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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 1934For the quarterly period ended September 30, 2004OR[   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from  to
 Commission File Number: 0-20135    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 200
Brentwood, Tennessee
(Address of principal executive offices)
    
    37027
(Zip Code)
 (615) 373-3100
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed under Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes 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 10,796,970 shares of common stock, par value $0.01 per share,
outstanding as of November 2, 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 September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Income for the quarters and nine month periods ended September 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    33PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    34Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 3. Defaults Upon Senior Securities
    
    
    36Item 4. Submission of Matters to a Vote of Security Holders
    
    
    36Item 5. Other Information
    
    
    36Item 6. Exhibits
    
    
    37Signatures
    
    
    38EX-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) September 30,
    
    December 31,2004
    
    2003(shown in 000s except share and pershare amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    14,026
    
    
    $
    1,157Accounts receivable: healthcare and other, less allowances
    
    
    79,745
    
    
    
    61,236Inventories
    
    
    7,490
    
    
    
    6,640Prepaid expenses and other current assets
    
    
    11,485
    
    
    
    12,104Current deferred tax assets
    
    
    4,187
    
    
    
    Total current assets
    
    
    116,933
    
    
    
    81,137Property and equipment, net
    
    
    4,826
    
    
    
    4,619Goodwill, net
    
    
    43,896
    
    
    
    43,896Contracts, net
    
    
    9,200
    
    
    
    10,421Other intangibles, net
    
    
    1,133
    
    
    
    1,283Other assets
    
    
    18,905
    
    
    
    17,067Noncurrent deferred tax assets
    
    
    5,815
    
    
    
    Total assets
    
    $
    200,708
    
    
    $
    158,423LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    44,980
    
    
    $
    32,059Medical claims liability
    
    
    28,738
    
    
    
    20,068Accrued expenses
    
    
    43,004
    
    
    
    38,581Deferred revenue
    
    
    9,497
    
    
    
    7,962Current portion of loss contract reserve
    
    
    9,500
    
    
    
    322Current portion of long-term debt
    
    
    
    
    
    
    1,667Revolving credit facility classified as current (see Note 13)
    
    
    
    
    
    
    365Total current liabilities
    
    
    135,719
    
    
    
    101,024Noncurrent portion of payables and accrued expenses
    
    
    15,383
    
    
    
    16,513Noncurrent portion of loss contract reserve
    
    
    
    
    
    
    402Long-term debt, net of current portion
    
    
    
    
    
    
    1,527Total liabilities
    
    
    151,102
    
    
    
    119,466Commitments and contingenciesStockholders equity:Preferred stock, $0.01 par value, 2,000,000 shares
authorized at September 30, 2004; no shares issued or
outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 20,000,000 shares authorized
at September 30, 2004; 10,794,933 and 10,581,830 shares
issued and outstanding at September 30, 2004 and December
31, 2003, respectively
    
    
    72
    
    
    
    71Additional paid-in capital
    
    
    54,477
    
    
    
    48,115Stockholder note receivable
    
    
    
    
    
    
    (48
    )Accumulated deficit
    
    
    (4,943
    )
    
    
    (9,181
    )Total stockholders equity
    
    
    49,606
    
    
    
    38,957Total liabilities and stockholders equity
    
    $
    200,708
    
    
    $
    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 INCOME
(UNAUDITED) Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(shown in 000s except share and per share amounts)Healthcare revenues
    
    $
    174,120
    
    
    $
    131,375
    
    
    $
    502,723
    
    
    $
    372,968Healthcare expenses
    
    
    162,227
    
    
    
    122,899
    
    
    
    468,749
    
    
    
    350,160Increase in reserve for loss contracts
    
    
    6,000
    
    
    
    
    
    
    
    12,800
    
    
    
    Gross margin
    
    
    5,893
    
    
    
    8,476
    
    
    
    21,174
    
    
    
    22,808Selling, general, and administrative expenses
    
    
    4,199
    
    
    
    3,692
    
    
    
    13,080
    
    
    
    10,694Depreciation and amortization
    
    
    956
    
    
    
    1,035
    
    
    
    2,905
    
    
    
    3,180Charge for settlement of Florida legal matter
    
    
    
    
    
    
    
    
    
    
    5,200
    
    
    
    Income (loss) from operations
    
    
    738
    
    
    
    3,749
    
    
    
    (11
    )
    
    
    8,934Interest, net
    
    
    493
    
    
    
    883
    
    
    
    1,457
    
    
    
    2,947Income (loss) from continuing operations before income taxes
    
    
    245
    
    
    
    2,866
    
    
    
    (1,468
    )
    
    
    5,987Income tax provision (benefit)
    
    
    98
    
    
    
    278
    
    
    
    (4,879
    )
    
    
    658Income from continuing operations
    
    
    147
    
    
    
    2,588
    
    
    
    3,411
    
    
    
    5,329Income from discontinued operations, net of taxes
    
    
    146
    
    
    
    2,739
    
    
    
    827
    
    
    
    972Net income
    
    $
    293
    
    
    $
    5,327
    
    
    $
    4,238
    
    
    $
    6,301Net income per common share  basic:Income from continuing operations
    
    $
    0.02
    
    
    $
    0.27
    
    
    $
    0.32
    
    
    $
    0.57Income from discontinued operations, net of taxes
    
    
    0.01
    
    
    
    0.29
    
    
    
    0.08
    
    
    
    0.10Net income
    
    $
    0.03
    
    
    $
    0.56
    
    
    $
    0.40
    
    
    $
    0.67Net income per common share  diluted:Income from continuing operations
    
    $
    0.02
    
    
    $
    0.26
    
    
    $
    0.31
    
    
    $
    0.55Income from discontinued operations, net of taxes
    
    
    0.01
    
    
    
    0.28
    
    
    
    0.07
    
    
    
    0.10Net income
    
    $
    0.03
    
    
    $
    0.54
    
    
    $
    0.38
    
    
    $
    0.65Weighted average common shares outstanding:Basic
    
    
    10,780,242
    
    
    
    9,534,773
    
    
    
    10,692,396
    
    
    
    9,430,215Diluted
    
    
    11,083,849
    
    
    
    9,901,373
    
    
    
    11,016,674
    
    
    
    9,687,723
 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) Nine months endedSeptember 30,2004
    
    2003(Amounts shown in
000s)Cash flows from operating activities:Net income
    
    $
    4,238
    
    
    $
    6,301Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
    
    
    2,938
    
    
    
    3,220Loss on retirement of fixed assets
    
    
    
    
    
    
    179Finance cost amortization
    
    
    493
    
    
    
    423Deferred income taxes
    
    
    (6,002
    )
    
    
    Increase in reserve for loss contracts
    
    
    12,800
    
    
    
    2,786Interest on stockholders notes receivable
    
    
    (2
    )
    
    
    (54
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (18,509
    )
    
    
    8,363Inventories
    
    
    (850
    )
    
    
    285Prepaid expenses and other current assets
    
    
    619
    
    
    
    (5,448
    )Other assets
    
    
    (2,299
    )
    
    
    (95
    )Accounts payable
    
    
    12,921
    
    
    
    (1,246
    )Medical claims liability
    
    
    8,670
    
    
    
    331Accrued expenses
    
    
    3,230
    
    
    
    1,294Deferred revenue
    
    
    1,535
    
    
    
    6,532Loss contract reserve utilization
    
    
    (4,024
    )
    
    
    (4,397
    )Net cash provided by operating activities
    
    
    15,758
    
    
    
    18,474Cash flows from investing activities:Capital expenditures
    
    
    (1,743
    )
    
    
    (918
    )Net cash used in investing activities
    
    
    (1,743
    )
    
    
    (918
    )Cash flows from financing activities:Net payments on line of credit and term loan
    
    
    (3,559
    )
    
    
    (21,805
    )Decrease in restricted cash
    
    
    
    
    
    
    6,250Proceeds from stockholders note receivable
    
    
    50
    
    
    
    141Issuance of common stock
    
    
    515
    
    
    
    205Exercise of stock options
    
    
    1,848
    
    
    
    2,597Net cash used in financing activities
    
    
    (1,146
    )
    
    
    (12,612
    )Net increase in cash and cash equivalents
    
    
    12,869
    
    
    
    4,944Cash and cash equivalents at beginning of period
    
    
    1,157
    
    
    
    3,770Cash and cash equivalents at end of period
    
    $
    14,026
    
    
    $
    8,714Noncash Transaction:Payable to Health Cost Solutions, Inc. (see Notes 11 and 12)
    
    $
    
    
    
    $
    5,632
 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
September 30, 2004
(unaudited) 1. Basis of Presentation The
interim Condensed Consolidated Financial Statements of America Service
Group Inc. and its consolidated subsidiaries (collectively, the Company) as
of September 30, 2004 and for the quarters and nine month periods ended
September 30, 2004 and 2003 are unaudited, but in the opinion of management,
have been prepared in conformity with U.S. generally accepted accounting
principles applied on a basis consistent with those of the annual audited
Consolidated Financial Statements. Such interim Condensed Consolidated
Financial Statements reflect all adjustments (consisting of normal recurring
accruals) necessary for a fair presentation of the financial position and the
results of operations for the quarters and nine month periods presented. The
results of operations for the quarters and nine month periods presented are not
necessarily indicative of the results to be expected for the year ending
December 31, 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. On September 24, 2004, the Companys Board of Directors authorized and
approved a three-for-two stock split effected in the form of a 50 percent
dividend on the Companys common stock. Such additional shares of common
stock were issued on October 29, 2004 to all shareholders of record as of the
close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. 2. Description of Business The Company provides managed healthcare services to correctional
facilities under contracts with state and local governments, certain private
entities and a medical facility operated by the Veterans Administration. The
health status of inmates impacts the results of operations under such
contractual arrangements. In addition to providing managed healthcare
services, the Company also provides pharmaceutical distribution services
through one of its operating subsidiaries, Secure Pharmacy Plus, LLC. 3. Recently Issued Accounting Pronouncement In December 2003, the FASB issued Interpretation No. 46R, Consolidation of
Variable Interest Entities, or FIN No. 46. This interpretation addresses
consolidation by business enterprises of variable interest entities when
certain characteristics are present. The Company adopted the provisions of FIN
No. 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,
which was acquired in January 1999, entered into a settlement agreement with
the Florida Attorney Generals office, related to allegations, first raised in
connection with an investigation of EMSA Correctional Services (EMSA) in
1997, that the Company may have played an indirect role in the improper billing
of Medicaid by independent providers treating incarcerated patients. The settlement agreement with the Florida Attorney Generals office
constitutes a complete resolution and settlement of the claims asserted against
EMSA and required EMSA Limited Partnership to pay $5.0 million to the State of
Florida. This payment was made by the Company on March 30, 2004. Under the
terms of the settlement agreement, the Company and all of its subsidiaries are
released from liability for any alleged actions which might have occurred from
December 1, 1998 to March 31, 2004. Both parties entered into the settlement
agreement to avoid the delay, uncertainty, inconvenience and expense of
protracted litigation. The settlement agreement states that it is not punitive
in purpose or effect, it should not be construed or used as admission of any
fault, wrongdoing 6




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or liability whatsoever, and that EMSA specifically denies intentionally
submitting any medical claims in violation of state or federal law. The Company recorded a charge of $5.2 million in its results of operations
for the first quarter of 2004, reflecting the settlement agreement with the
Florida Attorney Generals office and related legal expenses. 5. Stock Options The Company has elected to follow Accounting Principles Board Opinion
(APB) No. 25, Accounting for Stock Issued to Employees,and related
Interpretations in accounting for its employee stock options. Under APB No.
25, compensation expense is generally recognized as the difference between the
exercise price of the Companys employee stock options and the market price of
the underlying stock on the date of grant. Pro forma information regarding net income and earnings per share is
required by Statement of Financial Accounting Standards 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 fair value of options issued during 2004 and 2003
was estimated at the date of grant using a Black-Scholes option pricing model
with the following weighted-average assumptions: 2004
    
    2003Volatility
    
    
    0.85
    
    
    
    0.85Interest rate
    
    
    3-4
    %
    
    
    4-5
    %Expected life (years)
    
    
    4
    
    
    
    3Dividend yields
    
    
    0.0
    %
    
    
    0.0
    %
 The following table illustrates the effect on net income (loss) per common
share as if the Company had applied the fair value recognition provisions of
SFAS No. 123 for each of the quarters and nine month periods ended September
30, 2004 and 2003 (in thousands except per share data): Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Income from continuing operations as reported
    
    $
    147
    
    
    $
    2,588
    
    
    $
    3,411
    
    
    $
    5,329Add: Stock based compensation expense included in
reported net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Stock based compensation expense determined
under SFAS No. 123, net of taxes
    
    
    540
    
    
    
    204
    
    
    
    1,006
    
    
    
    508Pro forma income (loss) from continuing operations
    
    
    (393
    )
    
    
    2,384
    
    
    
    2,405
    
    
    
    4,821Income from discontinued operations, net of taxes
    
    
    146
    
    
    
    2,739
    
    
    
    827
    
    
    
    972Pro forma
net income (loss) attributable to common shares
    
    $
    (247
    )
    
    $
    5,123
    
    
    $
    3,232
    
    
    $
    5,793Pro forma
net income (loss) per common share  basic:Pro forma income (loss) from continuing operations
    
    $
    (0.03
    )
    
    $
    0.25
    
    
    $
    0.22
    
    
    $
    0.51Pro forma income from discontinued operations
    
    
    0.01
    
    
    
    0.29
    
    
    
    0.08
    
    
    
    0.10Pro forma net income (loss)
    
    $
    (0.02
    )
    
    $
    0.54
    
    
    $
    0.30
    
    
    $
    0.61Pro forma
net income (loss) per common share  diluted:Pro forma income (loss) from continuing operations
    
    $
    (0.03
    )
    
    $
    0.24
    
    
    $
    0.22
    
    
    $
    0.50Pro forma income from discontinued operations
    
    
    0.01
    
    
    
    0.28
    
    
    
    0.07
    
    
    
    0.10Pro forma net income (loss)
    
    $
    (0.02
    )
    
    $
    0.52
    
    
    $
    0.29
    
    
    $
    0.60
 The resulting pro forma disclosures may not be representative of that to
be expected in future years. The weighted average fair value of options
granted during the nine month periods ended September 30, 2004 and 2003 as
determined under the fair value provisions of SFAS No. 123, is $14.63 and
$6.22, respectively. The weighted average fair value of options granted during
the quarter ended September 30, 2004 as determined under the fair value
provisions of SFAS No. 123 is $15.44. No options were issued during the
quarter ended September 30, 2003. For periods prior to July 1, 2004, the above
pro forma adjustments do not include any offsetting income tax benefits due to
the Companys use of a tax valuation allowance during those periods. 7




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6. Discontinued Operations In August 2001, the FASB issued Statement of Financial Accounting
Standards 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 correctional healthcare services contract terminates, by
expiration or otherwise, the contracts operations generally will be eliminated
from the ongoing operations of the Company and classified as discontinued
operations. Accordingly, the operations of such contracts, that have expired
during 2004 and 2003, net of applicable income taxes, have been presented as
discontinued operations and prior period Condensed Consolidated Statements of
Income have been reclassified. The components of income from discontinued operations, net of taxes, are
as follows (in thousands): Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Healthcare revenues
    
    $
    5,450
    
    
    $
    15,103
    
    
    $
    17,808
    
    
    $
    47,736Healthcare expenses
    
    
    5,190
    
    
    
    14,059
    
    
    
    16,834
    
    
    
    43,875Reduction in reserve for loss contracts (see Note 12)
    
    
    
    
    
    
    1,714
    
    
    
    
    
    
    
    1,714Increase in reserve for loss contracts (see Note 12)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,500Gross margin
    
    
    260
    
    
    
    2,758
    
    
    
    974
    
    
    
    1,075Depreciation and amortization
    
    
    17
    
    
    
    10
    
    
    
    33
    
    
    
    42Income from discontinued operations before taxes
    
    
    243
    
    
    
    2,748
    
    
    
    941
    
    
    
    1,033Income tax provision
    
    
    97
    
    
    
    9
    
    
    
    114
    
    
    
    61Income from discontinued operations, net of taxes
    
    $
    146
    
    
    $
    2,739
    
    
    $
    827
    
    
    $
    972
 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): September 30,
    
    December 31,2004
    
    2003Prepaid insurance
    
    $
    11,162
    
    
    $
    11,670Prepaid performance bonds
    
    
    284
    
    
    
    253Prepaid other
    
    
    39
    
    
    
    181$
    11,485
    
    
    $
    12,104
 8. Property and Equipment Property and equipment are stated at cost and comprised of the following
(in thousands): September 30,
    
    December 31,
    
    Estimated2004
    
    2003
    
    Useful LivesLeasehold improvements
    
    $
    1,237
    
    
    $
    1,237
    
    
    5 yearsEquipment and furniture
    
    
    11,592
    
    
    
    10,764
    
    
    5 yearsComputer software
    
    
    2,203
    
    
    
    1,449
    
    
    3 yearsMedical equipment
    
    
    2,621
    
    
    
    2,485
    
    
    5 yearsAutomobiles
    
    
    30
    
    
    
    30
    
    
    5 years17,683
    
    
    
    15,965Less: Accumulated depreciation
    
    
    (12,857
    )
    
    
    (11,346
    )$
    4,826
    
    
    $
    4,619
 8




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Depreciation expense for the quarters ended September 30, 2004 and 2003
was approximately $516,000 and $589,000, respectively. Depreciation expense
for the nine months ended September 30, 2004 and 2003 was approximately
$1,567,000 and $1,851,000, respectively. 9. Other Assets Other assets are comprised of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Deferred financing costs
    
    $
    1,695
    
    
    $
    1,686Less: Accumulated amortization
    
    
    (1,067
    )
    
    
    (636
    )628
    
    
    
    1,050Estimated prepaid professional liability claims losses
    
    
    9,560
    
    
    
    7,366Estimated refundable professional liability claims deposits
    
    
    8,660
    
    
    
    8,465Other refundable deposits
    
    
    57
    
    
    
    186$
    18,905
    
    
    $
    17,067
 10. Contracts and Other Intangible Assets The gross and net values of contracts and other intangible assets consist of
the following (in thousands): September 30,
    
    December 31,2004
    
    2003Contracts:Gross value
    
    $
    15,870
    
    
    $
    15,870Less: Accumulated amortization
    
    
    (6,670
    )
    
    
    (5,449
    )$
    9,200
    
    
    $
    10,421Non-compete agreements:Gross value
    
    $
    2,400
    
    
    $
    2,400Less: Accumulated amortization
    
    
    (1,267
    )
    
    
    (1,117
    )$
    1,133
    
    
    $
    1,283
 Estimated aggregate amortization expense related to the above
intangibles for the remainder of 2004 is $450,000 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): September 30,
    
    December 31,2004
    
    2003Trade payables
    
    $
    42,444
    
    
    $
    28,737Payable to Health Cost Solutions, Inc. (see Note 12)
    
    
    2,536
    
    
    
    5,02344,980
    
    
    
    33,760Less: Noncurrent portion
    
    
    
    
    
    
    (1,701
    )$
    44,980
    
    
    $
    32,059
 The noncurrent portion at December 31, 2003 consists of approximately $1.7
million payable to Health Cost Solutions, Inc. (see Note 12) and approximately
$27,000 of other noncurrent payables. 9




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Accrued expenses consist of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Salaries and employee benefits
    
    $
    23,147
    
    
    $
    22,273Professional liability claims
    
    
    18,883
    
    
    
    18,312Accrued workers compensation claims
    
    
    6,112
    
    
    
    4,859Other
    
    
    10,245
    
    
    
    7,94958,387
    
    
    
    53,393Less: Noncurrent portion of professional liability claims
    
    
    (15,383
    )
    
    
    (14,812
    )$
    43,004
    
    
    $
    38,581
 12. Reserve for Loss Contracts The Company accrues losses under its fixed price contracts when it is
probable that a material loss will be incurred and the amount of the loss can
be reasonably estimated. The Company performs this loss accrual analysis on a
specific contract basis taking into consideration such factors as future
contractual revenue, projected future labor, pharmacy and healthcare costs,
including hospitalization and outpatient services, and each contracts specific
terms related to risk-sharing arrangements. The projected future healthcare
costs are estimated based on historical trends and managements estimate of
future cost increases. 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 Department of Corrections (the
Kansas DOC). The primary causes for the increase in healthcare expenses in
this contract were hospitalization and outpatient costs. The Company increased
its reserve for loss contracts by $4.5 million, as of June 30, 2003, to cover
estimated future losses 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, therefore the operating results of this contract
have been reclassified to discontinued operations for all periods presented.
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. 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). As discussed in the Companys Form 10-Q for the period ended March 31,
2004, the Companys contract with the Maryland Department of Public Safety and
Correctional Services (Maryland DPS) has historically underperformed,
fluctuating between minimal profitability, breakeven and losses. This contract
was entered into on July 1, 2000, to provide comprehensive medical services to
four regions of the Maryland prison system. The initial term of the contract
was for the three years ended June 30, 2003, with the Maryland DPS having the
ability to renew the contract for two additional one-year terms. The contract
is presently in its second renewal term and is non-cancelable by the Company.
The Maryland DPS pays the Company a flat fee per month with certain limited
cost-sharing adjustments for staffing costs, primarily nurses, and the cost of
medications related to certain specific 10




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illnesses. The Company is fully at risk for increases in hospitalization
and outpatient costs under the terms of the contract with the Maryland DPS.
The contract also contains provisions that allow the Maryland DPS to assess
penalties if certain staffing or performance criteria are not maintained. The
flat fee paid to the Company is increased annually based on a portion of the
consumer price index. Due to the flat fee nature of this contract, the Companys margin under
the contract can be significantly impacted by changes in healthcare costs,
utilization trends or inmate population. The Company incurred losses under
this contract in April 2004 at a level slightly above expectations. The losses
under the contract increased significantly in May 2004 to approximately $1.1
million for the month. The primary cause for the increased loss was an
unanticipated increase in hospitalization costs beginning in May, resulting
from the volume and acuity of services being provided, the number of HIV and
mental health patients and the costs associated with current treatment
guidelines. During the second quarter of 2004, the Company recorded a pre-tax
loss contract charge of $6.8 million, effective June 1, 2004, which represented
its most likely estimate, at that date, of the future losses and allocated
corporate overhead under the Maryland DPS contract through its expiration on
June 30, 2005. This estimate assumed monthly losses under the contract would
diminish from the May 2004 level, which was viewed as an aberration, to
approximately $523,000 per month, including allocated overhead, an amount
significantly above recent historical levels. During the third quarter of 2004, the Company utilized $2.6 million of its
loss contract reserve, almost entirely due to the underperformance of the
Maryland DPS contract. While actual monthly losses incurred under the Maryland
DPS contract had trended downward from the record loss in May, losses once
again increased in September, driven primarily by off-site medical costs. Off-site medical costs under the Maryland DPS contract averaged $1.3
million per month for June through September 2004, as compared with initial
estimates of $974,000 per month, based on historical results. As a result of
this new and more severe trend, the Company recorded a pre-tax charge of $6.0
million, effective September 30, 2004, to increase its reserve for estimated
future losses and allocated corporate overhead under the Maryland DPS contract
until its expiration in June 2005. A fundamental assumption of the $6.0 million
increase in loss reserve is that the contract will incur on average $1.4
million per month of off-site medical costs for the remaining nine months of
the contract. As of September 30, 2004, the Company had a loss contract reserve totaling
$9.5 million, which relates to the Maryland DPS contract discussed above and a
county contract. Negative gross margin and overhead costs charged against the
loss contract reserve related to loss contracts, including contracts classified
as discontinued operations, totaled approximately $4.0 and $4.4 million for the
nine months ended September 30, 2004 and 2003, respectively. The amounts
charged against the loss contract reserve during 2004 represent losses
associated with the Maryland DPS contract and a county contract. The amounts
charged against the loss contract reserve during 2003 relate to the Kansas DOC
contract discussed above and a county contract. In the course of performing its reviews in future periods, the Company
might revise its estimate of future losses related to the contracts currently
identified as loss contacts. It might also identify additional contracts which
have become loss contracts due to a change in circumstances. Circumstances
that might change and result in a revised estimate of future losses or the
identification of a contract as a loss contract in a future period include
unanticipated adverse changes in the healthcare cost structure, inmate
population or the utilization of outside medical services in a contract, where
such changes are not offset by increased healthcare revenues. Should the
Company identify circumstances that would result in a revision of its estimate
of future losses for a loss contract, the Company would, in the period in which
the revision is made, increase or decrease the reserve for loss contracts.
Should a contract be identified as a loss contract in a future period, the
Company would record, in the period in which such identification is made, a
reserve for the estimated future losses that would be incurred under the
contract. A revision to a current loss contract or the identification of a
loss contract in the future could have a material adverse effect on the
Companys results of operations in the period in which the reserve is recorded. 11




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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 a
$55.0 million revolving credit facility (the
Revolver) and prior to the third quarter of 2004 also
included a $5.0 million
term loan (the Term Loan). Proceeds from the CapitalSource Credit Facility
were used to repay the borrowings outstanding pursuant to the Companys
previously existing revolving credit facility. In June 2003, the Company and CapitalSource Finance LLC entered into an
amendment to the CapitalSource Credit Facility. Under the terms of the
amendment, the Company may have standby letters of credit issued under the loan
agreement in amounts up to $10.0 million. The amount available to the Company
for borrowings under the CapitalSource Credit Facility is reduced by the amount
of each outstanding standby letter of credit. At September 30, 2004, the
Company had outstanding standby letters of credit totaling $4.0 million, which
were used to collateralize performance bonds. The CapitalSource Credit Facility is secured by substantially all assets
of the Company and its operating subsidiaries. At September 30, 2004, the
Company had no borrowings outstanding under the Revolver and $38.2 million
available for additional borrowing, based on the Companys collateral base on
that date and outstanding standby letters of credit. Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined in the Revolver) or (2) $55.0 million (the
Revolver Capacity). Interest under the Revolver is payable monthly at the
greater of 5.75% or the Citibank N.A. prime rate plus 1.0%. The Company is
also required to pay a monthly collateral management fee, equal to an annual
rate of 1.38%, on average borrowings outstanding under the Revolver.
Additionally, the Company is required to pay a monthly letter of credit fee
equal to an annual rate of 3.5% on the outstanding balance of letters of credit
issued pursuant to the Revolver. Under the terms of the CapitalSource Credit Facility, the Company is
required to pay a monthly unused line fee equal to an annual rate of 0.6% on
the Revolver Capacity less the actual average borrowings outstanding under the
Revolver for the month and the balance of any outstanding letters of credit. 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. During the third quarter, the Company paid the remaining balance totaling
approximately $2.1 million of its Term Loan which was set to mature on October
31, 2005 and a $100,000 loan fee which was due upon maturity. As a result of
these payments, the Company no longer has a balance outstanding related to the
Term Loan. The CapitalSource Credit Facility requires the Company to meet certain
financial covenants related to minimum levels of earnings. At September 30,
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. 12




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##### Table of Contents



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. Income Taxes The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes(SFAS No. 109).
Under the asset and liability method of SFAS No. 109, deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases. The Company regularly reviews its deferred tax assets for recoverability
taking into consideration such factors as historical losses, projected future
taxable income and the expected timing of the reversals of existing temporary
differences. SFAS No. 109 requires the Company to record a valuation
allowance when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. It further states forming a
conclusion that a valuation allowance is not needed is difficult when there is
negative evidence such as cumulative losses in recent years. Since December
31, 2001 and until June 30, 2004, the Company maintained a 100% valuation
allowance equal to the deferred tax assets after considering deferred tax
assets that can be realized through offsets to existing taxable temporary
differences. Based upon the Companys results of operations since December 31, 2001,
and its expected profitability in this and future years, the Company concluded,
effective June 30, 2004, that it is more likely than not that substantially all
of its net deferred tax assets will be realized. As a result, in accordance
with SFAS No. 109, substantially all of the valuation allowance applied to such
net deferred tax assets was reversed in the second quarter of 2004. Reversal
of the valuation allowance resulted in a non-cash income tax benefit in the
second quarter of 2004 totaling $5.3 million. This benefit represented the
Companys estimated realizable deferred tax assets, excluding those deferred
tax assets that resulted from the exercise of employee stock options. The
reversal of the valuation allowance that related to the Companys estimated
realizable deferred tax assets resulting from the exercises of employee stock
options totaled $3.9 million and was recorded as a direct increase to
additional paid-in capital in the stockholders equity portion of the Companys
balance sheet as of June 30, 2004. Beginning in the third quarter of 2004, the Company began providing for an
income tax provision at a rate on income before taxes equal to 40 percent, the
estimated combined federal and state effective tax rates. 15. Professional and General Liability Self-insurance Retention The Company records a liability for reported and unreported professional
and general liability claims. Amounts accrued were $18.9 and $18.3 million at
September 30, 2004 and December 31, 2003, respectively, and are included in
accrued expenses and non-current portion of accrued expenses on the Condensed
Consolidated Balance Sheets. Changes in estimates of losses resulting from
the continuous review process and differences between estimates and loss
payments are recognized in the period in which the estimates are changed or
payments are made. Reserves for professional and general liability exposures
are subject to fluctuations in frequency and severity. Given the inherent
degree of variability in any such estimates, the reserves reported at
September 30, 2004 represent managements best estimate of the amounts
necessary to discharge the Companys obligations. 16. Commitments and Contingencies Catastrophic Limits Many of the Companys contracts require the Companys customers to
reimburse the Company for all treatment costs or, in some cases, only treatment costs related to certain catastrophic events, and/or
for AIDS or AIDS-related illnesses. Certain contracts do not contain such
limits. The Company attempts to compensate for the increased financial risk
when pricing contracts that do not contain individual, catastrophic or
specific disease 13




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##### Table of Contents



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 cap of $1.0 million per
event or $2.0 million per inmate.
The Company believes this insurance helps mitigate its exposure to
unanticipated expenses of catastrophic hospitalization. Catastrophic
insurance premiums and recoveries, neither of which is significant, are
included in healthcare expenses. Receivables for insurance recoveries, which
are not significant, are included in accounts receivable. Litigation and Claims EMSA lease matter.On July 12, 2004, EMSA Limited Partnership, a limited
partnership owned by the Company, received an unexpected adverse jury verdict
in the Circuit Court, 11th Judicial Circuit, Miami-Dade County, Florida of
approximately $1.2 million plus potential interest. This verdict relates to a
12 year old case filed by the plaintiff, Community Health Related Services,
Inc. (wholly owned by Dr. Carlos Vicaria) seeking unspecified damages involving
a lease dispute in connection with a line of business managing physician
clinics operated by EMSA Limited Partnership prior to its acquisition by the
Company in 1999. The Company did not acquire this line of business or assume
the expired sublease from the seller under the transaction. The Company has,
to date, been forced to defend the case as the seller has not yet assumed
responsibility. The jury verdict is not a final judgment.
Post-verdict motions were heard on November 2, 2004, with
briefing and additional motions to follow. As of September 30, 2004, the Company maintained a
reserve of $446,000, which represents managements current estimate of probable
losses related to this matter. Upon final resolution, the ultimate cost may be
different and could result in a material adverse effect on the Companys
financial position and its quarterly or annual results of operations. In
addition to its rights under post-verdict motions and the potential for appeal,
the Company has filed suit against the seller for reimbursement for all costs
associated with this case as well as any judgment returned. Such reimbursement
has not been reflected in the Companys reserve estimate discussed above. 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 appellate 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 Prison Health Services, Inc.
(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 parties agreed to submit the
matter to nonbinding arbitration and the Company received a successful ruling
in July 2004. FACT has now requested the matter go forward to trial. The
Company believes it will ultimately 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. As of September 30, 2004, the Company has reserved approximately
$448,000 related to probable costs associated with this proceeding. 14




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##### Table of Contents



Other matters.In addition to the matters discussed above, the Company
is a party to various legal proceedings incidental to its business. Certain
claims, suits and complaints arising in the ordinary course of business have
been filed or are pending against the Company. An estimate of the amounts
payable on existing claims for which the liability of the Company is probable
is included in accrued expenses at September 30, 2004 and December 31, 2003.
The Company is not aware of any material unasserted claims and would not
anticipate that potential future claims would have a material adverse effect
on its consolidated financial position, results of operations or cash flows. Performance Bonds The Company is required under certain contracts to provide performance
bonds. At September 30, 2004, the Company has outstanding performance bonds
totaling approximately $24.7 million. These performance bonds are
collateralized by letters of credit totaling $4.0 million (see Note 13). 17. 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 options to purchase shares of the
Companys common stock. The table below sets forth the computation of basic
and diluted earnings per share as required by SFAS No. 128, Earnings Per Share,
for the quarters and nine month periods ended September 30, 2004 and 2003
(dollars in thousands, except per share amounts). Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Numerator:Income from continuing operations
    
    $
    147
    
    
    $
    2,588
    
    
    $
    3,411
    
    
    $
    5,329Income from discontinued operations, net of taxes
    
    
    146
    
    
    
    2,739
    
    
    
    827
    
    
    
    972Numerator for basic and diluted net income
    
    $
    293
    
    
    $
    5,327
    
    
    $
    4,238
    
    
    $
    6,301Denominator:Denominator for basic net income per share -
weighted average shares
    
    
    10,780,242
    
    
    
    9,534,773
    
    
    
    10,692,396
    
    
    
    9,430,215Effect of dilutive securities:Employee stock options
    
    
    303,607
    
    
    
    366,600
    
    
    
    324,278
    
    
    
    257,508Denominator for diluted net income per share -
adjusted weighted average shares and assumed
conversions
    
    
    11,083,849
    
    
    
    9,901,373
    
    
    
    11,016,674
    
    
    
    9,687,723Net income
per common share  basic:Income from continuing operations
    
    $
    0.02
    
    
    $
    0.27
    
    
    $
    0.32
    
    
    $
    0.57Income from discontinued operations, net of taxes
    
    
    0.01
    
    
    
    0.29
    
    
    
    0.08
    
    
    
    0.10Net income
    
    $
    0.03
    
    
    $
    0.56
    
    
    $
    0.40
    
    
    $
    0.67Net income
per common share  diluted:Income from continuing operations
    
    $
    0.02
    
    
    $
    0.26
    
    
    $
    0.31
    
    
    $
    0.55Income from discontinued operations, net of taxes
    
    
    0.01
    
    
    
    0.28
    
    
    
    0.07
    
    
    
    0.10Net income
    
    $
    0.03
    
    
    $
    0.54
    
    
    $
    0.38
    
    
    $
    0.65
 On September 24, 2004, the Companys Board of Directors authorized and
approved a three-for-two stock split effected in the form of a 50 percent
dividend on the Companys common stock. Such additional shares of common
stock were issued on October 29, 2004 to all shareholders of record as of the
close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. 15




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##### Table of Contents



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 ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Options excluded from computation of diluted
income per share as effect would be anti-dilutive
    
    
    22,500
    
    
    
    297,000
    
    
    
    7,500
    
    
    
    720,000Weighted average exercise price of excluded options
    
    $
    24.67
    
    
    $
    14.24
    
    
    $
    24.67
    
    
    $
    11.86
 18. Comprehensive Income For the quarters and nine month periods ended September 30, 2004 and
2003, the Companys comprehensive income was equal to net income. 19. 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 September 30, 2004:Healthcare revenues
    
    $
    162,445
    
    
    $
    23,156
    
    
    $
    (11,481
    )
    
    $
    174,120Healthcare expenses
    
    
    151,910
    
    
    
    21,798
    
    
    
    (11,481
    )
    
    
    162,227Increase in reserve for loss contracts
    
    
    6,000
    
    
    
    
    
    
    
    
    
    
    
    6,000Gross margin
    
    $
    4,535
    
    
    $
    1,358
    
    
    $
    
    
    
    $
    5,893Depreciation and amortization expense
    
    $
    717
    
    
    $
    239
    
    
    $
    
    
    
    $
    956Quarter ended September 30, 2003:Healthcare revenues
    
    $
    120,159
    
    
    $
    19,997
    
    
    $
    (8,781
    )
    
    $
    131,375Healthcare expenses
    
    
    112,743
    
    
    
    18,937
    
    
    
    (8,781
    )
    
    
    122,899Gross margin
    
    $
    7,416
    
    
    $
    1,060
    
    
    $
    
    
    
    $
    8,476Depreciation and amortization expense
    
    $
    786
    
    
    $
    249
    
    
    $
    
    
    
    $
    1,035Nine month period ended September 30,
2004:Healthcare revenues
    
    $
    471,383
    
    
    $
    63,017
    
    
    $
    (31,677
    )
    
    $
    502,723Healthcare expenses
    
    
    441,453
    
    
    
    58,973
    
    
    
    (31,677
    )
    
    
    468,749Increase in reserve for loss contracts
    
    
    12,800
    
    
    
    
    
    
    
    
    
    
    
    12,800Gross margin
    
    $
    17,130
    
    
    $
    4,044
    
    
    $
    
    
    
    $
    21,174Depreciation and amortization expense
    
    $
    2,194
    
    
    $
    711
    
    
    $
    
    
    
    $
    2,905Nine month period ended September 30,
2003:Healthcare revenues
    
    $
    338,668
    
    
    $
    58,398
    
    
    $
    (24,098
    )
    
    $
    372,968Healthcare expenses
    
    
    318,786
    
    
    
    55,472
    
    
    
    (24,098
    )
    
    
    350,160Gross margin
    
    $
    19,882
    
    
    $
    2,926
    
    
    $
    
    
    
    $
    22,808Depreciation and amortization expense
    
    $
    2,438
    
    
    $
    742
    
    
    $
    
    
    
    $
    3,180
 16




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##### Table of Contents



Correctional
    
    PharmaceuticalHealthcare
    
    DistributionServices
    
    Services
    
    ConsolidatedAs of September 30, 2004:Inventories
    
    $
    4,364
    
    
    $
    3,126
    
    
    $
    7,490Property and
equipment, net
    
    $
    2,687
    
    
    $
    2,139
    
    
    $
    4,826Goodwill, net
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    185,767
    
    
    $
    14,941
    
    
    $
    200,708As of December 31, 2003:Inventories
    
    $
    3,794
    
    
    $
    2,846
    
    
    $
    6,640Property and
equipment, net
    
    $
    2,779
    
    
    $
    1,840
    
    
    $
    4,619Goodwill, net
    
    $
    40,771
    
    
    $
    3,125
    
    
    $
    43,896Total assets
    
    $
    144,221
    
    
    $
    14,202
    
    
    $
    158,423
 17




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS General America Service Group Inc. (ASG or the Company) is the leading
non-governmental provider of managed correctional healthcare services in the
United States. The Company is a provider of managed healthcare services to
county/municipal jails and detention centers and is also a distributor of
pharmaceuticals and medical supplies. The Company provides managed healthcare
and/or pharmaceutical distribution services under 108 contracts to
approximately 271,000 inmates at over 357 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. On September 24, 2004, the Companys Board of Directors authorized and
approved a three-for-two stock split effected in the form of a 50 percent
dividend on the Companys common stock. Such additional shares of common
stock were issued on October 29, 2004 to all shareholders of record as of the
close of business on October 8, 2004. All share and per share amounts have
been adjusted to reflect the stock split. The following discussion should be read in conjunction with the unaudited
Condensed Consolidated Financial Statements and accompanying notes included
herein. Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements
made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements represent
managements current expectations regarding future events. 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 outcome of pending litigation;
    
    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; 18




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##### Table of Contents




    
    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 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 with revenue adjustments for census fluctuations and risk
sharing arrangements, such as stop-loss provisions and aggregate limits for
off-site or pharmaceutical costs. Such contracts typically have a term of one
to three years with subsequent renewal options and generally may be terminated
by either party at will and without cause
upon proper notice. Revenues earned under contracts with correctional
institutions are recognized in the period that services are rendered. Cash
received in advance for future services is recorded as deferred revenue and
recognized as income when the service is performed. Revenues are calculated based on the specific contract terms and fall into
one of three general categories: fixed fee, population based, or cost plus a
margin. For fixed fee contracts, revenues are recorded based on fixed monthly 19




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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 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. An actuarial analysis is
also prepared monthly by an independent actuary to evaluate the
adequacy of the Companys total accrual related to contracts
which have sufficient claims payment history. The
analysis takes into account historical claims experience (including the average
historical costs and billing lag time for such services) and other actuarial
data. 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 20




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##### Table of Contents



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 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, therefore the operating results of this contract
have been reclassified to discontinued operations for all periods presented.
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 discussed in the Companys Form 10-Q for the period ended March 31,
2004, the Companys contract with the Maryland Department of Public Safety and
Correctional Services (Maryland DPS) has historically underperformed,
fluctuating between minimal profitability, breakeven and losses. This contract
was entered into on July 1, 2000, to provide comprehensive medical services to
four regions of the Maryland prison system. The initial term of the contract
was for the three years ended June 30, 2003, with the Maryland DPS having the
ability to renew the contract for two additional one-year terms. The contract
is presently in its second renewal term and is non-cancelable by the Company.
The Maryland DPS pays the Company a flat fee per month with certain limited
cost-sharing adjustments for staffing costs, primarily nurses, and the cost of
medications related to certain specific illnesses. The Company is fully at
risk for increases in hospitalization and outpatient costs under the terms of
the contract with the Maryland DPS. The contract also contains provisions that
allow the Maryland DPS to assess penalties if certain staffing or performance
criteria are not maintained. The flat fee paid to the Company is increased
annually based on a portion of the consumer price index. Due to the flat fee nature of this contract, the Companys margin under
the contract can be significantly impacted by changes in healthcare costs,
utilization trends or inmate population. The Company incurred losses under
this contract in April 2004 at a level slightly above expectations. The losses
under the contract increased significantly in May 2004 to approximately $1.1
million for the month. The primary cause for the increased loss was an
unanticipated increase in hospitalization costs beginning in May, resulting
from the volume and acuity of services being provided, the number of HIV and
mental health patients and the costs associated with current treatment
guidelines. During the second quarter of 2004, the Company recorded a pre-tax
loss contract charge of $6.8 million, effective June 1, 2004, which represented
its most likely estimate, at that date, of the future losses and allocated
corporate overhead under the Maryland DPS contract through its expiration on
June 30, 2005. This estimate assumed monthly losses under the contract would
diminish from the May 2004 level, which was viewed as an aberration, to
approximately $523,000 per month, including allocated overhead, an amount
significantly above recent historical levels. 21




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##### Table of Contents



During the third quarter of 2004, the Company utilized $2.6 million of its
loss contract reserve, almost entirely due to the underperformance of the
Maryland DPS contract. While actual monthly losses incurred under the Maryland
DPS contract had trended downward from the record loss in May, losses once
again increased in September, driven primarily by off-site medical costs. Off-site medical costs under the Maryland DPS contract averaged $1.3
million per month for June through September 2004, as compared with initial
estimates of $974,000 per month, based on historical results. As a result of
this new and more severe trend, the Company recorded a pre-tax charge of $6.0
million, effective September 30, 2004, to increase its reserve for estimated
future losses and allocated corporate overhead under the Maryland DPS contract
until its expiration in June 2005. A fundamental assumption of the $6.0
million increase in loss reserve is that the contract will incur on average
$1.4 million per month of off-site medical costs for the remaining nine months
of the contract. As of September 30, 2004, the Company had a loss contract reserve totaling
$9.5 million, which relates to the Maryland DPS and a county contract. In the course of performing its reviews in future periods, the Company
might revise its estimate of future losses related to the contracts currently
identified as loss contacts. It might also identify additional contracts which
have become loss contracts due to a change in circumstances. Circumstances
that might change and result in a revised estimate of future losses or the
identification of a contract as a loss contract in a future period include
unanticipated adverse changes in the healthcare cost structure, inmate
population or the utilization of outside medical services in a contract, where
such changes are not offset by increased healthcare revenues. Should the
Company identify circumstances that would result in a revision of its estimate
of future losses for a loss contract, the Company would, in the period in which
the revision is made, increase or decrease the reserve for loss contracts.
Should a contract be identified as a loss contract in a future period, the
Company would record, in the period in which such identification is made, a
reserve for the estimated future losses that would be incurred under the
contract. A revision to a current loss contract or the identification of a
loss contract in the future could have a material adverse effect on the
Companys results of operations in the period in which the reserve is recorded. Professional and General Liability Self-Insurance Retention As a healthcare provider, the Company is subject to medical malpractice
claims and lawsuits. The most significant source of potential liability in
this regard is the risk of suits brought by inmates alleging lack of timely or
adequate healthcare services. The Company may also be liable, as employer, for
the negligence of healthcare professionals it employs or the healthcare
professionals it engages as independent contractors. The Companys contracts
generally require it to indemnify the governmental agency for losses incurred
related to healthcare provided by the Company or its agents. To mitigate a portion of this risk, the Company maintains its primary
professional liability insurance program, principally on a claims-made basis.
However, the Company assumes significant self-insurance risks resulting from
the use of large deductibles in 2000 and 2001 and the use of adjustable premium
policies in 2002, 2003 and 2004. For 2002, 2003 and 2004, the Company is
covered by separate policies each of which contains a 42-month retro-premium
with adjustment based on actual losses after 42 months. The Companys ultimate
premium for its 2002, 2003 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 September 30, 2004, the Companys reserves for known and incurred but
not reported claims totaled $18.9 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 22




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##### Table of Contents



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 September 30, 2004, the Company had approximately $8.2 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 changes
in assumptions, new developments or changes in approach, such as a change in
settlement strategy in dealing with such litigation. See discussion of certain
outstanding legal matters in Part II  Item 1 Legal Proceedings. Impairment of Intangible Assets and Goodwill 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 No.
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 determined
that goodwill was 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. 23




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##### Table of Contents



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. Income Taxes The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes(SFAS No. 109).
Under the asset and liability method of SFAS No. 109, deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases. The Company regularly reviews its deferred tax assets for recoverability
taking into consideration such factors as historical losses, projected future
taxable income and the expected timing of the reversals of existing temporary
differences. SFAS No. 109 requires the Company to record a valuation
allowance when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. It further states forming a
conclusion that a valuation allowance is not needed is difficult when there is
negative evidence such as cumulative losses in recent years. Since December
31, 2001 and until June 30, 2004, the Company maintained a 100% valuation
allowance equal to the deferred tax assets after considering deferred tax
assets that can be realized through offsets to existing taxable temporary
differences. Based upon the Companys results of operations since December 31, 2001,
and its expected profitability in this and future years, the Company concluded,
effective June 30, 2004, that it is more likely than not that substantially all
of its net deferred tax assets will be realized. As a result, in accordance
with SFAS No. 109, substantially all of the valuation allowance applied to such
net deferred tax assets was reversed in the second quarter of 2004. Reversal
of the valuation allowance resulted in a non-cash income tax benefit in the
second quarter of 2004 totaling $5.3 million. This benefit represented the
Companys estimated realizable deferred tax assets, excluding those deferred
tax assets that resulted from the exercise of employee stock options. The
reversal of the valuation allowance that related to the Companys estimated
realizable deferred tax assets resulting from the exercises of employee stock
options totaled $3.9 million and was recorded as a direct increase to
additional paid-in capital in the stockholders equity portion of the Companys
balance sheet as of June 30, 2004. Beginning with the third quarter of 2004, the Company began providing for
an income tax provision at a rate on income before taxes equal to 40 percent,
the estimated combined federal and state effective tax rates. 24




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##### Table of Contents



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 Income. Quarter ended
    
    Nine months endedSeptember 30,
    
    September 30,Percentage of Healthcare Revenues
    
    2004
    
    2003
    
    2004
    
    2003Healthcare revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Healthcare expenses
    
    
    93.2
    
    
    
    93.5
    
    
    
    93.2
    
    
    
    93.9Increase in reserve for loss contracts
    
    
    3.4
    
    
    
    
    
    
    
    2.6
    
    
    
    Gross margin
    
    
    3.4
    
    
    
    6.5
    
    
    
    4.2
    
    
    
    6.1Selling, general and administrative expenses
    
    
    2.4
    
    
    
    2.8
    
    
    
    2.6
    
    
    
    2.9Depreciation and amortization
    
    
    0.6
    
    
    
    0.8
    
    
    
    0.6
    
    
    
    0.8Charge for settlement of Florida legal matter
    
    
    
    
    
    
    
    
    
    
    1.0
    
    
    
    Income (loss) from operations
    
    
    0.4
    
    
    
    2.9
    
    
    
    0.0
    
    
    
    2.4Interest, net
    
    
    0.3
    
    
    
    0.7
    
    
    
    0.3
    
    
    
    0.8Income (loss) from continuing operations before income taxes
    
    
    0.1
    
    
    
    2.2
    
    
    
    (0.3
    )
    
    
    1.6Income tax provision (benefit)
    
    
    0.0
    
    
    
    0.2
    
    
    
    (1.0
    )
    
    
    0.2Income from continuing operations
    
    
    0.1
    
    
    
    2.0
    
    
    
    0.7
    
    
    
    1.4Income from discontinued operations, net of taxes
    
    
    0.1
    
    
    
    2.1
    
    
    
    0.1
    
    
    
    0.3Net income
    
    
    0.2
    %
    
    
    4.1
    %
    
    
    0.8
    %
    
    
    1.7
    %
 Quarter Ended September 30, 2004 Compared to Quarter Ended September 30, 2003 Healthcare revenues.Healthcare revenues for the quarter ended September
30, 2004 increased $42.7 million, or 32.5%, from $131.4 million for the quarter
ended September 30, 2003 to $174.1 million for the quarter ended September 30,
2004. Healthcare revenues in 2004 included $28.8 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 September 30, 2004
experienced revenue growth of 11.7% consisting of additional revenue of $11.3
million during the third quarter of 2004 as the result of contract
renegotiations and automatic price adjustments and additional revenue of $2.1
million as the result of risk-sharing arrangements. Risk-sharing revenues on
shared-risk contracts offset increases in certain healthcare expenses,
primarily off-site and pharmacy expenses, by reimbursing the Company for those
certain expenses above mutually agreed upon thresholds. These additional
revenues do not generate additional gross margin for the Company. In addition
to these revenue increases, SPP pharmaceutical distribution revenue increased
$0.5 million. As discussed in the discontinued operations section below, the
Companys correctional healthcare services contracts that have expired or
otherwise been terminated have been classified as discontinued operations. Healthcare expenses.Healthcare expenses for the quarter ended September
30, 2004 increased $39.3 million, or 32.0%, from $122.9 million for the quarter
ended September 30, 2003 to $162.2 million for the quarter ended September 30,
2004. Expenses related to new correctional healthcare services contracts added
in 2003 and 2004 through marketing activities accounted for $25.2 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 $2.3 million and $32,000
in negative operating margin related to the Companys loss contracts was
charged against the loss contract reserve during the quarters ended September
30, 2004 and 2003, respectively. Increase in reserve for loss contracts.As discussed in the Companys
Form 10-Q for the period ended March 31, 2004, the Companys contract with the
Maryland DPS has historically underperformed, fluctuating between minimal
profitability, breakeven and losses. This contract was entered into on July 1,
2000, to provide comprehensive medical services to four regions of the Maryland
prison system. The initial term of the contract was for the three years ended
June 30, 2003, with the Maryland DPS having the ability to renew the contract
for two additional one-year terms. The contract is presently in its second
renewal term and is non-cancelable by the Company. The Maryland DPS pays the
Company a flat fee per month with certain limited cost-sharing adjustments for
staffing costs, primarily nurses, and the cost of medications related to
certain specific illnesses. The Company is 25




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fully at risk for increases in hospitalization and outpatient costs under
the terms of the contract with the Maryland DPS. The contract also contains
provisions that allow the Maryland DPS to assess penalties if certain staffing
or performance criteria are not maintained. The flat fee paid to the Company
is increased annually based on a portion of the consumer price index. Due to the flat fee nature of this contract, the Companys margin under
the contract can be significantly impacted by changes in healthcare costs,
utilization trends or inmate population. The Company incurred losses under
this contract in April 2004 at a level slightly above expectations. The losses
under the contract increased significantly in May 2004 to approximately $1.1
million for the month. The primary cause for the increased loss was an
unanticipated increase in hospitalization costs beginning in May, resulting
from the volume and acuity of services being provided, the number of HIV and
mental health patients and the costs associated with current treatment
guidelines. During the second quarter of 2004, the Company recorded a pre-tax
loss contract charge of $6.8 million, effective June 1, 2004, which represented
its most likely estimate, at that date, of the future losses and allocated
corporate overhead under the Maryland DPS contract through its expiration on
June 30, 2005. This estimate assumed monthly losses under the contract would
diminish from the May 2004 level, which was viewed as an aberration, to
approximately $523,000 per month, including allocated overhead, an amount
significantly above recent historical levels. During the third quarter of 2004, the Company utilized $2.6 million of its
loss contract reserve, almost entirely due to the underperformance of the
Maryland DPS contract. While actual monthly losses incurred under the Maryland
DPS contract had trended downward from the record loss in May, losses once
again increased in September, driven primarily by off-site medical costs. Off-site medical costs under the Maryland DPS contract averaged $1.3
million per month for June through September 2004, as compared with initial
estimates of $974,000 per month, based on historical results. As a result of
this new and more severe trend, the Company recorded a pre-tax charge of $6.0
million, effective September 30, 2004, to increase its reserve for estimated
future losses and allocated corporate overhead under the Maryland DPS contract
until its expiration in June 2005. Selling, general and administrative expenses.Selling, general and
administrative expenses were $4.2 million, or 2.4% of healthcare revenues, for
the quarter ended September 30, 2004 as compared to $3.7 million, or 2.8% of
healthcare revenues, for the quarter ended September 30, 2003. The percentage
of revenue decrease is primarily the result of the increase in healthcare
revenues discussed above. Approximately $323,000 and $161,000 in overhead
costs associated with the Companys loss contracts were charged against the
loss contract reserve during the quarters ended September 30, 2004 and 2003,
respectively. Depreciation and amortization. Depreciation and amortization expense for
each of the quarters ended September 30, 2004 and 2003 was $1.0 million. Interest, net. Net interest expense decreased to $0.5 million, or 0.3% of
healthcare revenues, for the quarter ended September 30, 2004 from $0.9
million, or 0.7% of healthcare revenues, for the quarter ended September 30,
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 September 30, 2004 was $0.1 million or 0% of healthcare revenues as
compared with a provision of $0.3 million or 0.2% of healthcare revenues for
the quarter ended September 30, 2003. During the quarter ended June 30, 2004,
the Company recorded an income tax benefit of $5.3 million which resulted from
the reversal, effective June 30, 2004, of substantially all of the valuation
allowance previously established for its net deferred tax assets. Prior to
June 30, 2004, the Company maintained a 100% valuation allowance, established
in the quarter ended December 31, 2001, related to its net deferred tax assets.
As a result of the valuation allowance in place during 2003, the income tax
provision for the quarter ended September 30, 2003 primarily reflects state
income taxes due. Income from continuing operations.Income from continuing operations for
the quarter ended September 30, 2004 was $0.1 million, as compared with $2.6
million for the quarter ended September 30, 2003, as the result of the factors
discussed above. 26




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Income from discontinued operations, net of taxes. Income from
discontinued operations for the quarter ended September 30, 2004 was $0.1
million as compared with $2.7 million for the quarter ended September 30, 2003.
Income from discontinued operations represents the operating results of the
Companys correctional healthcare services contracts that have expired or
otherwise been terminated. The classification of these expired contracts is
the result of the Companys adoption of SFAS No. 144 effective January 1, 2002.
See Note 6 of the Companys Condensed Consolidated Financial Statements for
further discussion of SFAS No. 144. Approximately $0 and $1.3 million in
negative operating margin related to the Companys loss contracts classified as
discontinued operations was charged against the loss contract reserve during
the quarters ended September 30, 2004 and 2003, respectively. Also included in income from discontinued operations for 2003 is a third
quarter decrease in the reserve for loss contracts of $1.7 million. On August
22, 2003, the Company entered into an assignment and novation agreement with
the Kansas DOC to assign the Kansas DOC contract to HCS effective October 1,
2003. The Company also entered into a general assignment, novation and
assumption agreement with HCS to transfer the Kansas DOC contract to HCS,
effective October 1, 2003. Beginning October 1, 2003, HCS became solely
responsible for the performance of the Kansas DOC contract, and the Company has
no obligation to the Kansas DOC or to HCS related to HCS performance of the
contract. Under the terms of the Companys agreement with HCS, the Company
agreed to pay HCS net consideration of $5.6 million in 21 monthly installments,
commencing October 31, 2003, and continuing through June 30, 2005. The net
consideration of $5.6 million is comprised of payments of $6.5 million to
assume the Companys obligations under the Kansas DOC contract, less $0.9
million of fixed assets and inventory purchased from the Company by HCS. Net income.Net income for the quarter ended September 30, 2004 was $0.3
million as compared with $5.3 million for the quarter ended September 30, 2003
as the result of the factors discussed above. Nine Months Ended September 30, 2004 Compared to Nine Months Ended September
30, 2003 Healthcare revenues.Healthcare revenues for the nine months ended
September 30, 2004 increased $129.7 million, or 34.8%, from $373.0 million for
the nine months ended September 30, 2003 to $502.7 million for the nine months
ended September 30, 2004. Healthcare revenues in the first nine months of 2004
included $90.1 million of revenue growth resulting from contracts added in 2003
and 2004 through marketing activities. Contracts in place at December 31, 2002
and continuing beyond September 30, 2004, experienced revenue growth of 12.8%
consisting of additional revenue of $33.2 million during the first nine months
of 2004 as the result of contract renegotiations and automatic price
adjustments and additional revenue of $9.4 million as the result of
risk-sharing arrangements. Risk-sharing revenues on shared-risk contracts
offset increases in certain healthcare expenses, primarily off-site and
pharmacy expenses, by reimbursing the Company for those certain expenses above
mutually agreed upon thresholds. These additional revenues do not generate
additional gross margin for the Company. Offsetting these revenue increases,
SPP pharmaceutical distribution revenue decreased $3.0 million primarily as a
result of the loss of a pharmaceutical distribution customer in the third
quarter of 2003. As discussed in the discontinued operations section below,
all contracts that expired subsequent to January 1, 2002 have been classified
as discontinued operations. Healthcare expenses.Healthcare expenses for the nine months ended
September 30, 2004 increased $118.5 million, or 33.9%, from $350.2 million for
the nine months ended September 30, 2003 to $468.7 million for the nine months
ended September 30, 2004. Expenses related to new contracts from marketing
activities accounted for $79.4 million of the increase. Healthcare expenses as
a percentage of revenues decreased by 0.7% in 2004 as compared to 2003. This
decrease results primarily from increases in revenues associated with the
Companys ongoing efforts when renewing or negotiating contracts to negotiate
risk-sharing arrangements, such as stop-loss provisions and aggregate limits
for off-site or pharmaceutical costs. Approximately $3.5 million and $0.3 in
negative operating margin related to the Companys loss contracts was charged
against the loss contract reserve during the nine months ended September 30,
2004 and 2003, respectively. Increase in
reserve for loss contracts.As discussed above in the section
titled Quarter Ended September 30, 2004 Compared to Quarter Ended September
30, 2003, during 2004, the Company has recorded a pre-tax
contract charge totaling $12.8 million to cover estimated future losses and allocated corporate overhead
under the Maryland DPS contract until its expiration in June 2005. 27




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##### Table of Contents



Selling, general and administrative expenses.Selling, general and
administrative expenses for the nine months ended September 30, 2004 increased
$2.4 million from $10.7 million, or 2.9% of revenues, for the nine months ended
September 30, 2003 to $13.1 million, or 2.6% of revenues, for the nine months
ended September 30, 2004. The percentage of revenue decrease is primarily the
result of the increase in healthcare revenues discussed above partially offset
by $500,000 in expense recorded in connection with the EMSA lease matter
discussed in Part II  Item 1 Legal Proceedings. Approximately $500,000 in
overhead costs associated with the Companys loss contracts was charged against
the loss contract reserve during the nine months ended September 30, 2004 and
2003. Depreciation and amortization. Depreciation and amortization expense for
each of the nine months ended September 30, 2004 and 2003 was $2.9 million and
$3.2 million, respectively. 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 $1.5 million, or 0.3% of
revenue, for the nine months ended September 30, 2004 from $2.9 million, or
0.8% of revenue, for the nine months ended September 30, 2003. This decrease is
primarily the result of a reduction in the level of debt outstanding. Income tax provision (benefit).The income tax benefit for the nine month
period ended September 30, 2004 was $4.9 million or 1.0% of healthcare revenues
as compared to an income tax provision of $0.7 million or 0.2% of healthcare
revenues for the nine month period ended September 30, 2003. As discussed
above in the section titled Quarter Ended September 30, 2004 Compared to
Quarter Ended September 30, 2003, in the second quarter of 2004, the Company
recorded an income tax benefit of $5.3 million which resulted from the
reversal, effective June 30, 2004, of substantially all of the valuation
allowance previously established for its net deferred tax assets. Income from continuing operations.Income from continuing operations for
the nine months ended September 30, 2004 was $3.4 million, or 0.7% of revenue,
as compared with $5.3 million, or 1.4% of revenue, for the nine months ended
September 30, 2003 as the result of the factors discussed above. Income from discontinued operations, net of taxes. Income from
discontinued operations for the nine months ended September 30, 2004 was $0.8
million, as compared with $1.0 million for the nine months ended September 30,
2003. Income from discontinued operations represents the operating results of
the Companys contracts that have expired or otherwise been terminated
subsequent to January 1, 2002. The classification of these expired contracts is
the result of the Companys adoption of SFAS No. 144 effective January 1, 2002.
See Note 6 of the Companys Condensed Consolidated Financial Statements for
further discussion of SFAS No. 144. Approximately $53,000 and $3.6 million in
negative operating margin related to the Companys loss contracts 28




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##### Table of Contents



classified as discontinued operations was charged against the loss
contract reserve during the nine months ended September 30, 2004 and 2003,
respectively. During the second quarter of 2003, the Company utilized its loss contract
reserve at a rate greater than previously anticipated. This increase in
utilization was primarily the result of an unexpected increase in healthcare
expenses associated with the Companys contract to provide services to the
Kansas DOC. The primary causes for the increase in healthcare expenses in this
contract were hospitalization and outpatient costs. As a result of the
utilization increase, the Company increased its reserve for loss contracts by
$4.5 million, as of June 30, 2003, to cover estimated future losses that may
occur under the Kansas DOC contract which was to expire in June 2005. As discussed above in the section titled Quarter Ended September 30, 2004
Compared to Quarter Ended September 30, 2003, in the third quarter of 2003,
the Company decreased its reserve for loss contracts by $1.7 million related to
the assignment and novation agreement with the Kansas DOC to assign the Kansas
DOC contract to HCS effective October 1, 2003. The second quarter increase in the reserve of $4.5 million and the third
quarter decrease of $1.7 million in the reserve for loss contracts are reflected as components
of income from discontinued operations, net of tax, in the Companys statements
of income. Net income.Net income for the nine months ended September 30, 2004 was
$4.2 million, or 0.8% of revenue, as compared with net income of $6.3 million,
or 1.7% of revenue, for the nine months ended September 30, 2003 as the result
of the factors discussed above. 29




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##### Table of Contents



Liquidity and Capital Resources Overview The Company had negative working capital of $18.8 million at September 30,
2004 compared to $19.9 million at December 31, 2004. Historically, the Company
has operated with negative or minimal positive working capital, primarily
because receivable collection periods are faster than the normal payment terms
on current liabilities. Days sales outstanding in accounts receivable were 41
at September 30, 2004 while accounts payable days outstanding at September 30,
2004 were 49 and medical claims liability days outstanding at September 30,
2004 were 67. The Company generated net income of $4.2 million for the nine months ended
September 30, 2004 compared to net income of $6.3 million for the nine months
ended September 30, 2003. The Company had stockholders equity of $49.6
million at September 30, 2004 as compared to $39.0 million at December 31,
2003. The Companys cash and cash equivalents increased to $14.0 million at
September 30, 2004 from $1.2 million at December 31, 2003, an increase of $12.8
million. The increase in cash was primarily the result of cash flows from
operations. Cash flows from operating activities represent the year to date net income
plus depreciation and amortization, changes in various components of working
capital and adjustments for various non-cash charges, such as increases or
reductions in the reserve for loss contracts. Cash flows from operating
activities during the nine months ended September 30, 2004 were $15.8 million,
a decrease of $2.7 million from cash flows from operations for the nine months
ended September 30, 2003 of $18.5 million. The decrease was primarily due to a
$5.2 million settlement related to a Florida legal matter discussed above and
an increase of $18.5 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 by an increase of $21.6
million in accounts payable and medical claims liability. Cash flows used in financing activities during the nine months ended
September 30, 2004 were $1.1 million and include net payments totaling $3.6
million to reduce the amount of debt outstanding from $3.6 million at December
31, 2003 to $0 at September 30, 2004. Also included in cash flows used in
financing activities during the first nine months of 2004 were cash receipts of
$2.4 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 a
$55.0 million revolving credit facility (the
Revolver) and prior to the third quarter of 2004 also
included a $5.0 million
term loan (the Term Loan). Proceeds from the CapitalSource Credit Facility
were used to repay the borrowings outstanding pursuant to the Companys
previously existing revolving credit facility. In June 2003, the Company and CapitalSource Finance LLC entered into an
amendment to the CapitalSource Credit Facility. Under the terms of the
amendment, the Company may have standby letters of credit issued under the loan
agreement in amounts up to $10.0 million. The amount available to the Company
for borrowings under the CapitalSource Credit Facility is reduced by the amount
of each outstanding standby letter of credit. At September 30, 2004, the
Company had outstanding standby letters of credit totaling $4.0 million, which
were used to collateralize performance bonds. The CapitalSource Credit Facility is secured by substantially all assets
of the Company and its operating subsidiaries. At September 30, 2004, the
Company had no borrowings outstanding under the Revolver and $38.2 million
available for additional borrowing, based on the Companys collateral base on
that date and outstanding standby letters of credit. Borrowings under the Revolver are limited to the lesser of (1) 85% of
eligible receivables (as defined in the Revolver) or (2) $55.0 million (the
Revolver Capacity). Interest under the Revolver is payable monthly at the
greater of 5.75% or the Citibank N.A. prime rate plus 1.0%. The Company is
also required to pay a monthly 30




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##### Table of Contents



collateral management fee, equal to an annual rate of 1.38%, on average
borrowings outstanding under the Revolver. Additionally, the Company is
required to pay a monthly letter of credit fee equal to an annual rate of 3.5%
on the outstanding balance of letters of credit issued pursuant to the
Revolver. Under the terms of the CapitalSource Credit Facility, the Company is
required to pay a monthly unused line fee equal to an annual rate of 0.6% on
the Revolver Capacity less the actual average borrowings outstanding under the
Revolver for the month and the balance of any outstanding letters of credit. All amounts outstanding under the Revolver will be due and payable on
October 31, 2005. If the Revolver is extinguished prior to July 1, 2005, the
Company will be required to pay an early termination fee equal to 1.0% of the
Revolver Capacity. In connection with the Revolver, the CapitalSource Credit
Facility requires a lockbox agreement, which provides for all cash receipts to
be swept daily to reduce borrowings outstanding. This agreement, combined with
the existence of a Material Adverse Effect (MAE) clause in the 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. During the third quarter, the Company paid the remaining balance totaling
approximately $2.1 million of its Term Loan which was set to mature on October
31, 2005 and a $100,000 loan fee which was due upon maturity. As a result of
these payments, the Company no longer has a balance outstanding related to the
Term Loan. 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, including increases or
decreases to the Companys loss contract reserve, and any losses from asset
sales outside of the normal course of business, minus gains on asset sales
outside the normal course of business, non-recurring gains, and charges against
the Companys loss contract reserve. The CapitalSource Credit Facility also requires the Company to maintain a
minimum fixed charge coverage ratio of 1.5 on a rolling three-month basis. The
CapitalSource Credit Facility defines the fixed charge coverage ratio as
EBITDA, as defined above, divided by the sum of principal payments on
outstanding debt, cash interest expense on outstanding debt, capital
expenditures, cash income taxes paid or accrued, and cash dividends paid or
accrued or declared. In addition, the Company is required to maintain a
minimum fixed charge ratio of 1.75 calculated using the most recent
twelve-month period. The Company was in compliance with these financial covenants as of
September 30, 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. 31




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##### Table of Contents



Other Financing Transactions At September 30, 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. Contractual Obligations And Commercial Commitments The Company has certain contractual obligations as of September 30, 2004,
summarized by the period in which payment is due, as follows (dollar amounts in
thousands): 2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    ThereafterOperating leases
    
    $
    346
    
    
    $
    1,500
    
    
    $
    1,408
    
    
    $
    1,352
    
    
    $
    847
    
    
    $
    285
 The amounts included in the table above do not include future cash
payments for interest. At September 30, 2004, the Company was contingently
liable for $24.7 million of performance bonds. The performance bonds are
collateralized by the standby letters of credit. Off-Balance Sheet Transactions As of September 30, 2004 the Company did not have any off-balance sheet
financing transactions or arrangements except the standby letters of credit
discussed above. Inflation Some of the Companys contracts provide for annual increases in the fixed
base fee based upon changes in the regional medical care component of the
Consumer Price Index. In all other contracts that extend beyond one year, the
Company utilizes a projection of the future inflation rate when bidding and
negotiating the fixed fee for future years. If the rate of inflation exceeds
the levels projected, the excess costs will be absorbed by the Company with the
financial impact dependent upon contract structure. Conversely, the Company may
benefit should the actual rate of inflation fall below the estimate used in the
bidding and negotiation process. Recently Issued Accounting Pronouncement In December 2003, the FASB issued Interpretation No. 46R, Consolidation of
Variable Interest Entities, or FIN No. 46. This interpretation addresses
consolidation by business enterprises of variable interest entities when
certain characteristics are present. The Company adopted the provisions of FIN
No. 46 effective January 1, 2004. Such adoption did not impact the Companys
consolidated financial position, results of operations or cash flows. 32




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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 0.3% and 0.8% of the Companys revenues,
respectively, for the nine month periods ended September 30, 2004 and 2003.
Total debt outstanding was reduced to zero at September 30, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES Disclosure controls and procedures are the Companys controls and other
procedures that are designed to ensure that information required to be
disclosed in the reports that the Company files or submits under the Securities
Exchange Act of 1934, as amended, (the Exchange Act) is recorded, processed,
summarized and reported, within the time periods specified in the Securities
and Exchange Commission (SEC) rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the reports that the
Company files or furnishes under the Exchange Act is accumulated and
communicated to management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. As of the end of the period covered by this report, the Company evaluated
under the supervision and with the participation of management, including the
Chief Executive Officer and Chief Financial Officer, the effectiveness of the
design and operation of the Companys disclosure controls and procedures,
pursuant to the Exchange Act. Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures are effective 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 control over
financial reporting during the third quarter of 2004 that have materially
affected, or are reasonably likely to materially affect, the Companys internal
control over financial reporting. 33




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PART II: OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS EMSA lease matter.On July 12, 2004, EMSA Limited Partnership, a limited
partnership owned by the Company, received an unexpected adverse jury verdict
in the circuit Court, 11th Judicial Circuit, Miami-Dade County, Florida of
approximately $1.2 million plus potential interest. This verdict relates to a
12 year old case filed by the plaintiff, Community Health Related Services,
Inc. (wholly owned by Dr. Carlos Vicaria) seeking unspecified damages
involving a lease dispute in connection with a line of business managing
physician clinics operated by EMSA Limited Partnership prior to its
acquisition by the Company in 1999. The Company did not acquire this line of
business or assume the expired sublease from the seller under the transaction.
The Company has, to date, been forced to defend the case as the seller has
not yet assumed responsibility. The jury verdict is not a final
judgment. Post-verdict motions were heard on November 2, 2004,
with briefing and additional motions to follow. As of September 30, 2004, the
Company maintained a reserve of $446,000 which represents managements current
estimate of probable losses related to this matter. Upon final resolution,
the ultimate cost may be different and could result in a material adverse
effect on the Companys financial position and its quarterly or annual results
of operations. In addition to its rights under post-verdict motions and the
potential for appeal, the Company has filed suit against the seller for
reimbursement for all costs associated with this case as well as any judgment
returned. Such reimbursement has not been reflected in the Companys reserve
estimate discussed above. 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 appellate 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 parties agreed to submit the matter to nonbinding
arbitration and the Company received a successful ruling in July 2004. FACT has
now requested the matter go forward to trial. The Company believes it will
ultimately 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. As of September 30,
2004, the Company has reserved approximately $488,000 related to probable costs
associated with this proceeding. Other matters.In addition to the matters discussed above, the Company
is a party to various legal proceedings incidental to its business. Certain
claims, suits and complaints arising in the ordinary course of business have
been filed or are pending against the Company. An estimate of the amounts
payable on existing claims for which the 34




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liability of the Company is probable is included in accrued expenses at
September 30, 2004 and December 31, 2003. The Company is not aware of any
material unasserted claims and would not
anticipate that potential future claims would have a material adverse effect
on its consolidated financial position, results of operations or cash flows. 35




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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable. 
 ITEM 3. DEFAULTS UPON
SENIOR SECURITIES Not applicable. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 
 ITEM 5. OTHER INFORMATION Not applicable. 36




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ITEM 6. EXHIBITS 3.1 
    
    Amended and Restated Certificate of Incorporation of America Service
Group Inc. (incorporated herein by reference to Exhibit 3.1 to the
Companys Quarterly Report on Form 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 3.2 to the
Companys Quarterly Report on Form 10-Q for the three month
period ended June 30, 2004).3.3 
    
    Amended and Restated By-laws of America Service Group Inc.
(incorporated herein by reference to Exhibit 3.2 to the Companys
Quarterly Report on Form 10-Q for the three month period ended June 30,
2002).3.4 
    
    Certificate of Amendment of Amended and Restated Certificate of
Incorporation of America Service Group Inc. (incorporated herein by
reference to Exhibit 3.4 to the Companys Quarterly Report on Form 10-Q
for the three month period ended June 30, 2004).4.1 
    
    Specimen Common Stock Certificate (incorporated herein by reference to
Exhibit 4.1 to the Companys Quarterly Report on Form 10-Q for the three
month period ended June 30, 2002).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 17
to the Condensed Consolidated Financial Statements in this report. 37




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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: November 9, 2004 38