**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**Form 10-Q**

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

**Forthe quarterly period ended June 30, 2006**

**or**

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

 

**Commission file number:1-32203**

** **

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** **

**Prospect Medical Holdings, Inc.**

(Exactname of registrant as specified in its charter)

| **Delaware**                              | ** ** | **33-0564370**       |
|-------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer     |
| incorporation or  organization)           |       | Identification  No.) |
|                                      |       |                 |
| **400  Corporate Pointe, Suite 525**      | ** ** | ** **           |
| **Culver  City, California**              | ** ** | **90230**            |
| (Address of  principal executive offices) |       | (Zip Code)           |

 

**(310)338-8677**

(Registrant’stelephone number, including area code)

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

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

Large accelerated filer o    Acceleratedfiler  ̈    Non-acceleratedfiler x

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

Yes  ̈   No  ý

The number of shares of the issuer’s Common Stock, parvalue $0.01 per share, outstanding as of August 8, 2006 was 7,055,127.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

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

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item1.    Financial Statements.**

**PROSPECT MEDICAL HOLDINGS, INC.**

**CONSOLIDATEDBALANCE SHEETS**
| ** **                                                                                                                                                  | ** ** | **June 30,   2006** | ** ** | **September 30   2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **(Unaudited)**               | ** ** | ** **                        | ** ** |
| **ASSETS**                                                                                                                                                  |       |                          |       |                              |       |
| **Current  assets**                                                                                                                                         |       |                          |       |                              |       |
| Cash and cash  equivalents                                                                                                                                  |       | $                             | 14,875,591 |                              | $          | 16,949,304 |   |
| Investments,  primarily restricted certificates of deposit                                                                                                  |       | 835,153                       |       | 1,100,000                         |       |
| Risk pool  receivables                                                                                                                                      |       | 792,387                       |       | 57,267                            |       |
| Other  receivables, net of allowances of $667,000 and $802,000 at June 30, 2006 and  September 30, 2005                                                     |       | 813,832                       |       | 1,940,536                         |       |
| Notes  receivable, current portion                                                                                                                          |       | 175,633                       |       | 52,160                            |       |
| Prepaid expenses  and other                                                                                                                                 |       | 589,954                       |       | 646,932                           |       |
| Refundable  income taxes                                                                                                                                    |       | 1,848,293                     |       | —                            |       |
| Deferred income  taxes, net                                                                                                                                 |       | 1,787,382                     |       | 1,904,137                         |       |
| Total current assets                                                                                                                                        |       | 21,718,225                    |       | 22,650,336                        |       |
|                                                                                                                                                        |       |                          |       |                              |       |
| Property,  improvements and equipment:                                                                                                                      |       |                          |       |                              |       |
| Land                                                                                                                                                        |       | 40,620                        |       | 40,620                            |       |
| Leasehold improvements                                                                                                                                      |       | 1,126,113                     |       | 726,973                           |       |
| Equipment                                                                                                                                                   |       | 3,387,946                     |       | 3,342,385                         |       |
| Furniture and fixtures                                                                                                                                      |       | 559,453                       |       | 546,523                           |       |
|                                                                                                                                                        |       | 5,114,132                     |       | 4,656,501                         |       |
| Less accumulated  depreciation and amortization                                                                                                             |       | (3,848,381                    | )          | (3,454,282                        | )          |
| Property,  improvements and equipment, net                                                                                                                  |       | 1,265,751                     |       | 1,202,219                         |       |
|                                                                                                                                                        |       |                          |       |                              |       |
| Notes  receivable, long term portion                                                                                                                        |       | 423,198                       |       | 572,979                           |       |
| Deposits                                                                                                                                                    |       | 654,239                       |       | 583,226                           |       |
| Goodwill                                                                                                                                                    |       | 38,623,322                    |       | 31,404,328                        |       |
| Other intangible  assets, net                                                                                                                               |       | 1,523,495                     |       | 1,317,614                         |       |
| Total assets                                                                                                                                                |       | $                             | 64,208,230 |                              | $          | 57,730,702 |   |
| ** **                                                                                                                                                  | ** ** | ** **                    | ** ** | ** **                        | ** ** |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                              |       |                          |       |                              |       |
| **Current  liabilities:**                                                                                                                                   |       |                          |       |                              |       |
| Accrued medical  claims and other health care costs payable                                                                                                 |       | $                             | 11,318,000 |                              | $          | 11,532,328 |   |
| Accounts payable  and other accrued liabilities                                                                                                             |       | 9,351,645                     |       | 9,799,968                         |       |
| Current  maturities of long-term debt and capital leases                                                                                                    |       | 2,800,000                     |       | 2,000,000                         |       |
| Total current  liabilities                                                                                                                                  |       | 23,469,645                    |       | 23,332,296                        |       |
|                                                                                                                                                        |       |                          |       |                              |       |
| Long-term debt,  less current maturities                                                                                                                    |       | 7,400,000                     |       | 6,166,667                         |       |
| Deferred income  taxes                                                                                                                                      |       | 1,113,442                     |       | 1,045,696                         |       |
| Other long-term  liabilities                                                                                                                                |       | 185,000                       |       | 185,000                           |       |
| Total liabilities                                                                                                                                           |       | 32,168,087                    |       | 30,729,659                        |       |
| **Minority  interest**                                                                                                                                      |       | 80,021                        |       | 65,405                            |       |
| ** **                                                                                                                                                  | ** ** | ** **                    | ** ** | ** **                        | ** ** |
| **Shareholders’  equity:**                                                                                                                             |       |                          |       |                              |       |
|                                                                                                                                                        |       |                          |       |                              |       |
| Common stock,  $0.01 par value; 40,000,000 shares authorized 7,046,128 and 6,640,362 shares  issued and outstanding at June 30, 2006 and September 30, 2005 |       | 70,462                        |       | 66,403                            |       |
| Additional  paid-in capital                                                                                                                                 |       | 19,757,909                    |       | 18,373,487                        |       |
| Retained  earnings                                                                                                                                          |       | 12,131,751                    |       | 8,495,748                         |       |
| Total shareholders’ equity                                                                                                                             |       | 31,960,122                    |       | 26,935,638                        |       |
|                                                                                                                                                        |       |                          |       |                              |       |
| Total  liabilities and shareholders’ equity                                                                                                            |       | $                             | 64,208,230 |                              | $          | 57,730,702 |   |

See accompanying notes.

3

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME****(Unaudited)**
| ** **                                          | ** ** | **Three months ended   June 30** | ** ** | **Nine months ended   June 30** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Revenues                                            |       | $                                                    | 34,818,020 |                                                | $          | 32,392,874 |   | $ | 102,854,925 |   | $ | 98,004,333 |   |
| Cost of Revenues                                    |       | 25,408,055                                           |       | 22,844,535                                          |       | 73,857,934 |   | 71,301,361 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Gross margin                                        |       | 9,409,965                                            |       | 9,548,339                                           |       | 28,996,991 |   | 26,702,972 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Operating  expenses:                                |       |                                                 |       |                                                |       |   |   |   |   |
| General and administrative                          |       | 7,286,083                                            |       | 7,551,833                                           |       | 22,878,291 |   | 20,674,911 |   |
| Depreciation and amortization                       |       | 338,140                                              |       | 308,167                                             |       | 995,729 |   | 805,077 |   |
| Total operating  expenses                           |       | 7,624,223                                            |       | 7,860,000                                           |       | 23,874,020 |   | 21,479,988 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income  from unconsolidated joint venture |       | 321,125                                              |       | 206,668                                             |       | 998,019 |   | 304,350 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income                                    |       | 2,106,867                                            |       | 1,895,007                                           |       | 6,120,990 |   | 5,527,334 |   |
| ** **                                          | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other (income)  expense:                            |       |                                                 |       |                                                |       |   |   |   |   |
| Investment income                                   |       | (219,589                                             | )          | (114,422                                            | )          | (658,778 | ) | (291,810 | ) |
| Interest expense                                    |       | 269,884                                              |       | 309,946                                             |       | 815,625 |   | 759,363 |   |
| Total other  (income) expense, net                  |       | 50,295                                               |       | 195,524                                             |       | 156,847 |   | 467,553 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Income before  income taxes                         |       | 2,056,572                                            |       | 1,699,483                                           |       | 5,964,143 |   | 5,059,781 |   |
| Provision for  income taxes                         |       | 743,949                                              |       | 674,344                                             |       | 2,313,524 |   | 2,021,153 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  before minority interest                |       | 1,312,623                                            |       | 1,025,139                                           |       | 3,650,619 |   | 3,038,628 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Minority  interest                                  |       | 8,632                                                |       | 10,459                                              |       | 14,616 |   | 15,403 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                          |       | $                                                    | 1,303,991  |                                                | $          | 1 014,680 |   | $ | 3,636,003 |   | $ | 3,023,225 |   |
|                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Net income per  common share:                       |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                               |       | $                                                    | 0.19       |                                                | $          | 0.22 |   | $ | 0.53 |   | $ | 0. 67 |   |
| Diluted                                             |       | $                                                    | 0.16       |                                                | $          | 0.12 |   | $ | 0.45 |   | $ | 0.35 |   |
| Weighted average  shares outstanding:               |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                               |       | 6,969,440                                            |       | 4,679,997                                           |       | 6,851,751 |   | 4,524,031 |   |
| Diluted                                             |       | 8,141,421                                            |       | 8,398,644                                           |       | 8,044,146 |   | 8,614,469 |   |

See accompanying notes.

4

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)**
| ** **                                                                         | ** ** | **Nine months ended   June 30** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Operating  activities**                                                          |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 3,636,003  |   | 3,023,225 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                      |       | 995,729                                             |       | 805,077 |   |
| Provision for bad debts                                                            |       | 85,366                                              |       | 75,349 |   |
| Gain on disposal of assets                                                         |       | 1,692                                               |       | — |   |
| Deferred income taxes, net                                                         |       | 184,501                                             |       | 257,211 |   |
| Change in deferred compensation                                                    |       | —                                              |       | 88,168 |   |
| Changes in operating assets and liabilities:                                       |       |                                                |       |   |   |
| Risk pool receivables                                                              |       | (735,120                                            | )          | 87,980 |   |
| Other receivables                                                                  |       | 1,045,836                                           |       | 143,941 |   |
| Prepaid expenses and other                                                         |       | 42,254                                              |       | (1,258,141 | ) |
| Recoverable income taxes                                                           |       | (2,643,588                                          | )          | (888,372 | ) |
| Excess tax benefits from options exercise                                          |       | (459,341                                            | )          | — |   |
| Deposits and other assets                                                          |       | (52,194                                             | )          | — |   |
| Accrued medical claims and other health care costs  payable                        |       | (1,212,191                                          | )          | (757,519 | ) |
| Accounts payable and other accrued liabilities                                     |       | 343,152                                             |       | (1,489,861 | ) |
| Net cash  provided by operating activities                                         |       | 1,232,099                                           |       | 87,058 |   |
|                                                                               |       |                                                |       |   |   |
| **Investing  activities**                                                          |       |                                                |       |   |   |
| Purchases of  property, improvements and equipment                                 |       | (466,833                                            | )          | (192,407 | ) |
| Proceeds from  note receivable                                                     |       | 26,307                                              |       | 264,965 |   |
| Cash paid for  acquisition, net of cash received                                   |       | (6,596,080                                          | )          | — |   |
| Decrease  (increase) in restricted certificates of deposit                         |       | 294,364                                             |       | (649,313 | ) |
| Capitalized  expenses related to acquisitions                                      |       | —                                              |       | 249,437 |   |
| Other investing  activities                                                        |       | 14,616                                              |       | 5,227 |   |
| Net cash used in  investing activities                                             |       | (6,727,626                                          | )          | (322,091 | ) |
|                                                                               |       |                                                |       |   |   |
| **Financing  activities**                                                          |       |                                                |       |   |   |
| Borrowings from  term loan                                                         |       | 4,000,000                                           |       | — |   |
| Borrowings on  line of credit                                                      |       | 2,000,000                                           |       | 1,000,000 |   |
| Repayments on  line of credit                                                      |       | (2,000,000                                          | )          | (5,000,000 | ) |
| Repayments of  note payable and capital leases                                     |       | (1,966,667                                          | )          | (1,341,888 | ) |
| Proceeds  (expenses) from issuance of common and preferred stock                   |       | 929,140                                             |       | (153,089 | ) |
| Excess tax benefits  from options exercised                                        |       | 459,341                                             |       | — |   |
| Net cash  provided by (used in) financing activities                               |       | 3,421,814                                           |       | (5,494,977 | ) |
|                                                                               |       |                                                |       |   |   |
| Net decrease in  cash and cash equivalents                                         |       | (2,073,713                                          | )          | (5,730,010 | ) |
|                                                                               |       |                                                |       |   |   |
| Cash and cash  equivalents at beginning of period                                  |       | 16,949,304                                          |       | 20,330,754 |   |
|                                                                               |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                                                   | 14,875,591 |   | $ | 14,600,744 |   |
| ** **                                                                         | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information**                                            |       |                                                |       |   |   |
| Cash paid during  the period for:                                                  |       |                                                |       |   |   |
| Income taxes                                                                       |       | $                                                   | 4,071,000  |   | $ | 3,625,286 |   |
| Interest                                                                           |       | $                                                   | 802,248    |   | $ | 759,363 |   |
|                                                                               |       |                                                |       |   |   |
| Details of  business acquired:                                                     |       |                                                |       |   |   |
| Fair value of assets acquired                                                      |       | $                                                   | 9,496,212  |   | $ | — |   |
| Liabilities assumed or created                                                     |       | (1,461,024                                          | )          | — |   |
| Less cash acquired                                                                 |       | (1,439,108                                          | )          | — |   |
| Net cash paid  for acquisition                                                     |       | $                                                   | 6,596,080  |   | $ | — |   |

 

5

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**PROSPECTMEDICAL HOLDINGS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS****June 30, 2006****(Unaudited)**

**1. Reporting Entity**

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

**2. Basis of Presentation**

The unaudited condensed consolidated interim financialstatements have been prepared under the assumption that users of the interimfinancial data have either read or have access to our audited consolidatedfinancial statements for the latest fiscal year ended September 30, 2005.Accordingly, certain note disclosures that would substantially duplicate thedisclosures contained in the September 30, 2005 audited financial statementshave been omitted. These unaudited condensed consolidated interim financialstatements should be read in conjunction with our September 30, 2005 auditedfinancial statements.

The unaudited condensed consolidated financialstatements include the accounts of the Company and all majority ownedsubsidiaries and controlled entities under Emerging Issues Task Force (EITF)No. 97-2, “*Application of FASB Statement No. 94 and APBOpinion No. 16 to Physician Practice Management Entities and Certain OtherEntities with Contractual Management Arrangements.”* In the opinionof management, all adjustments considered necessary for a fair presentation ofthe results as of the date and for the interim periods presented, which consistsolely of normal recurring adjustments, have been included. All significantinter-company balances and transactions have been eliminated in consolidation.The consolidated results of operations for the current interim period are notnecessarily indicative of the results that may be expected for the entire yearending September 30, 2006.

Revenuesare comprised of the following amounts:
|                 | ** ** | **Three Months Ended June 30** | ** ** | **Nine Months Ended June 30** | ** ** |
|-----------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **      | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Capitation      |       | $                                                  | 33,170,653 |                                              | $          | 30,577,983 |   | $ | 99,442,631 |   | $ | 94,507,961 |   |
| Fee for service |       | 472,181                                            |       | 632,637                                           |       | 1,595,946 |   | 1,696,242 |   |
| Management fees |       | 296,123                                            |       | 171,216                                           |       | 927,890 |   | 598,150 |   |
| Other           |       | 879,063                                            |       | 1,011,038                                         |       | 888,458 |   | 1,201,980 |   |
| Total revenues  |       | $                                                  | 34,818,020 |                                              | $          | 32,392,874 |   | $ | 102,854,925 |   | $ | 98,004,333 |   |

**3.  StockBased Compensation**

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

Under the modifiedprospective method, prior periods are not restated to reflect the impact ofSFAS No. 123(R).  Compensation cost isrecognized for all awards granted, modified or settled subsequent to theadoption date, or where the

6

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requisite service periodhas not been completed prior to the date of adoption. Compensation cost forawards granted prior to, but not vested as of the adoption date would be basedon the same estimated grant-date fair value previously used for pro formadisclosure purposes under SFAS No. 123. Compensation costs for awards granted,modified, or settled after the adoption date are measured and recognized in thefinancial statements based on their grant date fair value, net of estimatedforfeitures over the awards’ service period, in accordance with SFAS No.123(R). The Company will continue to use the Black-Scholes option pricing modeland a single option award approach to estimate the fair value of optionsgranted. The adoption of SFAS No. 123R did not result in adjustments that arerequired to be reported as the cumulative effect of a change in accountingprinciple. Equity-based compensation, if any, is classified within the sameline items as cash compensation paid to employees. Cash retained as a result ofexcess tax benefits relating to share-based payments are presented in thestatement of cash flows as a financing cash inflow. Previously, the cashretained from excess tax benefits was presented in operating cash flows.

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

Option Activity for the nine months ended June 30,2006 is summarized below:
| ** **                            | ** ** | **Shares** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Aggregate  Intrinsic Vale** | ** ** | **Weighted  Average  Remaining  Contractual  Terms (months)** | ** ** |
|---------------------------------------|------------|------------|------------|--------------------------------------------|------------|------------------------------------|------------|--------------------------------------------------------------------|------------|
| Outstanding as  of September 30, 2005 |       | 3,375,863  |       | 3.89                                       |       |                               |       |                                                               |       |
| Granted                               |       | 500        |       | 6.75                                       |       |                               |       |                                                               |       |
| Exercised                             |       | (405,766   | )          | 2.28                                       |       |                               |       |                                                               |       |
| Forfeited                             |       | (13,886    | )          | 5.75                                       |       |                               |       |                                                               |       |
| Outstanding as  of June 30, 2006      |       | 2,956,711  |       | 3.99                                       |       | 4,464,634                          |       | 30                                                                 |       |
| Exercisable as of June  30, 2006      |       | 2,956,711  |       | 3.99                                       |       | 4,464,634                          |       | 30                                                                 |       |

 

The aggregate intrinsic value is calculated as thedifference between the exercise price of the underlying awards and the quotedprice of our common stock for those awards that have an exercise pricecurrently below the quoted value.

During the nine monthsended June 30, 2006, the company granted 500 fully vested options andrecognized compensation expense of $1,745 (included in general andadministrative expenses) which represents the grant date fair value of theseoption awards. During the nine months ended June 30, 2006, options for 405,766common shares were exercised for net proceeds of approximately $929,000 and13,886 options were forfeited. The aggregate intrinsic value of the optionsexercised was $471,894. The Company realized net tax benefits of $459,341 fromthese exercises where the price paid was below the fair value of the commonshares on the exercise date. The tax benefits reduced income tax payable andincreased additional paid-in capital. At June 30, 2006, there are nounvested awards and no unrecognized stock-based compensation costs.

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

7

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companies to value employee stock options using an assumed volatilityof zero. The minimum value method is not an acceptable approach under SFAS No.123(R) and the minimum-value disclosures for the 2005 periods are nolonger provided.   The fair value of theoptions granted after the Company became a public reporting entity wasestimated at the date of the grant using the Black-Scholes option pricingmodel.

 

Fair value for optionsgranted during the nine months ended June 30, 2006 was estimated with thefollowing weighted average assumptions:

|                                                                                | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|
| Expected market  price of the Company’s common stock on the date of grant |       | $        | 6.75       |   |
| Weighted average  expected life of the options                                 |       | 4 years  |       |
| Risk-free  interest rate                                                       |       | 4.35     | %          |
| Volatility                                                                     |       | 63.00    | %          |
| Dividend yield                                                                 |       | 0.00     | %          |
|                                                                                |            |          |            |  |

Thefollowing table is a summary of options outstanding under all of the Company’soption plans as of June 30, 2006:

| Range of Exercise Prices | ** ** | **Number   Outstanding** | ** ** | **Weighted  Average  Remaining   Contractual  Life (Months)** | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Number   Exercisable** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|-------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------|------------|--------------------------------------------------------|------------|
|                                    |       |                          |       |                                                                    |       |                                                   |       |                          |       |                                                   |       |
| $3.00                                   |       | 1,547,900                     |       | 21                                                                      |       | $                                                      | 3.00       |                          | 1,547,900  |                                                   | $          | 3.00 |   |
| $4.86 -  $5.00                     |       | 1,103,061                     |       | 41                                                                      |       | $                                                      | 4.98       |                          | 1,103,061  |                                                   | $          | 4.98 |   |
| $6.45 -  $7.15                     |       | 305,750                       |       | 41                                                                      |       | $                                                      | 6.51       |                          | 305,750    |                                                   | $          | 6.51 |   |
| $3.00 -  $7.15                     |       | 2,956,711                     |       | 30                                                                      |       | $                                                      | 3.99       |                          | 2,956,711  |                                                   | $          | 3.99 |   |

 

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**4.  EarningsPer Share**

The denominators for thecomputation of basic and diluted earnings per share are calculated as follows:
| ** **                                                               | ** ** | **Three months ended   June 30,** | ** ** | **Nine months ended   June 30** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Basic earnings per  common share:                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Numerator – net  income                                             |       | $                                                     | 1,303,991  |                                                | $          | 1,014,680 |   | $ | 3,636,003 |   | $ | 3,023,225 |   |
|                                                                     |       |                                                  |       |                                                |       |   |   |   |   |
| Denominator –  weighted average number of common shares outstanding |       | 6,969,440                                             |       | 4,679,997                                           |       | 6,851,751 |   | 4,524,031 |   |
|                                                                     |       |                                                  |       |                                                |       |   |   |   |   |
| Basic earnings per  common share                                         |       | $                                                     | 0.19       |                                                | $          | 0.22 |   | $ | 0.53 |   | $ | 0.67 |   |
|                                                                     |       |                                                  |       |                                                |       |   |   |   |   |
| Diluted earnings per  common share:                                      |       |                                                  |       |                                                |       |   |   |   |   |
| Numerator – net  income                                             |       | $                                                     | 1,303,991  |                                                | $          | 1,014,680 |   | $ | 3,636,003 |   | $ | 3,023,225 |   |
|                                                                     |       |                                                  |       |                                                |       |   |   |   |   |
| Denominator:                                                             |       |                                                  |       |                                                |       |   |   |   |   |
| Weighted average  number of common shares outstanding                    |       | 6,969,440                                             |       | 4,679,997                                           |       | 6,851,751 |   | 4,524,031 |   |
| Dilutive stock  options, warrants and preferred shares                   |       | 1,171,981                                             |       | 3,718,647                                           |       | 1,192,395 |   | 4,090,438 |   |
|                                                                     |       | 8,141,421                                             |       | 8,398,644                                           |       | 8,044,146 |   | 8,614,469 |   |
|                                                                     |       |                                                  |       |                                                |       |   |   |   |   |
| Diluted earnings per common share                                        |       | $                                                     | 0.16       |                                                | $          | 0.12 |   | $ | 0.45 |   | $ | 0.35 |   |

 

**5.  Related Party Transactions**

We have an employment agreementwith our Chief Executive Officer, Jacob Y. Terner that runs throughAugust 1, 2008 and provides for compensation of $250,000 per year. Theagreement further provides that if we terminate Dr. Terner’s employmentwithout cause, we will be required to pay him $12,500 for each month of pastservice as our Chief Executive Officer, commencing as of July 31, 1996.Effective September 8, 2004, the Company’s maximum contingent obligation underthis termination provision was frozen at $1,237,500.

Prospect MedicalGroup, Inc. (PMG), which is wholly owned by Dr. Terner, and whoseaccounts are consolidated in these financial statements under EITF 97-2,maintains an intercompany account receivable due from Prospect MedicalHoldings, Inc. The intercompany receivable was created in connection withprevious acquisitions. In the event that PMG is required by the healthmaintenance organizations (HMO’s) or regulatory agencies to maintain a positivetangible net equity and positive working capital, Dr. Terner had previouslyagreed to personally guarantee the intercompany account receivable due fromProspect Medical Holdings, Inc. up to a level sufficient to enable PMG toattain positive tangible net equity and working capital.

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

**6.  Long Term Debt**

Long-term debt at June30, 2006 and September 30, 2005, respectively, consists of the following:
|                            | ** ** | **June 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|----------------------------|------------|-----------------------------|------------|----------------------------------|------------|
| Term loan                  |       | $                           | 10,200,000 |                             | $          | 8,166,667 |   |
| Revolving credit  facility | ** ** | **—**                  | ** ** | ** **                       | ** ** |
| Less current  maturities   |       | (2,800,000                  | )          | (2,000,000                       | )          |
|                       |       | $                           | 7,400,000  |                             | $          | 6,166,667 |   |

 

9

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On September 27, 2004,the Company entered into a credit facility with Residential Funding Corporation(RFC), comprised of a $5,000,000 revolving credit facility and a $10,000,000term loan.

On September 28, 2004,the Company borrowed $10,000,000 on the RFC term loan and paid off its existingterm loan and revolving credit facility with another lender. The Companyborrowed $5,000,000 on the RFC revolving credit facility on September 29, 2004,which was repaid on October 4, 2004 and borrowed $5,000,000 on December 30,2004 which was repaid on January 3, 2005. No amounts are outstanding under thecredit facility at June 30, 2006.

The RFC revolving creditfacility commitment is for three years, with interest at prime plus 0.5% perannum and an unused line fee of 0.25% per annum. The RFC term loan is amortizedover a five-year period with principal payments of $166,667 per month, plusinterest payable monthly on the outstanding balance at prime plus 2.0% perannum. The remaining balance of the term loan is due and payable in full after36 months. The Company is subject to certain financial covenants under the loanagreement, including a maximum senior debt/EBITDA ratio, minimum fixed chargecoverage ratio, minimum consolidated net worth, minimum liquidity and a limiton capital expenditures. The Company is also restricted, without consent, fromusing the net proceeds of any sale of equity securities except to pay downindebtedness under the loan agreement.

The Company exceeded the1.50 maximum senior debt/EBITDA ratio as of September 30, 2004 and December 31,2004. The actual senior debt/EBITDA ratio as of September 30, 2004 and December31, 2004 was 1.57 and 1.51, respectively. Effective April 7, 2005, RFC haswaived these covenant violations. RFC, in addition, agreed to exclude certainitems from the covenant computations for a twelve month period, the exclusionof which enabled the Company to meet the minimum fixed charge coverage ratio atDecember 31, 2004. We have been in compliance with all required RFC covenantsfor all subsequent periods.

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

**7.  Acquisition**

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

|                            | ** ** | **Genesis** | ** ** |
|----------------------------|------------|-------------|------------|
| Current assets             |       | $           | 1,445,653  |   |
| Goodwill                   |       | 7,218,994   |       |
| Identifiable  intangibles  |       | 800,000     |       |
| Other assets  acquired     |       | 31,565      |       |
| Total assets               |       | $           | 9,496,212  |   |
| Current  liabilities       |       | 1,461,024   |       |
| Total  liabilities assumed |       | 1,461,024   |       |
| Net assets acquired        |       | $           | 8,035,188  |   |

 

Under theacquisition agreement, differences between the estimated claims and taxliabilities recorded on the closing date and the ultimate payment amounts willbe paid to or received from the seller. The agreement also guarantees certain 

10

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minimum risk poolincentives for the 2005 calendar year. To the extent actual amounts are lessthan the guaranteed amounts, we will be entitled to receive monies up to$500,000 from the seller, in addition to any other amounts due. These amountswill be recorded as purchase price adjustments if and when received. The selleralso provides customary indemnification of up to $1.5 million for eligiblenon-medical and non-tax claims submitted within a two year period. Theindemnification period is reduced ratably over 24 months. In conjunction withthe acquisition, we have entered into an employment agreement with the soleselling shareholder of Genesis and 2 of its employees.

The following unauditedpro forma information for the three and nine months ended June 30, 2006 and2005 gives effect to the Genesis acquisition as if it had occurred onOctober 1, 2004.  Such unaudited proforma information is based on historical financial information with respect tothe acquisition and does not include operational or other changes that mighthave been effected by the Company.
|                            | ** ** | **Three months ended ** | ** ** | **Nine months ended ** | ** ** |
|----------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **June 30**                       | ** ** | **June 30**                      | ** ** |
| ** **                 | ** ** | **(unaudited)**                        | ** ** |
| ** **                 | ** ** | **2006**                               | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net revenue                |       | $                                      | 34,818,020 |                                  | $          | 34,650,095 |   | $ | 103,744,378 |   | $ | 104,775,996 |   |
| Net income                 |       | 1,303,991                              |       | 1,153,661                             |       | 3,673,922 |   | 3,473,189 |   |
| Basic earnings per  share  |       | $                                      | 0.19       |                                  | $          | 0.25 |   | $ | 0.54 |   | $ | 0.77 |   |
| Diluted earnings per share |       | $                                      | 0.16       |                                  | $          | 0.14 |   | $ | 0.46 |   | $ | 0.40 |   |

 

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

Effective August 31, 2005, the Company acquiredan approximately 38% stake in Brotman Medical Center, Inc. for $1,000,000.The Company made the investment with the intention that it, with the Hospital,would be able to offer joint contracting to HMOs operating in the area surroundingthe Hospital. The Hospital, previously owned by Tenet HealthCare, had beenincurring significant operating deficits. The new investors in the Hospital,including Prospect, hoped to help turn around the Hospital operations andrestore profitability.

During September 2005, the first month ofoperation under new ownership, the Hospital experienced a net loss ofapproximately $1,100,000, of which Prospect’s portion totaled approximately$400,000. The Hospital has continued to incur significant losses afterSeptember 30, 2005, and, with its limited capital, may not ultimately beable to survive.

As of September 30, 2005, based on the Hospital’scurrent significant operating deficits, uncertain ability to increase revenuesand cut costs and limited capital, we concluded that our remaining investmentin Brotman Medical Center was impaired and wrote off our entire investment inthe Hospital.

We are not obligated, nor do we have any currentintention, to invest any additional monies in the Hospital.

**9.  New Accounting Pronouncements**

In May 2005, the Financial Accounting Standards Board(FASB) issued Statement No. 154 (SFAS No. 154), *Accounting Changes and Error Corrections*,which replaced APB Opinion No. 20, *AccountingChanges*, and SFAS No. 3, *ReportingChanges in Interim Financial Statements*. SFAS No. 154 requiresretrospective application to prior periods’ financial statements of voluntarychanges in accounting principles and changes required by a new accountingstandard when the standard does not include specific transition provisions.Previous guidance required most voluntary changes in accounting principle to berecognized by including in net income of the period in which the change wasmade the cumulative effect of changing to the new accounting principle. SFASNo. 154 carries forward existing guidance regarding the reporting of thecorrection of an error and a change in accounting estimate. SFAS No. 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. Adoption of SFAS No. 154 asof October 1, 2006 is not expected to have a material effect on ourconsolidated financial position or results of operations.

In July 2006, the FASB issued Final Interpretation No.(FIN) 48, *Accounting for Uncertainty inIncome Taxes*, an interpretation of SFAS No. 109 *Accounting for Income Taxes*. FIN 48 clarifies the accountingfor income taxes by 

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prescribingthe minimum recognition threshold a tax position is required to meet beforebeing recognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. In addition, FIN 48 excludesincome taxes from the scope of SFAS No. 5, *Accounting for Contingencies*. FIN 48 is effective for fiscalyears beginning after December 15, 2006. Differences between the amountsrecognized in the consolidated balance sheets prior to the adoption of FIN 48and the amounts reported after adoption are accounted for as acumulative-effect adjustment to the beginning balance of retained earnings.Adoption of FIN 48 as of October 1, 2007 is not expected to have a materialeffect on our consolidated financial position or results of operations.

Other recent accounting pronouncements issued by theFASB (including its Emerging Issues Task Force), the AICPA, and the SEC didnot, or are not believed by management to, have a material impact on ourpresent or future consolidated financial statements.

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

**Forward-Looking Statements**

The following discussion of our financial conditionand results of operations should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and the notes to thosestatements appearing elsewhere in this report and the audited financialstatements for the year ended September 30, 2005 appearing in our annual reporton Form 10-K filed with the Securities and Exchange Commission.

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

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

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

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

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

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

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

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

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

·                  Our operating results could be adverselyaffected if our actual health care claims exceed our reserves.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

·                  We are required to upgrade and modify our managementinformation systems to accommodate growth in our business and changes intechnology and to satisfy new government regulations. As we seek to implementthese changes, we may experience complications, delays and increasing costs,which could disrupt our business and reduce our profitability.

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

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

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

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

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

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

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

Investors should also refer to our Form 10-K annualreport filed with the Securities and Exchange Commission on December 27, 2005for a discussion of risk factors. Given these risks and uncertainties, we cangive no assurances that any forward-looking statements will in fact occur andtherefore caution investors not to place undue reliance on them.

**Overview**

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

The IPAs contract with physicians (primary care andspecialist) and other health care providers to provide all of their medicalservices. The medical clinics employ their primary care physicians, whichprovide the vast majority of their medical services, while contracting with specialistphysicians and other health care providers to provide other required medicalservices.

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

Our management subsidiaries currently provide managementservices to thirteen affiliated physician organizations, which include ProspectMedical Group, eleven other affiliated physician organizations that ProspectMedical Group owns or controls, and one affiliated physician organization(AMVI/Prospect Health Network) that is an unconsolidated joint venture in whichProspect Medical Group owns a 50% interest. We have utilized Prospect Medical Group, which was our first affiliatedphysician organization, to acquire the ownership interest in all of our other affiliatedphysician organizations.  Thus, whileProspect Medical Group is itself an affiliated physician organization that doesthe same business in its own service area as all of our other affiliatedphysician organizations do in theirs, Prospect Medical Group also serves as aholding company for our other affiliated physician organizations.

Thethirteen affiliated physician organizations provide medical services to acombined total of approximately 175,300 HMO enrollees at  June 30, 2006, including approximately 7,500AMVI Prospect Health Network enrollees that we manage for the economic benefitof our partner in this joint venture, and for which we earn management feeincome.

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

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

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

Operating revenue consists primarily of fees formedical services provided by our affiliated physician organizations undercapitated contracts with various HMOs or under fee-for-service arrangements.Capitation revenue under HMO contracts is prepaid monthly to the affiliatesbased on the number of enrollees electing any one of the affiliates as theirhealth care provider. Management fees primarily comprise amounts earned frommanaging the operations of AMVI, Inc., which is our joint venture partner inthe AMVI/Prospect Health Network joint venture. Management services havehistorically related only to MediCal members. However, starting in fiscal 2006,this was expanded to also include management services related to Medicaremembers enrolling in CalOPTIMA’s OneCare HMO; as well as management servicesprovided to Brotman Medical Center. OneCare is a Medicare Advantage SpecialNeeds Plan launched in August 2005 by CalOPTIMA to serve dually eligiblemembers in Orange County who are entitled to Medicare benefits and are alsoMediCal eligible. Other revenues include incentive payments from HMOs under “pay-for-performance”programs for quality medical care based on various criteria. These incentivesare generally received in the third and fourth quarters of our fiscal year andare recorded when such amounts are known.

Revenues are comprised of the following amounts:
|                 | ** ** | **Three months ended** | ** ** | ** **          | ** ** | **Nine months ended** | ** ** | ** **          | ** ** |
|-----------------|------------|----------------------------------|------------|---------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **      | ** ** | **June 30,**                | ** ** | **% Increase** | ** ** | **June 30,**               | ** ** | **% Increase** | ** ** |
| ** **      | ** ** | **2006**                         | ** ** | **2005**            | ** ** | **(Decrease)**                  | ** ** | **2006**            | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Capitation      |       | 33,170,653                       |       | $                   | 30,577,983 |                            | 9          | %                   | 99,442,631 |   | $ | 94,507,961 |   | 5 | % |
| Fee for service |       | 472,181                          |       | 632,637             |       | (25                             | )%         | 1,595,946           |       | 1,696,242 |   | (6 | )% |
| Management fees |       | 296,123                          |       | 171,216             |       | 73                              | %          | 927,890             |       | 598,150 |   | 55 | % |
| Other           |       | 879,063                          |       | 1,011,038           |       | (13                             | )%         | 888,458             |       | 1,201,980 |   | (26 | )% |
|            |       |                             |       |                |       |                            |       |                |       |   |   |   |   |
| Total           |       | $                                | 34,818,020 |                | $          | 32,392,874                      |       | 8                   | %          | $ | 102,854,925 |   | $ | 98,004,333 |   | 5 | % |
|                 |            |                                  |            |                     |            |                                 |            |                     |            |  |  |  |  |  |  |  |  |

 

We have increased our membership through acquisitions.These increases through acquisition are offset by HMO enrollment declines atour affiliated physician organizations, similar to the general HMO enrollmenttrends in California in recent years. The following table sets forth theapproximate number of members, by category, as of the dates indicated.
| Member Category    | ** ** | **As of   June 30,   2006** | ** ** | **As of   June 30,   2005** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Commercial              |       | 144,500                                         |       | 150,100                                         |       |
| Senior – owned     |       | 14,400                                          |       | 13,100                                          |       |
| Senior – managed   |       | 300                                             |       | —                                          |       |
| MediCal – owned    |       | 8,900                                           |       | 7,200                                           |       |
| MediCal –  managed |       | 7,200                                           |       | 7,300                                           |       |
|                    | ** ** | ** **                                      |       |                                            |       |
| Total                   |       | 175,300                                         |       | 177,700                                         |       |

 

The following table details total paid member months,by member category, for the three-month and nine-month periods ended June 30,2006 and 2005:
| ** **              | ** ** | **Three months ended ** | ** ** | ** **          | ** ** | **Nine months ended ** | ** ** | ** **          | ** ** |
|-------------------------|------------|----------------------------------------|------------|---------------------|------------|---------------------------------------|------------|---------------------|------------|
| ** **              | ** ** | **June 30,**                      | ** ** | **% Increase** | ** ** | **June 30,**                     | ** ** | **% Increase** | ** ** |
| ** **              | ** ** | **2006**                               | ** ** | **2005**            | ** ** | **(Decrease)**                        | ** ** | **2006**            | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Commercial              |       | 431,000                                |       | 454,000             |       | (5                                    | )%         | 1,325,000           |       | 1,407,000 |   | (6 | )% |
| Senior – owned     |       | 42,000                                 |       | 43,000              |       | (2                                    | )%         | 130,000             |       | 129,000 |   | 1 | % |
| Senior – managed   |       | 1,000                                  |       | —              |       | 100                                   | %          | 2,000               |       | — |   | 100 | % |
| MediCal – owned    |       | 27,000                                 |       | 21,000              |       | 29                                    | %          | 74,000              |       | 64,000 |   | 16 | % |
| MediCal –  managed |       | 21,000                                 |       | 22,000              |       | (5                                    | )%         | 65,000              |       | 67,000 |   | (3 | )% |
|                    |       |                                   |       |                |       |                                  |       |                |       |   |   |   |   |
| Total                   |       | 522,000                                |       | 540,000             |       | (3                                    | )%         | 1,596,000           |       | 1,667,000 |   | (4 | )% |

 

16

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

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

Capitation payments are fixed in advance of periodscovered and are not subject to significant accounting estimates. These paymentsare expensed in the period the providers are obligated to provide services.Fee-for-service payments are expensed in the period services are provided toour members. Medical care costs include actual historical claims experience andestimates of medical expenses incurred but not reported, or IBNR. Monthly, weestimate our IBNR based on a number of factors, including prior claims experience.As part of this review, we also consider estimates of amounts to coveruncertainties related to fluctuations in provider billing patterns, claimspayment patterns, membership and medical cost trends. These estimates areadjusted monthly as more information becomes available. In addition to our ownIBNR estimation process, we obtain twice annual certifications of our IBNRliability from independent actuaries. We believe that our process forestimating IBNR is adequate, but there can be no assurance that medical carecosts will not exceed such estimates.

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

17

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**Results of Operations**

The following table sets forth selected revenuecategories, cost of revenue categories and other income statement items for thethree and nine month periods ended June 30, 2005 and 2006:
| ** **                                | ** ** | **Three months ended ** | ** ** | ** **                | ** ** | **Nine months ended ** | ** ** | ** **                | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|---------------------------------------|------------|---------------------------|------------|
| ** **                                | ** ** | **June 30,**                      | ** ** | **% Increase ** | ** ** | **June 30,**                     | ** ** | **% Increase ** | ** ** |
| ** **                                | ** ** | **2006**                               | ** ** | **2005**                  | ** ** | **(Decrease)**                        | ** ** | **2006**                  | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Revenues:                                 |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Capitation                                |       | $                                      | 33,170,653 |                      | $          | 30,577,983                            |       | 8.5                       | %          | $ | 99,442,631 |   | $ | 94,507,961 |   | 5.2 | % |
| Fee for service                           |       | 472,181                                |       | 632,637                   |       | (25.4                                 | )%         | 1,595,946                 |       | 1,696,242 |   | (5.9 | )% |
| Management fees                           |       | 296,123                                |       | 171,216                   |       | 73.0                                  | %          | 927,890                   |       | 598,150 |   | 55.1 | % |
| Other revenues                            |       | 879,063                                |       | 1,011,038                 |       | (13.1                                 | )%         | 888,458                   |       | 1,201,980 |   | (26.1 | )% |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Total revenues                            |       | 34,818,020                             |       | 32,392,874                |       | 7.5                                   | %          | 102,854,925               |       | 98,004,333 |   | 4.9 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Cost of  revenues:                        |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| PCP capitation                            |       | 5,803,349                              |       | 5,654,861                 |       | 2.6                                   | %          | 17,571,823                |       | 18,044,279 |   | (2.6 | )% |
| Specialists  capitation                   |       | 5,251,308                              |       | 5,279,637                 |       | (0.5                                  | )%         | 15,930,505                |       | 17,052,359 |   | (6.6 | )% |
| Claims expense                            |       | 13,045,513                             |       | 10,710,814                |       | 21.8                                  | %          | 37,191,218                |       | 33,695,075 |   | 10.4 | % |
| Physician  salaries                       |       | 1,196,248                              |       | 926,040                   |       | 29.2                                  | %          | 2,504,511                 |       | 1,998,882 |   | 25.3 | % |
| Other cost of  revenues                   |       | 111,637                                |       | 273,183                   |       | (59.1                                 | )%         | 659,877                   |       | 510,766 |   | 29.2 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Total cost of  revenues                   |       | 25,408,055                             |       | 22,844,535                |       | 11.2                                  | %          | 73,857,934                |       | 71,301,361 |   | 3.6 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Gross margin                              |       | 9,409,965                              |       | 9,548,339                 |       | (1.4                                  | )%         | 28,996,991                |       | 26,702,972 |   | 8.6 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| General and  administrative expenses      |       | 7,286,083                              |       | 7,551,833                 |       | (3.5                                  | )%         | 22,878,291                |       | 20,674,911 |   | 10.7 | % |
| Depreciation and  amortization expense    |       | 338,140                                |       | 308,167                   |       | 9.7                                   | %          | 995,729                   |       | 805,077 |   | 23.7 | % |
| Total operating  expenses                 |       | 7,624,223                              |       | 7,860,000                 |       | (3.0                                  | )%         | 23,874,020                |       | 21,479,988 |   | 11.1 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Income from  unconsolidated joint venture |       | 321,125                                |       | 206,668                   |       | 55.4                                  | %          | 998,019                   |       | 304,350 |   | 227.9 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Operating income                          |       | 2,106,867                              |       | 1,895,007                 |       | 11.2                                  | %          | 6,120,990                 |       | 5,527,334 |   | 10.7 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Other expense,  net                       |       | 50,295                                 |       | 195,524                   |       | (74.3                                 | )%         | 156,847                   |       | 467,553 |   | (66.5 | )% |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Income before  income taxes               |       | 2,056,572                              |       | 1,699,483                 |       | 21.0                                  | %          | 5,964,143                 |       | 5,059,781 |   | 17.9 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Provision for  income taxes               |       | 743,949                                |       | 674,344                   |       | 10.3                                  | %          | 2,313,524                 |       | 2,021,153 |   | 14.5 | % |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Minority  interest                        |       | 8,632                                  |       | 10,459                    |       | (17.5                                 | )%         | 14,616                    |       | 15,403 |   | (5.1 | )% |
|                                      |       |                                   |       |                      |       |                                  |       |                      |       |   |   |   |   |
| Net income                                |       | $                                      | 1,303,991  |                      | $          | 1,014,680                             |       | 28.5                      | %          | $ | 3,636,003 |   | $ | 3,023,225 |   | 20.3 | % |

 

18

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The followingtable sets forth selected operating items, expressed as a percentage of totalrevenue:
| ** **                                | ** ** | **Three Months   Ended June 30,** | ** ** | **Nine months   Ended June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                              | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                 |       |                                                  |       |                                                 |       |   |   |   |   |
| Capitation  revenue                       |       | 95.30                                                 | %          | 94.40                                                | %          | 96.70 | % | 96.50 | % |
| Fee for service  revenue                  |       | 1.40                                                  | %          | 2.00                                                 | %          | 1.50 | % | 1.70 | % |
| Management fees                           |       | 0.80                                                  | %          | 0.50                                                 | %          | 0.90 | % | 0.60 | % |
| Other revenues                            |       | 2.50                                                  | %          | 3.10                                                 | %          | 0.90 | % | 1.20 | % |
| Total revenues                            |       | 100.00                                                | %          | 100.00                                               | %          | 100.00 | % | 100.00 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Cost of  revenues:                        |       |                                                  |       |                                                 |       |   |   |   |   |
| PCP capitation                            |       | 16.70                                                 | %          | 17.50                                                | %          | 17.10 | % | 18.40 | % |
| Specialists  capitation                   |       | 15.10                                                 | %          | 16.30                                                | %          | 15.50 | % | 17.40 | % |
| Claims expense                            |       | 37.40                                                 | %          | 33.10                                                | %          | 36.20 | % | 34.50 | % |
| Physician  salaries                       |       | 3.50                                                  | %          | 2.80                                                 | %          | 2.40 | % | 2.00 | % |
| Other cost of  revenues                   |       | 0.30                                                  | %          | 0.80                                                 | %          | 0.60 | % | 0.50 | % |
| Total cost of  revenues                   |       | 73.00                                                 | %          | 70.50                                                | %          | 71.80 | % | 72.80 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Gross margin                              |       | 27.00                                                 | %          | 29.50                                                | %          | 28.20 | % | 27.20 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| General and  administrative expenses      |       | 20.90                                                 | %          | 23.30                                                | %          | 22.20 | % | 21.10 | % |
| Depreciation and  amortization expense    |       | 1.00                                                  | %          | 1.00                                                 | %          | 1.00 | % | 0.80 | % |
| Total operating  expenses                 |       | 21.90                                                 | %          | 24.30                                                | %          | 23.20 | % | 21.90 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Income from  unconsolidated joint venture |       | .90                                                   | %          | 0.60                                                 | %          | .90 | % | 0.30 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Operating income                          |       | 6.00                                                  | %          | 5.80                                                 | %          | 5.90 | % | 5.60 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Other expense,  net                       |       | 0.10                                                  | %          | 0.70                                                 | %          | 0.20 | % | 0.50 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Income before  income taxes               |       | 5.90                                                  | %          | 5.10                                                 | %          | 5.70 | % | 5.10 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Provision for  income taxes               |       | 2.10                                                  | %          | 2.10                                                 | %          | 2.20 | % | 2.00 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Minority  Interest                        |       | 0.00                                                  | %          | 0.00                                                 | %          | 0.00 | % | 0.00 | % |
|                                      |       |                                                  |       |                                                 |       |   |   |   |   |
| Net income                                |       | 3.80                                                  | %          | 3.00                                                 | %          | 3.50 | % | 3.10 | % |

 

**ThreeMonths Ended June 30, 2006 Compared to Three Months Ended June 30, 2005**

*CapitationRevenue*

Capitation revenue for the three months ended June 30,2006 was $33,170,654 representing an increase of 8.5% over capitation revenuefor the three months ended June 30, 2005, of $30,577,983.

The increase is comprised of three main factors. Weestimate that higher capitation rates on our core business, exclusive ofacquisitions, contributed approximately $4,000,000 in increased capitationrevenue during the 2006 period as compared to the 2005 period. We estimate thatenrollment declines reduced capitation revenue by approximately $4,200,000during the 2006 period, as compared to the 2005 period. The November 2005 acquisitionof Genesis HealthCare of Southern California (Genesis) increased capitationrevenue by approximately $2,800,000 for the 2006 period.

19

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*Fee forService Revenue*

Fee for service revenue for the three months endedJune 30, 2006 was $472,181, representing a decrease of $160,456 (25.4%) fromfee for service revenue for the three months ended June 30, 2005, of $632,637.

The decrease in fee for service revenue during the2006 period was primarily due to fluctuations in bad debt expense.

*ManagementFee Revenue*

Management fee revenue for the three months ended June30, 2006 was $296,123, representing an increase of 73% over management feerevenue for the three months ended June 30, 2005 of $171,216.

The increase in management fee revenue during the 2006quarter was primarily the result of new management contracts with BrotmanMedical Center and the One Care product line.

*OtherRevenues*

Other revenues for the three months ended June 30,2006 was $879,063 representing a decrease of $131,975 (13.1%) from otherrevenues for the three months ended June 30, 2005, of $1,011,038.

Amounts primarily represent incentive payments fromHMOs under “pay-for-performance” programs for quality medical care based onvarious criteria. These incentives are generally received in the third andfourth quarters of our fiscal year and are recorded when such amounts areknown.

Thedecrease in other revenues during the 2006 quarter was primarily the result oftiming of the pay-for-performance incentives received from our contractedHealth Plans.

*PCPCapitation Expense*

PrimaryCare Physician (“PCP”) capitation expense for the three months ended June 30,2006 was $5,803,349, representing an increase of $148,488 (2.6%) from PCPcapitation expense for the three months ended June 30, 2005, of $5,654,861.

Weestimate that net membership growth from the November 1, 2005 acquisition ofGenesis contributed approximately $660,000 in increased PCP capitation expenseduring the 2006 period. We estimate that higher capitation rates on our corebusiness, exclusive of acquisitions, increased PCP capitation expense byapproximately $280,000 during the 2006 period as compared to the 2005 period.We estimate that enrollment declines related to our core business, exclusive ofthe acquisitions, reduced PCP capitation expense by approximately $790,000during the 2006 period, as compared to the 2005 period.

*SpecialistCapitation Expense*

Specialistcapitation expense for the three months ended June 30, 2006 was $5,251,308representing a decrease of $28,329 (.5%) from specialist capitation expense forthe three months ended June 30, 2005, of $5,279,637.

Weestimate that net membership growth from the November 1, 2005 acquisition ofGenesis contributed approximately $250,000 in increased specialist capitationexpense during the 2006 period. We estimate that higher capitation rates on ourcore business, exclusive of acquisitions, increased specialist capitationexpense by approximately $460,000 during the 2006 period as compared to the2005 period. We estimate that enrollment declines related to our core business,exclusive of the acquisitions, reduced specialist capitation expense byapproximately $740,000 during the 2006 period, as compared to the 2005 period.

*ClaimsExpense*

Claimsexpense for the three months ended June 30, 2006 was $13,045,513, representingan increase of $2,334,699 (21.8%) over claims expense for the three monthsended June 30, 2005, of $10,710,814.

20

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Weestimate that net membership growth from acquisitions contributed approximately$1,500,000 in increased claims expense during the 2006 period, as compared tothe 2005 period. We estimate that higher claims per member rates on our corebusiness, exclusive of acquisitions, increased claims expense by approximately$2,300,000 during the 2006 period as compared to the 2005 period. We estimatethat enrollment declines related to our core business, exclusive of theacquisitions, reduced claims expense by approximately $1,500,000 during the2006 period, as compared to the 2005 period.

*PhysicianSalaries Expense*

Physiciansalaries expense for the three months ended June 30, 2006 was $1,196,248,representing an increase of $270,208 (29.2%) over physician salaries expensefor the three months ended June 30, 2005, of $926,040.

Theincrease in physician salaries expense during the 2006 quarter was primarilythe result of higher bonus accruals compared to the 2005 quarter. Physician salariesexpense includes discretionary performance bonuses awarded annually toproviders at the sole discretion of the Board of Directors. These bonuses aregenerally recorded in the same periods we record pay-for-performance and sharedrisk incentives from the health plans as a portion of these incentives form thebasis of these discretionary awards to our providers.

*OtherCost of Revenues*

Othercost of revenues for the three months ended June 30, 2006 was $111,637,representing a decrease of $161,546 (59.1%) over other cost of revenue for thethree months ended June 30, 2005, of $273,183.

Thedecrease in other cost of revenues during the 2006 quarter was primarily theresult of healthplan payments/recoveries for stop loss insurance and a decreasein the level of certain pharmacy and injectibles costs.

*Gross Margin*

Medicalcare costs as a percentage of medical revenues (the medical care ratio) largelydetermines our gross margin. Our gross margin decreased by 2.5%, to 27.0% inthe 2006 quarter, from 29.5% in the 2005 quarter.

Thedecrease in our gross margin percentage between the 2005 and 2006 periods wasthe result of the decrease in PCP, specialist capitation and other cost of revenuesas a percent of revenue by 0.8%, 1.2% and 0.5%, respectively compared to thesame quarter in 2005.  This was offset byan increase in the claims expense and physician compensation of 4.3% and .7%,respectively, as a percent of revenue. The reasons for these fluctuations arediscussed above.

*General and Administrative Expenses*

Generaland administrative expenses were $7,286,083 for the 2006 quarter, representing20.9% of total revenues, as compared with $7,551,833, or 23.3% of totalrevenues, for the 2005 quarter.

Thedecrease in general and administrative expenses during the 2006 quarter wasprimarily the result of decreased cost of outside services related to the acquisitionof Brotman, which was completed in 2005.

*Depreciation and Amortization*

Depreciationand amortization expense for the three months ended June 30, 2006 increased to$338,140 from $308,167 for the same period of the prior year. The increase wasprimarily due to accelerating, effective April 1, 2005, the rate ofamortization of identifiable intangible assets acquired in the November 2003and February 1, 2004 acquisitions of Northwest Orange County and GatewayMedical Group and affiliates, as well as depreciation expense associated withincreased capital expenditures.

*Income (Loss) From UnconsolidatedJoint Venture*

The increase in income from unconsolidated jointventure during the 2006 period results from the fiscal year 2006 participationin the OneCare program, whereby some of the Medicare beneficiaries joiningCalOPTIMA’s OneCare program were assigned to the AMVI/Prospect Medical Group.

21

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*Other Expense, Net*

Otherexpense, net for the three months ended June 30, 2006 decreased to a netexpense of $50,295 from a net expense of $195,524 for the same period of theprior year. The decrease in net interest expense during the 2006 period wasprimarily due to increased investment income, partially offset by additionalinterest expenses on the $4 million GMAC Residential Funding Corporation creditfacility entered into on November 1, 2005 to finance the Genesis acquisitionand interest expense of $108,000 related to the exercise of warrants byComerica in the three months ended June 30, 2005.

*Provisionfor Income Taxes*

Incometax expense increased approximately 10.3%, or $69,605 to $743,949 for the 2006quarter, from $674,344 in the 2005 quarter. The increase in income tax expensewas principally due to a $357,089 or 21% increase in pretax income. Theeffective tax rate decreased from 39.7% in the three months ended June 30, 2005to 36.2% in the three months ended June 30, 2006 due to approximately $200,000of non-taxable income in the 2006 period.

**Nine Months Ended June 30, 2006Compared to Nine Months Ended June 30, 2005**

*Capitation Revenue*

Capitationrevenue for the nine months ended June 30, 2006 was $99,442,631, representingan increase of $4,934,670 (5.2%) over capitation revenue for the nine months endedJune 30, 2005, of $94,507,961.

Theincrease is comprised of three main factors. We estimate that net membershipgrowth from the Genesis acquisition and higher capitation rates on our corebusiness, exclusive of the acquisition, contributed approximately $7,500,000and $10,300,000 in increased capitation revenue, respectively, during the 2006period as compared to the 2005 period. We estimate that enrollment declinesrelated to our core business, exclusive of the acquisition, reduced capitationrevenue by approximately $12,800,000 during the 2006 period, as compared to the2005 period.

*Fee for Service Revenue*

Feefor service revenue for the nine months ended June 30, 2006 was $1,595,946representing a decrease of $100,296 (5.9%) from fee for service revenue for thenine months ended June 30, 2005, of $1,696,242.

Thedecrease in fee for service revenue during the 2006 period was primarily due tofluctuations with bad debt expenses.

*Management Fee Revenue*

Managementfee revenue for the nine months ended June 30, 2006 was $927,890, representingan increase of $329,740 (55.1%) over management fee revenue for the nine monthsended June 30, 2005, of $598,150.

Theincrease in management fee revenue during the 2006 period was primarily the resultof new management contracts with Brotman Medical Center and the new One Careproduct line.

*Other Revenues*

Otherrevenues for the nine months ended June 30, 2006 was $888,458, representing adecrease of $313,522 (26.1%) from other revenues for the nine months ended June30, 2005, of $1,201,980.

Amountsprimarily represent incentive payments from HMOs under “pay-for-performance”programs for quality medical care based on various criteria. These incentivesare generally received in the third and fourth quarters of our fiscal year andare recorded when such amounts are known.

Thedecrease in other revenues during the 2006 period was primarily the result oftiming of pay-for-performance incentives from one of our contracted HealthPlans.

*PCPCapitation Expense*

PrimaryCare Physician (PCP) Capitation expense for the nine months ended June 30, 2006was $17,571,823, representing a decrease of $472,456 (2.6%) from PCP capitationexpense for the nine months ended June 30, 2005, of $18,044,279.

22

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Weestimate that net membership growth from the November 1, 2005 Genesis acquisitioncontributed approximately $1,760,000 in increased PCP capitation expense duringthe 2006 period. We estimate that higher capitation rates on our core business,exclusive of the acquisition, increased PCP capitation expense by approximately$230,000 during the 2006 period as compared to the 2005 period. We estimatethat enrollment declines related to our core business, exclusive of the acquisition,reduced PCP capitation expense by approximately $2,460,000 during the 2006period, as compared to the 2005 period.

*SpecialistCapitation Expense*

Specialistcapitation expense for the nine months ended June 30, 2006 was $15,930,505representing a decrease of $1,121,854 (6.6%) from specialist capitation expensefor the nine months ended June 30, 2005, of $17,052,359.

Weestimate that net membership growth from the November 1, 2005 Genesis acquisitioncontributed approximately $720,000 in increased specialist capitation expenseduring the 2006 period. We estimate that higher capitation rates on our corebusiness, exclusive of the acquisition, increased specialist capitation expenseby approximately $500,000 during the 2006 period as compared to the 2005 period.We estimate that enrollment declines related to our core business, exclusive ofthe acquisition, reduced specialist capitation expense by approximately$2,330,000 during the 2006 period, as compared to the 2005 period.

*ClaimsExpense*

Claimsexpense for the nine months ended June 30, 2006 was $37,191,218, representingan increase of $3,496,143 (10.4%) over claims expense for the nine months endedJune 30, 2005, of $33,695,075.

Weestimate that net membership growth from the Genesis acquisition contributedapproximately $3,640,000 in increased claims expense during the 2006 period. Weestimate that higher claims per member rates on our core business, exclusive ofthe acquisition, increased claims expense by approximately $4,780,000 duringthe 2006 period as compared to the 2005 period. We estimate that enrollmentdeclines related to our core business, exclusive of the acquisition, reducedclaims expense by approximately $4,920,000 during the 2006 period, as comparedto the 2005 period. The increase in claims expense is partially due toconversion of contracts from capitation to fee-for-service.

*PhysicianSalaries Expense*

Physiciansalaries expense for the nine months ended June 30, 2006 was $2,504,511,representing an increase of $505,629 (25.3%) over physician salaries expensefor the nine months ended June 30, 2005, of $1,998,882.

Theincrease in physician salaries expense during the 2006 period was primarily theresult of higher bonus accruals than in the 2005 period. Physician salariesinclude discretionary performance bonuses awarded to providers. As discussedabove, these awards are based in part on “pay-for-performance” and shared riskincentives we receive from the health plans. As such, the bonuses may fluctuatebased on the amount and timing of these HMO incentive payments.

*OtherCost of Revenues*

Othercost of revenues for the nine months ended June 30, 2006 was $659,877,representing an increase of $149,111 (29.2%) over other cost of revenues forthe nine months ended June 30, 2005, of $510,766.

Theincrease in other cost of revenue during the 2006 period was primarily theresult of an increase in the level of certain pharmacy and injectibles beingpaid as contracted, although such increase did not continue into the thirdquarter ended June 30, 2006.  Also, inthe 2005 period there was a stoploss recovery that offset costs in that period.

*Gross Margin*

Medicalcare costs as a percentage of medical revenues (the medical care ratio) largelydetermines our gross margin. Our gross margin increased 1.0%, to 28.2% for thenine months ended June 30, 2006, from 27.2% for the nine months ended June 30,2005.

Theincrease in our gross margin percentage between the 2005 and 2006 periods wasthe result of the decrease in PCP and specialist capitation as a percent ofrevenue by 1.3% and 1.9% , respectively compared to the same period in2005.  This was offset by an increase inclaims expense and physician compensation of 1.7% and 0.4% as a percent ofrevenue, respectively. The reasons for these fluctuations are discussed above.

23

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*General and Administrative Expenses*

Generaland administrative expenses were $22,878,291 for the 2006 period, representing22.2% of total revenues, as compared with $20,674,911, or 21.1% of totalrevenues, for the 2005 period.

Theincrease in general and administrative expenses during the 2006 period wasprimarily the result of increased salary and related costs associated withfilling open positions and increases in outside services related to SOXcompliance and information technology consulting and increased management feesrelated to Genesis. These increases have slowed in the third quarter ended June30, 2006.

*Depreciation and Amortization*

Depreciationand amortization expense for the nine months ended June 30, 2006 increased to$995,729 from $805,077 for the same period of the prior year. The increase of$190,652 was primarily due to the accelerating amortization of identifiableintangible assets acquired in the September 30, 2003 and February 1, 2004acquisitions referred to above, as well as additional depreciation expense forincreased capital expenditures.

*Income (Loss) From UnconsolidatedJoint Venture*

The increase in income from unconsolidated jointventure during the 2006 period results from the fiscal year 2006 participationin the OneCare program, whereby some of the Medicare beneficiaries joiningCalOPTIMA’s OneCare program were assigned to the AMVI/Prospect Medical Group.

*Other Expense, Net*

Otherexpense, net for the nine months ended June 30, 2006 decreased to a net expenseof $156,847 from $467,553 for the same period of the prior year. The decreasein net interest expense during the 2006 period was primarily due to increased investmentincome, partially offset by additional interest on the $4 million GMACResidential Funding Corporation credit facility entered into on November 1,2005 to finance the Genesis acquisition.

*Provisionfor Income Taxes*

Incometax expense increased approximately 14.5%, or $292,371 to $2,313,524 for the2006 period, from $2,021,153 in the 2005 period. The increase in income taxexpense was principally due to a 17.9% increase in pretax income. The effectivetax rate decreased from 40% in the nine months ended June 30, 2005 to 38.8%in the nine months ended June 30, 2006 due to approximately $200,000 ofnon-taxable income in the 2006 period.

**Liquidity and Capital Resources**

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

Ourinvestment policies are designed to preserve principal, maintain liquidity foroperations and statutory requirements,  and maximize investment return. As of June 30, 2006 we invested asubstantial portion of our cash in a portfolio that included Federal Home Loanbonds with an average maturity of approximately 60 days, and overnight and highyield money market funds. All of these amounts are classified as current assetsand included in cash and cash equivalents in the accompanying balance sheets.We are also required by some of our HMO contracts to set aside certain amountsin restricted certificates of deposit to secure our ability to pay medicalclaims. These restricted certificates of deposit, with an average maturity ofapproximately 115 days as of June 30, 2006, are included in Investments in theaccompanying financial statements.

Netcash provided by operations was $1,232,099 for the nine months ended June 30,2006 and $87,058 for the nine months ended June 30, 2005. The increase in netcash provided by operations for the nine months ended June 30, 2006 whencompared to the nine months ended June 30, 2005 was largely due to changes inworking capital and timing of our cash receipts and disbursements:

·                  Increasednet income ($612,778 higher in 2006);

24

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·                  changesin risk pool receivable balances, a use of $735,120 in the nine months endedJune 30, 2006 compared to a source of $87,980 in the nine months ended June 30,2005;

·                  changesin accounts receivable balances, a source of $1,045,836 in the nine monthsended June 30, 2006 compared to a source of $143,941 in the nine months endedJune 30, 2005;

·                  changesin prepaid expenses and other, a source of $42,254 in the nine months endedJune 30, 2006 compared to a use of $1,258,141 in the nine months ended June 30,2005;

·                  changesin recoverable income taxes, a use of $2,643,588 for the nine months ended June30, 2006 compared to a use of $888,372 for the nine months ended June 30, 2006;

·                  changesin medical claims liabilities, a use of $1,212,191 in the nine months endedJune 30, 2006 compared to a use of $757,519 in the nine months ended June 30,2005;

·                  changesin accounts payable, a source of $343,152 in the nine months ended June 30,2006 compared to a use of $1,489,861 in the nine months ended June 30, 2005;

Net cash used in investing activities was $6,727,626for the nine months ended June 30, 2006 and $322,091 for the nine months endedJune 30, 2005. The increase in net cash used in investing activites was due tothe cash paid for acquisition of $6,596,080 for the November 2005 Genesisacquisition. $4,000,000 of the purchase price was financed through borrowings.Investing activities also include changes in restricted certificates ofdeposit, a source of $294,364 in the nine months ended June 30, 2006 comparedto a use of $649,313 in the nine months ended June 30, 2005.

Net cash providedby financing activities was $3,421,814 for the nine months ended June 30, 2006and cash used in financing activities was $5,494,977 for the nine months endedJune 30, 2005. The increase in net cash provided by financing activities wasdue to the following factors:

·                  proceedsfrom issuance of notes payable, a source of $4,000,000 in the nine months endedJune 30, 2006 to finance the November 2005 Genesis acquisition compared to nonein the six months ended June 30, 2005;

·                  $4,000,000repayments of line of credit, during the nine months ended June 30, 2005, nonein the nine months ended June 30, 2006.

·                  $929,140in proceeds from common stock issuances

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·                  taxbenefit from options exercised, a source of $459,341 in the nine months endedJune 30, 2006 compared to none in the nine months ended June 30, 2005.

AtJune 30, 2006, we had negative working capital of $1,751,420 as compared tonegative working capital of $681,960 at September 30, 2005. At June 30, 2006and September 30, 2005, cash and cash equivalents were $14,875,591 and$16,949,304, respectively.

Oursubsidiaries are required to maintain minimum capital prescribed by variousHMOs with whom we contract. As of June 30, 2006, all of our subsidiaries werein compliance with the minimum capital requirements. Barring any change inregulatory requirements, we believe that we will continue to be in compliancewith these requirements at least through the end of fiscal 2006. We alsobelieve that our cash resources and internally generated funds will besufficient to support our operations, regulatory requirements and capitalexpenditures for at least the next 12 months.

Weexpect to refinance existing debt upon maturity, September 27, 2007.

**Contractual Obligations**

Inour annual report on Form 10-K filed on December 27, 2005, we reported on ourcontractual obligations as of that date. There have been no material changes toour contractual obligations since that report.

**Critical Accounting Policies**

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

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

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

Weconsider historical activity for the current month, plus the prior 24 months,in our IBNR calculation. For the months of service five months prior to thereporting date and earlier, we estimate our outstanding claims liability basedupon actual claims paid, adjusted for estimated completion factors. Completionfactors seek to measure the cumulative percentage of claims expense that willhave been paid for a given month of service as of a date subsequent to thatmonth of service. Completion factors are based upon historical paymentpatterns. For the four months of service immediately prior to the reportingdate, actual claims paid are not a reliable measure of our ultimate liability,given the delay inherent between the patient/physician encounter and the actualsubmission of a claim for payment. For these months of service we estimate ourclaims liability based upon trended per member per month (“PMPM”) costestimates. These estimates reflect recent trends in payments and expense,utilization patterns, authorized services and other relevant factors. Thefollowing tables reflect (i) the change in our estimate of claims liability asof June 30, 2006 that would have resulted had we changed our completion factorsfor all applicable months of service included in our IBNR calculation (i.e.,the preceding 5th through 25th months) by thepercentages indicated; and (ii) the change in our estimate of claims liabilityas of June 30, 2006 that would have resulted had we changed trended PMPMfactors for all applicable months of service included in our IBNR calculation(i.e., the preceding 1st through 4th months) by the percentages indicated.

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

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

 

Additionally,for each 1% (hypothetical) difference between our June 30, 2006 estimatedclaims liability (of $11,318,000) and the actual claims incurred run-out, netincome for the nine months ended June 30, 2006 would increase or decrease byapproximately $67,000, or approximately $0.01 per diluted share.

Thefollowing table shows the components of the change in medical claims andbenefits payable for the nine months ended June 30, 2006 and June 30, 2005: 
| ** **                                                         | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| IBNR as of beginning of  period                                    |       | $                       | 11,532,328 |                    | $          | 13,323,622 |   |
| Health care  claims expense incurred during the period related to: |       |                    |       |                    |       |
| Current year                                                       |       | 37,953,115              |       | 34,984,790              |       |
| Prior years                                                        |       | (761,897                | )          | (1,289,715              | )          |
| Total incurred                                                     |       | 37,191,218              |       | 33,695,075              |       |
| Health care  claims paid during the period related to:             |       |                    |       |                    |       |
| Current year                                                       |       | (27,336,714             | )          | (23,117,828             | )          |
| Prior years                                                        |       | (11,066,695             | )          | (11,334,766             | )          |
| Total paid                                                         |       | (38,403,409             | )          | (34,452,594             | )          |
| IBNR acquired  during the period                                   |       | 997,863                 |       | —                  |       |
| IBNR as of end of  period                                          |       | $                       | 11,318,000 |                    | $          | 12,566,103 |   |

 

**Inflation**

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

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

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

**Concentrations of Credit Risk**

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

Asof June 30, 2006, we had cash and cash equivalents of $14,875,591. Cashequivalents consist of highly liquid securities with original maturities of upto three months. We invest a substantial portion of our cash equivalents inFederal Home Loan bonds and overnight, high yield money market funds. We alsohad $835,153 of investments, primarily consisting of restricted,interest-bearing certificates of deposit required by various HMOs with whom wedo business. These investments are subject to interest rate risk and willdecrease in value if market rates increase. All non-restricted investments aremaintained at fair market value on the balance sheet. We have the ability tohold these investments until maturity, and as a result, we would not expect thevalue of these investments to decline significantly as a result of a suddenchange in market interest rates. Declines in interest rates over time willreduce our investment income. Concentration of credit risk related toreceivables is generally limited to amounts due from large HMO’s.

Ourterm loan with Residential Funding Corporation (RFC), with a balance of$10,200,000 at June 30, 2006, requires monthly principal payments of $233,333and monthly interest payments at prime plus 2% per annum. The fair value ofthis debt instrument is affected by changes in market interest rates. As ofJune 30, 2006, the carrying value of our term loan approximated its estimatedfair value. Considerable judgment is required to develop estimates of fairvalue. Accordingly, the estimate is not necessarily indicative of the amount wecould realize in a current market exchange. The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. For terms relating to our long-term debt, seeNote 6 of the Notes to Condensed Consolidated Financial Statements.

**Item 4.Controls and Procedures.**

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

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

***Changes in Internal Controls:***Therewere no changes in the Company’s internal control over financial reportingduring the nine months ended June 30, 2006 that have materially affected, orare reasonably likely to materially affect, the Company’s internal controlsover financial reporting.

***Sarbanes-Oxley 404 Compliance:***Wehave begun a detailed assessment of our internal controls as called for by theSarbanes-Oxley Act of 2002. We are still in the evaluation of design phase. Wehave supplemented our internal project team with the services of an outsidespecialist. Although we have made this project a priority for the Company,there can be no assurances that all control deficiencies that may be identifiedand validated will be remediated before the required due date of September 30,2007.

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**PART II –OTHER INFORMATION**

**Item 1.    Legal Proceedings.**

*OtherMatters*—We and our affiliated physician organizationsare parties to legal actions arising in the ordinary course of business. Webelieve that liability, if any, under these claims will not have a materialadverse effect on our consolidated financial position or results of operations.

**Item 1A.  Risk Factors.**

None.

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

None.

**Item 3.    DefaultsUpon Senior Securities.**

None.

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

None.

**Item 5.    OtherInformation.**

None.

**Item 6.    Exhibits.**

The following documentsare being filed as exhibits to this report:
| Exhibit No. | ** ** | **Title**                                                                                                                               |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Amended and Restated Certificate of Incorporation of  Prospect Medical Holdings, Inc.(1)                                                |
|             |       |                                                                                                                                    |
| 3.2              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical  Holdings, Inc.(1)                   |
|             |       |                                                                                                                                    |
| 3.3              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical  Holdings, Inc.(1)                   |
|             |       |                                                                                                                                    |
| 3.4              |       | Certificate of Designation of Series A Convertible  Preferred Stock of Prospect Medical Holdings, Inc.(1)                               |
|             |       |                                                                                                                                    |
| 3.5              |       | Amended and Restated Bylaws of Prospect Medical  Holdings, Inc.(1)                                                                      |
|             |       |                                                                                                                                    |
| 3.6              |       | First Amendment to Amended and Restated Bylaws of  Prospect Medical Holdings, Inc.(1)                                                   |
|             |       |                                                                                                                                    |
| 4.1              |       | Specimen Common Stock Certificate(1)                                                                                                    |
|             |       |                                                                                                                                    |
| 31.1             |       | Certification of Chief Executive Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934, as  amended. |
|             |       |                                                                                                                                    |
| 31.2             |       | Certification of Chief Financial Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934, as  amended. |

29

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| 32.1   |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 32.2   |   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

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(1)           Previously filed as an exhibit to ourForm 10 registration statement on May 27, 2004, and incorporated herein byreference.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                 |       | PROSPECT MEDICAL HOLDINGS, INC.                                                                                 |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------|
|            |       | (Registrant)                                                                                                    |
|            |       |                                                                                                            |
| August 14, 2006 |       | /s/ JACOB Y. TERNER                                                                                             |
|            | ** ** | **Jacob Y. Terner, M.D.   Chairman of the Board and   Chief Executive Officer   (Principal Executive Officer)** |
|            | ** ** | ** **                                                                                                      |
| August 14, 2006 |       | /s/ MIKE HEATHER                                                                                                |
|            | ** ** | **Mike Heather   Chief Financial Officer   (Principal Financial Officer)**                                      |

 

31

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Exhibit Index
| Exhibit No. | ** ** | **Title**                                                                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                 |
| 3.1              |       | Amended and Restated Certificate of Incorporation of  Prospect Medical Holdings, Inc.(1)                                                             |
|             |       |                                                                                                                                                 |
| 3.2              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical  Holdings, Inc.(1)                                |
|             |       |                                                                                                                                                 |
| 3.3              |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation of Prospect Medical  Holdings, Inc.(1)                                |
|             |       |                                                                                                                                                 |
| 3.4              |       | Certificate of Designation of Series A Convertible  Preferred Stock of Prospect Medical Holdings, Inc.(1)                                            |
|             |       |                                                                                                                                                 |
| 3.5              |       | Amended and Restated Bylaws of Prospect Medical Holdings,  Inc.(1)                                                                                   |
|             |       |                                                                                                                                                 |
| 3.6              |       | First Amendment to Amended and Restated Bylaws of  Prospect Medical Holdings, Inc.(1)                                                                |
|             |       |                                                                                                                                                 |
| 4.1              |       | Specimen Common Stock Certificate(1)                                                                                                                 |
|             |       |                                                                                                                                                 |
| 31.1             |       | Certification of Chief Executive Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934, as  amended.              |
|             |       |                                                                                                                                                 |
| 31.2             |       | Certification of Chief Financial Officer pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934, as  amended.              |
|             |       |                                                                                                                                                 |
| 32.1             |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                 |
| 32.2             |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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(1)          Previously filed as an exhibit to our Form 10 registration statement on May 27,2004, and incorporated herein by reference.

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