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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q   (Mark One) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 OR [   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission File Number: 0-20135   AMERICA SERVICE GROUP INC.  Delaware(State or other jurisdiction of
incorporation or organization)
    
    51-0332317(I.R.S. Employer
Identification No.)105 Westpark Drive, Suite 200Brentwood, 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 x  No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x  No o There were 7,085,667 shares of common stock, par value $0.01 per share,
outstanding as of May 3, 2004.




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AMERICA SERVICE GROUP INC. QUARTERLY REPORT ON FORM 10-Q
INDEX PageNumberPART I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the quarters ended March 31, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the quarters ended March 31, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 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
    
    
    32EX-10.1 CREDIT AGREEMENT AMENDMENT 03/31/04EX-10.2 LAWRENCE H. POMERY EMPLOYMENT AGREEMENTEX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEOEX-32.2 SECTION 906 CERTIFICATION OF THE CFO
  2




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PART I: FINANCIAL INFORMATION 
 ITEM 1.  FINANCIAL STATEMENTS AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 March 31,
    
    December 31,2004
    
    2003(shown in 000s except shareand per share amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    3,412
    
    
    $
    1,157Accounts receivable: healthcare and other
    
    
    72,404
    
    
    
    61,236Inventories
    
    
    6,080
    
    
    
    6,640Prepaid expenses and other current assets
    
    
    11,033
    
    
    
    12,104Total current assets
    
    
    92,929
    
    
    
    81,137Property and equipment, net
    
    
    4,663
    
    
    
    4,619Goodwill, net
    
    
    43,896
    
    
    
    43,896Contracts, net
    
    
    10,014
    
    
    
    10,421Other intangibles, net
    
    
    1,233
    
    
    
    1,283Other assets
    
    
    16,966
    
    
    
    17,067Total assets
    
    $
    169,701
    
    
    $
    158,423LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    38,704
    
    
    $
    32,059Medical claims liability
    
    
    24,854
    
    
    
    20,068Accrued expenses
    
    
    39,390
    
    
    
    38,581Deferred revenue
    
    
    8,565
    
    
    
    7,962Current portion of loss contract reserve
    
    
    414
    
    
    
    322Current portion of long-term debt
    
    
    1,667
    
    
    
    1,667Revolving credit facility classified as current (see Note 13)
    
    
    285
    
    
    
    365Total current liabilities
    
    
    113,879
    
    
    
    101,024Noncurrent portion of payable to HCS and accrued expenses
    
    
    15,618
    
    
    
    16,513Noncurrent portion of loss contract reserve
    
    
    172
    
    
    
    402Long-term debt, net of current portion
    
    
    1,111
    
    
    
    1,527Total liabilities
    
    
    130,780
    
    
    
    119,466Commitments and contingenciesStockholders equity:Common stock, $0.01 par value, 10,000,000 shares authorized;
7,076,047 and 7,054,553 shares issued and outstanding at
March 31, 2004 and December 31, 2003, respectively
    
    
    71
    
    
    
    71Additional paid-in capital
    
    
    48,438
    
    
    
    48,115Stockholders notes receivable
    
    
    (49
    )
    
    
    (48
    )Accumulated deficit
    
    
    (9,539
    )
    
    
    (9,181
    )Total stockholders equity
    
    
    38,921
    
    
    
    38,957Total liabilities and stockholders equity
    
    $
    169,701
    
    
    $
    158,423
 The accompanying notes to condensed consolidated financial statements
are an integral part of these balance sheets. The condensed consolidated balance sheet at
December 31, 2003 is taken from the audited financial statements at that date. 3




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AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
 Quarter endedMarch 31,2004
    
    2003(shown in 000s except shareand per share amounts)Healthcare revenues
    
    $
    167,760
    
    
    $
    123,515Healthcare expenses
    
    
    156,581
    
    
    
    115,581Gross margin
    
    
    11,179
    
    
    
    7,934Selling, general, and administrative expenses
    
    
    4,416
    
    
    
    3,478Depreciation and amortization
    
    
    975
    
    
    
    1,084Charge for settlement of Florida legal matter
    
    
    5,200
    
    
    
    Income from operations
    
    
    588
    
    
    
    3,372Interest, net
    
    
    511
    
    
    
    1,063Income from continuing operations before income taxes
    
    
    77
    
    
    
    2,309Income tax provision
    
    
    361
    
    
    
    160Income (loss) from continuing operations
    
    
    (284
    )
    
    
    2,149Income (loss) from discontinued operations, net of taxes
    
    
    (74
    )
    
    
    750Net income (loss)
    
    $
    (358
    )
    
    $
    2,899Net income
(loss) per common share - basic:Income (loss) from continuing operations
    
    $
    (0.04
    )
    
    $
    0.35Income (loss) from discontinued operations, net of taxes
    
    
    (0.01
    )
    
    
    0.12Net income (loss)
    
    $
    (0.05
    )
    
    $
    0.47Net income (loss) per common share  diluted:Income (loss) from continuing operations
    
    $
    (0.04
    )
    
    $
    0.34Income (loss) from discontinued operations, net of taxes
    
    
    (0.01
    )
    
    
    0.12Net income (loss)
    
    $
    (0.05
    )
    
    $
    0.46Weighted average common shares outstanding:Basic
    
    
    7,069,083
    
    
    
    6,207,920Diluted
    
    
    7,069,083
    
    
    
    6,350,495
 The accompanying notes to condensed consolidated financial statements are an
integral part of these statements. 4




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AMERICA SERVICE GROUP INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 Quarter endedMarch 31,2004
    
    2003(Amounts shown in 000s)Cash
flows from operating activities:Net income (loss)
    
    $
    (358
    )
    
    $
    2,899Adjustments to reconcile net income (loss) to net cash provided by
operating activities:Depreciation and amortization
    
    
    979
    
    
    
    1,101Loss on retirement of fixed assets
    
    
    
    
    
    
    114Finance cost amortization
    
    
    147
    
    
    
    139Interest on stockholders notes receivable
    
    
    (1
    )
    
    
    (19
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (11,168
    )
    
    
    11,176Inventories
    
    
    560
    
    
    
    15Prepaid expenses and other current assets
    
    
    1,071
    
    
    
    1,533Other assets
    
    
    (46
    )
    
    
    618Accounts payable
    
    
    5,844
    
    
    
    (3,316
    )Medical claims liability
    
    
    4,786
    
    
    
    (1,290
    )Accrued expenses
    
    
    712
    
    
    
    (3,720
    )Deferred revenue
    
    
    603
    
    
    
    (1,159
    )Loss contract reserve
    
    
    (138
    )
    
    
    (1,129
    )Net cash provided by operating activities
    
    
    2,991
    
    
    
    6,962Cash
flows from investing activities:Capital expenditures
    
    
    (563
    )
    
    
    (252
    )Net cash used in investing activities
    
    
    (563
    )
    
    
    (252
    )Cash
flows from financing activities:Net payments on line of credit and term loan
    
    
    (496
    )
    
    
    (8,474
    )Issuance of common stock
    
    
    206
    
    
    
    205Exercise of stock options
    
    
    117
    
    
    
    1,159Net cash used in financing activities
    
    
    (173
    )
    
    
    (7,110
    )Net increase (decrease) in cash and cash equivalents
    
    
    2,255
    
    
    
    (400
    )Cash and cash equivalents at beginning of period
    
    
    1,157
    
    
    
    3,770Cash and cash equivalents at end of period
    
    $
    3,412
    
    
    $
    3,370
 The accompanying notes to condensed consolidated financial statements are an
integral part of these statements. 5




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AMERICA SERVICE GROUP INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2004
 1. Basis of Presentation The interim condensed consolidated financial statements of America Service
Group Inc. and its consolidated subsidiaries (collectively, the Company) as of
March 31, 2004 and for the quarters ended March 31, 2004 and 2003 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 presented. The results of operations for the quarters presented are
not necessarily indicative of the results to be expected for the year ending
December 31, 2004. The interim condensed consolidated financial statements
should be read in connection with the audited consolidated financial statements
for the year ended December 31, 2003 available in the Companys Annual Report
on Form 10-K. 2. Description of Business The Company provides managed healthcare services to correctional
facilities under contracts with state and local governments, certain private
entities and a medical facility operated by the Veterans Administration. The
health status of inmates impacts the results of operations under such
contractual arrangements. 3. Recently Issued Accounting Pronouncement 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. The Company adopted the provisions of FIN 46
effective January 1, 2004. Such adoption did not impact the Companys
consolidated financial position, results of operations or cash flows. 4. Settlement of Florida Legal Matter On March 30, 2004, EMSA Limited Partnership, a subsidiary of the Company,
entered into a settlement agreement with the Florida Attorney Generals office,
related to allegations, first raised in connection with an investigation of
EMSA Correctional Services (EMSA) in 1997, that the Company may have played
an indirect role in the improper billing of Medicaid by independent providers
treating incarcerated patients. The settlement agreement with the Florida Attorney Generals office
constitutes a complete resolution and settlement of the claims asserted against
EMSA and required EMSA Limited Partnership to pay $5.0 million to the State of
Florida. This payment was made by the Company on March 30, 2004. Under the
terms of the settlement agreement, the Company and all of its subsidiaries are
released from liability for any alleged actions which might have occurred from
December 1, 1998 to March 31, 2004. Both parties entered into the settlement
agreement to avoid the delay, uncertainty, inconvenience and expense of
protracted litigation. The settlement agreement states that it is not punitive
in purpose or effect, it should not be construed or used as admission of any
fault, wrongdoing or liability whatsoever, and that EMSA specifically denies
intentionally submitting any medical claims in violation of state or federal
law. The Company recorded a charge of $5.2 million in its results of operations
for the first quarter of 2004, reflecting the settlement agreement with the
Florida Attorney Generals office and related legal expenses. 6




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5. 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 (SFAS No.
123), which also requires that the information be determined as if the Company
has accounted for its employee stock options granted subsequent to December 31,
1994 under the fair value method of SFAS No. 123. 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 No.
123 for each of the quarters ended March 31, 2004 and 2003 (in thousands except
per share data): Quarter endedMarch 31,2004
    
    2003Income (loss) from continuing operations as reported
    
    $
    (284
    )
    
    $
    2,149Add: Stock based compensation expense included in
reported net income
    
    
    
    
    
    
    Deduct: Stock based compensation expense determined
under SFAS No. 123
    
    
    263
    
    
    
    141Pro forma income (loss) from continuing operations
    
    
    (547
    )
    
    
    2008Income
(loss) from discontinued operations, net of taxes
    
    
    (74
    )
    
    
    750Pro forma net income (loss) attributable to common shares
    
    $
    (621
    )
    
    $
    2,758Pro forma net income (loss) per common share  basic:Pro forma income (loss) from continuing operations
    
    $
    (0.08
    )
    
    $
    0.32Pro forma income (loss) from discontinued operations
    
    
    (0.01
    )
    
    
    0.12Pro forma net income (loss)
    
    $
    (0.09
    )
    
    $
    0.44Pro forma net income (loss) per common share  diluted:Pro forma income (loss) from continuing operations
    
    $
    (0.08
    )
    
    $
    0.31Pro forma income (loss) from discontinued operations
    
    
    (0.01
    )
    
    
    0.12Pro forma net income (loss)
    
    $
    (0.09
    )
    
    $
    0.43
 The resulting pro forma disclosures may not be representative of that to
be expected in future years. No options were issued during the quarters ended
March 31, 2004 and 2003. 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. 6. Discontinued Operations In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets(SFAS No. 144).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. 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 correctional healthcare services 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 and classified as discontinued operations. 7




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Accordingly, the operations of such contracts, that have expired during
2004 and 2003, net of applicable income taxes, have been presented as
discontinued operations and prior period Consolidated Statements of Operations
have been reclassified. The components of income (loss) from discontinued operations, net of
taxes, are as follows (in thousands): Quarter ended March 31,2004
    
    2003Healthcare revenues
    
    $
    545
    
    
    $
    13,368Healthcare expenses
    
    
    611
    
    
    
    12,591Gross margin
    
    
    (66
    )
    
    
    777Depreciation and amortization
    
    
    4
    
    
    
    17Income (loss) from discontinued operations before taxes.
    
    
    (70
    )
    
    
    760Income tax provision
    
    
    4
    
    
    
    10Income (loss) from discontinued operations, net of taxes
    
    $
    (74
    )
    
    $
    750
 7. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets are stated at amortized cost and
comprised of the following (in thousands): March 31,
    
    December 31,2004
    
    2003Prepaid insurance
    
    $
    10,485
    
    
    $
    11,670Prepaid performance bonds
    
    
    182
    
    
    
    253Prepaid other
    
    
    366
    
    
    
    181$
    11,033
    
    
    $
    12,104
 8. Property and Equipment Property and equipment are stated at cost and comprised of the following
(in thousands): March 31,
    
    December 31,
    
    Estimated2004
    
    2003
    
    Useful LivesLeasehold improvements
    
    $
    1,237
    
    
    $
    1,237
    
    
    5 yearsEquipment and furniture
    
    
    11,049
    
    
    
    10,764
    
    
    5 yearsComputer software
    
    
    1,664
    
    
    
    1,449
    
    
    3 yearsMedical equipment
    
    
    2,548
    
    
    
    2,485
    
    
    5 yearsAutomobiles
    
    
    30
    
    
    
    30
    
    
    5 years16,528
    
    
    
    15,965Less: Accumulated depreciation
    
    
    (11,865
    )
    
    
    (11,346
    )$
    4,663
    
    
    $
    4,619
 Depreciation expense for the quarters ended March 31, 2004 and 2003 was
approximately $522,000 and $644,000, respectively. 9. Other Assets Other assets are comprised of the following (in thousands): March 31,
    
    December 31,2004
    
    2003Deferred financing costs
    
    $
    1,686
    
    
    $
    1,686Less: Accumulated amortization
    
    
    (779
    )
    
    
    (636
    )907
    
    
    
    1,050Estimated prepaid professional liability claims losses
    
    
    7,636
    
    
    
    7,366Estimated refundable professional liability claims deposits
    
    
    8,195
    
    
    
    8,465Other refundable deposits
    
    
    228
    
    
    
    186$
    16,966
    
    
    $
    17,067
 8




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10. Contracts and Other Intangible Assets The gross and net values of contracts and other intangible assets consist of
the following (in thousands): March 31,
    
    December 31,2004
    
    2003Contracts:Gross value
    
    $
    15,870
    
    
    $
    15,870Accumulated amortization
    
    
    (5,856
    )
    
    
    (5,449
    )$
    10,014
    
    
    $
    10,421Non-compete agreements:Gross value
    
    $
    2,400
    
    
    $
    2,400Accumulated amortization
    
    
    (1,167
    )
    
    
    (1,117
    )$
    1,233
    
    
    $
    1,283
  Estimated aggregate amortization expense related to the above intangibles
for the remainder of 2004 is $1.4 million and for each of the next four
years is $1.8 million. 11. Accounts Payable and Accrued Expenses Accounts payable consist of the following (in thousands): March 31,
    
    December 31,2004
    
    2003Trade payables
    
    $
    35,416
    
    
    $
    28,737Payable to Health Cost Solutions, Inc. (see Note 12).
    
    
    4,198
    
    
    
    5,02339,614
    
    
    
    33,760Less: Noncurrent portion
    
    
    (910
    )
    
    
    (1,701
    )$
    38,704
    
    
    $
    32,059
  The noncurrent portion at March 31, 2004 and December 31, 2003 consists
of approximately $873,000 and $1.7 million payable to Health Cost Solutions,
Inc. (see Note 12) and approximately $37,000 and $27,000 of other noncurrent
payables, respectively. Accrued expenses consist of the following (in thousands): March 31,
    
    December 31,2004
    
    2003Salaries and employee benefits
    
    $
    23,502
    
    
    $
    22,273Professional liability claims
    
    
    18,209
    
    
    
    18,312Accrued workers compensation
    
    
    5,416
    
    
    
    4,859Other
    
    
    6,971
    
    
    
    7,94954,098
    
    
    
    53,393Less: Noncurrent portion of professional liability claims
    
    
    (14,708
    )
    
    
    (14,812
    )$
    39,390
    
    
    $
    38,581
 12. 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 of March 31, 2004, the
Company had a loss contract reserve totaling approximately $586,000, which
relates to a county contract that 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 approximately $138,000 and $1.1 million for the quarters ended March
31, 2004 and 2003, respectively. The amounts charged against the loss contract
reserve during 2004 represent losses associated with the remaining county
contract. The amounts charged against 9




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the loss contract reserve during 2003 relate to the Kansas Department of
Corrections (the Kansas DOC) contract discussed below and the remaining loss
contract. In August 2003, the Company began discussions with Health Cost Solutions,
Inc. (HCS) and the Kansas DOC related to a proposal pursuant to which 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 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, which commenced October 31, 2003 and will continue through June
30, 2005. As a result of the financial terms of the Companys agreement with
HCS, in the third quarter of 2003, the Company reclassified $6.5 million of its
reserve for loss contracts to accounts payable and recorded a gain of $1.7
million, to reduce its reserve for loss contracts. The Companys liability
under this agreement has been classified as accounts payable and noncurrent
payable to HCS on its consolidated balance sheets (see Note 11). In the course of performing its reviews 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, inmate
population or the utilization of outside medical services in a contract, where
such changes are not offset by increased healthcare revenues. 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. 13. 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
$55.0 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 $726,000 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 March 31, 2004, the Company
had borrowings outstanding under the Revolver totaling approximately
$285,000 and $30.2
million 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 $10.0 million. The amount available to the Company
for borrowings under the CapitalSource Credit Facility is reduced by the amount
of each outstanding standby letter of credit. At March 31, 2004, the Company
had outstanding standby letters of credit totaling $4.0 million, which were
used to collateralize performance bonds. Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined in the Revolver) or (2) $55.0 million (the Revolver
Capacity). Interest under the Revolver is payable monthly at the greater of
5.75% or the Citibank N.A. prime rate plus 1.0%. The Company is also required
to pay a monthly collateral management fee, equal to an annual rate of 1.38%,
on average borrowings outstanding under the Revolver. Additionally, the
Company is required to pay a monthly letter of credit fee equal to an annual
rate of 3.5% on the outstanding balance of letters of credit issued pursuant to
the Revolver. 10




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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 terminated 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 CapitalSource 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. At March 31, 2004, $2.8 million was outstanding under the Term Loan. The
Term Loan requires monthly principal payments of approximately
$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 requires the Company to meet certain
financial covenants related to minimum levels of earnings. At March 31, 2004,
the Company was in compliance with these covenants. The CapitalSource Credit
Facility also contains restrictions on the Company with respect to certain
types of transactions including acquisition of the Companys own stock,
payment of dividends, indebtedness and sales or transfers of assets. 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 2004.
Management believes that the Company can comply with the terms of the
CapitalSource Credit Facility and meet its expected obligations throughout
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. 14. Professional and General Liability Self-insurance Retention The Company records a liability for reported and unreported professional
and general liability claims. Amounts accrued were $18.2 and $18.3 million at
March 31, 2004 and December 31, 2003, respectively, and are included in
accrued expenses and non-current portion of accrued expenses on the
Consolidated Balance Sheets. Changes in estimates of losses resulting from
the continuous review process and differences between estimates and loss
payments are recognized in the period in which the estimates are changed or
payments are made. Reserves for professional and general liability exposures
are subject to fluctuations in frequency and severity. Given the inherent
degree of variability in any such estimates, the reserves reported at March
31, 2004 represent managements best estimate of the amounts necessary to
discharge the Companys obligations. 15. 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 11




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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 $500,000 per inmate
up to an annual per inmate cap of $2.0 million. The Company believes this
insurance helps mitigate its exposure to unanticipated expenses of
catastrophic hospitalization. Catastrophic insurance premiums and recoveries,
neither of which is significant, are included in healthcare expenses.
Receivables for insurance recoveries, which are not significant, are included
in accounts receivable. Litigation and Claims Polk County matter.During 2003, the Company was successful on its appeal
of a previous summary judgment granted against it in January 2002 on an
indemnification claim by the insurer of a client. The case has now been
remanded to the lower court in accordance with the appelate courts 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 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. In addition, the Sheriffs Office
released the Company from liability for this claim subsequent to filing the
lawsuit. 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 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. The Company believes it will be successful at the
trial court level. However, 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. The Company has entered into possible settlement negotiations with
the plaintiffs. As of March 31, 2004, the Company has reserved approximately
$491,000 related to probable costs associated with this proceeding. Other matters.In addition to the matter discussed above, the Company is
a party to various legal proceedings incidental to its business. Certain
claims, suits and complaints arising in the ordinary course of business have
been filed or are pending against the Company. An estimate of the amounts
payable on existing claims for which the liability of the Company is probable
is included in accrued expenses at March 31, 2004 and December 31, 2003. 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, results of
operations or cash flows. Performance Bonds The Company is required under certain contracts to provide performance
bonds. At March 31, 2004, the Company has outstanding performance bonds
totaling approximately $24.8 million. These performance bonds are
collateralized by letters of credit totaling $4.0 million (see Note 13). 12




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16. 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 ended March 31, 2004 and 2003
(dollars in thousands, except per share amounts). Quarter EndedMarch 31,2004
    
    2003Numerator:Income (loss) from continuing operations
    
    $
    (284
    )
    
    $
    2,149Income (loss) from discontinued operations, net of taxes
    
    
    (74
    )
    
    
    750Numerator for basic and diluted net income (loss)
    
    $
    (358
    )
    
    $
    2,899Denominator:Denominator for basic net income (loss) per share -
weighted average shares
    
    
    7,069,083
    
    
    
    6,207,920Effect of dilutive securities:Warrants
    
    
    
    
    
    
    20,659Employee stock options
    
    
    
    
    
    
    121,916Denominator for diluted net income (loss) per share 
adjusted weighted average shares and assumed
conversions
    
    
    7,069,083
    
    
    
    6,350,495Net income
(loss) per common share - basic:Income (loss) from continuing operations
    
    $
    (0.04
    )
    
    $
    0.35Income (loss) from discontinued operations, net of
taxes
    
    
    (0.01
    )
    
    
    0.12Net income (loss)
    
    $
    (0.05
    )
    
    $
    0.47Net income (loss) per common share  diluted:Income (loss) from continuing operations
    
    $
    (0.04
    )
    
    $
    0.34Income (loss) from discontinued operations, net of
taxes
    
    
    (0.01
    )
    
    
    0.12Net income (loss)
    
    $
    (0.05
    )
    
    $
    0.46
 The table below sets forth information regarding options that have been
excluded from the computation of diluted net income per share because the
Company generated a net loss from continuing operations for the period or the
options exercise price was greater than the average market price of the
common shares for the periods shown and, therefore, the effect would be
anti-dilutive. Quarter EndedMarch 31,2004
    
    2003Options excluded from computation of diluted
income per share as effect would be anti-dilutive
    
    
    505,274
    
    
    
    707,117Weighted average exercise price of excluded options
    
    $
    14.39
    
    
    $
    16.82
 17. Comprehensive Income For the quarters ended March 31, 2004 and 2003, the Companys
comprehensive income (loss) was equal to net income (loss). 13




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18. Segment Data The Company has two reportable segments: correctional healthcare services
and pharmaceutical distribution services. The correctional healthcare services
segment contracts with state, county and local governmental agencies to provide
healthcare services to inmates of prisons and jails. The pharmaceutical
distribution services segment contracts with federal, state and local
governments and certain private entities to distribute pharmaceuticals and
certain medical supplies to inmates of correctional facilities. The accounting
policies of the segments are the same. The Company evaluates segment
performance based on each segments gross margin without allocation of
corporate selling, general and administrative expenses, interest expense or
income tax provision (benefit). The following table presents the summary financial information related to
each segment that is used by the Companys chief operating decision maker (in
thousands): Correctional
    
    Pharmaceutical
    
    Elimination ofHealthcare
    
    Distribution
    
    IntersegmentServices
    
    Services
    
    Sales
    
    ConsolidatedQuarter ended March 31, 2004:Healthcare revenues
    
    $
    158,231
    
    
    $
    19,056
    
    
    $
    (9,527
    )
    
    $
    167,760Healthcare expenses
    
    
    148,230
    
    
    
    17,878
    
    
    
    (9,527
    )
    
    
    156,581Gross margin
    
    $
    10,001
    
    
    $
    1,178
    
    
    $
    
    
    
    $
    11,179Depreciation and amortization expense
    
    $
    741
    
    
    $
    234
    
    
    $
    
    
    
    $
    975Quarter ended March 31, 2003:Healthcare revenues
    
    $
    112,397
    
    
    $
    18,906
    
    
    $
    (7,788
    )
    
    $
    123,515Healthcare expenses
    
    
    105,291
    
    
    
    18,078
    
    
    
    (7,788
    )
    
    
    115,581Gross margin
    
    $
    7,106
    
    
    $
    828
    
    
    $
    
    
    
    $
    7,934Depreciation and amortization expense
    
    $
    839
    
    
    $
    245
    
    
    $
    
    
    
    $
    1,084
 Correctional
    
    PharmaceuticalHealthcare
    
    DistributionServices
    
    Services
    
    ConsolidatedAs of March 31, 2004:Inventory
    
    $
    3,757
    
    
    $
    2,323
    
    
    $
    6,080Fixed assets, net
    
    $
    2,766
    
    
    $
    1,897
    
    
    $
    4,663Goodwill
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    155,845
    
    
    $
    13,856
    
    
    $
    169,701As of December 31, 2003:Inventory
    
    $
    3,794
    
    
    $
    2,846
    
    
    $
    6,640Fixed assets, net
    
    $
    2,779
    
    
    $
    1,840
    
    
    $
    4,619Goodwill
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    144,221
    
    
    $
    14,202
    
    
    $
    158,423
 14




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19. INCOME TAXES As of March 31, 2004, the Company had deferred tax assets totaling
approximately $9.0 million, all of which have been offset by a valuation
allowance. Statement of Financial Accounting Standards No. 109, Accounting
for Income Taxes(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 that forming a
conclusion that a valuation allowance is not needed is difficult when there is
negative evidence such as cumulative losses in recent years. The Companys
assessment of the valuation allowance could change in the future based upon its
levels of pre-tax income. Removal of the valuation allowance in whole or in
part would result in a non-cash reduction in income tax expense during the
period of removal. In addition, because a portion of the valuation allowance as
of March 31, 2004 was established to reserve certain deferred tax assets
resulting from the exercise of employee stock options, in accordance with SFAS
No. 109, removal of the valuation allowance related to these assets would
result in a credit to additional paid in capital. Due
to the existence of a valuation allowance, the Companys provision for
income taxes of approximately $361,000 and $160,000 for the quarters ended
March 31, 2004 and 2003, respectively, primarily reflect state income taxes
paid. To the extent no valuation allowance is established for the Companys
deferred tax assets in future periods, future financial statements would
reflect a provision for income taxes at the applicable federal and state tax
rates on income before taxes. 15




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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. The Company is a provider of managed healthcare services to
county/municipal jails and detention centers and also a distributor
pharmaceuticals and medical supplies. The Company provides managed healthcare
and/or pharmaceutical distribution services under 115 contracts to
approximately 267,000 inmates at over 300 sites in 35 states. The Company operates through its subsidiaries Prison Health Services, Inc.
(PHS), EMSA Limited Partnership (EMSA), 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, 2003 under the heading Item 1. Business  Cautionary
Statements. Because these risk factors could cause actual results or outcomes
to differ materially from those expressed in any 16




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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 self-insurance retention,
    
    other self-funded insurance reserves,
    
    legal contingencies,
    
    impairment of intangible assets and goodwill, and
    
    income taxes. The Company bases its estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions. The Company believes the following critical accounting policies are
affected by its more significant judgments and estimates used in the
preparation of its consolidated financial statements. Revenue and Cost Recognition The Companys contracts with correctional institutions are principally
fixed price contracts adjusted for census fluctuations. Such contracts
typically have a term of one to three years with subsequent renewal options and
generally may be terminated by the correctional institution at will and without
cause upon proper notice. The contracts typically 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. Revenues for population based
contracts are calculated either as a fixed fee adjusted using a per diem rate
for variances in the inmate population from predetermined population levels or
by a per 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. For
contracts which include provisions limiting the Companys exposure to off-site
medical services utilization or pharmacy utilization, the Company recognizes
the additional revenues that would be due from clients based on contract to
date utilization compared to the corresponding pro rata contractual limit for
such costs. Under all contracts, the Company records 17




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revenues net of any estimated contractual allowances for potential
adjustments resulting from performance or staffing related criteria. If
necessary, the Company revises its estimates for such adjustments in future
periods when the actual amount of the adjustment is determined. Revenues for the distribution of pharmaceutical and medical supplies are
recognized upon delivery of the related products. Healthcare expenses include the compensation of physicians, nurses and
other healthcare professionals including any related benefits and all other
direct costs of providing the managed care including the costs of professional
and general liability insurance and other self-funded insurance reserves
discussed more fully below. The cost of healthcare services provided or
contracted for are recognized in the period in which they are provided based in
part on estimates, including an accrual for estimated unbilled medical services
rendered through the balance sheet date. The Company estimates the accrual
for unbilled medical services using actual utilization data including
hospitalization, one day surgeries, physician visits and emergency room and
ambulance visits and their corresponding costs which are estimated
using the average historical cost of such services. For contracts which have
sufficient claims payment history, an actuarial analysis is also prepared
monthly by an independent actuary to evaluate the adequacy of the accrual. 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. 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 fourth
quarter 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. Subsequent to September 30,
2002, 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 due to 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 18




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of June 30, 2003, to cover estimated future losses under the Kansas DOC
contract, which was to expire in June 2005. 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 pursuant to which 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 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 agreed to pay HCS net consideration of $5.6 million in 21
monthly installments, which commenced October 31, 2003 and will continue
through June 30, 2005. As a result of the financial terms of the Companys
agreement with HCS, in the third quarter of 2003, the Company reclassified $6.5
million of its reserve for loss contracts to accounts payable and recorded a
gain of $1.7 million, to reduce its reserve for loss contracts. As of March 31, 2004, the Company had a loss contract reserve totaling
$0.6 million, which relates to a county contract that expires on June 30, 2005. In the course of performing its reviews 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, inmate
population or the utilization of outside medical services in a contract where
such changes are not offset by increased healthcare revenues. The Companys contract with the Maryland Department of Public Safety and
Correctional Services (DPS), continues to be an underperforming contract.
This contract was entered into on July 1, 2000, to provide comprehensive
medical services to four regions of the Maryland prison system. The initial
term of the contract was for three years ending June 30, 2003, with DPS having
the ability to renew the contract for two additional one year terms. The
contract is presently in its first renewal term. DPS pays PHS a flat fee per
month with certain limited cost sharing adjustments for staffing costs,
primarily nurses, and the cost of medications related to certain specific
illnesses. The contract also contains provisions that allow DPS to assess
penalties if certain staffing or performance criteria are not maintained. The
flat fee paid to PHS is increased annually based on a portion of the consumer
price index. DPS may terminate the contract by giving notice at least ninety
days before the end of a yearly term. PHS does not have a similar ability to
terminate the contract. Under the terms of the contract, the Company must
maintain a performance bond. Due to the flat fee nature of this contract, the Companys margin under
this contract can be significantly impacted by changes in healthcare costs,
utilization trends or inmate population. As of March 31, 2004, management has
concluded that it is not probable that this contract will incurr
material future losses through its final termination date of June 30, 2005.
Due to this contracts marginal performance and fixed revenue stream, an
adverse change in utilization trends, inmate population or underlying
healthcare costs in future periods could result in this contract being
identified as a loss contract. 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. 19




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Professional and General Liability Self-Insurance Retention As a healthcare provider, the Company is subject to medical malpractice
claims and lawsuits. The most significant source of potential liability in
this regard is the risk of suits brought by inmates alleging lack of timely or
adequate healthcare services. The Company may also be liable, as employer, for
the negligence of healthcare professionals it employs or the healthcare
professionals it engages as independent contractors. The Companys contracts
generally require it to indemnify the governmental agency for losses incurred
related to healthcare provided by the Company or its agents. To mitigate a portion of this risk, the Company maintains its primary
professional liability insurance program, principally on a claims-made basis.
However, the Company assumes significant self-insurance risks resulting from
the use of large deductibles in 2000 and 2001 and the use of adjustable premium
policies in 2002, 2003 and 2004. For 2002, 2003 and 2004, the Company is
covered by separate policies each of which contains a 42-month retropremium
with adjustment based on actual losses after 42 months. The Companys ultimate
premium for its 2002, 2003 and 2004 policies will depend on the final incurred
losses related to each of these separate policy periods. Reserves for
estimated losses related to known claims are provided for on an undiscounted
basis using internal and external evaluations of the merits of the individual
claims, analysis of claim history and the estimated reserves assigned by the
Companys third-party administrator. Any adjustments resulting from the review
are reflected in current earnings. In addition to its reserves for known claims, the Company maintains a
reserve for incurred but not reported claims. The reserve for incurred but not
reported claims is recorded on an undiscounted basis. The Companys estimates
of this reserve are supported by an independent actuarial analysis, which is
obtained on a quarterly basis. At March 31, 2004, the Companys reserves for known and incurred but not
reported claims totaled $18.2 million. Reserves for medical malpractice
liability fluctuate because the number of claims and the severity of the
underlying incidents change from one period to the next. Furthermore, payments
with respect to previously estimated liabilities frequently differ from the
estimated liability. Changes in estimates of losses resulting from such
fluctuations and differences between actuarial estimates and actual loss
payments are recognized by an adjustment to the reserve for medical malpractice
liability in the period in which the estimates are changed or payments are
made. The reserves can also be affected by changes in the financial health of
the third-party insurance carriers used by the Company. Changes in reserve
requirements resulting from a change in the financial health of a third-party
insurance carrier are recognized in the period in which such factor becomes
known. Other Self-Funded Insurance Reserves At March 31, 2004, the Company has approximately $7.4 million in accrued
liabilities for employee health and workers compensation claims. The Company
is significantly self-insured for employee health and workers compensation
claims. As such, its insurance expense is largely dependent on claims
experience and the ability to control claims. The Company accrues the estimated
liability for employee health insurance based on its history of claims
experience and the time lag between the incident date and the date of actual
claim payment. The Company accrues the estimated liability for workers
compensation claims based on internal and external evaluations of the merits of
the individual claims, analysis of claim history and the estimated reserves
assigned by the Companys third-party administrator. These estimates could
change in the future. Legal Contingencies In addition to professional and general liability claims, the Company is
also subject to other legal proceedings in the ordinary course of business.
Such proceedings generally relate to labor, employment or contract matters.
When estimable, the Company accrues an estimate of the probable costs for the
resolution of these claims. Such estimates are developed in consultation with
outside counsel handling the Companys defense in these matters and is based
upon an estimated range of potential results, assuming a combination of
litigation and settlement strategies. The Company does not believe these
proceedings will have a material adverse effect on its consolidated financial
position. However, it is possible that future results of operations for any
particular quarterly or annual period could be materially affected by 20




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changes in assumptions, new developments or changes in approach, such as a
change in settlement strategy in dealing with such litigation. Impairment of Intangible Assets and Goodwill The Company adopted Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets,(SFAS No. 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 performed its annual review as of December
31, 2003. Based on the results of this annual review, management has
determined that goodwill is not impaired as of December 31, 2003. Future
events could cause the Company to conclude that impairment indicators exist and
that goodwill is impaired. Any resulting impairment loss could have a material
adverse impact on the Companys financial condition and results of operations. The Companys other identifiable intangible assets, such as customer
contracts acquired in acquisitions and covenants not to compete, are amortized
on the straight-line method over their estimated useful lives. The Company
also assesses the impairment of its other identifiable intangibles whenever
events or changes in circumstances indicate that the carrying value may not be
recoverable. Important factors taken into consideration when evaluating the need for an
impairment review include the following:  
    
    significant underperformance or loss of key contracts
relative to expected historical or projected future operating
results;
    
    significant changes in the manner of use of the Companys
assets or in the Companys overall business strategy; and
    
    significant negative industry or economic trends. If the Company determines that the carrying value of goodwill may be
impaired based upon the existence of one or more of the above indicators of
impairment or as a result of its annual impairment review, any impairment is
measured using a fair-value-based goodwill impairment test as required under
the provisions of SFAS No. 142. Fair value is the amount at which the asset
could be bought or sold in a current transaction between willing parties and
may be estimated using a number of techniques, including quoted market prices
or valuations by third parties, present value techniques based on estimates of
cash flows, or multiples of earnings or revenues. The fair value of the asset
could be different using different estimates and assumptions in these valuation
techniques. When the Company determines that the carrying value of other intangible
assets may not be recoverable based upon the existence of one or more of the
above indicators of impairment, any impairment is measured using an estimate of
the assets fair value based on the projected net cash flows expected to result
from that asset, including eventual disposition. 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. 21




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Income Taxes The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes (SFAS No.
109). Under the asset and liability method of SFAS No. 109, deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. The Company regularly reviews its deferred tax assets for recoverability
taking into consideration such factors as historical losses, projected future
taxable income and the expected timing of the reversals of existing temporary
differences. SFAS No. 109 requires the Company to record a valuation
allowance when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. It further states forming a
conclusion that a valuation allowance is not needed is difficult when there is
negative evidence such as cumulative losses in recent years. At March 31,
2004 and December 31, 2003, 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. The Companys assessment of the valuation allowance could change in the
future based upon its levels of pre-tax income. Removal of the valuation
allowance in whole or in part would result in a non-cash reduction in income
tax expense during the period of removal. In addition, because a portion of the
valuation allowance as of March 31, 2004 was established to reserve certain
deferred tax assets resulting from the exercise of employee stock options, in
accordance with SFAS No. 109, removal of the valuation allowance related to
these assets would result in a credit to additional paid in capital. If the
valuation allowance of $9.0 million as of March 31, 2004 were to be removed in
its entirety, the credit to paid in capital would amount to approximately $3.3
million. To the extent no valuation allowance is established for the Companys
deferred tax assets in future periods, future financial statements would
reflect a provision for income taxes at the applicable federal and state tax
rates on income before taxes. 22




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Results of Operations The following table sets forth, for the periods indicated, the percentage
relationship to healthcare revenues of certain items in the Condensed
Consolidated Statements of Operations. Quarter endedMarch 31,Percentage of Healthcare Revenues
    
    2004
    
    2003Healthcare revenues
    
    
    100.0
    %
    
    
    100.0
    %Healthcare expenses
    
    
    93.3
    
    
    
    93.6Gross margin
    
    
    6.7
    
    
    
    6.4Selling, general and administrative expenses
    
    
    2.6
    
    
    
    2.8Depreciation and amortization
    
    
    0.6
    
    
    
    0.9Charge for settlement of Florida legal matter
    
    
    3.1
    
    
    
    Income from operations
    
    
    0.4
    
    
    
    2.7Interest, net
    
    
    0.4
    
    
    
    0.8Income from continuing operations before income taxes
    
    
    
    
    
    
    1.9Income tax provision
    
    
    0.2
    
    
    
    0.2Income (loss) from continuing operations
    
    
    (0.2
    )
    
    
    1.7Income (loss) from discontinued operations, net of taxes
    
    
    
    
    
    
    0.6Net income (loss)
    
    
    (0.2
    )%
    
    
    2.3
    %
 Quarter Ended March 31, 2004 Compared to Quarter Ended March 31, 2003 Healthcare revenues.Healthcare revenues for the quarter ended March 31,
2004 increased $44.3 million, or 35.8%, from $123.5 million for the quarter
ended March 31, 2003 to $167.8 million for the quarter ended March 31, 2004.
Healthcare revenues in 2004 included $29.6 million of revenue growth resulting
from correctional healthcare services contracts added in 2003 and 2004 through
marketing activities. Correctional healthcare services contracts in place at
December 31, 2002 and continuing beyond March 31, 2004, provided additional
revenue of $16.3 million during the first quarter of 2004 as the result of
contract renegotiations, automatic price adjustments and risk-sharing
arrangements. Correctional healthcare services contracts in place throughout
the entire quarter during both 2004 and 2003 experienced revenue growth of
14.4%. Offsetting these revenue increases, SPP pharmaceutical distribution
revenue decreased $1.6 million primarily as a result of a pharmaceutical
distribution contract that terminated in the third quarter of 2003. As
discussed in the discontinued operations section below, the Companys
correctional healthcare services contracts that have expired or otherwise been
terminated have been classified as discontinued operations. Healthcare expenses.Healthcare expenses for the quarter ended March 31,
2004 increased $41.0 million, or 35.5%, from $115.6 million for the quarter
ended March 31, 2003 to $156.6 million for the quarter ended March 31, 2004.
Expenses related to new correctional healthcare services contracts added in
2003 and 2004 through marketing activities accounted for $26.2 million of the
increase. Healthcare expenses as a percentage of healthcare revenues
decreased by 0.3% in 2004 as compared to 2003. This percentage decrease
results primarily from increased healthcare revenues associated with the
Companys ongoing efforts, when renewing or negotiating contracts, to negotiate
risk-sharing arrangements, such as stop-loss provisions and aggregate limits
for off-site or pharmaceutical costs. Approximately $71,000 and $141,000 in
negative operating margin related to the Companys remaining loss contract was
charged against the loss contract reserve during the quarters ended March 31,
2004 and 2003, respectively. Selling, general and administrative expenses.Selling, general and
administrative expenses were $4.4 million, or 2.6% of healthcare revenues, for
the quarter ended March 31, 2004 as compared to $3.5 million, or 2.8% of
healthcare revenues, for the quarter ended March 31, 2003. The percentage
decrease is primarily the result of the increased healthcare revenues discussed
above. Approximately $16,000 and $163,000 in overhead costs associated with
the Companys loss contracts was charged against the loss contract reserve
during the quarters ended March 31, 2004 and 2003, respectively. Depreciation and amortization. Depreciation and amortization expense for
each of the quarters ended March 31, 2004 and 2003 was $1.0 million and $1.1
million, respectively. 23




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Charge for settlement of Florida legal matter.One of the Companys
subsidiaries, EMSA Limited Partnership, entered into a settlement agreement
with the Florida Attorney Generals office on March 30, 2004, related to
allegations, first raised in connection with an investigation of EMSA
Correctional Services (EMSA) in 1997, that the Company may have played an
indirect role in the improper billing of Medicaid by independent providers
treating incarcerated patients. The Company acquired EMSA in 1999. EMSA was a
party to several contracts to provide healthcare to inmates at Florida
correctional facilities. Typically, in those contracts, which were approved by
government lawyers, the clients required EMSA to seek all available third party
reimbursement for medical services provided to inmates, specifically including
Medicaid. It was the implementation of these contract requirements that the
Florida Attorney Generals office alleged was improper. The settlement agreement with the Florida Attorney Generals office
constitutes a complete resolution and settlement of the claims asserted against
EMSA and required EMSA Limited Partnership to pay $5.0 million to the State of
Florida. This payment was made by the Company on March 30, 2004. Under the
terms of the settlement agreement, the Company and all of its subsidiaries are
released from liability for any alleged actions which might have occurred from
December 1, 1998 to March 31, 2004. Both parties entered into the settlement
agreement to avoid the delay, uncertainty, inconvenience and expense of
protracted litigation. The settlement agreement states that it is not punitive
in purpose or effect, it should not be construed or used as admission of any
fault, wrongdoing or liability whatsoever, and that EMSA specifically denies
intentionally submitting any medical claims in violation of state or federal
law. The Company recorded a charge of $5.2 million in its results of operations
for the first quarter of 2004, reflecting the settlement agreement with the
Florida Attorney Generals office and related legal expenses. Interest, net. Net interest expense decreased to $0.5 million, or 0.4% of
healthcare revenues, for the quarter ended March 31, 2004 from $1.1 million, or
0.8% of healthcare revenues, for the quarter ended March 31, 2003. This
decrease is primarily the result of a reduction in the level of debt
outstanding. Income tax provision.The provision for income taxes for the quarter
ended March 31, 2004 was $0.4 million, or 0.2% of healthcare revenues, as
compared with a provision of $0.2 million, or 0.2% of healthcare revenues, for
the quarter ended March 31, 2003. The income tax provision primarily reflects
state income taxes paid, as the Company established a 100% valuation allowance
in the fourth quarter of 2001 related to its deferred tax assets. Income (loss) from continuing operations.The loss from continuing
operations for the quarter ended March 31, 2004 was $0.3 million, as compared
with income from continuing operations of $2.1 million for the quarter ended
March 31, 2003, as the result of the factors discussed above. Income (loss) from discontinued operations, net of taxes. The loss from
discontinued operations for the quarter ended March 31, 2004 was $0.1 million
as compared with income of $0.8 million for the quarter ended March 31, 2003. Income
(loss) from discontinued operations represents the operating results of the Companys
correctional healthcare services contracts that have expired or otherwise been
terminated. The classification of these expired contracts is the result of the
Companys adoption of SFAS No. 144 effective January 1, 2002. See Note 6 of
the Companys consolidated financial statements for further discussion of SFAS
No. 144. Approximately $51,000 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 March
31, 2004 and 2003, respectively. Net income (loss).Net loss for the quarter ended March 31, 2004 was $0.4
million as compared with net income of $2.9 million for the quarter ended March
31, 2003 as the result of the factors discussed above. 24




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Liquidity and Capital Resources Overview The Company generated a net loss of $0.4 million for the quarter ended
March 31, 2004 compared to net income of $2.9 million for the quarter ended
March 31, 2003. The net loss was primarily attributable to the settlement of a
Florida legal matter discussed above. The Company had stockholders equity of
$38.9 million at March 31, 2004 as compared to $39.0 million at December 31,
2003. The Companys cash and cash equivalents increased to $3.4 million at
March 31, 2004 from $1.2 million at December 31, 2003,
an increase of $2.2
million. The increase in cash was primarily the result of cash flows from
operations. Cash flows from operating activities represents the year to date net
income (loss) 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 decrease in
cash flows from operating activities of $4.0 million for the quarter ended
March 31, 2004 was primarily due to a $5.2 million settlement related to a
Florida legal matter discussed above and an increase of $11.2 million in
outstanding accounts receivable which resulted from a combination of increased
revenues due to risk sharing arrangements and new contracts. These negative
factors were offset during the quarter ended March 31, 2004 by a reduction in
interest expense due to lower amounts outstanding on the Companys credit
facility and an increase of $10.6 million in accounts payable and medical
claims liability. Cash flows used in financing activities during the quarter ended March 31,
2004 were $0.2 million and include net payments totaling $0.5 million to
reduce the amount of debt outstanding from $3.6 million at December 31, 2003 to
$3.1 million at March 31, 2004. Also included in cash flows used in financing
activities during the first quarter of 2004 were cash receipts of $0.3 million
resulting from option exercises and issuance of common stock under an employee
stock purchase plan. 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 $726,000 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 March 31, 2004, the Company
had borrowings outstanding under the Revolver totaling approximately
$285,000 and $30.2
million 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 $10.0 million. The amount available to the Company
for borrowings under the CapitalSource Credit Facility is reduced by the amount
of each outstanding standby letter of credit. At March 31, 2004, the Company
had outstanding standby letters of credit totaling $4.0 million, which were
used to collateralize performance bonds. Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined in the Revolver) or (2) $55.0 million (the Revolver
Capacity). Interest under the Revolver is payable monthly at the greater of
5.75% or the Citibank N.A. prime rate plus 1.0%. The Company is also required
to pay a monthly collateral management fee, equal to an annual rate of 1.38%,
on average borrowings outstanding under the Revolver. Additionally, the
Company is required to pay a monthly letter of credit fee equal to an annual
rate of 3.5% on the outstanding balance of letters of credit issued pursuant to
the Revolver. 25




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##### Table of Contents



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 CapitalSource
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. At March 31, 2004, $2.8 million was outstanding under the Term Loan. The
Term Loan requires monthly principal payments of approximately
$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 requires the Company to achieve a
minimum level of EBITDA of $3.0 million on a rolling three-month measurement
period. The CapitalSource Credit Facility, as amended, defines EBITDA as net
income plus interest expense, income taxes, depreciation expense, amortization
expense, $5.0 million related to the Companys settlement of the Florida legal
matter, 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 March
31, 2004. 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 2004.
Management believes that the Company can comply with the terms of the
CapitalSource Credit Facility and meet its expected obligations throughout
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 March 31, 2004, the Company had standby letters of credit outstanding
totaling $4.0 million which were collateralized by a reduction of availability
under the CapitalSource Credit Facility. 26




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##### Table of Contents



Off-Balance Sheet Transactions As of March 31, 2004 the Company did not have any off-balance sheet
financing transactions or arrangements. 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 Pronouncement 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. The Company adopted the provisions of FIN 46
effective January 1, 2004. Such adoption did not impact the Companys
consolidated financial position or results of operations. 27




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##### Table of Contents



ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may impact the consolidated
financial statements of the Company due to adverse changes in financial market
prices and rates. The Companys exposure to market risk is primarily related
to changes in the variable interest rate under the CapitalSource Credit
Facility. The CapitalSource Credit Facility carries an interest rate based on
the Citibank N.A. prime rate, subject to a minimum stated interest rate;
therefore the Companys cash flow may be affected by changes in the prime rate.
A hypothetical 10% change in the underlying interest rate would have had no
effect on interest expense paid under the CapitalSource Credit Facility, as the
resulting interest rate would have remained below the minimum stated interest
rate. Interest expense represents 0.4% and 0.8% of the Companys revenues,
respectively, for the quarters ended March 31, 2004 and 2003. Debt of $3.1
million at March 31, 2004 represents 1.8% 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 Security and
Exchange Commission (SEC) rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the reports that the
Company files or furnishes under the Exchange Act is accumulated and
communicated to management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. As of the end of the period covered by this report, the Company evaluated
under the supervision and with the participation of management, including the
Chief Executive Officer and Chief Financial Officer, the effectiveness of the
design and operation of the Companys disclosure controls and procedures,
pursuant to the Exchange Act. Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures are effective in timely alerting them to material
information that is required to be included in the Companys periodic SEC
filings. There were no changes in the Companys internal controls over
financial reporting during the first quarter of 2004 that have materially
affected, or are reasonably likely to materially affect, the Companys internal
control over financial reporting. 28




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##### Table of Contents



PART II: OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS Polk County matter.During 2003, the Company was successful on its appeal
of a previous summary judgment granted against it in January 2002 on an
indemnification claim by the insurer of a client. The case has now been
remanded to the lower court in accordance with the appelate courts 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 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. In addition, the Sheriffs Office
released the Company from liability for this claim subsequent to filing the
lawsuit. 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 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. The Company believes it will be successful at the
trial court level. However, 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. The Company has entered into possible settlement negotiations with
the plaintiffs. As of March 31, 2004, the Company has reserved approximately
$491,000 related to probable costs associated with this proceeding. Other matters.In addition to the matter discussed above, the Company is
a party to various legal proceedings incidental to its business. Certain
claims, suits and complaints arising in the ordinary course of business have
been filed or are pending against the Company. An estimate of the amounts
payable on existing claims for which the liability of the Company is probable
is included in accrued expenses at March 31, 2004 and December 31, 2003. 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. 29




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ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K (A)
    
    Exhibits3.1 
    
    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 
    
    Certificate of Designation of the Series A Convertible Preferred Stock
(incorporated herein by reference to Exhibit 99.3 to the Companys Current
Report on Form 8-K filed on February 10, 1999).3.3 
    
    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 
    
    Amendment No. 2 to Revolving Credit, Term Loan and Security Agreement,
dated as of March 31, 2004, between America Service Group Inc. and
CapitalSource Finance LLC.10.2 
    
    Employment agreement dated March 24, 1998 between Lawrence H. Pomeroy
and America Service Group, Inc.11
    
    Computation of Per Share Earnings.*31.1 
    
    Certification of the Chief Executive Officer pursuant to Rule
13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.31.2 
    
    Certification of the Chief Financial Officer pursuant to Rule
13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.32.1
    
    Certification of the Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.32.2
    
    Certification of the Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
 * Data required by SFAS No. 128, Earnings Per Share, is provided in note 16
to the condensed consolidated financial statements in this report. 30




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(B)
    
    Reports on Form 8-K On January 30, 2004, the Company filed a Current Report on Form 8-K which
announced, under Item 5, that the Company was in discussions with the Florida
Attorney Generals office. The Company also furnished under Item 12 a
reaffirmation of its previous guidance related to 2003 results and announced
guidance for 2004 results. On February 24, 2004, the Company furnished a Current Report on Form 8-K under
Item 12 related to its press release dated February 23, 2004 containing
information about the Companys financial position or results of operations for
the quarter and year ended December 31, 2003. On March 31, 2004, the Company filed a Form Current Report on 8-K under Items 5
and 7 related to its press release dated March 30, 2004 announcing that the
Companys subsidiary, EMSA Limited Partnership, had entered into a settlement
agreement with the Florida Attorney Generals office related to previously
announced allegations. 31




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. AMERICA SERVICE GROUP INC./s/ MICHAEL CATALANOMichael CatalanoChairman, President & Chief Executive Officer(Duly Authorized Officer)/s/ MICHAEL W. TAYLORMichael W. TaylorSenior Vice President & Chief Financial Officer(Principal Financial Officer)
 Dated: May 10, 2004 32