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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, 2006

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:



|                                          |  |                                                   
|----------------------------------------- |  | --------------------------------------------------
|Title of Each Class                       |  | Name of Exchange on Which
Registered              
|Common Stock, $0.0001 par value per share |  | The Nasdaq Stock Market LLC (Nasdaq Global Market)

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

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, 2006, the aggregate market value of the common equity held by non-affiliates of the
registrant was $65,189,240 based on the closing sale price of $3.76 on such date as reported on the NASDAQ Global Market.

As of
March 5, 2007, the registrant had 25,481,270 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 2007 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, 2006.



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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; changes in reimbursement policies, the timing of reimbursements, and other legislative initiatives aimed at reducing health care costs associated with Medicare and
Medicaid, including, without limitation, the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 and the uncertainties relating to inhalation drug reimbursement; issues relating to reimbursement by government and
third party payors for our products and services generally; the costs associated with government regulation of the health care industry; health care reform and the effect of changes in federal and state health care regulations generally; whether we
will be able to successfully complete the process of switching patients to commercially available drug products; the impact of switching patients to commercially available drug products on our revenue and profit; whether we will be subject to
enforcement action or other negative actions in connection with the FDAs warning letter; whether we will be subject to additional regulatory restrictions or penalties; compliance with confidentiality requirements with respect to patient
information; the effects of competition and industry consolidation; our ability to meet our working capital, capital expenditures and other liquidity needs; our access to funds under our senior secured credit facility; our ability to make the
upcoming interest payments on our senior subordinated notes; our ability to maintain compliance with the covenants contained in our credit agreement; compliance with various settlement agreements and corporate compliance programs established by us;
risks related to acquired businesses; the costs and effects of legal proceedings; the risks and uncertainties discussed under the heading Risk Factors in Part I, Item 1A of this report and under the heading Certain Significant
Risks and Uncertainties in Note 16 of the Consolidated Financial Statements included herein and other factors described in our filings with the Securities and Exchange Commission. 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 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. As used
herein, unless otherwise specified or the context otherwise requires, references to the we, our and us refer to the business and operations of Rotech Healthcare Inc. and its subsidiaries.



|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 500 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, which accounted for 87.8% and 88.5% of net revenues for the years ended December 31, 2005 and 2006, respectively. Revenues from respiratory equipment rental and related services 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, which accounted for 11.2% and 11.5% of net revenues for the years ended December 31, 2005 and 2006, respectively. Revenues from rental and sale of durable medical equipment include 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, 2006, we generated net revenues of $498.8 million and incurred a net loss of $534.1 million (including the impact of
a $529.0 million non-cash goodwill impairment charge). For the same period, net cash provided by operating activities was $15.5 million, net cash used in investing activities was $61.7 million and net cash provided by financing activities was $42.2
million.

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. 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 513 full time respiratory therapists. Respiratory therapy equipment rental and related services represented 88.5% of our net revenues for the year ended December 31, 2006.

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;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | 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 provide mechanical breathing assistance to individuals who suffer from certain other respiratory conditions. 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 500 operating centers, which we operate through three geographic 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 and sales functions, as well as our billing and collections services, are administered centrally at our principal offices in Orlando, Florida by our Chief Operating Officer, clinical functions are administered by our
Chief Clinical Officer who reports to our Chief Operating Officer and financial controls are provided by our Chief Financial Officer who reports to our Chief Executive 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.

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 continue
to improve our operating efficiencies in order to position ourselves for future growth by utilizing our proprietary



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information technology platform, as well as third-party software products, to improve our billing, compliance and inventory systems. In addition, we have
reorganized our billing center employees into cross-functional teams, increased billing center staffing levels, and reduced our reliance on temporary labor in order to improve operating efficiencies.

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 for each of the years ended December 31, 2004, 2005 and 2006:



|                                                                                           |  |      |   |  |      |   |  |      |  
|------------------------------------------------------------------------------------------ |  | ---- | - |  | ---- | - |  | ---- | -
|                                                                                           |  | 2004 |   |  | 2005 |   |  | 2006 |  
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 71.0 | % |  | 66.7 | % |  | 67.8 | %
|Commercial payors                                                                          |  | 25.5 | % |  | 29.9 | % |  | 28.7 | %
|Private payors                                                                             |  | 3.5  | % |  | 3.4  | % |  | 3.5  | %

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. Effective January 31, 2006, CIGNA Healthcare (CIGNA) amended its contract with Gentiva Health Services (Gentiva), whereby Gentiva would no longer coordinate specific
respiratory therapy and DME services on behalf of CIGNA. Through our contract with Gentiva, we were a primary provider of such respiratory therapy and DME services to CIGNA patients and as a result of this contract amendment, we experienced a
reduction of approximately $19.3 million in net revenues for the year ended December 31, 2006.

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 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 September 15, 2006, we entered into a credit agreement with
Highland Financial Corp., as lead arranger and sole bookrunner, Nexbank, SSB, as collateral agent and administrative agent, and the several banks and other



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financial institutions or entities from time to time parties to the credit agreement. The credit facility has a maximum credit amount of $120.0 million that
consists of a $25.0 million revolving line of credit including any outstanding stand-by letters of credit, and a $95.0 million term loan (the commitment to fund the last $5.0 million of the revolving line of credit is subject to the approval of
lenders holding a majority of maximum credit amount then outstanding). The credit agreement expires in September 2008 and replaced our previous credit facility. The credit agreement provides for mandatory prepayment and defined prepayment premiums
upon the occurrence of certain specified events.

The credit agreement contains customary events of default. Such events of default
include, but are not limited to: (i) the failure to pay principal or interest when due, (ii) the breach or failure to perform certain covenants or obligations and the failure to cure the same within a specified number of days,
(iii) material breach of our representations and warranties, (iv) the occurrence of a change of control (as defined in the credit agreement), and (v) the commencement of any proceeding relating to bankruptcy by us or any guarantor.
Under certain circumstances, if an event of default occurs and is continuing, payment of amounts due under the credit agreement may be accelerated and the lending commitments under the credit agreement may be terminated.

During 2006, we made term loan principal payments in the amount of $0.4 million (including $0.2 million regularly scheduled term loan amortization
payments under the previous credit facility). At December 31, 2006, the $25.0 million revolving credit facility had not been drawn upon, although standby letters of credit totaling $14.1 million have been issued under this credit facility.

Interest rates and fees

The interest rates per annum applicable to the senior secured credit facilities are Eurodollar -based or, at our option, an alternate base rate, which is the higher of (i) the rate publicly quoted from time to time by The Wall Street
Journal as the Index Rate on corporate loans posted by at least 75% of the nations 30 largest banks and (ii) the Federal Funds Effective Rate plus 50 basis points per annum plus the applicable margin. The applicable
margin is determined in accordance with a pricing grid. The pricing grid is fixed through September 30, 2007, with revolving credit loan margins of 3.00% and 2.00% on Eurodollar and base rate loans, respectively, and term loan margins of
3.50% and 2.50% on Eurodollar and base rate loans, respectively. As of December 31, 2006, the all-in interest rate on our outstanding term loan was 8.85%. Effective October 1, 2007, the applicable margin is subject to quarterly increases
dependent upon our consolidated total leverage ratio. Such increases range from 0.00% to 2.00% per quarter on the applicable margin for all amounts outstanding under the credit facility. We are also obligated to pay a commitment fee
0.375% per annum on the unused portion of our revolving credit facility. We will also be charged a letter of credit fee (plus bank issuance charges) at a rate equal to 3.00% per annum times the undrawn amount of all outstanding letters of
credit, payable monthly in arrears. In addition, the Administrative Agent is entitled to a fronting fee, for its own account, equal to 0.125% per annum times the undrawn amount of all outstanding letters of credit issued by it.

Covenants

The credit agreement
contains customary covenants for financings of this type, including, but not limited to, limitations on liens; limitations on guarantee obligations; limitations on mergers, consolidations, liquidations and dissolutions; limitations on optional
payments and modifications of subordinated and other debt instruments; limitations on transactions with affiliates; limitations on granting negative pledges; limitations on changes in lines of business; and restrictions on our ability to incur
indebtedness, dispose of property, make investments, pay dividends or make capital expenditures. The credit agreement also contains certain financial covenants, including requirements regarding certain specified EBITDA thresholds and a specified
consolidated total leverage ratio. At December 31, 2006, we were in compliance with the covenants under the credit agreement.

Security and guarantees

Our obligations under the credit facilities are guaranteed by each of our direct and indirect
domestic subsidiaries. All obligations under the credit facilities and the guarantees are secured by a first priority security



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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.

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.

Under the terms of the indenture governing our senior subordinated
notes, the notes are subordinated in right of payment to our existing and future senior debt. In the event of a bankruptcy, liquidation, dissolution or similar proceeding, or certain other events, including a payment default on our senior secured
credit facilities, we may be prevented from making payments to the holders of our senior subordinated notes. The indenture governing the senior subordinated notes contains covenants that, among other things, limit our ability to incur additional
indebtedness and issue certain capital stock; pay dividends on, redeem or repurchase capital stock; make investments; sell assets; engage in transactions with affiliates; create certain liens; and consolidate, merge or transfer all or substantially
all of our assets. The indenture also provides that a default under the credit agreement governing our senior secured credit facilities that results in the acceleration of our obligations under such agreement will result in a cross default under the
indenture, which will allow the holders of at least 25% of the principal amount of the then outstanding senior subordinated notes to declare all of the notes immediately due and payable.

Our business is dependent on the availability of funds under our senior secured credit facilities and our ability to make payments to our creditors
including holders of our senior subordinated notes. If we are unable to access funds under the senior credit facilities or make payments on our senior subordinated notes, we may be required to consider all of our alternatives in restructuring our
business and our capital structure including filing for bankruptcy protection. For risks associated with our indebtedness see Item 1ARisk FactorsRisks related to our liquidity and our financing and capital structures.

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 legislative and 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 payors and 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
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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 65 and older 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 addition, Medicaid may cover financially needy children, refugees and pregnant women. In 2006,
Medicare, Medicaid and other federally funded programs (primarily Veterans Administration contracts) accounted for approximately 67.8% of our revenues.

Medicare Laws and Regulations.

Under existing Medicare laws and regulations, the sale and rental of
our products generally are reimbursed by the Medicare program according to prescribed fee schedule amounts calculated using statutorily-prescribed formulas. The Balanced Budget Act of 1997 granted authority to the Secretary of the Department of
Health and Human Services, or DHHS, to increase or reduce the fee schedule amounts for home medical equipment, including oxygen, by up to 15% each year under an inherent reasonableness procedure. The final rule implementing the inherent
reasonableness authority establishes a process for adjusting payments for certain items and services covered by Medicare Part B when existing payment amounts are determined to be grossly excessive or deficient. Using its inherent reasonableness
authority, the Centers for Medicare and Medicaid Services, or CMS, the agency within the U.S. Department of Health and Human Services responsible for administering the Medicare program, and its contractors may reduce reimbursement levels for certain
items and services covered by Medicare Part B, including products and services we offer, which could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations.

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 may be applied to particular products and
services by CMS and its contractors 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 LCA authority, CMS and its contractors may reduce reimbursement levels for certain items and services covered by Medicare Part B, including products and services we offer, which could have a material adverse effect on our revenues,
profit margins, profitability, operating cash flows and results of operations.

Our business has been, and will 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 home medical equipment from 2004 to 2008, competitive bidding requirements, new clinical conditions for reimbursements, accreditation requirements and quality
standards.

(1) 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



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exemption will be applied have not yet been determined and therefore, the impact of such an exemption on our business is uncertain. On April 24, 2006,
CMS issued proposed regulations regarding the implementation of competitive bidding. The proposed regulations include, among other things, proposals regarding how CMS will determine in which MSAs to initiate the program, conditions to be met for
awarding contracts, and the grandfathering of existing oxygen and other HME agreements with beneficiaries if a supplier is not selected. The proposed regulations also would revise the methodology CMS would use to price new products not
included in competitive bidding. The proposed regulations do not provide many of the details needed to assess the impact that competitive bidding and other elements of the rule will have on our business. Until the regulations are finalized,
significant uncertainty remains as to how the competitive bidding program will be implemented. At this time, we do not know which of our products will be subject to competitive bidding, nor can we predict the impact that it will have on our
business.

(2) Certain Clinical Conditions, Accreditation Requirements and Quality Standards. The MMA requires that
new clinical conditions of coverage for HME products and quality standards for HME suppliers be established and implemented. Some clinical conditions have been implemented, such as the requirement for a face-to-face visit by treating physicians for
beneficiaries seeking power mobility devices. On August 14, 2006, CMS published its quality standards for HME suppliers. As an entity that bills Medicare and receives payment from the program, we are subject to these standards. We have revised our
policies and procedures to ensure compliance in all material respects with the quality standards. These standards, which became effective upon publication, will be applied by independent accreditation organizations. The final standards include
business-related standards, such as financial 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
product-specific standards address several of our products, including oxygen and oxygen equipment, CPAP and power and manual wheelchairs and other mobility equipment. The proposed-competitive bidding-regulations also indicate that CMS may require
suppliers participating in the program to meet additional financial standards. At this time, however, we cannot predict the full impact that the clinical conditions, final quality standards or proposed financial standards will have on our business
or the effect such conditions and standards will have on our ability to continue to provide products to Medicare beneficiaries.

On
July 31, 2006, CMS issued a final rule, which implements criteria for accrediting organizations to be selected by CMS to apply the final quality standards. In addition, on November 22, 2006, CMS announced that the Joint Commission on
Accreditation of Healthcare Organizations, or JCAHO, has been selected to be one of the recognized accrediting organizations. Currently, approximately 96.9% of our operating centers are accredited by JCAHO. CMS has not addressed whether suppliers
that are already accredited by the selected accreditation organizations, such as JCAHO, will be grandfathered. The final rule does not provide us with sufficient information to predict the impact of competitive bidding or the final
accreditation criteria on our business.

(3) Reduction in Payments for HME and Inhalation Drugs.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 DHHS, or OIG. The FEHBP adjusted
payments are to remain frozen through 2008 unless the particular item becomes subject to competitive bidding.

On
March 30, 2005, CMS released the new Medicare fee schedule amounts for oxygen equipment that reflect the FEHBP reductions. The new Medicare fee schedule amounts have resulted in a payment reduction of approximately 8.5% and 8.6% for each of the
years ended December 31, 2005 and 2006, respectively, for home oxygen equipment provided by us to Medicare beneficiaries. Any additional reductions in Medicare reimbursement rates for home oxygen equipment could have a material adverse effect
on our revenues, profit margins, profitability, operating cash flows and results of operations. Subsequent changes to the fee schedule amounts for oxygen equipment, which became effective beginning 2007, are discussed below.



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Reductions in payment rates for 2005 established by CMS for the non-oxygen HME items subject to the FEHBP
provisions ranged between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for approximately 4.1% of our recorded revenues for year ended December 31, 2006. Furthermore, the reductions in the Medicare fee
schedules for home oxygen equipment 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 recorded revenues in the
amount of approximately $17.7 million and $17.9 million for the years ended December 31, 2005 and 2006, respectively.

MMA also
revised the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. For the year ended December 31, 2006, Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 11.5% of
our recorded revenues after allowing for the reduction in revenues related to the decreased reimbursement rate for compounded budesonide, which is further described below.

Prior to MMA, Medicare paid for inhalation 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 from 95% to 80% of AWP, a reduction of approximately 15 basis points. Average sale price, or 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, if the ASP exceeds the widely
available market price or the average manufacturer price by more than a threshold amount, ASP is substituted with the lesser of the widely available market price or 103% of the average manufacturer price. This threshold amount was 5% in 2006, which
is to be continued for 2007. 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 example, the payment amounts for albuterol sulfate and ipratropium bromide, two prevalent inhalation drugs, have been
significantly reduced under ASP. Albuterol sulfate has been reduced from an average of $0.390 per milligram in 2004 (80% of AWP) to an average of $0.071 per milligram in 2005 (106% of ASP) and to an average of $0.069 per milligram in 2006 (106% of
ASP). Ipratropium bromide has been reduced from an average of $2.820 per milligram in 2004 (80% of AWP) to an average of $0.210 per milligram in 2005 (106% of ASP) and to an average of $0.217 per milligram in 2006 (106% of ASP).

The change from 80% of AWP to 106% of ASP reduced our revenues by approximately $39.0 million for the year ended December 31, 2005. This reduction
was partially offset by shifts in patient and product mix.

In addition to MMA changes in payment methodology, given the overall reduction
in payment for inhalation drugs dispensed through nebulizers, CMS established a dispensing fee for inhalation drugs shipped to a beneficiary. The 2005 dispensing fee was $57 for a 30-day period or $80 for a 90-day period. Effective January 1,
2006, the dispensing fee for inhalation drugs furnished to beneficiaries remained at $57 for the first 30-day period in which a Medicare beneficiary uses inhalation drugs and was reduced to $33 for each subsequent 30-day period. The dispensing fee
for a 90-day supply of inhalation drugs was likewise reduced to $66. These reductions in the 2006 Medicare dispensing fees reduced our net revenue by approximately $9.8 million for the year ended December 31, 2006. Although CMS has indicated
that the dispensing fee for 2007 will continue to be paid at the 2006 rate, future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows
and results of operations. While we were able, based upon the dispensing fees, to continue to offer inhalation drugs to Medicare patients through 2006, the reductions in dispensing fees for 2006, along with the pricing changes resulting from the ASP
payment rates have resulted 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



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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, profit margins, profitability, operating cash flows and results of operations.

Effective January 1, 2006, CMS established a new billing code and payment methodology for compounded budesonide, which includes compounded budesonide formulations that we provide to Medicare beneficiaries based
on a physicians prescription. Medicare reimbursement rates for compounded budesonide, beginning January 1, 2006, are based on pharmacy invoices submitted for individual claims. This payment amount reflects a reimbursement rate based on
the acquisition of raw materials and is far below the prior years payment amounts. For the year ended December 31, 2006, the new reimbursement rates for compounded budesonide resulted in a reduction in our recorded revenues of
approximately $30.4 million. In light of the reduced reimbursement rates for compounded budesonide and to resolve certain issues associated with a warning letter received from the Food and Drug Administration (FDA) which is discussed in more detail
below, we are not accepting new prescriptions for certain compounded products (including compounded formulations of budesonide) and, where clinically appropriate, have instituted a process to transition patients currently on these compounded
products to commercially available alternative products. In addition, we have taken a one-time, non-cash charge of $4.0 million for the three months and year ended December 31, 2006, to write-off our pharmacy compounding equipment, capitalized
costs associated with our compounding facility, and substantially all remaining balances for budesonide-related accounts receivable. The transition of these patients to commercially available alternative products is expected to have a positive
impact on our revenues during 2007 when compared to 2006, however these products have lower margins and, accordingly, this patient transition will have a material adverse effect on our profit margins, profitability, operating cash flows and results
of operations when compared to the reimbursements for the compounded products under the prior billing code and payment methodology in effect prior to 2006.

Effective January 1, 2007, CMS established new billing codes and payment methodologies for other compounded inhalation drugs, including albuterol and ipratropium. The revised codes distinguish compounded from
non-compounded drugs, and Medicare payments for compounded formulations are to be based on invoices for the compounded materials. Our compounding activities with respect to other inhalation drugs are not material, as such we do not expect that the
new billing codes and payment methodologies with respect to such drugs will have a material adverse effect on our revenues, profit margins, profitability, operating cash flows or results of operations.

In addition to the abovementioned changes for inhalation drugs, in March 2006, Medicare contractors issued a draft local coverage determination, or LCD,
for nebulizers and inhalation drugs dispensed through nebulizers that are covered by Medicare Part B, which proposes to change significantly the payment rates and coverage criteria for several inhalation drugs that we dispense to beneficiaries, in
part using the LCA mechanism discussed above. Specifically, the draft LCD proposes to reduce the payment amount for two FDA-approved drugs. The formulation of levalbuterol (commercially available under the name Xopenex®) would be reduced to the maximum allowable
payment for generic albuterol, and the payment amount for the commercially available combination of levalbuterol and ipratropium (commercially available under the name DuoNeb®) to the maximum allowable payment for separate unit dose vials of albuterol and ipratropium. If implemented,
these reductions could be as much as 95% for Xopenex and 74% for DuoNeb based on January 1, 2007 reimbursement rates. The draft LCD also would eliminate coverage for certain other nebulizer drugs due to a lack of sufficient scientific support for
their administration with a nebulizer and would establish maximum monthly utilization limits for budesonide. The Medicare contractors have accepted written public comments on the proposed changes and also held public meetings to receive comments on
the draft LCD. If adopted as proposed, the draft LCD could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations. Further as to coverage policies, CMS has initiated a national
coverage analysis to evaluate Medicare coverage at the national level for beta adrenergic agonist therapy drugs used for lung diseases. CMS expects to issue its national coverage memorandum on September 18, 2007. At this time we cannot predict
the full impact of the national coverage analysis on our business.



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Further, as to changes under the MMA, CMS has commenced transitioning responsibility for the processing
and payment of claims for home medical equipment under Medicare Part B to four specialty carriers known as Durable Medical Equipment Medicare Administrative Contractors (DME MACs). The transition to the DME MACs, which are replacing the Durable
Medical Equipment Regional Carriers (DMERCs), began on July 1, 2006 and is expected to end on June 1, 2007. As a result of this transitioning process, there have been disruptions and temporary delays in payment of our Part B claims. At
this time, we cannot predict the full impact that the transition will have on claims processing and our ability to collect accounts receivable in a timely manner.

Deficit Reduction Act

The Deficit Reduction Act of 2005, or DRA, which was signed into law on
February 8, 2006, has 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 that began January 1, 2006 for all oxygen equipment. In addition to the changes in the duration of the rental period for capped rental items and oxygen equipment, the DRA permits payments for servicing and maintenance of the products
after ownership transfers to the beneficiary.

On November 1, 2006, CMS released a final rule to implement the DRA changes, which went
into effect January 1, 2007. Under the rule, CMS explains the DRAs 36-month rental cap on oxygen equipment, which went into effect on January 1, 2006. CMS also revised categories and payment amounts for the oxygen equipment and
contents during the rental period and for oxygen contents after equipment ownership by the beneficiary as follows:



| |  |  | Payment for Rental Period. For stationary oxygen equipment, the 2007 payment amount is $198.40, a decrease of $1.44 from the 2006 amount. The portable oxygen
add-on amount remains unchanged from 2006, at $31.79. CMS also created a new class for oxygen-generating portable oxygen equipment and a new monthly rental payment amount of $51.63 for this equipment.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Payment for Contents After Beneficiary Ownership. Payment is based on the type of equipment owned and whether it is oxygen-generating. Previously, CMS paid a
combined average monthly payment amount of $154.90 for furnishing oxygen contents for beneficiary-owned stationary and portable systems. This amount included payment for both stationary contents and portable contents. CMS will split this payment
into a separate monthly payment amount for stationary oxygen content of $77.45 and a separate monthly payment amount for portable oxygen content of $77.45. This payment amount is for oxygen contents for equipment that is not oxygen-generating. If
the beneficiary owns both stationary and portable equipment that is not oxygen-generating, the monthly payment amount for oxygen contents is $154.90. For stationary or portable oxygen equipment that is oxygen-generating, there will be no monthly
payment for contents.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In its November 1, 2006 final rule, CMS also acknowledges certain other payments after
ownership transfers, including payment for supplies such as tubing and masks. In addition, CMS details several requirements regarding a suppliers responsibility to maintain and service capped rental items and provides for a general maintenance
and servicing payment for certain oxygen-generating equipment beginning six months after title has transferred to the beneficiary. While we do not expect the changes in rental periods and payment



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amounts for capped rental items and oxygen equipment to have a material impact on our business in 2007, at this time, we anticipate that the changes in
rental period for capped rental items and oxygen equipment will have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations beginning in 2009. We cannot predict the impact that any
future rulemaking by CMS will have on our business. If payment amounts for oxygen equipment and contents are further reduced in the future, this could have a material adverse effect on our revenues, profit margins, profitability, operating cash
flows and results of operations. Additionally, President George W. Bushs proposed 2008 budget includes a further reduction in the maximum rental period for home oxygen equipment from 36 months to 13 months. It is not clear at this time whether
this proposal or any other proposal will be included in the final 2008 budget approved by Congress, however, any further reductions to the maximum rental period for home oxygen equipment would likely have a material adverse affect on our revenues,
profit margins, profitability, operating cash flows and results of operations.

Food, Drug and Cosmetic Act and FDA Warning Letter and
State Investigation.

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, and similar state 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 and state authorities for compliance with the cGMP and other regulatory requirements. In the past year, several of our sites have been inspected by regulatory authorities. Where required, we took
corrective actions to address the inspectional observations identified during these inspections. For example, during 2006, the Florida State Department of Health (DOH) inspected twelve of our medical gas facilities in Florida. At the conclusion of
each inspection, the DOH inspector presented us with an H-Form 1038 identifying inspectional observations at the applicable location. Of the 12 investigations conducted, five had no observational findings requiring written response. For each of the
remaining seven investigations, we submitted a written response detailing the corrective actions taken in response to the inspectional observations. In addition, as result of the observations made by DOH during these inspections, we developed
Florida-specific policies and procedures intended to ensure that our medical gas facilities in Florida comply with applicable DOH statutes and regulations. We continue to expend significant time, money and other resources in our effort to achieve
substantial compliance with the FDAs cGMP regulations and the state laws applicable to our medical gas operations in the jurisdictions in which we do business. Failure to comply with the FDA and other federal and state regulatory requirements
could subject us 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.

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 the FDA,
is considered to be within the practice of pharmacy and is regulated primarily under state law. Although pharmacy compounding is primarily regulated by state law, the FDA asserts that it has jurisdiction over pharmacy compounding activities that it
believes exceeds the scope of the practice of pharmacy. The FDA may consider such compounding activities to constitute the manufacturing of a new drug subject to the requirements of the FFDCA. The 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, the FDA initiated an inspection of our compounding activities at our Pulmo-Dose pharmacy in Murray, Kentucky. The FDA
completed its audit on August 12, 2005 and, at the conclusion of the audit, the FDA presented us with an FDA Form 483 noting three inspectional observations. We submitted a response to the FDA Form 483 and continued to engage in ongoing
communications with the FDA regarding the inspection and the FDAs continuing review of our pharmacys activities. On August 10, 2006, we received a warning letter from



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the FDA relating to the pharmacy activities at Pulmo-Dose. The warning letter states that Pulmo-Doses compounding of formulations of budesonide,
albuterol/ipratropium, and formoterol/budesonide exceeds the scope of the practice of pharmacy and that Pulmo-Dose is operating as a pharmaceutical manufacturer and not a pharmacy engaged in extemporaneous compounding.

We submitted a formal response to the warning letter on September 8, 2006, explaining that while we disagree with the FDAs assertions, we have
commenced, in collaboration with our patients physicians, a process to switch patients currently taking the compounded products identified in the warning letter to drug products that are commercially available, where clinically appropriate. In
addition, we are not accepting any new prescriptions for these compounded products. As of March 5, 2007, of the approximately 15,000 patients previously receiving compounded drug products, over 12,500 have been successfully switched to
commercially available drug products. We continue to work with our patients physicians to switch the remaining patients and expect completion of this process within the next few months. As a result of our decision to switch these patients to
commercially available drug products, we have taken a one-time, non-cash charge of $4.0 million for the three months and year ended December 31, 2006, to write-off our pharmacy compounding equipment, capitalized costs associated with our
compounding facility, and substantially all remaining balances for budesonide-related accounts receivable. The transition of these patients to commercially available alternative products is expected to have a positive impact on our revenues during
2007 when compared to 2006, however, these products have lower margins and, accordingly, this patient transition will have a material adverse effect on our profit margins, profitability, operating cash flows and results of operations when compared
to the reimbursements for the compounded products under the prior billing code and payment methodology in effect prior to 2006.

On
January 8, 2007, the FDA responded to our letter and indicated that, based on its reanalysis of the assertions made in the warning letter, it remains the FDAs view that Pulmo-Dose is a drug manufacturer within the meaning of
the FFDCA. The FDA further stated that this conclusion applies to all of the preparations compounded at Pulmo-Dose and not just those identified in the warning letter. We submitted our written response to the FDAs January 8, 2007 letter
on March 5, 2007 and we remain committed to working with the FDA to resolve this matter. However, we are unable to predict whether or when we will be able to reach a satisfactory resolution of this matter. As noted above, our compounding
activities with respect to other inhalation drugs are not material.

In February of 2007, a representative from the California Department
of Health Services (the Department) conducted surveys at two locations; 1175 Chess Drive, Unit B, Foster City, CA and 907 Trancas Street, Napa, CA. Each location is licensed by the Department as a Home Medical Device Retailer
and as such, must comply with certain statutes under the California Health and Safety Code (the Code). The Departments representative alleged that each location was in violation of certain sections of the Code. In the Napa
location, an embargo notice was also issued with respect to the dispensing of legend items. Certain legend items were erroneously dispensed during the embargo resulting in an additional notice of violation for the Napa location. The embargo was
lifted by the Department after immediate corrective actions were taken. Both locations are preparing a final corrective action plan for the alleged violations for submission to the Department. In addition, we have provided information relating to
equipment maintenance requirements requested by the representative. This investigation remains open, we intend to continue to cooperate with the investigation and we have suspended billings from these locations to government healthcare programs and
all other payors pending implementation of certain corrective actions. If the Department so elects, the Code allows it to pursue administrative or civil action, with maximum civil penalties of up to $1,000 per violation. In addition, any violation
of an embargo is a misdemeanor under California law. If the matter is referred for criminal prosecution, and there is a criminal conviction, the penalty is imprisonment for not more than one year in the county jail and/or a maximum fine of $1,000
per violation. If we are found to have failed to comply with applicable regulatory requirements, any resulting enforcement action, including related fines, injunctions, and civil or criminal penalties, could limit our ability to operate our Foster
City and Napa locations, which could adversely affect our business and results of operations.



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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 licenses from each state to which we deliver pharmaceuticals. Most states, and the 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. 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.
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. Further, we are required to
maintain state licenses and permits in those states in which we are doing business to meet Medicare and Medicaid requirements. A finding that the state requirements have not been met can result in the recoupment of reimbursement or revocation of our
supplier numbers. 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, including doing Medicare and Medicaid
business in such state or states, would be limited, which could adversely impact our business and results of operations.

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.

Claims Audits

DME MACs and
Durable Medical Equipment Program Safeguard Contractors are private organizations that contract to serve as the governments agents for processing of claims and for conducting periodic pre-payment and post-payment reviews and other audits of
claims for home medical equipment and inhalation drugs dispensed through a nebulizer under Part B of the Medicare program. Medicaid agencies also conduct similar reviews and 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



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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 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



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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.

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
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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 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 we believe we comply 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.



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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.

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

In February 2002, our
predecessor, Rotech Medical Corporation, and the Office of Inspector General of the DHHS, or OIG, 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 term of the Corporate Integrity Agreement expired in February 2007, however, certain sections of the agreement (including, OIG inspection, audit and
review rights and document retention obligations) will remain in effect until the OIG has completed its review of our final annual report and any additional materials submitted by us pursuant to OIGs request. We are required to submit our
final annual report on or before July 11, 2007.

Among other things, the Corporate Integrity Agreement requires us to conduct internal
claims reviews related to our Medicare billing, imposes various training requirements and mandates that we have certain procedures in place with respect to our acquisition process, including the requirement to have an Acquisition Committee which
approves all acquisitions before they are consummated. We believe we are in compliance with these requirements in all material respects.

In addition, 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 96.9% 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



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above factors and that we have an established record as a quality provider of a range of complementary home medical equipment and services.

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

As of March 5, 2007, we have approximately 4,900 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 |  | 58  |  | President, Chief Executive Officer and Director
|Michael R. Dobbs |  | 57  |  | Chief Operating Officer                        
|Steven P. Alsene |  | 37  |  | 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.

Steven P. Alsene became Chief Financial Officer and Treasurer of
our company in September 2006. Prior to his formal appointment as Chief Financial Officer and Treasurer, Mr. Alsene served in such capacity on an interim basis since June 2006. Mr. Alsene joined our company in June 2003 as the Vice
President of Internal Audit and has also served as our Vice President of Finance. From June 1999 to June 2003, Mr. Alsene was the Head of Corporate Audit Services of Harcourt Education, a division of Reed Elsevier PLC. From 1992 to 1999,
Mr. Alsene served in various audit department capacities including audit manager with PricewaterhouseCoopers LLP. Mr. Alsene is a certified public accountant in the State of Florida. He received his Bachelor of Science in Accounting from
Florida State University and holds a Masters in Accounting from Florida State University.



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

You should carefully consider each
of the following risks and all of the other information set forth in this Annual Report on Form 10-K. Based on the information currently known to us, we believe that the following information identifies the most significant risk factors affecting
our company in each of these categories of risk. However, the risks and uncertainties our company faces are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be
immaterial may also adversely affect our business. Past financial performance may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods.

Risks related to our liquidity and our financing and capital structures

Our failure to comply with the financial covenants contained in our credit agreement could materially and adversely affect our operating results and financial condition.

Our current credit agreement contains certain financial covenants, including requirements regarding
certain specified EBITDA thresholds and a specified consolidated total leverage ratio. We failed to comply with the financial covenants contained in our former credit agreement and we may be unable to maintain compliance with the EBITDA threshold
and consolidated total leverage ratio included in our current credit agreement. If we are unable to comply the covenants contained in our current credit agreement, we will be in default under our credit agreement and, under certain circumstances,
the lenders could elect to terminate their commitments thereunder, declare all outstanding borrowings, together with accrued interest and other fees, to be immediately due and payable, could elect to exercise control over our cash through their
rights under the deposit account and control agreement, and institute foreclosure proceedings against those assets that secure the borrowings under our credit agreement. Any such actions could force us into bankruptcy or liquidation. Furthermore, if
our lenders caused all outstanding amounts with respect to the credit agreement debt to be due and payable immediately, we would simultaneously cross default under the indenture governing our 91/2% senior subordinated notes. If accelerated, upon an event of default, our assets and cash flow would be insufficient to fully repay borrowings under our
outstanding debt instruments. Also, if the indebtedness were accelerated, this would raise substantial doubt about our ability to continue as a going concern, which would likely cause a deterioration of our relationships with our



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customers and suppliers and adversely affect our revenues, profit margins, profitability, operating cash flows, results of operations and financial
condition. 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 in which case we may be required to consider all of our alternatives in restructuring our business
and our capital structure including filing for bankruptcy protection.

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

As of December 31, 2006, our total consolidated long-term debt (including current
maturities) accounted for approximately 90% of our total capitalization. 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, including our ability and our decision to make interest payments thereunder when due and payable;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | our existing credit agreement limits our ability to acquire businesses and incur indebtedness required to finance such acquisitions;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to finance and consummate transactions that may be critical to our strategic and financial condition could be limited;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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;
| | - |  | ---------------------------------------------------------------------------------------------------------------



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



| |  |  | our flexibility in planning for, or reacting to, changes in our business and industry may be limited; 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. 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 our credit facility and our senior subordinated notes, on commercially reasonable terms or at all in which case we may be required to consider all of our alternatives in restructuring our business and our capital structure
including filing for bankruptcy protection.

We may not be able to generate sufficient cash to enable us to pay our debt or fund our
other liquidity needs.

Our business may not generate sufficient cash flow from operations and future borrowings may not be
available to us under our credit facilities in an amount sufficient to enable us to pay our debt, or to fund our other liquidity needs. If additional unfavorable regulatory actions are taken with respect to the reimbursement rates that apply to our
business, we experience any significant changes in non-cash working capital (including accounts receivable), we experience material adverse changes in payment patterns from CMS and its contractors or other third-party payors, we experience another
payment hold by CMS similar to that experienced in September 2006, or if we are negatively impacted by other unforeseen factors, we may not have sufficient cash available to meet our working capital, capital expenditure and other cash needs through
2007. In addition, we may need, but be unable to obtain, access to our full credit facility (the commitment to fund the last $5.0 million of the revolving line of credit is subject to the approval of lenders holding a majority of the maximum credit
amount then



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outstanding) in connection with meeting our cash needs. If these or other events take place, we may be required to consider all of our alternatives in
restructuring our business and our capital structure including filing for bankruptcy protection.

We have substantial upcoming
interest payments which we may be unable to pay.

We have interest payments
of $13.6 million each due on April 2 and October 2, 2007 under the indenture governing our 91/2% senior subordinated
notes. It is our current intention to make these interest payments when due and our current cash projections indicate that the cash generated from our operations and funds available under our credit facility will be sufficient to make these interest
payments. However, there can be no assurance that our current cash projections will be realized and if additional unfavorable regulatory actions are taken with respect to the reimbursement rates that apply to our business, we experience any
significant changes in non-cash working capital (including accounts receivable), we experience material adverse changes in payment patterns from CMS and its contractors or other third-party payors, we experience another payment hold by CMS similar
to that experienced in September 2006, or we are negatively impacted by other unforeseen factors, we may not have sufficient cash available to make these interest payments. In addition, we may need, but be unable to obtain, access to our full credit
facility (the commitment to fund the last $5.0 million of the revolving line of credit is subject to the approval of lenders holding a majority of the maximum credit amount then outstanding) in connection with making such interest payments.

If we fail to make the required interest payments on our senior subordinated
notes, we will be in default under the indenture governing our 91/2% senior subordinated notes and, under certain circumstances,
the indenture trustee or the holders of at least 25% in principal amount of the then outstanding notes may declare all notes to be immediately due and payable. Furthermore, if the indenture trustee or our noteholders declared all of our 91/2% senior subordinated notes to be due and payable immediately, it would result in a cross default under our credit agreement. Our
assets and cash flow would not be sufficient to fully repay borrowings under our outstanding debt instruments, if accelerated, upon an event of default. If the indebtedness were accelerated, this would raise substantial doubt about our ability to
continue as a going concern, which would likely cause a deterioration of our relationships with our customers and suppliers and adversely affect our revenues, profit margins, profitability, operating cash flows, results of operations and financial
condition. Any such actions could force us into bankruptcy or liquidation.

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. Recently, a higher percentage of our accounts receivables have been remaining outstanding for longer periods. This increase in the aging of accounts receivable is due to numerous
factors, including, increased transaction volumes from patient growth, general slowdowns in payment processing by Medicare and other third-party payors, delays caused by Medicare beneficiaries switching to HMOs, and billing disruptions related to
the transition to electronic billing for certain third-party payors. We have reorganized our billing centers as well as billing functions in order to improve our collection process and



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also appointed a Vice President of Billing and Collections to implement these initiatives. While these initiatives are designed to improve the collection
process, there can be no assurance that such initiatives will result in improved collections.

Further, even if our billing procedures
comply with all third-party payor requirements, some of our payors may experience financial difficulties, may delay payments or may otherwise not pay accounts receivable when due, which would result in increased write-offs or provisions for doubtful
accounts. For example, CMS placed a hold on payments for all claims under Medicare Parts A and B from all providers and all physicians during the last nine days of the 2006 Federal fiscal year (September 22September 30, 2006). Information is
not available to determine the exact impact of this payment hold; however, we have estimated the impact to be between $4.1 million and $7.7 million, which resulted in a corresponding increase in accounts receivable and decrease in cash at
September 30, 2006. We received payment for claims impacted by the payment hold during the first two weeks of October 2006. In addition, we also continue to experience unpredictable and volatile payment patterns from CMS, its contractors and
other third-party payors. As such, 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 significantly 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.

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 December 31, 2006, our five
largest stockholders held in the aggregate approximately 67% 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. In addition, any of these large stockholders acting singly could work to frustrate the majority.

Risks related to our reliance on Medicare, Medicaid and other third-party reimbursement

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 is 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 71.0%, 66.7% and 67.8% for each of the
years ended December 31, 2004, 2005 and 2006, respectively.

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



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bidding requirements, new clinical conditions for payment and accreditation requirements 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, profit margins, profitability, operating cash flows and results of operations. We cannot predict the impact that any federal legislation enacted in the future will have on our revenues, profit margins, profitability,
operating cash flows and results of operations.

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 frozen at the 2003 level 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 reduced based on this calculation.

The non-oxygen HME items subject to the Medicare price cuts accounted for
approximately 4.1% of our recorded revenues in 2006. Furthermore, the reductions in the Medicare fee schedules for home oxygen equipment 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 2006 recorded revenues in the amount of approximately $17.9 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.

The Deficit Reduction Act of 2005, or DRA, which was signed into law on February 8, 2006, also has 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



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period that began 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.

On November 1, 2006, CMS released a final rule to implement the DRA changes, which went into effect
January 1, 2007. Under the rule, CMS explains the DRAs 36-month rental cap on oxygen equipment that began on January 1, 2006. CMS also revised categories and payment amounts for the oxygen equipment and contents during the rental
period and for oxygen contents after equipment ownership by the beneficiary as follows:



| |  |  | Payment for Rental Period. For stationary oxygen equipment, the 2007 payment amount is $198.40, a decrease of $1.44 from the 2006 amount. The portable oxygen
add-on amount remains unchanged from 2006, at $31.79. CMS also created a new class for oxygen-generating portable oxygen equipment and a new monthly rental payment amount of $51.63 for this equipment.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Payment for Contents After Beneficiary Ownership. Payment is based on the type of equipment owned and whether it is oxygen-generating. Previously, CMS paid a
combined average monthly payment amount of $154.90 for furnishing oxygen contents for beneficiary-owned stationary and portable systems. This amount included payment for both stationary contents and portable contents. CMS will split this payment
into a separate monthly payment amount for stationary oxygen content of $77.45 and a separate monthly payment amount for portable oxygen content of $77.45. This payment amount is for oxygen contents for equipment that is not oxygen-generating. If
the beneficiary owns both stationary and portable equipment that is not oxygen-generating, the monthly payment amount for oxygen contents is $154.90. For stationary or portable oxygen equipment that is oxygen-generating, there will be no monthly
payment for contents.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In its November 1, 2006 final rule, CMS also acknowledges certain other payments after
ownership transfers, including payment for supplies such as tubing and masks. In addition, CMS details several requirements regarding a suppliers responsibility to maintain and service capped rental items and provides for a general maintenance
and servicing payment for certain oxygen-generating equipment beginning six months after title has transferred to the beneficiary. While we do not expect the changes in rental periods and payment amounts for capped rental items and oxygen equipment
to have a material impact on our business in 2007, at this time, we anticipate that the changes in rental period for capped rental items and oxygen equipment will have a material adverse effect on our revenues, profit margins, profitability,
operating cash flows and results of operations beginning in 2009. We cannot predict the impact that any future rulemaking by CMS will have on our business. If payment amounts for oxygen equipment and contents are further reduced in the future, this
could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations. Additionally, President George W. Bushs proposed 2008 budget includes a further reduction in the maximum
rental period for home oxygen equipment from 36 months to 13 months. It is not clear at this time whether this proposal or any other proposal will be included in the final 2008 budget approved by Congress, however, any further reductions to the
maximum rental period for home oxygen equipment would likely have a material adverse affect on our revenues, profit margins, profitability, operating cash flows and results of operations.

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.

The MMA revised 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



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reported by drug manufacturers. Beginning January 1, 2004, Medicare payments for inhalation drugs 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 $39 million in 2005. The reduction in 2005 was partially offset by shifts in patient and product mix.

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, if the ASP exceeds the widely available market price or the average manufacturer price by more than a threshold amount, ASP is substituted with the lesser of the widely available
market price or 103% of the average manufacturer price. This threshold amount was 5% in 2006, which is to be continued for 2007. 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, fourth quarter 2005 data was used to calculate the ASP
payment amounts for the second quarter of 2006. ASP payment amounts for our products may fluctuate from quarter to quarter. For each of the quarters of 2005, as well as each of the quarters 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. Albuterol sulfate has been reduced from an average of $0.390 per milligram in 2004 (80% of AWP) to an
average of $0.071 per milligram in 2005 (106% of ASP) and to an average of $0.069 per milligram in 2006 (106% of ASP). Ipratropium bromide has been reduced from an average of $2.820 per milligram in 2004 (80% of AWP) to an average of $0.210 per
milligram in 2005 (106% of ASP) and to an average of $0.217 per milligram in 2006 (106% of ASP).

In addition to MMA changes in payment
methodology, given the overall reduction in payment for inhalation drugs dispensed through nebulizers, CMS established a dispensing fee for inhalation drugs shipped to a beneficiary. The 2005 dispensing fee was $57 for a 30-day period or $80 for a
90-day period. Effective January 1, 2006, the dispensing fee for inhalation drugs furnished to beneficiaries remained at $57 for the first 30-day period in which a Medicare beneficiary uses inhalation drugs and was reduced to $33 for each
subsequent 30-day period. The dispensing fee for a 90-day supply of inhalation drugs was likewise reduced to $66. These reductions in the 2006 Medicare dispensing fees reduced our net revenue by approximately $9.8 million for the year ended
December 31, 2006. Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 18.2% and 11.5% of our recorded revenues for the years ended December 31, 2005 and 2006, respectively. The reduction experienced in
2006 was caused primarily by the decreased reimbursement rate for budesonide. The dispensing fees offset, to some extent, the reductions in payment rates for inhalation drugs established under the ASP methodology. Although CMS has indicated that the
dispensing fee for 2007 will continue to be paid at the 2006 rate, future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results
of operations. While we were able, based upon the dispensing fees, to continue to offer inhalation drugs to Medicare patients through 2006, the reductions in dispensing fees for 2006, along with the pricing changes resulting from the ASP payment
rates have resulted 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, profit margins,
profitability, operating cash flows and results of operations.

Effective January 1, 2006, CMS established a new billing code and
payment methodology for compounded budesonide, which includes compounded budesonide formulations that we provide to Medicare beneficiaries



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based on a physicians prescription. Medicare reimbursement rates for compounded budesonide, beginning January 1, 2006, are based on pharmacy
invoices submitted for individual claims. This payment amount reflects a reimbursement rate based on the acquisition of raw materials and is far below the prior years payment amounts. For the year ended December 31, 2006, the new
reimbursement rates for compounded budesonide resulted in a reduction in our recorded revenues of approximately $30.4 million. In light of the reduced reimbursement rates for compounded budesonide and to resolve certain issues associated with a
warning letter received from the Food and Drug Administration (FDA) which is discussed in more detail below, we are not accepting new prescriptions for certain compounded products (including compounded formulations of budesonide) and, where
clinically appropriate, have instituted a process to transition patients currently on these compounded products to commercially available alternative products. As a result of our decision to switch these patients to commercially available drug
products, we have taken a one-time, non-cash charge of $4.0 million for the three months and year ended December 31, 2006, to write-off our pharmacy compounding equipment, capitalized costs associated with our compounding facility, and
substantially all remaining balances for budesonide-related accounts receivable. The transition of these patients to commercially available alternative products is expected to have a positive impact on our revenues during 2007 when compared to 2006,
however these products have lower margins and, accordingly, this patient transition will have a material adverse effect on our profit margins, profitability, operating cash flows and results of operations when compared to the reimbursements for the
compounded products under the prior billing code and payment methodology in effect prior to 2006.

Effective January 1, 2007, CMS
established new billing codes and payment methodologies for other compounded inhalation drugs, including albuterol and ipratropium. The revised codes distinguish compounded from non-compounded drugs, and Medicare payments for compounded formulations
are to be based on invoices for the compounded materials. Our compounding activities with respect to other inhalation drugs are not material, as such we do not expect that the new billing codes and payment methodologies with respect to such drugs
will have a material adverse effect on our revenues, profit margins, profitability, operating cash flows or results of operations.

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.

On April 24, 2006, CMS issued proposed regulations regarding the implementation of competitive bidding. The proposed regulations include, among
other things, proposals regarding how CMS will determine in which MSAs to initiate the program and which products and product categories to competitively bid, conditions to be met for awarding contracts, and the grandfathering of
existing oxygen and other HME agreements with beneficiaries if a supplier is not selected. CMS proposed a number of methodologies it is considering to evaluate bids and set the payment rates for the products that are competitively bid. The proposed
regulations also would revise the methodology CMS would use to price new products not included in competitive bidding. The proposed regulations do not provide many of the details needed to assess the impact that competitive bidding and other
elements of the rule will have on our business. Until the regulations are finalized, significant uncertainty remains as to how the competitive bidding program will be implemented.



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Regulatory and other policy 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 up to 15% each year under an inherent reasonableness
procedure. On December 13, 2005, CMS published a final rule implementing the inherent reasonableness authority, which became effective on February 11, 2006. The agencys final rule essentially left in place the criteria already
articulated in an earlier interim final rule. The final rule allows the agency and its contractors 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 its contractors 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 its contractors 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.

In addition to its inherent reasonableness authority, CMS has the discretion to reduce the
reimbursement for home medical equipment 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 may be applied to
particular products and services 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 its contractors 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, profit margins, profitability, operating cash flows and results of operations.

In March 2006, Medicare contractors issued a
draft local coverage determination, or LCD, for nebulizers and inhalation drugs dispensed through nebulizers that are covered by Medicare Part B, which proposes to change significantly the payment rates and coverage criteria for several inhalation
drugs that we dispense to beneficiaries, in part using the LCA mechanism discussed above. Specifically, the draft LCD proposes to reduce the payment amount for two FDA-approved drugs. The formulation of levalbuterol (commercially available under the
name Xopenex®) would be reduced to the
maximum allowable payment for generic albuterol, and the payment amount for the commercially available combination of levalbuterol and ipratropium (commercially available under the name DuoNeb®) to the maximum allowable payment for separate unit dose vials of albuterol and
ipratropium. If implemented, these reductions could be as much as 95% for Xopenex and 74% for DuoNeb based on January 1, 2007 reimbursement rates. The draft LCD also would eliminate coverage for certain other nebulizer drugs due to a lack of
sufficient scientific support for their administration with a nebulizer and would establish maximum monthly utilization limits for budesonide. The Medicare contractors have accepted written public comments on the proposed changes and also held
public meetings to receive comments on the draft LCD. If adopted as proposed, the draft LCD could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations. Further, as to coverage
policies, CMS has initiated a national coverage analysis to evaluate Medicare coverage at the national level for beta adrenergic agonist therapy drugs used for lung diseases. CMS expects to issue its national coverage memorandum on
September 18, 2007. At this time we cannot predict the full impact of the national coverage analysis on our business.

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.



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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.

Risks related to our compliance with federal and state
regulatory agencies, as well as accreditation standards

The FDA has asserted that our pharmacy compounding practices with respect
to certain products constitute drug manufacturing which could require us to discontinue compounding activities for these and other products, and we could be subject to enforcement action, including temporary or permanent suspension of part or all of
our compounding operations or seizure of part or all of our compounded formulations.

Our Pulmo-Dose pharmacy in Murray, Kentucky
dispenses 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 the Food and Drug Administration (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 the FDA under the Federal Food Drug and Cosmetic Act (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, the 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, the
FDA initiated an inspection of our Pulmo-Dose pharmacy in Murray, Kentucky. The FDA completed its audit on August 12, 2005 and noted three inspectional observations. We promptly submitted a response to the FDA and continued to engage in ongoing
communications with the FDA regarding the inspection and the FDAs continuing review of our pharmacys activities.

On
August 10, 2006, we received a warning letter from the FDA relating to our subsidiary, Pulmo-Dose, Inc. The warning letter states that Pulmo-Doses compounding of formulations of budesonide, albuterol/ipratropium, and formoterol/budesonide
exceeds the scope of the practice of pharmacy and that Pulmo-Dose is operating as a pharmaceutical manufacturer and not a pharmacy engaged in extemporaneous compounding.

We submitted a formal response to the warning letter on September 8, 2006, explaining that while we disagree with the FDAs assertions, we have commenced, in collaboration with our patients physicians,
a process to switch patients currently taking the compounded products identified in the warning letter to drug products that are commercially available, where clinically appropriate. In addition, we are not accepting any new prescriptions for these
compounded products. As of March 5, 2007, of the approximately 15,000 patients previously receiving compounded drug products, over 12,500 have been successfully switched to commercially available drug products. We continue to work with our
patients physicians to switch the remaining patients and expect completion of this process within the next few months. As a result of our decision to switch these patients



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to commercially available drug products, we have taken a one-time, non-cash charge of $4.0 million for the three months and year ended December 31,
2006, to write-off our pharmacy compounding equipment, capitalized costs associated with our compounding facility, and substantially all remaining balances for budesonide-related accounts receivable. The transition of these patients to commercially
available alternative products is expected to have a positive impact on our revenues during 2007 when compared to 2006, however, these products have lower margins and, accordingly, this patient transition will have a material adverse effect on our
profit margins, profitability, operating cash flows and results of operations when compared to the reimbursements for the compounded products under the prior billing code and payment methodology in effect prior to 2006.

On January 8, 2007, the FDA responded to our letter and indicated that, based on its reanalysis of the assertions made in the warning letter, it
remains the FDAs view that Pulmo-Dose is a drug manufacturer within the meaning of the FFDCA. The FDA further stated that this conclusion applies to all of the preparations compounded at Pulmo-Dose and not just those identified in
the warning letter. We submitted our written response to the FDAs January 8, 2007 letter on March 5, 2007 and we remain committed to working with the FDA to resolve this matter. However, we are unable to predict whether or when we
will be able to reach a satisfactory resolution of this matter. As noted above, our compounding activities with respect to other inhalation drugs are not material.

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



| |  |  | confidentiality, privacy and security issues in connection with medical records and patient information;
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| |  |  | relationships with physicians and other referral sources;
| | - |  | ---------------------------------------------------------



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



| |  |  | 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;
| | - |  | ---------------------------------------------------------------------------------



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| |  |  | 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
that 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.

In February of 2007, a representative from the California Department of
Health Services (the Department) conducted surveys at two locations; 1175 Chess Drive, Unit B, Foster City, CA and 907 Trancas Street, Napa, CA. Each location is licensed by the Department as a Home Medical Device Retailer
and as such, must comply



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with certain statutes under the California Health and Safety Code (the Code). The Departments representative alleged that each location was
in violation of certain sections of the Code. In the Napa location, an embargo notice was also issued with respect to the dispensing of legend items. Certain legend items were erroneously dispensed during the embargo resulting in an additional
notice of violation for the Napa location. The embargo was lifted by the Department after immediate corrective actions were taken. Both locations are preparing a final corrective action plan for the alleged violations for submission to the
Department. In addition, we have provided information relating to equipment maintenance requirements requested by the representative. This investigation remains open, we intend to continue to cooperate with the investigation and we have suspended
billings from these locations to government healthcare programs and all other payors pending implementation of certain corrective actions. If the Department so elects, the Code allows it to pursue administrative or civil action, with maximum civil
penalties of up to $1,000 per violation. In addition, any violation of an embargo is a misdemeanor under California law. If the matter is referred for criminal prosecution, and there is a criminal conviction, the penalty is imprisonment for not more
than one year in the county jail and/or a maximum fine of $1,000 per violation. If we are found to have failed to comply with applicable regulatory requirements, any resulting enforcement action, including related fines, injunctions, and civil or
criminal penalties, could limit our ability to operate our Foster City and Napa locations, which could adversely affect our business and results of operations.

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.

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 96.9% of our operating
centers are accredited by the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO. 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 must be accredited as meeting quality standards issued by CMS as a
condition of receiving payment from the Medicare program. On August 14, 2006, CMS published its quality standards for HME suppliers. As an entity that bills Medicare and receives payment from the program, we will be subject to these standards.
The final standards consist of business-related standards, such as financial 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 power and manual wheelchairs and other mobility equipment. We have revised our policies and procedures to
ensure compliance in all material respects with the quality standards.

On July 31, 2006, CMS issued a final rule, which implements
criteria for accrediting organizations to be selected by CMS to apply the final quality standards. In addition, on November 22, 2006, CMS announced that JCAHO has been selected to be one of the recognized accreditation organizations. CMS has
not addressed whether suppliers that are already accredited by the selected accreditation organizations, such as JCAHO, will be grandfathered. The final rule does not provide us with sufficient information to predict the impact of
competitive bidding or the final accreditation criteria on our business.

MMA also authorizes CMS to establish clinical conditions for
payment for home medical equipment. These new 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



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and are subject to any new clinical conditions for payment, our failure to meet such conditions could affect our ability to bill and therefore could have a
material adverse effect on our business, revenues, profit margins, profitability, operating cash flows and results of operations. At this time, we cannot predict the full impact that the clinical conditions will have on our business.

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 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 the 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, the 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 160 medical gas facilities subject to federal and state regulatory requirements, and we expend significant time, money and resources in an effort to achieve substantial compliance
with the cGMP regulations and other federal and state law requirements at each of our medical gas facilities. However, there can be no assurance that these efforts will be successful and that our medical gas facilities will achieve and maintain
compliance with federal and state law 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.

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
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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 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.

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 term of the Corporate Integrity Agreement expired in February 2007, however, certain sections of the agreement
(including, OIG inspection, audit and review rights and document retention obligations) remain in effect until the OIG has completed its review of our final annual report and any additional materials submitted by us pursuant to OIGs request.
We are required to submit our final annual report on or before July 11, 2007. Among other things, the Corporate Integrity Agreement requires us to conduct internal claims reviews relating to our Medicare billing. 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 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.

Risks
related to operational and financial performance

Inability to maintain significant vendor relationships could result in a
significant disruption in our business, materially adversely affect our results of operations and result in an inability to serve our patients if we lose these relationships.

We currently have certain critical vendor relationships. Although we have been able to maintain such relationships without material interruption in the
past, there can be no assurance that such relationships will continue. Should any of these vendors elect not to provide services, equipment, inhalation drugs or supplies to us, there would likely be a significant disruption to our business, a
material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations and an inability to serve our patients until such time as a replacement vendor could be identified. This could occur if there is a
deterioration or perceived deterioration of our financial position, including our standing with respect to our senior subordinated debt. Moreover, there can be no assurance that the pricing structure that we currently enjoy would be matched by a
replacement vendor. Additionally, any future issues with liquidity, debt covenant compliance or declines in our results of operations, could adversely impact our ability to leverage our purchasing activities with new or existing vendors.



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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.

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. We have
devoted significant resources to remediate any deficiencies we have discovered 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, 2006, management concluded that our internal control over financial reporting was effective as of such date. 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 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.

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 additional intangible assets, such as goodwill.

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 of reorganization value in excess of fair value of identifiable assets-goodwill. As of December 31, 2006, the reorganization value in excess of fair value of identifiable assets-goodwill
was approximately $163.2 million after we recorded $529.0 million



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in impairment charges, as described below. Other goodwill represents the excess of cost over fair value of assets acquired and liabilities assumed of
purchased operations. As of December 31, 2006, this goodwill was approximately $43.9 million. Any future acquisitions by us will likely result in the recognition of additional intangible assets.

Due to an overall decline in our profitability which resulted primarily from decreases in Medicare reimbursement rates, including the recent reductions
for compounded budesonide and the resulting decline in our market capitalization, we recorded non-cash goodwill impairment charges of $529.0 million for the year ended December 31, 2006.

On an ongoing basis, we evaluate whether facts and circumstances indicate any impairment of value of intangible assets. 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.

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.

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



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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 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.

Risks related to
competition and referral sources

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 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. Effective January 31, 2006, CIGNA Healthcare (CIGNA) amended its contract with Gentiva Health Services
(Gentiva), whereby Gentiva would no longer coordinate specific respiratory therapy and DME services on behalf of CIGNA. Through our contract with Gentiva, we were a primary provider of such respiratory therapy and DME services to CIGNA
patients and as a result of this contract amendment, we experienced a reduction of approximately $19.3 million in net revenues for the year ended December 31, 2006.

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.

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



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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.

Risks related to recruiting, hiring and retaining qualified
employees and directors

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 4,900 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. Further, in the event that our business operations or financial condition further deteriorate, we may not be able to maintain or
recruit critical employees.

We may be unable to recruit independent individuals to serve as members of our Board of Directors.

Our board of directors is currently comprised of five members, three of whom are independent under applicable NASDAQ marketplace
rules. The chairman of our board of directors is not independent under applicable NASDAQ marketplace rules and currently serves on certain of our board committees under an exception to NASDAQs independence requirements. In addition, there are
currently two vacancies on our board of directors. Due to our current financial condition and the regulatory environment in which we operate, we may be unable to recruit independent individuals to serve on our board if required.



|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 $53,812 per month (including sales tax), plus operating costs (which have historically been approximately $6,000 per month (including sales tax)). In addition to our corporate headquarters, we lease
office facilities for approximately 500 locations. These facilities are primarily used for general office work and the dispatching of registered respiratory



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therapists, registered nurses, registered pharmacists and delivery personnel. Our office facilities vary in size from approximately 550 to 60,000 square
feet. The total space leased for these offices is approximately 2.37 million square feet at an average price of $8.81 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 in lawsuits that arise in the ordinary course of business. Management does not believe that any lawsuit we (or our predecessor, Rotech Medical Corporation) 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 previously disclosed internal investigation regarding VA contracts and we have
provided documents in response to such requests. We have not had any communications with the SEC regarding this matter since 2003. In addition, on August 25, 2005, we received a request for information and documents from the Division of
Enforcement of the SEC related to our restatement of prior period financial results discussed in Note 21 to the consolidated financial statements included in our annual report on Form 10-K/A for the year ended December 31, 2004. We are fully
cooperating with the SEC and have provided documents in response to such request. We have 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. The case
is currently stayed until April 30, 2007. In addition, on November 7, 2006, one of our subsidiaries, Rotherts Hospital Equipment, Inc., received a subpoena from the Office of Inspector General for the Department of Health and Human
Services. The subpoena requested documents relating to Medicare billing in the Covington, Kentucky, area between January 2003 and February 2004, as well as certain personnel records. We have produced the requested documents and we will continue to
cooperate with the investigation.

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 Global 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, 2005 through November 7, 2005) and the NASDAQ Global Market (November 8, 2005 through
December 31, 2006), as applicable:



|                                                            |  |      |       |     |   |      
|----------------------------------------------------------- |  | ---- | ----- | --- | - | -----
|                                                            |  | High |       | Low
|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
|                                                            |  |     
|Fiscal 2006                                                 |  |      |       |     |   |      
|First Quarter                                               |  | $    | 17.49 |     | $ | 14.26
|Second Quarter                                              |  | $    | 14.92 |     | $ | 3.58 
|Third Quarter                                               |  | $    | 3.81  |     | $ | 0.90 
|Fourth Quarter                                              |  | $    | 2.94  |     | $ | 0.74 

As of March 5, 2007, there were 25,481,720 shares of our common stock outstanding and
approximately 109 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, 2005 or 2006, 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



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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 the amount of $0.9 million were declared on our Series A Preferred and such dividends were paid during the first quarter of 2005. At each of the 2005 and 2006 annual meetings of the board of directors, dividends in the amount
of $0.5 million were declared on our Series A Preferred. The 2005 dividend was paid in December 2005 and the 2006 dividend was paid in January 2007. In addition, 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.

We periodically repurchase shares of Series A Preferred from the Rotech Healthcare Inc. Employees Plan (the 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 us. During 2004 and 2006, we repurchased 804 and 2,688 shares, respectively. There were no such repurchases in 2005.



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Performance Graph

The following graph shows changes from July 2002 to December 2006 in the value of $100 invested in Rotech Healthcare Inc., the NASDAQ Composite Index and the NASDAQ Health Services Index. The value of each investment
is based on share price appreciation, with reinvestment of all dividends. The investments are assumed to have occurred at the beginning of the period presented. 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 the predecessors 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 of 1933 provided by Section 1145 of the Bankruptcy Code. We have been informed by the transfer agent for our common stock that our common stock was distributed to the senior creditors of our
predecessor on July 12, 2002. Prior to such distribution, we believe that our common stock may have traded on a when-issued and distributed basis. Accordingly, we have used July 12, 2002 as the beginning measurement point in
the below performance graph. Our common stock was not registered under Section 12 of the Exchange Act until September 2004. It should be noted that this graph represents historical price performance and is not necessarily indicative of any
future stock price performance.

LOGO

Cumulative Total Return



|                       |  |      |        |       |   |       |  |       |        |       |   |        |  |   |        |  |   |       
|---------------------- |  | ---- | ------ | ----- | - | ----- |  | ----- | ------ | ----- | - | ------ |  | - | ------ |  | - | ------
|                       |  | 7/02 |        | 12/02 |   | 12/03 |  | 12/04 |        | 12/05 |   | 12/06 
|Rotech Healthcare Inc. |  | $    | 100.00 |       | $ | 83.46 |  | $     | 114.94 |       | $ | 125.19 |  | $ | 83.76  |  | $ | 11.19 
|NASDAQ Composite       |  |      | 100.00 |       |   | 92.32 |  |       | 137.48 |       |   | 150.17 |  |   | 154.57 |  |   | 175.77
|NASDAQ Health Services |  |      | 100.00 |       |   | 82.88 |  |       | 115.08 |       |   | 144.70 |  |   | 159.72 |  |   | 159.78



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|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, 2005 and 2006 have been derived from our audited financial statements included in this report. The
consolidated statement of operations data for the year ended December 31, 2004 have been derived from our audited financial statements included in this report. The consolidated balance sheet data for the years ended December 31, 2002, 2003
and 2004 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. 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.



|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|--------------------------------------------------------------------------------- |  | -------------------------- | -------- | - | ---------------------------- | - | ----------------------- |  | ---- | ------- |  | ---- | ------- | ---- |  | - | ------- |  | - | --------- | -
|                                                                                  |  | PredecessorCompany         |          |   | Successor Company            |  
|                                                                                  |  | Three monthsendedMarch 31, |          |   | Nine monthsendedDecember 31, |   | Year ended December 31, | 
|(dollars in thousands)                                                            |  | 2002                       |          |   | 2002(1)                      |   | 2003                    |  | 2004 |         |  | 2005 |         | 2006 | 
|Statement of Operations Data:                                                     |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Net revenues                                                                      |  | $                          | 152,545  |   |                              | $ | 472,941                 |  | $    | 580,599 |  | $    | 535,329 |      |  | $ | 533,182 |  | $ | 498,751   |  
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|                                                                                  |  |                            |          |   |                              |  
|Costs and expenses                                                                |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Cost of net revenues                                                              |  |                            | 40,009   |   |                              |   | 124,264                 |  |      | 193,411 |  |      | 148,729 |      |  |   | 166,186 |  |   | 172,513   |  
|Provision for doubtful accounts                                                   |  |                            | 4,055    |   |                              |   | 17,119                  |  |      | 19,462  |  |      | 19,614  |      |  |   | 17,858  |  |   | 14,340    |  
|Selling, general and administrative                                               |  |                            | 79,647   |   |                              |   | 256,941                 |  |      | 291,910 |  |      | 257,000 |      |  |   | 290,215 |  |   | 301,427   |  
|Depreciation and amortization(2)                                                  |  |                            | 2,839    |   |                              |   | 8,572                   |  |      | 16,828  |  |      | 15,191  |      |  |   | 18,123  |  |   | 17,162    |  
|Goodwill impairment(3)                                                            |  |                            |         |   |                              |   |                        |  |      |        |  |      |        |      |  |   |        |  |   | 529,000   |  
|Interest (income) expense, net                                                    |  |                            | (17      | ) |                              |   | 33,093                  |  |      | 41,177  |  |      | 33,696  |      |  |   | 31,503  |  |   | 36,225    |  
|Other (income) expense, net                                                       |  |                            |         |   |                              |   |                        |  |      | 2,473   |  |      | (2,475  | )    |  |   | 138     |  |   | (187      | )
|Loss on debt extinguishment                                                       |  |                            |         |   |                              |   |                        |  |      |        |  |      |        |      |  |   |        |  |   | 1,178     |  
|Provision for inventory losses                                                    |  |                            | 264      |   |                              |   |                        |  |      |        |  |      |        |      |  |   |        |  |   |          |  
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Total costs and expenses                                                          |  |                            | 126,797  |   |                              |   | 439,989                 |  |      | 565,261 |  |      | 471,755 |      |  |   | 524,023 |  |   | 1,071,658 |  
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Earnings (loss) before reorganization items, income taxes and extraordinary items |  |                            | 25,748   |   |                              |   | 32,952                  |  |      | 15,338  |  |      | 63,574  |      |  |   | 9,159   |  |   | (572,907  | )
|Reorganization items(4)                                                           |  |                            | 182,291  |   |                              |   | 3,899                   |  |      |        |  |      |        |      |  |   |        |  |   |          |  
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Earnings (loss) before income taxes and extraordinary items                       |  |                            | (156,543 | ) |                              |   | 29,053                  |  |      | 15,338  |  |      | 63,574  |      |  |   | 9,159   |  |   | (572,907  | )
|Federal and state income (benefit) taxes                                          |  |                            | (1,206   | ) |                              |   | 12,567                  |  |      | 6,731   |  |      | 27,564  |      |  |   | 3,613   |  |   | (38,808   | )
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Earnings (loss) before extraordinary items                                        |  |                            | (155,337 | ) |                              |   | 16,486                  |  |      | 8,607   |  |      | 36,010  |      |  |   | 5,546   |  |   | (534,099  | )
|Extraordinary gain on debt discharge, net of taxes                                |  |                            | 20,441   |   |                              |   |                        |  |      |        |  |      |        |      |  |   |        |  |   |          |  
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  
|Net earnings (loss)(2)                                                            |  | $                          | (134,896 | ) |                              | $ | 16,486                  |  | $    | 8,607   |  | $    | 36,010  |      |  | $ | 5,546   |  | $ | (534,099  | )
|                                                                                  |  |                            |          |   |                              |   |                         |  |      |         |  |      |         |      |  |   |         |  |   |           |  



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|                                       |  |                   |           |      |   |           |  |      |           |      |   |           |  |   |        
|-------------------------------------- |  | ----------------- | --------- | ---- | - | --------- |  | ---- | --------- | ---- | - | --------- |  | - | -------
|                                       |  | Successor Company
|                                       |  | December 31,     
|(dollars in thousands)                 |  | 2002              |           | 2003 |   | 2004      |  | 2005 |           | 2006
|Balance Sheet Data                     |  |                   |           |      |   |           |  |      |           |      |   |           |  |   |        
|Current assets                         |  | $                 | 146,733   |      | $ | 122,194   |  | $    | 157,385   |      | $ | 104,433   |  | $ | 104,181
|Working capital                        |  |                   | 61,143    |      |   | 43,704    |  |      | 90,824    |      |   | 25,110    |  |   | 31,870 
|Total assets                           |  |                   | 1,104,399 |      |   | 1,007,981 |  |      | 1,019,359 |      |   | 1,018,684 |  |   | 497,133
|Total debt, including current portion  |  |                   | 478,513   |      |   | 368,000   |  |      | 330,171   |      |   | 329,514   |  |   | 384,866
|Convertible redeemable preferred stock |  |                   | 5,346     |      |   | 6,101     |  |      | 5,343     |      |   | 5,343     |  |   | 5,343  
|Stockholders equity                   |  |                   | 511,141   |      |   | 520,181   |  |      | 561,897   |      |   | 569,515   |  |   | 35,717 



|                                                      |  |                            |         |   |                              |   |         |                         |  |   |          |   |  |      |         |   |      |   |          |   |  |   |         |  
|----------------------------------------------------- |  | -------------------------- | ------- | - | ---------------------------- | - | ------- | ----------------------- |  | - | -------- | - |  | ---- | ------- | - | ---- | - | -------- | - |  | - | ------- | -
|                                                      |  | PredecessorCompany         |         |   | Successor Company            |  
|                                                      |  | Three monthsendedMarch 31, |         |   | Nine monthsendedDecember 31, |   |         | Year ended December 31, | 
|(dollars in thousands)                                |  | 2002                       |         |   | 2002                         |   |         | 2003                    |  |   | 2004     |   |  | 2005 |         |   | 2006 |  
|Selected Historical Financial Data:                   |  |                            |         |   |                              |   |         |                         |  |   |          |   |  |      |         |   |      |   |          |   |  |   |         |  
|Capital expenditures                                  |  | $                          | 15,299  |   |                              | $ | 47,273  |                         |  | $ | 41,993   |   |  | $    | 54,003  |   |      | $ | 78,768   |   |  | $ | 59,878  |  
|Cash flows provided by operating activities           |  |                            | 26,409  |   |                              |   | 99,698  |                         |  |   | 148,279  |   |  |      | 134,225 |   |      |   | 60,681   |   |  |   | 15,549  |  
|Cash flows used in investing activities               |  |                            | (15,299 | ) |                              |   | (50,176 | )                       |  |   | (45,022  | ) |  |      | (54,003 | ) |      |   | (109,545 | ) |  |   | (61,694 | )
|Cash flows (used in)/provided by financing activities |  |                            | (5,545  | ) |                              |   | (21,487 | )                       |  |   | (110,289 | ) |  |      | (36,379 | ) |      |   | (1,737   | ) |  |   | 42,188  |  

---

|(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 1 to the audited financial statements for the years ended December 31, 2004, 2005 and 2006.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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) | 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
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | 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.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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) | Due to an overall decline in our profitability which resulted primarily from decreases in Medicare reimbursement rates, including reductions for compounded budesonide, and the
resulting decline in our market capitalization, we recorded non-cash goodwill impairment charges of $529.0 million during the year ended December 31, 2006. Other than approximately $0.1 million paid in September 2006 in connection with the
fifth amendment and limited waiver to our former credit agreement, these impairment charges did not result in cash expenditures and will not result in future cash expenditures.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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



|                                                                                                                                                                                     |  |                            |         |                               |   |      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------- | ------- | ----------------------------- | - | -----
|                                                                                                                                                                                     |  | PredecessorCompany         |         | SuccessorCompany             
|                                                                                                                                                                                     |  | Three monthsendedMarch 31, |         | Nine months endedDecember 31,
|(dollars in thousands)                                                                                                                                                               |  | 2002                       |         | 2002                         
|Severance and terminations                                                                                                                                                           |  | $                          | 837     |                               | $ |     
|Legal, accounting and consulting fees                                                                                                                                                |  |                            | 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 |  |                            | 1,596   |                               |   | 1,802
|                                                                                                                                                                                     |  |                            |         |                               |   |      
|                                                                                                                                                                                     |  | $                          | 182,291 |                               | $ | 3,899
|                                                                                                                                                                                     |  |                            |         |                               |   |      



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|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 500 operating centers located primarily in non-urban markets.

Our revenues are principally derived from respiratory
equipment rental and related services, which accounted for 87.8% and 88.5% of net revenues for the years ended December 31, 2005 and 2006, respectively. Revenues from respiratory equipment rental and related services 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, which accounted for 11.2% and 11.5% of net revenues for the years ended December 31, 2005 and 2006, respectively. Revenues from rental and sale of durable medical equipment include 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.

We are focused on specific initiatives to continue the growth in patient and product counts experienced during 2005 and 2006. These initiatives include
expanded sales and operational training programs, as well as new sales commission and recognition programs. We believe these programs will better equip and motivate our sales force, and ultimately drive additional growth. In addition, we have
reorganized our billing center employees into cross-functional teams, increased billing center staffing levels, and reduced our reliance on temporary labor in order to improve operating efficiencies. We also continue to actively monitor and manage
our cash position and capital expenditures on a daily basis.

Strategic Initiatives.As a result of our highly leveraged position
and the regulatory environment in which we operate, we are actively exploring and are engaged in discussions regarding various strategic transactions, such as an acquisition, debt exchange or equity offering or a combination of any such
transactions. At December 31, 2006, we had approximately $384.9 million of long-term debt outstanding. One of the greatest risks relating to our high leverage is the possibility that a substantial down-turn in earnings, including as a result of
adverse regulatory changes, could jeopardize our ability to service our debt payment obligations as discussed below. We continue to face the risk of future material adverse regulatory changes, similar to those experienced over the past several
years. As a result of CMS final rule to implement the DRA changes with regard to oxygen reimbursement as released in November 2006, we do not expect to be materially impacted with respect to oxygen reimbursement until 2009, when we do expect
to be materially adversely impacted as a result of the DRAs 36-month rental cap on oxygen equipment. In addition, there are other proposed reimbursement changes which could materially impact our financial position, including proposed changes
outlined in CMS National Coverage Analysis. The risks and uncertainties related to the DRAs 36-month rental cap and the proposed changes in reimbursement outlined in CMS National Coverage Analysis, as well as the current impact of
recent reimbursement changes, are discussed in more detail under the heading BusinessGovernment Regulation in Part I, Item 1 above. We believe that a strategic transaction may be necessary to delever our balance sheet and
strengthen our operating and financial conditions. Such a transaction could also strengthen our competitive position.



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Upcoming Interest Payments. We have
interest payments of $13.6 million each due on April 2 and October 2, 2007 under the indenture governing our 91/2%
senior subordinated notes. Management believes they have the ability to manage our cash flows in order to be able to meet our obligations as they become due during 2007. It is our current intention to make these interest payments when due and our
current cash projections indicate that the cash generated from our operations and funds available under our credit facility will be sufficient to make these interest payments. However, if our current cash projections are not realized, additional
unfavorable regulatory actions are taken with respect to the reimbursement rates that apply to our business, we experience any significant changes in non-cash working capital (including accounts receivable), we experience material adverse changes in
payment patterns from CMS and its contractors or other third-party payors, we experience another payment hold by CMS similar to or longer than that experienced in September 2006, or we are negatively impacted by other unforeseen factors, we may not
have sufficient cash available to make these interest payments. In addition, we may need, but be unable to obtain, access to our full credit facility (the commitment to fund the last $5.0 million of the revolving line of credit is subject to the
approval of lenders holding a majority of the maximum credit amount then outstanding) in connection with making such interest payments.

If we fail to make the required interest payments on our senior subordinated notes, we will be in
default under the indenture governing our 91/2% senior subordinated notes and, under certain circumstances, the indenture
trustee or the holders of at least 25% in principal amount of the then outstanding notes may declare all notes to be immediately due and payable. Furthermore, if the indenture trustee or our noteholders declared all of our 91/2% senior subordinated notes to be due and payable immediately, it would result in a cross default under our credit agreement. Our
assets and cash flow would not be sufficient to fully repay borrowings under our outstanding debt instruments, if accelerated, upon an event of default. If the indebtedness were accelerated, this would raise substantial doubt about our ability to
continue as a going concern, which would likely cause a deterioration of our relationships with our customers and suppliers and adversely affect our revenues, profit margins, profitability, operating cash flows, results of operations and financial
condition. Any such actions could force us into bankruptcy or liquidation.

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 67.8%
of our patient revenue for the year ended December 31, 2006. 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 home medical equipment from 2004 to 2008, competitive bidding requirements, new clinical conditions for reimbursements, accreditation
requirements and quality standards. The impact of competitive bidding, new clinical conditions, accreditation requirements 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, FEHBP median 2002 payments were approximately 12.4% less than Medicare payments for stationary
home oxygen equipment and approximately 10.8% less than



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Medicare payments for portable home oxygen equipment. The implementation of the new Medicare payment amounts during 2005 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 ranged between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for approximately 4.1% of our recorded revenues in 2006. Furthermore, the reductions in
the Medicare fee schedules for home oxygen equipment 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 2006
recorded revenues in the amount of approximately $17.9 million.

MMA also revised the payment methodology for certain drugs, including
inhalation drugs dispensed through nebulizers. For the year ended December 31, 2006, Medicare-reimbursed inhalation drug therapies provided by us accounted for approximately 11.5% of our recorded revenues after allowing for the reduction in
revenues related to the decreased reimbursement rate for compounded budesonide. 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 from 95% to 80% 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. Beginning in 2006, MMA required that payment amounts for most drugs be based on either ASP or competitive bidding for drugs administered by physicians.

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, if the ASP exceeds the widely available market price or the average manufacturer price by more than a threshold
amount, ASP is substituted with the lesser of the widely available market price or 103% of the average manufacturer price. This threshold amount was 5% in 2006, which is to be continued for 2007. 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 example, the payment amounts for albuterol sulfate and ipratropium bromide, two prevalent inhalation drugs, have been significantly reduced under ASP. Albuterol sulfate has been reduced from an
average of $0.390 per milligram in 2004 (80% of AWP) to an average of $0.071 per milligram in 2005 (106% of ASP) and to an average of $0.069 per milligram in 2006 (106% of ASP). Ipratropium bromide has been reduced from an average of $2.820 per
milligram in 2004 (80% of AWP) to an average of $0.210 per milligram in 2005 (106% of ASP) and to an average of $0.217 per milligram in 2006 (106% of ASP).

The change from 80% of AWP to 106% of ASP reduced our revenues by approximately $39 million for the year ended December 31, 2005. This reduction was partially offset by shifts in patient and product mix.

Effective January 1, 2006, CMS established a new billing code and payment methodology for compounded budesonide, which includes
compounded budesonide formulations that we provide to Medicare beneficiaries based on a physicians prescription. Medicare reimbursement rates for compounded budesonide, beginning January 1, 2006, are based on pharmacy invoices submitted
for individual claims. This payment amount reflects a reimbursement rate based on the acquisition of raw materials and is far below the prior years payment amounts. For the year ended December 31, 2006, the new reimbursement rates for
compounded budesonide resulted in a reduction in our recorded revenues of approximately $30.4 million. In light of the reduced reimbursement rates for compounded budesonide and to resolve certain issues associated with a warning letter received from
the Food and Drug Administration (FDA) which is discussed in more detail under the heading



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BusinessGovernment Regulation in Part I, Item 1 above, we are not accepting new prescriptions for certain compounded products (including
compounded formulations of budesonide) and, where clinically appropriate, have instituted a process to transition patients currently on these compounded products to commercially available alternative products. As a result of our decision to switch
these patients to commercially available drug products, we have taken a one-time, non-cash charge of $4.0 million for the three months and year ended December 31, 2006, to write-off our pharmacy compounding equipment, capitalized costs
associated with our compounding facility, and substantially all remaining balances for budesonide-related accounts receivable. The transition of these patients to commercially available alternative products is expected to have a positive impact on
our revenues during 2007 when compared to 2006, however these products have lower margins and, accordingly, this patient transition will have a material adverse effect on our profit margins, profitability, operating cash flows and results of
operations when compared to the reimbursements for the compounded products under the prior billing code and payment methodology in effect prior to 2006.

Effective January 1, 2007, CMS established new billing codes and payment methodologies for other compounded inhalation drugs, including albuterol and ipratropium. The revised codes distinguish compounded from
non-compounded drugs, and Medicare payments for compounded formulations are to be based on invoices for the compounded materials. Our compounding activities with respect to other inhalation drugs are not material, as such we do not expect that the
new billing codes and payment methodologies with respect to such drugs will have a material adverse effect on our revenues, profit margins, profitability, operating cash flows or results of operations.

In addition to MMA changes in payment methodology, given the overall reduction in payment for inhalation drugs dispensed through nebulizers, CMS
established a dispensing fee for inhalation drugs shipped to a beneficiary. The 2005 dispensing fee was $57 for a 30-day period or $80 for a 90-day period. Effective January 1, 2006, the dispensing fee for inhalation drugs furnished to
beneficiaries remained $57 for the first 30-day period in which a Medicare beneficiary uses inhalation drugs and was reduced to $33 for each subsequent 30-day period. The dispensing fee for a 90-day supply of inhalation drugs was likewise reduced to
$66. These reductions in the 2006 Medicare dispensing fees reduced our net revenue by approximately $9.8 million for the year ended December 31, 2006. Although CMS has indicated that the dispensing fee for 2007 will continue to be paid at the
2006 rate, future dispensing fee reductions or eliminations, if they occur, could have a material adverse effect on our revenues, profit margins, profitability, operating cash flows and results of operations. While we were able, based upon the
dispensing fees, to continue to offer inhalation drugs to Medicare patients through 2006, the reductions in dispensing fees for 2006, along with the pricing changes resulting from the ASP payment rates have resulted 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, profit margins, profitability, operating cash flows 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



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principles with limited or no need for managements judgment. There are also areas in which managements 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

Revenues are recognized when persuasive evidence of an arrangement exists;
delivery has occurred; our price to the buyer is fixed or determinable; and collectibility is reasonably assured.

Our rental arrangements
generally provide for fixed monthly payments established by fee schedules for as long as the patient is using the equipment and medical necessity continues (subject to capped rentals which limit the rental payment period in some instances). 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. Revenues derived from capitation arrangements are
insignificant.

Net Patient Service Revenues

Net patient service revenues are recorded at net realizable amounts estimated to be paid by customers and third-party payors. Our billing system contains payor-specific price tables that reflect the fee schedule
amounts, as available, in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. Net patient service revenues are recorded based upon the applicable fee schedule.

We track collections and adjustments as a percentage of related revenues. Historical collection and adjustment percentages serve as the
basis for our provisions for contractual adjustments and doubtful accounts. The provision for contractual adjustments is recorded as a reduction to net patient service revenues and consists of:

(1) Differences between the non-contracted third-party payors allowable amounts and our usual and customary billing rate. We
do not have contracts or fee schedules with all third-party payors. Accordingly, for non-contracted payors where no fee schedule is available, we record revenue based upon our usual and customary billing rates. Actual adjustments that result from
differences between the non-contracted third-party payors allowable amounts and our usual and customary billing rates are recorded against the allowance for contractual adjustments and are typically identified and recorded at the point of cash
application.

(2) Services for which payment is denied by governmental or third-party payors, or otherwise deemed
non-billable by us. Final payment under governmental programs, and most third-party contracts, is subject to administrative review and audit. Furthermore, the complexity of governmental and third-party billing reimbursement arrangements,
including patient qualification and medical necessity requirements, may result in adjustments to amounts originally recorded. Such adjustments may be recorded as the result of the denial of claims billed to governmental or third-party payors, or as
the result of our review procedures prior to submission of the claim to the governmental or third-party payor. Actual adjustments that result from services for which payment is denied by governmental or third-party payors, or otherwise deemed
non-billable by us are recorded against the allowance for contractual adjustments.

The provision for contractual adjustments reduces
amounts recorded through our billing system to estimated net realizable amounts. We record the provision for contractual adjustments based on a percentage of revenue



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using historical company-specific data. The percentage and amounts used to record the provision for contractual adjustments are supported by various methods
including current and historical cash collections, as well as actual contractual adjustment experience. This percentage, which is adjusted at least on an annual basis, has proven to be the best indicator of expected realizable amounts.

We closely monitor our historical contractual adjustment 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. Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required in order to record net
patient service revenues at their net realizable values. Inherent in these estimates is the risk that they may have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing
arrangements, patient qualification for medical necessity of equipment 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.

The provision for doubtful accounts is recorded
as an operating expense and consists of billed charges that are ultimately deemed uncollectible due to the patients or third-party payors inability or refusal to pay, as described below.

Provision for Doubtful Accounts

Medicare and most other government and commercial payors that provide coverage to our customers include a 20 percent co-payment provision in addition to a nominal deductible. Co-payments are generally not collected at the time of service
and are invoiced to the customer or applicable secondary payor (supplemental providers of insurance coverage) on a monthly billing cycle as products are provided. A majority of our customers maintain, or are entitled to, secondary or supplemental
insurance benefits providing gap coverage of this co-payment amount. In the event coverage is denied by the third-party payor, the customer is ultimately responsible for payment of charges for all services rendered by us.

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 risk, with regard to doubtful accounts, relates to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We record a provision for
doubtful accounts based on a percentage of revenue using historical company-specific data. The percentage and amounts used to record the provision for doubtful accounts are supported by various methods including current and historical cash
collections, actual write-offs, and accounts receivable agings. Accounts are written off against the allowance for doubtful accounts when all collection efforts have been exhausted. We routinely review accounts receivable balances in conjunction
with our historical 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, 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.

Accounts Receivable, net

Accounts
receivable are presented net of allowances for contractual adjustments and doubtful accounts. Allowances for contractual adjustments and doubtful accounts are initially recorded based upon historical collection experience through the provisions for
contractual adjustment and doubtful accounts, as described above. If the payment amount received differs from the net realizable amount, an adjustment is made to the net realizable amount in the period that these payment differences are determined.
Actual accounts receivable write-offs due to contractual adjustments or accounts deemed uncollectible are applied against these allowance accounts in the normal course of business. On a quarterly basis, we perform analyses to evaluate the estimated



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net realizable value of accounts receivable. As a result of this quarterly review process, the allowances for contractual adjustments and doubtful accounts
are adjusted, as necessary, to reflect that estimated net realizable value. Specifically, we consider historical collection data, accounts receivable aging trends, other operating trends and relevant business conditions.

Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required in order to record net revenues
and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they may have to be revised or updated as additional information becomes available. It is possible that managements estimates could change,
which could have an impact on operations and cash flows. For example, a 1% decline in the overall collection rate would reduce net patient service revenue and associated net accounts receivable by $6.0 million (based upon $600.0 million in annual
gross patient service revenue). Additionally, the complexity of many third-party billing arrangements, patient qualification for medical necessity of equipment and the uncertainty of reimbursement amounts for certain services from certain payors may
result in adjustments to amounts originally recorded.

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. These amounts are not amortized, but instead
tested for impairment in accordance with the provisions of Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets. To the extent the carrying amount of reporting unit goodwill is greater than
the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference. Fair values for goodwill and intangible assets are determined based upon discounted cash flows, market multiples or appraised values as
appropriate. Our branch locations have similar economic characteristics and are aggregated into one reporting unit for assessing fair value. The impairment evaluation for goodwill and other intangible assets is conducted annually, or more
frequently, if events or changes in circumstances indicate that an asset might be impaired.

We account for our business combinations in
accordance with the purchase method of accounting. Purchase prices are allocated to the various underlying tangible and intangible assets and liabilities on the basis of estimated fair value. The fair value of acquired finite-lived identifiable
intangible assets is amortized over the period of their expected useful life, generally 2 to 20 years.

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 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 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, 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



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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.

Income Taxes

In connection with our
predecessors (Rotech Medical Corporation) plan of reorganization (the Plan), we entered into a tax sharing agreement with our predecessor and Integrated Health Services, Inc. that sets forth our rights and obligations with respect
to taxes arising from and in connection with the implementation of the Plan. The tax sharing agreement provides that the parties to the agreement will, for tax purposes, treat the transfer of our predecessors assets to us 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 our predecessors assets to
us. As a result of such election, we accounted for the acquisition of the stock of all of our predecessors subsidiaries as if we had acquired the assets of those subsidiaries for income tax purposes.

We account 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.

Net operating loss carryforwards and credits (NOLs) are subject to review
and possible adjustments by the Internal Revenue Service and may be limited by the occurrence of certain events, including significant changes in ownership interests. The effect of an ownership change would be the imposition of an annual limitation
on the use of the NOL carryfowards attributable to periods before the change. We regularly monitor changes in ownership and any implications thereof under Section 382 of the Internal Revenue Code.

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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Results of Operations

The following tables show our results of operations for the years ended December 31, 2004, 2005 and 2006:



|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|---------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- |  | - | --------- | -
|                                         |  | For the Years Ended December 31, |        
|(dollars in thousands)                   |  | 2004                             |         |   | 2005 |   | 2006    | 
|Statements of Operations Data:           |  |                                  |         |   |      |   |         |  |   |           |  
|Net revenues                             |  | $                                | 535,329 |   |      | $ | 533,182 |  | $ | 498,751   |  
|Costs and expenses:                      |  |                                  |         |   |      |   |         |  |   |           |  
|Cost of net revenues:                    |  |                                  |         |   |      |   |         |  |   |           |  
|Product and supply costs                 |  |                                  | 70,583  |   |      |   | 95,182  |  |   | 103,302   |  
|Patient service equipment depreciation   |  |                                  | 61,362  |   |      |   | 47,409  |  |   | 45,155    |  
|Operating expenses                       |  |                                  | 16,784  |   |      |   | 23,595  |  |   | 24,056    |  
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Total cost of net revenues               |  |                                  | 148,729 |   |      |   | 166,186 |  |   | 172,513   |  
|Provision for doubtful accounts          |  |                                  | 19,614  |   |      |   | 17,858  |  |   | 14,340    |  
|Selling, general and administrative      |  |                                  | 257,000 |   |      |   | 290,215 |  |   | 301,427   |  
|Depreciation and amortization            |  |                                  | 15,191  |   |      |   | 18,123  |  |   | 17,162    |  
|Goodwill impairment                      |  |                                  |        |   |      |   |        |  |   | 529,000   |  
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Total costs and expenses                 |  |                                  | 440,534 |   |      |   | 492,382 |  |   | 1,034,442 |  
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Operating income (loss)                  |  |                                  | 94,795  |   |      |   | 40,800  |  |   | (535,691  | )
|Interest expense, net                    |  |                                  | 33,696  |   |      |   | 31,503  |  |   | 36,225    |  
|Other expense (income), net              |  |                                  | (2,475  | ) |      |   | 138     |  |   | (187      | )
|Loss on extinguishment of debt           |  |                                  |        |   |      |   |        |  |   | 1,178     |  
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Total other expenses                     |  |                                  | 31,221  |   |      |   | 31,641  |  |   | 37,216    |  
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Earnings (loss) before income taxes      |  |                                  | 63,574  |   |      |   | 9,159   |  |   | (572,907  | )
|Federal and state income taxes (benefit) |  |                                  | 27,564  |   |      |   | 3,613   |  |   | (38,808   | )
|                                         |  |                                  |         |   |      |   |         |  |   |           |  
|Net earnings (loss)                      |  | $                                | 36,010  |   |      | $ | 5,546   |  | $ | (534,099  | )
|                                         |  |                                  |         |   |      |   |         |  |   |           |  



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The following tables show our results of operations as a percentage of net revenues for the years ended
December 31, 2004, 2005 and 2006:



|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|---------------------------------------- |  | ------------------------------- | - |  | -------------------------- | - |  | ------ | - |  | ----------- | - |  | ----------- | -
|                                         |  | For the Years EndedDecember 31, |   |  | Percent Increase(Decrease) |  
|                                         |  | 2004                            |   |  | 2005                       |   |  | 2006   |   |  | 2005vs.2004 |   |  | 2006vs.2005 |  
|Statements of Operations Data:           |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Net revenues                             |  | 100.0                           | % |  | 100.0                      | % |  | 100.0  | % |  | -0.4        | % |  | -6.5        | %
|Costs and expenses:                      |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Cost of net revenues:                    |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Product and supply costs                 |  | 13.2                            | % |  | 17.9                       | % |  | 20.7   | % |  | 34.9        | % |  | 8.5         | %
|Patient service equipment depreciation   |  | 11.5                            | % |  | 8.9                        | % |  | 9.1    | % |  | -22.7       | % |  | -4.8        | %
|Operating expenses                       |  | 3.1                             | % |  | 4.4                        | % |  | 4.8    | % |  | 40.6        | % |  | 2.0         | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Total cost of net revenues               |  | 27.8                            | % |  | 31.2                       | % |  | 34.6   | % |  | 11.7        | % |  | 3.8         | %
|Provision for doubtful accounts          |  | 3.7                             | % |  | 3.3                        | % |  | 2.9    | % |  | -9.0        | % |  | -19.7       | %
|Selling, general and administrative      |  | 48.0                            | % |  | 54.4                       | % |  | 60.4   | % |  | 12.9        | % |  | 3.9         | %
|Depreciation and amortization            |  | 2.8                             | % |  | 3.4                        | % |  | 3.4    | % |  | 19.3        | % |  | -5.3        | %
|Goodwill impairment                      |  |                                | % |  |                           | % |  | 106.1  | % |  |            | % |  |            | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Total costs and expenses                 |  | 82.3                            | % |  | 92.3                       | % |  | 207.4  | % |  | 11.8        | % |  | 110.1       | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Operating income (loss)                  |  | 17.7                            | % |  | 7.7                        | % |  | -107.4 | % |  | -57.0       | % |  | -1413.0     | %
|                                         |  |                                 |   |  |                           
|Interest expense, net                    |  | 6.3                             | % |  | 5.9                        | % |  | 7.3    | % |  | -6.5        | % |  | 15.0        | %
|Other expense (income), net              |  | -0.5                            | % |  |                           | % |  |       | % |  | -105.6      | % |  | -235.5      | %
|Loss on extinguishment of debt           |  |                                | % |  |                           | % |  | 0.2    | % |  |            | % |  |            | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Total other expenses                     |  | 5.8                             | % |  | 5.9                        | % |  | 7.5    | % |  | 1.3         | % |  | 17.6        | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Earnings (loss) before income taxes      |  | 11.9                            | % |  | 1.8                        | % |  | -114.9 | % |  | -85.6       | % |  | -6355.1     | %
|Federal and state income taxes (benefit) |  | 5.1                             | % |  | 0.7                        | % |  | -7.8   | % |  | -86.9       | % |  | -1174.1     | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  
|Net earnings (loss)                      |  | 6.8                             | % |  | 1.1                        | % |  | -107.1 | % |  | -84.6       | % |  | -9730.3     | %
|                                         |  |                                 |   |  |                            |   |  |        |   |  |             |   |  |             |  

Year ended December 31, 2006 as compared to year ended December 31, 2005

Total net revenues for the year ended December 31, 2006 were $498.8 million as compared to $533.2 million for the comparable
period in 2005, a decrease of $34.4 million or 6.5%. The net decrease for the year ended December 31, 2006 was primarily attributable to (i) reduced Medicare reimbursement rates for compounded budesonide which reduced net revenues by
approximately $30.4 million, (ii) additional provisions for accounts receivable contractual allowances recorded as a result of a deterioration in the aging of accounts receivable as described belowincluding $17.5 million recorded during
the quarter ended June 30, 2006 and $4.0 million recorded during the quarter ended December 31, 2006 as the result of an increased monthly provision rate for accounts receivable contractual allowances; (iii) reduction in the 2006
dispensing fee for nebulizer medications which reduced net revenues by approximately $9.8 million; and (iv) volume reductions under our contract with Gentiva Health Services (Gentiva) which reduced net revenue by approximately $19.3
million as a result of an amendment to their contract with CIGNA Healthcare (CIGNA), whereby Gentiva would no longer coordinate specific respiratory therapy and DME services on behalf of CIGNA effective January 31, 2006. These
decreases were partially offset by an increase of $13.5 million in net revenue for the year ended December 31, 2006 from locations acquired during 2005 and 2006 and $33.6 million in net revenue for the year ended December 31, 2006 from a
6.6% increase in oxygen and drug patient counts (excluding acquisitions) and a 9.2% increase in other DME respiratory product counts (excluding acquisitions).

The $17.5 million in additional provision for accounts receivable contractual allowances which was recorded as a reduction to net revenue for the year ended December 31, 2006, was attributable to a shift in the



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composition of our accounts receivable, whereby a higher percentage of receivables are remaining outstanding for longer periods. This increase in the aging
of accounts receivable is due to numerous factors, including increased transaction volumes from patient growth, general slowdowns in payment processing by Medicare and other third-party payors, delays caused by Medicare beneficiaries switching to
HMOs, and billing disruptions related to the transition to electronic billing for certain third-party payors. The increased provision for accounts receivable contractual allowances was calculated primarily using a historical collections model.
Shifts in the aging of accounts receivable, when compared to historical aging levels, resulted in the need for additional accounts receivable allowances, reflecting an inherent reduction in collectibility as accounts receivable age. We continue to
pursue collection of accounts receivable in the normal course of business and this increased allowance does not reflect a write-off of specific accounts receivable. We have reorganized our billing center operations and increased staffing to address
those factors above that are under our control. We have also appointed a Vice President of Billing and Collections to implement these initiatives. While these initiatives are designed to improve the collection process, there can be no assurance that
such initiatives will result in improved collections. We also increased our monthly provision rate effective in the fourth quarter of 2006 to provide a higher level of contractual allowances.

Cost of net revenues for the year ended December 31, 2006 increased $6.3 million, or 3.8%, to $172.5 million, from the comparable period in 2005.
The net increase was primarily attributable to an $8.1 million 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 $0.5
million as the result of an increase in the number of respiratory therapists employed. These increases were offset by a $2.3 million decrease in patient service equipment depreciation as a result of decreased capital expenditures and a significant
portion of our oxygen rental equipment becoming fully depreciated. Cost of net revenues as a percentage of net revenue was 34.6% for the year ended December 31, 2006 as compared to 31.2% for the comparable period in 2005.

The provision for doubtful accounts for the year ended December 31, 2006 decreased by $3.5 million, or 19.7%, to $14.3 million, from the comparable
period in 2005. The provision for doubtful accounts expense as a percentage of net revenues decreased to 2.9% for the year ended December 31, 2006 as compared to 3.3% for 2005. This decrease was mainly attributable to a shift in the overall
allowance accrual rate, reducing the monthly provision for bad debt expense and increasing the monthly provision for contractual adjustments recorded as a reduction of net revenues. The shift in the accrual rate is based on historical adjustment
experience.

Selling, general and administrative expenses for the year ended December 31, 2006 totaled $301.7 million, an increase of
$11.2 million or 3.9% from the comparable period in 2005. The increase primarily resulted from: (i) $3.2 million of costs related to discussions regarding a potential strategic transaction which have terminated and were therefore expensed;
(ii) a $2.9 million increase in automobile expenses; (iii) a $2.8 million increase in salaries related to locations acquired during 2005 and 2006; and (iv) a $2.6 million increase in insurance costs. Selling, general and
administrative expenses as a percentage of net revenues increased to 60.4% for the year ended December 31, 2006 from 54.4% for the year ended December 31, 2005. This increase as a percentage of net revenues is attributable to the decline
in net revenue for the year ended December 31, 2006 and the increases in selling, general and administrative expenses described above.

Depreciation and amortization for the year ended December 31, 2006 totaled $17.2 million, a decrease of $1.0 million from the comparable period in 2005.

Due to an overall decline in our profitability which resulted primarily from decreases in Medicare reimbursement rates, including reductions for compounded budesonide, and the resulting decline in our market
capitalization, we recorded non-cash goodwill impairment charges of $529.0 million during the year ended December 31, 2006. Other than approximately $0.1 million paid in September 2006 in connection with the fifth amendment and limited waiver
to our former credit agreement, these impairment charges did not result in cash expenditures and will not result in future cash expenditures.



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Net interest expense for the year ended December 31, 2006 increased $4.7 million from the comparable
period in 2005. The increase is primarily attributable to increased borrowing under our former senior credit facility and a 200 basis point increase in the LIBOR rate.

We recorded a $38.8 million benefit for federal and state income taxes for the year ended December 31, 2006 for current period losses that offset deferred tax liabilities previously recorded. We have recorded a
full valuation allowance on our remaining net deferred tax assets, as it appears more likely than not that such assets will not be realized through offset of future taxable income.

Net loss for the year ended December 31, 2006 was $534.1 million compared to net earnings of $5.5 million for the year ended December 31, 2005.
As outlined above, $529.0 million of the current year net loss is attributable to non-cash goodwill impairment charges, $40.2 million to Medicare reimbursement cuts and $21.5 million to additional provisions for accounts receivable contractual
allowances. The internal growth described above has not been sufficient to offset the impact of these items.

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 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 $33.2 million, or 12.9%, to $290.2 million, from the comparable period in 2004. Selling, general and administrative expenses as a percentage of net revenues increased to
54.4% 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.



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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.

Net earnings for the year ended December 31, 2005 was $5.5 million compared to net earnings of $36.0 million for the year ended December 31,
2004. As outlined above, internal growth was not sufficient to offset approximately $56.3 million in Medicare reimbursement cuts.

Liquidity and Capital
Resources

Net cash provided by operating activities was $60.7 million and $15.5 million for the years ended December 31, 2005 and
2006, respectively. Cash flows, cash on hand, and the ability to draw on our former and current senior secured revolving credit facility were sufficient to fund operations, capital expenditures and required repayments of debt during the years ended
December 31, 2005 and 2006.

Accounts receivable before allowance for doubtful accounts increased from $90.2 million at
December 31, 2005 to $91.2 million at December 31, 2006. Days sales outstanding (DSO) (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 55.7 days at December 31, 2006 compared to 49.0 days at December 31, 2005. Although the balance of accounts receivable before allowance for doubtful accounts did not change significantly from December 31, 2005 to 2006, we
experienced a 13.7% increase in DSO as a result of lower net revenues. This increase in DSO is indicative of increased transaction volumes, as well as previously disclosed slow-downs in the collection of accounts receivable.

The following table sets forth the percentage breakdown of our accounts receivable by payor and aging category as of December 31, 2005 and 2006:

December 31, 2005



|                                                 |  |            |   |  |                        |   |  |                        |   |  |       |  
|------------------------------------------------ |  | ---------- | - |  | ---------------------- | - |  | ---------------------- | - |  | ----- | -
|Accounts receivable by payor and aging category: |  | Government |   |  | Managed Care and Other |   |  | Patient Responsibility |   |  | Total |  
|Aged 0-90 days                                   |  | 43.8       | % |  | 19.9                   | % |  | 2.6                    | % |  | 66.3  | %
|Aged 91-180 days                                 |  | 8.6        | % |  | 5.6                    | % |  | 2.0                    | % |  | 16.2  | %
|Aged 181-360 days                                |  | 6.6        | % |  | 4.9                    | % |  | 2.5                    | % |  | 14.0  | %
|Aged over 360 days                               |  | 1.0        | % |  | 2.2                    | % |  | 0.3                    | % |  | 3.5   | %
|                                                 |  |            |   |  |                        |   |  |                        |   |  |       |  
|Total                                            |  | 60.0       | % |  | 32.6                   | % |  | 7.4                    | % |  | 100.0 | %
|                                                 |  |            |   |  |                        |   |  |                        |   |  |       |  
|                                                 |  |            |   | 
|December 31, 2006                                |  |            |   |  |                        |   |  |                        |   |  |       |  
|                                                 |  |            |   | 
|Accounts receivable by payor and aging category: |  | Government |   |  | Managed Care and Other |   |  | Patient Responsibility |   |  | Total |  
|Aged 0-90 days                                   |  | 41.1       | % |  | 14.9                   | % |  | 1.8                    | % |  | 57.8  | %
|Aged 91-180 days                                 |  | 7.5        | % |  | 8.5                    | % |  | 2.0                    | % |  | 18.0  | %
|Aged 181-360 days                                |  | 7.4        | % |  | 7.6                    | % |  | 2.8                    | % |  | 17.8  | %
|Aged over 360 days                               |  | 2.2        | % |  | 3.2                    | % |  | 1.0                    | % |  | 6.4   | %
|                                                 |  |            |   |  |                        |   |  |                        |   |  |       |  
|Total                                            |  | 58.2       | % |  | 34.2                   | % |  | 7.6                    | % |  | 100.0 | %
|                                                 |  |            |   |  |                        |   |  |                        |   |  |       |  



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Included in accounts receivable are earned but unbilled receivables of $28.1 million and $26.8 million at
December 31, 2005 and 2006, respectively. These amounts include $5.1 million at December 31, 2006 and $5.3 million at December 31, 2005 of receivables for which a prior authorization is required but has not yet been received. 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 the
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 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. For example, for the year
ended December 31, 2006, we had $5.6 million of changes in estimates (increasing contractual adjustments and the provision for doubtful accounts) related to the prior period recorded during the current period.

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. Revenue is recognized at net realizable amounts estimated to be paid by customers and third party payors. Our billing system contains payor-specific price tables that
reflect the fee schedule amounts in effect or contractually agreed upon by various government and commercial payors for each item of the equipment or supply provided to a customer. For Medicare and Medicaid revenues, as well as most other managed
care and private payors, final payment is subject to administrative review and audit. Management makes estimated provisions for adjustments, which may result from administrative review and audit, based upon historical experience. 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 record bad debt expense based on a percentage of revenue using historical company-specific data. The percentage and amounts used to record bad
debt expense and the allowance for doubtful accounts are supported by various methods including current and historical cash collections, bad debt write-offs, and aging of accounts receivable. Accounts are written off against the allowance when all
collection efforts (including payor appeals processes) have been exhausted. 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. We manage billing and collection of accounts receivable through our own billing and collection centers.
Further, even if our billing procedures comply with all third-party payor requirements, some of our payors may experience financial difficulties, may delay payments or may otherwise not pay accounts receivable when due, which would result in
increased write-offs or provisions for doubtful accounts. For example, CMS placed a hold on payments for all claims under Medicare Parts A and B from all



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providers and all physicians during the last nine days of the 2006 Federal fiscal year (September 22September 30, 2006). Information is not available
to determine the exact impact of this payment hold; however, we have estimated the impact to be between approximately $4.1 million and $7.7 million, which resulted in a corresponding increase in accounts receivable and decrease in cash at
September 30, 2006. We received payment for claims impacted by the payment hold during the first two weeks of October 2006. In addition, we also continue to experience inconsistent payment patterns from CMS and its contractors and other
third-party payors. As such, we may not be able to maintain our current levels of collectibility. In addition, third-party payors may experience financial difficulties which could impact their ability to make timely payments to us. If we are unable
to collect our accounts receivable on a timely basis, our revenues, profitability and cash flow likely will significantly decline.

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 $61.7 million for the years ended December 31, 2005 and December 31, 2006, 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. The decrease in net cash used in
investing activities during 2006 is attributed to: (i) increased utilization of existing equipment, which decreased our capital expenditures from $78.8 million (14.8% of our net revenues) to $59.9 million (12.0% of our net revenues) for the
years ended December 31, 2005 and 2006, respectively; and (ii) discontinuance of business acquisitions, which decreased cash outlays for businesses acquired from $30.8 million to $1.8 million for the years ended December 31, 2005 and
2006, respectively.

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, 2006, we had the following credit facilities and outstanding debt:



| |  |  | Two-year $25 million senior secured revolving line of credit for general corporate purposes including working capital, capital expenditures and permitted
acquisitions. As of December 31, 2006, we did not have any amounts outstanding under this revolving credit facility; however, we had $14.1 million committed under standby letters of credit.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Two-year $95 million senior secured term loan, the proceeds of which were used to repay the outstanding balance under our former term loan and revolving credit
facility and for other general corporate purposes. The term loan is repayable, quarterly, in an aggregate annual amount equal to 1% of the principal amount commencing on December 31, 2006, with the remaining balance due in September 2008.
Advances outstanding on the term loan bear interest at the rate of LIBOR plus 3.50%. As of December 31, 2005, we had a balance of $42.2 million outstanding under our former term loan and accrued interest on borrowings under our former term loan
of $7.2 million. During the year ended December 31, 2006, we made regularly scheduled amortization payments of $0.2 million on our former term loan. As of December 31, 2006, we had a balance of $95.0 million outstanding under our current
term loan and accrued interest on borrowings under our current term loan was $0.3 million. At December 31, 2006, our current term loan interest rate was 8.82%. Interest paid during the years ended December 31, 2005 and 2006 was $2.7
million and $7.1 million, respectively.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $300 million aggregate principal amount 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, 2005 and 2006, we had a balance of $287.0 million outstanding. Interest paid during each of the years ended December 31, 2005 and 2006 was $27.3 million.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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On September 15, 2006, we entered into a credit agreement with Highland Financial Corp., as lead
arranger and sole bookrunner, Nexbank, SSB, as collateral agent and administrative agent, and the several banks and other financial institutions or entities from time to time parties to the credit agreement. This credit facility has a maximum credit
amount of $120.0 million that consists of a $25.0 million revolving line of credit and a $95.0 million term loan (the commitment to fund the last $5.0 million of the revolving line of credit is subject to the approval of lenders holding a majority
of maximum credit amount then outstanding). A portion of the revolving line of credit, not in excess of $15.0 million is available for the issuance of letters of credit.

Borrowings under the senior secured revolving line of credit and term loan are secured by substantially all of our assets and the agreements with respect to such revolving credit facility and term loan impose numerous
restrictions, including, but not limited to, covenants with respect to certain specified EBITDA thresholds and a specified consolidated total leverage ratio requirement, limitations on additional borrowing, capital expenditures, acquisitions and
investments.

Our continuation as a going concern is dependent upon our ability to generate sufficient cash flow to meet our obligations on
a timely basis, continued funding of our revolving line of credit and ultimately to achieve successful operations. Our working capital requirements relate primarily to the working capital needed for general corporate purposes. 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,
2007. Prior to 2006, we have historically satisfied our working capital requirements and capital expenditures from operating cash flow.

Our current cash projections indicate that the cash generated from our operations and the funds available under our credit facility will be sufficient and we expect to be able to meet our working capital, capital expenditure and other cash
needs through 2007. Management believes they have the ability to manage our cash flows in order to be able to meet our obligations as they become due during 2007. However, if our current cash projections are not realized, additional unfavorable
regulatory actions are taken with respect to the reimbursement rates that apply to our business, we experience any significant changes in non-cash working capital (including accounts receivable), we experience material adverse changes in payment
patterns from CMS and its contractors or other third-party payors, we experience another payment hold by CMS similar to or longer than that experienced in September 2006, or we are negatively impacted by other unforeseen factors, we may not have
sufficient cash available to meet our working capital, capital expenditure and other cash needs through 2007. In addition, we may need, but be unable to obtain, access to our full credit facility (the commitment to fund the last $5.0 million of the
revolving line of credit is subject to the approval of lenders holding a majority of the maximum credit amount then outstanding) in connection with meeting our cash needs. If these or other events take place, we may be required to consider all of
our alternatives in restructuring our business and our capital structure including filing for bankruptcy protection.

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 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 $0.9 million were declared on our Series A Preferred and such dividends were paid
during the first quarter of 2005. At each of the 2005 and 2006 annual meetings of the board of directors, dividends in the amount of $0.5 million were declared on our Series A Preferred. The 2005 dividend was paid in December 2005 and the 2006
dividend was paid in January 2007. In addition, 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.

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.



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Selected Quarterly Financial Data (unaudited)

The following tables present our unaudited quarterly results of operations for 2005 and 2006. 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, 2005 and December 31, 2006:



|                                             |  |                                       |         |   |              |   |                   |  |                  |         |               |   |         |              |   |         |                   |  |   |                  |   |  |   |         |   |  |   |         |  
|-------------------------------------------- |  | ------------------------------------- | ------- | - | ------------ | - | ----------------- |  | ---------------- | ------- | ------------- | - | ------- | ------------ | - | ------- | ----------------- |  | - | ---------------- | - |  | - | ------- | - |  | - | ------- | -
|                                             |  | Three Months Ended                    |        
|                                             |  | March 31,2005                         |         |   | June 30,2005 |   | September 30,2005 |  | December 31,2005 |         | March 31,2006 |   |         | June 30,2006 |   |         | September 30,2006 |  |   | December 31,2006 |  
|                                             |  | (in thousands, except per share data) |        
|Summary Statement of Operations Information: |  |                                       |         |   |              |   |                   |  |                  |         |               |   |         |              |   |         |                   |  |   |                  |   |  |   |         |   |  |   |         |  
|Net revenues                                 |  | $                                     | 123,253 |   |              | $ | 133,043           |  | $                | 136,969 |               | $ | 139,917 |              | $ | 132,474 |                   |  | $ | 111,846          |   |  | $ | 127,218 |   |  | $ | 127,213 |  
|Cost of net revenues                         |  |                                       | 39,153  |   |              |   | 41,743            |  |                  | 43,095  |               |   | 48,391  |              |   | 43,551  |                   |  |   | 40,359           |   |  |   | 41,484  |   |  |   | 47,119  |  
|Net earnings (loss)                          |  |                                       | (2,953  | ) |              |   | 1,077             |  |                  | 3,103   |               |   | 4,320   |              |   | (3,021  | )                 |  |   | (430,861         | ) |  |   | (84,008 | ) |  |   | (16,659 | )
|Net earnings (loss) per common sharebasic   |  |                                       | (0.12   | ) |              |   | 0.04              |  |                  | 0.12    |               |   | 0.17    |              |   | (0.12   | )                 |  |   | (16.95           | ) |  |   | (3.30   | ) |  |   | (0.65   | )
|Net earnings (loss) per common sharediluted |  |                                       | (0.12   | ) |              |   | 0.04              |  |                  | 0.12    |               |   | 0.17    |              |   | (0.12   | )                 |  |   | (16.95           | ) |  |   | (3.30   | ) |  |   | (0.65   | )
|Market prices:                               |  |                                       |         |   |              |   |                   |  |                  |         |               |   |         |              |   |         |                   |  |   |                  |   |  |   |         |   |  |   |         |  
|High                                         |  |                                       | 28.45   |   |              |   | 27.70             |  |                  | 27.77   |               |   | 23.70   |              |   | 17.49   |                   |  |   | 14.92            |   |  |   | 3.81    |   |  |   | 2.94    |  
|Low                                          |  |                                       | 25.00   |   |              |   | 24.10             |  |                  | 22.02   |               |   | 15.00   |              |   | 14.26   |                   |  |   | 3.58             |   |  |   | 0.90    |   |  |   | 0.74    |  

Contractual Obligations

As of December 31, 2006, 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) |  | $                                     | 539,476 |                 | $ | 36,542    |  | $         | 154,532 |                  | $ | 54,530 |  | $ | 293,872
|Operating lease obligations(3)                                                  |  |                                       | 65,921  |                 |   | 23,268    |  |           | 29,115  |                  |   | 13,199 |  |   | 339    
|Other liabilities reflected on our balance sheet under GAAP(4)                  |  |                                       | 6,941   |                 |   | 4,399     |  |           | 1,988   |                  |   | 554    |  |   |       
|                                                                                |  |                                       |         |                 |   |           |  |           |         |                  |   |        |  |   |        
|Total                                                                           |  | $                                     | 612,338 |                 | $ | 64,209    |  | $         | 185,635 |                  | $ | 68,283 |  | $ | 294,211
|                                                                                |  |                                       |         |                 |   |           |  |           |         |                  |   |        |  |   |        

---

|(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 10 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 11 to the consolidated financial statements included in this report for
further discussion of our lease commitments.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



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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

FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), which prescribes a recognition
threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim
periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for us beginning January 1, 2007. We are in the process of determining the effect, if any, the adoption of FIN 48 will have
on our financial statements.

SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements When
Quantifying Misstatements in Current Year Financial Statements

In September 2006, the Securities and Exchange Commission (SEC) issued
Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides guidance on how the effects of the carryover or
reversal of prior year financial statement misstatements should be considered in quantifying a current year misstatement. Prior practice allowed the evaluation of materiality on the basis of (1) the error quantified as the amount by which the
current year income statement was misstated (rollover method) or (2) the cumulative error quantified as the cumulative amount by which the current year balance sheet was misstated (iron curtain method). The guidance
provided in SAB 108 requires both methods to be used in evaluating materiality. If applying the provisions of SAB 108 results in errors that are deemed material, than such errors, along with any additional immaterial errors, would be corrected
through a cumulative effect adjustment. The cumulative effect of the correction would be reflected in the opening balance sheet with appropriate disclosure of the nature and amount of each individual error corrected in the cumulative adjustment, as
well as a disclosure of the cause of the error and whether the error had been deemed to be immaterial in the past. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. We adopted SAB 108
as of December 31, 2006 and such adoption had no financial impact on our results of operation or financial condition.

Inflation and Seasonality

Management believes that there has been no material effect on our operations or financial condition as a result of inflation during the
past three fiscal years. However, we are impacted by rising costs for certain inflation-sensitive operating expenses, such as labor and employee benefits, facility and equipment leases, and vehicle fuel. 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. Management also believes that the seasonal impact
on our business is not material.



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|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

We are exposed to changes in interest rates as a result of our senior secured revolving credit facility and our senior secured term loan (collectively referred to as the Senior Secured Credit Facilities). Variable interest rates
may rise, which could increase the amount of interest expense. For the year ended December 31, 2006, we incurred $7.1 million of interest expense on our Senior Secured Credit Facilities. Assuming a hypothetical increase of one percentage point
for the variable interest rate applicable to the Senior Secured Credit Facilities (of which $95.0 million was outstanding as of December 31, 2006), we would incur approximately $1.0 million in additional interest expense for the period of
January 1, 2007 through December 31, 2007.



|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 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, 2006.

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, 2006 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.



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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s Annual Report on Internal Control over Financial Reporting that Rotech Healthcare Inc. and its subsidiaries (the Company) maintained effective internal control over
financial reporting as of December 31, 2006, 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 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, 2006, 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, 2006, 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, 2006 of the Company and our report dated March 16, 2007, expressed an unqualified opinion on those financial statements and financial statement schedule.

/s/ DELOITTE & TOUCHE LLP

Certified Public
Accountants

Orlando, Florida

March 16, 2007



67



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##### Table of Contents

Changes in Internal Control over Financial Reporting

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.
During the fourth quarter of fiscal year 2006, there were no changes in our internal control over financial reporting identified in connection with the evaluation described above in Managements Annual Report on Internal Control Over
Financial Reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

None



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##### Table of Contents

PART III



|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
|-------- | ---------------------------------------------------------

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 2007 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 2007 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 2007 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, AND DIRECTOR INDEPENDENCE
|-------- | -------------------------------------------------------------------------

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 2007 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 2007 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.



69



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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, 2005 and 2006                                                                                                                                                   |  | F-3    
|   |  | Consolidated Statements of Operations for the years ended December 31, 2004, 2005 and 2006                                                                                                                     |  | F-4    
|   |  | Consolidated Statements of Changes in Stockholders Equity for the years ended December 31, 2004, 2005 and 2006                                                                                                |  | F-5    
|   |  | Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2005 and 2006                                                                                                                     |  | 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, 2004, 2005 and 2006                                                                                                             |  | 71     
|   |  | 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).



70



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##### Table of Contents

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

For the years ended December 31, 2004, 2005 and 2006

(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, 2004           |  | $                            | 28,429 |                             | $ | 39,411                  |  | $             |      |  | $                        | (40,266 | ) |  | $ | 27,574
|Year ended December 31, 2005           |  |                              | 27,574 |                             |   | 44,687                  |  |               |      |  |                          | (49,176 | ) |  |   | 23,085
|Year ended December 31, 2006           |  |                              | 23,085 |                             |   | 70,355                  |  |               | 906   |  |                          | (73,057 | ) |  |   | 21,289
|                                       |  |                              |        |                             |  
|Allowance for Doubtful Accounts:       |  |                              |        |                             |   |                         |  |               |       |  |                          |         |   |  |   |       
|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
|Year ended December 31, 2006           |  |                              | 14,766 |                             |   | 14,340                  |  |               | 1,814 |  |                          | (18,457 | ) |  |   | 12,463

---

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



71



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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, 2007 |  |  |  | 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.
CARTER Philip L. Carter   |  | President, Chief Executive Officer and Director (Principal Executive Officer) |  | March 16, 2007
|                                           |  |                                                                              
|/s/    STEVEN P.
ALSENE Steven P. Alsene   |  | Chief Financial Officer (Principal Financial and Accounting Officer)          |  | March 16, 2007
|                                           |  |                                                                              
|/s/    ARTHUR J.
REIMERS Arthur J. Reimers |  | Chairman of the Board                                                         |  | March 16, 2007
|                                           |  |                                                                              
|/s/    JAMES H.
BLOEM James H. Bloem       |  | Director                                                                      |  | March 16, 2007
|                                           |  |                                                                              
|/s/    EDWARD L.
KUNTZ Edward L. Kuntz     |  | Director                                                                      |  | March 16, 2007
|                                           |  |                                                                              
|/s/    ARTHUR
SIEGEL Arthur Siegel         |  | Director                                                                      |  | March 16, 2007



72



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##### Table of Contents

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)       |  | Amendment No. 4 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                        
|              | 
|10.6(h)       |  | Form of Common Stock Option Agreement.                                                                                                                                                                                                                                                                                         
|              | 
|10.7(d)       |  | Rotech Healthcare Inc. Nonemployee Director Restricted Stock Plan.                                                                                                                                                                                                                                                             
|              | 
|10.8(d)       |  | Form of Restricted Stock Award Agreement.                                                                                                                                                                                                                                                                                      
|              | 
|10.9(c)       |  | Rotech Healthcare Inc. Senior Management Incentive Plan (2005-2007).                                                                                                                                                                                                                                                           
|              | 
|10.10         |  | Rotech Healthcare Inc. Performance Bonus Plan                                                                                                                                                                                                                                                                                  
|              | 
|10.11(i)      |  | Credit Agreement dated as of September 15, 2006 among Rotech Healthcare Inc., Highland Financial Corp., as lead arranger and sole bookrunner, Nexbank, SSB, as collateral agent and administrative
agent, and the several banks and other financial institutions or entities from time to time parties to the Credit Agreement.
|              | 
|10.12         |  | Amendment, dated as of December 22, 2006, to the Companys Credit Agreement dated as of September 15, 2006.                                                                                                                                                                                                                    
|              | 
|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(j)      |  | Amendment and Restatement of the Rotech Healthcare Inc. Employees Plan effective January 1, 2003.                                                                                                                                                                                                                              



73



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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(g)      |  | Letter agreement with Steven P. Alsene with Respect to Rights upon Termination of Employment dated November 8, 2006.                                                          
|              | 
|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, 2006 filed with the Securities and Exchange Commission on November 9,
2006.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(h) | 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.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(i) | Incorporated by Reference to our Current Report on Form 8-K filed with the Securities and Exchange Commission on September 19, 2006.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(j) | 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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



74



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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, 2005 and 2006                                              |  | F-3 
|                                                                                                          | 
|Consolidated Statements of Operations for the years ended December 31, 2004, 2005 and 2006                |  | F-4 
|                                                                                                          | 
|Consolidated Statements of Changes in Stockholders Equity for the years December 31, 2004, 2005 and 2006 |  | F-5 
|                                                                                                          | 
|Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2005 and 2006                |  | 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, 2005 and
2006, and the related consolidated statements of operations, stockholders equity and cash flows for each of the three years in the period ended December 31, 2006. 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 these 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 the Company as of December 31, 2005 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 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, 2006, 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, 2007 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, 2007



F-2



---

##### Table of Contents

ROTECH
HEALTHCARE INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and 2006

(In
thousands, except share and per share data)



|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | --------- | ---------------- | - | -------- | -
|                                                                                                                                                                                                        |  | December 31,2005 |           | December 31,2006 |  
|Assets                                                                                                                                                                                                  |  |                  |           |                  |   |          |  
|Current assets:                                                                                                                                                                                         |  |                  |           |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                                               |  | $                | 14,222    |                  | $ | 10,265   |  
|Accounts receivable, net                                                                                                                                                                                |  |                  | 75,475    |                  |   | 78,692   |  
|Other accounts receivable                                                                                                                                                                               |  |                  | 973       |                  |   | 1,114    |  
|Inventories                                                                                                                                                                                             |  |                  | 9,206     |                  |   | 9,486    |  
|Prepaid expenses                                                                                                                                                                                        |  |                  | 4,557     |                  |   | 4,624    |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|Total current assets                                                                                                                                                                                    |  |                  | 104,433   |                  |   | 104,181  |  
|Property and equipment, net                                                                                                                                                                             |  |                  | 148,168   |                  |   | 148,153  |  
|Intangible assets (less accumulated amortization of $4,731 in 2005 and $6,121 in 2006)                                                                                                                  |  |                  | 20,583    |                  |   | 19,904   |  
|Other goodwill                                                                                                                                                                                          |  |                  | 42,044    |                  |   | 43,876   |  
|Reorganization value in excess of fair value of identifiable assetsgoodwill                                                                                                                            |  |                  | 692,154   |                  |   | 163,154  |  
|Deferred tax asset, net                                                                                                                                                                                 |  |                  |          |                  |   | 4,803    |  
|Other assets                                                                                                                                                                                            |  |                  | 11,302    |                  |   | 13,062   |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|                                                                                                                                                                                                        |  | $                | 1,018,684 |                  | $ | 497,133  |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|                                                                                                                                                                                                        |  |                 
|Liabilities and Stockholders Equity                                                                                                                                                                    |  |                  |           |                  |   |          |  
|Current liabilities:                                                                                                                                                                                    |  |                  |           |                  |   |          |  
|Accounts payable                                                                                                                                                                                        |  | $                | 24,386    |                  | $ | 22,124   |  
|Accrued expenses and other current liabilities                                                                                                                                                          |  |                  | 25,436    |                  |   | 19,213   |  
|Accrued interest                                                                                                                                                                                        |  |                  | 7,246     |                  |   | 7,194    |  
|Deferred revenue                                                                                                                                                                                        |  |                  | 9,258     |                  |   | 10,330   |  
|Deferred tax liabilities, net                                                                                                                                                                           |  |                  | 10,717    |                  |   | 8,172    |  
|Income taxes payable                                                                                                                                                                                    |  |                  | 1,646     |                  |   | 1,225    |  
|Current portion of long-term debt                                                                                                                                                                       |  |                  | 634       |                  |   | 4,053    |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|Total current liabilities                                                                                                                                                                               |  |                  | 79,323    |                  |   | 72,311   |  
|Deferred tax liabilities, net                                                                                                                                                                           |  |                  | 31,574    |                  |   |         |  
|Priority tax claim                                                                                                                                                                                      |  |                  | 3,476     |                  |   | 2,313    |  
|Other long-term liabilities                                                                                                                                                                             |  |                  | 573       |                  |   | 636      |  
|Long-term debt, less current portion                                                                                                                                                                    |  |                  | 328,880   |                  |   | 380,813  |  
|                                                                                                                                                                                                        |  |                 
|Series A convertible redeemable preferred stock, stated value $20 per share, 1,000,000 shares authorized, 249,196 and 246,508 shares issued
and outstanding at December 31, 2005 and 2006, respectively |  |                  | 5,343     |                  |   | 5,343    |  
|                                                                                                                                                                                                        |  |                 
|Stockholders equity:                                                                                                                                                                                   |  |                  |           |                  |   |          |  
|Common stock, par value $.0001 per share 50,000,000 shares authorized, 25,417,270 and 25,481,270 shares issued and outstanding at
December 31, 2005 and 2006, respectively                              |  |                  | 3         |                  |   | 3        |  
|Additional paid-in capital                                                                                                                                                                              |  |                  | 504,559   |                  |   | 505,310  |  
|Retained earnings (accumulated deficit)                                                                                                                                                                 |  |                  | 64,953    |                  |   | (469,596 | )
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|Total stockholders equity                                                                                                                                                                              |  |                  | 569,515   |                  |   | 35,717   |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  
|                                                                                                                                                                                                        |  | $                | 1,018,684 |                  | $ | 497,133  |  
|                                                                                                                                                                                                        |  |                  |           |                  |   |          |  

See accompanying notes to consolidated financial statements.



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##### Table of Contents

ROTECH
HEALTHCARE INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

For the Years Ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share data)



|                                                      |  |      |            |   |      |   |            |  |   |            |  
|----------------------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- |  | - | ---------- | -
|                                                      |  | 2004 |            |   | 2005 |   | 2006       | 
|Net revenues                                          |  | $    | 535,329    |   |      | $ | 533,182    |  | $ | 498,751    |  
|Costs and expenses:                                   |  |      |            |   |      |   |            |  |   |            |  
|Cost of net revenues:                                 |  |      |            |   |      |   |            |  |   |            |  
|Product and supply costs                              |  |      | 70,583     |   |      |   | 95,182     |  |   | 103,302    |  
|Patient service equipment depreciation                |  |      | 61,362     |   |      |   | 47,409     |  |   | 45,155     |  
|Operating expenses                                    |  |      | 16,784     |   |      |   | 23,595     |  |   | 24,056     |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Total cost of net revenues                            |  |      | 148,729    |   |      |   | 166,186    |  |   | 172,513    |  
|Provision for doubtful accounts                       |  |      | 19,614     |   |      |   | 17,858     |  |   | 14,340     |  
|Selling, general and administrative                   |  |      | 257,000    |   |      |   | 290,215    |  |   | 301,427    |  
|Depreciation and amortization                         |  |      | 15,191     |   |      |   | 18,123     |  |   | 17,162     |  
|Goodwill impairment                                   |  |      |           |   |      |   |           |  |   | 529,000    |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Total costs and expenses                              |  |      | 440,534    |   |      |   | 492,382    |  |   | 1,034,442  |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Operating income (loss)                               |  |      | 94,795     |   |      |   | 40,800     |  |   | (535,691   | )
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Other (income) expenses:                              |  |      |            |   |      |   |            |  |   |            |  
|Interest expense, net                                 |  |      | 33,696     |   |      |   | 31,503     |  |   | 36,225     |  
|Other income, net                                     |  |      | (2,475     | ) |      |   | 138        |  |   | (187       | )
|Loss on extinguishment of debt                        |  |      |           |   |      |   |           |  |   | 1,178      |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Total other expenses                                  |  |      | 31,221     |   |      |   | 31,641     |  |   | 37,216     |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Earnings (loss) before income taxes                   |  |      | 63,574     |   |      |   | 9,159      |  |   | (572,907   | )
|Federal and state income taxes (benefit)              |  |      | 27,564     |   |      |   | 3,613      |  |   | (38,808    | )
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Net earnings (loss)                                   |  |      | 36,010     |   |      |   | 5,546      |  |   | (534,099   | )
|Accrued dividends on redeemable preferred stock       |  |      | 450        |   |      |   | 450        |  |   | 450        |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Net earnings (loss) available for common stockholders |  | $    | 35,560     |   |      | $ | 5,096      |  | $ | (534,549   | )
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Net earnings (loss) per common share:                 |  |      |            |   |      |   |            |  |   |            |  
|Basic                                                 |  | $    | 1.41       |   |      | $ | 0.20       |  | $ | (20.99     | )
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Diluted                                               |  | $    | 1.39       |   |      | $ | 0.20       |  | $ | (20.99     | )
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Weighted average shares outstanding:                  |  |      |            |   |      |   |            |  |   |            |  
|Basic                                                 |  |      | 25,146,315 |   |      |   | 25,379,173 |  |   | 25,461,434 |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  
|Diluted                                               |  |      | 25,544,016 |   |      |   | 25,817,774 |  |   | 25,461,434 |  
|                                                      |  |      |            |   |      |   |            |  |   |            |  

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

For the Years Ended December 31, 2004, 2005 and 2006

(In thousands, except share data)



|                                                      |  |                      |  |                      |   |                          |   |                                       |  |   |                          |   |  |   |          |  
|----------------------------------------------------- |  | -------------------- |  | -------------------- | - | ------------------------ | - | ------------------------------------- |  | - | ------------------------ | - |  | - | -------- | -
|                                                      |  | Shares ofCommonStock |  | Par ValueCommonStock |   | AdditionalPaid-inCapital |   | RetainedEarnings/(AccumulatedDeficit) |  |   | TotalStockholdersEquity |  
|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  |  
|                                                      |  |                      |  |                      |   |                          |   |                                       |  |   |                          |   |  |   |          |  
|Net loss for the year ended December 31, 2006         |  |                     |  |                      |  |                          |   |                                      |  |   | (534,099                 | ) |  |   | (534,099 | )
|Tax benefit from prior year exercise of stock options |  |                     |  |                      |  |                          |   | 85                                    |  |   |                         |   |  |   | 85       |  
|Restricted stock awards released                      |  | 64,000               |  |                      |  |                          |   |                                      |  |   |                         |   |  |   |         |  
|Non-cash stock compensation expense                   |  |                     |  |                      |  |                          |   | 666                                   |  |   |                         |   |  |   | 666      |  
|Accrued dividends on redeemable preferred stock       |  |                     |  |                      |  |                          |   |                                      |  |   | (450                     | ) |  |   | (450     | )
|                                                      |  |                      |  |                      |   |                          |   |                                       |  |   |                          |   |  |   |          |  
|Balance at December 31, 2006                          |  | 25,481,270           |  | $                    | 3 |                          | $ | 505,310                               |  | $ | (469,596                 | ) |  | $ | 35,717   |  
|                                                      |  |                      |  |                      |   |                          |   |                                       |  |   |                          |   |  |   |          |  

See accompanying notes to consolidated financial statements.



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##### Table of Contents

ROTECH
HEALTHCARE INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2004, 2005 and 2006

(In thousands)



|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|----------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                                                                |  | 2004 |         |   | 2005 |   |          | 2006 | 
|Net earnings (loss)                                                                             |  | $    | 36,010  |   |      | $ | 5,546    |      |  | $ | (534,099 | )
|Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:      |  |      |         |   |      |   |          |      |  |   |          |  
|Provision for doubtful accounts                                                                 |  |      | 19,614  |   |      |   | 17,858   |      |  |   | 14,340   |  
|Depreciation and amortization                                                                   |  |      | 79,124  |   |      |   | 66,915   |      |  |   | 64,559   |  
|Loss on extinguishment of debt                                                                  |  |      | 910     |   |      |   |         |      |  |   | 1,178    |  
|Gain on legal settlement                                                                        |  |      |        |   |      |   | (1,481   | )    |  |   |         |  
|Goodwill impairment                                                                             |  |      |        |   |      |   |         |      |  |   | 529,000  |  
|Deferred income taxes                                                                           |  |      | 22,587  |   |      |   | 5,118    |      |  |   | (38,922  | )
|Other adjustments to reconcile net earnings (loss) to net cash provided by operating activities |  |      | 602     |   |      |   | (209     | )    |  |   | 1,013    |  
|Changes in operating assets and liabilities:                                                    |  |      |         |   |      |   |          |      |  |   |          |  
|Accounts receivable                                                                             |  |      | (11,820 | ) |      |   | (32,839  | )    |  |   | (17,557  | )
|Other accounts receivable                                                                       |  |      | (280    | ) |      |   | 199      |      |  |   | (141     | )
|Inventories                                                                                     |  |      | (737    | ) |      |   | (266     | )    |  |   | (280     | )
|Prepaid expenses                                                                                |  |      | (466    | ) |      |   | 237      |      |  |   | (67      | )
|Income tax receivable                                                                           |  |      | 2,531   |   |      |   |         |      |  |   |         |  
|Other assets                                                                                    |  |      | (1,179  | ) |      |   | (130     | )    |  |   | (652     | )
|Accounts payable and accrued expenses                                                           |  |      | (9,705  | ) |      |   | 5,074    |      |  |   | (3,484   | )
|Accrued interest                                                                                |  |      | (2,885  | ) |      |   | (49      | )    |  |   | (52      | )
|Income taxes payable                                                                            |  |      | 3,225   |   |      |   | (1,148   | )    |  |   | (421     | )
|Deferred revenue                                                                                |  |      | (3,306  | ) |      |   | (4,717   | )    |  |   | 1,072    |  
|Other long-term liabilities                                                                     |  |      |        |   |      |   | 573      |      |  |   | 62       |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Net cash provided by operating activities                                                       |  |      | 134,225 |   |      |   | 60,681   |      |  |   | 15,549   |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Cash flows from investing activities:                                                           |  |      |         |   |      |   |          |      |  |   |          |  
|Purchases of property and equipment                                                             |  |      | (54,003 | ) |      |   | (78,768  | )    |  |   | (59,878  | )
|Business acquisitions                                                                           |  |      |        |   |      |   | (30,777  | )    |  |   | (1,816   | )
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Net cash used in investing activities                                                           |  |      | (54,003 | ) |      |   | (109,545 | )    |  |   | (61,694  | )
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Cash flows from financing activities:                                                           |  |      |         |   |      |   |          |      |  |   |          |  
|Proceed from short-term borrowings                                                              |  |      |        |   |      |   |         |      |  |   | 59,300   |  
|Payments on short-term borrowings                                                               |  |      |        |   |      |   |         |      |  |   | (63,237  | )
|Payments of long-term borrowings                                                                |  |      | (39,240 | ) |      |   | (657     | )    |  |   | (456     | )
|Retirement of long-term borrowings                                                              |  |      |        |   |      |   |         |      |  |   | (42,013  | )
|Proceeds from long-term borrowings                                                              |  |      |        |   |      |   |         |      |  |   | 95,000   |  
|Debt issuance costs                                                                             |  |      |        |   |      |   |         |      |  |   | (5,158   | )
|Payments of liabilities subject to compromise/priority tax claim                                |  |      | (2,645  | ) |      |   | (1,265   | )    |  |   | (966     | )
|Payments of capital leases                                                                      |  |      |        |   |      |   |         |      |  |   | (282     | )
|Net proceeds from stock option exercises                                                        |  |      | 5,506   |   |      |   | 1,535    |      |  |   |         |  
|Payments of dividends on redeemable preferred stock                                             |  |      |        |   |      |   | (1,350   | )    |  |   |         |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Net cash provided by (used in) financing activities                                             |  |      | (36,379 | ) |      |   | (1,737   | )    |  |   | 42,188   |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Increase (decrease) in cash and cash equivalents                                                |  |      | 43,843  |   |      |   | (50,601  | )    |  |   | (3,957   | )
|Cash and cash equivalents, beginning of year                                                    |  |      | 20,980  |   |      |   | 64,823   |      |  |   | 14,222   |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Cash and cash equivalents, end of year                                                          |  | $    | 64,823  |   |      | $ | 14,222   |      |  | $ | 10,265   |  
|                                                                                                |  |      |         |   |      |   |          |      |  |   |          |  
|Supplemental disclosures of noncash investing and financing activities                          |  |      |         |   |      |   |          |      |  |   |          |  
|Property and equipment acquired through capital leases                                          |  | $    | 500     |   |      | $ |         |      |  | $ | 3,103    |  
|Property and equipment unpaid and included in accounts payable                                  |  | $    | 3,858   |   |      | $ | 5,638    |      |  | $ | 3,447    |  
|Supplemental disclosures of cash flow information:                                              |  |      |         |   |      |   |          |      |  |   |          |  
|Interest paid                                                                                   |  | $    | 33,002  |   |      | $ | 31,359   |      |  | $ | 34,959   |  
|Income taxes paid (refunded)                                                                    |  | $    | 1,202   |   |      | $ | (103     | )    |  | $ | 406      |  

See accompanying notes to consolidated financial statements.



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##### Table of Contents

ROTECH
HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For years ended December 31, 2004, 2005 and 2006

(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, we, our, and us refer to the business and operations of Rotech
Healthcare Inc. and its subsidiaries and not any other person.

Our 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.

Our certificate of incorporation authorizes us to issue up to 250,000 shares of Series A Convertible Redeemable Preferred Stock with an aggregate stated
value of $5,000. Concurrent with the effectiveness of the Plan, we issued all of the shares of Series A Convertible Redeemable Preferred Stock to an employee profit sharing plan.

In connection with our emergence from bankruptcy, we adopted 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.

Our common stock currently trades on the
NASDAQ Global Market under the trading symbol ROHI.

(2) Liquidity

We are highly leveraged. As of December 31, 2006, we had $384,866 of long-term debt outstanding. We have also experienced significant declines in net
cash provided by operating activities, which were $134,225, $60,681 and $15,549 for the years ended December 31, 2004, 2005 and 2006, respectively, primarily as the result of Medicare reimbursement cuts. Although we are highly leveraged and
have experienced declines in net cash provided by operating activities, our current cash projections indicate that the cash generated from our operations and the funds available under our credit facility will be sufficient and we expect to be able
to meet our working capital, capital expenditure and other cash needs through 2007. Management believes they have the ability to manage our cash flows in order to be able to meet our obligations as they become due during 2007.

On March 12, 2007, we drew $7,000 from the revolving credit facility in preparation for the upcoming interest payment due on April 2, 2007.
Following this draw, we have $5,352 remaining under the $25,000 revolving credit facility (the commitment to fund the last $5,000 of the revolving line of credit is subject to the approval of lenders holding a majority of maximum credit amount then
outstanding). As of March 14, 2007, including the $7,000 drawn from the revolving credit facility, we had approximately $13,300 in cash. We currently project our balance to increase over the next three weeks leading up to our April 2
interest payment of $13,633.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



We are also required to comply with certain financial covenants under our credit agreement, including
requirements regarding certain specified EBITDA thresholds and a specified consolidated total leverage ratio. We were in compliance with such covenants as of December 31, 2006. Our budget indicates that we will meet these covenant requirements
for 2007 (see Note 10, Long-Term Debt, for a discussion of the consequences of failing to comply with our covenant requirements and the events of default under our credit agreement).

(3) 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 amounts reported in the financial statements and accompanying notes. 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. In general, managements estimates
are based upon historical experience, information from third party professionals and various other assumptions that we believe to be reasonable under the facts and circumstances. Actual results and outcomes may differ from managements
estimates and assumptions.

Fresh-Start Reporting

We 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, we 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 our 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; our price to the buyer is fixed or determinable; and collectibility is reasonably assured.

Our rental arrangements generally provide for fixed monthly payments established by fee schedules for as long as the patient is using the equipment and
medical necessity continues (subject to capped rentals which limit the rental payment period in some instances). 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.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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. Revenues derived from capitation arrangements are insignificant.

Net Patient Service Revenues

Net patient service revenues are recorded at net realizable amounts estimated to be paid by customers and third-party payors. Our billing system contains
payor-specific price tables that reflect the fee schedule amounts, as available, in effect or contractually agreed upon by various government and commercial payors for each item of equipment or supply provided to a customer. Net patient service
revenues are recorded based upon the applicable fee schedule.

We track collections and adjustments as a percentage of related revenues.
Historical collection and adjustment percentages serve as the basis for our provisions for contractual adjustments and doubtful accounts. The provision for contractual adjustments is recorded as a reduction to net patient service revenues and
consists of:

(1) Differences between the non-contracted third-party payors allowable amounts and our usual and
customary billing rate. We do not have contracts or fee schedules with all third-party payors. Accordingly, for non-contracted payors where no fee schedule is available, we record revenue based upon our usual and customary billing rates. Actual
adjustments that result from differences between the non-contracted third-party payors allowable amounts and our usual and customary billing rates are recorded against the allowance for contractual adjustments and are typically identified and
recorded at the point of cash application.

(2) Services for which payment is denied by governmental or third-party
payors, or otherwise deemed non-billable by us. Final payment under governmental programs, and most third-party contracts, is subject to administrative review and audit. Furthermore, the complexity of governmental and third-party billing
reimbursement arrangements, including patient qualification and medical necessity requirements, may result in adjustments to amounts originally recorded. Such adjustments may be recorded as the result of the denial of claims billed to governmental
or third-party payors, or as the result of our review procedures prior to submission of the claim to the governmental or third-party payor. Actual adjustments that result from services for which payment is denied by governmental or third-party
payors, or otherwise deemed non-billable by us are recorded against the allowance for contractual adjustments.

The provision for
contractual adjustments reduces amounts recorded through our billing system to estimated net realizable amounts. We record the provision for contractual adjustments based on a percentage of revenue using historical Company-specific data. The
percentage and amounts used to record the provision for contractual adjustments are supported by various methods including current and historical cash collections, as well as actual contractual adjustment experience. This percentage, which is
adjusted at least on an annual basis, has proven to be the best indicator of expected realizable amounts.

We closely monitor our
historical contractual adjustment 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 it believes to be available. Due to the nature of
the industry and the reimbursement environment in which we operate, certain estimates are required in order to record net patient service revenues at their net realizable values.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Inherent in these estimates is the risk that they may have to be revised or updated as additional information becomes available. Specifically, the complexity
of many third-party billing arrangements, patient qualification for medical necessity of equipment 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.

The provision for
doubtful accounts is recorded as an operating expense and consists of billed charges that are ultimately deemed uncollectible due to the patients or third-party payors inability or refusal to pay, as described below.

Provision for Doubtful Accounts

Medicare and most other government and commercial payors that provide coverage to our customers include a 20 percent co-payment provision in addition to a nominal deductible. Co-payments are generally not collected at the time of service
and are invoiced to the customer or applicable secondary payor (supplemental providers of insurance coverage) on a monthly billing cycle as products are provided. A majority of our customers maintain, or are entitled to, secondary or supplemental
insurance benefits providing gap coverage of this co-payment amount. In the event coverage is denied by the third-party payor, the customer is ultimately responsible for payment of charges for all services rendered by us.

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 risk, with regard to doubtful accounts, relates to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We record a provision for
doubtful accounts based on a percentage of revenue using historical Company-specific data. The percentage and amounts used to record the provision for doubtful accounts are supported by various methods including current and historical cash
collections, actual write-offs, and accounts receivable agings. Accounts are written off against the allowance for doubtful accounts when all collection efforts have been exhausted. We routinely review accounts receivable balances in conjunction
with our historical 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, 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.

Accounts Receivable, net

Accounts receivable are presented net of allowances for contractual adjustments and doubtful accounts. Allowances for contractual adjustments and doubtful accounts are initially recorded based upon historical collection experience through
the provisions for contractual adjustment and doubtful accounts, as described above. If the payment amount received differs from the net realizable amount, an adjustment is made to the net realizable amount in the period that these payment
differences are determined. Actual accounts receivable write-offs due to contractual adjustments or accounts deemed uncollectible are applied against these allowance accounts in the normal course of business. On a quarterly basis, we perform
analyses to evaluate the estimated net realizable value of accounts receivable. As a result of this quarterly review process, the allowances for contractual adjustments and doubtful accounts are adjusted, as necessary, to reflect that estimated net
realizable value. Specifically, we consider historical collection data, accounts receivable aging trends, other operating trends and relevant business conditions.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Due to the nature of the industry and the reimbursement environment in which we operate, certain
estimates are required in order to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they may have to be revised or updated as additional information becomes available. It is
possible that managements estimates could change, which could have an impact on operations and cash flows. Specifically, the complexity of many third-party billing arrangements, patient qualification for medical necessity of equipment and the
uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

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 our investment. Our 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 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 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.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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. These amounts are not amortized, but instead tested for
impairment in accordance with the provisions of Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets. To the extent the carrying amount of reporting unit goodwill is greater than the implied
fair value of reporting unit goodwill, we would record an impairment charge for the difference. Fair values for goodwill and intangible assets are determined based upon discounted cash flows, market multiples or appraised values as appropriate. Our
branch locations have similar economic characteristics and are aggregated into one reporting unit for assessing fair value. The impairment evaluation for goodwill and other intangible assets is conducted annually, or more frequently, if events or
changes in circumstances indicate that an asset might be impaired.

We account for our business combinations in accordance with the
purchase method of accounting. Purchase prices are allocated to the various underlying tangible and intangible assets and liabilities on the basis of estimated fair value. The fair value of acquired finite-lived identifiable intangible assets is
amortized over the period of their expected useful life, generally 2 to 20 years.

Impairment of Long-Lived Assets

Periodically, when indicators of impairment are present, we evaluate the recoverability of the net carrying value of our property
and equipment and our 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, we consider factors such as the effects of external changes to our business environment, competitive pressures, market erosion, technological and regulatory changes as factors which
could provide indications of impairment.

Deferred Financing Costs

Deferred financing costs related to our outstanding debt instruments are included in other assets on the consolidated balance sheet and amortized to
interest expense based upon the term of the associated debt instruments using the effective interest rate method.

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 our respiratory services and pharmacy operations. Beginning in 2005, certain costs and expenses associated with our 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 2004 have been reclassified in the accompanying consolidated
financial statements to conform to this presentation.

Advertising Expense

Advertising costs are expensed as incurred. For the years ended December 31, 2004, 2005 and 2006, advertising expenses were $395, $335 and $414,
respectively.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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

We account 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 us 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. We record 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

In connection with the Plan, we entered into a Tax Sharing Agreement with the Predecessor and Integrated Health Services,
Inc. that sets forth our 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 us 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 us. As a result of such election, we accounted for the acquisition of the stock of all of the Predecessors subsidiaries as if we had acquired the assets of those
subsidiaries for income tax purposes.

We account 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.

NOL
carryforwards and credits are subject to review and possible adjustments by the Internal Revenue Service and may be limited by the occurrence of certain events, including significant changes in ownership interests. The effect of an ownership change
is the imposition of an annual limitation on the use of the NOL carryfowards attributable to periods before the change. We regularly monitor changes in ownership and any implications thereof under Section 382 of the Internal Revenue Code.

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 are excluded from the computation of diluted earnings per share in periods where they have an anti-dilutive effect. We use the treasury stock method to compute the dilutive effects of potentially dilutive securities.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Stock-Based Compensation

Through December 31, 2005, we accounted for our stock-based compensation under FASB Statements No. 123 and 148, Accounting for Stock-Based
CompensationTransition and Disclosurean amendment of FASB Statement No. 123 and APB Opinion No. 25, Accounting for Stock Issued to Employees, which prescribes the intrinsic value method of accounting for our
stock-based awards issued to employees and directors.

We adopted FASB Statement 123R, Share-Based Payment, effective
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. See Note 12 for the impact
of adoption of this accounting principle on our prior years. In accordance with FASB Staff Position 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (FSP 123R-3), we utilize the alternative
transition method to establish the beginning balance of a tax benefit pool comprised of the additional paid-in capital (APIC) related to the tax effects of employee stock-based compensation expense, and to determine the subsequent impact on the APIC
tax benefit pool and the statement of cash flows of stock-based awards that were outstanding upon adoption of Statement 123R. Based on our historical losses, we did not have cumulative excess tax benefits from share-based compensation available in
APIC that could be used to offset an equal amount of future tax shortfalls (i.e., the amount of the tax deductible share-based compensation is less than the related share-based compensation cost).

Fair Value of Financial Instruments

We believe 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 our 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 us. The fair value of our senior subordinated notes is based on quoted market prices. The estimated fair value of the senior subordinated notes at
December 31, 2005 and 2006 was $299,915 and $277,314, respectively.

Segment Information

We follow a centralized approach to management of our 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.We operate in one reportable segment, as defined by Statement 131; the provision of home medical equipment and related products and services.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), which prescribes a
recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in
interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for us beginning January 1, 2007. We are in the process of determining the effect, if any, the adoption of FIN 48
will have on our financial statements.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin
No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides guidance on how the effects of the carryover or reversal of prior year financial
statement misstatements should be considered in quantifying a current year misstatement. Prior practice allowed the evaluation of materiality on the basis of (1) the error quantified as the amount by which the current year income statement was
misstated (rollover method) or (2) the cumulative error quantified as the cumulative amount by which the current year balance sheet was misstated (iron curtain method). The guidance provided in SAB 108 requires both
methods to be used in evaluating materiality. If applying the provisions of SAB 108 results in errors that are deemed material, than such errors, along with any additional immaterial errors, would be corrected through a cumulative effect adjustment.
The cumulative effect of the correction would be reflected in the opening balance sheet with appropriate disclosure of the nature and amount of each individual error corrected in the cumulative adjustment, as well as a disclosure of the cause of the
error and whether the error had been deemed to be immaterial in the past. We adopted SAB 108 as of December 31, 2006 and such adoption had no financial impact on our results of operation or financial condition.

Reclassifications

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

(4) Accounts Receivable

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



|                                     |  |      |        |      |   |       
|------------------------------------ |  | ---- | ------ | ---- | - | ------
|                                     |  | 2005 |        | 2006
|Patient accounts receivable          |  | $    | 90,241 |      | $ | 91,155
|Less allowance for doubtful accounts |  |      | 14,766 |      |   | 12,463
|                                     |  |      |        |      |   |       
|                                     |  | $    | 75,475 |      | $ | 78,692
|                                     |  |      |        |      |   |       

Included in patient accounts receivable at December 31, 2005 and 2006 are amounts due from
Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) which represents 60.0% and 58.2% of total outstanding receivables, respectively.

Included in patient accounts receivable are earned but unbilled receivables of $28,054 and $26,848 at December 31, 2005 and 2006, 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.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



(5) Business Acquisitions

During 2006, our business acquisition activities resulted in a total aggregate cost of $2,644 of which $1,816 was paid in cash. Additionally, we recorded a $300 deferred acquisition obligation, which is included in
our accompanying consolidated balance sheet within accrued expenses and other current liabilities as of December 31, 2006. Payments in the aggregate amount of $4,237 were made on the deferred acquisitions obligations during 2006 and the
remaining balance of $1,500 is included in accrued expenses and other current liabilities as of December 31, 2006.

During 2005, we
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, we recorded $5,437 in deferred acquisition obligations which are
included in the consolidated balance sheet within accrued expenses and other current liabilities as of December 31, 2005. In 2005, we 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.

We had no acquisitions
during 2004.

Our acquisitions are accounted for using the purchase method of accounting. The results of the operations of these
acquisitions are included in the condensed consolidated financial statements from the purchase date. We allocated the purchase price related to our business acquisitions during the years ended December 31, 2005 and 2006 to the following assets:



|                       |  |      |        |      |   |      
|---------------------- |  | ---- | ------ | ---- | - | -----
|                       |  | 2005 |        | 2006
|Current assets         |  | $    | 218    |      | $ |     
|Property and equipment |  |      | 2,317  |      |   | 339  
|Intangible assets      |  |      | 5,235  |      |   | 699  
|Goodwill               |  |      | 30,788 |      |   | 1,606
|                       |  |      |        |      |   |      
|Total assets acquired  |  | $    | 38,558 |      | $ | 2,644
|                       |  |      |        |      |   |      

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
|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.

Pro forma results of operations reflecting the 2006 acquisition activity as if it had occurred at the beginning of each of the respective periods have not been presented since the amounts are immaterial to us.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



(6) Property and Equipment

Property and equipment consist of the following at December 31:



|                                                    |  |      |         |      |   |        
|--------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                    |  | 2005 |         | 2006
|Patient service equipment                           |  | $    | 307,100 |      | $ | 351,253
|Furniture, office equipment, computers and software |  |      | 70,404  |      |   | 82,538 
|Vehicles                                            |  |      | 4,345   |      |   | 3,883  
|Leasehold improvements                              |  |      | 13,041  |      |   | 12,890 
|                                                    |  |      |         |      |   |        
|                                                    |  |      | 394,890 |      |   | 450,563
|Less accumulated depreciation                       |  |      | 246,722 |      |   | 302,411
|                                                    |  |      |         |      |   |        
|                                                    |  | $    | 148,168 |      | $ | 148,153
|                                                    |  |      |         |      |   |        

Depreciation expense was $75,481, $64,195 and $60,928 for the years ended December 31, 2004,
2005, and 2006, respectively.

(7) Goodwill and Intangible Assets

In accordance with FASB Statement No. 142, Goodwill and Other Intangible Assets (Statement 142), we determined that an interim test of impairment was required as of June 30, 2006, due to an overall
decline in our profitability which resulted primarily from decreases in Medicare reimbursement rates, including reductions for compounded budesonide and the resulting decline in market capitalization since the previous annual impairment test.
Statement 142 provides a two-step impairment test. The first step of the impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the
second step of the goodwill impairment test is performed to measure the amount of the impairment loss, if any. Our branch locations have similar economic characteristics and are aggregated into one reporting unit for assessing fair value.

We completed the first step of the interim impairment test as of June 30, 2006 and determined that an impairment loss had occurred.
We were unable to complete the second step of the impairment test prior to the filing of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 and therefore recorded a preliminary estimated non-cash impairment charge of $449,000
as of June 30, 2006, in accordance with Statement 142. This amount was recorded as a reduction to reorganization value in excess of fair value of identifiable assetsgoodwill. The estimated impairment charge was calculated based upon
market capitalization (i.e., quoted market prices) and the carrying value of our assets and liabilities, excluding goodwill. Other than approximately $117 paid in September 2006 in connection with the fifth amendment and limited waiver to our former
credit agreement, the estimated $449,000 impairment charge did not result in cash expenditures and will not result in future cash expenditures.

We completed the second step of the interim impairment test during the quarter ended September 30, 2006 with the assistance of independent valuation specialists. The second step of the impairment test compares the fair value of the
Company, determined in the same manner as in a business combination, to the fair value of its assets and liabilities with the remainder being the implied fair value of goodwill. The second step was performed to determine the actual amount of the
impairment as of June 30, 2006. Based upon the completed impairment test, we determined that the actual impairment was $529,000 as of June 30, 2006. As such, in accordance with Statement 142, we recorded an additional non-cash impairment
charge of $80,000 for the three months ended



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



September 30, 2006. This impairment charge did not result in cash expenditures and will not result in future cash expenditures.

Upon completion of the interim impairment analysis, we performed our annual impairment assessment as of September 30, 2006 with the assistance of
independent valuation specialists. Based upon this analysis, and after consideration of the June 30, 2006 impairment charge, we determined that no additional impairment charge was necessary as of September 30, 2006.

Estimated amortization expense of intangible assets subject to amortization for the next five fiscal years is as follows: 2007$1,376;
2008$1,354; 2009$1,352; 2010$1,280; 2011$1,208. Accumulated amortization was $4,731 and $6,121 at December 31, 2005 and 2006, respectively. The weighted-average useful life of other intangible assets was 17.8 years and
17.8 years as of December 31, 2005 and 2006, 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, 2004 through December 31, 2006:



|                                                      |  |                                         |        |   |          |   |                                                                          |  |   |          |  
|----------------------------------------------------- |  | --------------------------------------- | ------ | - | -------- | - | ------------------------------------------------------------------------ |  | - | -------- | -
|                                                      |  | Intangibleassets subjectto amortization |        |   | Goodwill |   | Reorganizationvaluein excess offair value of identifiableassetsgoodwill | 
|Balance at January 1, 2004                            |  | $                                       | 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  |  
|Acquisitions during the year ended December 31, 2006  |  |                                         | 699    |   |          |   | 1,606                                                                    |  |   |         |  
|Other intangibles                                     |  |                                         | 12     |   |          |   | 226                                                                      |  |   |         |  
|Goodwill impairment                                   |  |                                         |       |   |          |   |                                                                         |  |   | (529,000 | )
|Amortization expense for year ended December 31, 2006 |  |                                         | (1,390 | ) |          |   |                                                                         |  |   |         |  
|                                                      |  |                                         |        |   |          |   |                                                                          |  |   |          |  
|Balance at December 31, 2006                          |  | $                                       | 19,904 |   |          | $ | 43,876                                                                   |  | $ | 163,154  |  
|                                                      |  |                                         |        |   |          |   |                                                                          |  |   |          |  

(8) Other Assets

Other assets consist of the following at December 31:



|                           |  |      |        |      |   |       
|-------------------------- |  | ---- | ------ | ---- | - | ------
|                           |  | 2005 |        | 2006
|Debt issue costs           |  | $    | 8,214  |      | $ | 10,311
|Prepaid expenseslong term |  |      | 468    |      |   | 226   
|Deposits                   |  |      | 2,620  |      |   | 2,525 
|                           |  |      |        |      |   |       
|                           |  | $    | 11,302 |      | $ | 13,062
|                           |  |      |        |      |   |       



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Amortization of the deferred financing costs was approximately $2,572, $1,384 and $2,241 for the
years ended December 31, 2004, 2005 and 2006, respectively. Accumulated amortization of the deferred financing costs was $10,568 and $12,809 as of December 31, 2005 and 2006, respectively.

(9) Accrued Expenses and Other Current Liabilities

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



|                                             |  |      |        |      |   |       
|-------------------------------------------- |  | ---- | ------ | ---- | - | ------
|                                             |  | 2005 |        | 2006
|Accrued salaries and wages                   |  | $    | 10,228 |      | $ | 7,749 
|Accounts receivable credit balances          |  |      | 3,203  |      |   | 2,776 
|Notes payable on acquisitions                |  |      | 5,437  |      |   | 1,500 
|Accrued health insurance and other claims    |  |      | 3,877  |      |   | 3,990 
|Current portion of priority tax claim        |  |      | 966    |      |   | 1,034 
|Dividends payable                            |  |      |       |      |   | 450   
|Sales tax payable                            |  |      | 860    |      |   | 857   
|Accrued employee/employer 401K contributions |  |      | 766    |      |   | 848   
|Other                                        |  |      | 99     |      |   | 9     
|                                             |  |      |        |      |   |       
|                                             |  | $    | 25,436 |      | $ | 19,213
|                                             |  |      |        |      |   |       

(10) Long-Term Debt

Our long-term debt consists of the following:



|                                                                                                                                                                                |  |      |         |      |   |        
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                                                                                                                |  | 2005 |         | 2006
|Capital lease obligations with interest at a fixed rate of 4.5%, due in monthly installments through October 2006, secured by
equipment                                         |  | $    | 282     |      | $ |       
|Capital lease obligation with interest at a fixed rate of 9.0%, due in two installments payable in 2007, secured by equipment                                                   |  |      |        |      |   | 3,103  
|Former senior secured term loan repaid in full on September 15, 2006                                                                                                            |  |      | 42,232  |      |   |       
|Current senior secured term loan; $238 payable quarterly through June 15, 2008 with remainder due September 15, 2008, interest
payable at LIBOR rate plus 3.5%, payable monthly |  |      |        |      |   | 94,763 
|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                                                                                                                                                                       |  |      | 329,514 |      |   | 384,866
|Less current portion                                                                                                                                                            |  |      | 634     |      |   | 4,053  
|                                                                                                                                                                                |  |      |         |      |   |        
|Total long-term debt                                                                                                                                                            |  | $    | 328,880 |      | $ | 380,813
|                                                                                                                                                                                |  |      |         |      |   |        

On September 15, 2006, we entered into a credit agreement with Highland Financial Corp., as
lead arranger and sole bookrunner, Nexbank, SSB, as collateral agent and administrative agent, and the several banks and other financial institutions or entities from time to time parties to the credit agreement. The credit facility has a maximum
credit amount of $120,000 that consists of a $25,000 revolving line of credit and a $95,000 term loan (the commitment to fund the last $5,000 of the revolving line of credit is subject to certain conditions). A portion of the revolving line of
credit, not in excess of $15,000 is available for the issuance of letters of credit. The



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



amount available for the issuance of letters of credit was temporarily increased from $15,000 to $24,000 to accommodate the transfer of letters of credit
under our former credit agreement to the issuing bank under our current credit agreement. As of December 31, 2006, standby letters of credit totaling $14,124 have been issued under this credit facility. The credit agreement expires in September
2008 and replaced our previous credit facility.

The credit agreement provides for mandatory prepayment and defined prepayment premiums
upon the occurrence of certain specified events. The credit agreement contains customary covenants for financings of this type, including, but not limited to, limitations on liens; limitations on guarantee obligations; limitations on mergers,
consolidations, liquidations and dissolutions; limitations on optional payments and modifications of subordinated and other debt instruments; limitations on transactions with affiliates; limitations on granting negative pledges; limitations on
changes in lines of business; and restrictions our ability to incur indebtedness, dispose of property, make investments, pay dividends or make capital expenditures. The credit agreement also contains certain financial covenants, including
requirements regarding certain specified EBITDA thresholds and a specified consolidated total leverage ratio.

The credit agreement
contains customary events of default. Such events of default include, but are not limited to: (i) the failure to pay principal or interest when due, (ii) the breach or failure to perform certain covenants (including the failure to comply
with financial covenants) or obligations and, as applicable, the failure to cure the same within a specified number of days, (iii) material breach of our representations and warranties, (iv) the occurrence of a change of control (as
defined in the credit agreement), and (v) the commencement of any proceeding relating to bankruptcy us or any guarantor. Under certain circumstances, if an event of default occurs and is continuing, payment of amounts due under the credit
agreement may be accelerated and the lending commitments under the credit agreement may be terminated.

Our obligations under the credit
facilities are guaranteed by each of our direct and indirect domestic subsidiaries. All obligations under the credit facilities and the guarantees are secured by a 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.

Under
terms of the indenture governing our senior subordinated notes, the notes are subordinated in right of payment to our existing and future senior debt. In the event of bankruptcy, liquidation, dissolution or similar proceeding, or certain other
events, including a payment default on our secured senior credit facilities, we may be prevented from making payments to the holders of its senior subordinated notes. The indenture governing the senior subordinated notes contains covenants that,
among other things, limit our ability to incur additional indebtedness and issue certain capital stock; pay dividends on, redeem or repurchase capital stock; make investments; sell assets; engage in transactions with affiliates; create certain
liens; and consolidate, merge or transfer all or substantially all of our assets. The indenture also provides that a default under the credit agreement governing our senior secured credit facilities that results in the acceleration of our
obligations under such agreement will result in a cross default under the indenture, which will allow the holders of at least 25% of the principal amount of the then outstanding senior subordinated notes to declare such notes immediately due and
payable.

Long-term debt maturities excluding capital lease obligations are as follows: 2007$950; 2008$93,813; 2009$0;
2010$0; 2011$0; and thereafter$287,000.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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



|                                                |  |               |      
|----------------------------------------------- |  | ------------- | -----
|                                                |  | CapitalLeases
|2007                                            |  | $             | 3,150
|                                                |  |               |      
|Total                                           |  |               | 3,150
|Less amount representing interest               |  |               | 47   
|                                                |  |               |      
|Present value of minimum capital lease payments |  | $             | 3,103
|                                                |  |               |      

At December 31, 2006, the equipment under capital leases is included in property and
equipment with a carrying amount of $3,103 and no accumulated depreciation as the related assets were received prior to December 31, 2006 but not placed in service until January 2007.

Interest expense, net was as follows for the years ended December 31, 2004, 2005 and 2006:



|                      |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                      |  | 2004 |        |   | 2005 |   |        | 2006 | 
|Interest expense      |  | $    | 33,967 |   |      | $ | 32,694 |      |  | $ | 36,907 |  
|Interest income       |  |      | (271   | ) |      |   | (1,191 | )    |  |   | (682   | )
|                      |  |      |        |   |      |   |        |      |  |   |        |  
|Interest expense, net |  | $    | 33,696 |   |      | $ | 31,503 |      |  | $ | 36,225 |  
|                      |  |      |        |   |      |   |        |      |  |   |        |  

(11) Lease Commitments

We operate principally in leased offices and warehouse facilities. In addition, our 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 we 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.

We recognize rent expense on a straight-line basis over the expected lease term. Rental expense for building
and vehicle leases approximated $22,079, $25,289 and $28,093 for the years ended December 31, 2004, 2005 and 2006, 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, 2006, the short term portion of the liability of $60 is included in the accompanying consolidated balance sheet
within accrued expenses and other current liabilities. The long term liability portion of $499 is included in the other long-term liabilities.

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



|                                  |  |   |       
|--------------------------------- |  | - | ------
|For the years ending December 31: |  |   |       
|2007                              |  | $ | 23,268
|2008                              |  |   | 16,733
|2009                              |  |   | 12,382
|2010                              |  |   | 8,662 
|2011                              |  |   | 4,537 
|Thereafter                        |  |   | 339   
|                                  |  |   |       
|                                  |  | $ | 65,921
|                                  |  |   |       



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



(12) Share-Based Compensation and Stockholders Equity

We adopted FASB Statement 123R, Share-Based Payment, effective January 1, 2006. Under the provisions of Statement 123R, share-based
compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employees requisite service period (generally the vesting period of the equity grant). Prior to
January 1, 2006, we accounted for our stock-based compensation under FASB Statements No. 123 and 148, Accounting for Stock-Based CompensationTransition and Disclosurean amendment of FASB Statement No. 123 and APB
Opinion No. 25, Accounting for Stock Issued to Employees, which prescribed the intrinsic value method of accounting for its stock-based awards issued to employees and directors. We followed the modified prospective method of
adoption of Statement 123R whereby earnings for prior periods have not been restated as though stock based compensation had been expensed.

Stock Options:Under the Rotech Healthcare Inc. Common Stock Option Plan (the Option Plan), which became effective March 26, 2002, we 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, 2006, options to acquire up to 64,878 shares of
common stock were available for grant pursuant to the Option Plan, options exercisable for 2,308,975 shares of common stock were outstanding at prices ranging from $14.55 to $27.55 per share, and 409,272 shares of common stock had been issued upon
the exercise of options granted under the Option Plan. For the year ended December 31, 2006, we recorded share-based compensation expense of $15, none of which related to awards prior to the adoption of Statement 123R. Share-based compensation
expense is included in selling, general and administrative expenses in the accompanying consolidated statements of operations. We did not incur any stock option related employee share-based compensation expense for either of the years ended
December 31, 2004 or 2005.

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 each of the respective years ended December 31:



|                                |  |       |   |  |       |   |  |       |  
|------------------------------- |  | ----- | - |  | ----- | - |  | ----- | -
|                                |  | 2004  |   |  | 2005  |   |  | 2006  |  
|Expected volatility             |  | 27.98 | % |  | 32.52 | % |  | 86.75 | %
|Dividend yield                  |  |      | % |  |      | % |  |      | %
|Expected option life (years)    |  | 6.86  |   |  | 7.31  |   |  | 7.45  |  
|Average risk-free interest rate |  | 3.60  | % |  | 3.93  | % |  | 4.77  | %



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



The following table summarizes our stock option transactions for the years ended December 31,
2004, 2005 and 2006:



|                                         |  |                 |   |  |                       |      
|---------------------------------------- |  | --------------- | - |  | --------------------- | -----
|                                         |  | Number ofShares |   |  | WeightedAverage Price
|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
|Granted                                  |  | 1,241,875       |   |  | $                     | 1.26 
|Exercised                                |  |                |   |  | $                     |     
|Forfeited                                |  | (818,625        | ) |  | $                     | 21.18
|                                         |  |                 |   |  |                       |      
|Options outstanding at December 31, 2006 |  | 3,550,850       |   |  | $                     | 12.47
|                                         |  |                 |   |  |                       |      

The following table summarizes our stock options outstanding and exercisable by ranges of option
price, as of December 31, 2006:



|                      |  |                             |  |                                      |  |                             |       |                             |           |                             |   |      
|--------------------- |  | --------------------------- |  | ------------------------------------ |  | --------------------------- | ----- | --------------------------- | --------- | --------------------------- | - | -----
|                      |  | Options Outstanding         |  | Options Exercisable                 
|Range of Option Price |  | Number ofOptionsOutstanding |  | WeightedAverageRemainingLife (Years) |  | WeightedAverageOption Price |       | Number ofOptionsExercisable |           | WeightedAverageOption Price
|$  1.26  $14.54      |  | 1,241,875                   |  | 9.88                                 |  | $                           | 1.26  |                             |          |                             |   |     
|$14.55  $16.99       |  | 24,000                      |  | 6.38                                 |  | $                           | 14.55 |                             | 24,000    |                             | $ | 14.55
|$17.00  $19.94       |  | 1,539,975                   |  | 6.13                                 |  | $                           | 17.00 |                             | 1,539,975 |                             | $ | 17.00
|$19.95  $20.00       |  | 435,000                     |  | 5.45                                 |  | $                           | 20.00 |                             | 435,000   |                             | $ | 20.00
|$20.01  $26.00       |  | 270,000                     |  | 7.09                                 |  | $                           | 23.61 |                             | 270,000   |                             | $ | 23.61
|$26.01  $27.55       |  | 40,000                      |  | 8.14                                 |  | $                           | 27.41 |                             | 40,000    |                             | $ | 27.41
|                      |  |                             |  |                                      |  |                             |       |                             |           |                             |   |      
|Total                 |  | 3,550,850                   |  | 7.45                                 |  | $                           | 12.47 |                             | 2,308,975 |                             | $ | 18.49
|                      |  |                             |  |                                      |  |                             |       |                             |           |                             |   |      

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, 2004, 2005 and 2006:



|                          |  |               |       |           |   |               |  |           |       |               |   |           |  |   |      |  |   |     
|------------------------- |  | ------------- | ----- | --------- | - | ------------- |  | --------- | ----- | ------------- | - | --------- |  | - | ---- |  | - | ----
|                          |  | 2004          |       | 2005      |   | 2006         
|                          |  | ExercisePrice |       | FairValue |   | ExercisePrice |  | FairValue |       | ExercisePrice |   | FairValue
|Options issued:           |  |               |       |           |   |               |  |           |       |               |   |           |  |   |      |  |   |     
|Less than market price    |  | $             |      |           | $ |              |  | $         |      |               | $ |          |  | $ |     |  | $ |    
|Equal to market price     |  | $             | 23.39 |           | $ | 3.88          |  | $         | 24.09 |               | $ | 8.89      |  | $ | 1.26 |  | $ | 0.72
|Greater than market price |  | $             |      |           | $ |              |  | $         |      |               | $ |          |  | $ |     |  | $ |    



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



Effective November 15, 2006, an aggregate of 1,241,875 stock options were granted under the
Option Plan to certain of our employees. Each of these options represents the right to purchase one share of our common stock and has an exercise price of $1.26 per share, which was the closing sales price per share of our common stock on
November 15, 2006 as quoted on NASDAQ. The options expire on November 15, 2016 and are subject to vesting and other terms and conditions.

Prior Period Pro Forma Presentation:Through December 31, 2005, we accounted for our stock-based compensation under FASB Statements No. 123 and 148, Accounting for Stock-Based CompensationTransition and
Disclosurean amendment of FASB Statement No. 123 and APB Opinion No. 25, Accounting for Stock Issued to Employees, which prescribes the intrinsic value method of accounting for our stock-based awards issued to employees
and directors.

Accordingly, through December 31, 2005, we did not recognize compensation expense for our stock options awarded to
employees and directors in the condensed consolidated statements of operations. Had compensation cost been determined on the basis of fair value pursuant to FASB Statement No. 123, our net earnings available to common stockholders and basic and
diluted earnings (loss) per share for the years ended December 31, 2004 and 2005 would have been as follows:



|                                                                                                                                                                             |  |                            |        |   |                            |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------ | - | -------------------------- | - | ------ | -
|                                                                                                                                                                             |  | Year endedDecember 31,2004 |        |   | Year endedDecember 31,2005 |  
|Net earnings:                                                                                                                                                                |  |                            |        |   |                            |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 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 |  |                            | (1,453 | ) |                            |   | (4,424 | )
|                                                                                                                                                                             |  |                            |        |   |                            |   |        |  
|Pro forma                                                                                                                                                                    |  | $                          | 34,557 |   |                            | $ | 1,122  |  
|                                                                                                                                                                             |  |                            |        |   |                            |   |        |  
|                                                                                                                                                                             |  |                           
|Basic net earnings per common share:                                                                                                                                         |  |                            |        |   |                            |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 1.41   |   |                            | $ | 0.20   |  
|Pro forma                                                                                                                                                                    |  | $                          | 1.36   |   |                            | $ | 0.03   |  
|                                                                                                                                                                             |  |                           
|Diluted net earnings per common share:                                                                                                                                       |  |                            |        |   |                            |   |        |  
|As reported                                                                                                                                                                  |  | $                          | 1.39   |   |                            | $ | 0.20   |  
|Pro forma                                                                                                                                                                    |  | $                          | 1.34   |   |                            | $ | 0.03   |  

Restricted Stock Awards and Units:Effective as of August 1, 2004, we established the
Rotech Healthcare Inc. Non-employee 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, 40,000 and 24,000 shares of common stock have been granted to our non-employee directors during the years ending December 31, 2004,
2005 and 2006, respectively. The weighted average per share fair value for the 2004, 2005 and 2006 grants was $20.50, $23.19 and $3.76, respectively. Stock compensation expense recognized by us in the years ended December 31, 2004, 2005 and
2006 under the restricted stock plan was approximately $232, $745 and $652, respectively.

Stock Option Acceleration:In November
2005, our Board of Directors approved the acceleration of the vesting of all the previously unvested stock options granted under 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 was



F-24



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



expected to reduce after-tax stock option expense that we 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 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.

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. The accelerated vesting of the options outlined above will not alter the vesting of grants of restricted common stock made by us.

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 762,500, 534,357 and 2,990,777 for the years ended December 31, 2004, 2005 and 2006, respectively, are excluded from the computation of diluted earnings per share in periods where
they have an anti-dilutive effect. We use 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, 2004, 2005 and 2006 are presented below:



|                                |  |                            |  |                            |  |                           
|------------------------------- |  | -------------------------- |  | -------------------------- |  | --------------------------
|                                |  | Year endedDecember 31,2004 |  | Year EndedDecember 31,2005 |  | Year EndedDecember 31,2006
|Weighted average basic shares   |  | 25,146,315                 |  | 25,379,173                 |  | 25,461,434                
|Effect of dilutive securities:  |  |                            |  |                            |  |                           
|Stock options                   |  | 395,256                    |  | 423,036                    |  |                          
|Stock awards                    |  | 2,445                      |  | 15,565                     |  |                          
|                                |  |                            |  |                            |  |                           
|Weighted average diluted shares |  | 25,544,016                 |  | 25,817,774                 |  | 25,461,434                
|                                |  |                            |  |                            |  |                           

(13) Income Taxes

Income tax expense (benefit) for the years ended December 31, 2004, 2005 and 2006 consists of:



|                                         |  |      |        |      |   |       |      |  |   |         |  
|---------------------------------------- |  | ---- | ------ | ---- | - | ----- | ---- |  | - | ------- | -
|                                         |  | 2004 |        | 2005 |   |       | 2006 | 
|Current:                                 |  |      |        |      |   |       |      |  |   |         |  
|Federal                                  |  | $    | 2,434  |      | $ | (754  | )    |  | $ | (80     | )
|State                                    |  |      | 2,454  |      |   | 856   |      |  |   | 438     |  
|                                         |  |      |        |      |   |       |      |  |   |         |  
|Total current provision                  |  |      | 4,888  |      |   | 102   |      |  |   | 358     |  
|                                         |  |      |        |      |   |       |      |  |   |         |  
|Deferred:                                |  |      |        |      |   |       |      |  |   |         |  
|Federal                                  |  |      | 20,403 |      |   | 3,158 |      |  |   | (35,241 | )
|State                                    |  |      | 2,273  |      |   | 353   |      |  |   | (3,925  | )
|                                         |  |      |        |      |   |       |      |  |   |         |  
|Total deferred provision                 |  |      | 22,676 |      |   | 3,511 |      |  |   | (39,166 | )
|                                         |  |      |        |      |   |       |      |  |   |         |  
|Federal and state income taxes (benefit) |  | $    | 27,564 |      | $ | 3,613 |      |  | $ | (38,808 | )
|                                         |  |      |        |      |   |       |      |  |   |         |  



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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 our deferred tax liabilities and assets as of December 31 are as follows:



|                                                      |  |      |         |   |      |   |         |  
|----------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                      |  | 2005 |         |   | 2006 |  
|Current deferred tax (asset) liabilities:             |  |      |         |   |      |   |         |  
|Deferred revenue                                      |  | $    | 9,992   |   |      | $ | 10,444  |  
|Other accrued liabilities                             |  |      | (1,188  | ) |      |   | (1,683  | )
|Other                                                 |  |      | 1,913   |   |      |   | (3,875  | )
|Less: valuation allowance                             |  |      |        |   |      |   | 3,286   |  
|                                                      |  |      |         |   |      |   |         |  
|Total current deferred tax (asset) liabilities, net   |  |      | 10,717  |   |      |   | 8,172   |  
|                                                      |  |      |         |   |      |   |         |  
|Long-term deferred tax (asset) liabilities:           |  |      |         |   |      |   |         |  
|Property and equipment                                |  |      | (181    | ) |      |   | (2,064  | )
|Intangible assets                                     |  |      | 66,462  |   |      |   | (54,788 | )
|Net operating loss (NOL) carryforward                 |  |      | (34,707 | ) |      |   | (23,066 | )
|Other deferred liabilities                            |  |      |        |   |      |   | 379     |  
|Other deferred assets                                 |  |      |        |   |      |   | (100    | )
|Less: valuation allowance                             |  |      |        |   |      |   | 74,836  |  
|                                                      |  |      |         |   |      |   |         |  
|Total long-term deferred tax (asset) liabilities, net |  |      | 31,574  |   |      |   | (4,803  | )
|                                                      |  |      |         |   |      |   |         |  
|Net deferred tax liabilities                          |  | $    | 42,291  |   |      | $ | 3,369   |  
|                                                      |  |      |         |   |      |   |         |  

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, 2004, 2005 and 2006:



|                                                                                 |  |      |        |      |   |       |      |  |   |          |  
|-------------------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ----- | ---- |  | - | -------- | -
|                                                                                 |  | 2004 |        | 2005 |   |       | 2006 | 
|Tax provision computed at the statutory rate                                     |  | $    | 22,251 |      | $ | 3,206 |      |  | $ | (200,518 | )
|State income taxes, net of federal income tax benefit                            |  |      | 2,100  |      |   | 320   |      |  |   | (18,811  | )
|Intangibles amortization and other book expenses not deductible for tax purposes |  |      | 374    |      |   | 236   |      |  |   | 364      |  
|Increase in deferred tax asset valuation allowance                               |  |      |       |      |   |      |      |  |   | 78,122   |  
|Write-off built-in losses under Section 382                                      |  |      |       |      |   |      |      |  |   | 69,992   |  
|Write-off NOLs under Section 382                                                 |  |      |       |      |   |      |      |  |   | 34,358   |  
|Other                                                                            |  |      | 2,839  |      |   | (149  | )    |  |   | (2,315   | )
|                                                                                 |  |      |        |      |   |       |      |  |   |          |  
|Total income tax expense                                                         |  | $    | 27,564 |      | $ | 3,613 |      |  | $ | (38,808  | )
|                                                                                 |  |      |        |      |   |       |      |  |   |          |  

We determined that an ownership change (as defined in Section 382 of the Internal Revenue
Code (Section 382)) occurred on December 31, 2006. Based upon application of the provisions of Section 382, we have an estimated annual NOL carryforward limitation of approximately $2,787 related to any future carryforward use
of NOLs generated prior to the change of ownership. Accordingly, we wrote-off deferred tax assets of $34,358 relating to $88,324 of NOLs during the year ended December 31, 2006 and have available federal NOLs of approximately $55,735 as of
December 31, 2006, which will fully expire in 2026.

In addition, we are subject to restrictions of future tax attributes related to
assets with built-in tax losses as defined under Section 382. These restrictions resulted in a write-off of $69,992 in deferred tax assets during the year ended December 31, 2006.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



We have provided a full valuation allowance against our net deferred tax assets due to our judgment
that it is more likely than not that the net deferred tax assets will not be realized. Based on a number of factors, including the goodwill impairment charge, future taxable income and the fact that the market in which we compete is competitive and
characterized by changing reimbursement, we believe that there is sufficient uncertainty regarding the realization of net deferred tax assets such that a full valuation allowance is required.

We believe that we have adequately provided for income tax issues not yet resolved with federal, state and local tax authorities. At December 31,
2006, $2,082 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 $1,600 currently provided. Based upon a consideration of all relevant facts and circumstances, we do not believe the ultimate resolution of tax issues for all open tax periods will have a material
adverse effect upon our results of operations or financial condition.

(14) Insurance Coverage

We have a self-insured plan for health and medical coverage for our 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 $2,921 and $2,936 as of December 31, 2005 and 2006, respectively.

We are subject to workers compensation and employee health benefit claims, which are primarily self-insured; however, we maintain certain stop-loss and other insurance coverage which we believe 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.

(15) Pharmacy Compounding

On August 10, 2006, we received a warning letter from the Food and Drug Administration (FDA) relating to our subsidiary,
Pulmo-Dose, Inc. The warning letter states that Pulmo-Doses compounding of formulations of budesonide, albuterol/ipratropium, and formoterol/budesonide exceeds the scope of the practice of pharmacy and that Pulmo-Dose is operating as a
pharmaceutical manufacturer and not a pharmacy engaged in extemporaneous compounding.

We submitted a formal response to the warning letter
on September 8, 2006, explaining that while we disagree with the FDAs assertions, we have commenced, in collaboration with our patients physicians, a process to switch patients currently taking the compounded products identified in
the warning letter to drug products that are commercially available, where clinically appropriate. In addition, we are not accepting any new prescriptions for these compounded products. As of March 5, 2007, of the approximately 15,000 patients
previously receiving compounded drug products, over 12,500 have been successfully switched to commercially available drug products. We continue to work with our patients physicians to switch the remaining patients and expect completion of this
process within the next few months. As a result of our decision to switch these patients



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



to commercially available drug products, we have taken a one-time, non-cash charge of $4,000 for the three months and year ended December 31, 2006, to
write-off our pharmacy compounding equipment, capitalized costs associated with our compounding facility, and substantially all remaining balances for budesonide-related accounts receivable.

(16) Certain Significant Risks and Uncertainties

We
and others in the health care business are subject to certain inherent risks, including the following:



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



| |  |  | Inconsistent payment patterns from Centers for Medicare and Medicaid Services and its contractors or other third party payors;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | Government regulations, government budgetary constraints and proposed legislative, reimbursement 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 financial statements and it is reasonably possible that changes in such estimates may occur.

Due to the nature of the business, we are involved in lawsuits that arise in the ordinary course of business. We do not believe that any lawsuit we (or
our predecessor, Rotech Medical Corporation, the Predecessor) are a party to, if resolved adversely, would have a material adverse effect on our financial condition or results of operations. We are also subject to malpractice and related
claims, which arise in the normal course of business and which could have a significant effect on us. As a result, we maintain occurrence basis professional and general liability insurance with coverage and deductibles which we believe to be
appropriate.

As previously disclosed, on February 2, 2000, Integrated Health Services 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 (the Plan) 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 we believe 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 us involving pre-petition claims. Since
the date of confirmation of the Plan, neither we nor the Predecessor has received any correspondence from a state challenging the pre-petition discharge of claims.

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



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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 previously disclosed internal investigation regarding VA 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 the Companys former
employees was unsealed and served on the Company and several of its 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, the Company 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.
The case is currently stayed until April 30, 2007. In addition, on November 7, 2006, one of our subsidiaries, Rotherts Hospital Equipment, Inc., received a subpoena from the Office of Inspector General for the Department of Health
and Human Services. The subpoena requested documents relating to Medicare billing in the Covington, Kentucky, area between January 2003 and February 2004, as well as certain personnel records. We have produced the requested documents and we will
continue to cooperate with the investigation.

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.

Our predecessor, Rotech Medical Corporation, and the Office of
Inspector General (the OIG) 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 the aforementioned
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 term of the Corporate Integrity Agreement expired in February
2007, however, certain sections of the agreement (including, OIG inspection, audit and review rights and document retention obligations) will remain in effect until the OIG has completed its review of our final annual report and any additional
materials submitted by us pursuant to OIGs request. We are required to submit our final annual report on or before July 11, 2007. If we were to be found in violation of any terms of the Corporate Integrity Agreement, we may be subject to
substantial penalties, including stipulated cash penalties



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



ranging from $1.00 per day to $2.50 per day for each day we are in breach of the agreement, and, possibly, exclusion from federal health care programs.

(17) Employee Benefit Plans

401(k) Savings Plan

We sponsor 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. Our contribution expense was approximately $565, $507 and $821 for the years ended December 31, 2004, 2005 and 2006, respectively.

Employee Profit Sharing Plan

Pursuant to the Plan, we contributed 250,000 shares of Series A Convertible Redeemable Preferred Stock (see Note 19) (the Initial Company Contribution) to a trust to establish a tax-qualified defined contribution employee profit
sharing retirement plan (the Employees Plan). Employees of the Company as of the effective date of the Employees Plan (the 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 January 1 or July 1 following their first day of employment with the Company. Our 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 us 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. 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 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 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 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 were declared on
our Series A Convertible Redeemable Preferred Stock and such dividends were paid during the first quarter of 2005. At each of the 2005 and 2006 annual meetings of the board of directors, dividends in the amount of $450 were declared on our Series A
Convertible Redeemable Preferred Stock. The 2005 dividend was paid in December 2005 and the 2006 dividend was paid in January 2007. In addition, in order to maintain compliance with certain requirements of Federal law applicable to the Employees
Plan, we made a cash contribution to the plan in the amount of $500 during the fourth quarter of 2005.

We periodically repurchase shares
of Series A Preferred 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 us. During 2004 and 2006, we repurchased 804 and
2,688 shares, respectively. There were no such repurchases during 2005.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



(18) Revenue Data and Concentration of Credit Risk

Net revenues are derived from the following principal service categories:



|                                     |  |                              |         |      |   |         |  |   |        
|------------------------------------ |  | ---------------------------- | ------- | ---- | - | ------- |  | - | -------
|                                     |  | For Years Ended December 31,
|                                     |  | 2004                         |         | 2005 |   | 2006   
|Oxygen and other respiratory therapy |  | $                            | 463,487 |      | $ | 468,187 |  | $ | 437,078
|Home medical equipment               |  |                              | 66,088  |      |   | 59,933  |  |   | 57,191 
|Other                                |  |                              | 5,754   |      |   | 5,062   |  |   | 4,482  
|                                     |  |                              |         |      |   |         |  |   |        
|                                     |  | $                            | 535,329 |      | $ | 533,182 |  | $ | 498,751
|                                     |  |                              |         |      |   |         |  |   |        

Our revenue is generated through approximately 500 locations in 48 states. We generally do not
require collateral or other security in extending credit to patients; however, we routinely obtain assignment of (or are 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). We receive payment for a significant portion of services rendered to patients from the federal government under Medicare and other federally funded programs (including the
Veterans Administration) and from the states under Medicaid. Revenues were derived from the following payor sources for the years ended December 31, 2004, 2005 and 2006:



|                                                                                           |  |       |   |  |       |   |  |       |  
|------------------------------------------------------------------------------------------ |  | ----- | - |  | ----- | - |  | ----- | -
|                                                                                           |  | 2004  |   |  | 2005  |   |  | 2006  |  
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 71.0  | % |  | 66.7  | % |  | 67.8  | %
|Commercial payors                                                                          |  | 25.5  | % |  | 29.9  | % |  | 28.7  | %
|Private payors                                                                             |  | 3.5   | % |  | 3.4   | % |  | 3.5   | %
|                                                                                           |  |       |   |  |       |   |  |       |  
|Total                                                                                      |  | 100.0 | % |  | 100.0 | % |  | 100.0 | %
|                                                                                           |  |       |   |  |       |   |  |       |  

(19) Series A Convertible Redeemable Preferred Stock

We 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 our employee profit sharing plan (see Note 17) and the total preferred stock authorized by us 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 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 preceding year.

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 us 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 our



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

For years ended December 31, 2004, 2005 and 2006

(In thousands, except share and per share
data)



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 us 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 246,508 shares of Preferred
Stock would be approximately $4,930 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.
We periodically repurchase shares of Series A Preferred 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 us. During 2004
and 2006, we repurchased 804 and 2,688 shares, respectively. There were no such repurchases during 2005.

In the event of any bankruptcy,
liquidation, dissolution or winding-up of the Company, whether voluntary or involuntary, each holder of Series A Preferred shall receive, out of our assets legally available for distribution to our stockholders, prior to any payment to the holder of
shares of common stock, the redemption amount described above as a preferential distribution.

No dividends will be declared or paid upon
our common stock, unless and until dividends have been declared on the Series A Preferred. Dividends on the Series A Preferred have been declared and paid as follows:



|         |  |        |     |                  |                |              |              
|-------- |  | ------ | --- | ---------------- | -------------- | ------------ | -------------
|         |  | Amount |     | Declaration Date |                | Payment Date
|Dividend |  | $      | 900 |                  | June 2004      |              | March 2005   
|Dividend |  | $      | 450 |                  | September 2005 |              | December 2005
|Dividend |  | $      | 450 |                  | June 2006      |              | January 2007 

Dividends payable on Series A Preferred in the amount of $450 are included in our accompanying
consolidated balance sheet as of December 31, 2006 within Accrued expenses and other current liabilities, including dividends payable.

(20) Restructuring Accruals

During 2004 and 2005, we undertook certain restructuring activities that included employee
reductions and real estate consolidations to improve operating effectiveness and efficiencies. During the year ended December 31, 2004, we recognized restructuring related charges, which consisted of severance and lease cancellation charges in
the amount of $538, and the payments in the amount of $1,698 relating to severance and lease cancellation charges. During the year ended December 31, 2005, we recognized restructuring related charges, which consisted of severance and lease
cancellation charges in the amount of $950, and payments in the amount of $346 relating to severance and lease cancellation charges. As of December 31, 2004, we had approximately $516 recorded in accrued expense related to restructuring
charges. As of December 31, 2005, we 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. No such expenses were recorded during 2006 and there are no remaining amounts in accrued expense related to restructuring charges and severance charges.



F-32