Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**Form 10-Q**

 

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

 

**For the quarterly period ended****March 31, 2010**

 

**or**

 

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

 

**For the transition period from               to               **

 

**Commissionfile number: 1-32203**

 

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**ProspectMedical Holdings, Inc.**

(Exact name of registrant as specified in its charter)

 

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

 

**(310) 943-4500**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x  No o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files). Yes o  No o

 

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

 

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct): Yes o  No x

 

The number of shares of the issuer’s Common Stock, parvalue $0.01 per share, outstanding as of May 12, 2010 was 20,868,753.

 

 

 

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Table of Contents

 

**PROSPECT MEDICAL HOLDINGS, INC.**

 

**Index**

 
| **Part I—Financial Information** |                                                                                                                                       |
|--------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------|
|                                       |                                                                                                                                       |   |
| Item 1.                               | Financial Statements                                                                                                                       | 1 |
|                                       | Condensed Consolidated Balance Sheets as of  March 31, 2010 (unaudited) and September 30, 2009                                   | 1 |
|                                       | Condensed Consolidated Statements of Operations for  the three-month and six-month periods ended March 31, 2010 and 2009  (unaudited) | 3 |
|                                       | Condensed Consolidated Statements of Cash Flows for  the six-month periods ended March 31, 2010 and 2009 (unaudited)                  | 4 |
|                                       | Notes to Condensed Consolidated Financial Statements  (unaudited)                                                                          | 5 |
| Item 2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                | 30 |
| Item 3.                               | Quantitative  and Qualitative Disclosures About Market Risk                                                                                | 59 |
| Item 4.                               | Controls and  Procedures                                                                                                                   | 59 |
| **Part II—Other  Information**   | ** **                                                                                                                                 |
| Item 1.                               | Legal Proceedings                                                                                                                          | 61 |
| Item 1A.                              | Risk Factors                                                                                                                               | 61 |
| Item 2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                               | 61 |
| Item 3.                               | Defaults  Upon Senior Securities                                                                                                           | 61 |
| Item 4.                               | Removed and  Reserved                                                                                                                      | 61 |
| Item 5.                               | Other information                                                                                                                          | 61 |
| Item 6.                               | Exhibits                                                                                                                                   | 61 |
| Signatures                                 |                                                                                                                                       | 62 |

 

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Table of Contents

 

**PART I—FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(in thousands)**

 
| ** **                                                                                                                                      | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                      | ** ** | **2010**           | ** ** | **2009**               | ** ** |
| ** **                                                                                                                                      | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                      |       |               |       |                   |       |
| **Current assets:**                                                                                                                             |       |               |       |                   |       |
| Cash  and cash equivalents                                                                                                                      |       | $                  | 40,892     |                   | $          | 37,768 |   |
| Restricted  cash                                                                                                                                |       | 2,340              |       | 1,395                  |       |
| Investments,  primarily restricted certificates of deposit                                                                                      |       | 634                |       | 665                    |       |
| Patient  accounts receivable, net of allowance for doubtful accounts of $14,106 and  $11,715 at March 31, 2010 and September 30, 2009 |       | 42,034             |       | 36,806                 |       |
| Government  program receivables                                                                                                                 |       | 2,100              |       | 4,852                  |       |
| Risk  pool receivables                                                                                                                          |       | 8                  |       | —                 |       |
| Other  receivables                                                                                                                              |       | 1,779              |       | 1,655                  |       |
| Third-party  settlements                                                                                                                        |       | 404                |       | 1,575                  |       |
| Notes  receivable, current portion                                                                                                              |       | 57                 |       | 56                     |       |
| Refundable  income taxes, net                                                                                                                   |       | 1,912              |       | 1,558                  |       |
| Deferred  income taxes, net                                                                                                                     |       | 6,566              |       | 6,644                  |       |
| Inventories                                                                                                                                     |       | 4,170              |       | 4,137                  |       |
| Prepaid  expenses and other current assets                                                                                                      |       | 5,965              |       | 5,380                  |       |
| **Total current assets**                                                                                                                        |       | 108,861            |       | 102,491                |       |
| Property,  improvements and equipment:                                                                                                          |       |               |       |                   |       |
| Land  and land improvements                                                                                                                     |       | 31,028             |       | 31,028                 |       |
| Buildings                                                                                                                                       |       | 24,270             |       | 23,665                 |       |
| Leasehold  improvements                                                                                                                         |       | 2,037              |       | 2,029                  |       |
| Equipment                                                                                                                                       |       | 21,453             |       | 20,255                 |       |
| Furniture  and fixtures                                                                                                                         |       | 892                |       | 913                    |       |
|                                                                                                                                            |       | 79,680             |       | 77,890                 |       |
| Less  accumulated depreciation and amortization                                                                                                 |       | (15,899            | )          | (14,166                | )          |
| Total  property, improvements and equipment, net                                                                                                |       | 63,781             |       | 63,724                 |       |
| Notes  receivable, less current portion                                                                                                         |       | 329                |       | 357                    |       |
| Deposits  and other assets                                                                                                                      |       | 268                |       | 694                    |       |
| Deferred  financing costs, net                                                                                                                  |       | 7,318              |       | 8,205                  |       |
| Goodwill                                                                                                                                        |       | 153,250            |       | 153,250                |       |
| Other  intangible assets, net                                                                                                                   |       | 44,225             |       | 46,425                 |       |
| Total  assets                                                                                                                                   |       | $                  | 378,032    |                   | $          | 375,146 |   |

 

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

 

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Table of Contents

 

**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

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

 
| ** **                                                                                                                                                                               | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **2010**           | ** ** | **2009**               | ** ** |
| ** **                                                                                                                                                                               | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                            |       |               |       |                   |       |
| **Current liabilities:**                                                                                                                                                                 |       |               |       |                   |       |
| Accrued  medical claims and other health care costs payable                                                                                                                              |       | $                  | 14,993     |                   | $          | 16,824 |   |
| Accounts  payable and other accrued liabilities                                                                                                                                          |       | 31,846             |       | 31,773                 |       |
| Accrued  salaries, wages and benefits                                                                                                                                                    |       | 21,217             |       | 24,903                 |       |
| Due  to government payer                                                                                                                                                                 |       | 13,834             |       | 13,834                 |       |
| Current  portion of capital leases                                                                                                                                                       |       | 867                |       | 820                    |       |
| Current  portion of long-term debt                                                                                                                                                       |       | 5,429              |       | 3,805                  |       |
| Other  current liabilities                                                                                                                                                               |       | 682                |       | 629                    |       |
| **Total current liabilities**                                                                                                                                                            |       | 88,868             |       | 92,588                 |       |
| Long-term  debt, net of current portion                                                                                                                                                  |       | 172,781            |       | 172,539                |       |
| Deferred  income taxes, net                                                                                                                                                              |       | 29,897             |       | 29,975                 |       |
| Malpractice  reserve                                                                                                                                                                     |       | 2,321              |       | 2,824                  |       |
| Capital  leases, net of current portion                                                                                                                                                  |       | 715                |       | 569                    |       |
| Other  long-term liabilities                                                                                                                                                             |       | 133                |       | 162                    |       |
| Total  liabilities                                                                                                                                                                       |       | 294,715            |       | 298,657                |       |
| **Commitments, Contingencies and Subsequent Events**                                                                                                                                     |       |               |       |                   |       |
| **Shareholders’ equity:**                                                                                                                                                           |       |               |       |                   |       |
| Prospect  Medical Holdings, Inc.’s shareholders’ equity                                                                                                                   |       |               |       |                   |       |
| Common  stock, $0.01 par value; 40,000,000 shares authorized; 20,859,565 and  20,619,278 shares issued and outstanding at March 31, 2010 and  September 30, 2009, respectively |       | 209                |       | 206                    |       |
| Additional  paid-in capital                                                                                                                                                              |       | 96,360             |       | 94,498                 |       |
| Accumulated  deficit                                                                                                                                                                     |       | (12,857            | )          | (18,303                | )          |
| **Total Prospect Medical Holdings, Inc.’s shareholders’  equity**                                                                                                         |       | 83,712             |       | 76,401                 |       |
| Noncontrolling  interest                                                                                                                                                                 |       | (395               | )          | 88                     |       |
| Total  shareholders’ equity                                                                                                                                                         |       | 83,317             |       | 76,489                 |       |
| Total  liabilities and shareholders’ equity                                                                                                                                         |       | $                  | 378,032    |                   | $          | 375,146 |   |

 

Theaccompanying notes are an integral part of the unaudited condensed consolidatedfinancial statements.

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 

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

 

**(Unaudited)**

 
| ** **                                                                        | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                        | ** ** | **2010**                               | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Revenues:                                                                         |       |                                   |       |                                 |       |   |   |   |   |
| Net  Hospital Services revenues                                                   |       | $                                      | 70,538     |                                 | $          | 37,908 |   | $ | 139,950 |   | $ | 73,230 |   |
| Medical  Group revenues                                                           |       | 46,124                                 |       | 48,159                               |       | 92,808 |   | 96,290 |   |
| Total  revenues                                                                   |       | 116,662                                |       | 86,067                               |       | 232,758 |   | 169,520 |   |
| Operating  expenses:                                                              |       |                                   |       |                                 |       |   |   |   |   |
| Hospital  operating expenses                                                      |       | 50,827                                 |       | 22,857                               |       | 100,495 |   | 45,003 |   |
| Medical  Group cost of revenues                                                   |       | 36,864                                 |       | 36,956                               |       | 73,708 |   | 74,567 |   |
| General  and administrative                                                       |       | 15,787                                 |       | 13,380                               |       | 31,917 |   | 25,765 |   |
| Depreciation  and amortization                                                    |       | 2,079                                  |       | 1,823                                |       | 4,157 |   | 3,589 |   |
| Total  operating expenses                                                         |       | 105,557                                |       | 75,016                               |       | 210,277 |   | 148,924 |   |
| Operating  income from unconsolidated joint venture                               |       | 580                                    |       | 595                                  |       | 1,031 |   | 947 |   |
| Operating  income                                                                 |       | 11,685                                 |       | 11,646                               |       | 23,512 |   | 21,543 |   |
| Other  (income) expense:                                                          |       |                                   |       |                                 |       |   |   |   |   |
| Investment  income                                                                |       | (26                                    | )          | (20                                  | )          | (55 | ) | (68 | ) |
| Interest  expense and amortization of deferred financing costs                    |       | 7,267                                  |       | 6,576                                |       | 14,156 |   | 12,714 |   |
| (Gain)  loss in value of interest rate swap arrangements                          |       | —                                 |       | (955                                 | )          | — |   | 8,713 |   |
| Total  other (income) expense, net                                                |       | 7,241                                  |       | 5,601                                |       | 14,101 |   | 21,359 |   |
| Income  before income taxes                                                       |       | 4,444                                  |       | 6,045                                |       | 9,411 |   | 184 |   |
| Provision  for income taxes                                                       |       | 1,944                                  |       | 2,496                                |       | 4,447 |   | 76 |   |
| Net  income                                                                       |       | 2,500                                  |       | 3,549                                |       | 4,964 |   | 108 |   |
| Net  income (loss) attributable to noncontrolling interest                        |       | (87                                    | )          | 1                                    |       | (483 | ) | 4 |   |
| Net  income attributable to Prospect Medical Holdings, Inc.                  |       | $                                      | 2,587      |                                 | $          | 3,548 |   | $ | 5,447 |   | $ | 104 |   |
|                                                                              |       |                                   |       |                                 |       |   |   |   |   |
| Per  share data:                                                                  |       |                                   |       |                                 |       |   |   |   |   |
| Net  income attributable to Prospect Medical Holdings, Inc. per common share |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                                                             |       | $                                      | 0.12       |                                 | $          | 0.17 |   | $ | 0.26 |   | $ | 0.01 |   |
| Diluted                                                                           |       | $                                      | 0.11       |                                 | $          | 0.17 |   | $ | 0.24 |   | $ | 0.01 |   |
|                                                                              |       |                                   |       |                                 |       |   |   |   |   |
| Weighted  average shares outstanding:                                             |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                                                             |       | 20,802                                 |       | 20,508                               |       | 20,727 |   | 20,508 |   |
| Diluted                                                                           |       | 22,735                                 |       | 20,679                               |       | 22,276 |   | 20,682 |   |

 

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

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 

**(inthousands)**

 

**(Unaudited)**

 
| ** **                                                                                         | ** ** | **Six  Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                         | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| **Operating activities**                                                                           |       |                                  |       |   |   |
| Net income                                                                                         |       | $                                     | 4,964      |   | $ | 108 |   |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities:       |       |                                  |       |   |   |
| Depreciation and amortization                                                                      |       | 4,157                                 |       | 3,589 |   |
| Amortization of deferred financing costs                                                           |       | 927                                   |       | 68 |   |
| Amortization of original issue discount                                                            |       | 855                                   |       | — |   |
| Provision for bad debts                                                                            |       | 14,640                                |       | 3,709 |   |
| Payment-in-kind interest expense                                                                   |       | —                                |       | 277 |   |
| Amortization of other accumulated comprehensive  income related to interest rate swap arrangements |       | —                                |       | 440 |   |
| Deferred income taxes, net                                                                         |       | —                                |       | (3,304 | ) |
| Stock-based compensation                                                                           |       | 1,712                                 |       | 582 |   |
| Gain on sale of assets                                                                             |       | (8                                    | )          | — |   |
| Loss on interest rate swap agreements                                                              |       | —                                |       | 8,713 |   |
| Changes in assets and liabilities:                                                                 |       |                                  |       |   |   |
| Risk pool receivables                                                                              |       | (8                                    | )          | 461 |   |
| Patient and other receivables                                                                      |       | (16,069                               | )          | (7,524 | ) |
| Prepaid expenses and other                                                                         |       | (584                                  | )          | 465 |   |
| Inventory                                                                                          |       | (31                                   | )          | (904 | ) |
| Refundable income taxes                                                                            |       | (354                                  | )          | 3,923 |   |
| Deposits and other assets                                                                          |       | 426                                   |       | (1,654 | ) |
| Accrued medical claims and other health care costs  payable                                        |       | (1,831                                | )          | (1,106 | ) |
| Accounts payable, accrued liabilities and other  liabilities                                       |       | (4,095                                | )          | (2,790 | ) |
| Net cash provided by operating activities                                                          |       | 4,701                                 |       | 5,053 |   |
| **Investing activities**                                                                           |       |                                  |       |   |   |
| Purchases of property, improvements and equipment                                                  |       | (1,382                                | )          | (437 | ) |
| Collections on notes receiveable                                                                   |       | 27                                    |       | 22 |   |
| Increase in restricted certificates of deposits                                                    |       | 31                                    |       | (27 | ) |
| Net cash used in investing activities                                                              |       | (1,324                                | )          | (442 | ) |
| **Financing activities**                                                                           |       |                                  |       |   |   |
| Borrowings on line of credit, net                                                                  |       | 1,541                                 |       | — |   |
| Repayments on Class 4 Note                                                                    |       | (531                                  | )          | — |   |
| Repayments of term loan                                                                            |       | —                                |       | (6,465 | ) |
| Payments on capital leases                                                                         |       | (432                                  | )          | (195 | ) |
| Change in restricted cash                                                                          |       | (945                                  | )          | — |   |
| Proceeds from exercises of stock options and  warrants                                             |       | 152                                   |       | — |   |
| Cash paid for deferred financing costs                                                             |       | (38                                   | )          | — |   |
| Net cash used in financing activities                                                              |       | (253                                  | )          | (6,660 | ) |
| Increase (decrease) in cash and cash equivalents                                                   |       | 3,124                                 |       | (2,049 | ) |
| Cash and cash equivalents at beginning of period                                                   |       | 37,768                                |       | 33,583 |   |
| Cash and cash equivalents at end of period                                                         |       | $                                     | 40,892     |   | $ | 31,534 |   |
| **Supplemental disclosure of cash  flow information**                                              |       |                                  |       |   |   |
| Equipment acquired under capital lease                                                             |       | $                                     | 641        |   | $ | 195 |   |
| Interest paid                                                                                      |       | $                                     | 10,922     |   | $ | 11,866 |   |
| Income taxes paid, net                                                                             |       | $                                     | 4,802      |   | $ | 3,148 |   |

 

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

 

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**PROSPECT MEDICAL HOLDINGS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**March 31,2010**

 

**(Unaudited)**

 

**1. Business**

 

Prospect Medical Holdings, Inc. (“Prospect” or the “Company”) is aDelaware corporation. Prior to the August 8, 2007 acquisition of AltaHospitals System, LLC (“Alta”), which was previously known as AltaHealthcare System, Inc., the Company was primarily engaged in providingmanagement services to affiliated physician organizations that operate asindependent physician associations (“Medical Groups”) or medical clinics.Following the Alta acquisition and acquisition of a majority stake in BrotmanMedical Center, Inc., a California corporation (“Brotman”) on April 14,2009 (see Note 7), and as of March 31, 2010, the Company owns andoperates five community-based hospitals in southern California, and itsoperations are organized into three primary reportable segments: HospitalServices, Medical Group, and Corporate as discussed below.

 

***Hospital Services Segment***

 

Alta and Brotman (collectively, the “Hospital Services segment”) ownand operate five hospitals in Los Angeles County, all accredited by the JointCommission (formerly the Joint Commission on Accreditation of HealthcareOrganizations), with a total of 759 licensed beds served by 751 on-staffphysicians at March 31, 2010. Alta owns (i) Alta Hollywood Hospitals, Inc.,a California corporation dba Hollywood Community Hospital and Van NuysCommunity Hospital; and (ii) Alta Los Angeles Hospitals, Inc., aCalifornia corporation dba Los Angeles Community Hospital and Norwalk CommunityHospital. On April 14, 2009 (the “Acquisition Date”), the Companyincreased its existing approximately 33.1% ownership stake in Brotman, toapproximately 71.9% via an investment of approximately $2.5 million incash, thereby obtaining a controlling interest. Brotman owns and operatesBrotman Medical Center, located in Culver City, California.

 

The three community hospitals in Hollywood, Los Angeles and Norwalkoffer a comprehensive range of medical and surgical services, including generalacute care hospital services, pediatrics, obstetrics and gynecology, pediatricsub-acute care, general surgery, medical-surgical services, orthopedic surgery,and diagnostic, outpatient, skilled nursing and urgent care services. Thehospital in Van Nuys provides acute inpatient and outpatient psychiatricservices on a voluntary basis. Brotman offers a comprehensive range of inpatientand outpatient services, including general surgery, orthopedic, spine andneurosurgery, cardiology, diagnostic outpatient, rehabilitation, psychiatricand detox services. In addition, Brotman has an active emergency room thatplays an integral part in providing emergency services to the West Los Angelesarea.

 

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

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

 

Admitting physicians are primarily practitioners in the local area. Thehospitals have payment arrangements with Medicare, Medi-Cal (the Californiaversion of Medicaid) and other third-party payers, including some commercialinsurance carriers, health maintenance organizations (“HMOs”) and preferredprovider organizations (“PPOs”).

 

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***Medical Group Segment***

 

The Medical Group segment is a health care management servicesorganization that provides management services to affiliated physicianorganizations that operate as independent physician associations (“MedicalGroups”). The affiliated physician organizations enter into agreements withhealth maintenance organizations (“HMOs”) to provide enrollees of the HMOs witha full range of medical services in exchange for fixed, prepaid monthly feesknown as “capitation” payments. The Medical Groups contract with physicians(primary care and specialist) and other health care providers to provideenrollees with all of their medical services. Prospect currently manages theprovision of prepaid health care services for its affiliated physicianorganizations in Southern California. The network consists of the followingphysician organizations as of March 31, 2010 (each, an “Affiliate”):

 

Prospect Medical Group, Inc. (“PMG”)

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

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

Prospect Professional Care Medical Group (“PPCM”)

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

Starcare Medical Group, Inc. (“PSC”)

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

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

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

Genesis HealthCare of Southern California (“Genesis”)

Pomona Valley Medical Group (“PVMG”)*

Upland Medical Group (“UMG”)*

 

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

 

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

 

Prospect Medical Systems, Inc. (“PMS”)

ProMed Health Care Administrators, Inc. (“PHCA”)

 

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

 

As of March 31, 2010, the Medical Group segment manages servicesto the following number of enrollees under contracts with various health plans(in thousands):

 
| ** ** | ** ** | **As of March 31** | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **2010**                | ** ** | **2009** | ** ** |
| Commercial |       | 126.3                   |       | 142.2 |   |
| Medicare   |       | 22.3                    |       | 21.7 |   |
| Medi-Cal   |       | 19.2                    |       | 19.3 |   |
| **Totals** |       | 167.8                   |       | 183.2 |   |

 

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**2. Summary of Significant Accounting Policies**

 

***Basis of Presentation***

 

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

 

The results of operations for the three months and six months ended March 31,2010 are not necessarily indicative of the results to be expected for the fullyear. The information included in this Quarterly Report on Form 10-Qshould be read in conjunction with the audited consolidated financialstatements for the year ended September 30, 2009 and notes theretoincluded in the Company’s Annual Report on Form 10-K filed with the SEC onDecember 21, 2009.

 

The Company adoptedauthoritative guidance on ASC 810, “*NoncontrollingInterests in Consolidated Financial Statements—an Amendment of ARB No. 51,*”(previously known as SFAS No. 160 issued by the Financial Accounting Standards Board (“FASB”))that establishes accounting and reporting principles for a noncontrolling interestin a subsidiary, including the accounting treatment upon the deconsolidation ofa subsidiary. As required by this guidance, the Company has adjusted thepresentation of noncontrolling interests in the prior period unaudited interimcondensed consolidated financial statements so that they are comparable tothose of the fiscal year 2010 period.

 

***Principles of Consolidation***

 

The unaudited interim condensed consolidated financial statementsinclude the accounts of the Company and all wholly owned and majority ownedsubsidiaries and controlled entities in accordance with ASC 810-10. Alladjustments considered necessary for a fair presentation of the results as ofthe date of, and for the interim periods presented, which consist solely ofnormal recurring adjustments, have been included. All significant inter-companybalances and transactions have been eliminated in consolidation. Theconsolidated unaudited results of operations for the current interim period arenot necessarily indicative of the results that may be expected for the fiscalyear ending September 30, 2010.

 

***Use of Estimates***

 

The preparation of financial statements in conformity with U.S. GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses, and the disclosure ofcontingent assets and liabilities at the dates, and for the periods, that theunaudited interim condensed consolidated financial statements are prepared.Actual results could materially differ from those estimates. Principal areasrequiring the use of estimates include third-party cost report settlements,receivables for medical services, allowances for contractual discounts anduncollectible accounts, accruals for medical claims, impairment of goodwill, long-livedassets and intangible assets, valuation of interest rate swaps, share-basedpayments, professional and general liability claims and workers’ compensationclaims, reserves for the outcome of litigation, and valuation allowances fordeferred tax assets.

 

***SubsequentEvents***

 

The Company’s unauditedinterim condensed consolidated financial statements are considered issued whenfiled with the SEC.  Accordingly, theCompany has evaluated subsequent events up to the filing date of this Form 10-Qwith the SEC (see Note 14).

 

***RestrictedCash***

 

At March 31, 2010, restricted cash was established at Brotmanpursuant to Brotman’s Amended Plan of Reorganization, consisting primarily ofcontingency reserves, totaling $2,107,000 held in escrow for property taxes,maintenance and emergency room construction required under the JHA loanagreement (see Note 6). Additionally, $233,000 was held in a restrictedaccount pursuant to workers compensation arrangements.

 

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***Restricted Investments***

 

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

 

***Dueto Governmental Payer and Third-Party Settlements***

 

Following theacquisition of Brotman, effective April 14, 2009, the Company consolidatedBrotman’s estimated liability to the Centers for Medicare and Medicaid Services(“CMS”) arising out of outlier payments received for services provided byBrotman to Medicare eligible inpatients, primarily for the last four months ofcalendar 2005 and all of calendar 2006.

 

While Brotman reportsfinancial statements on a fiscal year ending September 30, Medicare costreports are filed on a calendar year basis. Acute care hospitals receiveMedicare reimbursement payments pursuant to a prospective payment methodologyprimarily based on the diagnosis of the patient, but are entitled to receiveadditional payments, referred to as “outliers” for patients whose treatment isunusually costly. When Brotman acquired the hospital in 2005, CMS provided aratio of cost to charges (the “RCC”) based on the statewide average. Paymentson this basis were an interim estimate, subject to final determination uponauditing of the hospital’s cost reports. The Hospital filed its Medicare costreports, but determined that its outlier reimbursement for services provided infiscal years 2005 and 2006 might be subject to adjustment based on certainoutlier reconciliation rules. Brotman filed its cost reports for 2005 and 2006,which have been tentatively reviewed by the fiscal intermediary. The Companybelieves that CMS has not conducted any outlier reconciliations under currentregulations, has not formally notified the hospital of any pendingreconciliation to be conducted regarding their cost reports and has notdetermined the amount of any liability at this point related to possibleoverpayments. As of March 31, 2010 and September 30, 2009, anestimated liability of $13,834,000 was included in the accompanying unauditedinterim condensed consolidated balance sheet related to this matter. Brotmanand Alta have also accrued estimated third-party settlement net receivables inthe amount of $404,000 for filed cost reporting years and estimates for the sixmonths ended March 31, 2010.  At September 30,2009, estimated net receivables for cost reports not yet finalized wereapproximately $1,575,000. Normal estimation differences between final settlements and amountsaccrued in previous years are reflected in net patient service revenue in theyear of final settlement, which amounts totaled approximately $525,000 in eachof the three-month and six-month periods ended March 31, 2009, and none ineach of the three-month and six-month periods ended March 31, 2010.

 

***Revenues***

 

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

 
| ** **                            | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|---------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2010**                               | ** ** | **2009 (1)**                         | ** ** | **2010** | ** ** | **2009 (1)** | ** ** |
| Net  Hospital Services                |       |                                   |       |                                 |       |   |   |   |   |
| Inpatient                             |       | $                                      | 59,645     |                                 | $          | 35,561 |   | $ | 120,970 |   | $ | 68,800 |   |
| Outpatient                            |       | 8,929                                  |       | 1,941                                |       | 16,854 |   | 3,663 |   |
| Other                                 |       | 1,964                                  |       | 406                                  |       | 2,126 |   | 767 |   |
| Total  net Hospital Services revenues |       | $                                      | 70,538     |                                 | $          | 37,908 |   | $ | 139,950 |   | $ | 73,230 |   |
| Medical  Group                        |       |                                   |       |                                 |       |   |   |   |   |
| Capitation                            |       | $                                      | 45,933     |                                 | $          | 47,874 |   | $ | 92,381 |   | $ | 95,636 |   |
| Management  fees                      |       | 158                                    |       | 144                                  |       | 312 |   | 288 |   |
| Other                                 |       | 33                                     |       | 141                                  |       | 115 |   | 366 |   |
| Total  Medical Group revenues         |       | $                                      | 46,124     |                                 | $          | 48,159 |   | $ | 92,808 |   | $ | 96,290 |   |
| Total  revenues                       |       | $                                      | 116,662    |                                 | $          | 86,067 |   | $ | 232,758 |   | $ | 169,520 |   |

 

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(1)      Brotman revenues have beenincluded in the accompanying unaudited interim condensed consolidated financialstatements effective April 14, 2009, when the Company acquired a majoritystake in Brotman.  Accordingly, the threemonths and six months ended March 31, 2010 include the operations of Brotman.

 

The Company presents segment information externally the same waymanagement uses financial data internally to make operating decisions andassess performance.  The Company’soperations are organized into three reporting segments: (i) HospitalServices, (ii) Medical Group, and (iii) Corporate (see Note 8).

 

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***Comprehensive Income (Loss)***

 

Comprehensive income (loss) includes net income (loss) attributable toProspect Medical Holdings, Inc., net of taxes, and changes in the fairvalue of interest rate swaps subject to hedge accounting that are recorded asother comprehensive income. As of April 1, 2008, the swaps ceased to beeligible for hedge accounting under ASC 815. As a result, all further changesin fair value of the swaps were recorded in the consolidated statements ofoperations and the effective portion of the swaps of approximately$5.4 million, after tax, that was recorded in other comprehensive incomethrough March 31, 2008 continued to be amortized to interest expense,using the effective interest method, over the remaining life of the swaps. Theremaining unamortized portion of the interest rate swaps was expensed in July 2009in connection with the Company’s termination of such swaps.

 

***Reclassification***

 

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

 

**3. Equity-Based Compensation Plans**

 

On August 13, 2008, following stockholder approval, the Companyadopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provideflexibility in implementing equity awards, including incentive stock options (“ISO”),non-qualified stock options (“NQSO”), restricted stock grants, stockappreciation rights (“SAR”) and performance based awards to employees,directors and outside consultants, as determined by the Compensation Committeeof the Board of Directors (the “Committee”). In conjunction with the adoptionof the 2008 Plan, effective August 13, 2008, additional equity awardsunder the Company’s 1998 Stock Option Plan (“1998 Plan”) have been discontinuedand new equity awards are now granted under the 2008 Plan. Remaining authorizedshares under the 1998 Plan that were not subject to outstanding awards as of August 13,2008, were canceled on August 13, 2008. The 1998 Plan will remain ineffect as to outstanding equity awards granted under the 1998 Plan prior to August 13,2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved forissuance under the 2008 Plan. As of March 31, 2010, there were 805,250shares available for future grants under the 2008 Plan.

 

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

 

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

 

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***Stock Options Activity***

 

The following table summarizes information about our stock optionsoutstanding at March 31, 2010 and activity during the six-month periodthen ended:

 
| ** **                                       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (Months)** | ** ** |
|--------------------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------|------------|---------------------------------------------------------------|------------|
| Outstanding as of September 30, 2009        |       | 4,333,335  |       | $                                      | 3.00       |                            |       |                                                          |       |   |
| Granted                                          |       | 420,000    |       | $                                      | 4.40       |                            |       |                                                          |       |   |
| Exercised                                        |       | 59,148     |       | $                                      | 2.58       |                            | $          | 170,000                                                       |       |   |   |
| Forfeited                                        |       | 10,000     |       | $                                      | 2.30       |                            |       |                                                          |       |   |
| Expired                                          |       | 58,420     |       | $                                      | 6.44       |                            |       |                                                          |       |   |
| Outstanding as of March 31, 2010            |       | 4,625,767  |       | $                                      | 3.09       |                            | $          | 16,935,000                                                    |       | 42 |   |
| Vested and exercisable as of March 31, 2010 |       | 3,555,763  |       | $                                      | 3.02       |                            | $          | 13,259,000                                                    |       | 41 |   |

 

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

 

***Stock-Based Compensation Expense***

 

Under ASC 718, compensation cost for all share-based payments inexchange for employee services (including stock options and restricted stock)is measured at fair value on the date of grant, estimated using an optionpricing model.

 

Compensation costs for stock-based awards are measured and recognizedin the financial statements, net of estimated forfeitures over the awardsrequisite service period. The Company uses the Black-Scholes option pricingmodel and a single option award approach to estimate the fair value of optionsgranted. Estimated forfeitures will be revised in future periods if actualforfeitures differ from the estimates and will impact compensation cost in theperiod in which the change in estimate occurs. The determination of fair valueusing the Black-Scholes option-pricing model is affected by the Company’s stockprice as well as assumptions regarding a number of complex and subjectivevariables, including expected stock price volatility, risk-free interest rate,expected dividends and projected employee stock option exercise behaviors.Equity-based compensation is classified within the same line items as cashcompensation paid to employees. Cash retained as a result of excess taxbenefits relating to share-based payments are presented in the statement ofcash flows as a financing cash inflow.

 

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

 
| ** **                                                                             | ** ** | **Six Months Ended  March 31, 2010** | ** **  |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| Weighted average fair value of option grants                                           |       | $                                         | 1.67        |   |
| Weighted average market price of the Company’s  common stock on the date of grant |       | $                                         | 4.40        |   |
| Weighted average expected life of the options                                          |       | 3.07                                      |  years |
| Risk-free interest rate                                                                |       | 1.38                                      | %           |
| Weighted average expected volatility                                                   |       | 54.49                                     | %           |
| Dividend yield                                                                         |       | 0.00                                      | %           |

 

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

 

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

 

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

 

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

 

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

 

During the six monthsended March 31, 2010, an aggregate of 420,000 options were issued underthe 2008 Plan, of which 220,000 were granted to Samuel S. Lee in connectionwith his employment as the Chief Executive Officer of the Company and 200,000were granted to Mike Heather in connection with his employment as ChiefFinancial Officer of the Company. As of March 31, 2010, all of the sharesgranted to the Chief Executive Officer had vested and one-third of sharesgranted to the Chief Financial Officer had vested.

 

Stock-based compensation expense for stock options recognized in thethree months ended March 31, 2010 and 2009 was approximately $336,000 and $248,000,respectively, and in the six months ended March 31, 2010 and 2009, wasapproximately $856,000 and $502,000, respectively. At March 31, 2010,there were 1,070,004 unvested options with related compensation expense ofapproximately $757,000 which will be recognized ratably over a weighted averageremaining vesting period of 47 months.

 

***Restricted Stock Award Activities***

 

On August 15, 2008, the Company granted 200,000 shares ofrestricted stock to its Chief Financial Officer with a grant date fair value of$2.40 per share. As of March 31, 2010, all such shares had fully vested.On December 18, 2009, the Company granted an aggregate of 210,000 sharesof restricted stock to its Chief Executive Officer and Chief Financial Officer.As of March 31, 2010, all of the shares granted to the Chief ExecutiveOfficer had vested and one-third of the shares granted to the Chief FinancialOfficer had vested.  Compensation expenserelating to restricted stock recorded in the three months ended March 31,2010 and 2009 was approximately $212,000 and $40,000, respectively and in the sixmonths ended March 31, 2010 and 2009, was approximately $722,000 and $80,000,respectively.

 

On November 12, 2009, the Companygranted an aggregate of 36,000 shares of restricted stocks to the outsidemembers of the Board of Directors. The expense relating to these shares, whichvested immediately, totaling approximately $144,000, was included in generaland administrative expenses in the accompanying unaudited interim condensedconsolidated financial statements during the six months ended March 31,2010.

 

**4. Earnings per Share**

 

The Company calculates basic net income per share by dividing netincome attributable to common stockholders by the weighted average number ofcommon shares outstanding. Diluted earnings per share is computed by dividingnet income attributable to common stockholders by the weighted average numberof common shares outstanding, after giving effect to potentially dilutiveshares computed using the treasury stock method. Such shares are excluded ifdetermined to be anti-dilutive.

 

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The calculations of basic and diluted net income attributable toProspect Medical Holdings, Inc. per share for the three months and sixmonths ended March 31, 2010 and 2009 are as follows (in thousands, exceptshare and per-share amounts):

 
| ** **                                                       | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                       | ** ** | **2010**                               | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net  income attributable to Prospect Medical Holdings, Inc. |       | $                                      | 2,587      |                                 | $          | 3,548 |   | $ | 5,447 |   | $ | 104 |   |
| Weighted  average common shares outstanding - basic              |       | 20,801,794                             |       | 20,508,444                           |       | 20,726,844 |   | 20,508,444 |   |
| Dilutive  effect of stock options and warrants                   |       | 1,933,685                              |       | 170,803                              |       | 1,549,569 |   | 173,078 |   |
| Weighted  average commonshares outstanding - diluted             |       | 22,735,479                             |       | 20,679,247                           |       | 22,276,413 |   | 20,681,522 |   |
|                                                             |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                                            |       | $                                      | 0.12       |                                 | $          | 0.17 |   | $ | 0.26 |   | $ | 0.01 |   |
| Diluted                                                          |       | $                                      | 0.11       |                                 | $          | 0.17 |   | $ | 0.24 |   | $ | 0.01 |   |

 

The Companyexcludes equity instruments from the calculation of diluted earnings per shareif the effect of including such instruments is antidilutive. Accordingly, acertain number of stock options and warrants have been excluded from thecalculation of diluted earnings per share totaling 965,874 shares, during thesix months ended March 31, 2010 and none during the three months ended March 31,2010, and totaling 4,452,957 and 475,774 shares, respectively, during the threemonths and six months ended March 31, 2009.

 

**5. Related Party Transactions**

 

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

 

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

 

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

 

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On August 1, 2005 and subsequently amended on October 25,2007, Prospect Medical Management, Inc. (now known as Prospect HospitalAdvisory Services, Inc. (“PHAS”)), an affiliate of the Company, enteredinto a consulting services agreement, to provide administrative, financial andmanagement consulting services to Brotman for a monthly fee of $100,000 plusexpenses. The agreement had an initial term of one year and automaticallyrenewed for additional one-year terms unless terminated by either party with90 days written notice. As discussed in Note 7, Brotman, which fileda voluntary petition for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code on October 25, 2007, emerged from the Chapter 11bankruptcy proceeding on April 14, 2009 (the “Effective Date”). On theEffective Date, the Company increased its approximately 33.1% ownership stakein Brotman, to approximately 71.9% via an incremental investment ofapproximately $2.5 million. For the three months and six months ended March 31,2009, total fees earned and paid under the consulting services agreement wereapproximately $300,000 and $600,000, respectively. Beginning April 14,2009, amounts earned under the agreement have been eliminated in consolidation.

 

On December 15, 2009, Brotman initiated arights offering (“Rights Offering”), whereby existing shareholders of theCompany could subscribe to purchase up to $5,500,000 of Brotman convertible subordinatedpromissory notes (the “Brotman Notes”). The Rights Offering deadline was originally December 30, 2009, butextended to January 7, 2010.  TheBrotman Notes will be due three years from the date of issuance, will bear 15%per annum, and will be convertible at the option of the holder into shares ofBrotman at $3.34 per share.  PHASexercised its right to purchase a portion of its pro rata (approximately 72%)share of the Brotman Notes and, effective January 7, 2010, purchased$3,500,000 of such Brotman Notes. Additionally, PHAS planned on exercising its right to purchase anyBrotman Notes offered that were not purchased by other Brotman shareholders.Brotman intends to use the remainder of the Rights Offering to repayapproximately $2 million currently due to Prospect.

 

Asa result of the Rights Offering, Culver Hospital Holdings, a minorityshareholder of Brotman, filed a shareholder complaint against Prospect MedicalHoldings, PHAS, Brotman, and each of the Brotman Board of Directors.  Culver also plans to file a motion forpreliminary injunction seeking to (1) enjoin Prospect from acquiring Culver’sshare of convertible promissory notes, (2) enjoin Prospect from converting theBrotman Notes into shares of Brotman common stock, (3) enjoin Prospect fromconverting Brotman’s debt owed to Prospect into shares of Brotman common stock,and (4) enjoin Prospect from using the proceeds of the Rights Offering to repaydebt Brotman owes to Prospect. The case is currently being litigated.

 

EffectiveDecember 15, 2009, the Board of Directors of Brotman authorized certaindesignated officers to enter into an amendment to the consulting servicesagreement between Brotman and PHAS (“Amended and Restated Consulting ServicesAgreement”).  The Amended and RestatedConsulting Services Agreement, which was executed on February 1, 2010,states *inter alia*, that commencing as of April 14,2009 and retroactive to such date, PHAS shall be entitled to receive a monthlyfee of 4.5% of Brotman’s net operating revenue. To the extent Brotman does not have sufficient cash to make such cashpayment, or otherwise restricted by agreements applicable to Brotman or PHAS,then PHAS shall be entitled to receive shares of common stock of Brotman.  All amounts under this agreement areeliminated upon consolidation.

 

PMG, an affiliated physician organization of the Company, entered intoa risk pool sharing agreement, dated May 1, 2005, with Brotman. Under theagreement, PMG and Brotman agreed to establish a Hospital Control Program (asdefined) to serve HMO enrollees and earn incentive revenue or incur penaltiesby sharing in the risk for hospitalization based on inpatient servicesutilized. Risk pools are generally settled in the following year. For the threemonths and six months ended March 31, 2009, all incentive revenue earnedunder the agreement was compromised pursuant to Brotman’s Chapter 11 Planof Reorganization. Beginning April 14, 2009, all amounts earned under theagreement are eliminated in consolidation.

 

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

 

On August 31, 2005, PMG, entered into a joint marketing agreementwith Brotman. The agreement is for an initial term of 20 years, renewablefor successive five-year terms unless terminated by either party with180 days written notice. During the term, Brotman will contractexclusively with PMG with regard to full risk contracting with HMOs for alllines of business, including Medicare, Medicaid and commercial enrollees.Brotman will not merge into, consolidate with, or sell substantially all of itsassets (unless the purchaser or surviving entity expressly assumes thesemanaged care exclusivity arrangements), alter such agreements without theconsent of PMG, and agrees to be bound by the exclusivity provision.

 

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

 

**6. Long-Term Debt**

 

Long-term debt consists of the following at March 31, 2010 and September 30,2009, respectively (in thousands):

 
| ** **                                 | ** ** | **March 31,********2010** | ** ** | **September 30,********2009** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| **Prospect’s debt:**                  |       |                           |       |                               |       |
| Senior secured notes                       |       | $                              | 160,000    |                               | $          | 160,000 |   |
| Less original issue discount               |       | (11,125                        | )          | (11,980                            | )          |
|                                       |       | 148,875                        |       | 148,020                            |       |
| **Brotman’s debt:**                   |       |                           |       |                               |       |
| Revolving credit facility                  |       | 4,430                          |       | 2,888                              |       |
| Term loan-A (net of discount)              |       | 15,655                         |       | 15,655                             |       |
| Term loan-B                                |       | 6,250                          |       | 6,250                              |       |
| Promissory Note—Creditors’ Trust |       | 3,000                          |       | 3,531                              |       |
|                                       |       | 29,335                         |       | 28,324                             |       |
| Less current maturities                    |       | (5,429                         | )          | (3,805                             | )          |
| Long-term portion                          |       | $                              | 172,781    |                               | $          | 172,539 |   |

 

**Prospect’s Debt**

 

***Senior Secured Notes***

 

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

 

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

 

The terms of the Notes are governed by an indenture among the Company,certain of its subsidiaries and affiliates (as guarantors), and U.S. BankNational Association (as trustee) (the “Indenture”). Interest is payablesemi-annually in arrears on January 15 and July 15, the first paymentof which was made on January 15, 2010. The terms of the revolving seniorsecured credit facility are governed by the Credit Agreement, dated as of July 29,2009, among the Company, Royal Bank of Canada (as administrative agent),Jefferies Finance LLC (as syndication agent) and the lenders party thereto(the “Credit Agreement”).

 

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

 

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The Indenture requires the Company to make an offer to repurchase theNotes at 101% of their principal amount in the event of a change of control ofthe Company and at 100% of the principal amount thereof with certain proceedsof sales of assets. The Indenture also contains certain covenants that, amongother things, limit the Company’s ability, and the ability of its restrictedsubsidiaries to: pay dividends or distributions on capital stock or equityinterests, prepay subordinated indebtedness or make other restricted payments;incur additional debt; make investments; create liens on assets; enter intotransactions with affiliates; engage in other businesses; sell or issue capitalstock of restricted subsidiaries; merge or consolidate with another company;transfer and sell assets; create dividend and other payment restrictionsaffecting subsidiaries; and designate restricted and unrestricted subsidiaries.The Credit Agreement contains a number of customary covenants as well ascovenants requiring the Company to maintain a maximum consolidated leverageratio, minimum fixed charge coverage ratio and a maximum consolidated totalleverage ratio. As of March 31, 2010, the Company was in compliance withthe financial covenants.

 

Pursuant to its definitive Prospectus filed with the SEC on September 26,2009, the Company commenced an offer to exchange (the “Exchange Offer”) up to$160 million of its newly registered 123/4% Senior Secured Notes, Series B,due 2014 (the “Exchange Notes” and together with the Original Notes, the “Notes”)for an equal amount of the Notes issued on July 29, 2009 (the “OriginalNotes”). The Exchange Notes are substantially identical to the Original Notes,except that the offer and sale of the Exchange Notes have been registered underthe Securities Act of 1933, as amended, and the Exchange Notes do not bear anylegend restricting their transfer. The Exchange Offer was extended on November 25,2009 until December 3, 2009, at which time $159 million of the$160 million aggregate principal amount of private notes had been tenderedand accepted for exchange. The Company filed the required Form S-4 underthe Registration Rights Agreement, on September 30, 2009 and wenteffective on October 23, 2009.

 

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

 

Effective July 23, 2009, the Company terminated the former masterswap agreement and the swap arrangements thereunder by payment, on July 29,2009, of $11.7 million to the swap counterparty in final settlement of allamounts owed under the swap arrangements. All related amounts included inaccumulated other comprehensive loss, including related deferred income taxes(of approximately $4.2 million) was recorded as interest expense and tothe tax provision, respectively, as of the effective date of the swapterminations.

 

**Brotman’s Debt**

 

The Brotman entity has debt under a Senior Secured Revolving CreditFacility, Secured Term Loans and Unsecured Promissory Note entered into inconjunction with effecting the Plan of Reorganization described in Note 7.The Company has not guaranteed any portion of Brotman’s debt or otherobligations. Given the Company’s majority ownership in Brotman, effective April 14,2009, all Brotman debt is included in the Company’s unaudited interim condensedconsolidated financial statements. The Company has no obligation and haslimited ability to fund Brotman’s operations post acquisition. Under the seniorsecured notes credit agreement, the Company is permitted to make additionalinvestments in Brotman in an aggregate amount not to exceed $10,000,000,provided that such investments can exceed $10,000,000 if the amounts are fundedsolely with the proceeds of Equity Interests of the Company (as defined).

 

***Senior Secured Revolving Credit Facility***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman obtained a commitment from Gemino HealthcareFinance, LLC (“Gemino”) for a three-year, $6.0 million (subsequentlyincreased to $7.0 million pursuant to an amendment described below), seniorcredit facility secured by Brotman’s accounts receivable. The facility expireson the earlier of April 14, 2012 and the Los Angeles Jewish Home for Aging(“JHA”) loan (see below) maturity date and bears interest at LIBOR plus 7% perannum (11.0% at March 31, 2010, given a LIBOR floor of 4%). Interest isincurred based on the greater of $2 million or the actual outstandingprincipal balance. The agreement also includes an unused line fee of 0.5% perannum and a collateral line fee, based on the average outstanding principalbalance, of 0.5% per annum. Loan fees associated with the Gemino loan totalingapproximately $120,000, were capitalized and have been included as deferredfinancing costs in the accompanying unaudited interim condensed consolidatedbalance sheet as of March 31, 2010, with the amount being amortized overthe term of the related debt using the effective interest method. The seniorcredit facility agreement contains customary covenants for facilities of thistype, including restrictions on the payment of dividends, change in ownershipand management, asset sales, incurrence of additional indebtedness,sale-leaseback transactions, and related party transactions. Brotman must alsocomply with certain financial covenants. Prior to the February 17, 2010amendment discussed below, Brotman was required to comply with a fixed chargecoverage ratio of not less than (i) 1.10:1.00 for the fiscal quarter endedJune 30, 2009, (ii) 1.15:1.00 originally for the fiscal quarter endedSeptember 30, 2009; and (iii) 1.20:1.00 for each fiscal quarterending thereafter. As of September 30, 2009, Brotman was not in compliancewith these financial covenants. 

 

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

 

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

 

On April 14, 2009, the effective date of the Plan ofReorganization, Brotman consummated the transactions contemplated in the JHAfinancing and the JHA loan documents. Under the terms of the JHA loanagreements, JHA agreed to provide Brotman with up to $22.25 million infinancing, consisting of two term loans: (i) a Term A loan of$16 million (the “Term A Loan”) with a 24-month term and (ii) a TermB loan of up to $6.25 million, with a term of 36 months (the “Term BLoan”). Subject to the notification requirements set forth in the loanagreements, the term of the Term A Loan can be extended up to 36 months.Interest on the Term A Loan is payable at 10% per annum for the first year ofthe loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10%per annum for the term of the loan. The Term A Loan and Term B Loan are securedby certain of Brotman’s personal property, and a mortgage on certain of Brotman’sreal property. The proceeds of the JHA loans were used to repay all existingsenior secured loans at Brotman as of April 14, 2009. Loan fees associatedwith the JHA loans totaling approximately $1,549,000, were capitalized and havebeen included as deferred financing costs in the accompanying unaudited interimcondensed consolidated balance sheet as of March 31, 2010, with thatamount being amortized over the term of the related debt using the effectiveinterest method.

 

With respect to the Term A Loan, JHA was granted the right (“Put Right”)to declare the unpaid loan amount, including remaining interest and any otheramounts due and payable under the loan agreements, immediately due and payableat any time after April 14, 2010 and prior to the date which istwenty-four months after the Closing Date, subject to JHA providing writtennotification to Brotman of its exercise of the Put Right at least 180 daysin advance.  Effective February 10,2010, JHA and Brotman entered into an amendment to the Term A Loan, whereby theearliest date on which JHA could provide notice of its exercise of the PutRight was extended from April 14, 2010 to October 14, 2010.  Based on such amendment, as of March 31,2010, the loan has been reflected as noncurrent in the accompanying unauditedinterim condensed consolidated balance sheet.

 

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

 

In accordance with relevant accounting pronouncements, the Term A Loan,which contains a real estate purchase option, is recorded at its present value,with any excess of the proceeds over that amount recorded as an option depositliability account. The present value of the loan is estimated using discountedcash flow analyses based on market rates obtained from independent thirdparties for similar type debt. Based on an estimated market interest rate of10.0%, the present value of the loan was estimated to be approximately $15,667,000at inception. The difference of $345,000 between the recorded present value andthe carrying value of the loan has been recorded as a discount against the loanand is being amortized to interest expense, using the effective interest ratemethod, over the term of the loan.

 

***Subordinated Promissory Note***

 

On April 14, 2009, the Effective Date of the Plan ofReorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, tobe held by the Creditor Trust (as defined in the Plan of Reorganization) forthe benefit of holders of allowed Class 4 claims (as defined in the Planof Reorganization) and paid pro rata to holders of allowed Class 4 claims.The Note bears interest at 7.50% per annum and is payable in sixteen equalquarterly installments of principal and accrued interest through February 15,2013. The Note contains a covenant which, so long as amounts remain outstandingunder the Note, restricts Brotman from paying Prospect Medical Holdings, Inc.in cash a consulting fee of more than $100,000 per month, as specified in theAmended and Restated Consulting Services Agreement (see Note 5).  As such, although the amount of theconsulting fee was increased to 4.5% of Brotman’s net operating revenueeffective April 14, 2009, the amount of such consulting fee actually paidin cash will remain at $100,000 per month until such time as permitted byapplicable agreement, or the Creditor Trust Note has been amended or repaid.

 

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**7. Acquisitions**

 

**Brotman Medical Center, Inc.**

 

On August 31, 2005, the Company invested $1 million for anapproximately 33.1% stake in Brotman, a 420-bed licensed and accredited acutecare hospital, located in Culver City, California, with the intention ofoffering joint contracting to HMOs operating in Brotman’s service area. Brotmanincurred significant losses before and after the Company’s initial investmentand, on October 25, 2007 (the “Petition Date”), Brotman filed forbankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.Effective April 22, 2008, Samuel S. Lee (Prospect’s CEO and Chairman ofthe Board) was appointed Chairman of the Board of Directors of Brotman. On April 14,2009 (The “Effective Date”), the U.S. Bankruptcy Court confirmed and declaredeffective the final Chapter 11 Plan of Reorganization (the “Plan ofReorganization”) of Brotman whereby, among other things, all of Brotman’soutstanding securities were canceled and, in exchange for their pro rata shareof the New Value Contribution (as defined in the Plan of Reorganization)totaling $3,500,000, holders of Brotman’s existing securities would receive NewCommon Stock in Brotman in the same percentage as their pro rata share of theNew Value Contribution. Pursuant to the terms of the Plan, the Company madeadditional cash investments in Brotman, totaling $2,519,000, thereby acquiringan additional 38.86% ownership interest, which brought its total ownershipinterest to 71.96%.

 

Forfinancial accounting purposes, the additional investment in Brotman wasreferred to as the “Brotman Acquisition” and in accordance with Statement ofFinancial Accounting Standards (“SFAS No. 141”), “*Business Combinations*,” the business combination,which was achieved in stages, provides for recognition of assets at currentfair value with respect to the proportion of the Company’s incrementalownership interest in Brotman. Under SFAS No. 141, the aggregate cost ofthe acquired assets, which includes cash paid of $2.5 million and expensesincurred in connection with the acquisition totaling $37,000, were allocated tothe assets acquired and liabilities assumed. SFAS No. 141 ispre-Codification literature, the provisions of ASC 805 were not effectivefor the Company until October 1, 2009. The excess of the considerationover the estimated fair value of the assets and liabilities assumed has beenallocated to goodwill and an identifiable intangible asset. Due to negative netbook value of assets acquired, goodwill attributable to the noncontrolling(formerly minority) interest was not recognized. As the noncontrolling interestin Brotman exceeds 20%, the accounting basis in the acquired ownership inBrotman have not been pushed-down to the financial statements of Brotman andhave been reflected in the Parent Company financial statements. The results ofoperations of Brotman have been included in the consolidated financialstatements since the April 14, 2009 acquisition date. Brotman’s operationsfor the three months and six months ended March 31, 2010 reflected a netloss. The Company does not have the intent or ability, including under theterms of its debt agreement, to provide significant financial support toBrotman. Prior to October 1, 2009, a pro rata share of net incomeattributable to minority interest was not included under minority interest inthe Company’s consolidated statement of operations, as the cumulative minorityshare of such income did not exceed their cumulative share of prior lossesabsorbed by the Company. Effective October 1, 2009, with the adoption dateof new accounting literature (see Note 11), a pro rata share of net lossattributable to noncontrolling interest was reported as a component of equityseparate from the Company’s equity in the unaudited interim condensedconsolidated balance sheet and as net loss attributable to noncontrollinginterest in the unaudited interim condensed consolidated statement ofoperations.

 

OnDecember 15, 2009, Brotman initiated a rights offering (“Rights Offering”),whereby existing shareholders of Brotman could subscribe to purchase up to$5,500,000 of Brotman convertible subordinated promissory notes (the “BrotmanNotes”). The Rights Offering deadline was originally December 30, 2009,but extended to January 7, 2010. The Brotman Notes are due three yearsfrom the date of issuance, bear interest at 15% per annum and are convertibleat the option of the holder into shares of Brotman, at $3.34 per share. PHASexercised its right to purchase a portion of its pro rata (approximately 72%)share of the Brotman Notes and, effective January 7, 2010, purchased$3,500,000 of such Brotman Notes. Additionally, PHAS planned on exercising its right to purchase anyBrotman Notes offered that were not purchased by other Brotman shareholders.Brotman intends to use the remainder of the Rights Offering to repayapproximately $2 million currently due to Prospect.  As a result of the Rights Offering, CulverHospital Holdings, a minority shareholder of Brotman, filed a shareholdercomplaint against Prospect Medical Holdings, PHAS, Brotman, and each of theBrotman Board of Directors.  Culver also plansto file a motion for preliminary injunction seeking to (1) enjoin Prospect fromacquiring Culver’s share of convertible promissory notes, (2) enjoin Prospectfrom converting the Brotman Notes into shares of Brotman common stock, (3)enjoin Prospect from converting Brotman’s debt owed to Prospect into shares ofBrotman common stock, and (4) enjoin Prospect from using the proceeds of theRights Offering to repay debt Brotman owes to Prospect.  The case is currently being litigated.

 

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

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

 

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

 

Goodwill from the Brotman Acquisition is primarily related to newcapacity for future growth, new geographic coverage, additional types ofhospital services and in-place workforce. Through the Brotman Acquisition, theCompany expanded into a new service market in the West Los Angeles, Californiaarea. As a stock purchase, the goodwill acquired in the Brotman Acquisition isnot deductible for income tax purposes. Brotman recorded income related todischarge of debt upon emergence from the Chapter 11 Bankruptcy reorganization.

 

The following unaudited pro forma financial information for thethree-month and six-month periods ended March 31, 2009 gives effect to theacquisition of Brotman as if it had occurred on October 1, 2008. Suchunaudited pro forma information is based on historical financial informationwith respect to the acquisition and does not include any synergies oroperational or other changes that might have been effected by the Company.Significant proforma adjustments include increased depreciation related to fixedassets acquired (in thousands).

 
| ** **                                             | ** ** | **Three Months Ended********March 31, 2009** | ** ** | **Six Months Ended********March 31, 2009** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | ** **                                        | ** ** | ** **                                      | ** ** |
| Net revenue                                            |       | $                                                 | 114,667    |                                            | $          | 226,080 |   |
| Net income (loss) attributable to common  stockholders |       | $                                                 | 3,240      |                                            | $          | (1,160 | ) |
| Net income (loss) per share:                           |       |                                              |       |                                            |       |
| Basic                                                  |       | $                                                 | 0.15       |                                            | $          | (0.06 | ) |
| Diluted                                                |       | $                                                 | 0.15       |                                            | $          | (0.06 | ) |

 

Since emergence from bankruptcy, Brotman has continued to incur lossesand experience liquidity issues. Management continues to implement operationalimprovements aimed at returning Brotman to profitability and is evaluatingfinancing requirements and alternatives. Prospect has limited ability to fundBrotman’s post acquisition operations (Note 6).

 

**8. SegmentInformation**

 

ASC 815 provides disclosure guidelines for segments of a company basedon a management approach to defining reporting segments.

 

The Company’s operations are organized into three reporting segments: (i) HospitalServices—which is comprised of Alta and Brotman reporting units, owns andoperates five hospitals—Los Angeles Community Hospital, Hollywood CommunityHospital, Norwalk Community Hospital, Van Nuys Community Hospital and BrotmanMedical Center; (ii) Medical Group—which is comprised of Prospect andProMed reporting units, provides management services to affiliated physicianorganizations that operate as independent physician associations; and (iii) Corporate.Corporate represents expenses incurred in Prospect Medical Holdings, Inc.(the “Parent Entity”), which were not allocated to the other reporting segments.

 

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

 

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

 

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

 
| ** **                                                     | ** ** | **As  of and for the Three Months Ended March 31, 2010** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                        | ** ** | **Medical  Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                             | 70,538     |   | $ | 46,124 |   | $ | — |   | $ | — |   | $ | 116,662 |   |
| Intersegment revenues                                          |       | —                                                        |       | 162 |   | — |   | (162 | ) | — |   |
| Total revenues                                                 |       | 70,538                                                        |       | 46,286 |   | — |   | (162 | ) | 116,662 |   |
| Operating income (loss)                                        |       | 11,863                                                        |       | 2,517 |   | (2,695 | ) | — |   | 11,685 |   |
| Investment income                                              |       | —                                                        |       | (26 | ) | (268 | ) | 268 |   | (26 | ) |
| Interest expense and amortization of deferred  financing costs |       | 1,262                                                         |       | 436 |   | 5,837 |   | (268 | ) | 7,267 |   |
| Income (loss) before income taxes                              |       | $                                                             | 10,601     |   | $ | 2,107 |   | $ | (8,264 | ) | $ | — |   | $ | 4,444 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                             | 268,040    |   | $ | 97,198 |   | $ | 16,415 |   | $ | (3,621 | ) | $ | 378,032 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                             | 849        |   | $ | 95 |   | $ | 6 |   | $ | — |   | $ | 950 |   |
| Segment goodwill                                               |       | $                                                             | 108,573    |   | $ | 44,677 |   | $ | — |   | $ | — |   | $ | 153,250 |   |

 
| ** **                                                     | ** ** | **As  of and for the Three Months Ended March 31, 2009** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                        | ** ** | **Medical  Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                             | 37,908     |   | $ | 48,159 |   | $ | — |   | $ | — |   | $ | 86,067 |   |
| Intersegment revenues                                          |       | —                                                        |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 37,908                                                        |       | 48,159 |   | — |   | — |   | 86,067 |   |
| Operating income (loss)                                        |       | 11,065                                                        |       | 3,435 |   | (2,854 | ) | — |   | 11,646 |   |
| Investment income                                              |       | —                                                        |       | (5 | ) | (15 | ) | — |   | (20 | ) |
| Interest expense and amortization of deferred financing  costs |       | 52                                                            |       | — |   | 6,524 |   | — |   | 6,576 |   |
| Loss on interest rate swap arrangements                        |       | —                                                        |       | — |   | (955 | ) | — |   | (955 | ) |
| Income (loss) before income taxes                              |       | $                                                             | 11,013     |   | $ | 3,440 |   | $ | (8,408 | ) | $ | — |   | $ | 6,045 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                             | 208,207    |   | $ | 161,715 |   | $ | (74,486 | ) | $ | — |   | $ | 295,436 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                             | 194        |   | $ | 21 |   | $ | — |   | $ | — |   | $ | 215 |   |
| Segment goodwill                                               |       | $                                                             | 22,339     |   | $ | 106,539 |   | $ | — |   | $ | — |   | $ | 128,878 |   |

 
| ** **                                                     | ** ** | **As  of and for the Six Months Ended March 31, 2010** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                      | ** ** | **Medical  Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                           | 139,950    |   | $ | 92,808 |   | $ | — |   | $ | — |   | $ | 232,758 |   |
| Intersegment revenues                                          |       | —                                                      |       | 240 |   | — |   | (240 | ) | — |   |
| Total revenues                                                 |       | 139,950                                                     |       | 93,048 |   | — |   | (240 | ) | 232,758 |   |
| Operating income (loss)                                        |       | 24,444                                                      |       | 5,266 |   | (6,198 | ) | — |   | 23,512 |   |
| Investment income                                              |       | —                                                      |       | (55 | ) | (374 | ) | 374 |   | (55 | ) |
| Interest expense and amortization of deferred financing  costs |       | 2,460                                                       |       | 435 |   | 11,635 |   | (374 | ) | 14,156 |   |
| Income (loss) before income taxes                              |       | $                                                           | 21,984     |   | $ | 4,886 |   | $ | (17,459 | ) | $ | — |   | $ | 9,411 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                           | 268,040    |   | $ | 97,198 |   | $ | 16,415 |   | $ | (3,621 | ) | $ | 378,032 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                           | 1,276      |   | $ | 95 |   | $ | 11 |   | $ | — |   | $ | 1,382 |   |
| Segment goodwill                                               |       | $                                                           | 108,573    |   | $ | 44,677 |   | $ | — |   | $ | — |   | $ | 153,250 |   |

 

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| ** **                                                     | ** ** | **As  of and for the Six Months Ended March 31, 2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Hospital  Services**                                      | ** ** | **Medical  Group** | ** ** | **Corporate** | ** ** | **Intersegment  Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues from external customers                               |       | $                                                           | 73,230     |   | $ | 96,290 |   | $ | — |   | $ | — |   | $ | 169,520 |   |
| Intersegment revenues                                          |       | —                                                      |       | — |   | — |   | — |   | — |   |
| Total revenues                                                 |       | 73,230                                                      |       | 96,290 |   | — |   | — |   | 169,520 |   |
| Operating income (loss)                                        |       | 20,182                                                      |       | 6,240 |   | (4,879 | ) | — |   | 21,543 |   |
| Investment income                                              |       | —                                                      |       | (31 | ) | (37 | ) | — |   | (68 | ) |
| Interest expense and amortization of deferred financing  costs |       | 93                                                          |       | — |   | 12,621 |   | — |   | 12,714 |   |
| Loss on interest rate swap arrangements                        |       | —                                                      |       | — |   | 8,713 |   | — |   | 8,713 |   |
| Income (loss) before income taxes                              |       | $                                                           | 20,089     |   | $ | 6,271 |   | $ | (26,176 | ) | $ | — |   | $ | 184 |   |
| Identifiable segment assets (liabilities)                      |       | $                                                           | 208,207    |   | $ | 161,715 |   | $ | (74,486 | ) | $ | — |   | $ | 295,436 |   |
| Segment capital expenditures, net of dispositions              |       | $                                                           | 375        |   | $ | 62 |   | $ | — |   | $ | — |   | $ | 437 |   |
| Segment goodwill                                               |       | $                                                           | 106,539    |   | $ | 22,339 |   | $ | — |   | $ | — |   | $ | 128,878 |   |

 

----

(1)                                  ProspectMedical Holdings, Inc. files consolidated tax returns and allocates costsfor shared services and corporate overhead to each of the reporting segments.With the exception of the Brotman Acquisition, all acquisition-related debt,including those related to the Medical Group and Hospital Services segment, isrecorded at the Parent entity level. As such, the Company does not allocateinterest expense, and gain or loss on interest rate swaps to each of thereporting segments.

 

(2)                               ProspectMedical Group (which serves as a holding company for the other affiliatedphysician organizations) files consolidated tax returns.

 

(3)                                  Certain prioryear amounts have been reclassified to conform to fiscal 2010 presentation.

 

(4)                                  Because Brotman amounts are includedonly after April 14, 2009, those amounts are not included for the threemonths and six months ended March 31, 2009. In connection with Brotman’sMedi-Cal contract renewal, effective May 6, 2010, Brotman was awarded$2,000,000 from the State of California Distressed Hospital Fund for Servicesrendered from July 1, 2009 to April 30, 2010. Brotman recognized $1,800,000 ofthis revenue during the three months ended March 31 2010.

 

**9. IncomeTaxes**

 

The Company recorded atax provision of approximately $1,944,000 and $4,447,000 for the three monthsand six months ended March 31, 2010, at effective tax rates of 43% and47%, respectively and a tax provision of approximately $2,496,000 and $76,000for the three months and six months ended March 31, 2009, at effective taxrates of 41% and 41%, respectively. The higher effective tax rate in the fiscal2010 period was primarily due to not recognizing the tax benefit from Brotman’sloss for federal tax purposes.

 

As part of the Brotman Acquisition, management ofthe Company adopted ASC 740-10, accounting for uncertain tax positions, forBrotman and determined that no material unrecognized tax benefits existed atthe date of acquisition and as of March 31, 2010.  Since its inception in 2005, Brotman hasgenerated, and still maintains substantial net operating loss carryfowardswhich are open for examination by taxing authorities.

 

**10. FairValue of Financial Investments**

 

Effective April 1, 2009, the Company adopted ASC 825-10. Thisliterature requires that the fair value of financial instruments be disclosedin the body or notes of an entity’s financial statements in both interim andannual periods. It also requires the disclosure of methods and assumptions usedto estimate fair values. It does not require comparative disclosures forperiods preceding adoption. The fair values of the Company’s current financialassets and liabilities approximate their reported carrying amounts. Thecarrying values and the fair values of non-current financial assets andliabilities, that qualify as financial instruments under ASC 825-10-50 were asfollows (in thousands).

 
| ** **                | ** ** | **At March 31, 2010** | ** ** |
|---------------------------|------------|----------------------------|------------|
| ** **                | ** ** | **Carrying  Amount**       | ** ** | **Fair Value** | ** ** |
| **Assets:**               |       |                       |       |   |   |
| Long-term note receivable |       | $                          | 329        |   | $ | 306 |   |
| **Liabilities:**          |       |                       |       |   |   |
| Long-term debt            |       | $                          | 172,781    |   | $ | 197,308 |   |

 

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The fair value of the notes receivable, which was received as part ofthe consideration for the sale of three medical clinics in April 2004, wasestimated based on expected future payments discounted at risk-adjusted rates.The fair value of the Company’s long-term debt was determined based on quotedmarket prices with respect to Prospect’s Notes and based on expected futurepayments discounted at risk-adjusted rates of 10.0% with respect to Brotman’sdebt.

 

The Company adopted ASC 820-10 for financial assets and liabilities on October 1,2008 and adopted the provisions for non-financial assets and liabilities on October 1,2009. ASC 820-10 defines fair value, establishes guidelines for measuring fairvalue and expands disclosure about fair value measurements.  It doesnot create or modify any current GAAP requirements to apply fair valueaccounting.  However, it provides a single definition for fair valuethat is to be applied consistently for all prior accountingpronouncements.  The adoption of this guidance did not have amaterial impact on the Company’s financial position or results of operations.  ASC 820-10 establishes a fair value hierarchythat prioritizes the inputs to valuation techniques used to measure fair value.The three levels of the fair value hierarchy under ASC 820-10 are describedbelow:

 

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

 

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

 

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

 

*FinancialItems Measured at Fair Value on a Recurring Basis*

 

Thefollowing table sets forth the Company’s financial assets and liabilitiesmeasured at fair value on a recurring basis and where they are classifiedwithin the hierarchy as of March 31, 2010 (in thousands):

 
| ** **                                                | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|-----------------------------------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
| **Restricted Assets:**                                    |       |      |       |             |       |             |       |             |       |
| Investments, primarily restricted certificates of deposit |       | $         | 634,000    |             | $          | 634,000          |       | $                | —     |   | $ | — |   |
|                                                           |            |           |            |                  |            |                  |            |                  |            |  |  |  |  |

 

TheCompany’s investments are classified within Level 1 of the fair valuehierarchy because they are valued using quoted market prices. The investmentinstruments that are valued based on quoted market prices in active markets areprimarily restricted certificates of deposit.

 

*NonfinancialItems Measured at Fair Value on a Nonrecurring Basis*

 

Nonfinancialassets such as goodwill and identifiable intangible assets are measured at fairvalue when there is an indicator of impairment and recorded at fair value onlywhen impairment is recognized. No impairment charges of goodwill and intangibleassets were recorded for the three months and six months ended March 31,2010. See Note 7 for additional information about goodwill and intangibleassets.

 

**11. Effect of Recent Accounting Pronouncements**

 

In December 2007,the FASB updated guidance on ASC 805. ASC 805 retains the fundamentalrequirements of guidance surrounding business combinations stating that theacquisition method of accounting be used for all business combinations and for anacquirer to be identified for each business combination. ASC 805 defines theacquirer as the entity that obtains control of one or more businesses in thebusiness combination and establishes the acquisition date as the date that theacquirer achieves control. ASC 805 requires an acquirer to recognize the assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree at the acquisition date, measured at their fair values as of thatdate, with limited exceptions specified in the statement. This statementapplies prospectively to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008. The Company adopted the pronouncementeffective October 1, 2009. The adoption did not have a material impact onthe Company’s condensed consolidated financial statements for prior periods;but the pronouncement will impact the accounting for any acquisitionssubsequent to that date.

 

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In June 2009,the FASB issued guidance on ASC 810-10, “*Consolidation of VariableInterest Entities, an interpretation of ARB No. 51,*” previouslyknown as FIN No. 46, to revise the approach to determine when a variableinterest entity (“VIE”) should be consolidated. The new consolidation model forVIEs considers whether the Company has the power to direct the activities thatmost significantly impact the VIE’s economic performance and shares in thesignificant risks and rewards of the entity. The guidance on VIE’s requirescompanies to continually reassess VIEs to determine if consolidation isappropriate and provide additional disclosures. The guidance is effective forfiscal years beginning after November 15, 2009. The Company will adopt theguidance for interim and annual reporting periods beginning in the firstquarter of fiscal 2011and is currently assessing the potential impact thisguidance will have on its consolidated financial statements.

 

In June 2008, theFASB issued guidance contained in FASB ASC 260-10, previously known as FASBStaff Position No. EITF 03-6-1. Under the guidance, unvested share-basedpayment awards that contain non-forfeitable rights to dividends or dividend equivalentsare participating securities and, therefore, are included in computing earningsper share (“EPS”) pursuant to the two-class method. The two-class methoddetermines earnings per share for each class of common stock and participatingsecurities according to dividends or dividend equivalents and their respectiveparticipation rights in undistributed earnings. The Company adopted theguidance effective October 1, 2009.  The adoption of thisguidance did not impact net income attributable to the Company per common sharefor prior periods and is not expected to have an impact on future periods untilsuch time as the Company declares a regular quarterly dividend.

 

In August 2009, the FASB issued AccountingStandards Update No. 2009-05, “*FairValue Measurements and Disclosures (Topic 820)—Measuring Liabilities at FairValue,”*which provides guidance on how to measure liabilities atfair value in circumstance in which a quoted price in an active market for theidentical liability is not available. This update is effective for the firstreporting period, including interim periods, beginning after issuance. TheCompany has no liabilities that are governed by this update but will apply itsprovisions in the future as applicable.

 

**12.Litigation and Contingencies**

 

The Company is in the process of finalizing certainpost-closing matters related to the 2007 ProMed acquisition, including closingbalance sheet reconciliations, escrow reconciliations and other matters. TheCompany has recorded estimated settlement accrual amounts relating to suchmatters in the accompanying unaudited condensed consolidated financialstatements.

 

Thecollective bargaining agreement entered into between Hollywood Community Hospital, which isone of the hospitals under the consolidated group of Alta HospitalsSystem, LLC, and Service EmployeesInternational Union, United Healthcare Workers-West (“SEIU”), covers asmall group of Hollywood Community Hospital’s employees and will expire on May 9, 2011. The collective bargaining agreements entered into between Brotman and theCalifornia Nurses Association (“CNA”) and Brotman and the SEIU both expired on February 28,2010. Both parties are currently engaged in good faith bargaining negotiationsand we currently do not anticipate that any changes reflected in any newagreements will have a material adverse effect on results of our HospitalServices operations in fiscal 2010.

 

Many of the Company’s payerand provider contracts are complex in nature and may be subject to differinginterpretations regarding amounts due for the provision of medical services.Such differing interpretations may not come to light until a substantial periodof time has passed following contract implementation. Liabilities for claimsdisputes are recorded when the loss is probable and can be estimated. Anyadjustments to reserves are reflected in current operations.

 

The Company is also subjectto a variety of claims and suits that arise from time to time in the ordinarycourse of its business, acquisition, or other transactions. While managementcurrently believes that resolving all of these matters, individually or inaggregate, will not have a material adverse impact on the Company’sconsolidated financial position or results of operations, the litigation andother claims that the Company faces are subject to inherent uncertainties andmanagement’s view of these matters may change in the future. Should anunfavorable final outcome occur, there exists the possibility of a materiallyadverse impact on the Company’s consolidated financial position, results ofoperations and cash flows for the period in which the effect becomes probableand reasonably estimable.

 

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The Company believes thatthe lines and amounts of insurance coverage that it, its subsidiaries, and ouraffiliated physician organizations maintain, and that it requires itscontracted physician providers to maintain, are customary in its industry andadequate for the risks insured. The Company cannot assure, however, that itwill not become subject to claims not covered or that exceed its insurancecoverage amounts.

 

Total actuarially determinedincurred but not reported claims and case reserves for estimated malpracticeliabilities at March 31, 2010 were $2,321,000. These estimates may changein the future, and such changes may be material.

 

Total actuarially determinedincurred but not reported claims and case reserves for estimated workers’compensation liabilities at March 31, 2010 were $2,915,000. Theseestimates are included in other accrued liabilities and may change in thefuture, and such changes may be material.

 

**13. Condensed consolidating financial statements ofProspect Medical Holdings, Inc. and subsidiaries as of March 31, 2010and September 30, 2009 and for the three months and six months ended March 31,2010**

 

On July 29, 2009, the Company closed the offering of$160 million in 12.75% senior secured notes due 2014 (the “Notes”) at anissue price of 92.335%, and entered into a three-year $15 millionrevolving credit facility which was undrawn at the closing. The Notes and therevolving senior credit facility are jointly and severally guaranteed on asenior secured basis by all of the Company’s restricted subsidiaries (the “Guarantors”),other than Brotman, Nuestra and certain immaterial subsidiaries. The Notes aresecured pari passu with the revolving credit facility on a first priority basisby liens on substantially all of the Company’s assets and assets of thesubsidiary guarantors (other than accounts receivable and proceeds therefrom)including all mortgages on the Company and its subsidiary guarantors’ hospitalproperties (but excluding a pledge of, or mortgage on, the stock, properties orother assets of Brotman, AMVI/Prospect Health Network and certain immaterialsubsidiaries). The lenders under the revolving credit facility have a firstpriority lien on certain of the accounts receivable of the Company and thesubsidiary guarantors and proceeds therefrom, while the holders of the Noteshave a second priority lien on such collateral (see Note 6).

 

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

 

Pursuant to Rule 3-10 of Regulation S-X, the followingsummarized consolidating information is provided for the Company (the “Parent”),the Guarantors, and the Company’s non-Guarantor subsidiaries with respect tothe Notes as of September 30, 2009 and as of and for the three months andsix months ended March 31, 2010. The Condensed Consolidating Statements of Operations and Cash Flows forthe three months and six months ended March 31, 2009 have not beenincluded, as the non-guarantor subsidiaries for the comparative period wereminor. This summarized financial information has been prepared from the booksand records maintained by the Company, the Guarantors and the non-Guarantorsubsidiaries. The summarized financial information may not necessarily beindicative of the results of operations or financial position had theGuarantors or non-Guarantor subsidiaries operated as independent entities. Inaddition, intercompany activities between subsidiaries and the Parent arepresented within operating activities on the unaudited condensed consolidatingstatement of cash flows.

 

Unaudited interim condensedconsolidating financial statements for the Company and its subsidiaries,including the Parent only, the combined Guarantor Subsidiaries and the combinedNon-Guarantor Subsidiaries are as follows:

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As of March31, 2010**

*(inthousands)*

* *

*(Unaudited)*

 
| ** **                                                             | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined  Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                             | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**            | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **ASSETS**                                                             |       |        |       |                    |       |                        |       |            |       |             |       |
| **Current assets:**                                                    |       |        |       |                    |       |                        |       |            |       |             |       |
| Cash and cash equivalents                                              |       | $           | (292       | )                       | $          | 40,855                      |       | $               | 329        |             | $          | — |   | $ | 40,892 |   |
| Restricted cash                                                        |       | —      |       | —                  |       | 2,340                       |       | —          |       | 2,340            |       |
| Investments, primarily restricted certificates of deposit              |       | —      |       | 634                     |       | —                      |       | —          |       | 634              |       |
| Patient accounts receivable, net                                       |       | —      |       | 21,227                  |       | 20,807                      |       | —          |       | 42,034           |       |
| Government program receivables                                         |       | —      |       | 300                     |       | 1,800                       |       | —          |       | 2,100            |       |
| Risk pool receivables                                                  |       | —      |       | 8                       |       | —                      |       | —          |       | 8                |       |
| Other receivables                                                      |       | —      |       | 1,779                   |       | —                      |       | —          |       | 1,779            |       |
| Third-party settlements                                                |       | —      |       | (180                    | )          | 584                         |       | —          |       | 404              |       |
| Notes receivable, current portion                                      |       | —      |       | 57                      |       | —                      |       | —          |       | 57               |       |
| Refundable income taxes, net                                           |       | 1,557       |       | 355                     |       | —                      |       | —          |       | 1,912            |       |
| Deferred income taxes, net                                             |       | 4,323       |       | 2,243                   |       | —                      |       | —          |       | 6,566            |       |
| Inventories                                                            |       | —      |       | 1,528                   |       | 2,642                       |       | —          |       | 4,170            |       |
| Prepaid expenses and other current assets                              |       | 815         |       | 3,016                   |       | 2,134                       |       | —          |       | 5,965            |       |
| Intercompany accounts                                                  |       | 66,018      |       | (89,652                 | )          | 23,552                      |       | 82              |       | —           |       |
| **Total current assets**                                               |       | 72,421      |       | (17,830                 | )          | 54,188                      |       | 82              |       | 108,861          |       |
| **Property, improvements and equipment:**                              |       |        |       |                    |       |                        |       |            |       |             |       |
| Land and land improvements                                             |       | —      |       | 27,604                  |       | 3,424                       |       | —          |       | 31,028           |       |
| Buildings                                                              |       | —      |       | 22,947                  |       | 1,323                       |       | —          |       | 24,270           |       |
| Leasehold improvements                                                 |       | 5           |       | 1,998                   |       | 34                          |       | —          |       | 2,037            |       |
| Equipment                                                              |       | 142         |       | 13,514                  |       | 7,797                       |       | —          |       | 21,453           |       |
| Furniture and fixtures                                                 |       | 21          |       | 871                     |       | —                      |       | —          |       | 892              |       |
|                                                                   |       | 168         |       | 66,934                  |       | 12,578                      |       | —          |       | 79,680           |       |
| Less accumulated depreciation and amortization                         |       | (146        | )          | (11,855                 | )          | (3,898                      | )          | —          |       | (15,899          | )          |
| **Total property, improvements and equipment, net**                    |       | 22          |       | 55,079                  |       | 8,680                       |       | —          |       | 63,781           |       |
| Notes receivable, less current portion                                 |       | 3,621       |       | 329                     |       | —                      |       | (3,621          | )          | 329              |       |
| Deposits and other assets                                              |       | 6           |       | 262                     |       | —                      |       | —          |       | 268              |       |
| Deferred financing costs, net                                          |       | 6,361       |       | —                  |       | 957                         |       | —          |       | 7,318            |       |
| Goodwill                                                               |       | —      |       | 153,250                 |       | —                      |       | —          |       | 153,250          |       |
| Other intangible assets, net                                           |       | —      |       | 44,225                  |       | —                      |       | —          |       | 44,225           |       |
| **Total assets**                                                       | ** ** | **$**       | 82,431     |                    | $          | 235,315                     |       | $               | 63,825     |             | $          | (3,539 | ) | $ | 378,032 |   |
| **LIABILITIES AND SHAREHOLDERS' EQUITY**                               |       |        |       |                    |       |                        |       |            |       |             |       |
| **Current liabilities:**                                               |       |        |       |                    |       |                        |       |            |       |             |       |
| Accrued medical claims and other health care costs payable             |       | $           | —     |                    | $          | 14,655                      |       | $               | 338        |             | $          | — |   | $ | 14,993 |   |
| Accounts payable and other accrued liabilities                         |       | 6,747       |       | 12,750                  |       | 12,349                      |       | —          |       | 31,846           |       |
| Accrued salaries, wages and benefits                                   |       | 2,488       |       | 12,071                  |       | 6,658                       |       | —          |       | 21,217           |       |
| Due to government payer                                                |       | —      |       | —                  |       | 13,834                      |       | —          |       | 13,834           |       |
| Income taxes payable, net                                              |       | (1,399      | )          | 1,456                   |       | (57                         | )          | —          |       | —           |       |
| Current portion of capital leases                                      |       | —      |       | 358                     |       | 509                         |       | —          |       | 867              |       |
| Current portion of long-term debt                                      |       | —      |       | —                  |       | 5,429                       |       | —          |       | 5,429            |       |
| Other current liabilities                                              |       | 28          |       | 654                     |       | —                      |       | —          |       | 682              |       |
| **Total current liabilities**                                          |       | 7,864       |       | 41,944                  |       | 39,060                      |       | —          |       | 88,868           |       |
| Long-term debt, net of current portion                                 |       | 148,875     |       | —                  |       | 27,527                      |       | (3,621          | )          | 172,781          |       |
| Deferred income taxes                                                  |       | 8,911       |       | 20,986                  |       | —                      |       | —          |       | 29,897           |       |
| Malpractice reserve                                                    |       | —      |       | 849                     |       | 1,472                       |       | —          |       | 2,321            |       |
| Capital leases, net of current portion                                 |       | —      |       | 653                     |       | 62                          |       | —          |       | 715              |       |
| Other long-term liabilities                                            |       | 44          |       | 89                      |       | —                      |       | —          |       | 133              |       |
| **Total liabilities**                                                  |       | 165,694     |       | 64,521                  |       | 68,121                      |       | (3,621          | )          | 294,715          |       |
| **Shareholders' equity (deficit):**                                    |       |        |       |                    |       |                        |       |            |       |             |       |
| Prospect Medical Holdings, Inc.'s shareholders' equity                 |       |        |       |                    |       |                        |       |            |       |             |       |
| Common stock                                                           |       | 209         |       | (53                     | )          | (114                        | )          | 167             |       | 209              |       |
| Additional paid-in capital                                             |       | 96,104      |       | 256                     |       | —                      |       | —          |       | 96,360           |       |
| Accumulated deficit                                                    |       | (179,576    | )          | 170,591                 |       | (4,182                      | )          | 310             |       | (12,857          | )          |
| Total Prospect Medical Holdings, Inc.'s shareholders' equity (deficit) |       | (83,263     | )          | 170,794                 |       | (4,296                      | )          | 477             |       | 83,712           |       |
| Noncontrolling interest                                                |       | —      |       | —                  |       | —                      |       | (395            | )          | (395             | )          |
| **Total shareholders' equity (deficit)**                               |       | (83,263     | )          | 170,794                 |       | (4,296                      | )          | 82              |       | 83,317           |       |
| **Total liabilities and shareholders' equity**                         |       | $           | 82,431     |                    | $          | 235,315                     |       | $               | 63,825     |             | $          | (3,539 | ) | $ | 378,032 |   |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**As of September 30,2009**

*(inthousands)*

 
| ** **                                                                             | ** ** | **Parent  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined Non-  Guarantor  Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------|------------|
| **ASSETS**                                                                             |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Current assets:                                                                        |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Cash and cash equivalents                                                              |       | $                   | (514       | )                                     | $          | 36,995                                     |       | $               | 1,287      |             | $          | — |   | $ | 37,768 |   |
| Restricted cash                                                                        |       | —              |       | —                                |       | 1,395                                      |       | —          |       | 1,395            |       |
| Investments, primarily  restricted certificates of deposit                             |       | —              |       | 665                                   |       | —                                     |       | —          |       | 665              |       |
| Patient accounts  receivable, net                                                      |       | —              |       | 19,543                                |       | 17,263                                     |       | —          |       | 36,806           |       |
| Government program  receivables                                                        |       | —              |       | 4,852                                 |       | —                                     |       | —          |       | 4,852            |       |
| Other receivables                                                                      |       | 8                   |       | 1,647                                 |       | —                                     |       | —          |       | 1,655            |       |
| Third-party settlements                                                                |       | —              |       | 790                                   |       | 785                                        |       | —          |       | 1,575            |       |
| Notes receivable, current  portion                                                     |       | —              |       | 56                                    |       | —                                     |       | —          |       | 56               |       |
| Refundable income taxes,  net                                                          |       | 1,545               |       | 13                                    |       | —                                     |       | —          |       | 1,558            |       |
| Deferred income taxes,  net                                                            |       | 4,323               |       | 2,321                                 |       | —                                     |       | —          |       | 6,644            |       |
| Inventories                                                                            |       | —              |       | 1,477                                 |       | 2,660                                      |       | —          |       | 4,137            |       |
| Prepaid expenses and  other current assets                                             |       | 72                  |       | 2,491                                 |       | 2,817                                      |       | —          |       | 5,380            |       |
| Intercompany accounts                                                                  |       | 90,190              |       | (119,113                              | )          | 28,841                                     |       | 82              |       | —           |       |
| **Total current assets**                                                               |       | 95,624              |       | (48,263                               | )          | 55,048                                     |       | 82              |       | 102,491          | ** ** |
| **Property, improvements and  equipment:**                                             |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Land and land  improvements                                                            |       | —              |       | 27,604                                |       | 3,424                                      |       | —          |       | 31,028           |       |
| Buildings                                                                              |       | —              |       | 22,400                                |       | 1,265                                      |       | —          |       | 23,665           |       |
| Leasehold improvements                                                                 |       | 5                   |       | 2,024                                 |       | —                                     |       | —          |       | 2,029            |       |
| Equipment                                                                              |       | 131                 |       | 12,396                                |       | 7,728                                      |       | —          |       | 20,255           |       |
| Furniture and fixtures                                                                 |       | 21                  |       | 892                                   |       | —                                     |       | —          |       | 913              |       |
| ** **                                                                             |       | 157                 |       | 65,316                                |       | 12,417                                     |       | —          |       | 77,890           | ** ** |
| Less accumulated  depreciation and amortization                                        |       | (138                | )          | (10,591                               | )          | (3,437                                     | )          | —          |       | (14,166          | )          |
| **Total property, improvement and  equipment, net**                                    |       | 19                  |       | 54,725                                |       | 8,980                                      |       | —          |       | 63,724           | ** ** |
| Notes receivable,  long-term portion                                                   |       | —              |       | 357                                   |       | —                                     |       | —          |       | 357              |       |
| Deposits and other assets                                                              |       | 6                   |       | 358                                   |       | 330                                        |       | —          |       | 694              |       |
| Deferred financing costs,  net                                                         |       | 6,878               |       | —                                |       | 1,327                                      |       | —          |       | 8,205            |       |
| Deferred income taxes,  net                                                            |       | (643                | )          | 643                                   |       | —                                     |       | —          |       | —           |       |
| Goodwill                                                                               |       | —              |       | 153,250                               |       | —                                     |       | —          |       | 153,250          |       |
| Other intangible assets,  net                                                          |       | —              |       | 46,425                                |       | —                                     |       | —          |       | 46,425           |       |
| **Total Assets**                                                                       | ** ** | **$**               | 101,884    |                                  | $          | 207,495                                    |       | $               | 65,685     |             | $          | 82 |   | $ | 375,146 | ** ** |
| **LIABILITIES &  SHAREHOLDERS’ EQUITY**                                  |       |                |       |                                  |       |                                       |       |            |       |             |       |
| **Current liabilities:**                                                               |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Accrued medical claims  and other healthcare costs payable                             |       | $                   | —     |                                  | $          | 16,613                                     |       | $               | 211        |             | $          | — |   | $ | 16,824 |   |
| Accounts payable and  other accrued liabilities                                        |       | 7,102               |       | 10,548                                |       | 14,123                                     |       | —          |       | 31,773           |       |
| Accrued salaries, wages  and benefits                                                  |       | 4,151               |       | 11,543                                |       | 9,209                                      |       | —          |       | 24,903           |       |
| Due to government payer                                                                |       | —              |       | —                                |       | 13,834                                     |       | —          |       | 13,834           |       |
| Income taxes payable, net                                                              |       | (1,029              | )          | 1,086                                 |       | (57                                        | )          | —          |       | —           |       |
| Current portion of  capital leases                                                     |       | —              |       | 383                                   |       | 437                                        |       | —          |       | 820              |       |
| Current portion of  long-term debt                                                     |       | —              |       | —                                |       | 3,805                                      |       | —          |       | 3,805            |       |
| Other current liabilities                                                              |       | 13                  |       | 616                                   |       | —                                     |       | —          |       | 629              |       |
| **Total current liabilities**                                                          |       | 10,237              |       | 40,789                                |       | 41,562                                     |       | —          |       | 92,588           | ** ** |
| Long-term debt, net of  current portion                                                |       | 148,020             |       | —                                |       | 24,519                                     |       | —          |       | 172,539          |       |
| Deferred income taxes                                                                  |       | 8,269               |       | 21,706                                |       | —                                     |       | —          |       | 29,975           |       |
| Malpractice reserve                                                                    |       | —              |       | 914                                   |       | 1,910                                      |       | —          |       | 2,824            |       |
| Capital leases, net of  current portion                                                |       | —              |       | 299                                   |       | 270                                        |       | —          |       | 569              |       |
| Other long-term  liabilities                                                           |       | 78                  |       | 84                                    |       | —                                     |       | —          |       | 162              |       |
| **Total liabilities**                                                                  |       | 166,604             |       | 63,792                                |       | 68,261                                     |       | —          |       | 298,657          | ** ** |
| **Shareholders’ equity (deficit):**                                               |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Prospect Medical Holdings, Inc.’s  Shareholders’ equity                 |       |                |       |                                  |       |                                       |       |            |       |             |       |
| Common stock                                                                           |       | 206                 |       | (53                                   | )          | (114                                       | )          | 167             |       | 206              |       |
| Additional paid-in-capital                                                             |       | 94,242              |       | 256                                   |       | —                                     |       | —          |       | 94,498           |       |
| Accumulated deficit                                                                    |       | (159,168            | )          | 143,500                               |       | (2,462                                     | )          | (173            | )          | (18,303          | )          |
| Total Prospect Medical  Holdings, Inc.’s Shareholders’ equity (deficit) |       | (64,720             | )          | 143,703                               |       | (2,576                                     | )          | (6              | )          | 76,401           |       |
| Noncontrolling interest                                                                |       | —              |       | —                                |       | —                                     |       | 88              |       | 88               |       |
| **Total Shareholders’ equity  (deficit)**                                         |       | (64,720             | **)**      | 143,703                               |       | (2,576                                     | **)**      | 82              | ** ** | 76,489           | ** ** |
| **Total liabilities and  Shareholders’ equity**                                   | ** ** | **$**               | 101,884    | ** **                            | **$**      | 207,495                                    | ** ** | **$**           | 65,685     | ** **       | **$**      | 82 | ** ** | **$** | 375,146 | ** ** |

 

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** **

**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For theThree Months Ended March 31, 2010**

*(in thousands)*

* *

*(Unaudited)*

 
| ** **                                                             | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined  Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                             | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**            | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **Revenues:**                                                          |       |        |       |                    |       |                        |       |            |       |             |       |
| Net Hospital Services revenues                                         |       | $           | —     |                    | $          | 38,512                      |       | $               | 33,490     |             | $          | (1,464 | ) | $ | 70,538 |   |
| Medical Group revenues                                                 |       | —      |       | 45,600                  |       | 686                         |       | (162            | )          | 46,124           |       |
| **Total revenues**                                                     |       | —      |       | 84,112                  |       | 34,176                      |       | (1,626          | )          | 116,662          |       |
| Operating expenses:                                                    |       |        |       |                    |       |                        |       |            |       |             |       |
| Hospital operating expenses                                            |       | —      |       | 22,620                  |       | 28,207                      |       | —          |       | 50,827           |       |
| Medical Group cost of revenues                                         |       | —      |       | 36,337                  |       | 527                         |       | —          |       | 36,864           |       |
| General and administrative                                             |       | 2,692       |       | 10,458                  |       | 4,263                       |       | (1,626          | )          | 15,787           |       |
| Depreciation and amortization                                          |       | 3           |       | 1,839                   |       | 237                         |       | —          |       | 2,079            |       |
| **Total operating expenses**                                           |       | 2,695       |       | 71,254                  |       | 33,234                      |       | (1,626          | )          | 105,557          |       |
| Operating income from unconsolidated joint venture                     |       | —      |       | 580                     |       | —                      |       | —          |       | 580              |       |
| Operating (loss) income                                                |       | (2,695      | )          | 13,438                  |       | 942                         |       | —          |       | 11,685           |       |
| Other (income) expense:                                                |       |        |       |                    |       |                        |       |            |       |             |       |
| Investment income                                                      |       | (268        | )          | (26                     | )          | —                      |       | 268             |       | (26              | )          |
| Interest expense and amortization-deferred financing cost              |       | 5,837       |       | 445                     |       | 1,253                       |       | (268            | )          | 7,267            |       |
| **Total other (income) expense, net**                                  |       | 5,569       |       | 419                     |       | 1,253                       |       | —          |       | 7,241            |       |
| Income (loss) before income taxes                                      |       | (8,264      | )          | 13,019                  |       | (311                        | )          | —          |       | 4,444            |       |
| Provision for income taxes                                             |       | 1,106       |       | 838                     |       | —                      |       | —          |       | 1,944            |       |
| Net income (loss)                                                      |       | (9,370      | )          | 12,181                  |       | (311                        | )          | —          |       | 2,500            |       |
| Income (loss) attributable to noncontrolling interest                  |       | —      |       | —                  |       | —                      |       | (87             | )          | (87              | )          |
| **Net income (loss) attributable to Prospect Medical  Holdings, Inc.** | ** ** | **$**       | (9,370     | )                       | **$**      | 12,181                      | ** ** | **$**           | (311       | )                | **$**      | 87 | ** ** | **$** | 2,587 | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**For the SixMonths Ended March 31, 2010**

*(inthousands)*

* *

*(Unaudited)*

 
| ** **                                                             | ** ** | **Parent**  | ** ** | **Combined  Guarantor** | ** ** | **Combined  Non-Guarantor** | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|-------------------------|------------|-----------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                             | ** ** | **Company** | ** ** | **Subsidiaries**        | ** ** | **Subsidiaries**            | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **Revenues:**                                                          |       |        |       |                    |       |                        |       |            |       |             |       |
| Net Hospital Services revenues                                         |       | $           | —     |                    | $          | 78,635                      |       | $               | 65,754     |             | $          | (4,439 | ) | $ | 139,950 |   |
| Medical Group revenues                                                 |       | —      |       | 91,732                  |       | 1,316                       |       | (240            | )          | 92,808           |       |
| **Total revenues**                                                     |       | —      |       | 170,367                 |       | 67,070                      |       | (4,679          | )          | 232,758          |       |
| Operating expenses:                                                    |       |        |       |                    |       |                        |       |            |       |             |       |
| Hospital operating expenses                                            |       | —      |       | 45,568                  |       | 54,927                      |       | —          |       | 100,495          |       |
| Medical Group cost of revenues                                         |       | —      |       | 72,688                  |       | 1,020                       |       | —          |       | 73,708           |       |
| General and administrative                                             |       | 6,191       |       | 20,467                  |       | 9,938                       |       | (4,679          | )          | 31,917           |       |
| Depreciation and amortization                                          |       | 7           |       | 3,677                   |       | 473                         |       | —          |       | 4,157            |       |
| **Total operating expenses**                                           |       | 6,198       |       | 142,400                 |       | 66,358                      |       | (4,679          | )          | 210,277          |       |
| Operating income from unconsolidated joint venture                     |       | —      |       | 1,031                   |       | —                      |       | —          |       | 1,031            |       |
| Operating (loss) income                                                |       | (6,198      | )          | 28,998                  |       | 712                         |       | —          |       | 23,512           |       |
| Other (income) expense:                                                |       |        |       |                    |       |                        |       |            |       |             |       |
| Investment income                                                      |       | (374        | )          | (55                     | )          | —                      |       | 374             |       | (55              | )          |
| Interest expense and amortization-deferred financing cost              |       | 11,635      |       | 461                     |       | 2,434                       |       | (374            | )          | 14,156           |       |
| (Gain) loss in value of interest rate swap arrangements                |       | —      |       | —                  |       | —                      |       | —          |       | —           |       |
| **Total other (income) expense, net**                                  |       | 11,261      |       | 406                     |       | 2,434                       |       | —          |       | 14,101           |       |
| Income (loss) before income taxes                                      |       | (17,459     | )          | 28,592                  |       | (1,722                      | )          | —          |       | 9,411            |       |
| Provision for income taxes                                             |       | 2,948       |       | 1,499                   |       | —                      |       | —          |       | 4,447            |       |
| Net income (loss)                                                      |       | (20,407     | )          | 27,093                  |       | (1,722                      | )          | —          |       | 4,964            |       |
| Income (loss) attributable to noncontrolling interest                  |       | —      |       | —                  |       | —                      |       | (483            | )          | (483             | )          |
| **Net income (loss) attributable to Prospect Medical  Holdings, Inc.** | ** ** | **$**       | (20,407    | )                       | **$**      | 27,093                      | ** ** | **$**           | (1,722     | )                | **$**      | 483 | ** ** | **$** | 5,447 | ** ** |

 

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**PROSPECTMEDICAL HOLDINGS, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**For the SixMonths ended March 31, 2010**

*(inthousands)*

* *

*(Unaudited)*

 
| ** **                                                                                           | ** ** | ** **  | ** ** | ** **       | ** ** | **Combined**     | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------|------------|------------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                           | ** ** | ** **  | ** ** | **Combined**     | ** ** | **Non-**         | ** ** | ** **      | ** ** | ** **       | ** ** |
| ** **                                                                                           | ** ** | **Parent**  | ** ** | **Guarantor**    | ** ** | **Guarantor**    | ** ** | ** **      | ** ** | ** **       | ** ** |
| ** **                                                                                           | ** ** | **Company** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
| **Operating activities**                                                                             |       |        |       |             |       |             |       |            |       |             |       |
| Net  income (loss)                                                                                   |       | $           | (20,407    | )                | $          | 27,092           |       | $               | (1,721     | )                | $          | — |   | $ | 4,964 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |        |       |             |       |             |       |            |       |             |       |
| Depreciation  and amortization                                                                       |       | 7           |       | 3,677            |       | 473              |       | —          |       | 4,157            |       |
| Amortization  of deferred financing costs                                                            |       | 556         |       | —           |       | 371              |       | —          |       | 927              |       |
| Amortization  of original issue discount                                                             |       | 855         |       | —           |       | —           |       | —          |       | 855              |       |
| Provision  for bad debts                                                                             |       | —      |       | 4,177            |       | 10,463           |       | —          |       | 14,640           |       |
| Stock-based  compensation                                                                            |       | 1,712       |       | —           |       | —           |       | —          |       | 1,712            |       |
| Gain  on sale of assets                                                                              |       | —      |       | (8               | )          | —           |       | —          |       | (8               | )          |
| Intercompany  accounts                                                                               |       | 24,174      |       | (29,462          | )          | 5,288            |       | —          |       | —           |       |
| Changes  in assets and liabilities:                                                                  |       |        |       |             |       |             |       |            |       |             |       |
| Risk  pool receivables                                                                               |       | —      |       | (8               | )          | —           |       | —          |       | (8               | )          |
| Patient  and other receivables                                                                       |       | 8           |       | (470             | )          | (15,607          | )          | —          |       | (16,069          | )          |
| Prepaid  expenses and other                                                                          |       | (743        | )          | (526             | )          | 685              |       | —          |       | (584             | )          |
| Inventory                                                                                            |       | —      |       | (50              | )          | 19               |       | —          |       | (31              | )          |
| Refundable  income taxes                                                                             |       | (12         | )          | (342             | )          | —           |       | —          |       | (354             | )          |
| Income  taxes payable                                                                                |       | (369        | )          | 369              |       | —           |       | —          |       | —           |       |
| Deposits  and other assets                                                                           |       | —      |       | 96               |       | 330              |       | —          |       | 426              |       |
| Accrued  medical claims and other health care costs payable                                          |       | —      |       | (1,959           | )          | 128              |       | —          |       | (1,831           | )          |
| Accounts  payable, accrued liabilities, and other liabilities                                        |       | (2,041      | )          | 2,708            |       | (4,762           | )          | —          |       | (4,095           | )          |
| Net  cash provided by operating activities                                                           |       | 3,740       |       | 5,294            |       | (4,333           | )          | —          |       | 4,701            |       |
| **Investing activities**                                                                             |       |        |       |             |       |             |       |            |       |             |       |
| Purchases  of property, improvements and equipment                                                   |       | (11         | )          | (1,251           | )          | (120             | )          | —          |       | (1,382           | )          |
| Collections  on (issuance of) notes receivable, net                                                  |       | (3,621      | )          | 27               |       | —           |       | 3,621           |       | 27               |       |
| Increase  in restricted certificates of deposits                                                     |       | —      |       | 31               |       | —           |       | —          |       | 31               |       |
| Net  cash used in investing activities                                                               |       | (3,632      | )          | (1,193           | )          | (120             | )          | 3,621           |       | (1,324           | )          |
| **Financing activities**                                                                             |       |        |       |             |       |             |       |            |       |             |       |
| Borrowings  on line of credit, net                                                                   |       | —      |       | —           |       | 5,162            |       | (3,621          | )          | 1,541            |       |
| Repayments  on Class 4 Note                                                                     |       | —      |       | —           |       | (531             | )          | —          |       | (531             | )          |
| Payments  on capital leases                                                                          |       | —      |       | (242             | )          | (190             | )          | —          |       | (432             | )          |
| Change  in restricted cash                                                                           |       | —      |       | —           |       | (945             | )          | —          |       | (945             | )          |
| Proceeds  from exercises of stock options and warrants                                               |       | 152         |       | —           |       | —           |       | —          |       | 152              |       |
| Cash  paid for deferred financing costs                                                              |       | (38         | )          | —           |       | —           |       | —          |       | (38              | )          |
| Net  cash (used in) provided by financing activities                                                 |       | 114         |       | (242             | )          | 3,496            |       | (3,621          | )          | (253             | )          |
| Increase  (decrease) in cash and cash equivalents                                                    |       | 222         |       | 3,859            |       | (957             | )          | —          |       | 3,124            |       |
| Cash  and cash equivalents at beginning of period                                                    |       | (514        | )          | 36,995           |       | 1,287            |       | —          |       | 37,768           |       |
| Cash  and cash equivalents at end of period                                                          |       | $           | (292       | )                | $          | 40,854           |       | $               | 330        |             | $          | — |   | $ | 40,892 |   |

 

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**14. Subsequent Event**

 

Effective May 1, 2010, PMS entered into agreementswith two unaffiliated medical groups to manage approximately 17,000 HMOenrollees. Monthly management fees range from 7.5% to 12.5% of revenuesdepending on the type of revenues managed. The agreements are for an initialthree year period, with automatic renewal provisions, and 90 day cancellationprovisions.

 

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** **

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

 

**Forward-LookingStatements**

 

The following discussion ofour financial condition and results of operations should be read in conjunctionwith the accompanying unaudited interim condensed consolidated financialstatements and the notes to those statements appearing elsewhere in this reportand the audited consolidated financial statements for the year ended September 30,2009 appearing in our annual report on Form 10-K and subsequent filingswith the Securities and Exchange Commission.

 

This discussion containsforward-looking statements that involve risks and uncertainties. Theseforward-looking statements are often accompanied by words such as “believe,” “should,”“anticipate,” “plan,” “expect,” “potential,” “scheduled,” “estimate,” “intend,”“seek,” “goal,” “may” and similar expressions. These statements include,without limitation, statements about our market opportunity, our growthstrategy, competition, expected activities and future acquisitions andinvestments and the adequacy of our available cash resources. Investors areurged to read these statements carefully, and are cautioned that matterssubject to forward-looking statements involve risks and uncertainties,including economic, regulatory, competitive and other factors that may affectour business. These statements are not guarantees of future performance and aresubject to risks, uncertainties and assumptions. Although we believe that theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, performance, orachievements. Moreover, we do not assume any responsibility for the accuracyand completeness of such statements in the future, and we do not undertake toupdate or revise any forward-looking statements to reflect future events or newinformation.

 

Forward-looking statementsinvolve known and unknown risks and uncertainties that may cause our actualresults 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:

 

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

·                  Growth of uninsured andunderinsured patients;

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

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

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

·                  Healthcare costs;

·                  Our ability to maintainrequired working capital;

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

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

·                  Reliance on key executivemanagement and key physicians;

·                  Labor costs;

·                  Competition;

·                  Government regulation;

·                  Changes in the regulatoryand healthcare policy environment;

·                  Changes to the manner and extent to which healthcareservices are covered, delivered and reimbursed that will occur, or may occur,as a result of the enactment in March 2010 of the Patient Protection and AffordableCare Act, as amended by the Health Care and Education Reconciliation Act of2010;

·                  Economic trends generallyand local economic conditions in southern California;

·                  Medical malpractice claimsand HMO bad-faith liability claims;

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

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

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

 

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Investors should also referto our Form 10-K annual report filed with the Securities and ExchangeCommission on December 21, 2009 for a discussion of risk factors. A copyof the Form 10-K annual report can be found on the internet at *www.prospectmedicalholdings.com* or throughthe SEC’s electronic data system called EDGAR at *www.sec.gov*. Given these risks and uncertainties, we cangive no assurances that results projected in any forward-looking statementswill in fact occur and therefore caution investors not to place undue relianceon them.

 

**Overview**

 

Prior to the acquisition ofAlta and Brotman, our organization was focused solely on providing medicalmanagement systems and services to affiliated medical organizations, primarilyIndependent Physician Associations. With the acquisition of Alta and Brotman,we now own and operate five hospitals in southern California and our operationsare now organized into three reporting segments: Hospital Services, MedicalGroup and Corporate. The Hospital Services segment includes the results ofoperations and financial position of Brotman beginning April 14, 2009.

 

**HospitalServices Segment**

 

TheHospital Services segment owns and operates five hospitals in Los AngelesCounty with a total of 759 licensed beds served by 751 on-staff physicians at March 31,2010. Each of the community hospitals in Hollywood, Los Angeles, Norwalk andCulver City offers a comprehensive range of medical and surgical services,including inpatient, outpatient, skilled nursing and urgent care services. Thepsychiatric hospital in Van Nuys provides acute inpatient and outpatientpsychiatric services to patients admitted on a voluntary basis. Admittingphysicians are primarily practitioners in the local area. The hospitals havepayment arrangements with Medicare, Medi-Cal and other third-party payersincluding some commercial insurance carriers, HMOs and Preferred ProviderOrganizations (“PPOs”). The basis for such payments involving inpatient andoutpatient services rendered includes prospectively determined rates perdischarge and cost-reimbursed methodologies. The Alta hospitals are eligible toreceive additional Disproportionate Share Hospital Program (“DSH”) paymentadjustments from Medicare and Medi-Cal based on a prospective payment systemfor hospitals that serve large proportions of low-income patients. Brotman is eligible to receive DSHpayment adjustments from Medicare and supplemental Distressed Hospital Fund paymentsfrom the California Medical Assistance Commission (“CMAC”).

 

Operating revenue of ourHospital Services segment consists primarily of payments for services rendered,including estimated retroactive adjustments under reimbursement arrangementswith third-party payers. In some cases, reimbursement is based on formulas andreimbursable amounts are not considered final until cost reports are filed andaudited or otherwise settled by the various programs. We accrue for amountsthat we believe will ultimately be due to or from Medicare and other third-partypayers and report such amounts as net patient revenues in the accompanyingunaudited condensed consolidated financial statements. We closely monitor ourhistorical collection rates, as well as changes in applicable laws, rules andregulations and contract terms, to assure that provisions are made using themost accurate information available. However, due to the complexities involvedin these estimations, actual payments from payers may be materially differentfrom the amounts we estimate and record. A summary of the payment arrangementswith major third-party payers follows:

 

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

 

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

 

*Managed care:* We also receive payment from certain commercial insurancecarriers, HMOs and PPOs. The basis for payment is in accordance with contractedrates or at our standard charges for services provided where no prior contractis in place.

 

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

 

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Hospital revenues dependupon inpatient occupancy levels, the medical and ancillary services and therapyprograms ordered by physicians and provided to patients, the volume of outpatientprocedures and the charges or negotiated payment rates for such services.Charges and reimbursement rates for inpatient routine services vary dependingon the type of services provided (e.g., medical/surgical, intensive careor behavioral health) and the geographic location of the hospital. Inpatientoccupancy levels fluctuate for various reasons, many of which are beyond ourcontrol. The percentage of patient service revenue attributable to outpatientservices has generally increased in recent years, primarily as a result ofadvances in medical technology that allow more services to be provided on anoutpatient basis, as well as increased pressure from Medicare, Medi-Cal andprivate insurers to reduce hospital stays and provide services, where possible,on a less expensive outpatient basis. We believe that our experience withrespect to our increased outpatient levels mirrors the general trend occurringin the healthcare industry and we are unable to predict the rate of growth andresulting impact on our future revenues.

 

Patients are generally notresponsible for any difference between customary hospital charges and amountsreimbursed for such services under Medicare, Medicaid, some private insuranceplans, and managed care plans, but are responsible for services not covered bysuch plans, exclusions, deductibles or co-insurance features of their coverage.The amount of such exclusions, deductibles and co-insurance has generally beenincreasing each year. Indications from recent federal and state legislation arethat this trend will continue. Collection of amounts due from individuals istypically more difficult than from governmental or business payers andincreases in uninsured and self-pay patients unfavorably impact thecollectability of our patient accounts, thereby increasing our provision fordoubtful accounts and charity care provided.

 

Operating expenses of ourHospital Services segment generally consist of salaries, benefits and othercompensation paid to healthcare professionals that are employees of ourhospitals, medical supplies, consultant and professional services, andprovision for doubtful accounts.

 

General and administrativeexpenses of our Hospital Services segment generally consists of salaries,benefits and other compensation for our hospital administrative employees,insurance, rent, operating supplies, legal, accounting and marketing.

 

**Hospital Services Results ofOperations**

 

The following table setsforth the unaudited results of operation for our hospitals and is used in the discussionbelow for the three-month and six-month periods ended March 31, 2010 and2009 (in thousands).

 
| ** **                                     | ** ** | **Three  Months Ended** | ** ** | **Six  Months Ended** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **March 31,**      | ** ** | **March 31,**    | ** ** |
| ** **                                     | ** ** | **2010**                | ** ** | **2009**              | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** |
| **Net Hospital Services revenues:**            |       |                    |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare                                       |       | $                       | 35,207     |                  | $          | 17,900 |   | $ | 17,307 |   | 96.7 | % | $ | 71,937 |   | $ | 34,758 |   | $ | 37,179 |   | 107.0 | % |
| Medi-Cal                                       |       | 17,054                  |       | 17,465                |       | (411 | ) | (2.4 | )% | 33,787 |   | 33,578 |   | 209 |   | 0.6 | % |
| Managed  care                                  |       | 11,392                  |       | 1,511                 |       | 9,881 |   | 653.9 | % | 23,064 |   | 2,994 |   | 20,070 |   | 670.3 | % |
| Self  pay                                      |       | 4,921                   |       | 626                   |       | 4,295 |   | 686.1 | % | 9,036 |   | 1,133 |   | 7,903 |   | 697.5 | % |
| Other                                          |       | 1,964                   |       | 406                   |       | 1,558 |   | 383.7 | % | 2,126 |   | 767 |   | 1,359 |   | 177.2 | % |
| **Total Hospital Services revenues**           |       | 70,538                  |       | 37,908                |       | 32,630 |   | 86.1 | % | 139,950 |   | 73,230 |   | 66,720 |   | 91.1 | % |
| **Hospital Services operating expenses:**      |       |                    |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Salaries,  wages and benefits                  |       | 32,018                  |       | 15,923                |       | 16,095 |   | 101.1 | % | 63,933 |   | 31,817 |   | 32,116 |   | 100.9 | % |
| Other  operating expenses                      |       | 5,149                   |       | 2,250                 |       | 2,899 |   | 128.8 | % | 9,360 |   | 4,434 |   | 4,926 |   | 111.1 | % |
| Supplies  expense                              |       | 5,270                   |       | 2,184                 |       | 3,086 |   | 141.3 | % | 11,130 |   | 4,377 |   | 6,753 |   | 154.3 | % |
| Provision  for doubtful accounts               |       | 7,670                   |       | 2,216                 |       | 5,454 |   | 246.1 | % | 14,641 |   | 3,709 |   | 10,932 |   | 294.7 | % |
| Lease  and rental expense                      |       | 720                     |       | 284                   |       | 436 |   | 153.5 | % | 1,431 |   | 666 |   | 765 |   | 114.9 | % |
| **Total Hospital Services operating expenses** |       | 50,827                  |       | 22,857                |       | 27,970 |   | 122.4 | % | 100,495 |   | 45,003 |   | 55,492 |   | 123.3 | % |
| General  and administrative expenses           |       | 6,629                   |       | 3,050                 |       | 3,579 |   | 117.3 | % | 12,587 |   | 6,218 |   | 6,369 |   | 102.4 | % |
| Depreciation  and amortization expense         |       | 1,219                   |       | 936                   |       | 283 |   | 30.2 | % | 2,424 |   | 1,827 |   | 597 |   | 32.7 | % |
| Total  non-medical expense                     |       | 7,848                   |       | 3,986                 |       | 3,862 |   | 96.9 | % | 15,011 |   | 8,045 |   | 6,966 |   | 86.6 | % |
| **Operating income**                           |       | $                       | 11,863     |                  | $          | 11,065 |   | $ | 798 |   | 7.2 | % | $ | 24,444 |   | $ | 20,182 |   | $ | 4,262 |   | 21.1 | % |

 

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The following table setsforth selected operating items, expressed as a percentage of total net hospitalservices revenue:

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **March 31,**     | ** ** | **March 31,**   | ** ** |
| ** **                                     | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Net Hospital Services revenues:**            |       |                   |       |                 |       |   |   |   |   |
| Medicare                                       |       | 49.9                   | %          | 47.2                 | %          | 51.4 | % | 47.5 | % |
| Medi-Cal                                       |       | 24.2                   | %          | 46.1                 | %          | 24.1 | % | 45.8 | % |
| Managed  care                                  |       | 16.1                   | %          | 4.0                  | %          | 16.5 | % | 4.1 | % |
| Self  pay                                      |       | 7.0                    | %          | 1.7                  | %          | 6.5 | % | 1.5 | % |
| Other  revenues                                |       | 2.8                    | %          | 1.0                  | %          | 1.5 | % | 1.1 | % |
| **Total Hospital Services revenues**           |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| **Hospital Services operating expenses:**      |       |                   |       |                 |       |   |   |   |   |
| Salaries,  wages and benefits                  |       | 45.4                   | %          | 42.0                 | %          | 45.7 | % | 43.4 | % |
| Other  operating expenses                      |       | 7.3                    | %          | 5.9                  | %          | 6.7 | % | 6.1 | % |
| Supplies  expense                              |       | 7.5                    | %          | 5.8                  | %          | 7.9 | % | 6.0 | % |
| Provision  for doubtful accounts               |       | 10.9                   | %          | 5.8                  | %          | 10.5 | % | 5.1 | % |
| Lease  and rental expense                      |       | 1.0                    | %          | 0.7                  | %          | 1.0 | % | 0.9 | % |
| **Total Hospital Services operating expenses** |       | 72.1                   | %          | 60.2                 | %          | 71.8 | % | 61.5 | % |
| General  and administrative expenses           |       | 9.4                    | %          | 8.0                  | %          | 9.0 | % | 8.5 | % |
| Depreciation  and amortization expense         |       | 1.7                    | %          | 2.5                  | %          | 1.7 | % | 2.5 | % |
| Total  non-medical expenses                    |       | 11.1                   | %          | 10.5                 | %          | 10.7 | % | 11.0 | % |
| **Operating income**                           |       | 16.8                   | %          | 29.3                 | %          | 17.5 | % | 27.5 | % |

 

The following table showscertain selected historical operating statistics for our hospitals as of andfor the three-month and six-month periods ended March 31, 2010 and 2009:

 
| ** **                                       | ** ** | **Three  Months Ended** | ** ** | **Six  Months Ended** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **March 31,**      | ** ** | **March 31,**    | ** ** |
| ** **                                       | ** ** | **2010**                | ** ** | **2009**              | ** ** | **Increase  (Decrease)** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase  (Decrease)** | ** ** |
| Net  inpatient revenues (in thousands) (1)       |       | $                       | 59,645     |                  | $          | 35,561 |   | 67.7 | % | $ | 120,970 |   | $ | 68,800 |   | 75.8 | % |
| Net  outpatient revenues (in thousands)(1)       |       | $                       | 8,929      |                  | $          | 1,941 |   | 360.0 | % | $ | 16,854 |   | $ | 3,663 |   | 360.1 | % |
| Other  hospital services revenues (in thousands) |       | $                       | 1,964      |                  | $          | 406 |   | 383.7 | % | $ | 2,126 |   | $ | 767 |   | 177.2 | % |
| Number  of hospitals at end of period            |       | 5                       |       | 4                     |       | 25.0 | % | 5 |   | 4 |   | 25.0 | % |
| Licensed  beds at end of the period              |       | 759                     |       | 339                   |       | 123.9 | % | 759 |   | 339 |   | 123.9 | % |
| Average  licensed beds                           |       | 759                     |       | 339                   |       | 123.9 | % | 759 |   | 339 |   | 123.9 | % |
| Average  available beds                          |       | 616                     |       | 330                   |       | 86.7 | % | 616 |   | 330 |   | 86.7 | % |
| Admissions  (2)                                  |       | 6,065                   |       | 3,639                 |       | 66.7 | % | 12,052 |   | 7,224 |   | 66.8 | % |
| Adjusted  patient adminissions (3)               |       | 6,795                   |       | 3,899                 |       | 74.3 | % | 13,496 |   | 7,607 |   | 77.4 | % |
| Net  inpatient revenue per admission             |       | $                       | 9,834      |                  | $          | 9,772 |   | 0.6 | % | $ | 10,037 |   | $ | 9,524 |   | 5.4 | % |
| Patient  days                                    |       | 38,246                  |       | 24,062                |       | 58.9 | % | 76,294 |   | 47,529 |   | 60.5 | % |
| Adjusted  patient days                           |       | 43,081                  |       | 25,600                |       | 68.3 | % | 85,849 |   | 50,553 |   | 69.8 | % |
| Average  length of patients’ stay (days)    |       | 6.3                     |       | 6.0                   |       | 5.0 | % | 6.3 |   | 5.9 |   | 6.8 | % |
| Net  inpatient revenue per patient day           |       | $                       | 1,560      |                  | $          | 1,478 |   | 5.5 | % | $ | 1,586 |   | $ | 1,448 |   | 9.5 | % |
| Outpatient  visits                               |       | 13,593                  |       | 5,223                 |       | 160.3 | % | 27,749 |   | 10,179 |   | 172.6 | % |
| Net  outpatient revenue per visit                |       | $                       | 657        |                  | $          | 372 |   | 76.6 | % | $ | 607 |   | $ | 360 |   | 68.6 | % |
| Occupancy  rate for licensed beds (4)            |       | 56.0                    | %          | 78.9                  | %          | (29.0 | )% | 56.0 | % | 77.0 | % | (27.3 | )% |
| Occupancy  rate for available beds (4)           |       | 69.0                    | %          | 81.0                  | %          | (14.8 | )% | 69.0 | % | 79.1 | % | (12.8 | )% |

 

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(1)                                  Net inpatient revenues andnet outpatient revenues are components of net patient revenues. Net inpatientrevenues include self-pay revenues of approximately $2,984,000 and $594,000,for the three months ended March 31, 2010 and 2009, respectively, and$4,909,000 and $1,076,000, for the six months ended March 31, 2010 and2009, respectively. Net outpatient revenues include self-pay revenues ofapproximately $1,937,000 and $32,000 for the three months ended March 31,2010 and 2009, respectively, and $4,127,000 and $57,000, for the six monthsended March 31, 2010 and 2009, respectively.

 

(2)                                  Charity care admissions represent 0.9%and 0.5% of total admissions for the three months ended March 31, 2010 and2009, respectively, and represent 1.0% and 0.6% of total admissions for the sixmonths ended March 31, 2010 and 2009, respectively.  Based on the Company’s gross charge rates,revenues foregone under the charity policy, including indigent accounts, wereapproximately $712,000 and $229,000 for the three months ended March 31,2010 and 2009, respectively, and approximately $1,916,000 and $625,000 for thesix months ended March 31, 2010 and 2009, respectively.

 

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

 

(4)                                  Utilization oflicensed beds represents patient days divided by average licensed beds dividedby number of days in the period. Occupancy rates are affected by many factors, including the populationsize and general economic conditions within particular market service areas,the degrees of variation in medical and surgical products, outpatient use ofhospital services, quality and treatment availability at competing hospitalsand seasonality.

 

(5)                                  The threemonths and six months ended March 31, 2010 include Brotman operatingresults, as the Company acquired a majority stake in, and began consolidating,Brotman, since April 14, 2009. Accordingly, the comparative period does not include any operatingresults of Brotman.

 

***Three Months Ended March 31, 2010 Compared to Three Months Ended March 31,2009***

 

*Net HospitalServices Revenues*

 

Net inpatient revenues forthe three months ended March 31, 2010 were approximately $59,645,000representing an increase of approximately $24,084,000 or 67.7% from netinpatient revenues for the three months ended March 31, 2009, of approximately$35,561,000. The three months ended March 31, 2010 include the results ofBrotman, which, accounted for $25,267,000 or 104.9% of the increase.

 

Excluding Brotman, on a samehospital basis, Alta’s net inpatient revenues decreased by approximately$1,183,000 or 3.3% during the fiscal 2010 period as compared to fiscal 2009period, primarily as a result of unusually high accute patient days in March2009, together with lower average length of Medi-Cal patient stays and approvedMedi-Cal patient days, partially offset by improved Medi-Cal and Medicarereimbursement rates in the 2010 period.

 

Same-hospital admissions,excluding the effect of Brotman, for the three months ended March 31, 2010increased by approximately 6.4% compared to the three months ended March 31,2009 primarily due to increases in the Medicare and Medi-Cal service lines.

 

Net outpatient revenues forthe three months ended March 31, 2010 were approximately $8,929,000representing an increase of approximately $6,988,000 or 360.0% from netoutpatient revenues for the three months ended March 31, 2009, ofapproximately $1,941,000. The three months ended March 31, 2010 includethe results of Brotman, which, accounted for $6,316,000 or 90.4% of theincrease.

 

Excluding Brotman, same hospitalnet outpatient revenues increased by approximately $672,000 or 34.6%.  The increase was primarily attributable toincreased outpatient surgery and emergency room visits.

 

*Salaries,Wages and Benefits*

 

Salaries, wages and benefitsfor the three months ended March 31, 2010 were approximately $32,018,000representing an increase of approximately $16,095,000 or 101.1% from salaries,wages and benefits for the three months ended March 31, 2009, ofapproximately $15,923,000. The three months ended March 31, 2010 includethe results of Brotman, which, accounted for $15,628,000 or 97.1% of theincrease.

 

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Excluding Brotman, Alta’ssame hospital salaries, wages and benefits expense as a percentage of netHospital Services revenues for the three months ended March 31, 2010 was44.2%, compared to 42.0% for the three months ended March 31, 2009, withsuch increase being primarily due to increased accruals for annual incentivecompensation,  increased labor expensedue to the conversion of certain hospital personnel from contracted to salariedbasis and increased health benefit costs, partially offset by productivitygains.

 

Asof March 31, 2010, approximately 6% and 79%, of the total employees at ourAlta and Brotman hospitals were represented by labor unions, respectively. Webelieve that labor relations at our hospital facilities generally have beensatisfactory. The collective bargaining agreement entered into between HollywoodCommunity Hospital, which is one of the hospitals under the consolidated groupof Alta Hospitals System, LLC, and Service Employees InternationalUnion, United Healthcare Workers-West (“SEIU”), covers a small group ofHollywood Community Hospital’s employees and will expire on May 9,2011. The collective bargaining agreements between Brotman and the CaliforniaNurses Association (“CNA”) and Brotman and the SEIU both expired on February 28,2010. Both parties are currently engaged in good faith bargaining negotiationsand we currently do not anticipate that any changes in these agreements willhave a material adverse effect on results of our Hospital operations in fiscal2010.

 

*OtherOperating Expenses*

 

Other operating expense forthe three months ended March 31, 2010 was approximately $5,149,000,representing an increase of $2,899,000 or 128.8% from other operating expensefor the three months ended March 31, 2009, of approximately $2,250,000.The three months ended March 31, 2010 include the results of Brotman,which accounted for $3,290,000 or 113.5% of the increase.

 

Excluding Brotman, Alta’ssame hospital other operating expense as a percentage of Alta’s net HospitalServices revenue for the three months ended March 31, 2010 wasapproximately 5.0%, representing a decrease of 15.2%, compared to 5.9% for thethree months ended March 31, 2009. The decrease was due primarily to thereduction of registry costs and decreased contract labor costs as a result ofthe conversion of certain hospital personnel from contracted to salaried basis.

 

*Supplies Expense*

 

Suppliesexpense for the three months ended March 31, 2010 was approximately$5,270,000, representing an increase of approximately $3,086,000 or 141.3% fromsupplies expense for the three months ended March 31, 2009, ofapproximately $2,184,000. The three months ended March 31, 2010 includethe results of Brotman, which accounted for $3,333,000 or 108.0% of theincrease.

 

Excluding Brotman, Alta’ssame hospital supplies expense as a percentage of Alta’s net Hospital Servicesrevenue for the three months ended March 31, 2010 was 5.2% representing adecrease of 10.3% compared to 5.8% for the three months ended March 31,2009. The decrease was due primarily to decreased utilization of high-costimplants and pharmaceuticals as a result of the outsourcing of our sub-acutepharmacy and improved efficiencies.

 

*Provisionfor Doubtful Accounts*

 

The provision for doubtfulaccounts as a percentage of net Hospital Services revenues was 10.9% for thethree months ended March 31, 2010 compared to 5.8% for the three monthsended March 31, 2009.  The threemonths ended March 31, 2010 included the results of Brotman, whichaccounted for 104.0% of the increase.

 

Excluding Brotman, Alta’ssame hospital provision for doubtful accounts for the three months ended March 31,2010 decreased slightly to approximately 5.2% of Alta’s net Hospital Servicesrevenue, compared to 5.8% for the three months ended March 31, 2009. The provision for doubtful accountsrelates principally to self-pay amounts. The slight decrease was dueto higher write offs in the prior year period; attributed to the economy.

 

The provision for doubtful accounts is furtherdiscussed in Part I, Item 2. *Management’sDiscussion and Analysis of Financial Condition and Results of Operations*,“Critical Accounting Policies.”

 

*Lease andRental Expense*

 

Lease and rental expense forthe three months ended March 31, 2010 was approximately $720,000,representing an increase of approximately $436,000 or 153.5% from lease andrental expense for the three months ended March 31, 2009, of approximately$284,000. The three months ended March 31, 2010 include the results ofBrotman, which accounted for $286,000 or 65.6% of the increase.

 

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Excluding Brotman, Alta’ssame hospital lease and rental expense as a percentage of Alta’s net HospitalServices revenue for the three months ended March 31, 2010 wasapproximately 1.2% compared to approximately 0.7% for the three months ended March 31,2009. This slight increase was primarily due to additional rental of hospitalbeds to accommodate increased inpatient admissions during the fiscal 2010period.

 

*Generaland Administrative Expense*

 

General and administrativeexpense for the three months ended March 31, 2010 was approximately$6,629,000, representing an increase of approximately $3,579,000 or 117.3% fromgeneral and administrative expense for the three months ended March 31,2009, of approximately $3,050,000. The three months ended March 31, 2010include the results of Brotman, which accounted for $2,479,000 or 69.3% of theincrease.

 

Excluding Brotman, samehospital general and administrative expense as a percentage of Alta’s netHospital Services revenue for the three months ended March 31, 2010 was11.2%, compared to 8.0% for the three months ended March 31, 2009, withthe current year increase was primarily due to increased property taxesresulting from reassessment of the property tax base following the acquisitionof Alta and increased facility maintenance.

 

*Depreciationand Amortization Expense*

 

Depreciation andamortization expense for the three months ended March 31, 2010 wasapproximately $1,219,000, representing an increase of approximately $283,000 or30.2% from depreciation and amortization expense for the three months ended March 31,2009, of approximately $936,000. The three months ended March 31, 2010include the results of Brotman, which accounted for $237,000, or 83.6% of theincrease.

 

Excluding Brotman,depreciation and amortization expenses as a percentage of Alta’s net HospitalServices revenues for the three months ended March 31, 2010 wereapproximately 2.7%, compared to 2.5% for the three months ended March 31,2009. The increase was primarily due to depreciation of additional capitalimprovements in the fiscal 2010 period. Included in depreciation andamortization expense was amortization of identifiable intangibles ofapproximately $354,000 and $317,000 in the three months ended March 31,2010 and 2009, respectively.

 

*Operating Income*

 

OurHospital Services segment reported operating income of approximately$11,863,000 and $11,065,000 for the three months ended March 31, 2010 and2009, respectively.  This increase wasthe result of the changes discussed above. These operating results from theHospital Services segment include certain corporate expense allocations forinsurance, professional fees, and amortization of identifiable intangibles thatrelate to this segment.

 

***Six Months Ended March 31, 2010 Compared to Six Months Ended March 31,2009***

 

*NetHospital Services Revenues*

 

Net inpatient revenues forthe six months ended March 31, 2010 were approximately $120,970,000,representing an increase of approximately $52,170,000 or 75.8% from netinpatient revenues for the six months ended March 31, 2009, ofapproximately $68,800,000. The six months ended March 31, 2010 include theresults of Brotman, which, accounted for $51,894,000 or 99.5% of the increase.

 

Excluding Brotman, samehospital net inpatient revenues increased by approximately $276,000 or 0.5%during fiscal 2010 period, as compared to fiscal 2009 period. The factorscontributing to such increase included increased admissions and improvedMedicare and MediCal reimbursement rates, partially offset by lower averagelength of MediCal patient stays and approved MediCal patient days.

 

Same-hospital admissions,excluding the effect of Brotman, for the six months ended March 31, 2010increased by approximately 7.5% compared to the six months ended March 31,2009 primarily due to increases in the Medicare and MediCal service lines.

 

Net outpatient revenues forthe six months ended March 31, 2010 were approximately $16,854,000,representing an increase of approximately $13,191,000 or 360.1% from netoutpatient revenues for the six months ended March 31, 2009, ofapproximately $3,663,000. The six months ended March 31, 2010 include theresults of Brotman, which, accounted for $11,866,000 or 90.0% of the increase.

 

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Excluding Brotman, samehospital net outpatient revenues increased by approximately $1,325,000 or36.2%, primarily due to increased outpatient surgery and emergency room visits.

 

*Salaries,Wages and Benefits*

 

Salaries, wages and benefitsfor the six months ended March 31, 2010 were approximately $63,933,000,representing an increase of approximately $32,116,000 or 100.9% from salaries,wages and benefits for the six months ended March 31, 2009, ofapproximately $31,817,000. The six months ended March 31, 2010 include theresults of Brotman, which, accounted for $31,016,000 or 96.6% of the increase.

 

Excluding Brotman, Alta’ssame hospital salaries, wages and benefits expense as a percentage of netHospital Services revenues for the six months ended March 31, 2010 was44.4%, compared to 43.4% for the six months ended March 31, 2009, withsuch change primarily the result of productivity gains.

 

*OtherOperating Expenses*

 

Other operating expense forthe six months ended March 31, 2010 was approximately $9,360,000,representing an increase of $4,926,000 or 111.1% from other operating expensefor the six months ended March 31, 2009, of approximately $4,434,000. Thesix months ended March 31, 2010 include the results of Brotman, whichaccounted for $5,861,000 or 119.0% of the increase.

 

Excluding Brotman, Alta’ssame hospital other operating expense as a percentage of Alta’s net HospitalServices revenue for the six months ended March 31, 2010 was approximately4.7%, representing a decrease from 6.1% for the six months ended March 31,2009, primarily as a result of reduced registry and contract labor costsfollowing conversion of certain hospital personnel from contracted to salariedbasis.

 

*Supplies Expense*

 

Suppliesexpense for the six months ended March 31, 2010 was approximately$11,130,000, representing an increase of approximately $6,753,000 or 154.3%from supplies expense for the six months ended March 31, 2009, ofapproximately $4,377,000. The six months ended March 31, 2010 include theresults of Brotman, which accounted for $7,095,000 or 105.1% of the increase.

 

Excluding Brotman, Alta’ssame hospital supplies expense as a percentage of Alta’s net Hospital Servicesrevenue for the six months ended March 31, 2010 was 5.4% representing adecrease of 10.0% compared to 6.0% for the six months ended March 31,2009. The decrease was due primarily to decreased utilization of high-costimplants and high-cost pharmaceuticals as a result of the outsourcing of our sub-acutepharmacy products and improved efficiencies.

 

*Provisionfor Doubtful Accounts*

 

The provision for doubtfulaccounts as a percentage of net Hospital Services revenues was 10.5% for thesix months ended March 31, 2010 compared to 5.1% for six months ended March 31,2009.  The six months ended March 31,2010 included the results of Brotman, which accounted for 95.7% of theincrease.

 

Excluding Brotman, Alta’shospital provision for doubtful accounts as a percentage of Alta’s net HospitalServices revenue for the six months ended March 31, 2010 was approximately5.6%, compared to 5.1% for the six months ended March 31, 2009. The slightincrease was due to an increase in uninsured patient admissions, attributed inpart to the economy.

 

*Lease andRental Expense*

 

Lease and rental expense forthe six months ended March 31, 2010 was approximately $1,431,000,representing an increase of approximately $765,000 or 114.9% from lease andrental expense for the six months ended March 31, 2009, of approximately$666,000. The six months ended March 31, 2010 include the results ofBrotman, which accounted for $491,000 or 64.2% of the increase.

 

Excluding Brotman, samehospital lease and rental expense as a percentage of Alta’s net HospitalServices revenue for the six months ended March 31, 2010 was approximately1.3% compared to approximately 0.9% for the six months ended March 31,2009. This slight increase was primarily due to additional rental of hospitalbeds, to accommodate increased inpatient admissions, during the fiscal 2010period.

 

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*Generaland Administrative Expense*

 

General and administrativeexpense for the six months ended March 31, 2010 was approximately$12,587,000 representing an increase of approximately $6,369,000 or 102.4% fromgeneral and administrative expense for the six months ended March 31,2009, of approximately $6,218,000. The six months ended March 31, 2010include the results of Brotman, which accounted for $4,962,000 or 77.9% of theincrease.

 

Excluding Brotman, samehospital general and administrative expense as a percentage of Alta’s netHospital Services revenue for the six months ended March 31, 2010 was10.3% compared to 8.5% for the six months ended March 31, 2009, with thecurrent year increase was primarily due to increased property taxes resultingfrom reassessment of the property tax base of Alta properties and increasedfacility maintenance.

 

*Depreciationand Amortization Expense*

 

Depreciation andamortization expense for the six months ended March 31, 2010 wasapproximately $2,424,000, representing an increase of approximately $597,000 or32.7% from depreciation and amortization expense for the six months ended March 31,2009, of approximately $1,827,000. The six months ended March 31, 2010include the results of Brotman, which accounted for $473,000 or 79.2% of theincrease.

 

Excluding Brotman,depreciation and amortization expenses as a percentage of Alta’s net HospitalServices revenues for the six months ended March 31, 2010 wereapproximately 2.7% compared to 2.5% for the six months ended March 31,2009. Included in depreciation and amortization expense was amortization ofidentifiable intangibles of approximately $708,000 and $634,000 in each of thesix months ended March 31, 2010 and 2009, respectively.

 

*Operating Income*

 

OurHospital Services segment reported operating income of approximately$24,444,000 and $20,182,000 for the six months ended March 31, 2010 and2009, respectively.  The increase was theresult of the changes discussed above. These operating results from theHospital Services segment include certain corporate expense allocations forinsurance, professional fees, stock-based compensation and amortization ofidentifiable intangibles that relate to this segment.

 

**MedicalGroup Segment**

 

The Medical Group segmentprovides management services to affiliated physician organizations that operateas independent physician associations (“Medical Groups”). The affiliatedphysician organizations enter into agreements with HMOs to provide HMOenrollees with a full range of medical services in exchange for fixed, prepaidmonthly fees known as “capitation” payments. The Medical Groups contract withphysicians and other healthcare providers to provide all necessary medicalservices.

 

Through our managementsubsidiaries—Prospect Medical Systems, Inc. (“PMS”), and ProMed HealthCare Administrators—we have entered into long-term agreements to providemanagement services to each of our affiliated physician organizations inexchange for a management fee. The management services we provide include HMOcontracting, physician recruiting, credentialing and contracting, humanresources services, claims administration, financial reporting services,provider relations, patient eligibility and related services, medicalmanagement including utilization management and quality assurance, datacollection, and management information systems.

 

Our management subsidiariescurrently provide management services to ten affiliated physicianorganizations, which include PMG, Nuestra Familia Medical Group, Inc. (“Nuestra”),eight other affiliated physician organizations that PMG owns or controls, andone affiliated physician organization (AMVI/Prospect Health Network) that is anunconsolidated joint venture in which PMG owns a 50% interest. PMG, which wasour first affiliated physician organization, has acquired the ownershipinterest in all of our other affiliated physician organizations, exceptNuestra.  Both PMG and Nuestra are ownedby our physician shareholder nominee, Dr. Arthur Lipper, and controlledthrough assignable option agreements and management services agreements (seeNote 5 to the Condensed Consolidated Financial Statements).  While PMG is itself an affiliated physicianorganization that does the same business in its own service area as all of ourother affiliated physician organizations do in theirs, PMG also serves as aholding company for our other affiliated physician organizations, exceptNuestra.

 

The affiliated physician organizationsprovided medical services to a combined total of approximately 167,800 HMOenrollees at March 31, 2010, including approximately 10,100 AMVI/ProspectHealth Network enrollees that we manage for the economic benefit of anindependent third party, and for which we earn management fee income.

 

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As of March 31, 2010,our affiliated physician organizations had contracts with approximately 16HMOs, from which our revenue was primarily derived. HMOs offer a comprehensivehealthcare benefits package in exchange for a capitation amount per enrolleethat does not vary through the contract period regardless of the quantity orcost of medical services required or used. HMOs enroll members by entering intocontracts with employer groups or directly with individuals to provide a broadrange of healthcare services for a prepaid charge, with minimal deductibles orco-payments required of the members. The contracts between our affiliatedphysician organizations and the HMOs provide for the provision of medicalservices by the affiliated physician organization to the HMO enrollees inconsideration for the prepayment of the fixed monthly capitation amount perenrollee.

 

Our Medical Group businesshas developed primarily through the acquisition of Medical Groups by PMG, andis concentrated in Orange County, California, Los Angeles County, Californiaand San Bernardino County, California.

 

Medical Group revenuesconsist primarily of amounts received for medical services provided by ouraffiliated physician organizations under capitated contracts with HMOs.Capitation revenue under HMO contracts is prepaid monthly to the affiliatesbased on the number of covered HMO enrollees. Capitation revenue may besubsequently adjusted to reflect changes in enrollment as a result ofretroactive terminations or additions. These adjustments have historically nothad a material effect on capitation revenue. Capitation revenue is also subjectto risk adjustment, whereby capitation with respect to Medicare enrollees issubject to subsequent adjustment for the acuity of the enrollees to whomservices were provided. Capitation for the current year is paid based on datasubmitted for each Medicare enrollee for preceding periods. Capitation is paidat interim rates during the year and is adjusted in subsequent periods(generally in our fourth fiscal quarter) after the final data is compiled.Positive or negative capitation adjustments are made for Medicare enrolleeswith conditions requiring more or less healthcare services than assumed in theinterim payments. Since we do not have the information necessary to reliablypredict these adjustments, periodic changes in capitation amounts earned as aresult of Risk Adjustment are recognized when those changes are communicated tous by the health plans, generally in the fourth quarter of the fiscal year towhich the adjustments relate. Management fees were primarily comprised ofamounts earned from managing the operations of AMVI, Inc. (our jointventure partner in the AMVI/Prospect Health Network joint venture) related toMedi-Cal members and Medicare members enrolling in CalOPTIMA’s OneCare HMO.OneCare is a Medicare Advantage Special Needs Plan serving dually-eligiblemembers in Orange County who are entitled to both Medicare and are Medi-Calbenefits. Management fee revenue is recognized in the month the services aredelivered.

 

Medical Group revenues alsoincluded incentive payments from HMOs under “pay-for-performance” programs forquality medical care based on various criteria. These incentives are generallyreceived in the third and fourth quarters of our fiscal year and are recordedwhen such amounts are known since we do not maintain the information necessaryto independently and reliably estimate these amounts.

 

We also potentially earnadditional incentive revenue or incur penalties under HMO contracts by sharingin the risk for hospitalization based upon inpatient services utilized. Theseamounts are included in capitation revenue. Shared risk deficits are generallynot payable until and unless we generated future risk-sharing surpluses. Riskpools are generally settled in the following year. Management estimates riskpool incentives based on information received from the HMOs or hospitals withwhom the risk-sharing arrangements were in place, and who typically maintainthe information and record keeping related to the risk pool arrangements.Differences between actual and estimated settlements are recorded when thefinal outcome is known. Risk pool and pay-for-performance incentives areaffected by many factors, some of which are beyond our control, and may varysignificantly from year to year.

 

As discussed in Note 5 tothe accompanying unaudited financial statements, effective March 1, 2010,we entered into a Capitation Arrangement whereby we agreed to provide hospital,medical and other health care services to approximately 2,000 seniormembers.  This is a major initiativewithin our future strategy, and we expect to enter into similar arrangementsgoing forward for an increasing number of our senior members.  Through March 31, 2010, this arrangementwas operating profitably.

 

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We have increased ourmembership through acquisitions in previous years. These increases throughacquisition were offset by HMO enrollment declines at our affiliated physicianorganizations, similar to the recent HMO enrollment trends in California. Thefollowing table sets forth the approximate number of members, by category (inthousands):

 
| ** **              | ** ** | **As of  March 31,** | ** ** |
|-------------------------|------------|---------------------------|------------|
| **Member Category**     | ** ** | **2010**                  | ** ** | **2009** | ** ** | **% Increase  (Decrease)** | ** ** |
| Commercial - owned      |       | 125                       |       | 141 |   | (11 | )% |
| Commercial - managed(l) |       | 2                         |       | 1 |   | 100 | % |
| Senior - owned          |       | 22                        |       | 22 |   | 0 | % |
| Senior - managed(1)     |       | —                    |       | — |   | 0 | % |
| Medi-Cal - owned        |       | 11                        |       | 11 |   | 0 | % |
| Medi-Cal - managed(1)   |       | 8                         |       | 8 |   | 0 | % |
| Total                   |       | 168                       |       | 183 |   | (8 | )% |

 

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

 

The following table detailstotal paid member months, by member category, for the three-month and six-monthperiods ended March 31, 2010 and 2009 (in thousands):

 
| ** **               | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2010**                               | ** ** | **2009**                             | ** ** | **% Increase  (Decrease)** | ** ** | **2010** | ** ** | **2009** | ** ** | **% Increase  (Decrease)** | ** ** |
| Commercial  - owned      |       | 375                                    |       | 428                                  |       | (12 | )% | 768 |   | 878 |   | (13 | )% |
| Commercial  - managed(1) |       | 5                                      |       | 4                                    |       | 25 | % | 10 |   | 8 |   | 25 | % |
| Senior  - owned          |       | 66                                     |       | 65                                   |       | 2 | % | 131 |   | 130 |   | 1 | % |
| Senior  - managed(1)     |       | 1                                      |       | 0                                    |       | 100 | % | 1 |   | 1 |   | 0 | % |
| Medi-Cal  - owned        |       | 33                                     |       | 34                                   |       | (3 | )% | 68 |   | 68 |   | 0 | % |
| Medi-Cal  - managed(1)   |       | 25                                     |       | 24                                   |       | 4 | % | 51 |   | 47 |   | 9 | % |
|                     |       | 505                                    |       | 555                                  |       | (9 | )% | 1,029 |   | 1,132 |   | (9 | )% |

 

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

 

Our operating expensesinclude expenses related to the provision of medical care services (medicalgroup cost of revenues) and general and administrative costs. Our results ofoperations depend on our ability to effectively manage expenses related tohealth benefits and accurately predict costs incurred.

 

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

 

Capitation payments arefixed in advance of periods covered and are not subject to significantaccounting estimates. These payments are expensed in the period the providersare obligated to provide services. Fee-for-service payments are expensed in theperiod services are provided to our members. Medical care costs include actualhistorical claims experience and estimates of incurred but not reported amounts(“IBNR”).  We estimate our IBNR monthly,based on a number of factors, including prior claims experience. As part ofthis review, we also consider estimates of amounts to cover uncertaintiesrelated to fluctuations in provider billing patterns, claims payment patterns,membership and medical cost trends. These estimates are adjusted each month asmore information becomes available. In addition to our own IBNR estimationprocess, we obtain semi-annual reviews of our IBNR liability from independentactuaries. We believe that our process for estimating IBNR is adequate andappropriate, but there can be no assurance that medical care costs will notmaterially differ from such estimates. In addition to contractualreimbursements to providers, we also make discretionary incentive payments tophysicians, which are in large part based on the pay-for-performance, sharedrisk revenues and any favorable senior capitation risk-adjustment payments wereceive. Since we record these revenues generally in the third or fourthquarter of each fiscal year, when the incentives and capitation adjustments duefrom the health plans are known, we also historically adjust interim accrualsof discretionary physician bonuses in the same period. Because incentives andrisk-adjustment revenues form the basis for these discretionary bonuses,variability in earnings due to fluctuations in revenues are mitigated byreductions in bonuses awarded.

 

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G&A costs are largelycomprised of wage and benefit costs and other administrative expenses. G&Afunctions include claims processing, information systems, provider relations,finance and accounting services, and legal and regulatory services.

 

**MedicalGroup Results of Operations**

 

The following tablessummarize our net operating revenue, operating expenses and operating incomefrom Medical Group operations and are used in the discussions below for thethree-month and six-month periods ended March 31, 2010 and 2009 (inthousands).

 
| ** **                                | ** ** | **Three  Months Ended  March 31,** | ** ** | **Six  Months Ended  March 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2010**                                | ** ** | **2009**                              | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** |
| **Medical Group revenues:**               |       |                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Capitation                                |       | $                                       | 45,933     |                                  | $          | 47,874 |   | $ | (1,941 | ) | (4.1 | )% | $ | 92,381 |   | $ | 95,636 |   | $ | (3,255 | ) | (3.4 | )% |
| Management  fees                          |       | 158                                     |       | 144                                   |       | 14 |   | 9.7 | % | 312 |   | 288 |   | 24 |   | 8.3 | % |
| Other  operating revenues                 |       | 33                                      |       | 141                                   |       | (108 | ) | (76.6 | )% | 115 |   | 366 |   | (251 | ) | (68.6 | )% |
| **Total Medical Group revenues**          |       | 46,124                                  |       | 48,159                                |       | (2,035 | ) | (4.2 | )% | 92,808 |   | 96,290 |   | (3,482 | ) | (3.6 | )% |
| **Medical Group cost of revenues:**       |       |                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| PCP  capitation                           |       | 8,187                                   |       | 8,466                                 |       | (279 | ) | (3.3 | )% | 16,593 |   | 17,134 |   | (541 | ) | (3.2 | )% |
| Specialist  capitation                    |       | 10,285                                  |       | 11,128                                |       | (843 | ) | (7.6 | )% | 20,633 |   | 22,147 |   | (1,514 | ) | (6.8 | )% |
| Claims  expense                           |       | 17,521                                  |       | 17,470                                |       | 51 |   | 0.3 | % | 35,514 |   | 35,163 |   | 351 |   | 1.0 | % |
| Physician  salaries                       |       | 190                                     |       | 287                                   |       | (97 | ) | (33.8 | )% | 223 |   | 1,065 |   | (842 | ) | (79.1 | )% |
| Other  cost of revenues                   |       | 681                                     |       | (395                                  | )          | 1,076 |   | (272.4 | )% | 745 |   | (942 | ) | 1,687 |   | (179.1 | )% |
| **Total Medical Group cost of revenues**  |       | 36,864                                  |       | 36,956                                |       | (92 | ) | (0.3 | )% | 73,708 |   | 74,567 |   | (859 | ) | (1.2 | )% |
| **Gross margin**                          |       | 9,260                                   |       | 11,203                                |       | (1,943 | ) | (17.3 | )% | 19,100 |   | 21,723 |   | (2,623 | ) | (12.1 | )% |
| General  and administrative expense       |       | 6,467                                   |       | 7,479                                 |       | (1,012 | ) | (13.5 | )% | 13,140 |   | 14,675 |   | (1,535 | ) | (10.5 | )% |
| Depreciation  and amortization expense    |       | 856                                     |       | 884                                   |       | (28 | ) | (3.1 | )% | 1,725 |   | 1,755 |   | (30 | ) | (1.7 | )% |
| Total  other expenses                     |       | 7,323                                   |       | 8,363                                 |       | (1,040 | ) | (12.4 | )% | 14,865 |   | 16,430 |   | (1,565 | ) | (9.5 | )% |
| Income  from unconsolidated joint venture |       | 580                                     |       | 595                                   |       | (15 | ) | (2.5 | )% | 1,031 |   | 947 |   | 84 |   | 8.9 | % |
| **Operating income**                      |       | $                                       | 2,517      |                                  | $          | 3,435 |   | $ | (918 | ) | (26.8 | )% | $ | 5,266 |   | $ | 6,240 |   | $ | (974 | ) | (15.6 | )% |
| **Medical cost ratio**                    |       | 80.3                                    | %          | 77.2                                  | %          |   |   |   |   | 79.8 | % | 78.0 | % |   |   |   |   |

 

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The following table setsforth selected operating items, expressed as a percentage of total revenue:

 
| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                | ** ** | **March 31,**     | ** ** | **March 31,**   | ** ** |
| ** **                                | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Medical Group revenues:**               |       |                   |       |                 |       |   |   |   |   |
| Capitation                                |       | 99.6                   | %          | 99.4                 | %          | 99.5 | % | 99.3 | % |
| Management  fees                          |       | 0.3                    | %          | 0.3                  | %          | 0.3 | % | 0.3 | % |
| Other  operating revenues                 |       | 0.1                    | %          | 0.3                  | %          | 0.1 | % | 0.4 | % |
| **Total Medical Group revenues**          |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| **Medical Group cost of revenues:**       |       |                   |       |                 |       |   |   |   |   |
| PCP  capitation                           |       | 17.8                   | %          | 17.6                 | %          | 17.9 | % | 17.8 | % |
| Specialist  capitation                    |       | 22.3                   | %          | 23.1                 | %          | 22.2 | % | 23.0 | % |
| Claims  expense                           |       | 38.0                   | %          | 36.3                 | %          | 38.3 | % | 36.5 | % |
| Physician  salaries                       |       | 0.4                    | %          | 0.6                  | %          | 0.2 | % | 1.1 | % |
| Other  cost of revenues                   |       | 1.5                    | %          | (0.8                 | )%         | 0.8 | % | (1.0 | )% |
| **Total Medical Group cost of revenues**  |       | 79.9                   | %          | 76.7                 | %          | 79.4 | % | 77.4 | % |
| **Gross margin**                          |       | 20.1                   | %          | 23.3                 | %          | 20.6 | % | 22.6 | % |
| General  and administrative expense       |       | 14.0                   | %          | 15.5                 | %          | 14.2 | % | 15.2 | % |
| Depreciation  and amortization expense    |       | 1.9                    | %          | 1.8                  | %          | 1.9 | % | 1.8 | % |
| Total  other expenses                     |       | 15.9                   | %          | 17.4                 | %          | 16.0 | % | 17.1 | % |
| Income  from unconsolidated joint venture |       | 1.3                    | %          | 1.2                  | %          | 1.1 | % | 1.0 | % |
| **Operating income**                      |       | 5.5                    | %          | 7.1                  | %          | 5.7 | % | 6.5 | % |

 

**ThreeMonths Ended March 31, 2010 Compared to Three Months Ended March 31,2009**

 

*CapitationRevenue*

 

Capitation revenue for thethree months ended March 31, 2010 was approximately $45,933,000,representing a decrease of approximately $1,941,000 or 4.1% from capitationrevenue for the three months ended March 31, 2009, of approximately$47,874,000.

 

The decrease in the fiscal2010 period was due primarily to a decrease in commercial enrollment givencurrent unemployment levels and cancellation of certain unprofitable Medi-Calcontracts, partly offset by rate increases and an increase in seniorenrollment.

 

*ManagementFee Revenue*

 

Management fee revenue for thethree months ended March 31, 2010 was approximately $158,000, representingan increase of approximately $14,000 or 9.7% from management fee revenue forthe three months ended March 31, 2009, of approximately $144,000.

 

The increase in management fee revenue during the fiscal 2010 period was primarily dueto an increase in the number of members of AMVICare Health Network, Inc.and an increase in management fee percentage with OneCare.

 

*Otherrevenue*

 

Other revenue for the threemonths ended March 31, 2010 was approximately $33,000, representing adecrease of approximately $108,000 or 76.6% over other revenue for the threemonths ended March 31, 2009, of approximately $141,000.

 

Amounts represent incentivepayments from HMOs under “pay-for-performance” programs for quality medicalcare based on various criteria. The incentives are recorded when such amountsare known.

 

The decrease in otherrevenue during the fiscal 2010 period was primarily the result of timing ofreceipt of pay-for-performance monies.

 

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*PCPCapitation Expense*

 

Primary care physician (“PCP”)capitation expense for the three months ended March 31, 2010 wasapproximately $8,187,000, representing a decrease of $279,000 or 3.3% over PCPcapitation expense for the three months ended March 31, 2009, ofapproximately $8,466,000.

 

The decrease in PCPcapitation expense during the fiscal 2010 period was primarily due to decreasedenrollment, partly offset by market rate adjustments made as part of our effortto attract new physicians and their members.

 

*SpecialistCapitation Expense*

 

Specialist Capitationexpense for the three months ended March 31, 2010 was approximately$10,285,000, representing a decrease of $843,000 or 7.6% from specialistcapitation expense for the three months ended March 31, 2009, ofapproximately $11,128,000.

 

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

 

*ClaimsExpense*

 

Claims expense for the threemonths ended March 31, 2010 was approximately $17,521,000, representing anincrease of $51,000 or 0.3% over claims expense for the three months ended March 31,2009, of approximately $17,470,000.  Theincrease was due primarily to moving more of certain specialties to afee-for-service basis in the current fiscal period, which move was consideredmore beneficial to the Company.

 

*PhysicianSalaries Expense*

 

Physician salaries expensefor the three months ended March 31, 2010 was approximately $190,000,representing a decrease of $97,000 or 33.8% over physician salaries expense forthe three months ended March 31, 2009, of approximately $287,000.

 

The decrease in physiciansalaries expense was primarily due to conversion of on-staff hospitalistphysicians from employment to capitation basis effective during the thirdquarter of fiscal 2009.

 

*Other Cost of Revenues*

 

Othercost of revenues for the three months ended March 31, 2010 wasapproximately $681,000, compared to a negative expense of approximately$395,000 for the three months ended March 31, 2009.

 

The change was primarily dueto unusually high stop-loss insurance recoveries, resulting in a contra expensein the prior year period.

 

*GrossMargin*

 

Medical care costs as apercentage of medical revenues (the medical cost ratio, a non-GAAP measure)largely determine our gross margin. Our gross margin decreased to 20.1% for thethree months ended March 31, 2010, from 23.3% for the three months ended March 31,2009.

 

The decrease in our grossmargin percentage between the fiscal 2010 and 2009 periods was primarily due tochanges in the level of receipts for stop-loss insurance recoveries, increasedclaims expense, and certain market rate adjustments given to our contractedphysicians as discussed above.

 

*Generaland Administrative Expense*

 

General and administrativeexpenses (“G&A”) were approximately $6,467,000 for the three months ended March 31,2010, representing 14.0% of total Medical Group revenues, as compared withapproximately $7,479,000 or 15.5% of total Medical Group revenues, for thefiscal 2009 period.

 

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The decrease in G&Aexpenses during the fiscal 2010 period was primarily due to the elimination ofcertain personnel, facility and outside service costs, in connection with theconsolidation of certain administrative functions among our Medical Groups.

 

*Depreciationand Amortization Expense*

 

Depreciation andamortization expense for the three months ended March 31, 2010 decreasedto approximately $856,000 from $884,000 for the same period of the prior year,primarily due to retirement of certain office equipment.

 

*Incomefrom Unconsolidated Joint Venture*

 

The income fromunconsolidated joint venture for the three months ended March 31, 2010 of$580,000 was comparable to the $595,000 for the same period of the prior yearand in line with expectations.

 

*OperatingIncome*

 

Our Medical Group segmentreported operating income of approximately $2,517,000 and $3,435,000, for thethree months ended March 31, 2010 and 2009, respectively, as a result ofthe changes discussed above. The operating results of the Medical Group segmentinclude certain corporate expense allocations for insurance, professional fees,and amortization of identifiable intangibles that relate to this segment.

 

***Six Months EndedMarch 31, 2010 Compared to Six Months Ended March 31, 2009***

 

*CapitationRevenue*

 

Capitation revenue for thesix months ended March 31, 2010 was approximately $92,381,000 representinga decrease of approximately $3,255,000 or 3.4% from capitation revenue for thesix months ended March 31, 2009, of approximately $95,636,000.

 

The decrease in the fiscal2010 period was due primarily to a decrease in commercial enrollment givencurrent unemployment levels and cancellation of certain unprofitable Medi-Calcontracts, partly offset by rate increases and an increase in seniorenrollment.

 

*ManagementFee Revenue*

 

Management fee revenue forthe six months ended March 31, 2010 was approximately $312,000representing an increase of approximately $24,000 or 8.3% from management feerevenue for the six months ended March 31, 2009, of approximately$288,000.

 

The increase in management fee revenue during the fiscal 2010 period was primarily dueto an increase in the number of members of AMVICare Health Network, Inc.and an increase in management fee percentage with OneCare.

 

*Otherrevenue*

 

Other revenue for the sixmonths ended March 31, 2010 was approximately $115,000, representing adecrease of approximately $251,000 or 68.6% over other revenue for the sixmonths ended March 31, 2009, of approximately $366,000.

 

Amounts represent incentivepayments from HMOs under “pay-per-performance” programs for quality medicalcare based on various criteria. The incentives are recorded when such amountsare known.

 

The decrease in otherrevenue during the fiscal 2010 period was primarily the result of timing ofreceipt of pay-for-performance monies.

 

*PCP CapitationExpense*

 

Primary care physician (“PCP”)capitation expense for the six months ended March 31, 2010 wasapproximately $16,593,000, representing a decrease of $541,000 or 3.2% over PCPcapitation expense for the six months ended March 31, 2009, of approximately$17,134,000.

 

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The decrease in PCPcapitation expense during the fiscal 2010 period was primarily due to decreasedenrollment, partly offset by market rate adjustments made as part of our effortto attract new physicians and their members.

 

*SpecialistCapitation Expense*

 

Specialist Capitationexpense for the six months ended March 31, 2010 was approximately$20,633,000, representing a decrease of $1,514,000 or 6.8% from specialistcapitation expense for the six months ended March 31, 2009, ofapproximately $22,147,000.

 

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

 

*ClaimsExpense*

 

Claims expense for the sixmonths ended March 31, 2010 was approximately $35,514,000, representing anincrease of $351,000 or 1.0% over claims expense for the six months ended March 31,2009, of approximately $35,163,000.  Theincrease was due primarily to moving more of certain specialties to a fee-for-servicebasis in the current fiscal period, which move was considered more beneficialto the Company, offset by decreased enrollment.

 

*PhysicianSalaries Expense*

 

Physician salaries expensefor the six months ended March 31, 2010 was approximately $223,000,representing a decrease of $842,000 or 79.1% over physician salaries expensefor the six months ended March 31, 2009, of approximately $1,065,000.

 

The decrease in physiciansalaries expense was primarily due to conversion of on-staff hospitalistphysicians from employment to capitation basis effective during the thirdquarter of fiscal 2009.

 

*Other Cost of Revenues*

 

Othercost of revenues for the six months ended March 31, 2010 was approximately$745,000, compared to a negative expense of approximately $942,000 for the sixmonths ended March 31, 2009.

 

The change was primarily dueto unusually high stop-loss insurance recoveries, resulting in a contra expensein the prior year period.

 

*Gross Margin*

 

Medicalcare costs as a percentage of medical revenues (the medical cost ratio, anon-GAAP measure) largely determine our gross margin. Our gross margindecreased to 20.6% for the six months ended March 31, 2010, from 22.6% forthe six months ended March 31, 2009.

 

The decrease in our grossmargin percentage between the fiscal 2010 and 2009 periods was primarily due tochanges in the level of stop-loss insurance recoveries, increased claimsexpense, and certain market rate adjustments given to our contractedphysicians, as discussed above.

 

*Generaland Administrative Expense*

 

General and administrativeexpenses (“G&A”) were approximately $13,140,000 for the six months ended March 31,2010, representing 14.2% of total Medical Group revenues, as compared withapproximately $14,675,000 or 15.2% of total Medical Group revenues, for thefiscal 2009 period.

 

The decrease in G&Aexpenses during the fiscal 2010 period was primarily due to the elimination ofcertain personnel, facility and outside service costs, in connection with theconsolidation of certain administrative functions among our Medical Groups.

 

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*Depreciationand Amortization Expense*

 

Depreciation andamortization expense for the six months ended March 31, 2010 decreased toapproximately $1,725,000 from $1,755,000 for the same period of the prior year,primarily due to retirement of certain office equipment.

 

*Incomefrom Unconsolidated Joint Venture*

 

The income fromunconsolidated joint venture for the six months ended March 31, 2010increased to $1,031,000 from $947,000 for the same period of the prior year.The increase was primarily due to increased risk pool income in the fiscal 2010period.

 

*OperatingIncome*

 

Our Medical Group segmentreported operating income of approximately $5,266,000 and $6,240,000, for thesix months ended March 31, 2010 and 2009, respectively, as a result of thechanges discussed above. The operating results of the Medical Group segmentinclude certain corporate expense allocations for insurance, professional fees,and amortization of identifiable intangibles that relate to this segment.

 

***Corporate Expenses***

 

Certain expensesincurred at Prospect Medical Holdings, Inc. (the “Parent Entity”) notspecifically allocable to the Hospital Services or Medical Group segments arerecorded in the Corporate segment.  Theseinclude salaries (including stock-based compensation), benefits, financing,rent, supplies, legal, SEC compliance, and Sarbanes-Oxley compliance.  We do not allocate interest expense, debtextinguishment loss, gain or loss on interest rate swaps and income taxes tothe other reporting segments.

 

The following tablesummarizes our corporate expense for the Parent Entity, and is used in thediscussion below for the three-month and six-month periods ended March 31,2010 and 2009 (in thousands).

 
| ** **                                                     | ** ** | **Three  Months Ended  March 31,** | ** ** | **Six  Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                     | ** ** | **2010**                                | ** ** | **2009**                              | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** | **2010** | ** ** | **2009** | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** |
| **Operating Expenses:**                                        |       |                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| General  and administrative expense                            |       | $                                       | 2,692      |                                  | $          | 2,851 |   | $ | (159 | ) | (5.6 | )% | $ | 6,191 |   | $ | 4,873 |   | $ | 1,318 |   | 27.0 | % |
| Depreciation  and amortization expense                         |       | 3                                       |       | 3                                     |       | 0 |   | 0.0 | % | 7 |   | 6 |   | 1 |   | 16.7 | % |
| **Total Operating Expenses**                                   |       | 2,695                                   |       | 2,854                                 |       | (159 | ) | (5.6 | )% | 6,198 |   | 4,879 |   | 1,319 |   | 27.0 | % |
| **Other (Income) Expense:**                                    |       |                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment  income                                             |       | —                                  |       | (15                                   | )          | 15 |   | -100 | % | — |   | (37 | ) | 37 |   | -100 | % |
| Interest  expense and amortization of deferred financing costs |       | 5,569                                   |       | 6,524                                 |       | (955 | ) | -14.6 | % | 11,261 |   | 12,621 |   | (1,360 | ) | -10.8 | % |
| (Gain)  loss in value of interest rate swap arrangements       |       | —                                  |       | (955                                  | )          | 955 |   | (100.0 | )% | — |   | 8,713 |   | (8,713 | ) | (100.0 | )% |
| **Total Other Expenses**                                       |       | 5,569                                   |       | 5,554                                 |       | 15 |   | 0.3 | % | 11,261 |   | 21,297 |   | (10,036 | ) | (47.1 | )% |
| **Total Corporate Expenses**                                   |       | $                                       | 8,264      |                                  | $          | 8,408 |   | $ | (143 | ) | (1.7 | )% | $ | 17,459 |   | $ | 26,176 |   | $ | (8,717 | ) | (33.3 | )% |

 

The following table setsforth selected operating items, expressed as a percentage of total consolidatedrevenues:

 
| ** **                                                     | ** ** | **Three Months Ended  March 31,** | ** ** | **Six Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2010**                               | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Operating Expenses:**                                        |       |                                   |       |                                 |       |   |   |   |   |
| General  and administrative expense                            |       | 2.3                                    | %          | 3.3                                  | %          | 2.7 | % | 2.9 | % |
| Depreciation  and amortization expense                         |       | 0.0                                    | %          | 0.0                                  | %          | 0.0 | % | 0.0 | % |
| **Total Operating Expenses**                                   |       | 2.3                                    | %          | 3.3                                  | %          | 2.7 | % | 2.9 | % |
| **Other (Income) Expense:**                                    |       |                                   |       |                                 |       |   |   |   |   |
| Investment  income                                             |       | 0.0                                    | %          | 0.0                                  | %          | 0.0 | % | 0.0 | % |
| Interest  expense and amortization of deferred financing costs |       | 4.9                                    | %          | 7.6                                  | %          | 4.9 | % | 7.4 | % |
| (Gain)  loss in value of interest rate swap arrangements       |       | 0.0                                    | %          | (1.1                                 | )%         | 0.0 | % | 5.1 | % |
| **Total Other Expenses**                                       |       | 4.9                                    | %          | 6.5                                  | %          | 4.9 | % | 12.6 | % |
| **Total Corporate Expenses**                                   |       | 7.1                                    | %          | 9.8                                  | %          | 7.5 | % | 15.4 | % |

 

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**ThreeMonths Ended March 31, 2010 Compared to Three Months Ended March 31,2009**

 

*Generaland Administrative Expense*

 

General and administrative (“G&A”)expense for the three months ended March 31, 2010 was approximately$2,692,000, representing approximately 2.3% of total consolidated revenues,compared to approximately $2,851,000 or approximately 3.3% of totalconsolidated revenues, for the three months ended March 31, 2009. Thedecrease in G&A expenses during the fiscal 2010 period was due primarily todecreased accruals for annual incentive compensation and legal costs, offset byincreased stock-based compensation.

 

*Depreciationand Amortization Expense*

 

Depreciation andamortization expense remained consistent at $3,000 for each of the three-monthperiod ended March 31, 2010 and 2009.

 

*InterestExpense and Amortization of Deferred Financing Costs*

 

Interest expense andamortization of deferred financing costs for the three months ended March 31,2010 was approximately $5,569,000, compared to approximately $6,524,000 for thethree months ended March 31, 2009, a decrease of approximately 14.6%.

 

Following our refinance on July 29,2009, (see Note 6 to the unaudited condensed consolidated financialstatements), the effective interest rate on our debt facilities was reduced,resulting in the decrease in quarterly interest expense..

 

*Loss inValue of Interest Rate Swap Arrangements*

 

We had two interest rateswaps in place in connection with our prior debt financing.  These swaps did not qualify for hedgeaccounting during the fiscal 2009 period and as such, all changes in fair valueof those swaps were treated as an expense.

 

Concurrent with the SeniorSecured Note transaction on July 29, 2009, we terminated the interest rateswap arrangements and expensed all previously unamortized swap fluctuationamounts.  Accordingly, there were nointerest rate swaps in existence or related expense during the quarter ended March 31,2010.

 

***Six Months Ended March 31, 2010Compared to Six Months Ended March 31, 2009***

 

*General and Administrative Expense*

 

Generaland administrative (“G&A”) expense for the six months ended March 31,2010 was approximately $6,191,000, representing approximately 2.7% of totalconsolidated revenues, compared to approximately $4,873,000 or approximately2.9% of total consolidated revenues, for the six months ended March 31,2009. The increase in G&A expense percentage during the fiscal 2010 periodwas due primarily to relative decreases in accruals for annual incentivecompensation and increased stock-based compensation.

 

*Depreciationand Amortization Expense*

 

Depreciation andamortization expense for the six months ended March 31, 2010 wasapproximately $7,000, compared to approximately $6,000 for the six months endedMarch 31, 2009, primarily due to depreciation expense of additional officeequipment incurred in the fiscal 2010 period.

 

*Interest Expense and Amortizationof Deferred Financing Costs*

 

Interest expense andamortization of deferred financing costs for the six months ended March 31,2010 was approximately $11,261,000, compared to approximately $12,621,000 forthe six months ended March 31, 2009, a decrease of approximately 10.8%.

 

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Following our refinance on July 29,2009, (see Note 6 to the unaudited condensed consolidated financialstatements), the effective interest rate on our debt facilities was reduced,resulting in the decrease in quarterly interest expense..

 

*Loss inValue of Interest Rate Swap Arrangements*

 

We had two interest rateswaps in place in connection with our prior debt financing.  These swaps did not qualify for hedgeaccounting during the fiscal 2009 period and as such, all changes in fair valueof those swaps were treated as an expense.

 

Concurrent with the SeniorSecured Note transaction on July 29, 2009, we terminated the interest rateswap arrangements and expensed all previously unamortized swap fluctuationamounts.  Accordingly, there were nointerest rate swaps in existence or related expense during the quarter ended March 31,2010.

 

**ConsolidatedResults of Operations**

 

**ThreeMonths Ended March 31, 2010 Compared to Three Months Ended March 31,2009**

 

*Provisionfor Income Taxes*

 

Income tax provision for thethree months ended March 31, 2010 was approximately $1,944,000 compared to$2,496,000 in the three months ended March 31, 2009 with the change beingdue to the change in income before taxes. The effective tax rate was 44% forthe three months ended March 31, 2010 compared to 41% for the three monthsended March 31, 2009. The higher effective tax rate in the fiscal 2010period was primarily due to not recognizing the deferred tax benefit fromBrotman’s current period loss, for federal tax purposes.

 

*Net LossAttributable to Noncontrolling Interest*

 

Net loss, net of tax attributable to noncontrollinginterests for the three months ended March 31, 2010 was approximately$87,000,as comparedto net income, net of tax of $1,000for the three months ended March 31, 2009. Thedecrease was due to consolidation of Brotman in the current year period.

 

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

 

Netincome attributable to Prospect Medical Holdings, Inc.’s commonstockholders for the three months ended March 31, 2010 was approximately$2,587,000 or $0.11 per diluted share, as compared to net income ofapproximately $3,548,000 or $0.17  perdiluted share, for the three months ended March 31, 2009, which change wasthe result of the items discussed above.

 

***Six Months Ended March 31, 2010 Compared to Six months Ended March 31,2009***

 

*Provisionfor Income Taxes*

 

Income tax provision for thesix months ended March 31, 2010 was approximately $4,447,000, compared to$76,000 for the six months ended March 31, 2009, with the change being dueto the change in income before taxes. The effective tax rate was higher at 47%for the six months ended March 31, 2010 compared to 41% for the six monthsended March 31, 2009. The higher effective tax rate in the fiscal 2010period was primarily due to not recognizing the deferred tax benefit fromBrotman’s current period loss, for federal tax purposes.

 

*Net LossAttributable to Noncontrolling Interest*

 

Net loss, net of tax attributable to noncontrollinginterests for the six months ended March 31, 2010 was approximately $483,000,as compared to net income, net of tax of$4,000for the sixmonths ended March 31, 2009. The decrease was due to consolidation ofBrotman in the current year period.

 

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

 

Netincome attributable to Prospect Medical Holdings, Inc.’s commonstockholders for the six months ended March 31, 2010 was approximately$5,447,000 or $0.24 per diluted share, as compared to net income ofapproximately $104,000 or $0.01 per diluted share, for the six months ended March 31,2009, which change was the result of the items discussed above.

 

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**Liquidityand Capital Resources**

 

Our primary sources of cashhave been funds provided by borrowings under our credit facilities, by theissuance of equity securities and by cash flow from operations. Prior to the August 8,2007 acquisition of Alta, our primary sources of cash from operations werehealthcare capitation revenues, fee-for-service revenues, risk pool paymentsand pay-for-performance incentives earned by our affiliated physicianorganizations. With the acquisition of Alta, and subsequently Brotman, oursources of cash from operations now include payments for hospital servicesrendered under reimbursement arrangements with third-party payers, whichinclude the federal government under the Medicare program, the state governmentunder the Medi-Cal program, private insurers, HMOs, PPOs, and self-paypatients.

 

Our primary uses of cash include healthcarecapitation and claims payments by our affiliated physician organizations,administrative expenses, debt service, acquisitions, costs associated with theintegration of acquired businesses, information systems and, with theacquisition of Alta and subsequently Brotman, operating, capital improvementand administrative expenses related to our hospital operations. Our affiliatedphysician organizations generally receive capitation revenue in advance ofhaving to make capitation and claims payments to their providers. However, ourhospitals receive payments for services rendered generally 30 to 90 daysafter the medical care is rendered. For some accounts and payer programs, thetime lag between service and reimbursement can exceed one year.

 

Our investment strategiesare designed to provide safety and preservation of capital, sufficientliquidity to meet the cash-flow needs, of our business operations, andattainment of a competitive return. At March 31, 2010, we invested ourcash in interest bearing money market accounts, interest-bearing certificatesof deposit and non interest-bearing checking accounts. All of these amounts areclassified as current assets and included in cash and cash equivalents in ourcondensed consolidated balance sheets.

 

*Cash Flow from Operations*

 

Net cash provided byoperating activities was approximately $4,701,000 for the six months ended March 31,2010 compared to net cash provided by operating activities of approximately$5,053,000 for the six months ended March 31, 2009. The decrease in netcash provided by operating activities for the six months ended March 31,2010 as compared to the six months ended March 31, 2009 was due to variousfactors, including the following:

 

·                  earnings,excluding non-cash charges and credits were approximately $27,247,000 in thefiscal 2010 period compared to approximately $14,182,000 in the fiscal 2009period;

·                  changes inpatient, government program and other receivables, a use of approximately$16,069,000 in the fiscal 2010 period compared to a use of approximately$7,524,000 in the fiscal 2009 period. The increase in the fiscal 2010 periodwas attributable primarily to increased inpatient volume in our HospitalServices segment, with Brotman contributing approximately 87% of the increase;

·                  changes inprepaid expenses and other assets, a use of approximately $584,000 in thefiscal 2010 period compared to a source of approximately $465,000 in the fiscal2009 period. The change in the fiscal 2010 period was primarily due to thetiming of employee health insurance premium payments in connection withswitching health insurance providers;

·                  changes inrefundable income tax and taxes payable, a use of approximately $354,000 in thefiscal 2010 period compared to a source of approximately $3,923,000 in thefiscal 2009 period. The decrease in the fiscal 2010 period was primarily due toincreased income tax deposits given higher taxable income in the 2010 period;

·                  changes inmedical claims and related liabilities, a use of approximately $1,831,000 in thefiscal 2010 period compared to a use of approximately $1,106,000 in the fiscal2009 period, with the increase in the fiscal 2010 period was primarily due todecreased enrollment and decreased accruals of IBNR in our Medical Groupsegment, to reflect current independent and in-house actuarial valuations; and

·                  changes inaccounts payable and other accrued liabilities, a use of approximately$4,095,000 in the fiscal 2010 period compared to a use of approximately$2,790,000 in the fiscal 2009 period. The increase in the fiscal 2010 periodwas primarily due to payout of Company match obligations under the Brotmandefined contribution plan for prior years, decreased accruals of medicalmalpractice and workers’ compensation insurance in our Hospital Servicessegment to reflect current independent actuarial valuation levels and increasedpayouts of accrued compensation in the 2010 period.

 

Netcash used in investing activities totaled approximately $1,324,000 for the sixmonths ended March 31, 2010, compared to a use of approximately $442,000for the six months ended March 31, 2009, the largest component of whichwas purchases of property, improvements and equipment, a use of approximately$1,382,000 in the fiscal 2010 period compared to a use of approximately$437,000 in the fiscal 2009 period, with the increase being partly due toinclusion of Brotman in the 2010 period.

 

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Net cash used by financingactivities totaled approximately $253,000 for the six months ended March 31,2010, compared to a use of approximately $6,660,000 for the six months ended March 31,2009. Net cash used in financing activities for the six months ended March 31,2010 was comprised primarily of payments related to the Brotman’s UnsecuredCreditors Note of $531,000, payments of $432,000 on capital leases, andincreased deposits into restricted cash of $945,000 as required by Brotman’sJHA financing, offset by cash provided by net borrowings under Brotman’srevolving line of credit for working capital purposes of approximately $1,541,000.Net cash used in financing activities for the six months ended March 31,2009 was comprised primarily of payments related to our former term debt ofapproximately $6,465,000 and payments of $195,000 on capital leases.

 

At March 31, 2010, wehad working capital of approximately $19,993,000 as compared to working capitalof approximately $9,903,000 at September 30, 2009.

 

At March 31, 2010 and September 30,2009, cash, cash equivalents and investments (including restricted amounts)totaled approximately $43,866,000 and $39,828,000 respectively.

 

*Prospect Note Offering*

 

On July 29, 2009, the Company closed the offering of $160 million in 12.75%senior secured notes due 2014 (the “Notes”) at an issue price of 92.335%. The sale was executed in accordance with Rule 144A under the SecuritiesAct of 1933 and Regulation S under the Securities Act of 1933.  Also, inconnection with the issuance of the Notes, the Company entered into athree-year $15 million revolving credit facility, which was undrawn atclosing.  The interest rate under the revolving credit facility will be atLIBOR plus an applicable margin of 7.00%, with a LIBOR floor of 2.00%.  The Company used the net proceeds from thesale of the Notes to repay all amounts outstanding under the Former CreditFacility, plus aprepayment premium of approximately $2.6 million.

 

*BrotmanFinancing*

 

As part of Brotman’semergence from bankruptcy on April 14, 2009, financing was secured fromthe Los AngelesJewish Home for the Aging (“JHA”) and Gemino HealthcareFinance, LLC (“Gemino”).

 

The JHA financing wascomprised of two term debt components, a $16.0 million tranche secured byassets on the west side of the Brotman campus commonly referred to as “DelmasWest” and a $6.25 million tranche on the main hospital pavilion on theeast side of the property. The $16.0 million tranche contains an optionfor JHA to acquire the Delmas West parcel for a purchase price equal to theoutstanding debt within 24 months of the effective date of the bankruptcy.If JHA does not exercise its option, Brotman will be required to refinance the$16.0 million tranche on or before April 14, 2011. With respect tothe $16.0 million tranche of the JHA facility, JHA also has the right todeclare the unpaid loan amount, immediately due and payable at any time after April 14,2010 and prior to April 14, 2011, provided that JHA gives 180 days’written notice of exercise. Effective February 10, 2010, JHA and Brotmanentered into an amendment to the Term A loan, whereby the earliest date onwhich JHA could provide notice of its exercise of the Put Right was extendedfrom April 14, 2010 to October 14, 2010.  In addition, the $6.25 million trancheof the JHA transaction will mature on April 14, 2012 and Brotman will needto secure financing to retire this portion of the debt.

 

The Geminofinancing was comprised of a $6.0 million (which was increased to $7.0 millionpursuant to an amendment described below), senior credit facility secured byaccounts receivable. The facility expires on the earlier of April 14, 2012and the JHA loan (see above) maturity date and bears interest at LIBOR plus 7%per annum, with a LIBOR floor of 4%. Interest is incurred based on the greaterof $2 million or the outstanding principal balance. The agreement also includesan unused line fee of 0.5% per annum and a collateral line fee, based on theaverage outstanding principal balance, of 0.5% per annum. The senior credit facilityagreement contains customary covenants for facilities of this type, includingrestrictions on the payment of dividends, change in ownership/management, assetsales, incurrence of additional indebtedness, sale-leaseback transactions, andrelated party transactions. Brotman must also comply with financial covenants.Prior to a recent amendment discussed below, Brotman was required to complywith a fixed charge coverage ratio of not less than (i) 1.10:1.00 for thefiscal quarter ending June 30, 2009, (ii) 1.15:1.00 for the fiscalquarter ending September 30, 2009; and (iii) 1.20:1.00 for eachfiscal quarter ending thereafter.  As of September 30,2009, Brotman was not in compliance with the required financial covenants underthe Gemino credit agreement.  Pursuant toan amendment entered into effective December 11, 2009, the Gemino creditagreement was amended to provide, among other things, a waiver of the specifiedevents of default and the amendment to the definition of fixed charge coverageratio.  Under the amended creditagreement, the fixed charge coverage ratio was amended to require not less than(i) 1.00:1.00 for the fiscal quarters ending December 31, 2009 and March 31,2010; (ii) 1.05:1.00 for the fiscal quarters ending June 30, 2010 andSeptember 30, 2010; (iii) 1.10:1.00 for the fiscal quarters ending December 31,2010 and March 31, 2011; and (iv) 1.20:1.00 for the fiscal quarterending June 30, 2011 and each fiscal quarter ending thereafter.  As of March 31, 2010, Brotman was incompliance with the required financial covenants under the amended creditagreement. Pursuant to an amendment entered into effective February 17, 2010,the Gemino credit agreement and promissory note were amended to increase theloan commitment by $1.0 million to a total commitment of $7.0 million as setforth above.

 

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The Class 4 Note, whichwas executed on April 14, 2009, the Effective Date of Brotman’s Plan ofReorganization, for the benefit of the allowed Class 4 claims (as definedin the Plan of Reorganization) bears interest at 7.50% per annum and is payablein sixteen equal quarterly installments of principal and accrued interestthrough February 15, 2013. The Note contains a covenant which, so long asamounts remain outstanding under the Note, restricts Brotman from payingProspect Medical Holdings, Inc. in cash a consulting fee of more than$100,000 per month, as specified in the Amended and Restated ConsultingServices Agreement (see Note 5 to the accompanying unaudited condensedconsolidated financial statements).  Assuch, although the amount of the consulting fee was increased to 4.5% ofBrotman’s net operating revenue effective April 14, 2009, the amount ofsuch consulting fee actually paid in cash will remain at $100,000 per monthuntil such time permitted by applicable agreement or the Creditor Trust Notehas been amended or repaid. For the period April 14, 2009 through March 31,2010, total principal repayments on the Class 4 Note were approximately$1,000,000.

 

We anticipate attempting tofinance future acquisitions and potential business expansion with a combinationof debt, issuances of equity instrument, and cash flow from operations.

 

In order to meet ourlong-term liquidity needs, we may incur, from time to time, additional bankindebtedness. Banks and traditional commercial lenders do not generally makeloans to companies without substantial tangible net worth. Since, by the natureof our business, we accumulate substantial goodwill and intangibles on ourbalance sheet, it may be difficult for us to obtain this type of financing inthe future. We may issue additional equity and debt securities, the availabilityand terms of which will depend upon market and other conditions. The corporatelending and equity markets have been affected by the current credit marketconditions, resulting in both a reduction in the number of transactions as wellas the amount of funds raised. Transactions that have been consummated arecompleted at lower valuations in the case of equity offerings and at higherinterest costs in the case of debt offerings. Our ability to issue any debt orequity instruments in a public or private sale is also restricted under certaincircumstances, pursuant to contractual restrictions in agreements with ourlenders and the indenture governing the Notes (see above). There can be noassurance that additional financing will be available upon terms acceptable tous, if at all. The failure to raise the funds necessary to finance our futurecash requirements could adversely affect our ability to pursue our strategy andcould adversely affect our future results of operations.

 

*Off-BalanceSheet Arrangements*

 

None.

 

**CriticalAccounting Policies**

 

The accounting policiesdescribed below are considered critical in preparing our unaudited interimcondensed consolidated financial statements. Critical accounting policies require difficult, subjective or complex judgments,often as a result of the need to make estimates about the effect of mattersthat are inherently uncertain. The judgments and uncertainties affecting theapplication of these policies include significant estimates and assumptionsmade by us using information available at the time the estimates are made.Actual results could differ materially from those estimates.

 

***Consolidation of Financial Statements***

 

Under applicable financialreporting requirements, the financial statements of the affiliated physicianorganizations with which we have management services agreements areconsolidated with our own financial statements. This consolidation is requiredunder FASB ASC 810-10 because we are deemed to hold a controllingfinancial interest in such organizations through a nominee shareholder. We can,through the assignable option agreements, change the nominee shareholder atwill on an unlimited basis and for nominal cost. There is no limitation on ourdesignation of a nominee shareholder except that any nominee shareholder mustbe a licensed physician or otherwise permitted by law to hold shares in aprofessional medical corporation. The operations of our affiliated physicianorganizations have a significant impact on our financial statements. Thefinancial statements of Brotman have been included in our consolidatedfinancial statements since April 14, 2009, when we acquired a majoritystake in that entity. All inter-company accounts and balances have beeneliminated in consolidation.

 

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***Revenue Recognition***

 

*Third-partyand Patient Reimbursement*

 

Operating revenueof the Hospital Services segment consists primarily of net patient servicerevenue. A summary of the payment arrangements with major third-party payersfollows:

 

*Medicare:* Medicare is a federal program that provides certain hospital and medicalinsurance benefits to persons aged 65 and over, some disabled persons andpersons with end-stage renal disease. Inpatient services rendered to Medicareprogram beneficiaries are paid at prospectively determined rates per discharge,according to a patient classification system based on clinical, diagnostic, andother factors. Outpatient services are paid based on a blend of prospectivelydetermined rates and cost-reimbursed methodologies. We are also reimbursed forvarious disproportionate share and Medicare bad debt components at tentativerates, with final settlement determined after submission of annual Medicarecost reports and audits thereof by the Medicare fiscal intermediary.

 

*Medi-Cal:* Medi-Cal is a joint federal-state funded healthcare benefit program thatis administered by the state of California to provide benefits to qualifyingindividuals who are unable to afford care. Inpatient services rendered toMedi-Cal program beneficiaries are paid at contracted per diem rates. The perdiem rates are not subject to retrospective adjustment. Outpatient services arepaid based on prospectively determined rates per procedure provided.

 

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

 

*Self-Pay:* Our hospitals also provide services to certain individuals that do nothave any form of healthcare coverage. Such patients are evaluated, at the timeof service or shortly thereafter, for their ability to pay based upon federaland state poverty guidelines, qualifications for Medi-Cal, as well as our localhospital’s indigent and charity care policy.

 

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

 

For Medicare and Medi-Calprograms, provisions for contractual adjustments are made to reduce patientcharges to the estimated cash receipts based on each program’s principles ofpayment/reimbursement (i.e., either prospectively determined or retrospectivelydetermined costs). Under the Medi-Cal program’s prospective reimbursementsystems, there is no adjustment or settlement of the difference between theactual cost to provide the service and the predetermined reimbursement rates.Certain types of payments by the Medicare program (e.g. MedicareDisproportionate Share Hospital and Medicare Allowable Bad Debts) are subjectto retroactive adjustment in future periods. Final settlements under theseprograms are subject to adjustment based on administrative review and audit bythird party intermediaries, which can take several years to resolve completely.Adjustments related to final settlements for 2005 through 2008 cost reportyears increased our revenues by approximately $1.1 million and $0.2 million forthe years ended September 30, 2009 and 2008, respectively and by approximately$525,000 in each of the three-month and six-month period ended March 31, 2009,and none in each of the three-month and six-month period ended March 31, 2010.

 

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

 

Weclosely monitor our historical collection rates, as well as changes inapplicable laws, rules and regulations and contract terms, to ensure thatprovisions are made using the most appropriate and current informationavailable. However, due to the complexities involved in these estimations,actual payments from payers may be materially different from the amounts weestimate and record. If the actual contractual reimbursement percentage undergovernment programs and managed care contracts differed by 1% from ourestimated percentage, we project that our consolidated net hospital servicesrevenue and net income would have changed by approximately $2.7 million and$1.5 million, respectively, for the three months ended March 31, 2010 andby approximately $5.3 million and $2.8 million, respectively, for the sixmonths ended March 31, 2010. The process of determining the allowancerequires us to estimate the amount expected to be received based on payercontract provisions, historical collection data as well as other factors andrequires a high degree of judgment. It is impacted by changes in legislation,managed care contracts and other related factors. A significant increase in ourestimate of contractual discounts for Medicare, Medi-Cal and managed care planswould significantly lower our earnings. This would adversely affect our resultsof operations, financial condition, liquidity and future access to capital.

 

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*Provisionfor Doubtful Accounts*

 

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

 

Statements aresent to self-pay patients indicating the outstanding balances on theiraccounts. If an account is still outstanding after a period of time, it isreferred to third-party collection agencies for assistance in collecting theamount due. Our policy is to write-off all self-pay accounts after allcollection efforts have failed, which is generally 130 days after the date ofdischarge of the patient. All accounts that have been placed with third-partycollection agencies are written off. Patient responsibility accounts representthe majority of our write-offs. Accounts that are identified as self-payaccounts with balances less than $25.00 are automatically written off by the 30th day of eachmonth. Non self-pay accounts are reviewed monthly and written-off on acase-by-case basis.

 

The largest componentof our allowance for doubtful accounts relates to self-pay accounts. Theseaccounts include both amounts payable by uninsured patients and co-payments anddeductibles payable by insured patients. In general, we attempt to collectdeductibles, co-payments and self-pay accounts prior to the time of service fornon-emergency care. If we do not collect these patient responsibility amountsprior to the delivery of care, the accounts are handled through our billing andcollections processes. We verify each patient’s insurance coverage as early aspossible before a scheduled admission or procedure, including with respect toeligibility, benefits and authorization/pre-certification requirements, inorder to notify patients of the amounts for which they will be responsible. Weattempt to verify insurance coverage within a reasonable amount of time for allemergency room visits and urgent admissions in compliance with applicable laws.

 

The table belowshows the net accounts receivable and allowance for doubtful accounts by payer(in thousands):

 
| ** **    | ** ** | **March 31, 2010**                                                  | ** ** | **September 30, 2009**                | ** ** |
|---------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **Accounts  Receivable  Before  Allowance  For Doubtful  Accounts** | ** ** | **Allowance  For Doubtful  Accounts** | ** ** | **Net** | ** ** | **Accounts  Receivable  Before  Allowance  For Doubtful  Accounts** | ** ** | **Allowance  For Doubtful  Accounts** | ** ** | **Net** | ** ** |
| Medicare      |       | $                                                                        | 13,112     |                                       | $          | 1,383 |   | $ | 11,729 |   | $ | 9,919 |   | $ | 1,064 |   | $ | 8,855 |   |
| Medi-Cal      |       | 16,869                                                                   |       | 1,648                                      |       | 15,221 |   | 15,383 |   | 883 |   | 14,500 |   |
| Managed  care |       | 9,761                                                                    |       | 1,005                                      |       | 8,756 |   | 10,803 |   | 1,324 |   | 9,479 |   |
| Self-pay      |       | 12,077                                                                   |       | 7,660                                      |       | 4,417 |   | 11,391 |   | 8,183 |   | 3,208 |   |
| Other         |       | 4,321                                                                    |       | 2,410                                      |       | 1,911 |   | 1,025 |   | 261 |   | 764 |   |
| Total         |       | $                                                                        | 56,140     |                                       | $          | 14,106 |   | $ | 42,034 |   | $ | 48,521 |   | $ | 11,715 |   | $ | 36,806 |   |

 

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When consideringthe adequacy of our allowances for doubtful accounts, accounts receivablebalances are routinely reviewed in conjunction with health care industrytrends/indicators, historical collection rates by payer and other business andeconomic conditions that might reasonably be expected to affect thecollectibility of patient accounts. We believe that our principal risk ofcollection continues to be uninsured patient accounts and patient accounts forwhich the primary insurance payer has paid but patient responsibility amounts(generally deductibles and co-payments) remain outstanding. If our actualcollection rate changed by 1% from the estimated percentage that we used, weproject that our allowance for doubtful accounts and consolidated net incomewould have changed by approximately $3.2 million and $1.8 million,respectively, for the three months ended March 31, 2010 and byapproximately $3.2 million and $1.7 million, respectively, for the six monthsended March 31, 2010. The provision for doubtful accounts as a percentageof net patient revenues was 9.0% for the six months ended March 31, 2010compared to 5.1% for the six months ended March 31, 2009. The increase wasattributable primarily to the current year inclusion of Brotman, whichhistorically has a higher percentage of self-pay patients. Excluding Brotman,the provision for doubtful accounts as a percentage of net patient revenues was5.4% and 5.6% for the six months ended March 31, 2010, respectively, whichincrease was due primarily to improved collection efforts.

 

Of theaccounts receivable identified as due from third party payers at the time ofbilling, a small percentage may convert to self-pay upon denials from thirdparty payers. Those accounts are closely monitored on a routine basis forpotential denial and are reclassified as appropriate.

 

Thirdparty payer and self-pay balances, as a percent of total gross billed accountsreceivable, as of March 31, 2010 and September 30, 2009, aresummarized in the tables below:

 
| ** **     | ** ** | **March 31, 2010** | ** ** | **September 30, 2009** | ** ** |
|----------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **Medicare**            | ** ** | **Medi-Cal**                | ** ** | **Managed  Care** | ** ** | **Self-Pay  & Other** | ** ** | **Total** | ** ** | **Medicare** | ** ** | **Medi-Cal** | ** ** | **Managed  Care** | ** ** | **Self-Pay  & Other** | ** ** | **Total** | ** ** |
| 0 - 60 days    |       | 90.0                    | %          | 67.0                        | %          | 53.0 | % | 20.0 | % | 65.0 | % | 83.7 | % | 77.4 | % | 50.1 | % | 25.1 | % | 68.0 | % |
| 61 - 120 days  |       | 5.0                     | %          | 17.0                        | %          | 24.0 | % | 29.0 | % | 17.0 | % | 8.8 | % | 11.3 | % | 22.2 | % | 23.0 | % | 14.2 | % |
| 121 - 180 days |       | 2.0                     | %          | 11.0                        | %          | 16.0 | % | 23.0 | % | 11.0 | % | 3.3 | % | 6.8 | % | 15.6 | % | 28.0 | % | 9.8 | % |
| Over 180 days  |       | 3.0                     | %          | 5.0                         | %          | 7.0 | % | 28.0 | % | 7.0 | % | 4.2 | % | 4.5 | % | 12.1 | % | 23.9 | % | 8.0 | % |
| **Total**      |       | 100.0                   | %          | 100.0                       | %          | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |

 

Theincrease in self-pay accounts receivable of 18.4% as a percentage of total netaccounts receivable is primarily attributable to the current year inclusion ofBrotman, which has historically had a higher percentage of self-pay patients.

 

Our AR Days fromHospital Services operations were 54.9 days at March 31, 2010 compared to51.6 days at September 30, 2009. AR Days at March 31, 2010 and September 30,2009 are within our target range. AR Days are calculated as our accountsreceivable from Hospital Services operations on the last date in the relevantquarter divided by our net patient revenues for the quarter ended on that datedivided by the number of days in the quarter.

 

Although we believe thatour existing allowance for doubtful accounts reserve policies for all payerclasses are appropriate and responsive to both the current health careenvironment and the overall economic climate, we will continue to review ouroverall reserve adequacy by monitoring historical cash collections as apercentage of trailing net revenue less provision for bad debts, as well as byanalyzing current period net revenue and admissions by payer classification,aged accounts receivable by payer, days revenue outstanding, and the impact ofour recent acquisition.

 

*Medical Group Segment*

 

Operating revenue of ourMedical Groups consists primarily of capitation payments for medical servicesprovided by our affiliated physician organizations under contracts with HMOs.Capitation revenue under HMO contracts is prepaid monthly to the affiliatedphysician organizations based on the number and type of enrollees assigned tophysicians in our affiliated physician organizations.

 

Capitation revenue paid byHMOs is recognized in the month in which the affiliated physician organizationis obligated to provide services. Capitation revenue may be subsequentlyadjusted to reflect changes in enrollment as a result of retroactiveterminations or additions. Such retroactive terminations or additions havehistorically not had a material effect on capitation revenue.

 

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Variability in capitationrevenue exists under Medicare’s capitation model referred to as “RiskAdjustment.” Under the model, capitation with respect to Medicare enrollees issubject to subsequent adjustment by CMS based on the acuity of the enrollees towhom services were provided. Capitation for the current year is paid based ondata submitted for each enrollee for previous periods. Capitation is paid atinterim rates during the year and is adjusted in subsequent periods (generallyin our fourth fiscal quarter) after the final data has been processed by CMS.Positive or negative capitation adjustments are made for Medicare enrolleeswith conditions requiring more or less healthcare services than assumed in theinterim payments. Since we cannot reliably predict these adjustments, periodicchanges in capitation amounts earned as a result of Risk Adjustment arerecognized when those changes are communicated from the health plans, generallyin the fourth quarter of the fiscal year to which the adjustments relate. Werecorded approximately $4.3 million and $1.6 million in increasedcapitation revenue in the fourth quarter of fiscal 2009 and 2008, respectively,for risk adjustment factors.

 

We also earn additionalincentive revenue or incur penalties under HMO contracts by sharing in the riskfor hospitalization based upon inpatient services utilized. As of March 31,2010, except for one contract where we are contractually obligated for down-siderisk, shared risk deficits are not payable unless and until we generate futurerisk-sharing surpluses. Risk pools are generally settled in the third or fourthquarter of the following year. Due to the lack of access to timely informationnecessary to estimate the related costs, shared-risk amounts receivable fromthe HMOs are recorded when such amounts are known. We also receive incentivesunder “pay-for-performance” programs for quality medical care based on variouscriteria. Pay-for-performance payments are generally recorded in the third andfourth quarters of our fiscal year when such amounts are known, once we are inreceipt of information necessary to reliably estimate these amounts. Risk pooland pay-for-performance incentives are affected by many factors, some of whichare beyond our control, and may vary significantly from year to year.

 

Management fee revenue isearned in the month the services have been performed.

 

***Accrued Medical Claims***

 

Our affiliated physicianorganizations are responsible for the medical services their contracted oremployed physicians provide to an assigned HMO enrollee. The cost of healthcareservices is recognized in the period in which it is provided and includes anestimate of the cost of services which have been incurred but not reported. Thedetermination of our claims liability and other healthcare costs payable isparticularly important to the determination of our financial position andresults of operations and requires the application of significant judgment byour management, and as a result, is subject to an inherent degree ofuncertainty.

 

Our medical care costsinclude actual historical claims experience and IBNR. We, together with ourindependent actuaries, estimate medical claims liabilities using actuarialmethods based upon historical data, adjusted for payment patterns, cost trends,product mix, utilization of healthcare services and other relevant factors. Theestimation methods and the resulting reserves are frequently reviewed andupdated, and adjustments, if necessary, are reflected in the period they becomeknown. While we believe our estimates are adequate and appropriate, it ispossible that future events could require us to make significant adjustments orrevisions to these estimates. In assessing the adequacy of accruals for medicalclaims liabilities, we consider our historical experience, the terms ofexisting contracts, our knowledge of trends in the industry, informationprovided by our customers and information available from other sources, asappropriate.

 

The most significantestimates involved in determining our claims liability concern thedetermination of claims payment completion factors and trended per member permonth cost estimates.

 

We consider historicalactivity for the current month, plus the prior 24 months, in our IBNRcalculation. For the fifth month of service prior to the reporting date andearlier, we estimate our outstanding claims liability based upon actual claimspaid, adjusted for estimated completion factors. Completion factors seek tomeasure 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 four monthsof service immediately prior to the reporting date, actual claims paid are nota reliable measure of our ultimate liability, given the delay inherent betweenthe patient/physician encounter and the actual submission of a claim forpayment. 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.

 

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The following tables reflect(i) the change in our estimate of claims liability as of March 31,2010 that would have resulted had we changed our completion factors for allapplicable months of service included in our IBNR calculation (i.e., thepreceding 5th through 25th months) by the percentages indicated; and (ii) thechange in our estimate of claims liability as of March 31, 2010 that wouldhave resulted had we changed trended PMPM factors for all applicable months ofservice included in our IBNR calculation (i.e., the preceding1st through 4th months) by the percentages indicated. Changes inestimate of the magnitude indicated in the ranges presented are consideredreasonably likely.

 
| **Increase  (Decrease) in Estimated Completion Factors** | ** ** | **Increase (Decrease) in  Accrued Medical  Claims Payable** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                               | ** ** | **(in thousands)**                                          | ** ** |
| (3)%                                                     |       | $                                                           | (4,884     | ) |
| (2)%                                                     |       | $                                                           | (3,256     | ) |
| (1)%                                                     |       | $                                                           | (1,628     | ) |
| 1%                                                       |       | $                                                           | 1,628      |   |
| 2%                                                       |       | $                                                           | 3,256      |   |
| 3%                                                       |       | $                                                           | 4,884      |   |

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

 

The following table showsthe components of the change in medical claims and benefits payable for the sixmonths ended March 31, 2010 and 2009 (in thousands):

 
| ** **                                            | ** ** | **Six Months Ended  March 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| IBNR  as of beginning of period                       |       | $                                    | 16,824     |   | $ | 20,480 |   |
| Healthcare  claims expense incurred during the period |       |                                 |       |   |   |
| Related  to current year                              |       | 37,004                               |       | 37,054 |   |
| Related  to prior years                               |       | (1,524                               | )          | (1,891 | ) |
| Total  incurred                                       |       | 35,480                               |       | 35,163 |   |
| Healthcare  claims paid during the period             |       |                                 |       |   |   |
| Related  to current year                              |       | (23,717                              | )          | (20,075 | ) |
| Related  to prior years                               |       | (13,594                              | )          | (16,194 | ) |
| Total  paid                                           |       | (37,311                              | )          | (36,269 | ) |
| IBNR  as of end of period                             |       | $                                    | 14,993     |   | $ | 19,374 |   |

 

Through March 31, 2010,the $1,524,000 change in estimate related to IBNR as of September 30, 2009represented approximately 9.1% of the IBNR balance as of September 30,2009, approximately 2.1 % of fiscal 2009 claims expense, and afterconsideration of tax effect, approximately 44% of net loss for the year thenended.

 

Through March 31,2009, the $1,891,000 change in estimate related to IBNR as of September 30,2008 represented approximately 9.2% of the IBNR balance as of September 30,2008, approximately 2.4% of fiscal 2008 claims expense, and after considerationof tax effect, approximately 45% of net loss from continuing operations for theyear then ended.

 

Past fluctuations in IBNRestimates might also be a useful indicator of the potential magnitude of futurechanges in these estimates. Quarterly IBNR estimates include provisions foradverse development based on historical volatility. We maintain similarprovisions at fiscal year end.

 

We also regularly evaluatethe need to establish premium deficiency reserves for the probability thatanticipated future healthcare costs could exceed future capitation paymentsfrom the HMOs. To date, we have determined that no material premium deficiencyreserves have been necessary.

 

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***Goodwill and Intangible Assets***

 

ASC 805 (previously issuedas SFAS No. 141) “*Business Combinations*,”requires all business combinations after June 30, 2001 to be accounted forusing the purchase method and prohibits the pooling-of-interest method ofaccounting. ASC 805 also states that acquired intangible assets should beseparately recognized upon meeting certain criteria. Such intangible assetsinclude, but are not limited to, trade and service marks, non-competeagreements, customer lists and licenses. We adopted the provisions ofASC 805 effective October 1, 2009.

 

ASC 350 (previously issuedas SFAS No. 142, “*Goodwill andOther Intangible Assets*,”) requires that goodwill and indefinitelife intangible assets not be subject to amortization but be evaluated forimpairment on at least an annual basis, or more frequently if certainindicators are present. Such indicators include adverse changes in market valueand/or stock price, laws and regulations, profitability, cash flows, ourability to maintain enrollment and renew payer contracts on favorable terms. Atwo-step impairment test is used to identify potential goodwill impairment andto measure the amount of goodwill impairment loss to be recognized (if any).The first step consists of estimating the fair value of the reporting unitbased on recognized valuation techniques, which include a weighted combinationof (i) the guideline company method that utilizes revenue or earningsmultiples for comparable publicly-traded companies, and (ii) a discountedcash flow model that utilizes future cash flows, the timing of those cashflows, and a discount rate (or weighted average cost of capital which considersthe cost of equity and cost of debt financing expected by a representativemarket participant) representing the time value of money and the inherent riskand uncertainty of the future cash flows. If the estimated fair value of thereporting unit is less than its carrying value, a second step is performed to computethe amount of the impairment by determining the “implied fair value” of thegoodwill, which is compared to its corresponding carrying value.

 

Long-lived assets, includingproperty, improvements and equipment and amortizable intangibles, are evaluatedfor impairment under ASC 360-10-35, (previously issued as SFAS No. 144,“*Accounting for the Impairment or Disposalof Long-Lived Assets*”) whenever events or changes in circumstancesindicate that the carrying value of such assets may not be recoverable. Weconsider assets to be impaired and write them down to fair value if estimatedundiscounted cash flows associated with those assets are less than theircarrying amounts.

 

In accordance with ASC 350,we performed our annual goodwill impairment analysis for each reporting unitthat constitutes a business for which discrete financial information isproduced and reviewed by operating segment management and provides servicesthat are distinct from the other reporting units. For the Hospital Servicessegment, the reporting unit for the annual goodwill impairment analysis wasdetermined to be at the segment level. For the Medical Group segment, we havedetermined that ProMed individually and Prospect (which includes all the otheraffiliated physician organizations) each represent a reporting unit, based onoperational characteristics. The ProMed Entities are geographically andmanagerially their own reporting unit.

 

Our impairment test at September 30,2009 resulted in no impairment charges. In addition, no triggering events were identified that would causeimpairment analysis at March 31, 2010.

 

The assessment of impairmentindicators, measurement of impairment loss, selection of appropriate valuationmethodology, assumptions and discount factors, involve significant judgment andrequires management to project future results which are inherently uncertain.

 

***RecentAccounting Pronouncements***

 

In December 2007, theFASB issued guidance on ASC 810, which establishes accounting and reportingstandards for the noncontrolling interest in a subsidiary and for thedeconsolidation of a subsidiary. Minority interests will be re characterized asnoncontrolling interests and will be reported as a component of equity separatefrom the parent’s equity, and purchases or sales of equity interests that donot result in a change in control will be accounted for as equity transactions.In addition, net income attributable to the noncontrolling interest will beincluded in consolidated net income on the face of the income statement and upona loss of control, the interest sold, as well as any interest retained, will berecorded at fair value with any gain or loss recognized in earnings. Thisliterature was effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. It requiresretroactive adoption of the presentation and expanded disclosure requirementsfor existing noncontrolling interests. All other requirements of the standardshall be applied prospectively. We adopted this literature effective October 1,2009. The adoption did not have a material impact on our condensed consolidatedfinancial statements.

 

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In December 2007, the FASB updated guidance onASC 805 retains the fundamental requirements of guidance surrounding businesscombinations stating that the acquisition method of accounting be used for allbusiness combinations and for an acquirer to be identified for each businesscombination. ASC 805 defines the acquirer as the entity that obtains control ofone or more businesses in the business combination and establishes theacquisition date as the date that the acquirer achieves control. ASC 805requires an acquirer to recognize the assets acquired, the liabilities assumed,and any noncontrolling interest in the acquiree at the acquisition date,measured at their fair values as of that date, with limited exceptionsspecified in the statement. This statement applies prospectively to businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008. Weadopted the pronouncement effective October 1, 2009. The adoption did nothave a material impact on our condensed consolidated financial statements forprior periods; but the pronouncement will impact the accounting foracquisitions subsequent to that date.

 

In June 2009, the FASB issued guidance on ASC810-10 to revise the approach to determine when a variable interest entity (“VIE”)should be consolidated. The new consolidation model for VIEs considers whetherthe Company has the power to direct the activities that most significantlyimpact the VIE’s economic performance and shares in the significant risks andrewards of the entity. The guidance on VIE’s requires companies to continuallyreassess VIEs to determine if consolidation is appropriate and provideadditional disclosures. The guidance is effective for fiscal years beginningafter November 15, 2009. We will adopt the guidance for interim and annualreporting periods beginning in the first quarter of fiscal 2011 and arecurrently assessing the potential impact this guidance will have on our consolidatedfinancial statements.

 

In June 2008, the FASB issued guidancecontained in FASB ASC 260-10. Under the guidance, unvested share-based paymentawards that contain non-forfeitable rights as to dividends or dividendequivalents are participating securities and, therefore, are included incomputing earnings per share (“EPS”) pursuant to the two-class method. Thetwo-class method determines earnings per share for each class of common stockand participating securities according to dividends or dividend equivalents andtheir respective participation rights in undistributed earnings. We adopted theguidance effective October 1, 2009.  The adoption of thisguidance did not impact net income attributable to our Company per common sharefor prior periods and is not expected to have an impact on future periods untilsuch time as we declare a regular quarterly dividend.

 

In August 2009, the FASB issued AccountingStandards Update No. 2009-05, “*Fair Value Measurementsand Disclosures (Topic 820) — Measuring Liabilities at Fair Value*,”which provides guidance on how to measure liabilities at fair value incircumstance in which a quoted price in an active market for the identicalliability is not available.  This updateis effective for the first reporting period, including interim periods,beginning after issuance.  The Companyhas no liabilities that are governed by this update but will apply itsprovisions in the future as applicable.

 

***Legal and Other Loss Contingencies***

 

We are subject tocontingencies, such as legal proceedings and claims arising out of ourbusiness. In accordance with ASC 450, we record accruals for such contingencieswhen it is probable that a liability will be incurred and the amount of losscan be reasonably estimated. A significant amount of management estimation isrequired in determining when, or if, an accrual should be recorded for acontingent matter and the amount of such accrual, if any.

 

We are in the process offinalizing certain post-closing matters related to the 2007 ProMed acquisition,including closing balance sheet reconciliations, escrow reconciliations andother matters. We have recorded an estimated settlement amount relating to suchmatters in the accompanying unaudited condensed consolidated financialstatements.

 

***Acquisitions***

 

Our business has grownthrough a series of business combinations. These business combinations were allaccounted for using the purchase method of accounting, and accordingly, theoperating results of each acquisition have been included in our consolidatedfinancial statements since their effective date of acquisition. The purchaseprice for each business combination was allocated to the assets, including theidentifiable intangible assets, and liabilities, based on estimated fair valuesdetermined using independent appraisals where appropriate. The excess ofpurchase price over the net tangible assets acquired was allocated to goodwilland other intangible assets.

 

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We have historically fundedour acquisition program with debt, the sale of our common stock, and cash flowfrom operations. The assets that we and our affiliated physician organizationshave acquired have been largely goodwill and intangible assets. The acquisitionof physician organizations consists primarily of HMO contracts, physiciancontracts and the right to manage each physician organization through amanagement services agreement. The physician organizations we acquire generallydo not have significant tangible net equity; therefore, our acquired assets arepredominantly goodwill and other intangible assets. The acquisition of hospitaloperations consists primarily of trade names, covenants-not-to-compete andproperty, improvements and equipment.

 

The following tablesummarizes all business combinations during the three years ended March 31,2010.

 
| **Business Combinations**                           | ** ** | **Effective  Date** | ** ** | **Purchase  Price** | ** **  | **Location** |
|-----------------------------------------------------|------------|---------------------|------------|---------------------|-------------|--------------|
| ProMed Entities                                     |       | June 1, 2007   |       | $                   | 48,392,000  |         | San Bernardino and Los Angeles Counties |
| Alta                                                |       | August 8, 2007 |       | $                   | 154,935,000 |         | Los Angeles County |
| Brotman (increased  investment to a 71.9% interest) |       | April 14, 2009 |       | $                   | 2,556,000   |         | Los Angeles County |

 

***Divestitures***

 

On August 1, 2008, wecompleted the sale of all of the outstanding stock of the AV Entities for totalcash consideration of $8,000,000. As required by ASC 360-10-35, the assets andliabilities of the AV Entities and their operations have been presented in ourrecently filed Form 10-K as discontinued operations for all periodspresented. All references to operating results reflect our ongoing operations,excluding the AV Entities, unless otherwise noted.

 

***Inflation***

 

According to U.S. Bureau ofLabor Statistics Data, the national healthcare cost inflation rate has exceededthe general inflation rate for the last four years. We use various strategiesto mitigate the negative effects of healthcare cost inflation. Specifically, wetry to control physician and hospital costs through contracts with independentproviders of healthcare services and close monitoring of cost trends,emphasizing preventive healthcare and appropriate use of specialty and hospitalservices.

 

Whilewe currently believe our strategies to mitigate healthcare cost inflation willcontinue to be successful, competitive pressures, new healthcare andpharmaceutical product introductions, demands from healthcare providers andcustomers, applicable regulations or other factors may affect our ability tocontrol healthcare costs.

 

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

 

Not applicable

 

**Item 4.  Controls and Procedures**

 

***Evaluation of Disclosure Controls andProcedures***

 

We carried out an evaluation as of March 31,2010, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as defined in Rule 13a-15(e) of the Securities ExchangeAct of 1934. Based upon that evaluation and in light of the material weaknessin the financial reporting process at Brotman Medical Center discussed below,the Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were ineffective as of that date in ensuringthat information required to be disclosed in the reports that we file with, orsubmit to, the Securities and Exchange Commission (the “SEC”) under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms. Inaddition, based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures wereineffective as of March 31, 2010 in ensuring that information required tobe disclosed by us in the reports that we file or submit under the SecuritiesExchange Act of 1934 is accumulated and communicated to our management,including the Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosures.

 

See below for discussion of material weaknesses ininternal control over financial reporting at Brotman, which became amajority-owned subsidiary effective April 14, 2009.

 

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*Summary of Material Weaknesses in Internal Control overFinancial Reporting:*

 

As part of our preliminaryassessment of internal control over financial reporting, we identified severaldeficiencies within the financial reporting process of Brotman. We believe thecombination of these deficiencies creates an environment where there is areasonable possibility that a material misstatement of Brotman’s financialstatements would not be detected in a timely manner. We have assessed amaterial weakness in the financial reporting process of Brotman and its relatedimpact on the corporate consolidating financial reporting process. Thedeficiencies within the financial reporting process are the lack of aformalized month-end close process, limited staff training and financialaccounting expertise and a lack of department accounting policies andprocedures.

 

During the financialreporting close for the period ended September 30, 2009, Brotman wasunable to implement a structured close process which resulted in multipledelays and iterations of their financial statements. Account reconciliationswere not prepared in an accurate or timely manner which resulted in asignificant amount of post-close adjustments. Also, Brotman’s accountingdepartment did not demonstrate a sufficient amount of expertise or training tosufficiently complete the steps needed to execute an accurate or timely close.Additionally, Brotman’s accounting department did not utilize or implementpolicies and procedures to organize or streamline the financial close process.

 

To address thesedeficiencies, we are in the process of implementing significant changes in theBrotman accounting department. We added additional resources and personnel withexperience in and an understanding of the complexities of the business and afinancial reporting process. Additional control processes and oversightprocedures have been implemented; however, a longer evaluation period is neededto reasonably validate that such processes and procedures are operating at alevel to have fully remediated the material weakness as of March 31, 2010.At Brotman, we continue to expend significant efforts on financial reportingactivities, integration of operations and expansion of our disclosure controlsand procedures.

 

*Remediation Steps to Address Material Weaknesses:*

 

Based on findings ofmaterial weaknesses in our internal control over financial reporting, we havetaken steps to strengthen our internal controls within the financial reportingprocess. We have added to the expertise and depth of personnel within theBrotman accounting department, including the appointment of a new Controller,with specific and significant expertise in the critical areas identified above.We also added additional resources to assist in the review and preparation ofsignificant account balance reconciliations as well as the implementation ofnew policies and procedures. Also, senior management has increased its scrutinyand oversight of Brotman’s financial statements and has performed significanttop-down financial statement analysis to gain additional assurance as to theaccuracy of Brotman’s financial information. As previously stated, we willcontinue to work on and improve the financial reporting process of Brotman andits impact on the corporate consolidating financial reporting process. Inreview, the principal measures that we are in the process of undertaking toremediate the deficiencies are as follows:

 

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

 

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

 

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

 

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

 

·                  Documenting formalaccounting policies and procedures with regular compliance reviews of key riskareas to evaluate the designing and effectiveness of controls; and

 

·                  Enhancing the corporatefinancial reporting process oversight of the above mentioned controls andprocesses.

 

***Changes in Internal Control over FinancialReporting***

 

Except as discussed above,regarding Brotman, there have been no changes in our Internal Control thatoccurred during the three months ended March 31, 2010 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

**Item 1A.  Risk Factors.**

 

Not applicable.

 

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

 

None.

 

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

 

None.

 

**Item 4.  Removed and Reserved.**

 

None

 

**Item 5.  Other Information**

 

None

 

**Item 6.  Exhibits.**

 

The following documents are being filed as exhibits tothis report:

 
| **Exhibit No.** | ** ** | **Title**                                                                                                                                                                            |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1*                |       | Second  Amendment to Credit Agreement, dated as of February 17, 2010, between  Brotman Medical Center, Inc. (as borrower) and Gemino Healthcare  Finance, LLC (as lender). |
|                 |       |                                                                                                                                                                                 |
| 31.1*                |       | Certification of  Chief Executive Officer pursuant to Rules 13a-14(a)/15d-14(a) under  the Securities Exchange Act of 1934, as amended.                                    |
|                 |       |                                                                                                                                                                                 |
| 31.2*                |       | Certification of  Chief Financial Officer pursuant to Rules 13a-14(a)/15d-14(a) under  the Securities Exchange Act of 1934, as amended.                                    |
|                 |       |                                                                                                                                                                                 |
| 32.1*                |       | Certification of  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                       |
|                 |       |                                                                                                                                                                                 |
| 32.2*                |       | Certification of  Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                       |

 

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*           Filed with this Quarterly Report on Form 10-Q.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 
|              | PROSPECT MEDICAL HOLDINGS, INC. |
|-------------------|--------------------------------------|
|              | (Registrant)                         |
|              |                                 |
| May 17, 2010 | **/**s**/**SAMUEL S. LEE             |
| ** **        | **Samuel S. Lee**                    |
| ** **        | **Chief Executive Officer**          |
| ** **        | **(Principal Executive Officer)**    |
| ** **        | ** **                           |
| May 17, 2010 | **/**s**/**MIKE HEATHER              |
| ** **        | **Mike Heather**                     |
| ** **        | **Chief Financial Officer**          |
| ** **        | **(Principal Financial Officer)**    |

 

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