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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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ANNUAL REPORT PURSUANT TO SECTION 13
OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For The Fiscal Year Ended December 31, 2005



Commission File Number 000-50940



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ROTECH HEALTHCARE INC.

(Exact Name of Registrant as Specified in Its Charter)



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 030408870                        
|(State or Other Jurisdiction of Incorporation or Organization) |  | (IRS Employer Identification No.)
|                                                               | 
|2600 Technology Drive, Suite 300, Orlando, Florida             |  | 32804                            
|(Address of Principal Executive Offices)                       |  | (Zip Code)                       



(407) 822-4600

(Registrants Telephone Number, Including Area Code)



Securities registered pursuant to Section 12(b) of the Act: None



Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.0001 par value per share



Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.    Yes ̈No  x



Indicate by check mark if the registrant is not required to
file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ̈No  x



Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by 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 ̈



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.    x



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule
12b-2 of the Exchange Act.    (Check one):  Large Accelerated Filer ̈Accelerated
Filer  x  Non-Accelerated Filer ̈



Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act.):    Yes ̈No  x



As of June 30, 2005, the aggregate market value of the
common equity held by non-affiliates of the registrant was $532,482,431 based on the closing sale price of $26.25 on such date as reported by the Pink Sheets, LLC.



As of March 6, 2006, the registrant had 25,417,270 shares of common stock outstanding.



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DOCUMENTS INCORPORATED BY REFERENCE: The information called for by Part III, to the extent not provided therein or elsewhere in this report, is
incorporated by reference to the Definitive Proxy Statement for the 2006 Annual Meeting of Stockholders of the registrant which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2005.



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TABLE OF CONTENTS



|           |  |          |  |                                                                                                              |  |     
|---------- |  | -------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|           |  |          |  |                                                                                                              |  | Page
|PART I     |  | 2       
|           |  | ITEM 1.  |  | BUSINESS                                                                                                     |  | 2   
|           |  | ITEM 1A. |  | RISK FACTORS                                                                                                 |  | 19  
|           |  | ITEM 1B. |  | UNRESOLVED STAFF COMMENTS                                                                                    |  | 33  
|           |  | ITEM 2.  |  | PROPERTIES                                                                                                   |  | 33  
|           |  | ITEM 3.  |  | LEGAL PROCEEDINGS                                                                                            |  | 34  
|           |  | ITEM 4.  |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                          |  | 34  
|           | 
|PART II    |  | 35      
|           |  | ITEM 5.  |  | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |  | 35  
|           |  | ITEM 6.  |  | SELECTED FINANCIAL DATA                                                                                      |  | 37  
|           |  | ITEM 7.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                        |  | 40  
|           |  | ITEM 7A. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                   |  | 55  
|           |  | ITEM 8.  |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                  |  | 55  
|           |  | ITEM 9.  |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                         |  | 55  
|           |  | ITEM 9A. |  | CONTROLS AND PROCEDURES                                                                                      |  | 55  
|           |  | ITEM 9B. |  | OTHER INFORMATION                                                                                            |  | 57  
|           | 
|PART III   |  | 58      
|           |  | ITEM 10. |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                           |  | 58  
|           |  | ITEM 11. |  | EXECUTIVE COMPENSATION                                                                                       |  | 58  
|           |  | ITEM 12. |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS               |  | 58  
|           |  | ITEM 13. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                               |  | 58  
|           |  | ITEM 14. |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                       |  | 58  
|           | 
|PART IV    |  | 59      
|           |  | ITEM 15. |  | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                   |  | 59  
|           | 
|SIGNATURES |  | 61      



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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS



This report contains certain statements that constitute forward-looking
statements. These forward-looking statements include all statements regarding the intent, belief or current expectations regarding the matters discussed in this report (including statements as to beliefs, expectations,
anticipations, intentions or similar words) and all statements which are not statements of historical fact. These forward-looking statements involve known and unknown risks, uncertainties, contingencies and other factors that
could cause results, performance or achievements to differ materially from those stated in this report. The following are some but not all of such risks, uncertainties, contingencies, assumptions and other factors, many of which are beyond our
control, that could cause results, performance or achievements to differ materially from those anticipated: general economic, financial and business conditions; issues relating to reimbursement by government and third party payors for our products
and services; the costs associated with government regulation of the health care industry; the effects of competition and industry consolidation; the costs and effects of legal proceedings; and other risks and uncertainties described under
Risk Factors. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, our actual results, performance or achievements could differ materially from those expressed in, or implied
by, such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date thereof. When you consider these forward-looking statements, you should keep in mind these
risk factors and other cautionary statements in this report, including the Managements Discussion and Analysis of Financial Condition and Results of Operations and Business. We do not undertake any obligation to
publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.



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PART I



Rotech Healthcare Inc.
was established upon the transfer to us of substantially all of the assets of our predecessor, Rotech Medical Corporation, when it emerged from bankruptcy on March 26, 2002. The financial information included herein reflect these transactions
effective as of March 31, 2002. As a result, references to we, our, and us refer to the operations of Rotech Healthcare Inc., a Delaware corporation, and its subsidiaries for all periods subsequent to
March 31, 2002 and the business and operations of our predecessor, Rotech Medical Corporation, a Florida corporation, and its subsidiaries for all periods prior to April 1, 2002. Financial data for the year-ended December 31, 2002
have been presented for the three months ended March 31, 2002 and the nine months ended December 31, 2002, rather than for the year-ended December 31, 2002, because we had only nine months of operating results since our predecessor
emerged from bankruptcy in such fiscal year. In connection with our predecessors emergence from bankruptcy, we reflected the terms of the plan of reorganization in our consolidated financial statements by adopting the fresh-start reporting
provisions of the American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code. Under fresh-start reporting, a new reporting entity is deemed
to be created and the recorded amounts of assets and liabilities are adjusted to reflect their estimated fair values. For accounting purposes, the fresh-start adjustments have been reflected in the operating results of our predecessor for the three
months ended March 31, 2002.



ITEM 1.    BUSINESS



We are one of the largest providers of home medical equipment and related products and services in the United States, with a comprehensive offering of respiratory therapy and durable home medical equipment and related services. We provide
equipment and services in 48 states through approximately 490 operating centers located primarily in non-urban markets. We provide our equipment and services principally to older patients with breathing disorders, such as chronic obstructive
pulmonary diseases, or COPD (which include chronic bronchitis and emphysema), obstructive sleep apnea and other cardiopulmonary disorders.



Our revenues are principally derived from respiratory equipment rental and related services (87.8% of net revenues for the year ended December 31,
2005), which include rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy systems, nebulizer equipment and sleep disorder breathing therapy systems, and the sale of nebulizer medications. We also
generate revenues through the rental and sale of durable medical equipment (11.2% of net revenues for the year ended December 31, 2005), including hospital beds, wheelchairs, walkers, patient aids and ancillary supplies. We derive our revenues
principally from reimbursement by third-party payors, including Medicare, Medicaid, the Veterans Administration (VA) and private insurers.



For the year ended December 31, 2005, we generated net revenues of $533.2 million and net earnings of $5.5 million. For the same period, net cash
provided by operating activities was $60.7 million and net cash used in investing activities and net cash used in financing activities were $109.5 million and $1.7 million, respectively. Earnings from continuing operations before interest, income
taxes, depreciation and amortization (EBITDA) for the year ended December 31, 2005 was $106.2 million. See Selected Financial Data, note (5) on page 39 for a detailed definition of EBITDA.



Our Service Lines



Respiratory Therapy



We provide a range of respiratory therapy equipment, including oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy
systems, nebulizer equipment, and sleep disorder breathing therapy systems, for rental or sale. Patients in need of respiratory equipment and services suffer from breathing disorders, such as COPD, obstructive sleep apnea and other cardiopulmonary
disorders. Individuals diagnosed with COPD or similar diseases are often elderly, and generally will require treatment for the rest of their lives.



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The majority of our respiratory therapy equipment is rented and reimbursed on a monthly basis. We also generate revenue from the sale of inhalation
medications, including albuterol and ipratropium. We provide driver technicians who deliver and/or install the respiratory care equipment, instruct the patient in its use, refill the high pressure and liquid oxygen systems as necessary and provide
continuing maintenance of the equipment. Respiratory therapy is monitored by licensed respiratory therapists and other clinical staff as prescribed by physicians. We currently employ approximately 522 full time respiratory therapists. Respiratory
therapy equipment rental and related services represented 87.8% of our net revenues for the year ended December 31, 2005.



Our home respiratory care equipment includes three types of oxygen systems:



| |  |  | stationary concentrators, which extract oxygen from room air and generally provide the least expensive supply of oxygen for patients who require a continuous supply of oxygen, are
not ambulatory and who do not require excessive flow rates;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | liquid oxygen systems, which store oxygen under pressure in a liquid form and act as both stationary and portable systems; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | high pressure oxygen cylinders, which are typically portable systems that permit greatly enhanced patient mobility.
| | - |  | -------------------------------------------------------------------------------------------------------------------



Other home respiratory care equipment includes non-invasive positive pressure
ventilators (NPPV), nebulizer devices, bi-level positive airway pressure and continuous positive airway pressure (CPAP) devices. NPPVs are used by individuals who suffer from certain other respiratory conditions by
mechanically assisting the individual to breathe. Nebulizer devices aerosolize our nebulizer medications and allow the medications to be inhaled directly into the patients lungs. CPAP devices deliver pressure into a patients airway
through a specially designed nasal mask or pillow to prevent airway collapse during sleep.



Durable Medical Equipment



We provide a comprehensive line of durable medical equipment, such as hospital beds, wheelchairs, walkers, patient aids and other ancillary supplies, for rental or sale, to serve the specific needs of our patients. Typically, lower cost
items, such as patient aids and walkers, are sold and higher cost items, such as hospital beds and wheelchairs, are rented. We consider durable medical equipment to be a complementary offering to respiratory therapy equipment and related services.



Our Operations



Organization



We have approximately 490 operating centers, which operate through three
divisions. Each of these divisions is managed by a team of division managers who provide management services to our operating centers in four service categories: operations, sales, billing and collection and clinical. These managers provide key
support services to our operating centers, including billing, purchasing, equipment maintenance and repair and warehousing. Each operating center delivers equipment and services to patients in their homes and other care sites through the operating
centers delivery fleet and qualified personnel. Operational control, purchasing, operating policies and sales functions for our divisions are administered centrally at our principal offices in Orlando, Florida through our Chief Operating
Officer, clinical functions are administered through our Chief Clinical Officer who reports to our Chief Operating Officer and financial control, billing and collection services are provided through our Chief Financial Officer. We believe that this
management structure provides control and consistency among our divisions and operating centers and allows us to implement standard policies and procedures across a large number of geographically remote operating centers.



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Operating Systems and Controls



Our operating systems provide management with information to measure and evaluate key components of our operations. We have
a proprietary billing system that is scalable and is used for substantially all of our billing sources, including Medicare, our largest source of revenues. All Medicare claims are aggregated, processed, archived and transmitted to Medicare on a
daily basis. The process is highly automated and has proven to be reliable and cost-effective.



Our billing and collection departments work closely with personnel at operating center locations and third-party payors and are responsible for the review of patient coverage, the adequacy and timeliness of
documentation and the follow-up with third-party payors to expedite reimbursement payments. We communicate with our operating centers through an intranet-based system that provides our managers with detailed information that allows us to address
operating efficiencies. We believe this reporting capability allows our managers to operate their businesses more effectively and allocate their resources more appropriately.



We will continue to improve our operating efficiencies in order to position ourselves for future growth by utilizing our
proprietary information technology platform, as well as third-party software products, to improve our billing, compliance and inventory systems. In 2005, we reduced the number of billing centers from 11 to 7. The reduction of billing centers allows
for increased control with fewer individuals administering the process, reduces our lease costs and facilitates the further implementation of compliance controls. In addition, we are continuing to develop our information technology platform that we
use to track inventory on a store-by-store basis. We believe that this may help to analyze whether our inventory is being used at its most efficient levels by tracking the useful life, maintenance and location of the equipment at all times.



Payors



We derive our revenues principally from reimbursement by third party payors.
We accept assignment of insurance benefits from patients and, in most instances, invoice and collect payments directly from Medicare, Medicaid and private insurance carriers, as well as directly from patients under co-insurance provisions. The
following table sets forth our payor mix:



|                                                                                           |  |                            |   |  |                            |   |  |                            |  
|------------------------------------------------------------------------------------------ |  | -------------------------- | - |  | -------------------------- | - |  | -------------------------- | -
|                                                                                           |  | Year EndedDecember 31,2003 |   |  | Year EndedDecember 31,2004 |   |  | Year EndedDecember 31,2005 |  
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 71.1                       | % |  | 71.0                       | % |  | 66.7                       | %
|Commercial payors                                                                          |  | 24.3                       | % |  | 25.5                       | % |  | 29.9                       | %
|Private payors                                                                             |  | 4.6                        | % |  | 3.5                        | % |  | 3.4                        | %



We contract with
insurers and managed care entities on a local, regional and national basis. We generally contract with those insurers and managed care entities having a significant patient population in the areas served by us, typically on a fee-for-service basis.
We have not historically contracted with insurers or managed care entities on a national basis; however, we are currently a party to several national service agreements with managed care companies and are pursuing additional managed care
relationships on a national level. Pursuant to our contracts with the Veterans Administration (VA), we provide equipment and services to persons eligible for VA benefits in the regions covered by the contracts. The VA contracts typically
provide for an annual term, subject to four or five one-year renewal periods unless terminated or not renewed by the VA.



Our Company History



Rotech Healthcare Inc. was incorporated in the State of Delaware on March 15, 2002. Rotech Medical Corporation, our predecessor, was founded in 1981.
In October 1997, Rotech Medical Corporation was acquired by Integrated Health Services, Inc. (IHS), a large, publicly-held provider of post-acute and related specialty



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health care services and products. Following the acquisition, Rotech Medical Corporation operated as a wholly-owned subsidiary of IHS. On February 2,
2000, IHS and substantially all of its subsidiaries, including Rotech Medical Corporation filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code with the United States Bankruptcy Court in the District of Delaware.
The principal reason for the commencement of Rotech Medical Corporations Chapter 11 case was that Rotech Medical Corporation had jointly guaranteed approximately $2.3 billion of obligations of IHS, under credit agreements with IHS senior
creditors. IHS defaulted on its obligations under those agreements in 1999. Rotech Medical Corporations plan of reorganization was confirmed on February 13, 2002 (and became final on February 25, 2002) and became effective on
March 26, 2002. As a result of the reorganization, substantially all of Rotech Medical Corporations assets, business and operations were transferred to us, an independent company. On December 20, 2004, the Bankruptcy Court entered a
final decree closing Rotech Medical Corporations bankruptcy case.



Senior Secured Credit Facilities



On
March 26, 2002, we entered into senior secured credit facilities for up to $275 million, with UBS Warburg LLC and Goldman Sachs Credit Partners L.P., as arrangers, Goldman Sachs Credit Partners, L.P., as syndication agent, UBS AG, Stamford
Branch, as administrative agent, and a syndicate of other financial institutions. The senior secured credit facilities consist of:



| |  |  | a $75 million five-year revolving credit facility; and
| | - |  | ------------------------------------------------------



| |  |  | a $200 million six-year term loan facility.
| | - |  | -------------------------------------------



The amount available for borrowings under the revolving credit facility is the lesser of (a) the total commitment amount of the revolving credit
facility minus the aggregate outstanding balance of revolving credit loans (including obligations in respect of letters of credit) and (b) certain percentages of our and our domestic subsidiaries eligible accounts receivable, eligible
inventory and eligible property, plant and equipment, minus the aggregate outstanding balance of revolving credit loans (including obligations in respect of letters of credit) and the term loans.



The term loan was drawn in full on the consummation of our predecessors
plan of reorganization, which occurred contemporaneously with the sale of our 91/2% senior subordinated notes
due 2012. The term loan is amortized with 1% of the term loan payable in each of the first five years and 95% of the initial aggregate term loan to be payable in year six, 2008. During 2005, we made payments on our term loan in the amount of $0.4
million. At December 31, 2005, the revolving credit facility had not been drawn upon, although standby letters of credit totaling $12.7 million have been issued under this credit facility.



Interest rates and fees



The interest rates per annum applicable to the senior secured credit
facilities is LIBOR or, at our option, the alternate base rate, which is the higher of (a) the rate of interest publicly announced by UBS AG as its prime rate in effect at its Stamford Branch, and (b) the federal funds effective rate from
time to time plus 0.50%, in each case, plus the applicable margin (as defined below). The applicable margin (a) with respect to the revolving credit facility, is determined in accordance with a performance grid based on our consolidated
leverage ratio and ranges from 3.25% to 2.25% in the case of LIBOR rate advances and from 2.25% to 1.25% in the case of alternate base rate advances, and (b) with respect to the term loan facility, is 3.00% in the case of LIBOR rate advances
and 2.00% in the case of alternate base rate advances. The default rate on the senior secured credit facilities is 2.00% above the otherwise applicable interest rate. We are also obligated to pay a commitment fee ranging, depending on usage, from
0.75% to 0.50% on the unused portion of our revolving credit facility.



Covenants



The senior secured credit
facilities contain customary affirmative and negative covenants, including, without limitation, limitations on indebtedness; limitations on liens; limitations on guarantee obligations; limitations on



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mergers, consolidations, liquidations and dissolutions; limitations on sales of assets; limitations on leases; limitations on dividends and other payments in
respect of capital stock; limitations on investments, loans and advances; limitations on capital expenditures; limitations on optional payments and modifications of subordinated and other debt instruments; limitations on transactions with
affiliates; limitations on granting negative pledges; and limitations on changes in lines of business. Our senior secured credit facilities also contain customary financial covenants including, maintenance of the following ratios: (a) a
consolidated total leverage ratio, (b) a consolidated senior leverage ratio, (c) a consolidated interest coverage ratio and (d) a consolidated fixed charge coverage ratio.



Security and guarantees



Our obligations under the credit facilities are guaranteed by each of our direct and indirect domestic subsidiaries, excluding specified immaterial
subsidiaries. All obligations under the credit facilities and the guarantees are secured by a perfected first priority security interest in substantially all of our tangible and intangible assets, including intellectual property, real property and
all of the capital stock of each of our direct and indirect subsidiaries, excluding immaterial subsidiaries in the process of dissolution and other specified immaterial subsidiaries and limited, in the case of each foreign subsidiary, to 65% of the
value of the stock of such entity.



Senior Subordinated Notes



In March 2002, we issued an aggregate principal amount of
$300 million of 91/2% senior subordinated notes due 2012 and received net proceeds of approximately $290 million, after deducting the initial purchasers discount and our expenses. We distributed the net proceeds
from the sale of the notes to our predecessor as partial consideration in exchange for substantially all of the assets used in connection with its business and operations as part of the restructuring and related transactions involving our
predecessor and us. Subsequently, our predecessor distributed the net proceeds to its former creditors as provided in its plan of reorganization. We did not retain any of the proceeds from the sale of the notes for use in our business.



Government Regulation



The health care industry is subject to extensive regulation by a number of
governmental entities at the federal, state and local levels. The industry is also subject to frequent regulatory changes. Our business is impacted not only by those laws and regulations that are directly applicable to us, but also by certain laws
and regulations that are applicable to our managed care and other patients. State laws also govern, among other things, pharmacies, nursing services, distribution of medical equipment and certain types of home health activities and apply to those
locations involved in such activities. Certain of our employees are subject to state laws and regulations governing the ethics and professional practice of respiratory therapy, pharmacy and nursing. If we fail to comply with the laws and regulations
applicable to our business, we could suffer civil and/or criminal penalties and we could be excluded from participating in Medicare, Medicaid and other federal and state health care programs.



The federal government has made a policy decision to significantly increase
the financial resources allocated to enforcing the health care fraud and abuse laws. Private insurers and various state enforcement agencies also have increased their level of scrutiny of health care claims in an effort to identify and prosecute
fraudulent and abusive practices in the health care area.



Medicare and Medicaid Reimbursement. As part of the Social Security Amendments of 1965, Congress enacted the Medicare program which provides for hospital, physician and other statutorily-defined health benefits for qualified
individuals, including persons over 65 and the disabled. The Medicaid program, also established by Congress in 1965, is a joint federal and state program that provides certain statutorily-defined health benefits to financially needy individuals who
are blind, disabled, aged or members of families with dependent children. In



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addition, Medicaid may cover financially needy children, refugees and pregnant women. In 2005, Medicare, Medicaid and other federally funded programs
(primarily Veterans Administration contracts) accounted for approximately 66.7% of our revenues.



Medicare Laws and Regulations. The Balanced Budget Act of 1997, or BBA 97, granted authority to the Secretary of the Department of Health and Human
Services, or DHHS, to increase or reduce the reimbursement for home medical equipment, including oxygen, by 15% each year under an inherent reasonableness procedure. On February 11, 2003, the Centers for Medicare and Medicaid Services, or CMS,
made effective an interim final rule implementing the inherent reasonableness authority, which allows the agency and carriers to adjust payment amounts by up to 15% per year for certain items and services covered by Part B when the existing
payment amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and the carriers to determine whether an existing reimbursement rate is grossly excessive or deficient and to determine what is a
realistic and equitable payment amount. Also, under the regulation, CMS and the carriers will not consider a payment amount to be grossly excessive or deficient and make an adjustment if they determine that an overall payment adjustment of less than
15% is necessary to produce a realistic and equitable payment amount. On December 13, 2005, CMS published a final rule implementing the inherent reasonableness authority, which became effective on February 11, 2006. This final rule
establishes regulatory criteria that are substantially the same as those put in place under the earlier interim final rule.



In addition to its inherent reasonableness authority, CMS has the discretion to reduce the reimbursement for home medical equipment, or HME, and other
non-HME services to an amount based on the payment amount for the least costly alternative treatment that meets the Medicare beneficiarys medical needs. Least costly alternative, or LCA, determinations are applied to particular products and
services by CMS and its carriers through the informal notice and comment process used in establishing local coverage policies for HME. This process need not be followed for LCA determinations made on individual claims. Using either its inherent
reasonableness or least costly alternative authority, CMS and the carriers may reduce reimbursement levels for certain items and services covered by Part B, including products and services we offer, which could have a material adverse effect on our
revenues, profitability and results of operations.



The
Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA significantly changed how Medicare Part B pays for our products, including HME items, such as oxygen, oxygen equipment and nebulizers, as well as inhalation drugs
dispensed through nebulizers. These changes include the following:



(1) Reductions and Payment Freeze for HME. Currently, Medicare payments to us for our HME products are based on the lesser of the actual charge for the item or the applicable Medicare fee schedule amount. Under
MMA, from 2004 through 2008, most payments for HME are set at the 2003 level and, therefore, are frozen, unless the item becomes subject to further reductions based on Federal Employee Health Benefits Program median payment amounts (as
described below), or is subject to competitive bidding. As of January 1, 2005, the fee schedule amounts for certain items of HME, including wheelchairs and nebulizers, were reduced based on the percentage difference between the amount of
payment otherwise determined for 2002 and the median amount of payment under the Federal Employee Health Benefits Program, or FEHBP, as determined by the Office of Inspector General of DHHS, or OIG. The FEHBP adjusted payments are to remain
frozen through 2008 unless the particular item becomes subject to competitive bidding.



The fee schedule amounts for oxygen and oxygen equipment were also to be reduced based on this calculation as of January 1, 2005.
Because of a delay in publication of the data needed to set these amounts, the oxygen fee schedule amounts were not reduced until the end of March 2005. According to a March 2005 OIG report, in 2002, FEHBP median payments were approximately 12.4%
less than Medicare payments for stationary home oxygen equipment and approximately 10.8% less than Medicare payments for portable home oxygen equipment. The March 2005 report superseded an earlier September 2004 OIG report that had found greater
differences between FEHBP and Medicare payment rates. On the same day that the OIG published its final 2005 report, CMS published 2005 payment amounts for home oxygen equipment and



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instructed the carriers to implement the payment amounts no later than April 8, 2005. Due to the delay in publication of the finalized OIG report, CMS
provided that Medicare claims for oxygen equipment furnished on or after January 1, 2005 which were submitted prior to the effective date are to be paid based on 2004 monthly payment amounts. Medicare claims submitted on or after the effective
date are to be paid according to the 2005 payment amounts. No retroactive adjustments are to be made to those claims submitted prior to implementation of the 2005 payment amounts.



We cannot predict the outcome of any future rulemaking by CMS. Any additional reductions in Medicare
reimbursement rates for home oxygen equipment could have a material adverse effect on our revenues, profitability and results of operations.



(2) Implementation of Competitive Bidding for HME. Starting in 2007, Medicare is scheduled to begin to phase in a nationwide
competitive bidding program to replace the existing fee schedule payment methodology. The program is to begin in 10 high-population metropolitan statistical areas, or MSAs, expanding to 80 MSAs in 2009 and additional areas thereafter. Under
competitive bidding, suppliers compete for the right to provide items to beneficiaries in a defined region. Only a limited number of suppliers will be selected in any given MSA, resulting in restricted supplier choices for beneficiaries. MMA permits
certain exemptions from competitive bidding, including exemptions for rural areas and areas with low population density within urban areas that are not competitive, unless there is a significant national market through mail-order for the particular
item. A large number of our facilities are located in such areas. However, the criteria for how the exemption will be applied have not yet been determined. Therefore, the impact on our business is uncertain. Also, MMA requires that contracts may
only be awarded to suppliers that meet certain quality and financial standards and that the amounts paid to suppliers under the contracts must be less than the amount paid under the current system. Beginning in 2009, CMS may use information on
payments from the competitive bidding program to adjust payments in regions not subject to competitive bidding. CMS has not yet published the proposed regulations regarding the implementation of competitive bidding. The inherent reasonableness
interim final regulation (see above) remains in effect after MMA, but the legislation precludes the use of inherent reasonableness authority for devices subject to competitive bidding. At this time, we do not know which of our products will be
subject to inherent reasonableness and/or competitive bidding, nor can we predict the impact that inherent reasonableness and competitive bidding will have on our business.



(3) Reduction in Payments for Inhalation Drugs. MMA also revises the payment methodology for certain
drugs, including inhalation drugs dispensed through nebulizers. Prior to MMA, Medicare paid for these drugs based on average wholesale price, or AWP, as reported by drug manufacturers. Beginning January 1, 2004, Medicare payments were reduced
for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately 15 basis points. As of January 1, 2005, as required by MMA, payment amounts for most drugs are based on the average sales price, or ASP. These
reductions in Medicare payment rates for inhalation drugs reduced our net revenues by approximately $10 million in 2004 and approximately $39 million in 2005. The reduction in 2005 was partially offset by shifts in patient and product mix.



Beginning in 2006, MMA requires that payment
amounts for most drugs are to be based on either ASP or competitive bidding for drugs administered by physicians. On June 27, 2005, CMS issued an interim final rule on the Part B competitive bidding program for outpatient drugs and biologicals,
or CAP. On November 21, 2005, CMS issued a final rule on CAP. CAP is to begin on July 1, 2006. Inhalation drugs dispensed through nebulizers are not to be included in the initial phase of the CAP. This means that 2006 payment amounts for
inhalation drugs administered by physicians are to be determined based upon ASP.



ASP is defined statutorily as the volume weighted average of manufacturers average sales prices, calculated by adding the
manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and then divided by the total number of units sold for all national drug codes assigned to the product. Under the ASP methodology, Medicare
generally will pay 106% of ASP for multiple source drugs and 106% of the lesser of ASP or wholesale acquisition cost for single source drugs. In addition, for 2006, if the ASP exceeds the widely available market price by more than 5%, CMS may
substitute the widely



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available market price for the ASP. ASP payment rates are calculated using the most recent manufacturer data available. Manufacturer ASP data submissions are
due to CMS not later than 30 days after the last day of each calendar quarter. Quarterly updates are to be implemented to reflect these quarterly submissions by manufacturers. For example, second quarter 2005 data was used to calculate the ASP
payment amounts for the fourth quarter of 2005. ASP payment amounts for our products may fluctuate from quarter to quarter. For each of the quarters of 2005, as well as the first quarter of 2006, the ASP payment amounts for many drugs, including two
prevalent inhalation drugs, albuterol sulfate and ipratropium bromide, are significantly less than the payment amounts for these drugs in 2004. The payment rate, as posted by CMS, for albuterol sulfate was reduced from $0.39 per milligram in 2004 to
$0.064 for the fourth quarter of 2005 and continued to slightly decline in the first quarter of 2006, to $0.060. The payment rate, as posted by CMS, for ipratropium bromide was reduced from $2.82 per milligram in 2004 to $0.165 for the fourth
quarter of 2005 and increased slightly in the first quarter of 2006, to $0.227.



Effective January 1, 2006, CMS established a new billing code for compounded budesonide, which includes compounded inhalation
medications that we provide to Medicare beneficiaries based on a physicians prescription. Medicare payment for compounded budesonide, beginning January 1, 2006, is based on pharmacy invoices submitted for individual claims. If the
resulting payment rates using the invoice methodology are significantly less than the 2005 ASP payment rates, this payment reduction could have a material adverse effect on our revenues, profitability and results of operations.



Given the overall reduction in payment for inhalation drugs
dispensed through nebulizers, for 2005, CMS established a $57 dispensing fee for inhalation drugs shipped to a beneficiary for a 30-day period or $80 for a 90-day period. In calculating these 2005 dispensing fees, CMS took into account data
submitted by members of the public, including a report commissioned by the American Association for Homecare, or AAHomecare, as well as an October 2004 report by the United States Government Accountability Office, or GAO, regarding inhalation drugs
dispensed through nebulizers. The GAO recommended that CMS evaluate the costs of dispensing inhalation therapy drugs and modify the existing dispensing fee, if warranted, to ensure that it reflects the costs necessary for dispensation of inhalation
therapy drugs. On November 2, 2005, CMS issued the 2006 physician fee schedule final rule, in which the agency reduced the dispensing fee for inhalation drugs furnished to beneficiaries. For 2006, the dispensing fee is $57 for the first 30-day
period in which a Medicare beneficiary uses inhalation drugs and $33 for inhalation drugs dispensed for each subsequent 30-day period. For a 90-day supply of inhalation drugs, the dispensing fee is $66. We believe that the reductions in the 2006
Medicare dispensing fees will result in a reduction in our 2006 projected revenue of approximately $15 million. We cannot predict the impact that any future rulemaking by CMS might have on our business. If the dispensing fees are reduced or
eliminated in 2007 or beyond, this could have a material adverse effect on our revenues, profitability and results of operations.



For the year ended December 31, 2005, Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 18.2%
of our recorded revenues. The 2005 dispensing fees offset to some extent the reductions in payment rates for inhalation drugs established under the ASP methodology. While we were able, based upon the increased dispensing fees, to continue to offer
inhalation drugs to Medicare patients in 2005, the reductions in dispensing fees for 2006, along with the pricing changes resulting from the ASP payment rates, are resulting in a further material reduction in the revenues and profitability of our
inhalation drug business, and we cannot predict whether it will continue to be economically feasible for us to provide inhalation drugs in the future.



(4) Implementation of Certain Clinical Conditions and Quality Standards. MMA requires that new clinical conditions of coverage be
developed for HME, with those products perceived as having a higher utilization to be given priority for implementation. Although not yet implemented, the quality standards being developed by CMS and are to be applied by independent accreditation
organizations. As an entity that bills Medicare and receives payment from the program, we will be subject to these standards. On September 23, 2005, CMS released draft quality standards for comment, which are expected to be finalized and
published in spring of 2006. The draft standards consist of business-related standards, such as financial



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and human resources management requirements, which would be applicable to all HME suppliers, and product-specific quality standards, which focus on product
specialization and service standards. The proposed product-specific standards address several of our products, including oxygen and oxygen equipment, CPAP and BiPAP, hospital beds, support surfaces, power and manual wheelchairs, and other mobility
equipment. CMS announced that it intends to introduce additional product-specific quality standards for other products in the future, and this could include standards that impact us. At this time, we cannot predict the full impact that the clinical
conditions or final quality standards will have on our business.



The Deficit Reduction Act of 2005, or DRA, which was signed into law on February 8, 2006, also made certain changes to the way Medicare Part B pays for our HME products, including capped rental items and oxygen equipment. For capped
rental items, including hospital beds, nebulizers and power wheelchairs, Medicare has in the past paid a monthly rental fee for a period not to exceed 15 months of continuous use. Under the DRA, the maximum number of months for which Medicare is to
make payment for such equipment decreased from 15 months to 13 months of continuous use, after which time ownership is automatically transferred to the beneficiary. This provision is effective for items furnished for which the first rental month is
during or after January 2006. As to power wheelchairs, the DRA preserves an existing provision requiring that beneficiaries be given the option to purchase the power wheelchair at the time it is furnished. For oxygen equipment, prior to the DRA,
Medicare made monthly rental payments indefinitely, provided medical need continued. The DRA capped the Medicare rental period for oxygen equipment at 36 months of continuous use, after which time ownership of the equipment transfers to the
beneficiary. For purposes of this cap, the DRA provides for a new 36 month rental period beginning January 1, 2006 for all oxygen equipment. This new 36 month rental period applies for beneficiaries starting to use the equipment as well as for
those who have been using it prior to 2006. In addition to the changes in the duration of the rental period for capped rental items and oxygen equipment, the DRA authorizes payments for servicing and maintenance of the products after ownership
transfers to the beneficiary if the Secretary of the Department of Health and Human Services determines the servicing and maintenance is reasonable and necessary. Prior to the changes by the DRA to the duration of the capped rental period and the
new transfer of ownership requirement, Medicare payment for the capped rental items was made automatically every six months for servicing and maintenance for those products for which a Medicare supplier retained ownership after the capped rental
period ended. We do not expect the changes in rental period for capped rental items and oxygen equipment to have a material impact on our business in 2006. At this time, we cannot predict the impact that the change in the rental period for oxygen
equipment will have on our business in future years.



Further
with respect to changes in rental periods, on January 26, 2006, CMS released a final rule revising the payment classification of certain respiratory assist devices. Those respiratory assist devices that have a backup rate feature were reclassified
as capped rental items effective April 1, 2006. Under the rule, for those Medicare beneficiaries who received these devices prior to April 1, 2006, only the rental payments for months after the effective date will count toward the 13 month cap. At
this time, we do not believe that the change will have a material adverse impact on our business.



Professional Licensure



Nurses, pharmacists and other health care professionals employed by us are required to be individually licensed or certified under applicable state law.
We take steps to assure that our employees possess all necessary licenses and certifications, and we believe that our employees comply in all material respects with applicable licensure or certification laws.



Pharmacy Licensing and Registration.



Under state law, our pharmacy locations must be licensed as in-state
pharmacies to dispense pharmaceuticals in the relevant state of location. We deliver pharmaceuticals from our pharmacy location in Kentucky to customers in 47 states, and, where required by state pharmacy law, we must obtain and maintain



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licenses from each state to which we deliver pharmaceuticals. Most states, and the U.S. Food and Drug Administration (FDA), adopt and enforce the official
standards of the US Pharmacopeia (USP) as the official compendia of drug standards. We are subject to state boards of pharmacy laws and regulations in nearly all jurisdictions where we do business. These laws vary from state to state and state
lawmakers regularly propose and, at times, enact new legislation establishing changes in state pharmacy laws and regulations. In addition, the USP is frequently supplemented and amended to create new standards for drugs. We continuously monitor
state activities and the USP and we have policies in place that we believe substantially comply with all state licensing and pharmacy laws currently applicable to our business. We are engaged in activities designed to achieve compliance with these
policies although there can be no assurance that we always operate in full compliance with our policies. Further, there can be no assurance that we are fully and immediately in compliance with all laws, regulations or standards at all times, as
licenses may lapse and laws may change or be misinterpreted or overlooked. Many states enforce their pharmacy laws, including the USP, through periodic facility inspections. State authorities may also raise inquiries or complaints regarding our
pharmacy practices in connection with the renewal of our state licensure or for other reasons. The FDA generally defers to state pharmacy boards during routine inspections of pharmacies, but will intervene and exercise its enforcement authority if
it determines that any of a pharmacys activities are more like those of a manufacturer or if FDA determines that the public health is at risk. See Government RegulationFood, Drug and Cosmetic Act. Failure to comply with
applicable regulatory requirements can result in enforcement action, including fines, revocation, suspension of or refusal to renew licensure, injunctions, seizures, and civil or criminal penalties. If we are unable to obtain and maintain our
licenses in one or more states, or if such states place burdensome restrictions or limitations on pharmacies, our ability to operate in such states would be limited, which could adversely impact our business and results of operations.



Food, Drug and Cosmetic Act.



Under the Federal Food Drug and Cosmetic Act (FFDCA), the FDA imposes
stringent regulations on the distribution, labeling, and other aspects of our medical gas and pharmacy operations. In particular, our medical gas facilities and operations are subject to the FDAs current Good Manufacturing Practice (cGMP)
regulations, which impose certain quality control, documentation, labeling and recordkeeping requirements on the receipt, processing and distribution of medical gas. We are required to register our medical gas facilities with the FDA, and are
subject to periodic, unannounced inspections by the FDA for compliance with the cGMP and other regulatory requirements. In September 2005, FDA inspected our medical gas facility in Coeur DAlene, Idaho. FDA presented us with a Form FD-483 at
the conclusion of the inspection noting two inspectional observations. The Company responded in writing to the FDA within two weeks of the inspection identifying the actions we have taken to correct the deficiencies identified in the Form FD-483. In
addition, following the inspection we conducted a general review of the compliance status of our medical gas facilities with the cGMP regulations and we are currently revising and updating our practices and procedures for medical gas receipt,
processing and distribution, and are enhancing our audit and training functions in connection with the results of such review. Accordingly, we are currently expending significant time, money and resources in an effort to achieve substantial
compliance with the cGMP regulations at each of our medical gas facilities. However, there can be no assurance that this effort will be successful and that our medical gas facilities will achieve and maintain compliance with the cGMP regulations.
Failure to comply with these regulatory requirements could subject the Company to possible legal or regulatory action, such as Warning Letters, product seizure or recalls, suspension of operations at a single facility or several facilities,
temporary or permanent injunctions, or possible civil or criminal penalties. Federal and state laws also require that we follow specific labeling, reporting and record-keeping requirements for pharmaceutical products that we distribute. Federal law
exempts many pharmaceuticals and medical devices from federal labeling and packaging requirements so long as they are not adulterated or misbranded and are dispensed in accordance with and pursuant to a valid prescription.



Some of the pharmacists at our Pulmo-Dose pharmacy in Murray, Kentucky
dispense compounded preparations of drug products that are not commercially available, based upon a patients individual need and at a physicians specific request. Pharmacy compounding, or the preparation of a dosage, combination or
variation of a drug that has not been approved by FDA, is considered to be within the practice of pharmacy and is regulated



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primarily under state law. We have policies and procedures for compounding practices that we believe are consistent with state law requirements and the USP.
Despite our efforts to comply with these standards, we may occasionally determine through subsequent testing that a preparation does not have acceptable strength, purity or sterility. In such a case, we may be required to dispose of the preparation,
discontinue the preparation, stop distribution of the preparation or initiate a recall of the preparation. Although pharmacy compounding is primarily regulated by state law, the FDA asserts that it has jurisdiction over pharmacy compounding. In May
2002, FDA issued a Compliance Policy Guide for Staff and Industry, Section 460.200, setting forth FDAs enforcement policy on pharmacy compounding. We believe that our compounding activities are consistent with the practice of pharmacy
under state law and as provided in the FDAs Compliance Policy Guide. However, some of the activities that we consider to be compounding, the FDA may consider to constitute the manufacturing of a new drug, because the FDA may define the scope
of drug manufacturing activities more broadly than we or the state pharmacy boards do. FDA may inspect a pharmacy that it believes may not be complying with regulatory requirements or that may be engaged in activities prohibited by the FFDCA. On
August 1, 2005, FDA initiated an inspection of our compounding pharmacy in Murray, Kentucky. The FDA completed its audit on August 12, 2005 and FDA, at the conclusion of the audit, presented the Company with an Form FD-483 noting three
inspectional observations. The Company submitted a response to the Form FD-483 and continues to engage in ongoing communications with the FDA regarding the inspection and FDAs continuing review of our pharmacys activities. We have
cooperated with the FDA during the course of the inspection and will continue to cooperate regarding any required follow-up activities. However, there is no assurance that FDA will agree that we are not a drug manufacturer and that our operations
are in compliance with all applicable regulatory requirements. If FDA determines that our compounding activities do not comply with regulatory requirements or are more consistent with those of a drug manufacturer, FDA could require us to discontinue
those activities and we could be subject to enforcement action.



Claims Audits



Durable medical equipment
regional carriers are private organizations that contract to serve as the governments agents for the processing of certain claims for items and services provided under Part B of the Medicare program. These carriers and Medicaid agencies
periodically conduct pre-payment and post-payment reviews and other audits of claims submitted. Medicare and Medicaid agents are under increasing pressure to scrutinize health care claims more closely. In addition, the industry in which we operate
is generally characterized by long collection cycles for accounts receivable due to complex and time-consuming documentation and claims processing and other requirements for obtaining reimbursement from private and governmental third-party payors.
Such protracted collection cycles can lead to delays in obtaining reimbursement. Furthermore, reviews and/or similar audits or investigations of our claims and related documentation could result in denials of claims for payment submitted by us. The
government could demand significant refunds or recoupments of amounts paid by the government for claims which, upon subsequent investigation, are determined by the government to be inadequately supported by the required documentation.



The Anti-Kickback Statute



As a provider of services under the Medicare and Medicaid programs, we are
subject to the Medicare and Medicaid fraud and abuse laws (sometimes referred to as the Anti-Kickback statute). At the federal level, the Anti-Kickback statute prohibits any person from knowingly and willfully soliciting, receiving,
offering or providing any remuneration, including a bribe, kickback or rebate, directly or indirectly, in return for or to induce the referral of patients, or the furnishing, recommending, or arranging for products or services covered by federal
health care programs. Federal health care programs have been defined to include plans and programs that provide health benefits funded by the federal government, including Medicare and Medicaid, among others. Violations of the Anti-Kickback statute
may result in civil and criminal penalties including fines of up to $25,000 per violation, civil monetary penalties of up to $50,000 per violation, assessments of up to three times the amount of the prohibited remuneration, imprisonment, and
exclusion from participation in the federal health care programs. The Office of the Inspector General of the DHHS has published regulations that identify a limited number of specific business practices that fall within safe harbors which are deemed
not to violate the Anti-Kickback



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statute. Although we attempt to structure our business relationships to meet safe harbor requirements, it is possible that not all of our business
relationships comply with the elements of one or more safe harbors. Conformity with the safe harbors is not mandatory and failure to meet all of the requirements of an applicable safe harbor does not make conduct per se illegal. The Office of
Inspector General is authorized to issue advisory opinions regarding the interpretation and applicability of the federal Anti-Kickback statute, including whether an activity constitutes grounds for the imposition of civil or criminal sanctions. We
have not, however, sought such an opinion.



In addition, a
number of states in which we operate have anti-fraud and anti-kickback laws similar to the Anti-Kickback Statute that prohibit certain direct or indirect payments if such arrangements are designed to induce or encourage the referral of patients or
the furnishing of goods or services. Some states anti-fraud and anti-kickback laws apply only to goods and services covered by Medicaid. Other states anti-fraud and anti-kickback laws apply to all health care goods and services,
regardless of whether the source of payment is governmental or private. Further, many states prohibit revenue sharing or fee splitting arrangements between physicians and other third parties. Possible sanctions for violation of these restrictions
include exclusion from state-funded health care programs, loss of licensure and civil and criminal penalties. Such statutes vary from state to state, are often vague and have seldom been interpreted by the courts or regulatory agencies.



Physician Self-Referrals



Certain provisions of the Omnibus Budget Reconciliation Act of 1993,
commonly known as Stark II, prohibit us, subject to certain exceptions, from submitting claims to the Medicare and Medicaid programs for designated health services if we have a financial relationship with the physician making
the referral for such services or with a member of such physicians immediate family. The term designated health services includes several services commonly performed or supplied by us, including durable medical equipment, home
health services and parenteral and enteral nutrition. In addition, financial relationship is broadly defined to include any ownership or investment interest or compensation arrangement involving remuneration between us and the physician
at issue. Violations of Stark II may result in loss of Medicare and Medicaid reimbursement, civil penalties and exclusion from participation in the Medicare and Medicaid programs. A person who engages in a scheme to circumvent the Stark Laws
referral prohibition may be subject to penalties as well.



On
January 4, 2001, CMS issued the first of two phases of final regulations (Phase I) to clarify the meaning and application of Stark II. On March 26, 2004, CMS released the second phase of the final regulations (Phase
II). The Phase I and Phase II final regulations address the primary substantive aspects of the prohibition and various exceptions. The Phase I regulations defined previously undefined key terms, clarified prior definitions, and created
exceptions for certain indirect compensation arrangements, fair market value transactions, arrangements involving non-monetary compensation up to $300, and risk-sharing arrangements, among others. For certain indirect
compensation relationships, the regulations permit providers to bill for items provided in connection with an otherwise prohibited referral, if the provider does not know, and does not act in reckless disregard or deliberate ignorance of, the
identity of the referring physician. Phase I of the final regulations became effective on January 4, 2002, except with respect to enforcement of the prohibitions application to certain percentage physician compensation arrangements, which
effectiveness was delayed several times by CMS. In the Phase II final regulations, which became effective on July 26, 2004, CMS addressed remaining Stark exceptions not addressed in the Phase I regulationprimarily related to compensation
arrangements, but also addressed certain exceptions related to ownership and investment interests, reporting requirements and sanctions. CMS also finalized its approach to percentage compensation arrangements, permitting them in certain
circumstances.



In addition, a number of the states in which we
operate have similar or broader prohibitions on physician self-referrals. Finally, enforcement activity and resulting case law developments have increased the legal risks of physician compensation arrangements that do not satisfy the terms of an
exception to Stark II, especially in the area of joint venture arrangements with physicians.



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False Claims



We are subject to state and federal laws that govern the submission of claims for reimbursement. The federal False Claims
Act imposes civil liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the False Claims Act may result in treble damages, civil monetary penalties for each false claim submitted and
exclusion from the Medicare and Medicaid programs. In addition, we could be subject to criminal penalties under a variety of federal statutes to the extent that we knowingly violate legal requirements under federal health programs or otherwise
present false or fraudulent claims or documentation to the government.



The False Claims Act also allows a private individual to bring a qui tam suit on behalf of the government against a health care provider for violations of the False Claims Act. A qui tam suit may be brought by, with only a few exceptions,
any private citizen who has material information of a false claim that has not yet been disclosed previously. Even if disclosed, the original source of the information leading to the public disclosure may still pursue such a suit. Although a
corporate insider is often the plaintiff in such actions, an increasing number of outsiders are pursuing such suits.



In a qui tam suit, the private plaintiff is responsible for initiating a lawsuit that may eventually lead to the government recovering money of which it
was defrauded. After the private plaintiff has initiated the lawsuit, the government must decide whether to intervene in the lawsuit and become the primary prosecutor. In the event the government declines to join the lawsuit, the private plaintiff
may choose to pursue the case alone, in which case the private plaintiffs counsel will have primary control over the prosecution (although the government must be kept apprised of the progress of the lawsuit and will still receive at least 70%
of any recovered amounts). In return for bringing the suit on the governments behalf, the statute provides that the private plaintiff is to receive up to 30% of the recovered amount from the litigation proceeds if the litigation is successful.
The number of qui tam suits brought against health care providers has increased dramatically. In addition, at least five statesCalifornia, Illinois, Florida, Tennessee and Texashave enacted laws modeled after the False Claims Act that
allow those states to recover money which was fraudulently obtained by a health care provider from the state (e.g., Medicaid funds provided by the state).



Health Insurance Portability and Accountability Act of 1996



The Health Insurance Portability and Accountability Act of 1996, or HIPAA,
mandates, among other things, the establishment of regulatory standards addressing the electronic exchange of health information, standards for the privacy and security of health information and standards for assigning unique health identifiers to
health care providers. Sanctions for failure to comply with HIPAA standards include civil and criminal penalties.



Three standards have been promulgated under HIPAA with which we currently are required to comply. The Standards for Electronic Transactions require the
use of standardized transactions and code sets for common health care transactions involving the exchange of certain types of information, including health care claims or equivalent encounter information, plan eligibility, referral certification and
authorization, claims status, plan enrollment and disenrollment, payment and remittance advice, health plan premium payments, and coordination of benefits. The Standards for Privacy of Individually Identifiable Information restricts use and
disclosure of certain individually identifiable health information, called protected health information, or PHI. These Privacy Standards not only require our compliance with standards restricting the use and disclosure of PHI, but also
require us to obtain satisfactory assurances that any business associate of ours who has access to our PHI similarly will safeguard such PHI. The Security Standards require us to implement certain security measures to protect electronic PHI. We
believe that we are in compliance in all material respects with each of these HIPAA standards.



One other standard has been promulgated under HIPAA, although compliance with this standard is not yet required. CMS published a final rule covering the assignment of Unique Health Identifiers for Health Care
Providers. The rule calls for the adoption of the National Provider Identifier as the standard unique health



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identifier for health care providers to use in filing and processing health care claims and other transactions. We are required to comply with this standard
by May 23, 2007. We have evaluated this rule to determine the effects of the rule on our business, and we believe that we will have taken the appropriate steps to ensure that we will comply with this standard in all material respects by the
compliance deadline.



HIPAA also has created health care
related crimes, and granted authority to the Secretary of the DHHS to impose certain civil penalties. Particularly, the Secretary may exclude from Medicare any individual with a direct or indirect ownership interest in an entity convicted of health
care fraud or excluded from the program. HIPAA encourages the reporting of health care fraud by allowing reporting individuals to share in any recovery made by the government. HIPAA also requires new programs to control fraud and abuse, and new
investigations, audits and inspections.



Under HIPAA it is a
crime to:



| |  |  | knowingly and willfully commit a federal health care offense relating to a health care benefit program; and
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | knowingly and willfully falsify, conceal or cover up a material fact or make any materially false or fraudulent statements in connection with claims and payment for health care
services by a health care benefit plan.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



These
provisions of HIPAA create criminal sanctions for situations that were previously handled exclusively through civil repayments of overpayments, off-sets and fines. While the Company believes it complies in all material respects with these HIPAA
requirements, we cannot provide any assurance that governmental authorities will find that our business practices comply with current or future administrative or judicial interpretations of HIPAA and its implementing regulations. A violation could
subject us to penalties, fines or possible exclusion from Medicare or Medicaid. Such sanctions could reduce our revenue or profits.



The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or
making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.



Compliance Program



In addition to our Corporate Integrity Agreement with the Office of
Inspector General described below under the caption Corporate Integrity Agreement, we have several voluntary programs to monitor compliance with federal and state laws and regulations applicable to health care entities which are designed
to minimize the likelihood that we would engage in conduct or enter into contracts in violation of the fraud and abuse laws. While we believe that our compliance program meets the relevant guidance provided by the Office of Inspector General of the
DHHS, we cannot provide any assurance that current or future administrative or judicial interpretations of existing laws or legislative enactment of new laws will not have a material adverse effect on our business.



Health Care Reform Legislation



Economic, political and regulatory influences are subjecting the health care
industry in the United States to fundamental change. Health care reform proposals have been formulated by the legislative and administrative branches of the federal government. In addition, some of the states in which we operate periodically
consider various health care reform proposals. We anticipate that federal and state government bodies will continue to review and assess alternative health care delivery systems and payment methodologies and public debate of these issues will
continue in the future. Due to uncertainties regarding the ultimate features of reform initiatives and their enactment and implementation, we cannot predict, which, if any, of such reform proposals will be adopted or when they may be adopted or that
any such reforms will not have a material adverse effect on our business, revenues, profitability and results of operations.



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Health care is an area of extensive and dynamic regulatory change. Changes in the law or new
interpretations of existing laws can have a dramatic effect on permissible activities, the relative costs associated with doing business and the amount of reimbursement by government and other third-party payors.



Corporate Integrity Agreement



Our predecessor, Rotech Medical Corporation, and the Office of Inspector
General of the DHHS entered into a Corporate Integrity Agreement as part of the process of settling the United States federal governments fraud claims against Rotech Medical Corporation in its bankruptcy proceeding. As the successor to the
business and operations of Rotech Medical Corporation, we are subject to the provisions of the Corporate Integrity Agreement.



Providers and suppliers enter into corporate integrity agreements as part of settlements with the federal government in order that the federal government
will waive its right to permissively exclude them from participating in federal health care programs.



The Corporate Integrity Agreement is for a term of five years beginning February 2002. Among other things, the Corporate Integrity Agreement requires us
to conduct internal claims reviews related to our Medicare billing. In the first year of the agreement, the internal claims reviews were also reviewed by an Independent Review Organization (IRO). Similarly, in the fourth year of the
agreement, the internal claims reviews will also be reviewed by an IRO. Under certain circumstances, the internal claims reviews may also be reviewed by the IRO in the fifth year of the agreement. KPMG LLP has acted as our IRO. We must file reports
of the reviews with the Office of Inspector General of the DHHS.



In addition, the Corporate Integrity Agreement imposes upon us (including in most instances our officers, directors, employees and others) various training requirements, as well as the need to have certain policies and procedures in place.
It also requires that we have a Compliance Officer, several Compliance Liaisons and a Compliance Committee. We believe we are in compliance with these requirements.



The Corporate Integrity Agreement also mandates that we have certain procedures in place with respect to our acquisition
process. More specifically, we are required to have an Acquisition Committee (which is comprised of members of senior management) which approves all acquisitions before they are consummated. As part of the acquisition process, we are required to
conduct operational and file reviews of potential entities in which we might acquire an interest. Assuming that we decide to acquire an entity, we are required to provide a report to the Office of Inspector General of the DHHS indicating that we
followed the acquisition procedures set forth in the Corporate Integrity Agreement and specifying any corrective action that might be necessary post acquisition.



The Corporate Integrity Agreement restricts us from hiring any person or contractor who is ineligible to participate in
federal health care programs, federal procurement or federal non-procurement programs or has been convicted of a criminal offense related to the provision of health care items or services. We are obligated to conduct ongoing reviews of the
qualifications of all of our employees and contractors. If a current employee or contractor is or becomes an ineligible employee as contemplated by the Corporate Integrity Agreement, such individual must be relieved of any responsibility for, and
removed from any involvement with, our business operations relating to federal health care programs.



As part of the Corporate Integrity Agreement, we also have certain obligations with respect to repayment of identified overpayments and reporting of
Material Deficiencies we may learn of with respect to our relationship with federal health care programs. We also must submit annual reports to the Office of Inspector General of the DHHS regarding our compliance with the Corporate
Integrity Agreement generally. To the extent that we violate the terms of the Corporate Integrity Agreement, we may be subject to substantial penalties, including stipulated cash penalties ranging from $1,000 per day to $2,500 per day for each day
we are in breach of the agreement and, possibly, exclusion from federal health care programs.



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Suppliers



We purchase our supplies from a variety of independent suppliers. We are not dependent upon any one supplier, and believe that our supplies can be
provided by several suppliers. We have long-standing relationships with most of our largest national suppliers in each product category. We typically focus on one or two suppliers in each product category in an effort to maximize delivery efficiency
and gross margins.



Sales



We believe that the sales and marketing skills of our employees are
instrumental to the success of our business. We provide marketing, training, product and service information to all of our technical personnel through our intranet and through seminars conducted on a company-wide basis so that they can communicate
effectively with physicians about our equipment and services. We emphasize the cross-marketing of all our equipment and services to physicians with which we have already developed professional relationships.



Quality Control



We are committed to providing consistently high quality equipment and services. Our quality control procedures and training
programs are designed to promote greater responsiveness and sensitivity to individual patient needs and to provide a high level of quality assurance and convenience to the patient and the referring physician. Licensed respiratory therapists and
registered nurses provide professional health care support.



The Joint Commission on Accreditation of Healthcare Organizations, or JCAHO, is a nationally recognized organization which develops standards for various health care industry segments and monitors compliance with those standards through
voluntary surveys of participating providers. Accreditation by JCAHO entails a lengthy review process that is conducted at least every three years. We believe that our accreditation by JCAHO is indicative of our commitment to providing consistently
high quality equipment and services. Currently, approximately 97.5% of our operating centers are accredited by JCAHO. The only entities not accredited are newly acquired entities.



Competition



The home medical equipment market is highly competitive and divided among a large number of providers, some of which are national providers, but most of
which are either regional or local providers. Our largest national home medical equipment provider competitors are Apria Healthcare Group, Inc., Lincare Holdings, Inc., American Home Patient, Inc., Praxair, Inc. and Air Products and Chemicals, Inc.
The rest of the market consists of several medium-size competitors, as well as numerous small (under $5 million in revenues) local operations. We also face competition from other types of health care providers, including hospitals, home health
agencies and health maintenance organizations. We believe that the most important competitive factors in the regional and local markets are:



| |  |  | reputation with referral sources, including local physicians and hospital-based professionals;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | service quality and responsiveness;
| | - |  | -----------------------------------



| |  |  | overall ease of doing business;
| | - |  | -------------------------------



| |  |  | quality of patient care, including clinical expertise;
| | - |  | ------------------------------------------------------



| |  |  | range of home medical equipment and services; and
| | - |  | -------------------------------------------------



| |  |  | being a low cost provider.
| | - |  | --------------------------



We believe that it is important to be able to offer a broad range of complementary equipment and services to provide patients access through a single
source. We believe that we compete effectively with respect to all of the above factors and that we have an established record as a quality provider of a range of complementary home medical equipment and services.



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Insurance



Our business is subject to general and professional liability, products liability, employment practices liability, workers compensation, automobile
liability, personal injury and other liability claims that are generally covered by insurance. We have insurance policies that contain various customary levels of deductibles and self- insured retentions and provide us with protection against claims
alleging bodily injury or property damage arising out of our operations. These insurance policies are subject to annual renewal. We believe that our insurance coverage is appropriate based upon historical claims and the nature and risks of our
business.



Employees



Currently, we have approximately 4,662 full time employees. Our employees
are not currently represented by a labor union or other labor organization. We believe our relations with our employees are good.



Principal Executive Office and Website Access to Information



Our principal executive offices are located at 2600 Technology Drive, Suite 300, Orlando, Florida, 32804 and our telephone number there is
(407) 822-4600. Our internet website address is www.rotech.com.



We make available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably
practicable after such material is electronically filed with or furnished to the SEC. Our reports are also available free of charge on the SECs website, www.sec.gov. Also available free of charge on our website are the following
corporate governance documents:



| |  |  | Certificate of Incorporation
| | - |  | ----------------------------



| |  |  | Bylaws
| | - |  | ------



| |  |  | Audit Committee Charter
| | - |  | -----------------------



| |  |  | Compensation Committee Charter
| | - |  | ------------------------------



| |  |  | Nominating and Corporate Governance Committee Charter
| | - |  | -----------------------------------------------------



| |  |  | Corporate Governance Guidelines
| | - |  | -------------------------------



| |  |  | Code of Ethics for Directors, Senior Executive, Financial and Accounting Officers
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Policy Statement on Business Ethics and Conflicts of Interests
| | - |  | --------------------------------------------------------------



All of our reports and corporate governance documents may also be obtained without charge, upon written request directed to the Chief Legal Officer,
Rotech Healthcare Inc., 2600 Technology Drive, Suite 300, Orlando, Florida, 32804. Information contained on our website is not incorporated by reference into this annual report and is not a part of this annual report.



Executive Officers



Our executive officers and their respective ages and positions are as follows:



|                 |  |     |  |                                                
|---------------- |  | --- |  | -----------------------------------------------
|Name             |  | Age |  | Position                                       
|Philip L. Carter |  | 57  |  | President, Chief Executive Officer and Director
|Michael R. Dobbs |  | 56  |  | Chief Operating Officer                        
|Barry E. Stewart |  | 51  |  | Chief Financial Officer and Treasurer          



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Philip L. Carter became President, Chief Executive Officer and a director of our company in
December 2002. From March 2002 to November 2002, Mr. Carter was self-employed. From May 1998 to February 2002, Mr. Carter was the Chief Executive Officer and a director of Apria Healthcare Group Inc. Prior to joining Apria Healthcare Group
Inc., Mr. Carter had served as President and Chief Executive Officer of Mac Frugals Bargains Close-Outs Inc., a chain of retail discount stores, since 1995.



Michael R. Dobbs became Chief Operating Officer of our company in January 2003. Prior to joining our company,
Mr. Dobbs was an officer of Apria Healthcare Group Inc., serving as Executive Vice President, Logistics from January 1999 to January 2003 and as Senior Vice President, Logistics from June 1998 to January 1999. Prior to joining Apria Healthcare
Group Inc., Mr. Dobbs served as Senior Vice President of Distribution for Mac Frugals Bargains Close-Outs Inc. from 1991 to 1998.



Barry E. Stewart, our Chief Financial Officer and Treasurer, joined us in July 2004. Prior to joining our company, Mr. Stewart was
Chief Financial Officer of Evolved Digital Systems, Inc. from 2001 to 2004, and Vice President of Finance of Community Health Systems, Inc. from 1996 to 2001. Prior to 1996, Mr. Stewart served in various managing director positions with
national commercial banks. Mr. Stewart currently serves as a director and the chairman of the audit committee of the board of directors for FloTek Industries, Inc., a publicly traded company headquartered in Houston, Texas. Mr. Stewart is
a licensed Certified Public Accountant.



|ITEM 1A.    RISK | FACTORS
|---------------- | -------



Health care is an area of extensive and dynamic regulatory change that involves a number of risks. The following discussion highlights some of these
risks. These and other risks discussed in this report could materially and adversely affect our business and financial condition.



A substantial percentage of our revenue is attributable to Medicare. Our business may be significantly impacted by changes in Medicare reimbursement
policies and recent legislative changes aimed at reducing health care costs.



A substantial percentage of our revenue is attributable to Medicare and, to a lesser extent, Medicaid. The remainder of our billings are paid by other third-party payors, including private insurers, and by the
patients themselves. Medicare, Medicaid and other federally funded programs (primarily Veterans Administration contracts) accounted for approximately 71.1% of our revenues for the year ended December 31, 2003, approximately 71.0% of our
revenues for the year ended December 31, 2004 and approximately 66.7% of our revenues for the year ended December 31, 2005.



There have been a number of legislative and regulatory proposals to change the health care system in ways that could impact our ability to sell our
products and services profitably. In the United States, federal and state lawmakers regularly propose and, at times, enact new legislation establishing significant changes in the healthcare system. News headlines continue to highlight the need to
control health care spending in the Medicare and Medicaid programs, and this pressure may continue to intensify over time. Legislation continues to impact and reduce Medicare payment levels. Under the Medicare Prescription Drug, Improvement and
Modernization Act of 2003, or MMA, additional reductions have been imposed. Changes under MMA include a reduction in payments for certain types of home medical equipment, including wheelchairs, nebulizers and oxygen equipment, a freeze in payments
for certain home medical equipment from 2004 through 2008, competitive bidding requirements, new clinical conditions for payment and quality standards. In addition, as of January 1, 2005, MMA also reduced payments for inhalation drugs delivered
through nebulizer equipment to an amount based on 106% of average sales price. Reductions in Medicare reimbursement for oxygen, nebulizers and inhalation medications could have a material adverse effect on our revenues, profitability and results of
operations. We cannot predict the impact that any federal legislation enacted in the future will have on our revenues and profitability.



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Changes in the law or new interpretations of existing laws can have a dramatic effect on permissible
activities, the relative costs associated with doing business and the amount of reimbursement by government and other third-party payors. Reimbursement from Medicare and other government programs is subject to federal and state statutory and
regulatory requirements, administrative rulings, interpretations of policy, implementation of reimbursement procedures, renewal of Veterans Administration contracts, retroactive payment adjustments and governmental funding restrictions. Our levels
of revenue and profitability, like those of other health care companies, are affected by the continuing efforts of government payors to contain or reduce the costs of health care by lowering reimbursement rates.



A substantial percentage of our business is derived from the sale of
Medicare-covered HME items, including oxygen, and laws and policies currently in effect reduce payment amounts for certain categories of HME, including those of many of our products.



Currently, Medicare payments to us for our HME products are based on the lesser of the actual charge for the item or the
applicable Medicare fee schedule amount. Under MMA, from 2004 through 2008, most payments for HME are set at the 2003 level and, therefore, are frozen, unless the item becomes subject to further reductions based on Federal Employee
Health Benefits Program median payment amounts (as described below), or is subject to competitive bidding. As of January 1, 2005, the fee schedule amounts for certain items of HME, including wheelchairs and nebulizers, were reduced based on the
percentage difference between the amount of payment otherwise determined for 2002 and the median amount of payment under the Federal Employee Health Benefits Program, or FEHBP, as determined by the Office of Inspector General of DHHS, or OIG. The
FEHBP adjusted payments are to remain frozen through 2008 unless the particular item becomes subject to competitive bidding.



The fee schedule amounts for oxygen and oxygen equipment were also to be reduced based on this calculation as of January 1, 2005. Because of a delay
in publication of the data needed to set these amounts, the oxygen fee schedule amounts were not reduced until the end of March 2005. According to a March 2005 OIG report, in 2002 FEHBP median payments were approximately 12.4% less than Medicare
payments for stationary home oxygen equipment and approximately 10.8% less than Medicare payments for portable home oxygen equipment. The March 2005 report superseded an earlier September 2004 OIG report that had found greater differences between
FEHBP and Medicare payment rates. On the same day that the OIG published its final 2005 report, CMS published 2005 payment amounts for home oxygen equipment, which were calculated using the information in the March 2005 OIG report, and instructed
the carriers to implement the payment amounts no later than April 8, 2005. Due to the delay in publication of the finalized OIG report, CMS provided that Medicare claims for oxygen equipment furnished on or after January 1, 2005 which were
submitted prior to the effective date are to be paid based on 2004 monthly payment amounts. Medicare claims submitted on or after the effective date are to be paid according to the 2005 payment amounts. No retroactive adjustments are to be made to
those claims submitted prior to implementation of the 2005 payment amounts.



The non-oxygen HME items subject to the Medicare price cuts accounted for approximately 3.7% of our recorded revenues in 2005. Furthermore, the reductions in the Medicare fee schedules for home oxygen equipment (as
set forth in the March 2005 OIG report discussed above) together with the additional reimbursement reductions mandated by the MMA in 2005 for other home medical equipment (excluding inhalation drugs) resulted in an aggregate reduction in our 2005
recorded revenues in the amount of approximately $17.7 million. We cannot predict the outcome of any future rulemaking by CMS. Any additional reductions in Medicare reimbursement rates for home oxygen equipment could have a material adverse effect
on our revenues, profitability and results of operations.



In
addition, DRA changes the way Medicare Part B pays for our HME products, including capped rental items and oxygen equipment. For capped rental items, including hospital beds, nebulizers and power wheelchairs, Medicare has in the past paid a monthly
rental fee for a period not to exceed 15 months of continuous use. Under the DRA, the maximum number of months for which Medicare is to make payment for such equipment decreased from 15 months to 13 months of continuous use, after which time
ownership is



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automatically transferred to the beneficiary. This provision is effective for items furnished for which the first rental month is during or after January
2006. As to power wheelchairs, the DRA preserves an existing provision requiring that beneficiaries be given the option to purchase the power wheelchair at the time it is furnished. For oxygen equipment, prior to the DRA, Medicare made monthly
rental payments indefinitely, provided medical need continued. The DRA capped the Medicare rental period for oxygen equipment at 36 months of continuous use, after which time ownership of the equipment transfers to the beneficiary. For purposes of
this cap, the DRA provides for a new 36 month rental period beginning January 1, 2006 for all oxygen equipment. This new 36 month rental period applies for beneficiaries starting to use the equipment as well as for those who have been using it prior
to 2006. In addition to the changes in the duration of the rental period for capped rental items and oxygen equipment, the DRA authorizes payments for servicing and maintenance of the products after ownership transfers to the beneficiary if the
Secretary of the Department of Health and Human Services determines the servicing and maintenance is reasonable and necessary. Prior to the changes by the DRA to the duration of the capped rental period and the new transfer of ownership requirement,
Medicare payment for the capped rental items was made automatically every six months for servicing and maintenance for those products for which a Medicare supplier retained ownership after the capped rental period ended. We do not expect the changes
in rental period for capped rental items and oxygen equipment to have a material impact on our business in 2006. At this time, we cannot predict the impact that the changes in rental period for capped rental items and oxygen equipment will have on
our financial condition or results of operations in future years.



A significant percentage of our business is derived from the sale of Medicare-covered respiratory medications, and laws and policies currently in effect impose significant reductions in Medicare reimbursement for such inhalation drugs.



MMA also revises the payment methodology for certain
drugs, including inhalation drugs dispensed through nebulizers. Prior to MMA, Medicare paid for these drugs based on average wholesale price, or AWP, as reported by drug manufacturers. Beginning January 1, 2004, Medicare payments were reduced
for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately 15 basis points. As of January 1, 2005, as required by MMA, payment amounts for most drugs are based on the average sales price, or ASP. These
reductions in Medicare payment rates for inhalation drugs reduced our net revenues by approximately $10 million in 2004 and approximately $39 million in 2005. The reduction in 2005 was partially offset by shifts in patient and product mix.



Beginning in 2006, MMA requires that payment amounts for most
drugs are to be based on either ASP or competitive bidding for drugs administered by physicians. On June 27, 2005, CMS issued an interim final rule on the Part B competitive bidding program for outpatient drugs and biologicals, or CAP. On
November 21, 2005, CMS issued a final rule on CAP. CAP is to begin on July 1, 2006. Inhalation drugs dispensed through nebulizers are not to be included in the initial phase of the CAP. This means that 2006 payment amounts for inhalation
drugs administered by physicians are to be determined based upon ASP.



ASP is defined statutorily as the volume weighted average of manufacturers average sales prices, calculated by adding the manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and then
divided by the total number of units sold for all national drug codes assigned to the product. Under the ASP methodology, Medicare generally will pay 106% of ASP for multiple source drugs and 106% of the lesser of ASP or wholesale acquisition cost
for single source drugs. In addition, for 2006, if the ASP exceeds the widely available market price by more than 5%, CMS may substitute the widely available market price for the ASP. ASP payment rates are calculated using the most recent
manufacturer data available. Manufacturer ASP data submissions are due to CMS not later than 30 days after the last day of each calendar quarter. Quarterly updates are to be implemented to reflect these quarterly submissions by manufacturers. For
example, second quarter 2005 data was used to calculate the ASP payment amounts for the fourth quarter of 2005. ASP payment amounts for our products may fluctuate from quarter to quarter. For each of the quarters of 2005, as well as the first
quarter of 2006, the ASP payment amounts for many drugs, including two prevalent inhalation drugs, albuterol sulfate and ipratropium bromide, are significantly less than the payment amounts for these drugs in 2004. The payment rate, as posted by
CMS, for albuterol sulfate was reduced from $0.39 per milligram in 2004



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to $0.064 for the fourth quarter of 2005 and continued to slightly decline in the first quarter of 2006, to $0.060. The payment rate, as posted by CMS, for
ipratropium bromide was reduced from $2.82 per milligram in 2004 to $0.165 for the fourth quarter of 2005 and increased slightly in the first quarter of 2006, to $0.227.



Effective January 1, 2006, CMS established a new billing code for compounded budesonide, which includes compounded
inhalation medications that we provide to Medicare beneficiaries based on a physicians prescription. Medicare payment for compounded budesonide, beginning January 1, 2006, is based on pharmacy invoices submitted for individual claims. If
the resulting payment rates using the invoice methodology are significantly less than the 2005 ASP payment rates, this payment reduction could have a material adverse effect on our revenues, profitability and results of operations.



Given the overall reduction in payment for inhalation drugs dispensed through
nebulizers, for 2005, CMS established a $57 dispensing fee for inhalation drugs shipped to a beneficiary for a 30-day period or $80 for a 90-day period. In calculating these 2005 dispensing fees, CMS took into account data submitted by members of
the public, including a report commissioned by the American Association for Homecare, or AAHomecare, as well as an October 2004 report by the United States Government Accountability Office, or GAO, regarding inhalation drugs dispensed through
nebulizers. The GAO recommended that CMS evaluate the costs of dispensing inhalation therapy drugs and modify the existing dispensing fee, if warranted, to ensure that it reflects the costs necessary for dispensation of inhalation therapy drugs. On
November 2, 2005, CMS issued the 2006 physician fee schedule final rule, in which the agency reduced the dispensing fee for inhalation drugs furnished to beneficiaries. For 2006, the dispensing fee is $57 for the first 30-day period in which a
Medicare beneficiary uses inhalation drugs and $33 for inhalation drugs dispensed for each subsequent 30-day period. For a 90-day supply of inhalation drugs, the dispensing fee is $66. We believe that the reductions in the 2006 Medicare dispensing
fees will result in a reduction in our 2006 projected revenue of approximately $15 million. We cannot predict the impact that any future rulemaking by CMS might have on our business. If the dispensing fees are reduced or eliminated in 2007 or
beyond, this could have a material adverse effect on our revenues, profitability and results of operations.



For the year ended December 31, 2005, Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 18.2% of our recorded
revenues. The 2005 dispensing fees offset to some extent the reductions in payment rates for inhalation drugs established under the ASP methodology. While we were able, based upon the increased dispensing fees, to continue to offer inhalation drugs
to Medicare patients in 2005, the reductions in dispensing fees for 2006, along with the pricing changes resulting from the ASP payment rates are resulting in a further material reduction in the revenues and profitability of our inhalation drug
business and we cannot predict whether it will continue to be economically feasible for us to provide inhalation drugs in the future.



Federal law establishing a competitive bidding process under Medicare could negatively affect our business and financial condition.



In 1999-2001, CMS conducted competitive bidding demonstrations for certain
Medicare services. Under MMA, starting in 2007, Medicare is scheduled to begin a nationwide competitive bidding program in ten high-population metropolitan statistical areas (MSAs) for certain high cost and high utilization items. The
program is to expand to cover 80 MSAs in 2009 and additional areas thereafter. Competitive bidding will require suppliers to compete for the rights to provide items to beneficiaries in a defined region. Only a limited number of suppliers will be
selected in any given MSA, resulting in restricted supplier choices for beneficiaries. Competitive bidding may result in lower reimbursement or the loss of our ability to provide services in certain regions. MMA permits certain exemptions from
competitive bidding, including exemptions for rural areas and areas with low population density within urban areas that are not competitive, unless there is a significant national market through mail-order for the particular item. A large number of
our facilities are located in such areas. However, the criteria for how the exemption will be applied have not yet been determined and CMS has not yet published the proposed regulations regarding the implementation of competitive bidding.
Accordingly, the impact on our business remains uncertain.



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Regulatory changes subject the Medicare reimbursement rates for our equipment and services to
potential discretionary adjustment by the Centers for Medicare and Medicaid Services.



The Balanced Budget Act of 1997, or BBA 97, granted authority to the Secretary of the Department of Health and Human Services, or DHHS, to increase or reduce the reimbursement for home medical equipment, including
oxygen, by 15% each year under an inherent reasonableness procedure. On February 11, 2003, CMS made effective an interim final rule implementing the inherent reasonableness authority, which allows the agency and carriers to adjust payment
amounts by up to 15% per year for certain items and services covered by Part B when the existing payment amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and the carriers to
determine whether an existing reimbursement rate is grossly excessive or deficient and to determine what is a realistic and equitable payment amount. Also, under the regulation, CMS and the carriers will not consider a payment amount to be grossly
excessive or deficient and make an adjustment if they determine that an overall payment adjustment of less than 15% is necessary to produce a realistic and equitable payment amount. On December 13, 2005, CMS published a final rule implementing
the inherent reasonableness authority, which became effective on February 11, 2006. This final rule establishes regulatory criteria that are substantially the same as those put in place under the earlier interim final rule.



In addition to its inherent reasonableness authority, CMS has the discretion
to reduce the reimbursement for home medical equipment and other non-HME services to an amount based on the payment amount for the least costly alternative treatment that meets the Medicare beneficiarys medical needs. Least costly alternative,
or LCA, determinations are applied to particular products and services by CMS and its carriers through the informal notice and comment process used in establishing local coverage policies for HME. This process need not be followed for LCA
determinations made on individual claims. Using either its inherent reasonableness or least costly alternative authority, CMS and the carriers may reduce reimbursement levels for certain items and services covered by Part B, including products and
services we offer, which could have a material adverse effect on our revenues, profitability and results of operations.



Future reductions in reimbursement rates under Medicaid could negatively affect our business and financial condition.



Due to budgetary shortfalls, many states are considering, or have enacted,
cuts to their Medicaid programs. These cuts have included, or may include, elimination or reduction of coverage for some or all of our equipment and services, amounts eligible for payment under co-insurance arrangements, or payment rates for covered
items. Continued state budgetary pressures could lead to further reductions in funding for the reimbursement for our equipment and services which, in turn, could have a material adverse effect on our revenues, profitability and results of
operations.



In addition to cost containment initiatives
associated with Medicare and Medicaid, we are affected by continuing efforts by private third-party payors to control their costs. If we lower our prices due to pricing pressures from private third-party payors, our results of operations and
financial condition would likely deteriorate.



Private
payors continually seek to control the cost of providing health care services through direct contracts with health care providers, increased oversight and greater enrollment of patients in managed care programs and preferred provider organizations.
These private payors are increasingly demanding discounted fee structures and the assumption by the health care provider of all or a portion of the financial risk. Reimbursement payments under private payor programs may not remain at current levels
and may not be sufficient to cover the costs allocable to patients eligible for reimbursement pursuant to such programs, and we may suffer deterioration in pricing flexibility, changes in payor mix and growth in operating expenses in excess of
increases in payments by private third-party payors. We may be compelled to lower our prices due to increased pricing pressures, which could cause our results of operations and financial condition to deteriorate.



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Failure to maintain current levels of collectibility of our accounts receivable would likely have a
significant negative impact on our profitability and cash flow.



Billing and collection for our services is a complex process requiring constant attention and involvement by senior management and ongoing enhancements to information systems and billing center operating procedures.



We are paid for our services by various payors, including patients, insurance
companies, Medicare, Medicaid and others, each with distinct billing requirements. We recognize revenue when we provide services to patients. However, our ability to collect these receivables is dependent on our submissions to payors of accurate and
complete documentation. In order for us to bill and receive payment for our services, the physician and the patient must provide appropriate billing information. Following up on incorrect or missing information generally slows down the billing
process and the collection of accounts receivable. Failure to meet the billing requirements of the different payors could result in a decline of our revenues, profitability and cash flow. We may experience significant delays in obtaining Medicare
provider numbers which may result in delayed billings and could have a negative impact on accounts receivable collection and cash flows.



Further, even if our billing procedures comply with all third-party payor requirements, some of our payors may experience financial difficulties or may
otherwise not pay accounts receivable when due, which would result in increased write-offs or provisions for doubtful accounts. There can be no assurance that we will be able to maintain our current levels of collectibility or that third-party
payors will not experience financial difficulties. If we are unable to collect our accounts receivable on a timely basis, our revenues, profitability and cash flow likely will decline.



In addition, in connection with our consolidation of billing centers, we have experienced in the past short-term disruptions
in our operations and collection efforts. If we experience such disruptions in the future, our revenues, profitability and cash flow may significantly decline.



We are subject to periodic audits by governmental and private payors.



We are subject to periodic audits by Medicare and Medicaid programs, and the oversight agencies for these programs have
rights and remedies they can assert against us if they determine we have overcharged the programs or failed to comply with program requirements. These agencies could seek to require us to repay any overcharges or amounts billed in violation of
program requirements, or could make deductions from future amounts otherwise due to us from these programs. We could also be subject to fines, criminal penalties or program exclusions. Private payors also reserve rights to conduct audits and make
monetary adjustments. See BusinessGovernment Regulation for a discussion of recent efforts by government payors to reduce health care costs.



Our business, including our participation in the Medicare and Medicaid program, is subject to extensive laws and government regulations. Failure by
us to comply with these laws and regulations could subject us to severe sanctions and have a significant negative impact on our operations.



We are subject to stringent laws and regulations at both the federal and state levels, including:



| |  |  | billing practices including substantiation and record keeping requirements;
| | - |  | ---------------------------------------------------------------------------



| |  |  | prohibitions on fraud and abuse, kickbacks, rebates and fee splitting;
| | - |  | ----------------------------------------------------------------------



| |  |  | licensing and certification requirements;
| | - |  | -----------------------------------------



| |  |  | confidentiality, privacy and security issues in connection with medical records and patient information;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | relationships with physicians and other referral sources;
| | - |  | ---------------------------------------------------------



| |  |  | operating policies and procedures;
| | - |  | ----------------------------------



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| |  |  | qualifications of health care and support personnel;
| | - |  | ----------------------------------------------------



| |  |  | quality of durable medical equipment and other medical equipment;
| | - |  | -----------------------------------------------------------------



| |  |  | handling, distribution and disposal of pharmaceutical products and medical waste;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | quality assurance; and
| | - |  | ----------------------



| |  |  | occupational safety.
| | - |  | --------------------



Existing United States laws governing Medicare and state health care programs such as Medicaid, as well as similar laws enacted in many states, impose a
broad variety of prohibitions on soliciting, receiving, offering or paying, directly or indirectly, any form of remuneration, payment or benefit for the referral of a patient for services or products reimbursable by Medicare or a state health care
program. The federal government has published regulations that provide exceptions or safe harbors for business transactions that will be deemed not to violate these prohibitions. Violation of these prohibitions may result in civil and
criminal penalties and exclusion from participation in Medicare and state health care programs.



The federal and state Stark Laws impose a broad range of restrictions upon referring physicians (and their immediate family) and providers of
certain designated health services under Medicare and state health care programs, including restrictions on financial relationships between the referring physicians and the providers of the designated health care services. Services which we provide
are classified as designated health services and fall within the regulatory scope of the Stark Laws. Significant criminal, civil and administrative penalties may be imposed for violation of these laws.



We are also subject to strict licensing and safety requirements by the
federal government and many states. Furthermore, many state laws prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to
practice medicine.



In addition, both federal and state
government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of health care companies, as well as their executives and managers. These investigations relate to a wide variety
of matters, including referral and billing practices.



Further,
amendments to the False Claims Act have made it easier for private parties to bring qui tam whistleblower lawsuits against companies. Some states have adopted similar state whistleblower and false claims provisions.



The Office of the Inspector General of the DHHS and the Department of
Justice, or the DOJ, have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Some of our activities could become the subject of governmental investigations or
inquiries. In 2002, we entered into a settlement agreement with the DOJ and the DHHS to settle claims against Rotech Medical Corporation relating to certain Medicare and Medicaid billings. In addition, we or our executives could be included in other
governmental investigations or named as defendants in private litigation, resulting in adverse publicity against us.



On April 30, 2003, federal agents served search warrants at our corporate headquarters and four other facilities in three states and were provided
access to a number of current and historical financial records and other materials. Since that time, we have received subpoenas on behalf of the United States Attorneys Office for the Northern District of Illinois relating to the same subject
matter including information relating to Medicare billing and Department of Veterans Affairs contracting. We are cooperating fully with the investigation. However, we can give no assurances as to the duration of the investigation or as to whether or
not the government will institute proceedings against us or any of our employees or as to the violations that may be asserted.



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If we fail to comply with the laws and regulations relevant to our business, we could be subject to civil
and/or criminal penalties, demands from the government for refunds or recoupment of amounts previously paid to us by the government, facility shutdowns and possible exclusion from participation in federal health care programs such as Medicare and
Medicaid, any of which could have a significant negative impact on our operations. Some statutory and regulatory provisions, principally in the area of billing, have not been interpreted by the courts and may be interpreted or applied in a manner
that might adversely affect us. Changes in health care laws or new interpretations of existing laws may have a dramatic effect on our business and results of operations.



Failure to maintain effective internal control over financial reporting in accordance with Section 404 of the
Sarbanes-Oxley Act could have a material adverse effect on our business, operating results and stock price.



If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results. As
a result, current and potential shareholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.



Effective internal control over financial reporting is necessary for us to provide reliable financial reports. If we cannot provide reliable financial
reports, our business and operating results could be harmed. The Sarbanes-Oxley Act of 2002, as well as related rules and regulations implemented by the SEC, have required changes in the corporate governance practices and financial reporting
standards for public companies. These laws, rules and regulations, including compliance with Section 404 of the Sarbanes-Oxley Act of 2002, have increased our legal and financial compliance costs and made many activities more time-consuming and
more burdensome. The costs of compliance with these laws, rules and regulations have adversely affected our financial results. Moreover, we run the risk of non-compliance, which could adversely affect our financial condition or results of operations
or the trading price of our stock.



We have in the past
discovered, and may in the future discover, areas of our internal control over financial reporting that need improvement. For example, material weaknesses in internal control over financial reporting were identified during managements
evaluation of our disclosure controls and procedures as described in Item 9A of our Annual Report on Form 10-K/A for the year ended December 31, 2004. These material weaknesses resulted in a more than remote risk that a material
misstatement of our annual or interim financial statements would not be prevented or detected.



We have devoted significant resources to remediate our deficiencies and improve our internal control over financial reporting and based upon managements assessment of the effectiveness of our internal control
over financial reporting as of December 31, 2005, management concluded that our internal control over financial reporting was effective as of such date. Although we believe that these efforts have strengthened our internal control over
financial reporting and addressed the concerns that gave rise to the material weaknesses reported as of December 31, 2004, we are continuing to work to improve our internal control over financial reporting. We cannot be certain that these measures
will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our
operating results or cause us to fail to meet our reporting obligations. Inferior internal control over financial reporting could also cause investors to lose confidence in our reported financial information, which could have a negative effect on
the trading price of our stock.



If we lose relationships
with managed care organizations and other third-party payors, we could lose access to patients and our revenue would likely decline.



Managed care organizations and other third-party payors have continued to consolidate in order to enhance their ability to influence the delivery of
health care services and to build volume that justifies discounted prices. Consequently, the health care needs of a large percentage of the United States population are now provided by a small number of managed care organizations and third-party
payors. These organizations, including the Veterans Administration, generally enter into service agreements with a limited number of providers for needed services. To the extent such organizations terminate agreements with us and/or engage our
competitors, our business could



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be materially adversely affected. If we lose relationships with managed care organizations and other third-party payors, including the Veterans
Administration, we could lose access to patients and our revenue would likely decline.



If we fail to cultivate new or maintain established relationships with the physician referral sources, our revenues may decline.



Our success, in part, is dependent upon referrals and our ability to maintain good relations with physician referral
sources. Physicians referring patients to us are not our employees, and are free to refer their patients to our competitors. If we are unable to successfully cultivate new referral sources and maintain strong relationships with our current referral
sources, our revenues may decline.



Our medical gas
facilities and operations are subject to extensive regulation by federal and state authorities and there can be no assurance that our medical gas facilities will achieve and maintain compliance with such regulations.



Our medical gas facilities and operations are subject to extensive
regulation by FDA and other federal and state authorities. The FDA regulates medical gases, including medical oxygen, pursuant to its authority under the federal Food, Drug and Cosmetic Act (FFDCA). Among other requirements, FDAs current Good
Manufacturing Practice (cGMP) regulations impose certain quality control, documentation and recordkeeping requirements on the receipt, processing and distribution of medical gas. The FDA and state authorities conduct periodic, unannounced
inspections at medical gas facilities to assess compliance with the cGMP and other regulations. We currently have approximately 155 medical gas facilities subject to federal and state regulatory requirements. In September 2005, FDA inspected our
medical gas facility in Coeur DAlene, Idaho and noted two inspectional observations which required corrective action. We promptly responded in writing to the FDA identifying the actions we took to correct the deficiencies identified by the FDA
during the inspection. In addition, following the inspection we conducted a general review of the compliance status of our medical gas facilities with the cGMP regulations and we are currently revising and updating our practices and procedures for
medical gas receipt, processing and distribution, and are enhancing our audit and training functions in connection with the results of such review. Accordingly, we are currently expending significant time, money and resources in an effort to achieve
substantial compliance with the cGMP regulations at each of our medical gas facilities. However, there can be no assurance that this effort will be successful and that our medical gas facilities will achieve and maintain compliance with the cGMP
regulations. Further, our medical gas facilities are subject to state regulation under health and safety laws that vary from state to state. As a result, our medical gas facilities are periodically inspected by state authorities, and we therefore
must expend resources in identifying and ensuring compliance with laws and regulations that apply to our medical gas operations in each state in which we do business. Our failure to achieve and maintain regulatory compliance at our medical gas
facilities could result in enforcement action, including warning letters, fines, product recalls or seizures, temporary or permanent injunctions, and civil or criminal penalties which would materially harm our business, financial condition and
results of operations.



Our pharmacy locations and
operations are subject to extensive regulation by state and federal authorities and there can be no assurance that we are fully compliant with such regulations.



Under state law, our pharmacy locations must be licensed as in-state pharmacies to dispense pharmaceuticals in the relevant
state of location. We deliver pharmaceuticals from our pharmacy location in Kentucky to customers in 47 states, and, where required by state pharmacy law, we must obtain and maintain licenses from each state to which we deliver such pharmaceuticals.
We are therefore subject to state boards of pharmacy laws and regulations in nearly all jurisdictions where we do business. These laws can vary significantly from state to state and, while we continuously monitor state activities and changes in the
law, there can be no assurance that we are fully compliant with all laws and regulations that may apply to our pharmacy operations in particular jurisdictions. Many states enforce their pharmacy laws through periodic facility inspections. State
authorities may also raise inquiries or complaints regarding our pharmacy practices in connection with the renewal of our license in a particular state or for other reasons. For instance, in January 2005, we received a



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request from the Montana Department of Labor and Industry that we respond to a complaint filed by a third-party alleging that certain of our activities
exceeded that scope of our pharmacy license in Montana. We have filed a response and continue to cooperate with Montana authorities as they review our pharmacy license and our activities in that state. In addition, in December 2005, the Texas
Department of Public Health requested information regarding our mail order pharmacy practices. We have responded to this request and have not had further communications with Texas state authorities regarding this matter. Failure to comply with
applicable state regulatory requirements can result in enforcement action, including fines, revocation, suspension or failure to renew our state pharmacy licenses, injunctions, seizures, and civil or criminal penalties.



Our pharmacy compounding practices may be deemed by FDA to constitute drug
manufacturing, which would subject these practices to regulation by FDA which could temporarily or permanently suspend part or all of our compounding operations.



Some of the pharmacists at our Pulmo-Dose pharmacy in Murray, Kentucky dispense compounded preparations of drug products
that are not commercially available, based upon a patients individual need and at a physicians specific request. Pharmacy compounding, or the preparation of a dosage, combination or variation of a drug that has not been approved by FDA,
is considered to be within the practice of pharmacy and is regulated primarily under state law. However, some of the activities that we consider to be compounding may be viewed by the FDA as the manufacture of a new drug product, which would subject
such activities to rigorous regulation by FDA under the FFDCA. The line between the activities that constitute drug compounding and the activities that constitute drug manufacturing is not clear, and the FDA may define the scope of drug
manufacturing activities more broadly than we or the state pharmacy board do. In recent years, FDA has increased its scrutiny of pharmacy compounding activities, and has issued several warning letters citing pharmacies for violations of the FFDCA
based, in part, on volumes and types of compounded pharmaceutical products. On August 1, 2005, FDA initiated an inspection of our compounding pharmacy in Murray, Kentucky. The FDA completed its audit on August 12, 2005 and noted three
inspectional observations. The Company promptly submitted a response to the FDA and continues to engage in ongoing communications with the FDA regarding the inspection and FDAs continuing review of our pharmacys activities. Although the
FDA did not conclude that the activities at our Murray, Kentucky pharmacy constitute drug manufacturing, there is no assurance that FDA will ultimately agree that we are not a drug manufacturer and that our operations are in compliance with all
applicable regulatory requirements. If the FDA determines that our compounding activities are more consistent with the activities of a drug manufacturer, the FDA could exercise its enforcement authority to temporarily or permanently suspend part or
all of our compounding operations, seize part or all of our compounding raw materials and compounded products, or require us to comply with the FFDCAs rigorous requirements for manufacturing and marketing a new drug. At this time, we cannot
predict the full impact that the FDA inspection will have on our business.



If we do not comply with laws and regulations governing the confidentiality of medical information, we could be subject to criminal penalties and civil sanctions.



In 1996, the Health Insurance Portability and Accountability Act (HIPAA) was
enacted, among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by
health care providers, health plans and health care clearinghouses.



Three standards have been promulgated under HIPAA with which we currently are required to comply. We must comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims
information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and individuals; security; privacy; and enforcement. We were required to comply with these Standards
by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restricts our use and disclosure of certain individually identifiable health information. We were required to comply with
the Privacy Standards by April 14, 2003. In addition, the Security Standards required us to implement certain security measures to safeguard certain electronic health information by April 20, 2005. We believe we are in compliance in all



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material respects with these HIPAA standards. One other standard relevant to our use of medical information has been promulgated under HIPAA, although our
compliance with this standard is not yet required. CMS published a final rule, which will require us to adopt a Unique Health Identifiers for use in filing and processing health care claims and other transactions by May 23, 2007. While the
government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could be
subject to criminal penalties and civil sanctions.



Lack of
accreditation of our operating centers or failure to meet government standards for coverage could result in a decline in our revenues.



Currently, approximately 97.5% of our operating centers are accredited by the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO. The
only entities not accredited are newly acquired entities. If future reviews by JCAHO do not result in continued accreditation of our operating centers, we would likely experience a decline in our revenues. Further, under MMA, any entity or
individual that bills Medicare for home medical equipment and certain supplies and has a supplier number for submission of claims will be subject to new quality standards as a condition of receiving payment from the Medicare program. These new
standards, which have not yet been implemented, are being developed by CMS and are to be applied by independent accreditation organizations. On September 23, 2005, CMS released draft quality standards for comment, which are expected to be
finalized and published in spring of 2006. The draft standards consist of business-related standards, such as financial and human resources management requirements applicable to all HME suppliers, and product-specific quality standards, which focus
on product specialization and service standards. The proposed product-specific standards address several of our products, including oxygen and oxygen equipment, CPAP and BiPAP, hospital beds, support surfaces, power and manual wheelchairs, and other
mobility equipment. CMS announced that it intends to introduce additional product-specific quality standards for other products in the future, and this could include standards that impact us. MMA also authorizes CMS to establish clinical conditions
for payment for home medical equipment. These new supplier standards and clinical conditions for payment could limit or reduce the number of individuals who can sell or provide our products and could restrict coverage for our products. In addition,
because we have Medicare supplier numbers and are subject to any new supplier standards, our failure to meet any new supplier standards could affect our ability to bill and therefore could have a material adverse effect on our business, financial
condition and results of operations. At this time, we cannot predict the full impact that the clinical conditions or final quality standards will have on our business.



If we fail to comply with our Corporate Integrity Agreement or the terms of our settlement with the federal government,
we could be subject to severe sanctions and be excluded from participating in federal and state health care programs, as well as adverse publicity, which could result in a material decrease in our revenue and seriously undermine our ability to
compete for business, negotiate acquisitions, hire new personnel and otherwise conduct our business.



On February 11, 2002, our predecessor entered into a Corporate Integrity Agreement with the DHHS. We have assumed the obligations under this
agreement (and the settlement with the federal government). Pursuant to the terms of this agreement, we are obligated to implement procedures designed to ensure compliance with the requirements of Medicare, Medicaid and all other federal health care
programs. The Corporate Integrity Agreement is effective for five years. Among other things, the Corporate Integrity Agreement requires us to conduct internal claims reviews relating to our Medicare billing. In the first year of the agreement, the
internal claims reviews were also reviewed by an Independent Review Organization. Similarly, in the fourth year of the agreement, the internal claims reviews must also be reviewed by an Independent Review Organization (currently KPMG LLP). We must
file reports of the reviews with the Office of Inspector General of the Department of Health and Human Services. As a result of these reviews we may be required to refund certain payments to the federal government and/or be subject to penalties
resulting from such overpayments. In addition, failure by us to comply with the Corporate Integrity Agreement could subject us to substantial monetary penalties, exclusion from participation in federal health care programs, as well as adverse
publicity, which could seriously undermine our ability to compete for business, negotiate acquisitions, hire new personnel and otherwise conduct our



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business, and could result in a deterioration in our financial condition and results of operations. See BusinessCorporate Integrity
Agreement for a more detailed description of the terms of the Corporate Integrity Agreement.



In June 2002, we uncovered a pattern of falsified bulk sales of equipment to the Department of Veterans Affairs, as well as certain improperly recorded
revenues from non-bulk VA service contracts.



In late June
2002, we discovered that an independent contractor (who was also a former employee) had falsified certain bulk sales to the Department of Veterans Affairs (VA) by fabricating documentation for nonexistent sales of medical equipment in
bulk to the VA. Upon learning of these falsified sales, we promptly conducted a comprehensive internal investigation.



The investigation confirmed the existence of a pattern of falsified bulk sales of equipment to the VA, as well as certain improperly recorded revenues
from non-bulk VA service contracts. The total of the falsified sales was originally recorded to our books and records as net revenue of $30.4 million. Of this amount, $14.8 million was recorded during the six-month period from October 1, 2001
to March 31, 2002. In addition, $8.1 million of receivables associated with non-bulk VA service contracts were reversed. In connection with the investigation, we recovered approximately $12.5 million of medical equipment inventory, virtually
all of which was in resalable condition. Although we have concluded our investigation, it is possible that our investigation did not uncover every instance of fraudulent activity. In addition, we received informal requests for information on
March 7, 2003 and on April 17, 2003, from the Division of Enforcement of the Securities and Exchange Commission related to our internal investigation regarding VA contracts, and provided documents in response to such requests. At this time
we have not received any further requests for information from the Securities and Exchange Commission, however, we can give no assurances as to whether or not the Securities and Exchange Commission will request additional information or take any
other action.



As a result of the investigation, during 2002,
we restated our consolidated financial statements for each of the years ended December 31, 1999, 2000 and 2001 and for the three months ended March 31, 2002. The restatement reflected a net after-tax charge of $14.1 million over a
three-year period.



We experience competition from numerous
other home medical equipment providers, and this competition could result in a deterioration in our revenues and business.



The home medical equipment market is highly competitive and divided among a large number of providers, some of which are national providers but most of
which are either regional or local providers. Home respiratory companies compete primarily on the basis of service rather than price since reimbursement levels are established by Medicare and Medicaid or by the individual determinations of private
health plans. Our ability to compete successfully and to increase our referrals of new customers are highly dependent upon our reputation within each local health care market for providing responsive, professional and high-quality service, a
professional staff with clinical and technical expertise and achieving strong customer satisfaction.



Some of our competitors may now or in the future have greater financial or marketing resources than we do. Our largest national home medical equipment
provider competitors are Apria Healthcare Group, Inc., Lincare Holdings, Inc., American Home Patient, Inc., Praxair, Inc. and Air Products and Chemicals, Inc. The rest of the market consists of several medium-size competitors, as well as hundreds of
smaller companies with under $5 million in revenues. Many of the smaller, owner-operated home medical equipment providers may have a higher level of service quality that is difficult to replicate. There are relatively few barriers to entry in local
home health care markets. The competitive nature of the home medical equipment environment could result in a deterioration in our revenues and our business.



We have substantial outstanding indebtedness, which could adversely affect our financial condition.



As of March 1, 2006, our total consolidated long-term debt (including
current maturities) accounted for approximately 37% of our total capitalization.



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The degree to which we are leveraged could have important consequences, because:



| |  |  | it could affect our ability to satisfy our obligations under our 91/2% senior subordinated notes due 2012;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | a substantial portion of our cash flow from operations will be required to be dedicated to interest and principal payments and may not be available for operations, working capital,
capital expenditures, expansion, acquisitions or general corporate or other purposes;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain additional financing in the future may be impaired;
| | - |  | -------------------------------------------------------------------------



| |  |  | we may be more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | our flexibility in planning for, or reacting to, changes in our business and industry may be limited;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | it may make us more vulnerable in the event of a downturn in our business, our industry or the economy in general; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | we are vulnerable to interest rate fluctuations because a portion of our debt is subject to variable interest rates.
| | - |  | --------------------------------------------------------------------------------------------------------------------



Our ability to make payments on and to refinance our debt will depend on our
ability to generate cash in the future. This, to a certain extent, is subject to general economic, business, financial, competitive, legislative, regulatory and other factors that are beyond our control.



Our business may not generate sufficient cash flow from operations and future
borrowings may not be available to us under credit facilities in an amount sufficient to enable us to pay our debt, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt, on or before maturity. We may not be
able to refinance any of our debt, including any credit facilities and the notes, on commercially reasonable terms or at all.



Our business and growth strategies will require additional capital, which we may not be able to raise on terms satisfactory to us, if at all.



Our business requires us to make significant capital
expenditures relating to the purchase and maintenance of the medical equipment used in our business. In the year ended December 31, 2005, our capital expenditures were approximately $78.8 million, representing 14.8% of our net revenues. In
addition, we may pursue our growth strategy in part through acquisitions (as competitive and pricing pressures encourage consolidation and economies of scale) and the start-up of new locations. We may need to incur additional indebtedness and/or
sell equity securities, from time to time, to fund such capital expenditures. Sufficient financing may not be available to us on terms satisfactory to us, if at all.



In the event that we acquire companies, we may incur unknown liabilities for their past practices, we may be unable to
successfully integrate such companies into our operations and our results of operations could deteriorate.



If we acquire additional companies, there can be no assurance that we will be able to integrate such companies successfully or manage our expanded
operations effectively and profitably. The process of integrating newly acquired businesses may be costly and disruptive. Our operational, financial and management systems may be incompatible with or inadequate to cost-effectively integrate and
manage the acquired systems. As a result, billing practices could be interrupted and cash collections on the newly acquired business could be delayed pending conversion of patient files onto our billing systems and receipt of appropriate licensures
and provider numbers from government payors. The integration may place significant demands on our management, diverting their attention from our existing operations. If we are not successful in integrating acquired businesses, our results of
operations would likely decline.



We may acquire businesses
with unknown or contingent liabilities, including liabilities for failure to comply with health care laws and regulations. We have policies to conform the practices of acquired facilities to our



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standards and applicable law and generally intend to seek indemnification from prospective sellers covering these matters. We may, however, incur material
liabilities for past activities of acquired businesses.



If
we do not enhance and maintain effective and efficient information systems, our operations may be disrupted and our anticipated operating efficiency may not be realized.



Our operations are dependent on the enhancement and uninterrupted performance of our information systems. Failure to enhance
and maintain reliable information systems or disruptions in our information systems could cause disruptions in our business operations, including billing and collections, loss of existing patients and difficulty in attracting new patients, patient
and payor disputes, regulatory problems, increases in administrative expenses or other adverse consequences, any or all of which could disrupt our operations and prevent us from achieving operating efficiency.



We are highly dependent on our key personnel.



Our performance is substantially dependent on the performance and continued
efforts of our senior management team. The loss of the services of any of our executive officers or other key employees could result in a decline in our business, results of operations and financial condition. In particular, the loss of the services
of our Chief Executive Officer, Philip L. Carter, could have a material adverse effect on our business and results of operations. We do not carry key person life insurance on any of our personnel. Our future success is dependent on the ability of
our managers and sales personnel to manage and promote our business, operations and growth. Any inability to manage our operations effectively could have a material adverse effect on our business, sales, results of operations and financial
condition.



If we are not able to hire qualified management
and other personnel, or if costs of compensation or employee benefits increase substantially, our ability to deliver equipment and services effectively could suffer and our profitability would likely decline.



The success of our business depends upon our ability to attract and retain
highly motivated, well-qualified management and other personnel. Our highest cost is in the payment of salaries to our approximately 4,662 full time employees. We face significant competition in the recruitment of qualified employees, which has
caused increased salary and wage rates. If we are unable to recruit or retain a sufficient number of qualified employees, or if the costs of compensation or employee benefits increase substantially, our ability to deliver services effectively could
suffer and our profitability would likely decline.



Increases in our costs could erode our profit margins and substantially reduce our net income and cash flows.



Cost containment in the health care industry, fueled, in part, by federal and state government budgetary shortfalls, is likely to result in constant or
decreasing reimbursement amounts for our equipment and services. As a result, we must control our operating cost levels, particularly labor and related costs. We compete with other health care providers to attract and retain qualified or skilled
personnel. We also compete with various industries for lower-wage administrative and service employees. Since reimbursement rates are established by fee schedules mandated by Medicare, Medicaid and private payors, we are not able to offset the
effects of general inflation in labor and related cost components, if any, through increases in prices for our equipment and services. Consequently, such cost increases could erode our profit margins and reduce our net income.



We may write-off intangible assets, such as goodwill.



Goodwill represents the excess of cost over fair value of assets acquired
and liabilities assumed of purchased operations. As of December 31, 2005, this goodwill was approximately $42.0 million. As a result of the implementation of fresh-start reporting during 2002, the assets and liabilities of Rotech
Medical Corporation were revalued, which resulted in approximately $692.2 million for reorganization value in excess of fair value of identifiable assetsgoodwill. As of December 31, 2005, the reorganization value in excess of fair value
of identifiable assetsgoodwill remains at a balance of approximately $692.2 million. Any future acquisitions by us will likely result in the recognition of additional intangible assets.



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On an ongoing basis, we evaluate whether facts and circumstances indicate any impairment of value of
intangible assets. As circumstances after an acquisition can change, the value of intangible assets may not be realized by us. If we determine that a significant impairment has occurred, we would be required to write-off the impaired portion of the
unamortized intangible assets, which could have a material adverse effect on our results of operations in the period in which the write-off occurs.



We may be subject to claims arising from investigations and legal proceedings, which could have a significant negative impact on our results of
operations and profitability.



The nature of our business
subjects us to litigation in the ordinary course of our business. In addition, we are from time to time involved in other legal proceedings. In connection with its emergence from bankruptcy, claims made against our predecessor prior to the date it
filed for bankruptcy protection were satisfied in accordance with the terms of its plan of reorganization or pursuant to settlement agreements approved by the Bankruptcy Court. However, although management believes that all pre-petition state claims
have also been discharged or dealt with in the plan of reorganization, states in other bankruptcy cases have challenged whether, as a matter of law, their claims could be discharged in a federal bankruptcy proceeding if they never made an appearance
in the case. The issue has not been finally settled by the United States Supreme Court. Therefore, there is no assurance that a court would find that emergence from bankruptcy would discharge all such state claims against us or our predecessor
involving pre-petition claims. Any such claim not discharged could result in a decline in our financial condition and profitability. Since the date of confirmation of the plan of reorganization, we have not and our predecessor has not received any
correspondence from a state challenging the pre-petition discharge of claims.



A significant number of our outstanding shares of common stock are concentrated in a small number of stockholders which, acting together, could exercise significant influence over certain aspects of our business.



As of March 1, 2006, our 7 largest stockholders held in
the aggregate approximately 65% of our outstanding common stock. These stockholders, acting together, could exercise significant influence on all matters requiring stockholder approval, including the election of directors and the approval of
significant corporate transactions.



If the coverage limits
on our insurance policies are inadequate to cover our liabilities or our insurance costs continue to increase, our financial condition and results of operations would likely decline.



Participants in the health care industry, including us, are subject to substantial claims and litigation in the ordinary
course, often involving large claims and significant defense costs. As a result of the liability risks inherent in our lines of business we maintain liability insurance intended to cover such claims. Our insurance policies are subject to annual
renewal. The coverage limits of our insurance policies may not be adequate, and we may not be able to obtain liability insurance in the future on acceptable terms or at all. In addition, we have been advised by our insurance broker that our
insurance premiums will be subject to increases in the future, which increases may be material. If the coverage limits are inadequate to cover our liabilities or our insurance costs continue to increase, our financial condition and results of
operations would likely decline.



ITEM 1B.    UNRESOLVED STAFF COMMENTS



None.



|ITEM 2. | PROPERTIES
|------- | ----------



We lease our offices and facilities. Our corporate headquarters currently consists of 31,223 square feet (of which we sublease 10,165 square feet) in an
office building located at 2600 Technology Drive, Orlando, Florida, 32804. It is leased to us for a seven-year period ending August 18, 2008 at a current base rate of $49,903 per month (including sales tax), plus operating costs (which have
historically been approximately $4,000 per month (including sales tax)). In addition to our corporate headquarters, we lease office facilities for approximately 490



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locations. These facilities are primarily used for general office work and the dispatching of registered respiratory therapists, registered nurses,
registered pharmacists and delivery personnel. Our office facilities vary in size from approximately 480 to 60,000 square feet. The total space leased for these offices is approximately 2.36 million square feet at an average price of $8.51 per
square foot. All of such office space is leased pursuant to operating leases. We believe that our office locations and other facilities are suitable and adequate for our planned needs.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------



Due to the nature of our business, we are involved from time to time in lawsuits that arise in the ordinary course of our business. We do not believe that
any lawsuit that we (or our predecessor) are a party to, if resolved adversely, would have a material adverse effect on our financial condition or results of operations.



On April 30, 2003, federal agents served search warrants at our corporate headquarters and four other facilities in
three states and were provided access to a number of current and historical financial records and other materials. We have also received subpoenas on behalf of the United States Attorneys Office for the Northern District of Illinois relating
to the same subject matter including information relating to Medicare billing and VA contracting. We are cooperating fully with the investigation; however, we can give no assurances as to the duration of the investigation or as to whether or not the
government will institute proceedings against us or any of our employees or as to the violations that may be asserted. In addition, we received informal requests for information on March 7, 2003 and April 17, 2003 from the Division of
Enforcement of the Securities and Exchange Commission related to matters that were the subject of our internal investigation regarding VA contracts discussed above under the caption Risk FactorsIn June 2002, we uncovered a pattern of
falsified bulk sales of equipment to the Department of Veterans Affairs, as well as certain improperly recorded revenues from non-bulk VA service contracts, and we have provided documents in response to such requests. The Company has not had
any communications with the SEC regarding this matter since 2003. In addition, on August 25, 2005, the Company received a request for information and documents from the Division of Enforcement of the SEC related to the Companys
restatement of prior period financial results discussed in Note 21 to the consolidated financial statements included in the Companys annual report on Form 10-K/A for the year ended December 31, 2004. The Company is fully cooperating with
the SEC and has provided documents in response to such request. The Company has not had any communications with the SEC regarding this matter since September 2005. In addition, on July 15, 2005, a qui tam complaint brought by one of our former
employees was unsealed and served on us and several of our subsidiaries. The complaint, filed in Texas federal court, alleges violations of the False Claims Act for fraudulent billing practices. The United States declined to intervene in the action.
On September 1, 2005, we filed a motion to dismiss the complaint which remains pending. On March 6, 2006, the parties filed a joint motion to stay all activities in the case in order to engage in further discussions. As a health care
provider, we are subject to extensive government regulation, including numerous laws directed at preventing fraud and abuse and laws regulating reimbursement under various government programs. The marketing, billing, documentation and other
practices of health care companies are all subject to government scrutiny. To ensure compliance with Medicare and other regulations, regional carriers often conduct audits and request patient records and other documents to support claims submitted
by us for payment of services rendered to patients. Similarly, government agencies periodically open investigations and obtain information from health care providers pursuant to legal process. Violations of federal and state regulations can result
in severe criminal, civil and administrative penalties and sanctions, including disqualification from Medicare and other reimbursement programs.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------



No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year covered by this report.



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PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES
|------- | --------------------------------------------------------------------------------------------------------------



Our common stock is traded on the NASDAQ National Market under the trading
symbol ROHI. Prior to November 8, 2005, there was no established trading market for our common stock and our common stock traded in interdealer and over-the-counter transactions and price quotations were provided in the pink
sheets by Pink Sheets LLC. Upon effectiveness of our predecessors plan of reorganization on March 26, 2002, all of our outstanding common stock was distributed to our predecessor for further distribution to its senior creditors as
contemplated by the plan of reorganization. Our common stock was issued pursuant to an exemption from the registration requirements of the Securities Act provided by Section 1145 of the Bankruptcy Code. Although we received no cash proceeds
from the initial distribution of our common stock pursuant to the plan of reorganization, we received substantially all of the assets of our predecessor in consideration of the issuance of such stock.



The following table sets forth the high and low sale prices of our common
stock for the periods indicated as reported by the Pink Sheets, LLC (January 1, 2004 through November 7, 2005) and the NASDAQ National Market (November 8, 2005 through December 31, 2005), as applicable:



|                                                            |  |      |       |     |   |      
|----------------------------------------------------------- |  | ---- | ----- | --- | - | -----
|                                                            |  | High |       | Low
|Fiscal 2004                                                 |  |      |       |     |   |      
|First Quarter                                               |  | $    | 24.00 |     | $ | 20.25
|Second Quarter                                              |  | $    | 26.50 |     | $ | 20.75
|Third Quarter                                               |  | $    | 24.60 |     | $ | 18.75
|Fourth Quarter                                              |  | $    | 28.20 |     | $ | 20.00
|Fiscal 2005                                                 |  |      |       |     |   |      
|First Quarter                                               |  | $    | 28.45 |     | $ | 25.00
|Second Quarter                                              |  | $    | 27.70 |     | $ | 24.10
|Third Quarter                                               |  | $    | 27.77 |     | $ | 22.02
|Fourth Quarter (through November 7, 2005)                   |  | $    | 23.70 |     | $ | 15.30
|Fourth Quarter (November 8, 2005 through December 31, 2005) |  | $    | 17.29 |     | $ | 15.00



As of March 6,
2006, there were 25,417,270 shares of our common stock outstanding and approximately 80 holders of record of our common stock. This number was derived from our stockholder records and does not include beneficial owners of our common stock whose
shares are held in the names of various dealers, clearing agencies, banks, brokers and other fiduciaries.



We did not pay any cash dividends on our common stock for the fiscal years ended December 31, 2004 and December 31, 2005, and it is unlikely
that we will pay any cash dividends on our common stock in the foreseeable future. The payment of cash dividends on our common stock will depend on, among other things, our earnings, capital requirements, financial condition and general business
conditions. We are restricted from paying dividends on our common stock or from acquiring our capital stock by certain debt covenants contained in our senior secured credit facilities and the indenture governing our 91/2% senior subordinated notes due 2012.



Each share of our Series A convertible redeemable preferred stock (Series A Preferred) has a stated value of $20 and entitles the holder to an annual cumulative dividend equal to 9% of its stated value, payable semi-annually at the
discretion of our board of directors in cash or in additional shares of Series A Preferred. In the event dividends are declared by our board of directors but not paid for six consecutive periods, the holders of the Series A Preferred are entitled to
vote as a separate class to elect one director to serve on our board of directors. Effective December 5, 2003, our board of directors adopted a policy of declaring dividends to the holders of the Series A Preferred under the Rotech Healthcare
Inc. Employees Plan on an annual basis, with each such declaration to be made at the annual meeting of the board of directors with respect to dividends payable for the



35



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preceding year. Such policy commenced at the 2004 annual meeting of the board of directors and, in order to account for the period from the inception of the
Rotech Healthcare Inc. Employees Plan to such date, the first declaration of dividends covered the preceding two years. Accordingly, in June 2004, dividends in the amount of $900,000 were declared on our Series A Preferred and such dividends were
paid during the first quarter of 2005. At the 2005 annual meeting of the board of directors held on September 27, 2005, dividends in the amount of $450,000 were declared on our Series A Preferred. Such dividends were paid during the fourth
quarter of fiscal 2005.



Effective October 12, 2004, we
repurchased 804 shares of our Series A convertible redeemable preferred stock from the Rotech Healthcare Inc. Employees Plan for approximately $0.02 million in order to fund the cash payment of benefits from the Rotech Healthcare Inc. Employees Plan
to certain plan participants that are no longer employed by us.



36



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##### Table of Contents

|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------



You should read the following selected financial data along with the section captioned Managements discussion and analysis of financial
condition and results of operations and the audited consolidated financial statements and the related notes included in this report. The consolidated statement of operations data and consolidated balance sheet data for the years ended
December 31, 2004 and December 31, 2005 have been derived from our audited financial statements included in this report. The consolidated statement of operations data for the year ended December 31, 2003 have been derived from our
audited financial statements included in this report. The consolidated balance sheet data for the years ended December 31, 2002 and December 31, 2003 and consolidated statement of operations data for the three months ended March 31,
2002 for our predecessor and the nine months ended December 31, 2002 for us, as the successor company, have been derived from our audited financial statements not included in this report. The statement of operations data and balance sheet data
for the year ended December 31, 2001 have been derived from the audited financial statements of our predecessor not included in this report. Data have been presented for the three months ended March 31, 2002 and nine months ended
December 31, 2002, rather than for the year ended on such date, because we had only nine months of operating results in fiscal year 2002 since our predecessor, Rotech Medical Corporation, emerged from bankruptcy on March 26, 2002. For all
periods prior to April 1, 2002, the results of operations and other financial data set forth below refer to the business and operations of our predecessor which, upon emerging from bankruptcy, transferred substantially all of its assets to us
in a restructuring transaction accounted for as of March 31, 2002. For all periods subsequent to March 31, 2002, the results of operations and other financial data refer to our business and operations, as the successor company to Rotech
Medical Corporation.



|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|------------------------------------------------------------------------------ |  | ---------------------- | ------- | - | -------------------------- | - | -------- | ---------------------------- |  | ----------------------- | ------- | ---- | - | ------- | ---- | - | ------- | - |  | - | ------- | -
|                                                                               |  | Predecessor Company    |         |   | Successor Company          |  
|                                                                               |  | Year endedDecember 31, |         |   | Three monthsendedMarch 31, |   |          | Nine monthsendedDecember 31, |  | Year ended December 31, |        
|(dollars in thousands)                                                         |  | 2001                   |         |   | 2002                       |   |          | 2002(1)                      |  | 2003                    |         | 2004 |   |         | 2005 |  
|Statement of Operations Data:                                                  |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Net revenues                                                                   |  | $                      | 583,176 |   |                            | $ | 152,545  |                              |  | $                       | 472,941 |      | $ | 580,599 |      | $ | 535,329 |   |  | $ | 533,182 |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Costs and expenses                                                             |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Cost of net revenues                                                           |  |                        | 162,886 |   |                            |   | 40,009   |                              |  |                         | 124,264 |      |   | 193,411 |      |   | 148,729 |   |  |   | 166,186 |  
|Provision for doubtful accounts                                                |  |                        | 8,044   |   |                            |   | 4,055    |                              |  |                         | 17,119  |      |   | 19,462  |      |   | 19,614  |   |  |   | 17,858  |  
|Selling, general and administrative                                            |  |                        | 308,476 |   |                            |   | 79,647   |                              |  |                         | 256,941 |      |   | 291,910 |      |   | 256,914 |   |  |   | 292,162 |  
|Depreciation and amortization(2)                                               |  |                        | 60,736  |   |                            |   | 2,839    |                              |  |                         | 8,572   |      |   | 16,828  |      |   | 15,191  |   |  |   | 18,123  |  
|Interest (income) expense, net                                                 |  |                        | (322    | ) |                            |   | (17      | )                            |  |                         | 33,093  |      |   | 41,177  |      |   | 33,696  |   |  |   | 31,503  |  
|Provision for settlement of government claims(3)                               |  |                        | 2,516   |   |                            |   |         |                              |  |                         |        |      |   |        |      |   |        |   |  |   |        |  
|Other (income) expense, net                                                    |  |                        |        |   |                            |   |         |                              |  |                         |        |      |   | 2,473   |      |   | (2,389  | ) |  |   | (1,809  | )
|Provision for inventory losses                                                 |  |                        | 2,141   |   |                            |   | 264      |                              |  |                         |        |      |   |        |      |   |        |   |  |   |        |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Total costs and expenses                                                       |  |                        | 544,477 |   |                            |   | 126,797  |                              |  |                         | 439,989 |      |   | 565,261 |      |   | 471,755 |   |  |   | 524,023 |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Earnings (loss) before reorganization items, income taxes, extraordinary items |  |                        | 38,699  |   |                            |   | 25,748   |                              |  |                         | 32,952  |      |   | 15,338  |      |   | 63,574  |   |  |   | 9,159   |  
|Reorganization items(4)                                                        |  |                        | 17,107  |   |                            |   | 182,291  |                              |  |                         | 3,899   |      |   |        |      |   |        |   |  |   |        |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Earnings (loss) before income taxes, extraordinary items                       |  |                        | 21,592  |   |                            |   | (156,543 | )                            |  |                         | 29,053  |      |   | 15,338  |      |   | 63,574  |   |  |   | 9,159   |  
|Federal and state income (benefit) taxes                                       |  |                        | 23,548  |   |                            |   | (1,206   | )                            |  |                         | 12,567  |      |   | 6,731   |      |   | 27,564  |   |  |   | 3,613   |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Earnings (loss) before extraordinary items                                     |  |                        | (1,956  | ) |                            |   | (155,337 | )                            |  |                         | 16,486  |      |   | 8,607   |      |   | 36,010  |   |  |   | 5,546   |  
|Extraordinary gain on debt discharge, net of taxes                             |  |                        |        |   |                            |   | 20,441   |                              |  |                         |        |      |   |        |      |   |        |   |  |   |        |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  
|Net earnings (loss)(2)                                                         |  | $                      | (1,956  | ) |                            | $ | (134,896 | )                            |  | $                       | 16,486  |      | $ | 8,607   |      | $ | 36,010  |   |  | $ | 5,546   |  
|                                                                               |  |                        |         |   |                            |   |          |                              |  |                         |         |      |   |         |      |   |         |   |  |   |         |  



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|                                       |  |                    |           |                   |      |           |      |   |           |  |   |           |  |   |          
|-------------------------------------- |  | ------------------ | --------- | ----------------- | ---- | --------- | ---- | - | --------- |  | - | --------- |  | - | ---------
|                                       |  | PredecessorCompany |           | Successor Company
|                                       |  | December 31,2001   |           | December 31,     
|(dollars in thousands)                 |  |                    | 2002      |                   | 2003 |           | 2004 |   | 2005     
|Balance Sheet Data                     |  |                    |           |                   |      |           |      |   |           |  |   |           |  |   |          
|Current assets                         |  | $                  | 163,067   |                   | $    | 146,733   |      | $ | 122,194   |  | $ | 157,385   |  | $ | 104,433  
|Working capital                        |  |                    | 68,305    |                   |      | 61,143    |      |   | 43,704    |  |   | 90,824    |  |   | 25,110   
|Total assets                           |  |                    | 1,217,133 |                   |      | 1,104,399 |      |   | 1,007,981 |  |   | 1,019,359 |  |   | 1,018,684
|Total debt, including current portion  |  |                    |          |                   |      | 478,513   |      |   | 368,000   |  |   | 330,171   |  |   | 329,514  
|Convertible redeemable preferred stock |  |                    |          |                   |      | 5,346     |      |   | 6,101     |  |   | 5,343     |  |   | 5,343    
|Stockholders equity                   |  |                    | 676,434   |                   |      | 511,141   |      |   | 520,181   |  |   | 561,897   |  |   | 569,515  



|                                            |  |                        |         |   |                            |   |          |                              |  |   |                         |   |  |      |          |   |      |   |         |   |  |   |          |  
|------------------------------------------- |  | ---------------------- | ------- | - | -------------------------- | - | -------- | ---------------------------- |  | - | ----------------------- | - |  | ---- | -------- | - | ---- | - | ------- | - |  | - | -------- | -
|                                            |  | Predecessor Company    |         |   | Successor Company          |  
|                                            |  | Year endedDecember 31, |         |   | Three monthsendedMarch 31, |   |          | Nine monthsendedDecember 31, |  |   | Year ended December 31, |  
|(dollars in thousands)                      |  | 2001                   |         |   | 2002                       |   |          | 2002                         |  |   | 2003                    |   |  | 2004 |          |   | 2005 |  
|Selected Historical Financial Data:         |  |                        |         |   |                            |   |          |                              |  |   |                         |   |  |      |          |   |      |   |         |   |  |   |          |  
|EBITDA(5)                                   |  | $                      | 126,685 |   |                            | $ | (121,133 | )                            |  | $ | 110,081                 |   |  | $    | 176,162  |   |      | $ | 173,823 |   |  | $ | 106,194  |  
|Capital expenditures                        |  |                        | 79,765  |   |                            |   | 15,299   |                              |  |   | 47,273                  |   |  |      | 41,993   |   |      |   | 54,003  |   |  |   | 78,768   |  
|Cash flows provided by operating activities |  |                        | 116,127 |   |                            |   | 26,409   |                              |  |   | 99,698                  |   |  |      | 148,279  |   |      |   | 134,225 |   |  |   | 60,681   |  
|Cash flows used in investing activities     |  |                        | (84,989 | ) |                            |   | (15,299  | )                            |  |   | (50,176                 | ) |  |      | (45,022  | ) |      |   | (54,003 | ) |  |   | (109,545 | )
|Cash flows used in financing activities     |  |                        | (39,121 | ) |                            |   | (5,545   | )                            |  |   | (21,487                 | ) |  |      | (110,289 | ) |      |   | (36,379 | ) |  |   | (1,737   | )

---

|(1) |  | We adopted fresh-start reporting upon our emergence from bankruptcy, effective as of March 31, 2002. Under fresh-start reporting, our reorganization value is allocated to our
assets based on their respective fair values in conformity with the purchase method of accounting for business combinations; any portion not attributed to specific tangible or identified intangible assets are reported as an intangible asset referred
to as reorganization value in excess of value of identifiable assetsgoodwill. In adopting fresh-start reporting, we engaged an independent financial advisor to assist in the determination of the reorganization value or fair value
of the entity. See note 2 to the audited financial statements for the years ended December 31, 2003, December 31, 2004 and December 31, 2005.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In connection with our adoption of fresh-start reporting, we have obtained valuations of the patient service equipment and
have reconsidered the estimated useful lives for this equipment and our other fixed assets. The new basis of patient service equipment, furniture and office equipment, and vehicles at March 31, 2002 are being depreciated over their respective
remaining useful lives. Purchases of such property and equipment since March 31, 2002 are being depreciated over five years for patient service equipment, three years for computer equipment and five years for vehicles; leasehold improvements
and furniture and equipment are unchanged. Prior to March 31, 2002, all such assets were depreciated over an average life of seven years. The effect of this change in estimate for the nine months ended December 31, 2002 was to increase
depreciation by $1,271.



|(2) |  | In July 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 142, Goodwill and Other Intangible Assets (Statement 142). Statement 142 requires that
goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with
estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of. We adopted the provisions of Statement 142 effective January 1, 2002. Had Statement 142 been in effect for the year ended December 31, 2001, amortization of goodwill would have been reduced
by $47.8 million and net earnings for such period would have increased by $42.2 million.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Prior to March 31, 2002, property and equipment was stated at cost. Subsequent to March 31, 2002, property and equipment are stated at cost,
adjusted for the impact of fresh start reporting. Patient service equipment represents medical equipment rented or held for rental to in-home patients. Certain patient service equipment is accounted for using a composite method, due to its
characteristics of high unit volumes of relative low dollar unit cost items. Under the composite method, the purchase cost of monthly purchases of certain patient service equipment are capitalized and depreciated over five years using the
straight-line convention, without specific physical tracking of individual items. We believe the five year depreciation period provides a proper matching of the cost of patient service equipment with the patient service revenues generated from use
of the equipment, when considering the wear and tear, damage, loss and ultimately scrapping of patient service equipment over its life. Other property and equipment (including other patient service equipment) is accounted for by a specific
identification system. Depreciation for other property and equipment is provided on the straight-line method over the estimated useful lives of the assets, seven years for furniture and office equipment, five years for vehicles, three years for
computer equipment, and the shorter of the remaining lease term or the estimated useful life for leasehold improvements.



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During the second quarter ended June 30, 2003, management completed an assessment of the
depreciation estimates made on April 1, 2002, related to long-lived assets acquired from our predecessor, Rotech Medical Corporation. Based on information then available, we revised our estimate of useful lives for certain of these assets from
an aggregate of four years from the date acquired from our predecessor, to depreciating the assets over a period ending five years from the date the assets were originally acquired by our predecessor. The revised estimates on depreciable lives for
approximately $138 million of rental property was necessary to more closely match the replacement rates of rental property acquired with its specific useful remaining life. As a result of that change in depreciation estimate, we recognized
approximately $42.5 million in additional depreciation expense for the year ended December 31, 2003 which has been included as a component of cost of sales. This change in estimate resulted in a decrease to net income of approximately $23.8
million. Cost of net revenues as a percentage of net revenue was 30.4% for 2003 as compared to 22.6% for 2002.



During 2004, we undertook a project to physically count the patient service equipment within all of our respective operating locations and to estimate the
equipment utilized for rental within patient homes. As a result of this project, we believe that certain of the equipment acquired from our predecessor company, Rotech Medical Corporation, is no longer in service or held by us or our patients. Such
equipment was determined to have been fully depreciated prior to December 31, 2004. Accordingly, we have reduced the gross patient service equipment accounts and the related accumulated depreciation accounts by offsetting $52 million. This
adjustment had no impact on our results of operations in 2004.



|(3) |  | In February 2002, we settled all outstanding government litigation and pre-petition and certain post-petition claims arising from Medicare payments made to certain of our operating
centers as well as claims in unliquidated amounts for a cash settlement of $17 million. In addition, on February 13, 2002, IHS and its subsidiaries, including us, entered into a stipulation with the Centers for Medicare and Medicaid Services,
or CMS, whereby CMS was permitted to off-set certain underpayments to IHS with certain overpayments to us in exchange for a full release of all CMS claims against IHS and its subsidiaries, including us, to the effective date of the stipulation. The
Bankruptcy Court signed the stipulation on April 12, 2002.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) |  | During the year ended December 31, 2001, the three months ended March 31, 2002, and the nine months ended December 31, 2002, we recorded the following as
reorganization items:
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                                                                                                                                                     |  |                        |        |                            |   |                               |  |   |      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------- | ------ | -------------------------- | - | ----------------------------- |  | - | -----
|                                                                                                                                                                                     |  | Predecessor Company    |        | Successor Company         
|                                                                                                                                                                                     |  | Year endedDecember 31, |        | Three monthsendedMarch 31, |   | Nine months endedDecember 31,
|(dollars in thousands)                                                                                                                                                               |  | 2001                   |        | 2002                       |   | 2002                         
|Severance and terminations                                                                                                                                                           |  | $                      | 753    |                            | $ | 837                           |  | $ |     
|Legal, accounting and consulting fees                                                                                                                                                |  |                        | 3,815  |                            |   | 175                           |  |   | 1,928
|Loss on sale/leaseback of vehicles                                                                                                                                                   |  |                        |       |                            |   | 4,686                         |  |   | 169  
|Priority tax claim allowed                                                                                                                                                           |  |                        |       |                            |   | 9,000                         |  |   |     
|Contribution of convertible redeemable preferred stock to an employee profit sharing plan                                                                                            |  |                        |       |                            |   | 5,000                         |  |   |     
|Administrative expense claims allowed                                                                                                                                                |  |                        |       |                            |   | 7,800                         |  |   |     
|Fresh-start reporting adjustments                                                                                                                                                    |  |                        |       |                            |   | 153,197                       |  |   |     
|Loss on closure of discontinued branch operations and discontinued product lines, long-term incentive compensation and other charges resulting
from reorganization and restructuring |  |                        | 12,539 |                            |   | 1,596                         |  |   | 1,802
|                                                                                                                                                                                     |  |                        |        |                            |   |                               |  |   |      
|                                                                                                                                                                                     |  | $                      | 17,107 |                            | $ | 182,291                       |  | $ | 3,899
|                                                                                                                                                                                     |  |                        |        |                            |   |                               |  |   |      



|(5) |  | EBITDA is defined as earnings before interest, income taxes, depreciation and amortization. EBITDA is commonly used as an analytical indicator within the health care industry, and
also serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles, and the items excluded from EBITDA are significant
components in understanding and assessing financial performance. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by operating, investing or financing activities or other financial statement data
presented in the consolidated financial statements as an indicator of financial performance or liquidity. Internally, management uses EBITDA as an indicator of financial performance as well as for operational planning and for decision making
purposes. Because EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations, EBITDA as presented may not be comparable to other similarly titled measures of
other companies. A reconciliation of net earnings to EBITDA for each period is presented below. EBITDA as defined herein reflects the effects of non-recurring items (including provision for settlement of government claims, provision for inventory
losses, reorganization items and extraordinary items) in amounts of $21,764, $162,114 and $3,899 for the year ended 2001, the three-months ended March 31, 2002 and the nine months ended December 31, 2002, respectively.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Reconciliation of Net Earnings (Loss) to EBITDA



|                              |  |                        |         |   |                            |   |          |                              |  |                        |         |      |   |         |  |   |         |  |   |        
|----------------------------- |  | ---------------------- | ------- | - | -------------------------- | - | -------- | ---------------------------- |  | ---------------------- | ------- | ---- | - | ------- |  | - | ------- |  | - | -------
|                              |  | Predecessor Company    |         |   | Successor Company         
|                              |  | Year endedDecember 31, |         |   | Three monthsendedMarch 31, |   |          | Nine monthsendedDecember 31, |  | Year endedDecember 31,
|(dollars in thousands)        |  | 2001                   |         |   | 2002                       |   |          | 2002                         |  | 2003                   |         | 2004 |   | 2005   
|Net earnings (loss)           |  | $                      | (1,956  | ) |                            | $ | (134,896 | )                            |  | $                      | 16,486  |      | $ | 8,607   |  | $ | 36,010  |  | $ | 5,546  
|Income taxes (benefit)        |  |                        | 23,548  |   |                            |   | (1,206   | )                            |  |                        | 12,567  |      |   | 6,731   |  |   | 27,564  |  |   | 3,613  
|Interest expense (income)     |  |                        | (322    | ) |                            |   | (17      | )                            |  |                        | 33,093  |      |   | 41,177  |  |   | 33,696  |  |   | 31,503 
|Depreciation and amortization |  |                        | 105,415 |   |                            |   | 14,986   |                              |  |                        | 47,935  |      |   | 119,647 |  |   | 76,553  |  |   | 65,532 
|EBITDA                        |  | $                      | 126,685 |   |                            | $ | (121,133 | )                            |  | $                      | 110,081 |      | $ | 176,162 |  | $ | 173,823 |  | $ | 106,194



|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------



The following discussion should be read in conjunction with the financial statements, related notes and other financial
information appearing elsewhere in this report. In addition, see Information Regarding Forward-Looking Statements and Risk Factors. Our predecessor, Rotech Medical Corporation emerged from bankruptcy on March 26, 2002
and subsequently transferred substantially all of its assets to us in a restructuring transaction. As used herein, unless otherwise specified or the context otherwise requires, references to we, our and us refer
to the business and operations of Rotech Healthcare Inc. and its subsidiaries for all periods subsequent to March 31, 2002 and to the business and operations of Rotech Medical Corporation and its subsidiaries for all periods prior to
April 1, 2002.



Introduction



Background. We provide home medical equipment and related products
and services in the United States, with a comprehensive offering of respiratory therapy and durable home medical equipment and related services. We provide equipment and services in 48 states through approximately 490 operating centers located
primarily in non-urban markets.



Our revenues are principally
derived from respiratory equipment rental and related services (87.8% of net revenues for the year-ended December 31, 2005), which include the rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy
systems, nebulizer equipment and sleep disorder breathing therapy systems, and the sale of nebulizer medications. We also generate revenues from the rental and sale of durable medical equipment (11.2% of net revenues for the year-ended
December 31, 2005), including hospital beds, wheelchairs, walkers, patient aids and ancillary supplies.



We have engaged in an ongoing series of activities to strengthen our organizational structure and reposition us for future growth. These actions have
included selective reduction in headcount, renegotiation of certain vendor contracts, substantial reduction in the number of billing centers, discontinuation of certain product lines and branch locations, centralization of certain administrative
functions (including billing and purchasing), development and implementation of an advanced information and billing system, and enhancement of regulatory compliance programs. We expect to continue to review our operations in order to improve
operating efficiencies.



Reimbursement by Third Party
Payors. We derive a majority of our revenues from reimbursement by third party payors, including Medicare, Medicaid, the Veterans Administration and private insurers. Revenue derived from Medicare, Medicaid and other federally funded programs
represented 66.7% of the Companys patient revenue for the year ended December 31, 2005. Our business has been, and may continue to be, significantly impacted by changes mandated by Medicare legislation. The Medicare Prescription Drug,
Improvement and Modernization Act of 2003, or MMA, significantly changed the Medicare reimbursement methodology and conditions for coverage for a number of our products. These changes include a freeze in reimbursement rates for



40



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##### Table of Contents

home medical equipment from 2004 to 2008, competitive bidding requirements, new clinical conditions for reimbursements and quality standards. The impact of
competitive bidding, new clinical conditions and quality standards is uncertain at this time. The MMA changes also include a reduction in reimbursement rates for oxygen equipment and certain other items of home medical equipment (including
wheelchairs, nebulizers, hospital beds and air mattresses) as of January 1, 2005, based on the percentage difference between the amount of payment otherwise determined for 2002 and the 2002 median reimbursement amount under the Federal Employee
Health Benefits Program, or FEHBP, as determined by the Office of the Inspector General of the Department of Health and Human Services, or OIG.



According to the OIGs report on oxygen prices, which was not published until March 30, 2005, in 2002, FEHBP median payments were approximately
12.4% less than Medicare payments for stationary home oxygen equipment and approximately 10.8% less than Medicare payments for portable home oxygen equipment. The March 2005 report superseded an earlier September 2004 OIG report that had found
greater differences between FEHBP and Medicare payment rates. On the same day that the OIG published its final report, CMS published 2005 payment amounts for home oxygen equipment and instructed the carriers to implement the payment amounts no later
than April 8, 2005. Due to the delay in publication of the finalized OIG report, CMS provided that Medicare claims for oxygen equipment furnished on or after January 1, 2005 which were submitted prior to the effective date are to be paid
based on 2004 monthly payment amounts. Medicare claims submitted on or after the effective date are to be paid according to the 2005 payment amounts. No retroactive adjustments are to be made to those claims submitted prior to implementation of the
2005 payment amounts. During 2005, the new Medicare payment amounts have resulted in a payment reduction of approximately 8.5% for home oxygen equipment provided by us to Medicare beneficiaries.



Reductions in payment rates for 2005 established by CMS for the non-oxygen
HME items subject to the FEHBP provisions range between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for approximately 3.7% of our recorded revenues in 2005. Furthermore, the reductions in the Medicare fee
schedules for home oxygen equipment (as set forth in the March 2005 OIG report discussed above) together with the additional reimbursement reductions mandated by the MMA in 2005 for other home medical equipment (excluding inhalation drugs) resulted
in an aggregate reduction in our 2005 recorded revenues in the amount of approximately $17.7 million.



MMA also revises the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. For the year ended December 31,
2005, Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 18.2% of our recorded revenues. Prior to MMA, Medicare paid for these drugs based on average wholesale price, or AWP, as reported by drug manufacturers.
Beginning January 1, 2004, Medicare payments were reduced for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately 15 basis points. As of January 1, 2005, payments for drugs delivered through
nebulizer equipment were based on 106% of average sales price, or ASP. These reductions in Medicare payment rates for inhalation drugs reduced our net revenues by approximately $10 million in 2004 and approximately $39 million in 2005. The reduction
in 2005 was partially offset by shifts in patient and product mix.



Beginning in 2006, MMA required that payment amounts for most drugs be based on either ASP or competitive bidding for drugs administered by physicians. On November 21, 2005, CMS issued a final rule on the Part B competitive bidding
program for outpatient drugs and biologicals, or CAP. CAP is to begin on July 1, 2006. Inhalation drugs dispensed through nebulizers are not to be included in the initial phase of the CAP. This means that 2006 payment amounts for inhalation
drugs administered by physicians are to be determined based upon ASP.



ASP is defined statutorily as the volume weighted average of manufacturers average sales prices, calculated by adding the manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and then
divided by the total number of units sold for all national drug codes assigned to the product. Under the ASP methodology, Medicare generally will pay 106% of ASP for multiple source drugs and 106% of



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the lesser of ASP or wholesale acquisition cost for single source drugs. In addition, for 2006, if the ASP exceeds the widely available market price by more
than 5%, CMS may substitute the widely available market price for the ASP. ASP payment rates are calculated and updated quarterly using the most recent manufacturer data available. ASP payment amounts for our products may fluctuate from quarter to
quarter, and if these payment amounts are reduced in future quarters, this could have a material adverse effect on our revenues, profitability and results of operations. For each of the quarters of 2005, as well as the first quarter of 2006, the ASP
payment amounts for many drugs, including two prevalent inhalation drugs, albuterol sulfate and ipratropium bromide, are significantly less than the payment amounts for these drugs in 2004. The payment rate, as posted by CMS, for albuterol sulfate
was reduced from $0.39 per milligram in 2004 to $0.064 for the fourth quarter of 2005 and continued to slightly decline in the first quarter of 2006, to $0.060. The payment rate, as posted by CMS, for ipratropium bromide was reduced from $2.82 per
milligram in 2004 to $0.165 for the fourth quarter of 2005 and increased slightly in the first quarter of 2006, to $0.227.



Effective January 1, 2006, CMS established a new billing code for compounded budesonide, which includes compounded inhalation medications that we
provide to Medicare beneficiaries based on a physicians prescription. Medicare payment for compounded budesonide, beginning January 1, 2006, is based on pharmacy invoices submitted for individual claims. If the resulting payment rates
using the invoice methodology are significantly less than the 2005 ASP payment rates, this payment reduction could have a material adverse effect on our revenues, profitability and results of operations.



Given the overall reduction in payment for inhalation drugs dispensed through
nebulizers, for 2005, CMS established a $57 dispensing fee for inhalation drugs shipped to a beneficiary for a 30-day period or $80 for a 90-day period. In the 2006 physician fee schedule final rule, CMS reduced the dispensing fee for inhalation
drugs furnished to beneficiaries. For 2006, the dispensing fee is $57 for the first 30-day period in which a Medicare beneficiary uses inhalation drugs and $33 for inhalation drugs dispensed for each subsequent 30-day period. For a 90-day supply of
inhalation drugs, the dispensing fee is $66.



We believe that
the reductions in the 2006 Medicare dispensing fees will result in a reduction in our 2006 projected revenue of approximately $15 million. Future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our
revenues, profitability and results of operations. While we were able, based upon the increased dispensing fees, to continue to offer inhalation drugs to Medicare patients in 2005, the reductions in dispensing fees for 2006, along with the pricing
changes resulting from the ASP payment rates are expected to result in a further material reduction in the revenues and profitability of our inhalation drug business and we cannot predict whether it will continue to be economically feasible for us
to provide inhalation drugs in the future. Reductions in Medicare reimbursement for oxygen, nebulizers and inhalation medications in 2006, many of which are expected to continue to exist for a number of years, could have a material adverse effect on
our revenues, profitability and results of operations.



Critical Accounting
Policies



The preparation of our financial statements in
accordance with generally accepted accounting principles requires us to make assumptions that affect the reported amounts of assets, liabilities and disclosure of contingencies as of the date of the financial statements, as well as the reported
amounts of revenues and expenses during the reporting periods. Critical accounting policies are those that require the most complex or subjective judgments often as a result of the need to make estimates about the effects of matters that are
inherently uncertain. Thus, to the extent that actual events differ from our estimates and assumptions, there could be a material impact to our financial statements. We believe that the critical accounting policies for our company are those related
to revenue recognition, accounts receivable, goodwill and other intangibles.



The below listing is not intended to be a comprehensive list of all our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted
accounting principles with limited or no need for managements judgment. There are also areas in which managements



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judgment in selecting available alternatives may or may not produce a materially different result. For more information, see our audited consolidated
financial statements and notes thereto.



Revenue Recognition
and Accounts Receivable



Revenues are recognized when
services and related products are provided to patients and are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors. Revenues derived from capitation arrangements are insignificant.



Our rental arrangements generally provide for fixed monthly payments
established by fee schedules (subject to capped rentals in some instances) for as long as the patient is using the equipment and medical necessity continues. Once initial delivery is made to the patient (initial setup), a monthly billing is
established based on the initial setup service date. We recognize rental arrangement revenues ratably over the monthly service period and defer revenue for the portion of the monthly bill which is unearned. No separate revenue is earned from the
initial setup process. We have no lease with the patient or third-party payor. During the rental period we are responsible for providing oxygen refills and for servicing the equipment based on manufacturers recommendations.



Revenues for the sale of durable medical equipment and related supplies,
including oxygen equipment, ventilators, wheelchairs, hospital beds and infusion pumps, are recognized at the time of delivery. Revenues for the sale of nebulizer medications, which are generally dispensed by our pharmacies and shipped directly to
the patients home, are recognized at the time of shipment.



Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk
that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may
result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review.



Management performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers
historical realization data, accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the healthcare industry and third-party reimbursement, it is possible that managements
estimates could change, which could have an impact on operations and cash flows.



Net Patient Service Revenues



We derive a significant portion of our revenues from the Medicare and Medicaid programs and from managed care health plans. Payments for services we render to patients covered by these programs may be less than billed charges. For Medicare
and Medicaid revenues, provisions for contractual adjustments are made to reduce the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively determined). Final payment
under these programs is subject to administrative review and audit, and we currently make provisions for any adjustments which may result. Our provisions for contractual adjustments under managed care health plans are based primarily on payment
terms. We closely monitor our historical contractual adjustment and bad debt rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information we believe
to be available. However, due to the complexities involved in these estimations, actual payments we receive could be different from the amounts we estimate and record.



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Provision for Doubtful Accounts



Collection of receivables from third party payors and patients is our primary source of cash and is critical to our
operating performance. Our primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We estimate provisions for
doubtful accounts based primarily upon the age of patients account, the economic ability of patients to pay and the effectiveness of our collection efforts. We routinely review accounts receivable balances in conjunction with our historical
contractual adjustment and bad debt rates and other economic conditions which might ultimately affect the collectibility of patient accounts when we consider the adequacy of the amounts we record as provision for doubtful accounts. Significant
changes in payor mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and results of operations.



Reorganization Value in Excess of Value of Identifiable
AssetsGoodwill and Intangible Assets



Reorganization
value in excess of value of identifiable assetsgoodwill, represents the portion of our reorganization value at March 26, 2002 that could not be attributed to specific tangible or identified intangible assets recorded in connection with
the implementation of fresh-start reporting.



Goodwill and
intangible assets prior to March 26, 2002, represent the excess of cost over the fair value of assets acquired and liabilities assumed in business combinations. Prior to January 1, 2002, such assets were amortized on a straight-line basis
over an estimated life of approximately 20 years.



Effective
January 1, 2002, we adopted the provisions of Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets (Statement 142). Statement 142 requires that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of Statement 142. Management has determined that branch locations have similar economic characteristics and
should be aggregated into one reporting unit for assessing fair value. If the carrying amount of the goodwill and intangible asset exceeds its fair value, an impairment loss is recognized. Fair values for goodwill and intangible assets are
determined based upon discounted cash flows, market multiples or appraised values as appropriate. As a result of adopting Statement 142, goodwill and a substantial amount of our intangible assets are no longer amortized. Pursuant to Statement 142,
goodwill and indefinite lived intangible assets must be periodically tested for impairment. We performed our annual impairment testing during our fourth quarter of each year and concluded there was no impairment of successor company goodwill or
identifiable intangibles in 2003, 2004 or 2005.



Property
and Equipment



Property and equipment are stated at cost,
adjusted for the impact of fresh start reporting. Patient service equipment represents medical equipment rented or held for rental to in-home patients. Certain patient service equipment is accounted for using a composite method, due to its
characteristics of high unit volumes of relative low dollar unit cost items. Under the composite method, the purchase cost of monthly purchases of certain patient service equipment are capitalized and depreciated over five years using the
straight-line convention, without specific physical tracking of individual items. We believe the five year depreciation period provides a proper matching of the cost of patient service equipment with the patient service revenues generated from use
of the equipment, when considering the wear and tear, damage, loss and ultimately scrapping of patient service equipment over its life. Other property and equipment (including other patient service equipment) is accounted for by a specific
identification system. Depreciation for other property and equipment is provided on the straight-line method over the estimated useful lives of the assets, seven years for furniture and office equipment, five years for vehicles, three years for
computer equipment, and the shorter of the remaining lease term or the estimated useful life for leasehold improvements.



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Capitalized Software



Included in property, equipment and improvements are costs related to internally-developed and purchased software that are
capitalized and amortized over periods from three to fifteen years. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and payroll-related costs for employees
directly involved in the development of internal-use software. The carrying value of capitalized software is reviewed if the facts and circumstances suggest that it may be impaired. Indicators of impairment may include a subsequent change in the
extent or manner in which the software is used or expected to be used, a significant change to the software is made or expected to be made or the cost to develop or modify internal-use software exceeds that expected amount. Management does not
believe any impairment of our capitalized software existed at December 31, 2005.



Income Taxes



We
account for income taxes under the asset and liability approach required by FASB Statement No. 109, Accounting for Income Taxes (Statement 109). For periods prior to March 31, 2002, under Statement 109, the current and deferred tax
expense was allocated among the members of the IHS controlled corporate group, including our predecessor.



Deferred tax assets and liabilities are determined based upon differences between financial reporting and the tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred income tax assets to amounts expected to be realized.



Contingencies



Our business is subject to extensive laws and government regulations,
including those related to the Medicare and Medicaid programs. We are also subject to a Corporate Integrity Agreement with the DHHS. Non-compliance with such laws and regulations or the Corporate Integrity Agreement could subject us to severe
sanctions, including penalties and fines.



FASB Statement
No. 5, Accounting for Contingencies, provides guidance on the application of generally accepted accounting principles related to these matters. We evaluate and record liabilities for contingencies based on known claims and legal actions
when it is probable a liability has been incurred and the liability can be reasonably estimated. We believe that our accrued liabilities related to such contingencies are appropriate and in accordance with generally accepted accounting principles.



Fresh-Start Reporting



We adopted fresh-start reporting upon our emergence from bankruptcy,
effective as of March 31, 2002. Under fresh-start reporting, our reorganization value was allocated to our assets based on their respective fair values in conformity with a method similar in nature to the purchase method of accounting for
business combinations. Any portion not attributed to specific tangible or identified intangible assets are reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. In
adopting fresh-start reporting, we engaged an independent financial advisor to assist in the determination of the reorganization value or fair value of the entity.



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##### Table of Contents

Results of Operations



The following tables show our results of operations for the years ended December 31, 2003, December 31, 2004 and December 31, 2005.



|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|-------------------------------------- |  | -------------------------------- | ------- | ---- | - | ------- | ---- |  | - | ------- | -
|                                       |  | For the Years Ended December 31, |        
|(dollars in thousands)                 |  | 2003                             |         | 2004 |   |         | 2005 | 
|Statements of Operations Data:         |  |                                  |         |      |   |         |      |  |   |         |  
|Net revenues                           |  | $                                | 580,599 |      | $ | 535,329 |      |  | $ | 533,182 |  
|Costs and expenses:                    |  |                                  |         |      |   |         |      |  |   |         |  
|Cost of net revenues:                  |  |                                  |         |      |   |         |      |  |   |         |  
|Product and supply costs               |  |                                  | 73,900  |      |   | 70,583  |      |  |   | 95,182  |  
|Patient service equipment depreciation |  |                                  | 102,819 |      |   | 61,362  |      |  |   | 47,409  |  
|Operating expenses                     |  |                                  | 16,692  |      |   | 16,784  |      |  |   | 23,595  |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|Total cost of net revenues             |  |                                  | 193,411 |      |   | 148,729 |      |  |   | 166,186 |  
|Provision for doubtful accounts        |  |                                  | 19,462  |      |   | 19,614  |      |  |   | 17,858  |  
|Selling, general and administrative    |  |                                  | 291,910 |      |   | 256,914 |      |  |   | 292,162 |  
|Depreciation and amortization          |  |                                  | 16,828  |      |   | 15,191  |      |  |   | 18,123  |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|Total costs and expenses               |  |                                  | 521,611 |      |   | 440,448 |      |  |   | 494,329 |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|Operating Income                       |  |                                  | 58,988  |      |   | 94,881  |      |  |   | 38,853  |  
|Interest expense, net                  |  |                                  | 41,177  |      |   | 33,696  |      |  |   | 31,503  |  
|Other expense (income), net            |  |                                  | 2,473   |      |   | (2,389  | )    |  |   | (1,809  | )
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|                                       |  |                                  | 43,650  |      |   | 31,307  |      |  |   | 29,694  |  
|Earnings before income taxes           |  |                                  | 15,338  |      |   | 63,574  |      |  |   | 9,159   |  
|Federal and state income taxes         |  |                                  | 6,731   |      |   | 27,564  |      |  |   | 3,613   |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|Net earnings                           |  | $                                | 8,607   |      | $ | 36,010  |      |  | $ | 5,546   |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  
|EBITDA(1)                              |  | $                                | 176,162 |      | $ | 173,823 |      |  | $ | 106,194 |  
|                                       |  |                                  |         |      |   |         |      |  |   |         |  



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The following tables show our results of operations as a percentage of net revenues for the years ended
December 31, 2003, 2004 and 2005.



|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|-------------------------------------- |  | ------------------------------- | - |  | -------------------------- | - |  | ----- | - |  | ----------- | - |  | ----------- | -
|                                       |  | For the Years EndedDecember 31, |   |  | Percent Increase(Decrease) |  
|                                       |  | 2003                            |   |  | 2004                       |   |  | 2005  |   |  | 2004vs.2003 |   |  | 2005vs.2004 |  
|Statements of Operations Data:         |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Net revenues                           |  | 100.0                           | % |  | 100.0                      | % |  | 100.0 | % |  | -7.8        | % |  | -0.4        | %
|Costs and expenses:                    |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Cost of net revenues:                  |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Product and supply costs               |  | 12.7                            | % |  | 13.2                       | % |  | 17.9  | % |  | -4.5        | % |  | 34.9        | %
|Patient service equipment depreciation |  | 17.7                            | % |  | 11.4                       | % |  | 8.9   | % |  | -40.3       | % |  | -22.7       | %
|Operating expenses                     |  | 2.9                             | % |  | 3.2                        | % |  | 4.4   | % |  | 0.6         | % |  | 40.6        | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Total cost of net revenues             |  | 33.3                            | % |  | 27.8                       | % |  | 31.2  | % |  | -23.1       | % |  | 11.7        | %
|Provision for doubtful accounts        |  | 3.4                             | % |  | 3.7                        | % |  | 3.3   | % |  | 0.8         | % |  | -9.0        | %
|Selling, general and administrative    |  | 50.3                            | % |  | 48.0                       | % |  | 54.8  | % |  | -12.0       | % |  | 13.7        | %
|Depreciation and amortization          |  | 2.9                             | % |  | 2.8                        | % |  | 3.4   | % |  | -9.7        | % |  | 19.3        | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Total costs and expenses               |  | 89.9                            | % |  | 82.3                       | % |  | 92.7  | % |  | -15.6       | % |  | 12.2        | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Operating Income                       |  | 10.1                            | % |  | 17.7                       | % |  | 7.3   | % |  | 60.8        | % |  | -59.1       | %
|Interest expense, net                  |  | 7.1                             | % |  | 6.3                        | % |  | 5.9   | % |  | -18.2       | % |  | -6.5        | %
|Other expense (income), net            |  | 0.4                             | % |  | -0.5                       | % |  | -0.3  | % |  | -196.6      | % |  | -24.3       | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|                                       |  | 7.5                             | % |  | 5.8                        | % |  | 5.6   | % |  | -28.3       | % |  | -5.2        | %
|Earnings before income taxes           |  | 2.6                             | % |  | 11.9                       | % |  | 1.7   | % |  | 314.5       | % |  | -85.6       | %
|Federal and state income taxes         |  | 1.2                             | % |  | 5.1                        | % |  | 0.7   | % |  | 309.5       | % |  | -86.9       | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  
|Net earnings                           |  | 1.4                             | % |  | 6.8                        | % |  | 1.0   | % |  | 318.4       | % |  | -84.6       | %
|                                       |  |                                 |   |  |                            |   |  |       |   |  |             |   |  |             |  

---

|(1) |  | See Selected Historical Consolidated Financial Data, note (5) on page 39 for a detailed definition of EBITDA and a reconciliation of net earnings to EBITDA. EBITDA
is commonly used as an analytical indicator within the health care industry, and also serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under generally accepted
accounting principles, and the items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by
operating, investing or financing activities or other financial statement data presented in the consolidated financial statements as an indicator of financial performance or liquidity. Because EBITDA is not a measurement determined in accordance
with generally accepted accounting principles and is thus susceptible to varying calculations, EBITDA as presented may not be comparable to other similarly titled measures of other companies.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Year ended December 31, 2005 as compared to year ended
December 31, 2004



Total net revenues for the
year ended December 31, 2005 decreased $2.1 million, or 0.4%, to $533.2 million, from the comparable period in 2004. The net decrease was primarily attributable to reductions in reimbursement rates for Medicare Part B drugs in the amount of
$38.6 million, reductions in reimbursement for HME equipment subject to FEHBP provisions and a reduction in oxygen and other equipment reimbursements in the aggregate amount of $17.7 million, offset by a 13.8% increase in oxygen and drug patient
counts (including an increase in net revenues of 2.4% related to business acquisitions) and increased DME sales and other respiratory equipment sales.



Cost of net revenues for the year ended December 31, 2005 increased $17.5 million, or 11.7%, to $166.2 million, from the comparable period in 2004.
The net increase was primarily attributable to a $24.6 million



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increase in product and supply cost resulting from an increase in the number of patients served, changes in our product mix and an increase in drug costs.
Operating costs increased $6.8 million as the result of an increase in the number of respiratory therapists employed. The foregoing increases were offset by a $14.0 million decrease in patient service equipment depreciation due to a significant
portion of our oxygen rental equipment becoming fully depreciated. Cost of net revenues as a percentage of net revenue was 31.2% for the year ended December 31, 2005 as compared to 27.8% for the comparable period in 2004.



The provision for doubtful accounts for the year ended December 31, 2005
decreased by $1.8 million, or 9.0%, to $17.9 million, from the comparable period in 2004. The provision for doubtful accounts expense as a percentage of net revenues decreased to 3.3% for the year ended December 31, 2005 as compared to 3.7% for
2004. In 2005, we experienced increased transaction volume which resulted in an increase in accounts receivable, and the related monetary increase in the allowance for doubtful accounts. In 2005, improved collection procedures resulted in the
decline of the required provision for doubtful accounts on a percentage basis.



Selling, general and administrative expenses for the year ended December 31, 2005 increased by $35.2 million, or 13.7%, to $292.2 million, from the comparable period in 2004. Selling, general and administrative
expenses as a percentage of net revenues increased to 54.8% for the year ended December 31, 2005 from 48.0% for 2004. The increase resulted primarily from both costs associated with the rollout of our announced growth strategy and the expenses
related to establishing new locations and operating newly acquired businesses which costs and expenses represent 4.1% of net revenues. The residual increase is mainly attributable to general cost inflation.



Depreciation and amortization for the year ended December 31, 2005
increased $2.9 million, or 19.3%, to $18.1 million, from the comparable period in 2004. This increase is primarily attributable to an increase in capital purchases of non-patient service equipment, computer software and computer software upgrades.



Net interest expense for the year ended December 31, 2005
decreased $2.2 million from the comparable period in 2004. The decrease is primarily attributable to the repayment of approximately $25.3 million of long-term bank debt principal during the first quarter of 2004, as well as the repurchase, in August
2004, of $13.0 million of our 9.5% senior subordinated notes due 2012.



Federal and state income taxes for the year ended December 31, 2005 decreased to $3.6 million from $27.6 million in the comparable period of 2004. The decrease in federal and state income taxes was primarily due to decreased taxable
income for the year ended December 31, 2005.



Year
ended December 31, 2004 as compared to year ended December 31, 2003



Total net revenues for the year ended December 31, 2004 decreased $45.3 million, or 7.8%, to $535.3 million, from the comparable period in 2003. The decrease was primarily attributable to a reduction in Medicare
payment rates for inhalation drugs and volume decreases, including decreases related to closing certain of our locations in 2003 due to various contract issues and failure to meet profitability targets.



Cost of net revenues for the year ended December 31, 2004 decreased
$44.7 million, or 23.1% to $148.7 million, from the comparable period in 2003. The decrease in cost of net revenues is mainly attributable to the decrease in patient service equipment depreciation of $41.5 million. In 2003, we changed the estimated
useful lives of the patient service equipment which resulted in a significant increase in patient service equipment depreciation charged for 2003. Cost of net revenues as a percentage of net revenue was 27.8% for 2004 as compared to 33.3% for 2003.



The provision for doubtful accounts for the year ended
December 31, 2004 increased by $0.2 million or 0.8% from the comparable period in 2003. The provision for doubtful accounts expense as a percentage of net revenues increased to 3.7% for the year ended December 31, 2004 as compared to 3.4%
for 2003. The increase is



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directly attributable to the current charge for a change in expense estimates for weighting percentages by aging class.



Selling, general and administrative expenses for the year ended
December 31, 2004 decreased by $35.0 million, or 12.0%, to $256.9 million, from the comparable period in 2003. The primary factors in the decrease of selling, general and administrative expenses were an $11.5 million decrease in salary expense,
a $4.6 million decrease in severance expense, a $6.6 million decrease in bonuses, and an $11.3 million decrease in insurance costs with the remainder attributable to a continued focus on cost controls. Selling, general and administrative expenses as
a percentage of net revenues decreased to 48.0% for the year ended December 31, 2004 from 50.3% for the year ended December 31, 2003.



Depreciation and amortization for the year ended December 31, 2004 decreased $1.6 million, or 9.7%, to $15.2 million, from the comparable period in
2003. The primary reason for the decrease was a decline in capital purchases of non-patient service equipment.



Interest expense, net for the year ended December 31, 2004 decreased $7.5 million from the comparable period in 2003. The decrease is primarily
attributable to debt payments in the amount of $25.3 million on our term loan and the repurchase, in August 2004, of $13 million of our 91/2% senior subordinated notes due 2012 with respect to which we paid a premium of $0.9
million associated with the retirement of such notes.



Federal and state income taxes for the year ended December 31, 2004 increased $20.8 million to $27.6 million, from the comparable period in 2003. The increase in federal and state income taxes was due to much higher earnings before
income taxes in the year ended December 31, 2004.



Liquidity and
Capital Resources



Net cash provided by operating
activities was $60.7 million for the year ended December 31, 2005 and was $134.2 million for the year ended December 31, 2004. Cash flows and cash on hand in both years were sufficient to fund capital expenditures and required repayments
of debt.



Accounts receivable before allowance for doubtful
accounts increased from $74.2 million at December 31, 2004 to $90.2 million at December 31, 2005. Days sales outstanding (calculated as of each period end by dividing accounts receivable, less allowance for doubtful accounts, by the 90-day
rolling average of net revenue) were 49 days at December 31, 2005 compared to 42 days at December 31, 2004. The increase in accounts receivable was primarily attributable to an increase in receivables from acquisitions held for assignment
of Medicare provider numbers.



Included in accounts receivable
are earned but unbilled receivables of $28.1 million at December 31, 2005 and $21.1 million at December 31, 2004. Delays, ranging from a day to several weeks, between the date of service and billing can occur due to delays in obtaining
certain required payor-specific documentation from internal and external sources. Earned but unbilled receivables are aged from date of service and are considered in our analysis of historical performance and collectibility.



Due to the nature of the industry and the reimbursement environment in which
we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes
available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are
typically identified and recorded at the point of cash application, claim denial or account review.



Management performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data,
accounts receivable aging trends, other operating trends and



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relevant business conditions. Because of continuing changes in the health care industry and third-party reimbursement, it is possible that managements
estimates could change, which could have an impact on operations and cash flows.



We derive a significant portion of our revenues from the Medicare and Medicaid programs and from managed care health plans. Payments for services rendered to patients covered by these programs may be less than billed
charges. For Medicare and Medicaid revenues, provisions for contractual adjustments are made to reduce the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively
determined). Final payment under these programs is subject to administrative review and audit, and management currently makes provisions for any adjustments which may result. Our provisions for contractual allowances under managed care health plans
are based primarily on payment terms. Management closely monitors its historical collection rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate
information management believes to be available. However, due to the complexities involved in these estimations, actual payments we receive could be different from the amounts we estimate and record.



Collection of receivables from third party payors and patients is our primary
source of cash and is critical to our operating performance. Our primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain
outstanding. We estimate provisions for doubtful accounts based primarily upon the age of patients account, the economic ability of patients to pay and the effectiveness of our collection efforts. We routinely review accounts receivable
balances in conjunction with our historical contractual adjustment and bad debt rates and other economic conditions which might ultimately affect the collectibility of patient accounts when we consider the adequacy of the amounts we record as
provision for doubtful accounts. Significant changes in payor mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and
results of operations.



Because of continuing changes in the
health care industry and third-party reimbursement, it is possible that managements estimates could change, which could have an impact on operations and cash flows. Our future liquidity may be materially adversely impacted by the Medicare
Prescription Drug, Improvement and Modernization Act of 2003. See Risk Factors above.



Net cash used in investing activities was $109.5 million and $54.0 million for the years ended December 31, 2005 and December 31, 2004,
respectively. We currently have no contractual commitments for capital expenditures over the next twelve months other than to acquire equipment as needed to supply our patients. Our business requires us to make significant capital expenditures
relating to the purchase and maintenance of the medical equipment used in our business. Capital expenditures totaled approximately $78.8 million for the year ended December 31, 2005 and $54.0 million for the year ended December 31, 2004,
representing 14.8% and 10.1% of our net revenues for each period, respectively. The increase in 2005 is attributed primarily to an increase in patient service equipment and enhancement and upgrades of software and computer systems. Cash outlays for
businesses acquired totaled $30.8 million for the year ended December 31, 2005. No businesses were acquired in 2004.



Cash flows used in financing activities primarily relate to repayment of debt facilities entered into on the effective date of our predecessors plan
of reorganization on March 26, 2002. As of December 31, 2005, we had the following debt facilities and outstanding debt:



| |  |  | a five-year $75 million senior secured revolving credit facility for general corporate purposes including working capital, capital expenditures and acquisitions. We did not draw
down on the revolving credit facility during 2005, although standby letters of credit totaling $12.7 million have been issued under this credit facility. Please see the section captioned BusinessSenior Secured Credit Facilities for
discussion of our senior secured credit facilities.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | a six-year $200 million senior secured term loan, the proceeds of which were used to repay certain pre-petition claims owed to our predecessors creditors as part of its plan
of reorganization. The term loan is repayable in an aggregate annual amount equal to 1% of the principal amount each year for the first five years with the balance due in year six. Interest is payable based on the election of the LIBOR rate plus
3.00% or the prime rate plus 2.00%. The term loan was advanced as a LIBOR rate advance. During 2005, we made regularly scheduled amortization payments of $0.4 million on the term loan. As of December 31, 2005 and December 31, 2004, we had
balances of $42.2 million and $42.7 million outstanding, respectively, under our term loan. At December 31, 2005, the term loan interest rate was 7.53%. Interest paid during the years ended December 31, 2005 and 2004 was $2.7 million and
$2.9 million, respectively.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an aggregate principal amount of $300 million of 91/2% senior subordinated notes, the proceeds of which were used to repay certain pre-petition
claims owed to the creditors of our predecessor as part of its plan of reorganization. The notes mature on April 1, 2012. Interest of 91/2% is payable semi-annually in arrears on April 1 and October 1 of each
year. As of both December 31, 2004 and December 31, 2005, we had a balance of $287 million outstanding. Interest paid during the years ended December 31, 2005 and 2004 was $27.3 million and $28.3 million, respectively.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Borrowings under the revolving
credit facility and term loan are secured by substantially all of our assets and the agreements with respect to such credit facility and term loan impose numerous restrictions, including, but not limited to, covenants requiring the maintenance of
certain financial ratios, limitations on additional borrowing, capital expenditures, acquisitions and investments. On June 15, 2005, we obtained a waiver of any defaults and events of default that arose under our credit agreement due to our
failure to timely deliver (i) our unaudited financial statements for the quarter ended March 31, 2005 and other related deliverables and (ii) an appraisal of certain of our assets. In July 2005, we delivered such financial statements
and other required documents in compliance with the terms of the waiver. As of September 30, 2005, we were not in compliance with certain financial condition covenants under our credit agreement. However, on November 8, 2005, we entered
into a third amendment to our credit agreement which, among other things (i) modified the meaning of Material Acquisition as used in the definition of Consolidated EBITDA, (ii) reset the ratio levels for the financial condition
covenants, (iii) reduced permitted capital expenditures for the years 2006 and 2007, (iv) increased our existing ability to make acquisitions by $10 million for 2006 and each year thereafter, provided that certain additional conditions and
requirements are met (the Acquisition Conditions), and (v) gave us the ability to make additional acquisitions up to an aggregate amount of $30 million, provided that each such acquisition or related series of acquisitions shall
(A) be in an amount equal to or greater than $15 million, (B) meet all or certain of the Acquisition Conditions depending on the type of acquisition, and (C) pass a stricter total leverage ratio test. As a result of the reset
financial ratio levels included in the third amendment to our credit agreement, we regained compliance with the financial condition covenants under our credit agreement. As of December 31, 2005, we were in compliance with the financial
condition covenants under our credit agreement.



Our working
capital requirements relate primarily to the working capital needed for general corporate purposes and our desire to grow through internal growth supplemented by selective acquisitions primarily in non-urban markets. Our business requires us to make
significant capital expenditures relating to the purchase and maintenance of the medical equipment used in our business. We do not expect to exceed our debt limitations for capital expenditures during the year ended December 31, 2006. We have
historically satisfied our working capital requirements and capital expenditures from operating cash flow. We believe that the cash generated from our operations, together with amounts available under our $75 million senior secured revolving credit
facility, will be sufficient to meet our working capital, capital expenditure and other cash needs into 2007. During the first quarter of 2006, we closed one business acquisition and are in the process of closing other business acquisitions that may
utilize operating cash flows in the range of $1 million to $10 million. In January 2006, we drew down approximately $10.0 million of our $75 million senior secured revolving credit facility. As of March 6, 2006, we had $52.3 million available for
drawdown on the senior secured revolving credit facility.



Effective December 5, 2003, our board of directors adopted a policy of declaring dividends to the holders of the Series A convertible redeemable preferred stock under the Rotech Healthcare Inc. Employees Plan on an



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annual basis, with each such declaration to be made at the annual meeting of the board of directors with respect to dividends payable for the preceding year.
Such policy commenced at the 2004 annual meeting of the board of directors and, in order to account for the period from the inception of the Rotech Healthcare Inc. Employees Plan to such date, the first declaration of dividends covered the preceding
two years. Accordingly, in June 2004, dividends in amount of $900,000 were declared on our Series A convertible redeemable preferred stock, which were paid in the first quarter of 2005. At the 2005 annual meeting of the board of directors held on
September 27, 2005, dividends in the amount of $450,000 were declared on our Series A convertible redeemable preferred stock. Such dividends were paid during the fourth quarter of fiscal 2005.



Effective August 3, 2004, we repurchased $13.0 million of our
91/2% senior subordinated notes due 2012 resulting in a loss on extinguishment of debt of $0.9 million for the premium paid in association with the retirement of such notes. The resulting loss on extinguishment of debt charge is
included in selling, distribution and administrative expenses. In addition, effective October 12, 2004, we repurchased 804 shares of our Series A convertible redeemable preferred stock from the Rotech Healthcare Inc. Employees Plan for
approximately $0.02 million in order to fund the cash payment of benefits from the Rotech Healthcare Inc. Employees Plan to certain plan participants that are no longer employed by us.



In order to maintain compliance with certain requirements of Federal law
applicable to the Rotech Healthcare Inc. Employees Plan, we made a cash contribution to the plan in the amount of $0.5 million during the fourth quarter of 2005.



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Selected Quarterly Financial Data (unaudited)



The following tables present our unaudited quarterly results of operations for 2004 and 2005. The following tables should be
read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. This unaudited information has been prepared on a basis consistent with the audited consolidated financial statements contained in
this report and includes all adjustments, consisting only of normal recurring adjustments, that are considered necessary for a fair presentation of our financial position and operating results for the quarters presented. No conclusions should be
drawn about our future results from the results of operations for any quarter.



The following is a summary of quarterly financial results for the years ended December 31, 2004 and December 31, 2005:



|                                            |  |                                       |         |              |   |                   |  |                                 |         |               |   |         |              |   |                   |   |                  |   |         |  |   |         |  |   |        
|------------------------------------------- |  | ------------------------------------- | ------- | ------------ | - | ----------------- |  | ------------------------------- | ------- | ------------- | - | ------- | ------------ | - | ----------------- | - | ---------------- | - | ------- |  | - | ------- |  | - | -------
|                                            |  | Three Months Ended                   
|                                            |  | March 31,2004                         |         | June 30,2004 |   | September 30,2004 |  | December 31,2004, asrestated(a) |         | March 31,2005 |   |         | June 30,2005 |   | September 30,2005 |   | December 31,2005
|                                            |  | (in thousands, except per share data) |         |             
|Summary Statement of Operations Information |  |                                       |         |              |   |                   |  |                                 |         |               |   |         |              |   |                   |   |                  |   |         |  |   |         |  |   |        
|Net revenues                                |  | $                                     | 133,010 |              | $ | 135,526           |  | $                               | 127,112 |               | $ | 139,682 |              | $ | 123,253           |   |                  | $ | 133,043 |  | $ | 136,969 |  | $ | 139,917
|Cost of net revenues                        |  |                                       | 36,248  |              |   | 37,438            |  |                                 | 37,112  |               |   | 43,009  |              |   | 39,153            |   |                  |   | 41,743  |  |   | 43,095  |  |   | 48,391 
|Net earnings (loss)                         |  |                                       | 9,135   |              |   | 12,862            |  |                                 | 5,074   |               |   | 8,939   |              |   | (2,953            | ) |                  |   | 1,077   |  |   | 3,103   |  |   | 4,320  
|Net earnings per common sharebasic         |  |                                       | 0.36    |              |   | 0.51              |  |                                 | 0.20    |               |   | 0.35    |              |   | (0.12             | ) |                  |   | 0.04    |  |   | 0.12    |  |   | 0.17   
|Net earnings per common sharediluted       |  |                                       | 0.35    |              |   | 0.49              |  |                                 | 0.19    |               |   | 0.34    |              |   | (0.12             | ) |                  |   | 0.04    |  |   | 0.12    |  |   | 0.17   
|Market prices:                              |  |                                       |         |              |   |                   |  |                                 |         |               |   |         |              |   |                   |   |                  |   |         |  |   |         |  |   |        
|High                                        |  |                                       | 24.00   |              |   | 26.50             |  |                                 | 24.60   |               |   | 28.20   |              |   | 28.45             |   |                  |   | 27.70   |  |   | 27.77   |  |   | 23.70  
|Low                                         |  |                                       | 20.25   |              |   | 20.75             |  |                                 | 18.75   |               |   | 20.00   |              |   | 25.00             |   |                  |   | 24.10   |  |   | 22.02   |  |   | 15.00  

---

|(a) |  | As restated, see Note 21 to the consolidated financial statements included in Rotech Healthcare Inc.s annual report on Form 10-K/A for the year ended December 31, 2004.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Contractual Obligations



As of December 31, 2005, our future contractual cash obligations are as
follows:



|                                                                                 |  |                                       |         |                 |   |           |  |           |         |                  |   |        |  |   |        
|-------------------------------------------------------------------------------- |  | ------------------------------------- | ------- | --------------- | - | --------- |  | --------- | ------- | ---------------- | - | ------ |  | - | -------
|Contractual Obligations (1)                                                      |  | Payments due by period (in thousands)
|                                                                                 |  | Total                                 |         | Less than1 year |   | 1-3 years |  | 3-5 years |         | More than5 years
|Obligations related to our senior secured notes and senior secured term loan (2) |  | $                                     | 506,002 |                 | $ | 30,872    |  | $         | 99,463  |                  | $ | 54,530 |  | $ | 321,137
|Operating lease obligations (3)                                                  |  |                                       | 55,036  |                 |   | 21,516    |  |           | 23,158  |                  |   | 9,873  |  |   | 489    
|Other liabilities reflected on our balance sheet under GAAP (4)                  |  |                                       | 4,727   |                 |   | 1,291     |  |           | 2,229   |                  |   | 1,207  |  |   | 0      
|Total                                                                            |  | $                                     | 565,765 |                 | $ | 53,679    |  | $         | 124,850 |                  | $ | 65,610 |  | $ | 321,626

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|(1) |  | We do not have any purchase obligations other than standard purchase orders in the ordinary course of business.
|--- |  | ---------------------------------------------------------------------------------------------------------------



|(2) |  | Our debt is comprised of our $287 million of 91/2% senior secured notes due 2012, our senior secured term loan and related interest charges.
See Note 9 to the consolidated financial statements included in this report for a discussion of our long-term debt.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) |  | Our operating lease obligations are primarily comprised of building and vehicle lease commitments. See Note 10 to the consolidated financial statements included in this report for
further discussion of our lease commitments.
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|(4) |  | Our other liabilities reflected on our balance sheet primarily relate to the priority tax claim and the required future payments for capital lease obligations.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



Off-balance Sheet Arrangements



We do not have off-balance sheet arrangements (as that term is defined in
Item 303(a)(4)(ii) of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.



Recent Accounting Pronouncements



In December 2004, the FASB issued Statement No. 123R, Share Based
Payment (Statement 123R). This statement revises Statement 123 and supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash Flows. This statement requires companies to expense the fair value of employee services received
in exchange for an award of equity instruments, including stock options. Statement 123R also provides guidance on valuing and expensing these awards, as well as disclosure requirements with respect to these equity arrangements.



We adopted Statement 123R effective as of January 1, 2006. We are
following the modified prospective method of adoption of Statement 123R whereby earnings for prior periods will not be restated as though stock based compensation had been expensed, rather than the modified retrospective
method which would entail restatement of previously published earnings. Statement 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash
flow, but this will not have a significant impact on our cash flow reporting. The impact of adoption of Statement 123R will depend on levels of share-based compensation, particularly stock options, granted in the future and the fair value assigned
thereto. We do not expect that the adoption of Statement 123R will have a material financial impact on us, unless a significant number of new options are granted.



In November 2005, our Board of Directors approved the acceleration of the vesting of all the previously unvested stock
options granted under the Rotech Healthcare Inc. Common Stock Option Plan (the Option Plan), effective November 22, 2005, representing options exercisable for the total of 1,148,187 shares of our common stock, including a total of 436,309
shares of common stock underlying options held by our executive officers. This acceleration is expected to reduce after-tax stock option expense that we would otherwise have been required to record by approximately $4.4 million. Of this amount,
which represents four years of charges with regard to the affected shares, approximately $0.9 million would have been recorded in our 2006 fiscal year absent the acceleration. The acceleration of the vesting schedule of our options was effected
pursuant to Section 5(a)(iv) of the Option Plan. Typically, stock options granted under the Option Plan vest over a four-year period. The decision to accelerate the vesting of stock options is expected to have a positive effect on employee
morale and employee retention.



Immediately prior to
November 22, 2005, all of our unvested options under the Option Plan had stated exercise prices that exceeded the current market price of our common stock and were out-of-the-money. Such options have exercise prices ranging from
$17.00 to $27.55 per share and represent approximately 36% of our total outstanding stock options. Except for the accelerated vesting of the options issued under the Option Plan, all other terms and conditions of the options granted under the Option
Plan remain the same.



In May 2005, FASB issued Statement 154,
Accounting Changes and Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement No. 3 (Statement 154). Statement 154 changes the requirements for the accounting for and reporting of a change in accounting
principle, and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This
statement requires retrospective application to prior periods financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Statement
154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. We do not expect that adoption of this Statement 154 will have a material impact on our results of operations or financial condition.



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Inflation



We have not experienced large increases in either the cost of supplies or operating expenses due to inflation. With reductions in reimbursement by
government and private medical insurance programs and pressure to contain the costs of such programs, we bear the risk that reimbursement rates set by such programs will not keep pace with inflation.



ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Concurrently with our predecessors emergence from bankruptcy and the transfer to us of its business and operations, we entered into (i) a
five-year $75 million senior secured revolving credit facility and (ii) a six-year $200 million senior secured term loan. Our earnings may be affected by changes in interest rates relating to these debt facilities. Variable interest rates may
rise, which could increase the amount of interest expense. In March 2002, in consideration for the transfer of the assets of our predecessor to us, we borrowed the entire amount of the $200 million term loan and transferred the proceeds of that loan
to Rotech Medical Corporation to fund a portion of the cash distributions made by Rotech Medical Corporation in connection with its plan of reorganization. During 2005, the $75 million senior secured revolving credit facility had not been drawn
upon, although standby letters of credit totaling $12.7 million have been issued under this credit facility. As of December 31, 2005, $42.2 million was outstanding on the $200 million senior secured term loan. In January 2006, the Company drew
down approximately $10.0 million of the $75 million senior secured revolving credit facility. For the year ended December 31, 2005, we incurred $31.5 million of interest expense on our long-term debt. Assuming a hypothetical increase of one
percentage point for the variable interest rate applicable to the debt facilities (of which $52.2 million was outstanding as of March 6, 2006), we would incur approximately $0.5 million in additional interest expense for the period
January 1, 2006 through December 31, 2006.



|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------



The financial statements and other financial information that are required by Item 8 are listed in Item 15 of Part IV. The financial statements
and supplementary financial information referenced in Item 15 are incorporated in this Item 8 by reference.



|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------



None.



ITEM 9A.    CONTROLS AND PROCEDURES



Disclosure Controls and Procedures



Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended, (the Exchange Act)) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our principal executive officer and principal
financial officer have concluded, as of the end of such period, that our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in our
reports that we file or submit under the Exchange Act.



Managements
Annual Report on Internal Control over Financial Reporting



Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Under the supervision and with the participation of our
management, including our principal executive officer and principal financial officer, we



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conducted an evaluation of the effectiveness of our internal control over financial reporting based on criteria established in the framework in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of
December 31, 2005.



Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.



Our independent registered public accounting firm, Deloitte & Touche LLP, has audited managements assessment of the effectiveness of our internal control over financial reporting as of December 31,
2005 as stated in their report which appears below. Deloitte & Touche LLP has also audited the financial statements included in this Annual Report on Form 10-K.



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders of

Rotech Healthcare Inc.

Orlando, Florida



We have
audited managements assessment, included in the accompanying Management Annual Report on Internal Control Over Financial Reporting of Rotech Healthcare Inc., that Rotech Healthcare Inc. and subsidiaries (the Company) maintained
effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The
Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on
managements assessment and an opinion on the effectiveness of Companys internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinions.



A companys
internal control over financial reporting is a process designed by, or under the supervision of, the companys principal executive and principal financial officers, or persons performing similar functions, and effected by the companys
board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting
principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts
and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the companys assets that could have a material effect on the financial statements.



Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override
of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal



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control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.



In our opinion, managements assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.



We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2005 of the Company and our report dated March 16, 2006 expressed an unqualified
opinion on those financial statements and financial statement schedule.



/s/    DELOITTE & TOUCHE LLP



Certified Public Accountants

Orlando, Florida

March 16, 2006



Changes in Internal Control over Financial Reporting



We evaluate our internal control over financial reporting on a regular
basis. If we identify a problem in our internal control over financial reporting during the course of our evaluations, we consider what revision, improvement and/or correction to make in order to ensure that our internal controls are effective. We
are currently in the process of enhancing internal controls to address issues identified through these evaluations, including ongoing improvements in our billing centers, increased system controls and improved controls over rental equipment to
provide more accurate and complete tracking. Pending full implementation of these enhancements, we have instituted additional procedures and policies to preserve our ability to accurately record, process and summarize financial data and prepare
financial statements for external purposes that fairly present our financial condition, results of operations and cash flows. Our principal executive and financial officers recognize that any set of controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Accordingly, we intend to continue to refine our internal control over financial reporting on an ongoing basis as we deem appropriate with a
view towards making improvements.



We have made no changes
during the fourth quarter of fiscal year 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



ITEM 9B.    OTHER INFORMATION



In our earnings release which was furnished to the Securities and Exchange Commission as an exhibit to our current report on Form 8-K dated February 23, 2006, we reported, as of December 31, 2005, other current assets
in the amount of $28.5 million of which $23.9 million was a current deferred tax asset. In connection with the completion of our audit for the year ended December 31, 2005, we reclassified our deferred tax asset of $34.7 million relating to net
operating loss carry-forwards from a current asset to a long-term asset. The reclassification is attributable to our estimate that we will not have sufficient taxable income in the current period to offset the net operating loss carry-forward. See
Note 11 to the consolidated financial statements included in this report for more information regarding our deferred tax liabilities and assets.



57



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##### Table of Contents

PART III



ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The information required by Part III, Item 10, to the extent not provided herein, is incorporated herein by reference to our definitive proxy
relating to the 2006 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K. Information regarding our executive officers is set forth under
the caption Executive Officers in Item 1 hereof.



Code of
Ethics



We have adopted a code of ethics that applies to
the members of our board of directors, principal executive officer, principal financial officer and other persons performing similar functions. We have also issued a Policy Statement on Business Ethics and Conflicts of Interests which is applicable
to all employees. Our code of ethics and Policy Statement on Business Ethics and Conflicts of Interests are posted on our internet website, www.rotech.com, and are available, without charge, upon written request directed to the Chief Legal
Officer, Rotech Healthcare Inc., 2600 Technology Drive, Suite 300, Orlando, Florida, 32804.



ITEM 11.    EXECUTIVE COMPENSATION



The information required by Part III, Item 11, to the extent not provided herein, is incorporated herein by reference to our definitive proxy statement relating to the 2006 annual meeting of shareholders to be
filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

AND RELATED STOCKHOLDER MATTERS



The information required by Part III, Item 12, to the extent not provided herein, is incorporated herein by reference
to our definitive proxy statement relating to the 2006 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The information required by Part III, Item 13, to the extent not provided herein, is incorporated herein by reference to our definitive proxy
statement relating to the 2006 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES



The information required by Part III, Item 14, to the extent not provided herein, is incorporated herein by reference to our definitive proxy
statement relating to the 2006 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



58



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##### Table of Contents

PART IV



ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



(a) The following documents are filed as part of this report:



|   |  |                                                                                                                                                                                                                |  |        
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
|   |  |                                                                                                                                                                                                                |  | PageNo.
|1. |  | Index to Financial Statements                                                                                                                                                                                  |  | F-1    
|   |  | Report of Independent Registered Public Accounting Firm                                                                                                                                                        |  | F-2    
|   |  | Consolidated Balance Sheets as of December 31, 2004 and 2005                                                                                                                                                   |  | F-3    
|   |  | Consolidated Statements of Operations for the years ended December 31, 2003, December 31, 2004 and December 31, 2005                                                                                           |  | F-4    
|   |  | Consolidated Statements of Changes in Stockholders Equity for the years ended December 31, 2003, December 31, 2004 and December 31,
2005                                                                      |  | F-5    
|   |  | Consolidated Statements of Cash Flows for the years ended December 31, 2003, December 31, 2004 and December 31, 2005                                                                                           |  | F-6    
|   |  | Notes to Consolidated Financial Statements                                                                                                                                                                     |  | F-7    
|   |  |                                                                                                                                                                                                               
|2. |  | Index to Financial Statement Schedule                                                                                                                                                                          |  |        
|   |  |                                                                                                                                                                                                               
|   |  | Schedule IIValuation and Qualifying Accounts for the years ended December 31, 2003, December 31, 2004 and December 31, 2005                                                                                   |  | 60     
|   |  |                                                                                                                                                                                                               
|   |  | Schedules other than those listed above are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.                                         |  |        
|   |  |                                                                                                                                                                                                               
|3. |  | Exhibits                                                                                                                                                                                                       |  |        
|   |  |                                                                                                                                                                                                               
|   |  | The exhibits required by Item 601 of Regulation S-K filed as part of, or incorporated by reference in, this report are listed in the accompanying Exhibit Index found after the signature page to
this report. |  |        



(b) See
Item 15(a)(3).



(c) See Item 15(a)(2).



59



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##### Table of Contents

SCHEDULE II



VALUATION AND QUALIFYING ACCOUNTS



For the years ended December 31, 2003, 2004 and 2005

(Dollars in thousands)



|                                       |  |                              |        |                             |   |                         |  |               |  |   |                          |   |  |   |       
|-------------------------------------- |  | ---------------------------- | ------ | --------------------------- | - | ----------------------- |  | ------------- |  | - | ------------------------ | - |  | - | ------
|                                       |  |                              |        | Additions                   |   |                         |  |               | 
|                                       |  | Balance atBeginningof Period |        | Charged toCosts andExpenses |   | Charged toOtherAccounts |  | Deductions(1) |  |   | Balance at End of Period
|Deducted from asset accounts:          |  |                              |        |                             |   |                         |  |               |  |   |                          |   |  |   |       
|Allowance for Contractual Adjustments: |  |                              |        |                             |   |                         |  |               |  |   |                          |   |  |   |       
|Year ended December 31, 2003           |  | $                            | 36,805 |                             | $ | 55,483                  |  |              |  | $ | (63,859                  | ) |  | $ | 28,429
|Year ended December 31, 2004           |  |                              | 28,429 |                             |   | 39,411                  |  |              |  |   | (40,266                  | ) |  |   | 27,574
|Year ended December 31, 2005           |  |                              | 27,574 |                             |   | 44,687                  |  |              |  |   | (49,176                  | ) |  |   | 23,085
|Allowance for Doubtful Accounts:       |  |                              |        |                             |   |                         |  |               |  |   |                          |   |  |   |       
|Year ended December 31, 2003           |  | $                            | 9,201  |                             | $ | 19,462                  |  |              |  | $ | (19,187                  | ) |  | $ | 9,476 
|Year ended December 31, 2004           |  |                              | 9,476  |                             |   | 19,614                  |  |              |  |   | (19,899                  | ) |  |   | 9,191 
|Year ended December 31, 2005           |  |                              | 9,191  |                             |   | 17,858                  |  |              |  |   | (12,283                  | ) |  |   | 14,766

---

|(1) |  | To record write-offs.
|--- |  | ---------------------



60



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##### Table of Contents

SIGNATURES



In accordance with
Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                      |  |  |  |                        |  |                         |  |                                                                                      
|--------------------- |  |  |  | ---------------------- |  | ----------------------- |  | -------------------------------------------------------------------------------------
|                      |  |  |  | ROTECH HEALTHCARE INC.
|                      |  |  | 
|Dated: March 16, 2006 |  |  |  | By:                    |  | /s/    PHILIP L. CARTER
|                      |  |  |  |                        |  |                         |  | Philip L. Carter, President and Chief Executive Officer (Principal Executive Officer)



POWER OF ATTORNEY



KNOW ALL MEN BY THESE PRESENTS, that each person whose
signature appears below hereby constitutes and appoints Philip L. Carter and Rebecca L. Myers, and each of them, as his true and lawful attorneys-in-fact, as agent with full power of substitution and resubstitution, for him and in his name, place
and stead, in any and all capacities, to sign any or all amendments (including post-effective amendments) to this Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, granting to each such attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully and to all intents and purposes as he
might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.



In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                          |  |                                                                               |  |               
|----------------------------------------- |  | ----------------------------------------------------------------------------- |  | --------------
|                                          |  |                                                                              
|/s/    PHILIP L. CARTERPhilip L. Carter   |  | President, Chief Executive Officer and Director (Principal Executive Officer) |  | March 16, 2006
|                                          |  |                                                                              
|/s/    BARRY E. STEWARTBarry E. Stewart   |  | Chief Financial Officer (Principal Financial and Accounting Officer)          |  | March 16, 2006
|                                          |  |                                                                              
|/s/    ARTHUR J. REIMERSArthur J. Reimers |  | Chairman of the Board                                                         |  | March 16, 2006
|                                          |  |                                                                              
|/s/    JAMES H. BLOEMJames H. Bloem       |  | Director                                                                      |  | March 16, 2006
|                                          |  |                                                                              
|/s/    BARBARA B. HILLBarbara B. Hill     |  | Director                                                                      |  | March 16, 2006
|                                          |  |                                                                              
|/s/    EDWARD L. KUNTZEdward L. Kuntz     |  | Director                                                                      |  | March 16, 2006
|                                          |  |                                                                              
|/s/    WILLIAM J. MERCERWilliam J. Mercer |  | Director                                                                      |  | March 16, 2006
|                                          |  |                                                                              
|/s/    ARTHUR SIEGELArthur Siegel         |  | Director                                                                      |  | March 16, 2006



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EXHIBIT INDEX



|              |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Title                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|              | 
|2.1(a)        |  | Second Amended Joint Plan of Reorganization of Rotech Medical Corporation and its subsidiaries under Chapter 11 of the Bankruptcy Code dated February 7, 2002.                                                                                                                                                                                                                                                                                                                                                                                                            
|              | 
|3.1(b)        |  | Certificate of Incorporation of Rotech Healthcare Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|              | 
|3.2(c)        |  | Amended and Restated Bylaws of Rotech Healthcare Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|              | 
|4.1(b)        |  | Form of specimen common stock certificate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|              | 
|4.2(a)        |  | Indenture dated as of March 26, 2002 by and among Rotech Healthcare Inc., each of the Guarantors named therein and The Bank of New York.                                                                                                                                                                                                                                                                                                                                                                                                                                  
|              | 
|4.3(a)        |  | Form of 91/2% Senior Subordinated Notes due 2012
(included with Exhibit 4.2).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|              | 
|10.1(d)       |  | Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|              | 
|10.2(d)       |  | Amendment No. 1 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|              | 
|10.3(e)       |  | Amendment No. 2 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|              | 
|10.4(f)       |  | Amendment No. 3 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|              | 
|10.5(g)       |  | Form of Common Stock Option Agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|              | 
|10.6(d)       |  | Rotech Healthcare Inc. Nonemployee Director Restricted Stock Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|              | 
|10.7(d)       |  | Form of Restricted Stock Award Agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|              | 
|10.8(c)       |  | Rotech Healthcare Inc. Senior Management Incentive Plan (2005-2007).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|              | 
|10.9(a)       |  | $275,000,000 Credit Agreement among Rotech Healthcare Inc., as Borrower, The Several Lenders From Time to Time Parties hereto, UBS Warburg LLC and Goldman Sachs Credit Partners L.P., as Joint
Lead Arrangers and Joint Bookrunners, Goldman Sachs Credit Partners L.P., as Syndication Agent, The Bank of Nova Scotia, Deutsche Banc Alex. Brown Inc. and General Electric Capital Corporation, as Co-Documentation Agents, General Electric Capital
Corporation, as Collateral Agent, and UBS AG, Stamford Branch, as Administrative Agent, dated as of March 26, 2002.
|              | 
|10.10(h)      |  | Amendment, dated as of December 31, 2002, to the Companys $275,000,000 Credit Agreement dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|              | 
|10.11(i)      |  | Second Amendment and Waiver, dated as of June 7, 2004, to the Companys $275,000,000 Credit Agreement dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|              | 
|10.12(j)      |  | Third Amendment, dated as of November 8, 2005, to the Companys $275,000,000 Credit Agreement dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|              | 
|10.13(a)      |  | Registration Rights Agreement dated as of March 26, 2002, by and among Rotech Healthcare Inc., each of the entities listed on Schedule A thereto, and UBS Warburg LLC, Goldman, Sachs &
Co., Deutsche Banc Alex. Brown Inc. and Scotia Capital (USA) Inc.                                                                                                                                                                                                                                                                                                                 
|              | 
|10.14(b)      |  | Amended and Restated Registration Rights Agreement dated June 21, 2002, between Rotech Healthcare Inc., and Oaktree Capital Management, LLC and General Electric Capital
Corporation.                                                                                                                                                                                                                                                                                                                                                                                     
|              | 
|10.15(a)      |  | Transfer Agreement between Rotech Healthcare Inc. and Rotech Medical Corporation dated March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|              | 
|10.16(a)      |  | Tax Sharing Agreement among Integrated Health Services, Inc., Rotech Healthcare Inc. and Rotech Medical Corporation dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                           
|              | 
|10.17(g)      |  | Trust Agreement by and among Wachovia Bank, National Association and Rotech Healthcare Inc. dated July 27, 2004 with respect to the Rotech Healthcare Inc. Employees Plan.                                                                                                                                                                                                                                                                                                                                                                                                
|              | 
|10.18(k)      |  | Amendment and Restatement of the Rotech Healthcare Inc. Employees Plan effective January 1, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



62



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##### Table of Contents

|              |  |                                                                                                                                                                               
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Title                                                                                                                                                                         
|              | 
|10.19(a)      |  | Corporate Integrity Agreement with the Office of Inspector General of the United States Department of Health and Human Services dated February 11, 2002.                      
|              | 
|10.20(c)      |  | First Amended and Restated Employment Agreement with Philip L. Carter dated January 31, 2005.                                                                                 
|              | 
|10.21(c)      |  | First Amended and Restated Employment Agreement with Michael R. Dobbs dated January 31, 2005.                                                                                 
|              | 
|10.22(f)      |  | Addendum to the Employment Agreement between Rotech Healthcare Inc. and Philip L. Carter dated March 19, 2004.                                                                
|              | 
|10.23(f)      |  | Addendum to the Employment Agreement between Rotech Healthcare Inc. and Michael R. Dobbs dated March 19, 2004.                                                                
|              | 
|10.24(c)      |  | Letter agreement with Barry E. Stewart with Respect to Rights upon Termination of Employment dated August 10, 2004.                                                           
|              | 
|12.1          |  | Ratio of Earnings to Fixed Charges                                                                                                                                            
|              | 
|21.1          |  | List of Subsidiaries.                                                                                                                                                         
|              | 
|23.1          |  | Consent of Deloitte & Touche LLP, independent registered public accountants.                                                                                                  
|              | 
|24.1          |  | Power of Attorney (included on signature page of this report).                                                                                                                
|              | 
|31.1          |  | Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       
|              | 
|31.2          |  | Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       
|              | 
|32.1          |  | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

---

|(a) |  | Incorporated by Reference to our Registration Statement on Form S-4 (file No. 333-100750) filed with the Securities and Exchange Commission on October 25, 2002, as amended
January 27, 2003, February 10, 2003 and February 13, 2003.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(b) |  | Incorporated by Reference to our Registration Statement on Form 8-A (file No. 000-50940) filed with the Securities and Exchange Commission on September 15, 2004.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



|(c) |  | Incorporated by Reference to our Annual Report on Form 10-K/A for the year ended December 31, 2004 filed with the Securities and Exchange Commission on July 14, 2005.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(d) |  | Incorporated by Reference to our Registration Statement on Form S-8 (file No. 333-119008) filed with the Securities and Exchange Commission on September 15, 2004.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(e) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 filed with the Securities and Exchange Commission on November 14,
2003.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(f) |  | Incorporated by Reference to our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on April 14, 2004.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(g) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the Securities and Exchange Commission on November 15,
2004.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(h) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2003 filed with the Securities and Exchange Commission on May 15, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(i) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 filed with the Securities and Exchange Commission on August 16, 2004.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(j) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed with the Securities and Exchange Commission on November 14,
2005.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(k) |  | Incorporated by Reference to our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 31, 2003.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



63



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



INDEX TO FINANCIAL STATEMENTS



|                                                                                                                                    |  |     
|----------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                                    |  | Page
|                                                                                                                                    | 
|Report of Independent Registered Public Accounting Firm                                                                             |  | F-2 
|                                                                                                                                    | 
|Consolidated Balance Sheets as of December 31, 2004 and 2005                                                                        |  | F-3 
|                                                                                                                                    | 
|Consolidated Statements of Operations for the years ended December 31, 2003, December 31, 2004 and December 31, 2005                |  | F-4 
|                                                                                                                                    | 
|Consolidated Statements of Changes in Stockholders Equity for the years December 31, 2003, December 31, 2004 and December 31, 2005 |  | F-5 
|                                                                                                                                    | 
|Consolidated Statements of Cash Flows for the years ended December 31, 2003, December 31, 2004 and December 31, 2005                |  | F-6 
|                                                                                                                                    | 
|Notes to Consolidated Financial Statements                                                                                          |  | F-7 



F-1



---

##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders of

Rotech Healthcare Inc.

Orlando, Florida



We have
audited the accompanying consolidated balance sheets of Rotech Healthcare Inc. and subsidiaries (the Company) as of December 31, 2004 and 2005, and the related consolidated statements of operations, shareholders equity, and cash flows for
each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of
the Companys management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for
our opinion.



In our opinion, such consolidated financial
statements present fairly, in all material respects, the financial position of Rotech Healthcare Inc. and subsidiaries as of December 31, 2004 and 2005, and the results of their operations and their cash flows for each of the three years in the
period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.



We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the
Companys internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated March 16, 2006 expressed an unqualified opinion on managements assessment of the effectiveness of the Companys internal control over financial reporting and an unqualified opinion on the effectiveness of the
Companys internal control over financial reporting.



/s/    DELOITTE & TOUCHE LLP



Certified Public Accountants

Orlando, Florida

March 16, 2006



F-2



---

##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

December 31, 2004 and 2005

(In
thousands, except share and per share data)



|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------- | --------- | ---------------- | - | ---------
|                                                                                                                                                                                                       |  | December 31,2004 |           | December 31,2005
|Assets                                                                                                                                                                                                 |  |                  |           |                  |   |          
|Current assets:                                                                                                                                                                                        |  |                  |           |                  |   |          
|Cash and cash equivalents                                                                                                                                                                              |  | $                | 64,823    |                  | $ | 14,222   
|Accounts receivable, net                                                                                                                                                                               |  |                  | 64,959    |                  |   | 75,475   
|Other accounts receivable                                                                                                                                                                              |  |                  | 1,172     |                  |   | 973      
|Inventories                                                                                                                                                                                            |  |                  | 8,726     |                  |   | 9,206    
|Prepaid expenses                                                                                                                                                                                       |  |                  | 4,794     |                  |   | 4,557    
|Deferred tax assets, net                                                                                                                                                                               |  |                  | 12,911    |                  |   |         
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|Total current assets                                                                                                                                                                                   |  |                  | 157,385   |                  |   | 104,433  
|Property and equipment, net                                                                                                                                                                            |  |                  | 129,403   |                  |   | 148,168  
|Intangible assets (less accumulated amortization of $3,394 in 2004 and $4,731 in 2005)                                                                                                                 |  |                  | 16,610    |                  |   | 20,583   
|Other goodwill                                                                                                                                                                                         |  |                  | 11,256    |                  |   | 42,044   
|Reorganization value in excess of fair value of identifiable assetsgoodwill                                                                                                                           |  |                  | 692,154   |                  |   | 692,154  
|Other assets                                                                                                                                                                                           |  |                  | 12,551    |                  |   | 11,302   
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|                                                                                                                                                                                                       |  | $                | 1,019,359 |                  | $ | 1,018,684
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|Liabilities and Stockholders Equity                                                                                                                                                                   |  |                  |           |                  |   |          
|Current liabilities:                                                                                                                                                                                   |  |                  |           |                  |   |          
|Accounts payable                                                                                                                                                                                       |  | $                | 18,463    |                  | $ | 24,386   
|Accrued expenses and other current liabilities                                                                                                                                                         |  |                  | 23,376    |                  |   | 25,436   
|Accrued interest                                                                                                                                                                                       |  |                  | 7,296     |                  |   | 7,246    
|Deferred revenue                                                                                                                                                                                       |  |                  | 13,975    |                  |   | 9,258    
|Deferred tax liabilities, net                                                                                                                                                                          |  |                  |          |                  |   | 10,717   
|Income taxes payable                                                                                                                                                                                   |  |                  | 2,805     |                  |   | 1,646    
|Current portion of long-term debt                                                                                                                                                                      |  |                  | 646       |                  |   | 634      
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|Total current liabilities                                                                                                                                                                              |  |                  | 66,561    |                  |   | 79,323   
|Deferred tax liabilities, net                                                                                                                                                                          |  |                  | 50,326    |                  |   | 31,574   
|Priority tax claim                                                                                                                                                                                     |  |                  | 5,707     |                  |   | 3,476    
|Other long-term liabilities                                                                                                                                                                            |  |                  |          |                  |   | 573      
|Long-term debt, less current portion                                                                                                                                                                   |  |                  | 329,525   |                  |   | 328,880  
|                                                                                                                                                                                                       |  |                 
|Series A convertible redeemable preferred stock, stated value $20 per share, 1,000,000 shares authorized, 249,196 shares issued and
outstanding at December 31, 2004 and 2005                          |  |                  | 5,343     |                  |   | 5,343    
|                                                                                                                                                                                                       |  |                 
|Stockholders equity:                                                                                                                                                                                  |  |                  |           |                  |   |          
|Common stock, par value $.0001 per share 50,000,000 shares authorized, 25,323,745 shares issued and outstanding at December 31, 2004 and
25,417,270 shares issued and outstanding at December 31, 2005 |  |                  | 3         |                  |   | 3        
|Additional paid-in capital                                                                                                                                                                             |  |                  | 502,037   |                  |   | 504,559  
|Retained earnings                                                                                                                                                                                      |  |                  | 59,857    |                  |   | 64,953   
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|Total stockholders equity                                                                                                                                                                             |  |                  | 561,897   |                  |   | 569,515  
|                                                                                                                                                                                                       |  |                  |           |                  |   |          
|                                                                                                                                                                                                       |  | $                | 1,019,359 |                  | $ | 1,018,684
|                                                                                                                                                                                                       |  |                  |           |                  |   |          



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)



|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|----------------------------------------------- |  | -------------------------------- | ---------- | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                |  | For the Years Ended December 31, |           
|                                                |  | 2003                             |            | 2004 |   |            | 2005 | 
|Net revenues                                    |  | $                                | 580,599    |      | $ | 535,329    |      |  | $ | 533,182    |  
|Costs and expenses:                             |  |                                  |            |      |   |            |      |  |   |            |  
|Cost of net revenues:                           |  |                                  |            |      |   |            |      |  |   |            |  
|Product and supply costs                        |  |                                  | 73,900     |      |   | 70,583     |      |  |   | 95,182     |  
|Patient service equipment depreciation          |  |                                  | 102,819    |      |   | 61,362     |      |  |   | 47,409     |  
|Operating expenses                              |  |                                  | 16,692     |      |   | 16,784     |      |  |   | 23,595     |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Total cost of net revenues                      |  |                                  | 193,411    |      |   | 148,729    |      |  |   | 166,186    |  
|Provision for doubtful accounts                 |  |                                  | 19,462     |      |   | 19,614     |      |  |   | 17,858     |  
|Selling, general and administrative             |  |                                  | 291,910    |      |   | 256,914    |      |  |   | 292,162    |  
|Depreciation and amortization                   |  |                                  | 16,828     |      |   | 15,191     |      |  |   | 18,123     |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Total costs and expenses                        |  |                                  | 521,611    |      |   | 440,448    |      |  |   | 494,329    |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Operating income                                |  |                                  | 58,988     |      |   | 94,881     |      |  |   | 38,853     |  
|Interest expense, net                           |  |                                  | 41,177     |      |   | 33,696     |      |  |   | 31,503     |  
|Other expense (income), net                     |  |                                  | 2,473      |      |   | (2,389     | )    |  |   | (1,809     | )
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|                                                |  |                                  | 43,650     |      |   | 31,307     |      |  |   | 29,694     |  
|Earnings before income taxes                    |  |                                  | 15,338     |      |   | 63,574     |      |  |   | 9,159      |  
|Federal and state income taxes                  |  |                                  | 6,731      |      |   | 27,564     |      |  |   | 3,613      |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Net earnings                                    |  |                                  | 8,607      |      |   | 36,010     |      |  |   | 5,546      |  
|Accrued dividends on redeemable preferred stock |  |                                  | 450        |      |   | 450        |      |  |   | 450        |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Net earnings available for common stockholders  |  | $                                | 8,157      |      | $ | 35,560     |      |  | $ | 5,096      |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Net earnings per common sharebasic             |  | $                                | 0.33       |      | $ | 1.41       |      |  | $ | 0.20       |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Net earnings per common sharediluted           |  | $                                | 0.32       |      | $ | 1.39       |      |  | $ | 0.20       |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Weighted average shares outstandingbasic       |  |                                  | 25,010,881 |      |   | 25,146,315 |      |  |   | 25,379,173 |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  
|Weighted average shares outstandingdiluted     |  |                                  | 25,363,107 |      |   | 25,544,016 |      |  |   | 25,817,774 |  
|                                                |  |                                  |            |      |   |            |      |  |   |            |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(In thousands, except share data)



|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|------------------------------------------------- |  | -------------------- |  | ------------------- | - | ------------------------ | - | ---------------- |  | - | ------------------------ | - |  | - | ------- | -
|                                                  |  | Shares ofCommonStock |  | ParValueCommonStock |   | AdditionalPaid-inCapital |   | RetainedEarnings |  |   | TotalStockholdersEquity |  
|Balance at December 31, 2002                      |  | 24,999,998           |  | $                   | 2 |                          | $ | 494,998          |  | $ | 16,140                   |   |  | $ | 511,140 |  
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Net earnings for the year ended December 31, 2003 |  |                     |  |                     |  |                          |   |                 |  |   | 8,607                    |   |  |   | 8,607   |  
|Tax benefit from exercise of stock options        |  |                     |  |                     |  |                          |   | 56               |  |   |                         |   |  |   | 56      |  
|Proceeds from exercise of stock options           |  | 42,031               |  |                     | 1 |                          |   | 827              |  |   |                         |   |  |   | 828     |  
|Accrued dividends on redeemable preferred stock   |  |                     |  |                     |  |                          |   |                 |  |   | (450                     | ) |  |   | (450    | )
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Balance at December 31, 2003                      |  | 25,042,029           |  |                     | 3 |                          |   | 495,881          |  |   | 24,297                   |   |  |   | 520,181 |  
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Net earnings for the year ended December 31, 2004 |  |                     |  |                     |  |                          |   |                 |  |   | 36,010                   |   |  |   | 36,010  |  
|Tax benefit from exercise of stock options        |  |                     |  |                     |  |                          |   | 419              |  |   |                         |   |  |   | 419     |  
|Proceeds from exercise of stock options           |  | 281,716              |  |                     |  |                          |   | 5,506            |  |   |                         |   |  |   | 5,506   |  
|Non-cash stock compensation expense               |  |                     |  |                     |  |                          |   | 231              |  |   |                         |   |  |   | 231     |  
|Accrued dividends on redeemable preferred stock   |  |                     |  |                     |  |                          |   |                 |  |   | (450                     | ) |  |   | (450    | )
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Balance at December 31, 2004                      |  | 25,323,745           |  |                     | 3 |                          |   | 502,037          |  |   | 59,857                   |   |  |   | 561,897 |  
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Net earnings for the year ended December 31, 2005 |  |                     |  |                     |  |                          |   |                 |  |   | 5,546                    |   |  |   | 5,546   |  
|Tax benefit from exercise of stock options        |  |                     |  |                     |  |                          |   | 242              |  |   |                         |   |  |   | 242     |  
|Proceeds from exercise of stock options           |  | 93,525               |  |                     |  |                          |   | 1,535            |  |   |                         |   |  |   | 1,535   |  
|Non-cash stock compensation expense               |  |                     |  |                     |  |                          |   | 745              |  |   |                         |   |  |   | 745     |  
|Accrued dividends on redeemable preferred stock   |  |                     |  |                     |  |                          |   |                 |  |   | (450                     | ) |  |   | (450    | )
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  
|Balance at December 31, 2005                      |  | 25,417,270           |  | $                   | 3 |                          | $ | 504,559          |  | $ | 64,953                   |   |  | $ | 569,515 |  
|                                                  |  |                      |  |                     |   |                          |   |                  |  |   |                          |   |  |   |         |  





See accompanying notes to consolidated financial statements.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|----------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                    |  | 2003 |          |   | 2004 |   |         | 2005 | 
|Net earnings                                                                        |  | $    | 8,607    |   |      | $ | 36,010  |      |  | $ | 5,546    |  
|Adjustments to reconcile net earnings to net cash provided by operating activities: |  |      |          |   |      |   |         |      |  |   |          |  
|Provision for doubtful accounts                                                     |  |      | 19,462   |   |      |   | 19,614  |      |  |   | 17,858   |  
|Depreciation and amortization                                                       |  |      | 119,647  |   |      |   | 79,124  |      |  |   | 66,915   |  
|Loss (gain) on disposal of fixed assets                                             |  |      | 367      |   |      |   | 371     |      |  |   | (169     | )
|Loss on extinguishment of debt                                                      |  |      |         |   |      |   | 910     |      |  |   |         |  
|Gain on legal settlement                                                            |  |      |         |   |      |   |        |      |  |   | (1,481   | )
|Deferred revenue acquired                                                           |  |      |         |   |      |   |        |      |  |   | (785     | )
|Non-cash stock compensation expense                                                 |  |      |         |   |      |   | 231     |      |  |   | 745      |  
|Deferred income taxes                                                               |  |      | 2,952    |   |      |   | 22,587  |      |  |   | 5,118    |  
|Changes in operating assets and liabilities:                                        |  |      |          |   |      |   |         |      |  |   |          |  
|Accounts receivable                                                                 |  |      | (5,111   | ) |      |   | (11,820 | )    |  |   | (32,839  | )
|Other receivables                                                                   |  |      | 1,174    |   |      |   | (280    | )    |  |   | 199      |  
|Inventories                                                                         |  |      | 3,994    |   |      |   | (737    | )    |  |   | (266     | )
|Prepaid expenses                                                                    |  |      | (699     | ) |      |   | (466    | )    |  |   | 237      |  
|Income tax receivable                                                               |  |      | (2,531   | ) |      |   | 2,531   |      |  |   |         |  
|Other assets                                                                        |  |      | 5,541    |   |      |   | (1,179  | )    |  |   | (130     | )
|Accounts payable and accrued expenses                                               |  |      | 1,574    |   |      |   | (9,705  | )    |  |   | 5,074    |  
|Accrued interest                                                                    |  |      | (103     | ) |      |   | (2,885  | )    |  |   | (49      | )
|Income taxes payable                                                                |  |      | (5,783   | ) |      |   | 3,225   |      |  |   | (1,148   | )
|Deferred revenue                                                                    |  |      | (812     | ) |      |   | (3,306  | )    |  |   | (4,717   | )
|Other long-term liabilities                                                         |  |      |         |   |      |   |        |      |  |   | 573      |  
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Net cash provided by operating activities                                           |  |      | 148,279  |   |      |   | 134,225 |      |  |   | 60,681   |  
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Cash flows from investing activities:                                               |  |      |          |   |      |   |         |      |  |   |          |  
|Purchases of property and equipment                                                 |  |      | (41,993  | ) |      |   | (54,003 | )    |  |   | (78,768  | )
|Business acquisitions                                                               |  |      | (3,029   | ) |      |   |        |      |  |   | (30,777  | )
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Net cash used in investing activities                                               |  |      | (45,022  | ) |      |   | (54,003 | )    |  |   | (109,545 | )
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Cash flows from financing activities:                                               |  |      |          |   |      |   |         |      |  |   |          |  
|Payments of long term borrowings                                                    |  |      | (110,513 | ) |      |   | (39,240 | )    |  |   | (657     | )
|Payments of liabilities subject to compromise/priority tax claim                    |  |      | (605     | ) |      |   | (2,645  | )    |  |   | (1,265   | )
|Net proceeds from stock option exercises                                            |  |      | 829      |   |      |   | 5,506   |      |  |   | 1,535    |  
|Payments of dividends on redeemable preferred stock                                 |  |      |         |   |      |   |        |      |  |   | (1,350   | )
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Net cash used in financing activities                                               |  |      | (110,289 | ) |      |   | (36,379 | )    |  |   | (1,737   | )
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|(Decrease) increase in cash and cash equivalents                                    |  |      | (7,032   | ) |      |   | 43,843  |      |  |   | (50,601  | )
|Cash and cash equivalents, beginning of year                                        |  |      | 28,012   |   |      |   | 20,980  |      |  |   | 64,823   |  
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Cash and cash equivalents, end of year                                              |  | $    | 20,980   |   |      | $ | 64,823  |      |  | $ | 14,222   |  
|                                                                                    |  |      |          |   |      |   |         |      |  |   |          |  
|Supplemental disclosures of noncash investing and financing activities              |  |      |          |   |      |   |         |      |  |   |          |  
|Property and equipment acquired through capital leases                              |  | $    |         |   |      | $ | 500     |      |  | $ |         |  
|Property and equipment unpaid and included in accounts payable                      |  | $    | 1,196    |   |      | $ | 3,858   |      |  | $ | 5,638    |  
|Supplemental disclosures of cash flow information:                                  |  |      |          |   |      |   |         |      |  |   |          |  
|Interest paid                                                                       |  | $    | 37,104   |   |      | $ | 33,002  |      |  | $ | 31,359   |  
|Income taxes paid (refunded)                                                        |  | $    | 4,451    |   |      | $ | 1,202   |      |  | $ | (103     | )



See accompanying notes
to consolidated financial statements.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)



(1) Basis of Presentation



These
footnotes and accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. As used in these notes, unless otherwise specified or the context otherwise
requires, references to the Company refer to the business and operations of Rotech Healthcare Inc. and its subsidiaries.



The Companys predecessor, Rotech Medical Corporation (the Predecessor), emerged from bankruptcy on March 26, 2002. Pursuant to its Plan of
Reorganization (the Plan), on March 26, 2002, Rotech Medical Corporation transferred to Rotech Healthcare Inc. substantially all of the assets it used in connection with its businesses and operations (including stock of substantially all of its
subsidiaries). As partial consideration for the transfer of the assets to Rotech Healthcare Inc., Rotech Healthcare Inc. transferred to Rotech Medical Corporation 24,999,998 shares of common stock, which represented all of its outstanding shares of
common stock, for further distribution by Rotech Medical Corporation to its senior creditors as contemplated by the Plan.



The Companys certificate of incorporation authorizes the Company to issue up to 250,000 shares of Series A Convertible Redeemable Preferred Stock
with an aggregate face value of $5,000. Concurrent with the effectiveness of the Plan, the Company issued all of the shares of Series A Convertible Redeemable Preferred Stock to an employee profit sharing plan.



In connection with its emergence from bankruptcy, the Company reflected the
terms of the Plan in its consolidated financial statements by adopting the fresh-start reporting provisions of the American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization
Under the Bankruptcy Code (SOP 90-7). Under fresh-start reporting, the reorganization value of the Company was allocated to the Companys assets based on their respective fair values similar in nature to the purchase method of accounting
for business combinations; any portion not attributed to specific tangible or identified intangible assets are reported as an intangible asset referred to as Reorganization value in excess of value of identifiable assetsgoodwill.



The Companys common stock currently trades on the NASDAQ
National Market under the trading symbol ROHI.



(2) Summary
of Significant Accounting Policies



Principles of
Consolidation



The consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and balances have been eliminated in the consolidated financial statements.



Use of Estimates



The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include disclosure of contingent assets and liabilities at the date of the financial statements; the reported amounts of revenues and expenses during the
reporting period(s); and the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns. Actual results and outcomes may differ from managements estimates and assumptions.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Fresh-Start Reporting



The Company adopted fresh-start reporting, effective March 31, 2002. Under fresh-start reporting, the reorganization
value of the Company is allocated to the Companys assets based on their respective fair values in conformity with a method similar in nature to the purchase method of accounting for business combinations; any portion not attributed to specific
tangible or identified intangible assets is reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. In adopting fresh-start reporting, the Company engaged an
independent financial advisor to assist in the determination of the reorganization value or fair value of the entity. The estimate of reorganization value was based upon the Companys cash flows, selected comparable market multiples of publicly
traded companies, lease obligations, and other applicable valuation techniques.



Revenue Recognition



Revenues are recognized when persuasive evidence of an arrangement exists; delivery has occurred; the Companys price to the buyer is fixed or determinable; and collectibility is reasonably assured. When services and related products
are provided to patients these revenues are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors. Revenues derived from capitation arrangements are insignificant.



The Companys rental arrangements generally provide for fixed monthly
payments established by fee schedules (subject to capped rentals in some instances) for as long as the patient is using the equipment and medical necessity continues. Once initial delivery is made to the patient (initial setup), a monthly billing is
established based on the initial setup service date. At the end of each reporting period, the Company defers revenue for the portion of the monthly bill which is unearned. No separate revenue is earned from the initial setup process. The Company has
no lease with the patient or third-party payor. During the rental period the Company is responsible for providing oxygen refills and for servicing the equipment based on manufacturers recommendations.



Revenues for the sale of durable medical equipment and related supplies,
including oxygen equipment, ventilators, wheelchairs, hospital beds and infusion pumps, are recognized at the time of delivery. Revenues for the sale of nebulizer medications, which are generally dispensed by Company pharmacies and shipped directly
to the patients home, are recognized at the time of shipment.



Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required in order to record revenues and accounts receivable at their net realizable values. Inherent in these
estimates is the risk that they may be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from
certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review.



Management performs analyses to evaluate the net realizable value of accounts
receivable. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the healthcare industry and third-party
reimbursement, it is possible that managements estimates could change, which could impact operations and cash flows.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Net Patient Service Revenues



The Company derives a significant portion of its revenues from the Medicare
and Medicaid programs and from managed care health plans. Payments for services we render to patients covered by these programs may be less than billed charges. For Medicare and Medicaid revenues, provisions for contractual adjustments are made to
reduce the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively determined). Final payment under these programs is subject to administrative review and audit, and the
Company currently makes provisions for any adjustments which may result. The Companys provisions for contractual allowances under managed care health plans are based primarily on payment terms. The Company closely monitors its historical
contractual adjustment and bad debt rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information the Company believes to be available. However, due
to the complexities involved in these estimations, actual payments the Company receives could be different from the amounts the Company estimates and records.



Provision for Doubtful Accounts



Collection of receivables from third party payors and patients is the Companys primary source of cash and is critical to its operating performance.
The Companys primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. The Company estimates provisions
for doubtful accounts based primarily upon the age of patients account, the economic ability of patients to pay and the effectiveness of the Companys collection efforts. The Company routinely reviews accounts receivable balances in
conjunction with its historical contractual adjustment and bad debt rates and other economic conditions which might ultimately affect the collectibility of patient accounts when the Company considers the adequacy of the amounts the Company records
as provision for doubtful accounts. Significant changes in payer mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and
results of operations.



Cash and Cash Equivalents



Cash and cash equivalents consist of highly liquid
debt instruments with original maturities of three months or less at the date of investment by the Company. The Companys cash and cash equivalents are invested in money market accounts.



Inventories



Inventories are stated at the lower of cost (first-in, first-out method) or
market, consisting principally of medical supplies, medical equipment and replacement parts, and pharmaceutical products.



Property and Equipment



Property and equipment are stated at cost, adjusted for the impact of fresh start reporting.



Patient service equipment represents medical equipment rented or held for rental to in-home patients. Patient service
equipment is accounted for using a composite method, due to its characteristics of high unit volumes of relative low dollar unit cost items. Under the composite method, the purchase cost of monthly



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





purchases of certain patient service equipment are capitalized and depreciated over five years using the straight-line convention, without specific physical
tracking of individual items. The Company believes the five year depreciation period provides a proper matching of the cost of patient service equipment with the patient service revenues generated from use of the equipment, when considering the wear
and tear, damage, loss and ultimately scrapping of patient service equipment over its life.



Other property and equipment is accounted for by a specific identification system. Depreciation for other property and equipment is provided on the straight-line method over the estimated useful lives of the assets,
seven years for furniture and office equipment, five years for vehicles, three years for computer equipment, and the shorter of the remaining lease term or the estimated useful life for leasehold improvements.



Capitalized Software



Included in property and equipment are costs related to internally developed
and/or purchased software that are capitalized and amortized over periods varying from three to fifteen years. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and
payroll-related costs for employees directly involved in the development of internal-use software. The carrying value of capitalized software is reviewed if the facts and circumstances suggest that it may be impaired. Indicators of impairment may
include a subsequent change in the extent or manner in which the software is used or expected to be used, a significant change to the software is made or expected to be made or the cost to develop or modify internal-use software exceeds that
expected amount. Management does not believe any impairment of its capitalized software existed at December 31, 2005.



Goodwill and Intangible Assets



Reorganization value in excess of fair value of identifiable assetsgoodwill, represents the portion of reorganization value of the Company at
March 26, 2002 that could not be attributed to specific tangible or identified intangible assets recorded in connection with the implementation of fresh-start reporting.



Effective January 1, 2002, the Company adopted the provisions of Financial Accounting Standards Board (FASB) Statement
No. 142, Goodwill and Other Intangible Assets (Statement 142). Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in
accordance with the provisions of Statement 142. As a result of adopting Statement 142, goodwill and a portion of the Companys intangible assets are no longer amortized. Pursuant to Statement 142, goodwill and indefinite lived intangible
assets are tested for impairment.



For impairment testing
purposes, management has determined that branch locations have similar economic characteristics and should be aggregated into one reporting unit for assessing fair value. If the carrying amount of the goodwill and intangible assets exceeds its fair
value, an impairment loss is recognized. Fair values for goodwill and intangible assets are determined based upon discounted cash flows, market multiples or appraised values as appropriate.



Management performs the required annual impairment test during the fourth
quarter each year, unless indicators of impairment are present and suggest earlier testing is warranted. During the years ended December 31, 2004 and 2005 the Company completed its impairment reviews, which indicated that there were no
impairments.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





The Company accounts for its business combinations in accordance with the purchase method of
accounting. The purchase prices were allocated to the various underlying tangible and intangible assets and liabilities on the basis of estimated fair value. In 2005 the carrying value of other goodwill increased $30,788 as a result of business
acquisitions (See Note 5). The fair value of acquired finite-lived identifiable intangible assets are amortized over the period of their expected useful life, generally 2 to 20 years.



Estimated amortization expense of intangible assets subject to amortization for the next five fiscal years is as follows:
2006$1,351; 2007$1,332; 2008$1,311; 2009$1,309; 2010$1,236. Accumulated amortization expense was $3,394 and $4,731 at December 31, 2004 and 2005, respectively. The weighted-average useful life of other intangible
assets was 17.7 years and 17.8 years as of December 31, 2004 and 2005, respectively.



Provided below is an accounting of intangible assets, other goodwill and reorganization value in excess of fair value of identifiable assetsgoodwill from January 1, 2003 through December 31, 2005



|                                                      |  |                                           |        |   |          |   |                                                                               |  |   |         |  
|----------------------------------------------------- |  | ----------------------------------------- | ------ | - | -------- | - | ----------------------------------------------------------------------------- |  | - | ------- | -
|                                                      |  | Intangible assets subject to amortization |        |   | Goodwill |   | Reorganization value in excess of fair value of identifiable assets goodwill | 
|Balance at January 1, 2003                            |  | $                                         | 18,966 |   |          | $ | 2,316                                                                         |  | $ | 692,730 |  
|Acquisitions during the year ended December 31, 2003  |  |                                           | 50     |   |          |   | 8,940                                                                         |  |   |        |  
|Final valuation adjustments to reorganization value   |  |                                           |       |   |          |   |                                                                              |  |   | (576    | )
|Amortization expense for year ended December 31, 2003 |  |                                           | (1,332 | ) |          |   |                                                                              |  |   |        |  
|                                                      |  |                                           |        |   |          |   |                                                                               |  |   |         |  
|Balance at December 31, 2003                          |  |                                           | 17,684 |   |          |   | 11,256                                                                        |  |   | 692,154 |  
|Amortization expense for year ended December 31, 2004 |  |                                           | (1,074 | ) |          |   |                                                                              |  |   |        |  
|                                                      |  |                                           |        |   |          |   |                                                                               |  |   |         |  
|Balance at December 31, 2004                          |  |                                           | 16,610 |   |          |   | 11,256                                                                        |  |   | 692,154 |  
|Acquisitions during the year ended December 31, 2005  |  |                                           | 5,235  |   |          |   | 30,788                                                                        |  |   |        |  
|Other intangibles                                     |  |                                           | 75     |   |          |   |                                                                              |  |   |        |  
|Amortization expense for year ended December 31, 2005 |  |                                           | (1,337 | ) |          |   |                                                                              |  |   |        |  
|                                                      |  |                                           |        |   |          |   |                                                                               |  |   |         |  
|Balance at December 31, 2005                          |  | $                                         | 20,583 |   |          | $ | 42,044                                                                        |  | $ | 692,154 |  
|                                                      |  |                                           |        |   |          |   |                                                                               |  |   |         |  



Impairment of
Long-Lived Assets



Periodically, when indicators of
impairment are present, the Company evaluates the recoverability of the net carrying value of its property and equipment and its other amortizable intangible assets by comparing the carrying values to the estimated future undiscounted cash flows,
excluding interest. A deficiency in these cash flows relative to the carrying amounts is an indication of the need for a write-down due to impairment. Among other variables, the Company considers factors such as the effects of external changes to
the Companys business environment, competitive pressures, market erosion, technological and regulatory changes as factors which could provide indications of impairment. Based on this analysis, no impairment charge was required for the years
ended December 31, 2003, 2004 and 2005.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Deferred Financing Costs



In conjunction with the closing of the Companys senior secured term loan and the 91/2% Senior
Subordinated Notes due 2012 in March 2002, the Company capitalized approximately $18,625 in financing costs incurred to obtain the bank loans. These costs are being amortized over eight years, the average life of the bank loans using the effective
interest rate method. Amortization of the deferred financing costs was approximately $4,746, $2,572 and $1,384 for the years ended December 31, 2003, 2004 and 2005, respectively. Accumulated amortization of the deferred financing costs was
$9,184 and $10,568 as of December 31, 2004 and 2005, respectively.



Cost of Net Revenues



Cost of net revenues includes the cost of products, drugs and supplies sold to patients, patient service equipment depreciation, and certain operating costs related to the Companys respiratory services and pharmacy operations. In
2005, certain costs and expenses associated with the Companys respiratory services and pharmacy operations were reclassified from selling general and administrative expense to cost of net revenues to reflect current industry practices. The
costs and expenses related to certain respiratory services and pharmacy operations in 2003 and 2004 have been reclassified in the accompanying consolidated financial statements to conform to the 2005 presentation.



Advertising Expense



Advertising costs are expensed as incurred. For the years ended
December 31, 2003, 2004 and 2005 the advertising expenses were $725, $395 and $335, respectively.



Rebates, Early Pay Discounts Earned, and Co-Sale and Marketing Agreements



The Company accounts for rebates, early pay discounts earned, and co-sale and marketing agreements, in accordance with FASB
Emerging Issues Task Force Issue No. 02-16: Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, (EITF 02-16). Rebates and early pay discounts for products sold during a reporting
period are estimated and recorded based on a systematic and rational allocation of the cash consideration offered from each vendor to each of the underlying transactions that results in progress by the Company toward earning the rebate or refund
provided the amounts are probable and reasonably estimable. Consideration earned related to co-sale and marketing agreements is recorded when the specific contractual obligation is completed. The co-sale and marketing agreement payments are
characterized as a reduction of the selling, general, and administrative expenses. The Company records all rebates based upon volume discounts as a reduction of the prices for those vendors products, and characterizes the rebate as a reduction
of cost of net revenues in the statement of operations. If the consideration is not probable and reasonably estimable, it is recognized as the milestones are achieved.



Income Taxes



The Company accounts for income taxes under the asset and liability method.



Deferred tax assets and liabilities are determined based upon differences between financial reporting and the tax bases of
assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred income tax assets to amounts
expected to be realized.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Earnings Per Common Share



Basic earnings per share (EPS) is computed by dividing net earnings
available to common shareholders by the weighted average number of common shares outstanding for the periods. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings and are based upon the weighted
average number of common and common equivalent shares outstanding during the year. Common equivalent shares related to employee stock options and preferred stock totaled 497,500, 762,500 and 534,357 for the years ended December 31, 2003, 2004
and 2005, respectively, are excluded from the computation of diluted earnings per share in periods where they have an anti-dilutive effect. The Company uses the treasury stock method to compute the dilutive effects of potentially dilutive
securities.



A reconciliation of the number of common shares
used in calculation of basic and diluted earnings per share for the years ended December 31, 2003, 2004 and 2005 are presented below:



|                                |  |                            |  |                             |  |                            
|------------------------------- |  | -------------------------- |  | --------------------------- |  | ---------------------------
|                                |  | Year endedDecember 31,2003 |  | Year ended December 31,2004 |  | Year ended December 31,2005
|Weighted average basic shares   |  | 25,010,881                 |  | 25,146,315                  |  | 25,379,173                 
|Effect of dilutive securities:  |  |                            |  |                             |  |                            
|Stock options                   |  | 352,226                    |  | 395,256                     |  | 423,036                    
|Stock awards                    |  |                           |  | 2,445                       |  | 15,565                     
|                                |  |                            |  |                             |  |                            
|Weighted average diluted shares |  | 25,363,107                 |  | 25,544,016                  |  | 25,817,774                 
|                                |  |                            |  |                             |  |                            



Stock-Based
Compensation



As permitted under FASB Statements 148
and 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees(APB 25), which prescribes the intrinsic value method of accounting for its stock-based awards issued
to employees and directors. Accordingly, the Company does not currently recognize compensation expense for its stock-based awards to employees in the consolidated statements of operations if issued at fair value.



The Company applies APB 25 for valuing options, and typically the exercise
price of the options granted to employees is equal to or exceeds the fair value of the underlying stock on the date of grant. The Company applies the fair value provisions of Statement 123 for options granted to non-employees who perform services
for the Company. There was no stock-based compensation expense related to stock options for any of the periods presented in the accompanying consolidated statements of operations.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Had compensation cost been determined on the basis of fair value pursuant to Statement 123, the
Companys net earnings (loss) and basic and diluted earnings (loss) per share would have been as follows for the years ended December 31, 2003, 2004 and 2005:



|                                                                                                                                                                             |  |                            |        |   |                            |   |        |                            |  |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------ | - | -------------------------- | - | ------ | -------------------------- |  | - | ------ | -
|                                                                                                                                                                             |  | Year endedDecember 31,2003 |        |   | Year endedDecember 31,2004 |   |        | Year endedDecember 31,2005 | 
|Net earnings:                                                                                                                                                                |  |                            |        |   |                            |   |        |                            |  |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 8,607  |   |                            | $ | 36,010 |                            |  | $ | 5,546  |  
|Less: employee stock compensation, net of tax, that would have been included in the determination of net earnings had the fair value based
method been applied to all awards |  |                            | (1,225 | ) |                            |   | (1,453 | )                          |  |   | (4,424 | )
|                                                                                                                                                                             |  |                            |        |   |                            |   |        |                            |  |   |        |  
|Pro forma                                                                                                                                                                    |  | $                          | 7,382  |   |                            | $ | 34,557 |                            |  | $ | 1,122  |  
|                                                                                                                                                                             |  |                            |        |   |                            |   |        |                            |  |   |        |  
|Basic net earnings per common share:                                                                                                                                         |  |                            |        |   |                            |   |        |                            |  |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 0.33   |   |                            | $ | 1.41   |                            |  | $ | 0.20   |  
|Pro forma                                                                                                                                                                    |  | $                          | 0.28   |   |                            | $ | 1.36   |                            |  | $ | 0.03   |  
|Diluted net earnings per common share:                                                                                                                                       |  |                            |        |   |                            |   |        |                            |  |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 0.32   |   |                            | $ | 1.39   |                            |  | $ | 0.20   |  
|Pro forma                                                                                                                                                                    |  | $                          | 0.27   |   |                            | $ | 1.34   |                            |  | $ | 0.03   |  



In November 2005, the
Board of Directors of the Company approved the acceleration of the vesting of all the previously unvested stock options granted under the Rotech Healthcare Inc. Common Stock Option Plan (the Option Plan), effective November 22, 2005,
representing options exercisable for the total of 1,148,187 shares of the Companys common stock, including a total of 436,309 shares of common stock underlying options held by the Companys executive officers. This acceleration is
expected to reduce after-tax stock option expense that the Company would otherwise have been required to record by approximately $4,424. Of this amount, which represents four years of charges with regard to the affected shares, approximately $934
would have been recorded in the Companys 2006 fiscal year absent the acceleration. The acceleration of the vesting schedule of the Companys options was effected pursuant to Section 5(a)(iv) of the Option Plan. Typically, stock
options granted under the Option Plan vest over a four-year period. The decision to accelerate the vesting of stock options is expected to have a positive effect on employee morale and employee retention.



Immediately prior to November 22, 2005, all of the Companys
unvested options under the Option Plan had stated exercise prices that exceeded the current market price of the Companys common stock and were out-of-the-money. Such options have exercise prices ranging from $17.00 to $27.55 per
share and represent approximately 36% of the Companys total outstanding stock options. Except for the accelerated vesting of the options issued under the Option Plan, all other terms and conditions of the options granted under the Option Plan
remain the same. The accelerated vesting of the options outlined above will not alter the vesting of grants of restricted common stock by the Company.



Fair Value of Financial Instruments



The Company believes the carrying amounts of cash, patient accounts receivable-net, other accounts receivable, prepaid expenses, accounts payable and
accrued expenses approximate fair value because of the short-term nature of these instruments.



The fair value of the Companys variable rate senior secured term loan approximates its carrying value, because the current interest rates approximate rates at which similar types of borrowing arrangements could
be currently obtained by the Company. The fair value of the Companys senior subordinated notes are estimated



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





based upon a discounted value of the future cash flows expected to be paid over the maturity period of these notes. The estimated fair value of the senior
subordinated notes at December 31, 2004 and 2005 was $315,700 and $299,915, respectively.



Concentrations of Credit Risk



The Companys revenue is generated through approximately 485 locations in 48 states. The Company generally does not require collateral or other security in extending credit to patients; however, the Company
routinely obtains assignment of (or is otherwise entitled to receive) benefits receivable under the health insurance programs, plans or policies of patients (e.g., Medicare, Medicaid, commercial insurance and managed care organizations). Revenues
were derived from the following payor sources for the periods ended:



|                                                                                           |  |                                 |   |  |       |   |  |       |  
|------------------------------------------------------------------------------------------ |  | ------------------------------- | - |  | ----- | - |  | ----- | -
|                                                                                           |  | Twelve Months EndedDecember 31, |  
|                                                                                           |  | 2003                            |   |  | 2004  |   |  | 2005  |  
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 71.1                            | % |  | 71.0  | % |  | 66.7  | %
|Private payors                                                                             |  | 4.6                             | % |  | 3.5   | % |  | 3.4   | %
|Commercial payors                                                                          |  | 24.3                            | % |  | 25.5  | % |  | 29.9  | %
|                                                                                           |  |                                 |   |  |       |   |  |       |  
|                                                                                           |  | 100.0                           | % |  | 100.0 | % |  | 100.0 | %
|                                                                                           |  |                                 |   |  |       |   |  |       |  



Segment
Information



The Company follows a centralized
approach to management of its branch locations through standard operating procedures developed and monitored at the corporate level. Each autonomous branch location provides essentially the same products and services to customers at similar margins
through similar distribution and delivery methods. Management reporting and analysis is done on a monthly basis for each location, and then aggregated for analysis as one operating segment for the chief operating decision maker. Additionally, each
location operates in a highly regulated environment principally subjected to the same Medicaid and Medicare reimbursements and operating regulations. Additionally, management continually monitors the revenue, profits and losses, and allocated assets
to each location for the assessments of whether quantitative thresholds have been exceeded under the aggregation criteria in FASB Statement 131, Disclosures about Segments of an Enterprise and Related Information.The Company operates in one
reportable segment, as defined by Statement 131; the provision of home medical equipment and related products and services.



Recent Accounting Pronouncements



In December 2004, the FASB issued Statement No. 123R, Share Based Payment (Statement 123R). This statement revises Statement 123 and
supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash Flows. This statement requires companies to expense the fair value of employee services received in exchange for an award of equity instruments, including stock
options. Statement 123R also provides guidance on valuing and expensing these awards, as well as disclosure requirements with respect to these equity arrangements.



The Company adopted Statement 123R effective as of January 1, 2006. The Company is following the modified
prospective method of adoption of Statement 123R whereby earnings for prior periods will not be restated as though stock based compensation had been expensed, rather than the modified retrospective method which would entail
restatement of previously published earnings. Statement 123R also requires the benefits of



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow, but this will not
have a significant impact on our cash flow reporting. The impact of adoption of Statement 123R will depend on levels of share-based compensation, particularly stock options, granted in the future and the fair value assigned thereto. The Company does
not expect that the adoption of Statement 123R will have a material financial impact on the Company, unless a significant number of new options are granted.



In May 2005, FASB issued SFAS 154, Accounting Changes and Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement
No. 3 (Statement 154). Statement 154 changes the requirements for the accounting for and reporting of a change in accounting principle, and applies to all voluntary changes in accounting principle. It also applies to changes required by an
accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior periods financial statements of changes in accounting
principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Statement 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company
does not expect that adoption of this Statement 154 will have a material impact on our results of operations or financial condition.



Reclassifications



Certain amounts presented in the prior periods have been reclassified to conform to the current period presentation.



(3) Petitions for Reorganization under Chapter 11 and Other Information



In October 1997, our predecessor, Rotech Medical
Corporation, was acquired by Integrated Health Services, Inc. (IHS), a large, publicly-held provider of post-acute and related specialty health care services and products. Following the acquisition, Rotech Medical Corporation operated as a
wholly-owned subsidiary of IHS. On February 2, 2000, IHS and substantially all of its subsidiaries, including the Predecessor and its subsidiaries, filed separate voluntary petitions for relief under Chapter 11 (Chapter 11) of the United States
Bankruptcy Code (the Bankruptcy Code) with the United States Bankruptcy Court in the District of Delaware (the Bankruptcy Court). On November 23, 2001, IHS filed a Plan of Reorganization for the Predecessor and its subsidiaries, which was
approved by the creditors and confirmed by the Bankruptcy Court on February 13, 2002. The Plan became effective on March 26, 2002 as the conditions to the effectiveness of the Plan were fulfilled. On the effective date, the Predecessor
transferred to the Company substantially all of the assets used by it in connection with its businesses and operations (including the stock of substantially all of its subsidiaries).



In February 2002, the Predecessor settled all outstanding government litigation and pre-petition and certain post-petition
claims arising from Medicare payments made to certain of the Companys operating centers as well as claims in unliquidated amounts for a cash settlement of $17 million. The settlement became effective on March 26, 2002, upon the
effectiveness of the Plan.



In addition, on February 13,
2002, IHS and its subsidiaries, including the Predecessor, entered into a stipulation with the Centers for Medicare and Medicaid Services (CMS), whereby CMS was permitted to set off certain underpayments to IHS with certain overpayments to the
Predecessor in exchange for a full release of all CMS claims against IHS and its subsidiaries, including the Predecessor, to the effective date of the stipulation. The Bankruptcy Court signed the stipulation on April 12, 2002.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Major Settlements and Other Bankruptcy Matters



Subsequent to the filing of the bankruptcy case on February 2, 2000 (which case was closed by the Delaware Bankruptcy
Court on December 20, 2004), the Predecessor was required to seek approval of the Bankruptcy Court for certain material decisions regarding its continued operations. The following summarizes the major matters approved during the bankruptcy
case:



Settlement with the United States Federal
Government. The federal government of the United States filed a $48,000 claim against the Predecessor claiming trebled damages with respect to an underlying $16,000 claim relating to, among other things, claims arising from Medicare
billings as well as claims in unliquidated amounts. Although the Predecessor disputed the validity of the claims and the allowability of a trebled damage claim, in an effort to compromise this and other issues, the Predecessor and the Department of
Justice, or DOJ, entered into a settlement agreement dated on or about February 11, 2002. Pursuant to the terms of the settlement agreement, which was approved by the Bankruptcy Court on February 13, 2002, the Predecessor paid the federal
government $17,000 in cash in full settlement and satisfaction of the aforementioned claims and certain claims which arose during the bankruptcy case.



The parties to the settlement agreement are the Predecessor and its affiliates, the DOJ and the Office of Inspector General for the Department of Health
and Human Services, or DHHS. On March 26, 2002, the effective date of the Plan, the DOJ provided a release of all administrative and civil monetary claims under the False Claims Act, Civil Monetary Penalties Law, Program Fraud Civil Remedies
Act, common law theories of payment by mistake, unjust enrichment, breach of contract, and fraud for the covered conduct in the agreement. The Office of Inspector General also provided the Predecessor with a release of its right to, with respect to
covered conduct in the agreement, permissively exclude us from participating in federal health care programs.



In connection with the settlement agreement, the Predecessor entered into a Corporate Integrity Agreement with the Office of Inspector General for the
DHHS. As the successor to Rotech Medical Corporation, the Company is subject to the terms of the Corporate Integrity Agreement as described below.



Settlement with IHS. During the pendency of the Chapter 11 case, the Predecessor and IHS operated pursuant to an integrated cash management
system controlled by IHS. Pursuant to the settlement agreement with IHS, among other things, the Predecessor and IHS have fully and finally satisfied the claims they have against each other by a transfer of $40,000 in cash and a $5,000 promissory
note. The Predecessor and IHS exchanged, effective as of the effective date of the Plan, general releases, which cover all intercompany claims against each other. As the successor to Rotech Medical Corporation, the Company is subject to the terms of
the settlement agreement.



Settlement with CMS. IHS
and its subsidiaries, including the Predecessor, receive reimbursement under Part B of the Medicare Program. The Centers for Medicare and Medicaid Services, or CMS, had asserted that it overpaid IHS Part B Providers, including the Predecessor,
approximately $1,100 in the aggregate for certain services and underpaid approximately $2,500 in the aggregate for certain services. CMS was holding the underpayments in administrative freeze pending a resolution of its right to set them off against
the overpayments. As part of a stipulation filed with the Bankruptcy Court, the parties agreed that CMS is permitted to off-set the underpayments against the overpayments and hold in administrative freeze the balance remaining after the off-set,
subject to (A) mutual agreement by the parties or (B) an order from the Court concerning the disposition of said funds. Effective March 26, 2002, all of (A) CMSs claims against IHS and its subsidiaries, including the
Predecessor, and (B) all of IHSs and its subsidiaries, including the Predecessors, claims against CMS for



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





underpayments arising under Medicare Part B before the February 13, 2002 settlement date have been released, subject to limited exceptions, including
insurance obligations retained by IHS. The Bankruptcy Court signed the stipulation on April 12, 2002.



Corporate Integrity Agreement



The Predecessor and the Office of Inspector General of the DHHS entered into a Corporate Integrity Agreement as part of the process of settling the federal governments fraud claims against the Predecessor in the bankruptcy proceeding.
As the successor to the business and operations of the Predecessor, the Company is subject to the provisions of the Corporate Integrity Agreement.



Providers and suppliers enter into corporate integrity agreements as part of settlements with the federal government in order that the federal government
will waive its right to permissively exclude them from participating in federal health care programs.



The Corporate Integrity Agreement is for a term of five years. Among other things, the Corporate Integrity Agreement requires the Company to conduct
internal claims reviews related to our Medicare billing. In the first year of the agreement, the internal claims reviews were also reviewed by an Independent Review Organization (IRO). Similarly, in the fourth year of the agreement, the internal
claims reviews will also be reviewed by an IRO. Under certain circumstances, the internal claims reviews may also be reviewed by the IRO in the fifth year of the agreement. KPMG LLP has acted as our IRO. The Company must file reports of the reviews
with the Office of Inspector General of the DHHS.



In addition,
the Corporate Integrity Agreement imposes upon the Company (including in most instances our officers, directors, employees and others) various training requirements, as well as the need to have certain policies and procedures in place. It also
requires that the Company have a Compliance Officer, several Compliance Liaisons, and a Compliance Committee.



The Corporate Integrity Agreement also mandates that the Company have certain procedures in place with respect to our acquisition process. More
specifically, the Company is required to have an Acquisition Committee (which is comprised of members of senior management) which approves all acquisitions before they are consummated. As part of the acquisition process, the Company is required to
conduct operational and file reviews of potential entities in which the Company might acquire an interest. Assuming that the Company decides to acquire an entity, the Company is required to provide a report to the Office of Inspector General of the
DHHS indicating that the Company followed the acquisition procedures set forth in the Corporate Integrity Agreement and specifying any corrective action that might be necessary post acquisition.



The Corporate Integrity Agreement restricts the Company from hiring any
person or contractor who is ineligible to participate in federal health care programs, federal procurement or federal non-procurement programs or has been convicted of a criminal offense related to the provision of health care items or services. The
Company is obligated to conduct ongoing reviews of the qualifications of all of our employees and contractors. If a current employee or contractor is or becomes an ineligible employee as contemplated by the Corporate Integrity Agreement, such
individual must be relieved of any responsibility for, and removed from any involvement with, our business operations relating to federal health care programs.



As part of the Corporate Integrity Agreement, the Company also has certain obligations with respect to repayment of identified overpayments and
reporting of Material Deficiencies the Company may learn of with respect to our relationship with federal health care programs. The Company also must submit annual reports to



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





the Office of Inspector General of the DHHS regarding our compliance with the Corporate Integrity Agreement generally. To the extent that the Company
violates the terms of the Corporate Integrity Agreement, the Company may be subject to substantial penalties, including stipulated cash penalties ranging from $1 per day to $2.50 per day for each day the Company is in breach of the agreement, and,
possibly, exclusion from federal health care programs.



(4) Accounts
Receivable



Accounts receivable, net of allowances for
doubtful accounts consist of the following at December 31:



|                                     |  |      |        |      |   |       
|------------------------------------ |  | ---- | ------ | ---- | - | ------
|                                     |  | 2004 |        | 2005
|Patient accounts receivable          |  | $    | 74,150 |      | $ | 90,241
|Less allowance for doubtful accounts |  |      | 9,191  |      |   | 14,766
|                                     |  |      |        |      |   |       
|                                     |  | $    | 64,959 |      | $ | 75,475
|                                     |  |      |        |      |   |       



Included in patient
accounts receivable at December 31, 2004 and 2005 are amounts due from Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) which represents 57% and 51% of total outstanding receivables, respectively.



Included in accounts receivable are earned but unbilled
receivables of $21,143 and $28,054 at December 31, 2004 and 2005, respectively. Billing backlogs, ranging from a day to several weeks, can occur due to delays in obtaining certain required payor-specific documentation from internal and external
sources.



(5) Business Acquisitions



During 2005, the Company acquired nine complementary home respiratory
therapy businesses in specific geographic markets, for an aggregate total cost of $38,558, of which $30,777 was paid in cash. Additionally, the Company recorded $5,437 in deferred acquisition obligations which are included in the consolidated
balance sheet within Accrued expenses and other current liabilities. In 2005, the Company recorded other income of $1,481 related to a legal settlement in conjunction with an acquisition in accordance with EITF 04-01 Accounting for
Preexisting Relationships between the Parties to a Business Combination.



No acquisitions were made in 2004. These transactions were accounted for as purchases and the results of operations of the acquired companies are included in the accompanying statements of operations from the dates of
acquisition. The purchase prices with respect to each acquisition were allocated to the various underlying tangible and intangible assets and liabilities on the basis of estimated fair value.



The aggregate purchase price of the Companys acquisitions during 2005
was allocated as follows:



|                       |  |      |       
|---------------------- |  | ---- | ------
|                       |  | 2005
|Current assets         |  | $    | 218   
|Property and equipment |  |      | 2,317 
|Intangible assets      |  |      | 5,235 
|Goodwill               |  |      | 30,788
|                       |  |      |       
|                       |  | $    | 38,558
|                       |  |      |       



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





The following unaudited pro forma supplemental information on the results of operations for the years
ended December 31, 2004 and 2005 includes the 2005 acquisitions as if they had been combined at the beginning of 2004:



|                                      |  |                                      |         |      |   |        
|------------------------------------- |  | ------------------------------------ | ------- | ---- | - | -------
|                                      |  | 2004                                 |         | 2005
|                                      |  | (In thousands, exceptper share data)
|Net revenues                          |  | $                                    | 564,589 |      | $ | 551,101
|                                      |  |                                      |         |      |   |        
|Net earnings                          |  | $                                    | 37,960  |      | $ | 5,488  
|                                      |  |                                      |         |      |   |        
|Basicnet earnings per common share   |  | $                                    | 1.51    |      | $ | 0.22   
|                                      |  |                                      |         |      |   |        
|Dilutednet earnings per common share |  | $                                    | 1.49    |      | $ | 0.21   
|                                      |  |                                      |         |      |   |        



The unaudited pro
forma financial information is not necessarily indicative of either the results of operations that would have occurred had the transactions been effected at the beginning of 2004 or of future results of operations of the combined companies.



(6) Property and Equipment



Property and equipment consist of the following at December 31:



|                                                    |  |      |         |      |   |        
|--------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                    |  | 2004 |         | 2005
|Patient service equipment                           |  | $    | 250,973 |      | $ | 307,100
|Furniture, office equipment, computers and software |  |      | 51,244  |      |   | 70,404 
|Vehicles                                            |  |      | 4,077   |      |   | 4,345  
|Leasehold improvements                              |  |      | 10,201  |      |   | 13,041 
|                                                    |  |      |         |      |   |        
|                                                    |  |      | 316,495 |      |   | 394,890
|Less accumulated depreciation                       |  |      | 187,092 |      |   | 246,722
|                                                    |  |      |         |      |   |        
|                                                    |  | $    | 129,403 |      | $ | 148,168
|                                                    |  |      |         |      |   |        



Depreciation expense
was $118,316, $75,481 and $64,195 for the years ended December 31, 2003, 2004, and 2005, respectively.



Effective April 1, 2003, the Company changed its estimated useful life on certain long-lived assets acquired from the Predecessor. The estimated
useful life of certain acquired rental property was changed from an aggregate of four years from the date acquired from our predecessor to a five-year useful life from the original acquisition date by our predecessor. The change increased
depreciation expense in the twelve months ended December 31, 2003 by $42,500 and decreased net income by approximately $23,800, or $0.95 per basic share and $0.94 per diluted share for the fiscal year ended December 31, 2003. The change in
estimate was made to more closely match the replacement rates of rental property acquired with its specific remaining useful life.



During 2004, the Company undertook a project to physically count the patient service equipment within all the respective operating locations and to
estimate the equipment utilized for rental within patient homes, in order to refine the estimate of patient service equipment being accounted for under the composite method (see Note 2). As a result of this project, the Company believes that certain
of the equipment acquired from the Predecessor, is no longer in service or held by the Company or its patients. Such equipment was determined to have been fully



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





depreciated prior to December 31, 2004. Accordingly, the Company has reduced the gross patient service equipment account and the related accumulated
depreciation by offsetting $52 million. This adjustment had no impact on our results of operations in 2004 and 2005.



(7) Other Assets



Other assets consist of the following at December 31:



|                           |  |      |        |      |   |       
|-------------------------- |  | ---- | ------ | ---- | - | ------
|                           |  | 2004 |        | 2005
|Debt issue costs           |  | $    | 9,445  |      | $ | 8,214 
|Prepaid expenseslong term |  |      | 531    |      |   | 468   
|Deposits                   |  |      | 2,575  |      |   | 2,620 
|                           |  |      |        |      |   |       
|                           |  | $    | 12,551 |      | $ | 11,302
|                           |  |      |        |      |   |       



Debt issue costs
relate to the long-term debt obtained upon emergence from bankruptcy.



(8) Accrued Expenses and Other Current Liabilities



Accrued expenses and other current liabilities consist of the following at December 31:



|                                             |  |      |        |      |   |       
|-------------------------------------------- |  | ---- | ------ | ---- | - | ------
|                                             |  | 2004 |        | 2005
|Accrued salaries and wages                   |  | $    | 9,094  |      | $ | 10,228
|Accounts receivable credit balances          |  |      | 7,668  |      |   | 3,203 
|Notes payable on acquisitions                |  |      |       |      |   | 5,437 
|Accrued health insurance and other claims    |  |      | 3,746  |      |   | 3,877 
|Current portion of priority tax claim        |  |      |       |      |   | 966   
|Dividends payable                            |  |      | 900    |      |   |      
|Sales tax payable                            |  |      | 846    |      |   | 860   
|Accrued employee/employer 401K contributions |  |      | 781    |      |   | 766   
|Other                                        |  |      | 341    |      |   | 99    
|                                             |  |      |        |      |   |       
|                                             |  | $    | 23,376 |      | $ | 25,436
|                                             |  |      |        |      |   |       



(9) Long-Term Debt



The Companys long-term debt consists of the
following at December 31:



|                                                                                                                                                                                       |  |      |         |      |   |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                                                                                                                       |  | 2004 |         | 2005
|Capital lease obligations with interest at a fixed rate of 4.5% at December 31, 2005, due in monthly installments through 2007, secured
by equipment                                   |  | $    | 500     |      | $ | 282    
|Senior Secured Term Loan; $109 payable quarterly through March 31, 2007 with remainder due quarterly through March 31, 2008,
interest payable at LIBOR rate plus 3%, payable quarterly |  |      | 42,671  |      |   | 42,232 
|91/2% Senior Subordinated Notes, due April 1, 2012, interest payable semi-annually on April 1 and
October 1                                                                            |  |      | 287,000 |      |   | 287,000
|                                                                                                                                                                                       |  |      |         |      |   |        
|Sub-total                                                                                                                                                                              |  |      | 330,171 |      |   | 329,514
|Less current portion                                                                                                                                                                   |  |      | 646     |      |   | 634    
|                                                                                                                                                                                       |  |      |         |      |   |        
|Total long-term debt                                                                                                                                                                   |  | $    | 329,525 |      | $ | 328,880
|                                                                                                                                                                                       |  |      |         |      |   |        



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





In addition to the above, as of December 31, 2005, the Company has a $75,000 five-year revolving
credit facility available. No debt was outstanding under this facility at December 31, 2005; however the Company has issued letters of credit totaling $12,700 under this facility.



Long-term debt maturities excluding capital lease obligations are as follows: 2006$439; 2007$31,372;
2008$10,421; 2009$0; 2010$0 and thereafter$287,000.



Required future payments for capital lease obligations and the present value of net minimum capital lease payments are as follows:



|                                                |  |               |    
|----------------------------------------------- |  | ------------- | ---
|                                                |  | CapitalLeases
|2006                                            |  | $             | 201
|2007                                            |  |               | 91 
|2008                                            |  |               | 0  
|                                                |  |               |    
|Total                                           |  |               | 292
|Less amount representing interest               |  |               | 10 
|                                                |  |               |    
|Present value of minimum capital lease payments |  | $             | 282
|                                                |  |               |    



At December 31,
2005, the equipment under capital leases is included in property and equipment with a carrying amount of $500 and accumulated depreciation of $231.



Interest expense, net was as follows for the twelve months ended December 31, 2003, 2004 and 2005:



|                      |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                      |  | 2003 |        |   | 2004 |   |        | 2005 | 
|Interest expense      |  | $    | 41,884 |   |      | $ | 33,967 |      |  | $ | 32,694 |  
|Interest income       |  |      | (707   | ) |      |   | (271   | )    |  |   | (1,191 | )
|                      |  |      |        |   |      |   |        |      |  |   |        |  
|Interest expense, net |  | $    | 41,177 |   |      | $ | 33,696 |      |  | $ | 31,503 |  
|                      |  |      |        |   |      |   |        |      |  |   |        |  



The senior secured
credit facilities contain customary affirmative and negative covenants, including limitations on indebtedness; limitations on liens; limitations on guarantee obligations; limitations on mergers, consolidations, liquidations and dissolutions;
limitations on sales of assets; limitations on leases; limitations on dividends and other payments in respect of capital stock; limitations on investments, loans and advances; limitations on capital expenditures; limitations on optional payments and
modifications of subordinated and other debt instruments; limitations on transactions with affiliates; limitations on granting negative pledges; and limitations on changes in lines of business. Our senior secured credit facilities also contain
customary financial covenants including, maintenance of the following ratios: (a) a consolidated total leverage ratio, (b) a consolidated senior leverage ratio, (c) a consolidated interest coverage ratio and (d) a consolidated
fixed charge coverage ratio. As of December 31, 2005, the Company is in compliance with its financial condition covenants under the credit agreement.



All obligations under the credit facilities and the guarantees are secured by a perfected first priority security interest in substantially all of the
Companys tangible and intangible assets, including intellectual property, real property and all of the capital stock of each of the Companys direct and indirect subsidiaries, excluding immaterial subsidiaries in the process of
dissolution and other specified immaterial subsidiaries.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





(10) Lease Commitments



The Company operates principally in leased offices and warehouse facilities. In addition, Company vehicles, delivery
vehicles and office equipment are leased under various operating leases. Lease terms range from four months to ten years with renewal options for additional periods. Many leases provide that the Company pay taxes, maintenance, insurance and other
expenses. Rentals are generally increased annually by the Consumer Price Index, subject to certain maximum amounts defined within individual agreements.



The Company recognizes rent expense on a straight-line basis over the expected lease term. Rental expense for building and vehicle leases approximated
$24,590, $22,079 and $25,289 for the years ended December 31, 2003, 2004 and 2005, respectively, and is included in selling, general and administrative expenses in the accompanying consolidated statement of operations. The difference between
the straight-line expense and the rent payments is recorded as a liability. At December 31, 2005, the short term portion of the liability of $46 is included in the accompanying consolidated balance sheet within accrued expenses and other
current liabilities. The long term liability portion of $487 is included in the other long-term liabilities.



Future minimum rental commitments under non-cancelable leases, for branch locations and vehicle leases, are as follows:



|                                  |  |   |       
|--------------------------------- |  | - | ------
|For the years ending December 31: |  |   |       
|2006                              |  | $ | 21,516
|2007                              |  |   | 14,159
|2008                              |  |   | 9,000 
|2009                              |  |   | 6,072 
|2010                              |  |   | 3,801 
|Thereafter                        |  |   | 488   
|                                  |  |   |       
|                                  |  | $ | 55,036
|                                  |  |   |       



(11) Income Taxes



In connection with the Plan, the Company entered into a
Tax Sharing Agreement with the Predecessor and IHS that sets forth the Companys rights and obligations with respect to taxes arising from and in connection with the implementation of the Plan. The Tax Sharing Agreement sets forth that the
parties to the agreement will, for tax purposes, treat the transfer of the Predecessors assets to the Company as a taxable event rather than as a tax-free reorganization. An election was made under Section 338(h)(10) of the Internal
Revenue Code of 1986, as amended, and under analogous state and local law, with respect to the transfer of the Predecessors assets to the Company. As a result of such election, the Company accounted for the acquisition of the stock of all of
the subsidiaries as if it had acquired the assets of those subsidiaries for income tax purposes. This deemed asset purchase agreement resulted in some increase in the immediate tax cost of the restructuring, but the Companys tax basis used in
calculating depreciation and amortization deductions for these assets increased substantially, resulting in future tax savings. The Company believes that the present value of such future tax savings will be significantly greater than the tax costs
incurred in making the election.



The parties have agreed to
provide assistance to each other in the preparation and filing of tax returns, defending audits and related matters. The Company has agreed to indemnify the Predecessor and IHS for all taxes attributable to the Company and incurred in connection
with the implementation of the Plan and will



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





indemnify the Predecessor and IHS for all taxes that they incur as a result of the Section 338(h)(10) and similar elections, other than up to $2 million
of certain specified taxes. Also, IHS has agreed to indemnify the Company and the Predecessor for all taxes attributable to IHS and subsidiaries that are not also subsidiaries of the Company or the Predecessor.



Prior to March 31, 2002, the Predecessor was included in IHSs
consolidated federal income tax return. The allocated provision for current income taxes is applied to increase balances due to the parent company. The allocated provision for income taxes on earnings before income taxes is summarized below for the
years ended December 31, 2003, 2004 and 2005:



|                         |  |      |       |   |      |   |        |  |   |       |  
|------------------------ |  | ---- | ----- | - | ---- | - | ------ |  | - | ----- | -
|                         |  | 2003 |       |   | 2004 |   | 2005   | 
|Current:                 |  |      |       |   |      |   |        |  |   |       |  
|Federal                  |  | $    |      |   |      | $ | 2,434  |  | $ | (754  | )
|State                    |  |      | 3,000 |   |      |   | 2,454  |  |   | 856   |  
|                         |  |      |       |   |      |   |        |  |   |       |  
|Total current provision  |  |      | 3,000 |   |      |   | 4,888  |  |   | 102   |  
|                         |  |      |       |   |      |   |        |  |   |       |  
|Deferred:                |  |      |       |   |      |   |        |  |   |       |  
|Federal                  |  |      | 3,753 |   |      |   | 20,403 |  |   | 3,158 |  
|State                    |  |      | (22   | ) |      |   | 2,273  |  |   | 353   |  
|                         |  |      |       |   |      |   |        |  |   |       |  
|Total deferred provision |  |      | 3,731 |   |      |   | 22,676 |  |   | 3,511 |  
|                         |  |      |       |   |      |   |        |  |   |       |  
|                         |  | $    | 6,731 |   |      | $ | 27,564 |  | $ | 3,613 |  
|                         |  |      |       |   |      |   |        |  |   |       |  



Deferred income taxes
reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Companys deferred tax
liabilities and assets as of December 31 are as follows:



|                                                        |  |      |         |   |      |   |         |  
|------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                        |  | 2004 |         |   | 2005 |  
|Long-term deferred tax (asset) liabilities:             |  |      |         |   |      |   |         |  
|Excess of book over tax basis of property and equipment |  | $    | 1,672   |   |      | $ | (181    | )
|Excess of book over tax basis of intangible assets      |  |      | 48,377  |   |      |   | 66,462  |  
|Net operating loss                                      |  |      |        |   |      |   | (34,707 | )
|Other                                                   |  |      | 277     |   |      |   |        |  
|                                                        |  |      |         |   |      |   |         |  
|Total long-term deferred tax (asset) liabilities, net   |  |      | 50,326  |   |      |   | 31,574  |  
|                                                        |  |      |         |   |      |   |         |  
|Current deferred tax (asset) liabilities:               |  |      |         |   |      |   |         |  
|Deferred revenue                                        |  |      | 8,084   |   |      |   | 9,992   |  
|Other accrued liabilities                               |  |      | (661    | ) |      |   | (1,188  | )
|Net operating loss                                      |  |      | (21,702 | ) |      |   |        |  
|Other                                                   |  |      | 1,368   |   |      |   | 1,913   |  
|                                                        |  |      |         |   |      |   |         |  
|Total current deferred tax (asset) liabilities, net     |  |      | (12,911 | ) |      |   | 10,717  |  
|                                                        |  |      |         |   |      |   |         |  
|Net deferred tax liabilities                            |  | $    | 37,415  |   |      | $ | 42,291  |  
|                                                        |  |      |         |   |      |   |         |  



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





A reconciliation of the tax provision computed at the statutory federal tax rate on earnings before
income taxes to the actual income tax provision is as follows for the years ended December 31, 2003, 2004 and 2005:



|                                                                                 |  |      |       |      |   |        |  |   |       |  
|-------------------------------------------------------------------------------- |  | ---- | ----- | ---- | - | ------ |  | - | ----- | -
|                                                                                 |  | 2003 |       | 2004 |   | 2005   | 
|Tax provision computed at the statutory rate                                     |  | $    | 5,290 |      | $ | 22,251 |  | $ | 3,206 |  
|State income taxes, net of federal income tax benefit                            |  |      | 642   |      |   | 2,100  |  |   | 320   |  
|Intangibles amortization and other book expenses not deductible for tax purposes |  |      | 476   |      |   | 374    |  |   | 236   |  
|Other                                                                            |  |      | 323   |      |   | 2,839  |  |   | (149  | )
|                                                                                 |  |      |       |      |   |        |  |   |       |  
|Total income tax expense                                                         |  | $    | 6,731 |      | $ | 27,564 |  | $ | 3,613 |  
|                                                                                 |  |      |       |      |   |        |  |   |       |  



Generally accepted
accounting principles require a valuation allowance to be provided to reduce the carrying value of deferred tax assets reported if, based on the weight of the evidence, it is more likely than not that some portion or all of the deferred tax assets
will not be realized. After consideration of all the evidence, both positive and negative, management has determined that a valuation allowance is not necessary as of December 31, 2004 and 2005.



At December 31, 2005, the Company has available federal net operating
loss carry-forwards of approximately $88,750, which expire in 2025. As of December 31, 2005, the Company has reclassified its deferred tax asset relating to net operating loss carry-forwards from a current asset to a long term asset. The
reclassification is attributable to the Companys estimate that it will not have sufficient taxable income in the current period to offset the net operating loss carry-forward.



The Company believes it has adequately provided for income tax issues not yet resolved with federal, state and local tax
authorities. At December 31, 2005, $3,000 was accrued for such federal, state and local tax matters and is included in income taxes payable. Although not probable, the most adverse resolution of these federal, state and local tax issues could
result in additional charges to earnings in future periods in addition to the $3,000 currently provided. Based upon a consideration of all relevant facts and circumstances, the Company does not believe the ultimate resolution of tax issues for all
open tax periods will have a material adverse effect upon its results of operations or financial condition.



(12)    Insurance Coverage



The Company has a self-insured plan for health and medical coverage for its employees. A stop-loss provision provides for coverage by a commercial insurance company of specific claims paid in the plan year in excess
of $175. Total recorded liabilities for group health insurance claims payable, including an estimate for incurred but not reported claims included in accrued expenses and other current liabilities in the accompanying consolidated balance sheets were
approximately $2,744 and $2,921 as of December 31, 2004 and 2005, respectively.



The Company is subject to workers compensation and employee health benefit claims, which are primarily self-insured; however, the Company does maintain certain stop-loss and other insurance coverage which
management believes to be appropriate. Provisions for estimated settlements relating to the workers compensation and health benefit plans are provided in the period of the related claim on a case-by-case basis plus an amount for incurred but
not reported claims. Differences between the amounts accrued and subsequent settlements are recorded in operations in the period of settlement.





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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





(13)    Certain Significant Risks and Uncertainties



The Company and others in the healthcare business are subject to certain
inherent risks, including the following:



| |  |  | Substantial dependence on revenues derived from reimbursement by the Federal Medicare and State Medicaid programs which have been reduced in recent years and which entail exposure
to various health care fraud statutes;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Government regulations, government budgetary constraints and proposed legislative and regulatory changes; and
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | Lawsuits alleging malpractice and related claims.
| | - |  | -------------------------------------------------



Such inherent risks require the use of certain management estimates in the preparation of the Companys consolidated financial statements and it is
reasonably possible that a change in such estimates may occur.



The Company receives payment for a significant portion of services rendered to patients from the Federal government under Medicare and other federally funded programs (primarily Veterans Administration) and from the states in which its
facilities and/or services are located under Medicaid. Revenue derived from Medicare, Medicaid and other federally funded programs represented a significant concentration of business (see Concentration of Credit Risk).



Federal law continues to impact and reduce Medicare payment levels. The
Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, significantly changed the Medicare reimbursement methodology and conditions for coverage for a number of our products. These changes include a freeze in payments for home
medical equipment from 2004 through 2008, competitive bidding requirements, new clinical conditions for payment and quality standards. The impact of competitive bidding, new clinical conditions and quality standards is uncertain at this time. The
MMA changes also include a reduction in reimbursement rates for oxygen equipment and certain other items of home medical equipment (including wheelchairs, nebulizers, hospital beds and air mattresses) as of January 1, 2005, based on the
percentage difference between the amount of payment otherwise determined for 2002 and the 2002 median reimbursement amount under the Federal Employee Health Benefits Program, or FEHBP, as determined by the Office of the Inspector General of the
Department of Health and Human Services, or OIG. Because of a delay in publication of the OIGs final report on oxygen prices, reduced rates for oxygen equipment were not implemented until April 2005. As of January 1, 2005, MMA also
reduced payments for inhalation drugs delivered through nebulizer equipment to an amount based on 106% of average sales price, or ASP. Reductions in Medicare reimbursement for oxygen equipment, non-oxygen HME items subject to the Medicare price cuts
and inhalation medications could have a material adverse effect on our revenues, profitability and results of operations.



The Companys operations are subject to a variety of Federal, State and Local legal and regulatory risks, including without limitation the Federal
Anti-Kickback Statute and the Federal Ethics in Patient Referral Act (so-called Stark Law) and the False Claims Act, many of which apply to virtually all companies engaged in the healthcare services industry. The Anti-Kickback Statute
prohibits, among other things, the offer, payment, solicitation or receipt of any form of remuneration in return for or to induce the referral of Medicare and Medicaid patients. The Stark Law prohibits certain financial relationships between
ancillary service providers and referring physicians. The False Claims Act prohibits any person from knowingly presenting, or causing to be presented for payment, a false or fraudulent claim for payment to the federal government. Other regulatory
risks assumed by the Company and other companies engaged in the health care industry are as follows:



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





| |  |  | Regulatory Requirement DeficienciesIn the ordinary course of business, health care facilities receive notices of deficiencies for failure to comply with various regulatory
requirements. In some cases, the reviewing agency may take adverse actions against a facility, including the imposition of fines, temporary suspension or decertification from participation in the Medicare and Medicaid programs and, in extreme cases,
revocation of a facilitys license.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Changes in laws and regulationsChanges in laws and regulations could have a material adverse effect on licensure, eligibility for participation in government programs,
permissible activities, operating costs and the levels of reimbursement from governmental and other sources.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In response to the aforementioned regulatory risks, the Company formed a Corporate Compliance Department to help identify, prevent and deter instances of
Medicare, Medicaid and other noncompliance. Although the Company strives to manage these regulatory risks, there can be no assurance that federal and/or state regulatory agencies that currently have jurisdiction over matters including, without
limitation, Medicare, Medicaid and other government reimbursement programs, will take the position that the Companys business and operations are in compliance with applicable law or with the standards of such regulatory agencies.



The Company is also subject to malpractice and related claims, which arise
in the normal course of business and which could have a significant effect on the Company. As a result, the Company maintains occurrence basis professional and general liability insurance with coverage and deductibles which management believes to be
appropriate.



(14)    Legal
ProceedingsContingencies



Due to the nature of the
business, the Company is involved from time to time in lawsuits that arise in the ordinary course of business. Management does not believe that any lawsuit the Company (or the Predecessor) are a party to, if resolved adversely, would have a material
adverse effect on the financial condition or results of operations.



As noted previously, on February 2, 2000, IHS and substantially all of its subsidiaries, including the Predecessor filed voluntary petitions in the Bankruptcy Court under Chapter 11 of the United States Bankruptcy Code. By order of the
Bankruptcy Court, the last day on which pre-bankruptcy claims could be filed, with certain exceptions, was August 29, 2000. Claims were asserted against the Predecessor with respect to various obligations. On February 13, 2002, the
Bankruptcy Court confirmed the Predecessors plan of reorganization which became effective on March 26, 2002. On December 20, 2004, the Bankruptcy Court entered a final decree closing the Predecessors bankruptcy case. In
connection with its emergence from bankruptcy, claims made against the Predecessor prior to the date it filed for bankruptcy protection were satisfied in accordance with the terms of the Plan or pursuant to settlement agreements approved by the
Bankruptcy Court. However, although management believes that all pre-petition state claims have also been discharged or dealt with in the Plan, states in other bankruptcy cases have challenged whether, as a matter of law, their claims could be
discharged in a federal bankruptcy proceeding if they never made an appearance in the case. The issue has not been finally settled by the United States Supreme Court. Therefore, there is no assurance that a court would find that emergence from
bankruptcy would discharge all such state claims against the Predecessor or the Company involving pre-petition claims. Since the date of confirmation of the Plan, neither the Company nor the Predecessor has received any correspondence from a state
challenging the pre-petition discharge of claims.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





(15)    Employee Benefit Plans



401(k) Savings Plan



The Company sponsors a 401(k) Savings Plan (the Savings Plan) covering all
full-time employees who have met certain eligibility requirements. The Savings Plan is funded by voluntary employee contributions and by discretionary Company contributions equal to a certain percentage of the employee contributions. Employees
interests in Company contributions vest over five years. The Companys contribution expense was approximately $608, $565 and $507 for the years ended December 31, 2003, 2004 and 2005, respectively.



Employee Profit Sharing Plan



Pursuant to the Plan, the Company contributed 250,000 shares of Series A
Convertible Redeemable Preferred Stock (see Note 18) (Initial Company Contribution) to a trust to establish a tax-qualified defined contribution employee profit sharing retirement plan (Employees Plan). Employees of the Company as of the effective
date of the Employees Plan (Effective Date), were the initial participants in the Employees Plan, and employees joining the Company after the Effective Date are eligible to join the Employees Plan on the January 1 or July 1 following their
first day of employment with the Company. Company contributions to the Employees Plan are fully discretionary. There are no employee contributions under the Employees Plan. Participants are fully and immediately vested in any and all Company
contributions made to the Employees Plan. Any contributions made by the Company to the Employees Plan are allocated to individual participant accounts on the basis of the respective compensation of each participant, as compared to the aggregate
compensation of all participants. The Initial Company Contribution to the Employees Plan was valued at $5,000 and was charged to operations of the Predecessor for the three months ended March 31, 2002. There were no Company contributions made
to the Employees Plan for the years ended December 31, 2003 or 2004. In February 2005, the Companys board of directors authorized a cash contribution in the amount of $500, which was paid on December 27, 2005.



Effective October 12, 2004, the Company repurchased 804 shares of Series
A Preferred for approximately $0.02 million from the Rotech Healthcare Inc. Employees Plan in order to fund the cash payment of benefits from the Employees Plan to certain plan participants that are no longer employed by the Company.



(16)    Stock Compensation Plans



Under the Companys Common Stock Option Plan, which became effective
March 26, 2002, the Company can grant to employees, directors, or consultants incentive and nonqualified options to purchase up to 4,025,000 shares of common stock. The stock options are exercisable over a period determined by the Board of
Directors, but no longer than ten years. At December 31, 2005, options to acquire up to 488,128 shares of common stock were available for grant pursuant to this plan, options exercisable for 3,127,600 shares of common stock were outstanding and
409,272 shares of common stock had been issued upon the exercise of options granted under the Companys Common Stock Option Plan.



The fair value of each option granted is estimated on the date of the grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions used for grants during the twelve months ended December 31, 2003, 2004 and 2005: expected volatility of 5% for 2003 and 27.98% for 2004 and 32.52% for 2005; dividend yield of 0.0%; expected option life of
approximately 5.00 years for 2003, 6.86 years for 2004 and 7.31 years for 2005; and an average risk-free interest rate of 2.98% for 2003, 3.6% for 2004 and 3.93% for 2005.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





The following table summarizes the Companys stock option transactions for the years ended
December 31, 2003, 2004 and 2005:



|                                         |  |                  |   |  |                       |      
|---------------------------------------- |  | ---------------- | - |  | --------------------- | -----
|                                         |  | Number of Shares |   |  | WeightedAverage Price
|Options outstanding at December 31, 2002 |  | 2,106,875        |   |  | $                     | 18.91
|Granted                                  |  | 1,627,500        |   |  |                       | 18.15
|Exercised                                |  | (42,031          | ) |  |                       | 19.68
|Forfeited                                |  | (401,094         | ) |  |                       | 19.28
|                                         |  |                  |   |  |                       |      
|Options outstanding at December 31, 2003 |  | 3,291,250        |   |  | $                     | 18.48
|Granted                                  |  | 440,000          |   |  |                       | 23.39
|Exercised                                |  | (281,716         | ) |  |                       | 19.54
|Forfeited                                |  | (235,159         | ) |  |                       | 18.70
|                                         |  |                  |   |  |                       |      
|Options outstanding at December 31, 2004 |  | 3,214,375        |   |  | $                     | 19.04
|Granted                                  |  | 125,000          |   |  |                       | 24.09
|Exercised                                |  | (85,525          | ) |  |                       | 25.24
|Forfeited                                |  | (126,250         | ) |  |                       | 21.00
|                                         |  |                  |   |  |                       |      
|Options outstanding at December 31, 2005 |  | 3,127,600        |   |  | $                     | 19.23
|                                         |  |                  |   |  |                       |      



Options to purchase
approximately 3,127,600 shares of common stock at prices ranging from $14.55 to $27.55 per share were outstanding as of December 31, 2005.



The following table summarizes the Companys stock options outstanding and exercisable by ranges of option price, as of December 31, 2005:



|                      |  |                             |  |                                       |  |                              |       |                             |           |                              |   |      
|--------------------- |  | --------------------------- |  | ------------------------------------- |  | ---------------------------- | ----- | --------------------------- | --------- | ---------------------------- | - | -----
|                      |  | Options Outstanding         |  | Options Exercisable                  
|Range of Option Price |  | Number ofOptionsOutstanding |  | Weighted AverageRemaining Life(Years) |  | Weighted AverageOption Price |       | Number ofOptionsExercisable |           | Weighted AverageOption Price
|$14.55 - 16.99        |  | 32,000                      |  | 7.38                                  |  | $                            | 14.55 |                             | 32,000    |                              | $ | 14.55
|$17.0 - 19.94         |  | 1,700,600                   |  | 7.14                                  |  | $                            | 17.00 |                             | 1,700,600 |                              | $ | 17.00
|$19.95 - 20.00        |  | 585,000                     |  | 6.44                                  |  | $                            | 20.00 |                             | 585,000   |                              | $ | 20.00
|$20.01 - 26.00        |  | 770,000                     |  | 8.26                                  |  | $                            | 23.33 |                             | 770,000   |                              | $ | 23.33
|$26.01 - 27.55        |  | 40,000                      |  | 9.14                                  |  | $                            | 27.41 |                             | 40,000    |                              | $ | 27.41
|                      |  |                             |  |                                       |  |                              |       |                             |           |                              |   |      
|Total                 |  | 3,127,600                   |  | 7.31                                  |  | $                            | 19.23 |                             | 3,127,600 |                              | $ | 19.23
|                      |  |                             |  |                                       |  |                              |       |                             |           |                              |   |      



The weighted average
exercise prices and grant date fair values of options with an exercise price that is less than, equal to, or greater than, the market price on the grant date are as follows for the years ended December 31, 2003, 2004 and 2005:



|                          |  |               |       |           |   |               |  |           |       |               |   |           |  |   |       |  |   |     
|------------------------- |  | ------------- | ----- | --------- | - | ------------- |  | --------- | ----- | ------------- | - | --------- |  | - | ----- |  | - | ----
|                          |  | 2003          |       | 2004      |   | 2005         
|                          |  | ExercisePrice |       | FairValue |   | ExercisePrice |  | FairValue |       | ExercisePrice |   | FairValue
|Options issued:           |  |               |       |           |   |               |  |           |       |               |   |           |  |   |       |  |   |     
|Less than market price    |  | $             |      |           | $ |              |  | $         |      |               | $ |          |  | $ |      |  | $ |    
|Equal to market price     |  | $             | 22.17 |           | $ | 3.10          |  | $         | 23.39 |               | $ | 3.88      |  | $ | 24.09 |  | $ | 8.89
|Greater than market price |  | $             | 17.00 |           | $ | 1.39          |  | $         |      |               | $ |          |  | $ |      |  | $ |    



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





Effective as of August 1, 2004, the Company established the Rotech Healthcare Inc. Nonemployee
Director Restricted Stock Plan. Under the terms of the plan, non-employee directors will receive a certain number of shares per year subject to transfer restrictions for a set period of time. The maximum number of shares issued under the plan cannot
exceed 200,000. Restricted stock awards for an aggregate amount of 32,000 shares and 40,000 shares of common stock have been granted to the Companys non-employee directors during the years ending December 31, 2004 and 2005, respectively. The
weighted average per share fair value for the 2004 and 2005 grants was $20.50 and $23.19, respectively. Stock compensation expense recognized by the Company in the years ended December 31, 2004 and December 31, 2005 under the restricted
stock plan was approximately $232 and $745, respectively.



(17)    Revenue Data



Net
revenues are derived from the following principal service categories:



|                                     |  |                              |         |      |   |         |  |   |        
|------------------------------------ |  | ---------------------------- | ------- | ---- | - | ------- |  | - | -------
|                                     |  | For Years Ended December 31,
|                                     |  | 2003                         |         | 2004 |   | 2005   
|Oxygen and other respiratory therapy |  | $                            | 487,045 |      | $ | 463,487 |  | $ | 468,187
|Home medical equipment               |  |                              | 85,922  |      |   | 66,088  |  |   | 59,933 
|Other                                |  |                              | 7,632   |      |   | 5,754   |  |   | 5,062  
|                                     |  |                              |         |      |   |         |  |   |        
|                                     |  | $                            | 580,599 |      | $ | 535,329 |  | $ | 533,182
|                                     |  |                              |         |      |   |         |  |   |        



(18)    Series
A Convertible Redeemable Preferred Stock



The Company
issued 250,000 shares of Series A Convertible Redeemable Preferred Stock (Series A Preferred) upon emergence from bankruptcy pursuant to the Plan. The Series A Preferred is held by the Companys employee profit sharing plan (see Note 15) and
the total preferred stock authorized by the Company is 1,000,000 shares. Each share of Series A Preferred has a stated value of $20 and entitles the holder to an annual cumulative dividend equal to 9% of its stated value, payable semi-annually at
the discretion of the Companys board of directors in cash or in additional shares of Series A Preferred.



The Series A Preferred has conditional redemption features. During the first five years, the Series A Preferred is only convertible immediately prior to
the consummation of an underwritten initial public offering of the Companys common stock pursuant to an effective registration statement under the Securities Act of 1933 at a price per share of at least $20 and with gross proceeds to the
Company of at least $100,000. After the fifth anniversary of the date of the first issuance of the Series A Preferred, the Series A Preferred is convertible into shares of the Companys common stock at any time at the option of the holder based
on the conversion ratio of 0.8 shares of common stock for each share of Series A Preferred. If the Series A Preferred is not converted, it must be redeemed by the Company on June 26, 2012 at a redemption amount of $20 per share, plus any
accrued and unpaid dividends. The amount of mandatory redemption of the outstanding 249,196 shares of Preferred Stock would be approximately $4,984 plus any accrued unpaid dividends. Since the Series A Preferred does not contain an unconditional
obligation to redeem as defined in FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity which would require the Series A Preferred to be classified as a liability, we have
presented the Series A Preferred as a mezzanine obligation in the accompanying consolidated financial statements. Effective October 12, 2004, the Company repurchased 804 shares of Series A Preferred for approximately $20 from the Rotech
Healthcare Inc. Employees Plan in order to fund the cash payment of benefits from the Companys employee profit sharing plan to certain plan participants that are no longer employed by the Company.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2003, 2004 and 2005

(In thousands, except share and per share data)





No dividends will be declared or paid upon the Companys common stock, unless and until
dividends have been declared on the Series A Preferred. During June 2004, the Companys Board of Directors declared a dividend in the amount of $900 payable to the holder of the Series A Preferred, which was paid on March 23, 2005.
During September 2005, the Companys Board of Directors declared a dividend in the amount of $450 payable to the holder of the Series A Preferred, which as paid on December 28, 2005.



In the event of any liquidation, or sale or merger, each holder of preferred
stock shall receive, out of the assets of the Company legally available for distribution to its stockholders, prior to any payment to any junior securities, the redemption amount described above as a preferential distribution.



(19)    Restructuring Accruals



During 2003, 2004 and 2005 the Company implemented certain restructuring
activities that included employee reductions and real estate consolidations to improve operating effectiveness and efficiencies. The Company terminated approximately 15% of its employees during the year ended December 31, 2003. The terminated
employees consisted of a variety of corporate and administrative personnel and field staff in a variety of capacities. During the year ended December 31, 2003, $6,508 of restructuring related charges were recognized, which consisted of
severance and lease cancellation charges. Of the $6,508 in charges, $6,232 was paid in cash. As of December 31, 2003, the Company had approximately $1,676 recorded in accrued expenses related to restructuring charges.



During the year ended December 31, 2004, restructuring related charges
were recognized, which consisted of severance and lease cancellation charges in the amount of $538, and the Company made payments in the amount of $1,698 relating to severance and lease cancellation charges.



During the year ending December 31, 2005, restructuring related charges
were recognized, which consisted of severance and lease cancellation charges in the amount of $950, and the Company made payments in the amount of $346 relating to severance and lease cancellation charges. As of December 31, 2005 the Company
had approximately $1,021 recorded in accrued expense related to restructuring charges and severance charges. The restructuring related charges are included in selling, general and administrative expenses in the accompanying consolidated statements
of operations.



F-31