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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****Form 10-Q**(Mark One)   þ **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934******For the quarterly period ended June 30, 2008******OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****Commission File Number: 1-14316****APRIA HEALTHCARE GROUP INC.***(Exact name of registrant as specified in its charter)*   **Delaware** **33-0488566***(State or Other Jurisdiction of* *(I.R.S. Employer**Incorporation or Organization)* *Identification Number)*   **26220 Enterprise Court, Lake Forest, CA** **92630***(Address of Principal Executive Offices)* *(Zip Code)***Registrant’s telephone number: (949) 639-2000**Indicate by check mark whether the registrant: (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No oIndicate by check mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of theExchange Act. (Check one):       Large Accelerated Filer þ Accelerated Filer o Non-Accelerated Filer o Smaller Reporting Company o    (Do not check if a smaller reporting company)  Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 ofthe Exchange Act). Yes o No þAsof September 10, 2008, there were outstanding 43,949,271 shares of the Registrant’s commonstock, par value $.001 per share, which is the only class of common stock of the Registrant (notincluding 17,112,574 shares held in treasury).  
 
 

 
**APRIA HEALTHCARE GROUP INC.****FORM 10-Q****For the period ended June 30, 2008**       **Page** **PART I. FINANCIAL INFORMATION**         Item 1. Financial Statements (unaudited)  4      **•** Condensed Consolidated Balance Sheets  4      **•** Condensed Consolidated Income Statements  5      **•** Condensed Consolidated Statements of Cash Flows  6      **•** Notes to Unaudited Condensed Consolidated Financial Statements  7      Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  21      Item 3. Quantitative and Qualitative Disclosures About Market Risk  37      Item 4. Controls and Procedures  38      **PART II. OTHER INFORMATION**         Item 1. Legal Proceedings  38      Item 1A. Risk Factors  39      Item 2. Unregistered Sale of Equity Securities and Use of Proceeds  41      Item 3. Defaults Upon Senior Securities  41      Item 4. Submission of Matters to a Vote of Security Holders  41      Item 5. Other Information  42      Item 6. Exhibits  43      SIGNATURES  44      **EXHIBITS INDEX AND EXHIBITS**  45       Exhibit 31.1 Exhibit 31.2 Exhibit 32.1 Exhibit 32.2
 
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**Cautionary statement for purposes of the “Safe Harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995:**Our business is subject to a number of risks which are partly orentirely beyond our control. We have described certain of those risks in our Annual Report on Form10-K/A for the fiscal year ended December 31, 2007, as filed with the Securities and ExchangeCommission on February 29, 2008. That report, as supplemented by the information set forth in thisQuarterly Report on Form 10-Q, including Part II, Item 1A, “Risk Factors,” may be used for purposesof the Private Securities Litigation Reform Act of 1995 as a readily available document containingmeaningful cautionary statements identifying important factors that could cause actual results todiffer materially from those projected in any forward-looking statements we may make from time totime. In some cases, forward-looking statements contain terminology such as “may,” “should,”“could,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,”or “continue” or variations of these terms or other comparable terminology. Key factors that mayhave an impact on us include the following:**•** trends and developments affecting the collectibility of accounts receivable; **•** government legislative and budget developments that could continue to affect reimbursementlevels; **•** potential reductions in reimbursement rates by government and third-party payors; **•** the effectiveness of our operating systems and controls; **•** healthcare reform and the effect of federal and state healthcare regulations; **•** economic and political events, international conflicts and natural disasters; **•** acquisition-related risks; **•** the failure to complete the proposed merger described herein; and **•** other factors described in our filings with the Securities and Exchange Commission.
 
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**PART I — FINANCIAL INFORMATION****ITEM 1.*****FINANCIAL STATEMENTS*****APRIA HEALTHCARE GROUP INC.****CONDENSED CONSOLIDATED BALANCE SHEETS****(Unaudited)****(Dollars in thousands, except share data)**           **June 30,**  **December 31,**   **2008**  **2007** **ASSETS**        CURRENT ASSETS        Cash and cash equivalents $23,061  $28,451 Accountsreceivable, less allowance for doubtful accounts of $32,962and $47,823 at June 30, 2008 and December 31, 2007, respectively  296,199   284,141 Inventories, net  49,515   52,079 Deferred income taxes  49,692   66,198 Deferred expenses  2,908   3,102 Prepaid expenses and other current assets  14,456   23,364        TOTAL CURRENT ASSETS  435,831   457,335 PATIENT SERVICE EQUIPMENT, less accumulated depreciation of $438,843 and$453,324 at June 30, 2008 and December 31, 2007, respectively  204,971   200,180 PROPERTY, EQUIPMENT AND IMPROVEMENTS, net  120,503   102,827 GOODWILL  715,120   715,235 INTANGIBLEASSETS, less accumulated amortization of $9,263 and $7,907 at June30, 2008 and December 31, 2007, respectively  105,683   107,757 DEFERRED DEBT ISSUANCE COSTS, net  5,025   2,834 OTHER ASSETS  13,395   11,634          $1,600,528  $1,597,802        **LIABILITIES AND STOCKHOLDERS’ EQUITY**        CURRENT LIABILITIES        Accounts payable $129,166  $120,360 Accrued payroll and related taxes and benefits  62,468   66,625 Income taxes payable  1,249   3,076 Other accrued liabilities  74,873   73,835 Deferred revenue  30,471   29,704 Current portion of long-term debt  253,806   254,252        TOTAL CURRENT LIABILITIES  552,033   547,852 LONG-TERM DEBT, net of current portion  371,184   433,031 DEFERRED INCOME TAXES  80,646   62,290 INCOME TAXES PAYABLE AND OTHER NON-CURRENT LIABILITIES  34,711   42,604        TOTAL LIABILITIES  1,038,574   1,085,777 COMMITMENTS AND CONTINGENCIES (Note 12)        STOCKHOLDERS’ EQUITY        Preferred stock, $.001 par value: 10,000,000 shares authorized; none issued  —   — Common stock, $.001 par value: 150,000,000 shares authorized; 61,043,341and 60,844,901 shares issued at June 30, 2008 and December 31, 2007,respectively; 43,935,741 and 43,794,492 shares outstanding at June 30,2008 and December 31, 2007, respectively  61   61 Additional paid-in capital  522,175   514,848 Treasury stock, at cost; 17,107,600 and 17,050,409 shares at June 30, 2008and December 31, 2007, respectively  (432,915)  (431,651)Retained earnings  472,464   428,538 Accumulated other comprehensive income  169   229        TOTAL STOCKHOLDERS’ EQUITY  561,954   512,025          $1,600,528  $1,597,802        See notes to unaudited condensed consolidated financial statements.
 
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**APRIA HEALTHCARE GROUP INC.****CONDENSED CONSOLIDATED INCOME STATEMENTS****(Unaudited)**                   **Three Months Ended**  **Six Months Ended**   **June 30,**  **June 30,** **(in thousands, except per share data)** **2008**  **2007**  **2008**  **2007**       (As Restated      (As Restated       — See Note 3)      — See Note 3) Net revenues:                Fee for service/product arrangements $488,078  $350,619  $973,434  $700,114 Capitation arrangements  43,170   41,310   85,792   82,594              TOTAL NET REVENUES  531,248   391,929   1,059,226   782,708              Costs and expenses:                Cost of net revenues:                Product and supply costs  159,557   90,840   315,461   181,731 Patient service equipment depreciation  26,918   27,257   54,095   55,267 Home respiratory therapy services  9,640   9,638   19,059   18,976 Nursing services  8,513   2,262   17,566   4,366 Other  4,832   4,434   8,549   8,708              TOTAL COST OF NET REVENUES  209,460   134,431   414,730   269,048 Provision for doubtful accounts  5,271   11,093   15,952   20,791 Selling, distribution and administrative  271,819   209,312   540,480   415,792 Amortization of intangible assets  1,049   706   2,117   1,698              TOTAL COSTS AND EXPENSES  487,599   355,542   973,279   707,329              OPERATING INCOME  43,649   36,387   85,947   75,379 Interest expense  5,556   5,722   13,872   12,042 Interest income and other  (362)  (722)  (870)  (1,216)             INCOME BEFORE TAXES  38,455   31,387   72,945   64,553 Income tax expense  15,300   12,136   29,018   24,452              NET INCOME $23,155  $19,251  $43,927  $40,101              Basic net income per common share $0.53  $0.44  $1.00  $0.92              Diluted net income per common share $0.52  $0.44  $0.99  $0.91              See notes to unaudited condensed consolidated financial statements.
 
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**APRIA HEALTHCARE GROUP INC.****CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)**           **Six Months Ended**   **June 30,** **(in thousands)** **2008**  **2007**       **(As Restated**       **— See Note 3)** OPERATING ACTIVITIES        Net income $43,927  $40,101 Items included in net income not requiring cash:        Provision for doubtful accounts  15,952   20,791 Depreciation and amortization  70,182   67,049 Amortization of deferred debt issuance costs  889   889 Deferred income taxes  33,863   5,607 Share-based compensation  7,271   4,664 Loss (gain) on disposition of assets and other  7,980   (138)Excess tax benefits from share-based compensation  (207)  (3,911)Changes in operating assets and liabilities        Accounts receivable  (16,110)  (21,001)Inventories, net  2,564   2,062 Prepaid expenses and other assets  7,144   4,712 Accounts payable, exclusive of book-cash overdraft  7,754   3,566 Accrued payroll and related taxes and benefits  (5,323)  (815)Income taxes payable  (9,276)  7,970 Deferred revenue, net of related expenses  960   1,291 Accrued expenses  (10,142)  (1,227)       NET CASH PROVIDED BY OPERATING ACTIVITIES  157,428   131,610        INVESTING ACTIVITIES        Purchases of patient service equipment and property, equipment and improvements  (96,301)  (55,811)Proceeds from disposition of assets  53   52 Cash paid for acquisitions  (3,036)  —        NET CASH USED IN INVESTING ACTIVITIES  (99,284)  (55,759)       FINANCING ACTIVITIES        Proceeds from revolving credit facilities  7,600   — Payments on revolving credit facilities  (67,600)  (80,000)Payments on other long-term debt  (2,293)  (2,145)Change in book-cash overdraft included in accounts payable  1,249   (345)Capitalized debt issuance costs  (3,079)  — Excess tax benefits from share-based compensation  207   3,911 Issuances of common stock  382   16,554        NET CASH USED IN FINANCING ACTIVITIES  (63,534)  (62,025)       NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS  (5,390)  13,826 Cash and cash equivalents at beginning of period  28,451   14,657        CASH AND CASH EQUIVALENTS AT END OF PERIOD $23,061  $28,483        SUPPLEMENTAL DISCLOSURES — See Note 7 and Note 10 for cash paid for interest and income taxes,respectively.NON-CASH TRANSACTIONS — See Note 8 for tax benefits from stock option exercises and non-cashcommon stock and treasury stock transactions.Purchases of patient service equipment and property, equipment and improvements excludepurchases that remain unpaid at the end of the respective quarter. Such amounts are then includedin the following period’s purchases when paid. Unpaid purchases were $13,181 and $10,994 at June30, 2008 and December 31, 2007, respectively.See notes to unaudited condensed consolidated financial statements.
 
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**APRIA HEALTHCARE GROUP INC.****NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS****NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES***Basis of Presentation:*The accompanying consolidated financial statements have been preparedin accordance with accounting principles generally accepted in the United States of America. Thesestatements include the accounts of Apria Healthcare Group Inc. (“Apria” or “the Company”) and itssubsidiaries. Intercompany transactions and accounts have been eliminated in consolidation. Thethree and six months ended June 30, 2007, respectively, have been restated, see Note 3 to theseunaudited condensed consolidated financial statements.All adjustments, consisting of normal recurring accruals necessary for a fair presentation ofthe results of operations for the interim periods presented, have been reflected herein. Theunaudited results of operations for interim periods are not necessarily indicative of the resultsto be expected for the entire year. For further information, refer to the consolidated financialstatements and notes thereto included in the Company’s Annual Report on Form 10-K/A for the fiscalyear ended December 31, 2007.*Use of Accounting Estimates:*The preparation of financial statements in conformity withaccounting principles generally accepted in the United States of America requires management tomake estimates and assumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results could materially differ from those estimates.*Revenue Recognition and Concentration of Credit Risk:*Revenues are recognized under fee forservice/product arrangements through equipment the Company rents to patients, sales of equipment,supplies, pharmaceuticals and other items the Company sells to patients and through capitationpayments received from third party payors for services and equipment the Company provides to thepatients of these payors. Revenue generated from equipment that the Company rents to patients isrecognized over the rental period, typically one month, and commences on delivery of the equipmentto the patients. Revenue related to sales of equipment, supplies and pharmaceuticals is recognizedon the date of delivery to the patients. Revenues derived from capitation arrangements wereapproximately 8% of total net revenues for the three and six months ended June 30, 2008 and 11% forthe three and six months ended June 30, 2007, respectively. Capitation revenue is earned as aresult of entering into a contract with a third party to provide its members certain serviceswithout regard to the actual services provided, therefore revenue is recognized in the period thatthe beneficiaries are entitled to health care services. All revenues are recorded at amountsestimated to be received under reimbursement arrangements with third-party payors, includingprivate insurers, prepaid health plans, Medicare and Medicaid. For the six months ended June 30,2008 and 2007, revenues reimbursed under arrangements with Medicare and Medicaid were approximately32% and 35%, respectively, as a percentage of total revenues. In both periods presented, no otherthird-party payor group represented more than 9% of the Company’s revenues. Rental and salerevenues in the fee for service/product arrangement revenue line item were approximately$188,296,000 or 38.6% and $299,782,000 or 61.4%, respectively, in the three months ended June 30,2008, $179,847,000 or 51.3% and $170,772,000 or 48.7%, respectively, in the three months ended June30, 2007, $373,507,000 or 38.4% and $599,927,000 or 61.6%, respectively, in the six months endedJune 30, 2008 and $360,838,000 or 51.5% and $339,276,000 or 48.5%, respectively in the six monthsended June 30, 2007.Emerging Issues Task Force (“EITF”) Topic 00-21, “*Revenue Arrangements with MultipleDeliverables,”*addresses the accounting for revenues in which multiple products and/or services aredelivered at different times under one arrangement with a customer, and provides guidance indetermining whether multiple deliverables should be considered as separate units of accounting. Inthe Company’s business, there are multiple products that are delivered to patients. Thesearrangements involve equipment that is rented and related supplies that may be sold that cannot bereturned. In the Company’s revenue recognition policy regarding arrangements with multipledeliverables, revenue is recognized when each deliverable is provided to the patient. For example,revenues from equipment rental supplies sales are recognized upon delivery of the products, as thesupplies sold are considered a separate unit of accounting.*Deferred Revenue and Deferred Expense:*Rental of equipment to patients is accounted for underStatement of Financial Accounting Standards (“SFAS”) No. 13, “*Accounting for Leases.”*Under SFASNo. 13, a lessor is required to recognize rental income over the lease term. Rental of patientequipment is billed on a monthly basis beginning on the date the equipment is delivered. Sincedeliveries can occur on any day during a month, the amount of billings that apply to the next monthare deferred.
 
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The accounting for the deferral of expenses by lessors is addressed by SFAS No. 91 *“Accountingfor Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial DirectCosts of Leases.”*Only the direct costs associated with the initial rental period are deferred inaccordance with SFAS No. 91.*Cash and Cash Equivalents:*Cash is maintained with various financial institutions. Thesefinancial institutions are located throughout the United States and the Company’s cash managementpractices limit exposure to any one institution. Book cash overdrafts, which are reported as acomponent of accounts payable, were $15,477,000 and $14,228,000 at June 30, 2008 and December 31,2007, respectively. Management considers all highly liquid instruments purchased with a maturity ofless than three months to be cash equivalents.*Accounts Receivable:*Included in accounts receivable are earned but unbilled receivables of$51,066,000 and $48,262,000 at June 30, 2008 and December 31, 2007, respectively. Delays rangingfrom a day up to several weeks between the date of service and billing can occur due to delays inobtaining certain required payor-specific documentation from internal and external sources. Earnedbut unbilled receivables are aged from date of service and are considered in the analysis ofhistorical performance and collectibility.Due to the nature of the industry and the reimbursement environment in which the Companyoperates, certain estimates are required to record net revenues and accounts receivable at theirnet realizable values. Inherent in these estimates is the risk that they will have to be revised orupdated as additional information becomes available. Specifically, the complexity of manythird-party billing arrangements and the uncertainty of reimbursement amounts for certain servicesfrom certain payors may result in adjustments to amounts originally recorded. Such adjustments aretypically identified and recorded at the point of cash application, claim denial or account review.Management performs periodic analyses to evaluate accounts receivable balances to ensure thatrecorded amounts reflect estimated net realizable value. Specifically, management considershistorical realization data, accounts receivable aging trends, other operating trends, the extentof contracted business and business combinations. Also considered are relevant business conditionssuch as governmental and managed care payor claims processing procedures and system changes.Additionally, focused reviews of certain large and/or problematic payors are performed. Due tocontinuing changes in the healthcare industry and third-party reimbursement, it is possible thatmanagement’s estimates could change in the near term, which could have an impact on operations andcash flows.Accounts receivable are reduced by an allowance for doubtful accounts which provides for thoseaccounts from which payment is not expected to be received, although services were provided andrevenue was earned. Upon determination that an account is uncollectible, it is written-off andcharged to the allowance.Beginningwith the quarter ended June 30, 2008, the Company corrected theclassification of certain obligations to its payors reclassifying theobligation from a reduction to accounts receivable to other accruedliabilities. The correction wasnot material to the condensed consolidated balance sheet as ofJune 30, 2008. No correction has been made to any prior periods.*Capitalized Software:*Included in property, equipment and improvements are costs related tointernally developed and purchased software that are capitalized and amortized over periods thatthe assets are expected to provide benefit and are accounted for under Statement of Position No.98-1, “*Accounting for the Costs of Computer Software Developed or Obtained for Internal Use*.”Capitalized costs include direct costs of materials and services incurred in developing orobtaining internal-use software and payroll and benefit costs for employees directly involved inthe development of internal-use software. Additions to capitalized software, including capitalizedinterest, totaled $8,779,000 and $14,697,000 for the three and six months ended June 30, 2008,respectively.*Home Respiratory Therapy Expenses:*Home respiratory therapy expenses presented within cost ofnet revenues are comprised primarily of employee salary and benefit costs or contract fees paid torespiratory therapists and other related professionals who are deployed to service a patient. Homerespiratory therapy personnel are also engaged in a number of administrative and marketing tasks,and accordingly, these costs are classified within selling, distribution and administrativeexpenses and amounted to $5,263,000 and $4,873,000 for the three month periods ended June 30, 2008and 2007, respectively, and $10,787,000 and $9,729,000 for the six month periods ended June 30,2008 and 2007, respectively.*Distribution Expenses:*Distribution expenses are included in selling, distribution andadministrative expenses and totaled $48,572,000 and $43,880,000 for the three months ended June 30,2008 and 2007, respectively, and $96,481,000 and $87,597,000 for the six month periods ended June30, 2008 and 2007, respectively. Such expenses represent the cost incurred to coordinate anddeliver products and services to patients. Included in distribution expenses are leasing,maintenance, licensing and fuel costs for the vehicle fleet; salaries and other costs related todrivers and dispatch personnel; and amounts paid to courier and other outside shipping vendors.Such expenses fall within the definition of “shipping and handling” costs as discussed in EITF No.00-10 *“Accounting for Shipping and Handling Fees and Costs,”*which permits such expenses to beclassified within selling and administrative expenses.
 
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*Salesand Certain Other Taxes:*In its consolidated financial statements, Apria accounts fortaxes imposed on revenue-producing transactions by government authorities on a net basis, andaccordingly, excludes such taxes from net revenues. Such taxes include, but are not limited tosales, use, privilege and excise taxes.*Other:*Beginningwith the quarter ended June 30, 2008, the Company corrected the classification oflosses on disposal of patient services equipment from areduction in its purchases of patient service equipment in investingactivities in the condensed consolidated statement of cash flows to a loss on disposalin the cash provided by operating activities in the condensed consolidated statementof cash flows. The correction was not material to the condensedconsolidated statement of cash flows as of June 30, 2008. No correction has been made to any prior periods.**NOTE 2 — RECENT DEVELOPMENTS***Merger Agreement.*On June 18, 2008, the Company entered into an Agreement and Plan of Merger(the “Merger Agreement”) with Sky Acquisition LLC, a Delaware limited liability company (“Buyer”)and Sky Merger Sub Corporation, a Delaware corporation and wholly-owned subsidiary of Buyer(“Merger Sub”). Buyer is controlled by a private investment fund affiliated with The BlackstoneGroup (“Blackstone”), which is providing a portion of the funding for the transaction.The Merger Agreement provides that, upon the terms and subject to the conditions set forth inthe Merger Agreement, Merger Sub will merge with and into the Company (the “Merger”) with theCompany continuing as the surviving corporation and a wholly-owned subsidiary of Buyer. As of theeffective time of the Merger, each issued and outstanding share of common stock of the Company willbe cancelled and converted into the right to receive $21.00 in cash, without interest and lessapplicable withholding taxes (the “Merger Consideration”). Buyer and Merger Sub have obtainedequity and debt financing commitments for the transactions contemplated by the Merger Agreement,the aggregate proceeds of which will be sufficient for Buyer to pay the aggregate MergerConsideration and all related fees and expenses. Debt financing commitments of $1.15 billion havebeen provided by a syndicate comprised of Bank of America, Wachovia Bank, and Barclays Capital.Consummation of the Merger is not subject to a financing condition, but is subject to various otherconditions, including approval of the Merger Agreement by the Company’s stockholders, expiration ortermination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of1976 as amended (the “HSR Act”), accuracy of the representations and warranties of the Company, andother customary closing conditions. On July 8, 2008, the Company received notice that the federalantitrust authorities have granted early termination of the waiting period under the HSR Act. Theparties expect to close the transaction later in 2008.The Company has made various representations and warranties and agreed to certain covenants inthe Merger Agreement, including covenants relating to the Company’s conduct of its business betweenthe date of the Merger Agreement and the closing of the Merger, governmental filings and approvals,public disclosures and other matters.The Merger Agreement contains certain termination rights for both the Company and Buyer. TheMerger Agreement provides that, upon termination under specified circumstances, the Company wouldbe required to pay Buyer a termination fee. The Merger Agreement further provides that, upontermination under other specified circumstances, Buyer would be required to pay the Company areverse termination fee. The reverse termination fee potentially payable by Buyer is guaranteed byan investment fund affiliated with Blackstone, in a separate limited guarantee.*Liquidity Credit Facility.*On June 18, 2008, the Company also entered into a $280 millioncredit facility pursuant to a Credit Agreement with Banc of America Bridge LLC, Barclays CapitalPLC and Wachovia Capital Markets, LLC (the “CreditAgreement”). On September 2, 2008 proceeds of the new credit facilitywere used to fund repurchases of the Company’s 3 3/8% Convertible Senior Notes due2033 and will be used to pay certain tax liabilities related thereto. The loans under the credit facility bearinterest at a rate of eleven per cent (11%) per year with a maturity date of March 1, 2009. Inaddition, the Company paid usual and customary bank fees in connection with entering into theCredit Agreement. The Credit Agreement includes restrictions on the Company regarding additionalindebtedness, business operations, liens, transfers and sales of assets, and transactions withaffiliates. The Credit Agreement also contains customary events of default which would permit thelenders to accelerate payments under the Credit Agreement if not cured within applicable graceperiods, including the failure to make timely payments under the Credit Agreement and the failureto follow certain covenants. As of June 30, 2008, the Companywas in compliance with all covenants, but, due to the non-timely filing ofthe Company’s quarterly report on Form 10-Q for the periodended June 30, 2008,the Company would have been in default of the reporting covenantsunder the Credit Agreement on August 15, 2008. However, theCompany’s lenders executed a waiver on August 14, 2008, which extended the filing requirementfrom 45 days to 90 days following the end of the quarter.Upon thefiling of this quarterly report on Form 10-Q for theperiod ended June 30, 2008, the Company will have remedied thenon-compliance with reporting requirements under its CreditAgreement. See Note 7 and Note 13.*ConvertibleSenior Notes.*On September 2, 2008, the Company repurchased$249.8 million in aggregate principal of its 3 3/8% Convertible Senior NotesDue 2033 (the “senior notes”) representing approximately 99.91% ofthe outstanding principal amount. $0.2 million in aggregate principal amount of thesenior notes remains outstanding.On August 26,2008, Apria received a notice of default from the trustee under the indenturegoverning the senior notes regarding Apria’s failure to deliver itsQuarterly Report on Form 10-Q for the period ended June 30, 2008 withinthe specified time period. Pursuant to the indenture, failure by Apria tocomply with such reporting requirements will become an event of default if notremedied within 60 days after the date on which written notice of suchfailure, requiring Apria to remedy the same, is given to Apria by the trustee,and the senior notes, together with accrued and unpaid interest thereon, shallbecome due and payable immediately upon notice to the Company from the Trusteeor the holders of not less than 25% in aggregate principal amount of the seniornotes then outstanding.Upon thefiling of this quarterly report on Form 10-Q for theperiod ended June 30, 2008,the Company will have remedied the default under its senior notes.**NOTE 3 — RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS**Historically, the Company accounted for deferred revenues and deferred expenses related toequipment it rents to patients under a “reimbursement contract” method. These deferred amounts wereincluded in its consolidated financial statements for the year ended December 31, 2006, on whichthe Company’s independent registered public accountants, Deloitte & Touche LLP, issued anunqualified opinion. In the course of the Company’s fourth quarter 2007 review of the Company’saccounting for deferred revenue and deferred expenses it was identified that the Company hadincorrectly deferred revenue related to all of the Company’s capitated contracts (in the fee forservice/product arrangements line item) and that the Company incorrectly deferred certain indirectand overhead expenses. The Company concluded that the rental of such equipment should be accountedfor under SFAS No. 13, *“Accounting for Leases.”*Under SFAS No. 13 lessors are required to recognizerental income over the lease term. The Company bills for the rental of patient equipment on amonthly basis beginning on the date the equipment is delivered. Since deliveries can occur on anyday during a month, revenue must be deferred for the amount of billings that apply to the nextmonth.
 
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The accounting for the deferral of expenses by lessors is addressed by SFAS No. 91 *“Accountingfor Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial DirectCosts of Leases.”*Under SFAS No. 91 only the direct costs associated with leases are to bedeferred. The Company has re-evaluated the amount of costs to be deferred and now will be deferringonly the direct costs associated with the initial rental period under SFAS No. 91 and have adjustedits financial statements accordingly.On December 31, 2007, the Company’s management concluded to restate its previously issuedfinancial statements because of reporting errors solely relating to its accounting for deferredrevenue and deferred expenses related to equipment it rents to patients. Accordingly, the Companyrestated its condensed consolidated statements of income for the three and six months ended June30, 2007 and its condensed consolidated statement of cash flows for the six months ended June 30, 2007. The impact of the restatementdecreased net income for the three months ended June 30, 2007 by $1.6 million or 7.6%, andincreased net income for the six months ended June 30, 2007 by $0.1 million or 0.3%.The following tables show the impact of the restatement.**CONDENSED CONSOLIDATED STATEMENT OF INCOME ITEMS**               **Three Months Ended June 30, 2007**   **(As Previously**      **(As** **(in thousands, except per share data)** **Reported)**  **(Adjustments)**  **Restated)** Fee for service/product arrangements $352,734  $(2,115) $350,619 Total net revenues  394,044   (2,115)  391,929 Product and supply costs  90,894   (54)  90,840 Total cost of net revenues  134,485   (54)  134,431 Selling, distribution and administrative expenses  209,406   (94)  209,312 Total costs and expenses  355,690   (148)  355,542 Operating income  38,354   (1,967)  36,387 Income before taxes  33,354   (1,967)  31,387 Income tax expense  12,525   (389)  12,136 Net income  20,829   (1,578)  19,251 Basic net income per common share  0.48       0.44 Diluted net income per common share $0.47      $0.44                **Six Months Ended June 30, 2007**   **(As Previously**      **(As** **(in thousands, except per share data)** **Reported)**  **(Adjustments)**  **Restated)** Fee for service/product arrangements $700,740  $(626) $700,114 Total net revenues  783,334   (626)  782,708 Product and supply costs  181,964   (233)  181,731 Total cost of net revenues  269,281   (233)  269,048 Selling, distribution and administrative expenses  415,985   (193)  415,792 Total costs and expenses  707,755   (426)  707,329 Operating income  75,579   (200)  75,379 Income before taxes  64,753   (200)  64,553 Income tax expense  24,780   (328)  24,452 Net income  39,973   128   40,101 Basic net income per common share  0.92       0.92 Diluted net income per common share $0.91      $0.91 
 
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**CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS ITEMS**               **Six Months Ended June 30, 2007**   **(As Previously**      **(As** **(in thousands)** **Reported)**  **(Adjustments)**  **Restated)** Net income $39,973  $128  $40,101 Deferred income taxes  5,935   (328)  5,607 Deferred revenue, net of deferred expenses $1,091  $200  $1,291 **NOTE 4 — RECENT ACCOUNTING PRONOUNCEMENTS**In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157,*“Fair Value Measurements,”*which defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles, and expands disclosures about fair valuemeasurements. The statement is effective for financial statements issued for fiscal years beginningafter November 15, 2007, and interim periods within those fiscal years. On January 1, 2008, theCompany adopted SFAS No. 157.In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-1, *“Application ofFASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13”*(“FSP FAS 157-1”). FSP FAS 157-1 provides a scope exception from SFAS No. 157 for the evaluationcriteria on lease classification and capital lease measurement under SFAS No. 13, *“Accounting forLeases”*and other related accounting pronouncements. Accordingly, the Company did not apply theprovisions of SFAS No. 157 in determining the classification of and accounting for leases and theadoption of FSP FAS 157-1 did not have an impact on the Company’s condensed consolidated financialstatements.FSP No. FAS 157-2 (“FSP 157-2”), “*Effective Date of FASB Statement No. 157”*was issued inFebruary 2008. FSP 157-2 delays the effective date of SFAS No. 157, for nonfinancial assets andnonfinancial liabilities, except for items that are recognized or disclosed at fair value at leastonce a year, to fiscal years beginning after November 15, 2008, and for interim periods withinthose fiscal years. The Company is currently assessing the impact of SFAS No. 157 for non-financialassets and non-financial liabilities on its consolidated statements of financial position andresults of operations.***Fair Value Hierarchy.***SFAS No. 157 defines the inputs used to measure fair value into thefollowing hierarchy:Level 1: Quoted market prices in active markets for identical assets or liabilities.Level 2: Observable market-based inputs or unobservable inputs that are corroborated by marketdata.Level 3: Unobservable inputs reflecting the reporting entity’s own assumptions.In February 2007, the FASB issued SFAS No. 159, “*The Fair Value Option for Financial Assetsand Financial Liabilities.”*SFAS No. 159 expands opportunities to use fair value measurement infinancial reporting and permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS No. 159 is effective for fiscal years beginning afterNovember 15, 2007. The Company adopted SFAS No. 159 on January 1, 2008. The Company evaluated SFASNo. 159 and did not elect the fair value accounting option for any of its eligible assets andliabilities; therefore, the adoption of SFAS No. 159 had no impact on its financial statements.In December 2007, the FASB issued SFAS No. 141(R), “*Business Combinations*.” SFAS No. 141(R)replaces SFAS No. 141, “*Business Combinations.”*SFAS No. 141(R) retains the fundamentalrequirements in SFAS No. 141 that the acquisition method of accounting be used for all businesscombinations and for an acquirer to be identified for each business combination. SFAS No. 141(R)amends the recognition provisions for assets and liabilities acquired in a business combination,including those arising from contractual and noncontractual contingencies. SFAS No. 141(R) alsoamends the recognition criteria for contingent consideration. In addition, under SFAS No. 141(R),changes in an acquired entity’s deferred tax assets and uncertain tax positions after themeasurement period will impact income tax expense. SFAS No. 141(R) is effective for fiscal yearsbeginning on or after December 15, 2008. Early adoption is not permitted.
 
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In December 2007, the FASB issued SFAS No. 160, “*Noncontrolling Interests in ConsolidatedFinancial Statements—An Amendment of ARB No. 51*.” SFAS No. 160 establishes new accounting andreporting standards for the non-controlling interest in a subsidiary and for the deconsolidation ofa subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008.Management does not currently expect the adoption of SFAS No. 160 to have a material impact on theCompany’s consolidated financial statements.In April 2008, FASB issued FSP No. 142-3 (“FSP 142-3”)*, “Determination of the Useful Life ofIntangible Assets”*, which amends the factors that must be considered in developing renewal orextension assumptions used to determine the useful life over which to amortize the cost of arecognized intangible asset under SFAS No. 142, “*Goodwill and Other Intangible Assets”*. FSP 142-3requires an entity to consider its own assumptions about renewal or extension of the term of thearrangement, consistent with its expected use of the asset. FSP 142-3 also requires the disclosureof the weighted-average period prior to the next renewal or extension for each major intangibleasset class, the accounting policy for the treatment of costs incurred to renew or extend the termof recognized intangible assets and for intangible assets renewed or extended during the period, ifrenewal or extension costs are capitalized, the costs incurred to renew or extend the asset and theweighted-average period prior to the next renewal or extension for each major intangible assetclass. FSP 142-3 is effective for financial statements for fiscal years beginning after December15, 2008. The Company is currently evaluating the impact of adopting FSP 142-3 on its consolidatedfinancial statements.In May 2008, the FASB issued SFAS No. 162, *“The Hierarchy of Generally Accepted AccountingPrinciples.”*SFAS No. 162 identifies the sources of accounting principles and the framework forselecting principles to be used in the preparation of financial statements of nongovernmentalentities that are presented in conformity with generally accepted accounting principles in theUnited States. This statement shall be effective 60 days following the SEC’s approval of thePublic Company Accounting Oversight Board’s amendments to AU section 411, The Meaning of PresentFairly in Conformity with Generally Accepted Accounting Principles. The Company is currentlyevaluating the impact of SFAS No. 162, but does not expect the adoption of this pronouncement willhave a material impact on its financial position, results of operations or cash flows.**NOTE 5 — BUSINESS COMBINATIONS**Apria periodically makes acquisitions of complementary businesses in specific geographicmarkets. The results of operations of the acquired companies are included in the accompanyingcondensed consolidated income statements from the dates of acquisition. No acquisitions were madeduring the six months ended June 30, 2008 and 2007. Cash paid for acquisitions, which includesamounts deferred from prior periods, totaled $3.0 million for the six months ended June 30, 2008.**NOTE 6 — GOODWILL AND INTANGIBLE ASSETS**Business combinations are accounted for in accordance with SFAS No. 141, *“BusinessCombinations,”*which requires that the purchase method of accounting be applied to all businesscombinations and addresses the criteria for initial recognition of intangible assets and goodwill.Additionally, in accordance with SFAS No. 142, *“Goodwill and Other Intangible Assets,”*goodwill andother intangible assets with indefinite lives are not amortized but are tested for impairmentannually, or more frequently if circumstances indicate the possibility of impairment. If thecarrying value of goodwill or an intangible asset exceeds its fair value, an impairment loss shallbe recognized.The intangible assets on the Company’s books consist of the following:                               **June 30, 2008**  **December 31, 2007**   **Average**  **Gross**          **Gross**      **Net**   **Life in**  **Carrying**  **Accumulated**  **Net Book**  **Carrying**  **Accumulated**  **Book** **(dollars in thousands)** **Years**  **Amount**  **Amortization**  **Value**  **Amount**  **Amortization**  **Value**                              Intangible assets subject to amortization:                            Covenants not to compete  5.0  $10,618  $(8,084) $2,534  $11,380  $(7,744) $3,636 Patient referral sources  20.0   34,300   (1,000)  33,300   34,300   (143)  34,157 Favorable leases  2.4   628   (179)  449   584   (20)  564                       Total  9.1   45,546   (9,263)  36,283   46,264   (7,907)  38,357 Intangible assets not subject to amortization:                            Trade names  —   69,400   —   69,400   69,400   —   69,400                       Total  9.1  $114,946  $(9,263) $105,683  $115,664  $(7,907) $107,757                       
 
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Amortization expense amounted to $1,049,000 and $706,000 for the three months ended June 30,2008 and 2007, respectively. Amortization expense amounted to $2,117,000 and $1,698,000 for the sixmonths ended June 30, 2008 and 2007. Estimated amortization expense for each of the fiscal yearsending December 31 is presented below:     **Year Ending December 31,** **(in thousands)** 2008 $7,194 2009  4,425 2010  2,611 2011  2,129 2012  1,992 **NOTE 7 — LONG-TERM DEBT***Revolving Credit Facility:*At June 30, 2008, borrowings under the Company’s revolving creditfacility were $364,000,000, outstanding letters of credit totaled $7,849,000, credit availableunder the revolving credit facility was $128,151,000, and Apria was in compliance with allcovenants required by the Fourth Amended and Restated Credit Agreement with certain lenders, datedNovember 23, 2004, as amended (the “2004 Credit Agreement”). The effective interest rate at June30, 2008, after consideration of the effect of the swap agreement described below, was 3.2%.*Convertible Senior Notes:*In August 2003, convertible senior notes in the aggregate principal amount of $250,000,000were issued under an indenture with U.S. Bank National Association. The notes were issued in aprivate placement at an issue price of $1,000 per note (100% of the principal amount at maturity)and were subsequently registered with the Securities and ExchangeCommission. At June 30, 2008, the fair value of the $250,000,000 in theCompany’s outstanding convertible senior notes was $249,300,000, as determined by reference toquoted market prices. On September 2, 2008, the Company repurchased$249,772,000 in aggregate principal of the senior notes, representingapproximately 99.91% of the outstanding principal amount.$228,000 in principal amount of the senior notes remains outstanding.On August 26,2008, Apria received a notice of default from the trustee under the indenturegoverning the senior notes regarding Apria’s failure to deliver itsQuarterly Report on Form 10-Q for the period ended June 30, 2008 withinthe specified time period. Pursuant to the indenture, failure by Apria tocomply with such reporting requirements will become an event of default if notremedied within 60 days after the date on which written notice of suchfailure, requiring Apria to remedy the same, is given to Apria by the trustee,and the remaining senior notes, together with accrued and unpaid interest thereon, shallbecome due and payable immediately upon notice to the Company from the Trusteeor the holders of not less than 25% in aggregate principal amount of the seniornotes then outstanding. Upon the filing of thisquarterly report on Form 10-Q for the period endedJune 30, 2008, theCompany will have remedied the default under its senior notes.*Liquidity Credit Facility:*On June 18, 2008, the Company entered into a $280 million creditfacility pursuant to the Credit Agreement. On September 2, 2008proceeds of the new credit facility were used to fund repurchases ofthe senior notes and willbe used to pay certaintax liabilities related thereto. The loans under the credit facility bear interest at a rate ofeleven per cent (11%) per year with a maturity date of March 1, 2009. In addition, the Company paidusual and customary bank fees in connection with entering into the Credit Agreement. The CreditAgreement includes restrictions on the Company regarding additional indebtedness, businessoperations, liens, transfers and sales of assets, and transactions with affiliates. The CreditAgreement also contains customary events of default which would permit the lenders to acceleratepayments under the Credit Agreement if not cured within applicable grace periods, including thefailure to make timely payments under the Credit Agreement and the failure to follow certaincovenants. As of June 30, 2008, the Company was in compliancewith all covenants, but, due to the non-timely filing of theCompany’s quarterly report on Form 10-Q, for the periodended June 30, 2008, the Company would have been in default of the reporting covenantsunder the Credit Agreement on August 15, 2008. However, the Company’slenders executed a waiver on August 14,2008, which extended the filing requirement from 45 days to 90 daysfollowing the end of the quarter. Upon thefiling of this quarterly report on Form 10-Q for theperiod ended June 30, 2008, the Company will have remedied thenon-compliance with reporting requirements under its CreditAgreement.*Hedging Activities:*Apria utilizes interest rate swap agreements to moderate its exposure tointerest rate fluctuations on its underlying variable rate long-term debt. Apria does not usederivative financial instruments for trading or other speculative purposes. At June 30, 2008, Apriahad one interest rate swap agreement in effect which will expire in January 2009, with a notionalamount of $25,000,000 and a fixed rate of 4.44%.
 
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The swap agreement is accounted for under SFAS No. 133, *“Accounting for Derivative Instrumentsand Hedging Activities.”*The difference between the interest received and interest paid isreflected as an adjustment to interest expense. Apria received a net settlement amount of $18,000and $58,000 related to the three-month period ended June 30, 2008 and 2007, respectively, and$69,000 and $117,000 for the six months ended June 30, 2008 and 2007, respectively. The aggregatefair value of the swap agreement was a liability of $198,000 and $105,000 at June 30, 2008 andDecember 31, 2007, respectively, and is reflected in the accompanying condensed consolidatedbalance sheets in other accrued liabilities. The Company’s interest rate swap agreement is valuedusing observable market based inputs and therefore is classified within Level 2 of the fair valuehierarchy. Unrealized gains and losses on the fair value of the swap agreement are reflected in netincome, as the transaction does not qualify for hedge accounting. Apria’s exposure to credit lossunder the swap agreement is limited to the interest rate spread in the event of counterpartynonperformance. Apria does not anticipate losses due to counterparty nonperformance as itscounterparties to the swap agreement are nationally recognized financial institutions with strongcredit ratings.On August 30, 2007, Apria acquired information systems software totaling $5,800,000 under aninstallment payment agreement, of which $3,600,000 is considered aslong-term debt as of June 30, 2008.Interest paid on debt totaled $4,172,000 and $2,899,000 for the three months ended June 30,2008 and 2007, respectively, and $14,045,000 and $10,685,000 for the six months ended June 30, 2008and 2007, respectively.**NOTE 8 — STOCKHOLDERS’ EQUITY**For the six months ended June 30, 2008, changes to stockholders’ equity were comprised of thefollowing amounts:     Net income $43,927 Issuances of common stock (including non-cash issuances)  480 Excess tax benefits from share-based compensation  207 Tax shortfalls on share-based compensation  (631)Restricted stock retained in treasury upon vesting  (1,264)Share-based compensation  7,271 Other comprehensive loss, net of taxes  (60)      $49,930     Net income and total comprehensive income differ by other comprehensive loss, net of taxes.Such loss represents the amortization of a balance in accumulated other comprehensive income thatwas previously recorded in connection with certain interest rate swap agreements. For the threemonths ended June 30, 2008 and 2007, total comprehensive income was $22,579,000 and $19,216,000 andfor the six months ended June 30, 2008 and 2007, $43,321,000 and $40,021,000, respectively.Common stock valued at $98,000 was issued during the six months ended June 30, 2008 in anon-cash transaction. This transaction was related to the exercise of a restricted stock purchaseright for an executive.**NOTE 9 — SHARE-BASED COMPENSATION**For the three and six months ended June 30, 2008, the Company recorded share-basedcompensation expense of $4,121,000 and $7,271,000. Share-based compensation expense was $3,228,000and $4,664,000, for the corresponding three and six-month periods in 2007. All such compensation isreflected in the accompanying condensed consolidated income statement within the selling,distribution and administrative expense line item. The related awards were granted to executive andcertain management personnel or members of the Company’s Board of Directors and therefore noportion of the share-based compensation has been classified within cost of net revenues.Share-based compensation expense recognized in the periods presented is based on awards ultimatelyexpected to vest; therefore, it has been reduced for estimated forfeitures.For the six months ended June 30, 2008 and 2007, cash received from the exercise ofshare-based awards totaled $382,000 and $16,554,000, respectively.
 
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The Company estimates the fair value of stock options using the Black-Scholes valuation model.Key input assumptions used to estimate the fair value of stock options include the exercise priceof the award, the expected option term, the expected volatility of the Company’s stock over theoption’s expected term, the risk-free interest rate over the option’s term, and the Company’sexpected annual dividend yield. Apria’s management believes that the valuation technique and theapproach utilized to develop the underlying assumptions are appropriate in calculating the fairvalues of the Company’s stock options granted in the three and six month periods ended June 30,2008 and June 30, 2007, respectively. Estimates of fair value are not intended to predict actualfuture events or the value ultimately realized by persons who receive equity awards. The key inputassumptions that were utilized in the valuation of the stock options granted during the six monthsended June 30, 2008 and 2007, are summarized in the table below.           **Six Months Ended**   **June 30,**   **2008**  **2007** Expected option term(1) 6.2 years  4.6 years Expected volatility(2)  37.3%  29.9%Risk-free interest rate(3)  3.1%  4.6%Expected annual dividend yield  0%  0%    (1) The expected option term is based on historical exercise and post-vesting terminationpatterns. (2) The expected volatility represents a combination of historical stock price volatility andimplied volatility from publicly-traded options on Apria’s common stock. (3) The risk-free interest rate is based on the implied yield on a U.S. Treasury zero couponissue with a remaining term equal to the expected term of the option.*Stock Options:*Apria’s incentive plan provides for the granting of stock options to employeesand non-employee directors. In the past, such grants to employees have included both non-qualifiedand incentive stock options; however, in May 2007 the Compensation Committee of the Company’s Boardof Directors determined to grant only non-qualified options in the future. The exercise price of anoption is established at the fair market value of a share of Apria common stock on the date ofgrant. Vesting of stock options is time-based and is generally over a three-year period.The following table summarizes the activity for stock options for the six months ended June30, 2008:                           **Weighted-Average**              **Remaining**  **Aggregate**       **Weighted-Average**  **Contractual Term**  **Intrinsic**   **Options**  **Exercise Price**  **(in Years)**  **Value** Outstanding at January 1, 2008  3,733,383  $26.60         Granted  15,000  $21.02         Exercised  (53,166) $7.20         Forfeited  (113,838) $29.89                         Outstanding at June 30, 2008  3,581,379  $26.76   5.87  $465,206              Vested or expected to vest as of June 30, 2008  3,396,051  $26.75   5.73  $464,455 Exercisable at June 30, 2008  2,790,393  $26.69   5.12  $462,006 The weighted-average fair value of stock options granted during the six months ended June 30,2008 and 2007 was $6.55 and $10.60, respectively. There were 646,830 stock options granted in thesix-month period ended June 30, 2007. The total intrinsic value of options exercised was $533,000and $9,371,000 for the six months ended June 30, 2008 and 2007, respectively.As of June 30, 2008, total unrecognized stock-based compensation cost related to unvestedstock options was $4,771,000, which is expected to be expensed over a weighted-average period of1.50 years.*Restricted Stock Purchase Rights:*In 2003 and 2004, Apria granted restricted stock purchaserights to certain members of executive management. The awards represented the right to purchase acertain number of shares of Apria common stock at a future date at a specified exercise price. Theexercise price was established at 25% of the fair market value of a share of Apria common stock onthe date of grant. Such awards generally require that certain performance conditions and/or serviceconditions be met before the awards will vest.
 
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The following table summarizes the activity for restricted stock purchase rights for the sixmonths ended June 30, 2008:                   **Restricted**      **Weighted-Average**      **Stock**      **Remaining**  **Aggregate**   **Purchase**  **Weighted-Average**  **Contractual Term**  **Intrinsic**   **Rights**  **Exercise Price**  **(in Years)**  **Value** Outstanding at January 1, 2008  277,000  $6.82         Granted  —  $—         Exercised  (15,000) $6.46         Forfeited  —  $—                         Outstanding at June 30, 2008  262,000  $6.84   5.29  $3,288,480              Vested or expected to vest as of June 30, 2008  208,055  $6.82   5.28  $2,616,074 Exercisable at June 30, 2008  8,000  $6.46   5.12  $103,440 The total intrinsic value of restricted stock purchase rights exercised was $193,950 and$534,000 for the six months ended June 30, 2008 and 2007, respectively. No such awards were grantedduring these two periods.As of June 30, 2008, total unrecognized stock-based compensation cost related to unvestedrestricted stock purchase rights was $1,580,000, which is expected to be expensed over aweighted-average period of 1.84 years.*Stock Appreciation Rights:*On February 29, 2008, Apria granted stock appreciation rights tocertain members of executive management under the 2003 Performance Incentive Plan. The awardsrepresent the right to receive a payment in stock, equal to the excess of the fair market value ofa specified number of shares of Apria common stock on the date the stock appreciation right isexercised over the fair market value of a share of Apria common stock on the date the stockappreciation right was granted (the “base price”). Generally, the base price may not be less thanthe per share fair market value on the date of grant. Vesting of stock appreciation rights istime-based and is over a four-year period.The following table summarizes the activity for stock appreciation rights for the six monthsended June 30, 2008:                           **Weighted-Average**      **Stock**      **Remaining**  **Aggregate**   **Appreciation**  **Weighted-Average**  **Contractual Term**  **Intrinsic**   **Rights**  **Exercise Price**  **(in Years)**  **Value** Outstanding at January 1, 2008  —  $—         Granted  773,850  $20.51         Exercised  —  $—         Forfeited  (5,960) $21.71                         Outstanding at June 30, 2008  767,890  $20.50   9.71  $220,052              Vested or expected to vest as of June 30, 2008  591,106  $20.50   9.71  $169,380 Exercisable atJune 30, 2008  —  $—   —  $— The weighted-average fair value of stock appreciation rights granted during the six monthsended June 30, 2008 was $8.59. There were no stock appreciation rights granted in the six-monthperiod ended June 30, 2007.As of June 30, 2008, total unrecognized stock-based compensation cost related to unvestedstock appreciation rights was $4,673,000, which is expected to be expensed over a weighted-averageperiod of 3.71 years.*Restricted Stock Awards and Units:*Apria’s incentive plan provides for the granting ofrestricted stock and restricted stock units to its non-employee directors and employees (limited toexecutive management). Such awards generally require that certain performance conditions andservice conditions be met before the awards will vest.
 
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The following table summarizes the activity for restricted stock awards and units for the sixmonths ended June 30, 2008:           **Shares**  **Weighted-Average**   **or**  **Grant-Date**   **Share Units**  **Fair Value** Nonvested restricted stock awards and units at January 1, 2008  640,871  $29.73 Granted  423,890  $21.35 Vested and released  (156,274) $31.04 Forfeited  (17,752) $25.54         Nonvested restricted stock awards and units at June 30, 2008  890,735  $25.59 The weighted-average fair value of restricted stock awards and units granted during the sixmonths ended June 30, 2008 and 2007 was $21.35 and $30.33, respectively. There were 372,710 awardsgranted in the six month period ended June 30, 2007. Restricted stock awards or units releasedduring the six months ended June 30, 2008 and 2007 were 156,274 and 108,491 shares, respectively,and the total intrinsic value was $3,357,000 for both periods, respectively.As of June 30, 2008, total unrecognized stock-based compensation cost related to unvestedrestricted stock awards and units was $15,006,000, which is expected to be expensed over aweighted-average period of 1.67 years.**NOTE 10 — INCOME TAXES**TheCompany’s effective tax rate was 39.8% for the three months ended June 30, 2008 comparedwith 38.7% for the three months ended June 30, 2007. The Company’s effective tax rate was 39.8%for the six months ended June 30, 2008 compared with 37.9% for the six months ended June 30, 2007.A reconciliation of the beginning and ending balances of the gross liability for unrecognizedtax benefits at June 30, 2008 is as follows (in thousands):     Total gross unrecognized tax benefits at December 31, 2007 $115,960 Additions for tax positions related to the current year  1,271 Additions for tax positions related to prior years  1,822 Reductions for tax positions related to prior years  (8,647)Settlements  (1,158)Reductions due to lapse in statute of limitations  (1,281)Other  (31)    Total gross unrecognized tax benefits at June 30, 2008 $107,936     Total gross unrecognized tax benefits of $107,936,000 is reflected on the Company’s June 30,2008 balance sheet as follows: (a) $18,090,000 included in income taxes payable and othernon-current liabilities and (b) $89,846,000 included in deferred income taxes.As of June 30, 2008, the amount of unrecognized tax benefits which, if ultimately recognized,would affect the effective tax rate in a future period is $15,055,000 (net of related taxbenefits). The $15,055,000 unrecognized tax benefits amount is inclusive of $3,637,000 ofpenalties and interest (net of related tax benefits).Based on purchase accounting rules at June 30, 2008, unrecognized tax benefits of $79,259,000(net) related to Coram, Inc. (“Coram”) would, if ultimately recognized, only impact goodwill(versus the Company’s effective tax rate). However, upon adoption of SFAS No. 141(R), the entire$79,259,000 of unrecognized tax benefits related to Coram would, if ultimately recognized, affectthe Company’s effective tax rate in a future period.As of June 30, 2008, it is reasonably possible that unrecognized tax benefits could beincreased or decreased by the following estimated amounts within the 12-month rolling period endingJune 30, 2009. **•** Aggregate gross increase of $2,500,000 for interest and penalties primarily related toother tax uncertainties taken in prior years and state tax uncertainties involving taxfiling positions. The gross increase is an annual expense which will be accrued until thetax uncertainties or related tax uncertainties (in the case of interest and penalties) areextinguished through such means as audit settlements, payment, or the expiration ofstatutes of limitations. **•** Aggregate gross decrease of $2,900,000 related to the timing uncertainty for whencertain deductions should be recognized for tax return purposes, allocation of expensesbetween affiliates, and state tax uncertainties. Ultimate realization of this decrease isdependent upon the occurrence of certain events (including the completion of audits by taxagencies and expiration of statutes of limitations).
 
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Interest expense and penalties related to unrecognized tax benefits are recognized as part ofthe provision for income taxes. Gross interest and penalties of $5,912,000 are provided for withinthe liability for unrecognized tax benefits as of June 30, 2008.The Company files federal and state income tax returns in jurisdictions with varying statutesof limitations expiration dates. The calendar 2004 through 2007 tax years generally remain subjectto examination by tax authorities. The Internal Revenue Service recently completed its examinationof the Company’s calendar 2005 and 2006 federal income tax returns. Certain state tax agencies arecurrently examining the calendar tax years 2001 through 2006.Asof June 30, 2008, federal net operating losses(“NOLs”) of approximately $113,784,000 areavailable to offset future federal taxable income. Such NOLs will expire at various times and invarying amounts during our calendar 2024 through 2026 tax years. These NOLs were acquired inconnection with the Company’s Coram acquisition and are subject to an annual utilization limitationof approximately $18,081,000 as required by Section 382 of the Internal Revenue Code of 1986, asamended (the “Code”). Additionally, the Company’s ability to utilize federal tax NOLs and certainacquisition-related state tax NOLs may be further limited due to certain tax rules involving theexchange of Coram stock for its debt and associated interest. These debt for stock exchangesoccurred in Coram’s 2000 through 2002 tax years.Additionally, Coram’s NOLs, tax assets and other attributes could be subject to substantialutilization limitations due to previous Section 382 ownership changes which may have occurred priorto the Company’s acquisition of Coram. In general, an “ownership change,” as defined by Section 382of the Code, occurs when a transaction or series of transactions over a three-year period resultsin an ownership change of more than 50 percentage points of the outstanding stock of a company. TheCompany is currently analyzing whether a Section 382 ownership change occurred prior to itsDecember 2007 acquisition of Coram and the impact, if any, that such an ownership change could haveon NOL carryforwards, tax assets and other tax attributes.Net income taxes paid for the six-month periods ended June 30, 2008 and 2007 amounted to$4,404,000 and $11,583,000, respectively.**NOTE 11 — PER SHARE AMOUNTS**The following table sets forth the computation of basic and diluted per share amounts:                   **Three Months Ended**  **Six Months Ended**   **June 30,**  **June 30,** **(in thousands, except per share data)** **2008**  **2007**  **2008**  **2007** **Numerator:**                Net income $23,155  $19,251  $43,927  $40,101 Numerator for basic and diluted per share amounts — net income available tocommon stockholders $23,155  $19,251  $43,927  $40,101 **Denominator:**                Denominator for basic per share amounts — weighted average shares  43,885   43,650   43,857   43,381 Effect of dilutive securities:                Employee stock options and awards — dilutive potential common shares  289   582   316   729              Denominator for diluted per share amounts — adjusted weighted average shares  44,174   44,232   44,173   44,110              Basic net income per common share $0.53  $0.44  $1.00  $0.92              Diluted net income per common share $0.52  $0.44  $0.99  $0.91              Employee stock options excluded from the computation of diluted per share amounts:                Shares for which exercise price exceeds average market price of common stock  4,263   1,033   3,931   1,521 Average exercise price per share that exceeds average market price of common stock $27.06  $32.65  $27.14  $31.93              
 
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**NOTE 12 — COMMITMENTS AND CONTINGENCIES***Litigation*: The Company is the defendant in a purported California class action lawsuitasserting blanket claims of liability under various California employee protection statutes andregulations relating to payment of regular and overtime wages, the timeliness of such payments, themaintenance and provision of access to required payroll records, and the provision of meal and restperiods. The original claim was filed by Jesus Venegas on February 21, 2006 in the CaliforniaSuperior Court for the County of San Francisco (Case No. CGC — 06 — 449669). The complaint, asamended, seeks compensatory damages in an unspecified amount as well as other relief on behalf of apurported class consisting of substantially all of the Company’s delivery drivers in the State ofCalifornia. The Company has answered the complaint denying all material allegations and asserting anumber of affirmative defenses. The Company has successfully pursued motions for summaryadjudication eliminating certain tort based claims and claims for unjust enrichment and declaratoryrelief. Based on the investigation of the allegations made to date, the Company believes there aremeritorious defenses to the remaining claims and intends to continue a vigorous defense of thelawsuit. The Court has not established a trial date and has indicated that the issue of whetherthe case may be certified as a class action is likely to be determined at a hearing which itexpects to hold in early 2009. Until a final decision is made with respect to the plaintiff’s classaction allegations, no assurances can be given that the ultimate disposition of this case will nothave a material adverse effect on the Company’s financial condition or results of operations.TheCompany has also been served with two complaints seeking to enjointhe proposed Merger as discussed in Note 2.The first complaint was filed on June 24, 2008 by Alaska Ironworkers Pension Trust, On Behalfof Itself and All Others Similarly Situated, in the Superior Court of the State of California,County of Orange, Case No. 30-2008-00078710. The complaint names the Company and its directors asdefendants, and asserts a single cause of action for breach of fiduciary duty and aiding andabetting against all defendants. The complaint seeks certification of a class of all commonstockholders of the Company who are being and will be harmed by defendants’ alleged actions; adeclaration that the proposed transaction is in breach of defendants’ fiduciary duties, and,therefore, unlawful and unenforceable; an order enjoining defendants and others from consummatingthe proposed transaction; an order directing the individual defendants to exercise their fiduciaryduties to obtain a transaction in the best interests of the Company’s stockholders; rescission ofthe proposed transaction to the extent already implemented; recovery of costs of suit, includingattorneys’ fees; and other relief.The second complaint was filed on July 2, 2008 by Bruce Ellis, On Behalf of Himself and AllOthers Similarly Situated, in the Superior Court of the State of California, County of Orange, CaseNo. 30-2008-00081027. The complaint names the Company, the Company’s directors, and BlackstoneGroup LP as defendants, and asserts two (2) causes of action: (1) breach of fiduciary duty againstthe individual defendants, and (2) aiding and abetting the individual defendants’ breach offiduciary duty against Blackstone Group LP. The complaint seeks certification of a class of allcommon stockholders of the Company who are being and will be harmed by defendants’ alleged actions;a declaration that the proposed transaction is in breach of defendants’ fiduciary duties, and,therefore, unlawful and unenforceable; an order enjoining defendants and others from consummatingthe proposed transaction; an order enjoining the defendants from holding a shareholder vote on theproposed transaction until curative disclosures are made; an order directing the individualdefendants to exercise their fiduciary duties to obtain a transaction which is in the bestinterests of the Company’s stockholders; rescission of the proposed transaction to the extentalready implemented; imposition of a constructive trust, in favor of plaintiff, upon any benefitsimproperly received by defendants; recovery of costs of suit, including attorneys’ fees; and otherrelief.On July 15, 2008, the Court issued an Order on Consolidation of Related Actions andAppointment of Lead Counsel, where the Court, among other things, consolidated the above actions,as well as other current or future actions arising out of the same set of facts that are filed inor transferred to the Court, into a single action, titled *In re Apria Healthcare Group Inc.Shareholder Litigation, Lead Case No. 30-2008-00078710. Coughlin, Stoia, Geller, Rudman & RobbinsLLP*was appointed as lead counsel for plaintiffs in the consolidated action. The Court furtherordered plaintiffs to file a consolidated complaint within 30 days of the July 24, 2008 filing withthe SEC of the Company’s preliminary proxy statement on Schedule 14A.The parties have stipulated to extend this deadline to September 22, 2008, andplaintiffs have not filed a consolidated complaint as of the date of the filing of thisForm 10-Q.Pursuant to the July 15, 2008order, the consolidated complaint will supersede all complaints filed in any consolidated action,and defendants shall respond to the consolidated complaint pursuant to a briefing schedule to beagreed upon by the parties and approved by the Court. Also pursuant to the order, defendants arenot required to, and have not, responded to the foregoing complaints.The Company is also engaged in the defense of certain claims and lawsuits arising out of theordinary course and conduct of its business, the outcomes of which are not determinable at thistime. Insurance policies covering such potential losses, where such coverage is cost effective, aremaintained. In the opinion of management, any liability that might be incurred upon the resolutionof these claims and lawsuits will not, in the aggregate, have a material adverse effect on theCompany’s financial condition or results of operations.
 
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*Medicare and Medicaid Reimbursement*: There are a number of provisions contained within recentlegislation or proposed legislation that affect or may affect Medicare reimbursement polices foritems and services provided. The Company cannot be certain of the ultimate impact of all legislatedand contemplated changes, and therefore, cannot provide assurance that these changes will not havea material adverse effect on the Company’s financial condition or results of operations.*Supplier Concentration:*Currently, approximately 75.2% of purchases for patient serviceequipment and supplies are from four vendors. Although there are a limited number of suppliers,management believes that other vendors could provide similar products on comparable terms. However,a change in suppliers could cause delays in service delivery and possible losses in revenue, whichcould adversely affect the Company’s financial condition or operating results.*Guarantees and Indemnities*: From time to time, certain types of contracts are entered intothat contingently require indemnification of parties against third party claims. These contractsprimarily relate to (i) certain asset purchase agreements, under which indemnification may beprovided to the seller of the business being acquired; (ii) certain real estate leases, which mayrequire indemnification to property owners for environmental or other liabilities and other claimsarising from use of the applicable premises; and (iii) certain agreements with officers, directorsand employees, which may require indemnification of such persons for liabilities arising out oftheir relationship with the Company.The terms of such obligations vary by contract and in most instances a specific or maximumdollar amount is not explicitly stated therein. Generally, amounts under these contracts cannot bereasonably estimated until a specific claim is asserted. Consequently, no liabilities have beenrecorded for these obligations on the balance sheets for any of the periods presented.**NOTE 13 — SUBSEQUENT EVENTS**OnSeptember 2, 2008, the Company repurchased $249.8 million inaggregate principal of the senior notes, representing approximately99.91% of the outstanding principal amount. $0.2 million in aggregateprincipal amount ofthe senior notes remains outstanding. This repurchase also triggereda tax liability of $30.0 million. The repurchase of$249.8 million was funded by a draw down on our liquidity creditfacility, entered into on June 18, 2008.
 
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**ITEM 2.** ***MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****This Management’s Discussion and Analysis of Financial Condition and Results of Operations isintended to assist in understanding and assessing the trends and significant changes in our resultsof operations and financial condition. Historical results may not indicate future performance. Ourforward-looking statements reflect our current views about future events, are based on assumptionsand are subject to known and unknown risks and uncertainties that could cause actual results todiffer materially from those contemplated by these statements. Factors that may cause differencesbetween actual results and those contemplated by forward-looking statements include, but are notlimited to, those discussed in Part II, Item 1A, “Risk Factors,” of our Annual Report on Form 10-K/Afor the fiscal year ended December 31, 2007. As used in this Management’s Discussion and Analysisof Financial Condition and Results of Operations, the words “we,” “our,” “us” and “the Company”refer to Apria Healthcare Group Inc. and its consolidated subsidiaries. This Management’sDiscussion and Analysis of Financial Condition and Results of Operations should be read inconjunction with our condensed consolidated financial statements and related notes included in thisreport.*All information set forth in this Item 2 – Management’s Discussion and Analysis with respectto 2007 includes the effects thereon of the restatement, of our condensed consolidated statementsof income for the three and six months ended June 30, 2007, if any. See Note 3 – Restatement ofConsolidated Financial Statements contained in the Notes to Unaudited Condensed ConsolidatedFinancial Statements in Item 1 for a more detailed discussion of the restatement.We operate in the home healthcare segment of the healthcare industry and provide services inthe home respiratory therapy, home infusion therapy and home medical equipment areas. In all threeservice lines, we provide patients with a variety of clinical and administrative support servicesand related products and supplies, most of which are prescribed by a physician as part of a careplan. We provide these services to patients through approximately 550 locations throughout theUnited States.We evaluate operating results on a service line basis and, therefore, view each service lineas a reporting unit. For financial reporting purposes, all our service lines are aggregated intoone reportable segment in accordance with the aggregation criteria of SFAS No. 131, *“Disclosuresabout Segments of an Enterprise and Related Information.”****Recent Developments***. On June 18, 2008, we entered into an Agreement and Plan of Merger (the“Merger Agreement”) with Sky Acquisition LLC, a Delaware limited liability company (“Buyer”) andSky Merger Sub Corporation, a Delaware corporation and wholly-owned subsidiary of Buyer (“MergerSub”). Buyer is controlled by a private investment fund affiliated with The Blackstone Group(“Blackstone”), which is providing a portion of the funding for the transaction.The Merger Agreement provides that, upon the terms and subject to the conditions set forth inthe Merger Agreement, Merger Sub will merge with and into the Company (the “Merger”) with theCompany continuing as the surviving corporation and a wholly-owned subsidiary of Buyer. As of theeffective time of the Merger, each issued and outstanding share of our common stock will becancelled and converted into the right to receive $21.00 in cash, without interest and lessapplicable withholding taxes (the “Merger Consideration”). Buyer and Merger Sub have obtainedequity and debt financing commitments for the transactions contemplated by the Merger Agreement,the aggregate proceeds of which will be sufficient for Buyer to pay the aggregate MergerConsideration and all related fees and expenses. Debt financing commitments of $1.15 billion havebeen provided by a syndicate comprised of Bank of America, Wachovia Bank, and Barclays Capital.Consummation of the Merger is not subject to a financing condition, but is subject to various otherconditions, including approval of the Merger Agreement by our stockholders, expiration ortermination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of1976, as amended (the “HSR Act”), accuracy of the representations and warranties of the Company andother customary closing conditions. On July 8, 2008, we received notice that the federal antitrustauthorities have granted early termination of the waiting period under the HSR Act. The partiesexpect to close the transaction later in 2008.We have made various representations and warranties and agreed to certain covenants in theMerger Agreement, including covenants relating to the Company’s conduct of its business between thedate of the Merger Agreement and the closing of the Merger, governmental filings and approvals,public disclosures and other matters.The Merger Agreement contains certain termination rights for both us and the Buyer. The MergerAgreement provides that, upon termination under specified circumstances, we would be required topay Buyer a termination fee. The Merger Agreement further provides that, upon termination underother specified circumstances, Buyer would be required to pay us a reverse termination fee. Thereverse termination fee potentially payable by Buyer is guaranteed by an investment fund affiliatedwith Blackstone, in a separate limited guarantee.
 
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On June 18, 2008, the Company entered into a $280 million credit facility pursuant to theCredit Agreement. On September 2, 2008 proceeds of the newcredit facility were used to fund repurchases ofthe Company’s 3 3/8% Convertible Senior Notes due 2033 and willbe used to pay certain tax liabilities relatedthereto. The loans under the credit facility bear interest at a rate of eleven per cent (11%) peryear with a maturity date of March 1, 2009. In addition, the Company paid usual and customary bankfees in connection with entering into the Credit Agreement. The Credit Agreement includesrestrictions on the Company regarding additional indebtedness, business operations, liens,transfers and sales of assets, and transactions with affiliates. The Credit Agreement also containscustomary events of default which would permit the lenders to accelerate payments under theCredit Agreement if not cured within applicable grace periods, including the failure to make timelypayments under the Credit Agreement and the failure to follow certaincovenants. As of June 30,2008, the Company was in compliance with all covenants, but, due to thenon-timely filing of the Company’s quarterly report on Form10-Q for the period ended June 30, 2008, the Company would havebeen in default of the reporting covenants under the Credit Agreementon August 15, 2008. However, theCompany’s lenders executed a waiver on August 14, 2008, whichextended the filing requirement from 45 to 90 days. Upon thefiling of this quarterly report on Form 10-Q for theperiod ended June 30, 2008,the Company will have remedied thenon-compliance with reporting requirements under its CreditAgreement.OnSeptember 2, 2008, the Company repurchased $249.8 million in aggregateprincipal of its senior notes representing approximately 99.91% of theoutstanding principal amount. $0.2 million in aggregate principal amount of thesenior notes remains outstanding.On August 26,2008, Apria received a notice of default from the trustee under the indenturegoverning the senior notes regarding Apria’s failure to deliver itsQuarterly Report on Form 10-Q for the period ended June 30, 2008 withinthe specified time period. Pursuant to the indenture, failure by Apria tocomply with such reporting requirements will become an event of default if notremedied within 60 days after the date on which written notice of suchfailure, requiring Apria to remedy the same, is given to Apria by the trustee,and the senior notes, together with accrued and unpaid interest thereon, shallbecome due and payable immediately upon notice to the Company from the Trusteeor the holders of not less than 25% in aggregate principal amount of the seniornotes then outstanding. Upon the filing of thisquarterly report on Form 10-Q for the period endedJune 30, 2008, theCompany will have remedied the default under its senior notes.***Strategy***. Our strategy is to position ourselves in the marketplace as the low cost, qualityprovider of a broad range of home healthcare services to managed care and government customers. Thespecific elements of our strategy are to: **•** achieve strong organic sales growth and increase market share;  **•** leverage our nationwide infrastructure to reduce costs and expand profits;  **•** deliver superior customer service;  **•** attract, develop and advance leaders within the Company;  **•** operate our business ethically; and  **•** maintain independent accreditation at all locations.***Critical Accounting Policies.***We consider the accounting policies that govern revenuerecognition and the determination of the net realizable value of accounts receivable to be the mostcritical in relation to our consolidated financial statements. These policies require the mostcomplex and subjective judgments of management. Additionally, the accounting policies related togoodwill, long-lived assets, share-based compensation and income taxes require significantjudgment. These policies are presented in detail in the “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” section in our Annual Report on Form 10-K/A for theyear ended December 31, 2007.**Government Regulation**We are subject to extensive government regulation, including numerous laws directed atregulating reimbursement of our products and services under various government programs andpreventing fraud and abuse, as more fully described below. We maintain certain safeguards intendedto reduce the likelihood that we will engage in conduct or enter into arrangements in violation ofthese restrictions. Corporate contract services and legal department personnel review and approvewritten contracts, such as billing contracts and discount agreements, subject to these laws. Wealso maintain various educational and audit programs designed to keep our managers updated andinformed regarding developments on these topics and to reinforce to employees our policy of strictcompliance in this area. Notwithstanding these measures, violations of these laws and regulationsmay still occur.*Medicare and Medicaid Reimbursement Revenues.*In 2007, approximately 35% of our revenues werereimbursed by the Medicare and state Medicaid programs. For the six months ended June 30, 2008 and2007, Medicare and Medicaid revenues represented 32% and 35% of our total net revenue,respectively. For the full year of 2008, we estimate that the percentage of our revenuesreimbursed under arrangements with Medicare and Medicaid will be approximately 31%. No otherthird-party payor represented more than 9% of our total net revenues for 2007 and for the quarterended June 30, 2008. The majority of our revenues are derived from rental income on equipmentrented and related services provided to patients, sales of equipment, supplies and pharmaceuticalsand other items we sell to patients for patient care under fee-for-service arrangements. Revenuesderived from capitation arrangements represented 8% and 11% of net revenues for the quarters endedJune 30, 2008 and 2007, respectively.
 
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*Medicare Reimbursement.*There are a number of historic and ongoing legislative and regulatoryactivities in Congress and at the Centers for Medicare and Medicaid Services (“CMS”) that affect ormay affect Medicare reimbursement policies for products and services we provide. Specifically, anumber of important legislative changes that affect our business were included in the MedicarePrescription Drug, Improvement, and Modernization Act (“MMA”), which was signed into law inDecember 2003, the Deficit Reduction Act of 2005 (“DRA”), which was signed into law in February2006, and most recently, the Medicare Improvements for Patients and Providers Act of 2008(“MIPPA”), which became law on July 15, 2008. These Acts and their implementing regulations andguidelines contain numerous provisions that were significant to us and continue to have an impacton our operations today, as described below:*DMEPOS Competitive Bidding.*The MMA required implementation of a competitive bidding programfor certain durable medical equipment, prosthetics, orthotics and supplies (“DMEPOS”) items. Bystatute, CMS was required to implement the DMEPOS competitive bidding program over time, with thefirst phase (“Round 1”) of competition occurring in portions of 10 of the largest metropolitanstatistical areas (called competitive bidding areas or “CBAs”) in 2007, launch of the program in2008 and in 70 additional markets in 2009, and in additional markets after 2009.In 2007 and 2008, CMS accepted and reviewed bids to begin Round 1 on July 1, 2008. CMSoffered us contracts in several CBAs in Round 1; we accepted the contracts for certain productcategories and declined others due to unacceptably low payment amounts in certain markets, whichwould not adequately cover the cost of providing quality service to our patients in those areas.Winning contract suppliers were to begin providing services under Round 1 on July 1, 2008.The bidding process for Round 1 was controversial and complex, which resulted in deadlineextensions. Moreover, CMS was subject to numerous lawsuits seeking a delay of Round 1. Then onJuly 15, 2008, MIPPA was enacted which, among other provisions, delays the DMEPOS competitivebidding program by requiring that Round 1 competition commence in 2009, and requires a number ofprogram reforms prior to CMS’ relaunching the program. As a result, contracts that were awardedunder Round 1 have been terminated and the contracting process will need to be restarted through are-bidding process in 2009. In addition, CMS has publicly announced that currently Medicarebeneficiaries in the fee-for-service Medicare program may use any provider in any geographic area,including the CBAs, to obtain home medical equipment and oxygen therapy services and products. CMSalso expects to notify Medicare beneficiaries in all former CBAs of this right and the delay of theprogram by direct mail by August 2008.Under MIPPA, the initial CBAs and product categories subject to rebidding will be very similarto those of Round 1. One difference, however, is that one of the 10 CBAs originally designated,Puerto Rico, will be excluded from the competitive bidding program. We do not service Puerto Rico.MIPPA also excludes Negative Pressure Wound Therapy Pumps and Related Supplies and Accessories as acompetitive bidding product category in Round 1 and permanently excludes Complex RehabilitativePower Wheelchairs and Related Accessories as a potential competitive bidding product category.The revenue associated with the items subject to competitive bidding in what was to be theinitial year of the program represents less than 2% of our 2007 total net revenues. CMS estimatedthe Round 1 Single Payment Amounts represented an average payment cut of approximately 26% from theexisting fee schedule for the impacted product categories. However, since the adoption of MIPPAand the required delay in re-bidding, the actual impact of competitive bidding on our total netrevenues will likely be different given the fact that a re-bidding process could result in pricingdiscounts different than what CMS published for Round 1. Under the Single Payment Amounts forRound 1, if the program had continued, competitive bidding payment reductions in 2008 would haveresulted in a decline of approximately 0.4% in our 2008 total net revenues from the level we wouldhave expected if competitive bidding had not been in effect.Notwithstanding the changes MIPPA requires, competitive bidding imposes a significant risk toDMEPOS suppliers. Under the rules governing Round 1, if a DMEPOS supplier operating in a CBA isnot awarded a contract for that CBA, the supplier generally will not be able to bill and bereimbursed by Medicare for DMEPOS items supplied in that CBA for the time period covered by thecompetitive bidding program unless the supplier meets certain exceptions or acquires a winningbidder. Because the applicable statutes mandate financial savings from the competitive biddingprogram, a winning contract supplier will receive lower Medicare payment rates under competitivebidding than the otherwise applicable DMEPOS fee schedule rates. As competitive bidding is phasedin across the country under the revised MIPPA implementation schedule, we will likely experience areduction in reimbursement, as will most if not all other DMEPOS suppliers in the impacted areas.In addition, there is a risk that the new competitive bidding prices will become a benchmark forreimbursement from private payors. MIPPA does not prevent CMS from adjusting prices for DMEPOSitems in non-bid areas; however, before using its authority to adjust prices in non-bid areas,MIPPA requires that CMS issue a regulation that specifies the methodology to be used and considerhow prices through competitive bidding compare to costs for those items and services in the non-bidareas. At this time, it is unclear what specific changes CMS will make to the bidding process andthe competitive bidding program as a whole to address the concerns that led to the passage ofMIPPA, and we cannot quantify what negative impact, if any, the revised program will have upon ourrevenue or operations once the program is reinitiated.
 
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Nevertheless, we believe that our geographic coverage, clinical marketing programs andpurchasing strength provide competitive advantages to maintain and enhance market share underMedicare competitive bidding. However, there is no guarantee that we will be selected as a winningcontract supplier and be awarded a competitive bidding contract by CMS in any phase of the revisedimplementation schedule for competitive bidding. Under the current competitive biddingregulations, if we are not selected as a winning contract supplier for a particular CBA, we willgenerally not be allowed to supply Medicare beneficiaries in the CBA with products subject tocompetitive bidding, unless we elect to continue to service existing patients under the“grandfathering provision” of the final rule or we acquire a winning supplier. Because of ourcombination of both managed care and traditional business, we believe we can nevertheless maintaina favorable overall market position in a particular CBA even if we are not selected as a contractsupplier for a particular CBA.*Medicare Fee Schedule for DMEPOS and CPI Adjustments.*In addition to the adoption of theDMEPOS competitive bidding program, the MMA implemented a five-year freeze on annual consumer priceindex (“CPI”) payment increases for most durable medical equipment (“DME”) from 2004 to 2008. InMIPPA, in order to offset the cost of, or “pay for” the delay in the implementation of the DMEPOScompetitive bidding program, Congress approved a nationwide 9.5% payment reduction in the DMEPOSfee schedule for those product categories included in Round 1, effective January 1, 2009. Theseproduct categories, could be subjected to a legislated CPI update in 2014, except if the item isstill subject to competitive bidding or CMS has otherwise adjusted the payment rate.The MIPPA legislation has also implemented nationwide CPI increases beginning in 2009 forthose DMEPOS items that were not subject to competitive bidding in July 2008. Those DMEPOS itemsthat were not subject to Round 1 competitive bidding will receive a full CPI update each year from2009 to 2013. In 2014, these items will receive the CPI update plus 2%.*CappedRentals and Oxygen Equipment.*Under the DRA, beginning with Medicare beneficiaries who received DMEPOSproducts and services as of January 2006, ownership of certain DME categorized by CMS in the“capped rental” category (e.g., hospital beds, wheelchairs, nebulizers, patient lifts andcontinuous positive airway pressure devices) automatically transfers to the Medicare beneficiary atthe end of a maximum rental period. As of January 1, 2006, the maximum rental period became 13months. Therefore, the first month in which the new policy had an impact on our revenue wasFebruary 2007. In addition, the service and maintenance fee, which had been paid to supplierstwice yearly after the rental period ended in order to cover various non-equipment service costsfor patients who require use of the equipment, was eliminated for those patients who commencedservice on or after January 1, 2006. However, the DRA provides for additional payments formaintenance and service of the item for repair parts and labor not covered by a supplier’s ormanufacturer’s warranty. Implementing regulations also imposed other repair and replacementobligations on suppliers with respect to equipment that does not last the useful lifetime of theequipment, which CMS has generally defined as being five years.With respect to oxygen equipment, the DRA converted Medicare reimbursement for oxygenequipment from an ongoing rental method to a capped rental and rent-to-purchase methodology andlimited reimbursement for rental of oxygen equipment to the current 36-month maximum. The DRA alsomandated that, after the 36-month rental period, the ownership of the equipment would transfer tothe Medicare beneficiary, who would assume primary responsibility for identifying when repairs orpreventive maintenance are needed. The existing implementing regulations to this DRA provisionalso limit supplier replacement of oxygen equipment during the rental period, and require suppliersto replace beneficiary-owned equipment that does not last the useful lifetime of the equipment,which CMS has generally defined as being five years. However, MIPPA repealed the mandatory titletransfer for oxygen equipment. As a result, the equipment will continue to be owned by the homeoxygen provider for as long as the patient’s medical need exists, after which time it will bereturned to the home oxygen provider. It is not yet known when CMS will issue new or updatedimplementing regulations concerning MIPPA’s repeal of mandatory title transfer for oxygenequipment.The 36-month rental period was retroactively applied to January 1, 2006 for all beneficiariesrequiring oxygen as of December 31, 2005. Accordingly, January 2009 is the first month in whichthe rental cap will impact us. Additional DRA regulations, which remain intact despite the repealof mandatory title transfer, established new payment classes for oxygen equipment, includingtransfilling and portable equipment, new monthly rental reimbursement rates, and new reimbursementrates for the delivery of oxygen contents for patient-owned equipment after title to the equipmenttransfers. CMS has not published any changes to these rates or policies as a result of MIPPA’spassage but has stated that CMS will update its regulations relating to the DRA in the future. Inits original regulations published in 2007, CMS stated that CMS would annually review theutilization patterns and fee schedule rates for oxygen and consider whether an adjustment to thepayment rates is needed in order to satisfy the statutory mandate of budget neutrality.
 
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Regarding repairs and maintenance of Medicare beneficiary-owned oxygen equipment, the existingimplementing DRA regulations permit payment to suppliers for general maintenance and servicing ofcertain patient-owned oxygen equipment every six months, beginning after the first six months thepatient owns the equipment. The existing final rule governing repairs andmaintenance of oxygen equipment limits payment for general maintenance and servicing visits to30 minutes of labor based on rates the Medicare contractors establish. In its last final rule onthis subject, CMS declined to offer general maintenance and servicing payments forbeneficiary-owned liquid and gas equipment with the exception of a single payment for pick-up andstorage or disposal of such equipment that a beneficiary no longer needs. Due to the recentpassage of MIPPA and the lack of implementing regulations from CMS arising from MIPPA, we cannotspeculate on any changes CMS may make to its repair, maintenance and service or other fee schedulesrelated to those oxygen patients who reach the cap but do not own their equipment. We may or maynot continue to provide repair and maintenance service on oxygen equipment that has met the cap andare continuing to evaluate the impact of the changes likely to occur due to both the DRA and MIPPA.In January 2006, CMS published a final regulation that shifted payment for certain respiratoryassist devices from the “frequent and substantial” payment category to the “capped rental”category. Under “frequent and substantial” payment, Medicare payment continues for the duration oftime the beneficiary requires the device, while “capped rental” payment continues for 13 months.The change in the payment category became effective April 1, 2006. The first claims received foreach Medicare beneficiary with a date of service on or after April 1, 2006, including beneficiarieswith existing rental equipment, are counted as the first rental month in the capped rental period.Thus, the first month in which the new categorization impacted our revenue was May 2007. Ourestimate for this change in payment categories was a reduction in 2007 revenues of approximately$2.5 million.In recent years, there were several legislative and executive branch efforts to further reducethe maximum rental period for oxygen therapy, equipment and related services. The President’s2007, 2008 and 2009 healthcare budget proposals sought to reduce the maximum rental period foroxygen equipment from the now-mandated 36 months to 13 months, which was recommended by the HHSOffice of Inspector General (“OIG”) in a limited study of the oxygen benefit published in 2006entitled “Medicare Home Oxygen: Equipment Cost and Servicing.” There are other initiatives toimplement a reduction to either the cap period or the monthly payment rate, but it is uncertainwhether any of these initiatives will ultimately be reintroduced and approved by Congress or theAdministration in future years.*Reimbursement for Inhalation and Infusion Therapy Drugs.*As a result of MMA, beginningJanuary 2005, Medicare Part B reimbursement for most drugs, including inhalation drugs, becamebased upon the manufacturer-reported average sales price (“ASP”) (subject to adjustment eachquarter), plus 6%, plus a separate dispensing fee per patient episode. CMS publishes the ASP plus6% payment levels in the month that precedes the first day of each quarter, and we have no way ofknowing if the quarterly ASPs will increase or decrease since manufacturers report applicable ASPinformation directly to CMS. Since 2006, dispensing fees have remained at $57.00 for a 30-daysupply for a new patient, $33.00 for each 30-day supply thereafter, and $66.00 for each 90-daysupply.The Medicare reimbursement methodology for non-compounded, infused drugs administered throughDME, such as infusion pumps, was not affected by this MMA change. It remains based upon either 95%of the October 1, 2003 Average Wholesale Price (“AWP”) or, for those drugs whose AWPs were notpublished in the applicable 2003 compendia, at 95% of the first published AWP.The 2007 Healthcare Common Procedure Coding System (“HCPCS”) list for Medicare Part Bmedications included new codes for certain compounded medications. The coding and reimbursementchanges did not have a material impact on us due to the extremely low volume of patient-specific,physician-prescribed compounding that was performed by our inhalation pharmacies.Although CMS had considered issuing a National Coverage Decision for certain inhalation drugtherapies, in the third quarter of 2007, CMS issued a National Coverage Decision that stated thatno national coverage policy was appropriate at that time. Rather, CMS stated that it wouldcontinue to defer decisions about the medical necessity of individual respiratory drugs to thelocal contractors. Thereafter, in April of 2008, the DME Medicare Administrative Contractorsfinalized a proposed local coverage determination policy for several respiratory drugs, includingXopenex®1 and DuoNeb®2. Each of these two drugs was subjected to a separate“least costly alternative (“LCA”) policy” which would have changed the reimbursement methodologyin a way that would effectively have eliminated Medicare beneficiary access to these drugs whichare frequently used to treat Chronic Obstructive Pulmonary Disease (COPD). After complaints werefiled by Medicare beneficiaries in the Federal District Court of the District of Columbia, CMSannounced that it planned to withdraw the LCA for Xopenex and take no LCA action on that productuntil at least January 1, 2009. After separate litigation was filed, the LCA for DuoNeb waspostponed until November 1, 2008. Both cases are still being litigated. At this time, we cannotpredict how these court actions will be resolved. Additionally, if or when CMS reconsidersthese issues, we do not know how any of these decisions might impact our operations, butfuture decisions with respect to the coverage of inhalation drugs may have a material adverseimpact on us.    1 Xopenex is a registered trademark of Sepracor, Inc. 2 DuoNeb is a registered trademark of Dey Labs, LLC.
 
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In 2007, there also were changes to the reimbursement methodology for certain inhalationdrugs. Beginning in the third quarter of 2007, CMS began reimbursing providers of Xopenex andalbuterol a blended ASP for these two inhalation drugs. On December 29, 2007, the President signedinto law the Medicare, Medicaid, and State Children’s Health Insurance Program Extension Act of2007, which partially reversed the CMS regulatory decision regarding Xopenex and albuterol.Beginning on April 1, 2008, Medicare began to reimburse providers for Xopenex by blending theaverage sales prices of Xopenex and albuterol, but it no longer reimbursed providers for albuterolat the blended price. Rather, albuterol is reimbursed using an albuterol-only ASP.We estimate that these changes to inhalation drug reimbursement will result in a totalincremental $5 million decline in revenue for 2008. However, we have undertaken strategiesintended to partially mitigate this negative impact.A limited number of infusion therapies, supplies and equipment are covered by Medicare Part B.The MMA, through the new Medicare Part D program, provided expanded coverage for certain homeinfusion therapy drugs, but excluded coverage for the corresponding supplies and clinical servicesneeded to safely and effectively administer these drugs. We have contracted with a limited numberof Medicare Part D prescription drug plans in order to provide continuity of care for certainpatients.Due to ongoing Part D coverage and payment issues associated with home infusion therapy, theindustry is continuing to work with CMS and Congress to rectify the Medicare coverage and paymentlimitations that limit patient and referral source access to quality home infusion therapyservices. Bills were introduced in Congress in both the 109th and 110th Congress to consolidatehome infusion therapy coverage under Part B. This legislation would provide for Medicare infusionbenefit coverage in a more comprehensive manner that is analogous to how the therapy is covered bythe managed care sector. Industry representatives continue to present the cost-saving advantagesof home infusion therapy to Members of Congress and the Administration. At this time, we cannotassess whether similar legislation may be introduced in the future or whether it will become law.*Enrollment and Accreditation of DME Suppliers.*While we support the elimination of fraudulentsuppliers and are working with CMS to support these initiatives, we also note that a number ofinitiatives and developments with respect to the enrollment and accreditation of providers couldimpact our operations in the future. For example, accreditation is mandatory for suppliers whowish to participate in the Medicare competitive bidding program. Accreditation also is becomingmandatory as a condition of enrollment and continuing participation as a Medicare DME supplier, notjust for those DME suppliers participating in the Medicare competitive bidding program. We and allof our branches currently are accredited. If we or any of our branches lose accreditation, or ifany of our new branches are unable to become accredited, that could have a material adverse effecton our results of operations, cash flow and capital resources.Another exampleis that in July 2007, CMS issued a proposed rule requiring all DMEPOSsuppliers to provide CMS with a surety bond of at least $65,000 for each National ProviderIdentifier the supplier holds. The rule would ensure that Medicare can recover any erroneouspayment amounts or civil money penalties up to $65,000 that result from fraudulent or abusivesupplier billing practices. There is a similar legislative proposal, introduced on February 7,2008 in the Senate, entitled the “Medicare Fraud Prevention Act of 2008,” which would increasefinancial penalties and prison sentences for certain civil and criminal violations of the SocialSecurity Act, including making false statements and violating the federal anti-kickback statute.The proposed Act would also increase the amount of the surety bond requirement for DME suppliers to$500,000. We cannot predict whether this legislation, or some revised form of it, will or will notbecome law.In January 2008, CMS proposed regulations expanding and strengthening enrollment requirementswhich DME suppliers must meet to establish and maintain Medicare billing privileges. Theserevisions would impose additional requirements in the areas of provider insurance, marketingpractices, document retention, facility location, and hours of operation. We submitted comments tothe proposal prior to the March 25, 2008 deadline. We believe there will not be any materialimpact on us if the proposal is finalized in its current form. It is uncertain whether any or allof these proposed regulations will be finalized, however, and we cannot predict or estimate theimpact of the final changes, if any.In June 2008, the Seniors and Taxpayers Obligation Protection Act (“STOP Act”) was introducedin the U.S. Senate. The bill, if implemented, would require the Secretary of HHS to implementprocedures to change the current system of using Social Security numbers as the MedicareBeneficiary Identifier (“MBI”) in an effort to reduce fraud and identity theft among seniors. Thismeasure also establishes prepaid fraud detection methods, which include pre-enrollment site visitsfor high risk areas and prepayment claim edits to detect submissions that are most likelyfraudulent. This bill also contains a surety bond requirement for DME suppliers. Wecannot predict whether this STOP Act bill, or an amended version, will or will not become lawor otherwise negatively impact our operations.
 
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*Inherent Reasonableness*. The Balanced Budget Act of 1997 granted authority to HHS to increaseor reduce Medicare Part B reimbursement for home medical equipment, including oxygen, by up to 15%each year under an “inherent reasonableness” authority. Pursuant to that authority, CMS publisheda final rule that established a process by which such adjustments may be made. The rule applies toall Medicare Part B services except those paid under a physician fee schedule, a prospectivepayment system, or a competitive bidding program. Neither HHS nor CMS has issued any subsequentcommunication or information for several years and, therefore, we cannot predict whether or whenHHS would exercise its authority in this area or predict any negative impact of any such change.*Use of Recovery Audit Contractors*. The MMA directed HHS to conduct a 3-year demonstrationprogram using Recovery Audit Contractors (“RACs”) to detect and correct improper payments in theMedicare fee-for-service program. The demonstration program began in March 2005 and ended in March2008 in California, Florida, and New York. The Report was issued in 2008 and CMS plans to phase inthe new RACs gradually beginning in the summer of 2008 through December 2009. The Tax Relief andHealth Care Act of 2006 requires HHS to establish the RAC initiative as a permanent, nationwideprogram by no later than January 1, 2010. We cannot at this time quantify any negative impact thatthe expansion of the RAC program may have on us.*Incentives for the Expansion of Medicare Part C (Medicare Advantage)*. The MMA includedfinancial incentives for managed care plans to expand their provision of Medicare Advantage plansin 2006 in an effort to attract more Medicare beneficiaries to managed care models. We maintaincontracts to provide home respiratory therapy, home infusion therapy services, home medicalequipment and related services to a significant number of managed care companies who maintainMedicare Advantage plans nationwide. Although MIPPA reduces certain Medicare Part C incentives,Medicare Advantage plans may continue to be attractive alternatives to traditional Medicarefee-for-service for those Medicare beneficiaries who choose them and the Company intends tocontinue to contract with them.*Beneficiary Access to Power Mobility Devices*. In late 2006, CMS revised the Local CoverageDetermination (“LCD”) for power mobility devices resulting in reductions to the Medicare powermobility devices fee schedule of about 15%. The initial changes took effect November 15, 2006.The reduction in our revenues for 2007 resulting from these fee schedule changes was approximately$1 million. The industry also believes that Medicare beneficiary access to power mobility will berestricted by this LCD and therefore has requested revisions to the fee schedule.We cannot estimate the combined possible impact of all legislative, regulatory andcontemplated reimbursement changes that could have a material adverse effect on our results ofoperations, cash flow, and capital resources. Moreover, our estimates of the impact of certain ofthese changes appearing in this “Government Regulation” section are based on a number ofassumptions and are subject to uncertainties and there can be no assurance that the actual impactwas not or will not be different from our estimates.*Medicaid Reimbursement.*State Medicaid programs implement reimbursement policies for theitems and services we provide that may or may not be similar to those of the Medicare program.Budget pressures on these state programs often result in pricing and coverage changes that may havea detrimental impact on our operations. States sometimes have adopted alternative pricingmethodologies for certain drugs, biologicals, and home medical equipment under their Medicaidprograms that reduce the level of reimbursement received by us without a corresponding offset orincrease to compensate for the service costs incurred. Historically, we frequently elected to stopaccepting new Medicaid patient referrals for the affected drugs, biologicals, and home medicalequipment. Should these types of changes occur in the future, we may or may not elect to makesimilar decisions. Other states have expanded coverage for certain products and services. Wecannot predict whether other states will consider reductions as well and whether any such changescould have a material adverse effect on our results of operations, cash flow and capital resources.*HIPAA.*The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) is comprisedof a number of components pertaining to the privacy and security of certain patient healthinformation, as well as the standard formatting of certain electronic health transactions. Manystates have similar, but not identical, restrictions. Existing and any new laws or regulationshave a significant effect on the manner in which we handle healthcare related data and communicatewith payors. We face potential administrative, civil, and criminal sanctions if we do not complywith the existing or new laws and regulations. Imposition of these sanctions could have a materialadverse effect on our operations.
 
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*Enforcement of Healthcare Fraud and Abuse Laws*. In recent years, the federal government hasmade a policy decision to significantly increase the financial resources allocated to enforcing thehealthcare fraud and abuse laws. In addition, private insurersand various state enforcement agencies have increased their level of scrutiny of healthcareclaims in an effort to identify and prosecute fraudulent and abusive practices in the healthcarearea. From time to time, we may be the subject of investigations or a party to additionallitigation which alleges violations of law. If any of those matters were successfully assertedagainst us, there could be a material adverse effect on our business, financial position, resultsof operations or prospects.*Anti-Kickback Statutes.*As a provider of services under the Medicare and Medicaid programs,we must comply with a provision of the federal Social Security Act, commonly known as the “federalanti-kickback statute.” The federal anti-kickback statute prohibits the offer or receipt of anybribe, kickback or rebate in return for the referral or arranging for the referral of patients,products or services covered by federal healthcare programs. Federal healthcare programs have beendefined to include plans and programs that provide health benefits funded by the United StatesGovernment, including Medicare, Medicaid and TRICARE (formerly known as the Civilian Health andMedical Program of the Uniformed Services or CHAMPUS), among others. Some courts and the OIGinterpret the statute to cover any arrangement where even one purpose of the remuneration is toinfluence referrals. Violations of the federal anti-kickback statute may result in civil andcriminal penalties and exclusion from participation in federal healthcare programs.Due to the breadth of the federal anti-kickback statute’s broad prohibition, there are a fewstatutory exceptions that protect various common business transactions and arrangements fromprosecution. In addition, the OIG has published safe harbor regulations that outline otherarrangements that also are deemed protected from prosecution under the federal anti-kickbackstatute, provided all applicable criteria are met. The failure of an activity to meet all of theapplicable safe harbor criteria does not necessarily mean that the particular arrangement violatesthe federal anti-kickback law, but these arrangements will be subject to greater scrutiny byenforcement agencies.Some states have enacted statutes and regulations similar to the federal anti-kickbackstatute, but which apply not only to the federal healthcare programs, but also to any payor sourceof the patient. These state laws may contain exceptions and safe harbors that are different fromthose of the federal law and that may vary from state to state. Additionally, a number of statesin which we operate have laws that prohibit fee-splitting arrangements between healthcareproviders, if such arrangements are designed to induce or encourage the referral of patients to aparticular provider. Possible sanctions for violations of these restrictions include exclusionfrom state-funded healthcare programs, loss of licensure and civil and criminal penalties. Suchstatutes vary from state to state, are often vague and often have been subject to only limitedcourt or regulatory agency interpretation.*Physician Self-Referral.*Certain provisions of the Omnibus Budget Reconciliation Act of 1993(“Stark”) prohibit healthcare providers such as us, subject to certain exceptions, from submittingclaims to the Medicare and Medicaid programs for designated health services if we have a financialrelationship with the physician making the referral for such services or with a member of suchphysician’s immediate family. The term “designated health services” includes several servicescommonly performed or supplied by us, including DME and home health services. In addition,“financial relationship” is broadly defined to include any ownership or investment interest orcompensation arrangement pursuant to which a physician receives remuneration from the provider atissue. The prohibition of Stark applies regardless of the reasons for the financial relationshipand the referral; and therefore, unlike the federal anti-kickback statute, an intent to violate thelaw is not required. Like the federal anti-kickback statute, Stark contains a number of statutoryand regulatory exceptions intended to protect certain types of transactions and businessarrangements from penalty. In order to qualify an arrangement under a Stark exception, compliancewith all of the exception’s requirements is necessary. Violations of Stark may result in loss ofMedicare and Medicaid reimbursement, civil penalties and exclusion from participation in theMedicare and Medicaid programs.In addition, a number of the states in which we operate have similar prohibitions againstphysician self-referrals, which may not necessarily be limited to Medicare or Medicaid services andmay not include the same statutory and regulatory exceptions found in Stark.*False Claims.*The federal False Claims Acts impose civil and criminal liability onindividuals or entities that submit false or fraudulent claims for payment to the government.Violations of the federal civil False Claims Act may result in treble damages, civil monetarypenalties and exclusion from the Medicare, Medicaid, and other federally funded healthcareprograms. If certain criteria are satisfied, the federal civil False Claims Act allows a privateindividual to bring a qui tam suit on behalf of the government and, if the case is successful, toshare in any recovery. Federal False Claims Act suits brought directly by the government orprivate individuals against healthcare providers, like us, are increasingly common and are expectedto continue to increase.
 
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The False Claims Corrections Act of 2007 introduced both in the House and the Senate andapproved by the House Committee on the Judiciary on July 16, 2008, proposes significant revisionsto the existing federal False Claims Act. Among other changes, the bill repeals the requirementthat false claims be presented to a government employee and clarifies under what circumstances agovernmentemployee may act as a qui tam relator under the False Claims Act. The bill extends thestatute of limitations period in federal False Claims Act cases to 10 years, but was recentlyrevised by the House Judiciary Committee to provide for an eight-year statute of limitations. TheFalse Claims Corrections Act would require, upon motion of the Attorney General’s Office, a courtto dismiss an action or claim if the allegations relating to all essential elements of liability ofthe action or claim are based exclusively on the public disclosure of allegations or transactionsin specified federal hearings or reports or from the news media. Only the Attorney General’sOffice may move for this dismissal and thus, the defendant is precluded from making this argument.The bill extends protection from retaliatory action to government contractors and agents, ratherthan just covering government employees.The federal government has used the federal False Claims Act to prosecute a wide variety ofalleged false claims and fraud allegedly perpetrated against Medicare and state healthcareprograms. The government and a number of courts also have taken the position that claims presentedin violation of certain other statutes, including the federal anti-kickback statute or the StarkLaw, can be considered a violation of the federal False Claims Act, based on the theory that aprovider impliedly certifies compliance with all applicable laws, regulations, and other rules whensubmitting claims for reimbursement.A number of states have enacted false claims acts that are similar to the federal False ClaimsAct. Even more states are expected to do so in the future because Section 6031 of the DRA amendedthe federal law to encourage these types of changes in law at the state level. In addition, thereis a corresponding increase in state-initiated false claims enforcement efforts. Under the DRA, ifa state enacts a false claims act that is at least as stringent as the federal statute and thatalso meets certain other requirements, the state will be eligible to receive a greater share of anymonetary recovery obtained pursuant to certain actions brought under the state’s false claims act.*Other Fraud and Abuse Laws.*HIPAA created, in part, two new federal crimes: “HealthcareFraud” and “False Statements Relating to Healthcare Matters.” The Healthcare Fraud statuteprohibits executing a knowing and willful scheme or artifice to defraud any healthcare benefitprogram. A violation of this statute is a felony and may result in fines and/or imprisonment. TheFalse Statements statute prohibits knowingly and willfully falsifying, concealing or covering up amaterial fact by any trick, scheme or device or making any materially false, fictitious orfraudulent statement in connection with the delivery of or payment for healthcare benefits, itemsor services. A violation of this statute is a felony and may result in fines and/or imprisonment.*Certificationof Compliance Agreement.*Pursuant to the merger agreement to acquire Coram, weassumed Coram’s obligations. On August 22, 2007, Coram entered into a Certification of ComplianceAgreement with the OIG (“Compliance Agreement”) which obligates Coram to maintain a complianceprogram to monitor, ensure compliance with federal healthcare program requirements and submittimely reports to the government regarding the same. Violation of the terms of the ComplianceAgreement could result in the imposition of penalties and sanctions, including disqualificationfrom Medicare and other reimbursement programs.*Facility and Clinician Licensure.*Various federal and state authorities and clinical practiceboards regulate the licensure of our facilities and clinical specialists working for us, eitherdirectly as employees or on a per diem or contractual basis. Regulations and requirements varyfrom state to state. Several states are currently contemplating the establishment or expansion offacility licensure related to the home healthcare industry. We are committed to complying with allapplicable licensing requirements and maintain centralized functions to manage over 4,500 facilitylicenses that are required to operate our business.*Healthcare Reform Legislation.*Economic, political and regulatory influences are causingfundamental changes in the healthcare industry in the United States. Various healthcare reformproposals are formulated and proposed by the legislative and administrative branches of the federalgovernment on a regular basis. In addition, some of the states in which we operate periodicallyconsider various healthcare reform proposals. We anticipate that federal and state governmentswill continue to review and assess alternative healthcare delivery systems and paymentmethodologies and public debate of these issues will continue in the future. Changes in the law ornew interpretations of existing laws can have a substantial effect on permissible activities, therelative costs associated with doing business in the healthcare industry and the amount ofreimbursement by governmental and other third-party payors. Due to uncertainties regarding theultimate features of reform initiatives and their enactment and implementation, we cannot predictwhich, if any, of such reform proposals will be adopted, or when they may be adopted, or that anysuch reforms will not have a material adverse effect on our results of operations, cash flow,capital resources and liquidity.
 
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**Results of Operations*****Three Months Ended June 30, 2008 and 2007****Net Revenues.*Net revenues increased $139.3 million, or 35.5%, to $531.2 million in the threemonths ended June 30, 2008 from $391.9 million in the three months ended June 30, 2007. The 35.5%increase resulted from an increase in sales volume that primarily related to the growth in our homeinfusion therapy service line due to the Coram acquisition. The revenue growth rate for 2008 wasimpacted by incremental Medicare revenue reductions of $6.1 million due to reimbursement changes.Had those reductions not been implemented, revenues for 2008 would have increased by 37.1%. TheMedicare reimbursement changes related to: **•** the reduction in the equipment rental period from 15 to 13 months for certain respiratoryequipment such as Continuous Positive Airway Pressure Units, Nebulizer Units, Hospital Beds andWheelchairs (regulation effective date of February 2007);  **•** changing the maximum rental period on certain equipment such as bi-level airway pressuredevices from an unlimited rental period to 13 months (regulation effective date of May2007);  **•** transfer of equipment ownership from us to the patient at the end of the 13-month rentalperiod (regulation effective date of February 2007); and  **•** respiratory drug reimbursement reductions effective April 1, 2008.We expect to face continued pricing pressures from Medicare as well as from our managed carecustomers as these payors seek to lower costs by obtaining more favorable pricing from providerssuch as us. In addition to the pricing reductions, such changes could cause us to provide reducedlevels of certain products and services in the future, resulting in a corresponding reduction inrevenue. However, given our high volume of managed care business, we are well-positioned among ourcompetitors with respect to the Medicare Advantage plan expansion. See “*Government Regulation”*above*.*The following table sets forth a summary of net revenues by service line:                   **Three Months Ended June 30,**               **Percentage** **(in thousands)** **2008**  **2007**  **Increase**  **Change** Home respiratory therapy $273,135  $267,325  $5,810   2.2%Home infusion therapy  205,509   72,297   133,212   184.3 Home medical equipment/other  52,604   52,307   297   0.6              Total net revenues $531,248  $391,929  $139,319   35.5%             *Home Respiratory Therapy**.*Home respiratory therapy revenues are derived primarily fromthe provision of oxygen systems, home ventilators, obstructive sleep apnea equipment, nebulizers,respiratory medications and related services. Revenues from the respiratory therapy service lineincreased by 2.2% in the three months ended June 30, 2008 compared to the same period in 2007. Themajority of the Medicare pricing reductions discussed above impacted the respiratory therapy line.Such reductions were $5.8 million in the three months ended June 30, 2008. Adjusted for the Medicare reductions, respiratory revenues increased by 4.3% in thethree months ended June 30, 2008 compared to the sameperiod in 2007. The growth in revenue dollarsin the three months ended June 30, 2008 resulted primarily from an increase in revenue from oxygenequipment rental revenue and an increase in the rental and sale of bi-level airway pressure devicesand related supplies. These increases were offset by a decrease in respiratory drug revenue,primarily as a result of the changes in Medicare reimbursement in this area.*Home Infusion Therapy**.*The home infusion therapy service line involves theadministration of drugs or nutrients directly into the body intravenously through a needle orcatheter. Infusion therapy services also include administering enteral nutrients directly into thegastrointestinal tract through a feeding tube. Home infusion therapy revenues increased by 184.3%in the three months ended June 30, 2008. During this period, growth resulted from the Coramacquisition that we completed in December 2007.*Home Medical Equipment/Other**.*Home medical equipment/other revenues are derived fromthe provision of equipment to assist patients with ambulation, safety and general care in andaround the home. Home medical equipment/other revenues increased by 0.6% in the three months endedJune 30, 2008. In 2008, $0.3 million of the Medicare reimbursement reductions impacted this serviceline. Excluding the impact of the Medicare reimbursement changes home medical equipment/otherrevenue would have increased by 1.2% for the three months ended June 30, 2008.
 
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*GrossProfit.*The gross profit margin in the three months ended June 30, 2008 was 60.6%compared to 65.7% in the three months ended June 30, 2007. The decrease in gross profit margin isdue to the acquisition of the Coram business, in December 2007, which has a lower profit marginthan our home respiratory therapy and home medical equipment service lines due to the nature of theinfusion business. This decrease was offset by improvement in the home respiratory therapy and homemedical equipment gross profit margin. The improvement in the home respiratory therapy and homemedical equipment services lines for the three months ended June 30, 2008 primarily resulted fromour ability to secure favorable pricing on the purchases of products and supplies, offset byincreased costs related to the write-off of the remaining net book value of rental equipment at thetime of transfer of equipment ownership from us to our patients.*Provision for Doubtful Accounts.*The provision for doubtful accounts is based on management’sestimate of the net realizable value of accounts receivable after considering actual write-offs ofspecific receivables. Accounts receivable estimated to be uncollectible are provided for bycomputing a required reserve using estimated future cash receiptsbased on historical cash receipts collections as a percentage ofrevenue. Management may adjust for changes in billing practices, cashcollection protocols or practices, or changes in general economicconditions, new markets or products. The provision for doubtful accounts, expressed as apercentage of net revenues, was 1.0% and 2.8% in the three months ended June 30, 2008 and 2007,respectively. The decrease in 2008 from the 2007 levels resulted primarily from an improvement inthe home infusion therapy service line provision for doubtful accounts due to the Coram acquisitionwhich has a lower percentage of doubtful accounts and a higher rate of collections of bad debts.Additionally, the home respiratory therapy and home medical equipment service lines improved due toour continued collection efforts and improvement in the aging of our accounts receivable.*Selling, Distribution and Administrative Expenses.*Selling, distribution and administrativeexpenses are comprised of expenses incurred in direct support of operations and those associatedwith administrative functions. Expenses incurred by the operating locations include salaries andother expenses in the following functional areas: selling, distribution, intake, reimbursement,warehousing and repair. Many of these operating costs are directly variable with revenue growthpatterns. Some are also very sensitive to market-driven price fluctuations such as facility leaseand fuel costs. The administrative expenses include overhead costs incurred by the operatinglocations and corporate support functions. These expenses do not fluctuate with revenue growth asclosely as do operating costs.Selling, distribution and administrative expenses, expressed as percentages of revenues were51.2% for the three months ended June 30, 2008 compared to 53.4% for the three months ended June30, 2007. The home infusion therapy services line selling, distribution and administrative expenseswere 33.8% for the three months ended June 30, 2008 compared to 22.7% for the three months endedJune 30, 2007. The home respiratory therapy services line and the home medical equipment serviceline selling, distribution and administrative were 62.1% for the three months ended June 30, 2008compared to 60.3% at June 30, 2007.Selling, distribution and administrative expenses increased by $62.5 million for the threemonths ended June 30, 2008 over the corresponding period in 2007. Labor and related expensesincreased $41.2 million, of which $36.7 million was attributable to our home infusion therapyservices line primarily related to our acquisition of Coram in December 2007. Other operating costsincreased $21.3 million, of which $16.7 million was attributable to our home infusion therapyservices line primarily related to our acquisition of Coram. The other increases in labor and otheroperating costs were primarily due to increases in delivery costs (primarily fuel and vehicle leasecosts), commissions, stock based compensation expense, initial expenses related to cost savingsprogram initiatives, costs incurred in support of enterprise wide information system project, andexpenses incurred related to the potential sale of the Company which resulted in the MergerAgreement with Blackstone, offset by decreases due to changes in estimates in general andprofessional liability insurance expense.*Amortization of Intangible Assets.*Amortization of intangible assets increased $0.3 million,or 48.6%, to $1.0 million in the three months ended June 30, 2008 from $0.7 million in the threemonths ended June 30, 2007. The increase in amortization expense for the three months ended June30, 2008, when compared to the corresponding period in 2007, resulted from amortization in 2008related to intangibles identified as part of our acquisition of Coram in December 2007 offset by adecrease in amortization on intangibles that have become fully amortized.*Interest Expense.*Interest expense decreased $0.2 million, or 2.9%, to $5.5 million in thethree months ended June 30, 2008 from $5.7 million in the three months ended June 30, 2007. Thisdecrease is due to reductions in interest rates offset by the impact of the $359 million weborrowed to purchase Coram in December 2007.*Interest Income.*Interest income decreased $0.3 million, or 49.9%, to $0.4 million in thethree months ended June 30, 2008 from $0.7 million in the three months ended June 30, 2007.
 
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*IncomeTax Expense.*Our effective tax rate was 39.8% for the three months ended June 30, 2008compared with 38.7% for the three months ended June 30, 2007.Our effective tax rate is based on expected income, statutory tax rates and tax planningopportunities available to us in the various jurisdictions in which we operate. Significantmanagement estimates and judgments are required in determining our effective tax rate. We areroutinely under audit by federal, state or local authorities regarding the timing and amount ofdeductions, allocation of income among various tax jurisdictions and compliance with federal, stateand local tax laws. Tax assessments related to these audits may not arise until several years aftertax returns have been filed. Although predicting the outcome of such tax assessments involvesuncertainty, we believe that the recorded tax liabilities appropriately reflect our potentialobligations under FASB Interpretation No. 48,“*Accounting for uncertainty in income taxes*”(“FIN 48”).***Six Months Ended June 30, 2008 and 2007****Net Revenues.*Net revenues increased $276.5 million, or 35.3%, to $1,059.2 million in the sixmonths ended June 30, 2008 from $782.7 million in the six months ended June 30, 2007. The 35.3%increase resulted from an increase in sales volume that primarily related to the growth in our homeinfusion therapy service line due to the Coram acquisition. The revenue growth rate for 2008 wasimpacted by incremental Medicare revenue reductions of $9.1 million due to reimbursement changes.Had those reductions not gone into place, revenues for 2008 would have increased by 36.5%. TheMedicare reimbursement changes related to: **•** the reduction in the equipment rental period from 15 to 13 months for certain respiratoryequipment such as Continuous Positive Airway Pressure Units, Nebulizer Units, Hospital Beds andWheelchairs (regulation effective date of February 2007);  **•** changing the maximum rental period on certain equipment such as bi-level airway pressuredevices from an unlimited rental period to 13 months (regulation effective date of May2007);  **•** transfer of equipment ownership from us to the patient at the end of the 13-month rentalperiod (regulation effective date of February 2007); and  **•** respiratory drugreimbursement reductions effective April 1, 2008.We expect to continue to face pricing pressures from Medicare as well as from our managed carecustomers as these payors seek to lower costs by obtaining more favorable pricing from providerssuch as us. In addition to the pricing reductions, such changes could cause us to provide reducedlevels of certain products and services in the future, resulting in a corresponding reduction inrevenue. However, given our high volume of managed care business, we are well-positioned among ourcompetitors with respect to the Medicare Advantage plan expansion. See “*Government Regulation”*above*.*The following table sets forth a summary of net revenues by service line:                   **Six Months Ended June 30,**               **Percentage** **(in thousands)** **2008**  **2007**  **Increase**  **Change** Home respiratory therapy $549,583  $537,086  $12,497   2.3%Home infusion therapy  406,027   141,265   264,762   187.4 Home medical equipment/other  103,616   104,357   (741)  (0.7)             Total net revenues $1,059,226  $782,708  $276,518   35.3%             *Home Respiratory Therapy**.*Home respiratory therapy revenues are derived primarily fromthe provision of oxygen systems, home ventilators, obstructive sleep apnea equipment, nebulizers,respiratory medications and related services. Revenues from the respiratory therapy service lineincreased by 2.3% in the six months ended June 30, 2008. The majority of the Medicare pricingreductions discussed above impacted the respiratory therapy line. Such reductions were $8.2 millionin the six months ended June 30, 2008. Adjusted for the Medicare reductions, respiratory revenuesincreased by 3.8% in the six months ended June 30, 2008. The growth in revenue dollars in the sixmonths ended June 30, 2008 resulted primarily from an increase in revenue from oxygen equipmentrental revenue and an increase in rental and sale of bi-level airway pressure devices and relatedsupplies. These increases were offset by a decrease in respiratory drug revenue, primarily as aresult of the changes in Medicare reimbursement in this area.*Home Infusion Therapy**.*The home infusion therapy service line involves theadministration of drugs or nutrients directly into the body intravenously through a needle orcatheter. Infusion therapy services also include administering enteral nutrients directly into thegastrointestinal tract through a feeding tube. Home infusion therapy revenues increased by187.4% in the six months ended June 30, 2008. During this period, growth resulted from the Coramacquisition that we completed in December 2007.
 
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*Home Medical Equipment/Other**.*Home medical equipment/other revenues are derived fromthe provision of equipment to assist patients with ambulation, safety and general care in andaround the home. Home medical equipment/other revenues decreased by 0.7% in the six months endedJune 30, 2008. In 2008, $0.9 million of the Medicare reimbursement reductions impacted this serviceline. Excluding the impact of the Medicare reimbursement changes home medical equipment/otherrevenue would have increased by 0.2% for the six months ended June 30, 2008.*GrossProfit.*The gross profit margin in the six months ended June 30, 2008 was 60.8% comparedto 65.6% in the six months ended June 30, 2007. The decrease in gross profit margin is due to theacquisition of the Coram business, in December 2007, which has a lower profit margin than our homerespiratory therapy and home medical equipment service lines due to the nature of the infusionbusiness. This decrease was offset by improvement in the home respiratory therapy and home medicalequipment gross profit margin. The improvement in the home respiratory therapy and home medicalequipment services lines for the six months ended June 30, 2008 primarily resulted from our abilityto secure favorable pricing on the purchases of products and supplies, offset by increased costsrelated to the write-off of the remaining net book value of rental equipment at the time oftransfer of equipment ownership from us to our patients.*Provision for Doubtful Accounts.*The provision for doubtful accounts is based on management’sestimate of the net realizable value of accounts receivable after considering actual write-offs ofspecific receivables. Accounts receivable estimated to be uncollectible are provided for byapplying specific percentages to each receivables aging category, which is determined by the numberof days the receivable is outstanding. The provision for doubtful accounts, expressed as apercentage of net revenues, was 1.5% and 2.7% in the six months ended June 30, 2008 and 2007,respectively. The decrease in 2008 from the 2007 levels resulted primarily from improvement in thehome infusion therapy service line provision for doubtful accounts due to the Coram acquisitionwhich has a lower percentage of doubtful accounts and significant collections of bad debts.Additionally, the home respiratory therapy and home medical equipment service lines improved due toour continued collection efforts and improvement in the aging of our accounts receivable.*Selling, Distribution and Administrative Expenses.*Selling, distribution and administrativeexpenses are comprised of expenses incurred in direct support of operations and those associatedwith administrative functions. Expenses incurred by the operating locations include salaries andother expenses in the following functional areas: selling, distribution, intake, reimbursement,warehousing and repair. Many of these operating costs are directly variable with revenue growthpatterns. Some are also very sensitive to market-driven price fluctuations such as facility leaseand fuel costs. The administrative expenses include overhead costs incurred by the operatinglocations and corporate support functions. These expenses do not fluctuate with revenue growth asclosely as do operating costs.Selling, distribution and administrative expenses, expressed as percentages of revenues were51.0% for the six months ended June 30, 2008 compared to 53.1% for the six months ended June 30,2007. The home infusion therapy services line selling, distribution and administrative expenseswere 34.3% at June 30, 2008 compared to 22.8% at June 30, 2007. The home respiratory therapyservices line and the home medical equipment service line selling, distribution and administrativewere 61.4% at June 30, 2008 compared to 59.8% at June 30, 2007.Selling, distribution and administrative expenses increased by $124.7 million for the sixmonths ended June 30, 2008 over the corresponding period in 2007. Labor and related expensesincreased $81.2 million, of which $73.9 million was in our home infusion therapy services lineprimarily related to our acquisition of Coram in December 2007. Other operating costs increased$43.5 million, of which $33.8 million was in our home infusion therapy services line primarilyrelated to our acquisition of Coram. The remaining increases in labor and other operating costswere primarily due to increases in delivery costs (primarily fuel and vehicle lease costs),commissions, stock based compensation expense, initial expenses related to cost savings programinitiatives and costs incurred in support of enterprise wide information system project andexpenses incurred related to the potential sale of the Company which resulted in the MergerAgreement with Blackstone, offset by decreases due to changes in estimates in general andprofessional liability insurance expense.*Amortization of Intangible Assets.*Amortization of intangible assets increased $0.4 million,or 24.7%, to $2.1 million in the six months ended June 30, 2008 from $1.7 million in the six monthsended June 30, 2007. The increase in amortization expense for the six months ended June 30, 2008,when compared to the corresponding period in 2007, resulted from amortization in 2008 related tointangibles identified as part of our acquisition of Coram in December 2007 offset by adecrease in amortization on intangibles that have become fully amortized.
 
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*Interest Expense.*Interest expense increased $1.8 million, or 15.2%, to $13.8 million in thesix months ended June 30, 2008 from $12.0 million in the six months ended June 30, 2007. Thisincrease is due to the impact of the $359 million we borrowed to purchase Coram in December 2007,partially offset by reductions in debt outstanding based upon repayments and lower interest rates.*InterestIncome.*Interest income decreased $0.3 million, or 28.5%, to $0.9 million in the sixmonths ended June 30, 2008 from $1.2 million in the six months ended June 30, 2007.*Income Tax Expense.*Our effective tax rate was 39.8% for the six months ended June 30, 2008compared with 37.9% for the six months ended June 30, 2007.Our effective tax rate is based on expected income, statutory tax rates and tax planningopportunities available to us in the various jurisdictions in which we operate. Significantmanagement estimates and judgments are required in determining our effective tax rate. We areroutinely under audit by federal, state or local authorities regarding the timing and amount ofdeductions, allocation of income among various tax jurisdictions and compliance with federal, stateand local tax laws. Tax assessments related to these audits may not arise until several years aftertax returns have been filed. Although predicting the outcome of such tax assessments involvesuncertainty, we believe that the recorded tax liabilities appropriately reflect our potentialobligations under FIN 48.**Liquidity and Capital Resources**Our principal source of liquidity is operating cash flow, which is supplemented by a $500million revolving credit facility. In recent years, we have generated operating cash flows inexcess of operating needs, which has afforded us the ability to pursue acquisitions and fundpatient service equipment purchases to support revenue growth. We believe that our operating cashflows will continue to be sufficient to fund our operations and growth strategies.On September 1, 2008 holders of our 3 3/8% convertible senior notes may require us to redeemsome or all of the notes. The principal amount of the convertible senior notes is currently $250million. In addition, if we are required to redeem all of the principal amount it would trigger taxpayments of approximately $30 million. On June 18, 2008, we entered into a $280 million creditfacility pursuant to the Credit Agreement. On September 2, 2008proceeds of the new credit facility were used to fund repurchases ofour 3 3/8% Convertible Senior Notes due 2033 and will be used to pay the taxliabilities related thereto. The loans under the credit facility bear interest at a rate of elevenper cent (11%) per year with a maturity date of March 1, 2009. In addition, we paid usual andcustomary bank fees in connection with entering into the Credit Agreement. The Credit Agreementincludes restrictions on additional indebtedness, business operations, liens, transfers and salesof assets, and transactions with affiliates. The Credit Agreement also contains customary events ofdefault which would permit the lenders to accelerate payments under the Credit Agreement if notcured within applicable grace periods, including the failure to make timely payments under theCredit Agreement and the failure to follow certain covenants. As of June 30, 2008, the Companywas in compliance with all covenants, but, due to the non-timely filing ofthe Company’s quarterly report on Form 10-Q for the periodended June 30, 2008,the Company would have been in default of the reporting covenantsunder the Credit Agreement on August 15, 2008. However, theCompany’s lenders executed a waiver on August 14, 2008, which extended the filing requirementfrom 45 days to 90 days following the end of the quarter.Upon thefiling of this quarterly report on Form 10-Q for theperiod ended June 30, 2008, the Company will have remedied thenon-compliance with reporting requirements under its CreditAgreement. OnSeptember 2, 2008, we repurchased $249.8 million inaggregate principal of the senior notes, representing approximately99.91% of the outstanding principal amount. $0.2 million ofprincipal of the senior notes remains outstanding.We have initiated a project to implement a new enterprise-wide information system. The overallobjective of the project is to deliver the necessary technology and automation across theorganization to enable improvements in service, productivity and access to information. Developmenton certain modules commenced in 2006 and continued in 2007 and 2008. The overall project plan isbeing designed and developed and is expected to be implemented over several years.In the six months ended June 30, 2008 and 2007, our free cash flow was $61.1 million and $75.8million, respectively. Free cash flow is defined as cash provided by operating activities lesspurchases of patient services equipment and property, equipment and improvements, exclusive ofeffects of acquisitions. It is presented as a supplemental performance measure and is not intendedas an alternative to any other cash flow measure calculated in accordance with generally acceptedaccounting principles. Further, free cash flow may not be comparable to similarly titled measuresused by other companies. A table reconciling free cash flow to net cash provided by operatingactivities is presented below.           **Six Months Ended**   **June 30,** **(dollars in thousands)** **2008**  **2007** **Reconciliation — Free Cash Flow:**        Net cash provided by operating activities $157,428  $131,610 Less: Purchases of patient service equipment and property, equipment and improvements  (96,301)  (55,811)       Free cash flow $61,127  $75,799        
 
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*Cash Flow.*The following table presents selected data from our consolidated statement of cashflows:           **Six Months Ended June 30,** **(in thousands)** **2008**  **2007** Net cash provided by operating activities $157,428  $131,610 Net cash used in investing activities  (99,284)  (55,759)Net cash used in financing activities  (63,534)  (62,025)       Net (decrease) increase in cash and equivalents  (5,390)  13,826 Cash and equivalents at beginning of period  28,451   14,657        Cash and equivalents at end of period $23,061  $28,483        ***Six Months Ended June 30, 2008 and 2007***Netcash provided by operations in the first half of 2008 was $157.4 million compared to$131.6 million in the first half of 2007, an increase of $25.8 million. The increase in net cashprovided by operations resulted from a $44.8 million increase in income before non-cash items to$179.8 million in 2008 from $135.0 million in 2007, offset by a $19.0 million increase in the cashused related to the change in operating assets and liabilities to a $22.4 million use of cash in2008 from a $3.4 million use of cash in 2007.The $19.4 million increase in cash used by the change in operating assets and liabilitiesconsisted primarily of the following: **•** $4.5 million increase in cash used by the change in accrued payroll and related taxes andbenefits, to a $5.3 million use of cash in the six months ended June 30, 2008 from a $0.8million use of cash in the six months ended June 30, 2007. The increase was primarily due toan additional accrual day in 2008, an increase in accrued vacation and the Coramacquisition;  **•** $8.9 million increase in cash used by accrued expenses to a $10.1 million use of cash inthe six months ended June 30, 2008 from a $1.2 million use of cash in the six months endedJune 30, 2007. The increase was primarily due to $4.5 million in accrued incentivecompensation and $5.0 million related to expenses from our Coram acquisition and a pay-downof an installment purchase; and  **•** $17.3 million increase in cash used by income taxes payable to a $9.3 million use of cashin the six months ended June 30, 2008 from a $8.0 million provision of cash in the sixmonths ended June 30, 2007. The increase in cash used primarily relates to 2008 reductionsin unrecognized tax benefits under FIN 48 and a lower amount of 2008 current tax liabilitiesdue to utilization of Coram’s tax net operating losses.Offset by: **•** $4.9 million decrease in cash used in accounts receivable, to a $16.1 million use of cashin the six months ended June 30, 2008 from a $21.0 million use of cash in the six monthsended June 30, 2007. This decrease in use of cash was primarily due to a net increase inaccounts receivable primarily related to Coram;  **•** $2.4 million increase in cash provided by prepaid expenses and other current assets to a$7.1 million provision of cash in the six months ended June 30, 2008 from a $4.7 millionprovision of cash in the six months ended June 30, 2007. The increase was primarily due toan increase in the prepaid infusion therapy inventory of $6.5 million from the prior year,offset by a $3.6 million decrease in prepaid insurance and a $0.8 million decrease in otherprepaids; and  **•** $4.2 million increase in cash provided by accounts payable to a $7.8 million provision ofcash in the six months ended June 30, 2008 from a $3.6 million provision of cash in the sixmonths ended June 30, 2007. The increase was primarily due to a $7.0 million increase intrade accounts payable offset by a $1.6 million change in book cash overdraft.Investingactivities used $99.3 million in the first half of 2008 compared to $55.8 million inthe first half of 2007. The primary use of funds in the first half of2008 was $96.3 million topurchase patient service equipment and property, equipment andimprovements; $64.0 million relatedto patient service equipment and $32.3 million related to property, plant and equipment, primarilydue to additions to our information systems hardware and software. The primary use of funds in thefirst half of 2007 was $55.8 million to purchase patient service equipment and property, equipmentand improvements. Of this $55.8 million, $38.8 million related to patient service equipment and$17.0 million related to property, plant and equipment.
 
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Net cash used in financing activities in the first half of 2008 was $63.5 million compared tonet cash used in financing of $62.0 million in the first half of 2007. In 2008, net cash providedby financing activities reflected our borrowing of $7.6 million under the revolving creditfacility, offset by $67.6 million of payments we made to reduce outstanding debt. Net cash used infinancing activities in 2007 reflected our repayment of $80.0 million under the revolving creditfacility, partially offset by issuances of common stock of $16.6 million in connection with theexercises of stock options and release of equity awards.*AccountsReceivable.*Accounts receivable before allowance for doubtfulaccounts were $329.2million at June 30, 2008 and $332.0 million at December 31, 2007. Days sales outstanding (calculated as ofeach period-end by dividing accounts receivable, less allowance for doubtful accounts, by the90-day rolling average of net revenues) were 51 days atJune 30, 2008 and 48 days at December 31, 2007.Accounts aged in excess of 180 days expressed as percentages of total receivables for certainpayor categories are as follows:           **June 30,**  **December 31,**   **2008**  **2007** Medicare  13.2%  23.9%Medicaid  20.4%  23.2%Self pay  44.7%  40.7%Managed care/other  18.5%  19.3%Total  18.2%  21.1%*Unbilled Receivables.*Included in accounts receivable are earned but unbilled receivables of$51.1 million and $48.3 million at June 30, 2008 and December 31, 2007, respectively. Delays,ranging from a day up to several weeks, between the date of service and billing can occur due todelays in obtaining certain required payor-specific documentation from internal and externalsources. Earned but unbilled receivables are aged from date of service and are considered in ouranalysis of historical performance and collectibility.*Inventories and Patient Service Equipment.*Inventories consist primarily of pharmaceuticalsand disposable products used in conjunction with patient service equipment. Patient serviceequipment consists of respiratory and home medical equipment that is provided to in-home patientsfor the course of their care plan, normally on a rental basis, and subsequently returned to us forredistribution after cleaning and maintenance is performed.The branch locations serve as the primary point from which inventories and patient serviceequipment are delivered to patients. Certain products and services, such as infusion therapy andrespiratory medications, bypass the branches and are provided directly to patients from pharmaciesor other central locations. The branches are supplied with inventory and equipment from centralwarehouses that service specific areas of the country. Such warehouses are also responsible forrepairs and scheduled maintenance of patient service equipment, which adds to the frequent movementof equipment between locations. Further, the majority of our patient service equipment is locatedin patients’ homes. While utilization varies widely between equipment types, on the average,approximately 86.1% of equipment is on rent at any given time. Inherent in this asset flow is thefact that losses will occur. Depending on the product type, we perform physical inventories on anannual or quarterly basis. Inventory and patient service equipment balances in the financialrecords are adjusted to reflect the results of these physical inventories. Inventory and patientservice equipment losses for the three months ended June 30, 2008 and 2007 were $1,023,000 and$821,000, respectively.*Long-term Debt.*At June 30, 2008, borrowings under our revolving credit facility were $364.0million; outstanding letters of credit totaled $7.8 million; credit available under the revolvingfacility was $128.2 million; and we were in compliance with all covenants required by the 2004Credit Agreement. The effective interest rate at June 30, 2008, after consideration of the effectof the swap agreement described under “Hedging Activities” below was 3.2%.*Liquidity Credit Facility:*OnJune 18, 2008, the Company entered into a $280 million creditfacility pursuant to the Credit Agreement. Proceeds of the new credit facilitywere used to fund potential repurchases of the Company’s 3 3/8%Convertible Senior Notes due 2033 and will be used to pay certain tax liabilities relatedthereto. The loans under the credit facility bear interest at a rate of elevenper cent (11%) per year with a maturity date of March 1, 2009. Inaddition, the Company paid usual and customary bank fees in connection withentering into the Credit Agreement. The Credit Agreement includes restrictionson the Company regarding additional indebtedness, business operations, liens,transfers and sales of assets, and transactions with affiliates. The CreditAgreement also contains customary events of default which would permit thelenders to accelerate payments under the Credit Agreement if not cured withinapplicable grace periods, including the failure to make timely payments underthe Credit Agreement and the failure to follow certain covenants. As ofJune 30, 2008, the Company was in compliance with all covenants, however,due to the non-timely filing of the Company’s Form 10-Q, the Companywould have been in default of the reporting covenants under the CreditAgreement on August 15, 2008. However, the Company’s lenders executeda waiver on August 14,2008, which extended the filing requirement from 45 days to 90 daysfollowing the end of the quarter.*Convertible Senior Notes.*At June 30, 2008, the fair value of the $250 million in convertiblesenior notes was $249 million, as determined by reference to quoted market prices.OnSeptember 2, 2008, the Company repurchased $249.8 million in aggregateprincipal of its senior notes representing approximately 99.91% of theoutstanding principal amount. $0.2 million in aggregate principal amount of thesenior notes remains outstanding.*Hedging Activities.*We are exposed to interest rate fluctuations on our underlying variablerate long-term debt. Our policy for managing interest rate risk is to evaluate and monitor allavailable relevant information, including but not limited to, the structure of our interest-bearingassets and liabilities, historical interest rate trends and interest rate forecasts published bymajor financial institutions. The tools we may utilize to moderate our exposure to fluctuations inthe relevant interest rate indices include, but are not limited to: (1) strategic determination ofrepricing periods and related principal amounts, and (2) derivative financial instruments such asinterest rate swap agreements, caps or collars. We do not use derivative financial instruments fortrading or other speculative purposes.
 
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At June 30, 2008, we had one interest rate swap agreement in effect which will expire inJanuary 2009 and has a notional amount of $25 million with a fixed rate of 4.44%.We account for our swap agreement under SFAS No. 133, *“Accounting for Derivative Instrumentsand Hedging Activities.”*The difference between the interest received and interest paid isreflected as an adjustment to interest expense. We received a net settlement amount of $18,000 and$58,000 related to the three-month period ended June 30, 2008 and 2007, respectively, and $69,000and $117,000 for the six months ended June 30, 2008 and 2007, respectively. The aggregate fairvalue of the swap agreement was a liability of $198,000 and $105,000 at June 30, 2008 and December31, 2007, respectively, and is reflected in the accompanying condensed consolidated balance sheetsin other accrued liabilities. Our interest rate swap agreement is valued using observable marketbased inputs and therefore is classified within Level 2. Unrealized gains and losses on the fairvalue of the swap agreement are reflected in net income, as the transaction does not qualify forhedge accounting. Our exposure to credit loss under the swap agreement is limited to the interestrate spread in the event of counterparty nonperformance. We do not anticipate losses due tocounterparty nonperformance as its counterparties to the swap agreement are nationally recognizedfinancial institutions with strong credit ratings.*Treasury Stock.*In the first six months of 2008, 57,191 shares of employee share-based awards,valued at $1,263,000 were tendered back to us to satisfy the related purchase and tax obligations.*Business Combinations.*Business combinations are accounted for as purchases and the results ofoperations of the acquired companies are included in the accompanying condensed consolidated incomestatements from the dates of acquisition. Covenants not to compete are being amortized over thelife of the respective agreements. Tradenames are being amortized over the period of their expectedbenefit.During the six months ended June 30, 2008 and 2007, we did not make any acquisitions. Cashpaid for acquisitions, which includes amounts deferred from prior periods, totaled $3.0 million.**Contractual Cash Obligations.**There were no material changes from December 31, 2007 reported amounts.**Off-Balance Sheet Arrangements**We are not a party to off-balance sheet arrangements as defined by the Securities and ExchangeCommission. However, from time to time we enter into certain types of contracts that contingentlyrequire us to indemnify parties against third-party claims. The contracts primarily relate to: (i)certain asset purchase agreements, under which we may provide customary indemnification to theseller of the business being acquired; (ii) certain real estate leases, under which we may berequired to indemnify property owners for environmental and other liabilities, and other claimsarising from our use of the applicable premises; and (iii) certain agreements with our officers,directors and employees, under which we may be required to indemnify such persons for liabilitiesarising out of their relationship with us.**ITEM 3.*****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK***We are exposed to interest rate fluctuations on our underlying variable rate long-term debt.We utilize interest rate swap agreements to moderate such exposure. We do not use derivativefinancial instruments for trading or other speculative purposes.At June 30, 2008, our revolving credit facility borrowings totaled $364.0 million. The 2004Credit Agreement, which governs the revolver, provides interest rate options based on the followingindices: Federal Funds Rate, the Bank of America prime rate or the London Interbank Offered Rate(“LIBOR”). All such interest rate options are subject to the application of an interest margin asspecified in the bank credit agreement. At June 30, 2008 all of our outstanding revolving debt wastied to LIBOR.During the first six months of 2008, we had one interest rate swap agreement in effect to fixour LIBOR-based variable rate debt. The agreement became effective in January 2006 for a three-yearterm, and has a notional amount of $25 million that fixes an equivalent amount of our variable ratelong-term debt at 4.44%.
 
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Based on the revolving debt outstanding and the swap agreement in place at June 30, 2008, a100 basis point change in the applicable interest rates would increase or decrease our annual cashflow and pretax earnings by approximately $3,390,000. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — Long-term Debt — Hedging Activities.”**ITEM4.*****CONTROLS AND PROCEDURES***(a) Evaluation of Disclosure Controls and ProceduresIn connection with the preparationof this Quarterly Report on Form 10-Q and in accordance with Exchange Act Rules 13a-15 and 15d-15, we carriedout an evaluation, under the supervision and with the participation of management, including our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end ofthe period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that the effectiveness of our disclosure controls and procedures were not effective as of June 30, 2008because of the material weakness in our internal control overfinancial reporting discussed below. A material weakness is a deficiency, or acombination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibilitythat a material misstatement of the company’s annual or interim financial statements will not be prevented or detectedon a timely basis. Management identified the following materialweakness:*Management’sestimate of the reserve for uncollectible accounts receivable.* We did not effectively design and perform controlactivities to prevent or detect material misstatements that might exist in our reserve for uncollectible accounts receivable.Specifically, we did not perform an analysis with a sufficient level of detail to support management’s estimate of the reservefor uncollectible accounts receivable.Notwithstanding the material weakness describedabove, based upon the work performed by the Company during August and September of 2008, including our review of accountsreceivable reserves as of June 30, 2008 we have concluded that there were no material adjustments required to the reported accounts receivable reserve amounts, and that our unaudited consolidated financial statements for the periods coveredby and included in this Form 10-Q are fairly stated in all material respects in accordance with generally acceptedaccounting principles in the United States of America.(b)      Changesin Internal Control Over Financial ReportingDuringthe three month period ended June 30, 2008 there have been no changes toour internal control over financial reporting that have materiallyaffected, or are reasonably likely to materially affect, our internalcontrol over financial reporting.(c)      FutureRemediation Plan for Material WeaknessDuringSeptember 2008, we completedthe design and implementation of control activities that we believe will prevent or detect material misstatements thatmight exist in our reserve for uncollectible accounts receivable. Specifically, we have developed a process to assessour historical cash receipts experience and consider other relevant factors to support management’s estimate for uncollectibleaccounts receivable. While management believes that these steps are appropriate to remediate the material weakness in ourinternal control over financial reporting, management cannot conclude that remediation is complete until such controlsoperate for a sufficient period of time and are tested further.Following testing of operating effectiveness, we believe ourremediation will be complete in the fourth quarter of 2008.**PART II — OTHER INFORMATION****ITEM 1.*****LEGAL PROCEEDINGS***We are the defendant in a purported California class action lawsuit asserting blanket claimsof liability under various California employee protection statutes and regulations relating topayment of regular and overtime wages, the timeliness of such payments, the maintenance andprovision of access to required payroll records, and the provision of meal and rest periods. Theoriginal claim was filed by Jesus Venegas on February 21, 2006 in the California Superior Court forthe County of San Francisco (Case No. CGC — 06 — 449669). The complaint, as amended, seekscompensatory damages in an unspecified amount as well as other relief on behalf of a purportedclass consisting of substantially all of our delivery drivers in the State of California. TheCompany has answered the complaint denying all material allegations and asserting a number ofaffirmative defenses. We have successfully pursued motions for summary adjudication eliminatingcertain tort based claims and claims for unjust enrichment and declaratory relief. Based on theinvestigation of the allegations made to date, we believe there are meritorious defenses to theremaining claims and intend to continue a vigorous defense of the lawsuit. The Court has notestablished a trial date and has indicated that the issue of whether the case may be certified as aclass action is likely to be determined at a hearing which it expects to hold in early 2009. Untila final decision is made with respect to the plaintiff’s class action allegations, no assurancescan be given that the ultimate disposition of this case will not have a material adverse effect onour financial condition or results of operations.We have also been served with two complaints seeking to enjoin the proposed Merger. The firstcomplaint was filed on June 24, 2008 by Alaska Ironworkers Pension Trust, On Behalf of Itself andAll Others Similarly Situated, in the Superior Court of the State of California, County of Orange,Case No. 30-2008-00078710. The complaint names the Company and its directors as defendants, andasserts a single cause of action for breach of fiduciary duty and aiding and abetting against alldefendants. The complaint seeks certification of a class of all common stockholders of the Companywho are being and will be harmed by defendants’ alleged actions; a declaration that the proposedtransaction is in breach of defendants’ fiduciary duties, and, therefore, unlawful andunenforceable; an order enjoining defendants and others from consummating the proposed transaction;an order directing the individual defendants to exercise their fiduciary duties to obtain atransaction in the best interests of the Company’s stockholders; rescission of the proposedtransaction to the extent already implemented; recovery of costs of suit, including attorneys’fees; and other relief.The second complaint was filed on July 2, 2008 by Bruce Ellis, On Behalf of Himself and AllOthers Similarly Situated, in the Superior Court of the State of California, County of Orange, CaseNo. 30-2008-00081027. The complaint names the Company, the Company’s directors, and BlackstoneGroup LP as defendants, and asserts two (2) causes of action: (1) breach of fiduciary duty againstthe individual defendants, and (2) aiding and abetting the individual defendants’ breach offiduciary duty against Blackstone Group LP. The complaint seeks certification of a class of allcommon stockholders of the Company who are being and will be harmed by defendants’ alleged actions;a declaration that the proposed transaction is in breach of defendants’ fiduciary duties, and,therefore, unlawful and unenforceable; an order enjoining defendants and others from consummatingthe proposed transaction; an order enjoining the defendants from holding a shareholder vote on theproposed transaction until curative disclosures are made; an order directing the individualdefendants to exercise their fiduciary duties to obtain a transaction which is in the bestinterests of the Company’s stockholders; rescission of the proposed transaction to the extentalready implemented; imposition of a constructive trust,in favor of plaintiff, upon any benefits improperly received by defendants; recovery of costsof suit, including attorneys’ fees; and other relief.
 
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On July 15, 2008, the Court issued an Order on Consolidation of Related Actions andAppointment of Lead Counsel, where the Court, among other things, consolidated the above actions,as well as other current or future actions arising out of the same set of facts that are filed inor transferred to the Court, into a single action, titled *In re Apria Healthcare Group Inc.Shareholder Litigation, Lead Case No. 30-2008-00078710. Coughlin, Stoia, Geller, Rudman & RobbinsLLP*was appointed as lead counsel for plaintiffs in the consolidated action. The Court furtherordered plaintiffs to file a consolidated complaint within 30 days of the July 24, 2008 filing withthe SEC of the Company’s preliminary proxy statement on Schedule 14A. The parties have stipulated toextend this deadline to September 22, 2008, and plaintiffs have not filed aconsolidated complaint as of the date of the filing of this Form 10-Q. Pursuant to the July 15, 2008order, the consolidated complaint will supersede all complaints filed in any consolidated action,and defendants shall respond to the consolidated complaint pursuant to a briefing schedule to beagreed upon by the parties and approved by the Court. Also pursuant to the order, defendants arenot required to, and have not, responded to the foregoing complaints.We are also engaged in the defense of certain claims and lawsuitsarising out of the ordinary course and conduct of our business, theoutcomes of which are not determinable at this time. Insurancepolicies covering such potential losses, where such coverage is costeffective, are maintained. In the opinion of management, anyliability that might be incurred upon the resolution of these claimsand lawsuits will not, in aggregate, have a material adverse effecton our financial condition or results of operations.**ITEM 1A.*****RISK FACTORS***The risk factors presented in our Annual Report on Form 10-K/A for the year ended December 31,2007, as filed with the Securities and Exchange Commission on February 29, 2008, are incorporatedherein by reference. With the exception of the risk factor amended and restated below, there havebeen no changes from those risk factors during the period covered by this report.***The failure to complete the pending sale of the Company could have a materially adverseimpact.***On June 18, 2008, we entered into a Merger Agreement, by and among Apria, Buyer and MergerSub. Buyer is controlled by a private investment fund affiliated with Blackstone. Consummation ofthe Merger with Merger Sub is subject to the terms and conditions of the Merger Agreement,including, but not limited to the approval of Apria’s stockholders. There can be no assurance thatApria’s stockholders will approve the Merger Agreement or that the other conditions to thecompletion of the Merger will be satisfied. If the Merger is not completed for any reason, theprice of Apria’s common stock will likely decline to the extent that the market price of the commonstock reflects market assumptions that the Merger will be completed. Additionally, Apria issubject to additional risks in connection with the Merger, including: (1) the occurrence of anevent, change or circumstance that could give rise to the payment of a termination fee to Buyerpursuant to the terms of the Merger Agreement, (2) the outcome of any legal proceedings that havebeen or may be instituted against Apria and others relating to the transactions contemplated by theMerger Agreement, (3) the failure of the Merger to close for any reason or the failure of Buyer toobtain the necessary debt financing set forth in the commitment letters provided to Apria inconnection with the Merger, (4) the restrictions imposed on Apria’s business, properties andoperations pursuant to the affirmative and negative covenants set forth in the Merger Agreement andthe potential impact of such covenants on Apria’s business, (5) the risk that the proposedtransaction will divert management’s attention resulting in a potential disruption of the Company’scurrent business plan, (6) potential difficulties in employee retention arising from the Merger,(7) the effect of the announcement of the Merger on Apria’s business relationships, operatingresults and business generally and (8) the amount of fees, expenses and charges incurred by theCompany in connection with the Merger.
 
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***Medicare/Medicaid Reimbursement Rates — Continued Reductions in Medicare and MedicaidReimbursement Rates Could Have a Material Adverse Effect on Our Results of Operations and FinancialCondition.***There are ongoing legislative and regulatory efforts to reduce or otherwise adversely affectMedicare reimbursement rates for products and services we provide. For example, the regulationsimplementing the mandates under the MMA reduced the reimbursement for a number of products andservices we provide and established a competitive bidding program for certain durable medicalequipment under Medicare Part B. The Medicare DMEPOS competitive bidding program is intended tofurther reduce reimbursement for certain products as well as decrease the number of companiespermitted to serve Medicare beneficiaries. Although the competitive bidding program began (“Round1”) in 10 of the CBAs on July 1, 2008, MIPPA, which was enacted on July 15, 2008, terminated theexisting agreements with Round 1 winning contract suppliers and required that Round 1 of the DMEPOScompetitive bidding program be delayed until 2009, with CMS also required to make certain changesto the competitive bidding process. At this time, it is unclear what specific changes CMS willmake to the bidding process and the competitive bidding program as a whole to address the concernsthat led to the passage of MIPPA, and we cannot quantify what negative impact, if any, the revisedprogram will have upon our revenue or operations once the program is reinitiated.In order toensure that the delay would achieve the same level of savings projected for theDMEPOS competitive bidding program, Congress adopted a nationwide 9.5% payment reduction in theDMEPOS fee schedule for those product categories included in Round 1, effective January 1, 2009.Those DMEPOS items that were not subject to Round 1 competitive bidding will receive a full CPIupdate each year from 2009 through 2013. In 2014 these items will receive the CPI update plus 2%.Further, the DRA resulted in reduced reimbursement rates for certain durable medicalequipment, including the home oxygen equipment and services we provide, a reduced period for rentalrevenue, and potential increased costs to us associated with replacement of certain patient-ownedequipment. There have been proposals by the President and Congress to further reduce the maximumcapped rental period for oxygen below the 36-month level mandated by the DRA to 13 and 18 months,respectively, and/or to reduce payment rates for oxygen equipment. While these proposals have notbeen enacted, similar proposals may be raised in the future.In addition to these activities, certain other proposed legislative and regulatory activitiesmay affect reimbursement policies and rates for other items and services we provide. These enactedand proposed changes, including actual or pending proposed reductions in Medicare reimbursementrates or rental periods for our products and services, could have a material adverse effect on ourresults of operations, cash flow, capital resources and liquidity.There are ongoing state and federal legislative and regulatory efforts to reduce or otherwiseadversely affect Medicaid reimbursement rates for products and services we provide. For a numberof years, some states have adopted alternative pricing methodologies for certain drugs, biologicalsand home medical equipment reimbursed under the Medicaid program. In a number of states, thechanges reduced the level of reimbursement we received for these items without a correspondingoffset or increase to compensate for the service costs we incurred. In several of those states, weelected to stop accepting new Medicaid patient referrals for the affected drugs and biologicals.In light of continuing budget pressure, states may continue to consider new or other reductions inMedicaid reimbursement for drugs, biologicals, and other durable medical equipment and affiliatedservices. In addition, changes to the federal regulations pertaining to prescription drug pricingmay also impact the Medicaid reimbursement available to us.We cannot estimate the ultimate impact of all legislated and contemplated Medicare andMedicaid reimbursement changes or provide assurance to investors that additional reimbursementreductions will not be made or will not have an adverse effect on our results of operations, cashflow, capital resources and liquidity.For furtherinformation, see “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Government Regulation.”***Government Regulation; Healthcare Reform — Non-Compliance with Laws and Regulations Applicableto Our Business and Future Changes in Those Laws and Regulations Could Have a Material AdverseEffect on Us.***We are subject to stringent laws and regulations at both the federal and state levels,requiring compliance with burdensome and complex billing, substantiation and record-keepingrequirements. Financial relationships between us and physicians and other referral sources are alsosubject to strict limitations. In addition, strict licensure, accreditation and safety requirementsapply to the provision of services, pharmaceuticals and medical equipment. Violations of these lawsand regulations could subject us to severe fines, facilityshutdowns and possible exclusion from participation in federal healthcare programs such asMedicare and Medicaid. In addition, from time to time, we may be the subject of investigations ora party to additional litigation which alleges violations of law. If any of those matters weresuccessfully asserted against us, there could be a material adverse effect on our business,financial position, results of operations or prospects.
 
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Government officials and the public will continue to debate healthcare reform. Potential newfederal or state public policy changes to cover the uninsured could ultimately also affect paymentrates to providers or initiate new provider fees or taxes. Changes in public policy, healthcarelaw, new interpretations of existing laws, or changes in payment methodology may have a significanteffect on our business, results of operations, cash flow, capital resources and liquidity.***Certification of Compliance Agreement — Non-Compliance with Requirements of Agreement CouldResult in the Imposition of Significant Penalties and Sanctions.***As part of our acquisition of Coram, we assumed Coram’s obligations including those imposed onCoram as part of its Certification of Compliance Agreement with the Health and HumanServices’ Office of Inspector General,which requires Coram to maintain a compliance program,monitor and ensure compliance with federal healthcare program requirements and submit timelyreports to the government regarding the same. Violation of the terms of the Compliance Agreementcould result in the imposition of significant penalties and sanctions, including disqualificationfrom Medicare and other reimbursement programs.**ITEM 2.*****UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS***None.**ITEM 3.*****DEFAULTS UPON SENIOR SECURITIES***None.**ITEM 4.*****SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS*** (a) The Annual Meeting of Stockholders of the Company on May 9, 2008.  (b) Directors elected or reelected at the Annual Meeting for a term of one year:    Vicente Anido, Jr.Terry P. BayerI.T. CorleyDavid L. GoldsmithLawrence M. HigbyRichard H. KoppesPhilip R. Lochner, Jr.Norman C. Payson, M.D.Mahvash Yazdi
 
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 (c) Matters Voted Upon at Annual Meeting:    As of May 9, 2008, the Company’s Board of Directors consisted of ninemembers. The results of the stockholder voting were as follows:                   WITHHOLD/  BROKER   FOR  ABSTENTIONS  NON-VOTES Vicente Anido, Jr.  40,556,117   450,721   — Terry P. Bayer  40,571,479   435,359   — I.T. Corley  38,981,473   2,025,365   — David L. Goldsmith  38,833,530   2,173,308   — Lawrence M. Higby  40,571,490   435,348   — Richard H. Koppes  40,571,696   435,142   — Philip R. Lochner, Jr.  38,724,831   2,282,007   — Norman C. Payson, M.D.  40,571,387   435,451   — Mahvash Yazdi  38,981,995   2,024,843   —    Ratification of the Company’s Independent Registered Public Accountants    The Board of Directors appointed Deloitte & Touche LLP as the Company’s independent registered publicaccounting firm for the fiscal year ending December 31, 2008, subject to shareholder approval. The results ofthe stockholder voting were as follows:     For  40,642,462 Against  360,664 Withhold/Abstentions  3,710 Broker Non-Votes  — **ITEM 5.*****OTHER INFORMATION******LateFiling of Form 10-Q for the Quarter ended June 30, 2008.In our press release on July 30, 2008, we announced that we were inthe process of evaluating our accounts receivable reserves and onAugust 15, 2008 we filed Form 12b-25 requesting an extension on thefiling of our Form 10-Q for the quarter ended June 30, 2008. OnSeptember 8, 2008, we reached final resolution on our accounts receivablereserves in which we concluded that our accounts receivable reserveswere over-reserved by $1.5 million, or 3.9% of pre-tax net income for the quarter endedJune 30, 2008. In addition, subsequentto the release of preliminary earnings on July 30, 2008, the Companyidentified and recorded a $650,000, or 1.7% of pre-tax net income forthe quarter ended June 30, 2008, warranty obligation relating to replacementobligations for Medicare equipment required to be transferred topatients after thirteen months. The net effect of these two itemsresulted in a $850,000, or 2.2% of pre-tax net income for the quarterended June 30, 2008, increase to the quarter’s pre-tax net income.These corrections have been recorded in the quarterly period ended June 30, 2008.The Company also conducted a review of its accounts receivable reservesin prior period financial statements andconcluded that none of the prior periods were materially misstated. Therefore,the Company concluded that no restatement is required for any prior periodas a result of these errors.
 
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**ITEM 6.*****EXHIBITS***     **Exhibit**  **Number** **Reference**      2.1  Agreement and Plan of Merger, dated as of June 18, 2008, by and among the Company, Buyer, and Merger Sub. (a)      3.1  Apria Healthcare Group Inc. Bylaws, as amended and restated as of February 19, 2008. (b)      10.1  Credit Agreement, dated as of June 18, 2008, by and among the Company, Lenders, Banc of America Bridge LLC,Barclays Capital and Wachovia Capital Markets, LLC. (a)      10.30 # Form of Employee Time-Based Stock Appreciation Rights Award Agreement under the Registrant’s 2003Performance Incentive Plan. (c)      10.31 # Revised Form of Employee Performance-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003Performance Incentive Plan. (c)      10.32 # Registrant’s 2008 Executive Bonus Plan. (c)      10.33 # Revised Form of Employee Time-Based Restricted Stock Unit Award Agreement under the Registrant’s 2003Performance Incentive Plan. (c)      31.1  Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a).*      31.2  Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-14(a).*      32.1  Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.*      32.2  Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.*    # Management contract or compensatory plan or arrangement. * Filed Herewith. (a) Incorporated by reference to Current Report on Form 8-K dated June 18, 2008, as filed on June20, 2008. (b) Incorporated by reference to Current Report on Form 8-K dated February 19, 2008, as filed onFebruary 26, 2008. (c) Incorporated by reference to Current Report on Form 8-K dated February 29, 2008, as filed onMarch 6, 2008.
 
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**SIGNATURES**Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto duly authorized.      APRIA HEALTHCARE GROUP INC.***