##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q   (Mark One)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005
 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission File Number: 0-20135   AMERICA SERVICE GROUP INC.
  Delaware
    
    51-0332317(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)105 Westpark Drive, Suite 200
    
    37027Brentwood, Tennessee
    
    (Zip Code)(Address of principal executive offices)
 (615) 373-3100
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be
filed under Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2
of the Exchange Act). Yes þ No o There were 10,871,502 shares of common stock, par value $0.01 per share, outstanding as of May
3, 2005.




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AMERICA SERVICE GROUP INC. QUARTERLY REPORT ON FORM 10-Q
INDEX PageNumberPART I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
    
    
    3Condensed Consolidated Statements of Operations for the quarters ended March 31, 2005 and 2004
    
    
    4Condensed Consolidated Statements of Cash Flows for the quarters ended March 31, 2005 and 2004
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    29PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    30Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    31Item 3. Defaults Upon Senior Securities
    
    
    31Item 4. Submission of Matters to a Vote of Security Holders
    
    
    31Item 5. Other Information
    
    
    31Item 6. Exhibits
    
    
    32Signatures
    
    
    33EX-31.1  SECTION 302 CERTIFICATION OF THE CEOEX-31.2  SECTION 302 CERTIFICATION OF THE CFOEX-32.1  SECTION 906 CERTIFICATION OF THE CEOEX-32.2  SECTION 906 CERTIFICATION OF THE CFO
  2




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PART I: FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED) March 31,
    
    
    December 31,2005
    
    
    2004(shown in 000s except shareand per share amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    15,576
    
    
    $
    7,191Accounts receivable: healthcare and other, less allowances of $447, and $162, respectively
    
    
    85,018
    
    
    
    93,111Inventories
    
    
    7,739
    
    
    
    7,639Prepaid expenses and other current assets
    
    
    16,612
    
    
    
    17,186Current deferred tax assets
    
    
    6,906
    
    
    
    9,349Total current assets
    
    
    131,851
    
    
    
    134,476Property and equipment, net
    
    
    5,869
    
    
    
    5,356Goodwill, net
    
    
    43,896
    
    
    
    43,896Contracts, net
    
    
    8,386
    
    
    
    8,793Other intangibles, net
    
    
    1,018
    
    
    
    1,076Other assets
    
    
    13,121
    
    
    
    12,548Total assets
    
    $
    204,141
    
    
    $
    206,145LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    44,647
    
    
    $
    49,786Accrued medical claims liability
    
    
    26,251
    
    
    
    25,808Accrued expenses
    
    
    46,877
    
    
    
    45,351Deferred revenue
    
    
    9,477
    
    
    
    11,869Loss contract reserve
    
    
    3,006
    
    
    
    6,062Total current liabilities
    
    
    130,258
    
    
    
    138,876Noncurrent portion of accrued expenses
    
    
    12,725
    
    
    
    11,259Noncurrent deferred tax liabilities
    
    
    1,043
    
    
    
    1,017Total liabilities
    
    
    144,026
    
    
    
    151,152Commitments and contingenciesStockholders equity:Preferred stock, $0.01 par value, 2,000,000 shares authorized at March 31, 2005 and
December 31, 2004; no shares issued or outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 30,000,000 shares authorized at March 31, 2005 and
December 31, 2004; 10,871,502 and 10,811,093 shares issued and outstanding at March 31,
2005 and December 31, 2004, respectively
    
    
    109
    
    
    
    108Additional paid-in capital
    
    
    56,397
    
    
    
    55,203Deferred compensation
    
    
    (129
    )
    
    
    (143
    )Retained earnings (accumulated deficit)
    
    
    3,738
    
    
    
    (175
    )Total stockholders equity
    
    
    60,115
    
    
    
    54,993Total liabilities and stockholders equity
    
    $
    204,141
    
    
    $
    206,145
 The accompanying notes to condensed consolidated financial statements
are an integral part of these balance sheets. The condensed consolidated balance sheet at
December 31, 2004 is taken from the audited financial statements at that date. 3




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AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED) Quarter endedMarch 31,2005
    
    
    2004(shown in 000s except shareand per share amounts)Healthcare revenues
    
    $
    168,717
    
    
    $
    157,026Healthcare expenses
    
    
    156,708
    
    
    
    146,170Gross margin
    
    
    12,009
    
    
    
    10,856Selling, general, and administrative expenses
    
    
    4,304
    
    
    
    4,416Depreciation and amortization
    
    
    980
    
    
    
    968Charge for settlement of Florida legal matter
    
    
    
    
    
    
    5,200Income from operations
    
    
    6,725
    
    
    
    272Interest, net
    
    
    228
    
    
    
    511Income (loss) from continuing operations before income taxes
    
    
    6,497
    
    
    
    (239
    )Income tax provision
    
    
    2,609
    
    
    
    352Income (loss) from continuing operations
    
    
    3,888
    
    
    
    (591
    )Income from discontinued operations, net of taxes
    
    
    25
    
    
    
    233Net income (loss)
    
    $
    3,913
    
    
    $
    (358
    )Net income (loss) per common share  basic:Income (loss) from continuing operations
    
    $
    0.36
    
    
    $
    (0.06
    )Income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03Net income (loss)
    
    $
    0.36
    
    
    $
    (0.03
    )Net income (loss) per common share  diluted:Income (loss) from continuing operations
    
    $
    0.35
    
    
    $
    (0.06
    )Income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03Net income (loss)
    
    $
    0.35
    
    
    $
    (0.03
    )Weighted average common shares outstanding:Basic
    
    
    10,846,671
    
    
    
    10,603,625Diluted
    
    
    11,161,051
    
    
    
    10,603,625
 The accompanying notes to condensed consolidated financial statements are an
integral part of these statements. 4




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AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) Quarter endedMarch 31,2005
    
    
    2004(Amounts shown in 000s)Cash flows from operating activities:Net income (loss)
    
    $
    3,913
    
    
    $
    (358
    )Adjustments to reconcile net income (loss) to net cash provided by
operating activities:Depreciation and amortization
    
    
    984
    
    
    
    979Finance cost amortization
    
    
    146
    
    
    
    147Stock option income tax benefits
    
    
    81
    
    
    
    Deferred income taxes
    
    
    2,469
    
    
    
    Amortization of deferred compensation
    
    
    14
    
    
    
    Interest on stockholders notes receivable
    
    
    
    
    
    
    (1
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    8,093
    
    
    
    (11,168
    )Inventories
    
    
    (100
    )
    
    
    560Prepaid expenses and other current assets
    
    
    574
    
    
    
    1,071Other assets
    
    
    (595
    )
    
    
    (46
    )Accounts payable
    
    
    (5,139
    )
    
    
    5,844Accrued medical claims liability
    
    
    443
    
    
    
    4,786Accrued expenses
    
    
    2,992
    
    
    
    712Deferred revenue
    
    
    (2,392
    )
    
    
    603Loss contract reserve utilization
    
    
    (3,056
    )
    
    
    (138
    )Net cash provided by operating activities
    
    
    8,427
    
    
    
    2,991Cash flows from investing activities:Capital expenditures, net
    
    
    (1,156
    )
    
    
    (563
    )Net cash used in investing activities
    
    
    (1,156
    )
    
    
    (563
    )Cash flows from financing activities:Net payments on line of credit and term loan
    
    
    
    
    
    
    (496
    )Issuance of common stock, net
    
    
    369
    
    
    
    206Exercise of stock options
    
    
    745
    
    
    
    117Net cash provided by (used in) financing activities
    
    
    1,114
    
    
    
    (173
    )Net increase in cash and cash equivalents
    
    
    8,385
    
    
    
    2,255Cash and cash equivalents at beginning of period
    
    
    7,191
    
    
    
    1,157Cash and cash equivalents at end of period
    
    $
    15,576
    
    
    $
    3,412
 The accompanying notes to condensed consolidated financial statements are an
integral part of these statements. 5




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AMERICA SERVICE GROUP INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(unaudited) 1. Basis of Presentation The interim condensed consolidated financial statements of America Service Group Inc. and its
consolidated subsidiaries (collectively, the Company) as of March 31, 2005 and for the quarters
ended March 31, 2005 and 2004 are unaudited, but in the opinion of management, have been prepared
in conformity with U.S. generally accepted accounting principles applied on a basis consistent with
those of the annual audited consolidated financial statements. Such interim condensed consolidated
financial statements reflect all adjustments (consisting of normal recurring accruals) necessary
for a fair presentation of the financial position and the results of operations for the quarters
presented. The results of operations for the quarters presented are not necessarily indicative of
the results to be expected for the year ending December 31, 2005. The interim condensed
consolidated financial statements should be read in connection with the audited consolidated
financial statements for the year ended December 31, 2004 available in the Companys Annual Report
on Form 10-K. On September 24, 2004, the Companys Board of Directors authorized and approved a
three-for-two stock split effected in the form of a 50 percent dividend on the Companys common
stock. Such additional shares of common stock were issued on October 29, 2004 to all shareholders
of record as of the close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. 2. Description of Business The Company provides managed healthcare services to correctional facilities under contracts
with state and local governments, certain private entities and a medical facility operated by the
Veterans Administration. The health status of inmates impacts the results of operations under such
contractual arrangements. In addition to providing managed healthcare services, the Company also
provides pharmaceutical distribution services through one of its operating subsidiaries, Secure
Pharmacy Plus, LLC. 3. Recently Issued Accounting Pronouncements On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment(SFAS No. 123(R)), which is a revision of Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation(SFAS No. 123).
SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock
options and any compensatory discounts received by employees in connection with stock purchased
under employee stock purchase plans, to be recognized in the financial statements based on their
fair values. Pro forma disclosure is no longer appropriate. SFAS No. 123(R) must be adopted for all fiscal years beginning after June 15, 2005. Early
adoption will be permitted in periods in which financial statements have not yet been issued. The
Company expects to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) permits the Company to adopt its requirements using one of two methods, a
modified prospective method or a modified retrospective method. When applying the modified
prospective method, compensation cost is recognized beginning with the effective date based on the
requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and
based on the requirements of SFAS No. 123 for all awards granted to employees prior to the
effective date of SFAS No. 123(R) that remain unvested on the effective date. The modified
retrospective method includes the requirements of the modified prospective method described above,
but also permits the Company to restate, based on the amounts previously recognized under SFAS No.
123 for purposes of pro forma disclosures, either all prior periods presented or prior interim
periods of the year of adoption. The Company plans to adopt SFAS No. 123(R) using the modified
prospective method. 6




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As permitted by SFAS No. 123, the Company currently accounts for share-based payments to
employees using Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to
Employees,intrinsic value method and, as such, generally recognizes no compensation cost for
employee stock options. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time
because it will depend on levels of share-based payments granted in the future. However, had the
Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have
approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and
earnings per share in Note 5. SFAS No. 123(R) also requires the benefits of tax deductions in
excess of recognized compensation cost to be reported as a financing cash flow, rather than as an
operating cash flow as required under current literature. This requirement may reduce net
operating cash flows and increase net financing cash flows in periods after adoption. While the
Company cannot estimate what those amounts will be in the future, the amount of operating cash
flows recognized in the quarter ended March 31, 2005 for such excess tax deductions was $0.1
million. No amounts were recognized in the Companys cash flow statement for the quarter ended
March 31, 2004 as the Company had a deferred tax valuation allowance in that quarter. 4. Settlement of Florida Legal Matter On March 30, 2004, EMSA Limited Partnership, a subsidiary of the Company, which was acquired
in January 1999, entered into a settlement agreement with the Florida Attorney Generals office,
related to allegations, first raised in connection with an investigation of EMSA Correctional
Services (EMSA) in 1997, that the Company may have played an indirect role in the improper
billing of Medicaid by independent providers treating incarcerated patients. The settlement agreement with the Florida Attorney Generals office constitutes a complete
resolution and settlement of the claims asserted against EMSA and required EMSA Limited Partnership
to pay $5.0 million to the State of Florida. This payment was made by the Company on March 30,
2004. Under the terms of the settlement agreement, the Company and all of its subsidiaries are
released from liability for any alleged actions which might have occurred from December 1, 1998 to
March 31, 2004. Both parties entered into the settlement agreement to avoid the delay,
uncertainty, inconvenience and expense of protracted litigation. The settlement agreement states
that it is not punitive in purpose or effect, it should not be construed or used as admission of
any fault, wrongdoing or liability whatsoever, and that EMSA specifically denies intentionally
submitting any medical claims in violation of state or federal law. The Company recorded a charge of $5.2 million in its results of operations for the first
quarter of 2004, reflecting the settlement agreement with the Florida Attorney Generals office and
related legal expenses. 5. Stock Options The Company has elected to follow APB No. 25 and related Interpretations in accounting for its
employee stock options. Under APB No. 25, compensation expense is generally recognized as the
difference between the exercise price of the Companys employee stock options and the market price
of the underlying stock on the date of grant. Pro forma information regarding net income and earnings per share is required by SFAS No. 123,
which also requires that the information be determined as if the Company has accounted for its
employee stock options granted subsequent to December 31, 1994 under the fair value method of SFAS
No. 123. No options were issued during the quarter ended March 31, 2004. The fair value of
options issued during the quarter ended March 31, 2005 was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average assumptions: 2005Volatility
    
    
    0.84Interest rate
    
    
    3-4
    %Expected life (years)
    
    
    4.5Dividend yields
    
    
    0.0
    %
 The following table illustrates the effect on net income (loss) per common share as if the
Company had applied the fair value recognition provisions of SFAS No. 123 for each of the quarters
ended March 31, 2005 and 2004 (in thousands except per share data): 7




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Quarter endedMarch 31,2005
    
    
    2004Income (loss) from continuing operations as reported
    
    $
    3,888
    
    
    $
    (591
    )Add: Stock based compensation expense included in reported net
income
    
    
    14
    
    
    
    Deduct: Stock based compensation expense determined under SFAS
No. 123, net of taxes
    
    
    (397
    )
    
    
    (263
    )Pro forma income (loss) from continuing operations
    
    
    3,505
    
    
    
    (854
    )Income from discontinued operations, net of taxes
    
    
    25
    
    
    
    233Pro forma net income (loss) attributable to common shares
    
    $
    3,530
    
    
    $
    (621
    )As reported net income (loss) per common share  basic:As reported income (loss) from continuing operations
    
    $
    0.36
    
    
    $
    (0.06
    )As reported income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03As reported net income (loss)
    
    $
    0.36
    
    
    $
    (0.03
    )Pro forma net income (loss) per common share  basic:Pro forma income (loss) from continuing operations
    
    $
    0.32
    
    
    $
    (0.08
    )Pro forma income from discontinued operations
    
    
    
    
    
    
    0.02Pro forma net income (loss)
    
    $
    0.32
    
    
    $
    (0.06
    )As reported net income (loss) per common share  diluted:As reported income (loss) from continuing operations
    
    $
    0.35
    
    
    $
    (0.06
    )As reported income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03As reported net income (loss)
    
    $
    0.35
    
    
    $
    (0.03
    )Pro forma net income (loss) per common share  diluted:Pro forma income (loss) from continuing operations
    
    $
    0.32
    
    
    $
    (0.08
    )Pro forma income from discontinued operations
    
    
    
    
    
    
    0.02Pro forma net income (loss)
    
    $
    0.32
    
    
    $
    (0.06
    )
 The resulting pro forma disclosures may not be representative of that to be expected in
future years. The weighted average fair value of options granted during the quarter ended March
31, 2005 as determined under the fair value provisions of SFAS No. 123, is $16.99. No options were
issued during the quarter ended March 31, 2004. For periods prior to July 1, 2004, the above pro
forma adjustments do not include any offsetting income tax benefits due to the Companys use of a
tax valuation allowance during those periods. 6. Discontinued Operations Pursuant to Statement of Financial Accounting Standards No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets(SFAS No. 144), each of the Companys correctional healthcare
services contracts is a component of an entity, whose operations can be distinguished from the rest
of the Company. Therefore, when a correctional healthcare services contract terminates, by
expiration or otherwise, the contracts operations generally will be eliminated from the ongoing
operations of the Company and classified as discontinued operations. Accordingly, the operations
of such contracts, net of applicable income taxes, have been presented as discontinued operations
and prior period condensed consolidated statements of operations have been reclassified. The components of income from discontinued operations, net of taxes, are as follows (in
thousands): Quarter endedMarch 31,2005
    
    
    2004Healthcare revenues
    
    $
    877
    
    
    $
    11,279Healthcare expenses
    
    
    832
    
    
    
    11,022Gross margin
    
    
    45
    
    
    
    257Depreciation and amortization
    
    
    4
    
    
    
    11Income from discontinued operations before taxes
    
    
    41
    
    
    
    246Income tax provision
    
    
    16
    
    
    
    13Income from discontinued operations, net of taxes
    
    $
    25
    
    
    $
    233
 8




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7. Accounts Receivable Accounts receivable consist of the following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Billed accounts receivable
    
    $
    57,728
    
    
    $
    60,691Unbilled accounts receivable
    
    
    26,963
    
    
    
    31,723Other accounts receivable
    
    
    774
    
    
    
    85985,465
    
    
    
    93,273Less: Allowances
    
    
    (447
    )
    
    
    (162
    )$
    85,018
    
    
    $
    93,111
 Unbilled accounts receivable primarily represent additional revenue earned under
shared-risk contracting models that remain unbilled at March 31, 2005, due to provisions within
the contracts governing the timing for billing such amounts. 8. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets are stated at amortized cost and comprised of the
following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Prepaid insurance
    
    $
    10,821
    
    
    $
    10,979Prepaid cash deposits for professional
liability claims losses
    
    
    5,100
    
    
    
    5,700Prepaid performance bonds
    
    
    152
    
    
    
    230Prepaid other
    
    
    539
    
    
    
    277$
    16,612
    
    
    $
    17,186
 9. Property and Equipment Property and equipment are stated at cost and comprised of the following (in thousands): March 31,
    
    
    December 31,
    
    
    Estimated2005
    
    
    2004
    
    
    Useful LivesLeasehold improvements
    
    $
    1,200
    
    
    $
    1,200
    
    
    5 yearsEquipment and furniture
    
    
    8,847
    
    
    
    8,519
    
    
    5 yearsComputer software
    
    
    1,451
    
    
    
    1,436
    
    
    3 yearsMedical equipment
    
    
    2,518
    
    
    
    2,559
    
    
    5 yearsAutomobiles
    
    
    50
    
    
    
    32
    
    
    5 yearsManagement information systems under development
    
    
    1,757
    
    
    
    1,076
    
    

15,823
    
    
    
    14,822Less: Accumulated depreciation
    
    
    (9,954
    )
    
    
    (9,466
    )$
    5,869
    
    
    $
    5,356
 Depreciation expense for the quarters ended March 31, 2005 and 2004 was approximately
$519,000 and $522,000, respectively. Under the provisions of the American Institute of Certified Public Accountants Statement of
Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal
Use, the Company capitalizes costs associated with internally developed software systems that have
reached the application development stage. Capitalized costs include external direct costs of
materials and services utilized in developing or obtaining internal-use software and payroll and
payroll-related expenses for employees who are directly associated with and devote time to the
internal-use software project. Capitalization of such costs begins when the preliminary project
stage is complete and ceases no later than the point at which the project is substantially
complete and ready for its intended purpose. 9




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10. Other Assets Other assets are comprised of the following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Deferred financing costs
    
    $
    1,698
    
    
    $
    1,695Less: Accumulated amortization
    
    
    (1,358
    )
    
    
    (1,212
    )340
    
    
    
    483Estimated prepaid professional liability claims losses
    
    
    5,614
    
    
    
    4,674Excess deposits for professional liability claims
    
    
    7,096
    
    
    
    7,321Other refundable deposits
    
    
    71
    
    
    
    70$
    13,121
    
    
    $
    12,548
 11. Contracts and Other Intangible Assets The gross and net values of contracts and other intangible assets consist of the following (in
thousands): March 31,
    
    
    December 31,2005
    
    
    2004Contracts:Gross value
    
    $
    15,870
    
    
    $
    15,870Less: Accumulated amortization
    
    
    (7,484
    )
    
    
    (7,077
    )$
    8,386
    
    
    $
    8,793Non-compete agreements:Gross value
    
    $
    2,400
    
    
    $
    2,400Less: Accumulated amortization
    
    
    (1,382
    )
    
    
    (1,324
    )$
    1,018
    
    
    $
    1,076
 Estimated aggregate amortization expense related to the above intangibles for the
remainder of 2005 is $1.4 million and for each of the next four years is $1.9 million, $1.9
million, $1.9 million and $354,000. 12. Accounts Payable and Accrued Expenses Accounts payable consist of the following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Trade payables
    
    $
    43,788
    
    
    $
    48,095Payable to Health Cost Solutions, Inc.
    
    
    859
    
    
    
    1,691$
    44,647
    
    
    $
    49,786
 Accrued expenses consist of the following (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Salaries and employee benefits
    
    $
    23,281
    
    
    $
    20,461Professional liability claims
    
    
    19,125
    
    
    
    18,659Accrued workers compensation claims
    
    
    6,645
    
    
    
    6,557Other
    
    
    10,551
    
    
    
    10,93359,602
    
    
    
    56,610Less: Noncurrent portion of professional liability claims
    
    
    (12,725
    )
    
    
    (11,259
    )$
    46,877
    
    
    $
    45,351
 10




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13. Reserve for Loss Contracts The Company accrues losses under its fixed price contracts when it is probable that a material
loss will be incurred and the amount of the loss can be reasonably estimated. The Company performs
this loss accrual analysis on a specific contract basis taking into consideration such factors as
future contractual revenue, projected future labor, pharmacy and healthcare costs, including
hospitalization and outpatient services, and each contracts specific terms related to risk-sharing
arrangements. The projected future healthcare costs are estimated based on historical trends and
managements estimate of future cost increases. The Companys contract with the Maryland Department of Public Safety and Correctional Services
(Maryland DPS) has historically underperformed, fluctuating between minimal profitability,
breakeven and losses. This contract was entered into on July 1, 2000, to provide comprehensive
medical services to four regions of the Maryland prison system. The initial term of the contract
was for the three years ended June 30, 2003, with the Maryland DPS having the ability to renew the
contract for two additional one-year terms. The contract is presently in its second renewal term
and is non-cancelable by the Company. The Maryland DPS pays the Company a flat fee per month with
certain limited cost-sharing adjustments for staffing costs, primarily nurses, and the cost of
medications related to certain specific illnesses. The Company is fully at risk for increases in
hospitalization and outpatient costs under the terms of the contract with the Maryland DPS. The
contract also contains provisions that allow the Maryland DPS to assess penalties if certain
staffing or performance criteria are not maintained. The flat fee paid to the Company is increased
annually based on a portion of the consumer price index. Due to the flat fee nature of this contract, the Companys margin under the contract can be
significantly impacted by changes in healthcare costs, utilization trends or inmate population.
The Company incurred losses under this contract in April 2004 at a level slightly above
expectations. The losses under the contract increased significantly in May 2004 to approximately
$1.1 million for the month. The primary cause for the increased loss was an unanticipated increase
in hospitalization costs beginning in May, resulting from the volume and acuity of services being
provided, the number of HIV and mental health patients and the costs associated with current
treatment guidelines. During the second quarter of 2004, the Company recorded a pre-tax loss
contract charge of $6.8 million, effective June 1, 2004, which represented its most likely
estimate, at that date, of the future losses and allocated corporate overhead under the Maryland
DPS contract through its expiration on June 30, 2005. This estimate assumed monthly losses under
the contract would diminish from the May 2004 level, which was viewed as an aberration, to
approximately $0.5 million per month, including allocated overhead, an amount significantly above
recent historical levels. During the third quarter of 2004, the Company utilized $2.6 million of its loss contract
reserve, almost entirely due to the underperformance of the Maryland DPS contract. While actual
monthly losses incurred under the Maryland DPS contract had trended downward from the record loss
in May, losses once again increased in September, driven primarily by off-site medical costs. Off-site medical costs under the Maryland DPS contract averaged $1.3 million per month for
June through September 2004, as compared with initial estimates of $1.0 million per month, based on
historical results. As a result of this new and more severe trend, the Company recorded a pre-tax
charge of $6.0 million, effective September 30, 2004, to increase its reserve for estimated future
losses and allocated corporate overhead under the Maryland DPS contract until its expiration in
June 2005. A fundamental assumption of the $6.0 million increase in loss reserve was that the
contract would continue to incur on average $1.4 million per month of off-site medical costs
through its termination on June 30, 2005. As of March 31, 2005, the Company had a loss contract reserve totaling $3.0 million, which
relates to the Maryland DPS contract discussed above and a county contract. Negative gross margin
and overhead costs charged against the loss contract reserve related to loss contracts, including
contracts classified as discontinued operations, totaled approximately $3.1 million and $0.1
million for the three months ended March 31, 2005 and 2004, respectively. The amounts charged
against the loss contract reserve during 2005 and 2004 represent losses associated with the
Maryland DPS contract and a county contract. In the course of performing its reviews in future periods, the Company might revise its
estimate of future losses related to the contracts currently identified as loss contracts. It
might also identify additional contracts which have become loss contracts due to a change in
circumstances. Circumstances that might change and result in a revised 11




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estimate of future losses or the identification of a contract as a loss contract in a future
period include unanticipated adverse changes in the healthcare cost structure, inmate population or
the utilization of outside medical services in a contract, where such changes are not offset by
increased healthcare revenues. Should the Company identify circumstances that would result in a
revision of its estimate of future losses for a loss contract, the Company would, in the period in
which the revision is made, increase or decrease the reserve for loss contracts. Should a contract
be identified as a loss contract in a future period, the Company would record, in the period in
which such identification is made, a reserve for the estimated future losses that would be incurred
under the contract. A revision to a current loss contract or the identification of a loss contract
in the future could have a material adverse effect on the Companys results of operations in the
period in which the reserve is recorded. 14. Banking Arrangements On October 31, 2002, the Company entered into a new credit facility with CapitalSource Finance
LLC (the CapitalSource Credit Facility). The CapitalSource Credit Facility matures on October
31, 2005 and includes a $55.0 million revolving credit facility (the Revolver) and prior to the
third quarter of 2004 also included a $5.0 million term loan (the Term Loan). In June 2003, the Company and CapitalSource Finance LLC entered into an amendment to the
CapitalSource Credit Facility. Under the terms of the amendment, the Company may have standby
letters of credit issued under the loan agreement in amounts up to $10.0 million. The amount
available to the Company for borrowings under the CapitalSource Credit Facility is reduced by the
amount of each outstanding standby letter of credit. At March 31, 2005, the Company had
outstanding standby letters of credit totaling $4.0 million, which were used to collateralize
performance bonds. The CapitalSource Credit Facility is secured by substantially all assets of the Company and
its operating subsidiaries. At March 31, 2005, the Company had no borrowings outstanding under the
Revolver and $43.1 million available for additional borrowing, based on the Companys collateral
base on that date and outstanding standby letters of credit. Borrowings under the Revolver are limited to the lesser of (1) 85% of eligible receivables (as
defined in the Revolver) or (2) $55.0 million (the Revolver Capacity). Interest under the
Revolver is payable monthly at the greater of 5.75% or the Citibank N.A. prime rate plus 1.0%. The
Company is also required to pay a monthly collateral management fee, equal to an annual rate of
1.38%, on average borrowings outstanding under the Revolver. Additionally, the Company is required
to pay a monthly letter of credit fee equal to an annual rate of 3.5% on the outstanding balance of
letters of credit issued pursuant to the Revolver. Under the terms of the CapitalSource Credit Facility, the Company is required to pay a monthly
unused line fee equal to an annual rate of 0.6% on the Revolver Capacity less the actual average
borrowings outstanding under the Revolver for the month and the balance of any outstanding letters
of credit. During the third quarter of 2004, the Company prepaid the remaining balance of $2.1 million
and retired its Term Loan which was set to mature on October 31, 2005. In conjunction with the
retirement of the Term Loan, the Company paid a $0.1 million loan fee which was due upon maturity. The CapitalSource Credit Facility requires the Company to meet certain financial covenants
related to minimum levels of earnings. At March 31, 2005, the Company was in compliance with
these covenants. The CapitalSource Credit Facility also contains restrictions on the Company with
respect to certain types of transactions including acquisition of the Companys own stock, payment
of dividends, indebtedness and sales or transfers of assets. 15. Income Taxes The Company accounts for income taxes under Statement of Financial Accounting Standards No.
109, Accounting for Income Taxes(SFAS No. 109). Under the asset and liability method of SFAS
No. 109, deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. 12




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The Company regularly reviews its deferred tax assets for recoverability taking into
consideration such factors as historical losses, projected future taxable income and the expected
timing of the reversals of existing temporary differences. SFAS No. 109 requires the Company to
record a valuation allowance when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. It further states forming a conclusion that a
valuation allowance is not needed is difficult when there is negative evidence such as cumulative
losses in recent years. Since December 31, 2001 and until June 30, 2004, the Company maintained a
100% valuation allowance equal to the deferred tax assets after considering deferred tax assets
that can be realized through offsets to existing taxable temporary differences. Based upon the Companys results of operations since December 31, 2001, and its expected
profitability in future years, the Company concluded, effective June 30, 2004, that it is more
likely than not that substantially all of its net deferred tax assets will be realized. As a
result, in accordance with SFAS No. 109, substantially all of the valuation allowance applied to
such net deferred tax assets was reversed in the second quarter of 2004. Reversal of the valuation
allowance resulted in a non-cash income tax benefit in the second quarter of 2004 totaling $5.3
million. This benefit represented the Companys estimated realizable deferred tax assets,
excluding those deferred tax assets that resulted from the exercise of employee stock options. The
reversal of the valuation allowance that related to the Companys estimated realizable deferred tax
assets resulting from the exercises of employee stock options totaled $3.9 million and was recorded
as a direct increase to additional paid-in capital in the stockholders equity portion of the
Companys balance sheet as of June 30, 2004. At March 31, 2005, the Companys valuation allowance
of approximately $0.2 million represents managements estimate of state net operating loss
carryforwards which will expire unused. The Company establishes accruals for certain tax contingencies when, despite the belief that
the Companys tax return positions are fully supported, the Company believes that certain positions
will be challenged and a risk exists that the Companys positions will not be fully sustained. The
tax contingency accruals are adjusted in light of changing facts and circumstances, such as the
progress of tax audits, case law, and emerging legislation. The Companys tax contingency accruals
are reflected as a component of accrued liabilities. 16. Professional and General Liability Self-insurance Retention The Company records a liability for reported and unreported professional and general
liability claims. Amounts accrued were $19.1 and $18.7 million at March 31, 2005 and December 31,
2004, respectively, and are included in accrued expenses and non-current portion of accrued
expenses on the condensed consolidated balance sheets. Changes in estimates of losses resulting
from the continuous review process and differences between estimates and loss payments are
recognized in the period in which the estimates are changed or payments are made. Reserves for
professional and general liability exposures are subject to fluctuations in frequency and
severity. Given the inherent degree of variability in any such estimates, the reserves reported
at March 31, 2005 represent managements best estimate of the amounts necessary to discharge the
Companys obligations. 17. Commitments and Contingencies Catastrophic Limits Many of the Companys contracts require the Companys customers to reimburse the Company for
all treatment costs or, in some cases, only treatment costs related to certain catastrophic
events, and/or for AIDS or AIDS-related illnesses. Certain contracts do not contain such limits.
The Company attempts to compensate for the increased financial risk when pricing contracts that do
not contain individual, catastrophic or specific disease diagnosis-related limits. However, the
occurrence of severe individual cases, AIDS-related illnesses or a catastrophic event in a
facility governed by a contract without such limitations could render the contract unprofitable
and could have a material adverse effect on the Companys operations. For contracts that do not
contain catastrophic protection, the Company maintains stop loss insurance from an unaffiliated
insurer for annual hospitalization amounts in excess of $500,000 per inmate up to an annual cap
of $1.0 million per inmate and a lifetime cap of $2.0 million per inmate. The Company believes
this insurance helps mitigate its exposure to unanticipated expenses of catastrophic
hospitalization. Catastrophic insurance premiums and recoveries, neither of which is significant,
are included in healthcare expenses. Receivables for insurance recoveries, which are not
significant, are included in accounts receivable. 13




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##### Table of Contents



Litigation and Claims EMSA lease matter.On July 12, 2004, EMSA Limited Partnership, a limited partnership owned by
the Company, received an unexpected adverse jury verdict in the Circuit Court, 11th
Judicial Circuit, Miami-Dade County, Florida of approximately $1.2 million plus potential interest
which has the potential to double the amount of the award to $2.5 million. This verdict relates to
a 12 year old case filed by the plaintiff, Community Health Related Services, Inc. (wholly owned by
Dr. Carlos Vicaria) seeking unspecified damages involving a lease dispute in connection with a line
of business managing physician clinics operated by EMSA Limited Partnership prior to its
acquisition by the Company in 1999. The Company did not acquire this line of business or assume
the expired sublease from the seller under the transaction. The Company has, to date, been forced
to defend the case as the seller has not yet assumed responsibility. The trial judge has yet to
enter the jurys verdict as a final judgment and the Company has filed a motion for new trial, a
motion for remittitur or new trial as to damages, a motion for judgment notwithstanding the
verdict, and for judgment in accordance with its previous motion for a directed verdict. The
matter currently remains under advisement with the court and the Company will continue to
vigorously defend the lawsuit and believes that it will ultimately be successful, through either
its post-trial motions or on appeal, in having the verdict award reduced or overturned. However,
in the event the Company is not successful at the trial court level or on appeal, or if the Company
decides not to appeal an unfavorable verdict, an adverse judgment could have a material adverse
effect on the Companys financial position and its quarterly or annual results of operations. As
of March 31, 2005, the Company, after giving consideration to its post-trial motions and appeal
rights, estimates that its probable loss related to this matter will be less than the $1.2 million
jury verdict amount. The Companys reserves related to this matter are included in its reserves
for all general legal matters, which total approximately $1.0 million as of March 31, 2005. In
addition to its rights under post-verdict motions and the potential for appeal, the Company has
filed suit against Caremark RX, Inc. (Caremark), the successor to the party who sold EMSA to the
Company, for indemnification for all costs associated with this case as well as any judgment
returned which is adverse to the Company. Caremark is defending this lawsuit and the Company does
not know whether it will prevail against Caremark. Accordingly, such reimbursement has not been
reflected in the Companys reserve estimate discussed above. Other matters.In addition to the matter discussed above, the Company is a party to various
legal proceedings incidental to its business. Certain claims, suits and complaints arising in the
ordinary course of business have been filed or are pending against the Company. An estimate of the
amounts payable on existing claims for which the liability of the Company is probable is included
in accrued expenses at March 31, 2005 and December 31, 2004. The Company is not aware of any
material unasserted claims and would not anticipate that potential future claims would have a
material adverse effect on its consolidated financial position, results of operations or cash
flows. Performance Bonds The Company is required under certain contracts to provide performance bonds. At March 31,
2005, the Company has outstanding performance bonds totaling approximately $22.3 million. These
performance bonds are collateralized by letters of credit totaling $4.0 million (see Note 14). 18. Net Income Per Share Net income (loss) per share is measured at two levels: basic income (loss) per share and
diluted income (loss) per share. Basic income (loss) per share is computed by dividing net income
(loss) by the weighted average number of common shares outstanding during the period. Diluted
income (loss) per share is computed by dividing net income (loss) by the weighted average number of
common shares outstanding after considering the additional dilution related to other dilutive
securities. The Companys other dilutive securities outstanding consist of options to purchase
shares of the Companys common stock. The table below sets forth the computation of basic and
diluted earnings per share as required by SFAS No. 128, Earnings Per Share,for the quarters ended
March 31, 2005 and 2004 (dollars in thousands, except per share amounts). 14




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##### Table of Contents



Quarter EndedMarch 31,2005
    
    
    2004Numerator:Income (loss) from continuing operations
    
    $
    3,888
    
    
    $
    (591
    )Income from discontinued operations, net of taxes
    
    
    25
    
    
    
    233Numerator for basic and diluted net income (loss)
    
    $
    3,913
    
    
    $
    (358
    )Denominator:Denominator for basic net income (loss) per share 
weighted average shares
    
    
    10,846,671
    
    
    
    10,603,625Effect of dilutive securities:Employee stock options
    
    
    314,380
    
    
    
    Denominator for diluted net income (loss) per share 
adjusted weighted average shares and assumed
conversions
    
    
    11,161,051
    
    
    
    10,603,625Net income (loss) per common share  basic:Income (loss) from continuing operations
    
    $
    0.36
    
    
    $
    (0.06
    )Income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03Net income (loss)
    
    $
    0.36
    
    
    $
    (0.03
    )Net income (loss) per common share  diluted:Income (loss) from continuing operations
    
    $
    0.35
    
    
    $
    (0.06
    )Income from discontinued operations, net of taxes
    
    
    
    
    
    
    0.03Net income (loss)
    
    $
    0.35
    
    
    $
    (0.03
    )
 On September 24, 2004, the Companys Board of Directors authorized and approved a
three-for-two stock split effected in the form of a 50 percent dividend on the Companys common
stock. Such additional shares of common stock were issued on October 29, 2004 to all shareholders
of record as of the close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. The table below sets forth information regarding options that have been excluded from the
computation of diluted net income per share because the Company generated a net loss from
continuing operations for the period or the options exercise price was greater than the average
market price of the common shares for the periods shown and, therefore, the effect would be
anti-dilutive. Quarter EndedMarch 31,2005
    
    
    2004Options excluded from computation of diluted
income per share as effect would be anti-dilutive
    
    
    25,000
    
    
    
    757,911Weighted average exercise price of excluded options
    
    $
    25.61
    
    
    $
    9.59
 19. Comprehensive Income For the quarters ended March 31, 2005 and 2004, the Companys comprehensive income (loss)
was equal to net income (loss). 20. Segment Data The Company has two reportable segments: correctional healthcare services and pharmaceutical
distribution services. The correctional healthcare services segment contracts with state, county
and local governmental agencies to provide healthcare services to inmates of prisons and jails.
The pharmaceutical distribution services segment contracts with federal, state and local
governments and certain private entities to distribute pharmaceuticals and certain medical supplies
to inmates of correctional facilities. The accounting policies of the segments are the same. The
Company evaluates segment performance based on each segments gross margin without allocation of
corporate selling, general and administrative expenses, interest expense or income tax provision
(benefit). The following table presents the summary financial information related to each segment that is
used by the Companys chief operating decision maker (in thousands): 15




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##### Table of Contents



Correctional
    
    
    Pharmaceutical
    
    
    Elimination ofHealthcare
    
    
    Distribution
    
    
    IntersegmentServices
    
    
    Services
    
    
    Sales
    
    
    ConsolidatedQuarter ended March 31, 2005:Healthcare revenues
    
    $
    157,759
    
    
    $
    22,300
    
    
    $
    (11,342
    )
    
    $
    168,717Healthcare expenses
    
    
    147,028
    
    
    
    21,022
    
    
    
    (11,342
    )
    
    
    156,708Gross margin
    
    $
    10,731
    
    
    $
    1,278
    
    
    $
    
    
    
    $
    12,009Depreciation and amortization expense
    
    $
    727
    
    
    $
    253
    
    
    $
    
    
    
    $
    980Quarter ended March 31, 2004:Healthcare revenues
    
    $
    147,497
    
    
    $
    19,056
    
    
    $
    (9,527
    )
    
    $
    157,026Healthcare expenses
    
    
    137,819
    
    
    
    17,878
    
    
    
    (9,527
    )
    
    
    146,170Gross margin
    
    $
    9,678
    
    
    $
    1,178
    
    
    $
    
    
    
    $
    10,856Depreciation and amortization expense
    
    $
    734
    
    
    $
    234
    
    
    $
    
    
    
    $
    968
 Correctional
    
    
    PharmaceuticalHealthcare
    
    
    DistributionServices
    
    
    Services
    
    
    ConsolidatedAs of March 31, 2005:Inventories
    
    $
    4,620
    
    
    $
    3,119
    
    
    $
    7,739Property and equipment, net
    
    $
    3,209
    
    
    $
    2,660
    
    
    $
    5,869Goodwill, net
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    187,917
    
    
    $
    16,224
    
    
    $
    204,141As of December 31, 2004:Inventories
    
    $
    4,410
    
    
    $
    3,229
    
    
    $
    7,639Property and equipment, net
    
    $
    3,118
    
    
    $
    2,238
    
    
    $
    5,356Goodwill, net
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    190,323
    
    
    $
    15,822
    
    
    $
    206,145
 16




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS General America Service Group Inc. (ASG or the Company) is the leading non-governmental provider
of managed correctional healthcare services in the United States. The Company is a provider of
managed healthcare services to county/municipal jails and detention centers and is also a
distributor of pharmaceuticals and medical supplies. The Company provides managed healthcare
and/or pharmaceutical distribution services under 109 contracts to approximately 270,000 inmates at
over 380 sites in 39 states. The Company operates through its subsidiaries Prison Health Services, Inc. (PHS), EMSA
Limited Partnership (EMSA), Correctional Health Services, LLC (CHS), Prison Health Services of
Indiana, LLC and Secure Pharmacy Plus, LLC (SPP). ASG was incorporated in 1990 as a holding
company for PHS. Unless the context otherwise requires, the terms ASG or the Company refer to
ASG and its direct and indirect subsidiaries. ASGs executive offices are located at 105 Westpark
Drive, Suite 200, Brentwood, Tennessee 37027. Its telephone number is (615) 373-3100. On September 24, 2004, the Companys Board of Directors authorized and approved a
three-for-two stock split effected in the form of a 50 percent dividend on the Companys common
stock. Such additional shares of common stock were issued on October 29, 2004 to all shareholders
of record as of the close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. The following discussion should be read in conjunction with the unaudited condensed
consolidated financial statements and accompanying notes included herein. Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking
statements represent managements current expectations regarding future events. All statements
other than statements of current or historical fact contained in this quarterly report including
statements regarding the Companys future financial position, business strategy, budgets, projected
costs, and plans and objectives of management for future operations are forward-looking statements.
Forward-looking statements typically are identified by use of terms such as may, will,
should, plan, expect, anticipate, estimate, believe, continue, intend, project
and similar words, although some forward-looking statements are expressed differently. These
statements are based on the Companys current plans but actual results may differ materially from
current expectations. Significant factors that could cause actual results to differ materially
from the forward-looking statements include, among other things, the following:  
    the Companys ability to retain existing client contracts and obtain new contracts;
    whether or not government agencies continue to privatize correctional healthcare services;
    the possible effect of adverse publicity regarding the Companys business;
    increased competition for new contracts and renewals of existing contracts;
    the Companys ability to comply with government regulations and/or orders of judicial authorities;
    the Companys ability to execute its expansion strategies;
    the Companys ability to limit its exposure for catastrophic illnesses and injuries in
excess of amounts covered under contracts or insurance coverage;
    the outcome of pending litigation; and 17




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##### Table of Contents




    the Companys dependence on key personnel. In addition to the risks referenced above, additional risks are highlighted in the Companys
Annual Report on Form 10-K for the year ended December 31, 2004 under the heading Item 1. Business
 Risk Factors. Because these risk factors could cause actual results or outcomes to differ
materially from those expressed in any forward-looking statements made by the Company or on the
Companys behalf, stockholders should not place undue reliance on any forward-looking statements.
Further, any forward-looking statement speaks only as of the date on which it is made, and the
Company undertakes no obligation to update any forward-looking statement to reflect events or
circumstances after the date on which the statement is made or to reflect the occurrence of
unanticipated events. New factors emerge from time to time, and it is not possible for the Company
to predict which factors will arise. In addition, the Company cannot assess the impact of each
factor on its business or the extent to which any factor, or combination of factors, may cause
actual results to differ materially from those contained in any forward-looking statements. Critical Accounting Policies And Estimates General The Companys discussion and analysis of its financial condition and results of operations are
based upon its consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation of these financial
statements requires the Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, the Company evaluates its estimates, including, but not limited
to, those related to:  
    revenue and cost recognition (including estimated medical claims);
    allowance for doubtful accounts;
    loss contracts;
    professional and general liability self-insurance retention;
    other self-funded insurance reserves;
    legal contingencies;
    impairment of intangible assets and goodwill; and
    income taxes. The Company bases its estimates on historical experience and on various other assumptions that
are believed to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these estimates under different assumptions or
conditions. The Company believes the following critical accounting policies are affected by its more
significant judgments and estimates used in the preparation of its consolidated financial
statements. Revenue and Cost Recognition The Companys contracts with correctional institutions are principally fixed price contracts
with revenue adjustments for census fluctuations and risk sharing arrangements, such as stop-loss
provisions and aggregate limits for off-site or pharmaceutical costs. Such contracts typically
have a term of one to three years with subsequent renewal options and generally may be terminated
by either party at will and without cause upon proper notice. Revenues earned under contracts with
correctional institutions are recognized in the period that services are rendered. Cash received in
advance for future services is recorded as deferred revenue and recognized as income when the
service is performed. Revenues are calculated based on the specific contract terms and fall into one of three
general categories: fixed fee, population based, or cost plus a margin. For fixed fee contracts,
revenues are recorded based on fixed monthly amounts established in the service contract. Revenues
for population based contracts are calculated either as a fixed fee adjusted using a per diem rate
for variances in the inmate population from predetermined population levels or by a per 18




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diem rate times the average inmate population for the period of service. For cost plus
contracts, revenues are calculated based on actual expenses incurred during the service period plus
a contractual margin. Normally, contracts will also include additional provisions which mitigate a portion of the
Companys risk related to cost increases. Off-site utilization risk is mitigated in the majority
of the Companys contracts through aggregate pools for off-site expenses, stop loss provisions,
cost plus fee arrangements or, in some cases, the entire exclusion of off-site service costs.
Pharmacy expense risk is similarly mitigated in certain of the Companys contracts. Typically
under the terms of such provisions, the Companys revenue under the contract increases to offset
increases in specified cost categories such as off-site expenses or pharmaceutical costs. For
contracts which include such provisions, the Company recognizes the additional revenues that would
be due from clients based on its estimates of applicable contract to date costs incurred as
compared to the corresponding pro rata contractual limit for such costs. Because such provisions
typically specify how often such additional revenue may be invoiced and require all such additional
revenue to be ultimately settled based on actual expenses, the additional revenues are initially
recorded as unbilled receivables until the time period for billing has been met and actual costs
are known. Any differences between the Companys estimates of incurred costs and the actual costs
are recorded in the period in which such differences become known along with the corresponding
adjustment to the amount of recorded additional revenues. Under all contracts, the Company records revenues net of any estimated contractual allowances
for potential adjustments resulting from a failure to meet performance or staffing related
criteria. If necessary, the Company revises its estimates for such adjustments in future periods
when the actual amount of the adjustment is determined. Revenues for the distribution of pharmaceutical and medical supplies are recognized upon
delivery of the related products. Healthcare expenses include the compensation of physicians, nurses and other healthcare
professionals including any related benefits and all other direct costs of providing the managed
care including the costs of professional and general liability insurance and other self-funded
insurance reserves discussed more fully below. The cost of healthcare services provided or
contracted for are recognized in the period in which they are provided based in part on estimates,
including an accrual for estimated unbilled medical services rendered through the balance sheet
date. The Company estimates the accrual for unbilled medical services using actual utilization
data including hospitalization, one-day surgeries, physician visits and emergency room and
ambulance visits and their corresponding costs, which are estimated using the average historical
cost of such services. An actuarial analysis is also prepared periodically by an independent
actuary to evaluate the adequacy of the Companys total accrual related to contracts which have
sufficient claims payment history. The analysis takes into account historical claims experience
(including the average historical costs and billing lag time for such services) and other actuarial
data. Additionally, the Companys utilization management personnel perform a monthly review of
inpatient hospital stays in order to identify any stays which would have a cost in excess of the
historical average rates. Once identified, reserves for such stays are determined which take into
consideration the specific facts of the stay. Actual payments and future reserve requirements will differ from the Companys current
estimates. The differences could be material if significant adverse fluctuations occur in the
healthcare cost structure or the Companys future claims experience. Changes in estimates of
claims resulting from such fluctuations and differences between actuarial estimates and actual
claims payments are recognized in the period in which the estimates are changed or the payments are
made. Allowance for Doubtful Accounts Accounts receivable are stated at estimated net realizable value. The Company recognizes
allowances for doubtful accounts to ensure receivables are not overstated due to uncollectibility.
Bad debt reserves are established based on a variety of factors, including the length of time
receivables are past due, significant one-time events, discussions with clients and historical
experience. If circumstances change, estimates of the recoverability of receivables would be
further adjusted. 19




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Loss Contracts The Company accrues losses under its fixed price contracts when it is probable that a loss has
been incurred and the amount of the loss can be reasonably estimated. The Company performs this
loss accrual analysis on a specific contract basis taking into consideration such factors as future
contractual revenue, projected future healthcare and maintenance costs, projected future stop-loss
insurance recoveries and each contracts specific terms related to future revenue increases as
compared to increased healthcare costs. The projected future healthcare and maintenance costs are
estimated based on historical trends and managements estimate of future cost increases. These
estimates are subject to the same adverse fluctuations and future claims experience as previously
noted. The Companys contract with the Maryland Department of Public Safety and Correctional Services
(Maryland DPS) has historically underperformed, fluctuating between minimal profitability,
breakeven and losses. This contract was entered into on July 1, 2000, to provide comprehensive
medical services to four regions of the Maryland prison system. The initial term of the contract
was for the three years ended June 30, 2003, with the Maryland DPS having the ability to renew the
contract for two additional one-year terms. The contract is presently in its second renewal term
and is non-cancelable by the Company. The Maryland DPS pays the Company a flat fee per month with
certain limited cost-sharing adjustments for staffing costs, primarily nurses, and the cost of
medications related to certain specific illnesses. The Company is fully at risk for increases in
hospitalization and outpatient costs under the terms of the contract with the Maryland DPS. The
contract also contains provisions that allow the Maryland DPS to assess penalties if certain
staffing or performance criteria are not maintained. The flat fee paid to the Company is increased
annually based on a portion of the consumer price index. Due to the flat fee nature of this contract, the Companys margin under the contract can be
significantly impacted by changes in healthcare costs, utilization trends or inmate population.
The Company incurred losses under this contract in April 2004 at a level slightly above
expectations. The losses under the contract increased significantly in May 2004 to approximately
$1.1 million for the month. The primary cause for the increased loss was an unanticipated increase
in hospitalization costs beginning in May, resulting from the volume and acuity of services being
provided, the number of HIV and mental health patients and the costs associated with current
treatment guidelines. During the second quarter of 2004, the Company recorded a pre-tax loss
contract charge of $6.8 million, effective June 1, 2004, which represented its most likely
estimate, at that date, of the future losses and allocated corporate overhead under the Maryland
DPS contract through its expiration on June 30, 2005. This estimate assumed monthly losses under
the contract would diminish from the May 2004 level, which was viewed as an aberration, to
approximately $523,000 per month, including allocated overhead, an amount significantly above
recent historical levels. During the third quarter of 2004, the Company utilized $2.6 million of its loss contract
reserve, almost entirely due to the underperformance of the Maryland DPS contract. While actual
monthly losses incurred under the Maryland DPS contract had trended downward from the record loss
in May, losses once again increased in September, driven primarily by off-site medical costs. Off-site medical costs under the Maryland DPS contract averaged $1.3 million per month for
June through September 2004, as compared with initial estimates of $974,000 per month, based on
historical results. As a result of this new and more severe trend, the Company recorded a pre-tax
charge of $6.0 million, effective September 30, 2004, to increase its reserve for estimated future
losses and allocated corporate overhead under the Maryland DPS contract until its expiration in
June 2005. A fundamental assumption of the $6.0 million increase in loss reserve is that the
contract will incur on average $1.4 million per month of off-site medical costs through its
termination on June 30, 2005. As of March 31, 2005, the Company had a loss contract reserve totaling $3.0 million, which
relates to the Maryland DPS and a county contract. While the Company believes it is adequately reserved at present, there can be no assurance
that in the course of performing its reviews in future periods, the Company might revise its
estimate of future losses related to the contracts currently identified as loss contracts. It
might also identify additional contracts which have become loss contracts due to a change in
circumstances. Circumstances that might change and result in a revised estimate of future losses
or the identification of a contract as a loss contract in a future period include unanticipated
adverse changes in the healthcare cost structure, inmate population or the utilization of outside
medical services in a 20




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contract, where such changes are not offset by increased healthcare revenues. Should the
Company identify circumstances that would result in a revision of its estimate of future losses for
a loss contract, the Company would, in the period in which the revision is made, increase or
decrease the reserve for loss contracts. Should a contract be identified as a loss contract in a
future period, the Company would record, in the period in which such identification is made, a
reserve for the estimated future losses that would be incurred under the contract. A revision to a
current loss contract or the identification of a loss contract in the future could have a material
adverse effect on the Companys results of operations in the period in which the reserve is
recorded. Professional and General Liability Self-Insurance Retention As a healthcare provider, the Company is subject to medical malpractice claims and lawsuits.
The most significant source of potential liability in this regard is the risk of suits brought by
inmates alleging lack of timely or adequate healthcare services. The Company may also be liable,
as employer, for the negligence of healthcare professionals it employs or the healthcare
professionals it engages as independent contractors. The Companys contracts generally require it
to indemnify the governmental agency for losses incurred related to healthcare provided by the
Company or its agents. To mitigate a portion of this risk, the Company maintains its primary professional liability
insurance program, principally on a claims-made basis. However, the Company assumes significant
self-insurance risks resulting from the use of large deductibles in 2000 and 2001 and the use of
adjustable premium policies in 2002, 2003, 2004 and 2005. For 2002, 2003, 2004 and 2005, the
Company is covered by separate policies each of which contains a 42-month retro-premium with
adjustment based on actual losses after 42 months. The Companys ultimate premium for its 2002,
2003, 2004 and 2005 policies will depend on the final incurred losses related to each of these
separate policy periods. Reserves for estimated losses related to known claims are provided for on
an undiscounted basis using internal and external evaluations of the merits of the individual
claims, analysis of claim history and the estimated reserves assigned by the Companys third-party
administrator. Any adjustments resulting from the review are reflected in current earnings. In addition to its reserves for known claims, the Company maintains a reserve for incurred but
not reported claims. The reserve for incurred but not reported claims is recorded on an
undiscounted basis. The Companys estimates of this reserve are supported by an independent
actuarial analysis, which is obtained on a quarterly basis. At March 31, 2005, the Companys reserves for known and incurred but not reported claims
totaled $19.1 million. Reserves for medical malpractice liability fluctuate because the number of
claims and the severity of the underlying incidents change from one period to the next.
Furthermore, payments with respect to previously estimated liabilities frequently differ from the
estimated liability. Changes in estimates of losses resulting from such fluctuations and
differences between actuarial estimates and actual loss payments are recognized by an adjustment to
the reserve for medical malpractice liability in the period in which the estimates are changed or
payments are made. The reserves can also be affected by changes in the financial health of the
third-party insurance carriers used by the Company. If a third party
insurance carrier fails to meet its contractual obligations under the
agreement with the Company, the Company would then be responsible for
such obligations. Changes in reserve requirements resulting from
a change in the financial health of a third-party insurance carrier are recognized in the period in
which such factor becomes known. Other Self-Funded Insurance Reserves At March 31, 2005, the Company had approximately $8.8 million in accrued liabilities for
employee health and workers compensation claims. The Company is significantly self-insured for
employee health and workers compensation claims. As such, its insurance expense is largely
dependent on claims experience and the ability to control claims. The Company accrues the estimated
liability for employee health insurance based on its history of claims experience and the time lag
between the incident date and the date of actual claim payment. The Company accrues the estimated
liability for workers compensation claims based on internal and external evaluations of the merits
of the individual claims, analysis of claim history and the estimated reserves assigned by the
Companys third-party administrator. On a periodic basis, the Company obtains an independent
actuarial analysis to further support the appropriateness of the workers compensation reserves.
These estimates of self-funded insurance reserves could change in the future based on changes in
the factors discussed above. Any adjustments resulting from such changes in estimates are
reflected in current earnings. 21




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##### Table of Contents



Legal Contingencies In addition to professional and general liability claims, the Company is also subject to other
legal proceedings in the ordinary course of business. Such proceedings generally relate to labor,
employment or contract matters. When estimable, the Company accrues an estimate of the probable
costs for the resolution of these claims. Such estimates are developed in consultation with outside
counsel handling the Companys defense in these matters and is based upon an estimated range of
potential results, assuming a combination of litigation and settlement strategies. The Company
does not believe these proceedings will have a material adverse effect on its consolidated
financial position. However, it is possible that future results of operations for any particular
quarterly or annual period could be materially affected by changes in assumptions, new developments
or changes in approach, such as a change in settlement strategy in dealing with such litigation.
See discussion of certain outstanding legal matters in Part II  Item 1 Legal Proceedings. Impairment of Intangible Assets and Goodwill In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets,(SFAS No. 142), goodwill acquired is not amortized but is reviewed for
impairment on an annual basis or more frequently whenever events or circumstances indicate that the
carrying value may not be recoverable. The Company performed its annual review as of December 31,
2004. Based on the results of this annual review, management determined that goodwill was not
impaired as of December 31, 2004. Future events could cause the Company to conclude that
impairment indicators exist and that goodwill is impaired. Any resulting impairment loss could
have a material adverse impact on the Companys financial condition and results of operations. The Companys other identifiable intangible assets, such as customer contracts acquired in
acquisitions and covenants not to compete, are amortized on the straight-line method over their
estimated useful lives. The Company also assesses the impairment of its other identifiable
intangibles whenever events or changes in circumstances indicate that the carrying value may not be
recoverable. Important factors taken into consideration when evaluating the need for an impairment review
include the following:  
    significant underperformance or loss of key contracts relative to expected
historical or projected future operating results;
    significant changes in the manner of use of the Companys assets or in the
Companys overall business strategy; and
    significant negative industry or economic trends. If the Company determines that the carrying value of goodwill may be impaired based upon the
existence of one or more of the above indicators of impairment or as a result of its annual
impairment review, any impairment is measured using a fair-value-based goodwill impairment test as
required under the provisions of SFAS No. 142. Fair value is the amount at which the asset could
be bought or sold in a current transaction between willing parties and may be estimated using a
number of techniques, including quoted market prices or valuations by third parties, present value
techniques based on estimates of cash flows, or multiples of earnings or revenues. The fair value
of the asset could be different using different estimates and assumptions in these valuation
techniques. When the Company determines that the carrying value of other intangible assets may not be
recoverable based upon the existence of one or more of the above indicators of impairment, any
impairment is measured using an estimate of the assets fair value based on the projected net cash
flows expected to result from that asset, including eventual disposition. The Company evaluates the estimated remaining useful life of its contract intangibles on at
least a quarterly basis, taking into account new facts and circumstances, including its retention
rate for acquired contracts. If such facts and circumstances indicate the current estimated life
is no longer reasonable, the Company adjusts the estimated useful life on a prospective basis. 22




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Income Taxes The Company accounts for income taxes under Statement of Financial Accounting Standards No.
109, Accounting for Income Taxes(SFAS No. 109). Under the asset and liability method of SFAS
No. 109, deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. The Company regularly reviews its deferred tax assets for recoverability taking into
consideration such factors as historical losses, projected future taxable income and the expected
timing of the reversals of existing temporary differences. SFAS No. 109 requires the Company to
record a valuation allowance when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. It further states forming a conclusion that a
valuation allowance is not needed is difficult when there is negative evidence such as cumulative
losses in recent years. Since December 31, 2001 and until June 30, 2004, the Company maintained a
100% valuation allowance equal to the deferred tax assets after considering deferred tax assets
that can be realized through offsets to existing taxable temporary differences. Based upon the Companys results of operations since December 31, 2001, and its expected
profitability in this and future years, the Company concluded, effective June 30, 2004, that it is
more likely than not that substantially all of its net deferred tax assets will be realized. As a
result, in accordance with SFAS No. 109, substantially all of the valuation allowance applied to
such net deferred tax assets was reversed in the second quarter of 2004. Reversal of the valuation
allowance resulted in a non-cash income tax benefit in the second quarter of 2004 totaling $5.3
million. This benefit represented the Companys estimated realizable deferred tax assets,
excluding those deferred tax assets that resulted from the exercise of employee stock options. The
reversal of the valuation allowance that related to the Companys estimated realizable deferred tax
assets resulting from the exercises of employee stock options totaled $3.9 million and was recorded
as a direct increase to additional paid-in capital in the stockholders equity portion of the
Companys balance sheet as of June 30, 2004. At March 31, 2005, the Companys valuation allowance
of approximately $0.2 million represents managements estimate of state net operating loss
carryforwards which will expire unused. The Company establishes accruals for certain tax contingencies when, despite the belief that
the Companys tax return positions are fully supported, the Company believes that certain positions
will be challenged and a risk exists that the Companys positions will not be fully sustained. The
tax contingency accruals are adjusted in light of changing facts and circumstances, such as the
progress of tax audits, case law, and emerging legislation. The Companys tax contingency accruals
are reflected as a component of accrued liabilities. 23




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Results of Operations The following table sets forth, for the periods indicated, the percentage relationship to
healthcare revenues of certain items in the condensed consolidated statements of operations. Quarter endedMarch 31,Percentage of Healthcare Revenues
    
    2005
    
    
    2004Healthcare revenues
    
    
    100.0
    %
    
    
    100.0
    %Healthcare expenses
    
    
    92.9
    
    
    
    93.1Gross margin
    
    
    7.1
    
    
    
    6.9Selling, general and administrative expenses
    
    
    2.5
    
    
    
    2.8Depreciation and amortization
    
    
    0.6
    
    
    
    0.6Charge for settlement of Florida legal matter
    
    
    
    
    
    
    3.3Income from operations
    
    
    4.0
    
    
    
    0.2Interest, net
    
    
    0.1
    
    
    
    0.4Income (loss) from continuing operations before income taxes
    
    
    3.9
    
    
    
    (0.2
    )Income tax provision
    
    
    1.6
    
    
    
    0.2Income (loss) from continuing operations
    
    
    2.3
    
    
    
    (0.4
    )Income from discontinued operations, net of taxes
    
    
    0.0
    
    
    
    0.2Net income (loss)
    
    
    2.3
    %
    
    
    (0.2
    )%
 Quarter Ended March 31, 2004 Compared to Quarter Ended March 31, 2005 Healthcare revenues.Healthcare revenues for the quarter ended March 31, 2005 increased $11.7
million, or 7.4%, from $157.0 million for the quarter ended March 31, 2004 to $168.7 million for
the quarter ended March 31, 2005. Healthcare revenues in 2005 included $2.6 million of revenue
growth resulting from correctional healthcare services contracts added in 2004 and 2005 through
marketing activities. Correctional healthcare services contracts in place at December 31, 2003 and
continuing beyond March 31, 2005 experienced revenue growth of 5.2% consisting of additional
revenue of $7.7 million during the first quarter of 2005 as the result of contract renegotiations
and automatic price adjustments. In addition to these revenue increases, SPP pharmaceutical
distribution revenue increased $1.4 million. As discussed in the discontinued operations section
below, the Companys correctional healthcare services contracts that have expired or otherwise been
terminated have been classified as discontinued operations. Healthcare expenses.Healthcare expenses for the quarter ended March 31, 2005 increased $10.5
million, or 7.2%, from $146.2 million for the quarter ended March 31, 2004 to $156.7 million for
the quarter ended March 31, 2005. Expenses related to new correctional healthcare services
contracts added in 2004 and 2005 through marketing activities accounted for $2.4 million of the
increase. Healthcare expenses as a percentage of healthcare revenues decreased by 0.2% in 2005 as
compared to 2004. This percentage decrease results primarily from increased healthcare revenues
associated with the Companys ongoing efforts, when renewing or negotiating contracts, to negotiate
risk-sharing arrangements, such as stop-loss provisions and aggregate limits for off-site or
pharmaceutical costs. Approximately $2.8 million and $0.1 million in negative operating margin
related to the Companys loss contracts was charged against the loss contract reserve during the
quarters ended March 31, 2005 and 2004, respectively. Selling, general and administrative expenses.Selling, general and administrative expenses
were $4.3 million, or 2.5% of healthcare revenues, for the quarter ended March 31, 2005 as compared
to $4.4 million, or 2.8% of healthcare revenues, for the quarter ended March 31, 2004. The
percentage of revenue decrease is primarily the result of the increase in healthcare revenues
discussed above. Approximately $0.3 million and $15,000 in overhead costs associated with the
Companys loss contracts were charged against the loss contract reserve during the quarters ended
March 31, 2005 and 2004, respectively. Depreciation and amortization. Depreciation and amortization expense for each of the quarters
ended March 31, 2005 and 2004 was approximately $1.0 million. Charge for settlement of Florida legal matter.One of the Companys subsidiaries, EMSA
Limited Partnership, entered into a settlement agreement with the Florida Attorney Generals office
on March 30, 2004, related to allegations, first raised in connection with an investigation of EMSA
Correctional Services (EMSA) in 1997, that 24




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the Company may have played an indirect role in the improper billing of Medicaid by
independent providers treating incarcerated patients. The Company acquired EMSA in 1999. EMSA was
a party to several contracts to provide healthcare to inmates at Florida correctional facilities.
Typically, in those contracts, which were approved by government lawyers, the clients required EMSA
to seek all available third party reimbursement for medical services provided to inmates,
specifically including Medicaid. It was the implementation of these contract requirements that the
Florida Attorney Generals office alleged was improper. The settlement agreement with the Florida Attorney Generals office constitutes a complete
resolution and settlement of the claims asserted against EMSA and required EMSA Limited Partnership
to pay $5.0 million to the State of Florida. This payment was made by the Company on March 30,
2004. Under the terms of the settlement agreement, the Company and all of its subsidiaries are
released from liability for any alleged actions which might have occurred from December 1, 1998 to
March 31, 2004. Both parties entered into the settlement agreement to avoid the delay,
uncertainty, inconvenience and expense of protracted litigation. The settlement agreement states
that it is not punitive in purpose or effect, it should not be construed or used as admission of
any fault, wrongdoing or liability whatsoever, and that EMSA specifically denies intentionally
submitting any medical claims in violation of state or federal law. The Company recorded a charge of $5.2 million in its results of operations for the first
quarter of 2004, reflecting the settlement agreement with the Florida Attorney Generals office and
related legal expenses. Interest, net. Net interest expense decreased to $0.2 million, or 0.1% of healthcare
revenues, for the quarter ended March 31, 2005 from $0.5 million, or 0.4% of healthcare revenues,
for the quarter ended March 31, 2004. This decrease is primarily the result of a reduction in the
level of debt outstanding. Income tax provision.The provision for income taxes for the quarter ended March 31, 2005 was
$2.6 million or 1.6% of healthcare revenues as compared with a provision of $0.4 million or 0.2% of
healthcare revenues for the quarter ended March 31, 2004. Prior to June 30, 2004, the Company
maintained a 100% valuation allowance, established in the quarter ended December 31, 2001, related
to its net deferred tax assets. As a result of the valuation allowance in place during the first
quarter of 2004, the income tax provision for the quarter ended March 31, 2004 primarily reflects
state income taxes paid and is significantly lower than the Companys statutory tax rate. Income (loss) from continuing operations.Income from continuing operations for the quarter
ended March 31, 2005 was $3.9 million, as compared with a loss from continuing operations of $0.6
million for the quarter ended March 31, 2004, as the result of the factors discussed above. Income from discontinued operations, net of taxes. Income from discontinued operations for
the quarter ended March 31, 2005 was $25,000 as compared with $0.2 million for the quarter ended
March 31, 2004. Income from discontinued operations represents the operating results of the
Companys correctional healthcare services contracts that have expired or otherwise been
terminated. The classification of these expired contracts is the result of the Companys adoption
of SFAS No. 144 effective January 1, 2002. See Note 6 of the Companys condensed consolidated
financial statements for further discussion of SFAS No. 144. Approximately $0.1 million in
negative operating margin related to the Companys loss contracts classified as discontinued
operations was charged against the loss contract reserve during the quarter ended March 31, 2004.
There was no income (loss) from discontinued operations, net of tax, charged against the loss
contract reserve for the quarter ended March 31, 2005. Net income (loss).Net income for the quarter ended March 31, 2005 was $3.9 million as
compared with a net loss of $0.4 million for the quarter ended March 31, 2004 as the result of the
factors discussed above. 25




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Liquidity and Capital Resources Overview The Company had positive working capital of $1.6 million at March 31, 2005 compared to
negative working capital of $4.4 million at December 31, 2004. The improvement in working capital
of $6.0 million was primarily the result of cash flows from operations. Days sales outstanding in
accounts receivable were 45 at March 31, 2005 while accounts payable days outstanding at March 31,
2005 were 55 and accrued medical claims liability days outstanding at March 31, 2005 were 73. The Company generated net income of $3.9 million for the quarter ended March 31, 2005 compared
to a net loss of $0.4 million for the quarter ended March 31, 2004. The Company had stockholders
equity of $60.1 million at March 31, 2005 as compared to $55.0 million at December 31, 2004. The
Companys cash and cash equivalents increased to $15.6 million at March 31, 2005 from $7.2 million
at December 31, 2004, an increase of $8.4 million. The increase in cash was primarily the result
of cash flows from operations. Cash flows from operating activities represent the year to date net income plus depreciation
and amortization, changes in various components of working capital and adjustments for various
non-cash charges, such as increases or reductions in the reserve for loss contracts. Cash flows
from operating activities during the quarter ended March 31, 2005 were $8.4 million, an increase of
$5.4 million from cash flows from operations for the quarter ended March 31, 2004 of $3.0 million.
The increase was primarily due to a decrease of $8.1 million in outstanding accounts receivable
which resulted from collection of certain client receivables that had become past due. Included in
the Companys net loss for the quarter ended March 31, 2004 was a cash payment of $5.2 million for
the settlement of a Florida legal matter. Cash flows used in investing activities were $1.2 million and $0.6 million for the quarters
ended March 31, 2005 and 2004, respectively. These amounts represent purchases of property and
equipment, which were financed through working capital. Cash flows provided by financing activities during the quarter ended March 31, 2005 were $1.1
million which represent cash receipts resulting from option exercises and issuance of common stock
under an employee stock purchase plan. The Company has no debt outstanding at March 31, 2005. Credit Facility On October 31, 2002, the Company entered into a new credit facility with CapitalSource Finance
LLC (the CapitalSource Credit Facility). The CapitalSource Credit Facility matures on October
31, 2005 and includes a $55.0 million revolving credit facility (the Revolver) and prior to the
third quarter of 2004 also included a $5.0 million term loan (the Term Loan). In June 2003, the Company and CapitalSource Finance LLC entered into an amendment to the
CapitalSource Credit Facility. Under the terms of the amendment, the Company may have standby
letters of credit issued under the loan agreement in amounts up to $10.0 million. The amount
available to the Company for borrowings under the CapitalSource Credit Facility is reduced by the
amount of each outstanding standby letter of credit. At March 31, 2005, the Company had
outstanding standby letters of credit totaling $4.0 million, which were used to collateralize
performance bonds. The CapitalSource Credit Facility is secured by substantially all assets of the Company and
its operating subsidiaries. At March 31, 2005, the Company had no borrowings outstanding under the
Revolver and $43.1 million available for additional borrowing, based on the Companys collateral
base on that date and outstanding standby letters of credit. Borrowings under the Revolver are limited to the lesser of (1) 85% of eligible receivables (as
defined in the Revolver) or (2) $55.0 million (the Revolver Capacity). Interest under the
Revolver is payable monthly at the greater of 5.75% or the Citibank N.A. prime rate plus 1.0%. The
Company is also required to pay a monthly collateral management fee, equal to an annual rate of
1.38%, on average borrowings outstanding under the Revolver. 26




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##### Table of Contents



Additionally, the Company is required to pay a monthly letter of credit fee equal to an annual
rate of 3.5% on the outstanding balance of letters of credit issued pursuant to the Revolver. Under the terms of the CapitalSource Credit Facility, the Company is required to pay a monthly
unused line fee equal to an annual rate of 0.6% on the Revolver Capacity less the actual average
borrowings outstanding under the Revolver for the month and the balance of any outstanding letters
of credit. During the third quarter of 2004, the Company prepaid the remaining balance of $2.1 million
and retired its Term Loan which was set to mature on October 31, 2005. In conjunction with the
retirement of the Term Loan, the Company paid a $0.1 million loan fee which was due upon maturity. The CapitalSource Credit Facility requires the Company to achieve a minimum level of EBITDA of
$3.0 million on a rolling three-month measurement period. The CapitalSource Credit Facility
defines EBITDA as net income plus interest expense, income taxes, depreciation expense,
amortization expense, any other non-cash non-recurring expense and loss from asset sales outside of
the normal course of business, minus gains on asset sales outside the normal course of business,
non-recurring gains, and utilization of the Companys loss contract reserve. The CapitalSource Credit Facility also requires the Company to maintain a minimum fixed charge
coverage ratio of 1.5 on a rolling three-month basis. The CapitalSource Credit Facility defines
the fixed charge coverage ratio as EBITDA, as defined above, divided by the sum of principal
payments on outstanding debt, cash interest expense on outstanding debt, capital expenditures, cash
income taxes paid or accrued, and cash dividends paid or accrued or declared. In addition, the
Company is required to maintain a minimum fixed charge ratio of 1.75 calculated using the most
recent twelve-month period. The Company was in compliance with these financial covenants as of March 31, 2005. The CapitalSource Credit Facility also contains restrictions on the Company with respect to
certain types of transactions, including acquisition of the Companys own stock, payment of
dividends, indebtedness and sales or transfers of assets. The Companys credit facility with CapitalSource Finance LLC expires on October 31, 2005. As
a result, the Company will be required to replace this credit facility during 2005. No assurances
can be made that the Company can obtain replacement financing arrangements on terms acceptable to
it, or at all. Other Financing Transactions At March 31, 2005, the Company had standby letters of credit outstanding totaling $4.0 million
which were collateralized by a reduction of availability under the CapitalSource Credit Facility. Contractual Obligations And Commercial Commitments The Company has certain contractual obligations for the nine month period in 2005 and the
years ended December 31, 2006, 2007, 2008 and 2009, summarized by the period in which payment is
due, as follows (dollar amounts in thousands): 2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    ThereafterOperating leases
    
    $
    1,245
    
    
    $
    1,564
    
    
    $
    1,504
    
    
    $
    860
    
    
    $
    285
    
    
    $
    Payable to Health
Cost Solutions,
Inc.
    
    $
    859
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 At March 31, 2005, the Company was contingently liable for $22.3 million of performance
bonds. The performance bonds are collateralized by the standby letters of credit discussed above. Off-Balance Sheet Transactions As of March 31, 2005 the Company did not have any off-balance sheet financing transactions or
arrangements except the standby letters of credit discussed above. 27




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Inflation Some of the Companys contracts provide for annual increases in the fixed base fee based upon
changes in the regional medical care component of the Consumer Price Index. In all other contracts
that extend beyond one year, the Company utilizes a projection of the future inflation rate when
bidding and negotiating the fixed fee for future years. If the rate of inflation exceeds the levels
projected, the excess costs will be absorbed by the Company with the financial impact dependent
upon contract structure. Conversely, the Company may benefit should the actual rate of inflation
fall below the estimate used in the bidding and negotiation process. Recently Issued Accounting Pronouncement On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment(SFAS No. 123(R)), which is a revision of SFAS No. 123. SFAS
No. 123(R) requires all share-based payments to employees, including grants of employee stock
options and any compensatory discounts received by employees in connection with stock purchased
under employee stock purchase plans, to be recognized in the financial statements based on their
fair values. Pro forma disclosure is no longer appropriate. SFAS No. 123(R) must be adopted for all fiscal years beginning after June 15, 2005. Early
adoption will be permitted in periods in which financial statements have not yet been issued. The
Company expects to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) permits the Company to adopt its requirements using one of two methods, a
modified prospective method or a modified retrospective method. When applying the modified
prospective method, compensation cost is recognized beginning with the effective date based on the
requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and
based on the requirements of SFAS No. 123 for all awards granted to employees prior to the
effective date of SFAS No. 123(R) that remain unvested on the effective date. The modified
retrospective method includes the requirements of the modified prospective method described above,
but also permits the Company to restate, based on the amounts previously recognized under SFAS No.
123 for purposes of pro forma disclosures, either all prior periods presented or prior interim
periods of the year of adoption. The Company plans to adopt SFAS No. 123(R) using the modified
prospective method. As permitted by SFAS No. 123, the Company currently accounts for share-based payments to
employees using APB No. 25s intrinsic value method and, as such, generally recognizes no
compensation cost for employee stock options. The impact of adoption of SFAS No. 123(R) cannot be
predicted at this time because it will depend on levels of share-based payments granted in the
future. However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that
standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro
forma net income and earnings per share in Note 5 of the Companys condensed consolidated financial
statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as
required under current literature. This requirement may reduce net operating cash flows and
increase net financing cash flows in periods after adoption. While the Company cannot estimate
what those amounts will be in the future, the amount of operating cash flows recognized in the
quarter ended March 31, 2005 for such excess tax deductions was $0.1 million. No amounts were
recognized in the Companys cash flow statement for the quarter ended March 31, 2004 as the Company
had a deferred tax valuation allowance in those years. 28




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##### Table of Contents



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may impact the consolidated financial statements
of the Company due to adverse changes in financial market prices and rates. The Companys
exposure to market risk is primarily related to changes in the variable interest rate under the
CapitalSource Credit Facility. The CapitalSource Credit Facility carries an interest rate based on
the Citibank N.A. prime rate, subject to a minimum stated interest rate; therefore the Companys
cash flow may be affected by changes in the prime rate. A hypothetical 10% change in the
underlying interest rate would have had no effect on interest expense paid under the CapitalSource
Credit Facility, as the resulting interest rate would have remained below the minimum stated
interest rate. Interest expense represents 0.1% and 0.4% of the Companys revenues, respectively,
for the quarters ended March 31, 2005 and 2004. The Company has no debt outstanding at March 31,
2005. 
 ITEM 4. CONTROLS AND PROCEDURES Disclosure controls and procedures are the Companys controls and other procedures that are
designed to ensure that information required to be disclosed in the reports that the Company files
or submits under the Securities Exchange Act of 1934, as amended, (the Exchange Act) is recorded,
processed, summarized and reported, within the time periods specified in the Securities and
Exchange Commission (SEC) rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information required to be disclosed in
the reports that the Company files or furnishes under the Exchange Act is accumulated and
communicated to management, including the Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. As of the end of the period covered by this report, the Company evaluated under the
supervision and with the participation of management, including the Chief Executive Officer and
Chief Financial Officer, the effectiveness of the design and operation of the Companys disclosure
controls and procedures, pursuant to the Exchange Act. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and
procedures are effective. There were no changes in the Companys internal control over financial
reporting during the first quarter of 2005 that have materially affected, or are reasonably likely
to materially affect, the Companys internal control over financial reporting. 29




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##### Table of Contents



PART II: OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS EMSA lease matter.On July 12, 2004, EMSA Limited Partnership, a limited partnership owned by
the Company, received an unexpected adverse jury verdict in the Circuit Court, 11th
Judicial Circuit, Miami-Dade County, Florida of approximately $1.2 million plus potential interest
which has the potential to double the amount of the award to $2.5 million. This verdict relates to
a 12 year old case filed by the plaintiff, Community Health Related Services, Inc. (wholly owned by
Dr. Carlos Vicaria) seeking unspecified damages involving a lease dispute in connection with a line
of business managing physician clinics operated by EMSA Limited Partnership prior to its
acquisition by the Company in 1999. The Company did not acquire this line of business or assume
the expired sublease from the seller under the transaction. The Company has, to date, been forced
to defend the case as the seller has not yet assumed responsibility. The trial judge has yet to
enter the jurys verdict as a final judgment and the Company has filed a motion for new trial, a
motion for remittitur or new trial as to damages, a motion for judgment notwithstanding the
verdict, and for judgment in accordance with its previous motion for a directed verdict. The
matter currently remains under advisement with the court and the Company will continue to
vigorously defend the lawsuit and believes that it will ultimately be successful, through either
its post-trial motions or on appeal, in having the verdict award reduced or overturned. However,
in the event the Company is not successful at the trial court level or on appeal, or if the Company
decides not to appeal an unfavorable verdict, an adverse judgment could have a material adverse
effect on the Companys financial position and its quarterly or annual results of operations. As
of March 31, 2005, the Company, after giving consideration to its post-trial motions and appeal
rights, estimates that its probable loss related to this matter will be less than the $1.2 million
jury verdict amount. The Companys reserves related to this matter are included in its reserves
for all general legal matters, which total approximately $1.0 million as of March 31, 2005. In
addition to its rights under post-verdict motions and the potential for appeal, the Company has
filed suit against Caremark RX, Inc. (Caremark), the successor to the party who sold EMSA to the
Company, for indemnification for all costs associated with this case as well as any judgment
returned which is adverse to the Company. Caremark is defending this lawsuit and the Company does
not know whether it will prevail against Caremark. Accordingly, such reimbursement has not been
reflected in the Companys reserve estimate discussed above. Other matters.In addition to the matters discussed above, the Company is a party to various
legal proceedings incidental to its business. Certain claims, suits and complaints arising in the
ordinary course of business have been filed or are pending against the Company. An estimate of the
amounts payable on existing claims for which the liability of the Company is probable is included
in accrued expenses at March 31, 2005 and December 31, 2004. The Company is not aware of any
material unasserted claims and would not anticipate that potential future claims would have a
material adverse effect on its consolidated financial position, results of operations or cash
flows. 30




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##### Table of Contents



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable. 
 ITEM 3. DEFAULTS UPON SENIOR SECURTIES Not applicable. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 
 ITEM 5. OTHER INFORMATION Not applicable. 31




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##### Table of Contents



ITEM 6. EXHIBITS 2.1 
    
    Securities Purchase Agreement, dated as of January 26, 1999, among America Service Group
Inc., Health Care Capital Partners L.P. and Health Care Executive Partners L.P. (incorporated
herein by reference to Exhibit 99.2 to the Companys Current Report on Form 8-K filed on
February 10, 1999).3.1 
    
    Amended and Restated Certificate of Incorporation of America Service Group Inc.
(incorporated herein by reference to Exhibit 3.1 to the Companys Quarterly Report on Form
10-Q for the three month period ended June 30, 2002).3.2 
    
    Amended and Restated By-Laws of America Service Group Inc. (incorporated herein by
reference to Exhibit 3.2 to the Companys Quarterly Report on Form 10-Q for the three-month
period ended June 30, 2002).3.3 
    
    Certificate of Amendment of Amended and Restated Certificate of Incorporation of America
Service Group Inc. (incorporated herein by reference to Exhibit 3.4 to the Companys Quarterly
Report on Form 10-Q for the three month period ended June 30, 2004).4.1 
    
    Specimen Common Stock Certificate (incorporated herein by reference to Exhibit 4.1 to the
Companys Quarterly Report on Form 10-Q for the three month period ended June 30, 2002).4.2 
    
    Certificate of Designation of the Series A Convertible Preferred Stock (incorporated
herein by reference to Exhibit 99.3 to the Companys Current Report on Form 8-K filed on
February 10, 1999).10.1 
    
    Consulting Agreement with healthprojects, LLC, dated April 22, 2005 (incorporated herein
by reference to Exhibit 99.1 to the Companys Current Report on Form 8-K filed on April 26,
2005).11
    
    Computation of Per Share Earnings.*31.1 
    
    Certification of the Chief Executive Officer pursuant to Rule 13a-14(a), as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2 
    
    Certification of the Chief Financial Officer pursuant to Rule 13a-14(a), as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the 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 the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
    32




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICA SERVICE GROUP INC./s/ MICHAEL CATALANOMichael CatalanoChairman, President & Chief Executive Officer(Duly Authorized Officer)/s/ MICHAEL W. TAYLORMichael W. TaylorSenior Vice President & Chief Financial Officer
(Principal Financial Officer)
 Dated: May 9, 2005 33