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**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 30,2010**

 

**or**

 

**o****         Transition report pursuant to Section 13or 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 past90 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, 2010 was 21,189,413

 

 

 

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Tableof Contents

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**Index**

 
| **Part I—Financial  Information** |
|---------------------------------------------|
|                                        |   |   |
| Item 1.                                | Financial Statements | 3 |
|                                        | Condensed  Consolidated Balance Sheets | 3-4 |
|                                        | Condensed  Consolidated Statements of Operations | 5 |
|                                        | Condensed Consolidated Statements of Cash Flows | 6 |
|                                        | Notes to Condensed Consolidated Financial Statements | 7 |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 36 |
| Item 3.                                | Quantitative  and Qualitative Disclosures about Market Risk | 63 |
| Item 4.                                | Controls and  Procedures | 64 |
| **Part II—Other  Information**    |
| Item 1.                                | Legal Proceedings | 65 |
| Item 1A.                               | Risk Factors | 65 |
| Item 2.                                | Unregistered  Sales of Equity Securities and Use of Proceeds | 65 |
| Item 3.                                | Defaults Upon  Senior Securities | 65 |
| Item 4.                                | Removed and Reserved | 65 |
| Item 5.                                | Other Information | 65 |
| Item 6.                                | Exhibits | 66 |
| Signatures                                  |   | 67 |

 

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**PART I—FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(inthousands)**

 
| ** **                                                                                                                                                   | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                                   | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ** **                                                                                                                                                   | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                   |       |              |       |                   |       |
| **Current assets:**                                                                                                                                          |       |              |       |                   |       |
| Cash  and cash equivalents                                                                                                                                   |       | $                 | 50,941     |                   | $          | 37,768 |   |
| Restricted  cash                                                                                                                                             |       | 2,793             |       | 1,395                  |       |
| Investments,  primarily restricted certificates of deposit                                                                                                   |       | 634               |       | 665                    |       |
| Patient  accounts receivable, net of allowance for doubtful accounts of $18,219 and  $11,715 at June 30, 2010 and September 30, 2009, respectively |       | 42,609            |       | 36,806                 |       |
| Due  from government payers                                                                                                                                  |       | 754               |       | 6,427                  |       |
| Other  receivables                                                                                                                                           |       | 4,039             |       | 1,711                  |       |
| Refundable  income taxes, net                                                                                                                                |       | —            |       | 1,558                  |       |
| Deferred  income taxes, net                                                                                                                                  |       | 6,567             |       | 6,644                  |       |
| Inventories  of supplies                                                                                                                                     |       | 4,130             |       | 4,137                  |       |
| Prepaid  expenses and other current assets                                                                                                                   |       | 4,955             |       | 5,380                  |       |
| **Total current assets**                                                                                                                                     |       | 117,422           |       | 102,491                |       |
|                                                                                                                                                         |       |              |       |                   |       |
| Property,  improvements and equipment, net                                                                                                                   |       | 63,638            |       | 63,724                 |       |
| Deferred  financing costs, net                                                                                                                               |       | 6,841             |       | 8,205                  |       |
| Goodwill                                                                                                                                                     |       | 153,250           |       | 153,250                |       |
| Intangible  assets, net                                                                                                                                      |       | 43,158            |       | 46,425                 |       |
| Other  assets                                                                                                                                                |       | 568               |       | 1,051                  |       |
| **Total assets**                                                                                                                                             |       | $                 | 384,877    |                   | $          | 375,146 |   |

 

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

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

** **

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 

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

 
| ** **                                                                                                                                                                             | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ** **                                                                                                                                                                             | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                          |       |              |       |                   |       |
| **Current liabilities:**                                                                                                                                                               |       |              |       |                   |       |
| Accrued  medical claims and other healthcare costs payable                                                                                                                             |       | $                 | 14,745     |                   | $          | 16,824 |   |
| Accounts  payable and other accrued liabilities                                                                                                                                        |       | 37,362            |       | 31,773                 |       |
| Accrued  salaries, wages and benefits                                                                                                                                                  |       | 18,777            |       | 24,903                 |       |
| Due  to government payers                                                                                                                                                              |       | 13,834            |       | 13,834                 |       |
| Income  taxes payable, net                                                                                                                                                             |       | 301               |       | —                 |       |
| Current  portion of capital leases                                                                                                                                                     |       | 757               |       | 820                    |       |
| Current  portion of long-term debt                                                                                                                                                     |       | 22,183            |       | 3,805                  |       |
| Other  current liabilities                                                                                                                                                             |       | 868               |       | 629                    |       |
| **Total current liabilities**                                                                                                                                                          |       | 108,827           |       | 92,588                 |       |
| Long-term  debt, net of current maturities                                                                                                                                             |       | 157,329           |       | 172,539                |       |
| Deferred  income taxes, net                                                                                                                                                            |       | 29,897            |       | 29,975                 |       |
| Malpractice  reserves                                                                                                                                                                  |       | 1,866             |       | 2,824                  |       |
| Capital  leases, net of current portion                                                                                                                                                |       | 617               |       | 569                    |       |
| Other  long-term liabilities                                                                                                                                                           |       | 158               |       | 162                    |       |
| Total  liabilities                                                                                                                                                                     |       | 298,694           |       | 298,657                |       |
| **Commitments Contingencies and Subsequent Events**                                                                                                                                    |       |              |       |                   |       |
| **Shareholders’ equity:**                                                                                                                                                         |       |              |       |                   |       |
| Common  stock, $0.01 par value; 40,000,000 shares authorized; 21,188,910 and  20,619,278 shares issued and outstanding at June 30, 2010 and  September 30, 2009,respectively |       | 212               |       | 206                    |       |
| Additional  paid-in capital                                                                                                                                                            |       | 97,014            |       | 94,498                 |       |
| Accumulated  deficit                                                                                                                                                                   |       | (10,008           | )          | (18,303                | )          |
| Total  shareholders’ equity                                                                                                                                                       |       | 87,218            |       | 76,401                 |       |
| Noncontrolling  interest                                                                                                                                                               |       | (1,035            | )          | 88                     |       |
| Total  Prospect Medical Holdings, Inc.’s shareholders’ equity                                                                                                           |       | 86,183            |       | 76,489                 |       |
| **Total liabilities and shareholders’ equity**                                                                                                                                    |       | $                 | 384,877    |                   | $          | 375,146 |   |

 

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

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 

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

 

**(Unaudited)**

 
| ** **                                                                                | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended********June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                | ** ** | **2010**                                    | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
| Revenues:                                                                                 |       |                                        |       |                                       |       |   |   |   |   |
| Net  Hospital Services revenues                                                           |       | $                                           | 69,540     |                                       | $          | 66,470 |   | $ | 209,490 |   | $ | 139,701 |   |
| Medical  Group revenues                                                                   |       | 47,367                                      |       | 47,848                                     |       | 140,175 |   | 144,138 |   |
| Total  revenues                                                                           |       | 116,907                                     |       | 114,318                                    |       | 349,665 |   | 283,839 |   |
| Operating  expenses:                                                                      |       |                                        |       |                                       |       |   |   |   |   |
| Hospital  operating expenses                                                              |       | 52,347                                      |       | 51,278                                     |       | 154,630 |   | 96,281 |   |
| Medical  Group cost of revenues                                                           |       | 37,422                                      |       | 36,968                                     |       | 111,130 |   | 111,535 |   |
| General  and administrative                                                               |       | 13,435                                      |       | 17,740                                     |       | 43,564 |   | 43,505 |   |
| Depreciation  and amortization                                                            |       | 2,078                                       |       | 2,162                                      |       | 6,236 |   | 5,751 |   |
| Total  operating expenses                                                                 |       | 105,282                                     |       | 108,148                                    |       | 315,560 |   | 257,072 |   |
| Operating  income from unconsolidated joint venture                                       |       | 482                                         |       | 535                                        |       | 1,514 |   | 1,482 |   |
| Operating  income                                                                         |       | 12,107                                      |       | 6,705                                      |       | 35,619 |   | 28,249 |   |
| Other  (income) expense:                                                                  |       |                                        |       |                                       |       |   |   |   |   |
| Interest  expense and amortization of deferred financing costs, net                       |       | 7,109                                       |       | 8,648                                      |       | 21,208 |   | 21,294 |   |
| (Gain)  loss on interest rate swap arrangements                                           |       | —                                      |       | (3,694                                     | )          | — |   | 5,019 |   |
| Total  other expense, net                                                                 |       | 7,109                                       |       | 4,954                                      |       | 21,208 |   | 26,313 |   |
| Income  before income taxes                                                               |       | 4,998                                       |       | 1,751                                      |       | 14,411 |   | 1,936 |   |
| Provision  for income taxes                                                               |       | 2,791                                       |       | 1,989                                      |       | 7,239 |   | 2,065 |   |
| Net  income (loss)                                                                        |       | 2,207                                       |       | (238                                       | )          | 7,172 |   | (129 | ) |
| Net  loss attributable to noncontrolling interest                                         |       | (640                                        | )          | —                                     |       | (1,123 | ) | 5 |   |
| Net  income (loss) attributable to Prospect Medical Holdings, Inc.                   |       | $                                           | 2,847      |                                       | $          | (238 | ) | $ | 8,295 |   | $ | (134 | ) |
|                                                                                      |       |                                        |       |                                       |       |   |   |   |   |
| Per  share data:                                                                          |       |                                        |       |                                       |       |   |   |   |   |
| Net  income (loss) attributable to Prospect Medical Holdings, Inc. per common  share |       |                                        |       |                                       |       |   |   |   |   |
| Basic                                                                                     |       | $                                           | 0.14       |                                       | $          | (0.01 | ) | $ | 0.40 |   | $ | (0.01 | ) |
| Diluted                                                                                   |       | $                                           | 0.12       |                                       | $          | (0.01 | ) | $ | 0.37 |   | $ | (0.01 | ) |
|                                                                                      |       |                                        |       |                                       |       |   |   |   |   |
| Weighted  average shares outstanding:                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Basic                                                                                     |       | 20,989                                      |       | 20,520                                     |       | 20,814 |   | 20,512 |   |
| Diluted                                                                                   |       | 23,119                                      |       | 20,520                                     |       | 22,567 |   | 20,512 |   |

 

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

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

** **

**(in thousands)**

** **

**(Unaudited)**

 
| ** **                                                                                           | ** ** | **Nine Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                           | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| **Operating activities**                                                                             |       |                                 |       |   |   |
| Net  income (loss)                                                                                   |       | $                                    | 7,172      |   | $ | (129 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                 |       |   |   |
| Depreciation  and amortization                                                                       |       | 6,235                                |       | 5,751 |   |
| Amortization  of deferred financing costs, net                                                       |       | 1,404                                |       | 259 |   |
| Amortization  of original issue discount                                                             |       | 1,385                                |       | — |   |
| Provision  for bad debts                                                                             |       | 21,993                               |       | 12,283 |   |
| Payment-in-kind  interest expense                                                                    |       | —                               |       | 277 |   |
| Amortization  of other comprehensive income related to interest rate swap arrangements               |       | —                               |       | 659 |   |
| Deferred  income taxes, net                                                                          |       | —                               |       | (1,628 | ) |
| Stock-based  compensation                                                                            |       | 1,895                                |       | 766 |   |
| (Gain)  loss on sale of assets                                                                       |       | (7                                   | )          | 34 |   |
| Loss  on interest rate swap agreements                                                               |       | —                               |       | 5,019 |   |
| Change  in assets and liabilities:                                                                   |       |                                 |       |   |   |
| Patient  and other receivables                                                                       |       | (24,449                              | )          | (9,016 | ) |
| Prepaid  expenses and other                                                                          |       | 425                                  |       | 431 |   |
| Inventories  of supplies                                                                             |       | 7                                    |       | 133 |   |
| Refundable  income taxes, net                                                                        |       | 1,558                                |       | 2,654 |   |
| Income  taxes payable, net                                                                           |       | 301                                  |       | — |   |
| Deposits  and other assets                                                                           |       | 481                                  |       | 171 |   |
| Accrued  medical claims and other healthcare costs payable                                           |       | (2,079                               | )          | (2,617 | ) |
| Accounts  payable and other accrued liabilities                                                      |       | (1,259                               | )          | (3,009 | ) |
| Net  cash provided by operating activities                                                           |       | 15,062                               |       | 12,038 |   |
| **Investing activities**                                                                             |       |                                 |       |   |   |
| Purchases  of property, improvements and equipment                                                   |       | (2,268                               | )          | (764 | ) |
| Cash  paid for acquisitions, net of cash received                                                    |       | —                               |       | (2,310 | ) |
| Capitalized  expenses related to acquisitions                                                        |       | —                               |       | (37 | ) |
| Decrease  (increase) in restricted certificates of deposit                                           |       | 31                                   |       | (28 | ) |
| Net  cash used in investing activities                                                               |       | (2,237                               | )          | (3,139 | ) |
| **Financing activities**                                                                             |       |                                 |       |   |   |
| Borrowings  (repayments) on line of credit, net                                                      |       | 2,681                                |       | (1,671 | ) |
| Repayments  on Class 4 Creditors Trust Note                                                     |       | (897                                 | )          | — |   |
| Repayments  of term loans                                                                            |       | —                               |       | (8,904 | ) |
| Payments  on capital leases                                                                          |       | (625                                 | )          | (395 | ) |
| Change  in restricted cash                                                                           |       | (1,399                               | )          | 1,047 |   |
| Proceeds  from exercises of stock options and warrants                                               |       | 627                                  |       | — |   |
| Cash  paid for deferred financing costs, net                                                         |       | (39                                  | )          | (972 | ) |
| Net  cash (used in) provided by financing activities                                                 |       | 348                                  |       | (10,895 | ) |
| Increase  (decrease) in cash and cash equivalents                                                    |       | 13,173                               |       | (1,996 | ) |
| Cash  and cash equivalents at beginning of period                                                    |       | 37,768                               |       | 33,583 |   |
| Cash  and cash equivalents at end of period                                                          |       | $                                    | 50,941     |   | $ | 31,587 |   |
| **Supplemental disclosure of cash flow information**                                                 |       |                                 |       |   |   |
| Equipment  acquired under capital lease                                                              |       | $                                    | 631        |   | $ | 509 |   |
| Interest  paid                                                                                       |       | $                                    | 12,305     |   | $ | 19,441 |   |
| Income  taxes paid, net                                                                              |       | $                                    | 5,380      |   | $ | 1,523 |   |

 

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

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**June30, 2010**

** **

**(Unaudited)**

 

**1. Organization**

 

Prospect Medical Holdings, Inc. (“Prospect,” “Company” or the “ParentEntity”) is a Delaware corporation. Prior to the August 8, 2007acquisition of Alta Hospitals System, LLC (“Alta”), which was previouslyknown as Alta Healthcare System, Inc., the Company was primarily engagedin providing management services to affiliated physician organizations thatoperate as independent physician associations (“Medical Groups”) or medicalclinics. Following the Alta acquisition and acquisition of a majority stake inBrotman Medical Center, Inc., a California corporation (“Brotman”), onApril 14, 2009 (see Note 8), and as of June 30, 2010, theCompany owns and operates five community-based hospitals in SouthernCalifornia, and its operations are organized into three primary reportablesegments: Hospital Services, Medical Group and Corporate as discussed below.

 

Effective August 16, 2010, the Company entered into a definitive mergeragreement (see Note 14).

 

***Hospital Services Segment***

 

Alta and Brotman (collectively, the “Hospital Services segment”) ownand operate five hospitals in Los Angeles County, all accredited by the JointCommission (formerly the Joint Commission on Accreditation of HealthcareOrganizations), with a total of 759 licensed beds served by 727 on-staffphysicians at June 30, 2010. Alta owns (i) Alta HollywoodHospitals, Inc., a California corporation, dba Hollywood CommunityHospital and Van Nuys Community Hospital; and (ii) Alta Los AngelesHospitals, Inc., a California corporation, dba Los Angeles CommunityHospital and Norwalk Community Hospital. On April 14, 2009 (the “AcquisitionDate”), the Company increased its existing approximately 33.1% ownership stakein Brotman, to approximately 72% via an investment of approximately$2.5 million in cash, thereby obtaining a controlling interest. Brotman ownsand operates Brotman Medical Center, located in Culver City, California.

 

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

 

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

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

 

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”).

 

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***Medical Group Segment***

 

The Medical Group segment is a healthcare management servicesorganization that provides management services to affiliated physicianorganizations that operate as independent physician associations (“Medical Groups”).The affiliated physician organizations enter into agreements with HMOs toprovide HMO enrollees with a full range of medical services in exchange forfixed, prepaid monthly fees known as “capitation” payments. The Medical Groupscontract with physicians (primary care and specialist) and other healthcareproviders to provide enrollees with all medical services. Prospect currentlymanages the provision of prepaid healthcare services for its affiliatedphysician organizations in Southern California. The network consists of thefollowing physician organizations as of June 30, 2010 (stand alone orindividually referred to as, an “Affiliate”):

 

Prospect Medical Group, Inc. (“PMG”)

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

Prospect Professional Care Medical Group, Inc. (“PPCM”)

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

Genesis HealthCare of Southern California, Inc. (“Genesis”)

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

StarCare Medical Group, Inc. (“PSC”)

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

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

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

Upland Medical Group, a Professional Medical Group (“UMG”)*

Pomona Valley Medical Group, Inc. (“PVMG”)*

 

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*       PVMG and UMG arecollectively referred to as the “ProMed Entities.”

 

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

 

Prospect Medical Systems, Inc. (“PMS”)

ProMed Healthcare Administrators, Inc. (“PHCA”)

 

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

 

The Medical Group segment manages services for the following enrolleesunder contracts with various health plans (in thousands, unaudited):

 
| ** **               | ** ** | **As of June 30,** | ** ** |
|--------------------------|------------|-------------------------|------------|
| **Member  Category**     | ** ** | **2010**                | ** ** | **2009** | ** ** |
| ** **               | ** ** | ** **              | ** ** | ** ** | ** ** |
| Commercial  — owned |       | 122                     |       | 136 |   |
| Commercial  - managed(l) |       | 8                       |       | 1 |   |
| Senior  — owned     |       | 22                      |       | 21 |   |
| Senior  - managed(1)     |       | 1                       |       | 0 |   |
| Medi-Cal  — owned   |       | 11                      |       | 12 |   |
| Medi-Cal  - managed(1)   |       | 12                      |       | 8 |   |
| Total                    |       | 176                     |       | 178 |   |

 

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(1)                                  Representsmembers that we manage on behalf of third parties in exchange for a managementfee.

 

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***Corporate Segment***

 

Corporate segment reflects certain expenses incurred at ProspectMedical Holdings, Inc. (the “Parent Entity”) not specifically allocable tothe Hospital Services or Medical Group segments. These include and are notlimited to salaries, benefits and other compensation for corporate employees,financing, insurance, rent, operating supplies, legal, accounting, SECcompliance, and Sarbanes-Oxley compliance. The Company does not allocateinterest expense, gain or loss on interest rate swaps and income taxes to theother reporting segments.

** **

**2. Summary of Significant Accounting Policies**

 

***Basis of Presentation***

 

The accompanying unaudited condensed consolidated financial statementsof the Company have been prepared in conformity with U.S. Generally AcceptedAccounting Principles (“U.S. GAAP”) for interim consolidated financialinformation and with the instructions for Form 10-Q and Article 10 ofRegulation S-X. In accordance with the instructions and regulations of theSecurities and Exchange Commission (“SEC”) for interim reports, certaininformation and footnote disclosures normally included in financial statementsprepared in conformity with U.S. GAAP for annual reports have been omittedor condensed. All adjustments (consisting of normal recurring adjustments) anddisclosures considered necessary for fair presentation have been included inthe accompanying unaudited condensed consolidated financial statements.

 

The unaudited results of operations for the three months and ninemonths ended June 30, 2010 are not necessarily indicative of the resultsto be expected for the full year. The information included in this QuarterlyReport on Form 10-Q should be read in conjunction with the auditedconsolidated financial statements for the year ended September 30, 2009and notes thereto included in the Company’s Annual Report on Form 10-Kfiled with the SEC on December 21, 2009.

 

***Principles of Consolidation***

 

The unaudited condensed consolidated financial statements include theaccounts of the Company and all wholly owned and majority owned subsidiariesand controlled entities in accordance with the accounting guidance for consolidations.All adjustments considered necessary for a fair presentation of the results asof the date of, and for the interim periods presented, which consist solely ofnormal recurring adjustments, have been included. All significant intercompanybalances and transactions have been eliminated in consolidation.

 

***Effect of Recent AccountingPronouncements***

 

Effective the firstquarter of fiscal year 2010, the Company adopted the revised accountingguidance for business combinations, which changed its previous accountingpractices regarding business combinations. The more significant changes includean expanded definition of a business and a business combination; recognition ofassets acquired, liabilities assumed and noncontrolling interests (includinggoodwill) measured at fair value at the acquisition date; recognition ofacquisition-related expenses and restructuring costs separately from thebusiness combination; recognition of assets acquired and liabilities assumed attheir acquisition-date fair values with subsequent changes recognized inearnings. The guidance also amends and clarifies the application issues oninitial recognition and measurement, subsequent measurement and accounting, anddisclosure of assets and liabilities arising from contingencies in a businesscombination. The adoption did not have a material impact on the Company’scondensed consolidated financial statements for prior periods; but thepronouncement will impact the accounting for any acquisitions subsequent tothat date.

 

Effective in the firstquarter of fiscal year 2010, the Company adopted revised accounting guidancewhich requires noncontrolling interests (formerly minority interest) to bepresented as a separate component from the Company’s equity in the equitysection of the consolidated balance sheets. As required by this guidance, theCompany has adjusted the presentation of noncontrolling interests in the priorperiod unaudited condensed consolidated financial statements so that they arecomparable to those of the fiscal year 2010 period. The adoption of thisaccounting guidance had no impact on the Company’s results of operations anddid not have a material impact on the Company’s financial position.

 

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InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issuedguidance to amend the disclosure requirements related to recurring andnonrecurring fair value measurements. The guidance requires newdisclosures on the transfers of assets and liabilities between Level 1 (quotedprices in active market for identical assets or liabilities) and Level 2(significant other observable inputs) of the fair value measurement hierarchy,including the reasons and the timing of the transfers. Additionally, theguidance requires a roll forward of activities on purchases, sales, issuance,and settlements of the assets and liabilities measured using significantunobservable inputs (Level 3 fair value measurements). Disclosures regardingtransfers are required beginning January 1, 2010 and the Level 3rollforward is to be disclosed in reporting periods beginning after December 15,2010.  Since the Company had no transfers between categories, the additionaldisclosures are not applicable for the periods presented.

 

OnOctober 1, 2009, the Company adopted guidance on fair value measurementfor nonfinancial assets and liabilities, except for items that are recognizedor disclosed at fair value in the financial statements on a recurring basis (atleast annually). Adoption of the new guidance did not have a material impact onthe Company’s financial statements.

 

InJune 2008, the FASB issued guidance for the accounting of share-basedpayment awards. Under the guidance, unvested share-based payment awards thatcontain non-forfeitable rights to dividends or dividend equivalents are deemedparticipating securities and, therefore, are included in computing earnings pershare (“EPS”) pursuant to the two-class method. The two-class method determinesearnings per share for each class of common stock and participating securitiesaccording to dividends or dividend equivalents and their respectiveparticipation rights in undistributed earnings. The Company adopted theguidance effective October 1, 2009.  The adoption of thisguidance did not impact net income attributable to the Company per common sharefor prior periods and is not expected to have an impact on future periods untilsuch time as the Company declares a regular quarterly dividend.

 

In June 2009, theFASB issued revised guidance for the accounting of variable interest entities.This revised guidance replaces the quantitative-based risks and rewardsapproach with a qualitative approach that focuses on identifying whichenterprise has the power to direct the activities of a variable interest entitythat most significantly impact the entity’s economic performance and has theobligation to absorb losses or the right to receive benefits from the entitythat could be potentially significant to the variable interest entity. Theaccounting guidance also requires an ongoing reassessment of whether anenterprise is the primary beneficiary and requires additional disclosures aboutan enterprise’s involvement in variable interest entities. This accountingguidance is effective for the Company beginning in the first quarter of fiscal2011. The Company is currently evaluating the impact that the adoption of thisguidance will have on its consolidated financial statements.

 

InJune 2009, the FASB issued revised guidance for the accounting oftransfers of financial assets. This guidance eliminates the concept of aqualifying special-purpose entity, removes the scope exception for qualifyingspecial-purpose entities when applying the accounting guidance related to theconsolidation of variable interest entities, changes the requirements forderecognizing financial assets, and requires enhanced disclosure. Thisaccounting guidance is effective for the Company beginning in the first quarterof fiscal 2011. The Company is currently evaluating the impact that theadoption of this guidance will have on its consolidated financial statements.

 

***Use of Estimates***

 

The preparation of financial statements in conformity with U.S. GAAPrequires Management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses, and the disclosure ofcontingent assets and liabilities at the dates, and for the periods, that theunaudited condensed consolidated financial statements are prepared. Actualresults could materially differ from those estimates. Principal areas requiringthe use of estimates include third party settlements, receivables for medicalservices, allowances for contractual discounts and doubtful accounts, accrualsfor medical claims, impairment of goodwill, long-lived assets and intangibleassets, valuation of interest rate swaps, share-based payments, professionaland general liability claims and workers’ compensation claims, reserves foroutcome of legislation and valuation allowances against deferred tax assets.

 

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***Restricted Cash***

 

At June 30, 2010, restricted cash primarily represent amounts setaside pursuant to the JHA loan agreements (see Note 7), totaling $2,560,000held in escrow for property taxes, maintenance and emergency room construction.Additionally, $233,000 was held in a restricted account in connection withworkers compensation arrangements.

 

***Investments***

 

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

 

***Due from/to Government Payers***

 

Following the acquisition of Brotman, effective April 14, 2009,the Company consolidated Brotman’s estimated liability to the Centers forMedicare and Medicaid Services (“CMS”) arising out of outlier payments receivedfor services provided by Brotman to Medicare eligible inpatients, primarily forthe last four months of calendar year 2005 and all of calendar year 2006.

 

WhileBrotman reports 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 primarily based on the diagnosis of the patient, but are entitledto receive additional payments, referred to as “outliers” for patients whosetreatment is very costly. When Brotman acquired the hospital in 2005, CMSprovided a ratio of cost to charges (the “RCC”) based on the statewide average.Payments on this basis were an interim estimate, subject to final determinationupon auditing of the Hospital’s cost reports. The Hospital filed its Medicarecost reports, but determined that its outlier reimbursement for servicesprovided in fiscal years 2005 and 2006 might be subject to adjustment based oncertain outlier reconciliation rules. The Company believes that CMS has not conductedany outlier reconciliations under current regulations, has not formallynotified the Hospital of any pending reconciliation to be conducted regardingtheir cost reports and has not determined the amount of any liability at thispoint related to possible overpayments. As of June 30, 2010 andSeptember 30, 2009, an estimated liability of $13,834,000 was included inthe accompanying unaudited condensed consolidated balance sheet related to thismatter. Brotman and Alta have also accrued estimated third party settlement netreceivables in the amount of $754,000 for filed cost reporting years andestimates for the nine months ended June 30, 2010.  At September 30, 2009, estimated netreceivables for cost reports not yet finalized were approximately $1,575,000.Normal estimation differences between final settlements and amounts accrued inprevious years are reflected in net patient service revenue in the year offinal settlement, which amounts totaled approximately $517,000 and $1,087,000in the three month and nine month periods ended June 30, 2009,respectively, and $377,000 in each of the three month and nine month periodsended June 30, 2010.

 

Thefollowing is a summary of due from and due to governmental payers (inthousands):

 
| ** **                             | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|----------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                             | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ** **                             | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| Due  from government payers:           |       |              |       |                   |       |
| Medi-Cal  Disproportionate Share (DSH) |       | $                 | —     |                   | $          | 4,852 |   |
| Medicare  cost report settlement       |       | 754               |       | 1,575                  |       |
|                                   |       | $                 | 754        |                   | $          | 6,427 |   |
| Due  to government payers:             |       |              |       |                   |       |
| Outlier  liability                     |       | $                 | 13,834     |                   | $          | 13,834 |   |

 

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***Revenues***

 

Revenues by reportable operating segment are comprised of the followingamounts (in thousands, unaudited):

 
| ** **                            | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended********June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                    | ** ** | **2009 (1)**                               | ** ** | **2010** | ** ** | **2009 (1)** | ** ** |
| Net  Hospital Services                |       |                                        |       |                                       |       |   |   |   |   |
| Inpatient                             |       | $                                           | 60,169     |                                       | $          | 59,039 |   | $ | 181,219 |   | $ | 127,839 |   |
| Outpatient                            |       | 8,786                                       |       | 6,651                                      |       | 25,559 |   | 10,315 |   |
| Other                                 |       | 585                                         |       | 780                                        |       | 2,712 |   | 1,547 |   |
| Total  net Hospital Services revenues |       | $                                           | 69,540     |                                       | $          | 66,470 |   | $ | 209,490 |   | $ | 139,701 |   |
| Medical  Group                        |       |                                        |       |                                       |       |   |   |   |   |
| Capitation                            |       | $                                           | 46,790     |                                       | $          | 47,369 |   | $ | 139,172 |   | $ | 143,005 |   |
| Management  fees                      |       | 293                                         |       | 149                                        |       | 604 |   | 437 |   |
| Other                                 |       | 284                                         |       | 330                                        |       | 399 |   | 696 |   |
| Total  Medical Group revenues         |       | $                                           | 47,367     |                                       | $          | 47,848 |   | $ | 140,175 |   | $ | 144,138 |   |
| Total  revenues                       |       | $                                           | 116,907    |                                       | $          | 114,318 |   | $ | 349,665 |   | $ | 283,839 |   |

 

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(1)      Brotman revenues have beenincluded in the accompanying unaudited condensed consolidated financialstatements effective April 14, 2009, when the Company acquired a majoritystake in Brotman.  Accordingly, the threemonths and nine months ended June 30, 2009 include 77 days for each period’soperations of Brotman.

 

The Company presents segment information externally the same way Managementuses financial data internally to make operating decisions and assessperformance.  The Company’s operationsare organized into three reporting segments: (i) Hospital Services,(ii) Medical Group, and (iii) Corporate (see Note 9).

 

***Comprehensive Income (Loss)***

 

Comprehensive income (loss) includes net income (loss) attributable toProspect, net of taxes, and changes in the fair value of interest rate swapssubject to hedge accounting that are recorded as other comprehensive income. Asof April 1, 2008, the Company’s swaps ceased to be eligible for hedgeaccounting. As a result, all further changes in fair value of the swaps wererecorded in the condensed consolidated statements of operations and theeffective portion of the swaps of approximately $5.4 million, after tax,that was recorded in other comprehensive income through June 30, 2008continued to be amortized to interest expense, using the effective interestmethod over the remaining life of the swaps. The remaining unamortized portionof the interest rate swaps was expensed in July 2009 in connection withthe Company’s termination of such swaps.

 

***Reclassification***

 

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

 

***Subsequent Events***

 

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

 

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**3. Property, Improvements and Equipment**

 

Property, improvements and equipmentconsisted of the following (in thousands):

 
| ** **                                 | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ** **                                 | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| Property,  improvements and equipment:     |       |              |       |                   |       |
| Land  and land improvements                |       | $                 | 31,028     |                   | $          | 31,028 |   |
| Buildings  and improvements                |       | 24,298            |       | 23,665                 |       |
| Leasehold  improvements                    |       | 2,480             |       | 2,029                  |       |
| Equipment                                  |       | 21,847            |       | 20,255                 |       |
| Furniture  and fixtures                    |       | 892               |       | 913                    |       |
|                                       |       | 80,545            |       | 77,890                 |       |
| Less  accumulated depreciation             |       | (16,907           | )          | (14,166                | )          |
| Property,  improvements and equipment, net |       | $                 | 63,638     |                   | $          | 63,724 |   |

 

**4. Equity-Based Compensation Plans**

 

On August 13, 2008, following shareholder 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 awards underthe Company’s 1998 Stock Option Plan (“1998 Plan”) were discontinued and newequity awards are now granted under the 2008 Plan. Remaining authorized sharesunder the 1998 Plan which were not subject to outstanding awards as ofAugust 13, 2008, were canceled on August 13, 2008. The 1998 Plan willremain in effect as to outstanding equity awards granted under the 1998 Planprior to August 13, 2008. At the inception of the 2008 Plan, 4,000,000shares were reserved for issuance under the 2008 Plan. As of June 30,2010, there were 805,250 shares available for future grants under the 2008Plan.

 

Under the terms of the 2008 Plan, the exercise price of an ISO may notbe less than 100% of the fair market value of the Company’s common stock on thedate of grant and, if granted to a shareholder owning more than 10% of theCompany’s common stock, then not less than 110%. Stock options granted underthe 2008 Plan have a maximum term of 10 years from the grant date, and areexercisable at such time and upon such terms and conditions as determined bythe Committee. Stock options granted to employees generally vest over fouryears, while options granted to certain executives typically vest over 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 anemployee during 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 Activity***

 

The following table summarizes information about our stock optionsoutstanding as of June 30, 2010 and activity during the nine month periodthen ended (unaudited):

 
| ** **                                       | ** ** | ** ** | ** ** | ** **   | ** ** | ** **    | ** ** | **Weighted**    | ** ** |
|--------------------------------------------------|------------|------------|------------|--------------|------------|---------------|------------|-----------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** **   | ** ** | ** **    | ** ** | **Average**     | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** **    | ** ** | **Remaining**   | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | **Average**  | ** ** | **Aggregate** | ** ** | **Contractual** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Term**        | ** ** |
| ** **                                       | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Value**     | ** ** | **(Months)**    | ** ** |
| Outstanding  as of September 30, 2009       |       | 4,333,335  |       | $            | 3.00       |          | —     |            | —     |   |
| Granted                                          |       | 430,000    |       | $            | 4.46       |          | —     |            | —     |   |
| Exercised                                        |       | (173,858   | )          | $            | 2.59       |          | $          | 689,582         |       | — |   |
| Forfeited                                        |       | (20,000    | )          | $            | 4.49       |          | —     |            | —     |   |
| Expired                                          |       | (58,420    | )          | $            | 6.44       |          | —     |            | —     |   |
| Outstanding  as of June 30, 2010            |       | 4,511,057  |       | $            | 3.10       |          | $          | 13,300,533      |       | 39 |   |
| Vested  and exercisable as of June 30, 2010 |       | 3,507,719  |       | $            | 3.06       |          | $          | 10,483,150      |       | 38 |   |

 

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 below the quoted value.

 

***Stock-Based Compensation Expense***

 

Stock-basedcompensation expense for all share-based payments in exchange for employeeservices (including stock options and restricted stock) is measured at fairvalue on the date of grant, estimated using an option pricing model and isrecognized in the financial statements, net of estimated forfeitures over theawards requisite service period.

 

Compensation expenses for stock-based awards are measured andrecognized in the financial statements, net of estimated forfeitures over theawards requisite service period. The Company uses the Black-Scholes optionpricing model and a single option award approach to estimate the fair value ofoptions granted. Estimated forfeitures will be revised in future periods ifactual forfeitures differ from the estimates and will impact compensation costin the period in which the change in estimate occurs. The determination of fairvalue using the Black-Scholes option-pricing model is affected by the Company’sstock price 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 (unaudited):

 
| ** **                                                                             | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                             | ** ** | **June 30, 2010** | ** ** |
| Weighted  average fair value of option grants                                          |       | $                      | 1.70       |   |
| Weighted  average market price of the Company’s common stock on the date of grant |       | $                      | 4.46       |   |
| Weighted  average expected life of the options                                         |       | 3.16  years            |       |
| Risk-free  interest rate                                                               |       | 1.39                   | %          |
| Weighted  average expected volatility                                                  |       | 54.51                  | %          |

 

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 the Securities and Exchange Commission Staff’sshortcut approach. The “simplified method” states that the expected term isequal to the sum of the vesting term plus the contract term, divided by two. “Plainvanilla” options are defined as those granted at-the-money, having service timevesting as a condition to exercise, providing that non-vested options areforfeited upon termination and that there is a limited time to exercise thevested options after termination of service, usually 90 days, andproviding the options are non-transferable and non-hedgeable.

 

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Risk-FreeInterest Rate—The Company bases the risk-free interest rate on the impliedyield in effect at the time of option grant on U.S. Treasury zero-coupon issueswith equivalent remaining terms.

 

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 sufficient historical volatilitydata available to predict the stock’s future volatility. The Company hasidentified a group of comparable companies to calculate historical volatilityfrom publicly 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.

 

Expected Dividend Yields —The Company has never paid any cash dividendson its common stock and does not anticipate paying any cash dividends in theforeseeable future.

 

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 data sinceMay 2005 to estimate pre-vesting option forfeitures.

 

Duringthe nine months ended June 30, 2010, an aggregate of 430,000 options wereissued under the 2008 Plan, of which 220,000 were granted to Samuel S. Lee inconnection with his employment as the Chief Executive Officer of the Companyand 200,000 were granted to Mike Heather in connection with his employment asChief Financial Officer of the Company. As of June 30, 2010, all of theoptions granted to the Chief Executive Officer had vested and two-thirds ofoptions granted to the Chief Financial Officer had vested.

 

Stock-based compensation expense for stock options recognized in thethree months ended June 30, 2010 and 2009 was approximately $181,000 and$163,000, respectively, and in the nine months ended June 30, 2010 and2009, was approximately $1,038,000 and $665,000, respectively. At June 30,2010, there were 1,003,338 unvested options with related unamortizedcompensation expense of approximately $735,000, which will be recognizedratably over a weighted average remaining vesting period of 44 months.

 

***Restricted Stock Award Activities***

 

On August 15, 2008, the Company granted 200,000 shares ofrestricted stock to its Chief Financial Officer with a grant date fair value of$2.40 per share. As of June 30, 2010, all such shares had fully vested. OnDecember 18, 2009, the Company granted an aggregate of 210,000 shares ofrestricted stock to its Chief Executive Officer and Chief Financial Officer. Asof June 30, 2010, all of the shares granted to the Chief Executive Officerhad vested and two-thirds of the shares granted to the Chief Financial Officerhad vested.  Compensation expenserelating to restricted stock recorded in the three months ended June 30,2010 and 2009 was approximately $67,000 and $33,000, respectively and in thenine months ended June 30, 2010 and 2009, was approximately $789,000 and$113,000, respectively.

 

On November 12, 2009, the Companygranted an aggregate of 36,000 shares of restricted stock to outside members ofthe Board of Directors. Approximately $144,000 of expense relating to theseshares, which vested immediately was included in general and administrativeexpense in the accompanying unaudited condensed consolidated financialstatements during the nine months ended June 30, 2010.

 

**5. Earnings per Share**

 

The Company calculates basic net income (loss) per share by dividingnet income (loss) attributable to common shareholders by the weighted averagenumber of common shares outstanding. Diluted earnings per share is computed bydividing net income (loss) attributable to common shareholders by the weightedaverage number of common shares outstanding, after giving effect to potentiallydilutive shares computed using the treasury stock method. Such shares areexcluded if determined to be anti-dilutive.

 

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The calculations of basic and diluted net income (loss) per shareattributable to Prospect are as follows (in thousands, except share andper-share amounts, unaudited):

 
| ** **                                                              | ** ** | **Three Months Ended********June 30,** | ** ** | **Nine Months Ended********June 30,** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                              | ** ** | **2010**                                    | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net  income (loss) attributable to Prospect Medical Holdings, Inc. |       | $                                           | 2,847      |                                       | $          | (238 | ) | $ | 8,295 |   | $ | (134 | ) |
|                                                                    |       |                                        |       |                                       |       |   |   |   |   |
| Weighted  average common shares outstanding - basic                     |       | 20,989,275                                  |       | 20,520,166                                 |       | 20,814,321 |   | 20,512,351 |   |
| Dilutive  effect of stock options and warrants                          |       | 2,129,949                                   |       | —                                     |       | 1,752,392 |   | — |   |
| Weighted  average common shares outstanding - diluted                   |       | 23,119,224                                  |       | 20,520,166                                 |       | 22,566,713 |   | 20,512,351 |   |
|                                                                    |       |                                        |       |                                       |       |   |   |   |   |
| Basic                                                                   |       | $                                           | 0.14       |                                       | $          | (0.01 | ) | $ | 0.40 |   | $ | (0.01 | ) |
| Diluted                                                                 |       | $                                           | 0.12       |                                       | $          | (0.01 | ) | $ | 0.37 |   | $ | (0.01 | ) |

 

TheCompany excludes equity instruments from the calculation of diluted earningsper share if the effect of including such instruments is anti-dilutive.Accordingly, a certain number of stock options and warrants have been excludedfrom the calculation of diluted earnings per share totaling 60,000 sharesduring the nine months ended June 30, 2010 and no shares during the threemonths ended June 30, 2010, and totaling 4,819,851 shares during each ofthe three months and nine months ended June 30, 2009, respectively.

 

**6. Related Party Transactions**

 

Prospect has a controlling financial interest in an affiliatedphysician organization included in its unaudited condensed consolidatedfinancial statements which is owned by a nominee physician shareholderdesignated by the Company. The control is effectuated through assignable optionagreements and management services agreements, which provide the Company with aunilateral right to establish or effect a change of the nominee shareholder forthe affiliated physician organizations at will, and without the consent of thenominee, on an unlimited basis and at nominal cost through the term of themanagement agreement. Jacob Y. Terner, M.D. was, through August 8, 2008,the sole shareholder, sole director and Chief Executive Officer of ProspectMedical Group, Inc. (“PMG”) and was the Chief Executive Officer of most ofPMG’s subsidiary physician organizations. Dr. Terner also served as thesole shareholder and a director and officer of Nuestra Familia MedicalGroup, Inc. (“Nuestra”), an affiliated physician organization.Dr. Terner is a shareholder of the Company, and formerly served as itsChairman and Chief Executive Officer through part of fiscal year 2008.

 

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

 

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

 

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On August 1, 2005 and subsequently amended on October 25,2007, Prospect Medical Management, Inc. (now known as Prospect HospitalAdvisory Services, Inc. (“PHAS”)), an affiliate of the Company, enteredinto a consulting services agreement, to provide administrative, financial andmanagement consulting services to Brotman for a monthly fee of $100,000 plusexpenses. The agreement had an initial term of one year and automaticallyrenewed for additional one-year terms unless terminated by either party with90 days written notice. As discussed in Note 8, Brotman, which fileda voluntary petition for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code on October 25, 2007, emerged from Chapter 11bankruptcy proceeding on April 14, 2009 (the “Effective Date”). On theEffective Date, the Company increased its approximately 33.1% ownership stakein Brotman, to approximately 72% via an incremental investment of approximately$2.5 million. For the 195 days ended April 13, 2009, total feesearned and paid under the consulting services agreement were approximately$650,000. Beginning April 14, 2009, amounts earned under the agreementhave been eliminated in consolidation.

 

OnDecember 15, 2009, Brotman initiated a rights offering (“Rights Offering”),whereby existing shareholders of the Company could subscribe to purchase up to$5,500,000 of Brotman convertible subordinated promissory notes (the “BrotmanNotes”).  The Brotman Notes are due threeyears from the date of issuance, bear interest at 15% per annum, and areconvertible at the option of the holder into shares of Brotman at $3.34 pershare.  PHAS exercised its right topurchase a portion of its pro rata (approximately 72%) share of the BrotmanNotes and, effective January 7, 2010, purchased $3,500,000 of such BrotmanNotes.  Additionally, PHAS planned onexercising its right to purchase any Brotman Notes offered that were notpurchased by other Brotman shareholders. Brotman intended to use the remainderof the Rights Offering to repay approximately $2 million currently due toProspect.

 

Asa result of the Rights Offering, Culver Hospital Holdings, a minorityshareholder of Brotman, filed a shareholder complaint against Prospect MedicalHoldings, PHAS, Brotman, and each of the Brotman Board of Directors.  The court granted a preliminary injunctionthat enjoins Prospect from taking the following actions: (1) acquiringCulver’s share of convertible promissory notes, (2) converting the BrotmanNotes into shares of Brotman common stock, (3) converting Brotman’s debtowed to Prospect into shares of Brotman common stock, and (4) using theproceeds of the Rights Offering to repay debt that Brotman owes to Prospect.Prospect has filed a notice of appeal.

 

EffectiveDecember 15, 2009, the Board of Directors of Brotman authorized certaindesignated officers to enter into an amendment to the consulting servicesagreement between Brotman and PHAS (“Amended and Restated Consulting ServicesAgreement”).  The Amended and RestatedConsulting Services Agreement, which was executed on February 1, 2010,states *inter alia*, that effectiveApril 14, 2009, PHAS shall be entitled to receive a monthly fee of 4.5% ofBrotman’s net operating revenue.  To theextent Brotman does not have sufficient cash to make such cash payment, or isotherwise restricted in its ability to pay all amounts due by agreements applicableto Brotman or PHAS, then PHAS shall be entitled to receive shares of commonstock of Brotman.  All amounts under thisagreement are eliminated in consolidation.

 

PMG, an affiliated physician organization of the Company, entered intoa risk pool sharing agreement, dated May 1, 2005, with Brotman. Under theagreement, PMG and Brotman agreed to establish a Hospital Control Program (asdefined) to serve HMO enrollees and earn incentive revenue or incur penaltiesby sharing in the risk for hospitalization based on inpatient servicesutilized. Risk pools are generally settled in the following year. For the threemonths and nine months ended June 30, 2009, all incentive revenue earnedunder the agreement was compromised pursuant to Brotman’s Chapter 11 Planof Reorganization. Beginning April 14, 2009, all amounts earned under theagreement are eliminated in consolidation.

 

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

 

On August 31, 2005, PMG, entered into a joint marketing agreementwith Brotman. The agreement is for an initial term of 20 years, renewablefor successive five-year terms unless terminated by either party with180 days written notice. During the term of this agreement, Brotman willcontract exclusively with PMG with regard to full risk contracting with HMOsfor all lines of business, including Medicare, Medi-Cal and commercialenrollees. Brotman will not merge into, consolidate with, or sell substantiallyall of its assets (unless the purchaser or surviving entity expressly assumesthese managed care exclusivity arrangements), alter such agreements without theconsent of PMG, and agrees to be bound by the exclusivity provision.

 

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On March 1, 2010, Alta entered into an agreement with an HMO,pursuant to which, Alta would provide hospital, medical, and other healthcareservices to approximately 2,000 senior HMO enrollees under a fixed capitationarrangement (“Capitation Arrangement”). Concurrently, on March 1, 2010,Alta entered into a risk pool sharing agreement with PMG and Prospect HealthSource Medical Group (“PHS”) and a management services agreement with PMS.Under the risk pool sharing agreement, Alta, PMG and PHS agreed to establish aHospital Control Program (as defined) to serve the HMO enrollees, pursuant towhich, PMG is allocated 90% residual interest in the profit or loss, afterdeductions for costs to Alta hospitals. Under the management servicesagreement, PMS would provide non-hospital and non-physician support activitiesthat are required under the agreement with the HMO, in return for a monthlymanagement fee of 10% of earned revenue (as defined).  All amounts earned under the risk poolsharing and management services agreements are eliminated in consolidation.

 

**7.Long-Term Debt**

 

Long-term debt consists of the following (in thousands):

 
| ** **                                                 | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| ** **                                                 | ** ** | **(Unaudited)**   | ** ** | ** **             | ** ** |
| **Prospect’s debt:**                                  |       |              |       |                   |       |
| Senior  secured notes                                      |       | $                 | 160,000    |                   | $          | 160,000 |   |
| Less  original issue discount                              |       | (10,671           | )          | (11,980                | )          |
|                                                       |       | 149,329           |       | 148,020                |       |
| **Brotman’s debt:**                                   |       |              |       |                   |       |
| Senior  secured revolving credit facility                  |       | 5,453             |       | 2,888                  |       |
| Secured  credit facilities term loan : A (net of discount) |       | 15,730            |       | 15,655                 |       |
| Secured  credit facilities term loan: B                    |       | 6,250             |       | 6,250                  |       |
| Subordinated  promissory Note                              |       | 2,750             |       | 3,531                  |       |
|                                                       |       | 30,183            |       | 28,324                 |       |
| Less  current maturities                                   |       | (22,183           | )          | (3,805                 | )          |
| Long-term  debt                                            |       | $                 | 157,329    |                   | $          | 172,539 |   |

 

**Prospect’s Debt:**

 

***Senior Secured Notes***

 

On July 29, 2009, the Company closed the offering of$160 million in 12.75% senior secured notes due 2014 (the “Notes”) at anissue price of 92.335%. The sale was executed in accordance with Rule 144Aunder the Securities Act of 1933 and Regulation S under the Securities Actof 1933. Concurrent with the issuance of the Notes, the Company entered into athree year $15 million revolving credit facility which was undrawn atclosing and is still undrawn, with any future borrowings bearing interest atLondon Interbank Offered Rate (“LIBOR”) plus 7.00%, with a LIBOR floor of2.00%.

 

The Company used the net proceeds from the sale of the Notes to repayall remaining amounts outstanding under its former $155 million seniorsecured credit facility, plus a prepayment premium of approximately$2.6 million. The Company reflected the prepayment premium, together withthe write-off of approximately $560,000 of deferred financing costs related toits former credit facilities, as interest expense in the fourth quarter offiscal 2009. Capitalized deferred financing costs and original issue discountrelated to the Notes is being amortized over the term of the related debt usingthe effective interest method.

 

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

 

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

 

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The Indenture requires the Company to offer to repurchase the Notes at101% of their principal amount in the event of a change of control of theCompany and at 100% of the principal amount with certain proceeds of sales ofassets. The Indenture also contains certain covenants that, among other things,limit the Company’s ability, and the ability of its restricted subsidiaries to:pay dividends or distributions on capital stock or equity interests, prepaysubordinated indebtedness or make other restricted payments; incur additionaldebt; make investments; create liens on assets; enter into transactions withaffiliates; engage in other businesses; sell or issue capital stock ofrestricted subsidiaries; merge or consolidate with another company; transferand sell assets; create dividend and other payment restrictions affecting subsidiaries;and designate restricted and unrestricted subsidiaries. The Credit Agreementcontains a number of customary covenants as well as covenants requiring theCompany to maintain a maximum consolidated leverage ratio, minimum fixed chargecoverage ratio and a maximum consolidated total leverage ratio. As of June 30,2010, the Company was in compliance with the financial covenants of theIndenture and Credit Agreement.

 

Pursuant to its definitive Prospectus filed with the SEC on form S-4 onOctober 26, 2009, the Company offered to exchange (the “Exchange Offer”)up to $160 million of its 123⁄4% Senior Secured Notes, Series B, due2014 (the “Exchange Notes” and together with the Original Notes, the “Notes”)for an equal amount of the Notes issued on July 29, 2009 (the “OriginalNotes”). The Exchange Notes are substantially identical to the Original Notes,except that the offer and sale of the Exchange Notes have been registered underthe Securities Act of 1933, as amended, and the Exchange Notes do not bear anylegend restricting their transfer. The Exchange Offer was finalized onDecember 3, 2009, at which time $159 million of the $160 millionaggregate principal amount of private notes had been tendered and accepted forexchange.

 

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

 

Effective July 23, 2009, the Company terminated the former masterswap agreement and the swap arrangements thereunder by payment, onJuly 29, 2009, of $11.7 million to the swap counterparty in finalsettlement of all amounts owing under the swap arrangements. All relatedamounts included in accumulated other comprehensive loss, including relateddeferred income taxes (of approximately $4.2 million) was recorded asinterest expense (and to the tax provision) as of the effective date of theswap terminations.

 

**Brotman’s Debt:**

 

Brotman has debt under a Senior Secured Revolving Credit Facility,Secured Term Loans and an Unsecured Subordinated Promissory Note entered intoin conjunction with affecting its Plan of Reorganization. The Company has notguaranteed any portion of Brotman’s debt or other obligations. Given theCompany’s majority ownership in Brotman, effective April 14, 2009, allBrotman debt is included in the Company’s consolidated financial statements.The Company has no obligation to fund Brotman’s operations. Under the seniorsecured revolving credit agreement, the Company is permitted to make additionalinvestments in Brotman in an aggregate amount not to exceed $10,000,000,provided that such investments can exceed $10,000,000 if the amounts are fundedsolely with the proceeds of Equity Interests of the Company (as defined).

 

***Senior Secured Revolving Credit Facility***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman obtained a commitment from Gemino Healthcare Finance, LLC(“Gemino”) for a three year, $6.0 million (subsequently increased to $7.0million pursuant to an amendment described below), senior credit facilitysecured by Brotman’s accounts receivable. The facility expires on the earlierof April 14, 2012 and the Los Angeles Jewish Home for Aging (“JHA”) loan(see below) maturity date and bears interest at LIBOR plus 7% per annum (11.0%as of June 30, 2010, given a LIBOR floor of 4%). Interest is incurredbased on the greater of $2 million or the actual outstanding principalbalance. The agreement also includes an unused line fee of 0.5% per annum and acollateral line fee, based on the average outstanding principal balance, of0.5% per annum. Loan fees associated with the Gemino loan totalingapproximately $120,000, were capitalized and have been included as deferredfinancing costs in the accompanying unaudited condensed consolidated balancesheet as of June 30, 2010, with the amount being amortized over the termof the related debt using the effective interest method. The senior creditfacility agreement contains customary covenants for facilities of this type,including restrictions on the payment of dividends, change in ownership andmanagement, asset sales, incurrence of additional indebtedness, sale-leasebacktransactions, and related party transactions. Brotman must also comply withcertain financial covenants. Prior to the February 17, 2010 amendmentdiscussed below, Brotman was required to comply with a fixed charge coverageratio of not less than (i) 1.10:1.00 for the fiscal quarter endedJune 30, 2009, (ii) 1.15:1.00 originally for the fiscal quarter endedSeptember 30, 2009; and (iii) 1.20:1.00 for each fiscal quarterending thereafter. As of September 30, 2009, Brotman was not in compliancewith these financial covenants.

 

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Pursuant to an amendment entered into effective December 11, 2009,the Gemino credit agreement was amended to provide, among other things, awaiver of the specified events of default and the amendment to the definitionof fixed charge coverage ratio. Under the amended credit agreement, the fixedcharge coverage ratio was amended to require not less than (i) 1.00:1.00for the fiscal quarters ended December 31, 2009 and March 31, 2010;(ii) 1.05:1.00 for the fiscal quarters ended June 30, 2010 and endingSeptember 30, 2010, (iii) 1.10:1.00 for the fiscal quarters endingDecember 31, 2010 and March 31, 2011, and (iv) 1.20:1.00 for thefiscal quarter ending June 30, 2011 and each fiscal quarter endingthereafter. As of June 30, 2010, Brotman was in compliance with therequired financial covenants under the amended credit agreement. Pursuant to anamendment entered into effective February 17, 2010, the Gemino creditagreement and promissory note were amended to increase the loan commitment by$1.0 million, to a total commitment of $7.0 million.

 

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

 

On April 14, 2009, the effective date of the Plan ofReorganization, JHA agreed to provide Brotman with up to $22.25 million infinancing, consisting of two term loans: (i) a Term A Loan of$16 million (the “Term A Loan”) with a 24-month term and (ii) a Term BLoan of up to $6.25 million, with a term of 36 months (the “Term BLoan”). Subject to the notification requirements set forth in the loanagreements, the term of the Term A Loan can be extended up to 36 months.Interest on the Term A Loan is payable at 10% per annum for the first year ofthe loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10%per annum for the term of the loan. The Term A Loan and Term B Loan are securedby certain of Brotman’s personal property, and a mortgage on certain of Brotman’sreal property. The proceeds of the JHA loans were used to repay all existingsenior secured loans at Brotman as of April 14, 2009. Loan fees associatedwith the JHA loans totaling approximately $1,549,000, were capitalized and havebeen included as deferred financing costs in the accompanying unauditedcondensed consolidated balance sheet as of June 30, 2010, with that amountbeing amortized over the term of the related debt using the effective interestmethod.

 

With respect to the Term A Loan, JHA was granted the right (“Put Right”)to declare the unpaid loan amount, including remaining interest and any otheramounts due and payable under the loan agreements, immediately due and payableat any time after April 14, 2010 and prior to the date which istwenty-four months after the Closing Date, subject to JHA providing writtennotification to Brotman of its exercise of the Put Right at least 180 daysin advance.  Effective February 10,2010, JHA and Brotman entered into an amendment to the Term A Loan, whereby theearliest date on which JHA could provide notice of its exercise of the PutRight was extended from April 14, 2010 to October 14, 2010,effectively extending the earliest maturity date for the Term A Loan to April 14,2011. Brotman and JHA are currently negotiating a comprehensive amendment toand extension of the Term A Loan, pending completion of which, amounts owingunder this loan have been reflected as current in the accompanying June 30,2010 unaudited condensed consolidated balance sheet.

 

As part of the JHA financing, Brotman granted JHA an option to purchasecertain Brotman-owned property, where JHA plans to construct a senior livingfacility, for a purchase price equal to the outstanding principal balance ofthe Term A Loan plus any prepaid amounts. In connection with JHA’s optionright, Brotman is required to deposit $130,000 monthly into a reserveaccount (up to a maximum of $3,120,000), with such funds specifically earmarkedfor the construction of a new Brotman emergency room. Additionally, Brotman isrequired to deposit $10,000 monthly into a reserve account for capitalimprovements and a Tax and Insurance Deposit Account.

 

In accordance with relevant accounting pronouncements, the Term A Loan,which contains a real estate purchase option, is recorded at its present value,with any excess of the proceeds over that amount recorded as an option depositliability account. The present value of the loan is estimated using discountedcash flow analyses based on market rates obtained from independent thirdparties for similar type debt. Based on an estimated market interest rate of10.0%, the present value of the loan was estimated to be approximately$15,655,000 at inception. The difference of $345,000 between the recordedpresent value and the face value of the loan has been recorded as a discountagainst the loan and is being amortized to interest expense, using theeffective interest rate method, over the term of the loan. The Company began amortizingthe discount during the current quarter in the amount of $75,000.

 

***Subordinated Promissory Note***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, tobe held by the Creditor Trust for the benefit of holders of allowedClass 4 claims (as defined in the Plan of Reorganization) and paid prorata to holders of allowed Class 4 claims. The Note bears interest at7.50% per annum and is payable in sixteen equal quarterly installments ofprincipal 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 Hospital Advisory Services, Inc.a consulting fee of more than $100,000 per month, as specified in the Amendedand Restated Consulting Services Agreement (see Note 6).  As such, although the amount of theconsulting fee was increased to 4.5% of Brotman’s net operating revenueeffective April 14, 2009, the amount of such consulting fee actually paidin cash will not exceed $100,000 per month until such time as permitted byapplicable agreement, or the Creditor Trust Note has been amended or repaid.

 

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**8. Acquisitions**

 

**Brotman Medical Center, Inc.**

 

On August 31, 2005, the Company invested $1 million for anapproximately 33.1% stake in Brotman, a 420-bed licensed and accredited acutecare hospital, located in Culver City, California, with the intention ofoffering joint contracting to HMOs operating in Brotman’s service area. Brotmanincurred significant losses before and after the Company’s initial investmentand, on October 25, 2007 (the “Petition Date”), Brotman filed forbankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.Effective April 22, 2008, Samuel S. Lee (Prospect’s CEO and Chairman ofthe Board) was appointed Chairman of the Board of Directors of Brotman. OnApril 14, 2009 (The “Effective Date”), the U.S. Bankruptcy Court confirmedand declared effective the final Chapter 11 Plan of Reorganization (the “Planof Reorganization”) of Brotman whereby, among other things, all of Brotman’soutstanding securities were canceled and, in exchange for their pro rata shareof the New Value Contribution (as defined in the Plan of Reorganization)totaling $3,500,000, holders of Brotman’s existing securities would receive newcommon stock in Brotman in the same percentage as their pro rata share of theNew Value Contribution. Pursuant to the terms of the Plan, the Company madeadditional cash investments in Brotman, totaling $2,519,000, thereby acquiringan additional 38.86% ownership interest, which brought its total ownershipinterest to approximately 72%.

 

Forfinancial accounting purposes, the additional investment in Brotman wasreferred to as the “Brotman Acquisition.” As required by U.S. GAAP, thebusiness combination, which was achieved in stages, provides for recognition ofassets at current fair value with respect to the proportion of the Company’sincremental ownership interest in Brotman. The aggregate cost of the acquiredassets, which includes cash paid of $2.5 million and expenses incurred inconnection with the acquisition totaling $37,000, were allocated to the assetsacquired and liabilities assumed. The excess of the consideration over theestimated fair value of the assets and liabilities assumed has been allocatedto goodwill and an identifiable intangible asset. Due to negative net bookvalue of assets acquired, goodwill attributable to the noncontrolling (formerlyminority) interest was not recognized. As the noncontrolling interest inBrotman exceeds 20%, the accounting basis in the acquired ownership in Brotmanhave not been pushed-down to the financial statements of Brotman and have beenreflected in the Parent Company financial statements. The results of operationsof Brotman have been included in the consolidated financial statements sincethe April 14, 2009 acquisition date. Brotman’s operations for the threemonths and nine months ended June 30, 2010 reflected a net loss. The Companydoes not have the intent or ability, including under the terms of its debtagreements, to provide significant financial support to Brotman. Prior toOctober 1, 2009, a pro rata share of net income attributable to minorityinterest was not included under minority interest in the Company’s consolidatedstatement of operations, as the cumulative minority share of such income didnot exceed their cumulative share of prior losses absorbed by the Company.Effective October 1, 2009, with the adoption date of new accountingliterature (see Note 2), a pro rata share of net loss attributable tononcontrolling interest was reported as a component of equity separate from theCompany’s equity in the unaudited condensed consolidated balance sheet and asnet loss attributable to noncontrolling interest in the unaudited condensedconsolidated statement of operations.

 

Asdiscussed at Note 6, on December 15, 2009, Brotman initiated a rightsoffering (“Rights Offering”), whereby existing shareholders of Brotman couldsubscribe to purchase up to $5,500,000 of Brotman convertible subordinatedpromissory notes (the “Brotman Notes”). The Brotman Notes are due three yearsfrom the date of issuance, bear interest at 15% per annum and are convertibleat the option of the holder into shares of Brotman, at $3.34 per share. PHASexercised its right to purchase a portion of its pro rata (approximately 72%)share of the Brotman Notes and, effective January 7, 2010, purchased$3,500,000 of such Brotman Notes. Additionally, PHAS planned on exercising its right to purchase anyBrotman Notes offered that were not purchased by other Brotman shareholders.Brotman intended to use the remainder of the Rights Offering to repayapproximately $2 million currently due to Prospect.  As a result of the Rights Offering, CulverHospital Holdings, a minority shareholder of Brotman, filed a shareholdercomplaint against Prospect Medical Holdings, PHAS, Brotman, and each of theBrotman Board of Directors.  The courtgranted a preliminary injunction that enjoins Prospect from taking thefollowing actions:  (1) acquiring Culver’sshare of convertible promissory notes, (2) converting the Brotman Notes intoshares of Brotman common stock, (3) converting Brotman’s debt owed to Prospectinto shares of Brotman common stock, and (4) using the proceeds of the RightsOffering to repay debt Brotman owes to Prospect.  Prospect has filed a notice of appeal.

 

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The following is an analysis of the final allocation of assets acquiredand liabilities assumed and the goodwill and identifiable intangible assetamount recognized in connection with the Brotman Acquisition, as ofApril 14, 2009 (in thousands):

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

 

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

 

Goodwill from the Brotman Acquisition is primarily related to newcapacity for future growth, new geographic coverage, additional types of hospitalservices and in-place workforce. Through the Brotman Acquisition, the Companyexpanded into a new service market in the West Los Angeles, California area. Asa stock purchase, the goodwill acquired in the Brotman Acquisition is notdeductible for income tax purposes. Brotman recorded income related todischarge of debt upon emergence from the Chapter 11 Bankruptcyreorganization.

 

The following unaudited proforma financial information for the threemonth and nine month periods ended June 30, 2009 gives effect to theacquisition of Brotman as if it had occurred on October 1, 2008. Suchunaudited proforma information is based on historical financial informationwith respect to the acquisition and does not include any synergies oroperational or other changes that might have been effected by the Company.Significant proforma adjustments include increased depreciation related tofixed assets acquired (in thousands, unaudited).

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **June 30, 2009**      | ** ** | **June 30, 2009**     | ** ** |
| ** **                                    | ** ** | ** **             |       |                  |       |
| Net  revenue                                  |       | $                      | 149,563    |                  | $          | 345,225 |   |
| Net  loss attributable to common shareholders |       | $                      | (4,111     | )                     | $          | (2,752 | ) |
| Net  loss per share:                          |       |                   |       |                  |       |
| Basic                                         |       | $                      | (0.20      | )                     | $          | (0.13 | ) |
| Diluted                                       |       | $                      | (0.20      | )                     | $          | (0.13 | ) |

 

Since emergence from bankruptcy, Brotman has continued to incur lossesand experience liquidity issues. Management continues to implement operationalimprovements aimed at returning Brotman to profitability and is evaluatingfinancing requirements and alternatives. Prospect has limited ability to fundBrotman’s post-acquisition operations (Note 7).

 

**9. Segment Information**

 

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

 

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

 

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

 

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

 
| ** **                                                          | ** ** | **As of and for the Three Months Ended June 30, 2010** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                          | ** ** | **Hospital  Services**                                 | ** ** | **Medical Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues  from external customers                                   |       | $                                                      | 69,540     |   | $ | 47,367 |   | $ | — |   | $ | — |   | $ | 116,907 |   |
| Intersegment  revenues                                              |       | —                                                 |       | 325 |   | — |   | (325 | ) | — |   |
| Total  revenues                                                     |       | 69,540                                                 |       | 47,692 |   | — |   | (325 | ) | 116,907 |   |
| Operating  income (loss)                                            |       | 12,093                                                 |       | 3,292 |   | (3,278 | ) | — |   | 12,107 |   |
| Interest  expense and amortization of deferred financing costs, net |       | 1,414                                                  |       | 130 |   | 5,565 |   | — |   | 7,109 |   |
| Income  (loss) before income taxes                                  |       | $                                                      | 10,679     |   | $ | 3,162 |   | $ | (8,843 | ) | $ | — |   | $ | 4,998 |   |
| Identifiable  segment assets (liabilities)                          |       | $                                                      | 269,503    |   | $ | 104,935 |   | $ | 14,198 |   | $ | (3,759 | ) | $ | 384,877 |   |
| Segment  capital expenditures, net of dispositions                  |       | $                                                      | 830        |   | $ | 53 |   | $ | 2 |   | $ | — |   | $ | 885 |   |
| Segment  goodwill                                                   |       | $                                                      | 130,912    |   | $ | 22,338 |   | $ | — |   | $ | — |   | $ | 153,250 |   |

 
| ** **                                                          | ** ** | **As of and for the Three Months Ended June 30, 2009** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                          | ** ** | **Hospital********Services**                           | ** ** | **Medical Group** | ** ** | **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 |   | (3,862 | ) | — |   | 6,705 |   |
| Interest expense and amortization of deferred  financing costs, net |       | 1,106                                                  |       | (20 | ) | 7,562 |   | — |   | 8,648 |   |
| Loss on interest rate swap arrangements                             |       | —                                                 |       | — |   | (3,694 | ) | — |   | (3,694 | ) |
| Income (loss) 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 Nine Months Ended June 30, 2010** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                          | ** ** | **Hospital  Services**                                | ** ** | **Medical Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues  from external customers                                   |       | $                                                     | 209,490    |   | $ | 140,175 |   | $ | — |   | $ | — |   | $ | 349,665 |   |
| Intersegment  revenues                                              |       | —                                                |       | 565 |   | — |   | (565 | ) | — |   |
| Total  revenues                                                     |       | 209,490                                               |       | 140,740 |   | — |   | (565 | ) | 349,665 |   |
| Operating  income (loss)                                            |       | 36,537                                                |       | 8,558 |   | (9,476 | ) | — |   | 35,619 |   |
| Interest  expense and amortization of deferred financing costs, net |       | 3,873                                                 |       | 510 |   | 16,825 |   | — |   | 21,208 |   |
| Income  (loss) before income taxes                                  |       | $                                                     | 32,664     |   | $ | 8,048 |   | $ | (26,301 | ) | $ | — |   | $ | 14,411 |   |
| Identifiable  segment assets (liabilities)                          |       | $                                                     | 269,503    |   | $ | 104,935 |   | $ | 14,198 |   | $ | (3,759 | ) | $ | 384,877 |   |
| Segment  capital expenditures, net of dispositions                  |       | $                                                     | 2,106      |   | $ | 148 |   | $ | 14 |   | $ | — |   | $ | 2,268 |   |
| Segment  goodwill                                                   |       | $                                                     | 130,912    |   | $ | 22,338 |   | $ | — |   | $ | — |   | $ | 153,250 |   |

 

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| ** **                                                          | ** ** | **As of and for the Nine Months Ended June 30, 2009** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                          | ** ** | **Hospital********Services**                          | ** ** | **Medical Group** | ** ** | **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 |   |
| Interest expense and amortization of deferred  financing costs, net |       | 1,198                                                 |       | (51 | ) | 20,147 |   | — |   | 21,294 |   |
| Loss on interest rate swap arrangements                             |       | —                                                |       | — |   | 5,019 |   | — |   | 5,019 |   |
| Income (loss) 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 |   |

 

----

(1)                                  Prospect filesconsolidated tax returns and allocates costs for shared services and corporateoverhead to each of the reporting segments. With the exception of the BrotmanAcquisition, all acquisition-related debt, including those related to theMedical Group and Hospital Services segment, is recorded at the Parent entitylevel. As such, the Company does not allocate interest expense, and gain orloss on interest rate swaps to the operating segments.

 

(2)                               Prospect MedicalGroup, Inc. (which serves as a holding company for the other affiliatedphysician organizations) files consolidated tax returns.

 

(3)                               The informationabove reflects the Hospital Services segment results for the periods sinceBrotman’s acquisition, which during the three months and nine months ended June30, 2009, represent 77 days of Brotman operations.

 

**10. Income Taxes**

 

TheCompany recorded a tax provision of approximately $2,791,000 and $7,239,000 forthe three months and nine months ended June 30, 2010, at effective tax rates of68% and 54%, respectively; and a tax provision of approximately $1,989,000 and$2,065,000 for the three months and nine months ended June 30, 2009, ateffective tax rates of 114% and 107% respectively. The high effective tax ratesin the fiscal 2010 and 2009 periods was primarily due to the consolidated groupnot being able to recognize the tax benefit from Brotman’s loss for Federal taxpurposes.

 

Aspart of the Brotman Acquisition, Management of the Company adopted ASC 740-10,accounting for uncertain tax positions. The Company determined that no material unrecognized tax benefitsexisted at the date of acquisition and as of June 30, 2010.  Since its inception in 2005, Brotmanmaintains substantial net operating loss carryfowards which are open forexamination by the taxing authorities.

 

**11. Fair Value of Financial Investments**

 

The Company adopted the revised accounting guidance for fair valuemeasurements and disclosure of its financial assets and liabilities and itsnon-financial assets and liabilities on October 1, 2008 and October 1, 2009,respectively. The guidance defines fair value, establishes guidelines formeasuring fair value and expands disclosure regarding fair valuemeasurements.  It does not create or modify any current GAAPrequirements to apply fair value accounting.  However, it provides asingle definition for fair value that is to be applied consistently for allprior accounting pronouncements.  The adoption of this guidance didnot have a material impact on the Company’s financial position or results ofoperations.  The guidance establishes afair value hierarchy that prioritizes the inputs to valuation techniques usedto measure fair value. The three levels of the fair value hierarchy aredescribed 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).

 

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

 

The following table sets forth the Company’s financial assets andliabilities measured at fair value on a recurring basis and where they areclassified within the hierarchy as of June 30, 2010 (in thousands):

 
| ** **                                                 | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|------------------------------------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |      |       |             |       |             |       |             |       |
| Investments, primarily restricted certificates of  deposit |       | $         | 634        |             | $          | 634              |       | $                | —     |   | $ | — |   |
|                                                            |            |           |            |                  |            |                  |            |                  |            |  |  |  |  |

 

The Company’s investments are classified within Level 1 of thefair value hierarchy because they are valued using quoted market prices.

 

*Nonfinancial Items Measured at Fair Value on aNonrecurring Basis*

 

Nonfinancialassets such as goodwill and identifiable intangible assets are measured at fairvalue when there is an indicator of impairment and recorded at fair value onlywhen impairment is recognized. No impairment charges related to goodwill andintangible assets were recorded for the three months and nine months ended June30, 2010. See Note 8 for additional information regarding goodwill andintangible assets relating to the Brotman acquisition. The remaining goodwilland intangible assets related to the prior acquisitions of Alta and ProMed.Management of the Company evaluates their intangibles and goodwill quarterlyfor “triggering events” that may be indicators of impairment. The Companyperforms an annual impairment test on the goodwill and intangibles. The impairmenttest at September 30, 2009 resulted in no impairment charges. In addition, notriggering events were identified that would cause impairment based on an analysisas of June 30, 2010.

 

Effective April 1, 2009, the Company adopted the accounting guidancefor disclosure regarding fair value of financial instruments. This adoptionrequires that the fair value of financial instruments be disclosed in the bodyor notes of an entity’s financial statements in both interim and annualperiods. The adoption also requires the disclosure of methods and assumptionsused to estimate fair values. It does not require comparative disclosures forperiods preceding adoption. The fair values of the Company’s current financialassets and liabilities approximate their reported carrying amounts. Thecarrying values and the fair values of non-current financial assets andliabilities that qualify as financial instruments under the guidance are asfollows (in thousands, unaudited).

 
| ** **                                             | ** ** | **As of June 30, 2010** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **Carrying  Amount**    | ** ** | **Fair Value** | ** ** |
| **Assets:**                                            |       |                    |       |   |   |
| Long-term  notes receivable (included in Other Assets) |       | $                       | 314        |   | $ | 290 |   |
| **Liabilities:**                                       |       |                    |       |   |   |
| Long-term  debt                                        |       | $                       | 157,329    |   | $ | 175,974 |   |

 

Included in other assets were long-term notes receivable, which amountwas received as part of the consideration for the sale of three medical clinicsin April 2004, the fair value of such notes receivable was estimated basedon expected future payments discounted at risk-adjusted rates. The fair valueof the Company’s long-term debt was determined based on quoted market priceswith respect to Prospect’s Notes and based on expected future paymentsdiscounted at risk-adjusted rates of 10% with respect to Brotman’s debt.

 

**12. Litigation and Contingencies**

 

The Company is in the process of finalizing certain post-closingmatters related to the 2007 ProMed acquisition, including closing balance sheetreconciliations, escrow reconciliations and other matters. The Company hasrecorded estimated settlement accrual amounts relating to such matters in the accompanyingunaudited condensed consolidated financial statements.

 

Thecollective bargaining 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, UnitedHealthcare Workers-West (“SEIU”), covers a small group of Hollywood CommunityHospital’s employees 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 expired on February 28,2010. Both parties are currently engaged in good faith bargaining negotiationsand we currently do not anticipate that any changes arising from any newagreements will have a material adverse effect on the results of our HospitalServices operations in fiscal 2010.

 

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.

 

TheState of California has enacted Assembly Bill 1838 (“AB1383”) effective January1, 2010, to provide supplemental payments to certain medical facilities whichserve a disproportionate share of indigent and low income patients. The billdid not receive the necessary appropriations and cannot be implemented until itis approved by the Center for Medicare and Medicaid Services (“CMS”), which isanticipated to occur sometime in 2010 and applied retroactively to April 3,2009. Under this proposed program, participating hospitals, including theCompany’s hospitals, would be assessed a fee to be paid into a pool of funds towhich the federal government will contribute matching funds. These funds willthen be distributed to qualifying hospitals based on a prescribed formula. TheCompany anticipates that it will be a net beneficiary from the fund. No amountshave been recognized in the Company’s financial statements, since Managementcannot currently predict whether CMS will ultimately approve this program orthe ultimate timing and amounts that the Company will have to pay into the fundor receive from the fund.

 

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The Company is also subject to a variety of claims and suits that arisefrom time to time in the ordinary course of its business, acquisitions, orother transactions. While Management currently believes that resolving all ofthese matters, individually or in the aggregate, will not have a materialadverse impact on the Company’s consolidated financial position or results ofoperations, the litigation and other claims that the Company faces are subjectto inherent uncertainties and Management’s view of these matters may change inthe future. Should an unfavorable final outcome occur, there exists thepossibility of a materially adverse impact on the Company’s consolidatedfinancial position, results of operations and cash flows for the period inwhich the effect becomes probable and reasonably estimable.

 

The Company believes that the lines and amounts of insurance coveragethat it, its subsidiaries, and its affiliated physician organizations maintain,and that it requires its contracted physician providers to maintain, arecustomary in its industry and adequate for the risks insured. The Companycannot assure, however, that it will not become subject to claims not coveredor that exceed its insurance coverage amounts.

 

Total actuarially determined incurred but not reported claims and casereserves for estimated malpractice liabilities at June 30, 2010 were$1,866,000. These estimates may change in the future, and such changes may bematerial.

 

Total actuarially determined incurred but not reported claims and casereserves for estimated workers’ compensation liabilities at June 30, 2010 were$3,034,000 and included in accounts payable and other accrued liabilities inthe condensed consolidated balance sheet. These estimates are included in otheraccrued liabilities and may change in the future, and such changes may bematerial.

 

Total actuarially determined incurred but not reported claims and casereserves for estimated medical services liabilities under the fixed capitationarrangement at June 30, 2010 were $14,745,000. These estimates may change inthe future, and such changes may be material.

 

Total incurred but not reported claims for estimated hospital servicesunder the Capitation Arrangements (see Note 6) at Alta and Brotman at June 30,2010 were $2,927,000. These estimates are included under Other AccruedLiabilities in the condensed consolidated balance sheets at June 30, 2010, maychange in the future, and such changes may be material.

 

**13. Condensed consolidating financial statements ofProspect Medical Holdings, Inc. and subsidiaries as of June 30, 2010 andSeptember 30, 2009 and for the three months and nine months ended June 30,2010 and 2009**

 

As discussed in Note 7, on July 29, 2009, the Company closed theoffering of $160 million in 12.75% senior secured notes due 2014 (the “Notes”)and entered into a three year $15 million revolving credit facility. TheNotes and the revolving senior credit facility are jointly and severallyguaranteed on a senior secured basis by all of the Company’s restrictedsubsidiaries (the “Guarantors”), other than Brotman, Nuestra and certainimmaterial subsidiaries. The Notes are secured *pari passu*with the revolving credit facility on a first priority basis by liens onsubstantially all of the Company’s assets and assets of the subsidiaryguarantors (other than accounts receivable and proceeds therefrom) includingall mortgages on the Company and its subsidiary guarantors’ hospital properties(but excluding a pledge of, or mortgage on, the stock, properties or otherassets of Brotman, AMVI/Prospect Health Network and certain immaterialsubsidiaries). The lenders under the revolving credit facility have a firstpriority lien on certain of the accounts receivable of the Company and thesubsidiary guarantors, while the holders of the Notes have a second prioritylien on such collateral (see Note 7).

 

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

 

Pursuant to Rule 3-10 of Regulation S-X, the followingsummarized consolidating information is provided for the Company (the “Parent”),the Guarantors, and the Company’s non-Guarantor subsidiaries with respect tothe Notes as of September 30, 2009, as of and for the three months andnine months ended June 30, 2010 and for the three months and nine months endedJune 30, 2009.  This summarized financialinformation has been prepared from the books and records maintained by theCompany, the Guarantors and the non-Guarantor subsidiaries. The summarizedfinancial information may not necessarily be indicative of the results ofoperations or financial position had the Guarantors or non-Guarantorsubsidiaries operated as independent entities. In addition, intercompanyactivities between subsidiaries and the Parent are presented within operatingactivities on the unaudited condensed consolidating statement of cash flows.

 

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

 

**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As of June30, 2010**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                            | ** ** | **Parent**  | ** ** | **Combined Guarantor** | ** ** | **Combined********Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------|------------|------------------------|------------|-----------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Company** | ** ** | **Subsidiaries**       | ** ** | **Subsidiaries**                  | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **ASSETS**                                                                            |       |        |       |                   |       |                              |       |            |       |             |       |
| **Current assets:**                                                                   |       |        |       |                   |       |                              |       |            |       |             |       |
| Cash  and cash equivalents                                                            |       | $           | (287       | )                      | $          | 48,158                            |       | $               | 3,070      |             | $          | — |   | $ | 50,941 |   |
| Restricted  cash                                                                      |       | —      |       | —                 |       | 2,793                             |       | —          |       | 2,793            |       |
| Investments                                                                           |       | —      |       | 634                    |       | —                            |       | —          |       | 634              |       |
| Patient  accounts receivable, net                                                     |       | —      |       | 21,907                 |       | 20,702                            |       | —          |       | 42,609           |       |
| Due  from government payers                                                           |       | —      |       | 78                     |       | 676                               |       | —          |       | 754              |       |
| Other  receivables                                                                    |       | —      |       | 4,039                  |       | —                            |       | —          |       | 4,039            |       |
| Refundable  income taxes, net                                                         |       | (355        | )          | 355                    |       | —                            |       | —          |       | —           |       |
| Deferred  income taxes, net                                                           |       | 4,323       |       | 2,244                  |       | —                            |       | —          |       | 6,567            |       |
| Inventories  of supplies                                                              |       | —      |       | 1,500                  |       | 2,630                             |       | —          |       | 4,130            |       |
| Prepaid  expenses and other current assets                                            |       | 661         |       | 2,502                  |       | 1,792                             |       | —          |       | 4,955            |       |
| Intercompany  accounts                                                                |       | 64,555      |       | (87,193                | )          | 22,556                            |       | 82              |       | —           |       |
| **Total current assets**                                                              |       | 68,897      |       | (5,776                 | )          | 54,219                            |       | 82              |       | 117,422          |       |
| Property,  improvements and equipment, net                                            |       | 21          |       | 55,133                 |       | 8,484                             |       | —          |       | 63,638           |       |
| Deferred  financing costs, net                                                        |       | 6,070       |       | —                 |       | 771                               |       | —          |       | 6,841            |       |
| Goodwill                                                                              |       | —      |       | 153,250                |       | —                            |       | —          |       | 153,250          |       |
| Intangible  assets, net                                                               |       | —      |       | 43,158                 |       | —                            |       | —          |       | 43,158           |       |
| Other  assets                                                                         |       | 3,764       |       | 562                    |       | —                            |       | (3,758          | )          | 568              |       |
| **Total assets**                                                                      | ** ** | **$**       | 78,752     |                   | $          | 246,327                           |       | $               | 63,474     |             | $          | (3,676 | ) | $ | 384,877 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                         |       |        |       |                   |       |                              |       |            |       |             |       |
| **Current liabilities:**                                                              |       |        |       |                   |       |                              |       |            |       |             |       |
| Accrued  medical claims and other healthcare costs payable                            |       | $           | —     |                   | $          | 14,445                            |       | $               | 300        |             | $          | — |   | $ | 14,745 |   |
| Accounts  payable and other accrued liabilities                                       |       | 12,171      |       | 12,187                 |       | 13,004                            |       | —          |       | 37,362           |       |
| Accrued  salaries, wages and benefits                                                 |       | 3,320       |       | 7,972                  |       | 7,485                             |       | —          |       | 18,777           |       |
| Due  to government payers                                                             |       | —      |       | —                 |       | 13,834                            |       | —          |       | 13,834           |       |
| Income  taxes payable, net                                                            |       | (1,513      | )          | 1,871                  |       | (57                               | )          | —          |       | 301              |       |
| Current  portion of capital leases                                                    |       | —      |       | 288                    |       | 469                               |       | —          |       | 757              |       |
| Current  portion of long-term debt                                                    |       | —      |       | —                 |       | 22,183                            |       | —          |       | 22,183           |       |
| Other  current liabilities                                                            |       | 27          |       | 841                    |       | —                            |       | —          |       | 868              |       |
| **Total current liabilities**                                                         |       | 14,005      |       | 37,604                 |       | 57,218                            |       | —          |       | 108,827          |       |
| Long-term  debt, net of current maturities                                            |       | 149,329     |       | —                 |       | 11,758                            |       | (3,758          | )          | 157,329          |       |
| Deferred  income taxes, net                                                           |       | 8,911       |       | 20,986                 |       | —                            |       | —          |       | 29,897           |       |
| Malpractice  reserves                                                                 |       | —      |       | 816                    |       | 1,050                             |       | —          |       | 1,866            |       |
| Capital  leases, net of current portion                                               |       | —      |       | 590                    |       | 27                                |       | —          |       | 617              |       |
| Other  long-term liabilities                                                          |       | 45          |       | 112                    |       | 1                                 |       | —          |       | 158              |       |
| **Total liabilities**                                                                 |       | 172,290     |       | 60,108                 |       | 70,054                            |       | (3,758          | )          | 298,694          |       |
| **Shareholders’ equity (deficit):**                                              |       |        |       |                   |       |                              |       |            |       |             |       |
| Common  stock                                                                         |       | 212         |       | (53                    | )          | (114                              | )          | 167             |       | 212              |       |
| Additional  paid-in capital                                                           |       | 96,758      |       | 256                    |       | —                            |       | —          |       | 97,014           |       |
| Accumulated  deficit                                                                  |       | (190,508    | )          | 186,016                |       | (6,466                            | )          | 950             |       | (10,008          | )          |
| Total  shareholders’ equity (deficit)                                            |       | (93,538     | )          | 186,219                |       | (6,580                            | )          | 1,117           |       | 87,218           |       |
| Noncontrolling  interest                                                              |       | —      |       | —                 |       | —                            |       | (1,035          | )          | (1,035           | )          |
| **Total Prospect Medical Holdings, Inc.’s shareholders’  equity (deficit)** |       | (93,538     | )          | 186,219                |       | (6,580                            | )          | 82              |       | 86,183           |       |
| **Total liabilities and shareholders’ equity**                                   |       | $           | 78,752     |                   | $          | 246,327                           |       | $               | 63,474     |             | $          | (3,676 | ) | $ | 384,877 |   |

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As ofSeptember 30, 2009**

*(inthousands)*

 
| ** **                                                                                 | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined********Non-Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|-------------------------------------------------|------------|-----------------|------------|------------------|------------|
| **ASSETS**                                                                                 |       |                |       |                                  |       |                                            |       |            |       |             |       |
| **Current assets:**                                                                        |       |                |       |                                  |       |                                            |       |            |       |             |       |
| Cash and cash  equivalents                                                                 |       | $                   | (514       | )                                     | $          | 36,995                                          |       | $               | 1,287      |             | $          | — |   | $ | 37,768 |   |
| Restricted cash                                                                            |       | —              |       | —                                |       | 1,395                                           |       | —          |       | 1,395            |       |
| Investments                                                                                |       | —              |       | 665                                   |       | —                                          |       | —          |       | 665              |       |
| Patient accounts  receivable, net                                                          |       | —              |       | 19,543                                |       | 17,263                                          |       | —          |       | 36,806           |       |
| Due from government  payers                                                                |       | —              |       | 5,642                                 |       | 785                                             |       | —          |       | 6,427            |       |
| Other receivables                                                                          |       | 8                   |       | 1,703                                 |       | —                                          |       | —          |       | 1,711            |       |
| Refundable income taxes,  net                                                              |       | 1,545               |       | 13                                    |       | —                                          |       | —          |       | 1,558            |       |
| Deferred income taxes,  net                                                                |       | 4,323               |       | 2,321                                 |       | —                                          |       | —          |       | 6,644            |       |
| Inventories of supplies                                                                    |       | —              |       | 1,477                                 |       | 2,660                                           |       | —          |       | 4,137            |       |
| Prepaid expenses and  other current assets                                                 |       | 72                  |       | 2,491                                 |       | 2,817                                           |       | —          |       | 5,380            |       |
| Intercompany accounts                                                                      |       | 90,190              |       | (119,113                              | )          | 28,841                                          |       | 82              |       | —           |       |
| **Total current assets**                                                                   |       | 95,624              |       | (48,263                               | )          | 55,048                                          |       | 82              |       | 102,491          |       |
| Property, improvements  and equipment, net                                                 |       | 19                  |       | 54,725                                |       | 8,980                                           |       | —          |       | 63,724           |       |
| Deferred financing  costs, net                                                             |       | 6,878               |       | —                                |       | 1,327                                           |       | —          |       | 8,205            |       |
| Goodwill                                                                                   |       | —              |       | 153,250                               |       | —                                          |       | —          |       | 153,250          |       |
| Intangible assets, net                                                                     |       | —              |       | 46,425                                |       | —                                          |       | —          |       | 46,425           |       |
| Other assets                                                                               |       | 6                   |       | 715                                   |       | 330                                             |       | —          |       | 1,051            |       |
| **Total Assets**                                                                           | ** ** | **$**               | 102,527    |                                  | $          | 206,852                                         |       | $               | 65,685     |             | $          | 82 |   | $ | 375,146 |   |
| **LIABILITIES &  SHAREHOLDERS’ EQUITY**                                      |       |                |       |                                  |       |                                            |       |            |       |             |       |
| **Current liabilities:**                                                                   |       |                |       |                                  |       |                                            |       |            |       |             |       |
| Accrued medical claims  and other healthcare costs payable                                 |       | $                   | —     |                                  | $          | 16,613                                          |       | $               | 211        |             | $          | — |   | $ | 16,824 |   |
| Accounts payable and  other accrued liabilities                                            |       | 7,102               |       | 10,548                                |       | 14,123                                          |       | —          |       | 31,773           |       |
| Accrued salaries, wages  and benefits                                                      |       | 4,151               |       | 11,543                                |       | 9,209                                           |       | —          |       | 24,903           |       |
| Due to government payers                                                                   |       | —              |       | —                                |       | 13,834                                          |       | —          |       | 13,834           |       |
| Income taxes payable,  net                                                                 |       | (1,029              | )          | 1,086                                 |       | (57                                             | )          | —          |       | —           |       |
| Current portion of  capital leases                                                         |       | —              |       | 383                                   |       | 437                                             |       | —          |       | 820              |       |
| Current portion of  long-term debt                                                         |       | —              |       | —                                |       | 3,805                                           |       | —          |       | 3,805            |       |
| Other current  liabilities                                                                 |       | 13                  |       | 616                                   |       | —                                          |       | —          |       | 629              |       |
| **Total current liabilities**                                                              |       | 10,237              |       | 40,789                                |       | 41,562                                          |       | —          |       | 92,588           |       |
| Long-term debt, net of  current maturities                                                 |       | 148,020             |       | —                                |       | 24,519                                          |       | —          |       | 172,539          |       |
| Deferred income taxes,  net                                                                |       | 8,912               |       | 21,063                                |       | —                                          |       | —          |       | 29,975           |       |
| Malpractice reserves                                                                       |       | —              |       | 914                                   |       | 1,910                                           |       | —          |       | 2,824            |       |
| Capital leases, net of  current portion                                                    |       | —              |       | 299                                   |       | 270                                             |       | —          |       | 569              |       |
| Other long-term  liabilities                                                               |       | 78                  |       | 84                                    |       | —                                          |       | —          |       | 162              |       |
| **Total liabilities**                                                                      |       | 167,247             |       | 63,149                                |       | 68,261                                          |       | —          |       | 298,657          |       |
| **Shareholders’ equity (deficit):**                                                   |       |                |       |                                  |       |                                            |       |            |       |             |       |
| Common stock                                                                               |       | 206                 |       | (53                                   | )          | (114                                            | )          | 167             |       | 206              |       |
| Additional paid-in-capital                                                                 |       | 94,242              |       | 256                                   |       | —                                          |       | —          |       | 94,498           |       |
| Accumulated deficit                                                                        |       | (159,168            | )          | 143,500                               |       | (2,462                                          | )          | (173            | )          | (18,303          | )          |
| Total shareholders’  equity (deficit)                                                 |       | (64,720             | )          | 143,703                               |       | (2,576                                          | )          | (6              | )          | 76,401           |       |
| Noncontrolling interest                                                                    |       | —              |       | —                                |       | —                                          |       | 88              |       | 88               |       |
| **Total Prospect Medical  Holdings, Inc.’s shareholders’ equity (deficit)** |       | (64,720             | **)**      | 143,703                               |       | (2,576                                          | **)**      | 82              |       | 76,489           |       |
| **Total liabilities and  shareholders’ equity**                                       | ** ** | **$**               | 102,527    | ** **                            | **$**      | 206,852                                         | ** ** | **$**           | 65,685     | ** **       | **$**      | 82 | ** ** | **$** | 375,146 | ** ** |

 

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**PROSPECT MEDICALHOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theThree Months Ended June 30, 2010**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                    | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined********Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                    | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**                  | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|                                                                          |       |        |       |                    |       |                              |       |            |       |             |       |
| **Revenues:**                                                                 |       |        |       |                    |       |                              |       |            |       |             |       |
| Net  Hospital Services revenues                                               |       | $           | —     |                    | $          | 41,305                            |       | $               | 29,394     |             | $          | (1,159 | ) | $ | 69,540 |   |
| Medical  Group revenues                                                       |       | —      |       | 46,809                  |       | 883                               |       | (325            | )          | 47,367           |       |
| **Total revenues**                                                            |       | —      |       | 88,114                  |       | 30,277                            |       | (1,484          | )          | 116,907          |       |
| Operating  expenses:                                                          |       |        |       |                    |       |                              |       |            |       |             |       |
| Hospital  operating expenses                                                  |       | —      |       | 24,892                  |       | 27,455                            |       | —          |       | 52,347           |       |
| Medical  Group cost of revenues                                               |       | —      |       | 36,874                  |       | 548                               |       | —          |       | 37,422           |       |
| General  and administrative                                                   |       | 3,275       |       | 8,737                   |       | 2,907                             |       | (1,484          | )          | 13,435           |       |
| Depreciation  and amortization                                                |       | 3           |       | 1,831                   |       | 244                               |       | —          |       | 2,078            |       |
| **Total operating expenses**                                                  |       | 3,278       |       | 72,334                  |       | 31,154                            |       | (1,484          | )          | 105,282          |       |
| Operating  income from unconsolidated joint venture                           |       | —      |       | 482                     |       | —                            |       | —          |       | 482              |       |
| Operating  (loss) income                                                      |       | (3,278      | )          | 16,262                  |       | (877                              | )          | —          |       | 12,107           |       |
| Other  expense:                                                               |       |        |       |                    |       |                              |       |            |       |             |       |
| Interest  expense and amortization-deferred financing cost, net               |       | 5,565       |       | 136                     |       | 1,408                             |       | —          |       | 7,109            |       |
| **Total other expense, net**                                                  |       | 5,565       |       | 136                     |       | 1,408                             |       | —          |       | 7,109            |       |
| Income  (loss) before income taxes                                            |       | (8,843      | )          | 16,126                  |       | (2,285                            | )          | —          |       | 4,998            |       |
| Provision  for income taxes                                                   |       | 2,090       |       | 701                     |       | —                            |       | —          |       | 2,791            |       |
| Net  income (loss)                                                            |       | (10,933     | )          | 15,425                  |       | (2,285                            | )          | —          |       | 2,207            |       |
| Loss  attributable to noncontrolling interest                                 |       | —      |       | —                  |       | —                            |       | (640            | )          | (640             | )          |
| **Net income (loss) attributable to Prospect****Medical Holdings, Inc.** | ** ** | **$**       | (10,933    | )                       | **$**      | 15,425                            | ** ** | **$**           | (2,285     | )                | **$**      | 640 | ** ** | **$** | 2,847 | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theThree Months Ended June 30, 2009**

*(in thousands)*

 

*(Unaudited)*

 
| ** **                                                                    | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined********Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                    | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**                  | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **Revenues:**                                                                 |       |        |       |                    |       |                              |       |            |       |             |       |
| Net  Hospital Services revenues                                               |       | $           | —     |                    | $          | 36,582                            |       | $               | 30,138     |             | $          | (250 | ) | $ | 66,470 |   |
| Medical  Group revenues                                                       |       | —      |       | 47,167                  |       | 681                               |       | —          |       | 47,848           |       |
| **Total revenues**                                                            |       | —      |       | 83,749                  |       | 30,819                            |       | (250            | )          | 114,318          |       |
| Operating  expenses:                                                          |       |        |       |                    |       |                              |       |            |       |             |       |
| Hospital  operating expenses                                                  |       | —      |       | 23,244                  |       | 28,034                            |       | —          |       | 51,278           |       |
| Medical  Group cost of revenues                                               |       | —      |       | 36,478                  |       | 490                               |       | —          |       | 36,968           |       |
| General  and administrative                                                   |       | 3,859       |       | 10,358                  |       | 3,773                             |       | (250            | )          | 17,740           |       |
| Depreciation  and amortization                                                |       | 3           |       | 1,962                   |       | 197                               |       | —          |       | 2,162            |       |
| **Total operating expenses**                                                  |       | 3,862       |       | 72,042                  |       | 32,494                            |       | (250            | )          | 108,148          |       |
| Operating  income from unconsolidated joint venture                           |       | —      |       | 535                     |       | —                            |       | —          |       | 535              |       |
| Operating  (loss) income                                                      |       | (3,862      | )          | 12,242                  |       | (1,675                            | )          | —          |       | 6,705            |       |
| Other  expense:                                                               |       |        |       |                    |       |                              |       |            |       |             |       |
| Interest  expense and amortization-deferred financing cost, net               |       | 7,562       |       | 3                       |       | 1,083                             |       | —          |       | 8,648            |       |
| Gain  on interest rate swap arrangements                                      |       | (3,694      | )          | —                  |       | —                            |       | —          |       | (3,694           | )          |
| **Total other expense, net**                                                  |       | 3,868       |       | 3                       |       | 1,083                             |       | —          |       | 4,954            |       |
| Income  (loss) before income taxes                                            |       | (7,730      | )          | 12,239                  |       | (2,758                            | )          | —          |       | 1,751            |       |
| Provision  for income taxes                                                   |       | 805         |       | 1,184                   |       | —                            |       | —          |       | 1,989            |       |
| Net  income (loss)                                                            |       | (8,535      | )          | 11,055                  |       | (2,758                            | )          | —          |       | (238             | )          |
| Income  (loss) attributable to noncontrolling interest                        |       | —      |       | —                  |       | —                            |       | —          |       | —           |       |
| **Net income (loss) attributable to Prospect****Medical Holdings, Inc.** | ** ** | **$**       | (8,535     | )                       | **$**      | 11,055                            | ** ** | **$**           | (2,758     | )                | **$**      | — | ** ** | **$** | (238 | ) |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theNine Months Ended June 30, 2010**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                    | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined********Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                    | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**                  | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|                                                                          |       |        |       |                    |       |                              |       |            |       |             |       |
| **Revenues:**                                                                 |       |        |       |                    |       |                              |       |            |       |             |       |
| Net  Hospital Services revenues                                               |       | $           | —     |                    | $          | 119,939                           |       | $               | 95,148     |             | $          | (5,597 | ) | $ | 209,490 |   |
| Medical  Group revenues                                                       |       | —      |       | 138,540                 |       | 2,199                             |       | (564            | )          | 140,175          |       |
| **Total revenues**                                                            |       | —      |       | 258,479                 |       | 97,347                            |       | (6,161          | )          | 349,665          |       |
| Operating  expenses:                                                          |       |        |       |                    |       |                              |       |            |       |             |       |
| Hospital  operating expenses                                                  |       | —      |       | 71,209                  |       | 83,421                            |       | —          |       | 154,630          |       |
| Medical  Group cost of revenues                                               |       | —      |       | 109,561                 |       | 1,569                             |       | —          |       | 111,130          |       |
| General  and administrative                                                   |       | 9,466       |       | 28,454                  |       | 11,805                            |       | (6,161          | )          | 43,564           |       |
| Depreciation  and amortization                                                |       | 10          |       | 5,509                   |       | 717                               |       | —          |       | 6,236            |       |
| **Total operating expenses**                                                  |       | 9,476       |       | 214,733                 |       | 97,512                            |       | (6,161          | )          | 315,560          |       |
| Operating  income from unconsolidated joint venture                           |       | —      |       | 1,514                   |       | —                            |       | —          |       | 1,514            |       |
| Operating  (loss) income                                                      |       | (9,476      | )          | 45,260                  |       | (165                              | )          | —          |       | 35,619           |       |
| Other  (income) expense:                                                      |       |        |       |                    |       |                              |       |            |       |             |       |
| Interest  expense and amortization-deferred financing cost, net               |       | 16,825      |       | 544                     |       | 3,839                             |       | —          |       | 21,208           |       |
| **Total other expense, net**                                                  |       | 16,825      |       | 544                     |       | 3,840                             |       | —          |       | 21,208           |       |
| Income  (loss) before income taxes                                            |       | (26,301     | )          | 44,716                  |       | (4,004                            | )          | —          |       | 14,411           |       |
| Provision  for income taxes                                                   |       | 5,039       |       | 2,200                   |       | —                            |       | —          |       | 7,239            |       |
| Net  income (loss)                                                            |       | (31,340     | )          | 42,516                  |       | (4,004                            | )          | —          |       | 7,172            |       |
| Income  (loss) attributable to noncontrolling interest                        |       | —      |       | —                  |       | —                            |       | (1,123          | )          | (1,123           | )          |
| **Net income (loss) attributable to Prospect****Medical Holdings, Inc.** | ** ** | **$**       | (31,340    | )                       | **$**      | 42,516                            | ** ** | **$**           | (4,004     | )                | **$**      | (1,123 | ) | **$** | 8,295 | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theNine Months Ended June 30, 2009**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                             | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|-----------------|------------|------------------|------------|
| **Revenues:**                                                          |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Net Hospital Services revenues                                         |       | $                   | —     |                                  | $          | 109,813                                   |       | $               | 30,138     |             | $          |  (250 | ) | $ | 139,701 |   |
| Medical Group revenues                                                 |       | —              |       | 141,981                               |       | 2,157                                     |       | —          |       | 144,138          |       |
| **Total revenues**                                                     |       | —              |       | 251,794                               |       | 32,295                                    |       | (250            | )          | 283,839          |       |
|                                                                   |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Operating expenses:                                                    |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Hospital operating expenses                                            |       | —              |       | 68,496                                |       | 28,035                                    |       | (250            | )          | 96,281           |       |
| Medical Group cost of revenues                                         |       | —              |       | 110,046                               |       | 1,489                                     |       | —          |       | 111,535          |       |
| General and administrative                                             |       | 8,731               |       | 30,782                                |       | 3,992                                     |       | —          |       | 43,505           |       |
| Depreciation and amortization                                          |       | 9                   |       | 5,546                                 |       | 196                                       |       | —          |       | 5,751            |       |
| **Total operating expenses**                                           |       | 8,740               |       | 214,870                               |       | 33,712                                    |       | (250            | )          | 257,072          |       |
| Operating income from unconsolidated joint venture                     |       | —              |       | 1,482                                 |       | —                                    |       | —          |       | 1,482            |       |
| Operating (loss) income                                                |       | (8,740              | )          | 38,406                                |       | (1,417                                    | )          | —          |       | 28,249           |       |
| Other expense:                                                         |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Interest expense and amortization-deferred  financing cost, net        |       | 20,147              |       | 65                                    |       | 1,082                                     |       | —          |       | 21,294           |       |
| Loss on interest rate swap arrangements                                |       | 5,019               |       | —                                |       | —                                    |       | —          |       | 5,019            |       |
| **Total other expense, net**                                           |       | 25,166              |       | 65                                    |       | 1,082                                     |       | —          |       | 26,313           |       |
| Income (loss) before income taxes                                      |       | (33,906             | )          | 38,341                                |       | (2,499                                    | )          | —          |       | 1,936            |       |
| Provision (benefit) for income taxes                                   |       | (781                | )          | 2,996                                 |       | (150                                      | )          | —          |       | 2,065            |       |
| Net income (loss)                                                      |       | (33,125             | )          | 35,345                                |       | (2,349                                    | )          | —          |       | (129             | )          |
|                                                                   |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Income attributable to noncontrolling interest                         |       | —              |       | —                                |       | —                                    |       | 5               |       | 5                |       |
| **Net income (loss) attributable  to Prospect Medical Holdings, Inc.** |       | $                   | (33,125    | )                                     | $          | 35,345                                    |       | $               | (2,349     | )                | $          |  (5 | ) | $ | (134 | ) |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**For theNine Months Ended June 30, 2010**

*(inthousands)*

* *

*(Unaudited)*

 
| ** **                                                                                           | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined********Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                           | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**                  | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|                                                                                                 |       |        |       |                    |       |                              |       |            |       |             |       |
| **Operating activities**                                                                             |       |        |       |                    |       |                              |       |            |       |             |       |
| Net  income (loss)                                                                                   |       | $           | (31,340    | )                       | $          | 42,516                            |       | $               | (4,004     | )                | $          | — |   | $ | 7,172 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |        |       |                    |       |                              |       |            |       |             |       |
| Depreciation  and amortization                                                                       |       | 10          |       | 5,509                   |       | 716                               |       | —          |       | 6,235            |       |
| Amortization  of deferred financing costs, net                                                       |       | 847         |       | —                  |       | 557                               |       | —          |       | 1,404            |       |
| Amortization  of original issue discount                                                             |       | 1,310       |       | —                  |       | 75                                |       | —          |       | 1,385            |       |
| Provision  for bad debts                                                                             |       | —      |       | 6,126                   |       | 15,867                            |       | —          |       | 21,993           |       |
| Stock-based  compensation                                                                            |       | 1,895       |       | —                  |       | —                            |       | —          |       | 1,895            |       |
| Gain  on sale of assets                                                                              |       | —      |       | (7                      | )          | —                            |       | —          |       | (7               | )          |
| Intercompany  accounts                                                                               |       | 25,636      |       | (31,868                 | )          | 6,232                             |       | —          |       | —           |       |
| Change  in assets and liabilities:                                                                   |       |        |       |                    |       |                              |       |            |       |             |       |
| Patient  and other receivables                                                                       |       | 8           |       | (5,259                  | )          | (19,198                           | )          | —          |       | (24,449          | )          |
| Prepaid  expenses and other                                                                          |       | (592        | )          | (9                      | )          | 1,026                             |       | —          |       | 425              |       |
| Inventories  of supplies                                                                             |       | —      |       | (24                     | )          | 31                                |       | —          |       | 7                |       |
| Refundable  income taxes, net                                                                        |       | 1,900       |       | (342                    | )          | —                            |       | —          |       | 1,558            |       |
| Income  taxes payable, net                                                                           |       | (484        | )          | 785                     |       | —                            |       | —          |       | 301              |       |
| Deposits  and other assets                                                                           |       | (3,758      | )          | 151                     |       | 330                               |       | 3,758           |       | 481              |       |
| Accrued  medical claims and other healthcare costs payable                                           |       | —      |       | (2,169                  | )          | 90                                |       | —          |       | (2,079           | )          |
| Accounts  payable and other accrued liabilities                                                      |       | 4,221       |       | (1,777                  | )          | (3,703                            | )          | —          |       | (1,259           | )          |
| Net  cash provided by (used in) operating activities                                                 |       | (347        | )          | 13,632                  |       | (1,981                            | )          | 3,758           |       | 15,062           |       |
| **Investing activities**                                                                             | ** ** | ** **  |       |                    |       |                              |       |            | ** ** | ** **       | ** ** |
| Purchases  of property, improvements and equipment                                                   |       | (14         | )          | (2,131                  | )          | (123                              | )          | —          |       | (2,268           | )          |
| Increase  in restricted certificates of deposit                                                      |       | —      |       | 31                      |       | —                            |       | —          |       | 31               |       |
| Net  cash used in investing activities                                                               |       | (14         | )          | (2,100                  | )          | (123                              | )          | —          |       | (2,237           | )          |
| **Financing activities**                                                                             |       |        |       |                    |       |                              |       |            |       |             |       |
| Borrowings  (repayments) on Brotman line of credit                                                   |       | —      |       | —                  |       | 6,439                             |       | (3,758          | )          | 2,681            |       |
| Repayments  on Brotman Creditors Trust Note                                                          |       | —      |       | —                  |       | (897                              | )          | —          |       | (897             | )          |
| Payments  on capital leases                                                                          |       | —      |       | (369                    | )          | (256                              | )          | —          |       | (625             | )          |
| Change  in restricted cash                                                                           |       | —      |       | —                  |       | (1,399                            | )          | —          |       | (1,399           | )          |
| Proceeds  from exercises of stock options and warrants                                               |       | 627         |       | —                  |       | —                            |       | —          |       | 627              |       |
| Cash  paid for deferred financing costs, net                                                         |       | (39         | )          | —                  |       | —                            |       | —          |       | (39              | )          |
| Net  cash (used in) provided by financing activities                                                 |       | 588         |       | (369                    | )          | 3,887                             |       | (3,758          | )          | 348              |       |
| Increase  in cash and cash equivalents                                                               |       | 227         |       | 11,163                  |       | 1,783                             |       | —          |       | 13,173           |       |
| Cash  and cash equivalents at beginning of period                                                    |       | (514        | )          | 36,995                  |       | 1,287                             |       | —          |       | 37,768           |       |
| Cash  and cash equivalents at end of period                                                          |       | $           | (287       | )                       | $          | 48,158                            |       | $               | 3,070      |             | $          | — |   | $ | 50,941 |   |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**For theNine Months Ended June 30, 2009**

*(inthousands)*

 

*(Unaudited)*

 
| ** **                                                                                          | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|-----------------|------------|------------------|------------|
| **Operating activities**                                                                            |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Net income (loss)                                                                                   |       | $                   | (33,125    | )                                     | $          | 35,345                                    |       | $               | (2,349     | )                | $          | — |   | $ | (129 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Depreciation and amortization                                                                       |       | 10                  |       | 5,544                                 |       | 197                                       |       | —          |       | 5,751            |       |
| Amortization of deferred financing costs, net                                                       |       | 102                 |       | —                                |       | 157                                       |       | —          |       | 259              |       |
| Payment-in-kind interest expense                                                                    |       | 277                 |       | —                                |       | —                                    |       | —          |       | 277              |       |
| Gain on interest rate swap arrangements                                                             |       | 5,019               |       | —                                |       | —                                    |       | —          |       | 5,019            |       |
| Provision for bad debts                                                                             |       | —              |       | 5,904                                 |       | 6,379                                     |       | —          |       | 12,283           |       |
| Loss on disposal of assets                                                                          |       | 34                  |       | —                                |       | —                                    |       | —          |       | 34               |       |
| Stock-based compensation                                                                            |       | 766                 |       | —                                |       | —                                    |       | —          |       | 766              |       |
| Deferred income taxes, net                                                                          |       | (1,628              | )          | —                                |       | —                                    |       | —          |       | (1,628           | )          |
| Amortization of other comprehensive income                                                          |       | 659                 |       | —                                |       | —                                    |       | —          |       | 659              |       |
| Intercompany                                                                                        |       | 32,976              |       | (33,790                               | )          | 814                                       |       | —          |       | —           |       |
| Changes in asset and liabilities:                                                                   |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Patient and other receivables                                                                       |       | 54                  |       | (6,505                                | )          | (3,166                                    | )          | 601             |       | (9,016           | )          |
| Prepaid expenses and other                                                                          |       | 74                  |       | 56                                    |       | 301                                       |       | —          |       | 431              |       |
| Inventories of supplies                                                                             |       | —              |       | (121                                  | )          | 254                                       |       | —          |       | 133              |       |
| Refundable income taxes, net                                                                        |       | 4,214               |       | (1,560                                | )          | —                                    |       | —          |       | 2,654            |       |
| Deposits and other assets                                                                           |       | —              |       | 171                                   |       | —                                    |       | —          |       | 171              |       |
| Accrued medical claims and other healthcare costs  payable                                          |       | —              |       | (2,617                                | )          | —                                    |       | —          |       | (2,617           | )          |
| Accounts payable and other accrued liabilities                                                      |       | (2,012              | )          | 935                                   |       | (1,331                                    | )          | (601            | )          | (3,009           | )          |
| Net cash provided by (used in) operating  activities                                                |       | 7,420               |       | 3,362                                 |       | 1,256                                     |       | —          |       | 12,038           |       |
|                                                                                                |       |                |       |                                  |       |                                      |       |            |       |             |       |
| **Investing activities**                                                                            |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Purchases of property, improvements and equipment                                                   |       | —              |       | (764                                  | )          | —                                    |       | —          |       | (764             | )          |
| Cash paid for acquisitions, net of cash received                                                    |       | (2,519              | )          | 209                                   |       | —                                    |       | —          |       | (2,310           | )          |
| Decrease in restricted certificates of deposit                                                      |       | —              |       | (28                                   | )          | —                                    |       | —          |       | (28              | )          |
| Capitalized expense related to acquisitions                                                         |       | (37                 | )          | —                                |       | —                                    |       | —          |       | (37              | )          |
| Net cash (used in) provided by investing  activities                                                |       | (2,556              | )          | (583                                  | )          | —                                    |       | —          |       | (3,139           | )          |
|                                                                                                |       |                |       |                                  |       |                                      |       |            |       |             |       |
| **Financing activities**                                                                            |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Payments on capital leases                                                                          |       | —              |       | (259                                  | )          | (136                                      | )          | —          |       | (395             | )          |
| Repayment of note payable                                                                           |       | (8,654              | )          |                                  |       | (250                                      | )          |            |       | (8,904           | )          |
| Repayments on line of credit                                                                        |       | —              |       | —                                |       | (1,671                                    | )          | —          |       | (1,671           | )          |
| Cash paid for deferred financing costs, net                                                         |       | (972                | )          | —                                |       | —                                    |       | —          |       | (972             | )          |
| Change in restricted cash                                                                           |       | —              |       | —                                |       | 1,047                                     |       | —          |       | 1,047            |       |
| Net cash used in financing activities                                                               |       | (9,626              | )          | (259                                  | )          | (1,010                                    | )          | —          |       | (10,895          | )          |
|                                                                                                |       |                |       |                                  |       |                                      |       |            |       |             |       |
| Increase (decrease) in cash and cash equivalents                                                    |       | (4,762              | )          | 2,520                                 |       | 246                                       |       | —          |       | (1,996           | )          |
| Cash and cash equivalents at beginning of period                                                    |       | (40                 | )          | 33,698                                |       | (75                                       | )          | —          |       | 33,583           |       |
| Cash and cash equivalents at end of period                                                          |       | $                   | (4,802     | )                                     | $          | 36,218                                    |       | $               | 171        |             | $          | — |   | $ | 31,587 |   |

 

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**14. Subsequent Event**

 

Asfurther described in a Form 8-K filed with the SEC on Monday, August 16, 2010,on that date the Company entered into a definitive merger agreement to beacquired for $8.50 per share in cash by an entity sponsored by Leonard Green& Partners, L.P. Certain stockholders of the Company will also participateas post-merger stockholders in the acquiring entity.

 

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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 (“MD&A”) should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and notes to thosestatements appearing elsewhere in this Report.

 

Certain prior period amounts have been reclassified to conform to thecurrent period presentation with no impact on the unaudited condensedconsolidated net loss.

 

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:

 

·        Government regulation;

·        Changes in the regulatoryand healthcare policy environment;

·        Compliance with debtcovenants;

·        Receipt of reimbursementfrom third party payers and collections of accounts receivable from uninsuredpatients;

·        Growth of uninsured andunderinsured patients;

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

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

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

·        Healthcare costs;

·        Ability to maintain requiredworking capital;

·        Ability to acquire advanceddiagnostic and surgical equipment and information technology systems;

·        Ability to make acquisitionsand integrate the operations of acquired hospitals;

·        Reliance on key executivemanagement and key physicians;

·        Labor costs;

·        Competition;

·        Changes to the manner andextent to which healthcare services are covered, delivered and reimbursed thatwill occur, or may occur, as a result of the enactment in March 2010 ofthe Patient Protection and Affordable Care Act, as amended by the Healthcareand Education Reconciliation Act of 2010;

·        Ability to sufficientlyrespond to, or comply with, governmental agency surveys and audits;

·        Economic trends generallyand local economic conditions in Southern California;

·        Medical malpractice andworkers compensation claims and HMO bad-faith liability claims;

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

 

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·        Losses at Brotman could havea significant negative impact on our consolidated financial position and ourability to refinance Brotman debt on favorable terms; and

·        Certain risks more fullydescribed under the heading “Risk Factors” in our other SEC filings and in Part II, Item 1A of thisQuarterly Report on Form 10-Q.

 

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

 

**Overview**

 

Prior to the acquisition of Alta and Brotman, our organization wasfocused solely on providing management services to affiliated physicianorganizations that operate as Independent Physician Associations (“MedicalGroups”). With the acquisition of Alta and Brotman, we now own and operate fivehospitals in Southern California and our operations are organized into threereporting segments: Hospital Services, Medical Group and Corporate. TheHospital Services segment includes the results of operations and financialposition of Brotman beginning April 14, 2009.

 

**Hospital Services Segment**

 

Alta and Brotman (collectively, the “Hospital Services segment”) ownand operate five hospitals in Los Angeles County, all accredited by the JointCommission (formerly the Joint Commission on Accreditation of HealthcareOrganizations), with a total of 759 licensed beds served by 727 on-staff physiciansat June 30, 2010. Alta owns (i) Alta Hollywood Hospitals, Inc.,a California corporation, dba Hollywood Community Hospital and Van NuysCommunity Hospital; and (ii) Alta Los Angeles Hospitals, Inc., aCalifornia corporation, dba Los Angeles Community Hospital and NorwalkCommunity Hospital. On April 14, 2009 (the “Acquisition Date”), theCompany increased its existing approximately 33.1% ownership stake in Brotman,to approximately 72% via an investment of approximately $2.5 million incash, thereby obtaining a controlling interest. Brotman owns and operatesBrotman Medical Center, located in Culver City, California.

 

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

 

*Medicare: *Medicare is a Federalprogram that provides certain hospital and medical insurance benefits topersons aged 65 and over, some disabled persons with end-stage renal 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 theannual Medicare cost report and audit thereof by the Medicare fiscalintermediary. Normal estimation differences between final settlements andamounts accrued in previous years are reflected in net patient service revenue.

 

*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.

 

*Managed care:*  We alsoreceive payment from certain commercial insurance carriers, HMOs and PPOs. Thebasis for payment is in accordance with negotiated contracted rates or at ourstandard charges for services provided.

 

*Self-Pay: *Self-pay patients representthose patients who do not have health insurance and are not covered by someother form of third party arrangement. Such patients are evaluated, at the timeof service or shortly thereafter, for their ability to pay based upon Federaland State poverty guidelines, qualifications for Medi-Cal, as well as our localhospital’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 thegeographic location of the hospital. Inpatient occupancy levels fluctuate forvarious reasons, many of which are beyond our control. The percentage ofpatient service revenue attributable to outpatient services has generallyincreased in recent years, primarily as a result of advances in medicaltechnology that allow more services to be provided on an outpatient basis, aswell as increased pressure from Medicare, Medi-Cal and private insurers toreduce hospital stays and provide services, where possible, on a less expensiveoutpatient basis. We believe that our experience with respect to our increasedoutpatient levels mirrors the general trend occurring in the healthcareindustry and we are unable to predict the rate of growth and resulting impacton our future revenues.

 

Patients are generally not responsible for any difference betweencustomary hospital charges and amounts reimbursed for such services underMedicare, Medi-Cal, 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.

 

The State of California has enacted assembly bill 1838 (“AB1383”)effective January 1, 2010, to provide supplemental payments to certainmedical facilities which serve a disproportionate share of indigent and lowincome patients. The bill did not receive the necessary appropriations andcannot be implemented until it is approved by the Center for Medicare andMedicaid Services (“CMS”), which is anticipated to occur sometime in 2010 andapplied retroactively to April 3, 2009. Under this proposed program,participating hospitals, including the Company’s hospitals, would be assessed afee to be paid into a pool of funds to which the federal government willcontribute matching funds. These funds will then be distributed to qualifyinghospitals based on a prescribed formula. The Company anticipates that it willbe a net beneficiary from the fund. No amounts have been recognized in theCompany’s financial statements, since Management cannot currently predictwhether CMS will ultimately approve this program or the ultimate timing andamounts that the Company will have to pay into the fund or receive from thefund.

 

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

 

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

 

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**Hospital Services Results of Operations**

 

The following table sets forth the unaudited results of operations forour Hospital Services segment and is used in the discussion below (inthousands):

 
| ** **                                      | ** ** | **Three  Months Ended  June 30,** | ** ** | **Nine  Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **2010**                          | ** ** | **2009**                         | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** |
| **Net  Hospital Services revenues:**            |       |                              |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare                                        |       | $                                 | 36,270     |                             | $          | 30,734 |   | $ | 5,536 |   | 18.0 | % | $ | 109,769 |   | $ | 65,493 |   | $ | 44,276 |   | 67.6 | % |
| Medi-Cal                                        |       | 17,427                            |       | 22,766                           |       | (5,339 | ) | -23.5 | % | 51,164 |   | 56,344 |   | (5,180 | ) | -9.2 | % |
| Managed care                                    |       | 7,692                             |       | 8,383                            |       | (691 | ) | -8.2 | % | 29,245 |   | 11,377 |   | 17,868 |   | 157.1 | % |
| Self pay                                        |       | 7,566                             |       | 3,807                            |       | 3,759 |   | 98.7 | % | 16,600 |   | 4,940 |   | 11,660 |   | 236.0 | % |
| Other                                           |       | 585                               |       | 780                              |       | (195 | ) | -25.0 | % | 2,712 |   | 1,547 |   | 1,165 |   | 75.3 | % |
| **Total net  Hospital Services revenues**       |       | 69,540                            |       | 66,470                           |       | 3,070 |   | 4.6 | % | 209,490 |   | 139,701 |   | 69,789 |   | 50.0 | % |
| **Hospital  Services operating expenses:**      |       |                              |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Salaries, wages and  benefits                   |       | 31,273                            |       | 29,461                           |       | 1,812 |   | 6.2 | % | 95,206 |   | 61,278 |   | 33,928 |   | 55.4 | % |
| Supplies                                        |       | 4,885                             |       | 6,360                            |       | (1,475 | ) | -23.2 | % | 16,014 |   | 10,738 |   | 5,276 |   | 49.1 | % |
| Provision for doubtful  accounts                |       | 7,352                             |       | 8,578                            |       | (1,226 | ) | -14.3 | % | 21,993 |   | 12,286 |   | 9,707 |   | 79.0 | % |
| Other operating expenses                        |       | 8,837                             |       | 6,879                            |       | 1,958 |   | 28.5 | % | 21,417 |   | 11,979 |   | 9,438 |   | 78.8 | % |
| **Total  Hospital Services operating expenses** |       | 52,347                            |       | 51,278                           |       | 1,069 |   | 2.1 | % | 154,630 |   | 96,281 |   | 58,349 |   | 60.6 | % |
| General and  administrative                     |       | 3,845                             |       | 6,595                            |       | (2,750 | ) | -41.7 | % | 14,644 |   | 12,813 |   | 1,831 |   | 14.3 | % |
| Depreciation and  amortization                  |       | 1,255                             |       | 1,270                            |       | (15 | ) | -1.2 | % | 3,679 |   | 3,098 |   | 581 |   | 18.8 | % |
| Total non-medical  expenses                     |       | 5,100                             |       | 7,865                            |       | (2,765 | ) | -35.2 | % | 18,323 |   | 15,911 |   | 2,412 |   | 15.2 | % |
| **Operating  income**                           |       | $                                 | 12,093     |                             | $          | 7,327 |   | $ | 4,766 |   | 65.0 | % | $ | 36,537 |   | $ | 27,509 |   | $ | 9,028 |   | 32.8 | % |

 

The following table sets forth selected operating items, expressed as apercentage of total net Hospital Services revenue (unaudited):

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| ** **                                     | ** ** | **2010**               | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                     | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net Hospital Services revenues:**            |       |                   |       |                  |       |   |   |   |   |
| Medicare                                       |       | 52.2                   | %          | 46.2                  | %          | 52.4 | % | 46.9 | % |
| Medi-Cal                                       |       | 25.1                   | %          | 34.3                  | %          | 24.4 | % | 40.3 | % |
| Managed  care                                  |       | 11.1                   | %          | 12.6                  | %          | 14.0 | % | 8.1 | % |
| Self  pay                                      |       | 10.9                   | %          | 5.7                   | %          | 7.9 | % | 3.5 | % |
| Other                                          |       | 0.7                    | %          | 1.2                   | %          | 1.3 | % | 1.2 | % |
| **Total net Hospital Services revenues**       |       | 100.0                  | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| **Hospital Services operating expenses:**      |       |                   |       |                  |       |   |   |   |   |
| Salaries,  wages and benefits                  |       | 45.0                   | %          | 44.3                  | %          | 45.4 | % | 43.9 | % |
| Supplies                                       |       | 7.0                    | %          | 9.6                   | %          | 7.6 | % | 7.7 | % |
| Provision  for doubtful accounts               |       | 10.6                   | %          | 12.9                  | %          | 10.5 | % | 8.8 | % |
| Other  operating expenses                      |       | 12.7                   | %          | 10.3                  | %          | 10.2 | % | 8.6 | % |
| **Total Hospital Services operating expenses** |       | 75.3                   | %          | 77.1                  | %          | 73.7 | % | 69.0 | % |
| General  and administrative                    |       | 5.5                    | %          | 9.9                   | %          | 7.0 | % | 9.2 | % |
| Depreciation  and amortization                 |       | 1.8                    | %          | 1.9                   | %          | 1.8 | % | 2.2 | % |
| Total  non-medical expenses                    |       | 7.3                    | %          | 11.8                  | %          | 8.8 | % | 11.4 | % |
| **Operating income**                           |       | 17.4                   | %          | 11.1                  | %          | 17.5 | % | 19.6 | % |

 

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The following table shows certain selected historical operatingstatistics for our hospitals (unaudited):

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **June 30,**           | ** ** | **June 30,**          | ** ** |
| ** **                                    | ** ** | **2010**               | ** ** | **2009**              | ** ** | **Increase********(Decrease)** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase********(Decrease)** | ** ** |
|                                          | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  inpatient revenues (in thousands) (1)    |       | $                      | 60,169     |                  | $          | 59,039 |   | 1.9 | % | $ | 181,219 |   | $ | 127,839 |   | 41.8 | % |
| Net  outpatient revenues (in thousands)(1)    |       | $                      | 8,786      |                  | $          | 6,651 |   | 32.1 | % | $ | 25,559 |   | $ | 10,315 |   | 147.8 | % |
| Other  services revenues (in thousands)       |       | $                      | 585        |                  | $          | 780 |   | -25.0 | % | $ | 2,712 |   | $ | 1,547 |   | 75.2 | % |
| Number  of hospitals at end of period         |       | 5                      |       | 5                     |       | 0.0 | % | 5 |   | 5 |   | 0.0 | % |
| Licensed  beds at end of the period           |       | 759                    |       | 759                   |       | 0.0 | % | 759 |   | 759 |   | 0.0 | % |
| Average  licensed beds                        |       | 759                    |       | 759                   |       | 0.0 | % | 759 |   | 759 |   | 0.0 | % |
| Average  available beds                       |       | 616                    |       | 616                   |       | 0.0 | % | 616 |   | 616 |   | 0.0 | % |
| Admissions  (2)                               |       | 5,608                  |       | 5,451                 |       | 2.9 | % | 17,660 |   | 12,675 |   | 39.3 | % |
| Adjusted  patient admissions (3)              |       | 6,372                  |       | 6,056                 |       | 5.2 | % | 19,868 |   | 13,655 |   | 45.5 | % |
| Net  inpatient revenue per admission          |       | $                      | 10,729     |                  | $          | 10,831 |   | -0.9 | % | $ | 10,262 |   | $ | 10,086 |   | 1.7 | % |
| Patient  days                                 |       | 35,881                 |       | 36,800                |       | -2.5 | % | 112,175 |   | 84,329 |   | 33.0 | % |
| Adjusted  patient days                        |       | 41,024                 |       | 40,072                |       | 2.4 | % | 126,872 |   | 90,625 |   | 40.0 | % |
| Average  length of patients’ stay (days) |       | 6.4                    |       | 6.3                   |       | 1.6 | % | 6.4 |   | 4.5 |   | 41.2 | % |
| Net  inpatient revenue per patient day        |       | $                      | 1,677      |                  | $          | 1,604 |   | 4.5 | % | $ | 1,616 |   | $ | 1,516 |   | 6.6 | % |
| Outpatient  visits                            |       | 12,829                 |       | 10,930                |       | 17.4 | % | 40,578 |   | 21,109 |   | 92.2 | % |
| Net  outpatient revenue per visit             |       | $                      | 685        |                  | $          | 609 |   | 12.5 | % | $ | 630 |   | $ | 489 |   | 28.8 | % |
| Occupancy  rate for licensed beds (4)         |       | 51.4                   | %          | 52.7                  | %          | -2.5 | % | 51.4 | % | 40.7 | % | 26.3 | % |
| Occupancy  rate for available beds (4)        |       | 63.3                   | %          | 64.9                  | %          | -2.4 | % | 63.3 | % | 50.2 | % | 26.1 | % |

 

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(1)                                  Net inpatient revenuesinclude self-pay revenues of approximately $5,541,000 and $3,309,000, for thethree months ended June 30, 2010 and 2009, respectively, and $10,449,000and $4,306,000, for the nine months ended June 30, 2010 and 2009,respectively. Net outpatient revenues include self-pay revenues ofapproximately $2,047,000 and $581,000 for the three months ended June 30,2010 and 2009, respectively, and $6,174,000 and $634,000, for the nine monthsended June 30, 2010 and 2009, respectively.

 

(2)                                  Charity careadmissions represent 0.4% and 0.6% of total admissions for the three monthsended June 30, 2010 and 2009, respectively, and represent 0.8% and 0.7% oftotal admissions for the nine months ended June 30, 2010 and 2009,respectively.  Based on the Company’sgross charge rates, revenues foregone under the charity policy, includingindigent accounts, were approximately $240,000 and $832,000 for the threemonths ended June 30, 2010 and 2009, respectively, and approximately$2,156,000 and $1,456,000 for the nine months ended June 30, 2010 and2009, 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. Occupancy rates are affected by many factors, including the populationsize and general economic conditions within particular market service areas,the degrees of variation in medical and surgical products, outpatient use ofhospital services, quality and treatment availability at competing hospitalsand seasonality.

 

(5)                                  The threemonths and nine months ended June 30, 2009 include only 77 days of Brotmanoperating results, as the Company acquired a majority stake in, and beganconsolidating, Brotman, effective April 14, 2009.

 

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***Three Months Ended June 30,2010 Compared to Three Months Ended June 30, 2009***

 

*Net Hospital Services revenues*

 

Net Hospital Services revenues increased $3,070,000 to approximately$69,540,000 for the three months ended June 30, 2010, from approximately$66,470,000 for the three months ended June 30, 2009. Included in NetHospital Services revenues in the fiscal 2010 period was capitation revenue ofapproximately $2,486,000 earned under the Capitation Arrangement entered intoon March 1, 2010 (see Note 6 to the unaudited condensed consolidatedfinancial statements). On a same-store basis, excluding revenue earned underthe Capitation Arrangement for the three months ended June 30, 2010, netAlta Hospital Services revenues increased 3.7%. This increase was primarilyattributable to increased inpatient admissions, increased outpatient visits andincreased Medicare reimbursement rates, offset by decreased Medi-Cal inpatientdays. The increase in inpatient admissions, on a same-store basis, reflects thesuccessful marketing effort in the targeted Medicare service lines, while theincrease in outpatient visits was attributable primarily to an increase influ-related outpatient visits.

 

*Salaries, Wages and Benefits*

 

Salaries,wages and benefits (“SWB”), as a percentage of net Hospital Services revenuesincreased 1.6% to 45.0% for the three months ended June 30, 2010, ascompared to 44.3% for the three months ended June 30, 2009. This increaseprimarily relates to Brotman, which offset efficiencies gained in our hospitalsowned throughout both periods. On a same-store basis, SWB as a percentage ofnet Alta Hospital Services revenues, net of revenue earned under the CapitationArrangement, decreased 5.1% to 42.8% for the three months ended June 30,2010, as compared to 45.1% for the three months ended June 30, 2009. Thisdecrease in same-store SWB expense as a percent of revenue was primarily theresult of a decrease in same-store patient days, decreased length of patientstays, and improved efficiencies, offset by increased labor expense due toinflation and merit rate increases and the conversion of certain hospital personnelfrom contracted to salaried basis and increased health benefit costs

 

*Supplies*

 

Supplies, as a percentage of net Hospital Services revenues, decreased27.1% to 7.0% for the three months ended June 30, 2010, as compared to9.6% for the three months ended June 30, 2009. On a same-store basis,supplies as a percentage of net Alta Hospital Services revenues, net of revenueearned under the Capitation Arrangement, decreased 14.5% to 5.3% for the threemonths ended June 30, 2010, as compared to 6.2% for the three months endedJune 30, 2009. The decrease was primarily the result of a decrease insame-store patient days, decreased length of patient stays and decreasedutilization of pharmaceuticals as a result of the outsourcing of our sub-acutepharmacy and improved efficiencies.

 

*Provision for Doubtful Accounts*

 

Provisionfor doubtful accounts, as a percentage of net Hospital Services revenues,decreased 17.8% to 10.6% for the three months ended June 30, 2010, ascompared to 12.9% for the three months ended June 30, 2009. On asame-store basis, provision for doubtful accounts as a percentage of net AltaHospital Services revenues, net of revenue earned under the CapitationArrangement, decreased 11.7% to 5.2% for the three months ended June 30,2010, as compared to 6.0% for the three months ended June 30, 2009. Theprovision for doubtful accounts relates principally to self-pay amounts duefrom patients and commercial managed care amounts. The fluctuation was due toan increase in same-store commercial managed care collection rate and decreasedbad debt write-off experience in the fiscal 2010 period.

 

*Other Operating Expenses*

 

Otheroperating expenses, as a percentage of net Hospital Services revenues,increased 23.3% to 12.7% for the three months ended June 30, 2010, ascompared to 10.3% for the three months ended June 30, 2009. Included inother operating expenses in the fiscal 2010 period was claims expense ofapproximately $2,550,000 incurred under the Capitation Arrangement. On asame-store basis, other operating expenses as a percentage of net Alta HospitalServices revenues, adjusted for the effect of the Capitation Arrangement,decreased 9.1% to 6.0% for the three months ended June 30, 2010, ascompared to 6.6% for the three months ended June 30, 2009. This decreasewas due primarily to the reduction in registry costs, in line with decreasedpatient days, decreased length of patient stays and decreased contract laborcosts as a result of the conversion of certain hospital personnel fromcontracted to salaried basis.

 

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*General and Administrative*

 

General and administrative expenses (“G&A”) consist primarily ofutilities, insurance, purchased services and property taxes. G&A were$3,845,000 for the three months ended June 30, 2010, or 5.5% of netHospital Services revenue, compared to $6,595,000 for the three months ended June 30,2009, or 9.9% of net Hospital Services revenue. On a same-store basis, G&A,as a percentage of net Alta Hospital Service revenues, net of revenue earnedunder the Capitation Arrangement, decreased 18.8% to 7.3% for the three monthsended June 30, 2010, as compared to 9.0% for the three months ended June 30,2009. This decrease was due primarily to lower malpractice costs andadjustments related to certain vendor credits.

 

*Depreciation and Amortization*

 

Depreciation and amortization expense decreased 1.2% in the threemonths ended June 30, 2010 to $1,255,000 compared to $1,270,000 in thethree months ended June 30, 2009. On a same-store basis, depreciation andamortization expenses as a percentage of Alta’s net Hospital Services revenues,net of revenue earned under the Capitation Arrangement, for the three monthsended June 30, 2010 were approximately 2.7% compared to 3.0% for the threemonths ended June 30, 2009. This decrease was due primarily to theaccelerated write-off of certain hospital equipment in the fiscal 2009 period.Included in depreciation and amortization expense was amortization ofidentifiable intangibles of approximately $394,000 and $383,000 in the threemonths ended June 30, 2010 and 2009, respectively.

 

*Operating Income*

 

Our Hospital Services segment reported operating income ofapproximately $12,093,000 and $7,327,000 for the three months ended June 30,2010 and 2009, respectively.  Thisincrease was the result of the changes discussed above. These operating resultsfrom the Hospital Services segment include certain corporate expenseallocations for insurance, professional fees, and amortization of identifiableintangibles that relate to this segment.

 

***Nine Months Ended June 30, 2010Compared to Nine Months Ended June 30, 2009***

 

*Net Hospital Services Revenues*

 

Net Hospital Services revenues increased $69,789,000 to approximately$209,490,000 for the nine months ended June 30, 2010, from approximately$139,701,000 for the nine months ended June 30, 2009. Included in NetHospital Services revenues in the fiscal 2010 period was capitation revenue ofapproximately $3,350,000 earned under the Capitation Arrangement. On asame-store basis, excluding revenue earned under the Capitation Arrangement forthe nine months ended June 30, 2010, net Alta Hospital Services revenuesincreased 1.3%. This increase was primarily attributable to increased inpatientadmissions, increased outpatient visits and increased Medicare reimbursementrates, offset by decreased Medi-Cal inpatient days. The increase in inpatientadmissions, on a same-store basis, reflects the successful marketing effort inthe targeted Medicare service lines, while the increase in outpatient visitswas attributable primarily to an increase in flu-related outpatient visits.

 

*Salaries, Wages and Benefits*

 

SWB,as a percentage of net Hospital Services revenues increased 0.4% to 45.4% forthe nine months ended June 30, 2010, as compared to 43.9% for the ninemonths ended June 30, 2009. This increase primarily relates to Brotman,which offset efficiencies gained in our hospitals owned throughout bothperiods. On a same-store basis, SWB, as a percentage of net Alta HospitalServices revenues, net of revenue earned under the Capitation Arrangement,increased 0.5% to 42.2% for the nine months ended June 30, 2010, ascompared to 44.0% for the nine months ended June 30, 2009. This slightincrease in same-store SWB expense as a percent of revenue was primarily theresult of increased labor expense due to inflation and merit rate increases andthe conversion of certain hospital personnel from contracted to salaried basisand increased health benefit costs, offset by a decrease in same-store patientdays, decreased length of patient stays, and improved efficiencies.

 

*Supplies*

 

Supplies,as a percentage of net Hospital Services revenues, decreased 1.3% to 7.6% forthe nine months ended June 30, 2010, as compared to 7.7% for the ninemonths ended June 30, 2009. On a same-store basis, supplies as apercentage of net Alta Hospital Services revenues, net of revenue earned underthe Capitation Arrangement, decreased 9.8% to 5.5% for the nine months ended June 30,2010, as compared to 6.1% for the nine months ended June 30, 2009. Thedecrease was primarily the result of a decrease in same-store patient days,decreased length of patient stays and decreased utilization of pharmaceuticalsas a result of the outsourcing of our sub-acute pharmacy and improvedefficiencies.

 

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*Provision for Doubtful Accounts*

 

Provisionfor doubtful accounts, as a percentage of net Hospital Services revenues,increased 19.3% to 10.5% for the nine months ended June 30, 2010, comparedto 8.8% for the nine months ended June 30, 2009. This increase isprimarily attributable to the current year inclusion of Brotman, which hashistorically had a higher percentage of self-pay patients and to the impact ofthe current economic conditions on individuals’ ability to pay. On a same-storebasis, provision for doubtful accounts as a percentage of net Alta HospitalServices revenues, net of revenue earned under the Capitation Arrangement,increased 1.9% to 5.5% for the nine months ended June 30, 2010, ascompared to 5.4% for the nine months ended June 30, 2009. The provisionfor doubtful accounts relates principally to self-pay amounts due from patientsand commercial managed care amounts. The fluctuation was due to increasedself-pay outpatient visits and also the impact of current economic conditionson individuals’ ability to pay.

 

*Other Operating Expenses*

 

Otheroperating expenses, as a percentage of net Hospital Services revenues,increased 18.6% to 10.2% for the nine months ended June 30, 2010, ascompared to 8.6% for the nine months ended June 30, 2009. Included inother operating expenses in the fiscal 2010 period were claims expenses of approximately$3,411,000 incurred under the Capitation Arrangement. On a same-store basis,other operating expenses as a percentage of net Alta Hospital Servicesrevenues, adjusted for the effect of the Capitation Arrangement, decreased13.2% to 5.9% for the nine months ended June 30, 2010, as compared to 6.8%for the nine months ended June 30, 2009. This decrease was due primarilyto the reduction of registry costs, in line with decreased patient days,decreased length of patient stays and decreased contract labor costs as aresult of the conversion of certain hospital personnel from contracted tosalaried basis.

 

*General and Administrative*

 

G&A consist primarily of utilities, insurance, purchased servicesand property taxes.  G&A were$14,644,000 for the nine months ended June 30, 2010, or 7.0% of netHospital Services revenue, compared to $12,813,000 for the nine months ended June 30,2009, or 9.2% of net Hospital Services revenue. On a same-store basis, G&A,as a percentage of net Alta Hospital Service revenues, net of revenue earnedunder the Capitation Arrangement, was consistent at 8.7% for the nine monthsended June 30, 2010, as compared the nine months ended June 30, 2009.

 

*Depreciation and Amortization*

 

Depreciation and amortization expense increased 18.8% in the ninemonths ended June 30, 2010 to $3,679,000 compared to $3,098,000 in thenine months ended June 30, 2009, primarily relates to Brotman.  On a same-store basis, depreciation and amortizationexpenses as a percentage of Alta’s net Hospital Services revenues, net ofrevenue earned under the Capitation Arrangement, for the nine months ended June 30,2010 were approximately 2.6% compared to 3.0% for the nine months ended June 30,2009. This decrease was due primarily to the accelerated write-off of certainhospital equipment in the fiscal 2009 period. Included in depreciation andamortization expense was amortization of identifiable intangibles ofapproximately $1,185,000 and $1,017,000 in the nine months ended June 30,2010 and 2009, respectively.

 

*Operating Income*

 

Our Hospital Services segment reported operating income ofapproximately $36,537,000 and $27,509,000 for the nine months ended June 30,2010 and 2009, respectively.  Thisincrease was the result of the changes discussed above. These operating resultsfrom the Hospital Services segment include certain corporate expenseallocations for insurance, professional fees, and amortization of identifiableintangibles that relate to this segment.

 

**Medical Group Segment**

 

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

 

Through our management subsidiaries—PMS and PHCA—we have entered intolong-term agreements to provide management services to each of our affiliatedphysician organizations in exchange for a management fee. The managementservices we provide include HMO contracting, physician recruiting,credentialing and contracting, human resources services, claims administration,financial reporting services, provider relations, patient eligibility andrelated services, medical management including utilization management andquality assurance, data collection, and management information systems.

 

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Our management subsidiaries currently provide management services toten affiliated physician organizations, which include PMG, Nuestra FamiliaMedical Group, Inc. (“Nuestra”), eight other affiliated physicianorganizations that PMG owns or controls, and one affiliated physicianorganization (AMVI/Prospect Health Network) that is an unconsolidated jointventure in which PMG owns a 50% interest. PMG, which was our first 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 through assignableoption agreements and management services agreements (see Note 6 to thecondensed consolidated Financial Statements). While PMG is itself an affiliated physician organization that performsthe same business in its own service area as all of our other affiliatedphysician organizations do in theirs, PMG also serves as a holding company forour other affiliated physician organizations, except Nuestra.

 

The affiliated physician organizations provided medical services to acombined total of approximately 176,000 HMO enrollees as of June 30, 2010,including approximately 21,000 enrollees that we manage for the economicbenefit of two independent third parties, and for which we earn management feeincome.

 

As of June 30, 2010, our Medical Groups have contracts withapproximately 16 HMOs, from which our revenue was primarily derived. HMOs offera comprehensive healthcare benefits package in exchange for a capitation amountper enrollee that does not vary through the contract period regardless of thequantity or cost of medical services required or used. HMOs enroll members byentering into contracts with employer groups or directly with individuals toprovide a broad range of healthcare services for a prepaid charge, with minimaldeductibles or co-payments required of the members. The contracts between ouraffiliated physician organizations and the HMOs provide for the provision ofmedical services by the affiliated physician organization to the HMO enrolleesin consideration for the prepayment of the fixed monthly capitation amount perenrollee.

 

Our Medical Group business has developed primarily through acquisitionsof Medical Groups by PMG, and is concentrated in Orange County, Los AngelesCounty, Riverside County and San Bernardino County, all within the State ofCalifornia.

 

MedicalGroup revenues consist primarily of amounts received 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 historically nothad a material effect on capitation revenue. Variability in capitation revenueexists under Medicare’s capitation model referred to as “Risk Adjustment.”Under the model, capitation with respect to Medicare enrollees is subject tosubsequent adjustment by CMS based on the acuity of the enrollees to whomservices were provided.  Capitation forthe current year is paid based on data submitted for each Medicare enrollee forpreceding periods. Capitation is paid at interim rates during the year and isadjusted in subsequent periods after the final data is compiled. Positive ornegative capitation adjustments are made for Medicare enrollees with conditionsrequiring more or less healthcare services than assumed in the interimpayments. Since we do not have the information necessary to reliably predictthese adjustments, periodic changes in capitation amounts earned as a result ofrisk adjustment are recognized once those changes are communicated to us by thehealth plans.

 

Management fees were primarily comprised of amounts earned frommanaging the operations of AMVI, Inc. (our joint venture partner in theAMVI/Prospect Health Network joint venture) and certain other third partyentities. Management fee revenue is recognized in the month the services aredelivered.

 

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

 

We also potentially earn additional incentive revenue or incurpenalties under HMO contracts by sharing in the risk for hospitalization basedupon inpatient services utilized. These amounts are included in capitationrevenue. Shared risk deficits are generally not payable until and unless wegenerated future risk-sharing surpluses. Risk pools are generally settled inthe following year. Management estimates risk pool incentives based oninformation received from the HMOs or hospitals with whom the risk-sharingarrangements were in place, and who typically maintain the information andrecord keeping related to the risk pool arrangements. Differences betweenactual and estimated settlements are recorded when the final outcome is known.Risk pool and pay-for-performance incentives are affected by many factors, someof which are beyond our control, and may vary significantly from year to year.

 

As discussed in Note 6 to the accompanying unaudited financialstatements, effective March 1, 2010, we entered into a Global CapitationArrangement whereby we agreed to provide hospital, medical and other healthcareservices to approximately 2,000 senior members.

 

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We have increased our membership through acquisitions in previousyears. These increases through acquisitions were offset by HMO enrollmentdeclines at our Medical Groups, similar to the recent HMO enrollment trends inCalifornia. The following table sets forth the approximate number of members,by category (in thousands, unaudited):

 
| ** **               | ** ** | **As of June 30,** | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | ** **              | ** ** | ** ** | ** ** | **% Increase** | ** ** |
| **Member  Category**     | ** ** | **2010**                | ** ** | **2009** | ** ** | **(Decrease)** | ** ** |
| Commercial  – owned |       | 122                     |       | 136 |   | -10 | % |
| Commercial  - managed(l) |       | 8                       |       | 1 |   | 700 | % |
| Senior  – owned     |       | 22                      |       | 21 |   | 5 | % |
| Senior  - managed(1)     |       | 1                       |       | 0 |   | 100 | % |
| Medi-Cal  – owned   |       | 11                      |       | 12 |   | -8 | % |
| Medi-Cal  - managed(1)   |       | 12                      |       | 8 |   | 50 | % |
| Total                    |       | 176                     |       | 178 |   | -1 | % |

 

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(1)                                  Representsmembers that we manage on behalf of third parties in exchange for a managementfee.

 

The following table details total paid member months, by membercategory (in thousands, unaudited):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| ** **               | ** ** | ** **             | ** ** | ** **            | ** ** | **% Increase** | ** ** | ** ** | ** ** | ** ** | ** ** | **% Increase** | ** ** |
| ** **               | ** ** | **2010**               | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** | **2010** | ** ** | **2009** | ** ** | **(Decrease)** | ** ** |
| Commercial  - owned      |       | 366                    |       | 412                   |       | -11 | % | 1,134 |   | 1,290 |   | -12 | % |
| Commercial  - managed(1) |       | 18                     |       | 4                     |       | 350 | % | 28 |   | 12 |   | 133 | % |
| Senior  - owned          |       | 66                     |       | 64                    |       | 3 | % | 197 |   | 194 |   | 2 | % |
| Senior  - managed(1)     |       | 1                      |       | 0                     |       | 100 | % | 3 |   | 1 |   | 200 | % |
| Medi-Cal  - owned        |       | 33                     |       | 35                    |       | -6 | % | 101 |   | 103 |   | -2 | % |
| Medi-Cal  - managed(1)   |       | 33                     |       | 24                    |       | 38 | % | 83 |   | 71 |   | 17 | % |
| Total                    |       | 517                    |       | 539                   |       | -4 | % | 1,546 |   | 1,671 |   | -8 | % |

 

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(1)                       Representsmembers that we manage on behalf of third parties in exchange for a managementfee.

 

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

 

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

 

Capitation payments are fixed in advance of 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-annual reviews of ourIBNR liability from independent actuaries. We believe that our process forestimating IBNR is adequate and appropriate, but there can be no assurance thatmedical care costs will not materially differ from such estimates. In additionto contractual reimbursements to providers, we also make discretionaryincentive payments to physicians, which are in large part based on thepay-for-performance, shared risk revenues and any favorable senior capitationrisk-adjustment payments we receive. Since we record these revenues generallyin the third or fourth quarter of each fiscal year, when the incentives andcapitation adjustments due from the health plans are known, we alsohistorically adjust interim accruals of discretionary physician bonuses in thesame period. Because incentives and risk-adjustment revenues form the basis forthese discretionary bonuses, variability in earnings due to fluctuations inrevenues are mitigated by the recording of physician bonuses.

 

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General and administrative expenses (“G&A”) are largely comprisedof wage and benefit costs and other administrative expenses. G&A functionsinclude, and are not limited to, claims processing, information systems,provider relations, finance and accounting services, and legal and regulatoryservices.

 

**Medical Group Results of Operations**

 

The following tables summarize our net operating revenue, cost of revenuesand operating income from Medical Group operations and are used in thediscussions below (in thousands, unaudited):

 
| ** **                                   | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **June 30,**       | ** ** | **June 30,**      | ** ** |
| ** **                                   | ** ** | **2010**                | ** ** | **2009**               | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** |
| **Medical  Group revenues:**                 |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Capitation                                   |       | $                       | 46,790     |                   | $          | 47,369 |   | $ | (579 | ) | -1.2 | % | $ | 139,172 |   | $ | 143,005 |   | $ | (3,833 | ) | -2.7 | % |
| Management fees                              |       | 293                     |       | 149                    |       | 144 |   | 96.6 | % | 604 |   | 437 |   | 167 |   | 38.2 | % |
| Other operating revenues                     |       | 284                     |       | 330                    |       | (46 | ) | -14.0 | % | 399 |   | 696 |   | (297 | ) | -42.7 | % |
| **Total  Medical Group revenues**            |       | 47,367                  |       | 47,848                 |       | (481 | ) | -1.0 | % | 140,175 |   | 144,138 |   | (3,963 | ) | -2.7 | % |
| **Medical  Group cost of revenues:**         |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| PCP capitation                               |       | 8,087                   |       | 8,335                  |       | (248 | ) | -3.0 | % | 24,679 |   | 25,470 |   | (791 | ) | -3.1 | % |
| Specialist capitation                        |       | 10,189                  |       | 10,940                 |       | (751 | ) | -6.9 | % | 30,823 |   | 33,086 |   | (2,263 | ) | -6.8 | % |
| Claims expense                               |       | 18,180                  |       | 17,139                 |       | 1,041 |   | 6.1 | % | 53,693 |   | 52,301 |   | 1,392 |   | 2.7 | % |
| Physician salaries                           |       | 795                     |       | 605                    |       | 190 |   | 31.4 | % | 1,787 |   | 1,670 |   | 117 |   | 7.0 | % |
| Other cost of revenues                       |       | 171                     |       | (51                    | )          | 222 |   | 435.3 | % | 148 |   | (992 | ) | 1,140 |   | 114.9 | % |
| **Total  Medical Group cost of****revenues** |       | 37,422                  |       | 36,968                 |       | 454 |   | 1.2 | % | 111,130 |   | 111,535 |   | (405 | ) | -0.4 | % |
| **Gross  margin**                            |       | 9,945                   |       | 10,880                 |       | (935 | ) | -8.6 | % | 29,045 |   | 32,603 |   | (3,558 | ) | -10.9 | % |
| General and  administrative                  |       | 6,315                   |       | 7,286                  |       | (971 | ) | -13.3 | % | 19,454 |   | 21,961 |   | (2,507 | ) | -11.4 | % |
| Depreciation and  amortization               |       | 820                     |       | 889                    |       | (69 | ) | -7.8 | % | 2,547 |   | 2,644 |   | (97 | ) | -3.7 | % |
| Total other expenses                         |       | 7,135                   |       | 8,175                  |       | (1,040 | ) | -12.7 | % | 22,001 |   | 24,605 |   | (2,604 | ) | -10.6 | % |
| Income from  unconsolidated joint venture    |       | 482                     |       | 535                    |       | (53 | ) | -9.9 | % | 1,514 |   | 1,482 |   | 32 |   | 2.2 | % |
| **Operating  income**                        |       | $                       | 3,292      |                   | $          | 3,240 |   | $ | 52 |   | 1.6 | % | $ | 8,558 |   | $ | 9,480 |   | $ | (922 | ) | -9.7 | % |
| **Medical  cost ratio**                      |       | 80.0                    | %          | 77.3                   | %          |   |   |   |   | 79.9 | % | 77.4 | % |   |   |   |   |

 

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

 
| ** **                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| ** **                                | ** ** | **2010**               | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Medical Group revenues:**               |       |                   |       |                  |       |   |   |   |   |
| Capitation                                |       | 98.8                   | %          | 99.0                  | %          | 99.3 | % | 99.2 | % |
| Management  fees                          |       | 0.6                    | %          | 0.3                   | %          | 0.4 | % | 0.3 | % |
| Other  operating revenues                 |       | 0.6                    | %          | 0.7                   | %          | 0.3 | % | 0.5 | % |
| **Total Medical Group revenues**          |       | 100.0                  | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| **Medical Group cost of revenues:**       |       |                   |       |                  |       |   |   |   |   |
| PCP  capitation                           |       | 17.1                   | %          | 17.4                  | %          | 17.6 | % | 17.7 | % |
| Specialist  capitation                    |       | 21.5                   | %          | 22.9                  | %          | 22.0 | % | 23.0 | % |
| Claims  expense                           |       | 38.4                   | %          | 35.8                  | %          | 38.3 | % | 36.3 | % |
| Physician  salaries                       |       | 1.7                    | %          | 1.3                   | %          | 1.3 | % | 1.2 | % |
| Other  cost of revenues                   |       | 0.4                    | %          | -0.1                  | %          | 0.1 | % | -0.7 | % |
| **Total Medical Group cost of revenues**  |       | 79.1                   | %          | 77.3                  | %          | 79.3 | % | 77.5 | % |
| **Gross margin**                          |       | 20.9                   | %          | 22.7                  | %          | 20.7 | % | 22.5 | % |
| General  and administrative               |       | 13.3                   | %          | 15.2                  | %          | 13.9 | % | 15.2 | % |
| Depreciation  and amortization            |       | 1.7                    | %          | 1.9                   | %          | 1.8 | % | 1.8 | % |
| Total  other expenses                     |       | 15.0                   | %          | 17.1                  | %          | 15.7 | % | 17.0 | % |
| Income  from unconsolidated joint venture |       | 1.0                    | %          | 1.1                   | %          | 1.1 | % | 1.0 | % |
| **Operating income**                      |       | 6.9                    | %          | 6.7                   | %          | 6.1 | % | 6.5 | % |

 

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**Three Months Ended June 30, 2010 Compared toThree Months Ended June 30, 2009**

* *

*Capitation Revenue*

 

Capitation revenue for the three months ended June 30, 2010 wasapproximately $46,790,000, representing a decrease of approximately $579,000 or1.2% from capitation revenue for the three months ended June 30, 2009, ofapproximately $47,369,000.

 

The decrease in the fiscal 2010 period was due primarily to a decreasein commercial enrollment given current unemployment levels, partly offset bycommercial and senior rate increases and increased senior enrollment. Inaddition, the Company recognized a senior risk adjustment net settlement ofapproximately $1,300,000 that, in prior years, was recognized in the fourthquarter. The change in recognition timing is due to timing of notification bythe HMOs.

 

*Management Fee Revenue*

 

Management fee revenue for the three months ended June 30, 2010was approximately $293,000, representing an increase of approximately $144,000or 96.6% from management fee revenue for the three months ended June 30,2009, of approximately $149,000.

 

Theincrease during the fiscal 2010 period was due primarily to the management feeearned under the new management agreement entered with an unaffiliated medicalgroup effective May 1, 2010. Under the agreement, Prospect currentlymanages approximately 11,000 HMO enrollees with monthly management fees rangingfrom 7.5% to 12.5% of revenues, depending on the type of revenues managed. Theagreement is for an initial three-year period, with an automatic renewalprovision and 90-day cancellation provision.

 

*Other Operating Revenue*

 

Other operating revenue for the three months ended June 30, 2010was approximately $284,000, representing a decrease of approximately $46,000 or14.0% over other revenue for the three months ended June 30, 2009, ofapproximately $330,000.

 

Amounts represent incentive payments from HMOs under “pay-for-performance”programs for quality medical care based on various criteria. The incentives arerecorded when such amounts are known. The decrease in other revenue during thefiscal 2010 period was primarily the result of timing of receipt ofpay-for-performance monies.

 

*PCP Capitation Expense*

 

Primary care physician (“PCP”) capitation expense for the three monthsended June 30, 2010 was approximately $8,087,000, representing a decreaseof $248,000 or 3.0% over PCP capitation expense for the three months ended June 30,2009, of approximately $8,335,000.

 

The decrease during the fiscal 2010 period was primarily due todecreased enrollment, partly offset by market rate adjustments made as part ofour effort to attract new physicians and their members.

 

*Specialist Capitation Expense*

 

Specialist Capitation expense for the three months ended June 30,2010 was approximately $10,189,000, representing a decrease of $751,000 or 6.9%from specialist capitation expense for the three months ended June 30,2009, of approximately $10,940,000.

 

The decrease during the fiscal 2010 period was due to a combination ofdecreased enrollment and moving more of certain specialties to afee-for-service basis in the current year period, which move was consideredmore beneficial to the Company.

 

*Claims Expense*

 

Claims expense for the three months ended June 30, 2010 wasapproximately $18,180,000, representing an increase of $1,041,000 or 6.1% overclaims expense for the three months ended June 30, 2009, of approximately$17,139,000.  The increase was dueprimarily to moving more of certain specialties to a fee-for-service basis inthe current fiscal period, which move was considered more beneficial to theCompany.

 

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*Physician Salaries Expense*

 

Physician salaries expense for the three months ended June 30,2010 was approximately $795,000, representing an increase of $190,000 or 31.4%over physician salaries expense for the three months ended June 30, 2009,of approximately $605,000.

 

The increase was primarily as a result of changing our hospitalscompensation structure from employees to contracted providers, which wasconsidered preferable for the Company.

 

*Other Cost of Revenues*

 

Other cost of revenues for the three months ended June 30, 2010was approximately $171,000, compared to a net recovery expense of approximately$51,000 for the three months ended June 30, 2009.

 

The change was primarily due to a decrease in stop-loss incurrencerecoveries.

 

*Medical Cost Ratio*

 

Medical care costs as a percentage of medical revenues (the medicalcost ratio, a non-GAAP measure) largely determine our gross margin. Our grossmargin decreased to 21.0% for the three months ended June 30, 2010, from22.7% for the three months ended June 30, 2009.

 

The decrease in our gross margin percentage between the fiscal 2010 and2009 periods was primarily due to changes in the level of receipts forstop-loss insurance recoveries, increased claims expense, and certain marketrate adjustments given to our contracted physicians as discussed above.

 

*General and Administrative*

 

G&A were approximately $6,315,000 for the three months ended June 30,2010, representing 13.3% of total Medical Group revenues, as compared withapproximately $7,286,000 or 15.2% of total Medical Group revenues, for thefiscal 2009 period.

 

The decrease during the fiscal 2010 period was primarily due to theelimination of certain personnel, facility and outside service costs, inconnection with the consolidation of certain administrative functions among ourMedical Groups and decreased legal costs.

 

*Depreciation and Amortization*

 

Depreciation and amortization expense for the three months ended June 30,2010 decreased to approximately $820,000 from $889,000 for the same period ofthe prior year, primarily due to retirement of certain office equipment.

 

*Income from Unconsolidated Joint Venture*

 

The income from unconsolidated joint venture for the three months endedJune 30, 2010 was $482,000 compared to $535,000 for the same period of theprior year, which decrease was primarily due to increased claims costs forOneCare members.

 

*Operating Income*

 

Our Medical Group segment reported operating income of approximately$3,292,000 and $3,240,000, for the three months ended June 30, 2010 and2009, respectively, as a result of the changes discussed above. The operatingresults of the Medical Group segment include certain corporate expenseallocations for insurance, professional fees, and amortization of identifiableintangibles that relate to this segment.

 

***Nine Months Ended June 30, 2010Compared to Nine Months Ended June 30, 2009***

 

*Capitation Revenue*

 

Capitation revenue for the nine months ended June 30, 2010 wasapproximately $139,172,000 representing a decrease of approximately $3,833,000or 2.7% from capitation revenue for the nine months ended June 30, 2009,of approximately $143,005,000.

 

The decrease in the fiscal 2010 period was due primarily to a decreasein commercial enrollment given current unemployment levels, partly offset bycommercial and senior rate increases and increased senior enrollment.

 

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*Management Fee Revenue*

 

Management fee revenue for the nine months ended June 30, 2010 wasapproximately $604,000 representing an increase of approximately $167,000 or38.2% from management fee revenue for the nine months ended June 30, 2009,of approximately $437,000.

 

Theincrease during the fiscal 2010 period was due primarily to the management feeearned under the new management agreement entered with an unaffiliated medicalgroup effective May 1, 2010, and partly to an increase in management feepercentage with OneCare. Under the agreement, Prospect currently managesapproximately 11,000 HMO enrollees with monthly management fees ranging from7.5% to 12.5% of revenues depending on the type of revenues managed. Theagreement is for an initial three-year period, with automatic renewal provisionand 90-day cancellation provision.

 

*Other Operating Revenue*

 

Other operating revenue for the nine months ended June 30, 2010was approximately $399,000, representing a decrease of approximately $297,000or 42.7% over other revenue for the nine months ended June 30, 2009, ofapproximately $696,000.

 

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.

 

*PCP Capitation Expense*

 

Primary care physician (“PCP”) capitation expense for the nine monthsended June 30, 2010 was approximately $24,679,000, representing a decreaseof $791,000 or 3.1% over PCP capitation expense for the nine months ended June 30,2009, of approximately $25,470,000.

 

The decrease during the fiscal 2010 period was primarily due todecreased enrollment, partly offset by market rate adjustments made as part ofour effort to attract new physicians and their members.

 

*Specialist Capitation Expense*

 

Specialist Capitation expense for the nine months ended June 30,2010 was approximately $30,823,000, representing a decrease of $2,263,000 or6.8% from specialist capitation expense for the nine months ended June 30,2009, of approximately $33,086,000.

 

The decrease during the fiscal 2010 period was due to a combination ofdecreased enrollment and moving more of certain specialties to afee-for-service basis in the current year period, which move was consideredmore beneficial to the Company.

 

*Claims Expense*

 

Claims expense for the nine months ended June 30, 2010 was approximately$53,693,000, representing an increase of $1,392,000 or 2.7% over claims expensefor the nine months ended June 30, 2009, of approximately$52,301,000.  The increase was dueprimarily to moving more of certain specialties to a fee-for-service basis inthe current fiscal period, which move was considered more beneficial to theCompany.

 

*Physician Salaries Expense*

 

Physician salaries expense for the nine months ended June 30, 2010was approximately $1,787,000, representing an increase of $117,000 or 7.0% overphysician salaries expense for the nine months ended June 30, 2009, ofapproximately $1,670,000.

 

The increase was primarily as a result of changing our hospitalscompensation structure from employees to contracted providers, which wasconsidered preferable for the Company.

 

*Other Cost of Revenues*

 

Other cost of revenues for the nine months ended June 30, 2010 wasapproximately $148,000, compared to a net recovery of approximately $992,000for the nine months ended June 30, 2009.

 

The change was primarily due to unusually high stop-loss insurancerecoveries, resulting in a contra expense in the prior year period.

 

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*Medical Cost Ratio*

 

Medical care costs as a percentage of medical revenues (the medicalcost ratio, a non-GAAP measure) largely determine our gross margin. Our grossmargin decreased to 20.7% for the nine months ended June 30, 2010, from22.6% for the nine months ended June 30, 2009.

 

The decrease in our gross margin percentage between the fiscal 2010 and2009 periods was primarily due to changes in the level of stop-loss insurancerecoveries, increased claims expense, and certain market rate adjustments givento our contracted physicians, as discussed above.

 

*General and Administrative*

 

G&A were approximately $19,454,000 for the nine months ended June 30,2010, representing 13.9% of total Medical Group revenues, as compared withapproximately $21,961,000 or 15.2% of total Medical Group revenues, for thefiscal 2009 period.

 

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

 

*Depreciation and Amortization*

 

Depreciation and amortization expense for the nine months ended June 30,2010 decreased to approximately $2,547,000 from $2,644,000 for the same periodof the prior year, primarily due to retirement of certain office equipment.

 

*Income from Unconsolidated Joint Venture*

 

The income from unconsolidated joint venture for the nine months ended June 30,2010 increased to $1,514,000 from $1,482,000 for the same period of the prioryear. The increase was primarily due to increased risk pool income in thefiscal 2010 period.

 

*Operating Income*

 

Our Medical Group segment reported operating income of approximately$8,558,000 and $9,480,000, for the nine months ended June 30, 2010 and2009, respectively, as a result of the changes discussed above. The operatingresults of the Medical Group segment include certain corporate expenseallocations for insurance, professional fees, and amortization of identifiableintangibles that relate to this segment.

 

***Corporate Segment***

 

Certain expenses incurred at the Parent Entity not specificallyallocable to the Hospital Services or Medical Group segments are recorded inthe Corporate segment.  These expensesinclude salaries (including stock-based compensation), benefits, financing,rent, supplies, legal, SEC compliance, and Sarbanes-Oxley compliance.  We do not allocate interest expense, gain orloss on interest rate swaps and income taxes to the other reporting segments.

 

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The following table summarizes our corporate expense for the ParentEntity, and is used in the discussion below (in thousands, unaudited):

 
| ** **                                                          | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                          | ** ** | **June 30,**       | ** ** | **June 30,**      | ** ** |
| ** **                                                          | ** ** | **2010**                | ** ** | **2009**               | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase********(Decrease)** | ** ** | **%** | ** ** |
| **Operating  Expenses:**                                            |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| General and  administrative                                         |       | $                       | 3,275      |                   | $          | 3,859 |   | $ | (584 | ) | -15.1 | % | $ | 9,466 |   | $ | 8,731 |   | $ | 735 |   | 8.4 | % |
| Depreciation and  amortization                                      |       | 3                       |       | 3                      |       | — |   | 0.0 | % | 10 |   | 9 |   | 1 |   | 11.0 | % |
| **Total  Operating Expenses**                                       |       | 3,278                   |       | 3,862                  |       | (584 | ) | -15.1 | % | 9,476 |   | 8,740 |   | 736 |   | 8.4 | % |
| **Other  (Income) Expense:**                                        |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense and  amortization of deferred financing costs, net |       | 5,565                   |       | 7,562                  |       | (1,997 | ) | -26.4 | % | 16,825 |   | 20,147 |   | (3,322 | ) | -16.5 | % |
| (Gain) loss in value of  interest rate swap arrangements            |       | —                  |       | (3,694                 | )          | 3,694 |   | 100.0 | % | — |   | 5,019 |   | (5,019 | ) | -100.0 | % |
| **Total  Other Expense, net**                                       |       | 5,565                   |       | 3,868                  |       | 1,697 |   | 43.8 | % | 16,825 |   | 25,166 |   | (8,341 | ) | -33.1 | % |
| **Total  Corporate Expenses**                                       |       | $                       | 8,843      |                   | $          | 7,730 |   | $ | 1,113 |   | 14.4 | % | $ | 26,301 |   | $ | 33,906 |   | $ | (7,605 | ) | -22.4 | % |

 

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

 
| ** **                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| ** **                                                          | ** ** | **2010**               | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Operating Expenses:**                                             |       |                   |       |                  |       |   |   |   |   |
| General  and administrative                                         |       | 2.8                    | %          | 3.3                   | %          | 2.7 | % | 3.1 | % |
| Depreciation  and amortization                                      |       | 0.0                    | %          | 0.0                   | %          | 0.0 | % | 0.0 | % |
| **Total Operating Expenses**                                        |       | 2.8                    | %          | 3.3                   | %          | 2.7 | % | 3.1 | % |
| **Other (Income) Expense:**                                         |       |                   |       |                  |       |   |   |   |   |
| Interest  expense and amortization of deferred financing costs, net |       | 4.8                    | %          | 6.5                   | %          | 4.8 | % | 7.0 | % |
| (Gain)  loss in value of interest rate swap arrangements            |       | 0.0                    | %          | -3.2                  | %          | 0.0 | % | 1.8 | % |
| **Total Other Expense, net**                                        |       | 4.8                    | %          | 3.3                   | %          | 4.8 | % | 8.8 | % |
| **Total Corporate Expenses**                                        |       | 7.6                    | %          | 6.6                   | %          | 7.5 | % | 11.9 | % |

 

**Three Months Ended June 30, 2010 Compared toThree Months Ended June 30, 2009**

 

*General and Administrative*

 

G&A expense for the three months ended June 30, 2010 wasapproximately $3,275,000, representing approximately 2.8% of total consolidatedrevenues, compared to approximately $3,859,000 or approximately 3.3% of totalconsolidated revenues, for the three months ended June 30, 2009. Thechange in G&A expenses during the fiscal 2010 period was due primarily todecreased accruals for annual incentive compensation, offset by increasedadministrative payroll and legal costs.

 

*Interest Expense and Amortization of DeferredFinancing Costs, net*

 

Interest expense and amortization of deferred financing costs, net forthe three months ended June 30, 2010 was approximately $5,565,000,compared to approximately $7,562,000 for the three months ended June 30,2009, a decrease of approximately 26.4%.

 

Following our refinance on July 29, 2009, (see Note 7 to theunaudited condensed consolidated financial statements), the effective interestrate on our debt facilities was reduced, resulting in the decrease in quarterlyinterest expense.

 

*Gain in Value of Interest Rate Swap Arrangements*

 

We had two interest rate swaps in place in connection with our priordebt financing.  These swaps did notqualify for hedge accounting during the fiscal 2009 period and as such, allchanges in fair value of those swaps were treated as an expense.

 

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Concurrent with the Senior Secured Note transaction on July 29,2009, we terminated the interest rate swap arrangements and expensed allpreviously unamortized swap fluctuation amounts.  Accordingly, there were no interest rateswaps in existence or related expense during the quarter ended June 30,2010.

 

**Nine Months Ended June 30,2010 Compared to Nine Months Ended June 30, 2009**

 

*General and Administrative*

 

G&A expense for the nine months ended June 30, 2010 wasapproximately $9,466,000, representing 2.7% of total consolidated revenues,compared to approximately $8,731,000 or 3.1% of total consolidated revenues,for the nine months ended June 30, 2009. The fluctuation in G&Aexpense percentage during the fiscal 2010 period was due primarily to decreasedaccruals for annual incentive compensation and legal costs, offset by increasedadministrative payroll costs and accruals for annual incentive stock-basedcompensation.

 

*Interest Expense and Amortization of Deferred FinancingCosts, net*

 

Interest expense and amortization of deferred financing costs, net forthe nine months ended June 30, 2010 was approximately $16,825,000,compared to approximately $20,147,000 for the nine months ended June 30,2009, a decrease of approximately 16.5%.

 

Following our refinance on July 29, 2009, (see Note 7 to theunaudited condensed consolidated financial statements), the effective interestrate on our debt facilities was reduced, resulting in the decrease in quarterlyinterest expense.

 

*Loss in Value of Interest Rate Swap Arrangements*

 

We had two interest rate swaps in place in connection with our priordebt financing.  These swaps did notqualify for hedge accounting during the fiscal 2009 period and as such, allchanges in fair value of those swaps were treated as an expense.

 

Concurrent with the Senior Secured Note transaction on July 29,2009, we terminated the interest rate swap arrangements and expensed allpreviously unamortized swap fluctuation amounts.  Accordingly, there were no interest rateswaps in existence or related expense during the fiscal 2010 period.

 

**Consolidated Results of Operations**

 

**Three Months Ended June 30, 2010 Compared toThree Months Ended June 30, 2009**

 

*Provision for Income Taxes*

 

Income tax provision for the three months ended June 30, 2010 wasapproximately $2,791,000 compared to $1,989,000 in the three months ended June 30,2009 with the fluctuation as a result of the change in income before taxes. Theeffective tax rate was 56% for the three months ended June 30, 2010compared to 114% for the three months ended June 30, 2009. The highereffective tax rate in the fiscal 2009 period was primarily due to theconsolidated group not being able to recognize the tax benefit from Brotman’sloss for Federal tax purposes.

 

*Net Loss Attributable to Noncontrolling Interest*

 

Netloss attributable to noncontrolling interests, net of tax for the three monthsended June 30, 2010 was approximately $640,000, as compared to none forthe three months ended June 30, 2009. The decrease was due toconsolidation of Brotman in the current year period. As discussed in Note 8 tothe accompanying condensed consolidated financial statements, prior to October 1,2009, a pro rata share of net income (loss) attributable to minority interestin Brotman was not included under minority interest in the Company’sconsolidated statement of operations, as the cumulative minority share of suchincome did not exceed their cumulative share of prior losses absorbed by theCompany.

 

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

 

Net income (loss) attributable to Prospect Medical Holdings, Inc.’scommon shareholders for the three months ended June 30, 2010 wasapproximately $2,847,000 or $0.12 per diluted share, as compared to net loss ofapproximately $238,000 or $0.01  perdiluted share, for the three months ended June 30, 2009, which change wasthe result of the items discussed above.

 

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**Nine Months Ended June 30,2010 Compared to Nine Months Ended June 30, 2009**

 

*Provision for Income Taxes*

 

Income tax provision for the nine months ended June 30, 2010 wasapproximately $7,239,000, compared to $2,065,000 for the nine months ended June 30,2009, with the change being due to the change in income before taxes. Theeffective tax rate was lower at 50% for the nine months ended June 30,2010 compared to 107% for the nine months ended June 30, 2009. The highereffective tax rate in the fiscal 2009 period was primarily due to theconsolidated group not being able to recognize the tax benefit from Brotman’sloss for Federal tax purposes.

 

*Net Loss Attributable to Noncontrolling Interest*

 

Netloss, net of tax attributable to noncontrolling interests for the nine monthsended June 30, 2010 was approximately $1,123,000, as compared to netincome of $5,000 for the nine months ended June 30, 2009. The change wasdue to consolidation of Brotman in the current year period. As discussed inNote 8 to the accompanying condensed consolidated financial statements, priorto October 1, 2009, a pro rata share of net income (loss) attributable tominority interest in Brotman was not included under minority interest in theCompany’s consolidated statement of operations, as the cumulative minorityshare of such income did not exceed their cumulative share of prior lossesabsorbed by the Company.

 

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

 

Net income (loss) attributable to Prospect Medical Holdings, Inc.’scommon shareholders for the nine months ended June 30, 2010 wasapproximately $8,295,000 or $0.37 per diluted share, as compared to a net lossof approximately $134,000 or $0.01 per diluted share, for the nine months endedJune 30, 2009.  This change was theresult of the items discussed above.

 

**Liquidity and Capital Resources**

 

Our primary sources of cash have been funds provided by borrowingsunder our credit facilities, by the issuance of equity securities and by cashflow from operations. Prior to the August 8, 2007 acquisition of Alta, ourprimary sources of cash from operations were healthcare capitation revenues,fee-for-service revenues, risk pool payments and pay-for-performance incentivesearned by our affiliated physician organizations. With the Alta acquisition andsubsequently, Brotman, our sources of cash from operations now include paymentsfor Hospital Services rendered under reimbursement arrangements with thirdparty payers, which include the Federal government under the Medicare program,the State government under the Medi-Cal program, private insurers, HMOs, PPOs,and self-pay patients.

 

Ourprimary uses of cash include healthcare capitation and claims payments by ourMedical Groups, administrative expenses, debt service, acquisitions, costsassociated with the integration of acquired businesses, information systemsand, with the acquisition of Alta and subsequently, Brotman, operating, capitalimprovement and administrative expenses related to our hospital operations. OurMedical Groups generally receive capitation revenue prior to processingprovider capitation and claims payments. However, our hospitals receivepayments for services rendered generally 30 to 90 days after the medicalcare is rendered. For some payors , the time lag between service andreimbursement can exceed one year.

 

Our investment strategies are designed to provide safety andpreservation of capital, sufficient liquidity to meet the cash flow needs ofour business operations and attainment of a competitive return. As of June 30,2010, we invested our cash in interest bearing money market accounts,interest-bearing certificates of deposit and non interest-bearing checkingaccounts. All of these amounts are classified as current assets and included incash and cash equivalents in our condensed consolidated balance sheets.

 

*Cash Flow from Operations*

 

Netcash provided by operating activities was approximately $15,062,000 for thenine months ended June 30, 2010 compared to net cash provided by operatingactivities of approximately $12,038,000 for the nine months ended June 30,2009. Key positive and negative factors contributing to the change between the2010 and 2009 periods include the following:

 

·                  Increased income fromoperations before income taxes of $7,854,000, excluding interest expense,income taxes, depreciation and amortization, and loss from on interest rateswap arrangements in the nine months ended June 30, 2010 compared tothe nine months ended June 30, 2009;

 

·                  Lower interest payments of$7,136,000  for the nine months ended June 30, 2010 compared to thenine months ended June 30, 2009, primarily due to lower effective interest rateon Prospect’s new debt facilities (see Note 7 to the unaudited condensedconsolidated financial statements) and the consolidation of Brotman for onlypart of the fiscal 2009 period;

 

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·                  Lower income tax refunds of$1,976,000 received in the nine months ended June 30, 2010, compared tothe nine months ended June 30, 2009; and

 

·                  Higher Medi-Cal DSH receiptsfor approximately $15,757,000 in the nine months ended June 30, 2010compared to $11,675,000 in the nine months ended June 30, 2009.

 

Net cash used in investing activities was approximately $2,237,000 forthe nine months ended June 30, 2010, compared to a use of approximately$3,139,000 for the nine months ended June 30, 2009. During the nine monthsended June 30, 2010 we spent $2,268,000 for capital expenditures forreplacement equipment and general improvements, primarily at our Alta facilities.During the nine months ended June 30, 2009, we invested approximately$2,310,000 in connection with the Brotman acquisition; and approximately$764,000 of capital expenditures for equipment, renovations and upgrades ofexisting facilities.

 

Net cash provided by financing activities was approximately $348,000for the nine months ended June 30, 2010, as compared to a use ofapproximately $10,895,000 for the nine months ended June 30, 2009. Duringthe first nine months of 2010, net cash provided by financing activitiesreflect the net proceeds from Brotman’s revolving line of credit and cashproceeds from exercises of stock options and warrants, offset by increaseddeposits into restricted cash as required by Brotman’s JHA financing, principalrepayments on Brotman’s Creditors’ Trust Note and repayment of capital leaseobligations. During the first nine months of 2009, we spent approximately$8,904,000 on repayments of our former term debt, approximately $1,671,000 onnet repayment of Brotman’s revolving line of credit, approximately $972,000 offinancing costs in connection with the issuance of Prospect’s senior securednotes and approximately $395,000 on principal repayments of capital leaseobligations.

 

As of June 30, 2010, we had working capital of approximately$8,594,000 as compared to working capital of approximately $9,903,000 atSeptember 30, 2009, with the current year decrease being primarily theresult of classifying Brotman’s Term A JHA Loan as current at June 30, 2010.

 

As of June 30, 2010 and September 30, 2009, cash, cashequivalents and investments (including restricted amounts) totaledapproximately $54,368,000 and $39,828,000, respectively.

 

*Prospect Note Offering*

 

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%.  The sale was executed in accordance with Rule 144A underthe Securities Act of 1933 and Regulation S under the Securities Act of1933.  Also, in connection with the issuance of the Notes, the Companyentered into a three year $15 million revolving credit facility, which was undrawnat closing.  The interest rate under the revolving credit facility will beat LIBOR plus an applicable margin of 7.00%, with a LIBOR floor of 2.00%.  The Company used the net proceeds from thesale of the Notes to repay all amounts outstanding under the Former CreditFacility, plus a prepayment premium of approximately $2.6 million.

 

*Brotman Financing*

 

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

 

The JHA financing was comprised of two term debt components, a$16.0 million tranche secured by assets on the west side of the Brotmancampus commonly referred to as “Delmas West” and a $6.25 million trancheon the main hospital pavilion on the east side of the property. The$16.0 million tranche contains an option for JHA to acquire the DelmasWest parcel for a purchase price equal to the outstanding debt within24 months of the effective date of the bankruptcy. If JHA does notexercise its option, Brotman will be required to refinance the$16.0 million tranche on or before April 14, 2011. With respect tothe $16.0 million tranche of the JHA facility, JHA also has the right todeclare the unpaid loan amount, immediately due and payable at any time afterApril 14, 2010 and prior to April 14, 2011, provided that JHA gives180 days’ written notice of exercise. Effective February 10, 2010,JHA and Brotman entered into an amendment to the Term A loan, whereby theearliest date on which JHA could provide notice of its exercise of the PutRight was extended from April 14, 2010 to October 14, 2010,effectively extending the earliest maturity date for the Term A Loan to April 14,2011. Brotman and JHA are currently negotiating a comprehensive amendment to,and extension of, the Term A Loan, pending completion of which amounts owingunder this loan have been reflected as current in the Company’s June 30,2010 unaudited condensed consolidated balance sheet. In addition, the$6.25 million tranche of the JHA transaction will mature on April 14,2012 and Brotman will need to secure financing to retire this portion of thedebt.

 

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The Gemino financing was comprised of a $6.0 million (which wasincreased to $7.0 million pursuant to an amendment described below), seniorcredit facility secured by accounts receivable. The facility expires on the earlierof April 14, 2012 and the JHA loan (see above) maturity date and bearsinterest at LIBOR plus 7% per annum, with a LIBOR floor of 4%. Interest isincurred based on the greater of $2 million or the outstanding principalbalance. The agreement also includes an unused line fee of 0.5% per annum and acollateral line fee, based on the average outstanding principal balance, of0.5% per annum. The senior credit facility agreement contains customarycovenants for facilities of this type, including restrictions on the payment ofdividends, change in ownership/management, asset sales, incurrence ofadditional indebtedness, sale-leaseback transactions, and related partytransactions. Brotman must also comply with financial covenants. Prior to arecent amendment discussed below, Brotman was required to comply with a fixedcharge coverage ratio of not less than (i) 1.10:1.00 for the fiscalquarter ending June 30, 2009, (ii) 1.15:1.00 for the fiscal quarterending September 30, 2009; and (iii) 1.20:1.00 for each fiscalquarter ending thereafter.  As ofSeptember 30, 2009, Brotman was not in compliance with the requiredfinancial covenants under the Gemino credit agreement.  Pursuant to an amendment entered intoeffective December 11, 2009, the Gemino credit agreement was amended toprovide, among other things, a waiver of the specified events of default andthe amendment to the definition of fixed charge coverage ratio.  Under the amended credit agreement, the fixedcharge coverage ratio was amended to require not less than (i) 1.00:1.00for the fiscal quarters ended December 31, 2009 and March 31, 2010;(ii) 1.05:1.00 for the fiscal quarters ended June 30, 2010 and endingSeptember 30, 2010; (iii) 1.10:1.00 for the fiscal quarters endingDecember 31, 2010 and March 31, 2011; and (iv) 1.20:1.00 for thefiscal quarter ending June 30, 2011 and each fiscal quarter endingthereafter.  As of June 30, 2010,Brotman was in compliance with the required financial covenants under theamended credit agreement. Pursuant to an amendment entered into effectiveFebruary 17, 2010, the Gemino credit agreement and promissory note wereamended to increase the loan commitment by $1.0 million to a total commitmentof $7.0 million as set forth above.

 

The Class 4 Note, which was executed on April 14, 2009, theEffective Date of Brotman’s Plan of Reorganization, for the benefit of theallowed Class 4 claims (as defined in the Plan of Reorganization) bearsinterest at 7.50% per annum and is payable in sixteen equal quarterlyinstallments of principal and accrued interest through February 15, 2013.The Note contains a covenant which, so long as amounts remain outstanding underthe Note, restricts Brotman from paying Prospect in cash a consulting fee ofmore than $100,000 per month, as specified in the Amended and RestatedConsulting Services Agreement (see Note 6 to the accompanying unauditedcondensed consolidated financial statements). As such, although the amount of the consulting fee was increased to 4.5%of Brotman’s net operating revenue retroactive to April 14, 2009, theamount of such consulting fee actually paid in cash will not exceed $100,000per month until such time permitted by applicable agreement or the CreditorTrust Note has been amended or repaid. For the period April 14, 2009through June 30, 2010, total principal repayments on the Class 4 Notewere approximately $1.3 million.

 

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

 

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

 

*Off-Balance Sheet Arrangements*

 

None.

 

**Critical Accounting Policies**

 

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

 

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***Consolidationof Financial Statements***

 

Under applicable financial reporting requirements, the financialstatements of the Medical Groups with which we have management servicesagreements are consolidated with our own financial statements. As provided bythe FASB issued interpretation guidance, the consolidation is required becausewe are deemed to hold a controlling financial interest in such organizationsthrough a nominee shareholder. We can, through the assignable optionagreements, change the nominee shareholder at will on an unlimited basis andfor nominal cost. There is no limitation on our designation of a nomineeshareholder except that any nominee shareholder must be a licensed physician orotherwise permitted by law to hold shares in a professional medicalcorporation. The operations of our affiliated physician organizations have asignificant impact on our financial statements. The financial statements ofBrotman have been included in our consolidated financial statements sinceApril 14, 2009, when we acquired a majority stake in that entity. Allintercompany accounts and balances have been eliminated in consolidation.

 

***RevenueRecognition***

 

*Third Partyand Patient Reimbursement*

 

Operating revenue of the Hospital Services segment consists primarilyof net patient service revenue. A summary of the payment arrangements withmajor 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.

 

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

 

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

 

*Self-Pay: *Self-pay patients represent those patients who do not have healthinsurance and are not covered by some other form of third party arrangement.Such patients are evaluated, at the time of service or shortly thereafter, fortheir ability to pay based upon Federal and State poverty guidelines,qualifications for Medi-Cal, as well as our local hospital’s indigent andcharity care policy.

 

Werecognize revenues in the period in which services are provided. Accountsreceivable primarily consist of amounts due from third party payers andpatients. Amounts we receive for treatment of patients covered by governmentalprograms, such as Medicare and Medi-Cal, and other third party payers such asHMOs, PPOs and other private insurers, are generally less than our establishedbilling rates. Accordingly, our gross revenues and accounts receivable arereduced to net realizable value through an allowance for contractual discounts.

 

ForMedicare and Medi-Cal programs, provisions for contractual adjustments are madeto reduce patient charges to the estimated cash receipts based on each program’sprinciples of payment/reimbursement (i.e., either prospectively determined orretrospectively determined costs). Under the Medi-Cal program’s prospectivereimbursement systems, there is no adjustment or settlement of the differencebetween the actual cost to provide the service and the predeterminedreimbursement rates. Certain types of payments by the Medicare program (e.g.Medicare Disproportionate Share Hospital and Medicare Allowable Bad Debts) aresubject to retroactive adjustment in future periods. Final settlements underthese programs are subject to adjustment based on administrative review and auditby third party intermediaries, which can take several years to resolvecompletely. Adjustments related to final settlements for 2005 through 2008 costreport years increased our revenues by approximately $517,000 and $1,087,000 ineach of the three month and nine month period ended June 30, 2009,respectively; and adjustments related to final settlements for 2009 cost reportyear increased our revenues by $377,000, in each of the three month and ninemonth periods ended June 30, 2010.

 

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Estimatesfor contractual allowances under managed care health plans are primarily basedon the payment terms of contractual arrangements, such as predetermined ratesper diagnosis, per diem rates or discounted fee for service rates.

 

Weclosely monitor our historical collection rates, as well as changes inapplicable laws, rules and regulations and contract terms, to ensure that provisionsare made using the most appropriate and current information available. However,due to the complexities involved in these estimations, actual payments frompayers may be materially different from the amounts we estimate and record. Ifthe actual contractual reimbursement percentage under government programs andmanaged care contracts differed by 1% from our estimated percentage, we projectthat our consolidated net hospital services revenue and net income would havechanged by approximately $2.5 million and $1.4 million, respectively, for thethree months ended June 30, 2010 and by approximately $7.8 million and$4.1 million, respectively, for the nine months ended June 30, 2010. Theprocess of determining the allowance requires us to estimate the amountexpected to be received based on payer contract provisions, historicalcollection data as well as other factors and requires a high degree ofjudgment. This process is impacted by changes in legislation, managed carecontracts and other related factors. A significant increase in our estimate ofcontractual discounts for Medicare, Medi-Cal and managed care plans wouldsignificantly lower our earnings. This would adversely affect our results ofoperations, financial condition, liquidity and future access to capital.

 

*Provisionfor Doubtful Accounts*

 

Substantiallyall of our accounts receivable are related to providing healthcare services toour hospital patients. Collection of these accounts receivable is a primarysource of cash and is critical to our operating performance. Our hospitalsprovide services to patients with healthcare coverage, as well as to thosewithout healthcare coverage. Those patients with healthcare coverage are oftenresponsible for a portion of their bill referred to as the co-payment ordeductible. This portion of the bill is determined by the patient’s individualhealthcare or insurance plan. Patients without healthcare coverage areevaluated at the time of service, or shortly thereafter, for their ability topay based on Federal and State poverty guidelines, qualification for Medi-Cal,as well as our policies for indigent and charity care. We maintain a uniformpolicy whereby patient account balances are characterized as charity andindigent care only if the patient meets certain percentages of the Federalpoverty level guidelines. Because we do not pursue collection of amountsdetermined to qualify as charity care, they are not reported in net revenues orin accounts receivable, net. We manage our provision for doubtful accountsusing hospital-specific goals and benchmarks such as total cash collections,point-of-service cash collections, accounts receivable days outstanding (“ARDays”), and accounts receivable aging. Accounts receivable balances arereserved at increasing percentages as they age. We establish a partial reservein the allowance for doubtful accounts for self-pay balances on the date ofdischarge. All hospital receivables are fully reserved if they have beenoutstanding for greater than 365 days from the date of discharge.

 

Statementsare sent to self-pay patients indicating the outstanding balances on theiraccounts. If an account is still outstanding after a period of time, it isreferred to third party collection agencies for assistance in collecting theamount due. Our policy is to write-off all self-pay accounts after allcollection efforts have been exhausted. All accounts that have been placed withthird party collection agencies are written off. Patient responsibilityaccounts represent the majority of our write-offs. Accounts that are identifiedas self-pay accounts with insignificant balances are automatically written offin accordance with our collection policy. Non self-pay accounts are reviewedmonthly and written-off on a case-by-case basis.

 

Thelargest component of our allowance for doubtful accounts relates to self-payaccounts. These accounts include both amounts payable by uninsured patients andco-payments and deductibles payable by insured patients. In general, we attemptto collect deductibles, co-payments and self-pay accounts prior to the time ofservice for non-emergency care. If we do not collect the self-pay portion fromthe patient prior to the delivery of care, the accounts are handled through ourbilling and collections processes. We verify each patient’s insurance coverageas early as possible before a scheduled admission or procedure, including withrespect to eligibility, benefits and authorization/pre-certificationrequirements, in order to notify patients of the amounts for which they will beresponsible. We attempt to verify insurance coverage within a reasonable amountof time for all emergency room visits and urgent admissions in compliance withapplicable laws.

 

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The table below shows the net accounts receivable and allowance fordoubtful accounts by payer (in thousands, unaudited):

 
| ** **   | ** ** | **June 30, 2010**                                                   | ** ** | **September 30, 2009**                | ** ** |
|--------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **   | ** ** | **Accounts  Receivable  Before  Allowance  For Doubtful  Accounts** | ** ** | **Allowance  For Doubtful  Accounts** | ** ** | **Net** | ** ** | **Accounts  Receivable  Before  Allowance  For Doubtful  Accounts** | ** ** | **Allowance  For Doubtful  Accounts** | ** ** | **Net** | ** ** |
| Medicare     |       | $                                                                        | 15,389     |                                       | $          | 1,548 |   | $ | 13,841 |   | $ | 9,919 |   | $ | 1,064 |   | $ | 8,855 |   |
| Medi-Cal     |       | 17,945                                                                   |       | 1,404                                      |       | 16,541 |   | 15,383 |   | 883 |   | 14,500 |   |
| Managed care |       | 10,161                                                                   |       | 1,133                                      |       | 9,028 |   | 10,803 |   | 1,324 |   | 9,479 |   |
| Self-pay     |       | 16,911                                                                   |       | 13,812                                     |       | 3,099 |   | 11,391 |   | 8,183 |   | 3,208 |   |
| Other        |       | 422                                                                      |       | 322                                        |       | 100 |   | 1,025 |   | 261 |   | 764 |   |
| Total        |       | $                                                                        | 60,828     |                                       | $          | 18,219 |   | $ | 42,609 |   | $ | 48,521 |   | $ | 11,715 |   | $ | 36,806 |   |

 

When considering the adequacy of our allowances for doubtful accounts,accounts receivable balances are routinely reviewed in conjunction withhealthcare industry trends/indicators, historical collection rates by payer andother business and economic conditions that might reasonably be expected toaffect the collectability of the balance. We believe that our principal risk ofcollection continues to be uninsured patient accounts and patient accounts forwhich the primary insurance payer has paid but patient responsibility amounts(generally deductibles and co-payments) remain outstanding. If our actualcollection rate changed by 1% from the estimated percentage that we used, weproject that our allowance for doubtful accounts and consolidated net incomewould have changed by approximately $3.4 million and $1.8 million,respectively, in each of the three month and nine month periods ended June 30,2010. The provision for doubtful accounts as a percentage of net patientrevenues was 10.9% for the nine months ended June 30, 2010 compared to9.4% for the nine months ended June 30, 2009. The increase wasattributable primarily to the current year inclusion of Brotman, whichhistorically has a higher percentage of self-pay patients. Excluding Brotman,the provision for doubtful accounts as a percentage of net patient revenues was5.4% for the nine months ended June 30, 2010, compared to 5.5% for thenine months ended June 30, 2009, which decrease was due primarily toimproved collection efforts.

 

Ofthe accounts receivable identified as due from third party payers at the timeof billing, a small percentage may convert to self-pay upon denials from thirdparty payers. Those accounts are closely monitored on a routine basis forpotential denial and are reclassified to the proper payer group as appropriate.

 

Thirdparty payer and self-pay balances, as a percent of total gross billed accountsreceivable are summarized in the tables below:

 
| ** **     | ** ** | **June 30, 2010** | ** ** | **September 30, 2009** | ** ** |
|----------------|------------|------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **Medicare**           | ** ** | **Medi-Cal**                | ** ** | **Managed  Care** | ** ** | **Self-Pay  & Other** | ** ** | **Total** | ** ** | **Medicare** | ** ** | **Medi-Cal** | ** ** | **Managed  Care** | ** ** | **Self-Pay  & Other** | ** ** | **Total** | ** ** |
| ** **     | ** ** | **(Unaudited)**        | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 0 - 60 days    |       | 80                     | %          | 66                          | %          | 56 | % | 20 | % | 65 | % | 84 | % | 77 | % | 50 | % | 25 | % | 68 | % |
| 61 - 120 days  |       | 12                     | %          | 19                          | %          | 23 | % | 21 | % | 18 | % | 9 | % | 11 | % | 22 | % | 23 | % | 14 | % |
| 121 - 180 days |       | 5                      | %          | 10                          | %          | 15 | % | 18 | % | 10 | % | 3 | % | 7 | % | 16 | % | 28 | % | 10 | % |
| Over 180 days  |       | 3                      | %          | 5                           | %          | 6 | % | 41 | % | 7 | % | 4 | % | 5 | % | 12 | % | 24 | % | 8 | % |
| **Total**      |       | 100                    | %          | 100                         | %          | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % |

 

Theincrease in over 180 days self-pay accounts receivable as a percentage of totalnet self-pay receivable is primarily attributable to the impact of currentconditions on individuals’ ability to pay.

 

Our AR Days from Hospital Services operations were 56.6 days at June 30,2010 compared to 51.6 days at September 30, 2009. AR Days at June 30,2010 and September 30, 2009 are within our target range. AR Days arecalculated as our accounts receivable from Hospital Services operations on thelast date in the relevant quarter divided by our net patient revenues for thequarter ended on that date divided by the number of days in the quarter.

 

Althoughwe believe that our existing allowance for doubtful accounts reserve policiesfor all payer classes are appropriate and responsive to both the currenthealthcare environment and the overall economic climate, we will continue toreview our overall reserve adequacy by monitoring historical cash collectionsas a percentage of trailing net revenue less provision for bad debts, as wellas by analyzing current period net revenue and admissions by payerclassification, aged accounts receivable by payer, days revenue outstanding,and the impact of our recent acquisition of Brotman.

 

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*Medical Group Segment*

 

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

 

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

 

Under the Risk Adjustment model, capitation for the current year ispaid based on data submitted for each enrollee for previous periods. Capitationis paid at interim rates during the year and is adjusted in subsequent afterthe final data has been processed by CMS. Positive or negative capitationadjustments are made for Medicare enrollees with conditions requiring more orless healthcare services than assumed in the interim payments. Since we cannotreliably predict these adjustments, periodic changes in capitation amountsearned as a result of risk adjustment are recognized when those changes arecommunicated from the health plans, generally in the fourth quarter of thefiscal year to which the adjustments relate. We recorded approximately $4.3million and $1.6 million in increased capitation revenue in the fourthquarter of fiscal 2009 and 2008, respectively, and approximately $1.7 millionin each of the three month and nine month periods ended June 30, 2010 andnone in each of the three month and nine month periods ended June 30, 2009for risk adjustment factors.

 

Wealso earn additional incentive revenue or incur penalties under HMO contractsby sharing in the risk for hospital related expenses including inpatientservices utilized. As of June 30, 2010, except for two contracts where we are contractually obligated for down-side risk,shared risk deficits are not payable unless and until we generate futurerisk-sharing surpluses. Risk pools are generally settled in the third orfourth quarter of the following calendar year. Due to the lack of access totimely information necessary to estimate the related costs, shared-risk amountsreceivable from the HMOs are recorded when such amounts are known. We alsoreceive incentives under “pay-for-performance” programs for quality medicalcare based on various criteria. Pay-for-performance payments are generallyrecorded in the third and fourth quarters of our fiscal year when such amountsare known, once we are in receipt of information necessary to reliably estimatethese amounts. Risk pool and pay-for-performance incentives are affected bymany factors, some of which are beyond our control, and may vary significantlyfrom year to year.

 

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

 

***AccruedMedical Claims***

 

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

 

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

 

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

 

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

 

The following unaudited tables reflect (i) the change in ourestimate of claims liability as of June 30, 2010 that would have resultedhad we changed our completion factors for all applicable months of serviceincluded in our 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, 2010 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                                                        | )%         | $                                                           | (4,322     | ) |
| (2                                                        | )%         | $                                                           | (2,882     | ) |
| (1                                                        | )%         | $                                                           | (1,441     | ) |
| 1                                                         | %          | $                                                           | 1,441      |   |
| 2                                                         | %          | $                                                           | 2,882      |   |
| 3                                                         | %          | $                                                           | 4,322      |   |

 
| **Increase (Decrease) in  Trended  PMPM Factors** | ** ** | **Increase (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                        | ** ** | **(in  thousands)**                                         | ** ** |
| (3                                                | )%         | $                                                           | (770       | ) |
| (2                                                | )%         | $                                                           | (513       | ) |
| (1                                                | )%         | $                                                           | (257       | ) |
| 1                                                 | %          | $                                                           | 257        |   |
| 2                                                 | %          | $                                                           | 513        |   |
| 3                                                 | %          | $                                                           | 770        |   |

 

The following table shows the components of the change in medicalclaims and benefits payable (in thousands, unaudited):

 
| ** **                                             | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **June 30,**     | ** ** |
| ** **                                             | ** ** | **2010**              | ** ** | **2009** | ** ** |
| IBNR  as of beginning of period                        |       | $                     | 16,824     |   | $ | 20,480 |   |
| Healthcare  claims expense incurred during the period: |       |                  |       |   |   |
| Current  year                                          |       | 55,599                |       | 53,648 |   |
| Prior  years                                           |       | (1,906                | )          | (1,347 | ) |
| Total  incurred                                        |       | 53,693                |       | 52,301 |   |
| Healthcare  claims paid during the period:             |       |                  |       |   |   |
| Current  year                                          |       | (41,687               | )          | (37,923 | ) |
| Prior  years                                           |       | (14,085               | )          | (16,995 | ) |
| Total  paid                                            |       | (55,772               | )          | (54,918 | ) |
| IBNR  as of end of period                              |       | $                     | 14,745     |   | $ | 17,863 |   |

 

Through June 30, 2010, the $1,928,000 change in estimate relatedto IBNR as of September 30, 2009 represented approximately 11.3% of theIBNR balance as of September 30, 2009, approximately 2.7% of fiscal 2009claims expense, and after consideration of tax effect, approximately 78.8% ofnet loss for the year then ended.

 

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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 operations for the year then ended.

 

Past fluctuations in IBNR estimates might also be a useful indicator ofthe potential magnitude of future changes in these estimates. Quarterly IBNRestimates include provisions for adverse development based on historicalvolatility. We maintain similar provisions at fiscal year end.

 

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

 

***Goodwill and Intangible Assets***

 

The FASB issued guidance for business combination requires acquired intangibleassets to be separately recognized upon meeting certain criteria. Suchintangible assets include, but are not limited to, trade and service marks,non-compete agreements, customer lists and licenses.

 

The FASB issued guidance for goodwill and other intangible assetsrequires that goodwill and indefinite life intangible assets not be subject toamortization but be evaluated for impairment on at least an annual basis, ormore frequently if certain indicators are present. Such indicators includeadverse changes in market value and/or stock price, laws and regulations,profitability, cash flows, our ability to maintain enrollment and renew payercontracts on favorable terms. A two-step impairment test is used to identifypotential goodwill impairment and to measure the amount of goodwill impairmentloss to be recognized (if any). The first step consists of estimating the fairvalue of the reporting unit based on recognized valuation techniques, whichinclude a weighted combination of (i) the guideline company method thatutilizes revenue or earnings multiples for comparable publicly-tradedcompanies, and (ii) a discounted cash flow model that utilizes future cashflows, the timing of those cash flows, and a discount rate (or weighted averagecost of capital which considers the cost of equity and cost of debt financingexpected by a representative market participant) representing the time value ofmoney and the inherent risk and uncertainty of the future cash flows. If theestimated fair value of the reporting unit is less than its carrying value, asecond step is performed to compute the amount of the impairment by determiningthe “implied fair value” of the goodwill, which is compared to itscorresponding carrying value.

 

Long-lived assets, including property, improvements and equipment andamortizable intangibles, are evaluated for impairment whenever events orchanges in circumstances indicate that the carrying value of such assets maynot be recoverable. We consider assets to be impaired and write them down tofair value if estimated undiscounted cash flows associated with those assetsare less than their carrying amounts.

 

We performed our annual goodwill impairment analysis for each reportingunit that constitutes a business for which discrete financial information isproduced and reviewed by operating segment management and provides servicesthat are distinct from the other reporting units. For the Hospital Servicessegment, the reporting unit for the annual goodwill impairment analysis wasdetermined to be at the segment level. For the Medical Group segment, we havedetermined that ProMed individually and Prospect (which includes all the otheraffiliated physician organizations) each represent a reporting unit, based onoperational characteristics. The ProMed Entities are geographically and manageriallytheir own reporting unit.

 

Our impairment test at September 30, 2009 resulted in noimpairment charges.  In addition, notriggering events were identified that would cause impairment analysis as of June 30,2010.

 

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.

 

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***Recent Accounting Pronouncements***

 

Effective the firstquarter of fiscal 2010, we adopted the revised accounting guidance for businesscombinations, which changed its previous accounting practices regardingbusiness combinations. The more significant changes include an expandeddefinition of a business and a business combination; recognition of assetsacquired, liabilities assumed and noncontrolling interests (including goodwill)measured at fair value at the acquisition date; recognition ofacquisition-related expenses and restructuring costs separately from thebusiness combination; recognition of assets acquired and liabilities assumed attheir acquisition-date fair values with subsequent changes recognized inearnings. The guidance also amends and clarifies the application issues oninitial recognition and measurement, subsequent measurement and accounting, anddisclosure of assets and liabilities arising from contingencies in a businesscombination. The adoption did not have a material impact on our condensedconsolidated financial statements for prior periods; but the pronouncement willimpact the accounting for any acquisitions subsequent to that date.

 

Effective in the firstquarter of fiscal year 2010, we adopted revised accounting guidance whichrequires noncontrolling interests (formerly referred to as minority interest)to be presented as a separate component from the Company’s equity in the equitysection of the consolidated balance sheets. As required by this guidance, wehave adjusted the presentation of noncontrolling interests in the prior periodunaudited condensed consolidated financial statements for comparability with thefiscal year 2010 period. The adoption of this accounting guidance had no impacton our results of operations and did not have a material impact on ourfinancial position.

 

In January 2010, theFinancial Accounting Standards Board (“FASB”) issued guidance to amend thedisclosure requirements related to recurring and nonrecurring fair valuemeasurements. The guidance requires new disclosures on the transfers ofassets and liabilities between Level 1 (quoted prices in active market foridentical assets or liabilities) and Level 2 (significant other observableinputs) of the fair value measurement hierarchy, including the reasons and thetiming of the transfers. Additionally, the guidance requires a rollforward of activities on purchases, sales, issuance, and settlements of theassets and liabilities measured using significant unobservable inputs (Level 3fair value measurements). Disclosures regarding transfers are requiredbeginning January 1, 2010 and the Level 3 rollforward is to be disclosedin reporting periods beginning after December 15, 2010.  Sincewe had no transfers between categories, the additional disclosures are notapplicable to us for the periods presented.

 

OnOctober 1, 2009, we adopted guidance on fair value measurement fornonfinancial assets and liabilities, except for items that are recognized ordisclosed at fair value in the financial statements on a recurring basis (atleast annually). Adoption of the new guidance did not have a material impact onour consolidated financial statements.

 

InJune 2008, the FASB issued guidance for the accounting of share-basedpayment awards. Under the guidance, unvested share-based payment awards thatcontain non-forfeitable rights to dividends or dividend equivalents are deemedparticipating securities and, therefore, are included in computing earnings pershare (“EPS”) pursuant to the two-class method. The two-class method determinesearnings per share for each class of common stock and participating securitiesaccording to dividends or dividend equivalents and their respectiveparticipation rights in undistributed earnings. The Company adopted theguidance effective October 1, 2009.  The adoption of thisguidance did not impact our net income per common share for prior periods andis not expected to have an impact on future periods until such time as wedeclare a regular quarterly dividend.

 

In June 2009, theFASB issued revised guidance for the accounting of variable interest entities.This revised guidance replaces the quantitative-based risks and rewardsapproach with a qualitative approach that focuses on identifying whichenterprise has the power to direct the activities of a variable interest entitythat most significantly impact the entity’s economic performance and has theobligation to absorb losses or the right to receive benefits from the entitythat could be potentially significant to the variable interest entity. Theaccounting guidance also requires an ongoing reassessment of whether anenterprise is the primary beneficiary and requires additional disclosures aboutan enterprise’s involvement in variable interest entities. This accountingguidance is effective for us beginning in the first quarter of fiscal 2011. Weare currently evaluating the impact that the adoption of this guidance will haveon its consolidated financial statements.

 

InJune 2009, the FASB issued revised guidance for the accounting oftransfers of financial assets. This guidance eliminates the concept of aqualifying special-purpose entity, removes the scope exception for qualifyingspecial-purpose entities when applying the accounting guidance related to theconsolidation of variable interest entities, changes the requirements forderecognizing financial assets, and requires enhanced disclosure. Thisaccounting guidance is effective for us beginning in the first quarter offiscal 2011. We are currently evaluating the impact that the adoption of thisguidance will have on its consolidated financial statements.

 

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***Legal and Other Loss Contingencies***

 

We are subject to contingencies, such as legal proceedings and claimsarising out of our business. We record accruals for such contingencies when itis probable that a liability will be incurred and the amount of loss can bereasonably estimated. A significant amount of Management estimation is requiredin determining when, or if, an accrual should be recorded for a contingentmatter and the amount of such accrual, if any.

 

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

 

***Acquisitions***

 

Our business has grown through a series of business combinations. Thesebusiness combinations were all accounted for using the purchase method ofaccounting, and accordingly, the operating results of each acquisition havebeen included in our consolidated financial statements since their effectivedate of acquisition. The purchase price for each business combination was allocatedto the assets, including the identifiable intangible assets, and liabilities,based on estimated fair values determined using independent appraisals whereappropriate. The excess of purchase price over the net tangible assets acquiredwas allocated to goodwill and other intangible assets.

 

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

 

The following table summarizes all business combinations during thethree years ended June 30, 2010:

 
| **Business Combinations**                        | ** ** | **Effective Date**  | ** ** | **Purchase Price** | ** **  | **Location** | ** **          |
|--------------------------------------------------|------------|---------------------|------------|--------------------|-------------|--------------|---------------------|
| Alta                                             |       | August 8, 2007 |       | $                  | 154,935,000 |         | Los  Angeles County |   |
| Brotman (increased investment to a 72% interest) |       | April 14, 2009 |       | $                  | 2,556,000   |         | Los  Angeles County |   |

 

***Divestitures***

 

On August 1, 2008, we completed the sale of all of the outstandingstock of the AV Entities for total cash consideration of $8,000,000. Asrequired by ASC 360-10-35, the assets and liabilities of the AV Entities andtheir operations have been presented in our recently filed Form 10-K asdiscontinued operations for all periods presented. All references to operatingresults reflect our ongoing operations, excluding the AV Entities, unlessotherwise noted.

 

***Inflation***

 

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

 

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

 

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

 

Not applicable

 

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**Item 4.  Controls and Procedures**

 

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

 

Wecarried out an evaluation as of June 30, 2010, under the supervision andwith the participation of our Management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof 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, 2010 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.

 

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

 

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

 

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

 

During the financial reporting close for the period endedSeptember 30, 2009, Brotman was unable to implement a structured closeprocess which resulted in multiple delays and iterations of their financialstatements. Account reconciliations were not prepared in an accurate or timelymanner which resulted in a significant amount of post-close adjustments.Brotman’s accounting department did not demonstrate a sufficient amount ofexpertise or training to sufficiently complete the steps needed to execute anaccurate or timely close. Additionally, Brotman’s accounting department did notutilize or implement policies and procedures to organize or streamline thefinancial close process.

 

To address these deficiencies, we are in the process of implementingsignificant changes in the Brotman accounting department. We added additionalresources and personnel with experience in understanding complexities of thebusiness and the required financial reporting process. Additional controlprocesses and oversight procedures have been implemented; however, a longerevaluation period is needed to reasonably validate that such processes andprocedures are operating at a level to have fully remediated the materialweakness as of June 30, 2010. 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 of material weaknesses in our internal control overfinancial reporting, we have taken steps to strengthen our internal controlswithin the financial reporting process. We have added to the expertise anddepth of personnel within the Brotman accounting department, including theappointment of a new Controller, with specific and significant expertise in thecritical areas identified above. We also added additional resources to assistin the review and preparation of significant account balance reconciliations aswell as the implementation of new policies and procedures. Senior Managementhas increased its scrutiny and oversight of Brotman’s financial statements andhas performed significant top-down financial statement analysis to gainadditional assurance as to the accuracy of Brotman’s financial information. Aspreviously stated, we will continue to work on and improve the financialreporting process of Brotman and its impact on the corporate consolidatingfinancial reporting process. In review, the principal measures that we are inthe process of undertaking to remediate these deficiencies are as follows:

 

·        Hired a new Controller andadded additional resources to implement a sound financial reporting process;

 

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

 

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

 

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

 

·        Documented formal accountingpolicies and procedures with regular compliance reviews of key risk areas toevaluate the designing and effectiveness of controls; and

 

·        Enhanced the corporatefinancial reporting process oversight of the above mentioned controls and processes.

 

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

 

Except as discussed above, regarding Brotman, there have been nochanges in our Internal Control that occurred during the three months ended June 30,2010 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**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.**

 

Our business is subject to a number of risks, including those set forthbelow or previously disclosed in the Company’s Annual Report on Form 10-K filedwith the SEC on December 21, 2009.

 

**Our proposed merger may cause disruption in our business and, if themerger does not occur, we will have incurred significant expenses and may needto pay a termination fee and expenses under the merger agreement, which couldhave a material adverse effect on our business and cause our stock price todecline.**

 

As described in Note 14 (Subsequent Events) above, on August 16, 2010,the Company entered into a definitive merger agreement to be acquired by anentity sponsored by Leonard Green & Partners, L.P.

 

The announcement of the proposed merger may result in a loss of keypersonnel and may disrupt our business and operations and adversely impact ourrelationships with third parties, which could have an adverse effect on ouroperating results.  The merger agreementgenerally requires us to operate our business in the ordinary course pendingconsummation of the merger, but includes certain contractual restrictions onthe conduct of our business that may affect our ability to execute on ourbusiness strategies and attain our financial goals.

 

Consummation of the merger is subject to various customary closingconditions, and the merger agreement may be terminated by any of the parties ifthe merger is not completed by February 15, 2011.  The merger agreement contains certain othertermination rights for both parties, and if the merger agreement underspecified circumstances we may be obligated to pay a termination fee of up to$6.2 million and expenses of the other parties not to exceed $2.25 million.

 

We cannot predict whether the closing conditions to the mergeragreement will be satisfied, and there is no assurance that the proposed mergerwill be completed.  If the closingconditions set forth in the merger agreement are not satisfied or waived, or ifthe merger is not completed for any other reason, the market price of ourcommon stock may decline.

 

These matters, alone or in combination, could have a material adverseeffect on our business, financial condition, results of operations and stockprice.

 

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

 

None.

 

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

 

None.

 

**Item 4.  Removed and Reserved.**

 

None

 

**Item 5.  Other Information**

 

None

 

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**Item 6.  Exhibits.**

 

The following documents are being filed as exhibits to this report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                                                                                                                                                                       |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Agreement  and Plan of Merger, dated as of August 16, 2010, by and among Prospect  Medical Holdings, Inc., Ivy Holdings Inc. and Ivy Merger Sub Corp.  (incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K  of Prospect Medical Holdings, Inc. filed on August 16, 2010).               |
|                 |       |                                                                                                                                                                                                                                                                                                            |
| 10.2                 |       | Fund  Guarantee, dated as of August 16, 2010, by and among Prospect Medical  Holdings, Inc., Green Equity Investors V, L.P. and Green Equity Investors  Side V, L.P. (incorporated by reference to Exhibit 2.2 to the Current Report  on Form 8-K of Prospect Medical Holdings, Inc. filed on August 16, 2010). |
|                 |       |                                                                                                                                                                                                                                                                                                            |
| 31.1                 |       | Certification  of Chief Executive Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of  1934, as amended.                                                                                                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                                            |
| 31.2                 |       | Certification  of Chief Financial Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of  1934, as amended.                                                                                                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                                            |
| 32.1                 |       | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                            |
| 32.2                 |       | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |

 

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**SIGNATURES**

 

Pursuant to the 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 16,  2010 | **/**s**/**SAMUEL S. LEE              |
| ** **            | **Samuel S. Lee**                     |
| ** **            | **Chief Executive Officer**           |
| ** **            | **(Principal Executive Officer)**     |
| ** **            | ** **                            |
| August 16,  2010 | **/**s**/**MIKE HEATHER               |
| ** **            | **Mike Heather**                      |
| ** **            | **Chief Financial Officer**           |
| ** **            | **(Principal Financial Officer)**     |

 

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