**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-Q**

| **x**      |   | **Quarterly report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**  |
|------------|--------|-----------------------------------------------------------------------------------------------|
| ** ** |   | ** **                                                                                    |
| ** ** |   | **For the quarterly period ended March 31, 2007**                                             |
| ** ** |   | ** **                                                                                    |
| ** ** |   | **or**                                                                                        |
| ** ** |   | ** **                                                                                    |
| **o**      |   | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
| ** ** |   | ** **                                                                                    |
| ** ** |   | **Commission  file number: 1-32203**                                                          |

 

**ProspectMedical Holdings, Inc.**

(Exact name of registrant as specified in itscharter)

| **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’s telephone number, including  area code) |

 

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 90 days.  Yes ý   No o

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

| Large accelerated  filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  x |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

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

Yes  o   No  x

The number of shares of the issuer’s Common Stock, parvalue $0.01 per share, outstanding as of May 10, 2007 was 7,939,990.

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**Index**
|                  | ** ** | **Part I – Financial  Information**                                                                                                 |       |       |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|             | ** ** | ** **                                                                                                                               |       |       |
| **Item 1.**      |       | **Financial Statements**                                                                                                                 |       |       |
| ** **       |       | ** **                                                                                                                               |       |       |
|             |       | **Condensed  Consolidated Balance Sheets as of March 31, 2007 (unaudited) and September  30, 2006**                                      |       |       |
|             |       | ** **                                                                                                                               |       |       |
|             |       | **Condensed Consolidated Statements of Operations for  the three-month and six-month periods ended March 31, 2007 and 2006 (unaudited)** |       |       |
|             |       | ** **                                                                                                                               |       |       |
|             |       | **Condensed  Consolidated Statements of Cash Flows for the six-month periods ended March  31, 2007 and 2006 (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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**PARTI - FINANCIAL INFORMATION**

**Item 1.Financial Statements.**

**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                | ** ** | **March 31,   2007** | ** ** | **September 30   2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **(Unaudited)**                | ** ** | ** **                        | ** ** |
| **ASSETS**                                                                                                                                                                                                |       |                           |       |                              |       |
| **Current assets:**                                                                                                                                                                                       |       |                           |       |                              |       |
| Cash and cash  equivalents                                                                                                                                                                                |       | $                              | 12,733,129 |                              | $          | 16,623,407 |   |
| Investments, primarily  restricted certificates of deposit                                                                                                                                                |       | 635,690                        |       | 836,244                           |       |
| Risk pool receivables                                                                                                                                                                                     |       | 2,355,284                      |       | 1,418,973                         |       |
| Other receivables, net  of allowances of $269,000 and $509,000 at March 31, 2007 and September 30,  2006                                                                                                  |       | 1,715,692                      |       | 1,916,883                         |       |
| Notes receivable,  current portion                                                                                                                                                                        |       | 179,902                        |       | 176,265                           |       |
| Prepaid expenses and  other                                                                                                                                                                               |       | 717,481                        |       | 645,466                           |       |
| Refundable income taxes                                                                                                                                                                                   |       | 3,648,995                      |       | 2,493,035                         |       |
| Deferred income taxes,  net                                                                                                                                                                               |       | 336,963                        |       | 657,678                           |       |
| Total current  assets                                                                                                                                                                                     |       | 22,323,136                     |       | 24,767,951                        |       |
|                                                                                                                                                                                                      |       |                           |       |                              |       |
| Property, improvements  and equipment:                                                                                                                                                                    |       |                           |       |                              |       |
| Land                                                                                                                                                                                                      |       | 40,620                         |       | 40,620                            |       |
| Leasehold  improvements                                                                                                                                                                                   |       | 979,741                        |       | 984,934                           |       |
| Equipment                                                                                                                                                                                                 |       | 3,819,217                      |       | 3,478,435                         |       |
| Furniture and  fixtures                                                                                                                                                                                   |       | 805,171                        |       | 782,087                           |       |
|                                                                                                                                                                                                      |       | 5,644,749                      |       | 5,286,076                         |       |
| Less accumulated  depreciation and amortization                                                                                                                                                           |       | (4,289,649                     | )          | (3,999,863                        | )          |
| Property, improvements  and equipment, net                                                                                                                                                                |       | 1,355,100                      |       | 1,286,213                         |       |
|                                                                                                                                                                                                      |       |                           |       |                              |       |
| Notes receivable, long  term portion                                                                                                                                                                      |       | 395,148                        |       | 413,577                           |       |
| Deposits                                                                                                                                                                                                  |       | 710,976                        |       | 613,087                           |       |
| Goodwill                                                                                                                                                                                                  |       | 38,213,828                     |       | 37,838,169                        |       |
| Other intangible assets,  net                                                                                                                                                                             |       | 1,245,236                      |       | 1,738,475                         |       |
| Total assets                                                                                                                                                                                              |       | $                              | 64,243,424 |                              | $          | 66,657,472 |   |
|                                                                                                                                                                                                      |       |                           |       |                              |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                            |       |                           |       |                              |       |
| **Current liabilities:**                                                                                                                                                                                  |       |                           |       |                              |       |
| Accrued medical claims  and other health care costs payable                                                                                                                                               |       | $                              | 13,165,000 |                              | $          | 11,400,000 |   |
| Accounts payable and  other accrued liabilities                                                                                                                                                           |       | 6,078,810                      |       | 8,191,849                         |       |
| Current maturities of  long-term debt and capital leases                                                                                                                                                  |       | 8,100,000                      |       | 5,300,000                         |       |
| Total current  liabilities                                                                                                                                                                                |       | 27,343,810                     |       | 24,891,849                        |       |
|                                                                                                                                                                                                      |       |                           |       |                              |       |
| Long-term debt, less  current maturities                                                                                                                                                                  |       | —                         |       | 6,700,000                         |       |
| Deferred income taxes                                                                                                                                                                                     |       | 1,240,112                      |       | 1,145,573                         |       |
| Other long-term  liabilities                                                                                                                                                                              |       | 231,368                        |       | 34,712                            |       |
| Total  liabilities                                                                                                                                                                                        |       | 28,815,290                     |       | 32,772,134                        |       |
| **Minority interest**                                                                                                                                                                                     |       | 71,320                         |       | 81,881                            |       |
|                                                                                                                                                                                                      |       |                           |       |                              |       |
| **Shareholders’ equity:**                                                                                                                                                                            |       |                           |       |                              |       |
| Common stock, $0.01 par  value; 40,000,000 shares authorized; 7,789,932 (including 40,197 shares held  in treasury) and 7,186,977 shares issued and outstanding at March 31, 2007  and September 30, 2006 |       | 77,899                         |       | 71,869                            |       |
| Additional paid-in  capital                                                                                                                                                                               |       | 22,650,728                     |       | 20,345,805                        |       |
| Retained earnings                                                                                                                                                                                         |       | 12,628,187                     |       | 13,385,783                        |       |
| Total  shareholders’ equity                                                                                                                                                                          |       | 35,356,814                     |       | 33,803,457                        |       |
| Total liabilities and  shareholders’ equity                                                                                                                                                          |       | $                              | 64,243,424 |                              | $          | 66,657,472 |   |

 

See accompanying notes.

3

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**
| ** **                                          | ** ** | **Three months ended   March 31,** | ** ** | **Six months ended   March 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                               | ** ** | **2006**                                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Revenues                                            |       | $                                                      | 33,326,986 |                                                 | $          | 34,572,146 |   | $ | 68,154,983 |   | $ | 68,036,905 |   |
| Cost of revenues                                    |       | 26,170,356                                             |       | 23,963,663                                           |       | 52,206,382 |   | 48,449,879 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Gross margin                                        |       | 7,156,630                                              |       | 10,608,483                                           |       | 15,948,601 |   | 19,587,026 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Non-medical  expenses:                              |       |                                                   |       |                                                 |       |   |   |   |   |
| General and administrative                          |       | 9,081,430                                              |       | 8,461,134                                            |       | 17,158,498 |   | 15,592,208 |   |
| Depreciation and amortization                       |       | 391,207                                                |       | 335,573                                              |       | 783,026 |   | 657,589 |   |
| Total non-medical  expenses                         |       | 9,472,637                                              |       | 8,796,707                                            |       | 17,941,524 |   | 16,249,797 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Operating income  from unconsolidated joint venture |       | 499,637                                                |       | 330,732                                              |       | 763,579 |   | 676,893 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Operating (loss)  income                            |       | (1,816,370                                             | )          | 2,142,508                                            |       | (1,229,344 | ) | 4,014,122 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Other (income)  expense:                            |       |                                                   |       |                                                 |       |   |   |   |   |
| Investment income                                   |       | (222,330                                               | )          | (204,722                                             | )          | (463,862 | ) | (439,189 | ) |
| Interest expense                                    |       | 234,598                                                |       | 288,229                                              |       | 501,579 |   | 545,740 |   |
| Total other  (income) expense, net                  |       | 12,268                                                 |       | 83,507                                               |       | 37,717 |   | 106,551 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| (Loss) income  before income taxes                  |       | (1,828,638                                             | )          | 2,059,001                                            |       | (1,267,061 | ) | 3,907,571 |   |
| (Benefit) provision  for income taxes               |       | (736,690                                               | )          | 825,392                                              |       | (511,338 | ) | 1,569,575 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Net (loss)  income before minority interest         |       | (1,091,948                                             | )          | 1,233,609                                            |       | (755,723 | ) | 2,337,996 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Minority  interest                                  |       | (675                                                   | )          | 4,386                                                |       | 1,872 |   | 5,984 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Net (loss)  income                                  |       | $                                                      | (1,091,273 | )                                                    | $          | 1,229,223 |   | $ | (757,595 | ) | $ | 2,332,012 |   |
|                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Net (loss)  income per common share:                |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                               |       | $                                                      | (0.14      | )                                                    | $          | 0.18 |   | $ | (0.10 | ) | $ | 0.34 |   |
| Diluted                                             |       | $                                                      | (0.14      | )                                                    | $          | 0.15 |   | $ | (0.10 | ) | $ | 0.29 |   |
| Weighted average  shares outstanding:               |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                               |       | 7,695,393                                              |       | 6,887,286                                            |       | 7,481,804 |   | 6,792,907 |   |
| Diluted                                             |       | 7,695,393                                              |       | 8,233,916                                            |       | 7,481,804 |   | 7,994,380 |   |

 

See accompanying notes.

4

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(Unaudited)**
| ** **                                                                            | ** ** | **Six months ended   March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| **Operating  activities**                                                             |       |                                                 |       |   |   |
| Net (loss)  income                                                                    |       | $                                                    | (757,595   | ) | $ | 2,332,012 |   |
| Adjustments to  reconcile net (loss) income to net cash used in operating activities: |       |                                                 |       |   |   |
| Depreciation and amortization                                                         |       | 783,026                                              |       | 657,589 |   |
| Provision for bad debts                                                               |       | (9,016                                               | )          | 119,492 |   |
| Gain on disposal of assets                                                            |       | —                                               |       | 151 |   |
| Stock based compensation                                                              |       | 355,200                                              |       | — |   |
| Deferred income taxes, net                                                            |       | 415,254                                              |       | 387,401 |   |
| Changes in operating assets and liabilities:                                          |       |                                                 |       |   |   |
| Risk pool receivables                                                                 |       | (936,311                                             | )          | (392,733 | ) |
| Other receivables                                                                     |       | 210,208                                              |       | 959,383 |   |
| Prepaid expenses and other                                                            |       | (47,464                                              | )          | (86,136 | ) |
| Recoverable income taxes                                                              |       | (1,155,960                                           | )          | (2,647,888 | ) |
| Deposits and other assets                                                             |       | (122,440                                             | )          | 38,836 |   |
| Accrued medical claims and other health care costs  payable                           |       | 1,765,000                                            |       | (835,191 | ) |
| Accounts payable and other accrued liabilities                                        |       | (1,916,384                                           | )          | (618,724 | ) |
| Net cash used in  operating activities                                                |       | (1,416,482                                           | )          | (85,808 | ) |
|                                                                                  |       |                                                 |       |   |   |
| **Investing  activities**                                                             |       |                                                 |       |   |   |
| Purchases of  property, improvements and equipment                                    |       | (358,674                                             | )          | (251,416 | ) |
| Collections on  note receivable                                                       |       | 14,792                                               |       | 17,429 |   |
| Cash paid for  acquisitions, net of cash received                                     |       | —                                               |       | (6,560,892 | ) |
| Decrease in  restricted certificates of deposit                                       |       | 200,554                                              |       | 294,364 |   |
| Capitalized  expenses related to acquisitions                                         |       | (375,659                                             | )          | (35,188 | ) |
| Other investing  activities                                                           |       | (10,562                                              | )          | 5,984 |   |
| Net cash used in  investing activities                                                |       | (529,549                                             | )          | (6,529,719 | ) |
|                                                                                  |       |                                                 |       |   |   |
| **Financing  activities**                                                             |       |                                                 |       |   |   |
| Borrowings from  term loan                                                            |       | —                                               |       | 4,000,000 |   |
| Borrowings on  line of credit                                                         |       | —                                               |       | 2,000,000 |   |
| Repayments on  line of credit                                                         |       | (2,500,000                                           | )          | — |   |
| Reduction of  term loan                                                               |       | (1,400,000                                           | )          | (1,266,667 | ) |
| Proceeds from  issuance of common stock                                               |       | 1,726,385                                            |       | 697,255 |   |
| Tax benefit from  options exercised                                                   |       | 229,368                                              |       | 269,511 |   |
| Net cash (used  in) provided by financing activities                                  |       | (1,944,247                                           | )          | 5,700,099 |   |
|                                                                                  |       |                                                 |       |   |   |
| Net decrease in  cash and cash equivalents                                            |       | (3,890,278                                           | )          | (915,428 | ) |
|                                                                                  |       |                                                 |       |   |   |
| Cash and cash  equivalents at beginning of period                                     |       | 16,623,407                                           |       | 16,949,304 |   |
|                                                                                  |       |                                                 |       |   |   |
| Cash and cash  equivalents at end of period                                           |       | $                                                    | 12,733,129 |   | $ | 16,033,876 |   |
|                                                                                  |       |                                                 |       |   |   |
| **Supplemental  cash flow information**                                               |       |                                                 |       |   |   |
| Cash paid during  the period for:                                                     |       |                                                 |       |   |   |
| Income taxes                                                                          |       | $                                                    | —     |   | $ | 2,756,000 |   |
| Interest                                                                              |       | $                                                    | 501,579    |   | $ | 513,367 |   |
|                                                                                  |       |                                                 |       |   |   |
| Details of  businesses acquired:                                                      |       |                                                 |       |   |   |
| Fair value of assets acquired                                                         |       | $                                                    | —     |   | $ | 9,457,160 |   |
| Liabilities assumed or created                                                        |       | —                                               |       | (1,457,160 | ) |
| Less cash acquired                                                                    |       | —                                               |       | (1,439,108 | ) |
| Net cash paid  for acquisition                                                        |       | $                                                    | —     |   | $ | 6,560,892 |   |

 

5

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**PROSPECT MEDICAL HOLDINGS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**March 31, 2007**

**(Unaudited)**

**1. Reporting Entity**

Prospect Medical Holdings, Inc. (Prospect or theCompany), a Delaware corporation, was incorporated on May 12, 1993. TheCompany is a health care management services organization that developsintegrated delivery systems, and provides medical management systems andservices to affiliated medical organizations. The affiliated medicalorganizations employ and/or contract with physicians and professional medicalcorporations, and contract with managed care payors. Prospect manages theprovision of prepaid health care services for its affiliated medicalorganizations in Southern California.

**2. Basis of Presentation**

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

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

Revenues are comprised of the following amounts:
|                 | ** ** | **Three Months Ended March 31,** | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **      | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Capitation      |       | $                                                    | 32,455,047 |                                               | $          | 33,653,872 |   | $ | 66,547,337 |   | $ | 66,271,978 |   |
| Fee for service |       | 516,999                                              |       | 558,015                                            |       | 899,879 |   | 1,123,765 |   |
| Management fees |       | 193,102                                              |       | 356,700                                            |       | 457,169 |   | 631,767 |   |
| Other           |       | 161,838                                              |       | 3,559                                              |       | 250,598 |   | 9,395 |   |
| Total revenues  |       | $                                                    | 33,326,986 |                                               | $          | 34,572,146 |   | $ | 68,154,983 |   | $ | 68,036,905 |   |

 

Certain prior yearamounts have been reclassified to conform to current period presentation.

**3. Stock Based Compensation**

The Company has stockoption agreements with certain directors, officers and employees. On October 1,2005, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 123(R), “*Share-Based Payment*,”by applying the modified prospective method 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 be measuredat fair value and eliminates the intrinsic value method previously permittedunder Accounting Principles Board (APB) Opinion 25, “*Accountingfor Stock Issued to Employees*” and SFAS No. 123 “*Accounting for Stock-Based Compensation*.” Under APB No. 25, compensationcosts were recognized only to the extent the market price of the underlyingstock exceeded the exercise price on the date of grant. Since the Companygenerally issues shared-based awards at or above the market price of theunderlying stock, these equity awards have not historically resulted incompensation expense.

Under the modifiedprospective method, compensation cost is recognized for all awards granted,modified or settled subsequent to the adoption date, or where the requisiteservice period has not been completed prior to the date of adoption.Compensation cost for awards granted prior to, but not vested as of theadoption date would be based on the same estimated grant-date fair valuepreviously used for pro

6

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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 uses the Black-Scholes option pricing model and a singleoption award approach to estimate the fair value of options granted. Theadoption of SFAS No. 123R did not result in adjustments that are required to bereported as the cumulative effect of a change in accounting principle.Equity-based compensation, if any, is classified within the same line items ascash compensation paid to employees. Cash retained as a result of excess taxbenefits relating to share-based payments are presented in the statement ofcash flows as a financing cash inflow.

The 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 thesix months ended March 31, 2007 is summarized below:
| ** **                                  | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic Value** | ** ** | **Weighted  Average  Remaining  Contractual  Terms  (Months)** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------------------|------------|-------------------------------------|------------|----------------------------------------------------------------|------------|
| Outstanding as of  September 30, 2006       |       | 2,812,247  |       | $                                      | 4.15       |                                |       |                                                           |       |   |
| Granted                                     |       | 120,000    |       | 5.81                                   |       |                                |       |                                                           |       |
| Exercised                                   |       | (495,917   | )          | 3.24                                   |       |                                |       |                                                           |       |
| Forfeited                                   |       | (46,932    | )          | 5.49                                   |       |                                |       |                                                           |       |
| Outstanding as of March  31, 2007           |       | 2,389,398  |       | $                                      | 4.39       |                                | $          | 1,949,136                                                      |       | 28 |   |
| Vested and exercisable as of March 31, 2007 |       | 2,389,398  |       | $                                      | 4.39       |                                | $          | 1,949,136                                                      |       | 28 |   |

 

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

During the six monthsended March 31, 2007, the Company granted 120,000 fully vested options to itsoutside directors at $5.81 per share and recognized expense of $355,200(included in general and administrative expenses) which represents the grantdate fair value of these option awards. During the six months ended March 31, 2006, the Company granted 500fully vested options at exercise price of $6.75 per share to employees andrecognized compensation expense of $1,745. During the six months ended March 31, 2007, options for 495,917 commonshares were exercised for cash and on a cashless basis for net proceeds of $940,223and 46,932 options were forfeited. The aggregate intrinsic value of the optionsexercised was $1,292,000.  During the sixmonths ended March 31, 2006, options for 282,466 common shares were exercisedfor net proceeds of $697,000 and 7,804 options were forfeited. The aggregateintrinsic value of the options exercised was approximately $748,914. TheCompany realized net tax benefits of $229,368 and $269,511 in the six monthsended March 31, 2007 and 2006, respectively, from these exercises where theprice paid was below the fair value of the common shares on the exercise date.The tax benefits reduced income tax payable and increased additional paid-incapital. At March 31, 2007, there are no unvested awards and no unrecognizedstock-based compensation costs.

In January 2007, warrantsfor 484,545 common shares were exercised for cash and on a cashless basis fornet proceeds of $786,162 and warrants for 14,564 common shares were forfeited.

7

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The following table is asummary of options outstanding under all of the Company’s option plans as ofMarch 31, 2007:
| **Range of Exercise Prices** | ** ** | **Number  Outstanding  and  Exercisable** | ** ** | **Weighted  Average  Remaining  Contractual  Terms  (Months)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------|------------|
| $3.00                        |       | 963,065                                   |       | 19                                                             |       | $                                      | 3.00       |   |
| $4.86 - $5.00                |       | 1,039,208                                 |       | 32                                                             |       | $                                      | 4.98       |   |
| $6.45-$7.15                  |       | 387,125                                   |       | 40                                                             |       | $                                      | 6.30       |   |
| $3.00 - $7.15                |       | 2,389,398                                 |       | 28                                                             |       | $                                      | 4.39       |   |

 

The fair value of the optionsgranted during the three and six months ended March 31, 2007 and 2006 wasestimated at the date of grant using the Black-Scholes pricing model with thefollowing weighted average assumptions:
| ** **                                                            | ** ** | **Three Months Ended March 31,** | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Market price of the  Company’s common stock on the date of grant |       | $                                                    | 5.81       |                                               | $          | 6.75 |   | $ | 5.81 |   | $ | 6.75 |   |
| Weighted average  expected life of the options                        |       | 5 years                                              |       | 4 years                                            |       | 5 years |   | 4 years |   |
| Risk-free interest rate                                               |       | 4.75                                                 | %          | 4.35                                               | %          | 4.75 | % | 4.35 | % |
| Volatility                                                            |       | 53                                                   | %          | 63                                                 | %          | 53 | % | 63 | % |
| Dividend Yield                                                        |       | 0                                                    | %          | 0                                                  | %          | 0 | % | 0 | % |
|                                                                       |            |                                                      |            |                                                    |            |  |  |  |  |  |  |  |  |

 

**4. Earnings Per Share**

The denominators for thecomputation of basic and diluted earnings (loss) per share are calculated asfollows:
| ** **                                                               | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                               | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Basic (loss) earnings  per common share:                                 |       |                                             |       |                                           |       |   |   |   |   |
| Numerator – net (loss)  income                                      |       | $                                                | (1,091,273 | )                                              | $          | 1,229,223 |   | $ | (757,595 | ) | $ | 2,332,012 |   |
|                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Denominator –  weighted average number of common shares outstanding |       | 7,695,393                                        |       | 6,887,286                                      |       | 7,481,804 |   | 6,792,907 |   |
|                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Basic (loss) earnings  per common share                                  |       | $                                                | (0.14      | )                                              | $          | 0.18 |   | $ | (0.10 | ) | $ | 0.34 |   |
|                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Diluted (loss) earnings  per common share:                               |       |                                             |       |                                           |       |   |   |   |   |
| Numerator – net (loss)  income                                      |       | $                                                | (1,091,273 | )                                              | $          | 1,229,223 |   | $ | (757,595 | ) | $ | 2,332,012 |   |
|                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Denominator:                                                             |       |                                             |       |                                           |       |   |   |   |   |
| Weighted average  number of common shares outstanding                    |       | 7,695,393                                        |       | 6,887,286                                      |       | 7,481,804 |   | 6,792,907 |   |
| Diluted stock  options, and warrants                                     |       | —                                           |       | 1,346,630                                      |       | — |   | 1,201,473 |   |
|                                                                     |       | 7,695,393                                        |       | 8,233,916                                      |       | 7,481,804 |   | 7,994,380 |   |
|                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Diluted (loss) earnings per common share                                 |       | $                                                | (0.14      | )                                              | $          | 0.15 |   | $ | (0.10 | ) | $ | 0.29 |   |

 

**5. Related Party Transactions**

We have an employmentagreement with our Chief Executive Officer, Jacob Y. Terner that runs throughAugust 1, 2008. The agreement provides that if we terminateDr. Terner’s employment without cause, we will be required to pay him$12,500 for each month of past service as our Chief Executive Officer,commencing as of July 31, 1996. The Company’s maximum contingentobligation under this termination provision was frozen at $1,237,500.

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

On June 1, 2003, inconsideration for Dr. Terner’s personal guarantee and pledge, the CompensationCommittee of the Board of Directors granted to Dr. Terner a six-year,non-qualified stock option to purchase 800,000 shares of common stock at $3.00per share. During its term, Dr. Terner’s personal guarantee was supportedthrough the pledge of certain of his personal assets. Dr. Terner agreed tomaintain his personal guarantee and collateral in effect until PMG had positivetangible net equity. This personal guarantee arrangement was terminated by theBoard of Directors effective January 19, 2005.

8

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**6. Long Term Debt**

Long-term debt at March31, 2007 and September 30, 2006, respectively, consists of the following:
|                                                                           | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                | ** ** | **2007**           | ** ** | **2006**               | ** ** |
| Term loan                                                                 |       | $                  | 8,100,000  |                   | $          | 9,500,000 |   |
| Revolving credit  facility, interest at prime rate plus applicable margin |       | —             |       | 2,500,000              |       |
|                                                                      |       | $                  | 8,100,000  |                   | $          | 12,000,000 |   |
| Less current  maturities                                                  |       | (8,100,000         | )          | (5,300,000             | )          |
|                                                                      |       | $                  | —     |                   | $          | 6,700,000 |   |

 

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

On September 28, 2004,the Company borrowed $10,000,000 on the RFC term loan and paid off its existingterm loan and revolving credit facility with another lender. The Companyborrows from the revolving credit facility, and repays the amounts, from timeto time. No amounts are outstanding under the revolving credit facility atMarch 31, 2007.

The RFC revolving creditfacility commitment was initially for three years, with interest at prime plus0.5% per annum (8.75% at March 31, 2007 and September 30, 2006) and an unusedline fee of 0.25% per annum. In September 2006, RFC extended the maturity andexpiration date of the term loan and revolving credit facility to January 31,2008. The Company may borrow, make repayments, and re-borrow under therevolving credit facility until January 31, 2008. The RFC term loan isamortized over a five-year period with principal payments of $166,667 per month(excluding the $4,000,000 term loan discussed below), plus interest payablemonthly on the outstanding balance at prime plus 2.0% per annum (10.25% atMarch 31, 2007 and September 30, 2006). The remaining balance of the term loanis due and payable in full on January 31, 2008. The Company is subject tocertain financial covenants under the loan agreement, including a maximumsenior debt/EBITDA ratio, minimum fixed charge coverage ratio, minimumconsolidated net worth, minimum liquidity and a limit on capital expenditures.The Company is also restricted, without consent, from using the net proceeds ofany sale of equity securities except to pay down indebtedness under the loanagreement.

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 identical to our existing term loan. This additional term loan wasinitially due on September 30, 2007 and requires monthly principal payments of$66,667 until that time.

At September 30, 2006,the Company reported a fixed charge coverage ratio of 1.12 compared to the minimumrequired ratio of 1.25.  In December2006, the Company and RFC amended the credit agreement effective September 30,2006 to reduce the ratio to 1.00 for the test periods September 30, 2006through December 31, 2006, after which the minimum ratio would return to 1.25.

At March 31, 2007, the Companywas not in compliance with the fixed charge coverage ratio (0.95, versus 1.25required minimum) and debt to EBITDA ratio (1.62 versus 1.50 requiredmaximum).  RFC and the Company are in theprocess of negotiating waivers for these past covenant violations and revisedcovenants for future periods.  Becausethe Company cannot predict future compliance with all terms of the RFC loanthrough March 31, 2008 and the loan is currently due on January 31, 2008, theentire loan balance has been classified as current in the accompanyingfinancial statements.

The Company believes thatit will have sufficient cash resources available to repay the loan when it isdue on January 31, 2008.

**7.Acquisition**

OnNovember 1, 2005 Prospect Medical Group, Inc., acquired the outstandingcommon stock of Genesis HealthCare of Southern California for $8,000,000 incash. The purchase price was funded using $4,000,000 of the Company’s existingcash and a

9

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$4,000,000 term loan fromRFC.  Revenues and expenses for thisacquisition have been included in our consolidated results starting November 1,2005. The following table summarizes the estimated fair values of the assetsacquired and liabilities assumed, as of the date of acquisition:
|                            | ** ** | **Genesis** | ** ** |
|----------------------------|------------|-------------|------------|
| Current assets             |       | $           | 1,520,539  |   |
| Goodwill                   |       | 6,526,256   |       |
| Identifiable  intangibles  |       | 1,378,800   |       |
| Other assets  acquired     |       | 31,565      |       |
| Total assets               |       | 9,457,160   |       |
| Current  liabilities       |       | 1,457,160   |       |
| Long-term  liabilities     |       | —      |       |
| Total  liabilities assumed |       | 1,457,160   |       |
| Net assets acquired        |       | $           | 8,000,000  |   |

 

Intangibles include tradename of $194,800, a covenantnot-to-compete of $199,200 and $984,800 for customer relations, which are beingamortized on a straightline basis over 18 months to four years. The Companymade a Section 338 election, and expects $7,905,056 of total goodwill andintangibles to be deductible for tax purposes.

Under the acquisition agreement, differences betweenthe estimated claims and tax liabilities recorded on the closing date and theultimate payment amounts will be paid to or received from the seller.  As of March 31, 2007 we recorded a liabilityto the seller approximately $120,000 relates to this item.

The agreement also guaranteed certain minimum riskpool collections for the 2005 calendar year, which were met. The seller alsoprovides customary indemnification of up to $1.5 million for eligiblenon-medical and non-tax claims submitted within a two year period. Theindemnification amount 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.

Thefollowing pro forma information for the six months ended March 31, 2006 giveseffect to the Genesis acquisition as if it had occurred on October 1,2005. Such unaudited pro forma information is based on historical financialinformation with respect to the acquisition and does not include operational orother changes that might have been effected by the Company.
|                             | ** ** | **Six months ended   March 31,  2006** | ** ** |
|-----------------------------|------------|------------------------------------------------------------|------------|
| Net revenue                 |       | $                                                          | 68,926,358 |   |
| Net income                  |       | $                                                          | 2,368,981  |   |
| Basic earnings  per share   |       | $                                                          | 0.35       |   |
| Diluted earnings per  share |       | $                                                          | 0.30       |   |

 

**Use ofEstimates**

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenues and expenses,and the disclosure of contingent assets and liabilities at the date and for theperiods that the financial statements are prepared. Actual results could differfrom those estimates. Principal areas requiring the use of estimates include medicalclaims and accruals, settlements under risk/savings sharing programs, medicalreceivables, determination of allowances for uncollectible accounts, impairmentof long-lived and intangible assets, professional and general liability claims,reserves for the outcome of litigation and valuation allowances for deferredtax assets.

Duringthe six months ended March 31, 2007 and 2006, we recorded approximately$336,000 and $829,000, respectively, in reduced claims expense related tofavorable development of fiscal 2006 and 2005 claims.

Duringthe six months ended March 31, 2007, we recorded approximately $190,000 inreduced hospital risk pool revenue as a result of lowered receivables estimatesfor fiscal 2006 risk/savings sharing programs.

**8.  New AccountingPronouncements**

In May2005, the Financial Accounting Standards Board (FASB) issued StatementNo. 154 (SFAS No. 154), *AccountingChanges and Error Corrections*, which replaced APB OpinionNo. 20, *Accounting Changes*,and SFAS No. 3, *Reporting Changes in InterimFinancial Statements*. SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements of voluntary changes inaccounting principles and changes required by a new accounting standard whenthe standard does not include specific transition provisions. Previous guidancerequired most voluntary changes in accounting principle to be

10

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recognizedby including in net income of the period in which the change was made thecumulative 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 did not have a material effect on our consolidatedfinancial position or results of operations.

InJuly 2006, the FASB issued Final Interpretation No. (FIN) 48, *Accounting for Uncertainty in Income Taxes**, an interpretation of SFAS No. 109**Accounting for Income Taxes*. FIN 48 clarifies the accountingfor income taxes by prescribing the minimum recognition threshold a taxposition is required to meet before being recognized in the financial statements.FIN 48 also provides guidance on derecognition, measurement, classification,interest and penalties, accounting in interim periods, disclosure andtransition. In addition, FIN 48 excludes income taxes from the scope of SFASNo. 5, *Accounting for Contingencies*.FIN 48 is effective for fiscal years beginning after December 15, 2006.Differences between the amounts recognized in the consolidated balance sheetsprior to the adoption of FIN 48 and the amounts reported after adoption areaccounted for as a cumulative-effect adjustment to the beginning balance ofretained earnings. Adoption of FIN 48 as of October 1, 2007 is not expected tohave a material effect on our consolidated financial position or results ofoperations.

InSeptember 2006, the FASB issued SFAS No. 157, “*Fair ValueMeasurements*.” This Statement defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements. This Statement appliesunder other accounting pronouncements that require or permit fair valuemeasurements, the Board having previously concluded in those accountingpronouncements that fair value is the relevant measurement attribute.Accordingly, this Statement does not require any new fair value measurements.This Statement is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those fiscalyears. The Company is currently evaluating the impact of the provisions of SFASNo. 157.

InSeptember 2006, the Securities and Exchange Commission (“SEC”) issuedStaff Accounting Bulletin (“SAB”) No. 108 regarding the process ofquantifying financial statement misstatements. SAB No. 108 states thatregistrants should use both a balance sheet approach and an income statementapproach when quantifying and evaluating materiality of a misstatement. Theinterpretations in SAB No. 108 contain guidance on correcting errors underthe dual approach as well as provide transition guidance for correcting errors.This interpretation does not change the requirements within SFAS No. 154for the correction of an error in financial statements. SAB No. 108 iseffective for annual financial statements covering the first fiscal year endingafter November 15, 2006. The Company adopted this interpretation onOctober 1, 2006.

Otherrecent accounting pronouncements issued by the FASB (including its EmergingIssues Task Force), the AICPA, and the SEC did not, or are not believed bymanagement to, have a material impact on our present or future consolidatedfinancial statements.

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

**Forward-LookingStatements**

The following discussionof our financial condition and results of operations should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements and the notes to those statements appearing elsewhere in this reportand the audited financial statements for the year ended September 30, 2006appearing in our annual report on Form 10-K filed with the Securities andExchange 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-lookingstatements involve known and unknown risks and uncertainties that may cause ouractual results in future periods to differ materially from those projected orcontemplated in the forward-looking statements as a result of, but not limitedto, the following factors:
| · | Continued operating losses, or reductions in our  ability to borrow under our RFC credit agreement, results in our having  insufficient cash to support future operations. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                       |
| · | Decreases in the number of HMO enrollees using our  provider networks reduce our profitability and inhibit future growth.                                                  |

 

11

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| · | Our historical working capital deficit could  adversely affect our ability to satisfy our obligations as they come due.                                                                                                                                                                                                                                                   |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | If the value of our goodwill and intangible assets  with indefinite useful lives becomes impaired, the impaired portion will have  to be written off, which could materially reduce the value of our assets and  reduce our net income for the year in which the write-off occurs.                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | We may not be able to make any additional significant  acquisitions without first obtaining additional financing and obtaining the  consent of our commercial lender.                                                                                                                                                                                                     |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | If we are not able to comply with the financial  covenants and other conditions required by our loan agreement with our  commercial lender, our lender could require full repayment of the loan, which  would negatively impact our liquidity and preclude us from making further  acquisitions.                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Substantially all of our revenues are generated from  contracts with a limited number of HMOs, and if our affiliated physician  organizations were to lose HMO contracts or to renew HMO contracts on less  favorable terms, our revenues and profitability could be significantly  reduced.                                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Our profitability may be reduced or eliminated if we  are not able to manage health care costs of our affiliated physician  organizations effectively.                                                                                                                                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Our operating results could be adversely affected if  our actual health care claims exceed our reserves.                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | We may be exposed to liability or fail to estimate  IBNR claims accurately if we cannot process our increased volume of claims  accurately and timely.                                                                                                                                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Medicare and private third-party payer cost  containment efforts and reductions in reimbursement rates could reduce our  revenue and our cash flow.                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Risk-sharing arrangements that our affiliated  physician organizations have with HMOs and hospitals could result in their  costs exceeding the corresponding revenues, which could reduce or eliminate  any shared risk profitability.                                                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | If we do not successfully integrate the operations  of acquired physician organizations into our service network, our costs could  increase, our business could be disrupted, and we may not be able to realize  the anticipated benefits from those acquisitions.                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | When we acquire operations that have historically  operated at a loss, we may not be able to reverse those losses and operate  those businesses at a profit, which could reduce our earnings.                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | If we are unable to identify suitable acquisition  candidates or to negotiate or complete acquisitions on favorable terms, our  prospects for growth could be limited.                                                                                                                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Any acquisitions we complete in the future could  potentially dilute the equity interests of our current stockholders or could  increase our indebtedness and cost of debt service, thereby reducing our net  income and profitability.                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | We operate in a competitive market; increased  competition could adversely affect our revenues.                                                                                                                                                                                                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Failure to comply with federal and state regulations  could result in substantial penalties and changes in business operations.                                                                                                                                                                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Future reforms in health care legislation and  regulation could reduce our revenues and profitability.                                                                                                                                                                                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Whenever we seek to acquire an IPA, an HMO that has  a contract with that IPA could potentially refuse to consent to the transfer  of its contract, and this could deter us from completing the acquisition or  could deprive us of the enrollees and revenues associated with that HMO  contract if we chose to complete the acquisition without the HMO’s consent. |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Our profitability could be adversely affected by any  changes that would reduce payments to HMOs under government-sponsored  health care programs.                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Our revenues and profits could be diminished if we  lose the services of key physicians in our affiliated physician  organizations.                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | Because our business is currently limited to the  Southern California area, any reduction in our revenues and profitability  from a local economic downturn would not be offset by operations in other  geographic areas.                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | We are required to upgrade and modify our management  information systems to accommodate growth in our business and changes in  technology and to satisfy new government regulations. As we seek to implement  these 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 of Dr. Terner  or other key members of management, we might not be able to replace them in a  timely manner with qualified personnel, which could disrupt our business and  reduce our profitability and revenue growth.                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                      |
| · | We and our affiliated physician organizations may  become subject to claims of medical malpractice or HMO bad-faith                                                                                                                                                                                                                                                       |

 

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|        | liability claims for which our insurance coverage  may not be adequate. Such claims could materially increase our costs and  reduce our profitability.                                                                                                                   |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                     |
| · | Fluctuations in our quarterly operating results 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 Securities Dealers  (NASD) has conducted an informal inquiry regarding trading in our common  stock. Both the inquiry and our response occurred in February 2004.We have  not received any subsequent communication from NASD on the matter. |
|   |                                                                                                                                                                                                                                                                     |
| · | If we are not able to develop or sustain an active  trading market for our common stock, it may be difficult for stockholders to  dispose of their common stock.                                                                                                         |
|   |                                                                                                                                                                                                                                                                     |
| · | Even if an active market develops for our common  stock, the market price of our stock is likely to be volatile.                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                     |
| · | If our common stock becomes subject to the SEC’s  penny stock rules, our stockholders may find it difficult to sell their  stock.                                                                                                                                   |

 

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

**Overview**

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

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

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, data collection,and management information systems.

Our management subsidiaries currently providemanagement services to thirteen affiliated physician organizations, whichinclude Prospect Medical Group, eleven other affiliated physician organizationsthat Prospect Medical Group owns or controls, and one affiliated physicianorganization (AMVI/Prospect Health Network) that is an unconsolidated jointventure in which Prospect Medical Group owns a 50% interest.  We have utilized Prospect Medical Group,which was our first affiliated physician organization, to acquire the ownershipinterest in all of our other affiliated physician organizations.  Thus, while Prospect Medical Group is itselfan affiliated physician organization that does the same business in its own servicearea as all of our other affiliated physician organizations do in theirs,Prospect Medical Group also serves as a holding company for our otheraffiliated physician organizations.

The thirteen affiliated physician organizationsprovide medical services to a combined total of approximately 168,800 HMOenrollees at March 31, 2007, including approximately 7,300 AMVI Prospect HealthNetwork and AmviCare enrollees that we manage for the economic benefit of ourpartner in this joint venture, and for which we earn management fee income.

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

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

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

Operating revenue consists primarily of fees 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. Capitation

13

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revenue may be subsequently adjusted to reflectchanges in enrollment as a result of retroactive terminations or additions.These adjustments have not had a material effect on capitation revenue and netincome. Capitation revenue is also subject to risk adjustments. Beginning incalendar 2004, Medicare began a four year phase-in of a revised capitationmodel referred to as “Risk Adjustment.” Under the new model, capitation withrespect to Medicare enrollees is subject to subsequent adjustment for theacuity of the enrollees to whom services were provided. Capitation for thecurrent year is paid based on data submitted for each enrollee for thepreceding year. Capitation is paid at interim rates during the year and isadjusted in subsequent periods (generally in the fourth quarter) after thefinal data is compiled. Positive or negative capitation adjustments are madefor seniors with conditions requiring more or less healthcare services thanassumed in the interim payments. Since we do not currently have the ability toreliably predict these adjustments, periodic changes in capitation amountsearned as a result of Risk Adjustment are recognized when those changes arecommunicated from the health plans, generally in the fourth quarter of thefiscal year to which the adjustments relate. Management fees primarily compriseamounts earned from managing the operations of AMVI, Inc., which is our jointventure partner in the AMVI/Prospect Health Network joint venture. Managementservices have historically related only to MediCal members. However, startingin fiscal 2006, this was expanded to also include management services relatedto Medicare members enrolling in CalOPTIMA’s OneCare HMO, as well as managementservices provided to Brotman Medical Center, an equity investee in which wehold a 38% interest. OneCare is a Medicare Advantage Special Needs Planlaunched in August 2005 by CalOPTIMA to serve dually-eligible members in OrangeCounty who are entitled to Medicare benefits and are also MediCal eligible.Management fee revenue is earned in the month the services are delivered. Otherrevenues 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 since we do not have the informationto reliably estimate these amounts. Risk pool and pay-for-performanceincentives are affected by many factors, some of which are beyond the Company’scontrol, and may vary significantly from year to year.

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

Revenues are comprised of the following amounts:
|                 | ** ** | **Three months ended  March 31,** | ** ** | **% Increase** | ** ** | **Six months ended  March 31,** | ** ** | **% Increase** | ** ** |
|-----------------|------------|--------------------------------------------------|------------|---------------------|------------|------------------------------------------------|------------|---------------------|------------|
| ** **      | ** ** | **2007**                                         | ** ** | **2006**            | ** ** | **(Decrease)**                                 | ** ** | **2007**            | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Capitation      |       | $                                                | 32,455,047 |                | $          | 33,653,872                                     |       | (4                  | )%         | $ | 66,547,337 |   | $ | 66,271,978 |   | 0 | % |
| Fee for service |       | 516,999                                          |       | 558,015             |       | (7                                             | )%         | 899,879             |       | 1,123,765 |   | (20 | )% |
| Management fees |       | 193,102                                          |       | 356,700             |       | (46                                            | )%         | 457,169             |       | 631,767 |   | (28 | )% |
| Other           |       | 161,838                                          |       | 3,559               |       | 4447                                           | %          | 250,598             |       | 9,395 |   | 2567 | % |
|            |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Total           |       | $                                                | 33,326,986 |                | $          | 34,572,146                                     |       | (4                  | )%         | $ | 68,154,983 |   | $ | 68,036,905 |   | 0 | % |

 

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.
| Member Category | ** ** | **As of  March 31,  2007** | ** ** | **As of  March 31,  2006** | ** ** | **% Increase  (Decrease)** | ** ** |
|----------------------|------------|--------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| Commercial - owned   |       | 136,800                              |       | 147,200                              |       | (7                              | )%         |
| Commercial - managed |       | 1,300                                |       | 1,300                                |       | 0                               | %          |
| Senior - owned       |       | 13,700                               |       | 15,100                               |       | (9                              | )%         |
| Senior - managed     |       | 100                                  |       | 300                                  |       | (67                             | )%         |
| MediCal - owned      |       | 11,000                               |       | 9,100                                |       | 21                              | %          |
| MediCal - managed    |       | 5,900                                |       | 5,800                                |       | 2                               | %          |
|                 |       |                                 |       |                                 |       |                            |       |
| Total                |       | 168,800                              |       | 178,800                              |       | (6                              | )%         |

 

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The following table details total paid member months,by member category, for the three-month and six-month periods ended March 31,2007 and 2006:
| ** **           | ** ** | **Three months ended  March 31,** | ** ** | **% Increase** | ** ** | **Six months ended  March 31,** | ** ** | **% Increase** | ** ** |
|----------------------|------------|--------------------------------------------------|------------|---------------------|------------|------------------------------------------------|------------|---------------------|------------|
| ** **           | ** ** | **2007**                                         | ** ** | **2006**            | ** ** | **(Decrease)**                                 | ** ** | **2007**            | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Commercial - owned   |       | 415,800                                          |       | 445,700             |       | (7                                             | )%         | 835,300             |       | 901,400 |   | (7 | )% |
| Commercial - managed |       | 3,900                                            |       | 3,900               |       | 0                                              | %          | 7,800               |       | 7,900 |   | (1 | )% |
| Senior - owned       |       | 41,800                                           |       | 48,700              |       | (14                                            | )%         | 83,800              |       | 87,600 |   | (4 | )% |
| Senior - managed     |       | 400                                              |       | 1,500               |       | (73                                            | )%         | 1,000               |       | 1,700 |   | (41 | )% |
| MediCal - owned      |       | 28,100                                           |       | 21,900              |       | 28                                             | %          | 58,900              |       | 39,800 |   | 48 | % |
| MediCal - managed    |       | 17,500                                           |       | 17,600              |       | (1                                             | )%         | 34,800              |       | 35,500 |   | (2 | )% |
|                 |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
|                 |       | 507,500                                          |       | 539,300             |       | (6                                             | )%         | 1,021,600           |       | 1,073,900 |   | (5 | )% |

 

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 contracted specialistsand the cost of employed physicians at the Company’s medical clinics. Ingeneral, primary care physicians are paid on a capitation basis, whilespecialists 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 to ourmembers. Medical care costs include actual historical claims experience andestimates of medical expenses incurred but not reported, or IBNR. Monthly, weestimate our IBNR based on a number of factors, including prior claimsexperience. As part of this review, we also consider estimates of amounts tocover uncertainties related to fluctuations in provider billing patterns,claims payment patterns, membership and medical cost trends. These estimatesare adjusted monthly as more information becomes available. In addition to ourown IBNR estimation process, we obtain semi-annual certifications of our IBNRliability from independent actuaries. We believe that our process forestimating IBNR is adequate, but there can be no assurance that medical care costswill not exceed such estimates. In addition to contractual reimbursements toproviders, we also make discretionary incentive payments to physicians, whichare in large part based on how much we receive from pay-for-performance awards,shared risk revenues and favorable senior capitation risk adjustment payments.Since the Company records these revenues generally in the third or fourthquarter of each fiscal year, when the incentives and capitation adjustments duefrom the health plans are known, the Company also records the discretionaryphysician bonuses in the same period. Since incentives and risk adjustmentrevenues form the basis for these discretionary bonuses, variability inearnings due to fluctuations in revenues are mitigated by reductions in bonusesawarded.

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.

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**Resultsof Operations**

The following table sets forth selected revenuecategories, cost of revenue categories and other income statement items for thethree month and six month periods ended March 31, 2007 and 2006
| ** **                                | ** ** | **Three months ended  March 31,** | ** ** | **% Increase** | ** ** | **Six months ended  March 31,** | ** ** | **% Increase** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|---------------------|------------|------------------------------------------------|------------|---------------------|------------|
| ** **                                | ** ** | **2007**                                         | ** ** | **2006**            | ** ** | **(Decrease)**                                 | ** ** | **2007**            | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Revenues:                                 |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Capitation                                |       | $                                                | 32,455,047 |                | $          | 33,653,872                                     |       | (3.6                | )%         | $ | 66,547,337 |   | $ | 66,271,978 |   | 0.4 | % |
| Fee for service                           |       | 516,999                                          |       | 558,015             |       | (7.4                                           | )%         | 899,879             |       | 1,123,765 |   | (19.9 | )% |
| Management fees                           |       | 193,102                                          |       | 356,700             |       | (45.9                                          | )%         | 457,169             |       | 631,767 |   | (27.6 | )% |
| Other revenues                            |       | 161,838                                          |       | 3,559               |       | 4447.3                                         | %          | 250,598             |       | 9,395 |   | 2567.4 | % |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Total revenues                            |       | 33,326,986                                       |       | 34,572,146          |       | (3.6                                           | )%         | 68,154,983          |       | 68,036,905 |   | 0.2 | % |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Cost of revenues:                         |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| PCP capitation                            |       | 6,018,320                                        |       | 5,864,165           |       | 2.6                                            | %          | 11,894,919          |       | 11,768,475 |   | 1.1 | % |
| Specialist capitation                     |       | 4,820,145                                        |       | 5,274,763           |       | (8.6                                           | )%         | 10,101,228          |       | 10,679,197 |   | (5.4 | )% |
| Claims expense                            |       | 14,411,274                                       |       | 11,939,058          |       | 20.7                                           | %          | 28,381,401          |       | 24,145,705 |   | 17.5 | % |
| Physician salaries                        |       | 741,854                                          |       | 617,238             |       | 20.2                                           | %          | 1,370,306           |       | 1,308,263 |   | 4.7 | % |
| Other cost of revenues                    |       | 178,763                                          |       | 268,439             |       | (33.4                                          | )%         | 458,528             |       | 548,239 |   | (16.4 | )% |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Total cost of revenues                    |       | 26,170,356                                       |       | 23,963,663          |       | 9.2                                            | %          | 52,206,382          |       | 48,449,879 |   | 7.8 | % |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Gross margin                              |       | 7,156,630                                        |       | 10,608,483          |       | (32.5                                          | )%         | 15,948,601          |       | 19,587,026 |   | (18.6 | )% |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| General and  administrative expenses      |       | 9,081,430                                        |       | 8,461,134           |       | 7.3                                            | %          | 17,158,498          |       | 15,592,208 |   | 10.0 | % |
| Depreciation and  amortization expense    |       | 391,207                                          |       | 335,573             |       | 16.6                                           | %          | 783,026             |       | 657,589 |   | 19.1 | % |
| Total non-medical  expenses               |       | 9,472,637                                        |       | 8,796,707           |       | 7.7                                            | %          | 17,941,524          |       | 16,249,797 |   | 10.4 | % |
|                                      |       |                                             |       |                |       |                                           |       |                |       |   |   |   |   |
| Income from  unconsolidated joint venture |       | 499,637                                          |       | 330,732             |       | 51.1                                           | %          | 763,579             |       | 676,893 |   | 12.8 | % |
| Operating (loss) income                   |       | (1,816,370                                       | )          | 2,142,508           |       | (184.8                                         | )%         | (1,229,344          | )          | 4,014,122 |   | (130.6 | )% |
| Other expense, net                        |       | 12,268                                           |       | 83,507              |       | (85.3                                          | )%         | 37,717              |       | 106,551 |   | (64.6 | )% |
| (Loss) income before  income taxes        |       | (1,828,638                                       | )          | 2,059,001           |       | (188.8                                         | )%         | (1,267,061          | )          | 3,907,571 |   | (132.4 | )% |
| (Benefit) provision for  income taxes     |       | (736,690                                         | )          | 825,392             |       | (189.3                                         | )%         | (511,338            | )          | 1,569,575 |   | (132.6 | )% |
| Minority interest                         |       | (675                                             | )          | 4,386               |       | (115.4                                         | )%         | 1,872               |       | 5,984 |   | (68.7 | )% |
| Net (loss) income                         |       | $                                                | (1,091,273 | )                   | $          | 1,229,223                                      |       | (188.8              | )%         | $ | (757,595 | ) | $ | 2,332,012 |   | (132.5 | )% |

 

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The following table sets forth selected operatingitems, expressed as a percentage of total revenue:
| ** **                                | ** ** | **Three Months  Ended March 31,** | ** ** | **Six months  Ended March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues:                                 |       |                                             |       |                                           |       |   |   |   |   |
| Capitation  revenue                       |       | 97.3                                             | %          | 97.3                                           | %          | 97.6 | % | 97.4 | % |
| Fee for service  revenue                  |       | 1.6                                              | %          | 1.6                                            | %          | 1.3 | % | 1.7 | % |
| Management fees                           |       | 0.6                                              | %          | 1.0                                            | %          | 0.7 | % | 0.9 | % |
| Other revenues                            |       | 0.5                                              | %          | 0.1                                            | %          | 0.4 | % | 0.0 | % |
| Total revenues                            |       | 100.0                                            | %          | 100.0                                          | %          | 100.0 | % | 100.0 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Cost of  revenues:                        |       |                                             |       |                                           |       |   |   |   |   |
| PCP capitation                            |       | 18.1                                             | %          | 16.9                                           | %          | 17.3 | % | 17.3 | % |
| Specialists  capitation                   |       | 14.5                                             | %          | 15.3                                           | %          | 14.8 | % | 15.7 | % |
| Claims expense                            |       | 43.2                                             | %          | 34.5                                           | %          | 41.6 | % | 35.5 | % |
| Physician  salaries                       |       | 2.2                                              | %          | 1.8                                            | %          | 2.1 | % | 1.9 | % |
| Other cost of  revenues                   |       | 0.5                                              | %          | 0.8                                            | %          | 0.8 | % | 0.8 | % |
| Total cost of  revenues                   |       | 78.5                                             | %          | 69.3                                           | %          | 76.6 | % | 71.2 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Gross margin                              |       | 21.5                                             | %          | 30.7                                           | %          | 23.4 | % | 28.8 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| General and  administrative expenses      |       | 27.2                                             | %          | 24.5                                           | %          | 25.2 | % | 22.9 | % |
| Depreciation and  amortization expense    |       | 1.2                                              | %          | 1.0                                            | %          | 1.1 | % | 1.0 | % |
| Total  non-medical expenses               |       | 28.4                                             | %          | 25.5                                           | %          | 26.3 | % | 23.9 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Income from  unconsolidated joint venture |       | 1.5                                              | %          | 1.0                                            | )%         | 1.1 | % | 1.0 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Operating (loss)  income                  |       | (5.4                                             | )%         | 6.2                                            | %          | (1.8 | )% | 5.9 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Other expense,  net                       |       | (0.1                                             | )%         | 0.2                                            | %          | 0.1 | % | 0.2 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| (Loss) income before  income taxes        |       | (5.5                                             | )%         | 6.0                                            | %          | (1.9 | )% | 5.7 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| (Benefit) provision  for income taxes     |       | (2.2                                             | )%         | 2.4                                            | %          | (0.8 | )% | 2.3 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Minority  interest                        |       | 0.0                                              | %          | 0.0                                            | %          | 0.0 | % | 0.0 | % |
|                                      |       |                                             |       |                                           |       |   |   |   |   |
| Net (loss) income                         |       | (3.3                                             | )%         | 3.6                                            | %          | (1.1 | )% | 3.4 | % |

 

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**ThreeMonths Ended March 31, 2007 Compared to Three Months Ended March 31, 2006**

*CapitationRevenue*

Capitation revenue for the three months ended March31, 2007 was $32,455,047, representing a decrease of $1,198,825 ( 3.6%) fromcapitation revenue for the three months ended March 31, 2006, of $33,653,872.

Effective January 1, 2007, the MediCal and HealthFamily enrollees under the CalOptima contract were reassigned from theAVMI/Prospect Joint Venture directly to Prospect Medical Group. As a result,revenues and service costs related to these enrollees, which were previouslyincluded in income from unconsolidated joint venture, are reported ascapitation revenue and medical costs, respectively, beginning in the secondquarter of fiscal 2007. This change in reporting accounted for $1,192,566 ofthe increase in capitation revenue in the 2007 quarter as compared to the priorperiod. Excluding this reporting change, capitation revenue decreased $2,391,391or 7.1% compared to the 2006 period.

The decrease is comprised of two main factors. Weestimate that higher capitation rates on our core business contributedapproximately $170,000 in increased capitation revenue during the 2007 periodas compared to the 2006 period. We estimate that enrollment declines related toour core business reduced capitation revenue by approximately $950,000 duringthe 2007 period, as compared to the 2006 period.  We estimate that lower hospital risk poolrevenue, primarily the result of the sale of certain of our key hospitalpartners in the 2007 period, contributed approximately $420,000 in decreasedcapitation revenue.

*Feefor service revenue*

Fee for service revenue for the three months endedMarch 31, 2007 was $516,999 representing a decrease of $41,016 (7.4%) from feefor service revenue for the three months ended March 31, 2006, of $558,015.

The decrease in fee for service revenue during the2007 period was primarily due to fluctuations in patient visits at our ownedclinics.

*Managementfee revenue*

Management fee revenue for the three months endedMarch 31, 2007 was $193,102, representing a decrease of $163,598 (45.9%) frommanagement fee revenue for the three months ended March 31, 2006, of $356,700.

The decrease in management fee revenue during the 2007period was primarily the result of the termination of a portion of our jointventure management contract related to CalOptima MediCal and Healthy Familyenrollees and a decrease in the management fee with Brotman Medical.

*Otherrevenue*

Other revenue for the three months ended March 31,2007 was $161,838, representing an increase of $158,279 (4,447%) over otherrevenue for the three months ended March 31, 2006, of $3,559.

The increase in other revenue during the 2007 periodwas primarily the result of timing of pay for performance incentives from oneof our contracted Health Plans.

*PCPCapitation Expense*

Primary care physician (PCP) capitation expense forthe three months ended March 31, 2007 was $6,018,320, representing an increaseof $154,155 (2.6%) over PCP capitation expense for the three months ended March31, 2006, of $5,864,165.

We estimate that higher capitation rates increased PCPcapitation expense by approximately $270,000 during the 2007 period as comparedto the 2006 period. We estimate that enrollment declines reduced PCP capitationexpense by approximately $110,000 during the 2007 period, as compared to the2006 period.

*SpecialistCapitation Expense*

Specialist Capitation expense for the three monthsended March 31, 2007 was $4,820,145, representing a decrease of $454,618 (8.6%)from specialist capitation expense for the three months ended March 31, 2006,of $5,274,763.

We estimate that higher capitation rates, combinedwith some specialties moving to fee for service, reduced specialist capitationexpense by approximately $350,000 during the 2007 period as compared to the2006 period. We estimate that enrollment declines reduced specialist capitationexpense by approximately $100,000 during the 2007 period, as compared to the2006 period.

*ClaimsExpense*

Claims expense for the three months ended March 31,2007 was $14,411,274, representing an increase of $2,472,216 (20.7%) overclaims expense for the three months ended March 31, 2006, of $11,939,058.

18

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We estimate that higher claims per member rates, includingthe result of moving some specialties from capitation to fee for service,increased claims expense by approximately $2,400,000 during the 2007 period ascompared to the 2006 period. We estimate that enrollment declines reducedclaims expense by approximately $240,000 during the 2007 period, as compared tothe 2006 period.

*PhysicianSalaries Expense*

Physician salaries expense for the three months endedMarch 31, 2007 was $741,854, representing an increase of $124,616 (20.2%) overphysician salaries expense for the three months ended March 31, 2006, of$617,238.

The increase in physician salaries expense during the2007 period was primarily the result of higher bonus accruals than in the 2006period.

*OtherCost of Revenue*

Other cost of revenue for the three months ended March31, 2007 was $178,763, representing a decrease of $89,676 (33.4%) from othercost of revenue for the three months ended March 31, 2006, of $268,439.

The decrease in other cost of revenue during the 2007period was primarily the result of a decrease in the level of certain pharmacyand injectibles being paid as contracted.

*GrossMargin*

Medical care costs as a percentage of medical revenues(the medical care ratio) largely determines our gross margin. Our gross margindecreased 9.2%, to 21.5% for the three months ended March 31, 2007, from 30.7%for the three months ended March 31, 2006.

The decrease in our gross margin percentage betweenthe 2006 and 2007 periods was primarily the result of the increase in claimsexpense and PCP capitation expense as a percent of revenue by 7.9% compared tothe same period in 2006.  This was offsetby a decrease in specialist capitation expense.

*Generaland Administrative Expenses*

General and administrative expenses were $9,081,430for the 2007 period, representing 27.2% of total revenues, as compared with$8,461,134, or 24.5% of total revenues, for the 2006 period.

The increase in general and administrative expensesduring the 2007 period was primarily the result of increased personnel andpersonnel related costs and outside services. This is due to the addition and upgrading of several key positions,staffing for Medicare Risk Score initiatives and hospital cost control initiatives,and higher levels of transaction and legal expenses in the current period.

*Depreciationand Amortization*

Depreciation and amortization expense for the threemonths ended March 31, 2007 increased to $391,207 from $335,573 for the sameperiod of the prior year. The increase of $55,634 was primarily due to the amortizationof identifiable intangible assets related to the Genesis acquisition, as wellas additional depreciation expense for increased capital expenditures.

*Income from Unconsolidated JointVenture*

The income from unconsolidated joint venture for the threemonths ended March 31, 2007 increased to $499,637 from $330,732 for the sameperiod of the prior year.  The increaseis due to the participation in the OneCare program effective January 1, 2006,whereby some of the Medicare beneficiaries joining Cal OPTIMA’s One Careprogram were assigned to AMVI/Prospect. Effective January 1, 2007, OneCare removed certain minimum healthcarespending requirements, improving the profitability of the program.  Also, on January 1, 2007, the MediCal and HealthyFamilies members that we have with CalOptima were reassigned directly toProspect Medical Group instead of the joint venture, leaving only the One Careprogram in AMVI/Prospect. Revenues and service costs related to the reassignedmembers are included in capitation revenue and medical costs beginningJanuary 1, 2007, rather than as income from the joint venture.

*Other expense net*

Other expense, net for the three months ended March31, 2007 decreased to a net expense of $12,268 from $83,507 for the same periodof the prior year. The decrease in net interest expense during the 2007 periodwas primarily due to increased investment income, and lower interest expense asthe senior debt is paid down.

19

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*Provision for Income Taxes*

We reported income tax expense of $825,392 in the 2006period compared to a benefit of $ 736,690 in the 2007 period. The effective taxrate is 40% for both the 2007 and 2006 periods.

**Sixmonths Ended March 31, 2007 Compared to Six months Ended March 31, 2006**

*CapitationRevenue*

Capitation revenue for the six months ended March 31,2007 was $66,547,337, representing an increase of $275,359 (0.4%) fromcapitation revenue for the six months ended March 31, 2006, of $66,271,978.

Effective January 1, 2007, the MediCal and HealthFamily enrollees under the CalOptima contract were reassigned from theAVMI/Prospect Joint Venture directly to Prospect Medical Group. As a result,revenues and service costs related to these enrollees, which were previouslyincluded in income from unconsolidated joint venture, are reported ascapitation revenue and medical costs, respectively, beginning in the secondquarter of fiscal 2007. This change in reporting accounted for $1,192,566 ofthe increase in capitation revenue in the 2007 quarter as compared to the prioryear period. Excluding this reporting change, capitation revenue decreased $917,206or 1.4% compared to the 2006 period. We estimate that higher capitation rateson our core business, exclusive of acquisitions, contributed approximately$1,900,000 in increased capitation revenue during the 2007 period as comparedto the 2006 period. We estimate that enrollment declines related to our corebusiness reduced capitation revenue by approximately $3,000,000 during the 2007period, as compared to the 2006 period. The November 2005 acquisition ofGenesis HealthCare of Southern California (Genesis) increased capitationrevenue approximately $1,000,000 in the 2007 period as compared to the 2006period.

*Feefor service revenue*

Fee for service revenue for the six months ended March31, 2007 was $899,879 representing a decrease of $223,886 (19.9%) from fee forservice revenue for the six months ended March 31, 2006, of $1,123,765.

The decrease in fee for service revenue during the2007 period was primarily due to fluctuations in patient visits at our ownedclinics.

*Managementfee revenue*

Management fee revenue for the six months ended March31, 2007 was $457,169, representing a decrease of $174,598 (27.6%) frommanagement fee revenue for the six months ended March 31, 2006, of $631,767.

The decrease in management fee revenue during the 2007period was primarily the result of the termination of a portion of our jointventure management contract related to the CalOptima MediCal and Healthy Familymembers and a decrease in the management fee with Brotman Medical.

*Otherrevenue*

Other revenue for the six months ended March 31, 2007was $250,598, representing an increase of $241,203 (2567.4%) over other revenuefor the six months ended March 31, 2006, of $9,395.

The increase in other revenue during the 2007 periodwas primarily the result of timing of pay for performance and other incentivesfrom our contracted Health Plans.

*PCPCapitation Expense*

Primary care physician (PCP) capitation expense forthe six months ended March 31, 2007 was $11,894,919, representing an increaseof $126,444 (1.1%) over PCP capitation expense for the six months ended March31, 2006, of $11,768,475.

We estimate that net membership growth from theNovember 1, 2005 acquisition of Genesis contributed approximately $220,000 inincreased PCP capitation expense during the 2007 period, as compared to the2006 period.  We estimate that highercapitation rates increased PCP capitation expense by approximately $510,000during the 2007 period, as compared to the 2006 period. We estimate that enrollmentdeclines reduced PCP capitation expense by approximately $610,000 during the2007 period, as compared to the 2006 period.

*SpecialistCapitation Expense*

Specialist capitation expense for the six months endedMarch 31, 2007 was $10,101,228, representing a decrease of $577,969 (5.4%) fromspecialist capitation expense for the six months ended March 31, 2006, of$10,679,197.

We estimate that net membership growth from theNovember 1, 2005 acquisition of Genesis contributed approximately $120,000 inincreased specialist capitation expense during the 2007 period, as compared tothe 2006 period. 

20

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We estimate that enrollment declines reducedspecialist capitation expense by approximately $550,000 during the 2007 period,as compared to the 2006 period.  Weestimate that the combined impact of higher capitation rates, plus an increasein specialty costs being paid for on a fee-for-service basis lowered specialistcapitation expense by approximately $140,000 during the 2007 period, ascompared to the 2006 period.

*ClaimsExpense*

Claims expense for the six months ended March 31, 2007was $28,381,401, representing an increase of $4,235,696 (17.5%) over claimsexpense for the six months ended March 31, 2006, of $24,145,705.

We estimate that net membership growth from theNovember 1, 2005 acquisition of Genesis contributed approximately $310,000 inincreased claims expense during the 2007 period, as compared to the 2006period. We estimate that higher claims per member rates, in part the result ofmoving some specialties from capitation to fee for service, increased claimsexpense by approximately $5,100,000 during the 2007 period as compared to the2006 period. We estimate that enrollment declines reduced claims expense byapproximately $1,250,000 during the 2007 period, as compared to the 2006 period

*PhysicianSalaries Expense*

Physician salaries expense for the six months endedMarch 31, 2007 was $1,370,306, representing an increase of $62,043 (4.7%) overphysician salaries expense for the six months ended March 31, 2006, of$1,308,263.

The increase in physician salaries expense during the2007 period was primarily the result of higher bonus accruals than in the 2006period.

*OtherCost of Revenue*

Other cost of revenue for the six months ended March31, 2007 was $458,528, representing decrease of $89,711 (16.4%) over other costof revenue for the six months ended March 31, 2007, of $548,239.

The decrease in other cost of revenue during the 2007period was primarily the result of decrease in the level of certain pharmacyand injectibles being paid as contracted.

*GrossMargin*

Medical care costs as a percentage of medical revenues(the medical care ratio) largely determine our gross margin. Our gross margindecreased 5.4%, to 23.4% for the six months ended March 31, 2007, from 28.8%for the six months ended March 31, 2006.

The decrease in our gross margin percentage betweenthe 2006 and 2007 periods was primarily the result of the increase in claimsexpense, partially offset by the decrease in specialist capitation as a percentof revenue as compared to the same period in 2006.

*Generaland Administrative Expenses*

General and administrative expenses were $17,158,498for the 2007 period, representing 25.2% of total revenues, as compared with$15,592,208, or 22.9% of total revenues, for the 2006 period.

The increase in general and administrative expensesduring the 2007 period was primarily the result of increase personnel andpersonnel related costs and outside services. This is due to the addition and upgrading of several key positions,staffing for Medicare Risk Score initiatives and hospital cost controlinitiatives, staffing for management of the Genesis operation which was broughtin house in October, 2006.

*Depreciationand Amortization*

Depreciation and amortization expense for the sixmonths ended March 31, 2007 increased to $783,026 from $657,589 for the sameperiod of the prior year. The increase of $125,437 was primarily due to theamortization of identifiable intangible assets related to the Genesisacquisition, as well as additional depreciation expense for increased capitalexpenditures.

*Income From Unconsolidated Joint Venture*

The income from unconsolidated joint venture for thesix months ended March 31, 2007 increased to $763,579 from $676,893 for thesame period of the prior year.  Theincrease is due to the participation in the OneCare program effective January1, 2006, whereby some of the Medicare beneficiaries joining Cal OPTIMA’s OneCare program were assigned to AMVI/Prospect. Effective January 1, 2007, OneCare removed certain minimum healthcarespending requirements improving the profitability of the program.  Also, on January 1, 2007, the medical andhealthy families members that we have with CalOptima were reassigned directly

21

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to Prospect Medical Group instead of the jointventure, leaving only the OneCare program in AMVI/Prospect. Revenues andservice costs related to the reassigned members are included in capitationrevenues and medical costs beginning in the second quarter of 2007 rather thanas income from the joint venture.

*Otherexpense net*

Other expense, net for the six months ended March 31,2007 decreased to a net expense of $37,717 from $106,551 for the same period ofthe prior year. The decrease in net other expense during the 2006 period wasprimarily due to increased investment income and lower interest expense as thesavior debt is paid down

*Provisionfor Income Taxes*

We reported income tax expense of $ 1,569,575 in the2006 period to a benefit of $ 511,338 in the 2007 period. The effective taxrate is 40% for the 2007 and 2006 periods.

**Liquidityand Capital Resources**

We generate cash from capitation revenue, healthcareservices provided on a fee-for-service basis at our clinics, management feerevenue and investment income. Our primary uses of cash include the payment ofexpenses related to medical care services and G&A expenses. We generallyreceive capitation revenue in advance of payment of capitation expenses andclaims for related health care services.

Our investment policies are designed to preserveprincipal, maintain liquidity for operations and statutory requirements, andmaximize investment return. As of March 31, 2007 we invested a substantialportion of our cash in a portfolio that included Federal Home Loan bonds withan average maturity of approximately 60 days, and overnight and high yieldmoney market funds. All of these amounts are classified as current assets andincluded in cash and cash equivalents in the accompanying balance sheets. Weare also required by some of our HMO contracts to set aside certain amounts inrestricted certificates of deposit to secure our ability to pay medical claims.These restricted certificates of deposit, with an average maturity of approximately90 days as of March 31, 2007, are included in current investments in theaccompanying financial statements as they are restricted for payment of currentliabilities.

Net cash used by operations was $1,416,482 for the sixmonths ended March 31, 2007 and $(85,808) for the six months ended March 31,2006.  The increase in net cash used byoperations for the six months ended March 31, 2007 when compared to the sixmonths ended March 31, 2007 was due to the following factors:

·              decreased net incomeof $3,089,607;

·              changes in risk poolreceivables, a use of $936,311 in the six months ended March 31, 2007 comparedto a use of $392,733 in the six months ended March 31, 2006; primarily as aresult of the timing of risk pool collections and Genesis risk pool receivablesin the 2007 period;

·              changes in otheraccounts receivable balances, a source of $210,208 in the six months endedMarch 31, 2007 compared to a source of $959,383 in the six months ended March31, 2006;

·              changes in prepaidexpenses and other, a use of $47,464 in the six months ended March 31, 2007compared to a use of $86,136 in the six months ended March 31, 2006;

·              changes in deposits,a use of $122,440 in the six months ended March 31, 2007 compared to a sourceof $38,836 in the six months ended March 31, 2006;

·              changes inrefundable income tax, a use of $1,155,960 for the six months ended March 31,2007 compared to a use of $2,647,888 for the six months ended March 31, 2006with the 2006 use being primarily due to receivables generated throughestimated tax overpayment and deductions from stock option exercises while the2007 receivables was generated primarily through current period tax losses;

·              changes in medicalclaims liabilities, a source of $1,765,000 in the six months ended March 31,2007 compared to a use of $835,191 in the six months ended March 31, 2006primarily the result of higher claims expense trends in the current periodwhich are reflected in the medical claims liability;

·              changes in accountspayable and other accrued liabilities, a use of $1,916,384 in the six monthsended March 31, 2007 compared to a use of $618,724 in the six months endedMarch 31, 2006 primarily as a result of physician bonus payments during the2007 period.

Net cash used in investing activities was $529,549 forthe six months ended March 31, 2007 and $6,529,719 for the six months endedMarch 31, 2006. The 2006 period included $6,596,080 in cash paid for theNovember 2005 Genesis acquisition. $4,000,000 of the purchase price wasfinanced through borrowings. Investing activities also included purchases offixed assets, a use of $358,674 in the six months ended March 31, 2007 comparedto a use of $251,416 in the six months ended March 31, 2006. Investingactivities also included capitalized expenses related to potential and actual acquisitions,a use of $375,659 in the six months ended March 31, 2007 compared to $35,188 inthe six months ended March 31, 2006.

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Net cash used by financing activities was $1,944,247for the six months ended March 31, 2007 and cash provided by financingactivities was $5,700,099 for the six months ended March 31, 2006. The decreasein net cash provided by financing activities was due to the following factors:

·              proceeds from termloans and borrowings on the line of credit, a source of $6,000,000 in the sixmonths ended March 31, 2006 of which $4,000,000 was to finance the November2005 Genesis acquisition, compared to none in the six months ended March 31,2007;

·              $3,900,000 inrepayments of line of credit and term loans, during the six months ended March31, 2007, compared to $1,266,667 in the six months ended March 31, 2006;

·              $1,726,385 inproceeds from common stock issuances related to stock option and warrant exercisesduring the six months ended March 31, 2007, compared to $697,255 in the sixmonths ended March 31, 2006;

·              tax benefit fromoptions exercised, a source of $229,368 in the six months ended March 31, 2007compared to $269,511 in the six months ended March 31, 2006.

At March 31, 2007, we had negative working capital of$5,020,674 as compared to negative working capital of $123,898 at September 30,2006. At March 31, 2007 and September 30, 2006, cash and cash equivalents were$12,733,129 and $16,623,407, respectively.

The reduction in working capital in 2007 is primarilydue to the classification of the term loans, which are due on January 31, 2008,as current liabilities at March 31, 2007. We are in discussion with lenders torefinance the term loans and line of credit facility prior to their scheduledmaturity.

Our subsidiaries are required to maintain minimumcapital prescribed by various HMOs with whom we contract. As of March 31, 2007,all of our subsidiaries were in compliance with the minimum capitalrequirements. Barring any change in regulatory requirements, we believe that wewill continue to be in compliance with these requirements at least through theend of fiscal 2007. We also believe that our cash resources and internallygenerated funds will be sufficient to support our operations, regulatoryrequirements, debt service, and capital expenditures for at least the next 12months.

**Contractual Obligations**

When we prepare our consolidated financial statements,we use estimates and assumptions that may affect reported amounts anddisclosures. The determination of our liability for medical claims and otherhealth care costs payable is particularly important to the determination of ourfinancial position and results of operations and requires the application ofsignificant judgment by our management and, as a result, is subject to aninherent degree of uncertainty.

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

The most significant estimates involved in determiningour claims liability concern the determination of claims payment completionfactors and trended per member per month cost estimates.

We consider historicalactivity for the current month, plus the prior 24 months, in our IBNRcalculation. For the months of service five months prior to the reporting dateand earlier, we estimate our outstanding claims liability based upon actualclaims paid, adjusted for estimated completion factors. Completion factors seekto measure the cumulative percentage of claims expense that will have been paidfor a given month of service as of a date subsequent to that month of service.Completion factors are based upon historical payment patterns. For the fourmonths of service immediately prior to the reporting date, actual claims paidare not a reliable measure of our ultimate liability, given the delay inherentbetween the patient/physician encounter and the actual submission of a claimfor payment. For these months of service we estimate our claims liability basedupon trended per member per month (“PMPM”) cost estimates. These estimatesreflect recent trends in payments and expense, utilization patterns, authorizedservices and other relevant factors. The following tables reflect (i) thechange in our estimate of claims liability as of March 31, 2007 that would haveresulted had we changed our completion factors for all applicable months ofservice 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 March 31, 2007 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.Changes in estimate of the magnitude indicated in the ranges presented areconsidered reasonably likely.

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

 
| Increase (Decrease) in  Trended PMPM Factors | ** ** | **Increase (Decrease) in Accrued Medical Claims  Payable** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| (5)%                                                             |       | $                                                                              | (1,100,000 | ) |
| (4)%                                                             |       | $                                                                              | (900,000   | ) |
| (3)%                                                             |       | $                                                                              | (700,000   | ) |
| (2)%                                                             |       | $                                                                              | (400,000   | ) |
| (1)%                                                             |       | $                                                                              | (200,000   | ) |
| 1%                                                               |       | $                                                                              | 200,000    |   |
| 2%                                                               |       | $                                                                              | 400,000    |   |
| 3%                                                               |       | $                                                                              | 700,000    |   |
| 4%                                                               |       | $                                                                              | 900,000    |   |
| 5%                                                               |       | $                                                                              | 1,100,000  |   |

 

Additionally, for each 1% difference between our March31, 2007 estimated claims liability (of $13,165,000) and the actual claimsincurred run-out, pre-tax loss for the three months ended March 31, 2007 wouldincrease or decrease by approximately $132,000.

The following table shows the components of the changein medical claims and benefits payable for the six months ended March 31, 2007and 2006: 
| ** **                                             | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------|------------|
|                                                        | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| IBNR as of beginning of  period                        |       | $                                   | 11,400,000 |   | 11,532,328 |   |
| Health care claims  expense incurred during the period |       |                                |       |   |   |
| Related to Current year                                |       | 28,717,324                          |       | 24,974,938 |   |
| Related to Prior years                                 |       | (335,923                            | )          | (829,233 | ) |
| Total incurred                                         |       | 28,381,401                          |       | 24,145,705 |   |
| Health care claims paid  during the period             |       |                                |       |   |   |
| Related to Current year                                |       | (16,639,645                         | )          | (14,571,178 | ) |
| Related to Prior years                                 |       | (9,976,756                          | )          | (10,409,718 | ) |
| Total paid                                             |       | (26,616,401                         | )          | (24,980,896 | ) |
| IBNR acquired during  the period                       |       | —                              |       | 997,863 |   |
| IBNR as of end of period                               |       | $                                   | 13,165,000 |   | 11,695,000 |   |

 

Bracketedamounts reported in the table above for the incurred related to prior periodsresult from claims being ultimately settled for amounts less than originallyestimated (a favorable development).  Apositive amount reported for incurred related to prior periods would resultfrom claims ultimately being settled for amounts greater than originallyestimated (an unfavorable development).

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Through March 31, 2007, the $335,923 changes inestimate related to IBNR as of September 30, 2006 represented approximately 3%of the IBNR balance as of September 30, 2006, and approximately 1% of claimsexpense for the year then ended. Through March 31, 2006, the $829,233changes in estimate related to IBNR as of September 30, 2005 representedapproximately 7.2% of the IBNR balance as of September 30, 2005, andapproximately 2% of claims expense for the year then ended.

Past fluctuations in the IBNR estimates might also bea useful indicator of the potential magnitude of future changes in these estimates.Quarterly IBNR estimates include provisions for adverse development based onhistorical volatility. We maintain similar provisions at each quarter end.

**Inflation**

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

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

**Item3. Quantitative and Qualitative Disclosures About Market Risk.**

**Concentrationsof Credit Risk**

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

As of March 31, 2007, we had cash and cash equivalentsof $12,733,129. Cash equivalents consist of highly liquid securities withoriginal maturities of up to three months. We invest a substantial portion ofour cash equivalents in high yield money market funds. We also had $635,690 ofinvestments, primarily consisting of restricted, interest-bearing certificatesof deposit required by various HMOs with whom we do business. These investmentsare subject to interest rate risk and will decrease in value if market ratesincrease. All non-restricted investments are maintained at fair market value onthe balance sheet. We have the ability to hold these investments untilmaturity, and as a result, we would not expect the value of these investmentsto decline significantly as a result of a sudden change in market interestrates. Declines in interest rates over time will reduce our investment income.Concentration of credit risk related to receivables is generally limited toamounts due from large HMO’s.

Our term loan with Residential Funding Corporation(RFC), with a balance of $8,100,000 at March 31, 2007, requires monthlyprincipal payments of $233,333 and monthly interest payments at prime plus 2%per annum. The fair value of this debt instrument is affected by changes inmarket interest rates. As of March 31, 2007, the carrying value of our termloan approximated its estimated fair value. Considerable judgment is requiredto develop estimates of fair value. Accordingly, the estimate is notnecessarily indicative of the amount we could realize in a current marketexchange. The use of different market assumptions and/or estimationmethodologies may have a material effect on the estimated fair value amounts.For terms relating to our long-term debt, see Note 6 of the Notes to CondensedConsolidated Financial Statements.

**Item4. Controls and Procedures.**

***Evaluation ofDisclosure Controls and Procedures:***Our management, withthe participation of our Chief Executive Officer and our Chief FinancialOfficer, has concluded, based upon its evaluation as of the end of the periodcovered by this report, that the Company’s “disclosure controls and procedures”(as defined in Rules 13(a)-15(e) and 15d-15(e) under the Securities ExchangeAct of 1934 (the “Exchange Act”)) are effective to ensure that informationrequired to be disclosed in the reports that the Company files or submits underthe Exchange Act is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Therefore,even those systems determined to be effective can provide only reasonableassurance with respect to financial statement preparation and presentation.

***Changes in InternalControls:***There were no changes in the Company’s internalcontrol over financial reporting during the three months ended March 31, 2007that have materially affected, or are reasonably likely to materially affect,the Company’s internal controls over financial reporting.

***Sarbanes-Oxley 404Compliance:***We have begun a detailed assessment of ourinternal controls as called for by the Sarbanes-Oxley Act of 2002. We are stillin the evaluation of design phase. We have supplemented our internal projectteam with the

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servicesof an outside specialist. Although we have made this project a priority for theCompany, there can be no assurances that all control deficiencies that may beidentified and validated will be remediated before the required due date ofSeptember 30, 2008.

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**PARTII – OTHER INFORMATION**

**Item1.****    LegalProceedings.**

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

**Item1A.****  RiskFactors.**

None.

**Item2.****    UnregisteredSales of Equity Securities and Use of Proceeds.**

None.

**Item 3.****    DefaultsUpon Senior Securities.**

At March 31, 2007, the Company was not in compliance with the fixedcharge coverage ratio (0.95, versus 1.25 required minimum) and debt to EBITDAratio (1.62 versus 1.50 required maximum) Residential Funding Corporation (RFC)and the Company are in the process of negotiating waivers for these pastcovenant violations and revised covenants for future periods. Because theCompany cannot predict compliance with all terms of the RFC loan throughMarch 31, 2008 and the loan is currently due on January 31, 2008, theentire loan balance has been classified as current in the accompanyingfinancial statements.

The Company believes that it will have sufficient cash resourcesavailable to repay the loan when it is due on January 31, 2008.

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

None.

**Item 5.****    OtherInformation.**

None.

**Item 6.****    Exhibits.**

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

 

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(1)                                  Previouslyfiled as an exhibit to our Form 10 registration statement on May 27, 2004, andincorporated herein by reference.

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**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.
|              |       | PROSPECT MEDICAL HOLDINGS, INC.                                                                              |
|--------------|------------|--------------------------------------------------------------------------------------------------------------|
|         |       | (Registrant)                                                                                                 |
|         |       |                                                                                                         |
| May 15, 2007 |       | /s/ JACOB Y. TERNER                                                                                          |
|         | ** ** | **Jacob Y. Terner, M.D.  Chairman of the Board and  Chief Executive Officer  (Principal Executive Officer)** |
|         |       |                                                                                                         |
| May 15, 2007 |       | /s/ MIKE HEATHER                                                                                             |
|         | ** ** | **Mike Heather  Chief Financial Officer  (Principal Financial Officer)**                                     |

 

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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 asan exhibit to our Form 10 registration statement on May 27, 2004, andincorporated herein by reference.

29

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