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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 June 30, 2006

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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



|                         |  |                      |  |                       
|------------------------ |  | -------------------- |  | ----------------------
|Large accelerated filer ̈ |  | Accelerated filer  x |  | Non-accelerated filer ̈

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

As of August 2, 2006, the Registrant had 7,516,538 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 June 30, 2006 and September 30, 2005                           |  | 3         
|                               |  |                                                                                                           
|                               |  | Condensed Consolidated Statements of Operations for the three and nine months ended June 30, 2006 and 2005 |  | 5         
|                               |  |                                                                                                           
|                               |  | Condensed Consolidated Statements of Cash Flows for the nine months ended June 30, 2006 and 2005           |  | 6         
|                               |  |                                                                                                           
|                               |  | Notes to Condensed Consolidated Financial Statements                                                       |  | 7         
|                               |  |                                                                                                           
|ITEM 2:                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                      |  | 18        
|                               |  |                                                                                                           
|ITEM 3:                        |  | Quantitative and Qualitative Disclosures about Market Risk                                                 |  | 30        
|                               |  |                                                                                                           
|ITEM 4:                        |  | Controls and Procedures                                                                                    |  | 30        
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                                           
|                               |  |                                                                                                           
|ITEM 1:                        |  | Legal Proceedings                                                                                          |  | 31        
|                               |  |                                                                                                           
|ITEM 6:                        |  | Exhibits                                                                                                   |  | 31        
|                               | 
|SIGNATURES                     |  | 32                                                                                                        



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)



|                                                                                                      |  |               |         |   |                   |   |         |  
|----------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                      |  | June 30, 2006 |         |   | September 30,2005 |  
|                                                                                                      |  | (Unaudited)   |         |   |                   |  
|ASSETS                                                                                                |  |               |         |   |                   |   |         |  
|Current assets:                                                                                       |  |               |         |   |                   |   |         |  
|Cash and cash equivalents                                                                             |  | $             | 53,116  |   |                   | $ | 19,037  |  
|Accounts receivable, less allowances for doubtful accounts of $2,183 and $3,000, respectively         |  |               | 26,115  |   |                   |   | 26,232  |  
|Prepaid expenses                                                                                      |  |               | 1,872   |   |                   |   | 1,255   |  
|Income taxes receivable                                                                               |  |               |        |   |                   |   | 549     |  
|Deferred income taxes                                                                                 |  |               | 6,878   |   |                   |   | 6,895   |  
|Workers compensation loss fund                                                                       |  |               | 4,587   |   |                   |   | 3,424   |  
|Insurance recoveries                                                                                  |  |               | 1,637   |   |                   |   | 1,376   |  
|Transition services                                                                                   |  |               | 8       |   |                   |   |        |  
|Other current assets                                                                                  |  |               | 283     |   |                   |   | 156     |  
|Assets held for sale                                                                                  |  |               |        |   |                   |   | 26,690  |  
|                                                                                                      |  |               |         |   |                   |   |         |  
|Total current assets                                                                                  |  |               | 94,496  |   |                   |   | 85,614  |  
|                                                                                                      |  |              
|Property and equipment:                                                                               |  |               |         |   |                   |   |         |  
|Home care equipment held for rental                                                                   |  |               | 32,698  |   |                   |   | 32,621  |  
|Furniture, fixtures and vehicles                                                                      |  |               | 12,165  |   |                   |   | 13,107  |  
|Leasehold improvements                                                                                |  |               | 2,928   |   |                   |   | 3,005   |  
|                                                                                                      |  |               |         |   |                   |   |         |  
|                                                                                                      |  |               | 47,791  |   |                   |   | 48,733  |  
|Accumulated depreciation and amortization                                                             |  |               | (37,412 | ) |                   |   | (38,489 | )
|                                                                                                      |  |               |         |   |                   |   |         |  
|                                                                                                      |  |               | 10,379  |   |                   |   | 10,244  |  
|                                                                                                      |  |              
|Other assets:                                                                                         |  |               |         |   |                   |   |         |  
|Goodwill, less accumulated amortization of approximately $6,371                                       |  |               | 27,302  |   |                   |   | 25,893  |  
|Certificates of need, less accumulated amortization of approximately $667 and $650, respectively      |  |               | 5       |   |                   |   | 22      |  
|Deferred financing fees, less accumulated amortization of approximately $836 at September 30, 2005    |  |               |        |   |                   |   | 535     |  
|Noncompete agreements, less accumulated amortization of approximately $1,180 and $1,258, respectively |  |               | 135     |   |                   |   | 22      |  
|Deferred income taxes                                                                                 |  |               | 1,562   |   |                   |   | 906     |  
|Workers compensation bond collateral                                                                 |  |               | 1,247   |   |                   |   | 1,525   |  
|Insurance cash surrender value and recoveries                                                         |  |               | 5,404   |   |                   |   | 4,122   |  
|Other                                                                                                 |  |               | 330     |   |                   |   | 270     |  
|                                                                                                      |  |               |         |   |                   |   |         |  
|                                                                                                      |  |               | 35,985  |   |                   |   | 33,295  |  
|                                                                                                      |  |               |         |   |                   |   |         |  
|Total assets                                                                                          |  | $             | 140,860 |   |                   | $ | 129,153 |  
|                                                                                                      |  |               |         |   |                   |   |         |  

See Accompanying Notes.



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PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS(Continued)

(In thousands)



|                                                                                                                                                           |  |              |         |                   |   |        
|---------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | ----------------- | - | -------
|                                                                                                                                                           |  | June 30,2006 |         | September 30,2005
|                                                                                                                                                           |  | (Unaudited)  |         |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                       |  |              |         |                   |   |        
|Current liabilities:                                                                                                                                       |  |              |         |                   |   |        
|Accounts payable                                                                                                                                           |  | $            | 3,013   |                   | $ | 6,032  
|Accrued compensation                                                                                                                                       |  |              | 5,526   |                   |   | 5,738  
|Income taxes payable                                                                                                                                       |  |              | 3,431   |                   |   |       
|Accrued insurance                                                                                                                                          |  |              | 6,489   |                   |   | 5,366  
|Refunds payable                                                                                                                                            |  |              | 2,936   |                   |   | 3,462  
|Accrued interest                                                                                                                                           |  |              | 42      |                   |   | 985    
|Transition services                                                                                                                                        |  |              | 159     |                   |   |       
|Professional service liabilities                                                                                                                           |  |              | 989     |                   |   | 743    
|Additional rent payable                                                                                                                                    |  |              | 1,301   |                   |   | 812    
|Other accrued liabilities                                                                                                                                  |  |              | 288     |                   |   | 371    
|Deferred revenue                                                                                                                                           |  |              | 891     |                   |   | 795    
|Held for sale liabilities                                                                                                                                  |  |              |        |                   |   | 236    
|                                                                                                                                                           |  |              |         |                   |   |        
|Total current liabilities                                                                                                                                  |  |              | 25,065  |                   |   | 24,540 
|                                                                                                                                                           |  |             
|Long-term accrued insurance                                                                                                                                |  |              | 12,244  |                   |   | 9,584  
|Long-term income taxes payable                                                                                                                             |  |              | 88      |                   |   | 88     
|Deferred compensation                                                                                                                                      |  |              | 1,199   |                   |   | 1,022  
|Long-term obligations, net of current maturities                                                                                                           |  |              |        |                   |   | 20,350 
|                                                                                                                                                           |  |              |         |                   |   |        
|Total liabilities                                                                                                                                          |  |              | 38,596  |                   |   | 55,584 
|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 7,515 and 7,262 shares issued and outstanding at June 30, 2006 and
September 30, 2005, respectively |  |              | 75      |                   |   | 73     
|Additional paid-in capital                                                                                                                                 |  |              | 55,359  |                   |   | 52,070 
|Retained earnings                                                                                                                                          |  |              | 46,830  |                   |   | 21,426 
|                                                                                                                                                           |  |              |         |                   |   |        
|Total stockholders equity                                                                                                                                 |  |              | 102,264 |                   |   | 73,569 
|                                                                                                                                                           |  |              |         |                   |   |        
|Total liabilities and stockholders equity                                                                                                                 |  | $            | 140,860 |                   | $ | 129,153
|                                                                                                                                                           |  |              |         |                   |   |        

See Accompanying Notes.



4



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PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|------------------------------------------------------------------------------ |  | -------------------------- | ------ | ----------- | ------------------------- | ------ | ----------- |  | - | ----------- | - |  | - | ------- | -
|                                                                               |  | Three Months EndedJune 30, |        |             | Nine Months EndedJune 30, |       
|                                                                               |  | 2006                       |        | 2005        |                           |        | 2006        |  |   | 2005        |  
|                                                                               |  | (Unaudited)                |        | (Unaudited) |                           |        | (Unaudited) |  |   | (Unaudited) |  
|Net revenue                                                                    |  | $                          | 44,645 |             | $                         | 43,481 |             |  | $ | 130,380     |   |  | $ | 129,777 |  
|Costs and expenses:                                                            |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Costs of goods and services (exclusive of depreciation shown separately below) |  |                            | 23,233 |             |                           | 21,938 |             |  |   | 67,064      |   |  |   | 65,450  |  
|Other operating costs and expenses                                             |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Salaries, wages and benefits                                                   |  |                            | 9,340  |             |                           | 8,815  |             |  |   | 27,367      |   |  |   | 26,834  |  
|Business insurance                                                             |  |                            | 1,718  |             |                           | 1,774  |             |  |   | 5,330       |   |  |   | 4,925   |  
|Overhead                                                                       |  |                            | 3,685  |             |                           | 3,867  |             |  |   | 11,135      |   |  |   | 10,904  |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Other operating costs and expenses                                             |  |                            | 14,743 |             |                           | 14,456 |             |  |   | 43,832      |   |  |   | 42,663  |  
|Corporate, general and administrative                                          |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Salaries, wages and benefits                                                   |  |                            | 3,516  |             |                           | 3,533  |             |  |   | 10,595      |   |  |   | 10,212  |  
|Business insurance                                                             |  |                            | 68     |             |                           | 62     |             |  |   | 191         |   |  |   | 152     |  
|Professional services                                                          |  |                            | 784    |             |                           | 1,227  |             |  |   | 2,722       |   |  |   | 3,030   |  
|Overhead                                                                       |  |                            | 746    |             |                           | 745    |             |  |   | 2,140       |   |  |   | 2,214   |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Corporate, general and administrative                                          |  |                            | 5,114  |             |                           | 5,567  |             |  |   | 15,648      |   |  |   | 15,608  |  
|Provision for doubtful accounts                                                |  |                            | 274    |             |                           | 712    |             |  |   | 738         |   |  |   | 2,351   |  
|Depreciation and amortization                                                  |  |                            | 1,069  |             |                           | 1,008  |             |  |   | 3,077       |   |  |   | 2,986   |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Total costs and expenses                                                       |  |                            | 44,433 |             |                           | 43,681 |             |  |   | 130,359     |   |  |   | 129,058 |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Operating income (loss)                                                        |  |                            | 212    |             |                           | (200   | )           |  |   | 21          |   |  |   | 719     |  
|Other income                                                                   |  |                            | 46     |             |                           |       |             |  |   | 54          |   |  |   | 65      |  
|Loss on early extinguishment of debt                                           |  |                            |       |             |                           |       |             |  |   | (837        | ) |  |   |        |  
|Interest income                                                                |  |                            | 656    |             |                           | 56     |             |  |   | 1,667       |   |  |   | 149     |  
|Interest expense                                                               |  |                            |       |             |                           | (628   | )           |  |   | (564        | ) |  |   | (1,873  | )
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Income (loss) from continuing operations, before income tax expense (benefit)  |  |                            | 914    |             |                           | (772   | )           |  |   | 341         |   |  |   | (940    | )
|Income tax expense (benefit)                                                   |  |                            | 358    |             |                           | (556   | )           |  |   | 384         |   |  |   | (405    | )
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Income (loss) from continuing operations                                       |  |                            | 556    |             |                           | (216   | )           |  |   | (43         | ) |  |   | (535    | )
|Discontinued operations:                                                       |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|                                                                               |  |                            |        |            
|Income from discontinued operations, net of tax                                |  |                            | 2      |             |                           | 1,690  |             |  |   | 779         |   |  |   | 4,641   |  
|Gain on disposal of discontinued operations, net of tax                        |  |                            | 66     |             |                           |       |             |  |   | 24,668      |   |  |   |        |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Net income                                                                     |  | $                          | 624    |             | $                         | 1,474  |             |  | $ | 25,404      |   |  | $ | 4,106   |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Basic net income per share data:                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Income (loss) from continuing operations                                       |  | $                          | 0.07   |             | $                         | (0.03  | )           |  | $ | (0.01       | ) |  | $ | (0.07   | )
|Income from discontinued operations, net of tax                                |  |                            | 0.00   |             |                           | 0.23   |             |  |   | 0.11        |   |  |   | 0.64    |  
|Gain on disposal of discontinued operations, net of tax                        |  |                            | 0.01   |             |                           |       |             |  |   | 3.34        |   |  |   |        |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Net income                                                                     |  | $                          | 0.08   |             | $                         | 0.20   |             |  | $ | 3.44        |   |  | $ | 0.57    |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Diluted net income per share data:                                             |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Income (loss) from continuing operations                                       |  | $                          | 0.07   |             | $                         | (0.03  | )           |  | $ | (0.01       | ) |  | $ | (0.07   | )
|Income from discontinued operations, net of tax                                |  |                            | 0.00   |             |                           | 0.23   |             |  |   | 0.11        |   |  |   | 0.64    |  
|Gain on disposal of discontinued operations, net of tax                        |  |                            | 0.01   |             |                           |       |             |  |   | 3.34        |   |  |   |        |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Net income                                                                     |  | $                          | 0.08   |             | $                         | 0.20   |             |  | $ | 3.44        |   |  | $ | 0.57    |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Weighted average shares outstanding:                                           |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Basic                                                                          |  |                            | 7,492  |             |                           | 7,252  |             |  |   | 7,378       |   |  |   | 7,185   |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  
|Diluted                                                                        |  |                            | 7,492  |             |                           | 7,252  |             |  |   | 7,378       |   |  |   | 7,185   |  
|                                                                               |  |                            |        |             |                           |        |             |  |   |             |   |  |   |         |  

See Accompanying Notes.



5



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                                                 |  |                           |         |   |             |   |        |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ----------- | - | ------ | -
|                                                                                                                 |  | Nine Months EndedJune 30, |        
|                                                                                                                 |  | 2006                      |         |   | 2005        |  
|                                                                                                                 |  | (Unaudited)               |         |   | (Unaudited) |  
|Operating activities:                                                                                            |  |                           |         |   |             |   |        |  
|Net income                                                                                                       |  | $                         | 25,404  |   |             | $ | 4,106  |  
|Less income from discontinued operations, net of income tax expense                                              |  |                           | (779    | ) |             |   | (4,641 | )
|Less gain on disposal from discontinued operations, net of income tax expense                                    |  |                           | (24,668 | ) |             |   |       |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Loss from continuing operations, net of income tax expense (benefit)                                             |  |                           | (43     | ) |             |   | (535   | )
|Adjustments to reconcile loss from continuing operations to net cash (used in) provided by operating activities: |  |                           |         |   |             |   |        |  
|Depreciation and amortization                                                                                    |  |                           | 3,077   |   |             |   | 2,986  |  
|Provision for doubtful accounts                                                                                  |  |                           | 738     |   |             |   | 2,351  |  
|Amortization of deferred financing fees                                                                          |  |                           | 37      |   |             |   | 181    |  
|Loss on early extinguishment of debt                                                                             |  |                           | 837     |   |             |   |       |  
|Incentive stock option expense                                                                                   |  |                           | 292     |   |             |   |       |  
|Nonqualified stock option expense                                                                                |  |                           | 700     |   |             |   |       |  
|Deferred income taxes                                                                                            |  |                           | (639    | ) |             |   | 413    |  
|Changes in operating assets and liabilities                                                                      |  |                           |         |   |             |   |        |  
|Accounts receivable                                                                                              |  |                           | (621    | ) |             |   | (1,319 | )
|Prepaid expenses                                                                                                 |  |                           | (617    | ) |             |   | (910   | )
|Other assets                                                                                                     |  |                           | (227    | ) |             |   | 309    |  
|Workers compensation loss fund                                                                                  |  |                           | (1,163  | ) |             |   | (364   | )
|Workers compensation bond collateral                                                                            |  |                           | 278     |   |             |   | 797    |  
|Accounts payable                                                                                                 |  |                           | (3,028  | ) |             |   | 569    |  
|Income taxes                                                                                                     |  |                           | (389    | ) |             |   | (281   | )
|Accrued compensation, insurance, liabilities, refunds and interest                                               |  |                           | 1,452   |   |             |   | 178    |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash provided by operating activities of continuing operations                                               |  |                           | 684     |   |             |   | 4,375  |  
|Net cash (used in) provided by operating activities of discontinued operations                                   |  |                           | (15,819 | ) |             |   | 3,814  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash (used in) provided by operating activities                                                              |  |                           | (15,135 | ) |             |   | 8,189  |  
|                                                                                                                 |  |                          
|Investing activities:                                                                                            |  |                           |         |   |             |   |        |  
|Purchases of property and equipment                                                                              |  |                           | (3,042  | ) |             |   | (3,399 | )
|Acquisition of a business                                                                                        |  |                           | (1,598  | ) |             |   |       |  
|Purchases of available for sale securities                                                                       |  |                           | (20,100 | ) |             |   |       |  
|Sales of available for sale securities                                                                           |  |                           | 20,100  |   |             |   |       |  
|Proceeds from the sale of discontinued operations                                                                |  |                           | 72,250  |   |             |   |       |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash provided by (used in) investing activities of continuing operations                                     |  |                           | 67,610  |   |             |   | (3,399 | )
|Net cash used in investing activities of discontinued operations                                                 |  |                           |        |   |             |   | (168   | )
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash provided by (used in) investing activities                                                              |  |                           | 67,610  |   |             |   | (3,567 | )
|                                                                                                                 |  |                          
|Financing activities:                                                                                            |  |                           |         |   |             |   |        |  
|Principal payments and extinguishment of long-term debt                                                          |  |                           | (20,689 | ) |             |   | (110   | )
|Disqualifying disposition of stock options                                                                       |  |                           | 307     |   |             |   | 54     |  
|Nonqualified stock options                                                                                       |  |                           | 351     |   |             |   | 450    |  
|Proceeds from exercise of stock options                                                                          |  |                           | 1,641   |   |             |   | 1,017  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash (used in) provided by financing activities of continuing operations                                     |  |                           | (18,390 | ) |             |   | 1,411  |  
|Net cash used in financing activities of discontinued operations                                                 |  |                           | (6      | ) |             |   | (35    | )
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Net cash (used in) provided by financing activities                                                              |  |                           | (18,396 | ) |             |   | 1,376  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Increase in cash and cash equivalents                                                                            |  |                           | 34,079  |   |             |   | 5,998  |  
|Cash and cash equivalents at beginning of year                                                                   |  |                           | 19,037  |   |             |   | 8,159  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Cash and cash equivalents at end of period                                                                       |  | $                         | 53,116  |   |             | $ | 14,157 |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Supplemental disclosure of cash flow information:                                                                |  |                           |         |   |             |   |        |  
|Cash paid for interest                                                                                           |  | $                         | 1,546   |   |             | $ | 2,234  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  
|Cash paid for taxes                                                                                              |  | $                         | 12,783  |   |             | $ | 1,850  |  
|                                                                                                                 |  |                           |         |   |             |   |        |  

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 and nine months ended June 30, 2006 are not
necessarily indicative of the results to be expected for the entire fiscal year ending September 30, 2006. These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements for
the year ended September 30, 2005 which are 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 2005 Annual Report.

2. Summary of Significant Accounting Policies

Description of Business

We provide a broad range of pediatric healthcare services and equipment including nursing,
respiratory therapy and rental and sale of durable medical equipment. 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 healthcare 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 services, we also provide respiratory 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 8).

Discontinued Operations

On November 18, 2005, we completed the sale of selected assets of our Pharmacy business to Accredo Health Group, Inc., a wholly-owned subsidiary of
Medco Health Solutions, Inc. The aggregate purchase price was $72.3 million. We have recorded a gain of approximately $24.6 million, net of approximately $15.9 million for income taxes. As part of the transaction, the parties executed a transition
services agreement that provides for the collection of outstanding accounts receivable for a period of 180 days and order fulfillment, billing services and related accounting services for a period of 120 days after closing. As of June 30, 2006,
we had completed our responsibilities under the transition services agreement. At June 30, 2006, we had a receivable of approximately $0.01 million related to transitioning the services to Accredo Health Group and a payable of approximately
$0.2 million related to cash collections payable to Accredo Health Group. This amount was collected and/or paid in July 2006 (See Note 3).

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. 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 in a limited number of financial
institutions and with institutional investors. We perform periodic evaluations of the relative financial position and credit standing of these financial intermediaries. As part of our corporate cash management program we are investing the retained
proceeds from the sale of the Pharmacy business in accordance with established investment policies. We have invested in a portfolio of highly liquid investment grade securities which are managed for us by institutional investors. The concentration
of credit risk with respect to accounts



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)

2.
Summary of Significant Accounting Policies - Continued



receivable, which are primarily healthcare industry related, represent a risk to us given the current healthcare 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.

Cash and Cash Equivalents

We consider all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Deposits with banks are
federally insured in limited amounts.

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 $5.3 million and $5.5 million for which services have been rendered but the amounts were unbilled as of June 30, 2006 and September 30, 2005, respectively.
Such unbilled amounts are primarily a result of the time required to process bills for services rendered.

Identifiable Intangible
Assets

Amortization expense on identifiable intangible assets was approximately $0.03 and $0.04 million for the three months ended
June 30, 2006 and 2005, respectively and $0.1 million for the nine months ended June 30, 2006 and 2005. Estimated amortization expense of identifiable intangible assets for each of the fiscal years ending September 30, is presented
below (in thousands):



|     |  |                                  |    
|---- |  | -------------------------------- | ---
|     |  | For The Year EndingSeptember 30,
|2006 |  | $                                | 138
|2007 |  | $                                | 115
|2008 |  | $                                | 114
|2009 |  | $                                | 114
|2010 |  | $                                | 114

Accrued Insurance/Insurance Recoveries

Our insurance broker retains 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.

On October 1, 2005, 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 self-insured retention amounts remained at $1.0 million with an annual aggregate self-insured retention amount of $8.0 million and an annual aggregate coverage
limit of $15.0 million. We changed carriers for our workers compensation policy to Charter Oak Fire Insurance, a subsidiary of St. Paul Travelers, rated A+ by AM Best Company, with the deductible remaining at $0.35 million.

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. The fees paid by us to Acordia were approximately $0.175 million during fiscal year 2005 and are expected to be $0.198 million for fiscal 2006.



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)

2.
Summary of Significant Accounting Policies - Continued



Workers Compensation Loss Fund

Our previous workers compensation insurance carrier, Argonaut Insurance Company, rated A by AM Best Company, requires a twelve month estimated loss
reserve to be funded entirely with cash each fiscal year which is reduced by the monthly loss fund payments. The policy for fiscal 2006 is underwritten by Charter Oak Fire Insurance, a subsidiary of St. Paul Travelers, rated A+ by AM Best Company
and will be funded in a similar manner with the annual cash requirement estimated to be $2.2 million. The net balance at June 30, 2006 and September 30, 2005 was $4.6 million and $3.4 million, respectively. The insurance carriers have 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 they have not indicated the need to do so.

Workers Compensation Bond Collateral

We have secured surety bonds of $1.4 million to satisfy our workers compensation program requirements for our former insurance carrier. As of June 30, 2006, the surety bonds were collateralized by $1.2 million cash posted to a
third party escrow account. During the nine months ended June 30, 2006, we were notified that this carrier received a downgrade in its AM Best financial strength rating to a B-. While we believe that our collateral remains secure, the potential
for the carrier to not pay claims in the ordinary course has increased. We are monitoring the situation in conjunction with our insurance brokers. During the three months ended June 30, 2006, the carrier executed a reinsurance contract which
improves its capital adequacy and future liquidity. Based upon information available to date, we believe the insurance carrier should be able to meet its obligations.

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.

A reconciliation of the income tax expense related to the statutory federal income tax rate for the nine months ended
June 30, 2006 is as follows:



|                                                                      |  |   |         |  
|--------------------------------------------------------------------- |  | - | ------- | -
|Statutory federal income tax rate of 34% applied to pre-tax income    |  | $ | 115,316 |  
|State income taxes, net of federal tax benefit                        |  |   | 16,178  |  
|Effect of change in state income tax effective rate on deferred items |  |   | 326,661 |  
|Change in valuation allowance                                         |  |   | (95,460 | )
|Effect of permanent differences                                       |  |   | 21,146  |  
|                                                                      |  |   |         |  
|Continuing operations                                                 |  | $ | 383,841 |  
|                                                                      |  |   |         |  

Net Revenue

We derive substantially all of our net revenue from patients who have a third party payor (insurance company or government) who either has contractually agreed to pay the patients account or is obligated to pay
based on the patients participation in its program (i.e. Medicare or Medicaid). Revenues are recorded based on estimated net realizable amounts to be received for products or services rendered during the period. The Companys accounting
system is programmed to calculate the expected reimbursement to be received on a patient-by-patient basis based on the type of payor and the contractual terms of the payor or pre-negotiated reimbursement rates. The Companys accounting system
is updated as changes occur to reimbursement rates. 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 per diem or contract amounts, we do not maintain records that provide a breakdown between the service and product
components. Substantially all of our revenue is fee for service.

Our net revenue 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
healthcare costs.

Certain equipment rentals are billed in advance of our rendering the related services. Such amounts are deferred in the
balance sheet until the related services are performed.

Stock Option Plans

At June 30, 2006, we have two stock-based compensation plans, the Stock Option Plan and the Directors Stock Option Plan (the
Directors Plan). Our Stock Option Plan (the Option Plan) provides for the granting of stock options covering up to 2,300,000 shares of Common Stock, of which 840,425 options are outstanding to eligible participants as
of June 30, 2006. Options may be issued as either incentive stock options or as nonqualified stock options. Options may be granted to those persons who are officers or employees of our company or to certain outside consultants. The terms and
conditions of options granted under the Option Plan, including the number of shares, the exercise price and the time at which such options become exercisable are determined by the Compensation Committee of the Board of Directors (the
Compensation Committee). The vesting period of the options is typically four years. Upon the occurrence of certain events,



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)

2.
Summary of Significant Accounting Policies - Continued



the vesting period of some options accelerate. The term of options granted under the Option Plan may not exceed 10 years. We have the right to repurchase the
Common Stock issued upon the exercise of these options at the then fair market value of such shares, if either party terminates their employment relationship.

Under our Directors Plan, directors of our company who are not officers or employees may receive stock options annually to purchase shares of Common Stock, at an exercise price equal to the fair market value on
the date of grant and expiring 10 years after issuance. The options vest on the first anniversary of their issuance, provided that the grantee is then a director of the Company. The Compensation Committee has the authority and sole discretion to
make grants of options under the Directors Plan in addition to the annual grants described above. A total of 650,000 shares of Common Stock have been reserved for issuance pursuant to options granted under the Directors Plan of which
287,500 options are outstanding to eligible participants as of June 30, 2006.

Prior to October 1, 2005, we accounted for these
plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related Interpretations, as permitted by FASB Statement No. 123,
Accounting for Stock-Based Compensation (Statement 123). No stock-based compensation cost was recognized in the statement of operations for the three and nine months ended June 30, 2005, as all options granted under our stock-based
compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective October 1, 2005, we adopted the fair value recognition provisions of FASB Statement No. 123(R),
Share-Based Payment (Statement 123(R)), using the modified-prospective-transition method. Under the transition method, compensation cost recognized in the three and nine months ended June 30, 2006 includes: (a) compensation
cost for all share-based payments granted prior to, but not yet vested as of October 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all
share-based payments granted subsequent to October 1, 2005, based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). Results for prior periods have not been restated.

The fair value of the options awarded under Statement 123(R) is estimated on the date of grant using the Black Scholes Merton option pricing formula that
used the assumptions noted in the following table. Expected volatilities are based on historical volatility of our stock and other factors. We use historical option exercise and employee termination dates to estimate the expected term. The expected
term represents the period of time that options granted are expected to be outstanding. We perform these calculations separately for each plan because the participants exhibit different behavior. The risk free rate for periods within the contractual
life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. We have elected to use the straightline method to recognize compensation expense under Statement 123(R).



|                         |  |             |   |  |                 |  
|------------------------ |  | ----------- | - |  | --------------- | -
|                         |  | Option Plan |   |  | Directors Plan |  
|Expected volatility      |  | 53          | % |  | 75              | %
|Expected dividends       |  | 0           | % |  | 0               | %
|Expected term (in years) |  | 4           |   |  | 8               |  
|Risk-free rate           |  | 4.43        | % |  | 4.49            | %

Option Plan

A summary of option activity under the Option Plan as of June 30, 2006, and changes during the period then ended is presented below:



|                                        |  |          |   |  |                                  |       |                                             |      |                           |   |          
|--------------------------------------- |  | -------- | - |  | -------------------------------- | ----- | ------------------------------------------- | ---- | ------------------------- | - | ---------
|Options                                 |  | Shares   |   |  | Weighted- Average Exercise Price |       | Weighted- Average Remaining ContractualTerm |      | Aggregate Intrinsic Value
|Outstanding at October 1, 2005          |  | 990,075  |   |  | $                                | 9.86  |                                             |      |                           |   |          
|Granted                                 |  | 82,500   |   |  |                                  | 14.74 |                                             |      |                           |   |          
|Exercised                               |  | (207,150 | ) |  |                                  | 6.42  |                                             |      |                           |   |          
|Forfeited or expired                    |  | (25,000  | ) |  |                                  | 12.26 |                                             |      |                           |   |          
|                                        |  |          |   |  |                                  |       |                                             |      |                           |   |          
|Outstanding at June 30, 2006            |  | 840,425  |   |  | $                                | 11.12 |                                             | 6.98 |                           | $ | 2,098,442
|                                        |  |          |   |  |                                  |       |                                             |      |                           |   |          
|Vested and exercisable at June 30, 2006 |  | 346,700  |   |  | $                                | 11.78 |                                             | 5.12 |                           | $ | 1,008,841
|                                        |  |          |   |  |                                  |       |                                             |      |                           |   |          



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)

2.
Summary of Significant Accounting Policies - Continued



The weighted-average grant-date fair value of options granted during the nine months ended
June 30, 2006 was $6.70. The total intrinsic value of options exercised during the nine months ended June 30, 2006 was $1.5 million.

As of June 30, 2006 there was $1.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Option Plan. That cost is expected to be recognized over a
weighted-average period of one year and two months.

Directors Plan

A summary of option activity under the Directors Plan as of June 30, 2006, and changes during the period then ended is presented below:



|                                        |  |         |   |  |                                |       |                                          |      |                          |   |          
|--------------------------------------- |  | ------- | - |  | ------------------------------ | ----- | ---------------------------------------- | ---- | ------------------------ | - | ---------
|Options                                 |  | Shares  |   |  | Weighted-AverageExercise Price |       | Weighted-AverageRemainingContractualTerm |      | AggregateIntrinsic Value
|Outstanding at October 1, 2005          |  | 318,500 |   |  | $                              | 8.66  |                                          |      |                          |   |          
|Granted                                 |  | 30,000  |   |  |                                | 15.07 |                                          |      |                          |   |          
|Exercised                               |  | (46,000 | ) |  |                                | 6.79  |                                          |      |                          |   |          
|Forfeited or expired                    |  | (15,000 | ) |  |                                | 20.88 |                                          |      |                          |   |          
|                                        |  |         |   |  |                                |       |                                          |      |                          |   |          
|Outstanding at June 30, 2006            |  | 287,500 |   |  | $                              | 8.99  |                                          | 5.45 |                          | $ | 1,403,665
|                                        |  |         |   |  |                                |       |                                          |      |                          |   |          
|Vested and exercisable at June 30, 2006 |  | 263,500 |   |  | $                              | 8.44  |                                          | 5.09 |                          | $ | 1,403,665
|                                        |  |         |   |  |                                |       |                                          |      |                          |   |          

The weighted-average grant-date fair value of options granted during the nine months ended
June 30, 2006 was $11.31.

As of June 30, 2006 there was $0.1 million of total unrecognized compensation cost related to
non-vested share-based compensation arrangements granted under the Directors Plan. That cost is expected to be recognized over a weighted-average period of four months.

As a result of adopting Statement 123(R) on October 1, 2005, our compensation expenses recognized in the three and nine months ended June 30,
2006 were approximately $0.3 million and $1.0 million, respectively. Our income from continuing operations, income before income taxes and net income for the three months ended June 30, 2006 was $0.3 million, $0.3 million and $0.2 million
lower, respectively, than if we had continued to account for share-based compensation under APB 25. Basic and diluted earnings per share for the three months ended June 30, 2006 is $0.03 lower than if we had continued to account for share-based
compensation under APB 25. Our income from continuing operations, income before income taxes and net income for the nine months ended June 30, 2006 was $1.0 million, $1.0 million and $0.7 million lower, respectively, than if we had continued to
account for share-based compensation under APB 25. Basic and diluted earnings per share for the nine months ended June 30, 2006 is $0.10 lower than if we had continued to account for share-based compensation under APB 25.

Prior to the adoption of Statement 123(R), we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash
flows in the Statement of Cash Flows. Statement 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as
financing cash flows.



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)

2.
Summary of Significant Accounting Policies - Continued



The following pro forma disclosures regarding net income and earnings per share are determined as if
we had applied the fair value recognition provisions of Statement 123 to options granted under our stock based compensation plans in the three and nine months ended June 30, 2005. For purposes of this pro forma disclosure, the value of the
options is estimated using a Black-Scholes-Merton option-pricing formula and amortized to expense over the options vesting periods (in thousands, except for net income per share information):



|                                                         |  |                                 |       |   |                                |   |        |  
|-------------------------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | ------ | -
|                                                         |  | Three Months EndedJune 30,
2005 |       |   | Nine Months EndedJune 30,
2005 |  
|Net Income                                               |  |                                 |       |   |                                |   |        |  
|As reported                                              |  | $                               | 1,474 |   |                                | $ | 4,106  |  
|Fair value based method compensation expense, net of tax |  |                                 | (688  | ) |                                |   | (1,764 | )
|                                                         |  |                                 |       |   |                                |   |        |  
|Pro forma net income                                     |  | $                               | 786   |   |                                | $ | 2,342  |  
|                                                         |  |                                 |       |   |                                |   |        |  
|Basic income per share                                   |  |                                 |       |   |                                |   |        |  
|As reported                                              |  | $                               | 0.20  |   |                                | $ | 0.57   |  
|                                                         |  |                                 |       |   |                                |   |        |  
|Pro forma                                                |  | $                               | 0.11  |   |                                | $ | 0.33   |  
|                                                         |  |                                 |       |   |                                |   |        |  
|Diluted income per share                                 |  |                                 |       |   |                                |   |        |  
|As reported                                              |  | $                               | 0.20  |   |                                | $ | 0.57   |  
|                                                         |  |                                 |       |   |                                |   |        |  
|Pro forma                                                |  | $                               | 0.11  |   |                                | $ | 0.33   |  
|                                                         |  |                                 |       |   |                                |   |        |  

Reclassifications

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

3.
Discontinued Operations

On November 18, 2005, we completed the sale of selected assets of our Pharmacy business to Accredo Health
Group, Inc., a wholly-owned subsidiary of Medco Health Solutions, Inc. The aggregate purchase price was $72.3 million (See Note 2). As a result, these operations are reflected as a discontinued operation. The consolidated financial statements for
all periods presented have been restated to reflect discontinued operations. The operating results of the discontinued operations are summarized as follows:



|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|------------------------------------------- | ---- | -------------------------- | ---- | ------------------------- |  | ---- | ------ | ---- | - | ------ |  | - | ------
|(In Thousands, except per share data)       |      | Three Months EndedJune 30, |      | Nine Months EndedJune 30,
|                                            | 2006 |                            |      | 2005                      |  | 2006 |        | 2005
|Discontinued Operations                     |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|                                            |      |                            |      |                          
|Net revenue                                 |      | $                          |     |                           |  | $    | 19,790 |      | $ | 11,318 |  | $ | 61,778
|Income before income tax expense            |      |                            |     |                           |  |      | 2,756  |      |   | 1,281  |  |   | 7,514 
|Income tax (benefit) expense                |      |                            | (2   | )                         |  |      | 1,066  |      |   | 502    |  |   | 2,873 
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Net income                                  |      | $                          | 2    |                           |  | $    | 1,690  |      | $ | 779    |  | $ | 4,641 
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Net income per share                        |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Basic                                       |      | $                          | 0.00 |                           |  | $    | 0.23   |      | $ | 0.11   |  | $ | 0.64  
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Diluted                                     |      | $                          | 0.00 |                           |  | $    | 0.23   |      | $ | 0.11   |  | $ | 0.64  
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Gain on Disposal                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|                                            |      |                            |      |                          
|Gain on disposal of discontinued operations |      | $                          |     |                           |  | $    |       |      | $ | 40,562 |  | $ |      
|Income tax (benefit) expense                |      |                            | (66  | )                         |  |      |       |      |   | 15,894 |  |   |      
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Net income                                  |      | $                          | 66   |                           |  | $    |       |      | $ | 24,668 |  | $ |      
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Net income per share                        |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Basic                                       |      | $                          | 0.01 |                           |  | $    |       |      | $ | 3.34   |  | $ |      
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       
|Diluted                                     |      | $                          | 0.01 |                           |  | $    |       |      | $ | 3.34   |  | $ |      
|                                            |      |                            |      |                           |  |      |        |      |   |        |  |   |       



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



3. Discontinued Operations  Continued

Assets of the discontinued operations have been reflected in the condensed consolidated balance sheet as current assets held for sale. The liabilities
that were assumed by the purchaser are reflected in current liabilities as held for sale liabilities. The following is a summary of assets and liabilities of discontinued operations at September 30, 2005:



|                                             |  |                   |       
|-------------------------------------------- |  | ----------------- | ------
|In Thousands                                 |  | September 30,2005
|Accounts receivable, net                     |  | $                 | 11,434
|Prepaid expenses                             |  |                   | 62    
|Inventory                                    |  |                   | 4,323 
|Property, net                                |  |                   | 199   
|Goodwill, net                                |  |                   | 10,647
|Other                                        |  |                   | 25    
|                                             |  |                   |       
|Total assets of discontinued operations      |  | $                 | 26,690
|                                             |  |                   |       
|Accrued compensation                         |  | $                 | 152   
|Other accrued liabilities                    |  |                   | 49    
|Current maturities of long-term obligations  |  |                   | 35    
|                                             |  |                   |       
|Total liabilities of discontinued operations |  | $                 | 236   
|                                             |  |                   |       

Accounts receivable for discontinued operations include approximately $1.7 million for which
services have been rendered but the amounts were unbilled as of September 30, 2005. Such unbilled amounts are primarily a result of the time required to process bills for services rendered. Certain liabilities were not assumed by the purchaser
in the sale of the Pharmacy business. These include accounts payable, additional accrued compensation and other accrued liabilities.

4. Acquisition of
a Business

On June 2, 2006 we acquired select assets of Melmedica Childrens Healthcare, Inc. for a purchase price of $1.6
million in cash. Under the terms of the Asset Purchase Agreement, Melmedica will retain all of the business accounts receivable arising from sales generated prior to the closing of the transaction. Melmedica is a multi-site pediatric private duty
nursing business operating in the Illinois and Indiana markets. We intend to integrate some of Melmedicas Illinois operations into our existing nursing operations in the Chicago area. We are in the process of finalizing our purchase price
allocation. The purchase price has been preliminarily allocated to identifiable intangible assets consisting principally of noncompete agreements of $0.1 million and goodwill of $1.4 million. The remaining purchase price was allocated to fixed
assets based on the fair value of those fixed assets. Effective with the adoption of SFAS No. 142, the purchase price allocation of $1.4 million of goodwill is not being amortized; however, it is being deducted for tax purposes.

The purchase method of accounting was used to record this acquisition and the results of the operations of the acquired company are included in the
accompanying consolidated statements of operations from the date of the acquisition.

5. Long-Term Borrowing Arrangements

On December 30, 2005, in connection with the sale of the Pharmacy Business, we redeemed in full our 10% Senior Subordinated Notes due 2008 in the
amount of $20.4 million. We recorded the write-off of approximately $0.5 million in related deferred financing fees and call premium in the nine months ended June 30, 2006.

On November 11, 2005, in connection with the sale of the Pharmacy Business, we terminated our credit agreement with General Electric Capital
Corporation. The credit agreement, consisting of a $10.0 million revolving credit facility and a $10.0 million acquisition credit facility had remained unused. We recorded the write-off of approximately $0.3 million in related deferred financing and
termination fees in the nine months ended June 30, 2006.



13



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



6. Stock Option Plans

During the three months ended June 30, 2006 and 2005, respectively, 45,100 and 3,375 options to acquire our Common Stock were exercised. During the nine months ended June 30, 2006 and 2005, respectively,
253,150 and 222,501 options to acquire our common stock were exercised.

7. 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). For the three and nine months ended June 30, 2006 and 2005, the
weighted average shares outstanding for continuing operations for basic and diluted computations are the same, as the impact of common equivalent shares on earnings per share is anti-dilutive.

The following table sets forth the reconciliation of denominators used in the computation of the basic and diluted income (loss) from continuing and
discontinued operations per share:



|                                                                          |      |                            |      |                           |      |       |      |      
|------------------------------------------------------------------------- | ---- | -------------------------- | ---- | ------------------------- | ---- | ----- | ---- | -----
|(In thousands)                                                            |      | Three Months EndedJune 30, |      | Nine Months EndedJune 30,
|                                                                          | 2006 |                            | 2005 |                           | 2006 |       | 2005
|Denominator for basic income per share-weighted average shares            |      | 7,492                      |      | 7,252                     |      | 7,378 |      | 7,185
|Effect of dilutive securities:                                            |      |                            |      |                           |      |       |      |      
|Options                                                                   |      |                           |      |                          |      |      |      |     
|                                                                          |      |                            |      |                           |      |       |      |      
|Denominator for diluted income per shareadjusted weighted average shares |      | 7,492                      |      | 7,252                     |      | 7,378 |      | 7,185
|                                                                          |      |                            |      |                           |      |       |      |      
|Antidilutive securities:                                                  |      |                            |      |                           |      |       |      |      
|Options                                                                   |      | 265                        |      | 251                       |      | 236   |      | 285  
|                                                                          |      |                            |      |                           |      |       |      |      

8. Segments

We have three reportable segments: Nursing, PPEC and Respiratory Therapy Equipment and Services (RTES). Our Nursing division consists primarily of private duty home nursing care for predominately pediatric patients.
Our PPEC division contains Prescribed Pediatric Extended Care Centers which provide daily medical care for medically fragile children. 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 following table summarizes goodwill
for each of our Companys operating segments (in thousands):



|        |  |              |        |                   |   |       
|------- |  | ------------ | ------ | ----------------- | - | ------
|        |  | Goodwill    
|        |  | June 30,2006 |        | September 30,2005
|Nursing |  | $            | 19,285 |                   | $ | 17,876
|PPEC    |  |              | 735    |                   |   | 735   
|RTES    |  |              | 7,282  |                   |   | 7,282 
|        |  |              |        |                   |   |       
|Total   |  | $            | 27,302 |                   | $ | 25,893
|        |  |              |        |                   |   |       



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



8. Segments - Continued

The following tables summarize certain information for each of our companys operating segments (in thousands):



|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|------------------------------------------------------------------------------ |  | ------- | ------ | ---- | - | ----- | ---------------------------------------- |  | ----------------- | ------ |  | - | ------
|                                                                               |  | Nursing |        | PPEC |   |       | RespiratoryTherapy,Equipment andServices |  | ConsolidatedTotal
|Three Months Ended June 30, 2006                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|                                                                               |  |         |        |     
|Net revenue                                                                    |  | $       | 27,582 |      | $ | 2,746 |                                          |  | $                 | 14,317 |  | $ | 44,645
|Costs of goods and services (exclusive of depreciation shown separately below) |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|                                                                               |  |         |        |     
|Nursing and therapist salaries, wages, benefits and supplies                   |  |         | 18,228 |      |   | 145   |                                          |  |                   | 265    |  |   | 18,638
|Pharmacy product and supplies                                                  |  |         |       |      |   |      |                                          |  |                   | 1,845  |  |   | 1,845 
|Disposables/Supplies                                                           |  |         | 12     |      |   | 10    |                                          |  |                   | 2,728  |  |   | 2,750 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Total cost of goods and services                                               |  |         | 18,240 |      |   | 155   |                                          |  |                   | 4,838  |  |   | 23,233
|Other operating costs and expenses                                             |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Administrative and marketing salaries, wages and benefits                      |  |         | 3,631  |      |   | 1,528 |                                          |  |                   | 4,181  |  |   | 9,340 
|Business Insurance                                                             |  |         | 1,112  |      |   | 105   |                                          |  |                   | 501    |  |   | 1,718 
|Overhead                                                                       |  |         | 1,444  |      |   | 437   |                                          |  |                   | 1,804  |  |   | 3,685 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Total operating costs and expenses                                             |  |         | 6,187  |      |   | 2,070 |                                          |  |                   | 6,486  |  |   | 14,743
|                                                                               |  |         |        |     
|Provision for doubtful accounts                                                |  |         | 59     |      |   | (62   | )                                        |  |                   | 277    |  |   | 274   
|Depreciation                                                                   |  |         | 45     |      |   | 46    |                                          |  |                   | 811    |  |   | 902   
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Branch office contribution margin                                              |  | $       | 3,051  |      | $ | 537   |                                          |  | $                 | 1,905  |  | $ | 5,493 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|                                                                               |  |         |        |     
|Three Months Ended June 30, 2005                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|                                                                               |  |         |        |     
|Net revenue                                                                    |  | $       | 25,850 |      | $ | 2,850 |                                          |  | $                 | 14,781 |  | $ | 43,481
|Costs of goods and services (exclusive of depreciation shown separately below) |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|                                                                               |  |         |        |     
|Nursing and therapist salaries, wages, benefits and supplies                   |  |         | 16,751 |      |   | 155   |                                          |  |                   | 242    |  |   | 17,148
|Pharmacy product and supplies                                                  |  |         | 1      |      |   |      |                                          |  |                   | 1,697  |  |   | 1,698 
|Disposables/Supplies                                                           |  |         | 10     |      |   | 7     |                                          |  |                   | 3,075  |  |   | 3,092 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Total cost of goods and services                                               |  |         | 16,762 |      |   | 162   |                                          |  |                   | 5,014  |  |   | 21,938
|Other operating costs and expenses                                             |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Administrative and marketing salaries, wages and benefits                      |  |         | 3,426  |      |   | 1,478 |                                          |  |                   | 3,911  |  |   | 8,815 
|Business Insurance                                                             |  |         | 1,020  |      |   | 97    |                                          |  |                   | 657    |  |   | 1,774 
|Overhead                                                                       |  |         | 1,361  |      |   | 407   |                                          |  |                   | 2,099  |  |   | 3,867 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Total operating costs and expenses                                             |  |         | 5,807  |      |   | 1,982 |                                          |  |                   | 6,667  |  |   | 14,456
|Provision for doubtful accounts                                                |  |         | 153    |      |   | 35    |                                          |  |                   | 524    |  |   | 712   
|Depreciation                                                                   |  |         | 36     |      |   | 52    |                                          |  |                   | 763    |  |   | 851   
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       
|Branch office contribution margin                                              |  | $       | 3,092  |      | $ | 619   |                                          |  | $                 | 1,813  |  | $ | 5,524 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |       



|                                                                              |  |                            |        |   |      |   |        |  
|----------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ---- | - | ------ | -
|                                                                              |  | Three Months EndedJune 30, |       
|                                                                              |  | 2006                       |        |   | 2005 |  
|Total profit for reportable segments                                          |  | $                          | 5,493  |   |      | $ | 5,524  |  
|                                                                              |  |                           
|Corporate, general and administrative                                         |  |                            | (5,114 | ) |      |   | (5,567 | )
|Corporate depreciation and amortization                                       |  |                            | (167   | ) |      |   | (157   | )
|Other income                                                                  |  |                            | 46     |   |      |   |       |  
|Interest income                                                               |  |                            | 656    |   |      |   | 56     |  
|Interest expense                                                              |  |                            |       |   |      |   | (628   | )
|                                                                              |  |                            |        |   |      |   |        |  
|Income (loss) from continuing operations, before income tax expense (benefit) |  | $                          | 914    |   |      | $ | (772   | )
|                                                                              |  |                            |        |   |      |   |        |  



15



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



8. Segments - Continued



|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|------------------------------------------------------------------------------ |  | ------- | ------ | ---- | - | ----- | ---------------------------------------- |  | ----------------- | ------ |  | - | -------
|                                                                               |  | Nursing |        | PPEC |   |       | RespiratoryTherapy,Equipment andServices |  | ConsolidatedTotal
|Nine Months Ended June 30, 2006                                                |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|                                                                               |  |         |        |     
|Net revenue                                                                    |  | $       | 79,361 |      | $ | 8,103 |                                          |  | $                 | 42,916 |  | $ | 130,380
|Costs of goods and services (exclusive of depreciation shown separately below) |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|                                                                               |  |         |        |     
|Nursing and therapist salaries, wages, benefits and supplies                   |  |         | 52,340 |      |   | 407   |                                          |  |                   | 813    |  |   | 53,560 
|Pharmacy product and supplies                                                  |  |         |       |      |   |      |                                          |  |                   | 5,330  |  |   | 5,330  
|Disposables/Supplies                                                           |  |         | 37     |      |   | 33    |                                          |  |                   | 8,104  |  |   | 8,174  
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Total cost of goods and services                                               |  |         | 52,377 |      |   | 440   |                                          |  |                   | 14,247 |  |   | 67,064 
|Other operating costs and expenses                                             |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Administrative and marketing salaries, wages and benefits                      |  |         | 10,419 |      |   | 4,451 |                                          |  |                   | 12,497 |  |   | 27,367 
|Business Insurance                                                             |  |         | 3,517  |      |   | 304   |                                          |  |                   | 1,509  |  |   | 5,330  
|Overhead                                                                       |  |         | 4,278  |      |   | 1,302 |                                          |  |                   | 5,555  |  |   | 11,135 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Total operating costs and expenses                                             |  |         | 18,214 |      |   | 6,057 |                                          |  |                   | 19,561 |  |   | 43,832 
|Provision for doubtful accounts                                                |  |         | 127    |      |   | (65   | )                                        |  |                   | 676    |  |   | 738    
|Depreciation                                                                   |  |         | 123    |      |   | 137   |                                          |  |                   | 2,331  |  |   | 2,591  
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Branch office contribution margin                                              |  | $       | 8,520  |      | $ | 1,534 |                                          |  | $                 | 6,101  |  | $ | 16,155 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|                                                                               |  |         |        |     
|Nine Months Ended June 30, 2005                                                |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|                                                                               |  |         |        |     
|Net revenue                                                                    |  | $       | 78,084 |      | $ | 7,959 |                                          |  | $                 | 43,734 |  | $ | 129,777
|Costs of goods and services (exclusive of depreciation shown separately below) |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|                                                                               |  |         |        |     
|Nursing and therapist salaries, wages, benefits and supplies                   |  |         | 50,800 |      |   | 409   |                                          |  |                   | 809    |  |   | 52,018 
|Pharmacy product and supplies                                                  |  |         | 1      |      |   |      |                                          |  |                   | 4,402  |  |   | 4,403  
|Disposables/Supplies                                                           |  |         | 31     |      |   | 27    |                                          |  |                   | 8,971  |  |   | 9,029  
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Total cost of goods and services                                               |  |         | 50,832 |      |   | 436   |                                          |  |                   | 14,182 |  |   | 65,450 
|Other operating costs and expenses                                             |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Administrative and marketing salaries, wages and benefits                      |  |         | 10,354 |      |   | 4,356 |                                          |  |                   | 12,124 |  |   | 26,834 
|Business Insurance                                                             |  |         | 3,039  |      |   | 286   |                                          |  |                   | 1,600  |  |   | 4,925  
|Overhead                                                                       |  |         | 4,031  |      |   | 1,193 |                                          |  |                   | 5,680  |  |   | 10,904 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Total operating costs and expenses                                             |  |         | 17,424 |      |   | 5,835 |                                          |  |                   | 19,404 |  |   | 42,663 
|Provision for doubtful accounts                                                |  |         | 591    |      |   | 25    |                                          |  |                   | 1,735  |  |   | 2,351  
|Depreciation                                                                   |  |         | 137    |      |   | 142   |                                          |  |                   | 2,233  |  |   | 2,512  
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        
|Branch office contribution margin                                              |  | $       | 9,100  |      | $ | 1,521 |                                          |  | $                 | 6,180  |  | $ | 16,801 
|                                                                               |  |         |        |      |   |       |                                          |  |                   |        |  |   |        



|                                                                              |  |                           |         |   |      |   |         |  
|----------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                              |  | Nine Months EndedJune 30, |        
|                                                                              |  | 2006                      |         |   | 2005 |  
|Total profit for reportable segments                                          |  | $                         | 16,155  |   |      | $ | 16,801  |  
|                                                                              |  |                          
|Corporate, general and administrative                                         |  |                           | (15,648 | ) |      |   | (15,608 | )
|Corporate depreciation and amortization                                       |  |                           | (486    | ) |      |   | (474    | )
|Other income                                                                  |  |                           | 54      |   |      |   | 65      |  
|Loss on early extinguishment of debt                                          |  |                           | (837    | ) |      |   |        |  
|Interest income                                                               |  |                           | 1,667   |   |      |   | 149     |  
|Interest expense                                                              |  |                           | (564    | ) |      |   | (1,873  | )
|                                                                              |  |                           |         |   |      |   |         |  
|Income (loss) from continuing operations, before income tax expense (benefit) |  | $                         | 341     |   |      | $ | (940    | )
|                                                                              |  |                           |         |   |      |   |         |  



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



8. Segments - Continued

Travel, auto, equipment leases and delivery charges which are included in other operating costs and expenses are not segregated between the portions related directly to patient care expenses and the portions related
to overhead. The following table summarizes these expenses (in thousands):



|                              |  |                            |       |                           |   |       |  |      |       |  |   |      
|----------------------------- |  | -------------------------- | ----- | ------------------------- | - | ----- |  | ---- | ----- |  | - | -----
|                              |  | Three Months EndedJune 30, |       | Nine Months EndedJune 30,
|                              |  | 2006                       |       | 2005                      |   | 2006  |  | 2005
|Travel                        |  | $                          | 91    |                           | $ | 56    |  | $    | 283   |  | $ | 216  
|Auto gas, mileage and repairs |  |                            | 535   |                           |   | 498   |  |      | 1,635 |  |   | 1,424
|Auto leases                   |  |                            | 215   |                           |   | 202   |  |      | 631   |  |   | 609  
|Delivery charges              |  |                            | 262   |                           |   | 260   |  |      | 789   |  |   | 775  
|                              |  |                            |       |                           |   |       |  |      |       |  |   |      
|                              |  | $                          | 1,103 |                           | $ | 1,016 |  | $    | 3,338 |  | $ | 3,024
|                              |  |                            |       |                           |   |       |  |      |       |  |   |      

9. Commitments and Contingencies

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 settlements; however, there can be no assurance that the ultimate resolution of such current pending legal proceedings will not have a material adverse effect on our financial condition or
liquidity position.

In December 2005, we received notice of a claim from one commercial payor primarily relating to our discontinued
pharmacy operations. The payor claims overpayments of approximately $1.1 million. We have reviewed the basis for the claim and believe it is substantially without merit. We have submitted our response and are working towards resolution of these
issues. At this time, we believe we are adequately reserved; however, there can be no assurance that ultimate resolution will not have a material adverse effect upon our future financial results.

On January 17, 2006, we were notified by Cigna Healthcare that effective May 1, 2006 it had entered into an exclusive contractual arrangement
with Apria Healthcare Group for the provision of a wide range of services to respiratory therapy and durable medical equipment patients. As a result of this agreement, we no longer provide services to a number of patients particularly in the North
Carolina and Colorado markets. Based on an analysis of billed net revenue for the trailing twelve months ended December 31, 2005, we estimated the impact to our RTES segment would have been a reduction of net revenue of approximately $2.3
million. As of June 30, 2006, substantially all patients have been transitioned.

10. Subsequent Events

We were recently informed that a company-owned laptop computer was stolen from an employees vehicle in a public parking lot. The laptop computer
contained certain personal information of approximately 51,000 current and former patients, including names and social security numbers and, in a limited number of cases, personal health information. The laptop computer was password protected and we
have no indication that any of the information has been accessed or misused. However, we will begin to contact the affected individuals in order to provide them with steps to take to protect themselves from any possible misuse of their personal
information.



17



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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, 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:



| |  |  | the financial implications of the sale of our Pharmacy business;
| | - |  | ----------------------------------------------------------------



| |  |  | our anticipated uses of the proceeds from the sale of our Pharmacy business;
| | - |  | ----------------------------------------------------------------------------



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



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



| |  |  | changes in healthcare regulations, including changes resulting from the pending Deficit Reduction Act of 2005 (DRA), the 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 healthcare 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.



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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

The DRA, which was signed into law on February 8, 2006, will have a significant impact on the
services we provide in a number of ways, including:

A. With respect to Medicaid services:



| |  |  | Expanding access to home and community-based services by establishing them as an optional Medicaid benefit that would not require a waiver for individuals whose income does not
exceed 150% of the federal poverty level (FPL).
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Creating a new optional Medicaid eligibility group for children with disabilities under the age of 19 who meet the severity of disability required under the Supplemental Security
Income (SSI) program without regard to any income or asset requirements that apply under SSI where family income does not exceed 300% of the FPL.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Establishing Family to Family Health Information Centers to provide information and assistance to help families of children with special health care needs navigate the system of
care and make decisions about the needs and available support mechanisms for their children. The DRA increases funding for this initiative under Title V of the Social Security Act.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Authorizing the Department of Health and Human Services Secretary (HHS Secretary) to conduct a demonstration project in states to increase the use of home and community-based
services instead of institutions. States awarded a demonstration project will receive 90% of the costs of home and community-based long-term care services (under a HCBS waiver and/or the State Plan) for 12 months following a demonstration
participants transition from an institution into the community.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

B. With respect to Medicare services:



| |  |  | Rental payments for capped durable medical equipment (DME) rental items first rented after January 1, 2006, may not extend beyond 13 months of continuous use (or,
for rental of oxygen equipment, 36 months) with title transferred to the beneficiary thereafter. Rental payments are set at 10% of the purchase price for each of the first three months and 7.5% of the purchase price for the remaining ten months.
After transfer of title, Medicare will pay only for reasonable and necessary maintenance and servicing.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Implementing annual spending caps beginning in 2006 of $1,740 per Medicare beneficiary for outpatient occupational therapy services and a combined cap of $1,740 per Medicare
beneficiary for outpatient physical therapy and speech-language pathology services, with an exemption from caps for beneficiaries who prove medical necessity.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (MMA) established new payment limits and procedures for drugs
reimbursed under Medicare Part B, including drugs used for inhalation therapy. The MMA provided that Medicare beneficiaries will be reimbursed at a rate of 106% of the volume-weighted average selling price (the ASP), rather than 95% of
average wholesale price. In addition, for calendar year 2006, the Centers for Medicare & Medicaid Services (CMS) significantly reduced its dispensing fee for such drugs from 2005 levels. These and other changes may have a
material adverse effect on our operations and financial results. There can be no assurance that we will not face increased margin pressures from the 2006 reimbursement changes or changes beyond 2006.

The MMA also mandated a phased-in competitive bidding process for Medicare procurement of certain DME, commencing in the ten largest Metropolitan
Statistical Areas (MSAs) (excluding New York, Los Angeles and Chicago) in 2007, followed by the next eighty largest MSAs in 2009. Moreover, the HHS Secretary has the authority to apply competitive bidding nationally for the highest cost,
highest volume items and services and those items and services that the HHS



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Secretary determines to have the largest savings potential. Providers participating in competitive bidding for DME will be required to meet
certain quality standards and to be accredited by a CMS-approved accreditation organization. The MMA also imposed 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, the Medicare Payment Advisory Commission (MedPAC), an independent federal body established to advise
Congress on issues affecting the Medicare Program, has recommended implementation of pay-for-performance initiatives for home care providers. If implemented, reimbursement to Medicare providers will be differentiated based on quality measures. While
we provide high quality services to our patients, there can be no assurances that a pay-for-performance reimbursement system will not adversely affect our Medicare reimbursement. Moreover,CMS has announced that Medicares Conditions of
Participation for Home Health Agencies are being revised. There can be no assurance that these and other changes will not adversely impact our operations and profits.

Many of the states in which we operate are evaluating and implementing program reforms that could impact patient eligibility and increase managed care administration of benefits. To date, we have not experienced any
reimbursement rate reductions in those certain states that have adopted these changes. In an effort to monitor and have an impact on 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.

Company Events & Updates

On June 2, 2006, we acquired select assets of Melmedica Childrens Healthcare, Inc. for a purchase price of $1.6 million in cash. Under the
terms of the Asset Purchase Agreement, Melmedica will retain all of the business accounts receivable arising from sales generated prior to the closing of the transaction. Melmedica is a multi-site pediatric private duty nursing business operating in
the Illinois and Indiana markets. We intend to integrate some of Melmedicas Illinois operations into our existing nursing operations in the Chicago area. We are in the process of finalizing our purchase price allocation. The purchase price has
been preliminarily allocated to identifiable intangible assets consisting principally of noncompete agreements of $0.1 million and goodwill of $1.4 million. The remaining purchase price was allocated to fixed assets based on the fair value of those
fixed assets. Effective with the adoption of SFAS No. 142, the purchase price allocation to $1.4 million of goodwill is not being amortized but is being deducted for tax purposes. The purchase method of accounting was used to record this
acquisition and the results of operations of the acquired company are included in the accompanying consolidated statements of operations from the date of the acquisition.

During the three months ended June 30, 2006, we implemented a program to approach our private duty nursing managed care payors with a request to increase reimbursement rates. In many cases, we have not had a rate
increase for a number of years and have incurred significant increases in nurse wage rates during that period. In select cases, we have negotiated and finalized rate increases, many of which become effective at the start of our 2007 fiscal year.
Negotiations are on-going with a number of other payors and we are hopeful we will achieve some level of rate increase. The fiscal year impact of such changes will be a function of relative census and wage rate levels.

On November 11, 2005, in connection with the sale of the Pharmacy Business, we terminated our credit agreement with General Electric Capital
Corporation. The credit agreement, consisting of a $10.0 million revolving credit facility and a $10.0 million acquisition credit facility had remained unused. We recorded the write-off of approximately $0.3 million in related deferred financing and
termination fees in the nine months ended June 30, 2006.

On November 18, 2005, we completed the sale of selected assets of our
Pharmacy business to Accredo Health Group, Inc., a wholly-owned subsidiary of Medco Health Solutions, Inc. The aggregate purchase price was $72.3 million. We have recorded the gain of approximately $24.6 million, net of approximately $15.9 million
for income taxes. As part of the transaction, the parties executed a transition services agreement that provided for the collection of outstanding accounts receivable for a period of 180 days and order fulfillment, billing services and related
accounting services for a period of 120 days after closing. As of June 30, 2006, we had completed our responsibilities under the transition services agreement.

On December 30, 2005, in connection with the sale of the Pharmacy Business, we redeemed in full our 10% Senior Subordinated Notes due 2008 in the amount of $20.4 million. We recorded the write-off of
approximately $0.5 million in related deferred financing fees and call premium in the nine months ended June 30, 2006.

On
January 17, 2006, the Company was notified by Cigna Healthcare that effective May 1, 2006 it had entered into an exclusive contractual arrangement with Apria Healthcare Group for the provision of a wide range of services to respiratory
therapy and durable medical equipment patients. As a result of this agreement, we no longer provide services to a number of patients particularly in the North Carolina and Colorado markets. Based on an analysis of billed net revenue for the trailing
twelve months ended December 31, 2005, we estimated the impact to our RTES segment would have been a reduction of net revenue of approximately $2.3 million. As of June 30, 2006, substantially all patients have been transitioned.



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Prior to October 1, 2005, we accounted for our stock option plans under the recognition and
measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based
Compensation. No stock-based compensation cost was recognized in the Statement of Operations for the three and nine months ended June 30, 2005, as all options granted under those plans had an exercise price equal to the market value of
the underlying common stock on the date of grant. Effective October 1, 2005, we adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, using the modified prospective-transition method. Under the
transition method, compensation cost recognized in the three and nine months ended June 30, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of October 1, 2005, based on the
grant date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based payments granted subsequent to October 1, 2005 based on the grant-date fair value estimated in
accordance with the provisions of Statement 123(R). Results for prior periods have not been restated (See Note 2).

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 and actively monitors claim adjustment activities. Our Risk Committee, which is comprised of members of the Compliance, Legal, Human
Resources, Finance 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, we have a $1.0 million per year, per claim, self-insured retention, with an aggregate self-insured retention limit of $8.0 million and an
annual aggregate coverage limit of $15.0 million. 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, (ii) PPEC and
(iii) RTES (see Notes to Condensed Consolidated Financial StatementsNote 8).

During the three months ended June 30, 2006,
we were able to expand our nursing hours staffed by approximately 3.8% over the previous quarter. We believe our nurse recruiting strategy, with its focus upon weekly staffed hours targets, for each branch office, as well as our incentive programs
to reward achievement of these targets best positions us to achieve our growth objectives. We have also instituted a variety of new programs to provide incentive to our nurses to increase the number of hours that they work for us. These programs
include both financial and recognition rewards. To stimulate same store revenue growth, we have established 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. We continue to experience wage pressures in select markets which have contributed to slight gross margin rate erosion. Our branch offices focus is upon increasing gross margin
dollars to improve the branch office contribution margin.

In the PPEC segment, we continue to be pleased with the financial results of our
Georgia centers. Our census has continued to grow, community acceptance of our business model has expanded and feedback from state officials is positive. In North Carolina, where our program is funded on an interim basis, our pilot project continues
to demonstrate the desired outcomes and we are in discussions with the appropriate agency managers to secure a permanent source of funding. In Florida, the most recent budget proposal for state fiscal year 2007 included a rate increase for PPEC
services of approximately 10% to the daily reimbursement. We expect this rate increase to improve our operating margins and enable us to more effectively compete for clinical staff. Unfortunately, conditions in the Orlando market, in particular long
standing barriers to eligibility and authorized levels of service, have resulted in ongoing losses at this center. As a result, the Company closed the center in the third quarter of fiscal 2006. We are continuing to monitor center profitability in
our other Florida centers.

In the RTES segment, the impact of the unit dose respiratory medication business, which had another reduction
in reimbursement for select medications effective January 1, 2006, worsened and the business recorded a negative branch office contribution margin of approximately $0.1 million during the three months ended June 30, 2006. During April
2006, we executed a contract to change our method of procuring oxygen contents and cylinders. We are moving away from renting cylinders to an upfront purchase and subsequent depreciation of such equipment. While the transition is underway, it is too
soon to estimate whether or not we will incur a rental return obligation. We continue to expect that future cost savings from the new prices will more than offset any rental return obligations. We continue to focus upon our sales and marketing



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program. In particular, we are focusing on the higher acuity respiratory patients to leverage our clinical competencies and more actively manage the core
product mix. As a result, we have seen increases in target referrals from managed care payors in select markets and we are cautiously optimistic that these increases will offset the loss of Cigna revenue. In order to address the continued margin
pressures on our RTES segment, we utilize a Product Review Committee to standardize product selections, aggregate product volumes, and source through a reduced number of vendors to maximize our purchasing power.

Source & Availability of Clinical Personnel

We believe that case hours staffed is the most appropriate measurement of nursing activity. During the 13 weeks ending July 1, 2006, our case hours staffed increased 31,000, or 3.8% to approximately 837,000 as
compared to 806,000 in the 13 weeks ended April 1, 2006. 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 investments in ten local market nurse recruiters to help reduce unstaffed hours.

CRITICAL ACCOUNTING POLICIES

This Form 10-Q reflects newly enacted or updated critical accounting policies. These critical accounting policies should be read in conjunction with our
audited consolidated financial statements for the year ended September 30, 2005 which are included in our Annual Report on Form 10-K for such year filed with the Securities and Exchange Commission.

Stock Option Expense

Prior to
October 1, 2005, we accounted for our stock option plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related
Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation. No stock based compensation cost was recognized in the statement of operations for the three and nine months ended June 30, 2005, as all
options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective October 1, 2005, we adopted the fair value recognition provisions of SFAS No. 123(R),
Share-Based Payment, using the modified prospective transition method. Under this transition method, compensation cost recognized in the three and nine months ended June 30, 2006 includes: (a) compensation cost for all
share-based payments granted prior to, but not yet vested as of October 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based
payments granted subsequent to October 1, 2005 based on the grant-date fair value estimated in accordance with the provisions of Statement 123(R). Results for prior periods have not been restated.

The fair value of the options awarded under Statement 123(R) is estimated on the date of grant using the Black-Scholes-Merton option pricing formula.
Expected volatilities are based on historical volatility of our stock and other factors. We use historical option exercise and employee termination dates to estimate the expected term. The expected term represents the period of time that options
granted are expected to be outstanding. We perform these calculations separately for each plan because the participants exhibit different behavior. The risk free rate for periods within the contractual life of the option is based on the U.S.
Treasury yield curve in effect at the time of grant. We have elected to use the straightline method to recognize compensation expense under Statement 123(R).

Net Revenue

We derive substantially all of our net revenue from patients who have a third
party (insurance company or government) who either has contractually agreed to pay the patients account or is obligated to pay based on the patients participation in its program (i.e. Medicare or Medicaid). Revenues are recorded based on
estimated net realizable amounts to be received for products or services rendered during the period. The Companys accounting system is programmed to calculate the expected reimbursement to be received on a patient-by-patient basis based on the
type of payor and the contractual terms of the payor or pre-negotiated reimbursement rates. The Companys accounting system is updated as changes occur to reimbursement rates. 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 amounts, we do not maintain records that provide a breakdown between the service and product components. Substantially all of our revenue is fee for service.

Due to the nature of the healthcare 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



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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 settlement of account review.

In December 2005, we received notice of a claim from one commercial payor primarily relating to our discontinued pharmacy operations. The payor claims
overpayments of approximately $1.1 million. We have reviewed the basis for the claim and believe it is substantially without merit. We have submitted our response and are working towards resolution of these issues. At this time, we believe we are
adequately reserved; however, there can be no assurance that ultimate resolution will not have a material adverse effect upon our future financial results. As of June 30, 2006, we had no material claims, disputes or unsettled matters with third
party payors except as disclosed above, nor were there any material pending settlements with third party payors.

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 0.5%, 0.4% and 0.7% of net
revenue for fiscal years ended 2005, 2004 and 2003, 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 of all patient net revenue adjustments over the trailing four quarters and applies
this methodology to reduce net revenues recognized in the current period. Included in this calculation is the reversal of revenue for patients without authorizations.

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. Co-payments are captured under the private pay category and a higher reserve percentage is applied to these balances based on historical collection patterns. 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.

The following table provides a comparison of
approximate percentages of our aging of net accounts receivable by payor for the periods ended June 30, 2006 and September 30, 2005:



|                                  |  |                    |   |  |              |   |  |              |   |  |              |   |  |           |   |  |       |  
|--------------------------------- |  | ------------------ | - |  | ------------ | - |  | ------------ | - |  | ------------ | - |  | --------- | - |  | ----- | -
|                                  |  | June 30, 2006      |   |  |              |   |  |              |  
|                                  |  | 0-120 days         |   |  | 121-180 days |   |  | 181-240 days |   |  | 241-365 days |   |  | >365 days |   |  | Total |  
|Commercial and contract insurance |  | 31.3               | % |  | 3.4          | % |  | 1.4          | % |  | 1.4          | % |  | -0.7      | % |  | 36.8  | %
|Medicaid                          |  | 25.5               | % |  | 3.1          | % |  | 1.6          | % |  | 1.6          | % |  | 0.7       | % |  | 32.5  | %
|Medicare                          |  | 4.3                | % |  | 0.5          | % |  | 0.2          | % |  | 0.4          | % |  | 0.2       | % |  | 5.6   | %
|Private pay                       |  | 2.6                | % |  | 1.5          | % |  | 0.6          | % |  | 1.0          | % |  | 0.1       | % |  | 5.8   | %
|Unbilled                          |  | 18.8               | % |  | 0.3          | % |  | 0.1          | % |  | 0.1          | % |  | 0.0       | % |  | 19.3  | %
|                                  |  |                    |   |  |              |   |  |              |   |  |              |   |  |           |   |  |       |  
|Total net accounts receivable     |  | 82.5               | % |  | 8.8          | % |  | 3.9          | % |  | 4.5          | % |  | 0.3       | % |  | 100.0 | %
|                                  |  |                    |  
|                                  |  | September 30, 2005 |   |  |              |   |  |              |  
|                                  |  | 0-120 days         |   |  | 121-180 days |   |  | 181-240 days |   |  | 241-365 days |   |  | >365 days |   |  | Total |  
|Commercial and contract insurance |  | 30.9               | % |  | 3.3          | % |  | 1.9          | % |  | 1.9          | % |  | 0.6       | % |  | 38.6  | %
|Medicaid                          |  | 24.2               | % |  | 2.4          | % |  | 1.4          | % |  | 1.5          | % |  | 1.0       | % |  | 30.5  | %
|Medicare                          |  | 4.5                | % |  | 0.7          | % |  | 0.3          | % |  | 0.3          | % |  | 0.0       | % |  | 5.8   | %
|Private pay                       |  | 2.3                | % |  | 0.9          | % |  | 0.9          | % |  | 1.4          | % |  | 0.6       | % |  | 6.1   | %
|Unbilled                          |  | 18.0               | % |  | 0.6          | % |  | 0.2          | % |  | 0.1          | % |  | 0.1       | % |  | 19.0  | %
|                                  |  |                    |   |  |              |   |  |              |   |  |              |   |  |           |   |  |       |  
|Total net accounts receivable     |  | 79.9               | % |  | 7.9          | % |  | 4.7          | % |  | 5.2          | % |  | 2.3       | % |  | 100.0 | %



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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 EndedJune 30, |   |  | Nine Months EndedJune 30,                       |    |  | Three Months EndedJune 30, |   |  | Nine Months EndedJune 30, |   
|                                                                               |  | 2006                       |   |  | 2005                                            |    |  | 2006                       |   |  | 2005                      |    |  | 2006  |   |  | 2006  |  
|Net Revenue                                                                    |  | 100.0                      | % |  | 100.0                                           | %  |  | 100.0                      | % |  | 100.0                     | %  |  | 3     | % |  | 0     | %
|Costs of goods and services (exclusive of depreciation shown separately below) |  | 52.0                       |   |  | 50.5                                            |    |  | 51.4                       |   |  | 50.4                      |    |  | 6     |   |  | 2     |  
|Other operating costs and expenses                                             |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Salaries, wages and benefits                                                   |  | 20.9                       |   |  | 20.3                                            |    |  | 21.0                       |   |  | 20.7                      |    |  | 6     |   |  | 2     |  
|Business insurance                                                             |  | 3.8                        |   |  | 4.1                                             |    |  | 4.1                        |   |  | 3.8                       |    |  | (3    | ) |  | 8     |  
|Overhead                                                                       |  | 8.3                        |   |  | 8.9                                             |    |  | 8.5                        |   |  | 8.4                       |    |  | (5    | ) |  | 2     |  
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Other operating costs and expenses                                             |  | 33.0                       |   |  | 33.3                                            |    |  | 33.6                       |   |  | 32.9                      |    |  | 2     |   |  | 3     |  
|Corporate, general and administrative                                          |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Salaries, wages and benefits                                                   |  | 7.9                        |   |  | 8.1                                             |    |  | 8.1                        |   |  | 7.9                       |    |  | 0     |   |  | 4     |  
|Business insurance                                                             |  | 0.2                        |   |  | 0.1                                             |    |  | 0.1                        |   |  | 0.1                       |    |  | 10    |   |  | 26    |  
|Professional services                                                          |  | 1.8                        |   |  | 2.8                                             |    |  | 2.1                        |   |  | 2.3                       |    |  | (36   | ) |  | (10   | )
|Overhead                                                                       |  | 1.7                        |   |  | 1.7                                             |    |  | 1.6                        |   |  | 1.7                       |    |  | 0     |   |  | (3    | )
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Corporate, general and administrative                                          |  | 11.6                       |   |  | 12.7                                            |    |  | 11.9                       |   |  | 12.0                      |    |  | (8    | ) |  | 0     |  
|Provision for doubtful accounts                                                |  | 0.6                        |   |  | 1.6                                             |    |  | 0.6                        |   |  | 1.8                       |    |  | (62   | ) |  | (69   | )
|Depreciation and amortization                                                  |  | 2.4                        |   |  | 2.3                                             |    |  | 2.4                        |   |  | 2.3                       |    |  | 6     |   |  | 3     |  
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Operating income (loss)                                                        |  | 0.4                        |   |  | (0.4                                            | )  |  | 0.1                        |   |  | 0.6                       |    |  | 206   |   |  | (97   | )
|Other income                                                                   |  | 0.1                        |   |  |                                                |    |  |                           |   |  | 0.1                       |    |  |      |   |  | (17   | )
|Loss on early extinguishment of debt                                           |  |                           |   |  |                                                |    |  | (0.6                       | ) |  |                          |    |  |      |   |  |      |  
|Interest income                                                                |  | 1.5                        |   |  | 0.1                                             |    |  | 1.3                        |   |  | 0.1                       |    |  | 1,071 |   |  | 1,019 |  
|Interest expense                                                               |  |                           |   |  | (1.4                                            | )  |  | (0.4                       | ) |  | (1.4                      | )  |  | (100  | ) |  | (70   | )
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Income (loss) from continuing operations, before income tax expense (benefit)  |  | 2.0                        |   |  | (1.7                                            | )  |  | 0.4                        |   |  | (0.6                      | )  |  | 218   |   |  | 136   |  
|Income tax expense (benefit)                                                   |  | 0.8                        |   |  | (1.3                                            | )  |  | 0.3                        |   |  | (0.3                      | )  |  | 164   |   |  | 195   |  
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  
|Income (loss) from continuing operations                                       |  | 1.2                        | % |  | (0.4                                            | )% |  | 0.1                        | % |  | (0.3                      | )% |  | 357   | % |  | 92    | %
|                                                                               |  |                            |   |  |                                                 |    |  |                            |   |  |                           |    |  |       |   |  |       |  

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 EndedJune 30, |   |  | Nine Months EndedJune 30, |  
|                                           |  | 2006% Total                |   |  | 2005 % Total              |   |  | 2006 % Total |   |  | 2005% Total |  
|Pediatric Home Health Care                 |  |                            |   |  |                           |   |  |              |   |  |             |  
|Nursing                                    |  | 54.5                       | % |  | 52.6                      | % |  | 53.9         | % |  | 53.4        | %
|PPEC                                       |  | 6.2                        | % |  | 6.6                       | % |  | 6.2          | % |  | 6.1         | %
|Respiratory Therapy Equipment and Services |  | 17.6                       | % |  | 18.6                      | % |  | 18.2         | % |  | 18.8        | %
|                                           |  |                            |   |  |                           |   |  |              |   |  |             |  
|Total Pediatric Home Health Care           |  | 78.3                       | % |  | 77.8                      | % |  | 78.3         | % |  | 78.3        | %
|                                           |  |                            |   | 
|Adult Home Health Care                     |  |                            |   |  |                           |   |  |              |   |  |             |  
|Nursing                                    |  | 7.3                        | % |  | 6.8                       | % |  | 7.0          | % |  | 6.8         | %
|Respiratory Therapy Equipment and Services |  | 14.4                       | % |  | 15.4                      | % |  | 14.7         | % |  | 14.9        | %
|                                           |  |                            |   |  |                           |   |  |              |   |  |             |  
|Total Adult Home Health Care               |  | 21.7                       | % |  | 22.2                      | % |  | 21.7         | % |  | 21.7        | %
|                                           |  |                            |   |  |                           |   |  |              |   |  |             |  
|Total                                      |  | 100.0                      | % |  | 100.0                     | % |  | 100.0        | % |  | 100.0       | %
|                                           |  |                            |   |  |                           |   |  |              |   |  |             |  

Billing and Collection

We derive substantially all of our net revenue from patients who have a third party payor (insurance company or government) who either has contractually
agreed to pay the patients account or is obligated to pay based on the patients participation in its program (i.e. Medicare or Medicaid). Net revenues from Medicaid and Medicare are generally based on reimbursement of the reasonable
direct and indirect costs of providing services to program participants. Revenues are recorded based on estimated net realizable amounts to be received for products or services rendered during the period. Our accounting system is programmed to
calculate the expected reimbursement to be received on a patient-by-patient basis based on the type of payor and the contractual terms of the payor or pre-negotiated reimbursement rates.



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Our accounting system is updated as changes occur to reimbursement rates. The current reimbursement
environment is complex, involving multiple payors with differing coverage and reimbursement policies. Our corporate reimbursement specialists work closely with the branch offices and the payors. Each specialist is responsible for ensuring the
adequacy of the documentation, submitting the documentation and claims to third party payors and expediting payment.

In most cases, the
third party payor will not pay the entire bill and the patient becomes responsible for the portion not paid by the third party (i.e. co-payment or deductible). Once the insurance company or other third party has paid its portion of such
patients bill, the patient becomes responsible for the remainder of the bill. After payment has been received from the respective third party, a patient receives monthly statements from the Company. We assess collectability monthly of all our
patients accounts receivable based on historical experience and emerging trends.

Management of accounts receivable, through
effective billing, collection and reimbursement procedures, is critical to the financial success of healthcare service providers due to lengthy reimbursement periods. Any significant delay in reimbursement could have a material adverse effect on our
financial condition.

The following table summarizes our days sales outstanding as of the dates indicated:



|                                                            |  |              |  |                  
|----------------------------------------------------------- |  | ------------ |  | -----------------
|                                                            |  | June 30,2006 |  | September 30,2005
|Days sales outstanding (calculated on year to date revenue) |  | 55           |  | 56               



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##### Table of Contents

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Net revenue increased $1.2 million, or 3%, to $44.6 million in the three months ended June 30, 2006 from $43.5 million in the three months ended
June 30, 2005. For the Nursing segment, net revenue increased $1.7 million, or 7%, to $27.6 million in the three months ended June 30, 2006 from $25.9 million in the three months ended June 30, 2005. Of the $1.7 million increase, $0.6
million was attributable to the Melmedica acquisition. For the PPEC segment, net revenue decreased $0.1 million, or 4%, to $2.7 million in the three months ended June 30, 2006 from $2.9 million in the three months ended June 30, 2005. RTES
net revenue decreased $0.5 million, or 3% to $14.3 million in the three months ended June 30, 2006 from $14.8 million in the three months ended June 30, 2005. Of the $0.5 million decrease, $0.3 million is primarily attributable to the
decreased reimbursement in the unit dose respiratory medications. In the three months ended June 30, 2006, we derived approximately 40% of our net revenue from commercial insurers and other private payors, 53% from Medicaid and 7% 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 $1.3 million, or 6%, to $23.2 million in the three months ended June 30, 2006 from $21.9 million in the three months ended June 30, 2005. Costs of goods and
services of the Nursing segment increased $1.5 million, or 9%, to $18.2 million in the three months ended June 30, 2006 from $16.8 million in the three months ended June 30, 2005. Costs of goods and services as a percentage of the Nursing
segment net revenue increased to 66% in the three months ended June 30, 2006 compared to 65% in the three months ended June 30, 2005. Costs of goods and services of the PPEC segment remained relatively constant at $0.2 million in the three
months ended June 30, 2006 as compared to the three months ended June 30, 2005. The RTES segment cost of goods and services decreased $0.2 million, or 4%, to $4.8 million in the three months ended June 30, 2006 from $5.0 million in
the three months ended June 30, 2005, despite the fact that cost of goods and services increased for unit dose respiratory medications. Overall RTES costs of goods and services as a percentage of net revenue remained relatively flat at 34% in
the three months ended June 30, 2006 as compared to the three months ended June 30, 2005.

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 $14.7 million in the three months
ended June 30, 2006 from $14.5 million in the three months ended June 30, 2005. In the Nursing segment, other operating costs and expenses increased $0.4 million, or 7% to $6.2 million in the three months ended June 30, 2006 from $5.8
million in the three months ended June 30, 2005. The increase includes a $0.1 million increase in nurse recruiting costs. In the PPEC segment, other operating costs and expenses increased $0.1 million, or 4%, to $2.1 million in the three months
ended June 30, 2006 from $2.0 million in the three months ended June 30, 2005. As a percentage of net revenue these costs increased to 75% in the three months ended June 30, 2006 compared to 70% in the three months ended June 30,
2005. In the RTES segment, costs and expenses decreased $0.2 million, or 3%, to $6.5 million in the three months ended June 30, 2006 compared to $6.7 million in the three months ended June 30, 2005. As a percentage of net revenue these
costs remained relatively constant at 45% in the three months ended June 30, 2006 as compared to the three months ended June 30, 2005.

Corporate, general and administrative costs decreased $0.5 million, or 8%, to $5.1 million in the three months ended June 30, 2006 from $5.6 million in the three months ended June 30, 2005. As a percentage of net revenue,
corporate, general and administrative costs decreased to 12% in the three months ended June 30, 2006 compared to 13% in the three months ended June 30, 2005. Administrative salaries, wages and benefits decreased $0.3 million; however it
was offset by approximately $0.3 million for compensation costs for employee stock options recorded in the three months ended June 30, 2006 relating to the adoption of FAS 123(R). In addition, as expected, year two SOX 404 costs have declined
over the prior year.

Provision for doubtful accounts decreased $0.4 million, or 62%, to $0.3 million in the three months ended
June 30, 2006 as compared to $0.7 million in the three months ended June 30, 2005. Cash collections as a percentage of net revenue were 100% and 101% in the three months ended June 30, 2006 and 2005, respectively. The cash collections
represent amounts posted to the accounts receivable. A timing difference exists between bank deposits and the posting of the remittances.

Depreciation and amortization increased $0.1 million, or 6%, to $1.1 million in the three months ended June 30, 2006 as compared to $1.0 million in the three months ended June 30, 2005.



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Interest income increased $0.6 million, or 1,071%, to $0.7 million in the three months ended
June 30, 2006, as compared to $0.1 million in the three months ended June 30, 2005 (See Liquidity and Capital Resources below for further discussion).

Interest expense decreased $0.6 million, or 100%, to $0 million in the three months ended June 30, 2006 from $0.6 million in the three months ended
June 30, 2005. (See Liquidity and Capital Resources below for further discussion).

Income tax expense for continuing
operations increased $0.9 million, or 164%, to an expense of $0.4 million in the three months ended June 30, 2006 from a benefit of $0.6 million in the three months ended June 30, 2005. (See Note 2 for further discussion).

Nine Months Ended June 30, 2006 Compared to Nine Months Ended June 30, 2005

Net revenue increased $0.6 million, or less than one half of a percentage point, to $130.4 million in the nine months ended June 30, 2006 from $129.8
million in the nine months ended June 30, 2005. For the Nursing segment, net revenue increased $1.3 million, or 2%, to $79.4 million in the nine months ended June 30, 2006 from $78.1 million in the nine months ended June 30, 2005. Of
the $1.3 million increase, $0.6 million was attributable to the Melmedica acquisition. PPEC net revenue increased $0.1 million, or 2%, to $8.1 million in the nine months ended June 30, 2006 from $8.0 million in the nine months ended
June 30, 2005. RTES net revenue decreased $0.8 million, or 2%, to $42.9 million in the nine months ended June 30, 2006 from $43.7 million in the nine months ended June 30, 2005. In the nine months ended June 30, 2006, we derived
approximately 39% of our net revenue from commercial insurers and other private payors, 53% from Medicaid and 8% 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 $1.6 million, or 2%, to $67.1 million in the nine months ended
June 30, 2006 from $65.5 million in the nine months ended June 30, 2005. Costs of goods and services of the Nursing segment increased $1.5 million, or 3%, to $52.4 million in the nine months ended June 30, 2006 from $50.8 million in
the nine months ended June 30, 2005. Costs of goods and services as a percentage of the Nursing segment net revenue increased to 66% in the nine months ended June 30, 2006 from 65% in the nine months ended June 30, 2005. For the PPEC
segment, cost of goods and services remained relatively constant at $0.4 million in the nine months ended June 30, 2006 as compared to the nine months ended June 30, 2005. PPEC costs of goods and services as a percentage of net revenue
remained relatively constant at 5% in the nine months ended June 30, 2006 as compared to the nine months ended June 30, 2005. For the RTES segment, cost of goods and services remained relatively constant at $14.2 million in the nine months
ended June 30, 2006 as compared to the nine months ended June 30, 2005. Costs of goods and services as a percentage of net revenue increased to 33% in the nine months ended June 30, 2006 from 32% in the nine months ended June 30,
2005.

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 $1.2 million, or 3%, to $43.8 million in the nine months ended June 30, 2006 from $42.7 million in the nine months ended June 30, 2005. In the
Nursing segment, other operating costs and expenses increased $0.8 million, or 5%, to $18.2 million in the nine months ended June 30, 2006 from $17.4 million in the nine months ended June 30, 2005. As a percentage of net revenue, the
Nursing segment costs increased to 23% in the nine months ended June 30, 2006 from 22% in the nine months ended June 30, 2005. The increase includes a $0.3 million increase in nurse recruiting costs. In the PPEC segment, other operating
costs and expenses increased $0.2 million, or 4%, to $6.1 million in the nine months ended June 30, 2006 from $5.8 million in the nine months ended June 30, 2005. As a percentage of net revenue these costs increased to 75% in the nine
months ended June 30, 2006 from 73% in the nine months ended June 30, 2005. In the RTES segment, costs and expenses increased $0.2 million, or 1%, to $19.6 million in the nine months ended June 30, 2006 from $19.4 million in the nine
months ended June 30, 2005. As a percentage of net revenue these costs increased to 46% in the nine months ended June 30, 2006 from 44% in the nine months ended June 30, 2005.

Corporate, general and administrative costs remained relatively constant at $15.6 million in the nine months ended June 30, 2006 as compared to the
nine months ended June 30, 2005. Administrative salaries, wages and benefits decreased approximately $0.6 million; however, it was offset by approximately $1.0 million for compensation costs for employee stock options recorded in the nine
months ended June 30, 2006 relating to the adoption of FAS 123(R). As a percentage of net revenue, corporate, general and administrative costs remained relatively constant at 12% in the nine months ended June 30, 2006 as compared to the
nine months ended June 30, 2005.

Provision for doubtful accounts decreased $1.6 million, or 69%, to $0.7 million in the nine months
ended June 30, 2006 from $2.4 million in the nine months ended June 30, 2005. Cash collections as a percentage of net revenue were 99% and 100% in the nine months ended June 30, 2006 and 2005, respectively. The cash collections
represent amounts posted to the accounts receivable. A timing difference exists between bank deposits and the posting of the remittances.



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Depreciation and amortization increased $0.1 million, or 3%, to $3.1 million in the nine months ended
June 30, 2006 as compared to $3.0 million in the nine months ended June 30, 2005.

Interest income increased $1.5 million, or
1,019%, to $1.7 million in the nine months ended June 30, 2006, as compared to $0.1 million in the nine months ended June 30, 2005 (See Liquidity and Capital Resources below for further discussion).

Interest expense decreased $1.3 million, or 70%, to $0.6 million in the nine months ended June 30, 2006 from $1.9 million in the nine months ended
June 30, 2005. (See Liquidity and Capital Resources below for further discussion).

Income tax expense for continuing
operations increased $0.8 million, or 195%, to an expense of $0.4 million in the nine months ended June 30, 2006 from a benefit of $0.4 million in the nine months ended June 30, 2005. (See Note 2 for further discussion).

LIQUIDITY AND CAPITAL RESOURCES

Operations

On November 11, 2005, we terminated our credit agreement with General Electric Capital Corporation. The
credit agreement, consisting of a $10.0 million revolving credit facility and a $10.0 million acquisition credit facility had remained unused. We recorded the write-off of approximately $0.3 million in related deferred financing and termination fees
in the nine months ended June 30, 2006.

On December 30, 2005, we redeemed in full the remainder of our 10% Senior Subordinated
Notes due 2008 of $20.4 million. We recorded the write-off of approximately $0.5 million in related deferred financing fees and call premium in the nine months ended June 30, 2006.

During the nine months ended June 30, 2006, a new incentive program aimed at collecting older receivable balances was successfully implemented
resulting in record cash receipts on accounts older than 120 days. These collections significantly improved our accounts receivable aging and reduced the allowance for doubtful accounts. 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.

For the three months ended June 30, 2006,
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.

For the nine months ended June 30, 2006, we had a current income tax expense of $16.6 million and a deferred income tax expense of
$0.2 million resulting in a total income tax expense of $16.8 million.

Asset Sales

On November 18, 2005, we completed the sale of selected assets of our Pharmacy business to Accredo Health Group, Inc., a wholly-owned subsidiary of
Medco Health Solutions, Inc. The aggregate purchase price was $72.3 million (See Note 2).

Asset Purchases

On June 2, 2006, we acquired select assets of Melmedica Childrens Healthcare, Inc. for a purchase price of $1.6 million in
cash. (See Note 4).

Risk Management

Our previous workers compensation insurance carrier, rated A by AM Best Company, required a twelve month estimated loss reserve to be funded entirely with cash each fiscal year, which is reduced by the monthly
loss fund payments.



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##### Table of Contents

The policy for fiscal 2006 is underwritten by Charter Oak Fire Insurance, a subsidiary of St. Paul Travelers rated A+ by AM Best Company and will be funded
in a similar manner with the cash requirement estimated to be $2.2 million. The net balance at June 30, 2006 and September 30, 2005 was $4.6 million and $3.4 million, respectively. The insurance carriers have 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 have not indicated the need to do so.

We have secured surety bonds of $1.4 million to satisfy our workers compensation program requirements for our former insurance carrier. As of June 30, 2006, the surety bonds were collateralized by $1.2
million cash posted to a third party escrow account. During the nine months ended June 30, 2006, we were notified that this carrier received a downgrade in its AM Best financial strength rating to a B-. While we believe that our collateral
remains secure, the potential for the carrier to not pay claims in the ordinary course has increased. We are monitoring the situation in conjunction with our insurance brokers. During the three months ended June 30, 2006, the carrier has
executed a reinsurance contract which improves its capital adequacy and future liquidity. Based upon information available to date, we believe the insurance carrier should be able to meet its obligations.

On January 1, 2006, we renewed our self-insured employee medical benefit plans. Our claim experience during the nine months ended June 30, 2006
improved measurably as compared to the prior fiscal year. In January 2006, we made minor design changes to our benefit plans and analyzed the impact of the removal of the employees who transitioned to Accredo Health Group, Inc. as part of the sale
of the Pharmacy business.

As a result of operating in the healthcare 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 June 30, 2006, 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, 2005, 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 self-insured retention amount remained at $1.0 million with an annual aggregate self-insured retention
amount of $8.0 million and an annual aggregate coverage limit of $15.0 million. We changed carriers for our workers compensation policy to Charter Oak Fire Insurance, a subsidiary of St. Paul Travelers, rated A+ by AM Best Company, with the
per claim deductible remaining at $0.35 million.

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 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 settlements; 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 financial results.

Capital
Resources

We have invested the retained proceeds from the sale of the Pharmacy business in accordance with the terms of our Investment
Policy which has been approved by the Board of Directors. This policy provides for the establishment of short-term, highly liquid investments within prescribed parameters. Some of these investments have maturities which range from 7 days to
approximately 40 days. In accordance with FASB 115, the purchase and redemption of these particular securities are classified as investing activities in the condensed consolidated statements of cash flows. As of the balance sheet date, all funds
were held in a money market fund and classified as a cash equivalent on the condensed consolidated balance sheet. The dividends and interest earned from such securities are not subject to Federal income taxes and will result in a permanent
difference between book and tax income.

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, income tax payments and potential acquisitions and start-up branch offices. Our current sources of liquidity are cash on
hand and cash flow from operations. We are exposed to fluctuations in cash collection results.



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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, 2005, we completed our annual renewal of our risk management programs and implemented several changes
(see Liquidity and Capital Resources).

The Company received notification of a claim from one commercial payor primarily
relating to our discontinued pharmacy operation (see Note 9).

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 deferred compensation liability as of June 30, 2006 and September 30, 2005 was approximately $1.3 million and $1.6 million, respectively. On April 6, 2006, we adopted a Long-Term Incentive
Compensation Plan (LTIP) for the Senior Management team. Under the LTIP, cash awards may be granted based upon the achievement of certain Performance Goals which are established at the outset of each three year Performance Period. The
LTIP will become the primary component of our long term compensation strategies and the future use of existing equity compensation programs is expected to decline.

The following table represents a schedule of our contractual obligations and commitments as of June 30, 2006:



|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|------------------------ |  | ------------------------------------- | ------ | --------------- | - | --------- |  | --------- | ----- | ---------------- | - | ----- |  | - | -----
|                         |  | Payments Due by Period (In thousands)
|                         |  | Total                                 |        | Less Than1 Year |   | 1-3 Years |  | 3-5 Years |       | More than5 Years
|Contractual Obligations: |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|Operating leases         |  | $                                     | 11,289 |                 | $ | 3,220     |  | $         | 4,167 |                  | $ | 2,576 |  | $ | 1,326
|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|                         |  | $                                     | 11,289 |                 | $ | 3,220     |  | $         | 4,167 |                  | $ | 2,576 |  | $ | 1,326
|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      

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 healthcare 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. 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 in a limited number of financial institutions and with
institutional investors. We perform periodic evaluations of the relative financial position and credit standing of these financial intermediaries. As part of our corporate cash management program, we are investing the retained proceeds from the sale
of the Pharmacy business in accordance with established investment policies. We have invested in a portfolio of highly liquid investment grade securities which are managed for us by institutional investors. The concentration of credit risk with
respect to accounts receivable, which are primarily healthcare industry related, represent a risk to us given the current healthcare 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.

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 our company (including our consolidated subsidiaries) required
to be included in our periodic SEC filings.



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(b) Changes in internal controls over financial reporting. 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.

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 damages 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 that 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 resolution; 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.



|            |  |                                                                                                                                          
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                              
|            | 
|10.1        |  | Asset Purchase Agreement, dated May 9, 2006, by and between Pediatric Services of America, Inc. and Melmedica Childrens Healthcare, Inc.
|            | 
|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)                                                                                                         



31



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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: August 9, 2006 |  | By:                                              |  | /S/ JAMES M. MCNEILL                                                                                                                              
|                     |  |                                                  |  | James M. McNeill Senior Vice President, Chief Financial Officer, Treasurer and Secretary (Duly
authorized officer and Principal Financial Officer)



32



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##### Table of Contents

INDEX OF EXHIBITS



|            |  |                                                                                                                                          
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                              
|            | 
|10.1        |  | Asset Purchase Agreement, dated May 9, 2006, by and between Pediatric Services of America, Inc. and Melmedica Childrens Healthcare, Inc.
|            | 
|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)                                                                                                         



33