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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended December 31, 2004



OR



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



For the transition period from  to



Commission file number 0-23946



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PEDIATRIC SERVICES OF AMERICA, INC.

(Exact name of Registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 58-1873345                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



310 Technology
Parkway, Norcross GA 30092-2929

(Address of principal executive offices, including zip code)



(770) 441-1580

(Registrants telephone number, including area code)



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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated
filer (as defined in Exchange Act Rule 12b-2).    Yes  x    No ̈



As of February 2, 2005 the Registrant had
7,179,921 shares of Common Stock, $0.01 Par Value, outstanding.



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##### Table of Contents

FORM 10-Q

PEDIATRIC SERVICES OF AMERICA, INC.



INDEX



|                             |  |                                                                                                       |  |           
|---------------------------- |  | ----------------------------------------------------------------------------------------------------- |  | ----------
|                             |  |                                                                                                       |  | PageNumber
|PART I
FINANCIAL INFORMATION |  |                                                                                                      
|                             |  |                                                                                                      
|ITEM 1:                      |  | Financial Statements                                                                                  |  |           
|                             |  |                                                                                                      
|                             |  | Condensed Consolidated Balance Sheets as of December 31, 2004 and September 30, 2004                  |  | 3         
|                             |  |                                                                                                      
|                             |  | Condensed Consolidated Statements of Operations for the three months ended December 31, 2004 and 2003 |  | 5         
|                             |  |                                                                                                      
|                             |  | Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2004 and 2003 |  | 6         
|                             |  |                                                                                                      
|                             |  | Notes to Condensed Consolidated Financial Statements                                                  |  | 7         
|                             |  |                                                                                                      
|ITEM 2:                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                 |  | 13        
|                             |  |                                                                                                      
|ITEM 3:                      |  | Quantitative and Qualitative Disclosures about Market Risk                                            |  | 22        
|                             |  |                                                                                                      
|ITEM 4:                      |  | Controls and Procedures                                                                               |  | 22        
|                             | 
|PART II
OTHER INFORMATION    |  |                                                                                                      
|                             |  |                                                                                                      
|ITEM 1:                      |  | Legal Proceedings                                                                                     |  | 23        
|                             |  |                                                                                                      
|ITEM 6:                      |  | Exhibits                                                                                              |  | 23        
|                             | 
|SIGNATURES                   |  | 24                                                                                                   



2



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##### Table of Contents

PART I  FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)



|                                                                                                      |  |                   |         |   |                    |   |         |  
|----------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ------------------ | - | ------- | -
|                                                                                                      |  | December 31, 2004 |         |   | September 30, 2004 |  
|                                                                                                      |  | (Unaudited)       |         |   |                    |  
|ASSETS                                                                                                |  |                   |         |   |                    |   |         |  
|Current assets:                                                                                       |  |                   |         |   |                    |   |         |  
|Cash and cash equivalents                                                                             |  | $                 | 4,831   |   |                    | $ | 8,159   |  
|Accounts receivable, less allowances for doubtful accounts of $5,470 and $4,840, respectively         |  |                   | 41,997  |   |                    |   | 40,403  |  
|Prepaid expenses                                                                                      |  |                   | 2,975   |   |                    |   | 1,102   |  
|Deferred income taxes                                                                                 |  |                   | 6,354   |   |                    |   | 6,557   |  
|Workers compensation loss fund                                                                       |  |                   | 3,657   |   |                    |   | 3,327   |  
|Inventory                                                                                             |  |                   | 4,108   |   |                    |   | 2,893   |  
|Insurance recoveries                                                                                  |  |                   | 2,906   |   |                    |   | 3,473   |  
|Other current assets                                                                                  |  |                   | 362     |   |                    |   | 630     |  
|                                                                                                      |  |                   |         |   |                    |   |         |  
|Total current assets                                                                                  |  |                   | 67,190  |   |                    |   | 66,544  |  
|                                                                                                      |  |                  
|Property and equipment:                                                                               |  |                   |         |   |                    |   |         |  
|Home care equipment held for rental                                                                   |  |                   | 33,233  |   |                    |   | 32,438  |  
|Furniture and fixtures                                                                                |  |                   | 12,596  |   |                    |   | 12,200  |  
|Vehicles                                                                                              |  |                   | 505     |   |                    |   | 505     |  
|Leasehold improvements                                                                                |  |                   | 2,438   |   |                    |   | 2,392   |  
|                                                                                                      |  |                   |         |   |                    |   |         |  
|                                                                                                      |  |                   | 48,772  |   |                    |   | 47,535  |  
|Accumulated depreciation and amortization                                                             |  |                   | (38,950 | ) |                    |   | (38,076 | )
|                                                                                                      |  |                   |         |   |                    |   |         |  
|                                                                                                      |  |                   | 9,822   |   |                    |   | 9,459   |  
|                                                                                                      |  |                  
|Other assets:                                                                                         |  |                   |         |   |                    |   |         |  
|Goodwill, less accumulated amortization of approximately $9,613                                       |  |                   | 36,540  |   |                    |   | 36,540  |  
|Certificates of need, less accumulated amortization of approximately $633 and $627, respectively      |  |                   | 40      |   |                    |   | 46      |  
|Deferred financing fees, less accumulated amortization of approximately $655 and $594, respectively   |  |                   | 716     |   |                    |   | 777     |  
|Noncompete agreements, less accumulated amortization of approximately $1,229 and $1,220, respectively |  |                   | 51      |   |                    |   | 60      |  
|Deferred income taxes                                                                                 |  |                   | 724     |   |                    |   | 1,301   |  
|Workers compensation bond collateral                                                                 |  |                   | 2,317   |   |                    |   | 2,311   |  
|Insurance cash surrender value and recoveries                                                         |  |                   | 8,578   |   |                    |   | 9,742   |  
|Other                                                                                                 |  |                   | 275     |   |                    |   | 302     |  
|                                                                                                      |  |                   |         |   |                    |   |         |  
|                                                                                                      |  |                   | 49,241  |   |                    |   | 51,079  |  
|                                                                                                      |  |                   |         |   |                    |   |         |  
|Total assets                                                                                          |  | $                 | 126,253 |   |                    | $ | 127,082 |  
|                                                                                                      |  |                   |         |   |                    |   |         |  



See accompanying
notes.



3



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS(Continued)

(In thousands)



|                                                                                                                                                               |  |                   |         |                    |   |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | ------------------ | - | -------
|                                                                                                                                                               |  | December 31, 2004 |         | September 30, 2004
|                                                                                                                                                               |  | (Unaudited)       |         |                   
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                           |  |                   |         |                    |   |        
|Current liabilities:                                                                                                                                           |  |                   |         |                    |   |        
|Accounts payable                                                                                                                                               |  | $                 | 5,808   |                    | $ | 4,672  
|Accrued compensation                                                                                                                                           |  |                   | 5,569   |                    |   | 6,029  
|Income taxes payable                                                                                                                                           |  |                   | 289     |                    |   | 281    
|Accrued insurance                                                                                                                                              |  |                   | 6,172   |                    |   | 6,935  
|Refunds payable                                                                                                                                                |  |                   | 1,307   |                    |   | 1,489  
|Accrued interest                                                                                                                                               |  |                   | 490     |                    |   | 998    
|Other accrued liabilities                                                                                                                                      |  |                   | 1,906   |                    |   | 2,453  
|Deferred revenue                                                                                                                                               |  |                   | 750     |                    |   | 800    
|Current maturities of long-term obligations                                                                                                                    |  |                   | 121     |                    |   | 157    
|                                                                                                                                                               |  |                   |         |                    |   |        
|Total current liabilities                                                                                                                                      |  |                   | 22,412  |                    |   | 23,814 
|                                                                                                                                                               |  |                  
|Long-term accrued insurance                                                                                                                                    |  |                   | 13,037  |                    |   | 14,046 
|Deferred compensation                                                                                                                                          |  |                   | 1,576   |                    |   | 2,386  
|Long-term obligations, net of current maturities                                                                                                               |  |                   | 20,373  |                    |   | 20,385 
|                                                                                                                                                               |  |                   |         |                    |   |        
|Total liabilities                                                                                                                                              |  |                   | 57,398  |                    |   | 60,631 
|Redeemable preferred stock, $.01 par value, 2,000 shares authorized, no shares issued and outstanding                                                          |  |                   |        |                    |   |       
|                                                                                                                                                               |  |                  
|Stockholders equity:                                                                                                                                          |  |                   |         |                    |   |        
|Common stock, $.01 par value, 80,000 shares authorized 7,146 and 7,031 shares issued and outstanding at December 31, 2004 and September 30,
2004, respectively |  |                   | 71      |                    |   | 70     
|Additional paid-in capital                                                                                                                                     |  |                   | 51,275  |                    |   | 50,621 
|Retained earnings                                                                                                                                              |  |                   | 17,509  |                    |   | 15,760 
|                                                                                                                                                               |  |                   |         |                    |   |        
|Total stockholders equity                                                                                                                                     |  |                   | 68,855  |                    |   | 66,451 
|                                                                                                                                                               |  |                   |         |                    |   |        
|Total liabilities and stockholders equity                                                                                                                     |  | $                 | 126,253 |                    | $ | 127,082
|                                                                                                                                                               |  |                   |         |                    |   |        



See accompanying
notes.



4



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                      |  |                                 |        |   |             |   |        |  
|------------------------------------- |  | ------------------------------- | ------ | - | ----------- | - | ------ | -
|                                      |  | Three Months Ended December 31, |       
|                                      |  | 2004                            |        |   | 2003        |  
|                                      |  | (Unaudited)                     |        |   | (Unaudited) |  
|Net revenue                           |  | $                               | 64,002 |   |             | $ | 59,830 |  
|Costs and expenses:                   |  |                                 |        |   |             |   |        |  
|Costs of goods and services           |  |                                 | 37,065 |   |             |   | 33,296 |  
|Other operating costs and expenses    |  |                                 |        |   |             |   |        |  
|Salaries, wages and benefits          |  |                                 | 11,070 |   |             |   | 10,222 |  
|Business insurance                    |  |                                 | 1,536  |   |             |   | 1,983  |  
|Overhead                              |  |                                 | 4,098  |   |             |   | 4,172  |  
|                                      |  |                                 |        |   |             |   |        |  
|Other operating costs and expenses    |  |                                 | 16,704 |   |             |   | 16,377 |  
|Corporate, general and administrative |  |                                 |        |   |             |   |        |  
|Salaries, wages and benefits          |  |                                 | 3,326  |   |             |   | 3,557  |  
|Business insurance                    |  |                                 | 30     |   |             |   | 44     |  
|Professional services                 |  |                                 | 804    |   |             |   | 520    |  
|Overhead                              |  |                                 | 663    |   |             |   | 734    |  
|                                      |  |                                 |        |   |             |   |        |  
|Corporate, general and administrative |  |                                 | 4,823  |   |             |   | 4,855  |  
|Provision for doubtful accounts       |  |                                 | 893    |   |             |   | 1,383  |  
|Depreciation and amortization         |  |                                 | 1,032  |   |             |   | 864    |  
|                                      |  |                                 |        |   |             |   |        |  
|Total costs and expenses              |  |                                 | 60,517 |   |             |   | 56,775 |  
|                                      |  |                                 |        |   |             |   |        |  
|Operating income                      |  |                                 | 3,485  |   |             |   | 3,055  |  
|Other income                          |  |                                 |       |   |             |   | 4      |  
|Interest income                       |  |                                 | 42     |   |             |   | 43     |  
|Interest expense                      |  |                                 | (603   | ) |             |   | (532   | )
|                                      |  |                                 |        |   |             |   |        |  
|Income before income tax expense      |  |                                 | 2,924  |   |             |   | 2,570  |  
|Income tax expense                    |  |                                 | 1,175  |   |             |   | 997    |  
|                                      |  |                                 |        |   |             |   |        |  
|Net income                            |  | $                               | 1,749  |   |             | $ | 1,573  |  
|                                      |  |                                 |        |   |             |   |        |  
|Net income per share data:            |  |                                 |        |   |             |   |        |  
|Basic                                 |  | $                               | 0.25   |   |             | $ | 0.23   |  
|                                      |  |                                 |        |   |             |   |        |  
|Diluted                               |  | $                               | 0.23   |   |             | $ | 0.22   |  
|                                      |  |                                 |        |   |             |   |        |  
|Weighted average shares outstanding:  |  |                                 |        |   |             |   |        |  
|Basic                                 |  |                                 | 7,093  |   |             |   | 6,882  |  
|                                      |  |                                 |        |   |             |   |        |  
|Diluted                               |  |                                 | 7,446  |   |             |   | 7,251  |  
|                                      |  |                                 |        |   |             |   |        |  



See accompanying
notes.



5



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                              |  |                                 |        |   |             |   |        |  
|----------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ----------- | - | ------ | -
|                                                                              |  | Three Months Ended December 31, |       
|                                                                              |  | 2004                            |        |   | 2003        |  
|                                                                              |  | (Unaudited)                     |        |   | (Unaudited) |  
|Operating activities:                                                         |  |                                 |        |   |             |   |        |  
|Net income                                                                    |  | $                               | 1,749  |   |             | $ | 1,573  |  
|Adjustments to reconcile net income to net cash used by operating activities: |  |                                 |        |   |             |   |        |  
|Depreciation and amortization                                                 |  |                                 | 1,032  |   |             |   | 864    |  
|Provision for doubtful accounts                                               |  |                                 | 893    |   |             |   | 1,383  |  
|Amortization of deferred financing fees                                       |  |                                 | 61     |   |             |   | 18     |  
|Disqualifying disposition of stock options                                    |  |                                 | 17     |   |             |   |       |  
|Nonqualified stock options                                                    |  |                                 | 238    |   |             |   |       |  
|Changes in operating assets and liabilities:                                  |  |                                 |        |   |             |   |        |  
|Accounts receivable                                                           |  |                                 | (2,487 | ) |             |   | (6,906 | )
|Prepaid expenses                                                              |  |                                 | (1,873 | ) |             |   | (1,465 | )
|Inventory                                                                     |  |                                 | (1,215 | ) |             |   | (361   | )
|Other assets                                                                  |  |                                 | 272    |   |             |   | 51     |  
|Workers compensation loss fund                                               |  |                                 | (330   | ) |             |   | (1,099 | )
|Workers compensation bond collateral                                         |  |                                 | (6     | ) |             |   | 484    |  
|Accounts payable                                                              |  |                                 | 1,136  |   |             |   | 787    |  
|Income taxes payable                                                          |  |                                 | 8      |   |             |   | (26    | )
|Accrued insurance, liabilities, refunds and interest                          |  |                                 | (1,818 | ) |             |   | (766   | )
|                                                                              |  |                                 |        |   |             |   |        |  
|Net cash used by operating activities                                         |  |                                 | (2,323 | ) |             |   | (5,463 | )
|Investing activities:                                                         |  |                                 |        |   |             |   |        |  
|Purchases of property and equipment                                           |  |                                 | (1,357 | ) |             |   | (1,568 | )
|                                                                              |  |                                 |        |   |             |   |        |  
|Net cash used in investing activities                                         |  |                                 | (1,357 | ) |             |   | (1,568 | )
|Financing activities:                                                         |  |                                 |        |   |             |   |        |  
|Principal payments of long-term debt                                          |  |                                 | (48    | ) |             |   | (48    | )
|Deferred financing fees                                                       |  |                                 |       |   |             |   | (47    | )
|Proceeds from exercise of stock options                                       |  |                                 | 400    |   |             |   | 14     |  
|                                                                              |  |                                 |        |   |             |   |        |  
|Net cash provided by (used in) financing activities                           |  |                                 | 352    |   |             |   | (81    | )
|                                                                              |  |                                 |        |   |             |   |        |  
|Decrease in cash and cash equivalents                                         |  |                                 | (3,328 | ) |             |   | (7,112 | )
|Cash and cash equivalents at beginning of period                              |  |                                 | 8,159  |   |             |   | 9,171  |  
|                                                                              |  |                                 |        |   |             |   |        |  
|Cash and cash equivalents at end of period                                    |  | $                               | 4,831  |   |             | $ | 2,059  |  
|                                                                              |  |                                 |        |   |             |   |        |  
|Supplemental disclosure of cash flow information:                             |  |                                 |        |   |             |   |        |  
|Cash paid for interest                                                        |  | $                               | 1,074  |   |             | $ | 1,073  |  
|                                                                              |  |                                 |        |   |             |   |        |  
|Cash paid for taxes                                                           |  | $                               | 139    |   |             | $ | 1,024  |  
|                                                                              |  |                                 |        |   |             |   |        |  



See accompanying
notes.



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited



1. Basis of Presentation



The accompanying unaudited condensed consolidated financial statements of Pediatric Services
of America, Inc. (the Company) and its majority-owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all
adjustments considered necessary for a fair presentation have been included. Results of operations for the three months ended December 31, 2004 are not necessarily indicative of the results to be expected for the entire fiscal year ending September
30, 2005. These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements for the year ended September 30, 2004 included in our Annual Report on Form 10-K for such year filed with
the Securities and Exchange Commission. Principal accounting policies are set forth in our 2004 Annual Report.



2. Summary of Significant Accounting Policies



Description of Business



We provide a broad range of pediatric health care services and equipment including nursing, respiratory therapy, rental and sale of durable medical equipment, pharmaceutical services and infusion therapy services. In addition, we provide
pediatric rehabilitation services, day treatment centers for medically fragile and chronically ill children and pediatric well care and immunization services. We also provide case management services in order to assist the family and patient by
coordinating the provision of services between the insurer or other payor, the physician, the hospital and other health care providers. Our services are designed to provide a high quality, lower cost alternative to prolonged hospitalization for
medically fragile children. As a complement to our pediatric respiratory and infusion therapy services, we also provide respiratory and infusion therapy and related services for adults. For financial reporting purposes, our branch offices are
aggregated into three reportable segments based on their predominant line of net revenue in accordance with the Statement of Financial Accounting Standards No. 131 Disclosures about Segments of an Enterprise and Related Information (see
Note 7).



Use of Estimates



The preparation of the condensed consolidated financial statements in
conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at
the dates of the financial statements and the reported amounts of net revenue and expenses during the reporting periods. Actual results could differ from those estimates and the differences could be material. For example, due to the nature of the
industry and the reimbursement environment in which we operate, certain estimates are required in recording net revenues and determining provisions for doubtful accounts. Inherent in these estimates is the risk that they will have to be revised or
updated as additional information becomes available to management.



Concentration of Credit Risk



Our principal
financial instruments subject to potential concentration of credit risk are cash and cash equivalents and accounts receivable. Cash and cash equivalents are held primarily in one financial institution. We perform periodic evaluations of the relative
credit standing of this financial institution. The concentration of credit risk with respect to accounts receivable, which are primarily health care industry related, represent a risk to us given the current health care environment. The risk is
somewhat limited due to the large number of payors including Medicaid and Medicare, insurance companies and individuals, and the diversity of geographic locations in which we operate. However, we have substantial geographic density in the eastern
United States, which we believe exposes us to payor initiated reimbursement changes. In addition, we are exposed to risk for a substantial amount of accounts receivable for a small number of hemophilia factor patients and disruptions to cash
collections due to the inability of some payors to process claims.



Accounts Receivable



Accounts receivable are
recorded based upon the amount of net revenue expected to be reimbursed by private and third party payors. Interest income is not recorded on trade accounts receivable. Accounts receivable include approximately $8.8 million and $7.0 million for
which services have been rendered but the amounts were unbilled as of December 31, 2004 and September 30, 2004, respectively. Such unbilled amounts are primarily a result of the time required to process bills for services rendered.



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



Summary of Significant Accounting Policies - continued



Workers Compensation Loss Fund



Our workers compensation insurance carrier, rated A by AM Best
Company, requires a twelve month estimated loss reserve to be funded entirely with cash each fiscal year which is then reduced by the monthly loss fund payments. The net balance at December 31, 2004 was $3.7 million. The insurance carrier has the
right to increase this cash requirement at the end of each fiscal year if the claim experience is greater than anticipated, but to date has not indicated the need to do so. The policy for fiscal 2005 will be funded in a similar manner with the cash
requirement estimated to be $1.0 million.



Identifiable
Intangible Assets



Amortization expense on identifiable intangible assets
was approximately $0.04 million and $0.03 million for the three months ended December 31, 2004 and 2003, respectively. Estimated amortization expense of identifiable intangible assets for each of the fiscal years ending September 30, is presented
below:



|     |  |                                   |        
|---- |  | --------------------------------- | -------
|     |  | For The Year Ending September 30,
|2005 |  | $                                 | 148,000
|2006 |  | $                                 | 129,000
|2007 |  | $                                 | 88,000 
|2008 |  | $                                 | 86,000 
|2009 |  | $                                 | 86,000 



Workers
Compensation Bond Collateral



We have secured surety bonds
of $2.5 million to satisfy our workers compensation program requirements for our former insurance carrier. As of December 31, 2004, the surety bonds were collateralized by $2.3 million cash posted to a third party escrow account. We have
received notification from the carrier of their intent to reduce the required cash collateral by approximately $0.8 million and to return that amount to us during fiscal 2005.



Accrued Insurance/Insurance Recoveries



We retain the services of an independent actuary to prepare an actuarial analysis of our development of reported and
incurred but not reported claims for workers compensation, medical malpractice and employee medical benefit plans. These estimates are updated as determined necessary based on recent claims history and other events. Inherent in these estimates
is the risk that they will need to be revised or updated, with the changes recorded in subsequent periods, as additional information becomes available to management. Accrued workers compensation and medical malpractice losses have been
discounted at 6%.



We renewed our insurance program on October
1, 2004 for medical malpractice, commercial and general liability coverage with Arch Specialty Insurance Company, rated A- by AM Best Company. Our Workers Compensation carrier, Argonaut Insurance Company, is rated A by AM Best Company.



Lillie Axelrod, spouse of director Michael Axelrod, is an
employee of Acordia Inc. Acordia provides insurance brokerage services to us. Mrs. Axelrod is paid a commission based on the fees paid to Acordia. During fiscal 2005, the fees expected to be paid by us to Acordia will be approximately $0.175
million.



Income Taxes



The liability method is used in accounting for income taxes. Under this
method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are
expected to reverse.



Reclassifications



Certain amounts for prior periods have been reclassified to conform to the
current years presentation.



8



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



Summary of Significant Accounting Policies - continued



Impact of Recently Issued Accounting Standards



See Note 4.



3. Long-Term Borrowing Arrangements



On January 27, 2004, we entered into a credit agreement with General Electric Capital Corporation (Credit Agreement). Subject to the terms and
conditions of the Credit Agreement, the Lender made available a credit facility consisting of a $10.0 million revolving line of credit and a $10.0 million line of credit for acquisitions. Availability in both components is subject to a borrowing
base calculation against our accounts receivable. Borrowings under the revolving line of credit bear interest at LIBOR plus 3.00% or the Index Rate plus 1.50%. Borrowings under the acquisition line of credit bear interest at LIBOR plus 3.50% or the
Index Rate plus 2.00%. The Credit Agreement provides for unused line fees of 0.50% for the revolving line of credit and 0.75% for the acquisition line of credit. The Credit Agreement contains several financial and non-financial covenants including,
but not limited to, certain leverage, coverage, days sales outstanding and maximum capital expenditures requirements.



On May 12, 2004, we amended the Credit Agreement to clarify a definition and increase the maximum capital expenditures covenant. We have made no
borrowings under this agreement since its inception.



On April
16, 1998, we issued, in a private placement, $75 million aggregate principal amount of 10% Senior Subordinated Notes due 2008, which were subsequently replaced on May 12, 1998, with $75 million aggregate principal amount of 10% Senior Subordinated
Notes due 2008, Series A, registered with the Securities and Exchange Commission (the Notes). The Indenture under which the Notes were issued allows us to repurchase the Notes at our discretion. All bids to repurchase have been based
upon a number of factors including cash availability, interest rates on invested cash, other capital investment alternatives, and relative ask prices quoted by the market maker. Each decision to repurchase the Notes has been arrived at independently
using the above criteria and we do not have a formal plan in place to repurchase the Notes. At December 31, 2004, total borrowings outstanding under the Notes were approximately $20.4 million.



4. Stock Option Plans



On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004),
Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95,
Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock
options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.



Statement 123(R) must be adopted by us no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet
been issued. We expect to adopt Statement 123(R) on July 1, 2005.



Statement 123(R) permits public companies to adopt its requirements using one of two methods:



| | 1. | A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all
share-based payments granted after the effective date and (b) based on the requirements of Statement 123(R) for all that remain unvested on the effective date.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | A modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the
amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We plan to adopt Statement 123 using the modified prospective method.



9



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



Stock Option Plans - continued



As permitted by Statement 123, we currently account for share-based payments to employees using Opinion 25s intrinsic
value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)s fair value method will have a significant impact on our results of operations, although it will have
no impact on our overall financial position. The impact of adoption of Statement 123(R) on our future financial statements cannot be predicted at this time because it will depend on levels of share-based payments granted in the future and the
fluctuation in our share price. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share
described below. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as financing cash flow, rather than as an operating cash flow as required under current literature. This
requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise
stock options), the amount of operating cash flows recognized in the three months ended December 31, 2004 and 2003 for such excess tax deductions were $0.3 million and $0.0 million, respectively.



Pro forma information regarding net income and earnings per share is required
by SFAS 123 as amended by SFAS 148, determined as if the Company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method. The fair value of these options was estimated at the date of grant
using a Black-Scholes option pricing model.



For purposes of
the pro forma disclosures, the estimated fair value of the options is amortized over the options vesting period. Our pro forma information follows (in thousands, except for net income per share information):



|                                                         |  |                                 |       |   |      |   |       |  
|-------------------------------------------------------- |  | ------------------------------- | ----- | - | ---- | - | ----- | -
|                                                         |  | Three Months Ended December 31, |      
|                                                         |  | 2004                            |       |   | 2003 |  
|Net Income                                               |  |                                 |       |   |      |   |       |  
|As reported                                              |  | $                               | 1,749 |   |      | $ | 1,573 |  
|Fair value based method compensation expense, net of tax |  |                                 | (486  | ) |      |   | (277  | )
|                                                         |  |                                 |       |   |      |   |       |  
|Pro forma net income                                     |  | $                               | 1,263 |   |      | $ | 1,296 |  
|                                                         |  |                                 |       |   |      |   |       |  
|Basic income per share                                   |  |                                 |       |   |      |   |       |  
|As reported                                              |  | $                               | 0.25  |   |      | $ | 0.23  |  
|                                                         |  |                                 |       |   |      |   |       |  
|Pro forma                                                |  | $                               | 0.18  |   |      | $ | 0.19  |  
|                                                         |  |                                 |       |   |      |   |       |  
|Diluted income per share                                 |  |                                 |       |   |      |   |       |  
|As reported                                              |  | $                               | 0.23  |   |      | $ | 0.22  |  
|                                                         |  |                                 |       |   |      |   |       |  
|Pro forma                                                |  | $                               | 0.17  |   |      | $ | 0.18  |  
|                                                         |  |                                 |       |   |      |   |       |  



5. Commitments and Contingencies



As a result of operating in the health care industry, our
business entails an inherent risk of lawsuits alleging malpractice, product liability or related legal theories, which can involve large claims and significant defense costs. From time to time, we are subject to such suits arising in the ordinary
course of business. We currently maintain professional and commercial liability insurance intended to cover such claims. As of December 31, 2004, this insurance coverage is provided under a claims-made policy which provides, subject to
the terms and conditions of the policy, coverage for certain types of claims made against us during the term of the policy and does not provide coverage for losses occurring during the terms of the policy for which a claim is made subsequent to the
termination of the policy. Should the policy not be renewed or replaced with equivalent insurance, claims based on occurrences during its term but asserted subsequently would be uninsured. There can be no assurance that our coverage limits of
insurance will be adequate.



In addition, we are subject to
claims and lawsuits arising in the ordinary course of business. Based upon information available to date, management believes it has provided adequate reserves if needed for any unfavorable settlement; however, there can be no assurance that the
ultimate resolution of such current pending legal proceedings would not have a material adverse effect on our consolidated financial or liquidity position.



We have entered into employment agreements with certain of our employees which provide, among other things, salary, benefits and perquisites, as well as
additional compensation for certain changes in control of the Company or a failure of the Company to comply with any material terms of the agreements.



10



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



6. Basic and Diluted Income Per Share



Basic income per share is computed using the weighted average number of shares of common stock outstanding during the
period. Diluted income per share is computed using the weighted average number of shares of common stock outstanding and the dilutive effect of common equivalent shares (calculated using the treasury stock method).



The following table sets forth the reconciliation of denominators used in the
computation of the basic and diluted net income per share:



|                                                                          |  |                                 |  |      
|------------------------------------------------------------------------- |  | ------------------------------- |  | -----
|                                                                          |  | Three Months Ended December 31,
|                                                                          |  | 2004                            |  | 2003 
|Denominator for basic income per share-weighted average shares            |  | 7,093                           |  | 6,882
|Effect of dilutive securities:                                            |  |                                 |  |      
|Options                                                                   |  | 353                             |  | 369  
|                                                                          |  |                                 |  |      
|Denominator for diluted income per shareadjusted weighted average shares |  | 7,446                           |  | 7,251
|                                                                          |  |                                 |  |      
|Antidilutive securities:                                                  |  |                                 |  |      
|Options                                                                   |  | 341                             |  | 308  
|                                                                          |  |                                 |  |      



7. Segments



We have three reportable segments: Nursing and PPEC; Respiratory Therapy
Equipment and Services (RTES); and Pharmacy. Our Nursing and PPEC division consists primarily of private duty home nursing care for predominately pediatric patients as well as Prescribed Pediatric Extended Care Centers which provide daily medical
care for medically fragile children. Our Pharmacy division provides pharmaceutical products and services for our patients in the home or physicians office. Our RTES division provides respiratory therapy equipment and services to patients in
the home.



The accounting policies of the operating segments
are the same as those described in the Summary of Significant Accounting Policies (see Note 2). We evaluate performance based on profit or loss from operating income, excluding corporate, general and administrative expenses. Asset information by
segment, including capital expenditures and net income (loss) beyond operating contribution margins are not provided to our Chief Operating Decision Maker (CODM). Inter-segment allocations have been eliminated.



Our reportable segments are defined based on the predominant line of net
revenue which is reviewed by the CODM. The reportable segments are managed separately.



11



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



Segments  continued



The following table summarizes certain information for each of our companys operating segments:



|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|------------------------------------------------------------ |  | ---------------- | ------ | -------- | - | ------------------------------------------- |  | - | ------------------ | - |  | - | ------
|                                                             |  | Nursing and PPEC |        | Pharmacy |   | Respiratory Therapy, Equipment and Services |  |   | Consolidated Total
|Three Months Ended December 31, 2004                         |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Net revenue                                                  |  | $                | 28,861 |          | $ | 22,181                                      |  | $ | 12,960             |   |  | $ | 64,002
|                                                             |  |                  |        |         
|Costs of goods and services                                  |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|                                                             |  |                  |        |         
|Nursing and therapist salaries, wages, benefits and supplies |  |                  | 17,183 |          |   | 371                                         |  |   | 249                |   |  |   | 17,803
|Pharmacy product and supplies                                |  |                  |       |          |   | 15,212                                      |  |   | 853                |   |  |   | 16,065
|Intercompany allocations                                     |  |                  |       |          |   |                                            |  |   |                   |   |  |   |      
|Disposables/Supplies                                         |  |                  | 17     |          |   | 143                                         |  |   | 3,037              |   |  |   | 3,197 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Total cost of goods and services                             |  |                  | 17,200 |          |   | 15,726                                      |  |   | 4,139              |   |  |   | 37,065
|Other operating costs and expenses                           |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Administrative and marketing salaries, wages and benefits    |  |                  | 4,891  |          |   | 2,298                                       |  |   | 3,881              |   |  |   | 11,070
|Business insurance                                           |  |                  | 942    |          |   | 203                                         |  |   | 391                |   |  |   | 1,536 
|Overhead                                                     |  |                  | 1,709  |          |   | 820                                         |  |   | 1,569              |   |  |   | 4,098 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Total operating costs and expenses                           |  |                  | 7,542  |          |   | 3,321                                       |  |   | 5,841              |   |  |   | 16,704
|Provision for doubtful accounts                              |  |                  | 161    |          |   | 313                                         |  |   | 419                |   |  |   | 893   
|Depreciation                                                 |  |                  | 80     |          |   | 82                                          |  |   | 718                |   |  |   | 880   
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Branch office contribution margin                            |  | $                | 3,878  |          | $ | 2,739                                       |  | $ | 1,843              |   |  | $ | 8,460 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|                                                             |  |                  |        |         
|Three Months Ended December 31, 2003                         |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Net revenue                                                  |  | $                | 26,013 |          | $ | 21,668                                      |  | $ | 12,149             |   |  | $ | 59,830
|                                                             |  |                  |        |         
|Costs of goods and services                                  |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|                                                             |  |                  |        |         
|Nursing and therapist salaries, wages, benefits and supplies |  |                  | 15,252 |          |   | 240                                         |  |   | 245                |   |  |   | 15,737
|Pharmacy product and supplies                                |  |                  | 2      |          |   | 13,823                                      |  |   | 821                |   |  |   | 14,646
|Intercompany allocations                                     |  |                  |       |          |   | 370                                         |  |   | (370               | ) |  |   |      
|Disposables/Supplies                                         |  |                  | 21     |          |   | 167                                         |  |   | 2,725              |   |  |   | 2,913 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Total cost of goods and services                             |  |                  | 15,275 |          |   | 14,600                                      |  |   | 3,421              |   |  |   | 33,296
|Other operating costs and expenses                           |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Administrative and marketing salaries, wages and benefits    |  |                  | 4,841  |          |   | 1,681                                       |  |   | 3,700              |   |  |   | 10,222
|Business insurance                                           |  |                  | 1,278  |          |   | 239                                         |  |   | 466                |   |  |   | 1,983 
|Overhead                                                     |  |                  | 1,868  |          |   | 718                                         |  |   | 1,586              |   |  |   | 4,172 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Total operating costs and expenses                           |  |                  | 7,987  |          |   | 2,638                                       |  |   | 5,752              |   |  |   | 16,377
|Provision for doubtful accounts                              |  |                  | 334    |          |   | 381                                         |  |   | 668                |   |  |   | 1,383 
|Depreciation                                                 |  |                  | 83     |          |   | 47                                          |  |   | 593                |   |  |   | 723   
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       
|Branch office contribution margin                            |  | $                | 2,334  |          | $ | 4,002                                       |  | $ | 1,715              |   |  | $ | 8,051 
|                                                             |  |                  |        |          |   |                                             |  |   |                    |   |  |   |       



|                                        |  |                                 |        |   |      |   |        |  
|--------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                        |  | Three Months Ended December 31, |       
|                                        |  | 2004                            |        |   | 2003 |  
|Total profit for reportable segments    |  | $                               | 8,460  |   |      | $ | 8,051  |  
|                                        |  |                                
|Corporate, general and administrative   |  |                                 | (4,823 | ) |      |   | (4,855 | )
|Corporate depreciation and amortization |  |                                 | (152   | ) |      |   | (141   | )
|Other income                            |  |                                 |       |   |      |   | 4      |  
|Interest income                         |  |                                 | 42     |   |      |   | 43     |  
|Interest expense                        |  |                                 | (603   | ) |      |   | (532   | )
|                                        |  |                                 |        |   |      |   |        |  
|Income before income tax expense        |  | $                               | 2,924  |   |      | $ | 2,570  |  
|                                        |  |                                 |        |   |      |   |        |  



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##### Table of Contents

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward-Looking Statements



This Form 10-Q contains certain forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995) relating
to future financial performance of our company. When used in this Form 10-Q, the words may, targets, goal, could, should, would, believe, feel,
expects, anticipate, estimate, intend, plan, potential and similar expressions may be indicative of forward-looking statements. These statements by their nature involve
substantial risks and uncertainties, certain of which are beyond our control. We caution that various factors, including the factors described below and elsewhere in this report, and including those set forth in Item 1 under the caption Risk
Factors in our 2004 Annual Report on Form 10-K, as well as those discussed in our other filings with the Securities and Exchange Commission, could cause actual results or outcomes to differ materially from those expressed in any
forward-looking statements made by us or on our behalf. The following are among the important factors that could cause actual results to differ materially from the results discussed herein:



| |  |  | changes in reimbursement rates or policies;
| | - |  | -------------------------------------------



| |  |  | payor relationships;
| | - |  | --------------------



| |  |  | changes in health care regulations, including changes resulting from the recently enacted Medicare Prescription Drug Act of 2003 (MMA) and the Health Insurance
Portability and Accountability Act (HIPAA);
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the ability to collect for equipment sold or rented;
| | - |  | ----------------------------------------------------



| |  |  | the ability to assimilate and manage previously acquired field operations;
| | - |  | --------------------------------------------------------------------------



| |  |  | the ability to collect accounts receivable for products and services we provide, including receivables related to acquired businesses and receivables under appeal;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the ability to comply with and respond to billing requirements issues, including those related to our billing and collection system;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | reduced state funding levels and nursing hours authorized by Medicaid programs;
| | - |  | -------------------------------------------------------------------------------



| |  |  | adverse litigation results;
| | - |  | ---------------------------



| |  |  | competitive factors;
| | - |  | --------------------



| |  |  | ability to hire and retain qualified health care professionals;
| | - |  | ---------------------------------------------------------------



| |  |  | the availability and cost of medical malpractice, workers compensation and employee medical benefit insurance;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | changes in industry practices; and
| | - |  | ----------------------------------



| |  |  | general economic condition and industry trends.
| | - |  | -----------------------------------------------



Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking
statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of an unanticipated event. New factors emerge from time to time, and it is not possible for management to predict
all of such factors. Further, management cannot assess the impact of each such factor on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any
forward-looking statements.



The following discussion
should be read in conjunction with the unaudited condensed consolidated financial statements included in this quarterly report.



EXECUTIVE SUMMARY



Recent Developments



Home Healthcare Industry Events & Updates



Historically, Medicare reimbursement for covered drugs has been limited to 95 percent of the published average wholesale price (AWP) for the
drug. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (MMA) establishes new payment limits and procedures for drugs reimbursed under Medicare Part B, including drugs used in inhalation therapy. The final rule,
as the MMA requires, provides that Medicare beneficiaries will be reimbursed at a rate of 106 percent of the volume-weighted average selling price (the ASP). In addition, providers of inhalation therapy, including our company, will
receive a dispensing fee for supplying inhalation therapy. The 2005 dispensing fee will be $57 for thirty (30) days of therapy or $80 for ninety (90) days. Within the Pharmacy segment, we are assessing the impact of these changes to our unit dose
respiratory products to determine the viability of our long term profitability. While the long term impact of the MMA reforms cannot yet be determined because the recently promulgated regulations are transitional in nature, these and other changes
may have a material adverse effect on our operations and financial results. For fiscal year 2005, the impact of these regulations to the approximately 31% of our net revenue that is derived from the Medicare program is expected to substantially
reduce our profitability in the Pharmacy segment. There can be no assurance that we will not face increased margin pressures from subsequent reimbursement changes beyond 2005.



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##### Table of Contents

A number of other pilots and demonstrations are mandated by the MMA, signaling the likelihood of
continued re-design of certain aspects of the Medicare program. While the more immediately visible changes mandated by the MMA relate to extension of the Medicare benefit to prescription drug coverage, other aspects may impact the operations and
profitability of health care providers, including our company. Among other things, the MMA mandates a phased-in competitive bidding process for Medicare procurement of certain durable medical equipment (DME), commencing in the ten (10) largest
Metropolitan Statistical Areas (MSAs) in 2007, followed by the next eighty (80) largest MSAs in 2009. Moreover, the Secretary of the United States Department of Health & Human Services has the authority to apply competitive bidding nationally
for the highest cost, highest volume items and services and those items and services that the Secretary determines to have the largest savings potential. There will also be at least a five (5) year freeze in the Consumer Price Index
update for reimbursement rates for DME where competitive bidding prices are not applicable. In addition, commencing in 2005, reimbursement for certain items and services (e.g., oxygen and oxygen equipment) that are not subject to competitive bidding
will be capped at the 2002 rate or the Median Federal Employee Health Plan Price established in 2002, whichever is lower. We are analyzing the impact of these reimbursement changes to our RTES segment and plan to address the proposed
reductions by altering our business model with changes such as reducing costs, growing revenue through our managed care marketing strategies and seeking additional ways to improve productivity. For fiscal year 2005, the impact of these regulations
to the approximately 38% of our net revenue that is derived from the Medicare program will be to reduce our profitability in the RTES segment. There can be no assurance that we will not face increased margin pressures from subsequent reimbursement
changes beyond 2005.



Under the MMA, there are major changes in
the Medicare payment rates for hemophilia products beginning in 2005. Currently, Medicare reimburses for blood clotting factor at 95 percent of AWP. Effective January 1, 2005, we will be paid for blood clotting factor based on the new ASP
methodology. We expect that the resulting payment rates will be lower than the current rates for these products. In addition, the Centers for Medicare & Medicaid Services (CMS) will make a separate payment to the entity that provides
blood clotting factor to a Medicare beneficiary for items and services related to the furnishing of such products. The amount of this separate payment is capped so that the total of the ASP payment rate and the separate payment amount cannot exceed
95 percent of AWP. It is possible that the proposed separate payment amount will be inadequate for the service level requirements of the Medicare beneficiary with hemophilia. While our current census of Medicare beneficiary hemophilia patients is
quite low, the potential for select state Medicaid programs to adopt changes to their payment rates based upon Medicare changes exists. Such changes could result in a payment amount that would be inadequate for the required service level. We are
analyzing the impact of these reimbursement changes to our Pharmacy segment and plan to address the proposed reductions by altering our business model with changes such as reducing costs, growing revenue through our managed care marketing strategies
and seeking additional ways to improve productivity. There can be no assurance that we will not face increased margin pressures from reimbursement changes.



As described in our prior SEC filings, Georgia Medicaids contractor (the Contractor) missed the original implementation date of October
1, 2002 and delayed the go live date until April 1, 2003 for its new Multi Health Network system (MHN). Georgia Medicaid is an important customer of ours and represents approximately 6% of our annual billed revenue. Some of
the continuing problems we are trying to resolve with Georgia Medicaid include: correcting conflicts between provider numbers, categories of service, membership identification, units of measure, authorized duration of service and corresponding
procedure codes within its authorization module. Given the States apparent unwillingness to agree to a timely settlement on a large number of claims from our RTES segment, we are working with external legal counsel on the range of alternatives
available to us, including initiating legal action. While we continue to evaluate our alternatives including litigation, we are continuing our collection efforts on these aged accounts receivable balances. Based upon the information available to
date, we believe we have recorded an adequate allowance against these receivable balances.



While certain states are realizing relief from prior revenue shortfalls and some are reporting surpluses, concern over a reduction in the future level of Federal Medical Assistance Percentages dampens the likelihood
that these Medicaid payment limitations will be abated at any time in the near future. While many of the states in which we operate are discussing alternatives which could have the effect of restricting eligibility for Medicaid benefits or increase
the use of managed care organizations in the administration of benefits, we are not aware of any specific proposals being actively evaluated which would have a material adverse impact upon our operations or financial results. In an effort to impact
these legislative issues, we have engaged consultants in selected markets to directly present our cost saving strategies and related rate requests to the Medicaid programs. Beginning in fiscal 2005, we received a rate increase for our Private Duty
Nursing services from two states. In addition, our local market staff routinely collaborates with the appropriate community and regulatory authorities on our behalf as well as our patients.



The HIPAA standard transaction in data set rules mandate that Covered
Entities, including our company, transmit claims and certain related healthcare information in standardized formats and data sets. Compliance was required on October 16, 2003, but many payors, including most state Medicaid agencies, were not in
compliance by that date. To date, many Medicaid agencies are running dual systems to accommodate HIPAA compliant transactions as well as non-compliant transactions. Some states, however, are running only HIPAA compliant systems and other states are
not yet HIPAA compliant. There is uncertainty as to when those states using dual systems will discontinue their non-HIPAA compliant systems. These uncertainties surrounding claims processing as a result of HIPAAs standard transaction and code
set rules, which uncertainties are outside our control, have resulted in delayed reimbursement by some payors, including Medicaid agencies. We expect that the impact to our cash collections from non-HIPAA compliant payors should continue to decline
throughout fiscal 2005.



14



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##### Table of Contents

Company Events & Updates



During the first quarter of fiscal 2005, Edward K. Wissing, Chairman of the Board, assumed the role as Executive Chairman of
the Board. Our new Chief Executive Officer, Daniel J. Kohl, began employment December 15, 2004. Upon Mr. Dan Kohls arrival, we have initiated a strategic review of our operations. This process seeks to bring clarity to our strategic focus,
validate the business models within each segment, determine our strategic path, rationalize our assets and determine the resulting capital structure.



With respect to compliance with Sarbanes-Oxley requirements related to internal controls over financial reporting, we continue to work with our
consultants on the documentation process and believe that our project is on schedule. The schedule allows for adequate time to perform the required testing and potential remediation tasks prior to required testing by our external auditors.



Risk Management



We have spent significant time and resources to move towards a fully
implemented Enterprise Risk Management Model. This approach to risk management emphasizes assessment of risk from a broader perspective and relies upon significant employee education initiatives and awareness of a variety of risk exposures. Our full
time risk manager, who possesses extensive homecare and occupational medicine experience, has strengthened the initial incident reporting and investigation process. We are seeing evidence that these process refinements are positively influencing
claim adjustment activities and ultimately, the actuarial estimates of loss history. Our Risk Committee, which is comprised of members of the Compliance, Legal, Human Resources, Internal Audit and Risk Management Departments, continues to monitor
incident reporting and claim adjustment activity, review existing patient census and discharge high-risk cases where legally permissible. Our Risk Committee employs a multi-functional approach to its decision making process. We continue to educate
branch office staff on risk management procedures including appropriate nurse staffing decisions. In addition, our third party actuary analyzes our medical malpractice loss history and quantifies liability recognition under the policy terms. Under
our medical malpractice policy, if our loss experience worsens it could have a material adverse effect on our financial results and liquidity position.



Operations



We have three reportable segments: (i) Nursing and PPEC, (ii) Pharmacy and (iii) RTES (see Notes to the Condensed Consolidated Financial Statements-Note
7).



In the Nursing and PPEC segment, we continue to see
pressures on both reimbursement levels and wage rates in key markets. Despite continued reductions in authorized levels of service in certain key Medicaid states, we have successfully increased the number of hours staffed. A renewed focus on same
store revenue growth is being undertaken. This initiative includes improving the alignment and establishing financial incentives for our local market sales and marketing resources to maximize the potential of existing managed care contracts by
pulling patient referrals through these relationships.



In the Pharmacy segment, we continue to experience a decline in gross margin rates across many of our key product offerings. For instance, within the hemophilia factor product, clinical changes in a patients condition can dictate
rapid changes to the specific type and amount of drugs provided. These alternative drugs may have relatively higher acquisition costs and lower reimbursement levels based on the payor. Given the expanded, though increasingly concentrated census,
changes of this type expose the Pharmacy segment revenue and contribution margin to significant volatility. Payor initiated reductions to reimbursement levels with no corresponding reduction to acquisition costs pose a significant threat to future
contribution margin levels. In response to these changing market conditions we have undertaken a series of initiatives including recruiting for a National Hemophilia Director to coordinate our existing programs and provide dedicated focus on
expansion. In addition, we have increased development of marketing materials which highlight our clinical and service expertise as integral components of our pharmacy programs, as well as explored potential business relationships with hemophilia
treatment centers to manage their patient populations and continued to refine operational best practices to assure maximized clinical compliance and efficiency. During the three months ended December 31, 2004, we experienced a year over year net
revenue increase of approximately $0.5 million in our seasonal Synagis product. The payor mix in the three months ended December 31, 2004 yielded a lower gross margin as compared to the three months ended December 31, 2003.



Our start up pharmacy in the Orlando market received its required licensure
late in the first quarter of fiscal 2005, which was later then we had anticipated. This delay caused start up losses of approximately $0.1 million in the three months ended December 31, 2004. Start up losses attributable to the Denver start-up
pharmacy were approximately $0.14 million in the three months ended December 31, 2004.



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In the RTES segment, we continue to invest in and expand our sales and marketing program. We are focusing
our sales and marketing efforts upon the higher acuity respiratory patients to leverage our clinical competencies and more actively manage the core product mix. As a result, we have begun to see increases in target referrals from managed care payors
in select markets. However, we have experienced an increased rate of replacement for several equipment items in our core rental fleet. These increasing capital expenditures reflect growing market acceptance of improved versions of these core
products. Many of those items have become smaller and more portable and are increasingly requested by patients and referring physicians. These items have higher acquisition costs and to date, reimbursement levels have not increased. In addition, we
are experiencing decreased reimbursement for certain disposable and supply items, as well as the elimination of reimbursement for other select items (see Home Healthcare Industry Events & Updates above for additional discussion). In
order to address the continued margin pressures on our RTES segment, our Product Review Committee continues to standardize product selections, aggregate product volumes and decrease our number of vendors in an attempt to maximize purchasing power.
As we seek to fill the vacant Divisional Vice President position, execution of these initiatives will be critical to achieving the desired objectives.



Source & Availability of Clinical Personnel



During the 13 weeks ending December 25, 2004, our case hours staffed increased to approximately 791,000 as compared to 763,000 in the 13 weeks ended
September 25, 2004. We continue to aggressively compete for nurses to staff hours ordered, retain nurses with select wage and benefit improvements and implement employee satisfaction initiatives. We have made additional investments in six new local
market nurse recruiters to help reduce unstaffed hours. We believe that case hours staffed is the most appropriate measurement of nursing activity. To date, we have seen inconsistent results in a number of markets and will continue to assess and
respond accordingly. We anticipate that over time, our nurse scheduling system, SHINE, will help to improve both un-staffed hours and gross margin levels; however, there can be no assurance that this will occur.



CRITICAL ACCOUNTING POLICIES



Net Revenue



Due to the nature of the health care industry and the reimbursement
environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will need to be revised or updated, with the changes
recorded in subsequent periods as additional information becomes available to us. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for services from certain payors may result in
adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application, claim denial or account review. As of December 31, 2004, we had no material claims, disputes or unsettled matters
with third-party payors, nor were there any material pending settlements with third-party payors except as disclosed under the Recent Developments section above.



Net revenue represents the estimated net realizable amounts from patients, third-party payors and others for patient
services rendered and products provided. Such net revenue is recognized as the treatment plan is administered to the patient and recorded at amounts estimated to be received under reimbursement arrangements with payors. Net revenues to be reimbursed
by contracts with third-party payors are recorded at an amount to be realized under these contractual arrangements. Net revenues from Medicaid and Medicare are generally based on reimbursement of the reasonable direct and indirect costs of providing
services to program participants. In certain situations, the services and products are recorded separately. In other situations, the services and products are billed and reimbursed on a per diem or contract basis whereby the insurance carrier pays
us one combined amount for treatment. Because the reimbursement arrangements in these situations are based on a per diem or contract amount, we do not maintain records that provide a breakdown between the service and product components.



We have developed a methodology to record the estimated net revenue as a
result of the inherent time lag between certain patient treatments and input of the related information into our billing and collection system. This methodology measures relative changes in the time and overall activity level at each branch office
location and aggregates these measurements to estimate the impact to consolidated net revenue. The estimated net revenue from the inherent time lag was approximately 0.3%, 0.5% and 0.5% of net revenue for fiscal years ended 2004, 2003 and 2002,
respectively. Any unforeseen volatility to either the time or activity level at specific branch offices has the potential to significantly impact the estimate.



In other select cases, patient treatments may cease for a number of reasons including re-hospitalizations, changes in treatment needs, or death, and a
time lag may exist before this information is reflected in our billing and collection system. We have developed a methodology which measures the historical experience over recent time periods and applies this methodology to reduce net revenues
recognized in the current period.



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Allowance for Doubtful Accounts



In determining the adequacy of the allowance and related provision for
doubtful accounts, we have developed a process that combines detailed analysis of historical collections and write-off activity with a detailed review of existing account balances meeting certain criteria and their likelihood of being collected at
the amounts recorded. This detailed review involves both the assigned corporate reimbursement department personnel and the respective branch office location personnel assessing each patient claim that falls within prescribed age and amount criteria.
These assessments are aggregated and compared to the results of the detailed analysis of historical collections to provide additional support to management in making the estimate of the allowance for doubtful accounts. Inherent in this estimate is
the risk that it will need to be revised or updated, with the changes recorded in subsequent periods, as additional information becomes available to management.



Goodwill and Other Acquired Intangible Assets



The Statement of Financial Accounting Standards (SFAS) No. 142 eliminated goodwill amortization from the consolidated statements of
operations and required an evaluation of goodwill for impairment on an annual basis, and more frequently if circumstances indicate a possible impairment. We perform our annual impairment test in the fourth quarter of each fiscal year and more
frequently if circumstances indicate a possible impairment. For these evaluations, we are using an implied fair value approach, which uses a discounted cash flow analysis and other valuation methodologies. These evaluations use many assumptions and
estimates in determining an impairment loss, including certain assumptions and estimates related to future earnings and comparable companies capital structure and earnings power. For fiscal 2004, we completed the impairment test and, at September
30, 2004, there was no resulting impairment. Subsequent impairments, if any, would be classified as operating expenses.



Intangible assets that meet certain criteria qualify for recording on the consolidated balance sheet and will continue to be amortized in the consolidated
statements of operations. Such intangible assets will be subject to a periodic impairment test based on estimated fair value.



Accrued Insurance



We retain the services of an independent actuary to prepare an actuarial analysis of our development of reported and incurred but not reported claims for
workers compensation, medical malpractice and employee benefit plans. These estimates are updated as determined necessary based on recent claims history and other events. Inherent in these estimates is the risk that they will need to be
revised or updated, with the changes recorded in subsequent periods, as additional information becomes available to us. Accrued workers compensation and medical malpractice losses have been discounted at 6%.



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##### Table of Contents

RESULTS OF OPERATIONS



The following table is derived from our unaudited condensed consolidated statements of operations for the periods indicated
and presents results of operations as a percentage of net revenue and the percentage change in the dollar of each item from the comparative prior period:



|                                                          |  |                                 |   |  |                                                 |   |  |      |  
|--------------------------------------------------------- |  | ------------------------------- | - |  | ----------------------------------------------- | - |  | ---- | -
|                                                          |  | Percentage of Net Revenue       |   |  | Period-to-Period Percentage Increase (Decrease) |  
|                                                          |  | Three Months Ended December 31, |   |  | Three Months Ended December 31,                 |  
|                                                          |  | 2004                            |   |  | 2003                                            |   |  | 2004 |  
|Net Revenue                                               |  | 100.0                           | % |  | 100.0                                           | % |  | 7    | %
|Costs of goods and services                               |  | 57.9                            |   |  | 55.7                                            |   |  | 11   |  
|Other operating costs and expenses                        |  |                                 |   |  |                                                 |   |  |      |  
|Administrative and marketing salaries, wages and benefits |  | 17.3                            |   |  | 17.1                                            |   |  | 8    |  
|Business insurance                                        |  | 2.4                             |   |  | 3.3                                             |   |  | (23  | )
|Overhead                                                  |  | 6.4                             |   |  | 7.0                                             |   |  | (2   | )
|                                                          |  |                                 |   |  |                                                 |   |  |      |  
|Other operating costs and expenses                        |  | 26.1                            |   |  | 27.4                                            |   |  | 2    |  
|Corporate, general and administrative                     |  |                                 |   |  |                                                 |   |  |      |  
|Salaries, wages and benefits                              |  | 5.2                             |   |  | 5.9                                             |   |  | (7   | )
|Business insurance                                        |  |                                |   |  | 0.1                                             |   |  | (32  | )
|Professional services                                     |  | 1.3                             |   |  | 0.9                                             |   |  | 55   |  
|Overhead                                                  |  | 1.0                             |   |  | 1.2                                             |   |  | (10  | )
|                                                          |  |                                 |   |  |                                                 |   |  |      |  
|Corporate, general and administrative                     |  | 7.5                             |   |  | 8.1                                             |   |  | (1   | )
|Provision for doubtful accounts                           |  | 1.4                             |   |  | 2.3                                             |   |  | (35  | )
|Depreciation and amortization                             |  | 1.7                             |   |  | 1.4                                             |   |  | 19   |  
|                                                          |  |                                 |   |  |                                                 |   |  |      |  
|Operating income                                          |  | 5.4                             |   |  | 5.1                                             |   |  | 14   |  
|Other income                                              |  |                                |   |  |                                                |   |  | (100 | )
|Interest income                                           |  | 0.1                             |   |  | 0.1                                             |   |  | (3   | )
|Interest expense                                          |  | (0.9                            | ) |  | (0.9                                            | ) |  | 13   |  
|                                                          |  |                                 |   |  |                                                 |   |  |      |  
|Income before income tax expense                          |  | 4.6                             | % |  | 4.3                                             | % |  | 14   | %
|                                                          |  |                                 |   |  |                                                 |   |  |      |  



We provide a broad
range of health care services and products principally for children and, to a lesser extent, young adults and geriatric patients. The following table summarizes both services and products based upon estimated percentages of net billings of each
major category for the periods indicated:



|                                           |  |                                 |   |  |              |  
|------------------------------------------ |  | ------------------------------- | - |  | ------------ | -
|                                           |  | Three Months Ended December 31, |  
|                                           |  | 2004 % Total                    |   |  | 2003 % Total |  
|Pediatric Home Health Care                 |  |                                 |   |  |              |  
|Nursing and PPEC                           |  | 41.5                            | % |  | 39.7         | %
|Respiratory Therapy Equipment and Services |  | 7.9                             | % |  | 7.8          | %
|Pharmacy                                   |  | 28.7                            | % |  | 29.2         | %
|                                           |  |                                 |   |  |              |  
|Total Pediatric Home Health Care           |  | 78.1                            | % |  | 76.7         | %
|                                           |  |                                
|Adult Home Health Care                     |  |                                 |   |  |              |  
|Nursing                                    |  | 4.6                             | % |  | 4.6          | %
|Respiratory Therapy Equipment and Services |  | 8.5                             | % |  | 8.9          | %
|Pharmacy                                   |  | 8.8                             | % |  | 9.8          | %
|                                           |  |                                 |   |  |              |  
|Total Adult Home Health Care               |  | 21.9                            | % |  | 23.3         | %
|                                           |  |                                 |   |  |              |  
|Total                                      |  | 100.0                           | % |  | 100.0        | %
|                                           |  |                                 |   |  |              |  



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Three Months Ended December 31, 2004 Compared to Three Months Ended December 31, 2003



Net revenue increased $4.2 million, or 7%, to $64.0 million in the three
months ended December 31, 2004 from $59.8 million in the three months ended December 31, 2003. For the Nursing and PPEC segment net revenue increased $2.9 million, or 11%, to $28.9 million in the three months ended December 31, 2004 from $26.0
million in the three months ended December 31, 2003. Of this growth, $0.2 million was attributable to the Macon start up PPEC branch and $0.3 million was from PPEC same store growth. The increase of $2.4 million in Nursing net revenue was
concentrated in the states of Florida, Massachusetts, Texas, Georgia, Virginia and Pennsylvania. Pharmacy net revenue increased $0.5 million, or 2%, to $22.2 million in the three months ended December 31, 2004 from $21.7 million in the three months
ended December 31, 2003. This increase in Pharmacy net revenue is attributable to increased seasonal Synagis product of approximately $0.5 million. We experienced net revenue declines in hemophilia factor and unit dose respiratory medications which
were offset by increases in growth hormone and other infusion therapies. RTES net revenue increased $0.8 million, or 7%, to $12.9 million in the three months ended December 31, 2004 from $12.1 million in the three months ended December 31, 2003. The
increase was across all core products. In the three months ended December 31, 2004, we derived approximately 52% of our net revenue from commercial insurers and other private payors, 42% from Medicaid and 6% from Medicare.



Costs of goods and services consist primarily of branch office nursing
compensation and benefits, medical equipment, pharmaceuticals and related supplies. Costs of goods and services increased $3.8 million, or 11%, to $37.1 million in the three months ended December 31, 2004 from $33.3 million in the three months ended
December 31, 2003. Costs of goods and services of the Nursing and PPEC segment increased $1.9 million, or 13%, to $17.2 million in the three months ended December 31, 2004 from $15.3 million in the three months ended December 31, 2003. Costs of
goods and services as a percentage of the Nursing and PPEC segment net revenue increased to 60% in the three months ended December 31, 2004 from 59% in the three months ended December 31, 2003. The Pharmacy segment cost of goods and services
increased $1.1 million, or 8%, to $15.7 million in the three months ended December 31, 2004 from $14.6 million in the three months ended December 31, 2003. Pharmacy costs of goods and services as a percentage of net revenue increased to 71% in the
three months ended December 31, 2004 from 67% in the three months ended December 31, 2003. Included in the 67% for the three months ended December 31, 2003 was an intercompany allocation of unit dose respiratory transfer pricing to the RTES segment
of approximately $0.4 million or 2% of net revenue. In response to the reimbursement reductions effective on January 1, 2005, we made a decision to eliminate the transfer pricing to the RTES segment. Normalized for this elimination the true impact
to the Pharmacy segment was a six percentage point increase of costs of goods and services as a percentage of net revenue. This 6% increase is attributable to the replacement of comparatively high gross margin hemophilia factor and unit dose
respiratory products with comparatively lower gross margin growth hormone, Synagis and other infusion therapies. The RTES segment cost of goods and services increased $0.7 million, or 21%, to $4.1 million in the three months ended December 31, 2004
from $3.4 million in the three months ended December 31, 2003. Costs of goods and services as a percentage of net revenue increased to 32% in the three months ended December 31, 2004 from 28% in the three months ended December 31, 2003. Included in
the 28% for the three months ended December 31, 2003 was a credit of $0.4 million or 3% of RTES net revenue related to the unit dose respiratory transfer pricing. Normalized for this elimination the true impact to the RTES segment was a one
percentage point increase of cost of goods and services as a percentage of net revenue. This increase is primarily attributable to higher consumption of disposals and supplies.



Other operating costs and expenses include branch office administrative and marketing compensation and benefits, allocated
business insurance costs, facility and overhead costs. Other operating costs and expenses increased $0.3 million, or 2%, to $16.7 million in the three months ended December 31, 2004 from $16.4 million in the three months ended December 31, 2003. In
the Nursing and PPEC segment, other operating costs and expenses decreased $0.5 million, or 6%, to $7.5 million in the three months ended December 31, 2004 from $8.0 million in the three months ended December 31, 2003. As a percentage of net
revenue, the Nursing and PPEC segment costs decreased to 26% in the three months ended December 31, 2004 from 31% in the three months ended December 31, 2003. The primary factor was decreased allocated business insurance costs. In the Pharmacy
segment, other operating costs and expenses increased $0.7 million, or 26%, to $3.3 million in the three months ended December 31, 2004 from $2.6 million in the three months ended December 31, 2003. As a percentage of net revenue these costs
increased to 15% in the three months ended December 31, 2004 from 12% in the three months ended December 31, 2003. This increase includes administrative salaries of approximately $0.2 million attributable to start up operations in the Orlando and
Denver markets. In addition, a decision was made to change management responsibility for the infusion visit program in select markets from the Nursing segment to the Pharmacy segment. This decision resulted in the reclassification of approximately
$0.2 million of administrative salaries in the three months ended December 31, 2004 as compared to the three months ended December 31, 2003. In the RTES segment, costs and expenses increased $0.1 million, or 2%, to $5.8 million in the three months
ended December 31, 2004 from $5.8 million in the three months ended December 31, 2003. As a percentage of net revenue these costs decreased to 45% in the three months ended December 31, 2004 from 47% in the three months ended December 31, 2003.



Corporate, general and administrative costs remained
relatively constant at $4.8 million in the three months ended December 31, 2004 as compared to the three months ended December 31, 2003. As a percentage of net revenue, corporate, general and administrative costs remained relatively constant at 8%
in the three months ended December 31, 2004 compared to the three months ended December 31, 2003.



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Provision for doubtful accounts decreased $0.5 million, or 35%, to $0.9 million in the three months ended
December 31, 2004 from $1.4 million in the three months ended December 31, 2003. Cash collections as a percentage of net revenue were 97% and 90% in the three months ended December 31, 2004 and 2003, respectively.



Depreciation and amortization increased $0.2 million, or 19% to $1.0 million
in the three months ended December 31, 2004 as compared to $0.9 million in the three months ended December 31, 2003.



Interest expense increased $0.1 million, or 13%, to $0.6 million in the three months ended December 31, 2004 from $0.5 million in the three months ended
December 31, 2003. Our average debt outstanding remained constant.



Income tax expense increased $0.2 million, or 18%, to $1.2 million in the three months ended December 31, 2004 from $1.0 million in the three months ended December 31, 2003.



LIQUIDITY AND CAPITAL RESOURCES



Operations



On January 27, 2004, we entered into a credit agreement with General Electric Capital Corporation (Credit Agreement). Subject to the terms and
conditions of the Credit Agreement, the Lender made available a credit facility consisting of a $10.0 million revolving line of credit and a $10.0 million line of credit for acquisitions. Availability in both components is subject to a borrowing
base calculation against our accounts receivable. Borrowings under the revolving line of credit bear interest at LIBOR plus 3.00% or the Index Rate plus 1.50%. Borrowings under the acquisition line of credit bear interest at LIBOR plus 3.50% or the
Index Rate plus 2.00%. The Credit Agreement provides for unused line fees of 0.50% for the revolving line of credit and 0.75% for the acquisition line of credit. The Credit Agreement contains several financial and non-financial covenants including,
but not limited to, certain leverage, coverage, DSO and maximum capital expenditures requirements.



On May 12, 2004, we amended the Credit Agreement to clarify a definition and increase the maximum capital expenditures covenant. We have made no
borrowings under the Credit Agreement since its inception.



Cash collections as a percentage of net revenue for the three months ended December 31, 2004 and 2003 was 97% and 90%, respectively. While we anticipate that we will continue to achieve our cash collection targets, there can be no assurance
that disruptions to cash flow will not occur.



During the three
months ended December 31, 2004, we purchased medical equipment to service existing patients and made routine purchases of computer equipment to maintain and upgrade our technology infrastructure. We anticipate future capital expenditures for
maintenance, support and enhancements of existing technology, continued investments in new start up locations and continued durable medical equipment purchases. We anticipate funding these capital expenditures with cash flow from operations.



HIPAAs standard transaction in data set rules mandate
that Covered Entities, including our company, transmit claims and certain related healthcare information in standardized formats and data sets. (See Recent Developments above.)



Risk Management



Our workers compensation insurance carrier, rated A by AM Best
Company, requires a twelve month estimated loss reserve to be funded entirely with cash each fiscal year which is then reduced by the monthly loss fund payments. This cash requirement is estimated to be $1.0 million for fiscal 2005. The net balance
at December 31, 2004 and September 30 2004 was $3.7 million and $3.3 million, respectively. The insurance carrier has the right to increase this cash requirement at the end of each fiscal year if the claim experience is greater than anticipated, but
to date has not indicated the need to do so.



We have secured
surety bonds of $2.5 million to satisfy our workers compensation program requirements for our former insurance carrier. As of December 31, 2004, the surety bonds were collateralized by $2.3 million cash posted to a third party escrow account.
We have received notification from the carrier of their intent to reduce the required cash collateral by approximately $0.8 million and return the funds to the Company during fiscal 2005.



We renewed our employee medical benefit plans on January 1, 2005. We determined it to be advantageous to continue to use a
self insured model instead of a guaranteed minimum premium model. Claim history for calendar 2004 was positive and calendar 2005 pricing is within market inflation estimates. This plan ultimately exposes us to greater risk, although the self-insured
models stop loss, aggregate loss and tail liability features provide sufficient protection such that it is more likely than not that we will realize cost savings, as compared to the guaranteed minimum premium model coverage. In addition, the
self-insured model carriers medical and



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disease management capabilities along with its pharmacy formulary protocols and wellness care programs should enable us to deliver to our employees a more
effective and competitive plan. We recognize that the features of our medical benefit plan are important to the recruiting and retention of clinical and administrative staff and we are committed to offering a plan that is fully competitive with
those offered by other home care providers.



As a result of
operating in the health care industry, our business entails an inherent risk of lawsuits alleging malpractice, product liability or related legal issues, which can involve large claims and significant defense costs. From time to time, we are subject
to such suits arising in the ordinary course of business. We currently maintain professional and commercial liability insurance intended to cover such claims. As of December 31, 2004, this insurance coverage is provided under a
claims-made policy which provides, subject to the terms and conditions of the policy, coverage for certain types of claims made against us during the term of the policy and does not provide coverage for losses occurring during the terms
of the policy for which a claim is made subsequent to the termination of the policy. Should the policy not be renewed or replaced with equivalent insurance, claims based on occurrences during its term but asserted subsequently would be uninsured.
There can be no assurance that the coverage limits of our insurance policy will be adequate.



On October 1, 2004, we completed our annual renewal of our risk management program and implemented several changes. We renewed our insurance program for medical malpractice, commercial and general liability coverage
with Arch Specialty Insurance Company, rated A- by AM Best Company. Per claim deductible limits remained at $1.0 million with an aggregate retention of $8.0 million and an annual aggregate limit of $15.0 million. The premiums increased 16% for
fiscal 2005 as compared to fiscal 2004.



In addition, we are
subject to accident claims arising out of the normal operation of our fleet of vans and small trucks, and we maintain insurance intended to cover such claims. A successful claim against us in excess of our insurance coverage could have a material
adverse effect upon our business. Claims against us, regardless of their merits or eventual outcome, also may have a material adverse effect upon our reputation and business.



We are, from time to time, subject to lawsuits arising in the ordinary course of business, some of which may allege damages
which would not be covered under our existing insurance policies. We establish our reserves for these lawsuits based upon the information available to date and believe our reserves are adequate, however there can be no assurance that the ultimate
settlement of these lawsuits will not have a material adverse effect on our operations and financial results.



Capital Resources



We currently believe that our liquidity position will be adequate to satisfy our working capital requirements, professional and commercial liability
insurance loss funding, workers compensation collateral requirements, and income tax payments. Our current source of liquidity is cash on hand, cash flow from operations and availability under the Credit Agreement. We are exposed to
fluctuations in cash collection results.



CONTINGENT
LIABILITIES AND COMMITMENTS



Our former workers
compensation carrier requires the estimated loss reserve to be secured by surety bonds (see Liquidity and Capital Resources).



On October 1, 2004, we completed our annual renewal of our risk management programs and implemented several changes (see Liquidity and Capital
Resources).



We have entered into employment agreements
with certain employees which provide, among other things, salary, benefits and perquisites, as well as additional compensation for certain changes in control or a failure to comply with any material terms of the agreements. We have a Non-Qualified
Deferred Compensation Plan for certain of our employees. The Plans deferred compensation liability as of December 31, 2004 was approximately $1.2 million.



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The following table represents a schedule of our contractual obligations and commitments as of December
31, 2004:



|                         |  |                                       |        |                  |   |           |  |           |       |               |   |        |  |   |      
|------------------------ |  | ------------------------------------- | ------ | ---------------- | - | --------- |  | --------- | ----- | ------------- | - | ------ |  | - | -----
|                         |  | Payments Due by Period (In thousands)
|                         |  | Total                                 |        | Less Than 1 Year |   | 1-3 Years |  | 3-5 Years |       | After 5 Years
|Contractual Obligations: |  |                                       |        |                  |   |           |  |           |       |               |   |        |  |   |      
|Long-term debt           |  |                                       |        |                  |   |           |  |           |       |               |   |        |  |   |      
|Subordinated Notes       |  | $                                     | 20,350 |                  | $ |          |  | $         |      |               | $ | 20,350 |  | $ |     
|Other notes payable      |  |                                       | 144    |                  |   | 121       |  |           | 23    |               |   |       |  |   |     
|Operating leases         |  |                                       | 16,516 |                  |   | 4,337     |  |           | 5,993 |               |   | 3,070  |  |   | 3,116
|                         |  |                                       |        |                  |   |           |  |           |       |               |   |        |  |   |      
|                         |  | $                                     | 37,010 |                  | $ | 4,458     |  | $         | 6,016 |               | $ | 23,420 |  | $ | 3,116
|                         |  |                                       |        |                  |   |           |  |           |       |               |   |        |  |   |      



Variation in Quarterly Operating
Results



Our quarterly results may vary significantly
depending primarily on factors such as re-hospitalizations of patients, seasonality and usage levels of pharmaceutical products and respiratory services, the timing of new branch office openings and pricing pressures due to legislative and
regulatory initiatives to contain health care costs. Because of these factors, our operating results for any particular quarter may not be indicative of the results for the full fiscal year.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We face a number of market risk exposures including risks related to cash and cash equivalents, accounts receivable and interest rates. Cash and cash
equivalents are held primarily in one financial institution. We perform periodic evaluations of the relative credit standing of this financial institution. The concentration of credit risk with respect to accounts receivable, which are primarily
health care industry related, represent a risk to us given the current environment in the health care industry. The risk is somewhat limited due to the large number of payors including Medicare and Medicaid, insurance companies, individuals and the
diversity of geographic locations in which we operate. However, we have substantial geographic density in the eastern United States, which we believe exposes us to payor initiated reimbursement changes, substantial accounts receivable for a small
number of hemophilia factor patients and disruptions to cash collections due to the inability of some payors to process claims.



Our Notes, issued in 1998, have a fixed coupon rate of 10%. The fair value of our Notes is subject to change as a result of changes in market prices or
interest rates. We estimate potential changes in the fair value of interest rate sensitive financial instruments based on the hypothetical increase (or decrease) in interest rates. Our use of this methodology to quantify the market risk of such
instruments should not be construed as an endorsement of its accuracy or the accuracy of the related assumptions. The quantitative information about market risk is necessarily limited because it does not take into account other factors such as our
financial performance and credit ratings.



Based on a
hypothetical immediate 150 basis point increase in interest rates at December 31, 2004 and 2003, the market value of our Notes would be reduced by approximately $0.8 million and $1.0 million, respectively. Conversely, a 150 basis point decrease in
interest rates would result in a net increase in the market value of our Notes outstanding at December 31, 2004 and 2003 of approximately $0.8 million and $1.0 million, respectively.



ITEM 4. CONTROLS AND PROCEDURES



(a)Evaluation of disclosure controls and procedures. Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of
1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that our disclosure controls and procedures are adequate and effective in timely alerting them to material information
relating to the Company (including its consolidated subsidiaries) required to be included in our periodic SEC filings.



(b)Changes in internal controls. There were no changes in our internal controls over financial reporting that occurred during our most recent
fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.



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##### Table of Contents

PART II  OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



From
time to time, we are involved in various pending or threatened legal actions, some of which seek relief or damages in amounts that are substantial. These actions and proceedings arise in the ordinary course of our business and allege lawsuits
relating to personal injury torts, product liability, and other legal issues. Because of the complex nature of some of these actions and proceedings, it may be a number of years before such matters ultimately are resolved. We currently maintain
professional and commercial liability insurance intended to cover such actions and proceedings as discussed in Part I, Item 2  Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and
Capital Resources. In addition, some of these lawsuits may allege damages which may not be covered under our existing insurance polices. Based upon information available to date, management believes it has provided adequate reserves if needed for
any unfavorable settlement; however, there can be no assurance that the ultimate resolution of such current pending legal proceedings would not have a material adverse effect on our consolidated financial or liquidity position.



ITEM 6. EXHIBITS.



|     |      |  |                                                                                     
|---- | ---- |  | ------------------------------------------------------------------------------------
|     |      |  | The following exhibits are filed with this report:                                  
|     |     
|10.9 | (gg) |  | Non-Qualified Deferred Compensation Plan, effective January 1, 2005, filed herewith.
|     |     
|31.1 |      |  | Rule 13a-14(a)/15d-14(a) Certification (CEO)                                        
|     |     
|31.2 |      |  | Rule 13a-14(a)/15d-14(a) Certification (CFO)                                        
|     |     
|32.1 |      |  | Section 1350 Certification (CEO)                                                    
|     |     
|32.2 |      |  | Section 1350 Certification (CFO)                                                    



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##### Table of Contents

SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                       |  |     |  |                                                                                                                                                   
|---------------------- |  | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|                       |  |     |  | PEDIATRIC SERVICES OF AMERICA, INC. (Registrant)                                                                                                  
|                       |  |    
|Date: February 8, 2005 |  | By: |  | /s/ JAMES M. MCNEILL                                                                                                                              
|                       |  |     |  | James M. McNeill Senior Vice President, Chief Financial Officer, Treasurer and Secretary (Duly
authorized officer and Principal Financial Officer)



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