.

 

*Salaries, Wages and Benefits*

 

Salaries, wages and benefits for the nine months ended June 30,2009 were approximately $61,278,000, representing an increase of approximately$17,073,000 or 38.6% from salaries, wages and benefits for the nine monthsended June 30, 2008, of approximately $44,205,000. Brotman, which resultswere included since April 14, 2009, accounted for $13,065,000 or 76.5% ofthe increase.

 

Excluding Brotman, same hospital salaries, wages and benefits expenseas a percentage of Alta’s net Hospital Services revenues for the nine monthsended June 30, 2009 were approximately 43.9%, representing a decrease of9.5% compared to 48.5% for the nine months ended June 30, 2008. Samehospital salaries, wages and benefits per adjusted patient day for the ninemonths ended June 30, 2009 was approximately $639, representing a decreaseof 2.1% compared to $653 for the nine months ended June 30, 2008. Thedecrease is primarily due to productivity gained through efficiencies,partially offset by merit increases for our employees.

 

Asof June 30, 2009, approximately 4.5% and 79% of the total employees at ourAlta and Brotman hospitals were represented by labor unions, respectively.Labor relations at our hospital facilities generally have been satisfactory. The collectivebargaining agreement entered into between Hollywood CommunityHospital, which is one of the hospitals under the consolidated group of AltaHospitals System, LLC, and  Service Employees International Union (“SEIU”),covers a small group of Hollywood Community Hospital’s employees and will expire on May 9,2011. The collective bargaining agreements entered into between Brotman and theCalifornia Nurses Association (“CNA”), and Brotman and the SEIU both expire on February 28,2010. We do not anticipate that any changes in these agreements will have amaterial adverse effect on results of our Hospital Services operations infiscal 2009.

 

*Other Operating Expenses*

 

Other operating expenses for the nine months ended June 30, 2009were approximately $10,715,000, representing an increase of approximately$5,241,000 or 95.8% from other operating expense for the nine months ended June 30,2008, of approximately $5,474,000. Brotman, which results were included since April 14,2009, accounted for $4,317,000 or 82.4% of the increase.

 

Excluding Brotman, Alta’s same hospital other operating expense as apercentage of Alta’s net Hospital Services revenue for the nine months ended June 30,2009 was approximately 5.8%, representing a decrease of 3.8%, compared to 6.0%for the nine months ended June 30, 2008. Same hospital other operatingexpenses per adjusted patient day increased approximately 4.4% to $84 in thenine months ended June 30, 2009 compared to $81 for the same period infiscal 2008.  The increase was due to adecrease in malpractice expense, primarily attributable to improved claimsexperience and a change in estimate relating to a certain vendor in the fiscal2008 period.

 

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*Supplies Expense*

 

Supplies expense for the nine months ended June 30, 2009 wasapproximately $10,738,000, representing an increase of approximately $4,255,000or 65.6% from supplies expense for the nine months ended June 30, 2008, ofapproximately $6,483,000. Brotman, which results were included since April 14,2009, accounted for $4,097,000 or 96.3% of the increase.

 

Excluding Brotman, same hospital supplies expense as a percentage ofAlta’s net Hospital Services revenue for the nine months ended June 30,2009 was approximately 6.0%, representing a decrease of 15.0%, compared to 7.1%for the nine months ended June 30, 2008. Same hospital supplies expenseper adjusted patient day for the nine months ended June 30, 2009 wasapproximately $88, representing a decrease of 8.1%, compared to approximately$96 for the nine months ended June 30, 2008. This decrease in suppliesexpense per adjusted patient day reflects improved efficiencies gained throughcontinued focus on supply management. We strive to control supplies expensethrough product standardization, bulk purchases, contract compliance, improvedutilization and operational improvements.

 

*Provision for Doubtful Accounts*

 

The provision for doubtful accounts as a percentage of net HospitalServices revenues was 8.8% for the nine months ended June 30, 2009compared to 3.1% for nine months ended June 30, 2008. Brotman, whichresults were included since April 14, 2009, accounted for 67.3% of theincrease.

 

Excluding Brotman, same hospital provision for doubtful accounts as apercentage of Alta’s net Hospital Services revenue for the nine months ended June 30,2009 was approximately 5.4%, representing an increase of 74.4%, compared to3.1% for the nine months ended June 30, 2008. The increase was due to anunusually low percentage in the prior year period, associated with refinementsin the Company’s bad debt write off and contractual allowance recording.

 

*Lease and Rental Expense*

 

Lease and rental expense for the nine months ended June 30, 2009was approximately $1,264,000, representing an increase of approximately$503,000 or 66.1% from lease and rental expense for the nine months ended June 30,2008, of approximately $761,000. Brotman, which results were included since April 14,2009, accounted for $177,000 or 35.1% of the increase.

 

Excluding Brotman, same hospital lease and rental expense as apercentage of Alta’s net Hospital Services revenue for the nine months ended June 30,2009 was 1.0%, representing an increase of 13.9%, compared to 0.8% for the ninemonths ended June 30, 2008. Included in lease and rental expenses wereoperating lease arrangements for our administrative offices with terms expiringat various dates through 2015. The office space is shared with Prospect.

 

*General and Administrative Expense*

 

General and administrative, or “G&A” expense for the nine monthsended June 30, 2009 was approximately $12,813,000, representing anincrease of approximately $4,058,000 or 46.4% from general and administrativeexpense for the nine months ended June 30, 2008, of approximately$8,755,000. Brotman, which results were included since April 14, 2009,accounted for $3,333,000 or 82.1% of the increase.

 

Excluding Brotman, same hospital general and administrative expense asa percentage of Alta’s net Hospital Services revenue for the nine months ended June 30,2009 was 8.6%, representing a decrease of 10.7%, compared to 9.6% for the ninemonths ended June 30, 2008. Included in general and administrativeexpenses were consulting and outside services, supplies, insurance, utilities,taxes and licenses, and maintenance which accounted for approximately 96.2% ofthe total expenses in the nine months ended June 30, 2009, as compared to93.2% for the nine months ended June 30, 2008.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the nine months ended June 30,2009 was approximately $3,097,000, representing an increase of approximately$12,000 or 0.4% from depreciation and amortization expense for the nine monthsended June 30, 2008, of approximately $3,085,000. Brotman, which resultswere included since April 14, 2009, accounted for $263,000 or 2,192.5% ofthe increase.

 

Excluding Brotman, depreciation and amortization expenses as apercentage of Alta’s net Hospital Services revenues for the nine months ended June 30,2009 were approximately 2.3%, representing a decrease of 32.3%, compared to3.4% for the nine months ended June 30, 2008. Included in depreciation andamortization expense was amortization of identifiable intangibles ofapproximately 

 

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$950,000and $950,000 in the nine months ended June 30, 2009 and 2008,respectively. During the nine months ended June 30, 2009 and 2008, totalcapital expenditures incurred of approximately $562,000 and $1,220,000,respectively, were within our budgeted expectations.

 

*Operating Income*

 

Our Hospital Services segment reported an operating income ofapproximately $27,509,000 and $19,524,000 for the nine months ended June 30,2009 and 2008, respectively, which increase was the result of the changesdiscussed above. The pre-tax operating results from the Hospital Servicessegment include certain corporate expense allocations for insurance,professional fees, and amortization of identifiable intangibles.

 

**IPA Segment**

 

The IPA segment is a healthcare management services organization thatprovides management services to affiliated physician organizations that operateas independent physician associations. The affiliated physician organizationsenter into agreements with HMOs to provide HMO enrollees with a full range ofmedical services in exchange for fixed, prepaid monthly fees known as “capitation”payments. The IPAs contract with physicians (primary care and specialist) andother healthcare providers to provide all necessary medical services.

 

Through our management subsidiaries—Prospect Medical Systems, Inc.(“PMS”), Sierra Medical Management (through August 1, 2008) and ProMedHealth Care Administrators—we have entered into long-term agreements to providemanagement services to each of our affiliated physician organizations inexchange for a management fee. The management services we provide include HMOcontracting, physician recruiting, credentialing and contracting, humanresources services, claims administration, financial services, providerrelations, patient eligibility and other services, medical management includingutilization management and quality assurance, data collection, and managementinformation systems.

 

Effective August 1, 2008, we sold all of the issued andoutstanding stock of the AV Entities. The assets, liabilities and operatingresults of the AV Entities have been classified as discontinued operations andare excluded from the disclosures below.

 

Our management subsidiaries currently provide management services toten affiliated physician organizations, which include PMG, Nuestra FamiliaMedical Group, Inc. (“Nuestra”), seven other affiliated physicianorganizations that PMG owns or controls, and one affiliated physicianorganization (AMVI/Prospect Health Network) that is an unconsolidated jointventure in which PMG owns a 50% interest. PMG, which was our first affiliatedphysician organization, has acquired the ownership interest in all of our otheraffiliated physician organizations, except Nuestra.  Both PMG and Nuestra are owned by ourphysician shareholder nominee, Dr. Arthur Lipper, and controlled throughassignable option agreements and management services agreements (see Note 6 tothe Notes to Condensed Consolidated Financial Statements).  While PMG is itself an affiliated physicianorganization that does the same business in its own service area as all of ourother affiliated physician organizations do in theirs, PMG also serves as aholding company for our other affiliated physician organizations, exceptNuestra.

 

The ten affiliated physician organizations provided medical services toa combined total of approximately 178,500 HMO enrollees at June 30, 2009,including approximately 9,600 AMVI/Prospect Health Network enrollees that wemanage for the economic benefit of an independent third party, and for which weearn management fee income.

 

As of June 30, 2009, our affiliated physician organizations hadcontracts with approximately 21 HMOs, from which our revenue was primarilyderived. HMOs offer a comprehensive healthcare benefits package in exchange fora capitation fee per enrollee that does not vary through the contract periodregardless of the quantity or cost of medical services required or used. HMOsenroll members by entering into contracts with employer groups or directly withindividuals to provide a broad range of healthcare services for a prepaidcharge, with minimal deductibles or co-payments required of the members. All ofthe contracts between our affiliated physician organizations and the HMOsprovide for the provision of medical services by the affiliated physicianorganization to the HMO enrollees in consideration for the prepayment of thefixed monthly capitation fee per enrollee.

 

Our IPA business has grown through the acquisition of IPAs by PMG, andis concentrated in Orange County, California, Los Angeles County, Californiaand San Bernardino County, California.

 

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Managed care revenues consist primarily of fees for medical servicesprovided by our affiliated physician organizations under capitated contractswith HMOs. Capitation revenue under HMO contracts is prepaid monthly to theaffiliates based on the number of covered HMO enrollees. Capitation revenue maybe subsequently adjusted to reflect changes in enrollment as a result ofretroactive terminations or additions. These adjustments have not had amaterial effect on capitation revenue. Capitation revenue is also subject torisk adjustment, whereby capitation with respect to Medicare enrollees issubject to subsequent adjustment for the acuity of the enrollees to whom serviceswere provided. Capitation for the current year is paid based on data submittedfor each enrollee for the preceding year. Capitation is paid at interim ratesduring the year and is adjusted in subsequent periods (generally in the fourthfiscal quarter) after the final data is compiled. Positive or negativecapitation adjustments are made for seniors with conditions requiring more orless healthcare services than assumed in the interim payments. Since we do notcurrently have the ability to reliably predict these adjustments, periodicchanges in capitation amounts earned as a result of Risk Adjustment arerecognized when those changes are communicated from the health plans, generallyin the fourth quarter of the fiscal year to which the adjustments relate.Management fees were primarily comprised of amounts earned from managing theoperations of AMVI, Inc., which is our joint venture partner in theAMVI/Prospect Health Network joint venture, related to Medi-Cal members andMedicare members enrolling in CalOPTIMA’s OneCare HMO. OneCare is a MedicareAdvantage Special Needs Plan launched in August 2005 by CalOPTIMA to servedually-eligible members in Orange County who are entitled to Medicare benefitsand are also Medi-Cal eligible. Management fee revenue is earned in the monththe services are delivered.

 

Managed care revenues also included incentive payments from HMOs under “pay-for-performance”programs for quality medical care based on various criteria. These incentivesare generally received in the third and fourth quarters of our fiscal year andare recorded when such amounts are known since we do not have the informationto independently and reliably estimate these amounts.

 

We also potentially earn additional incentive revenue or incurpenalties under HMO contracts by sharing in the risk for hospitalization basedupon inpatient services utilized. These amounts were included in capitationrevenue. As of June 30, 2009, except for one minor contract where we werecontractually obligated for down-side risk, shared risk deficits were notpayable until and unless we generated future risk-sharing surpluses. Risk poolsare generally settled in the following year. Management estimates risk poolincentives based on information received from the HMOs or hospitals with whomthe risk-sharing arrangements were in place, and who typically maintain theinformation and record keeping related to the risk pool arrangements.Differences between actual and estimated settlements are recorded when thefinal outcome is known. Risk pool and pay-for-performance incentives areaffected by many factors, some of which are beyond our control, and may varysignificantly from year to year.

 

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

 

| ** **                 | ** ** | **As of June 30,** | ** ** |
|----------------------------|------------|-------------------------|------------|
| **Member Category**        | ** ** | **2009**                | ** ** | **2008(2)** | ** ** | **% Increase  (Decrease)** | ** ** |
| Commercial—owned      |       | 136.1                   |       | 157.3 |   | (13.5 | )% |
| Commercial—managed(l) |       | 1.3                     |       | 1.4 |   | (7.1 | )% |
| Senior—owned          |       | 21.3                    |       | 19.5 |   | 9.2 | % |
| Senior—managed(1)     |       | 0.1                     |       | 0.1 |   | 0.0 | % |
| Medi-Cal—owned(3)     |       | 11.5                    |       | 16.0 |   | (28.1 | )% |
| Medi-Cal—managed(1)   |       | 8.2                     |       | 7.5 |   | 9.3 | % |
| Total                      |       | 178.5                   |       | 201.8 |   | (11.5 | )% |

 

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

 

(2)           The aboveamounts exclude HMO enrollment related to the AV Entities, given theirclassification as discontinued operations.

 

(3)           The Companycancelled certain unprofitable Medi-Cal contracts during fiscal 2008.

 

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The following table details total paid member months, by membercategory, for the three-month and nine-month periods ended June 30, 2009and 2008 (in thousands):

 
| ** **              | ** ** | **Three Months Ended  June 30,** | ** ** | **% Increase** | ** ** | **Nine Months Ended  June 30,** | ** ** | **% Increase** | ** ** |
|-------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| ** **              | ** ** | **2009**                              | ** ** | **2008(2)**         | ** ** | **(Decrease)**                       | ** ** | **2009**            | ** ** | **2008(2)** | ** ** | **(Decrease)** | ** ** |
| Commercial—owned   |       | 411.7                                 |       | 473.2               |       | (13.0                                | )%         | 1,289.9             |       | 1,475.4 |   | (12.6 | )% |
| Commercial—managed |       | 4.0                                   |       | 4.0                 |       | 0.0                                  | %          | 12.1                |       | 12.0 |   | 0.8 | % |
| Senior—owned       |       | 64.1                                  |       | 57.8                |       | 10.9                                 | %          | 193.7               |       | 194.4 |   | (0.4 | )% |
| Senior—managed (1) |       | 0.4                                   |       | 0.4                 |       | 0.0                                  | %          | 1.2                 |       | 1.3 |   | (7.7 | )% |
| MediCal—owned (3)  |       | 34.9                                  |       | 48.1                |       | (27.4                                | )%         | 102.9               |       | 143.5 |   | (28.3 | )% |
| MediCal—managed(2) |       | 24.3                                  |       | 22.4                |       | 8.5                                  | %          | 71.1                |       | 63.7 |   | 11.6 | % |
|                    |       | 539.4                                 |       | 605.9               |       | (11.0                                | )%         | 1,670.9             |       | 1,890.3 |   | (11.6 | )% |

 

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

 

(2)           The aboveamounts exclude HMO enrollment related to the AV Entities, given theirclassification as discontinued operations.

 

(3)           The Companycancelled certain unprofitable Medi-Cal contracts during fiscal 2008.

 

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

 

Expenses related to medical care services include payments tocontracted primary care physicians, payments to contracted specialists and thecost of employed physicians at our medical clinics (through August 1,2008). In general, primary care physicians are paid on a capitation basis,while specialists are paid on either a capitation or a fee-for-service basis.

 

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

 

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

 

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**IPA Results of Operations**

 

The following tables summarize our net operating revenue, operatingexpenses and operating income from continuing IPA operations and are used inthe discussions below for the three-month and the nine-month periods ended June 30,2009 and 2008. Effective August 1, 2008, we sold the AV Entities’operations. The operating results of the AV Entities are reflected as loss fromdiscontinued operations, net of income tax and are excluded from thedisclosures below for each period presented.

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **% Increase** | ** ** | **Nine Months Ended  June 30,** | ** ** | **% Increase** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|----------------|------------|--------------------------------------|------------|----------------|------------|
| ** **                                | ** ** | **2009**                              | ** ** | **2008**       | ** ** | **(Decrease)**                       | ** ** | **2009**       | ** ** | **2008** | ** ** | **(Decrease)** | ** ** |
| **Managed care revenues:**                |       |                                  |       |           |       |                                 |       |           |       |   |   |   |   |
| Capitation                                |       | $                                     | 47,369     |           | $          | 49,057                               |       | (3.4           | )%         | $ | 143,005 |   | $ | 149,832 |   | (4.6 | )% |
| Management  fees                          |       | 149                                   |       | 150            |       | (0.7                                 | )%         | 437            |       | 404 |   | 8.2 | % |
| Other  revenues                           |       | 330                                   |       | 241            |       | 36.9                                 | %          | 696            |       | 461 |   | 51.0 | % |
| **Total managed care revenues**           |       | 47,848                                |       | 49,448         |       | (3.2                                 | )%         | 144,138        |       | 150,697 |   | (4.4 | )% |
| **Managed care cost of revenues:**        |       |                                  |       |           |       |                                 |       |           |       |   |   |   |   |
| PCP  capitation                           |       | 8,335                                 |       | 8,969          |       | (7.1                                 | )%         | 25,470         |       | 27,964 |   | (8.9 | )% |
| Specialist  capitation                    |       | 10,940                                |       | 10,774         |       | 1.5                                  | %          | 33,086         |       | 31,736 |   | 4.3 | % |
| Claims  expense                           |       | 17,139                                |       | 18,537         |       | (7.5                                 | )%         | 52,301         |       | 59,324 |   | (11.8 | )% |
| Physician  salaries                       |       | 605                                   |       | 858            |       | (29.5                                | )%         | 1,670          |       | 1,625 |   | 2.8 | % |
| Other  cost of revenues                   |       | (51                                   | )          | (165           | )          | (69.2                                | )%         | (992           | )          | (201 | ) | 393.5 | % |
| **Total managed care cost of revenues**   |       | 36,968                                |       | 38,973         |       | (5.1                                 | )%         | 111,535        |       | 120,448 |   | (7.4 | )% |
| **Gross margin**                          |       | 10,880                                |       | 10,475         |       | 3.9                                  | %          | 32,603         |       | 30,249 |   | 7.8 | % |
| General  and administrative expenses      |       | 7,286                                 |       | 7,263          |       | 0.3                                  | %          | 21,961         |       | 22,265 |   | (1.4 | )% |
| Depreciation  and amortization expense    |       | 889                                   |       | 879            |       | 1.1                                  | %          | 2,644          |       | 2,609 |   | 1.3 | % |
| Total  other expenses                     |       | 8,175                                 |       | 8,142          |       | 0.4                                  | %          | 24,605         |       | 24,874 |   | (1.1 | )% |
| Income  from unconsolidated joint venture |       | 535                                   |       | 955            |       | (44.0                                | )%         | 1,482          |       | 2,124 |   | (30.2 | )% |
| **Operating Income**                      |       | $                                     | 3,240      |           | $          | 3,288                                |       | (1.5           | )%         | $ | 9,480 |   | $ | 7,499 |   | 26.4 | % |

 

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

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                | ** ** | **2009**                              | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Managed care revenues:**                |       |                                  |       |                                 |       |   |   |   |   |
| Capitation  revenue                       |       | 99.0                                  | %          | 99.2                                 | %          | 99.2 | % | 99.4 | % |
| Management  fees                          |       | 0.3                                   | %          | 0.3                                  | %          | 0.3 | % | 0.3 | % |
| Other  revenues                           |       | 0.7                                   | %          | 0.5                                  | %          | 0.5 | % | 0.3 | % |
| **Total managed care revenues**           |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 |   |
| **Managed care cost of revenues:**        |       |                                  |       |                                 |       |   |   |   |   |
| PCP  capitation                           |       | 17.4                                  | %          | 18.1                                 | %          | 17.7 | % | 18.6 | % |
| Specialists  capitation                   |       | 22.9                                  | %          | 21.8                                 | %          | 23.0 | % | 21.1 | % |
| Claims  expense                           |       | 35.8                                  | %          | 37.5                                 | %          | 36.3 | % | 39.4 | % |
| Physician  salaries                       |       | 1.3                                   | %          | 1.7                                  | %          | 1.2 | % | 1.1 | % |
| Other  cost of revenues                   |       | (0.1                                  | )%         | (0.3                                 | )%         | (0.7 | )% | (0.1 | )% |
| **Total managed care cost of revenues**   |       | 77.3                                  | %          | 78.8                                 | %          | 77.5 | % | 80.1 | % |
| **Gross margin**                          |       | 22.7                                  | %          | 21.2                                 | %          | 22.5 | % | 19.9 | % |
| General  and administrative expenses      |       | 15.2                                  | %          | 14.7                                 | %          | 15.2 | % | 14.8 | % |
| Depreciation  and amortization expense    |       | 1.9                                   | %          | 1.8                                  | %          | 1.8 | % | 1.7 | % |
| Total  non-medical expenses               |       | 17.1                                  | %          | 16.5                                 | %          | 17.0 | % | 16.5 | % |
| Income  from unconsolidated joint venture |       | 1.1                                   | %          | 1.9                                  | %          | 1.0 | % | 1.4 | % |
| **Operating Income**                      |       | 6.7                                   | %          | 6.6                                  | %          | 6.5 | % | 4.8 | % |

 

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***Three Months Ended June 30, 2009Compared to Three Months Ended June 30, 2008***

 

*Capitation Revenue*

 

Capitation revenue for the three months ended June 30, 2009 wasapproximately $47,369,000, representing a decrease of approximately $1,688,000or 3.4% from capitation revenue for the three months ended June 30, 2008,of approximately $49,057,000.

 

The decrease in the fiscal 2009 period was due to lower enrollment,partially offset by increased capitation rates.

 

*Management Fee Revenue*

 

Management fee revenue for the three months ended June 30, 2009was approximately $149,000, representing a decrease of approximately $1,000 or0.6% from management fee revenue for the three months ended June 30, 2008,of approximately $150,000.

 

The decrease inmanagement fee revenue during the fiscal 2009 period was due to the eliminationon consolidation of the Brotman management fee effective April 14, 2009, offsetby an increase in the number of members of AMVICare Health Network, Inc.,which we manage on their behalf in exchange for a fee.

 

*Other revenue*

 

Other revenue for the three months ended June 30, 2009 wasapproximately $330,000, representing an increase of approximately $89,000 or36.9% over other revenue for the three months ended June 30, 2008, ofapproximately $241,000.

 

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

 

The increase in other revenue during the fiscal 2009 period wasprimarily the result of the timing of pay-for-performance incentives from oneof our contracted Health Plans.

 

*PCP Capitation Expense*

 

Primary care physician (“PCP”) capitation expense for the three monthsended June 30, 2009 was $8,335,000, representing a decrease of $634,000 or7.1% over PCP capitation expense for the three months ended June 30, 2008,of approximately $8,969,000.

 

Member month declines related to our IPA business reduced PCPcapitation expense by approximately $1,061,000 during the fiscal 2009 period,as compared to the fiscal 2008 period. Higher capitation rates increased PCPcapitation expense by approximately $428,000 during the fiscal 2009 period ascompared to the fiscal 2008 period.

 

*Specialist Capitation Expense*

 

Specialist Capitation expense for the three months ended June 30,2009 was approximately $10,940,000, representing an increase of $166,000 or1.5% from specialist capitation expense for the three months ended June 30,2008, of approximately $10,774,000.

 

Higher capitation rates on our IPA business increased specialist capitationexpense by approximately $1,441,000 during the fiscal 2009 period as comparedto the fiscal 2008 period. Member months declines related to our IPA businessreduced specialist capitation expense by approximately $1,275,000 during thefiscal 2009 period, as compared to the fiscal 2008 period.  During fiscal 2009, we also capitated a largeportion of our radiology services at the legacy Prospect IPAs, which hadpreviously been provided on a fee-for-service basis.

 

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*Claims Expense*

 

Claims expense for the three months ended June 30, 2009 wasapproximately $17,139,000, representing a decrease of $1,399,000, or 7.5% overclaims expense for the three months ended June 30, 2008, of approximately$18,537,000.

 

Member month declines related to our IPA business reduced claimsexpense by approximately $2,194,000 in the fiscal 2009 period, as compared tothe fiscal 2008 period. Higher claims per member rates on our IPA business,increased claims expense by approximately $795,000 during the fiscal 2008period as compared to the fiscal 2008 period.

 

*Physician Salaries Expense*

 

Physician salaries expense for the three months ended June 30,2009 was approximately $605,000, representing a decrease of $252,000 or 29.5%over physician salaries expense for the three months ended June 30, 2008,of $858,000.

 

The decrease in physician salaries expense during the fiscal 2009period was primarily the result of the conversion of certain physicians from employmentto capitation basis effective during the third quarter of fiscal 2009 period.

 

*Other Cost of Revenues*

 

Other cost of revenues for the three months ended June 30, 2009was a negative expense of approximately $51,000 compared to a negative expenseof $165,000 for the three months ended June 30, 2008. The negative expenserepresents reinsurance recoveries.

 

*Gross Margin*

 

Medical care costs as a percentage of medical revenues (the medicalcare ratio) largely determine our gross margin. Our gross margin increased to22.7% for the three months ended June 30, 2009, from 21.2% for the threemonths ended June 30, 2008.

 

The increase in our gross margin percentage between the fiscal 2009 and2008 periods was primarily the result of the decreased fee for service claims following a newradiology specialty capitation services agreement, and decreased PCP capitationexpense and lower claims cost per member per month in the fiscal 2009 period,discussed above.

 

*General and Administrative Expense*

 

General and administrative expenses were approximately $7,286,000 forthe three months ended June 30, 2009, representing 15.2% of total IPArevenues, as compared with approximately $7,263,000, or 14.7% of totalrevenues, for the fiscal 2008 period.

 

The increase in general and administrative expenses during the fiscal2009 period was primarily related to increased bonus and legal fee accruals atProMed.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended June 30,2009 increased to approximately $889,000 from $879,000 for the same period ofthe prior year. The increase of $10,000 was primarily due to additionaldepreciation expense for increased capital expenditures.

 

*Income from Unconsolidated Joint Venture*

 

The income from unconsolidated joint venture for the three months endedJune 30, 2009 decreased to $535,000 from $955,000 for the same period ofthe prior year. The decrease resulted from lower accrual of risk poolreceivables due to decreased membership.

 

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*Operating Income*

 

Our IPA segment reported an operating income of approximately$3,240,000 and $3,288,000, for the three months ended June 30, 2009 and2008, respectively, which decrease was the result of the changes discussedabove. The pre-tax operating results from the IPA segment include certaincorporate expense allocations for insurance, professional fees, andamortization of identifiable intangibles.

 

**Nine Months Ended June 30, 2009 Compared to NineMonths Ended June 30, 2008**

 

*Capitation Revenue*

 

Capitation revenue for the nine months ended June 30, 2009 wasapproximately $143,005,000, representing a decrease of approximately $6,827,000or 4.6% from capitation revenue for the nine months ended June 30, 2008,of approximately $149,832,000.

 

The decrease in the fiscal 2009 period was due to lower enrollment, partiallyoffset by increased capitation rates.

 

*Management fee revenue*

 

Management fee revenue for the nine months ended June 30, 2009 wasapproximately $437,000, representing an increase of approximately $32,000 or8.1% from management fee revenue for the nine months ended June 30, 2008,of approximately $404,000.

 

The increase in management fee revenue during the fiscal 2009 periodwas primarily due to an increase in management fee, resulting from an increasein the number of members of AMVICare Health Network, Inc., which we manageon their behalf in exchange for a fee.

 

*Other revenue*

 

Other revenue for the nine months ended June 30, 2009 wasapproximately $696,000, representing an increase of $235,000 or 51% over otherrevenue for the nine months ended June 30, 2008, of approximately$461,000.

 

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

 

The increase in other revenue during the fiscal 2009 period wasprimarily the result of the timing of pay-for-performance incentives from oneof our contracted Health Plans.

 

*PCP Capitation Expense*

 

Primary care physician (“PCP”) capitation expense for the nine monthsended June 30, 2009 was approximately $25,470,000, representing a decreaseof approximately $2,494,000 or 8.9% over PCP capitation expense for the ninemonths ended June 30, 2008, of approximately $27,964,000.

 

Member month declines related to our IPA business reduced PCPcapitation expense by approximately $3,546,000, during the fiscal 2009 period,as compared to the fiscal 2008 period. Higher capitation rates increased PCPcapitation expense by approximately $1,052,000 during the fiscal 2009 period ascompared to the fiscal 2008 period.

 

*Specialist Capitation Expense*

 

Specialist Capitation expense for the nine months ended June 30,2009 was approximately $33,086,000, representing an increase of $1,356,000 or4.3% from specialist capitation expense for the nine months ended June 30,2008, of approximately $31,736,000.

 

Higher capitation rates on our IPA business increased specialistcapitation expense by approximately $5,375,000 during the fiscal 2009 period ascompared to the fiscal 2008 period. Member months declines related to our IPAbusiness reduced specialist capitation expense by approximately $4,025,000during the fiscal 2009 period, as compared to the fiscal 2008 period.  During fiscal 2009, we also capitated a largeportion of our radiology services at the legacy Prospect IPAs, which hadpreviously been provided on a fee-for-service basis.

 

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*Claims Expense*

 

Claims expense for the nine months ended June 30, 2009 wasapproximately $52,301,000, representing a decrease of $7,023,000 or 11.8% overclaims expense for the nine months ended June 30, 2008, of approximately$59,324,000.

 

Member month declines related to our IPA business reduced claimsexpense by approximately $7,523,000 in the fiscal 2009 period, as compared tothe fiscal 2008 period. Higher claims per member rates on our IPA business,increased claims expense by approximately $500,000 during the fiscal 2008 periodas compared to the fiscal 2008 period.

 

*Physician Salaries Expense*

 

Physician salaries expense for the nine months ended June 30, 2009was approximately $1,670,000, representing an increase of $45,000 or 2.8%,compared to physician salaries expense for the nine months ended June 30,2008 of approximately $1,625,000.

 

The increase in physician salaries expense wasprimarily the result of an increase in bonus accrual, offset by a decrease inphysician salaries as a result of the conversion of certain physicians fromemployment to capitation basis effective during the third quarter of fiscal2009 period.

 

*Other Cost of Revenues*

 

Other cost of revenues for the nine months ended June 30, 2009 wasa negative expense of approximately $992,000 compared to a negative expense ofapproximately $201,000 for the nine months ended June 30, 2008. Thenegative expense represents reinsurance recoveries.

 

*Gross Margin*

 

Medical care costs as a percentage of medical revenues (the medicalcare ratio) largely determine our gross margin. Our gross margin increased to 20.5%for the nine months ended June 30, 2009, from 20.1% for the nine monthsended June 30, 2008.

 

The increase in our gross margin percentage between the fiscal 2009 and2008 periods was primarily the result of the decreased fee for service claims expense followinga new radiology specialty capitation services agreement, and decreased PCPcapitation expense and lower claims cost per member per month in the fiscal2009 period, discussed above.

 

*General and Administrative Expense*

 

General and administrative expenses were approximately $21,961,000 forthe nine months ended June 30, 2009, representing 15.2% of total IPArevenues, as compared with $22,265,000, or 14.8% of total revenues, for thefiscal 2008 period.

 

The increase in general and administrative expenses during the fiscal2009 period was primarily related to increased bonus and legal fee accruals atProMed.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the nine months ended June 30,2009 increased to approximately $2,644,000 from $2,609,000 for the same periodof the prior year. The increase of $35,000 was primarily due to additionaldepreciation expense for increased capital expenditures.

 

*Income from Unconsolidated Joint Venture*

 

The income from unconsolidated joint venture for the nine months ended June 30,2009 decreased to approximately $1,482,000 from approximately $2,124,000 forthe same period of the prior year. The decrease resulted from lower accrual ofrisk pool receivables due to decreased membership.

 

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*Operating Income (Loss)*

 

Our IPA segment reported operating incomes of approximately $9,480,000and $7,499,000 for the nine months ended June 30, 2009 and 2008,respectively, which increase was the result of the changes discussed above. Thepre-tax operating results from the IPA segment include certain corporateexpense allocations for insurance, professional fees, and amortization ofidentifiable intangibles.

 

**Corporate Results of Operations**

 

Certain expenses incurred at Prospect Medical Holdings, Inc. (the “ParentEntity”) not specifically allocable to the Hospital Services or IPA segmentsare recorded in the Corporate segment. These include certain salaries, benefitsand other compensation for corporate employees, financing, insurance, rent,operating supplies, legal, accounting, SEC compliance, and Sarbanes-Oxleycompliance. We also do not allocate interest expense, debt extinguishment loss,gain or loss on interest rate swaps and income taxes to the other reportingsegments.

 

The following table summarizes our corporate expense for the ParentEntity, and is used in the discussion below for the three-month and thenine-month periods ended June 30, 2009 and 2008.

 
| ** **                                                     | ** ** | **Three  Months Ended********June 30,** | ** ** | **%********Increase** | ** ** | **Nine  Months Ended  June 30,** | ** ** | **%********Increase** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2009**                                     | ** ** | **2008**              | ** ** | **(Decrease)**                        | ** ** | **2009**              | ** ** | **2008** | ** ** | **(Decrease)** | ** ** |
| **Operating Expenses:**                                        |       |                                         |       |                  |       |                                  |       |                  |       |   |   |   |   |
| General and administrative expense                             |       | $                                            | 3,858      |                  | $          | 5,640                                 |       | (31.6                 | )%         | $ | 8,731 |   | $ | 12,038 |   | (27.5 | )% |
| Depreciation and amortization expense                          |       | 3                                            |       | 4                     |       | (25.1                                 | )%         | 10                    |       | 17 |   | (41.2 | )% |
| **Total Operating Expenses**                                   |       | 3,861                                        |       | 5,644                 |       | 31.6                                  | %          | 8,741                 |       | 12,055 |   | (27.5 | )% |
| **Other (Income) Expense:**                                    |       |                                         |       |                  |       |                                  |       |                  |       |   |   |   |   |
| Investment income                                              |       | (13                                          | )          | (17                   | )          | (23.4                                 | )%         | (50                   | )          | (319 | ) | (84.3 | )% |
| Interest expense and amortization of deferred  financing costs |       | 7,576                                        |       | 6,522                 |       | 16.2                                  | %          | 20,197                |       | 15,935 |   | 26.7 | % |
| (Gain) loss in value of interest rate swap  arrangements       |       | (3,694                                       | )          | (4,948                | )          | (25.3                                 | )%         | 5,019                 |       | (4,072 | ) | (223.3 | )% |
| Loss on debt extinguishment                                    |       | —                                       |       | 8,309                 |       | (100.0                                | )%         | —                |       | 8,309 |   | (100.0 | )% |
| **Total Other Expense**                                        |       | 3,869                                        |       | 9,866                 |       | (60.8                                 | )%         | 25,166                |       | 19,853 |   | 26.8 | % |
| **Total Corporate Expenses**                                   |       | $                                            | 7,730      |                  | $          | 15,510                                |       | (50.2                 | )%         | $ | 33,907 |   | $ | 31,908 |   | 6.3 | % |

 

Thefollowing table sets forth selected operating items, expressed as a percentageof total consolidated revenues from continuing operations:

 
| ** **                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                              | ** ** | **2008**                             | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Operating Expenses:**                                        |       |                                  |       |                                 |       |   |   |   |   |
| General and administrative expense                             |       | 3.3                                   | %          | 7.0                                  | %          | 3.1 | % | 5.0 | % |
| Depreciation and amortization expense                          |       | 0.0                                   | %          | 0.0                                  | %          | 0.0 | % | 0.0 | % |
| **Total Operating Expenses**                                   |       | 3.3                                   | %          | 7.0                                  | %          | 3.1 | % | 5.0 | % |
| **Other (Income) Expense:**                                    |       |                                  |       |                                 |       |   |   |   |   |
| Investment income                                              |       | 0.0                                   | %          | 0.0                                  | %          | 0.0 | % | (0.1 | )% |
| Interest expense and amortization of deferred  financing costs |       | 6.5                                   | %          | 8.1                                  | %          | 7.0 | % | 6.6 | % |
| (Gain) loss in value of interest rate swap  arrangements       |       | (3.2                                  | )%         | (6.1                                 | )%         | 1.8 | % | (1.7 | )% |
| Loss on debt extinguishment                                    |       | 0.0                                   | %          | 10.3                                 | %          | 0.0 | % | 3.4 | % |
| **Total Other Expense**                                        |       | 3.3                                   | %          | 12.3                                 | %          | 8.8 | % | 8.2 | % |
| **Total Corporate Expenses**                                   |       | 6.6                                   | %          | 19.3                                 | %          | 11.9 | % | 13.2 | % |

 

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***Three Months Ended June 30,2009 Compared to Three Months Ended June 30, 2008***

 

*General and Administrative Expense*

 

General and administrative (“G&A”) expenses for the three monthsended June 30, 2009 were approximately $3,858,000, representingapproximately 3.3% of total revenues from continuing operations, compared toapproximately $5,640,000, or approximately 7.0% of total revenues fromcontinuing operations, for the three months ended June 30, 2008, adecrease of approximately 31.6%. The decrease in general and administrativeexpenses during the fiscal 2009 period primarily related to reduction in audit,legal, bank fee, insurance and Sarbanes-Oxley compliance consultingexpenditures, including related to bringing certain functions in-house, offsetby additional accrued compensation and an increase in employee stock optiongrant and issuance costs.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the three months ended June 30,2009 was approximately $3,000, compared to approximately $4,000 for the threemonths ended June 30, 2008, a decrease of approximately 25%. The decreasewas primarily due to retirement of certain capital equipment.

 

*Investment Income*

 

Investment income for the three months ended June 30, 2009 wasapproximately $13,000, compared to approximately $17,000, for the three monthsended June 30, 2008, a decrease of approximately 23.4%. Following theamendment of our former senior credit facility agreement on May 15, 2008,we were required by Bank of America, N.A. to maintain the majority of our cashin non-interest bearing accounts at that bank.

 

*Interest Expense and Amortization of DeferredFinancing Costs*

 

Interest expense and amortization of deferred financing costs for thethree months ended June 30, 2009 was approximately $7,576,000, compared to$6,522,000 for the three months ended June 30, 2008, an increase ofapproximately 16.2%. We were in default under our credit facilities and underthe resulting April 2008 forbearance agreements, the applicable margins onthe first and second lien term loans were permanently increased to 750 and1,175 basis points, respectively, and the range of applicable margins on therevolving line of credit was increased from 500 to 750 basis points effective April 10,2008. The agreements also provided for a minimum LIBOR rate of 3.50%.  Additionally, effective with the firstasserted default on March 19, 2009, our lenders began assessing defaultrates on all borrowings.  Finally,effective April 14, 2009, following the Brotman transaction, we beganincluding interest on all Brotman debt in our consolidated financialstatements.

 

*Gain (Loss) in Value of Interest Rate SwapArrangements*

 

We had two interest rate swaps in place for initial notional principalamounts of $48.0 million and $97.8 million, respectively. Theinterest rate swaps were designated as cash flow hedges of our floating rateterm debt, with the effective date of the $48.0 million swap being December 31,2007 and the effective date of the $97.8 million swap being September 6,2007. As of April 1, 2008, in anticipation of modifications to the termsof our credit agreements, the swaps were determined to no longer be effectivein offsetting the hedged items. As a result, cash flow hedge accountingtreatment was discontinued and all further changes in fair value of the swapswere included in earnings. These amounts are unpredictable and likely to besignificant. In the three months ended June 30, 2009, gain on interestrate swaps totaled approximately $3,694,000.

 

In the three months ended June 30, 2008, gain on interest rateswaps totaled approximately $4,948,000, representing the change in fair valueof the $48.0 million swap that was not yet subject to hedge accounting,which amount was charged to earnings.

 

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***Nine Months Ended June 30, 2009Compared to Nine Months Ended June 30, 2008***

 

*General and Administrative Expense*

 

General and administrative expenses for the nine months ended June 30,2009 were approximately $8,731,000 representing approximately 3.1% of totalrevenues from continuing operations, compared to approximately $12,038,000, orapproximately 5.0% of total revenues from continuing operations, for the ninemonths ended June 30, 2008, a decrease of approximately 27.5%. Thedecrease in G&A expenses during the fiscal 2009 period primarily related toreduction in audit, legal, bank fee, and outside consultant expenditures, includingrelated to bringing certain functions in-house, offset by additional accruedcompensation expense.

 

*Depreciation and Amortization Expense*

 

Depreciation and amortization expense for the nine months ended June 30,2009 was approximately $10,000, compared to approximately $17,000 for the ninemonths ended June 30, 2008, a decrease of approximately 41.2%. Thedecrease was primarily due to retirement of certain capital equipment.

 

*Investment Income*

 

Investment income for the nine months ended June 30, 2009 wasapproximately $50,000, compared to approximately $319,000, for the nine monthsended June 30, 2008, a decrease of approximately 84.3%. Following theamendment of our former senior credit facility agreement on May 15, 2008,we were required by Bank of America, N.A. to maintain the majority of our cashin non-interest bearing accounts at that bank.

 

*Interest Expense and Amortization of DeferredFinancing Costs*

 

Interest expense and amortization of deferred financing costs for thenine months ended June 30, 2009 was approximately $20,197,000, compared to$15,935,000, for the nine months ended June 30, 2008, an increase ofapproximately 26.7%. We were in default under our credit facilities and underthe resulting April 2008 forbearance agreements, the applicable margins onthe first and second lien term loans were permanently increased to 750 and1,175 basis points, respectively, and the range of applicable margins on therevolving line of credit was increased from 500 to 750 basis points effective April 10,2008. The agreements also provided for a minimum LIBOR rate of 3.50%. In May 2008,the debt agreements were further modified to add a 1% “payment-in-kind” (“PIK”)interest to the outstanding balance of the debt plus an additional 4% PIKinterest to the interest rate applicable to the second lien debt. The 4%accrues and is added to the principal balance on a monthly basis. The 4% PIKcould potentially be reduced in the future to the extent that we reduce ourconsolidated leverage ratio. Additionally, effective on the March 19, 2009notice date for an asserted non-monetary event of default, our lenders beganassessing default rates on all borrowings. Finally, effective April 14, 2009, following the Brotmantransaction, we began including interest on all Brotman debt in ourconsolidated financial statements.

 

*Gain (Loss) in Value of Interest Rate SwapArrangements*

 

We had two interest rate swaps in place for initial notional principalamounts of $48.0 million and $97.8 million, respectively. Theinterest rate swaps were designated as cash flow hedges of our floating rateterm debt, with the effective date of the $48.0 million swap being December 31,2007 and the effective date of the $97.8 million swap being September 6,2007. As of April 1, 2008, in anticipation of modifications to the termsof our credit agreements, the swaps were determined to no longer be effectivein offsetting the hedged items. As a result, cash flow hedge accountingtreatment was discontinued and all further changes in fair value of the swapswere included in earnings. These amounts are unpredictable and likely to besignificant. In the nine months ended June 30, 2009, loss on interest rateswaps totaled approximately $5,019,000.

 

In the nine months ended June 30, 2008, gain on interest rateswaps totaled approximately $4,072,000, representing the change in fair valueof the $48.0 million swap that was not yet subject to hedge accounting,which amount was charged to earnings.

 

**Consolidated Results of Operations**

 

***Three months Ended June 30,2009 Compared to Three months Ended June 30, 2008***

 

*Provision for Income Taxes*

 

Income tax provision (benefit) for the three months ended June 30,2009 was approximately $1,989,800 compared to approximately $(2,083,000) in thethree months ended June 30, 2008. The effective tax rate was higher at 114%in the three months 

 

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endedJune 30, 2009 compared to 36% in the three months ended June 30,2008. The higher effective tax rate in the fiscal 2009 period was primarily dueto not recognizing the deferred tax benefit from Brotman’s loss, for whichrealization does not meet the more likely than not standard of SFAS 109.

 

*Net Income (Loss) from Continuing Operations*

 

Net loss from continuing operations attributable to common stockholdersfor the three months ended June 30, 2009 was approximately $388,000, or$0.02 per diluted share, as compared to a net loss of $5,640,000, or $0.48 perdiluted share, for the three months ended June 30, 2008, which decrease inloss was the result of the changes discussed above.

 

*Net Loss from Discontinued Operations*

 

Net income from discontinued operations for the three months ended June 30,2008 was approximately $188,000 or $0.02 per diluted share, as compared to nonefor the three months ended June 30, 2009. As previously discussed, we soldthe AV Entities effective August 1, 2008.

 

***Nine Months Ended June 30, 2009Compared to Nine Months Ended June 30, 2008***

 

*Provision for Income Taxes*

 

Income tax provision (benefit) for the nine months ended June 30,2009 was approximately $2,065,000 compared to approximately $(1,728,000) in thenine months ended June 30, 2008. The effective tax rate was higher at 107%in the nine months ended June 30, 2009 compared to 36% in the nine monthsended June 30, 2008. The higher effective tax rate in the fiscal 2009period was primarily due to not recognizing the deferred tax benefit fromBrotman’s loss, for which realization does not meet the more likely than notstandard of SFAS 109.

 

*Net Income (Loss) from Continuing Operations*

 

Net loss from continuing operations attributable to common stockholdersfor the nine months ended June 30, 2009 was approximately $284,000, or$0.02 per diluted share, as compared to a net loss of $8,882,000, or $0.75 perdiluted share, for the nine months ended June 30, 2008, which decrease inloss was the result of the changes discussed above.

 

*Net Loss from Discontinued Operations*

 

Net loss from discontinued operations for the nine months ended June 30,2008 was approximately $203,000 or $0.02 per diluted share, as compared to nonefor the nine months ended June 30, 2009. As previously discussed, we soldthe AV Entities effective August 1, 2008.

 

**Liquidity and Capital Resources**

 

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

 

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

 

Our investment strategies are designed to provide safety andpreservation of capital, sufficient liquidity to meet cash-flow needs, theintegration of investment strategy with our business operations and objectives,and attainment of a competitive return. At June 30, 2009, we invested aportion of our cash in interest bearing money market accounts and, followingthe amendment of our former senior credit facility agreement on May 15,2008, we were also required to maintain the majority of our cash innon-interest bearing accounts with Bank of America, N.A. All of these amountsare classified as current assets and included in cash and cash equivalents inour condensed consolidated balance sheets.

 

*Cash Flow from Continuing Operations*

 

Net cash provided by continuing operations was approximately $12,004,000for the nine months ended June 30, 2009 compared to net cash provided bycontinuing operations of approximately $5,751,000 for the nine months ended June 30,2008. The increase in net cash provided by continuing operations for the ninemonths ended June 30, 2009 as compared to the nine months ended June 30,2008 was due to various factors, including the following:

 

·      earnings,excluding non-cash charges and credits were approximately $23,286,000 in thefiscal 2009 period compared to approximately $6,132,000 in the fiscal 2008period;

 

·      changes inpatient, government program and other receivables, a use of approximately $9,160,000in the fiscal 2009 period compared to a use of approximately $2,582,000 in thefiscal 2008 period. The increase in the fiscal 2009 period was primarilyrelated to our Hospital Services segment;

 

·      changes inprepaid expenses and other, a source of approximately $431,000 in the fiscal2009 period compared to a use of approximately $655,000 in the fiscal 2008period;

 

·      changes inrefundable income tax and taxes payable, a source of approximately $2,654,000in the fiscal 2009 period compared to a source of $3,248,000 in the fiscal 2008period;

 

·      changes inmedical claims and related liabilities, a use of approximately $2,617,000 inthe fiscal 2009 period compared to a use of approximately $771,000 in thefiscal 2008 period; and

 

·      changes inaccounts payable and other accrued liabilities, a use of approximately $3,009,000in the fiscal 2009 period compared to a source of approximately $805,000 in thefiscal 2008 period due to a reduction in general and administrative expenses inthe fiscal 2009 period relating to legal, audit, insurance and Sarbanes-Oxleycompliance consulting expenditures.

 

Net cash used in investing activities totaled approximately $3,105,000for the nine months ended June 30, 2009, compared to a use of approximately$1,636,000 for the nine months ended June 30, 2008, the largest componentof which was the acquisition costs net paid in connection with the Brotman acquisitiontotaling approximately $2,310,000 purchases of property, improvements andequipment, a use of approximately $1,764,000 in the fiscal 2009 period comparedto a use of approximately $1,532,000 in the fiscal 2008 period.

 

Net cash used by financing activities totaled approximately $10,895,000for the nine months ended June 30, 2009, compared to a source ofapproximately $240,000 for the nine months ended June 30, 2008. Net cashused in financing activities for the nine months ended June 30, 2009 wascomprised primarily of the principal repayment of the first-lien term debt ofapproximately $8,904,000 repayment of the revolving line of credit ofapproximately $1,671,000 and payment of $972,000 in fees paid in connection withthe issuance of the $160 million bond financing. Net cash provided by financingactivities during the nine months ended June 30, 2008 included a $4,000,000borrowing on our line of credit and $1,200,000 received from the exercise ofstock options, net of payment of $3,750,000 on our long-term debt and paymentof $757,000 on our term debt and lein of credit.

 

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*Cash Flow from Discontinued Operations*

 

During the nine months ended June 30, 2008, net cash used inoperating activities in our discontinued operations was approximately $8,000,compared to none for the nine months ended June 30, 2009, and net cashused in investing activities, was approximately $3,000 compared to none for thenine months ended June 30, 2009. As previously discussed, we sold the AVEntities effective August 1, 2008. We do not believe that the eventualexclusion of such amounts from our consolidated cash flows in future periodswill have a material effect on our liquidity or financial position.

 

At June 30, 2009, we had negative working capital of approximately$1,976,000 as compared to positive working capital of $12,373,000 at September 30,2008, primarily resulting from the reclassification of approximately$11.0 million for the interest rate swap liability as a current liability.

 

At June 30, 2009 and September 30, 2008, cash, cashequivalents and investments were approximately $31,587,000 and $33,583,000,respectively.

 

*Former Credit Facility*

 

On August 8, 2007, in connection with the closing of the Altaacquisition, we obtained an aggregate $155 million syndicated seniorsecured credit facility which was comprised of a first-lien facility andsecond-lien facility (the “Former Credit Facility”). The term loans were usedto refinance approximately $41.5 million of existing Alta debt, torefinance approximately $48 million of our existing debt incurred inconnection with our acquisition of the ProMed Entities and to pay the cashportion of the Alta purchase price. The maturity dates of the first-lienrevolver, the first-lien term facility and the second-lien term facility were August 8,2012, August 8, 2014 and February 8, 2015, respectively.

 

The Former Credit Facility was subject to certain financial andadministrative covenants, cross default provisions and other conditions,including a maximum senior debt/EBITDA ratio, a minimum fixed-charge coverageratio and a minimum EBITDA level. There were also various administrativecovenants and other restrictions.

 

The Company made all scheduled payments of principal and interest sinceinception of the Former Credit Facility. On March 19, 2009, we receivedwritten notices that the Former Credit Facility’s lenders deemed us in defaultof a credit facility requirement regarding the required sale of one of ourentities by a specified date. Additionally, on April 17, 2009, we received written notices of analleged event of default related to our increased ownership interest inBrotman.

 

Effective with the first asserted event of default, the lenders beganassessing default interest; however, they did not exercise any otherremedies.  We disputed the lenders’characterization of the asserted defaults.

 

On June 30, 2009, we entered into amendments to our Former CreditFacility pursuant to which, among other things, the lenders waived all assertedevents of default and stopped assessing default rates. The amendments furtherrequired  that we refinance the FormerCredit Facility no later than October 31, 2009.

 

*New Note Offering*

 

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

 

*Interest Rate Swaps*

 

As required by the Former Credit Facility on May 16, 2007, weentered into a $48 million interest rate swap, to effectively convert thevariable interest rate (the LIBOR component) under the original credit facilityto a fixed rate of 5.3%, plus the applicable margin per year throughout theterm of the loan. This interest rate swap remained in effect after the relatedterm loan was repaid in August 2007 in contemplation of the $155,000,000Former Credit Facility entered into in August, 2007. In addition to thepre-existing $48,000,000 interest rate swap described above, on September 5,2007, we entered into a separate interest rate swap agreement, initiallytotaling $97,750,000, to effectively convert the variable interest rate (theLIBOR component) under the incremental portion of the Former Credit Facility toa fixed rate of 5.05%, plus the applicable margin, per year, throughout theterm of the loan. The notional amounts of these interest rate swaps werescheduled to decline as the principal balances owing under the term loansdeclined. Under 

 

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theseswaps, we were required to make monthly fixed-rate payments to the swapcounterparties calculated on the notional amount of the swap times the interestrate for the particular swap, while the swap counterparties were obligated tomake certain monthly floating rate payments to us referencing the same notionalamount. As of June 30, 2009, the negative fair value of the swaps was$11,032,000.

 

On July 29, 2009, in connection with the issuance of the $160 million Notes, the Companyterminated its interest rate swap arrangements and paid the swap counterparty $11.7 million in final settlement of allamounts owing under the swap arrangements.

 

*Brotman Financing*

 

As part of Brotman’s bankruptcy plan of reorganization, financing wassecured from the Los AngelesJewish Home for the Aging (“JHA”)  and Gemino.

 

The JHA financing was comprised of two term debt components, a$16.0 million tranche secured by assets on the west side of the Brotmancampus commonly referred to as “Delmas West” and a $6.25 million trancheon the main hospital pavilion on the east side of the property. The$16.0 million tranche contains an option for JHA to acquire the DelmasWest parcel for a purchase price equal to the outstanding debt within24 months of the effective date of the bankruptcy. If JHA does notexercise its option, Brotman will be required to refinance the $16.0 milliontranche on or before April 14, 2011. With respect to the$16.0 million tranche of the JHA facility, JHA also has the right todeclare the unpaid loan amount, including remaining interest and any otheramounts due and payable, immediately due and payable at any time after April 14,2010 and prior to April 14, 2011, provided that JHA gives 180 days’written notice of exercise. In addition, the $6.25 million tranche of theJHA transaction will mature on April 14, 2012 and Brotman will need tosecure financing to retire this portion of the debt.

 

The Geminofinancing was comprised of a $6.0 million, senior credit facility secured byaccounts receivable. The facility expires on the earlier of April 14, 2012and the JHA loan (see above) maturity date and bears interest at Libor plus 7%per annum, with a LIBOR floor of 4%. Interest is incurred based on the greaterof $2 million or the outstanding principal balance. The agreement also includesan unused line fee at 0.5% per annum and a collateral line fee, based on the averageoutstanding principal balance, of 0.5% per annum. The senior credit facilityagreement contains customary covenants for facilities of this type includingrestrictions on the payment of dividends, change in ownership/management, assetsales, incurrence of additional indebtedness, sale-leaseback transactions, andrelated party transactions. In addition, Brotman must also comply withfinancial covenants, including a fixed charge coverage ratio of not less than (i) 1.10:1.00for the fiscal quarter ending June 30, 2009, (ii) 1.15:1.00 for thefiscal quarter ending September 30, 2009; and (iii) 1.20:1.00 foreach fiscal quarter ending thereafter. As of June 30, 2009, Brotman didnot have borrowings outstanding under the Gemino financing and was not in compliancewith the required financial covenants.

 

We anticipate attempting to finance future acquisitions and potentialbusiness expansion with a combination of debt, issuances of equity instrument,and cash flow from operations. Additionally, we may seek to reduce our totalasset holdings and/or raise financing through the sale of certain of ourassets.

 

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

 

*Off-Balance Sheet Arrangements*

 

None.

 

**Critical Accounting Policies**

 

The accounting policies described below are considered critical inpreparing our unaudited condensed consolidated financial statements. Criticalaccounting policies require difficult, subjective or complex judgments, oftenas a result of the need to make 

 

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estimatesabout the effect of matters that are inherently uncertain. The judgments anduncertainties affecting the application of these policies include significantestimates and assumptions made by us using information available at the timethe estimates are made. Actual results could differ materially from thoseestimates.

 

***Consolidation of FinancialStatements***

 

Under applicable financial reporting requirements, the financialstatements of the affiliated physician organizations with which we havemanagement services agreements are consolidated with our own financialstatements. This consolidation is required under EITF Issue No. 97-2, “Applicationof FASB Statement No. 94 and APB Opinion No. 16 to Physician PracticeManagement Entities and Certain Other Entities with Contractual ManagementArrangements” issued by the Emerging Issues Task Force of the FinancialAccounting Standards Board because we are deemed to hold a controllingfinancial interest in such organizations through a nominee shareholder. We can,through two assignable option agreements, change the nominee shareholder atwill on an unlimited basis and for nominal cost. There is no limitation on ourdesignation of a nominee shareholder except that any nominee shareholder mustbe a licensed physician or otherwise permitted by law to hold shares in aprofessional medical corporation. We have also concluded that underInterpretation No. 46, “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51” we are required to consolidate ouraffiliated physician organizations. The operations of our affiliated physicianorganizations have a significant impact on our financial statements. Thebalance sheet and statement of operations of Brotman have been included from April 14,2009. All inter-company accounts and balances have been eliminated inconsolidation.

 

***Revenue Recognition***

 

*Hospital Services Segment*

 

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

 

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

 

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

 

*Managed Care:*  We also receive payment from certaincommercial insurance carriers, HMOs, and PPOs, though generally do not enterinto contracts with these entities. The basis for payment under theseagreements includes our standard charges for services.

 

*Self-Pay:*  Our hospitals provide services to individualsthat do not have any form of healthcare coverage. Such patients are evaluated,at the time of service or shortly thereafter, for their ability to pay basedupon federal and state poverty guidelines, qualifications for Medi-Cal, as wellas our local hospital’s indigent and charity care policy.

 

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

 

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*IPA Segment*

 

Operating revenue of our IPAs consists primarily of capitation paymentsfor medical services provided by our affiliated physician organizations undercontracts with HMOs. Capitation revenue under HMO contracts is prepaid monthlyto the affiliated physician organizations based on the number and type ofenrollees assigned to physicians in our affiliated physician organizations.

 

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

 

Variability in capitation revenue increased beginning in calendar 2004,when Medicare began a four-year phase-in of a revised capitation model referredto as “Risk Adjustment.” Under the new model, capitation with respect toMedicare enrollees is subject to subsequent adjustment by CMS based on theacuity of the enrollees to whom services were provided. Capitation for thecurrent year is paid based on data submitted for each enrollee for previousperiods. Capitation is paid at interim rates during the year and is adjusted insubsequent periods (generally in our fourth fiscal quarter) after the finaldata has been processed by CMS. Positive or negative capitation adjustments aremade for seniors with conditions requiring more or less healthcare servicesthan assumed in the interim payments. Since we do not currently have theability to reliably predict these adjustments, periodic changes in capitationamounts earned as a result of Risk Adjustment are recognized when those changesare communicated from the health plans, generally in the fourth quarter of thefiscal year to which the adjustments relate. We recorded approximately$1.6 million and $1.5 million increase in capitation revenue in thefourth quarter of fiscal 2008 and 2007, respectively, for risk adjustmentfactors.

 

We also earn additional incentive revenue or incur penalties under HMOcontracts by sharing in the risk for hospitalization based upon inpatientservices utilized. As of June 30, 2009, except for one contract where weare contractually obligated for down-side risk, shared risk deficits are notpayable unless and until we generate future risk-sharing surpluses. Risk poolsare generally settled in the third or fourth quarter of the following year. Dueto the lack of access to timely inpatient utilization information and the difficultyin estimating the related costs, shared-risk amounts receivable from the HMOsare recorded when such amounts are known. We also receive incentives under “pay-for-performance”programs for quality medical care based on various criteria. Pay-for-performancepayments are generally recorded in the third and fourth quarters of our fiscalyear when such amounts are known, since we do not have the ability to reliablyestimate these amounts. Risk pool and pay-for-performance incentives areaffected by many factors, some of which are beyond our control, and may varysignificantly from year to year.

 

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

 

***Accrued Medical Claims***

 

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

 

Our medical care costs include actual historical claims experience andIBNR. We, together with our independent actuaries, estimate medical claimsliabilities using actuarial methods based upon historical data adjusted forpayment patterns, cost trends, product mix, utilization of healthcare servicesand other relevant factors. The estimation methods and the resulting reservesare frequently reviewed and updated, and adjustments, if necessary, arereflected in the period known. While we believe our estimates are adequate, itis possible that future events could require us to make significant adjustmentsor revisions to these estimates. In assessing the adequacy of accruals for medicalclaims liabilities, we consider our historical experience, the terms ofexisting contracts, our knowledge of trends in the industry, informationprovided by our customers and information available from other sources asappropriate.

 

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

 

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

 

The following tables reflect (i) the change in our estimate ofclaims liability as of June 30, 2009 that would have resulted had wechanged our completion factors for all applicable months of service included inour IBNR calculation (i.e., the preceding 5th through25th months) by the percentages indicated; and (ii) the change in ourestimate of claims liability as of June 30, 2009 that would have resultedhad we changed trended PMPM factors for all applicable months of serviceincluded in our IBNR calculation (i.e., the preceding 1st through4th months) by the percentages indicated. Changes in estimate of themagnitude indicated in the ranges presented are considered reasonably likely.

 
| **Increase (Decrease) in  Estimated Completion Factors** | ** ** | **Increase (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                               | ** ** | **(in  thousands)**                                         | ** ** |
| (3)%                                                     |       | $                                                           | 3,801      |   |
| (2)%                                                     |       | $                                                           | 2,534      |   |
| (1)%                                                     |       | $                                                           | 1,267      |   |
| 1%                                                       |       | $                                                           | (1,267     | ) |
| 2%                                                       |       | $                                                           | (2,534     | ) |
| 3%                                                       |       | $                                                           | (3,801     | ) |

 
| **Increase (Decrease) in  Trended PMPM Factors** | ** ** | **Increase (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                       | ** ** | **(in  thousands)**                                         | ** ** |
| (3)%                                             |       | $                                                           | (720       | ) |
| (2)%                                             |       | $                                                           | (480       | ) |
| (1)%                                             |       | $                                                           | (240       | ) |
| 1%                                               |       | $                                                           | 240        |   |
| 2%                                               |       | $                                                           | 480        |   |
| 3%                                               |       | $                                                           | 720        |   |

 

Additionally, for each 1% (hypothetical) difference between our June 30,2009 estimated claims liability of $17,863,000 and the actual claims incurredrun-out, pre-tax loss for the nine months ended June 30, 2009 wouldincrease or decrease by approximately $179,000 or approximately $0.01 perdiluted share.

 

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The following table shows the components of the change in medicalclaims and benefits payable for the nine months ended June 30, 2009 and2008 (in thousands):

 
| ** **                                            | ** ** | **Nine Months Ended  June 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2009**                             | ** ** | **2008(1)** | ** ** |
| IBNR as of beginning of period                        |       | $                                    | 20,480     |   | $ | 21,406 |   |
| Healthcare claims expense incurred during the  period |       |                                 |       |   |   |
| Related to current year                               |       | 53,648                               |       | 61,425 |   |
| Related to prior years                                |       | (1,347                               | )          | (2,101 | ) |
| Total incurred                                        |       | 52,301                               |       | 59,324 |   |
| Healthcare claims paid during the period              |       |                                 |       |   |   |
| Related to current year                               |       | (37,923                              | )          | (42,091 | ) |
| Related to prior years                                |       | (16,995                              | )          | (18,004 | ) |
| Total paid                                            |       | (54,918                              | )          | (60,095 | ) |
| IBNR as of end or period                              |       | $                                    | 17,863     |   | $ | 20,635 |   |

 

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(1)                                  Amounts excludechanges in medical claims and benefits payable related to the AV Entities whichare reported in discontinued operations.

 

Through June 30, 2009, the $1,347,000 change in estimate relatedto IBNR as of September 30, 2008 represented approximately 6.5% of theIBNR balance as of September 30, 2008, approximately 2.3% of fiscal 2008claims expense, and after consideration of tax effect, approximately 68.7% ofnet loss from continuing operation for the year then ended.

 

Through June 30, 2008, the $2,101,000 change in estimate relatedto IBNR as of September 30, 2007 represented approximately 10.8% of theIBNR balance as of September 30, 2007, approximately 5.2% of fiscal 2007claims expense and after consideration of tax effect, approximately 8.9% of netloss from continuing operation for the year then ended.

 

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

 

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

 

***Goodwill and Intangible Assets***

 

Statement of Financial Accounting Standards (“SFAS”) No. 141, “*Business Combinations*,” requires allbusiness combinations after June 30, 2001 to be accounted for using thepurchase method and prohibits the pooling-of-interest method of accounting.SFAS No. 141 also states that acquired intangible assets should be separatelyrecognized upon meeting certain criteria. Such intangible assets include, butare not limited to, trade and service marks, non-compete agreements, customerlists and licenses.

 

SFAS No. 142, “*Goodwill andOther Intangible Assets*,” requires that goodwill and indefinite lifeintangible assets not be subject to amortization but be evaluated forimpairment on at least an annual basis, or more frequently if certainindicators are present. Such indicators include adverse changes in market valueand/or stock price, laws and regulations, profitability, cash flows, ourability to maintain enrollment and renew payer contracts on favorable terms. Atwo-step impairment test is used to identify potential goodwill impairment andto measure the amount of goodwill impairment loss to be recognized (if any).The first step consists of estimating the fair value of the reporting unitbased on recognized valuation techniques, which include a weighted combinationof (i) the guideline company method that utilizes revenue or earningsmultiples for comparable publicly-traded companies, and (ii) a discountedcash flow model that utilizes future cash flows, the timing of those cashflows, and a discount rate (or weighted average cost of capital which considersthe cost of equity and cost of debt financing expected by a representativemarket participant) representing the time value of money and the inherent riskand uncertainty of the future cash flows. If the estimated fair value of thereporting unit is less than its carrying value, a second step is performed tocompute the amount of the impairment by determining the “implied fair value” ofthe goodwill, which is compared to its corresponding carrying value.

 

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Long-lived assets, including property, improvements and equipment andamortizable intangibles, are evaluated for impairment under SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets*” whenever events or changes in circumstancesindicate that the carrying value of such assets may not be recoverable. Weconsider assets to be impaired and write them down to fair value if estimatedundiscounted cash flows associated with those assets are less than theircarrying amounts.

 

In accordance with SFAS No. 142, we performed our annual goodwillimpairment analysis for each reporting unit that constitutes a business forwhich discrete financial information is produced and reviewed by operatingsegment management and provides services that are distinct from the otherreporting units. For the Hospital Services segment, the reporting unit for theannual goodwill impairment analysis was determined to be at the segment level.For the IPA segment, we have determined that ProMed individually and Prospect(which includes all the other affiliated physician organizations) eachrepresent a reporting unit, based on operational characteristics. The ProMedEntities are geographically and managerially their own reporting unit.

 

Our impairment test at September 30, 2008 resulted in noimpairment charges.

 

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

 

***Legal and Other Loss Contingencies***

 

We are subject to contingencies, such as legal proceedings and claimsarising out of our business. In accordance with SFAS No. 5, “*Accounting for Contingencies*,” we recordaccruals for such contingencies when it is probable that a liability will beincurred and the amount of loss can be reasonably estimated. A significantamount of management estimation is required in determining when, or if, anaccrual should be recorded for a contingent matter and the amount of suchaccrual, if any.

 

We are in theprocess of finalizing certain post-closing matters related to the 2007 ProMedacquisition, including closing balance sheet reconciliations, escrowreconciliations and other matters. We have recorded an estimated settlementamount relating such matters in the accompanying unaudited condensedconsolidated financial statements.

 

***Acquisitions***

 

During the five years ended September 30, 2008 and nine monthsended June 30, 2009, we completed several business combinations. Thesebusiness combinations were all accounted for using the purchase method ofaccounting, and accordingly, the operating results of each acquisition havebeen included in our consolidated financial statements since their effectivedate of acquisition. The purchase price for each business combination wasallocated to the assets, including the identifiable intangible assets, andliabilities, based on estimated fair values determined using independentappraisals where appropriate. The excess of purchase price over the nettangible assets acquired was allocated to goodwill and other intangible assets.

 

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

 

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The following table summarizes all business combinations for the fiveyears ended September 30, 2008 and nine-month period ended June 30,2009.

 
| **Business Combinations**                                                                            | ** ** | **Effective Date**    | ** ** | **Purchase Price** | ** **  | **Location** | ** **             |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|-------------|--------------|------------------------|
| Prospect NWOC Medical Group, Inc.                                                               |       | February 1, 2004 |       | $                  | 2,000,000   |         | North  Orange County   |   |
| StarCare Medical Group, Inc., APAC Medical  Group, Inc. and Pinnacle Health Resources |       | February 1, 2004 |       | $                  | 8,500,000   |         | North  Orange County   |   |
| Genesis HealthCare of Southern California                                                            |       | November 1, 2005 |       | $                  | 8,000,000   |         | Central  Orange County |   |
| ProMed Entities                                                                                      |       | June 1, 2007     |       | $                  | 48,392,000  |         | San  Bernardino County |   |
| Alta                                                                                                 |       | August 8, 2007   |       | $                  | 154,935,000 |         | Los  Angeles County    |   |
| Brotman (71.9% interest)                                                                             |       | April 14, 2009   |       | $                  | 2,556,000   |         | Los  Angeles County    |   |

 

The intangible assets we acquire in our acquisitions include HMO andprovider contracts, trade names, covenants not-to-compete and customerrelationships. We typically require that our acquisition targets have cash or acombination of cash and current assets equal to current liabilities, andpositive tangible net worth. As discussed above, in fiscal 2007, all goodwilland intangible assets were written off except those related to the ProMedEntities and Alta.

 

***Divestitures***

 

On August 1, 2008, we completed the sale of all of the outstandingstock of the AV Entities for total cash consideration of $8,000,000. Asrequired by SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” the assets andliabilities of the AV Entities and their operations have been presented in ourmost recently filed consolidated financial statements as discontinuedoperations for all periods presented. All references to operating resultsreflect our ongoing operations, excluding the AV Entities, unless otherwisenoted.

 

**Inflation**

 

According to U.S. Bureau of Labor Statistics Data, the nationalhealthcare cost inflation rate has exceeded the general inflation rate for thelast four years. We use various strategies to mitigate the negative effects ofhealthcare cost inflation. Specifically, we try to control medical and hospitalcosts through contracts with independent providers of healthcare services.Through these contracted providers, we emphasize preventive healthcare andappropriate use of specialty and hospital services.

 

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

 

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

 

Not applicable

 

**Item 4T. Controls and Procedures.**

 

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

 

We carried out an evaluation as of June 30, 2009, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures as defined in Rule 13a-15(e) ofthe Securities Exchange Act of 1934. Based upon that evaluation and in light ofthe material weakness in the financial reporting process at Brotman MedicalCenter discussed below, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were ineffective as ofthat date in ensuring that information required to be disclosed in the reportsthat we file with, or submit to, the Securities and Exchange Commission (the “SEC”)under the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andforms. In addition, based on that evaluation, the Chief Executive Officer andChief Financial Officer concluded that our disclosure controls and procedureswere ineffective as of June 30, 2009 in ensuring that information requiredto be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934 is accumulated and communicated to ourmanagement, including the Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosures.

 

See below for discussionof material weaknesses in internal control over financial reporting at Brotman,which became a majority-owned subsidiary effective April 14, 2009.

 

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***Brotman–Material Weakness in Internal Control over Financial Reporting***

 

*Summaryof Material Weaknesses in Internal Control Over Financial Reporting:*

 

As part of our quarterlymanagement assessment of internal controls over financial reporting, weidentified several deficiencies within the financial reporting process ofBrotman. We believe the combination of these deficiencies creates anenvironment where there is a reasonable possibility that a materialmisstatement of Brotman’s interim financial statements would not be detected ina timely manner. We have assessed a material weakness in the financialreporting process of Brotman and its related impact on the corporate consolidatingfinancial reporting process (“FRP”).  Thedeficiencies within the financial reporting process are the lack of aformalized month-end close process, limited staff training and financialaccounting expertise and a lack of department accounting policies andprocedures.

 

During the financialreporting close for the quarter ended June 30, 2009, Brotman was unable toimplement a structured close process which resulted in multiple delays andreiterations of their financial statements. Account reconciliations were notprepared in an accurate or timely manner which resulted in a significant amountof post close adjustments. Also, Brotman’s accounting department did notdemonstrate a sufficient amount of expertise or training to sufficientlycomplete the steps needed to execute an accurate or timely close.  Additionally, Brotman’s accounting departmentdid not utilize or implement policies and procedures to organize or streamlinethe close process.

 

As a result of thesedeficiencies, we are in the process of implementing significant changes in theBrotman accounting department. We added additional resources and personnel withexperience in and an understanding of the complexities of the business and afinancial reporting process. Additional control processes and oversightprocedures have been implemented; however, a longer evaluation period is neededto reasonably validate that such processes and procedures are operating at alevel to have fully remediated the material weakness as of June 30,2009.  At Brotman, we continue to expendsignificant efforts on financial reporting activities, integration ofoperations and expansion of our disclosure controls and procedures.

 

*RemediationSteps to Address Material Weaknesses:*

 

Based on findings ofmaterial weaknesses in our internal control over financial reporting as of June 30,2009, we have taken steps to strengthen our internal controls within thefinancial reporting process. We have added to the expertise and depth ofpersonnel within the Brotman accounting department, including the appointmentof a new Chief Financial Officer, with specific and significant expertise inthe critical areas identified above. We also added additional resources toassist in the review and preparation of significant account balancereconciliations as well as the implementation of new policies and procedures.Also, senior management has increased its scrutiny and oversight of Brotman’sfinancial statements and has performed significant top-down financial statementanalysis to gain additional assurance as to the accuracy of Brotman’s financialinformation. As previously stated, we will continue to work on and improve thefinancial reporting process of Brotman and its impact on the corporateconsolidating FRP. In review, the principal measures that we are in the processof undertaking to remediate the deficiencies are as follows:

 

·                  Hired a new Chief Financial Officer and added additional resources toimplement a sound financial reporting process;

 

·                  Enhanced Brotman’s accounting and finance policies and implementedrobust monitoring control procedures and analytics to prevent or detect amisstatement on a timely basis;

 

·                  In the process of developing a financial reporting responsibilitymatrix, close calendar and checklist for Brotman, whereby all general ledgeraccounts and financial statement line items are specifically assigned to aspecific member of the accounting department to perform monthly, quarterly andyear-end analysis. The analysis will be reviewed by senior members of theaccounting department team for accuracy and integrity;

 

·                  Developing a formal monthly, quarterly and annual reporting package,including specific reporting and information for identified key risk areas,with formal sign off by the financial executive with specific oversight of eacharea; and

 

·                  Writing formal accounting policies and procedures with regularcompliance reviews of key risk areas to evaluate the designing andeffectiveness of controls.

 

·                  Enhancing the corporate FRP oversight of theabove mentioned controls and process.

 

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

 

Except as discussed above, regarding Brotman, there were no changes inour internal control over financial reporting that occurred during the ninemonths ended June 30, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

**Item 1A.  Risk Factors.**

 

Not applicable.

 

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

 

None.

 

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

 

The Company was subject to certain financial and administrativecovenants, cross default provisions and other conditions required by thenow-repaid loan agreements with its former lenders as of June 30, 2009,including a maximum senior debt/EBITDA ratio, a minimum fixed-charge coverageratio and a minimum EBITDA level.  TheCompany exceeded the maximum senior debt/EBITDA ratio of 3.75 as of September 30,2007. The Company also exceeded the maximum senior debt/EBITDA ratio of 3.75and failed to meet the minimum fixed charge coverage ratio of 1.25 as of andfor the rolling twelve-month periods ended December 31, 2007 and March 31,2008. In addition, the Company did not comply with certain administrativecovenants for periods ended September 30, 2007, December 31, 2007,and March 31, 2008.

 

On February 13, 2008, April 10, 2008 and May 14, 2008,the Company and its former lenders entered into forbearance agreements, wherebythe lenders agreed not to exercise their rights under the credit facilitythrough May 15, 2008, subject to satisfaction of specified conditions. Forthe period January 28, 2008 through April 10, 2008, interest wasassessed at default rates. Under the April 2008 forbearance agreements,the applicable margin on the first and second lien term loans was permanentlyincreased to 750 and 1,175 basis points, respectively, and the range ofapplicable margins on the revolving line of credit was increased to 500 to 750basis points. The agreements also provide that the LIBOR rate shall not be lessthan 3.5% over the term of the credit facilities. During the forbearanceperiods, the Company had limited or no access to the line of credit. TheCompany also agreed to pay certain fees and expenses to the former lenders andtheir advisors as described below.

 

On May 15, 2008, the Company and its former lenders entered intoagreements to waive past covenant violations and amended the financial covenantprovisions prospectively starting in April 2008 to modify the requiredratios and to increase the frequency of compliance reporting from quarterly tomonthly for a specified period. Effective May 15, 2008, the maximum seniordebt/EBITDA ratios were increased to levels ranging from 3.90 to 7.15 formonthly reporting periods from April 30, 2008 through June 30, 2009and were increased to levels ranging from 3.30 to 3.75 beginning with the September 30,2009 quarterly reporting period through maturity of the term loan. The minimumfixed charge coverage ratios were reduced to levels ranging from 0.475 to 0.925for monthly reporting periods from April 30, 2008 through June 30,2009 and were reduced to levels ranging from 0.85 to 0.90 beginning with the September 30,2009 quarterly reporting periods through maturity of the term loan. The Companywas also required to meet a new minimum EBITDA requirement for future reportingperiods and has met all debt service requirements on a timely basis.

 

In connection with obtaining the forbearance and waivers, during thesecond and third quarters of 2008, the Company paid $450,000 in fees to Bank ofAmerica, N.A., which was included in general and administrative expenses and$1,525,000 in forbearance fees to the former lenders, which was included ininterest expense. In addition, the Company incurred $860,000 in legal andconsulting fees to the lenders’ advisors related to the forbearance activities,which was included in general and administrative expenses. Pursuant to theamended senior credit facility agreement, the Company was required to pay anamendment fee of $758,000 in cash and add 1% to the principal balance of thefirst and second-lien debt and the revolving line of credit totaling$1,514,000. The Company was also required to incur an additional 4% “payment-in-kind”interest expense on the second lien debt, which was added to the principalbalance on a monthly basis. The 4% could be reduced on a quarterly basis by0.50% for each 0.25% reduction in the Company’s consolidated leverage ratio. Inconnection with the modifications of the first and second-lien term debt andthe revolving line of credit, the Company wrote off the remaining unamortizeddiscount and debt issuance costs relating to the early extinguishment of theCompany’s existing debt totaling of $6,036,000, and expensed as debtextinguishment costs the amendment fees of $758,000 that was paid to its formerlenders and the $1,514,000 “payment-in-kind” interest added to the new debt,resulting in a total charge of $8,308,000 in connection with this debtextinguishment. Additionally, the Company capitalized $327,000 of legal andconsulting fees to the lenders’ advisors related to the new credit agreements.

 

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The Company was in compliance with the amended financial covenant provisions for the April 2008 through March 2009 monthly reporting periods. The Company continued to meet all debt service requirements on a timely basis; however, on March 19, 2009, it received written notices from its former lenders  which provided that they would begin assessing default interest rates based on assertions that the Company was in default of a requirement to sell certain of the Company’s assets by a specified date.  Additionally, on April 17, 2009, the Company received notices from its former lenders asserting that the Company’s April 14, 2009 increase in ownership of Brotman Medical Center, Inc. violated certain provisions of the amended credit agreements.  Effective with the first asserted default, interest was assessed at default rates on all loans. The Company contested both asserted events of default. On June 30, 2009, the Company entered into amendments to its former credit facility pursuant to which, among other things, the lenders waived all asserted events of default and stopped assessing default interest.  In connection with these amendments, the Company also entered into an amendment and waiver related to its swap agreements which provided that the alleged events of default under the former credit facility would not trigger an event of default under the swap agreements. The amendments required the Company to refinance the former credit facility no later than October 31, 2009, which requirement was fulfilled as set forth in the following paragraph.

 

On July 29,2009, the Company closed the offering of $160 million in 12.75% senior securednotes due 2014 (the “Notes”) at an issue price of 92.335%.  The sale wasexecuted in accordance with Rule 144A under the Securities Act of 1933 andRegulation S under the Securities Act of 1933.  Also, in connection withthe issuance of the Notes, the Company entered into a three-year $15 millionrevolving credit facility, which was undrawn at closing.  The interestrate under the revolving credit facility will be at LIBOR plus an applicablemargin of 7.00% with a LIBOR floor of 2.00%. The Company used the net proceedsfrom the sale of the Notes to repay in full all amounts outstanding under theformer credit facility discussed above, plus a prepayment premium ofapproximately $2.6 million.  On July 23,2009, the Company terminated the master swap agreement and the swaparrangements thereunder, and on July 29, 2009, the Company paid the swapcounterparty $11.7 million in final settlement of all amounts owing under theswap arrangements.

 

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

 

None

 

**Item 5.  Other Information**

 

Effective May 12, 2009, the Company and Samuel S. Lee (our ChiefExecutive Officer and Chairman of our Board of Directors) entered into anAmended and Restated Executive Employment Agreement (“Agreement”).  The Agreement amends and restates theOriginal Agreement (as amended by the First, Second, and Third Amendments) inits entirety, and provides for an increased annual base salary for Mr. Leeduring fiscal year 2009 in the amount of $950,000 (retroactive to April 1,2009).  It also provides that Mr. Leewill be eligible for an annual bonus tied to the Company’s attainment ofcertain EBITDA targets and allows the Compensation Committee of the Company’sBoard of Directors to grant discretionary bonuses as it determines appropriate.

 

**Item 6.  Exhibits.**

 

The followingdocuments are being filed as exhibits to this report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1*                |       | Indenture, dated  July 29, 2009, among  the Company, certain of its subsidiaries and affiliates (as subsidiary  guarantors) and U.S. Bank National Association (as trustee).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.2*                |       | Registration Rights  Agreement, dated July 29, 2009, among the Company, certain of its  subsidiaries and affiliates (as guarantors) and RBC Capital Markets  Corporation and Jefferies & Company, Inc. (as the initial  purchasers).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.3*                |       | Credit Agreement, dated  July 29, 2009, among  the Company, Royal Bank of Canada (as administrative agent), Jefferies  Finance LLC (as syndication agent) and the lenders party thereto.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.4**               |       | Continuing Guaranty, dated  July 29, 2009, in favor of Royal Bank of Canada (as administrative  agent), by: Alta Hospitals System, LLC; Alta Hollywood Hospitals, Inc.;  Alta Los Angeles Hospitals, Inc.; Genesis Healthcare of Southern  California, Inc., a Medical Group; Pomona Valley Medical  Group, Inc.; ProMed Health Care Administrators; ProMed Health Services  Company; Prospect Hospital Advisory Services, Inc.; Prospect Health  Source Medical Group, Inc.; Prospect Medical Group, Inc.; Prospect  Medical Systems, Inc.; Prospect NWOC Medical Group, Inc.; Prospect  Professional Care Medical Group, Inc.; Starcare Medical  Group, Inc.; and Upland Medical Group, a Professional Medical  Corporation. |

 

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| 10.5**  |   | Intercreditor Agreement,  dated July 29, 2009, among Prospect Medical Holdings, Inc. and  certain of it subsidiaries from time to time parties thereto, Royal Bank of  Canada (as first lien collateral agent), U.S. Bank National Association (as  second lien collateral agent) and Royal Bank of Canada (as control agent). |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.6**  |   | Credit Agreement, dated  April 14, 2009, between Brotman Medical Center, Inc. (as borrower)  and Gemino Healthcare Finance, LLC (as lender).                                                                                                                                                                                   |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.7**  |   | Loan Agreement, dated  July 9, 2008, between Brotman Medical Center, Inc. (as borrower)  and JHA West 16, LLC (as lender).                                                                                                                                                                                                     |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.8**  |   | Amendment No. 1 to  Loan Agreement, dated April 14, 2009, between Brotman Medical  Center, Inc. (as borrower) and JHA West 16, LLC (as lender).                                                                                                                                                                           |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.9**  |   | Loan Agreement, dated  July 9, 2008, between Brotman Medical Center, Inc. (as borrower)  and JHA East 7, LLC (as lender).                                                                                                                                                                                                      |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.10** |   | Amendment No. 1 to  Loan Agreement, dated April 14, 2009, between Brotman Medical  Center, Inc. (as borrower) and JHA East 7, LLC (as lender).                                                                                                                                                                            |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.11** |   | Amendment to Fifth Amended  and Restated Assignable Option Agreement, dated July 29, 2009, among  Prospect Medical Systems, Inc., Prospect Medical Group, Inc. and  Arthur Lipper, M.D.                                                                                                                                   |
|    |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.12** |   | Amendment to Third Amended  and Restated Option Agreement, dated July 29, 2009, between Prospect  Medical Group, Inc. and Arthur Lipper, 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.                                                                                                                                                                           |

 

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| *      | Filed by the Company  with the Securities and Exchange Commission on July 29, 2009 as an  exhibit to the Company’s Current Report on Form 8-K****and  incorporated herein by reference. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                   |
| **     | Filed with this  Quarterly Report on Form 10-Q.                                                                                                                                                   |

 

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**SIGNATURES**

 

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

 
|                  | PROSPECT  MEDICAL HOLDINGS, INC. |
|-----------------------|---------------------------------------|
|                  | (Registrant)                          |
|                  |                                  |
| August 19,  2009 | **/**s**/**SAMUEL S. LEE              |
| ** **            | **Samuel S. Lee**                     |
| ** **            | **Chief Executive Officer**           |
| ** **            | **(Principal Executive Officer)**     |
| ** **            | ** **                            |
| August 19,  2009 | **/**s**/**MIKE HEATHER               |
| ** **            | **Mike Heather**                      |
| ** **            | **Chief Financial Officer**           |
| ** **            | **(Principal Financial Officer)**     |

 

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