**UNITED STATES********SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES AND EXCHANGE ACT OF 1934** |
|------------|------------|------------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended June 30, 2005**

 

**OR**

 
| **o** | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND  EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                to                **

 

**Commission file number 0-27444**

 

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**SOURCECORP, INCORPORATED**

(Exact name of registrant as specified in its charter)

 
| **DELAWARE**                                                   | ** ** | **75-2560895**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                           |       |                                 |
| **3232 MCKINNEY AVENUE, SUITE 1000  DALLAS, TEXAS**            | ** ** | **75204**                            |
| (Address of principal executive offices)                       |       | (Zip code)                           |

 

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: **(214) 740-6500**

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  ý  No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2). Yes  ý  No  o

 

Asof****July 29, 2005, 15,677,476 sharesof the registrant’s Common Stock, $.01 par value per share, were outstanding.

 

 

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2005**

 

**INDEX**

 
|       | **PART I. FINANCIAL  INFORMATION**                                                                                     |   |
|------------|-----------------------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                                        |   |
| Item 1     | Financial Statements                                                                                                        |   |
|       |                                                                                                                        |   |
|       | Condensed Consolidated  Balance Sheets — December 31, 2004 and June 30, 2005 (unaudited)                     |   |
|       |                                                                                                                        |   |
|       | Condensed Consolidated  Statements of Operations — Three and six months ended June 30, 2004 and  2005 (unaudited) |   |
|       |                                                                                                                        |   |
|       | Condensed Consolidated  Statements of Cash Flows — Three and six months ended June 30, 2004 and  2005 (unaudited) |   |
|       |                                                                                                                        |   |
|       | Notes to Condensed Consolidated  Financial Statements (unaudited)                                                           |   |
|       |                                                                                                                        |   |
| Item 2     | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                 |   |
|       |                                                                                                                        |   |
| Item 3     | Quantitative and Qualitative Disclosures about Market  Risk                                                                 |   |
|       |                                                                                                                        |   |
| Item 4     | Controls and Procedures                                                                                                     |   |
|       |                                                                                                                        |   |
|       | **PART  II. OTHER INFORMATION**                                                                                        |   |
|       |                                                                                                                        |   |
| Item 1     | Legal Proceedings                                                                                                           |   |
|       |                                                                                                                        |   |
| Item 2     | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                |   |
|       |                                                                                                                        |   |
| Item 4     | Submission of Matters to a Vote of Security Holders                                                                         |   |
|       |                                                                                                                        |   |
| Item 6     | Exhibits                                                                                                                    |   |
|       |                                                                                                                        |   |
| ** ** | **SIGNATURES**                                                                                                              |   |
|       |                                                                                                                        |   |
| ** ** | **Index to Exhibits**                                                                                                       |   |

 

2

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**PART I.****FINANCIAL INFORMATION**

 

**Item 1.**                   **Financial Statements**

**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS, EXCEPT SHARE DATA)**

 
| ** **                                                                                                                                                                                                             | ** ** | **December 31,  2004** | ** ** | **June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **(Unaudited)**             | ** ** |
| **ASSETS**                                                                                                                                                                                                             |       |                        |       |                    |       |
| **CURRENT ASSETS:**                                                                                                                                                                                                    |       |                        |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                           | 3,722      |                    | $          | 798 |   |
| Accounts and notes receivable, less  allowance for doubtful accounts of $9,331 and $8,128, respectively                                                                                                                |       | 65,315                      |       | 78,799                  |       |
| Inventories                                                                                                                                                                                                            |       | 875                         |       | 1,106                   |       |
| Deferred income taxes                                                                                                                                                                                                  |       | 5,272                       |       | 6,852                   |       |
| Income tax receivable                                                                                                                                                                                                  |       | 5,077                       |       | —                  |       |
| Prepaid expenses and other current assets                                                                                                                                                                              |       | 6,142                       |       | 7,410                   |       |
| Non qualified retirement plan assets                                                                                                                                                                                   |       | —                      |       | 8,714                   |       |
| Assets of discontinued operations                                                                                                                                                                                      |       | 842                         |       | —                  |       |
| Total current assets                                                                                                                                                                                                   |       | 87,245                      |       | 103,679                 |       |
| **PROPERTY, PLANT AND EQUIPMENT,**  net of accumulated depreciation of $45,166 and $50,797, respectively                                                                                                               |       | 39,603                      |       | 40,997                  |       |
| **GOODWILL**                                                                                                                                                                                                           |       | 326,139                     |       | 325,185                 |       |
| **INTANGIBLES,** net  of amortization of $1,700 and $2,113, respectively                                                                                                                                               |       | 4,904                       |       | 4,492                   |       |
| **NON QUALIFIED RETIREMENT PLAN ASSETS**                                                                                                                                                                               |       | 8,870                       |       | —                  |       |
| **OTHER NONCURRENT ASSETS**                                                                                                                                                                                            |       | 2,654                       |       | 1,814                   |       |
| Total assets                                                                                                                                                                                                           |       | $                           | 469,415    |                    | $          | 476,167 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                         |       |                        |       |                    |       |
| **CURRENT LIABILITIES:**                                                                                                                                                                                               |       |                        |       |                    |       |
| Accounts payable and accrued liabilities                                                                                                                                                                               |       | $                           | 52,549     |                    | $          | 44,005 |   |
| Current maturities of long-term obligations                                                                                                                                                                            |       | 258                         |       | 89,152                  |       |
| Non qualified retirement plan obligations                                                                                                                                                                              |       | —                      |       | 8,714                   |       |
| Income tax payable                                                                                                                                                                                                     |       | —                      |       | 6,050                   |       |
| Liabilities of discontinued operations                                                                                                                                                                                 |       | 326                         |       | —                  |       |
| Total current liabilities                                                                                                                                                                                              |       | 53,133                      |       | 147,921                 |       |
| **LONG-TERM OBLIGATIONS, net of current maturities**                                                                                                                                                                   |       | 87,547                      |       | 1,668                   |       |
| **DEFERRED INCOME TAXES**                                                                                                                                                                                              |       | 13,210                      |       | 14,502                  |       |
| **LONG-TERM CUSTOMER LIABILITY**                                                                                                                                                                                       |       | 4,147                       |       | 442                     |       |
| **DEFERRED REVENUE**                                                                                                                                                                                                   |       | 8,010                       |       | 3,302                   |       |
| **NON QUALIFIED RETIREMENT PLAN OBLIGATIONS**                                                                                                                                                                          |       | 8,870                       |       | —                  |       |
| **OTHER LONG-TERM OBLIGATIONS**                                                                                                                                                                                        |       | 2,077                       |       | 1,946                   |       |
| Total liabilities                                                                                                                                                                                                      |       | 176,994                     |       | 169,781                 |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                                                                      |       |                        |       |                    |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                                                         |       |                        |       |                    |       |
| Preferred stock, $.01 par value, 1,000,000  shares authorized, no shares issued or outstanding                                                                                                                         |       | —                      |       | —                  |       |
| Series A Cumulative Participating  Preferred stock, no par value, 50,000 shares authorized, no shares issued or  outstanding                                                                                      |       | —                      |       | —                  |       |
| Common stock, $.01 par value, 26,000,000  shares authorized, 15,703,586 and 15,715,146 shares issued and 15,666,916 and  15,678,476 shares outstanding at December 31, 2004 and June 30,  2005, respectively |       | 157                         |       | 157                     |       |
| Additional paid-in-capital                                                                                                                                                                                             |       | 193,925                     |       | 198,556                 |       |
| Retained earnings                                                                                                                                                                                                      |       | 103,136                     |       | 115,644                 |       |
|                                                                                                                                                                                                                   |       | 297,218                     |       | 314,357                 |       |
| Less—Treasury stock, at cost, 36,670 shares                                                                                                                                                                       |       | (501                        | )          | (501                    | )          |
| Less—Deferred compensation                                                                                                                                                                                        |       | (4,296                      | )          | (7,470                  | )          |
| Total stockholders’ equity                                                                                                                                                                                        |       | 292,421                     |       | 306,386                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                        |       | $                           | 469,415    |                    | $          | 476,167 |   |
|                                                                                                                                                                                                                        |            |                             |            |                         |            |  |  |  |  |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

3

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                     | ** ** |
| **REVENUE**                                            |       | $                                     | 97,098     |                                | $          | 106,453 |   | $ | 192,914 |   | $ | 212,385 |   |
| **COST OF SERVICES EXCLUSIVE OF DEPRECIATION**         |       | 57,590                                |       | 59,818                              |       | 113,983 |   | 118,354 |   |
| **DEPRECIATION**                                       |       | 2,963                                 |       | 3,545                               |       | 6,163 |   | 6,968 |   |
| Gross profit                                           |       | 36,545                                |       | 43,090                              |       | 72,768 |   | 87,063 |   |
| **SELLING, GENERAL AND ADMINISTRATIVE  EXPENSES**      |       | 24,108                                |       | 29,820                              |       | 55,176 |   | 60,041 |   |
| **AMORTIZATION**                                       |       | 312                                   |       | 206                                 |       | 401 |   | 412 |   |
| Operating income                                       |       | 12,125                                |       | 13,064                              |       | 17,191 |   | 26,610 |   |
| **OTHER (INCOME) EXPENSE:**                            |       |                                  |       |                                |       |   |   |   |   |
| Interest expense                                       |       | 697                                   |       | 1,240                               |       | 1,357 |   | 2,451 |   |
| Interest income                                        |       | (3                                    | )          | (33                                 | )          | (7 | ) | (78 | ) |
| Other (income) expense, net                            |       | 254                                   |       | 18                                  |       | 373 |   | 333 |   |
| Income from continuing operations before  income taxes |       | 11,177                                |       | 11,839                              |       | 15,468 |   | 23,904 |   |
| **PROVISION FOR INCOME TAXES**                         |       | 4,471                                 |       | 5,805                               |       | 6,187 |   | 10,515 |   |
| **INCOME FROM CONTINUING OPERATIONS**                  |       | 6,706                                 |       | 6,034                               |       | 9,281 |   | 13,389 |   |
| **LOSS FROM DISCONTINUED OPERATIONS, NET OF  TAX**     |       | (1,860                                | )          | (660                                | )          | (2,370 | ) | (881 | ) |
| **NET INCOME**                                         |       | $                                     | 4,846      |                                | $          | 5,374 |   | $ | 6,911 |   | $ | 12,508 |   |
| **NET INCOME PER COMMON SHARE**                        |       |                                  |       |                                |       |   |   |   |   |
| **BASIC**                                              |       |                                  |       |                                |       |   |   |   |   |
| **Continuing Operations**                              |       | $                                     | 0.42       |                                | $          | 0.38 |   | $ | 0.58 |   | $ | 0.85 |   |
| **Discontinued Operations**                            |       | (0.12                                 | )          | (0.04                               | )          | (0.15 | ) | (0.05 | ) |
| **Total**                                              |       | $                                     | 0.30       |                                | $          | 0.34 |   | $ | 0.43 |   | $ | 0.80 |   |
| **DILUTED**                                            |       |                                  |       |                                |       |   |   |   |   |
| **Continuing Operations**                              |       | $                                     | 0.41       |                                | $          | 0.37 |   | $ | 0.57 |   | $ | 0.84 |   |
| **Discontinued Operations**                            |       | (0.11                                 | )          | (0.04                               | )          | (0.15 | ) | (0.06 | ) |
| **Total**                                              |       | $                                     | 0.30       |                                | $          | 0.33 |   | $ | 0.42 |   | $ | 0.78 |   |
| **WEIGHTED AVERAGE COMMON SHARES OUTSTANDING**         |       |                                  |       |                                |       |   |   |   |   |
| **BASIC**                                              |       | 16,014                                |       | 15,673                              |       | 16,055 |   | 15,672 |   |
| **DILUTED**                                            |       | 16,374                                |       | 16,084                              |       | 16,411 |   | 16,024 |   |
|                                                        |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

4

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

 
| ** **                                                                                | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                            | ** ** | **2005** | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)**                     | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Income from continuing operations                                                         |       | $                                   | 9,281      |   | $ | 13,389 |   |
| Adjustments to reconcile income to net cash  provided by operating activities:            |       |                                |       |   |   |
| Depreciation and amortization                                                             |       | 6,564                               |       | 7,380 |   |
| Deferred income tax provision (benefit)                                                   |       | 3,153                               |       | (882 | ) |
| Compensation expense on restricted stock  grants                                          |       | 1,120                               |       | 1,421 |   |
| Loss on sale of property, plant and  equipment                                            |       | 125                                 |       | 81 |   |
| Change in operating assets and liabilities:                                               |       |                                |       |   |   |
| Accounts and notes receivable                                                             |       | (13,310                             | )          | (13,787 | ) |
| Inventories, prepaid expenses and other  assets                                           |       | (393                                | )          | (660 | ) |
| Accounts payable and accrued liabilities                                                  |       | (1,671                              | )          | (724 | ) |
| Net cash provided by operating activities  from continuing operations                     |       | 4,869                               |       | 6,218 |   |
| Net cash used in operating activities from  discontinued operations                       |       | (1,034                              | )          | (171 | ) |
| Net cash provided by operating activities                                                 |       | 3,835                               |       | 6,047 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Net proceeds received from divestitures                                                   |       | 750                                 |       | 793 |   |
| Purchase of property, plant and equipment                                                 |       | (8,337                              | )          | (8,431 | ) |
| Proceeds from disposition of property,  plant and equipment                               |       | 21                                  |       | 7 |   |
| Cash paid for acquisitions, net of cash  acquired                                         |       | (14,958                             | )          | (4,367 | ) |
| Net cash used in investing activities from  continuing operations                         |       | (22,524                             | )          | (11,998 | ) |
| Net cash used in investing activities from  discontinued operations                       |       | (187                                | )          | — |   |
| Net cash used in investing activities                                                     |       | (22,711                             | )          | (11,998 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Proceeds from exercise of common stock  options                                           |       | 389                                 |       | 32 |   |
| Cash paid for common stock repurchased                                                    |       | (9,298                              | )          | — |   |
| Proceeds from long-term obligations                                                       |       | 174,634                             |       | 109,551 |   |
| Principal payments on long-term obligations                                               |       | (143,510                            | )          | (106,556 | ) |
| Net cash provided by financing activities  from continuing operations                     |       | 22,215                              |       | 3,027 |   |
|                                                                                      |       |                                |       |   |   |
| **NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS**                                 |       | 3,339                               |       | (2,924 | ) |
| **CASH AND CASH EQUIVALENTS, beginning of  period**                                       |       | 2,097                               |       | 3,722 |   |
| **CASH AND CASH EQUIVALENTS, end of period**                                              |       | $                                   | 5,436      |   | $ | 798 |   |
| **SUPPLEMENTAL DATA:**                                                                    |       |                                |       |   |   |
| Cash paid for:                                                                            |       |                                |       |   |   |
| Income taxes                                                                              |       | $                                   | 609        |   | $ | 179 |   |
| Interest                                                                                  |       | $                                   | 1,352      |   | $ | 1,281 |   |
| **NONCASH FINANCING TRANSACTIONS:**                                                       |       |                                |       |   |   |
| Assets acquired through financing and  capital lease arrangements                         |       | $                                   | 147        |   | $ | 20 |   |
| Restricted stock grant (177,300 and 245,170  shares, respectively)                        |       | $                                   | 4,486      |   | $ | 4,594 |   |
| Common stock accrued related to business  acquisitions (9,623 and 0 shares, respectively) |       | $                                   | 261        |   | $ | — |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

5

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**SOURCECORP, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1. Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements and related notes tothe condensed consolidated financial statements include the accounts ofSOURCECORP, Incorporated and subsidiaries (collectively, the “Company”).  All significant intercompany accounts andtransactions have been eliminated in consolidation. These condensedconsolidated financial statements have been prepared by the Company, withoutaudit, pursuant to the rules and regulations of the Securities andExchange Commission (the “Commission”). Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations.However, the Company believes that all disclosures are adequate to make theinformation presented not misleading. These condensed consolidated financial statements should be read inconjunction with the Company’s consolidated financial statements and therelated notes thereto in the Annual Report on Form 10-K filed with theCommission on March 31, 2005.

 

Inthe opinion of management, all adjustments necessary to fairly present theCompany’s financial position at June 30, 2005, and results of operationsand cash flows for the three and six months ended June 30, 2005 and 2004have been included. The results of operations for the three and six monthsended June 30, 2005 are not necessarily indicative of the results to beexpected for the full fiscal year or for any future periods.

 

TheCompany uses estimates and assumptions required for preparation of thefinancial statements. The estimates are primarily based on historicalexperience and business knowledge and are revised as circumstances change.However, actual results could differ from the estimates.

 

**2. Reserves and Other Loss Contingencies**

 

*Self-Insurance Liabilities and Reserves*  

 

TheCompany is self-insured for workmen’s compensation liabilities and asignificant portion of its employee medical costs. The Company accounts for itsself-insurance programs based on actuarial estimates of the amount of lossinherent in that period’s claims, including losses for which claims have notbeen reported. These loss estimates rely on actuarial observations of ultimateloss experience for similar historical events. The Company limits its risk bycarrying stop-loss policies for significant claims incurred for both workmen’scompensation liabilities and medical costs. The Company’s exposure under thestop-loss policies for workmen’s compensation and medical costs is limitedbased on fixed dollar amounts.  Forworkman’s compensation, the fixed dollar amount of stop-loss coverage is$500,000 per occurrence.  For medicalcosts, the fixed dollar amount of stop-loss coverage is $100,000 per coveredparticipant for the fiscal plan year ended June 30, 2005, with a lifetimelimit of liability per covered participant of $1,900,000.  The Company’s stop-loss policy for medicalcosts expired on June 30, 2005.  Thestop-loss policy was renewed for one year, effective July 1, 2005.  The fixed dollar amount of stop-loss coverageunder the new policy is $200,000 per covered participant with a lifetime limitof liability per covered participant of $1,800,000.

 

Accrual balances related to workmen’s compensationand medical costs, included in accrued liabilities in the condensed consolidatedbalance sheets, are as follows (in thousands):

 
| ** **                  | ** ** | **December 31,  2004** | ** ** | **June 30,  2005** | ** ** |
|-----------------------------|------------|-----------------------------|------------|-------------------------|------------|
| Workmen’s Compensation |       | $                           | 2,407      |                    | $          | 2,098 |   |
| Employee Medical Insurance  |       | 2,229                       |       | 2,480                   |       |
| Total                       |       | $                           | 4,636      |                    | $          | 4,578 |   |

 

*Other Loss Contingencies *

 

TheCompany records liabilities when it is probable that a liability has beenincurred and the amount of the loss is reasonably estimable in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 5, *Accounting for Contingencies*.  Contingent liabilities are often resolvedover long periods of time. Estimating probable losses requires analysis ofmultiple forecasts that often depend on judgments about potential actions bythird parties such as regulators. The Company’s loss contingencies consistprimarily of estimates related to the probable outcome of pending litigation.  See Note 8.

 

6

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**3. Stockholders’ Equity and Stock-Based Compensation**

 

*Stock-Based Compensation*

 

In2002, the Board of Directors and Shareholders of the Company approved theSOURCECORP, Incorporated 2002 Long-Term Incentive Plan (the “2002 Plan”), whichreplaced the 1995 Stock Option Plan, as amended (the “1995 Plan”). The 2002Plan authorizes awards of options to purchase common stock and may includeincentive stock options (“ISOs”) and/or non-qualified stock options (“NQSOs”),stock appreciation rights, restricted stock, deferred stock, bonus stock andawards in lieu of cash obligations, dividend equivalents and other stock basedawards.

 

TheBoard of Directors has appointed a committee (the “Committee”), which is composedof independent, non-employee directors, to administer the 2002 Plan. Personseligible to receive awards under the plan include directors, officers,employees of the Company and its subsidiaries, and persons who provideconsulting services to the Company deemed by the Committee, or the Board as awhole, to be of substantial value to the Company, persons who have been offeredemployment by the Company or its subsidiaries, and persons employed by anentity that the Committee reasonably expects to become a subsidiary of theCompany. Awards granted under the 2002 Plan may, at the discretion of theCommittee, be granted either alone or in addition to, in tandem with or insubstitution for any other award granted under the 2002 Plan or any other planof the Company, any subsidiary or any business entity to be acquired by theCompany or one of its subsidiaries. The Committee determines vesting in awardsgranted under the 2002 Plan.

 

TheCompany applies Accounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees*, and related interpretations inaccounting for stock-based compensation and awards. Stock option and warrantawards are granted at the market price of the Company’s common stock on thedate of grant. Accordingly, no compensation expense has been recognized forstock options and warrants. Had compensation expense been determined based uponthe fair value at each grant date for stock options and warrants consistentwith the provisions of SFAS No. 123, *Accountingfor Stock-Based Compensation,* the Company’s net income and earningsper share would have been as follows (in thousands, except per share data):

 
| ** **                                                                                                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income as reported                                                                                                               |       | $                                     | 4,846      |                                | $          | 5,374 |   | $ | 6,911 |   | $ | 12,508 |   |
| Add: Deferred compensation expense included  in reported net income, net of related tax effect                                       |       | 320                                   |       | 402                                 |       | 652 |   | 788 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax effect |       | (676                                  | )          | (498                                | )          | (1,585 | ) | (1,266 | ) |
| Proforma net income                                                                                                                  |       | $                                     | 4,490      |                                | $          | 5,278 |   | $ | 5,978 |   | $ | 12,030 |   |
| Earnings per share:                                                                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Reported basic earnings per share                                                                                                    |       | $                                     | 0.30       |                                | $          | 0.34 |   | $ | 0.43 |   | $ | 0.80 |   |
| Proforma basic earnings per share                                                                                                    |       | $                                     | 0.28       |                                | $          | 0.34 |   | $ | 0.37 |   | $ | 0.77 |   |
|                                                                                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Reported diluted earnings per share                                                                                                  |       | $                                     | 0.30       |                                | $          | 0.33 |   | $ | 0.42 |   | $ | 0.78 |   |
| Proforma diluted earnings per share                                                                                                  |       | $                                     | 0.27       |                                | $          | 0.33 |   | $ | 0.36 |   | $ | 0.75 |   |

 

Thefair value of stock options and warrants was estimated on the date of grantusing the Black-Scholes option pricing model using the following assumptions:

 
| ** **                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                               | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| Weighted-average risk-free interest rate |       | 3.6                                   | %          | N/A                                 |       | 3.3 | % | N/A |   |
| Weighted-average dividend yield          |       | 0.0                                   | %          | N/A                                 |       | 0.0 | % | N/A |   |
| Weighted-average volatility              |       | 41.6                                  | %          | N/A                                 |       | 41.5 | % | N/A |   |
| Weighted-average expected life           |       | 4.0 years                             |       | N/A                                 |       | 4.0 years |   | N/A |   |

 

On December 18, 2004, the Compensation Committee of the Board ofDirectors approved, and the Board of Directors ratified, the acceleration ofthe vesting of certain options and warrants (specifically options and warrantsissued in 2002 or earlier, and only those options and warrants that by theirterms would not vest before June 30, 2005), provided that the holders wereemployed by the

 

7

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Company as of December 31, 2004. The action was taken as a methodto provide a further incentive to option holders to maximize shareholder valuewithout creating an immediate windfall (as substantially all of such optionsand warrants had exercise prices above $30 per share). In taking such action,the Compensation Committee and the Board were mindful that the accountingtreatment of stock options and warrants was anticipated to change in the secondhalf of 2005 (which date has changed to the first quarter of 2006), requiringthe expensing of unvested stock options and warrants. As such, the CompensationCommittee and the Board were mindful that accelerating the vesting of suchoptions and warrants would avoid an expense in future periods that did notprovide any direct associated benefit to individuals and that could otherwisenegatively impact the Company’s reported results in future periods. This actionresulted in the acceleration of vesting of 364,100 stock options and warrantsat a weighted-average strike price of $30.38 during the fourth quarter of 2004.Although this action established a new measurement date for the stock optionsand warrants under the intrinsic value method, there was no compensationexpense associated with the vesting acceleration as the strike price related tothe accelerated stock options and warrants was above the fair market value ofthe Company’s common stock on December 17, 2004.  As a result of the acceleration, additionalexpense of approximately $2.1 million, net of tax, was included in thepro-forma disclosure during the three months ended December 31, 2004related to the acceleration.

 

During2003, the Company awarded 164,300 shares of restricted stock under the 2002Plan. The restricted shares were issued at no cost to the recipients;therefore, the Company recorded deferred compensation of approximately $2.9million based on the market value of the stock at the date of issuance.  Subsequent to the grant date, certainforfeitures of restricted stock have occurred resulting in a total award of155,000 shares and total deferred compensation of $2.8 million.  The deferred compensation charge is beingamortized to expense over the vesting period of the restricted stock. Therestricted shares vest over a three-year period ending July 1, 2006, withacceleration of the vesting period occurring if a certain stock price orperformance target is achieved. 

 

Duringthe three months ended March 31, 2004, the Company awarded 132,000 sharesof restricted stock under the 2002 Plan. The restricted shares were issued at no cost to the recipients;therefore, the Company recorded deferred compensation of approximately $3.5million based on the market value of the stock at the date of issuance.  Subsequent to the grant date, certain forfeituresof restricted stock have occurred resulting in a total award of 126,750 sharesand total deferred compensation of $3.3 million.  The deferred compensation charge is beingamortized to expense over the vesting period of the restricted stock.  The restricted shares vest at the end of athree-year period ending January 10, 2007, with acceleration of thevesting period occurring if certain performance targets are achieved.  

 

Duringthe three months ended June 30, 2004, the Company awarded 50,550 shares ofrestricted stock under the 2002 Plan. The restricted shares were issued at no cost to the recipients;therefore, the Company recorded deferred compensation of approximately $1.2million based on the market value of the stock at the date of issuance.  The deferred compensation charge is beingamortized to expense over the vesting period of the restricted stock.  The restricted shares vest on January 10,2007 and May 26, 2007, with acceleration of the vesting period for certainshares occurring if certain performance targets are achieved.

 

Duringthe three months ended June 30, 2005, the Company awarded 245,170 sharesof restricted stock under the 2002 Plan. The restricted shares were issued atno cost to the recipients; therefore, the Company recorded deferredcompensation of approximately $4.6 million based on the market value of thestock at the date of issuance.  Thedeferred compensation charge is being amortized to expense over the vestingperiod of the restricted stock.  Of therestricted shares granted, 10,170 restricted shares vest over a three yearperiod ending May 23, 2008, and 235,000 restricted shares vest on December 18,2009, with acceleration of the vesting period for certain shares occurring ifcertain performance targets are achieved.

 

Deferredcompensation amortized to expense, included in selling, general andadministrative expenses in the condensed consolidated statements of operations,related to the restricted stock grants discussed above is as follows (inthousands):

 
| ** **              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **              | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| May 2003 grant     |       | $                                     | 198        |                                | $          | 233 |   | $ | 465 |   | $ | 471 |   |
| January 2004 grant |       | 265                                   |       | 277                                 |       | 553 |   | 553 |   |
| May 2004 grant     |       | 69                                    |       | 114                                 |       | 69 |   | 231 |   |
| May 2005 grant     |       | —                                |       | 166                                 |       | — |   | 166 |   |
| Total                   |       | $                                     | 532        |                                | $          | 790 |   | $ | 1,087 |   | $ | 1,421 |   |

 

*Common Stock Repurchase Program*

 

During2003, the Company activated the $30.0 million stock repurchase programauthorized by the Board of Directors in April 2001 and purchased 1,306,979shares of its common stock at a cost of approximately $20.7 million.  During the three months ended June 30,2004, the Company purchased an additional 361,415 shares of its common stock ata cost of approximately $9.3 million completing the original repurchaseprogram.

 

8

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Duringthe third quarter of 2004, the Board of Directors authorized the purchase of anadditional $20.0 million of shares from time to time in the open market asconditions warrant.  During the threemonths ended September 30, 2004, the Company purchased 34,800 shares ofcommon stock at a cost of approximately $0.8 million.  During the three months ended December 31,2004, the Company purchased 82,724 shares of common stock at a cost ofapproximately $1.8 million (with the last such repurchase occurring on October 26,2004).  

 

Therepurchased shares were recorded in the balance sheet as a reduction to commonstock, additional paid-in-capital, and retained earnings.  These shares have been retired and returnedto the status of authorized but unissued shares of the Company.

 

*Net Income Per Share*

 

Basicand diluted net income per common share were computed in accordance with SFAS No. 128,*Earnings Per Share*. Thedifferences between basic weighted average common shares and diluted weightedaverage common shares and potentially dilutive common shares are as follows (inthousands):

 
| ** **                                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                               | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| Basic weighted average common shares                     |       | 16,014                                |       | 15,673                              |       | 16,055 |   | 15,672 |   |
| Weighted average options, warrants and  restricted stock |       | 330                                   |       | 411                                 |       | 329 |   | 352 |   |
| Other contingent consideration                           |       | 30                                    |       | —                              |       | 27 |   | — |   |
| Diluted weighted average common shares                   |       | 16,374                                |       | 16,084                              |       | 16,411 |   | 16,024 |   |

 

AtJune 30, 2004 and 2005, approximately 2.0 million and 3.0 million,respectively, of common shares were not included in the diluted earnings pershare calculation because they were anti-dilutive.  These common shares may be dilutive in futureearnings per share calculations.

 

**4. Stockholders’ Rights Plan**

 

On June 24, 2005,the Company adopted a stockholders’ rights plan, (the Rights Plan). Under theRights Plan, each holder of the Company’s common stock, at the close ofbusiness on July 4, 2005, received a dividend distribution of one Rightfor each share of common stock held.  Exceptas provided below, each Right entitles stockholders to buy one one-thousandthof a share (“Share Fraction”) of Series A Cumulative ParticipatingPreferred Stock of the Company at an exercise price of $90.00, subject toadjustment in certain circumstances, e.g. for stock splits or stockdividends.  Each preferred Share Fractionis designed to be equivalent in voting and dividend rights to one share ofcommon stock.

 

If any person or groupacquires 15% or more of the Company’s common stock (other than pursuant to atender or exchange offer for all common stock at a price and on terms approvedby the Board of Directors), each Right will entitle its holder to purchase, atthe Right’s exercise price, common stock of the Company having a market valueof twice the Right’s exercise price. This amounts to the right to buy theCompany common stock at half price. Rights owned by the party triggering theexercise of Rights will not be exercisable. 

 

In addition, if after anyperson or group has become a 15%-or-more stockholder, the Company is involvedin a merger or other business combination transaction with another person inwhich its shares of common stock are changed or converted, or sells 50% or moreof its assets or earning power to another person, each Right will entitle itsholder to purchase, at the Right’s exercise price, shares of common stock ofsuch other person having a market value of twice the Right’s exercise price.

 

**The Rights will beexercisable and will trade separately from the shares of common stock only if aperson or group, with certain exceptions, acquires 15% or more the Company’scommon stock or commences a tender or exchange offer that would result in suchperson or group owning 15% or more of the Company’s common stock.  Prior to that, the Rights will not tradeseparately from the common stock. The Company may redeem the Rights for $0.001per Right prior to the time any person or group acquires 15% or more of theCompany’s common stock. All Rights expire on June 24, 2015.**

 

This summary description is qualified in its entirety by reference tothe Rights Agreement, which has been filed as an exhibit to the Company’sRegistration Statement on Form 8-A.

** **

**5. Discontinued Operations**

 

*2005 Divestiture*

* *

During the first quarter of 2005, the Company formally committed to aplan of divestiture for a non-strategic asset group related to its litigationservice operations reported in the Healthcare, Regulatory and Legal Compliancesegment in prior periods.  During 2004, theoperation contributed approximately $3.7 million of revenue and loss beforeincome taxes of approximately $0.3 million.

 

9

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The Company has concluded the asset group meets the requirements fordiscontinued operations accounting treatment as outlined in SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets”* during the quarter ended March 31,2005.  As such, the operating assets andliabilities of this operation are presented in the condensed consolidatedbalance sheet as Assets and Liabilities of Discontinued Operations and theresults associated with this operation are presented in the condensedconsolidated statement of operations as Income (Loss) from DiscontinuedOperations, net of tax.

 

During the first quarter of 2005, the Company completed the sale ofthis non strategic asset group, resulting in the recognition of a pre-tax lossof approximately $0.2 million.  Inconnection with this transaction, the Company received approximately $0.2million of cash proceeds and a promissory note of approximately $0.1 million.

 

Due to unrealizable capital losses associatedwith this transaction for tax purposes, additional tax expense of approximately$0.7 million was recognized during the second quarter of 2005. 

 

Summarizedselected financial information for the 2005 divestiture discussed above is asfollows (in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                     | ** ** |
| **REVENUE**                                            |       | $                                     | 849        |                                | $          | — |   | $ | 1,909 |   | $ | 260 |   |
| **COST OF SERVICES**                                   |       | 604                                   |       | —                              |       | 1,352 |   | 194 |   |
| **DEPRECIATION**                                       |       | 20                                    |       | —                              |       | 41 |   | 6 |   |
| Gross profit                                           |       | 225                                   |       | —                              |       | 516 |   | 60 |   |
| **SELLING, GENERAL AND ADMINISTRATIVE  EXPENSES**      |       | 306                                   |       | —                              |       | 635 |   | 191 |   |
| Operating loss                                         |       | (81                                   | )          | —                              |       | (119 | ) | (131 | ) |
| **OTHER (INCOME) EXPENSE:**                            |       |                                  |       |                                |       |   |   |   |   |
| Loss on sale of asset group                            |       | (2                                    | )          | —                              |       | (2 | ) | 168 |   |
| Loss from discontinued operations before  income taxes |       | (79                                   | )          | —                              |       | (117 | ) | (299 | ) |
| **PROVISION (BENEFIT) FOR INCOME TAXES**               |       | (32                                   | )          | 660                                 |       | (47 | ) | 543 |   |
| **LOSS FROM DISCONTINUED OPERATIONS**                  |       | $                                     | (47        | )                                   | $          | (660 | ) | $ | (70 | ) | $ | (842 | ) |

 

Theassets and liabilities of the discontinued operation are stated separately onthe condensed consolidated balance sheets. The major asset and liability categories are as follows (in thousands):

 
| ** **                                                             | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                             | ** ** | **(Unaudited)**             | ** ** |
| **ASSETS  OF DISCONTINUED OPERATION**                                  |       |                        |       |
| **CURRENT ASSETS:**                                                    |       |                        |       |
| Accounts and notes receivable, net of  allowance for doubtful accounts |       | $                           | 731        |   |
| Prepaid expenses and other current assets                              |       | 17                          |       |
| Total current assets                                                   |       | 748                         |       |
| **PROPERTY, PLANT AND EQUIPMENT,**net  of accumulated depreciation     |       | 94                          |       |
| Total assets of discontinued operation                                 |       | $                           | 842        |   |
| **LIABILITIES OF DISCONTINUED OPERATION**                              |       |                        |       |
| **CURRENT LIABILITIES:**                                               |       |                        |       |
| Accounts payable and accrued liabilities                               |       | $                           | 326        |   |
| Total liabilities of discontinued operation                            |       | $                           | 326        |   |

 

*2004 Divestitures*

* *

Duringthe first quarter of 2004, the Company completed a strategic evaluation of itsoperations based on certain criteria, such as strategic and financial fit, andfuture growth prospects. As a result, on May 6, 2004, the Company formallycommitted to a plan of divestiture for certain non-strategic asset groupsrelated to its Direct Mail operations reported in the Information Managementand Distribution segment in prior periods, and two medical records managementoperations reported in the Healthcare, Regulatory and Legal Compliance segmentin prior periods. The Direct Mail operations and the two medical recordsmanagement operations are accounted for as discontinued operations. As such,the results associated with these operations are presented in the consolidatedstatement of operations as Income (Loss) from Discontinued Operations, net oftax.

 

10

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Duringthe second quarter of 2004, the Company completed the sale of one of themedical records management operations, which resulted in approximately $0.7million of cash proceeds and a pre-tax gain on disposal of approximately $0.5million. Additionally, the Company recognized a pre-tax loss on disposalrelated to the Direct Mail operations of approximately $2.2 million.

 

Duringthe third quarter of 2004, the Company completed the sale of the Direct Mailoperations and the remaining medical records management operation, resulting inthe recognition of a net pretax gain of $0.4 million. In connection with thesetransactions, the Company received approximately $6.1 million of cash proceeds,net of transaction costs, approximately $1.5 million of 12 percent securedsubordinated notes, which the Company fully reserved, related to the DirectMail operations, and $0.6 million of contingent consideration related to acontract renewal at the medical records management operation.

 

Duringthe fourth quarter of 2004, the contingency surrounding the contract renewal atthe medical records management operation was resolved. As such, the Companyrecognized additional consideration of $0.6 million offset by approximately$0.1 million of incremental loss related to finalizing the considerationrelated to the divestiture.

 

Thecollection of the reserved subordinated notes could result in a futurereduction of the total loss related to the disposition of the Direct Mailoperations.  See Note 10.

 

Summarizedselected financial information for the 2004 divestitures discussed above is asfollows (in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                     | ** ** |
| **REVENUE**                                            |       | $                                     | 6,937      |                                | $          | — |   | $ | 15,526 |   | $ | 7 |   |
| **COST OF SERVICES**                                   |       | 6,332                                 |       | —                              |       | 12,732 |   | 49 |   |
| **DEPRECIATION**                                       |       | 128                                   |       | —                              |       | 529 |   | — |   |
| Gross profit                                           |       | 477                                   |       | —                              |       | 2,265 |   | (42 | ) |
| **SELLING, GENERAL AND ADMINISTRATIVE  EXPENSES**      |       | 1,735                                 |       | —                              |       | 4,346 |   | 4 |   |
| Operating loss                                         |       | (1,258                                | )          | —                              |       | (2,081 | ) | (46 | ) |
| **OTHER (INCOME) EXPENSE:**                            |       |                                  |       |                                |       |   |   |   |   |
| Interest and other expense (income), net               |       | 32                                    |       | —                              |       | 21 |   | — |   |
| Loss on sale of asset group                            |       | 1,732                                 |       | —                              |       | 1,732 |   | 17 |   |
| Loss from discontinued operations before  income taxes |       | (3,022                                | )          | —                              |       | (3,834 | ) | (63 | ) |
| **PROVISION (BENEFIT) FOR INCOME TAXES**               |       | (1,209                                | )          | —                              |       | (1,534 | ) | (24 | ) |
| **LOSS FROM DISCONTINUED OPERATIONS**                  |       | $                                     | (1,813     | )                                   | $          | — |   | $ | (2,300 | ) | $ | (39 | ) |

 

**6. Business Combinations**

 

*Goodwill and Intangibles*

 

Thechanges in the carrying value of goodwill and the components of intangibles areas follows (in thousands):

 

Goodwill:

 
| ** **                             | ** ** | **Information  Management and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------|------------|-----------|------------|
| Net balance as of January 1, 2005 |       | $                                             | 167,660    |                                               | $          | 158,479   |       | $ | 326,139 |   |
| Adjusment related to past acquisition  |       | (935                                          | )          | —                                             |       | (935      | )          |
| Finalize purchase price allocation     |       | —                                        |       | (19                                                | )          | (19       | )          |
| Net balance as of June 30, 2005   |       | $                                             | 166,725    |                                               | $          | 158,460   |       | $ | 325,185 |   |
|                                        |            |                                               |            |                                                    |            |           |            |  |  |  |  |  |  |

 

Intangibles:

 
| ** **             | ** ** | **December 31, 2004** | ** ** | **June 30, 2005**        | ** ** |
|------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Gross Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Customer relationships |       | $                          | 4,283      |                          | $          | (1,084 | ) | $ | 4,283 |   | $ | (1,216 | ) |
| Non-compete agreements |       | 2,321                      |       | (616                          | )          | 2,321 |   | (896 | ) |
| Total                  |       | $                          | 6,604      |                          | $          | (1,700 | ) | $ | 6,604 |   | $ | (2,112 | ) |

 

11

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Aggregateamortization expense related to intangibles for the six months ended June 30,2004 and 2005 was approximately $0.4 million and $0.4 million,respectively.  Estimated amortizationexpense for the years ending December 31, 2005 through December 31,2016 is presented in the table below.

 
| **Years  Ending  December 31,** | ** ** | **Estimated Amortization  Expense** | ** ** |
|--------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                  | ** ** |
| 2005                                 |       | $                                   | 825        |   |
| 2006                                 |       | 825                                 |       |
| 2007                                 |       | 737                                 |       |
| 2008                                 |       | 384                                 |       |
| 2009                                 |       | 267                                 |       |
| Thereafter                           |       | 1,866                               |       |
| Total                                |       | $                                   | 4,904      |   |

*Contingent Consideration*

 

Management’sevaluation of the cumulative earnings of acquired companies through December 31,2004 indicated that an acquired company had met specified earnings targetsbeyond a reasonable doubt.  As a result,at December 31, 2004, in connection with the 2002 purchase of UIS,approximately $5.3 million of additional consideration remained accrued and wasclassified as accounts payable and accrued liabilities in the condensedconsolidated balance sheets.  There wereno changes to management’s evaluation during the six months ended June 30,2005.  Pursuant to the terms of the UISpurchase agreement, approximately $4.3 million of contingent consideration waspaid in cash to the former shareholders during the three months ended June 30,2005 and approximately $1.0 million of additional contingent considerationremains accrued.  The Company reservesthe right to change the payment mix to use common stock versus cash insatisfying contingent consideration liabilities.  The accrued additional consideration isincluded in accounts payable and accrued liabilities in the condensedconsolidated balance sheets and is expected to be paid in cash by the firstquarter of 2006. 

 

Asof June 30, 2005, all periods applicable for earnout targets of pastacquisitions are completed.

 

**7. Segment Reporting**

 

TheCompany aggregates its service offerings and operations into two reportablesegments: (i) Information Management and Distribution, and (ii) Healthcare,Regulatory, and Legal Compliance. The Company’s reportable segments areorganized around customer types and service offerings possessing similareconomic characteristics. Management evaluates segment performance based onrevenue and income before income taxes. All centrally incurred corporate costsare allocated to the segments based principally on operating income of thereportable segments.  The reportingsegments follow the same accounting policies used for the Company’sconsolidated financial statements.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Thissegment offers Business Process Outsourcing (“BPO”) solutions that help itscustomers manage the *Document In-flow*,*Workflow Processing* and *Statement Out-flow* of their missioncritical business document processes. This segment’s BPO solutions enablecustomers to automate their complex workflow processes by digitizing largevolumes of documents, capturing information from the documents, hostingelectronic documents on the Company’s Web-based repository, and preparingstatements that customers mail or present electronically to their end users.

 

**Healthcare, Regulatory and Legal Compliance.**  Thissegment offers specialized knowledge-based processing and consulting servicesthat include medical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, providing managedcare compliance reviews, class action claims administration sevices, andprofessional economic research and litigation services.

 

12

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TheCompany measures segment profit as income from continuing operations beforeincome taxes. Information on the segments follows (in thousands):

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30, 2005**      | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 56,601     |   | $ | 49,852 |   | $ | 106,453 |   |
| Income from continuing operations before  income taxes |       | 5,291                                          |       | 6,548 |   | 11,839 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30, 2004**      | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 50,027     |   | $ | 47,071 |   | $ | 97,098 |   |
| Income from continuing operations before  income taxes |       | 4,555                                          |       | 6,622 |   | 11,177 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **SIX MONTHS ENDED JUNE 30, 2005**        | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 112,896    |   | $ | 99,489 |   | $ | 212,385 |   |
| Income from continuing operations before  income taxes |       | 11,107                                         |       | 12,797 |   | 23,904 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 
| ** **                                             | ** ** | **SIX MONTHS ENDED JUNE 30, 2004**        | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **Information  Management  and  Distribution** | ** ** | **Healthcare,  Regulatory  and Legal  Compliance** | ** ** | **Consolidated** | ** ** |
| Revenue                                                |       | $                                              | 98,054     |   | $ | 94,860 |   | $ | 192,914 |   |
| Income from continuing operations before  income taxes |       | 2,926                                          |       | 12,542 |   | 15,468 |   |
|                                                        |            |                                                |            |  |  |  |  |  |  |  |

 

**8.Litigation**

 

TheCompany is, from time to time, a party to litigation. The following is adescription of the most significant legal matters that the Company is involvedin.  In the event of an adverse outcomein one or more of the legal proceedings our business, financial condition,results of operations or cash flows could be materially adversely affected.

### *** ***

### ***Jana Suit***

 

In July 2005, three affiliated stockholders filed suit against theCompany and its directors alleging that the adoption by the Company of recentamendments to its Bylaws and the adoption of its shareholder Rights Agreementconstituted a breach of fiduciary duties. The suit was styled *Jana PartnersLLC, Jana Piranha Master Fund, Ltd. and Jana Master Fund, Ltd. v. SOURCECORP,Incorporated, Thomas C. Walker, Ed H. Bowman, Jr., G. Michael Bellenghi,Michael J. Bradley, David Lowenstein, Donald F. Moorehead, Jr. and EdwardM. Rowell* and was filed in the Court of Chancery for the State ofDelaware in and for New Castle County. The suit did not seek monetary damages other than costs, such asattorneys’ fees.  On August 9, 2005,Jana dismissed this suit without prejudice.

 

### ***Putative Securities Class Action***

### ** **

TheCompany, and the Company’s CEO and CFO individually, have been named asdefendants in several putative securities class actions, in response to theCompany’s press releases dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. Thecomplaints (collectively, the “Actions”) were filed in the United StatesDistrict Court for the Northern District of Texas, Dallas Division, with thefirst action being filed November 1, 2004. The Actions are putativeshareholder class action lawsuits alleging violations of Federal SecuritiesLaws, including alleged violations of Sections 10(b) and 20(a), and Rule 10b-5of the Securities Exchange Act of 1934, as amended. The four Actions have beentransferred to a single judge in the Northern District of Texas, DallasDivision, these actions have been consolidated into a single action now styled *In re Sourcecorp, Inc. Securities Litigation,*and a lead plaintiff has been appointed. The consolidated Action is purportedly on behalf of all persons whopurchased the Company’s common stock during the period between May 3, 2001,and October 27, 2004, and seeks unspecified damages.  The Company intends to vigorously defend thismatter.

 

13

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#### ***Purported Derivative Action and Demand Letter***

#### ** **

Apurported stockholder derivative action was filed on December 28, 2004,against certain of the Company’s current and former officers and directors asindividual defendants and the Company as a nominal defendant in the 116thDistrict Court for Dallas County, Texas (the “Purported Derivative Action”).The Purported Derivative Action alleges breach of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of assets, and unjust enrichment related tothe Company’s press release dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon. All of these claims are asserted derivatively on behalfof the Company and seek unspecified damages against those individuals.  Further, the Chairman of the Company’s Boardof Directors received from a purported shareholder a demand letter (the “DemandLetter”) based on the same set of facts as the Purported DerivativeAction.  The Demand Letter requests theBoard to take certain action, but does not seek damages against theCompany.  The Company has formed aspecial committee of the Board of Directors that is evaluating the claims madein the Purported Derivative Action and the Demand Letter.

 

*DigitalImaging Systems*

 

On August 5, 2004,Digital Imaging Systems, Inc. filed suit against the Company in the UnitedStates District Court-Southern District of New York alleging, among otherthings, that a portion of the Company’s process for scanning and indexingimages violates one of Digital Imaging Systems’ patents.  The plantiff in this matter filed to dismissthis matter with prejudice in June 2005, which the Judge approved in July 2005.  As such, the Company views this matter asclosed.

 

*Various ROI Copy Charge Matters*

 

Fromtime to time, various subsidiaries of the Company that perform release ofinformation (“ROI”) services become defendants to putative class actionlawsuits generally alleging that the charge for reproducing certain medicalrecords is not in conformity with such plaintiffs’ reading of the applicableregulated charge. Such suits typically include multiple ROI companies andhospitals as defendants and demand reimbursement for prior charges as well asfor prospective pricing adjustments. The Company is currently a party toseveral such suits in various stages of development.

 

Onesuch suit originally styled *McShane v.Recordex Acquisition Corp. & Sourcecorp, Incorporated* (and now styled *Liss & Marion, PC v. Recordex Acquisition Corp., &Sourcecorp, Inc.*) filed February 10, 2003, in theCourt of Common Pleas Philadelphia County, Pennsylvania, alleges among otherthings that the Company intentionally charged more for providing copies of medicalrecords than is permitted under Pennsylvania law.  The complaint does not specify the amount ofdamages sought.  On June 10, 2005,the Court in this matter granted judgment in favor of the plantiffs for anamount as yet to be determined.  TheCompany has filed a motion for clarification of the Court’s order and if andwhen a judgement is entered, the Company will assess its appeallate options.

 

*SEC Investigation*

 

OnJanuary 14, 2005, the Company received written confirmation from the SECthat the SEC had converted its informal inquiry in connection with the Company’sinternal investigation and restatement into a formal investigation. The Companyintends to fully cooperate with the SEC in connection with the investigation.The Company initially had contacted the enforcement division of the SEC on avoluntary basis to notify the agency of the Company’s understanding of theevents leading to its internal investigation. The Company is unable to predictthe outcome of the investigation, the scope of matters that the SEC may chooseto investigate in the course of this investigation or in the future, the SEC’sviews of the issues being investigated, or any action that the SEC might take,including the imposition of fines, penalties, or other available remedies.

 

**9. Long-Term Customer Liability and Deferred Revenue**

** **

DuringOctober 2004, the Company, with the oversight and approval of the AuditCommittee of its Board of Directors, initiated an investigation of thefinancial results of one of its operating subsidiaries in the InformationManagement and Distribution reportable segment (the “Operating Subsidiary”).The findings of the investigation concluded that the Operating Subsidiary hadincorrectly recognized revenue for certain customer arrangements and omitted certainoperating expenses from its financial results which in turn resulted inoverpayments and over accruals of contingent consideration amounts due underthe earn-out provisions of the acquisition agreement for the OperatingSubsidiary.  The overpayments and overaccruals of contingent consideration amounts had been originally recognized asadditional goodwill of the acquired business. 

 

Asdescribed in the Company’s critical accounting policies, revenue isrecognizable when each of the following conditions is met: persuasiveevidence of an arrangement exists, the price is fixed or determinable, deliveryhas occurred or services have been rendered and collection is reasonablyassured. The investigation identified certain instances where one or more ofthe aforementioned revenue recognition conditions as applied to certaincustomer contracts were not met by the Operating Subsidiary. As a result, therevenue previously recognized that did not meet all the mentioned revenuerecognition conditions was reversed, resulting in a downward adjustment tocertain asset accounts or the recognition of a customer liability or deferredrevenue.  

 

14

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During the first quarter of 2005, the Company entered into an agreementwith one of its customers impacted by the facts relating to the subject of theinternal investigation.  As a result ofthe agreement, during the first quarter of 2005, the Company recognizedremediation revenue of $4.1 million related to revenue reversals; however, suchrevenue did not contribute to the Company’s operating cash flow in the currentyear.  

 

During the second quarter of 2005, the Company entered into agreementswith two of its customers impacted by the facts relating to the subject of theinternal investigation.  As a result ofthe agreements, during the second quarter of 2005, the Company recognizedremediation revenue of $2.7 million related to revenue reversals; however, suchrevenue did not contribute to the Company’s operating cash flow in the currentyear.

 

Additionally, during the first quarter of 2005, agreements from othercustomers impacted by the facts relating to the subject of the internalinvestigation were received and the customer agreed to apply certain balances,classified as long-term customer liability and/or deferred revenue, againstcurrent trade accounts receivable the Company has outstanding from suchcustomers.  The net amount appliedagainst trade accounts receivable during the three and six month periods ended June 30,2005 was approximately $1.0 million and $1.6 million, respectively.

 

The balances classified as Long-Term Customer Liability and DeferredRevenue related to customers impacted by the facts relating to the subject ofthe internal investigation are as follows (in thousands):

 
| ** **                   | ** ** | **December 31,  2004** | ** ** | **June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| Long-Term Customer Liability |       | $                           | 4,147      |                    | $          | 442 |   |
| Deferred Revenue             |       | 8,010                       |       | 3,302                   |       |
| Total                        |       | $                           | 12,157     |                    | $          | 3,744 |   |

 

The remaining balances at June 30, 2005, will be recognized inaccordance with agreements negotiated and finalized with each applicablecustomer.

 

**10. Subsequent Events**

 

In May 2005, theBoard of Directors approved the termination of the Non-Qualified RetirementPlan (“Plan”), effective July 1, 2005. As a result, the assets and liabilities associated with the Plan areincluded in current assets and current liabilities in the condensedconsolidated balance sheet at June 30, 2005.  Distributions to Plan participants will becompleted during the quarter ended September 30, 2005.

 

On August 1, 2005,the Company received approximately $1.5 million in proceeds related to thecollection of the subordinated notes receivable associated with the dispositionof the Company’s Direct Mail operations in the third quarter of 2004.  These notes were fully reserved for and willresult in a reduction to the total loss related to this divestiture. 

 

15

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**Item 2.**                   **Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**Overview**

 

We were founded in September 1994, to create anational, single source provider of document and information outsourcingsolutions to document and information intensive industries, includinghealthcare insurance, financial services, healthcare provider, transportation/logistics,federal and state government, and legal industries.  We acquired the seven founding companies (the“Founding Companies”) simultaneously with the closing of our initial publicoffering (the “IPO”) on January 26, 1996, and effectively began operationsat that time. The consideration for the Founding Companies consisted of acombination of cash and common stock of our Company.  

 

Since the IPO and through June 30, 2005,we have acquired 66 companies and divested 22 operating units by sales or closures.We evaluate candidates for acquisition and periodically for divestiture as apart of our strategic plan of providing customers a single solution forbusiness process outsourcing and knowledge-based processing and consultingservices. The criteria for evaluation include geographic need, additionaltechnology, market growth potential, industry expertise, service expansion tobroaden service offerings, expansion of our customer base, revenue and earningsgrowth potential, and expected sources and uses of capital.

 

On May 4, 2004, we announced theacquisition of KeyPoint Consulting, LLC (“KeyPoint”).  KeyPoint is an economic consulting firm withapproximately 26 principals and staff, and a network of academicaffiliates.  KeyPoint provides economic,financial, and forensic accounting services in matters involving complexlitigation and regulation.  KeyPoint’sclients include companies, law firms, and government and regulatoryagencies.  The acquisition of KeyPointsignificantly expands our expertise in new practice areas and helps usstrategically position for additional growth in our legal consulting area.  KeyPoint joined our legal consulting serviceoffering and is reported in the Healthcare, Regulatory and Legal Compliancesegment. Key Point contributed $5.6 million in revenue in 2004, orapproximately 2.9% of total segment revenue, and was moderately accretive to2004 earnings after consideration of related financing costs and amortizationof identified intangibles. 

 

Duringthe first quarter of 2004, we completed a strategic evaluation of ouroperations based on certain criteria, such as strategic and financial fit, andfuture growth prospects.  As a result, onMay 6, 2004, we formally committed to a plan of divestiture for certainnon-strategic asset groups.  The assetgroups to be divested included our Direct Mail operations, previously reportedin our Information Management and Distribution segment, and two medical recordsmanagement operations that were reported in our Healthcare, Regulatory and LegalCompliance segment. Collectively, these asset groups incurred losses, net oftax, of $0.8 million for the full year ended December 31, 2003.  During the quarter ended June 30, 2004,we completed the sale of one of the medical records management operations.  The divestiture of the other medical recordsmanagement operation and the Direct Mail operations were completed during thequarter ended September 30, 2004. See Note 5, Discontinued Operations, of notes to condensed consolidatedfinancial statements, for a more detailed discussion.  

 

Duringthe first quarter of 2005, we completed the sale of an asset group thatprovides computer application software and services to the public sector.  This asset group was related to ourlitigation services operations and was previously reported in our Healthcare,Regulatory and Legal Compliance segment. This asset group incurred losses, net of tax, of $0.2 million for thefull year ended December 31, 2004. See Note 5, Discontinued Operations, of notes to condensed consolidatedfinancial statements, for a more detailed discussion. 

 

**Basis for Management Discussion and Analysis**

 

Thefollowing discussion and analysis focuses on the results of operations andfinancial condition from the Company’s continuing operations; as such, inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets,* references and comparisons to prior periodsexclude the impact of our discontinued operations.

 

Ourrevenue possesses both project and recurring characteristics.  Project revenue includes one-time projects inwhich the customer relationship is not expected to continue after projectcompletion. Project revenue margins are usually higher than our average marginsand the workload can be highly volatile. Project revenue is typically based on time and material arrangements andpredominately occurs within the Healthcare, Regulatory and Legal Compliancesegment.  Recurring revenue ischaracterized by customer relationships that are generally for one year and maycontinue for longer.  Recurring revenueis typically based on transaction volumes sent to us by our customers at anagreed upon fixed rate per unit.  Ourcustomers’ volumes are generally not contractually or otherwiseguaranteed.  Recurring revenue typicallypossesses lower margins than project revenue but is usually more predictable.

 

Costof services consists primarily of compensation and benefits to employeesproviding goods and services to our clients; occupancy costs; equipment costsand supplies. Our cost of services also includes, to a limited extent, the costof products sold for micrographics supplies and equipment; computer hardwareand software; and business imaging supplies and equipment.

 

16

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Selling,general and administrative expenses (“SG&A”) consist primarily ofcompensation and related benefits to sales and marketing, executive management,accounting, human resources and other administrative employees; other sales andmarketing costs; communications costs; insurance costs; and legal andaccounting professional fees and expenses.

 

Inaddition, the condensed consolidated financial statements included in Item 1 “FinancialStatements”, should be read in conjunction with our consolidated financialstatements and the related notes thereto in the Annual Report on Form 10-Kfiled with the Securities and Exchange Commission on March 31, 2005.

 

**Business Segments**

 

Weaggregate our service offerings and operations into two reportable segments: (i) InformationManagement and Distribution, and (ii) Healthcare, Regulatory, and LegalCompliance. Service offerings are aggregated when they are similar in thefollowing areas: economic characteristics, products and services, productionprocesses, methods for distributing or delivering products, and type or classof customers. We evaluate segment performance based on revenue and incomebefore income taxes. All centrally incurred corporate costs are allocated tothe segments based principally on operating income of the reportable segments.The reporting segments follow the same accounting policies used for ourconsolidated financial statements as described in the summary of criticalaccounting policies.

 

Theidentified segments are as follows:

 

**Information Management and Distribution.**  Weoffer Business Process Outsourcing (“BPO”) solutions that help our customersmanage the *Document In-flow*, *Workflow Processing* and *Statement**Out-flow* of their mission critical business documentprocesses. Our BPO solutions enable customers to automate their complexworkflow processes by digitizing extremely large volumes of documents,capturing information from the documents, hosting electronic documents on ourWeb-based repository, and preparing statements that customers mail or presentelectronically to their end users.  Weoffer our BPO solutions to businesses in document intensive industries, such ashealthcare insurance, financial services, healthcare provider,transportation/logistics, and federal and state government.  For the three months ended June 30, 2004and 2005, revenue in the Information Management and Distribution segmentconsisted of approximately $44.3 million and $49.4 million of recurringrevenue, respectively, and $5.7 million and $7.2 million of project revenue,respectively.  For the six months ended June 30,2004 and 2005, revenue in the Information Management and Distribution segmentconsisted of approximately $87.5 million and $97.3 million of recurringrevenue, respectively, and $10.6 million and $15.6 million of project revenue,respectively. 

 

**Healthcare, Regulatory and Legal Compliance.**  Weoffer specialized knowledge-based processing and consulting services thatinclude medical records release, record management services for healthcareinstitutions, temporary staffing for healthcare institutions, temporarystaffing for healthcare institutions, providing managed care payment compliancereviews, class action claims administration services, professional economicresearch and litigation services, and tax benefit services.  For the three months ended June 30, 2004and 2005, revenue in the Healthcare, Regulatory and Legal Compliance segmentconsisted of approximately $18.9 million and $15.9 million of recurringrevenue, respectively, and $28.2 million and $34.0 million of project revenue,respectively.  For the six months ended June 30,2004 and 2005, revenue in the Healthcare, Regulatory and Legal Compliancesegment consisted of approximately $37.1 million and $32.7 million of recurringrevenue, respectively, and $57.8 million and $66.8 million of project revenue,respectively.

 

**InternalInvestigation**

** **

DuringOctober 2004, the Company, with the oversight and approval of the AuditCommittee of our Board of Directors, initiated an investigation of thefinancial results of one of our operating subsidiaries in the InformationManagement and Distribution reportable segment (the “Operating Subsidiary”).The findings of the investigation concluded that the Operating Subsidiary had incorrectlyrecognized revenue for certain customer arrangements and omitted certainoperating expenses from its financial results which in turn resulted inoverpayments and over accruals of contingent consideration amounts due underthe earn-out provisions of the acquisition agreement for the OperatingSubsidiary.  The overpayments and overaccruals of contingent consideration amounts had been originally recognized asadditional goodwill of the acquired business. 

 

Asdescribed in our critical accounting policies, revenue is recognizable wheneach of the following conditions is met: persuasive evidence of anarrangement exists, the price is fixed or determinable, delivery has occurredor services have been rendered and collection is reasonably assured. Our investigationidentified certain instances where one or more of the aforementioned revenuerecognition conditions as applied to certain customer contracts were not met bythe Operating Subsidiary. As a result, the revenue previously recognized thatdid not meet all the mentioned revenue recognition conditions was reversed,resulting in a downward adjustment to certain asset accounts or the recognitionof a customer liability or deferred revenue. 

 

During the first quarter of 2005, we entered into an agreement with oneof our customers impacted by the facts relating to the subject of our internalinvestigation.  As a result of theagreement, during the first quarter of 2005, we recognized remediation revenue

 

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of $4.1 million related to revenue reversals. Additionally, during the second quarterof 2005, we entered into agreements with two of our customers impacted by thefacts relating to the subject of our internal investigation.  As a result of these agreements, during thesecond quarter of 2005, we recognized remediation revenue of $2.7 millionrelated to revenue reversals.  The revenuereversals did not contribute to the Company’s operating cash flow in thecurrent year.  Although the exact timingis indeterminable, additional remediation revenue may be recognized in futureperiods in accordance with agreements negotiated and finalized with eachapplicable customer.

 

**THREE MONTHS ENDED JUNE 30, 2004 COMPARED TOTHREE MONTHS ENDED JUNE 30, 2005**

 
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                             | ** ** | **2005** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                    | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| **Revenue**                                                |       | $                                    | 97,098     |   | 100.0 | % | $ | 106,453 |   | 100.0 | % |
| **Gross Profit**                                           |       | 36,545                               |       | 37.6 | % | 43,090 |   | 40.5 | % |
| **SG&A**                                               |       | 24,106                               |       | 24.8 | % | 29,820 |   | 28.0 | % |
| **Operating income**                                       |       | 12,126                               |       | 12.5 | % | 13,064 |   | 12.3 | % |
| **Income from continuing operations before  income taxes** |       | 11,179                               |       | 11.5 | % | 11,839 |   | 11.1 | % |
| **Income from continuing operations**                      |       | 6,707                                |       | 6.9 | % | 6,034 |   | 5.7 | % |
|                                                            |            |                                      |            |  |  |  |  |  |  |  |  |

 

**Revenue**

 

Ouroperations generated revenues of $106.5 million for the three months ended June 30,2005, an increase of 9.6% compared to the same period in 2004.  As previously discussed, during the secondquarter of 2005, we recognized remediation revenue of $2.7 million related torevenue reversals in previous years. After considering the positive revenue variance related to theremediation revenue, our remaining operations achieved revenue growth of 6.9%during the second quarter of 2005.  Thisrevenue growth resulted primarily from strong volumes in our project orientedclass action claims administration service offering and in our informationmanagement service offering that contributed approximately $4.4 million and$3.9 million, respectively.  Projectrevenue accounted for $41.2 million or 38.7% of revenue in the current yearquarter compared to $33.9 million or 34.9% of revenue in the prior yearquarter. (See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Basis for Management Discussion and Analysis.”)

 

Revenueswithin our Information Management and Distribution segment increased 13.1% from$50.0 million for the three months ended June 30, 2004, to $56.6 millionfor the three months ended June 30, 2005. The increase in segment revenues were primarily the result of: (i) 2004new business wins converted to revenue during 2005 and increased volumes fromexisting customers contributing approximately $3.9 million, particularly inwithin our mortgage, federal and state government and healthcare payer verticalmarkets, and (ii) the previously discussed remediation revenues of $2.7million related to revenue reversals in previous years.  Revenues in the statement processing serviceoffering were flat when compared to the prior year quarter.

 

Revenueswithin our Healthcare, Regulatory and Legal Compliance segment increased 5.9%from $47.1 million for the three months ended June 30, 2004, to $49.9million for the three months ended June 30, 2005.  Contributing to the revenue increase werehigher volumes of medium to large size projects (i.e. projects greater than$500k of total revenue) in our class action claims administration serviceoffering, which increased approximately $4.4 million or 64.6% and increasedvolumes in our legal consulting service offering which increased approximately$1.3 million or 11.3%.  Offsettingincreases in segment revenues were lower volumes of approximately $0.6 millionrelated to our medical record coding staffing services and lower revenues ofapproximately $2.0 million in our medical records release services attributableto lower volumes and certain collectibility issues.  

 

**Gross profit**

 

Grossprofit increased 17.9% from $36.5 million, or 37.6% of revenue, for the threemonths ended June 30, 2004, to $43.1 million, or 40.5% of revenue, for thethree months ended June 30, 2005.  Grossmargin increased 290 basis points primarily due to: (i) the previouslydiscussed remediation revenues of $2.7 million contributing 160 basis points, (ii) lowerproduction personnel cost as a percentage of revenue contributing 390 basispoints and (iii) increased volumes within our class action claimsadministration and legal consulting service offerings, which typically producehigher margins.  Gross margin improvementresulting from personnel costs occurred in our information management serviceoffering due to productivity and quality initiatives which included:  introduction of Lean/Six Sigma qualityinitiatives, implementation of high speed scanning technology to replace laborintensive low speed scanners, implementation of pay for performance compensationstrategies, and increased utilization of offshore labor.  Partially offsetting the gross marginimprovements were higher facilities related expenses, increased outsideservices primarily associated with offshore production and higher depreciationexpense. 

 

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**Selling, general and administrative expenses**

 

SG&Aincreased 23.7% from $24.1 million, or 24.8% of revenue, for the three monthsended June 30, 2004, to $29.8 million, or 28.0% of revenue, for the threemonths ended June 30, 2005.  Theincrease in SG&A expense relates primarily to the following:  (i) higher compensation expense ofapproximately $1.8 million primarily related to new management, sales andstaffing hires within our information management, claims administration andlegal consulting service offerings where a significant portion of our organicgrowth is being generated, (ii) higher incentive compensation ofapproximately $1.0 million due to improved performance at an operational level,(iii) higher legal fees of approximately $1.1 million related primarily toongoing litigation within our Healthcare, Regulatory and Legal Compliancesegment and other legal matters, (iv) higher accounting and related feesassociated with ongoing Sarbanes Oxley compliance related activity ofapproximately $0.7 million, and (v) ongoing investigation related costs of$0.4 million.

 

**Income from continuing operations before income taxes**

 

Incomefrom continuing operations before income taxes increased from $11.2 million forthe three months ended June 30, 2004 to $11.8 million for the three monthsended June 30, 2005.  The increasewas due to the factors impacting gross profit and SG&A discussedabove.  Offsetting the positive factorswas higher interest expense in the current year quarter of approximately $0.5million due primarily higher average debt levels and to a higher interest rateenvironment.  Each 100 basis pointincrease in interest rates results in incremental annual interest expense ofapproximately $0.8 million at current debt levels.

** **

**Provision for income taxes**

 

During thesecond quarter of 2005, an adjustment to correct previously recorded deferredtax accounts increased our effective tax rate for the quarter from 39% to49%.  Management determined that theimpact of this adjustment to the prior year’s reported financial statements wasimmaterial; consequently, the entire impact, which was identified as part ofthe quarterly review process, was reflected in the current quarter.  The change in the tax rate affects the secondquarter only.  Our effective tax rate forthe remainder of 2005 is expected to return to approximately 39%, with thefull-year average tax rate at approximately 41%.

 

**SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIXMONTHS ENDED JUNE 30, 2005**

 
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                             | ** ** | **2005** | ** ** |
| ** **                                                 | ** ** | **($000’s)**                    | ** ** | **% of  Revenue** | ** ** | **($000’s)** | ** ** | **% of  Revenue** | ** ** |
| **Revenue**                                                |       | $                                    | 192,914    |   | 100.0 | % | $ | 212,385 |   | 100.0 | % |
| **Gross Profit**                                           |       | 72,768                               |       | 37.7 | % | 87,063 |   | 41.0 | % |
| **SG&A**                                               |       | 55,174                               |       | 28.6 | % | 60,041 |   | 28.3 | % |
| **Operating income**                                       |       | 17,192                               |       | 8.9 | % | 26,610 |   | 12.5 | % |
| **Income from continuing operations before  income taxes** |       | 15,469                               |       | 8.0 | % | 23,904 |   | 11.3 | % |
| **Income from continuing operations**                      |       | 9,281                                |       | 4.8 | % | 13,389 |   | 6.3 | % |
|                                                            |            |                                      |            |  |  |  |  |  |  |  |  |

 

**Revenue**

 

Ouroperations generated revenues of $212.4 million for the six months ended June 30,2005, an increase of 10.1% compared to the same period in 2004.  During the second quarter of 2004, weacquired KeyPoint Consulting, LLC (“KeyPoint”) as a part of our Healthcare,Regulatory and Legal Compliance segment. KeyPoint contributed approximately $2.6 million to the year over yearrevenue increase.  In addition, aspreviously discussed, during the first half of 2005, we recognized remediationrevenue of $6.8 million related to revenue reversals in previous years.  After considering the positive revenuevariance related to the KeyPoint acquisition and the remediation revenue, ourremaining operations achieved revenue growth of 5.6% during the first half of2005.  This revenue growth resultedprimarily from strong volumes in our information management service offeringand in our project oriented class action claims administration service offeringthat contributed approximately $8.4 million and $6.5 million,respectively.  Including the KeyPointacquisition, project revenue accounted for $82.4 million or 38.8% of revenue inthe current year compared to $68.4 million or 35.5% of revenue in the prioryear. (See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Basis for Management Discussion and Analysis.”)

 

Revenueswithin our Information Management and Distribution segment increased 15.1% from$98.1 million for the six months ended June 30, 2004, to $112.9 millionfor the six months ended June 30, 2005. The increase in segment revenues were primarily the result of: (i) increasedvolumes from existing customers and 2004 new business wins converted to revenueduring 2005, particularly in our healthcare payer, federal and state governmentand mortgage vertical markets, and (ii) the previously discussedremediation revenues of $6.8 million related to revenue reversals in previousyears.  Revenues in the statementprocessing service offering were down slightly when compared to the prior year.

 

Revenueswithin our Healthcare, Regulatory and Legal Compliance segment increased 4.9%from $94.9 million for the six months ended June 30, 2004, to $99.5million for the six months ended June 30, 2005.  As mentioned previously, the acquisition ofKeyPoint contributed approximately $2.6 million to the year over yearincrease.  Also contributing to therevenue increase were higher volumes of medium to large size projects (i.e.projects with total revenue greater than $500k) in our class action claimsadministration

 

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serviceoffering, which increased approximately $6.5 million or 44.0%.  Offsetting increases in segment revenues werelower volumes of approximately $1.7 million related to our medical recordcoding staffing services and lower revenues of approximately $2.9 million inour medical records release services attributable to lower volumes and certaincollectibility issues.

 

**Gross profit**

 

Grossprofit increased 19.6% from $72.8 million, or 37.7% of revenue, for the sixmonths ended June 30, 2004, to $87.1 million, or 41.0% of revenue, for thesix months ended June 30, 2005. Gross margin increased 330 basis points primarily due to: (i) thepreviously discussed remediation revenues of $6.8 million contributing 190basis points, (ii) lower production personnel cost as a percentage ofrevenue contributing 280 basis points and (iii) increased volumes within ourclass action claims administration service offering, which typically produceshigher margins.  Gross margin improvementresulting from personnel costs occurred in our information management serviceoffering due to productivity and quality initiatives which included:  introduction of Lean/Six Sigma qualityinitiatives, implementation of high speed scanning technology to replace laborintensive low speed scanners, implementation of pay for performancecompensation strategies, and increased utilization of offshore labor.

 

Factorspartially offsetting the gross margin improvements were higher facilitiesrelated expenses (an increase of 50 basis points), increased outside servicesprimarily associated with offshore production (an increase of 70 basis points)and higher depreciation expense (an increase of 20 basis points). 

 

**Selling, general and administrative expenses**

 

SG&Aincreased 8.8% from $55.2 million, or 28.6% of revenue, for the six monthsended June 30, 2004, to $60.0 million, or 28.3% of revenue, for the sixmonths ended June 30, 2005. The increase in SG&A expense relatesprimarily: (i) $1.7 million of investigation costs incurred during thecurrent year, (ii) $1.1 million of incremental SG&A related to theKeypoint acquisition which was acquired during the second quarter of 2004, (iii) $0.8million of accounting and related fees associated with ongoing Sarbanes Oxleycompliance related activity and (iv) $5.4 million of higher personnelrelated cost.  We have experienced higherpersonnel related costs as a result of the following: (i) investment inmanagement and sales resources within our class action claims administrationservice offering, (ii) investment in technology and sales resources withinour information management service offering, and (iii) higher incentivecompensation related to recent new business win successes and improved yearover year performance at the operating level. Partially offsetting the increase in SG&A were lower legal expensesof $3.8 million related primarily to the settlement of a significant legalmatter in our Information Management and Distribution segment during the firstquarter of 2004.  

 

**Income from continuing operations before income taxes**

 

Incomefrom continuing operations before income taxes increased from $15.5 million forthe six months ended June 30, 2004 to $23.9 million for the six monthsended June 30, 2005.  The increasewas due to the factors impacting gross profit and SG&A discussedabove.  Offsetting the positive factorswas higher interest expense in the current year of approximately $1.0 milliondue to higher average debt balances and a higher interest rate environment.  Each 100 basis point increase in interestrates results in incremental annual interest expense of approximately $0.8million at current debt levels.

 

**Provision for income taxes**

 

During thesecond quarter of 2005, an adjustment to correct previously recorded deferredtax accounts increased our effective tax rate for the quarter from 39% to49%.  Management determined that theimpact of this adjustment to the prior year’s reported financial statements wasimmaterial; consequently, the entire impact, which was identified as part ofthe quarterly review process, was reflected in the current quarter.  The change in the tax rate affects the secondquarter only.  Our effective tax rate forthe remainder of 2005 is expected to return to approximately 39%, with thefull-year average tax rate at approximately 41%.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

AtJune 30, 2005, we had negative working capital of $44.2 million, including$0.8 million of cash.  Working capital atMarch 31, 2005 was $41.7 million, including $0.2 million of cash.  The key driver resulting in negative workingcapital is current maturities of debt. Our current line of credit agreement is scheduled to mature on April 1,2006, as discussed below, and all outstanding balances under such agreement areclassified as current liabilities at June 30, 2005.  Excluding the impact of the outstandingbalances under our credit facility at June 30, 2005, working capital wouldhave been $44.7 million.  Managementfully expects to replace or refinance the line of credit agreement prior to, orupon, its maturity scheduled for April 1, 2006.

 

Forthe first six months of 2005, net cash provided by operating activities fromcontinuing operations was $6.2 million compared to cash provided by operatingactivities from continuing operations of $4.9 million for the same period in2004.  Improved year over year earningswas the key driver for the increase in operating cash flow.

 

Dayssales outstanding increased 3 business days during the quarter to 46 businessdays at June 30, 2005, compared to 43 business days at March 31, 2005due primarily to slower collections within our Healthcare, Regulatory and LegalCompliance segment.  Excluding thepositive effects of the remediation revenue recognized during the quarter, dayssales outstanding at June 30,

 

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2005,were 47 business days compared to 45 business days at March 31, 2005.

 

Basedon our current expectations of full year operating results and expectationsregarding improvements in accounts receivable collections, we expect to achievean operating cash flow level for 2005 within a range of $30 million to $45million. 

 

Forthe six months ended June 30, 2005, investing activities from continuingoperations consisted of acquisitions of property, plant and equipment of $8.4million, partially offset by divestiture proceeds of $0.8 million andacquisition related payments of $4.3 million. Divestiture proceeds consistedof: (i) $0.2 million associated with the sale of a non-strategic assetgroup related to our litigation services operations during the first quarter of2005 and (ii) the collection in the current year quarter of $0.6 millionof contingent purchase proceeds related to the divestiture of a medical recordsmanagement operation completed during the third quarter of 2004.  Pursuant to the terms of the UIS purchaseagreement approximately $4.3 million of contingent consideration was paid incash to the former shareholders during the three months ended June 30,2005 and approximately $1.0 million of additional contingent considerationremains accrued.  The accrued additionalconsideration is included in accounts payable and accrued liabilities in the condensedconsolidated balance sheets and is expected to be paid in cash by the firstquarter of 2006.

 

Netcash provided by financing activities from continuing operations was $3.0million for the six months ended June 30, 2005.  Borrowings from our line of credit of $109.6million were partially offset by payments on our line of credit and other debtarrangements of $106.6 million.  Weutilize our line of credit to fund general operating requirements of theCompany as well as fund significant investments such as acquisitions or capitalexpenditures.

 

InApril 2001, we entered into a line of credit agreement with Bank of America,SunTrust Bank and Wells Fargo Bank, as co-agents (the “2001 Credit Agreement”).Under this agreement, we could from time to time borrow funds up to$297.5 million through April 2, 2004, subject to certain financialcovenants and ratios. Meeting these requirements is highly dependent uponmaintaining a minimum level of operating results and the continued demand forour services, among other factors.

 

EffectiveApril 3, 2002, we extended $220.0 million of the $297.5 millioncommitment for an additional year to April 2, 2005. In September 2002,additional extensions were granted by member banks, bringing the totalcommitment extended to April 2, 2005, to $290.0 million. Total feespaid in 2002 related to the extensions and amendments to the 2001 CreditAgreement were $0.3 million.

 

EffectiveApril 3, 2003, we extended $230.0 million of the $297.5 millioncommitment to April 1, 2006. During the fourth quarter of 2003, aparticipating bank in the 2001 Credit Agreement assigned $7.5 million ofits commitment to another bank who, effective December 4, 2003, extendedthis commitment to April 1, 2006. Total fees paid in 2003 related to theextensions and amendments to the 2001 Credit Agreement were $0.3 million.

 

AtJune 30, 2005, the remaining commitment under the 2001 Credit Agreement is$237.5 million and is scheduled to mature on April 1, 2006.

 

Asof June 30, 2005, we are in compliance with loan covenants after givingeffect to the amendments and waivers discussed below, which among other thingsprovided for an amended definition of EBITDA. As of June 30, 2005, the availability under the 2001 CreditAgreement was approximately $32.8 million.

 

Ourability to borrow is contingent on certain leverage and fixed cost coverageratios. These ratios were scheduled to become more restrictive beginning in thequarter ended December 31, 2002 with the leverage ratio declining from 3.0times to 2.5 times and the fixed charge coverage ratio increasing from 1.25times to 1.50 times. However, in September 2002, an amendment was approvedthat extended the fixed cost coverage ratio requirement of 1.25 until January 1,2004 and will increase to 1.35 at all times thereafter. In addition to theleverage and fixed cost coverage ratios, we are subject to minimum net worthrequirements. Effective March 26, 2003, an amendment was approved thatallows for the reduction to the minimum net worth requirement for up to$30 million of share repurchases. In addition, effective July 30,2004, an amendment was approved that allows for the reduction to the minimumnet worth requirement for an additional $30 million of share repurchases.

 

Asa result of our internal investigation, described above in “InternalInvestigation”, we were unable to file our September 30, 2004 QuarterlyReport on Form 10-Q within the timeframe prescribed by the SecuritiesExchange Act of 1934.  The failure totimely file the September 30, 2004 Quarterly Report on Form 10-Qresulted in a default under the 2001 Credit Agreement.  We entered into a waiver agreement on November 12,2004 with the lenders party to the 2001 Credit Agreement.  Pursuant to the terms of the waiveragreement, the lenders agreed, among other things, to waive any default underthe 2001 Credit Agreement that resulted from potential non-compliance with adesignated fixed charge coverage ratio, and our failure to timely file ourQuarterly Report on Form 10-Q for the September 30, 2004quarter.  The waiver agreement alsoprovides that during the period that the waiver agreement was in effect, theoutstanding principal amount of the loans under the 2001 Credit Agreement couldnot exceed $112,000,000. The waiver agreement was to expire on March 15, 2005;  however, on March 15, 2005, we enteredinto on Extension and Modification of Waiver to Credit Agreement, whichextended such waiver through March 23, 2005.

 

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Effective March 23,2005, we entered into an amendment to the 2001 Credit Agreement that allows forthe exclusion of certain contingent consideration overpayments to the formerowners of the Operating Subsidiary, as discussed above, from the definition ofEarnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”).Pursuant to the terms of the Company’s 2001 Credit Agreement, EBITDA is used incalculating certain leverage and fixed cost coverage ratios. By not having the March 23,2005 amendment in place, the Company was in a default under the 2001 CreditAgreement due to the Company exceeding the allowable leverage ratio of 2.5times for the quarters ended June 30, 2004 and September 30, 2004 asa result of certain contingent consideration overpayments discussed above in “InternalInvestigation”.  As a result, the Companyclassified the debt under such Credit Agreement as a Current Maturity includedin the current liability section of its balance sheet at June 30 and September 30,2004. Upon entering the March 23, 2005 amendment, the Company cured thedefault under the 2001 Credit Agreement, as such, reclassifying debt under theCredit Agreement as Long-Term Obligations. As the maturity date of the debtunder the 2001 Credit Agreement is April 1, 2006, all debt outstandingunder the 2001 Credit Agreement is classified as a Current Maturity during thesecond quarter of 2005.

 

Management believes thatit has sufficient liquidity from its cash flow and its revolving creditfacility to meet ongoing business needs. Additionally, depending on the mix of stock and cash used in ourstrategic acquisition program, if any, we may need to seek further financingthrough the public or private sale of equity or debt securities.  However, there can be no assurance we couldsecure such financing if and when it is needed or with terms we deemacceptable.

 

InJanuary 2000, we registered on Form S-4 (Registration No. 333-92981)3,012,217 shares of common stock for issuance in connection with ouracquisition program (the “Acquisition Shelf”), of which 1,359,852 shares wereavailable as of June 30, 2005; however, such registration statement mayrequire amendment prior to use.

 

**Critical Accounting Policies**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations arebased on the related consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America. The preparation of the financial statements requiresthe use of estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses.

 

Wehave identified the following critical accounting policies that, as a result ofthe judgments, uncertainties, uniqueness and complexities of the underlyingaccounting standards and operations involved, could result in material changesto our financial condition or results of operations under different conditionsor using different assumptions. We apply a consistent methodology at the end ofeach quarter to determine our account balances that require judgmentalanalysis.

 

**Revenue Recognition.** Revenue is recognized as it becomes realized or realizable and earnedaccording to the criteria provided by Staff Accounting Bulletin 104, *Revenue Recognition*. Revenue recognitionoccurs once persuasive evidence of an arrangement exists, delivery has occurredor services have been rendered, the sales price is fixed or otherwisedeterminable, and collection is reasonably assured. Our revenue-earningsactivities possess project and recurring customer relationships.

 

Project revenue includes one-time projects in which the customerrelationship is not expected to continue after project completion. Projectrevenue is typically based on time and material arrangements. Revenuerecognition occurs at the contractual rates as the labor hours and directexpenses are incurred. Project revenue represents approximately 34% of total2004 revenues and typically occurs within our Healthcare, Regulatory, and LegalCompliance segment.

 

Recurring revenue is characterized by customer relationships that aregenerally for one year and may continue for longer. Recurring revenue istypically based on the transaction volumes provided by our customers at anagreed upon fixed rate per unit. Our customer’s volumes are typically notcontractual or otherwise guaranteed. Revenue recognition occurs once work iscompleted and delivery has occurred or services have been rendered. Recurringrevenue represents 66% of total 2004 revenues and typically occurs within ourInformation Management and Distribution segment.

 

Revenuerecognition policies related to offerings within our Information Management andDistribution segment are based upon objective criteria that do not requiresignificant estimates or uncertainties. For example, business processoutsourcing services are recognized proportionally as services are rendered,based on specific, objective criteria under the contracts for the number ofaccounts or transactions processed. Accordingly, revenues recognized underthese methods do not require the use of significant estimates that aresusceptible to change.

 

Revenue recognition policies within our Healthcare, Regulatory, andLegal Compliance segment are based upon objective criteria that do not requiresignificant estimates or uncertainties. For example, transaction volumes and time and costs under time andmaterial and cost reimbursable arrangements are based on specific, objectivecriteria under the contracts.  Thefollowing outlines specific revenue recognition policies related to certainofferings within this segment:

 

*Medical records release services* — revenue is recognized upon completion ofthe processing of the requested medical records.  Revenue recognition for this service is basedon an agreed upon and in some cases, a regulated rate applied to the number of

 

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recordsprocessed.  When a fee is paid to thehospital, the revenue related to that fee is reported on a net basis inaccordance with Emerging Issues Task Force (“EITF”) 99-19, *Reporting Revenue Gross as a Principal versus Net asan Agent,* due to the fact that: (a) the primary obligation inthe arrangement is borne partially by both the Company and the hospital; (b) theCompany has no discretion with respect to the supplier of the medical record;and (c) the Company is not involved in the determination of product orservice specifications.

 

*Record management services* — revenue is recognized as storage servicesare provided based linear feet of documents stored times a monthly rate forshelf storage and based on a monthly per image rate for images storedelectronically.  We recognize fees forprocessing, retrieval, delivery and return to storage as revenue uponcompletion of the service at the agreed upon rate applied to the unit count ofitems serviced.

 

*Additional healthcare and compliance services* — revenue is recognized for document and dataconversion services as the services are provided based upon an agreed upon rateper patient file applied to the number of files processed.  Storage and archiving fees are recognized asrevenue as the services are provided based upon an agreed upon monthly rate perfile stored or otherwise archived. Revenue related to coding and abstracting of medical records andstaffing services is recognized as the services are provided based on an agreedupon rate applied to the billable hours worked and eligible out-of-pocketexpenses defined by the service agreement. The out-of-pocket expense component is recognized as revenue and cost ofservices on a gross basis in accordance with EITF Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred. *Revenue related to compliance reviews is based primarily onan agreed upon percentage (or commission) of amounts identified and recoveredfrom the third party payers as a fee for services provided.  Revenue is recognized upon successfulrecovery of underpayments to our clients by their managed care and commercialpayers at the agreed upon percentage (or commission).

 

*Class action claims administration services* — revenue is recognized as these services areprovided based on the agreed upon rate applied to the number of hours spentproviding services related to administering the legal settlements and expensesincurred.  The out-of-pocket expensecomponent is recognized as revenue and cost of services on a gross basis inaccordance with EITF Issue 01-14, *IncomeStatement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred. *Inaddition, revenue related to the design and implementation of comprehensivenotification plans is based on an agreed upon percentage (i.e., commission) ofthe cost to place the media communication. Revenue is recognized at the time of public delivery of the notificationthrough the various media outlets at the agreed upon percentage (orcommission).

 

*Professional economic research and litigation services* — revenue is recognized as these services areprovided based on consulting hours worked at agreed upon rates at the timeservices are rendered and expenses are incurred.  The out-of-pocket expense component is recognizedas revenue and cost of services on a gross basis in accordance with EITF Issue01-14, *Income Statement Characterization ofReimbursements Received for “Out-of-Pocket” Expenses Incurred.*

 

Asa part of providing services to our customers, we incurs incidental expensescommonly referred to as “out-of-pocket” expenses. These expenses include itemssuch as airfare, hotels, mileage, etc. and are often reimbursable by ourcustomers. When reimbursable, we record both revenue and direct cost ofservices in accordance with the provisions of EITF Issue 01-14, *Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket’ Expenses Incurred.*

 

Unearnedincome, included in other current liabilities, represents payments from theCompany’s customers in advance of services being provided. Advanced paymentsare deferred as unearned income when received and recognized as revenue asservices are rendered.

 

**Allowance for Doubtful Accounts.**  Theallowance for doubtful accounts is established and maintained based on ourestimate of accounts receivable collectibility. Management estimatescollectibility by specifically analyzing accounts receivable aging and otherhistorical factors that affect collections. Such factors include the historicaltrends of write-offs and recovery of previously written-off accounts, thefinancial strength of the customer and projected economic and marketconditions. The evaluation of these factors involves subjective judgments andchanges in these factors may significantly impact our consolidated financialstatements.

 

**Long-Lived Asset and Other Intangible Asset Impairment.**  Asrequired by SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,*managementcontinually evaluates whether events and circumstances indicate that thecarrying value of long-lived assets and intangible assets may not berecoverable. When events require, management performs the valuation bycomparing the estimated undiscounted future cash flows over the remaining lifeof the long-lived assets and intangible assets to the carrying amount of theasset being evaluated. An impairment loss is recognized if the carrying amountof assets being evaluated exceeds the expected future undiscounted cash flowbased on the difference between the carrying value and fair value..

 

**Goodwill Impairment.**  On January 1, 2002, weadopted SFAS No. 142, *Goodwill andOther Intangible Assets.* This statement states that goodwill andintangible assets that have indefinite useful lives will not be amortized butrather will be tested at least annually for impairment. Our annual impairmenttest is performed at October 31. The impairment test is based on fair value rather than undiscounted cashflows. Additionally, goodwill is tested at a reporting unit level rather thanthe individual operating unit level. A reporting unit is either at theoperating segment level or one reporting level below and could consist ofseveral service

 

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offeringsaggregated into a single reporting unit. Service offerings are aggregated whenthey are similar in the following areas: economic characteristics, products andservices, production processes, methods for distributing or deliveringproducts, and type or class of customers. Valuation methods used in determiningfair value include an analysis of the cash flows that the reporting units canbe expected to generate in the future (Income Approach) and the fair value of areporting unit as compared to similar publicly traded companies (MarketApproach). In preparing these valuations, management utilizes estimates todetermine fair value of the reporting units. These estimates include futurecash flows, growth rates, capital needs, and projected earning margins amongother factors. Estimates utilized in future calculations could differ fromestimates used in the current period. Future years’ estimates that areunfavorable compared to current estimates could cause an impairment of goodwilland other intangible assets. Due to the fact that we are primarily a servicescompany, our business acquisitions typically result in significant amounts ofgoodwill and other intangible assets. Therefore, an impairment charge resultingfrom goodwill or other intangible assets could result in a material adverseimpact on our financial statements during the period incurred.

 

**Self-Insurance Liabilities and Reserves.**  We areself-insured for workmen’s compensation liabilities and a significant portionof our employee medical costs. We account for our self-insurance programs basedon actuarial estimates of the amount of loss inherent in that period’s claims,including losses for which claims have not been reported. These loss estimatesrely on actuarial observations of ultimate loss experience for similarhistorical events. We limit our risk by carrying stop-loss policies forsignificant claims incurred for both workmen’s compensation liabilities andmedical costs. Our exposure under the stop-loss policies for workmen’scompensation and medical costs is limited based on fixed dollar amounts.  For workman’s compensation, the fixed dollaramount of stop-loss coverage is $500,000 per occurrence.  For medical costs, the fixed dollar amount ofstop-loss coverage is $100,000 per covered participant for the fiscal plan yearended June 30,2005, with a lifetime limit of liability per coveredparticipant of $1,900,000.  Our stop-losspolicy for medical costs expired on June 30, 2005.  The stop-loss policy was renewed for oneyear, effective July 1, 2005.  Thefixed dollar amount of stop-loss coverage under the new policy is $200,000 percovered participant with a lifetime limit of liability per covered participantof $1,800,000.

 

**Other Loss Contingencies.**  Werecord liabilities when it is probable that a liability has been incurred andthe amount of the loss is reasonably estimable in accordance with SFAS No. 5,*Accounting for Contingencies*.Disclosure is required when there is a reasonable possibility that the ultimateloss will exceed the recorded provision. Contingent liabilities are oftenresolved over long periods of time. Estimating probable losses requiresanalysis of multiple forecasts that often depend on judgments about potentialactions by third parties such as regulators. Our loss contingencies consistprimarily of estimates related to the probable outcome of current litigation.

 

**RISKS ASSOCIATED WITH FORWARD-LOOKING STATEMENTS**

 

ThisReport contains certain forward-looking statements such as our intentions,hopes, beliefs, expectations, strategies, predictions or any other variationthereof or comparable phraseology of our future activities or other futureevents or conditions within the meaning of Section 27A of the SecuritiesAct of 1933, as amended (the “Act”), and Section 21E of the SecuritiesExchange Act of 1934, as amended, which are intended to be covered by the safeharbors created thereby. Investors are cautioned that all forward-lookingstatements involve risks and uncertainty, including, without limitation, theactual final costs of our internal investigation, the Company’s ongoing SECinvestigation, the potential impairment of our ability to enter into governmentcontracts as a result of the conduct that was the subject of our investigation,remediation costs relating to our investigation, the potential customer impactof the results of our investigation, the effect of our investigation andfinancial statement restatement on the trading price of our stock, the risk of integrating our operatingcompanies, of managing our rapid growth, of the timing and magnitude of technologicaladvances, of the occurrences of future events that could diminish our customers’needs for our services, of a change in the degree to which companies continueto outsource business processes, of an adverse outcome in any given legalproceeding or claim, of the denial of insurance on a particular claim or of aparty obligated to provide indemnification being financially unable to do so,as well as such other risks set forth under the heading Risk Factors includedin our most recent annual report on Form 10-K.

 

Althoughwe believe that the assumptions underlying the forward-looking statementscontained herein are reasonable, any of the assumptions could be inaccurate,and, therefore, there can be no assurance that the forward-looking statementsincluded in this Report will prove to be accurate. In light of the significantuncertainties inherent in the forward-looking statements included herein, theinclusion of such information should not be regarded as a representation by usor any other person that our objectives and plans will be achieved. Further, wedisclaim any obligation to update any such forward-looking statements, exceptas required by law.

 

**Item 3****.**                **Quantitative and QualitativeDisclosures about Market Risk**

 

Weare subject to interest rate risk on our term loans, revolving credit facilityand Industrial Revenue Bonds. A 100 basis point increase in short-term interestrates would result in approximately $0.8 million of additional expense in 2005based on our expected average balance outstanding under the credit facilityduring 2005. Interest rates are fixed on the capitalized lease obligations.

 

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**Item 4****.**           **Controls and Procedures**

 

*(a) Evaluation of disclosure controlsand procedures.*

 

The Company maintains disclosure controls and procedures, which it hasdesigned to ensure that material information related to the Company, includingits consolidated subsidiaries, is made known to a group comprised of designatedmembers of the Company’s senior management, designated members of functionaldivisions of the Company, and/or the certifying officers (i.e. Chief ExecutiveOfficer and Chief Financial Officer) (collectively, the “Disclosure Committee”),on a timely basis and that information required to be disclosed in reports itfiles under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms.  As of June 30, 2005, theCompany carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedurespursuant to Securities Exchange Act of 1934, as amended, Rule 13a-15 and15d-15. Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective in timely alerting them to material informationrelating to the Company (including its consolidated subsidiaries) required tobe included in the Company’s periodic SEC Filings.  Because of the inherent limitations ofdisclosure controls, including the possibility of collusion or impropermanagement override of controls, no matter how comprehensive or well designedsuch controls are, management may not in all cases be alerted to materialinformation relating to the Company (including its consolidated subsidiaries)required to be included in the Company’s periodic SEC filings.

 

*(b) Changes in internal controls.*

 

During the most recent fiscal quarter, there have been no changes tothe Company’s internal controls over financial reporting that occurred sincethe beginning of the Company’s first quarter of 2005 that have materiallyaffected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

However, during the second quarter of 2005, the following changes weremade to the Company’s internal control environment as a result of its policy ofcontinuous control improvement:

 

•                  Management implemented a Control Self Assessmentprocess whereby financial control owners of each operating unit and thecorporate office must review significant control documentation on a quarterlybasis and verify or update the process documentation.  The control ownersmust also verify that the processes occurred as documented during the fiscalquarter.  Senior management then reviews process changes and verificationsduring the quarterly compliance process prior to quarterly certification. 

 

•                  General ledger accounting functions for the anoperating subsidiary within the Information Management and Distribution segmentwere consolidated to the corporate office during the fiscal quarter.

 

In addition,certain personnel changes occurred after the current fiscal quarter.  

 

•                  The Company’s Chief Accounting Officer (“CAO”)resigned from the Company, effective July 29, 2005, after the end of thefiscal quarter, but prior to filing the quarterly financial statements.  Areorganization of the Accounting and Finance function resulted in replacing theCAO with a Vice President and Corporate Controller position and a VicePresident of Operation Financial Planning and Analysis position.

 

**PART II.OTHER INFORMATION**

** **

**Item 1.**                     **Legal Proceedings**

 

Weare, from time to time, a party to litigation. The following is a descriptionof the most significant legal matters that we are involved in.  In the event of an adverse outcome in one ormore of our legal proceedings our business, financial condition, results ofoperations or cash flows could be materially adversely affected.

 

### ***Jana Suit***

 

In July 2005, three affiliatedstockholders filed suit against the Company and its directors alleging that theadoption by the Company of recent amendments to its Bylaws and the adoption ofits shareholder Rights Agreement constituted a breach of fiduciary duties.  The suit was styled *Jana Partners LLC, Jana Piranha Master Fund, Ltd. andJana Master Fund, Ltd. v. SOURCECORP, Incorporated, Thomas C. Walker, Ed H.Bowman, Jr., G. Michael Bellenghi, Michael J. Bradley, David Lowenstein,Donald F. Moorehead, Jr. and Edward M. Rowell* and was filed inthe Court of Chancery for the State of Delaware in and for New CastleCounty.  The suit did not seek monetarydamages other than costs, such as attorneys’ fees.  On August 9, 2005, Jana dismissed this suitwithout prejudice.

 

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### ***Putative Securities Class Action***

### ** **

TheCompany, and the Company’s CEO and CFO individually, have been named asdefendants in several putative securities class actions, in response to theCompany’s press releases dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. Thecomplaints (collectively, the “Actions”) were filed in the United StatesDistrict Court for the Northern District of Texas, Dallas Division, with thefirst action being filed November 1, 2004. The Actions are putativeshareholder class action lawsuits alleging violations of Federal SecuritiesLaws, including alleged violations of Sections 10(b) and 20(a), and Rule 10b-5of the Securities Exchange Act of 1934, as amended.  The four Actions have been transferred to asingle judge in the Northern District of Texas, Dallas Division, these actionshave been consolidated into a single action now styled *In re Sourcecorp, Inc. Securities Litigation,*and a lead plaintiff has been appointed. The consolidated Action is purportedly on behalf of all persons whopurchased the Company’s common stock during the period between May 3, 2001,and October 27, 2004, and seeks unspecified damages.  The Company intends to vigorously defend thismatter.

 

#### ***Purported Derivative Action and Demand Letter***

#### ** **

Apurported stockholder derivative action was filed on December 28, 2004,against certain of the Company’s current and former officers and directors asindividual defendants and the Company as a nominal defendant in the 116thDistrict Court for Dallas County, Texas (the “Purported Derivative Action”).The Purported Derivative Action alleges breach of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of assets, and unjust enrichment related tothe Company’s press release dated October 27, 2004, in which the Companydisclosed that its financial statements for certain prior periods should nolonger be relied upon, and also provided updated financial guidance. All ofthese claims are asserted derivatively on behalf of the Company and seeksunspecified damages against those individuals. Further, the Chairman of the Company’s Board of Directors received froma purported shareholder a demand letter (the “Demand Letter”) based on the sameset of facts as the Purported Derivative Action.  The Demand Letter requests the Board to takecertain action, but does not seek damages against the Company.  The Company has formed a special committee ofthe Board of Directors that is evaluating the claims made in the PurportedDerivative Action and the Demand Letter.

 

*DigitalImaging Systems*

 

OnAugust 5, 2004, Digital Imaging Systems, Inc. filed suit against theCompany in the United States District Court-Southern District of New Yorkalleging, among other things, that a portion of the Company’s process forscanning and indexing images violates one of Digital Imaging Systems’patents.  The plantiff in this matterfiled to dismiss this matter with prejudice in June 2005, which the Judgeapproved in July 2005.  As such, theCompany views this matter as closed.

 

*Various ROI Copy Charge Matters*

 

Fromtime to time, various subsidiaries of the Company that perform release ofinformation (“ROI”) services become defendants to putative class actionlawsuits generally alleging that the charge for reproducing certain medicalrecords is not in conformity with such plaintiffs’ reading of the applicableregulated charge. Such suits typically include multiple ROI companies andhospitals as defendants and demand reimbursement for prior charges as well asfor prospective pricing adjustments. The Company is currently a party toseveral such suits in various stages of development.

 

Onesuch suit originally styled*McShane v. RecordexAcquisition Corp. &**Sourcecorp, Incorporated*(and now styled *Liss & Marion, PC v. RecordexAcquisition Corp., & Sourcecorp, Inc.*) filed February 10,2003, in the Court of Common Pleas Philadelphia County, Pennsylvania, allegesamong other things that the Company intentionally charged more for providingcopies of medical records than is permitted under Pennsylvania law.  The complaint does not specify the amount ofdamages sought.  On June 10, 2005,the Court in this matter granted judgment in favor of the plantiffs for anamount as yet to be determined.  TheCompany has filed a motion for clarification of the Court’s order and if andwhen a judgement is entered, the Company will assess its appeallate options.

* *

*SEC Investigation*

* *

OnJanuary 14, 2005, the Company received written confirmation from the SECthat the SEC had converted its informal inquiry in connection with the Company’sinternal investigation and restatement into a formal investigation. The Companyintends to fully cooperate with the SEC in connection with the investigation.The Company initially had contacted the enforcement division of the SEC on avoluntary basis to notify the agency of the Company’s understanding of theevents leading to its internal investigation. The Company is unable to predictthe outcome of the investigation, the scope of matters that the SEC may chooseto investigate in the course of this investigation or in the future, the SEC’sviews of the issues being investigated, or any action that the SEC might take,including the imposition of fines, penalties, or other available remedies.

 

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**Item 2.****          ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

Items2(a) and (b) are inapplicable.

 

(c) STOCKREPURCHASES

 
| **Period**                                | ** ** | **(a) Total Number of  Shares Purchased** | ** ** | **(b) Average  Price Paid per  Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number of Shares (or  Approximate Dollar Value of Shares)  that May Yet Be Purchased Under  the Plans or Programs** | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                      |       |                                           |       |                                        |       |                                                                                                   |       |                                                                                                                                        |       |
| Apr 1, 2005 – Apr 30, 2005           |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |
| May 1, 2005 – May 31, 2005 |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |
| Jun 1, 2005 – Jun 30, 2005           |       | —                                         |       | $                                           | —     |                                                                                                   | —     |                                                                                                                                        | $          | 17,415,551 |   |

 

**Item4.  Submission of Matters to a Vote of Security Holders**

 

On May 23, 2005, weheld our annual meeting of stockholders. The stockholders elected seven (7) directors.The director nominees received the following votes:

 
| ** **                    | ** ** | **Number of Votes** | ** ** |
|-------------------------------|------------|---------------------|------------|
| **Nominee**                   | ** ** | **For**             | ** ** | **Against/Withheld** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
| Ed H. Bowman, Jr.        |       | 14,571,377          |       | 221,422 |   | — |   | — |   |
| G. Michael Bellenghi          |       | 14,201,521          |       | 591,010 |   | — |   | 268 |   |
| Michael J. Bradley            |       | 14,230,383          |       | 562,148 |   | — |   | 268 |   |
| David Lowenstein              |       | 13,750,190          |       | 1,042,609 |   | — |   | — |   |
| Donald F. Moorehead, Jr. |       | 14,170,899          |       | 621,632 |   | — |   | 268 |   |
| Hon. Edward M. Rowell         |       | 14,613,239          |       | 179,292 |   | — |   | 268 |   |
| Thomas C. Walker              |       | 14,224,127          |       | 568,672 |   | — |   | — |   |

 

Additionally, the appointment of Deloitte &Touche LLP as the Company’s independent registered public accounting firm forthe fiscal year ending December 31, 2005 was ratified with the followingvotes:

 
| **Number of Votes** | ** ** |
|---------------------|------------|
| **For**             | ** ** | **Against/Withheld** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|                |       |   |   |   |   |   |   |
| 14,256,041          |       | 526,126 |   | 10,364 |   | 268 |   |

 

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**Item 6.**           **Exhibits**

 

(a) Exhibits

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.1                 |       | Restated  Certificate of Incorporation of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment  No.1 to the Company’s Registration Statement on Form 8-A filed on  February 15, 2002)                                                                                                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 3.2                 |       | Amended  and Restated By-Laws of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s  Current Report on Form 8-K filed on June 27, 2005)                                                                                                                                                                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 3.3                 |       | Form of  Rights Agreement, dated as of June 24, 2005, between the Company and  American Stock Transfer & Trust Company which includes as  Exhibit A the form of Certificate of Designation of Series A  Participating Preferred Stock, as Exhibit B the form of Right  Certificate and as Exhibit C the summary of Rights to Purchase  Series A Participating Preferred Stock (Incorporated by reference to  Exhibit 4.1 to the Company’s Registration Statement on Form 8-A  filed June 27, 2005) |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 4                   |       | Specimen  certificate for the Common Stock, par value $.01 per share, of the  Registrant. (Incorporated by reference to Exhibit 99.1 to Amendment  No. 1 to the Company’s Registration Statement on Form 8-A filed on  February 15, 2002)                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.1*               |       | Consulting  Agreement Second Amended Addendum effective as of December 18, 2004,  supplement to, and modification of, that certain Consulting agreement by and  between F.Y.I. Incorporated (n/k/a SOURCECORP, Incorporated) and David  Lowenstein, dated January 1, 2000                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.2*               |       | Non-Employee  Director’s Compensation Summary                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.1                |       | Certification  Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.2                |       | Certification  Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.1                |       | Certification  Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.2                |       | Certification  Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

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* Compensatory plan or arrangement.

 

28

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this Report on Form 10-Q to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                        | SOURCECORP,  INCORPORATED |
|-----------------------------|---------------------------|
|                        |                      |   |
| Date:  August 10, 2005 | By:                       | /s/ ED H. BOWMAN, JR. |
|                        |                      | Ed H. Bowman, Jr. Chief Executive  Officer and President |
|                        |                      |   |
| Date:  August 10, 2005 | By:                       | /s/ BARRY L. EDWARDS |
|                        |                      | Barry L. Edwards Executive Vice  President and Chief Financial Officer  (Principal Financial and Accounting  Officer) |

 

29

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**INDEX TOEXHIBITS**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.1                |       | Restated Certificate of  Incorporation of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 99.3 to Amendment  No.1 to the Company’s Registration Statement on Form 8-A filed on  February 15, 2002)                                                                                                                                                                                                                                                                                                                          |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.2                |       | Amended and Restated  By-Laws of *SOURCECORP*,  Incorporated (Incorporated by reference to Exhibit 3.2 to the Company’s Current  Report on Form 8-K filed on June 27, 2005)                                                                                                                                                                                                                                                                                                                                                                   |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.3                |       | Form of Rights  Agreement, dated as of June 24, 2005, between the Company and American  Stock Transfer & Trust Company which includes as Exhibit A the  form of Certificate of Designation of Series A Participating Preferred  Stock, as Exhibit B the form of Right Certificate and as Exhibit C  the summary of Rights to Purchase Series A Participating Preferred Stock  (Incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form 8-A filed June 27, 2005) |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4                  |       | Specimen certificate for  the Common Stock, par value $.01 per share, of the Registrant. (Incorporated  by reference to Exhibit 99.1 to Amendment No. 1 to the Company’s  Registration Statement on Form 8-A filed on February 15, 2002)                                                                                                                                                                                                                                                                                                 |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1*              |       | Consulting Agreement  Second Amended Addendum effective as of December 18, 2004, supplement  to, and modification of, that certain Consulting agreement by and between  F.Y.I. Incorporated (n/k/a SOURCECORP, Incorporated) and David Lowenstein,  dated January 1, 2000                                                                                                                                                                                                                                                                               |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.2*              |       | Non-Employee Director’s  Compensation Summary                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31.1               |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31.2               |       | Certification Pursuant to section 302 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.1               |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|               |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.2               |       | Certification Pursuant to section 906 of Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

----

* Compensatory plan or arrangement.

 

30

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