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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549




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FORM 10-Q



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(Mark One)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2003ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934For the transition period from ______________________ to _____________________


Commission File Number: 0-20135



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AMERICA SERVICE GROUP INC.

(Exact name of registrant as specified in its charter)


Delaware(State or other jurisdiction of
incorporation or organization)
    
    51-0332317(I.R.S. Employer
Identification No.)105 Westpark Drive, Suite 200
Brentwood, Tennessee
(Address of principal executive offices)
    
    37027
(Zip Code)


(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 Act. Yes
o No þ

There
were 6,692,840 shares of Common Stock outstanding as of
November 12,
2003.



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TABLE OF CONTENTS



|                                                                                                |                                                      |  |  |  |  |  |  | 
|----------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  |  | 
|PART I: FINANCIAL INFORMATION                                                                  
|ITEM 1.  FINANCIAL STATEMENTS                                                                 
|                                                                                                | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                                                                                                | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|ITEM 2.  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                             
|ITEM 4. CONTROLS AND PROCEDURES                                                                
|PART II: OTHER INFORMATION                                                                     
|ITEM 1. LEGAL PROCEEDINGS                                                                      
|ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                                                                                     
|EX-31.1  SECTION 302 CERTIFICATION OF THE CEO                                                  
|EX-31.2  SECTION 302 CERTIFICATION OF THE CFO                                                  
|EX-32.1  SECTION 906 CERTIFICATIOIN OF THE CEO                                                 
|EX-32.2  SECTION 906 CERTIFICATION OF THE CFO                                                  



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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 September 30, 2003 and December 31, 2002
    
    
    3Condensed Consolidated Statements of Operations for the quarters and nine month periods
endedSeptember 30, 2003 and 2002
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine month periods ended
September 30, 2003 and 2002
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4. Controls and Procedures
    
    
    28PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    29Item 6. Exhibits and Reports on Form 8-K
    
    
    30Signatures
    
    
    32


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PART I:

FINANCIAL INFORMATION







ITEM 1.  FINANCIAL STATEMENTS

AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

September 30,
    
    December 31,2003
    
    2002(shown in
000s except share andper share
amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,714
    
    
    $
    3,770Restricted cash
    
    
    
    
    
    
    6,250Accounts receivable: healthcare and other, less allowances
    
    
    64,114
    
    
    
    72,477Inventories
    
    
    5,917
    
    
    
    6,390Prepaid expenses and other current assets
    
    
    18,548
    
    
    
    13,100Total current assets
    
    
    97,293
    
    
    
    101,987Property and equipment, net
    
    
    4,448
    
    
    
    6,240Goodwill
    
    
    43,896
    
    
    
    43,896Contracts, net
    
    
    10,827
    
    
    
    12,048Other intangibles, net
    
    
    1,333
    
    
    
    1,483Other assets
    
    
    5,526
    
    
    
    5,852Total assets
    
    $
    163,323
    
    
    $
    171,506LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    42,897
    
    
    $
    40,892Medical claims liability
    
    
    14,028
    
    
    
    13,697Accrued expenses
    
    
    36,902
    
    
    
    33,482Deferred revenue
    
    
    12,735
    
    
    
    6,203Current portion of loss contract reserve
    
    
    451
    
    
    
    3,306Current portion of long-term debt
    
    
    1,667
    
    
    
    1,667Revolving credit facility classified as current (see Note 11)
    
    
    20,580
    
    
    
    41,135Total current liabilities
    
    
    129,260
    
    
    
    140,382Noncurrent portion of accounts payable and accrued expenses
    
    
    8,179
    
    
    
    7,924Noncurrent portion of loss contract reserve
    
    
    425
    
    
    
    5,681Long-term debt, net of current portion
    
    
    1,944
    
    
    
    3,194Total liabilities
    
    
    139,808
    
    
    
    157,181Commitments and contingenciesStockholders equity:Common stock, $.01 par value, 10,000,000 shares authorized; 6,399,000 and
6,122,000 shares issued and outstanding at September 30, 2003 and December 31, 2002,
respectively
    
    
    64
    
    
    
    61Additional paid-in capital
    
    
    39,360
    
    
    
    36,561Stockholders notes receivable
    
    
    (1,154
    )
    
    
    (1,241
    )Accumulated deficit
    
    
    (14,755
    )
    
    
    (21,056
    )Total stockholders equity
    
    
    23,515
    
    
    
    14,325Total liabilities and stockholders equity
    
    $
    163,323
    
    
    $
    171,506


The accompanying notes to condensed consolidated financial statements
are an integral part of these balance sheets. The condensed consolidated balance sheet at
December 31, 2002 is taken from the audited financial statements at that date.

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AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002(shown in
000's except per share amounts)Healthcare revenues
    
    $
    140,184
    
    
    $
    111,498
    
    
    $
    397,309
    
    
    $
    321,180Healthcare expenses
    
    
    130,555
    
    
    
    104,122
    
    
    
    371,150
    
    
    
    300,915Reduction in reserve for loss contracts
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,320Gross margin
    
    
    9,629
    
    
    
    7,376
    
    
    
    26,159
    
    
    
    23,585Selling, general, and administrative expenses
    
    
    3,692
    
    
    
    3,394
    
    
    
    10,694
    
    
    
    10,958Depreciation and amortization
    
    
    1,042
    
    
    
    1,228
    
    
    
    3,200
    
    
    
    3,495Income from operations
    
    
    4,895
    
    
    
    2,754
    
    
    
    12,265
    
    
    
    9,132Interest, net
    
    
    883
    
    
    
    1,223
    
    
    
    2,947
    
    
    
    4,627Income from continuing operations before income taxes
    
    
    4,012
    
    
    
    1,531
    
    
    
    9,318
    
    
    
    4,505Income tax provision
    
    
    287
    
    
    
    322
    
    
    
    698
    
    
    
    214Income from continuing operations
    
    
    3,725
    
    
    
    1,209
    
    
    
    8,620
    
    
    
    4,291Income (loss) from discontinued operations, net of taxes
    
    
    1,602
    
    
    
    1,076
    
    
    
    (2,319
    )
    
    
    5,281Net income
    
    $
    5,327
    
    
    $
    2,285
    
    
    $
    6,301
    
    
    $
    9,572Net income per common share  basic:Income from continuing operations
    
    $
    0.59
    
    
    $
    0.22
    
    
    $
    1.37
    
    
    $
    0.78Income (loss) from discontinued operations, net of
taxes
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.37
    )
    
    
    0.97Net income
    
    $
    0.84
    
    
    $
    0.41
    
    
    $
    1.00
    
    
    $
    1.75Net income per common share  diluted:Income from continuing operations
    
    $
    0.56
    
    
    $
    0.22
    
    
    $
    1.33
    
    
    $
    0.77Income (loss) from discontinued operations, net of
taxes
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.35
    )
    
    
    0.95Net income
    
    $
    0.81
    
    
    $
    0.41
    
    
    $
    0.98
    
    
    $
    1.72Weighted average common shares outstanding:Basic
    
    
    6,357
    
    
    
    5,526
    
    
    
    6,287
    
    
    
    5,472Diluted
    
    
    6,601
    
    
    
    5,631
    
    
    
    6,458
    
    
    
    5,578


The accompanying notes to condensed consolidated financial statements are an
integral part of these statements.

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AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Nine months endedSeptember 30,2003
    
    2002(Amounts
shown in 000's)Operating ActivitiesNet income
    
    $
    6,301
    
    
    $
    9,572Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    3,220
    
    
    
    3,573Loss on retirement of fixed assets
    
    
    179
    
    
    
    Finance cost amortization
    
    
    423
    
    
    
    821Increase in reserve for loss contracts
    
    
    4,500
    
    
    
    Reduction in reserve for loss contracts
    
    
    (1,714
    )
    
    
    (3,320
    )Interest on stockholders notes receivable
    
    
    (54
    )
    
    
    (58
    )Other comprehensive income charged to interest expense
    
    
    
    
    
    
    542Changes in operating assets and liabilities:Accounts receivable, net
    
    
    8,363
    
    
    
    (2,021
    )Inventories
    
    
    285
    
    
    
    271Prepaid expenses and other current assets
    
    
    (5,448
    )
    
    
    (7,410
    )Other assets
    
    
    (95
    )
    
    
    397Accounts payable
    
    
    (1,246
    )
    
    
    10,361Medical claims liability
    
    
    331
    
    
    
    (1,269
    )Accrued expenses
    
    
    1,294
    
    
    
    2,299Deferred revenue
    
    
    6,532
    
    
    
    2,668Loss contract reserve
    
    
    (4,397
    )
    
    
    (5,188
    )Net cash provided by operating activities
    
    
    18,474
    
    
    
    11,238Investing ActivitiesCapital expenditures
    
    
    (918
    )
    
    
    (925
    )Net cash used in investing activities
    
    
    (918
    )
    
    
    (925
    )Financing ActivitiesNet payments on line of credit and term loan
    
    
    (21,805
    )
    
    
    (16,511
    )Decrease in restricted cash
    
    
    6,250
    
    
    
    Payment of deferred financing costs
    
    
    
    
    
    
    (550
    )Proceeds from stockholders notes receivable
    
    
    141
    
    
    
    83Issuance of common stock
    
    
    205
    
    
    
    Exercise of stock options
    
    
    2,597
    
    
    
    Net cash used in financing activities
    
    
    (12,612
    )
    
    
    (16,978
    )Net increase (decrease) in cash and cash equivalents
    
    
    4,944
    
    
    
    (6,665
    )Cash and cash equivalents at beginning of period
    
    
    3,770
    
    
    
    10,382Cash and cash equivalents at end of period
    
    $
    8,714
    
    
    $
    3,717Noncash TransactionPayable to Health Cost Solutions, Inc. (see Notes 9 and 10)
    
    $
    5,632
    
    
    $
    


The accompanying notes to condensed consolidated financial statements are an
integral part of these statements.

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AMERICA SERVICE GROUP INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003(dollar amounts shown in 000s except per share amounts)
(unaudited)

1. Basis of Presentation

The interim condensed consolidated financial statements of America Service
Group Inc. and its consolidated subsidiaries (the Company) as of September
30, 2003 and for the quarters and nine month periods ended September 30, 2003
and 2002 are unaudited, but in the opinion of management, have been prepared in
conformity with accounting principles generally accepted in the United States
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 and nine month periods presented. The results of operations for
the quarters and nine month periods presented are not necessarily indicative of
the results to be expected for the year ending December 31, 2003. The interim
condensed consolidated financial statements should be read in connection with
the audited consolidated financial statements for the year ended December 31,
2002.

2. Description of Business

The Company provides managed healthcare services to correctional
facilities under capitated contracts (with certain adjustments) with state and
local governments and certain private entities. The health status of inmates
may impact results of operations under such contractual arrangements.

3. Recently Issued Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed ofand resolves significant implementation issues that
had evolved since the issuance of SFAS No. 121. SFAS No. 144 established a
single accounting model for long-lived assets to be disposed of by sale or
abandonment. Additionally, SFAS No. 144 expanded the scope of financial
accounting and reporting of discontinued operations to require that all
components of an entity that have either been disposed of (by sale, by
abandonment, or in a distribution to owners) or are held for sale and whose
operations and cash flows can be clearly distinguished, operationally and for
financial reporting purposes from the rest of the entity, should be presented
as discontinued operations. SFAS No. 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001. The
provisions for presenting the components of an entity as discontinued
operations are effective only for disposal activities after the effective date
of SFAS No. 144. The Company adopted the provisions of SFAS No. 144 effective
January 1, 2002. Pursuant to SFAS No. 144, each of the Companys contracts is
a component of the entity, whose operations can be distinguished from the rest
of the Company. Therefore, when a contract terminates, by expiration or
otherwise, the contracts operations generally will be eliminated from the
continuing operations of the Company. Accordingly, the operations of such
contracts, net of applicable income taxes, have been presented as discontinued
operations and prior period Consolidated Statements of Operations have been
reclassified. See Note 5 for a further discussion of discontinued operations.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities(FIN 46), which requires the consolidation of
certain variable interest entities, as defined by FIN 46. FIN 46 requires an
assessment of contractual arrangements to determine if they represent interests
in variable interest entities. Variable interest entities created prior to
February 1, 2003, will be subject to the consolidation provisions of FIN 46 in
fiscal periods ending after December 15, 2003. Variable interest entities
created subsequent to February 1, 2003 are subject to the consolidation
provisions currently. Additionally, disclosures are required currently if the
Company expects to consolidate any variable interest entities in the future.
The Company continues to evaluate the consolidation requirements of FIN 46 with
respect to variable interest entities created prior to February 1, 2003.

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4. Stock Options

The Company has elected to follow Accounting Principles Board Opinion
(APB) No. 25, Accounting for Stock Issued to Employeesand 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, Accounting for Stock-Based Compensation, 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 that Statement. The fair value of options issued during
2003 and 2002 was estimated at the date of grant using a Black-Scholes option
pricing model with the following weighted-average assumptions:

2003
    
    2002Volatility
    
    
    0.85
    
    
    
    0.80Interest rate
    
    
    4-5
    %
    
    
    3-4
    %Expected life (years)
    
    
    3
    
    
    
    3Dividend yields
    
    
    0.0
    %
    
    
    0.0
    %


The following table illustrates the effect on net income per common share
as if the Company had applied the fair value recognition provisions of SFAS 123
for each of the quarters and nine month periods ended September 30, 2003 and
2002:

Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Income from continuing operations as reported
    
    $
    3,725
    
    
    $
    1,209
    
    
    $
    8,620
    
    
    $
    4,291Add: Stock based compensation expense included in
reported net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Stock based compensation expense determined
under SFAS 123
    
    
    204
    
    
    
    574
    
    
    
    508
    
    
    
    1,427Pro forma income from continuing operations
    
    
    3,521
    
    
    
    635
    
    
    
    8,112
    
    
    
    2,864Income (loss) from discontinued operations
    
    
    1,602
    
    
    
    1,076
    
    
    
    (2,319
    )
    
    
    5,281Pro forma net income attributable to common shares
    
    $
    5,123
    
    
    $
    1,711
    
    
    $
    5,793
    
    
    $
    8,145Pro forma net income per common share  basic:Pro forma income from continuing operations
    
    $
    0.56
    
    
    $
    0.12
    
    
    $
    1.29
    
    
    $
    0.52Pro forma income (loss) from discontinued operations
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.37
    )
    
    
    0.97Pro forma net income
    
    $
    0.81
    
    
    $
    0.31
    
    
    $
    0.92
    
    
    $
    1.49Pro forma net income per common share  diluted:Pro forma income from continuing operations
    
    $
    0.53
    
    
    $
    0.11
    
    
    $
    1.25
    
    
    $
    0.51Pro forma income (loss) from discontinued operations
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.35
    )
    
    
    0.95Pro forma net income
    
    $
    0.78
    
    
    $
    0.30
    
    
    $
    0.90
    
    
    $
    1.46


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 nine month periods ended September 30, 2003 and 2002 as determined
under the fair value provisions of SFAS No. 123, is $9.33 and $6.10,
respectively. No options were issued during the quarters ended September 30,
2003 and 2002. 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 the periods presented.

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5. Discontinued Operations

Pursuant to the provisions of SFAS No. 144 and as previously described in
Note 3, the Company has classified contracts that expired subsequent to January
1, 2002, the effective date of SFAS No. 144, as discontinued operations. The
components of income (loss) from discontinued operations, net of taxes, are as
follows:

Quarter ended September 30,
    
    Nine months ended September 30,2003
    
    2002
    
    2003
    
    2002Healthcare revenues
    
    $
    6,294
    
    
    $
    29,877
    
    
    $
    23,395
    
    
    $
    96,555Healthcare expenses
    
    
    6,403
    
    
    
    28,764
    
    
    
    22,885
    
    
    
    91,174Reduction in loss contract reserve (see Note 10)
    
    
    1,714
    
    
    
    
    
    
    
    1,714
    
    
    
    Increase in loss contract reserve (see Note 10)
    
    
    
    
    
    
    
    
    
    
    4,500
    
    
    
    Gross margin
    
    
    1,605
    
    
    
    1,113
    
    
    
    (2,276
    )
    
    
    5,381Depreciation and amortization
    
    
    3
    
    
    
    28
    
    
    
    22
    
    
    
    78Income (loss) from discontinued operations before taxes
    
    
    1,602
    
    
    
    1,085
    
    
    
    (2,298
    )
    
    
    5,303Income tax provision
    
    
    
    
    
    
    9
    
    
    
    21
    
    
    
    22Income (loss) from discontinued operations, net of taxes
    
    $
    1,602
    
    
    $
    1,076
    
    
    $
    (2,319
    )
    
    $
    5,281


6. Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets are comprised of the following:

September 30,
    
    December 31,2003
    
    2002Prepaid insurance
    
    $
    15,973
    
    
    $
    10,458Prepaid performance bonds
    
    
    432
    
    
    
    390Deposit  appeal bond collateral
    
    
    2,035
    
    
    
    2,035Prepaid other
    
    
    108
    
    
    
    217$
    18,548
    
    
    $
    13,100


7. Property and Equipment

Property and equipment are stated at cost and comprised of the following:

September 30,
    
    December 31,
    
    Estimated2003
    
    2002
    
    Useful LivesLeasehold improvements
    
    $
    1,237
    
    
    $
    1,183
    
    
    5 yearsEquipment and furniture
    
    
    10,207
    
    
    
    11,327
    
    
    5 yearsComputer software
    
    
    1,390
    
    
    
    1,404
    
    
    3 yearsMedical equipment
    
    
    2,407
    
    
    
    2,384
    
    
    5 yearsAutomobiles
    
    
    30
    
    
    
    14
    
    
    5 years15,271
    
    
    
    16,312Less: Accumulated depreciation
    
    
    (10,823
    )
    
    
    (10,072
    )$
    4,448
    
    
    $
    6,240


Depreciation expense for the quarters ended September 30, 2003 and 2002
was $589 and $682, respectively. Depreciation expense for the nine months
ended September 30, 2003 and 2002 was $1,851 and $2,067, respectively.

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##### Table of Contents



8. Contracts and Other Intangible Assets

The gross and net values of contracts and other intangible assets consist of
the following:

September 30,
    
    December 31,2003
    
    2002Contracts:Gross value
    
    $
    15,200
    
    
    $
    15,200Accumulated amortization
    
    
    (4,373
    )
    
    
    (3,152
    )$
    10,827
    
    
    $
    12,048Non-compete agreements:Gross value
    
    $
    2,400
    
    
    $
    2,400Accumulated amortization
    
    
    (1,067
    )
    
    
    (917
    )$
    1,333
    
    
    $
    1,483


Estimated aggregate amortization expense related to the above intangibles
for the remainder of 2003 is $456 and for each of the next four years is
$1,827.

9. Accounts Payable and Accrued Expenses

Accounts payable consist of the following:

September 30,
    
    December 31,2003
    
    2002Trade payables
    
    $
    39,662
    
    
    $
    40,892Payable to Health Cost Solutions, Inc (see Note 10)
    
    
    5,632
    
    
    
    45,294
    
    
    
    40,892Less: Noncurrent portion
    
    
    (2,397
    )
    
    
    $
    42,897
    
    
    $
    40,892


The noncurrent portion of accounts payable consists of $2,381 payable to
Health Cost Solutions, Inc., (see Note 10) and $16 of other noncurrent trade
payables.

Accrued expenses consist of the following:

September 30,
    
    December 31,2003
    
    2002Salaries and employee benefits
    
    $
    21,754
    
    
    $
    21,818Professional liability claims
    
    
    7,782
    
    
    
    8,924Professional liability insurance premiums
    
    
    3,448
    
    
    
    Accrued workers compensation
    
    
    4,362
    
    
    
    3,773Other
    
    
    5,338
    
    
    
    6,89142,684
    
    
    
    41,406Less: Noncurrent portion of professional liability claims
    
    
    (5,782
    )
    
    
    (7,924
    )$
    36,902
    
    
    $
    33,482


10. Reserve for Loss Contracts

On a quarterly basis, the Company performs a review of its portfolio of
contracts for the purpose of identifying loss contracts and developing a
contract loss reserve for succeeding periods. As a result of its 2001 review,
the Company identified five non-cancelable contracts that, based upon
managements projections, were expected to continue to incur negative gross
margins over their remaining terms. In December 2001, the Company recorded a
charge of $18.3 million to establish a reserve for future losses under these
non-cancelable contracts. The five contracts covered by the charge had
expiration dates ranging from June 30, 2002 through June 30, 2005. Ninety
percent of the charge related to the State of Kansas Department of Corrections
(the Kansas DOC) contract, which was to expire on June 30, 2005, and the City
of Philadelphia contract, which was renewable annually, at the clients option,
through June 30, 2004.

In June 2002, the Company and the City of Philadelphia reached a mutual
agreement that the contract between the Companys subsidiary and the City of
Philadelphia would expire effective June 30, 2002. As a result of the

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earlier than anticipated expiration of this loss contract, the Company
recorded a gain of $3,320, in the second quarter of 2002, to reduce its
reserve for loss contracts. From July 1, 2002 to September 30, 2002, the
Company provided services to the City of Philadelphia under a transition
arrangement. On September 30, 2002, the Company and the City of Philadelphia
entered into a new contract amendment under which the Company is continuing to
provide healthcare services to the City of Philadelphia under modified
contract terms.

During the second quarter of 2003, the Company experienced a significant
increase in healthcare expenses associated with its contract to provide
healthcare service to the Kansas DOC. As a result of this negative trend, in
June 2003, the Company recorded a charge of $4,500 to increase its reserve for
future losses under its contract with the Kansas DOC which was to expire June
30, 2005.

On August 22, 2003, the Company entered into an assignment and novation
agreement with the Kansas DOC to assign the Kansas DOC contract to HCS
effective October 1, 2003. The Company also entered into a general assignment,
novation and assumption agreement with Health Cost Solutions, Inc. (HCS) to
transfer the Kansas DOC contract to HCS, effective October 1, 2003. Beginning
October 1, 2003, HCS became solely responsible for the performance of the
Kansas DOC contract, and the Company has no obligation to the Kansas DOC or to
HCS related to HCS performance of the contract. Under the terms of the
Companys agreement with HCS, the Company will pay HCS net consideration of
$5,632 in 21 monthly installments, commencing October 31, 2003, and continuing
through June 30, 2005. The net consideration of $5,632 is comprised of payments
of $6,500 to assume the Companys obligations under the Kansas DOC contract,
less $868 related to fixed assets and inventory purchased from the Company by
HCS.

As a result of the financial terms of the Companys agreement with HCS,
the Company has reclassified $6,500 of its reserve for loss contracts to
accounts payable on the Companys consolidated balance sheet. The Company has
also recorded a gain of $1,714, in the third quarter of 2003, to reduce its
reserve for loss contracts. This reduction in the reserve, as well as the
second quarter increase in the reserve of $4,500, are reflected as components
of income (loss) from discontinued operations, net of tax, in the Companys
statements of operations.

As of September 30, 2003, the Company had a loss contract reserve totaling
$876, which relates to a county contract which expires on June 30, 2005.
Negative gross margin and overhead costs charged against the loss contract
reserve related to loss contracts, including contracts classified as
discontinued operations, totaled $1,485 and $1,204 for the quarters ended
September 30, 2003 and 2002, respectively. Negative gross margin and overhead
costs charged against the loss contract reserve related to loss contracts,
including contracts classified as discontinued operations, totaled $4,397 and
$5,189 for the nine month period ended September 30, 2003 and 2002,
respectively. The amounts charged against the loss contract reserve during
2002 represented losses associated with all five of the contracts that were
identified during 2001. The amounts charged against the loss contract reserve
during 2003 relate only to the Kansas DOC contract discussed above and the
remaining loss contract, a county contract, which expires on June 30, 2005.

There
is a potential that in the course of performing its quarterly review in
future periods, the Company might identify additional contracts which have
become loss contracts due to a change in circumstances. Circumstances that
might change and result in the identification of a contract as a loss
contract in a future period include unanticipated adverse changes in the
healthcare cost structure or the utilization of outside medical services in
a contract where such changes are not offset by increased revenue. 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.
Such a reserve could have a material adverse effect on the
Companys results of operations in the period in which it is recorded.

11. 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 both a
$55,000 revolving credit facility (the Revolver) and a $5,000 term loan (the
Term Loan). Proceeds from the CapitalSource Credit Facility were used to
repay the borrowings outstanding pursuant to the Companys previously existing
revolving credit facility (the Prior Credit Facility), at which time the
Company wrote off approximately $726 of deferred loan costs related to the
Prior Credit Facility.

The CapitalSource Credit Facility is secured by substantially all assets
of the Company and its operating subsidiaries. At September 30, 2003, the
Company had borrowings outstanding under the CapitalSource Credit Facility
totaling $24,191 and $19,145 available for additional borrowing, based on the
Companys collateral base on that date and outstanding standby letters of
credit.

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 $10,000. The amount available to the Company for
borrowings under the

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CapitalSource Credit Facility is reduced by the amount of each outstanding
standby letter of credit. At September 30, 2003, the Company had outstanding
standby letters of credit totaling $4,000, which were used to collateralize
performance bonds. Prior to this amendment, the performance bonds were
collateralized by restricted cash. As a result of this amendment, the Company
is no longer required to maintain the restricted cash balances that were
previously used as collateral for the performance bonds.

Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined) or (2) $55,000 (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.

All amounts outstanding under the Revolver will be due and payable on
October 31, 2005. If the Revolver is extinguished prior to July 1, 2005, the
Company will be required to pay an early termination fee equal to 1.0% of the
Revolver Capacity. In connection with the Revolver, the CapitalSource Credit
Facility requires a lockbox agreement, which provides for all cash receipts to
be swept daily to reduce borrowings outstanding. This agreement, combined with
the existence of a Material Adverse Effect (MAE) clause in the Capital Source
Credit Facility, requires the Revolver to be classified as a current liability,
in accordance with the Financial Accounting Standards Boards Emerging Issues
Task Force Issue No. 95-22, Balance Sheet Classification of Borrowings
Outstanding under Revolving Credit Agreements that Include Both a Subjective
Acceleration Clause and a Lock-Box Arrangement. The MAE clause, which is a
typical requirement in commercial credit agreements, allows the lender to
require the loan to become due if the lender determines there has been a
material adverse effect on the Companys operations, business, properties,
assets, liabilities, condition or prospects. The classification of the Revolver
as a current liability is a result only of the combination of the two
aforementioned factors: the lockbox agreements and the MAE clause. The
Revolver does not expire or have a maturity date within one year. As discussed
above, the Revolver has a final expiration date of October 31, 2005.

The Term Loan requires monthly principal payments of $139 through its
maturity on October 31, 2005. Interest under the Term Loan is payable monthly
at the greater of 8.5% or the Citibank, N.A. prime rate plus 3.5%. Upon
expiration of the Term Loan, the Company will be required to pay a fee of $100.

The CapitalSource Credit Facility requires the Company to meet certain
financial covenants related to minimum levels of earnings. At September 30,
2003, the Company was in compliance with the 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.

The Company is dependent on the availability of borrowings pursuant to the
CapitalSource Credit Facility to meet its working capital needs, capital
expenditure requirements and other cash flow requirements during 2003 and 2004.
Management believes that the Company can comply with the terms of the
CapitalSource Credit Facility and meet its expected obligations throughout 2003
and 2004. However, should the Company fail to meet its projected results, it
may be forced to seek additional sources of financing in order to fund its
working capital needs.

12. Professional and General Liability Insurance

The Company records a liability for reported and unreported professional
and general liability claims based upon an actuarial estimate of the cost of
settling losses and loss adjustment expenses. Amounts accrued were $7,782 and
$8,924 at September 30, 2003 and December 31, 2002, respectively, and are
included in accrued expenses and non-current portion of accrued expenses.
Changes in estimates of losses resulting from the continuous review process and
differences between estimates and actual loss payments are recognized in the
period in which the estimates are changed or payments are made. Reserves for
professional liability exposures are subject to fluctuations in frequency

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and severity. Given the inherent degree of variability in any such
estimates, the reserves reported at September 30, 2003 represent managements
best estimate of the amounts necessary to discharge the Companys obligations.

13. 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
out-of-pocket 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 insurance
from an unaffiliated insurer for annual hospitalization amounts in excess of
$500 per inmate up to an annual per inmate cap of $2,000. The Company believes
this insurance significantly mitigates 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.

Litigation and Claims

The Company was successful on its appeal of a summary judgment granted
against it on an indemnification claim by the insurer of a client. The case
has been remanded to the lower court in accordance with the appelate opinion as
discussed below. In December 1995, the Florida Association of Counties Trust
(FACT), as the insurer for the Polk County Sheriffs Office, and the Sheriff
of Polk County, Florida, brought an action against Prison Health Services, Inc.
(a wholly owned subsidiary of the Company and PHS) in the Circuit Court, 10th
Judicial Circuit, Polk County, Florida seeking indemnification for $1,000 paid
on behalf of the plaintiffs for settlement of a lawsuit brought against the
Sheriffs Office. The recovery is sought for amounts paid in settlement of a
wrongful death claim brought by the estate of an inmate who died as a result of
injuries sustained from a beating from several corrections officers employed by
the Sheriffs Office. The plaintiffs contend that an indemnification provision
in the contract between PHS and the Sheriffs Office obligates the Company to
indemnify the Sheriffs Office against losses caused by its own wrongful acts.
The Company was represented by counsel provided by Reliance Insurance Company
(Reliance), the Companys insurer. In April 2001, FACTs motion for summary
judgment on the question of liability for indemnity was denied, but on
rehearing in July 2001 the prior denial was reversed and summary judgment was
granted. In October 2001, Reliance filed for receivership. In January 2002,
the court entered final judgment in favor of FACT for approximately $1,700 at a
hearing at which the Company was not represented, as counsel provided by
Reliance had simultaneously filed a motion to withdraw. The Company retained
new counsel in February 2002 and obtained a reversal of the summary judgment
motion on October 31, 2003. The Company expects to be able to apply for
release of its appeal bond in the amount of $2,035, which has been classified
as a deposit and included in prepaid expenses and other current assets on its
Consolidated Balance Sheets. As of September 30, 2003, the Company has
reserved $461 related to costs associated with this proceeding. The case has
been remanded to the trial court to determine if the actions of the officers,
for which some of them were indicted and convicted, were intentional and
whether the claims for which indemnity was sought arose out of the provision of
medical services and not the actions of the officers. In addition, the
Sheriffs Office released the Company from liability for this claim subsequent
to filing the lawsuit. The Company believes it will be successful at the trial
court level. In the event that the Company is not successful at the trial
court level, an adverse judgment could have a material adverse effect on the
Companys financial position and its quarterly or annual results of operations.

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 September 30, 2003 and December 31, 2002. The Company is
not aware of any material unasserted claims and, based on its past experience,
would not anticipate that potential future claims would have a material adverse
effect on its consolidated financial position or results of operations.

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Performance Bonds

The Company is required under certain contracts to provide performance
bonds. At September 30, 2003, the Company has outstanding performance bonds
totaling approximately $33,475. These performance bonds are collateralized by
standby letters of credit totaling $4,000 (see Note 11).

14. Net Income Per Share

Net income per share is measured at two levels: basic income per share and
diluted income per share. Basic income per share is computed by dividing net
income by the weighted average number of common shares outstanding during the
period. Diluted income per share is computed by dividing net income 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 warrants and 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 and nine month periods ended
September 30, 2003 and 2002.

Quarter Ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Numerator:Income from continuing operations
    
    $
    3,725
    
    
    $
    1,209
    
    
    $
    8,620
    
    
    $
    4,291Income (loss) from discontinued operations, net of taxes
    
    
    1,602
    
    
    
    1,076
    
    
    
    (2,319
    )
    
    
    5,281Numerator for basic and diluted net income
    
    $
    5,327
    
    
    $
    2,285
    
    
    $
    6,301
    
    
    $
    9,572Denominator:Denominator
for basic net income per share 
weighted average shares
    
    
    6,357,000
    
    
    
    5,526,000
    
    
    
    6,287,000
    
    
    
    5,472,000Effect of dilutive securities:Warrants
    
    
    
    
    
    
    32,000
    
    
    
    
    
    
    
    57,000Employee stock options
    
    
    244,000
    
    
    
    73,000
    
    
    
    171,000
    
    
    
    49,000Denominator
for diluted net income per share 
adjusted weighted average shares and assumed
conversions
    
    
    6,601,000
    
    
    
    5,631,000
    
    
    
    6,458,000
    
    
    
    5,578,000Net income per common share  basic:Income from continuing operations
    
    $
    0.59
    
    
    $
    0.22
    
    
    $
    1.37
    
    
    $
    0.78Income (loss) from discontinued operations, net of
taxes
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.37
    )
    
    
    0.97Net income
    
    $
    0.84
    
    
    $
    0.41
    
    
    $
    1.00
    
    
    $
    1.75Net income per common share  diluted:Income from continuing operations
    
    $
    0.56
    
    
    $
    0.22
    
    
    $
    1.33
    
    
    $
    0.77Income (loss) from discontinued operations, net of
taxes
    
    
    0.25
    
    
    
    0.19
    
    
    
    (0.35
    )
    
    
    0.95Net income
    
    $
    0.81
    
    
    $
    0.41
    
    
    $
    0.98
    
    
    $
    1.72


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The table below sets forth information regarding options that have been
excluded from the computation of diluted net income per share because the
options exercise price was greater than the average market price for the
period of the common shares and, therefore, the effect would be anti-dilutive.

Quarter Ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Options excluded from computation of diluted
income per share as effect would be anti-dilutive
    
    
    198,000
    
    
    
    1,050,000
    
    
    
    480,000
    
    
    
    1,204,000Weighted average exercise price of excluded options
    
    $
    21.36
    
    
    $
    15.93
    
    
    $
    17.79
    
    
    $
    15.05


15. Comprehensive Income

The components of comprehensive income, net of related taxes, are as
follows for the quarters and nine month periods ended September 30, 2003 and
2002:

Quarter Ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Net income
    
    $
    5,327
    
    
    $
    2,285
    
    
    $
    6,301
    
    
    $
    9,572Amortization of fair
value of interest rate
swaps previously
qualifying as cash flow
hedges
    
    
    
    
    
    
    181
    
    
    
    
    
    
    
    542Other comprehensive income
    
    
    
    
    
    
    181
    
    
    
    
    
    
    
    542Comprehensive income
    
    $
    5,327
    
    
    $
    2,466
    
    
    $
    6,301
    
    
    $
    10,114


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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 and provider of healthcare services to county/municipal jails and
detention centers. The Company provides healthcare services to approximately
208,000 inmates at over 210 sites in 27 states. The Company also distributes
pharmaceuticals and medical supplies to approximately 186,000 inmates at over
340 sites in 38 states. Many of the inmates to whom the Company distributes
pharmaceuticals and medical supplies also receive its healthcare services.

The Company operates through its subsidiaries Prison Health Services, Inc.
(PHS), EMSA Correctional Care, Inc. (EMSA Correctional), EMSA Military
Services, Inc. (EMSA Military), Correctional Health Services, LLC (CHS),
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.

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. Forward-looking
statements typically are identified by use of terms such as may, will,
should, plan, expect, anticipate, estimate and similar words,
although some forward-looking statements are expressed differently. Actual
results may differ materially from current expectations. Significant factors
that could cause actual results to differ materially from the forward-looking
statements include 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;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | increased competition for new contracts and renewals of existing contracts;
| | - |  | ---------------------------------------------------------------------------



| |  |  | 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 Companys dependence on key personnel;
| | - |  | ------------------------------------------



| |  |  | the Companys ability to attract and retain highly skilled healthcare personnel;
| | - |  | --------------------------------------------------------------------------------



| |  |  | the Companys ability to obtain adequate levels of professional
liability insurance coverage at a reasonable cost;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | the Companys ability to maintain compliance with the terms of its credit facility; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | the Companys ability to obtain new or renew existing performance bonds.
| | - |  | ------------------------------------------------------------------------

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, 2002 under the heading Item 1. Business  Cautionary Statements

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and the Companys Registration Statement (File No. 333-98355) on Form S-3
filed on August 19, 2002 (as amended) under the heading 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),
| | - |  | ------------------------------------------------------------------



| |  |  | loss contracts,
| | - |  | ---------------



| |  |  | professional and general liability insurance,
| | - |  | ---------------------------------------------



| |  |  | 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 adjusted for census fluctuations. Such contracts
typically have a term of one to three years with subsequent renewal options.
The contracts may also contain certain risk sharing arrangements, such as
stop-loss provisions and aggregate limits for off-site or pharmaceutical costs.
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. Revenue for population based
contracts is 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 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. Under
all contracts, the Company records revenues net of any estimated contractual
allowances for potential adjustments resulting from performance or staffing
related criteria, as well as the impact of any risk sharing arrangements, on an
accrual basis in

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the period the services are provided. 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. 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 an actuarial
analysis prepared monthly by an independent actuary. The analysis takes into
account historical claims experience (including the average historical costs
and billing lag time for such services) and other actuarial data.

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.

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. Some of the Companys contracts provide for
annual increases in the fixed base fee upon changes in the regional medical
care component of the Consumer Price Index, while others contain fixed
increases.

On a quarterly basis, the Company performs a review of its portfolio of
contracts for the purpose of identifying loss contracts and developing a
contract loss reserve for succeeding periods. As a result of its 2001 review,
the Company identified five non-cancelable contracts that, based upon
managements projections, were expected to continue to incur negative gross
margins over their remaining terms. In December 2001, the Company recorded a
charge of $18.3 million to establish a reserve for future losses under these
non-cancelable contracts. The five contracts covered by the charge had
expiration dates ranging from June 30, 2002 through June 30, 2005. Ninety
percent of the charge related to the State of Kansas Department of Corrections
(the Kansas DOC) contract, which was to expire on June 30, 2005, and the City
of Philadelphia contract, which was renewable annually, at the clients option,
through June 30, 2004.

In June 2002, the Company and the City of Philadelphia reached a mutual
agreement that the contract between PHS and the City of Philadelphia would
expire effective June 30, 2002. As a result of the earlier than anticipated
expiration of this loss contract, the Company recorded a gain of $3.3 million,
in the second quarter of 2002, to reduce its reserve for loss contracts. From
July 1, 2002 to September 30, 2002, the Company provided services to the City
of Philadelphia under a transition arrangement. On September 30, 2002, the
Company and the City of Philadelphia entered into a new contract amendment
under which the Company is continuing to provide healthcare services to the
City of Philadelphia under modified contract terms.

During the quarter ended June 30, 2003, the Company utilized its loss
contract reserve at a rate greater than previously anticipated. This increase
in utilization was primarily the result of an unexpected increase in healthcare
expenses associated with the Companys contract to provide services to the
Kansas DOC. The primary causes for the increase in healthcare expenses in
this contract were hospitalization and outpatient costs. The Company increased
its reserve for loss contracts by $4.5 million, as of June 30, 2003, to cover
estimated future losses that may have occurred under the Kansas DOC contract
which was to expire in June 2005.

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During the second and third quarters of 2003, the Company participated in
active discussions with the Kansas DOC related to a proposal from the Company
that would significantly reduce the remaining length of the current contract.
In response to the proposal, the Kansas DOC solicited and received proposals
from several other vendors to provide healthcare services to the Kansas DOC.
After the Kansas DOCs evaluation of the proposals from the other vendors, in
August 2003, the Company began discussions with Health Cost Solutions, Inc.
(HCS) and the Kansas DOC related to a proposal that HCS would assume the
Companys performance obligation under the Kansas DOC contract.

On August 22, 2003, the Company entered into an assignment and novation
agreement with the Kansas DOC to assign the Kansas DOC contract to HCS
effective October 1, 2003. The Company also entered into a general assignment,
novation and assumption agreement with Health Cost Solutions, Inc. (HCS) to
transfer the Kansas DOC contract to HCS, effective October 1, 2003. Beginning
October 1, 2003, HCS became solely responsible for the performance of the
Kansas DOC contract, and the Company has no obligation to the Kansas DOC or to
HCS related to HCS performance of the contract. Under the terms of the
Companys agreement with HCS, the Company will pay HCS net consideration of
$5.6 million in 21 monthly installments, commencing October 31, 2003, and
continuing through June 30, 2005. The net consideration of $5.6 million is
comprised of payments of $6.5 million to assume the Companys obligations under
the Kansas DOC contract, less $0.9 million related to fixed assets and
inventory purchased from the Company by HCS.

As a result of the financial terms of the Companys agreement with HCS,
the Company has reclassified $6.5 million of its reserve for loss contracts to
accounts payable on the Companys consolidated balance sheet. The Company has
also recorded a gain of $1.7 million, in the third quarter of 2003, to reduce
its reserve for loss contracts. This reduction in the reserve, as well as the
second quarter increase in the reserve of $4.5 million, are reflected as
components of income (loss) from discontinued operations, net of tax, in the
Companys statements of operations.

As of September 30, 2003, the Company had a loss contract reserve totaling
$0.9 million, which relates to a county contract which expires on June 30,
2005. Negative gross margin and overhead costs charged against the loss
contract reserve related to loss contracts, including contracts classified as
discontinued operations, totaled $1.5 million and $1.2 million for the quarters
ended September 30, 2003 and 2002, respectively. Negative gross margin and
overhead costs charged against the loss contract reserve related to loss
contracts, including contracts classified as discontinued operations, totaled
$4.4 million and $5.2 million for the nine month period ended September 30,
2003 and 2002, respectively. The amounts charged against the loss contract
reserve during 2002 represented losses associated with all five of the
contracts that were identified during 2001. The amounts charged against the
loss contract reserve during 2003 relate only to the Kansas DOC contract
discussed above and the remaining loss contract, a county contract, which
expires on June 30, 2005.

There is a
potential that in the course of performing its quarterly review in future
periods, the Company might identify additional contracts which have become
loss contracts due to a change in circumstances. Circumstances that might
change and result in the identification of a contract as a loss contract in a
future period include unanticipated adverse changes in the healthcare cost
structure or the utilization of outside medical services in a contract where
such changes are not offset by increased revenue. 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. Such a reserve
could have a material adverse effect on the Companys results of operations in the
period in which it is recorded.

Professional and General Liability Insurance

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 professional
liability insurance, primarily on a claims made basis. However, the Company
assumes certain self-insurance risks resulting from the use of large
deductibles in 2000 and 2001 and the use of adjustable premium policies in 2002
and 2003. For 2002 and 2003, 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 policy and
its 2003 policy will depend on the final incurred losses related to each of
these separate policy periods. Reserves for estimated losses are provided for
on an undiscounted basis in the period of the related coverage based on an
independent actuarial analysis. These reserves are monitored for adequacy on a
quarterly basis using internal and external evaluations of the merits of the

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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.

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. 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.

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.
The Company accrues an estimate of the probable costs for the resolution of
these claims. This estimate is 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.

Amortization and Impairment of Intangible Assets and Goodwill

The Company adopted Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets,(SFAS 142) on January 1, 2002, at which
time it ceased amortization of goodwill. In accordance with SFAS 142, goodwill
acquired 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 will perform its annual review as of December 31,
2003.

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
acquired in an acquisition relative to expected historical or
projected future operating results;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | significant changes in the manner of use of the Companys
acquired 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 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,

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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.

Future events could cause the Company to conclude that impairment
indicators exist and that goodwill associated with its acquired businesses is
impaired. Any resulting impairment loss could have a material adverse impact
on the Companys financial position and results of operations.

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. In the third quarter of 2002, the Company revised the estimated life of
the contract intangibles, acquired in its 1999 acquisition of EMSA, from 20
years to 10 years. The revised life impacted contract intangibles with a gross
value of $11.2 million and, beginning October 1, 2002, resulted in an increase
to annual amortization expense of $867,000.

Income Taxes

The Company accounts for income taxes under Statement of Financial
Accounting Standards (SFAS) No. 109, Accounting for Income Taxes.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. At September 30,
2003 and December 31, 2002, a 100% valuation allowance has been recorded equal
to the deferred tax assets after considering deferred tax assets that can be
realized through offsets to existing taxable temporary differences. Assuming
the Company achieves sufficient profitability in future years to realize the
deferred income tax assets, the valuation allowance will be reduced in future
years through a credit to income tax expense (increasing stockholders equity).
Due to the Companys net income in the nine months ended September 30, 2003,
the Companys deferred tax valuation allowance was reduced approximately $2.8
million from $11.3 million at December 31, 2002 to $8.5 million at September
30, 2003, as a reduction to the Companys income tax provision.

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Results of Operations

The following table sets forth, for the periods indicated, the percentage
relationship to total revenue of certain items in the Condensed Consolidated
Statements of Operations.

Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,Percentage of Healthcare Revenues
    
    2003
    
    2002
    
    2003
    
    2002Healthcare revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Healthcare expenses
    
    
    93.1
    
    
    
    93.4
    
    
    
    93.4
    
    
    
    93.7Reduction in reserve for loss contracts
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.0Gross margin
    
    
    6.9
    
    
    
    6.6
    
    
    
    6.6
    
    
    
    7.3Selling, general and administrative expenses
    
    
    2.6
    
    
    
    3.0
    
    
    
    2.7
    
    
    
    3.4Depreciation and amortization
    
    
    0.8
    
    
    
    1.1
    
    
    
    0.8
    
    
    
    1.1Income from operations
    
    
    3.5
    
    
    
    2.5
    
    
    
    3.1
    
    
    
    2.8Interest, net
    
    
    0.6
    
    
    
    1.1
    
    
    
    0.8
    
    
    
    1.4Income from continuing operations before income taxes
    
    
    2.9
    
    
    
    1.4
    
    
    
    2.3
    
    
    
    1.4Income tax provision
    
    
    0.2
    
    
    
    0.3
    
    
    
    0.1
    
    
    
    0.1Income from continuing operations
    
    
    2.7
    
    
    
    1.1
    
    
    
    2.2
    
    
    
    1.3Income (loss) from discontinued operations, net of taxes
    
    
    1.1
    
    
    
    1.0
    
    
    
    (0.6
    )
    
    
    1.7Net income
    
    
    3.8
    %
    
    
    2.1
    %
    
    
    1.6
    %
    
    
    3.0
    %


Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002

Healthcare revenues.Healthcare revenues for the quarter ended September
30, 2003 increased $28.7 million, or 25.7%, from $111.5 million for the quarter
ended September 30, 2002 to $140.2 million for the quarter ended September 30,
2003. Healthcare revenues in 2003 included $10.3 million of revenue growth
resulting from contracts added in 2002 and 2003 through marketing activities.
Contracts in place at December 31, 2001 and continuing beyond September 30,
2003, provided additional revenue of $15.7 million during the third quarter of
2003 as the result of contract renegotiations and automatic price adjustments.
Correctional contracts in place throughout the entire quarter during both 2003
and 2002 experienced revenue growth of 14.1%. In addition to these revenue
increases, SPP pharmaceutical distribution revenue increased $2.7 million as a
result of new contracts added in 2002 and 2003. As discussed in the
discontinued operations section below, all contracts that expired subsequent to
January 1, 2002 have been classified as discontinued operations.

Healthcare expenses.Healthcare expenses for the quarter ended September
30, 2003 increased $26.5 million, or 25.4%, from $104.1 million for the quarter
ended September 30, 2002 to $130.6 million for the quarter ended September 30,
2003. Expenses related to new contracts from marketing activities accounted for
$8.9 million of the increase. Healthcare expenses as a percentage of revenues
decreased by 0.3% in 2003 as compared to 2002. This decrease results primarily
from increases in 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 $0.1 million and $0.3 million in negative operating
margin related to the Companys loss contracts was charged against the loss
contract reserve during the quarter ended September 30, 2003 and 2002,
respectively.

Selling, general and administrative expenses.Selling, general and
administrative expenses were $3.7 million, or 2.6% of revenue, for the quarter
ended September 30, 2003 as compared to $3.4 million, or 3.0% of revenue, for
the quarter ended September 30, 2002. The percentage of revenue decrease is
primarily the result of the increased revenue discussed above. Approximately
$0.2 million in overhead costs associated with the Companys loss contracts was
charged against the loss contract reserve during each of the quarters ended
September 30, 2003 and 2002.

Depreciation and amortization. Depreciation and amortization expense for
each of the quarters ended September 30, 2003 and 2002 was $1.0 million and
$1.2 million, respectively.

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Interest, net. Net interest expense decreased to $0.9 million, or 0.6% of
revenue, for the quarter ended September 30, 2003 from $1.2 million, or 1.1% of
revenue, for the quarter ended September 30, 2002. 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 September 30, 2003 was $0.3 million, or 0.2% of revenue, as compared with
a provision of $0.3 million, or 0.3% of revenue, for the quarter ended
September 30, 2002. The Company established a 100% valuation allowance in the
fourth quarter of 2001 related to its deferred tax assets.

Income from continuing operations.Income from continuing operations for
the quarter ended September 30, 2003 was $3.7 million, as compared with $1.2
million for the quarter ended September 30, 2002, as the result of the factors
discussed above.

Income from discontinued operations, net of taxes. Income from
discontinued operations for the quarter ended September 30, 2003 was $1.6
million as compared with $1.1 million for the quarter ended September 30, 2002.
Income from discontinued operations represents the operating results of the
Companys contracts that have expired or otherwise been terminated subsequent
to January 1, 2002. The classification of these expired contracts is the
result of the Companys adoption of SFAS No. 144 effective January 1, 2002.
See Notes 3 and 5 of the Companys consolidated financial statements for
further discussion of SFAS No. 144. Approximately $1.3 million and $0.8
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 quarters ended September 30, 2003 and 2002, respectively.

Also included in income from discontinued operations for 2003 is a third
quarter decrease in the reserve for loss contracts of $1.7 million. On August
22, 2003, the Company entered into an assignment and novation agreement with
the Kansas DOC to assign the Kansas DOC contract to HCS effective October 1,
2003. The Company also entered into a general assignment, novation and
assumption agreement with HCS to transfer the Kansas DOC contract to HCS,
effective October 1, 2003. Beginning October 1, 2003, HCS became solely
responsible for the performance of the Kansas DOC contract, and the Company has
no obligation to the Kansas DOC or to HCS related to HCS performance of the
contract. Under the terms of the Companys agreement with HCS, the Company
will pay HCS net consideration of $5.6 million in 21 monthly installments,
commencing October 31, 2003, and continuing through June 30, 2005. The net
consideration of $5.6 million is comprised of payments of $6.5 million to
assume the Companys obligations under the Kansas DOC contract, less $0.9
million of fixed assets and inventory purchased from the Company by HCS.

As a result of the financial terms of the Companys agreement with HCS,
the Company has reclassified $6.5 million of its reserve for loss contracts to
accounts payable on the Companys consolidated balance sheet. The Company has
also recorded a gain of $1.7 million, in the third quarter of 2003, to reduce
its reserve for loss contracts.

Net income.Net income for the quarter ended September 30, 2003 was $5.3
million, or 3.8% of revenue, as compared with net income of $2.3 million, or
2.1% of revenue, for the quarter ended September 30, 2002 as the result of the
factors discussed above.

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

Healthcare revenues.Healthcare revenues for the nine months ended
September 30, 2003 increased $76.1 million, or 23.7%, from $321.2 million for
the nine months ended September 30, 2002 to $397.3 million for 2003.
Healthcare revenues in the first nine months of 2003 included $23.6 million of
revenue growth resulting from contracts added in 2002 and 2003 through
marketing activities. Contracts in place at December 31, 2001 and continuing
beyond September 30, 2003, provided additional revenue of $40.6 million during
the first nine months of 2003 as the result of contract renegotiations and
automatic price adjustments. Correctional contracts in place throughout the
entire nine months during both 2003 and 2002 experienced revenue growth of
12.3%. In addition to these revenue increases, SPP pharmaceutical distribution
revenue increased $11.9 million as a result of new contracts added in 2002 and
2003. As discussed in the discontinued operations section below, all
contracts that expired subsequent to January 1, 2002 have been classified as
discontinued operations.

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Healthcare expenses.Healthcare expenses for the nine months ended
September 30, 2003 increased $70.3 million, or 23.3%, from $300.9 million for
the nine months ended September 30, 2002 to $371.2 million in 2003. Expenses
related to new contracts from marketing activities accounted for $20.4 million
of the increase. Healthcare expenses as a percentage of revenues decreased by
0.3% in 2003 as compared to 2002. This decrease results primarily from
increases in 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 $0.3 million and $2.4 million in negative operating
margin related to the Companys loss contracts was charged against the loss
contract reserve during the nine months ended September 30, 2003 and 2002,
respectively.

Reduction in loss contract reserve.In June 2002, the Company and the
City of Philadelphia reached a mutual agreement that the contract between the
Companys subsidiary and the City of Philadelphia would expire effective June
30, 2002. As a result of the earlier than anticipated expiration of this loss
contract, the Company recorded a gain of $3.3 million in the second quarter of
2002 to reduce its reserve for loss contracts. From July 1, 2002 to
September 30, 2002, the Company provided services to the City of Philadelphia
under a transition arrangement. On September 30, 2002, the Company and the
City of Philadelphia entered into a new contract amendment under which the
Company is continuing to provide healthcare services to the City of
Philadelphia under modified contract terms.

Selling, general and administrative expenses.Selling, general and
administrative expenses for the nine months ending September 30, 2003 decreased
$0.3 million from $11.0 million, or 3.4% of revenues, for the nine months ended
September 30, 2002 to $10.7 million, or 2.7% of revenues, in 2003. The
percentage of revenue decrease is primarily the result of the increased revenue
discussed above and a reduction in salary expense that occurred in the fourth
quarter of 2002. Approximately $0.5 million and $0.9 million in overhead costs
associated with the Companys loss contracts was charged against the loss
contract reserve during the nine months ended September 30, 2003 and 2002,
respectively.

Depreciation and amortization. Depreciation and amortization expense for
the nine months ended September 30, 2003 decreased $0.2 million from $3.5
million for the nine months ended September 30, 2002 to $3.2 million in 2003.
This overall decrease is primarily the result of a reduction in amortization
associated with certain contract intangibles that became fully amortized in
December 2002 which was partially offset by an increase in quarterly
amortization of $0.2 million, due to an adjustment, in the third quarter of
2002, of the estimated life for a portion of the Companys contract intangibles
from 20 years to 10 years.

Interest, net. Net interest expense decreased to $2.9 million, or 0.8% of
revenue, for the nine months ended September 30, 2003 from $4.6 million, or
1.4% of revenue, for the nine months ended September 30, 2002. 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 nine months
ended September 30, 2003 was $0.7 million, or 0.1% of revenue, as compared with
$0.2 million, or 0.1% of revenue, for the nine months ended September 30, 2002.
Due to the Companys net income in 2003, the Companys deferred tax valuation
allowance, established in the fourth quarter of 2001, was reduced $2.8 million
from $11.3 million at December 31, 2002 to $8.5 million at September 30, 2003
as a reduction to income tax provision.

Income from continuing operations.Income from continuing operations for
the nine months ended September 30, 2003 was $8.6 million, or 2.2% of revenue,
as compared with $4.3 million, or 1.3% of revenue, for the nine months ended
September 30, 2002 as the result of the factors discussed above.

Income (loss) from discontinued operations, net of taxes. Loss from
discontinued operations for the nine months ended September 30, 2003 was $2.3
million, as compared with income from discontinued operations of $5.3 million
for the nine months ended September 30, 2002. Income from discontinued
operations represents the operating results of the Companys contracts that
have expired or otherwise been terminated subsequent to January 1, 2002. The
classification of these expired contracts is the result of the Companys
adoption of SFAS No. 144 effective January 1, 2002. See Notes 3 and 5 of the
Companys consolidated financial statements for further discussion of SFAS No.
144. Approximately $3.6 million and $1.9 million in negative operating margin
related to

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the Companys loss contracts classified as discontinued operations was
charged against the loss contract reserve during the nine months ended
September 30, 2003 and 2002, respectively.

Also included in income (loss) from discontinued operations for 2003 is a
second quarter increase in the reserve for loss contracts of $4.5 million and a
third quarter decrease in the reserve for loss contracts of $1.7 million.

During the second quarter of 2003, the Company utilized its loss contract
reserve at a rate greater than previously anticipated. This increase in
utilization was primarily the result of an unexpected increase in healthcare
expenses associated with the Companys contract to provide services to the
Kansas DOC. The primary causes for the increase in healthcare expenses in this
contract were hospitalization and outpatient costs. As as result of the
utilization increase, the Company increased its reserve for loss contracts by
$4.5 million, as of June 30, 2003, to cover estimated future losses that may
occur under the Kansas DOC contract which was to expire in June 2005.

On August 22, 2003, the Company entered into an assignment and novation
agreement with the Kansas DOC to assign the Kansas DOC contract to HCS
effective October 1, 2003. The Company also entered into a general assignment,
novation and assumption agreement with HCS to transfer the Kansas DOC contract
to HCS, effective October 1, 2003. Beginning October 1, 2003, HCS became
solely responsible for the performance of the Kansas DOC contract, and the
Company has no obligation to the Kansas DOC or to HCS related to HCS
performance of the contract. Under the terms of the Companys agreement with
HCS, the Company will pay HCS net consideration of $5.6 million in 21 monthly
installments, commencing October 31, 2003, and continuing through June 30,
2005. The net consideration of $5.6 million is comprised of payments of $6.5
million to assume the Companys obligations under the Kansas DOC contract, less
$0.9 million of fixed assets and inventory purchased from the Company by HCS.

As a result of the financial terms of the Companys agreement with HCS,
the Company has reclassified $6.5 million of its reserve for loss contracts to
accounts payable on the Companys consolidated balance sheet. The Company has
also recorded a gain of $1.7 million, in the third quarter of 2003, to reduce
its reserve for loss contracts. This reduction in the reserve, as well as the
second quarter increase in the reserve of $4.5 million, are reflected as
components of income (loss) from discontinued operations, net of tax, in the
Companys statements of operations.

Net income.Net income for the nine months ended September 30, 2003 was
$6.3 million, or 1.6% of revenue, as compared with net income of $9.6 million,
or 3.0% of revenue, for the nine months ended September 30, 2002 as the result
of the factors discussed above.

Liquidity and Capital Resources

Overview

The Company generated net income of $6.3 million for the nine months ended
September 30, 2003 compared to net income of $9.6 million for the nine months
ended September 30, 2002. The Company had stockholders equity of $23.5
million at September 30, 2003 as compared to $14.3 million at December 31,
2002. The Companys cash and cash equivalents increased to $8.7 million at
September 30, 2003 from $3.8 million at December 31, 2002, an increase of $4.9
million. The increase in cash was primarily the result of increased cash flows
from operations and a reduction of restricted cash. Restricted cash was $6.3
million at December 31, 2002.

Cash flows from operating activities represents 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. The increase in cash flows
from operating activities of $7.2 million for the nine months ended September
30, 2003 was due to increased gross margins and a reduction in interest
expense, resulting from reductions in debt outstanding and the refinancing of
our revolving credit facility in October 2002. Additionally, in 2003 we
recorded a net increase to our reserve for loss contracts of $2.8 million as
compared to a reduction of the reserve for loss contracts of $3.3 million in
2002. During 2003 we reduced accounts receivables by $8.4 million as compared
to an increase of $2.0 million during 2002. The reduction in accounts
receivables was the combined result of improved payments terms on new contracts
and a reduction in days sales

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outstanding due to collection efforts. Finally, in the third quarter of
2003, we received prepayments for services and professional liability insurance
premiums associated with two corrections contracts. As a result of these
prepayments our deferred revenue has increased $6.5 million during the nine
months ended September 30, 2003 as compared with a $2.7 million increase for
the same period in 2002. These favorable changes in working capital were
partially offset by a decrease of $1.2 million in accounts payable during the
nine months ended September 30, 2003 as compared to a $10.4 million increase in
accounts payable for the same period in 2002.

Cash flows used in financing activities during the nine months ended
September 30, 2003 were $12.6 million and include net payments totaling $21.8
million to reduce the amount of debt outstanding from $46.0 million at December
31, 2002 to $24.2 million at September 30, 2003. Also included in cash flows
used in financing activities during the first nine months of 2003 were cash
receipts of $2.8 million resulting from option exercises and issuance of common
stock under an employee stock purchase plan and $6.3 million resulting from the
elimination of restricted cash balances.

Credit Facility

The Companys primary sources of liquidity are cash flows from operating
activities and borrowings under its 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 both a $55.0 million revolving credit facility
(the Revolver) and a $5.0 million term loan (the Term Loan). Proceeds from
the CapitalSource Credit Facility were used to repay the borrowings outstanding
pursuant to the Companys previously existing revolving credit facility (the
Prior Credit Facility) at which time the Company wrote-off approximately $0.7
million of deferred loan costs related to the Prior Credit Facility.

The CapitalSource Credit Facility is secured by substantially all assets
of the Company and its operating subsidiaries. At September 30, 2003, the
Company had borrowings outstanding under the CapitalSource Credit Facility
totaling $24.2 million and $19.1 million available for additional borrowing,
based on the Companys collateral base and outstanding standby letters of
credit on that date.

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 September 30, 2003, the
Company had outstanding standby letters of credit totaling $4.0 million, which
were used to collateralize performance bonds. Prior to this amendment, the
performance bonds were collateralized by restricted cash. As a result of this
amendment, the Company is no longer required to maintain the restricted cash
balances that were previously used as collateral for the performance bonds.

Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined) 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.

All amounts outstanding under the Revolver will be due and payable on
October 31, 2005. If the Revolver is extinguished prior to July 1, 2005, the
Company will be required to pay an early termination fee equal to 1.0% of the
Revolver Capacity. In connection with the Revolver, the CapitalSource Credit
Facility requires a lockbox agreement, which provides for all cash receipts to
be swept daily to reduce borrowings outstanding. This agreement, combined with
the existence of a Material Adverse Effect (MAE) clause in the Capital Source
Credit Facility, requires the Revolver to be classified as a current liability,
in accordance with the Financial Accounting Standards Boards Emerging Issues
Task Force Issue (EITF) No. 95-22, Balance Sheet Classification of Borrowings
Outstanding under Revolving Credit Agreements that Include Both a Subjective
Acceleration Clause and a Lock-

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Box Arrangement. The MAE clause, which is a typical requirement in
commercial credit agreements, allows the lender to require the loan to become
due if the lender determines there has been a material adverse effect on the
Companys operations, business, properties, assets, liabilities, condition or
prospects. The classification of the Revolver as a current liability is a
result only of the combination of the two aforementioned factors: the lockbox
agreements and the MAE clause. The Revolver does not expire or have a maturity
date within one year. As discussed above, the Revolver has a final expiration
date of October 31, 2005.

The Term Loan requires monthly principal payments of $139,000 through its
maturity on October 31, 2005. Interest under the Term Loan is payable monthly
at the greater of 8.5% or the Citibank, N.A. prime rate plus 3.5%. Upon
expiration of the Term Loan, the Company will be required to pay a fee of
$100,000.

The CapitalSource Credit Facility will require 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 charges against 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
September 30, 2003.

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 is dependent on the availability of borrowings pursuant to the
CapitalSource Credit Facility to meet its working capital needs, capital
expenditure requirements and other cash flow requirements during 2003 and 2004.
Management believes that the Company can comply with the terms of the
CapitalSource Credit Facility and meet its expected obligations throughout 2003
and 2004. However, should the Company fail to meet its projected results, it
may be forced to seek additional sources of financing in order to fund its
working capital needs.

Other Financing Transactions

At September 30, 2003, the Company had standby letters of credit
outstanding totaling $4.0 million which were collateralized by a reduction of
availability under the Credit Facility.

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.
Conversely, the Company will benefit should the actual rate of inflation fall
below the estimate used in the bidding and negotiation process.

Recently Issued Accounting Pronouncements

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed ofand resolves significant implementation issues that
had evolved since the issuance of SFAS No. 121. SFAS No. 144 established a
single accounting model for long-lived assets to be disposed of by sale or
abandonment. Additionally, SFAS No. 144 expanded the scope of financial
accounting and

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reporting of discontinued operations to require that all components of an
entity that have either been disposed of (by sale, by abandonment, or in a
distribution to owners) or are held for sale and whose operations and cash
flows can be clearly distinguished, operationally and for financial reporting
purposes from the rest of the entity, should be presented as discontinued
operations. SFAS No. 144 is effective for financial statements issued for
fiscal years beginning after December 15, 2001. The provisions for presenting
the components of an entity as discontinued operations are effective only for
disposal activities after the effective date of SFAS No. 144. The Company
adopted the provisions of SFAS No. 144 effective January 1, 2002. Pursuant to
SFAS No. 144, each of the Companys contracts is a component of an entity,
whose operations can be distinguished from the rest of the Company. Therefore,
when a contract terminates, by expiration or otherwise, the contracts
operations generally will be eliminated from the ongoing operations of the
Company. Accordingly, the operations of such contracts, net of applicable
income taxes, have been presented as discontinued operations and prior period
Consolidated Statements of Operations have been reclassified to reflect those
contracts consistently. See Note 5 to the Companys consolidated financial
statements for further discussion of discontinued operations.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities(FIN 46), which requires the consolidation of
certain variable interest entities, as defined by FIN 46. FIN 46 requires an
assessment of contractual arrangements to determine if they represent interests
in variable interest entities. Variable interest entities created prior to
February 1, 2003, will be subject to the consolidation provisions of FIN 46
beginning in fiscal periods ending after December 15, 2003. Variable interest
entities created subsequent to February 1, 2003 are subject to the
consolidation provisions currently. Additionally, disclosures are required
currently if the Company expects to consolidate any variable interest entities
in the future. The Company is continues to evaluate the consolidation
requirements of FIN 46 with respect to variable interest entities created prior
to February 1, 2003.

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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 Credit Facility, as the resulting
interest rate would have remained below the minimum stated interest rate.
Interest expense represents 0.8% and 1.4% of the Companys revenues,
respectively, for the nine month periods ended September 30, 2003 and 2002.
Debt of $24.2 million at September 30, 2003 represents 14.8% of the Companys
total liabilities and stockholders equity.

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 SECs 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 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 Exchange Act Rule 13a-14 and Rule 13a-15. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Companys disclosure controls and procedures are effective in timely
alerting them to material information that is required to be included in the
Companys periodic SEC filings. There have been no significant changes in the
Companys internal controls during the third quarter of 2003 that have
materially affected, or are reasonably likely to materially affect, the
Companys internal control over financial reporting.

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PART II:

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company was successful on its appeal of a summary judgment granted
against it on an indemnification claim by the insurer of a client. The case
has been remanded to the lower court in accordance with the appelate opinion as
discussed below. In December 1995, the Florida Association of Counties Trust
(FACT), as the insurer for the Polk County Sheriffs Office, and the Sheriff
of Polk County, Florida, brought an action against Prison Health Services, Inc.
(a wholly owned subsidiary of the Company and PHS) in the Circuit Court, 10th
Judicial Circuit, Polk County, Florida seeking indemnification for $1.0 million
paid on behalf of the plaintiffs for settlement of a lawsuit brought against
the Sheriffs Office. The recovery is sought for amounts paid in settlement of
a wrongful death claim brought by the estate of an inmate who died as a result
of injuries sustained from a beating from several corrections officers employed
by the Sheriffs Office. The plaintiffs contend that an indemnification
provision in the contract between PHS and the Sheriffs Office obligates the
Company to indemnify the Sheriffs Office against losses caused by its own
wrongful acts. The Company was represented by counsel provided by Reliance
Insurance Company (Reliance), the Companys insurer. In April 2001, FACTs
motion for summary judgment on the question of liability for indemnity was
denied, but on rehearing in July 2001 the prior denial was reversed and summary
judgment was granted. In October 2001, Reliance filed for receivership. In
January 2002, the court entered final judgment in favor of FACT for
approximately $1.7 million at a hearing at which the Company was not
represented, as counsel provided by Reliance had simultaneously filed a motion
to withdraw. The Company retained new counsel in February 2002 and obtained a
reversal of the summary judgment motion on October 31, 2003. The Company
expects to be able to apply for release of its appeal bond in the amount of
$2.0 million, which has been classified as a deposit and included in prepaid
expenses and other current assets on its Consolidated Balance Sheets. As of
September 30, 2003, the Company has reserved approximately $461,000 related to
costs associated with this proceeding. The case has been remanded to the trial
court to determine if the actions of the officers, for which some of them were
indicted and convicted, were intentional and whether the claims for which
indemnity was sought arose out of the provision of medical services and not the
actions of the officers. In addition, the Sheriffs Office released the
Company from liability for this claim subsequent to filing the lawsuit. The
Company believes it will be successful at the trial court level. In the event
that the Company is not successful at the trial court level, an adverse
judgment could have a material adverse effect on the Companys financial
position and its quarterly or annual results of operations.

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 September 30, 2003 and December 31, 2002. The Company is
not aware of any material unasserted claims and, based on its past experience,
would not anticipate that potential future claims would have a material adverse
effect on its consolidated financial position or results of operations.

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ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(A) Exhibits

|     |  |   |  |                                                                                                                                                                                                                                                   
|---- |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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 10-Q for the three month period ended June
30, 2002)                        
|     |  |   |  |                                                                                                                                                                                                                                                   
|3.2  |  |  |  | Amended and Restated Bylaws of America Service Group, Inc.
(incorporated herein by reference to Exhibit 3.2 to the Companys
Quarterly Report on 10-Q for the three month period ended June 30, 2002)                                             
|     |  |   |  |                                                                                                                                                                                                                                                   
|4.1  |  |  |  | Specimen Common Stock Certificate (incorporated herein by reference to
Exhibit 4.1 to the Companys Quarterly Report on
10-Q for the three month period ended June 30, 2002)                                                                      
|     |  |   |  |                                                                                                                                                                                                                                                   
|10.1 |  |  |  | Contract between Prison Health Services, Inc. and the Commonwealth of
Pennsylvania Department of Corrections (incorporated herein by reference
to Exhibit 10.1 of the Companys Current Report on Form 8-K filed on
August 28, 2003)              
|     |  |   |  |                                                                                                                                                                                                                                                   
|10.2 |  |  |  | Amendment No. 9  Assignment of Agreement Between Kansas Department of
Corrections and Prison Health Services, Inc. (incorporated herein by
reference to Exhibit 10.1 of the Companys Current Report on Form 8-K
filed on August 22, 2003)       
|     |  |   |  |                                                                                                                                                                                                                                                   
|10.3 |  |  |  | General Assignment, Novation and Assumption Agreement between Prison
Health Services, Inc. and Health Cost Solutions, Inc. (incorporated herein
by reference to Exhibit 10.2 of the Companys Current Report on Form 8-K
filed on August 22, 2003)
|     |  |   |  |                                                                                                                                                                                                                                                   
|11   |  |  |  | Computation of Per Share Earnings.*                                                                                                                                                                                                               
|     |  |   |  |                                                                                                                                                                                                                                                   
|31.1 |  |  |  | Certification of the Chief Executive Officer Pursuant to Form of 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 Form of 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.                                                                                            



---

|* |  | Data required by SFAS No. 128, Earnings Per Share, is provided in note 14
to the condensed consolidated financial statements in this report.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

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(B) Reports on Form 8-K

On July 28, 2003, the Company furnished a Form 8-K under Item 12 related to its
press release dated July 28, 2003 containing information about the Companys
financial position or results of operations for the quarterly period ended June
30, 2003.

On August 22, 2003, the Company filed a Form 8-K under Item 5 relating to its
press release dated August 22, 2003 which announced it had executed an
agreement with the Kansas Department of Corrections (Kansas DOC) to assign the
Kansas DOC contract to Health Cost Solutions, Inc. (HCS) effective October 1,
2003. The Company had expected the contract to continue until June 30, 2005.

On August 28, 2003, the Company filed a Form 8-K under Item 5 relating to its
press release dated August 28, 2003 which announced that its wholly owned
subsidiary, Prison Health Services, Inc. had executed a contract with the
Commonwealth of Pennsylvania Department of Corrections to provide statewide
medical services, commencing September 1, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly authorized 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: November 14, 2003