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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended December 31, 2005



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 February 7, 2006 the Registrant had 7,286,288 shares of Common Stock, $0.01 par value, outstanding.



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##### Table of Contents

FORM 10-Q

PEDIATRIC SERVICES OF AMERICA, INC.



INDEX



|                             |  |         |  |                                                                                                       |  |           
|---------------------------- |  | ------- |  | ----------------------------------------------------------------------------------------------------- |  | ----------
|                             |  |         |  |                                                                                                       |  | PageNumber
|PART I FINANCIAL INFORMATION |  |        
|                             |  |         | 
|                             |  | ITEM 1: |  | Financial Statements                                                                                  |  |           
|                             |  |         | 
|                             |  |         |  | Condensed Consolidated Balance Sheets as of December 31, 2005 and September 30, 2005                  |  | 3         
|                             |  |         | 
|                             |  |         |  | Condensed Consolidated Statements of Operations for the three months ended December 31, 2005 and 2004 |  | 5         
|                             |  |         | 
|                             |  |         |  | Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2005 and 2004 |  | 6         
|                             |  |         | 
|                             |  |         |  | Notes to Condensed Consolidated Financial Statements                                                  |  | 7         
|                             |  |         | 
|                             |  | ITEM 2: |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                 |  | 17        
|                             |  |         | 
|                             |  | ITEM 3: |  | Quantitative and Qualitative Disclosures about Market Risk                                            |  | 26        
|                             |  |         | 
|                             |  | ITEM 4: |  | Controls and Procedures                                                                               |  | 26        
|                             | 
|PART II OTHER INFORMATION    |  |        
|                             |  |         | 
|                             |  | ITEM 1: |  | Legal Proceedings                                                                                     |  | 26        
|                             |  |         | 
|                             |  | ITEM 6: |  | Exhibits                                                                                              |  | 27        
|                             | 
|SIGNATURES                   |  | 28     



2



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PART I  FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)



|                                                                                                      |  |                  |         |   |                   |   |         |  
|----------------------------------------------------------------------------------------------------- |  | ---------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                      |  | December 31,2005 |         |   | September 30,2005 |  
|                                                                                                      |  | (Unaudited)      |         |   |                   |  
|ASSETS                                                                                                |  |                  |         |   |                   |   |         |  
|Current Assets:                                                                                       |  |                  |         |   |                   |   |         |  
|Cash and cash equivalents                                                                             |  | $                | 64,272  |   |                   | $ | 19,037  |  
|Accounts receivable, less allowances for doubtful accounts of $2,995 and $3,000, respectively         |  |                  | 25,760  |   |                   |   | 26,232  |  
|Prepaid expenses                                                                                      |  |                  | 2,679   |   |                   |   | 1,255   |  
|Income taxes receivable                                                                               |  |                  |        |   |                   |   | 549     |  
|Deferred income taxes                                                                                 |  |                  | 6,552   |   |                   |   | 6,895   |  
|Workers compensation loss fund                                                                       |  |                  | 4,071   |   |                   |   | 3,424   |  
|Insurance recoveries                                                                                  |  |                  | 1,155   |   |                   |   | 1,376   |  
|Transition services and purchase price receivable                                                     |  |                  | 1,100   |   |                   |   |        |  
|Workers compensation bond collateral                                                                 |  |                  | 319     |   |                   |   |        |  
|Other current assets                                                                                  |  |                  | 297     |   |                   |   | 156     |  
|Assets held for sale                                                                                  |  |                  |        |   |                   |   | 26,690  |  
|                                                                                                      |  |                  |         |   |                   |   |         |  
|Total current assets                                                                                  |  |                  | 106,205 |   |                   |   | 85,614  |  
|                                                                                                      |  |                 
|Property and equipment:                                                                               |  |                  |         |   |                   |   |         |  
|Home care equipment held for rental                                                                   |  |                  | 32,627  |   |                   |   | 32,621  |  
|Furniture, fixtures and vehicles                                                                      |  |                  | 13,400  |   |                   |   | 13,107  |  
|Leasehold improvements                                                                                |  |                  | 2,914   |   |                   |   | 3,005   |  
|                                                                                                      |  |                  |         |   |                   |   |         |  
|                                                                                                      |  |                  | 48,941  |   |                   |   | 48,733  |  
|Accumulated depreciation and amortization                                                             |  |                  | (38,665 | ) |                   |   | (38,489 | )
|                                                                                                      |  |                  |         |   |                   |   |         |  
|                                                                                                      |  |                  | 10,276  |   |                   |   | 10,244  |  
|Other assets:                                                                                         |  |                  |         |   |                   |   |         |  
|Goodwill, less accumulated amortization of approximately $6,371                                       |  |                  | 25,893  |   |                   |   | 25,893  |  
|Certificates of need, less accumulated amortization of approximately $655 and $650, respectively      |  |                  | 17      |   |                   |   | 22      |  
|Deferred financing fees, less accumulated amortization of approximately $836 at September 30, 2005    |  |                  |        |   |                   |   | 535     |  
|Noncompete agreements, less accumulated amortization of approximately $1,168 and $1,258, respectively |  |                  | 12      |   |                   |   | 22      |  
|Deferred income taxes                                                                                 |  |                  | 1,611   |   |                   |   | 906     |  
|Workers compensation bond collateral                                                                 |  |                  | 1,220   |   |                   |   | 1,525   |  
|Insurance cash surrender value and recoveries                                                         |  |                  | 4,361   |   |                   |   | 4,122   |  
|Other                                                                                                 |  |                  | 246     |   |                   |   | 270     |  
|                                                                                                      |  |                  |         |   |                   |   |         |  
|                                                                                                      |  |                  | 33,360  |   |                   |   | 33,295  |  
|                                                                                                      |  |                  |         |   |                   |   |         |  
|Total assets                                                                                          |  | $                | 149,841 |   |                   | $ | 129,153 |  
|                                                                                                      |  |                  |         |   |                   |   |         |  



See accompanying
notes.



3



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS(Continued)

(In thousands)



|                                                                                                                                                               |  |                  |         |                   |   |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ------- | ----------------- | - | -------
|                                                                                                                                                               |  | December 31,2005 |         | September 30,2005
|                                                                                                                                                               |  | (Unaudited)      |         |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                           |  |                  |         |                   |   |        
|Current liabilities:                                                                                                                                           |  |                  |         |                   |   |        
|Accounts payable                                                                                                                                               |  | $                | 6,000   |                   | $ | 6,032  
|Accrued compensation                                                                                                                                           |  |                  | 6,120   |                   |   | 5,738  
|Income taxes payable                                                                                                                                           |  |                  | 15,860  |                   |   |       
|Accrued insurance                                                                                                                                              |  |                  | 5,581   |                   |   | 5,366  
|Refunds payable                                                                                                                                                |  |                  | 2,925   |                   |   | 3,462  
|Accrued interest                                                                                                                                               |  |                  | 42      |                   |   | 985    
|Other accrued liabilities                                                                                                                                      |  |                  | 2,495   |                   |   | 1,926  
|Deferred revenue                                                                                                                                               |  |                  | 765     |                   |   | 795    
|Held for sale liabilities                                                                                                                                      |  |                  |        |                   |   | 236    
|                                                                                                                                                               |  |                  |         |                   |   |        
|Total current liabilities                                                                                                                                      |  |                  | 39,788  |                   |   | 24,540 
|                                                                                                                                                               |  |                 
|Long-term accrued insurance                                                                                                                                    |  |                  | 10,604  |                   |   | 9,584  
|Long-term income taxes payable                                                                                                                                 |  |                  | 88      |                   |   | 88     
|Deferred compensation                                                                                                                                          |  |                  | 1,057   |                   |   | 1,022  
|Long-term obligations, net of current maturities                                                                                                               |  |                  |        |                   |   | 20,350 
|                                                                                                                                                               |  |                  |         |                   |   |        
|Total liabilities                                                                                                                                              |  |                  | 51,537  |                   |   | 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 7,283 and 7,262 shares issued and outstanding at December 31, 2005 and
September 30, 2005, respectively |  |                  | 73      |                   |   | 73     
|Additional paid-in capital                                                                                                                                     |  |                  | 52,623  |                   |   | 52,070 
|Retained earnings                                                                                                                                              |  |                  | 45,608  |                   |   | 21,426 
|                                                                                                                                                               |  |                  |         |                   |   |        
|Total stockholders equity                                                                                                                                     |  |                  | 98,304  |                   |   | 73,569 
|                                                                                                                                                               |  |                  |         |                   |   |        
|Total liabilities and stockholders equity                                                                                                                     |  | $                | 149,841 |                   | $ | 129,153
|                                                                                                                                                               |  |                  |         |                   |   |        



See accompanying
notes.



4



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                                                                                             |  |                                |        |   |             |   |        |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------------ | ------ | - | ----------- | - | ------ | -
|                                                                                                             |  | Three Months EndedDecember 31, |       
|                                                                                                             |  | 2005                           |        |   | 2004        |  
|                                                                                                             |  | (Unaudited)                    |        |   | (Unaudited) |  
|Net revenue                                                                                                  |  | $                              | 42,233 |   |             | $ | 43,242 |  
|                                                                                                             |  |                               
|Costs and expenses:                                                                                          |  |                                |        |   |             |   |        |  
|Costs of goods and services                                                                                  |  |                                | 21,531 |   |             |   | 21,745 |  
|Other operating costs and expenses                                                                           |  |                                |        |   |             |   |        |  
|Salaries, wages and benefits                                                                                 |  |                                | 8,996  |   |             |   | 9,014  |  
|Business insurance                                                                                           |  |                                | 1,646  |   |             |   | 1,358  |  
|Overhead                                                                                                     |  |                                | 3,666  |   |             |   | 3,453  |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Other operating costs and expenses                                                                           |  |                                | 14,308 |   |             |   | 13,825 |  
|Corporate, general and administrative                                                                        |  |                                |        |   |             |   |        |  
|Salaries, wages and benefits ($408 in stock-based compensation for the three months ended December 31, 2005) |  |                                | 3,750  |   |             |   | 3,326  |  
|Business insurance                                                                                           |  |                                | 64     |   |             |   | 30     |  
|Professional services                                                                                        |  |                                | 894    |   |             |   | 804    |  
|Overhead                                                                                                     |  |                                | 719    |   |             |   | 663    |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Corporate, general and administrative                                                                        |  |                                | 5,427  |   |             |   | 4,823  |  
|Provision for doubtful accounts                                                                              |  |                                | 445    |   |             |   | 609    |  
|Depreciation and amortization                                                                                |  |                                | 995    |   |             |   | 979    |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Total costs and expenses                                                                                     |  |                                | 42,706 |   |             |   | 41,981 |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Operating (loss) income                                                                                      |  |                                | (473   | ) |             |   | 1,261  |  
|Other income                                                                                                 |  |                                | 3      |   |             |   |       |  
|Loss on early extinguishment of debt                                                                         |  |                                | (837   | ) |             |   |       |  
|Interest income                                                                                              |  |                                | 385    |   |             |   | 42     |  
|Interest expense                                                                                             |  |                                | (560   | ) |             |   | (603   | )
|                                                                                                             |  |                                |        |   |             |   |        |  
|Income (loss) from continuing operations, before income tax expense (benefit)                                |  |                                | (1,482 | ) |             |   | 700    |  
|Income tax expense (benefit)                                                                                 |  |                                | (308   | ) |             |   | 330    |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Income (loss) from continuing operations                                                                     |  |                                | (1,174 | ) |             |   | 370    |  
|Discontinued operations:                                                                                     |  |                                |        |   |             |   |        |  
|Income from discontinued operations, net of tax                                                              |  |                                | 777    |   |             |   | 1,379  |  
|Gain on disposal of discontinued operations, net of tax                                                      |  |                                | 24,579 |   |             |   |       |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Net income                                                                                                   |  | $                              | 24,182 |   |             | $ | 1,749  |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Basic net income per share data:                                                                             |  |                                |        |   |             |   |        |  
|Income (loss) from continuing operations                                                                     |  | $                              | (0.16  | ) |             | $ | 0.05   |  
|Income from discontinued operations, net of tax                                                              |  |                                | 0.11   |   |             |   | 0.20   |  
|Gain on disposal of discontinued operations, net of tax                                                      |  |                                | 3.38   |   |             |   |       |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Net income                                                                                                   |  | $                              | 3.33   |   |             | $ | 0.25   |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Diluted net income per share data:                                                                           |  |                                |        |   |             |   |        |  
|Income (loss) from continuing operations                                                                     |  | $                              | (0.16  | ) |             | $ | 0.05   |  
|Income from discontinued operations, net of tax                                                              |  |                                | 0.11   |   |             |   | 0.18   |  
|Gain on disposal of discontinued operations, net of tax                                                      |  |                                | 3.38   |   |             |   |       |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Net income                                                                                                   |  | $                              | 3.33   |   |             | $ | 0.23   |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Weighted average shares outstanding:                                                                         |  |                                |        |   |             |   |        |  
|Basic                                                                                                        |  |                                | 7,269  |   |             |   | 7,093  |  
|                                                                                                             |  |                                |        |   |             |   |        |  
|Diluted                                                                                                      |  |                                | 7,269  |   |             |   | 7,446  |  
|                                                                                                             |  |                                |        |   |             |   |        |  



See accompanying
notes.



5



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                                            |  |                                |         |   |             |   |        |  
|----------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ----------- | - | ------ | -
|                                                                                                            |  | Three Months EndedDecember 31, |        
|                                                                                                            |  | 2005                           |         |   | 2004        |  
|                                                                                                            |  | (Unaudited)                    |         |   | (Unaudited) |  
|Operating activities:                                                                                       |  |                                |         |   |             |   |        |  
|Income (loss) from continuing operations                                                                    |  | $                              | (1,174  | ) |             | $ | 370    |  
|Adjustments to reconcile income (loss) from continuing operations to net cash used in operating activities: |  |                                |         |   |             |   |        |  
|Depreciation and amortization                                                                               |  |                                | 995     |   |             |   | 979    |  
|Provision for doubtful accounts                                                                             |  |                                | 445     |   |             |   | 609    |  
|Amortization of deferred financing fees                                                                     |  |                                | 37      |   |             |   | 61     |  
|Loss on early extinguishment of debt                                                                        |  |                                | 837     |   |             |   |       |  
|Incentive stock option expense                                                                              |  |                                | 109     |   |             |   |       |  
|Nonqualified stock option expense                                                                           |  |                                | 299     |   |             |   |       |  
|Deferred income taxes                                                                                       |  |                                | (362    | ) |             |   | 781    |  
|Changes in operating assets and liabilities                                                                 |  |                                |         |   |             |   |        |  
|Accounts receivable                                                                                         |  |                                | 27      |   |             |   | (2,650 | )
|Prepaid expenses                                                                                            |  |                                | (1,424  | ) |             |   | (1,883 | )
|Other assets                                                                                                |  |                                | (140    | ) |             |   | 272    |  
|Workers compensation loss fund                                                                             |  |                                | (647    | ) |             |   | (330   | )
|Workers compensation bond collateral                                                                       |  |                                | (14     | ) |             |   | (6     | )
|Accounts payable                                                                                            |  |                                | (32     | ) |             |   | 1,136  |  
|Income taxes                                                                                                |  |                                | (40     | ) |             |   | 8      |  
|Accrued insurance, liabilities, refunds and interest                                                        |  |                                | 318     |   |             |   | (1,882 | )
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash used in operating activities of continuing operations                                              |  |                                | (766    | ) |             |   | (2,535 | )
|Net cash used in operating activities of discontinued operations                                            |  |                                | (4,373  | ) |             |   | (43    | )
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash used in operating activities                                                                       |  |                                | (5,139  | ) |             |   | (2,578 | )
|                                                                                                            |  |                               
|Investing activities:                                                                                       |  |                                |         |   |             |   |        |  
|Purchases of property and equipment                                                                         |  |                                | (991    | ) |             |   | (1,310 | )
|Proceeds from the sale of discontinued operations                                                           |  |                                | 71,915  |   |             |   |       |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash provided by (used in) investing activities of continuing operations                                |  |                                | 70,924  |   |             |   | (1,310 | )
|Net cash used in investing activities of discontinued operations                                            |  |                                |        |   |             |   | (47    | )
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash provided by (used in) investing activities                                                         |  |                                | 70,924  |   |             |   | (1,357 | )
|Financing activities:                                                                                       |  |                                |         |   |             |   |        |  
|Principal payments and extinguishment of long-term debt                                                     |  |                                | (20,689 | ) |             |   | (37    | )
|Disqualifying disposition of stock options                                                                  |  |                                | 44      |   |             |   | 17     |  
|Nonqualified stock options                                                                                  |  |                                |        |   |             |   | 238    |  
|Proceeds from exercise of stock options                                                                     |  |                                | 101     |   |             |   | 400    |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash provided by (used in) financing activities of continuing operations                                |  |                                | (20,544 | ) |             |   | 618    |  
|Net cash used in financing activities of discontinued operations                                            |  |                                | (6      | ) |             |   | (11    | )
|                                                                                                            |  |                                |         |   |             |   |        |  
|Net cash provided by (used in) financing activities                                                         |  |                                | (20,550 | ) |             |   | 607    |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Increase (decrease) in cash and cash equivalents                                                            |  |                                | 45,235  |   |             |   | (3,328 | )
|Cash and cash equivalents at beginning of year                                                              |  |                                | 19,037  |   |             |   | 8,159  |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Cash and cash equivalents at end of year                                                                    |  | $                              | 64,272  |   |             | $ | 4,831  |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Supplemental disclosure of cash flow information:                                                           |  |                                |         |   |             |   |        |  
|Cash paid for interest                                                                                      |  | $                              | 1,482   |   |             | $ | 1,074  |  
|                                                                                                            |  |                                |         |   |             |   |        |  
|Cash paid for taxes                                                                                         |  | $                              | 50      |   |             | $ | 139    |  
|                                                                                                            |  |                                |         |   |             |   |        |  



See accompanying
notes.



6



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited



1. Basis of Presentation



The accompanying unaudited condensed consolidated financial statements of
Pediatric Services of America, Inc. (the Company) and its majority-owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all information and notes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of
management, all adjustments considered necessary for a fair presentation have been included. Results of operations for the three months ended December 31, 2005 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 7).



Discontinued Operations



On November 18, 2005, we concluded 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
in tax. 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. At December 31, 2005, we had a receivable of approximately $0.8 million related to transitioning the services to Accredo Health Group and $0.3 million related to the settlement of the purchase
price. Both amounts were collected in January 2006.



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. We perform
periodic evaluations of the relative credit standing of these financial institutions. As part of our corporate cash management program we will be investing the retained proceeds from the sale of the Pharmacy business in accordance with established
investment policies. We will be investing in a portfolio of highly liquid investment grade securities which may be managed for us by



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



2. Summary of Significant Accounting Policies  Continued



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.



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 $5.4 million and $5.5 million for which services have been rendered but the amounts were unbilled as of December 31, 2005 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 $0.04 million for the three months ended December 31, 2005 and 2004,
respectively. 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 |  | $                                | 128
|2007 |  | $                                | 84 
|2008 |  | $                                | 83 
|2009 |  | $                                | 83 
|2010 |  | $                                | 83 



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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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 December 31, 2005 and
September 30, 2005 was $4.1 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.



Workers Compensation
Bond Collateral



We have secured surety bonds of $1.7
million to satisfy our workers compensation program requirements for our former insurance carrier. As of December 31, 2005, the surety bonds were collateralized by $1.5 million cash posted to a third party escrow account. In January,
2006, the Company received $0.3 million in cash from our former insurance carrier, which will reduce the collateral and surety bond by the same amount.



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.



Net Revenue



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



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 December 31, 2005, 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 1,033,975 options are outstanding to eligible participants as
of December 31, 2005. 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 Board of Directors Compensation Committee. The vesting
period of the options is typically four years. Upon the occurrence of certain events, 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.



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



2. Summary of Significant Accounting Policies - Continued



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 Board of Directors Compensation Committee has the authority and sole discretion to make grants of options under the 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 348,500 options are outstanding to eligible participants as of December 31, 2005.



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 months ended December 31, 2004, 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 months ended December 31, 2005 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).



|                         |  |                                     |   |  |                 |  
|------------------------ |  | ----------------------------------- | - |  | --------------- | -
|                         |  | Three Months EndedDecember 31, 2005 |  
|                         |  | 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            | %



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



2. Summary of Significant Accounting Policies - Continued



Option Plan



A summary of option activity under the Option Plan as of December 31,
2005, and changes during the period then ended is presented below:



|                                            |  |           |   |  |                               |       |                                          |      |                         |   |           
|------------------------------------------- |  | --------- | - |  | ----------------------------- | ----- | ---------------------------------------- | ---- | ----------------------- | - | ----------
|Options                                     |  | Shares    |   |  | Weighted-AverageExercisePrice |       | Weighted-AverageRemainingContractualTerm |      | AggregateIntrinsicValue
|Outstanding at October 1, 2005              |  | 990,075   |   |  | $                             | 9.86  |                                          |      |                         |   |           
|Granted                                     |  | 82,500    |   |  |                               | 14.74 |                                          |      |                         |   |           
|Exercised                                   |  | (21,400   | ) |  |                               | 4.75  |                                          |      |                         |   |           
|Forfeited or expired                        |  | (17,200   | ) |  |                               | 13.42 |                                          |      |                         |   |           
|                                            |  |           |   |  |                               |       |                                          |      |                         |   |           
|Outstanding at December 31, 2005            |  | 1,033,975 |   |  | $                             | 10.30 |                                          | 7.49 |                         | $ | 10,647,742
|                                            |  |           |   |  |                               |       |                                          |      |                         |   |           
|Vested and exercisable at December 31, 2005 |  | 532,850   |   |  | $                             | 9.97  |                                          | 6.27 |                         | $ | 5,310,905 
|                                            |  |           |   |  |                               |       |                                          |      |                         |   |           



The weighted-average
grant-date fair value of options granted during the three months ended December 31, 2005 was $6.85. The total intrinsic value of options exercised during the three months ended December 31, 2005 was $0.2 million.



As of December 31, 2005 there was $1.7 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 four months.



Directors Plan



A summary of option activity under the Directors Stock Option Plan as
of December 31, 2005, and changes during the period then ended is presented below:



|                                            |  |         |  |                               |       |                                          |      |                         |   |          
|------------------------------------------- |  | ------- |  | ----------------------------- | ----- | ---------------------------------------- | ---- | ----------------------- | - | ---------
|Options                                     |  | Shares  |  | Weighted-AverageExercisePrice |       | Weighted-AverageRemainingContractualTerm |      | AggregateIntrinsicValue
|Outstanding at October 1, 2005              |  | 318,500 |  | $                             | 8.66  |                                          |      |                         |   |          
|Granted                                     |  | 30,000  |  |                               | 15.07 |                                          |      |                         |   |          
|Exercised                                   |  |        |  |                               |       |                                          |      |                         |   |          
|Forfeited or expired                        |  |        |  |                               |       |                                          |      |                         |   |          
|                                            |  |         |  |                               |       |                                          |      |                         |   |          
|Outstanding at December 31, 2005            |  | 348,500 |  | $                             | 9.21  |                                          | 6.09 |                         | $ | 3,211,060
|                                            |  |         |  |                               |       |                                          |      |                         |   |          
|Vested and exercisable at December 31, 2005 |  | 318,500 |  | $                             | 8.66  |                                          | 5.74 |                         | $ | 2,758,960
|                                            |  |         |  |                               |       |                                          |      |                         |   |          



The weighted-average
grant-date fair value of options granted during the three months ended December 31, 2005 was $11.31.



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



2. Summary of Significant Accounting Policies  Continued



As of December 31, 2005 there was $0.3 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 seven months.



As a result of adopting Statement 123(R) on October 1, 2005, our
compensation expenses recognized in the months ended December 31, 2005 was approximately $0.4 million. Our loss from continuing operations, income before income taxes and net income for the three months ended December 31, 2005 was $0.4 million,
$0.4 million and $0.3 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 December 31, 2005 would have been $3.37, if we had
not adopted Statement 123(R), compared to reported basic and diluted earnings per share of $3.33.



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.



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 months ended December 31, 2004. 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).



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



Reclassifications



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



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



3. Discontinued Operations



On November 18, 2005, we concluded 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:



|                                            |  |                                 |        |      |   |       
|------------------------------------------- |  | ------------------------------- | ------ | ---- | - | ------
|                                            |  | Three Months Ended December 31,
|In Thousands                                |  | 2005                            |        | 2004
|Discontinued Operations                     |  |                                 |        |      |   |       
|                                            |  |                                
|Net revenue                                 |  | $                               | 11,318 |      | $ | 20,760
|Income before income tax expense            |  |                                 | 1,281  |      |   | 2,224 
|Income tax expense                          |  |                                 | 504    |      |   | 845   
|                                            |  |                                 |        |      |   |       
|Net income                                  |  | $                               | 777    |      | $ | 1,379 
|                                            |  |                                 |        |      |   |       
|Net income per share                        |  |                                 |        |      |   |       
|Basic                                       |  | $                               | 0.11   |      | $ | 0.20  
|                                            |  |                                 |        |      |   |       
|Diluted                                     |  | $                               | 0.11   |      | $ | 0.18  
|                                            |  |                                 |        |      |   |       
|Gain on Disposal                            |  |                                 |        |      |   |       
|                                            |  |                                
|Gain on disposal of discontinued operations |  | $                               | 40,524 |      | $ |      
|Income tax expense                          |  |                                 | 15,945 |      |   |      
|                                            |  |                                 |        |      |   |       
|Net income                                  |  | $                               | 24,579 |      | $ |      
|                                            |  |                                 |        |      |   |       
|Net income per share                        |  |                                 |        |      |   |       
|Basic                                       |  | $                               | 3.38   |      | $ |      
|                                            |  |                                 |        |      |   |       
|Diluted                                     |  | $                               | 3.38   |      | $ |      
|                                            |  |                                 |        |      |   |       



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   
|                                             |  |                   |       



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



3. Discontinued Operations - Continued



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. Long-Term Borrowing Arrangements



On December 30, 2005, 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 three months ended December 31, 2005.



On November 11, 2005, we terminated our credit agreement with General Electric Capital Corporation. The credit agreement, consisting of $10.0 million revolving credit facility and $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 three months ended December 31, 2005.



5. Stock Option Plans



During the three months ended December 31, 2005 and 2004, respectively, 21,400 and 114,359 options to acquire our Common Stock were exercised.



6. Basic and Diluted Income Per Share



Basic income per share is computed using the weighted average number of
shares of common stock outstanding during the period. Diluted income per share is computed using the weighted average number of shares of common stock outstanding and the dilutive effect of common equivalent shares (calculated using the treasury
stock method). For the three months ended December 31, 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:



|                                                                          |  |                                |  |      
|------------------------------------------------------------------------- |  | ------------------------------ |  | -----
|                                                                          |  | Three Months EndedDecember 31,
|                                                                          |  | 2005                           |  | 2004 
|Denominator for basic income per share-weighted average shares            |  | 7,269                          |  | 7,093
|Effect of dilutive securities:                                            |  |                                |  |      
|Options                                                                   |  |                               |  | 353  
|                                                                          |  |                                |  |      
|Denominator for diluted income per shareadjusted weighted average shares |  | 7,269                          |  | 7,446
|                                                                          |  |                                |  |      
|Antidilutive securities:                                                  |  |                                |  |      
|Options                                                                   |  | 168                            |  | 341  
|                                                                          |  |                                |  |      



7. 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).



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PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



7. Segments - Continued



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



|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|------------------------------------------------------------ |  | ------- | ------ | - | ---- | - | ----- | ---------------------------------------- |  | ----------------- | ------ |  | - | ------
|                                                             |  | Nursing |        |   | PPEC |   |       | RespiratoryTherapy,Equipment andServices |  | ConsolidatedTotal
|Three Months Ended December 31, 2005                         |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|                                                             |  |         |        |  
|Net revenue                                                  |  | $       | 25,375 |   |      | $ | 2,558 |                                          |  | $                 | 14,300 |  | $ | 42,233
|                                                             |  |         |        |  
|Costs of goods and services                                  |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|                                                             |  |         |        |  
|Nursing and therapist salaries, wages, benefits and supplies |  |         | 16,771 |   |      |   | 136   |                                          |  |                   | 226    |  |   | 17,133
|Pharmacy product and supplies                                |  |         |       |   |      |   |      |                                          |  |                   | 1,722  |  |   | 1,722 
|Disposables/Supplies                                         |  |         | 13     |   |      |   | 8     |                                          |  |                   | 2,655  |  |   | 2,676 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Total cost of goods and services                             |  |         | 16,784 |   |      |   | 144   |                                          |  |                   | 4,603  |  |   | 21,531
|Other operating costs and expenses                           |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Administrative and marketing salaries, wages and benefits    |  |         | 3,380  |   |      |   | 1,421 |                                          |  |                   | 4,195  |  |   | 8,996 
|Business Insurance                                           |  |         | 1,103  |   |      |   | 93    |                                          |  |                   | 450    |  |   | 1,646 
|Overhead                                                     |  |         | 1,434  |   |      |   | 424   |                                          |  |                   | 1,808  |  |   | 3,666 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Total operating costs and expenses                           |  |         | 5,917  |   |      |   | 1,938 |                                          |  |                   | 6,453  |  |   | 14,308
|                                                             |  |         |        |  
|Provision for doubtful accounts                              |  |         | (38    | ) |      |   | 43    |                                          |  |                   | 440    |  |   | 445   
|Depreciation                                                 |  |         | 40     |   |      |   | 45    |                                          |  |                   | 753    |  |   | 838   
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Branch office contribution margin                            |  | $       | 2,672  |   |      | $ | 388   |                                          |  | $                 | 2,051  |  | $ | 5,111 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Three Months Ended December 31, 2004                         |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|                                                             |  |         |        |  
|Net revenue                                                  |  | $       | 26,423 |   |      | $ | 2,438 |                                          |  | $                 | 14,381 |  | $ | 43,242
|                                                             |  |         |        |  
|Costs of goods and services                                  |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|                                                             |  |         |        |  
|Nursing and therapist salaries, wages, benefits and supplies |  |         | 17,067 |   |      |   | 116   |                                          |  |                   | 250    |  |   | 17,433
|Pharmacy product and supplies                                |  |         |       |   |      |   |      |                                          |  |                   | 1,217  |  |   | 1,217 
|Disposables/Supplies                                         |  |         | 8      |   |      |   | 9     |                                          |  |                   | 3,078  |  |   | 3,095 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Total cost of goods and services                             |  |         | 17,075 |   |      |   | 125   |                                          |  |                   | 4,545  |  |   | 21,745
|Other operating costs and expenses                           |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Administrative and marketing salaries, wages and benefits    |  |         | 3,470  |   |      |   | 1,419 |                                          |  |                   | 4,125  |  |   | 9,014 
|Business Insurance                                           |  |         | 854    |   |      |   | 87    |                                          |  |                   | 417    |  |   | 1,358 
|Overhead                                                     |  |         | 1,299  |   |      |   | 394   |                                          |  |                   | 1,760  |  |   | 3,453 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Total operating costs and expenses                           |  |         | 5,623  |   |      |   | 1,900 |                                          |  |                   | 6,302  |  |   | 13,825
|                                                             |  |         |        |  
|Provision for doubtful accounts                              |  |         | 177    |   |      |   | (15   | )                                        |  |                   | 447    |  |   | 609   
|Depreciation                                                 |  |         | 52     |   |      |   | 45    |                                          |  |                   | 729    |  |   | 826   
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       
|Branch office contribution margin                            |  | $       | 3,496  |   |      | $ | 383   |                                          |  | $                 | 2,358  |  | $ | 6,237 
|                                                             |  |         |        |   |      |   |       |                                          |  |                   |        |  |   |       



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##### Table of Contents

PEDIATRIC SERVICES OF AMERICA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  Unaudited (Continued)



7. Segments - Continued



|                                                                    |  |                                 |        |   |      |   |        |  
|------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                    |  | Three Months Ended December 31, |       
|                                                                    |  | 2005                            |        |   | 2004 |  
|Total profit for reportable segments                                |  | $                               | 5,111  |   |      | $ | 6,237  |  
|                                                                    |  |                                
|Corporate, general and administrative                               |  |                                 | (5,427 | ) |      |   | (4,823 | )
|Corporate depreciation and amortization                             |  |                                 | (157   | ) |      |   | (153   | )
|Other income                                                        |  |                                 | 3      |   |      |   |       |  
|Loss on early extinguishment of debt                                |  |                                 | (837   | ) |      |   |       |  
|Interest income                                                     |  |                                 | 385    |   |      |   | 42     |  
|Interest expense                                                    |  |                                 | (560   | ) |      |   | (603   | )
|                                                                    |  |                                 |        |   |      |   |        |  
|Income (loss) from continuing operations, before income tax benefit |  | $                               | (1,482 | ) |      | $ | 700    |  
|                                                                    |  |                                 |        |   |      |   |        |  



8. 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 would not have a material adverse effect on our financial condition or liquidity position.



We have recently 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 preliminarily reviewed the basis for the claim and believe it is substantially without merit. We are continuing to review the facts and circumstances of this particular claim, including the related
documentation, and will proceed to work toward resolution of these issues. At this time, we are unable to estimate a possible loss or range of loss, if any. 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, the Company was notified by Cigna Healthcare that effective May 1, 2006 it has 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. This agreement will cause us to 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 estimate the impact to our RTES segment would have been a reduction of net revenue of approximately $2.3 million. As a result, we will review our cost structures in those markets and make whatever reductions are
deemed appropriate.



16



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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, 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.



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 Deficit
Reduction Act of 2005 (DRA), which passed the Senate on December 21, 2005, and the House of Representatives on February 1, 2006, is expected to be signed into law and 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).
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | 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 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 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 other ten months. After transfer of title, Medicare will pay
only for reasonable and necessary maintenance and servicing.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Implementing spending caps beginning in 2006 of $1,740 per Medicare beneficiary for outpatient therapy, 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. MMA provided that Medicare beneficiaries will be reimbursed at a rate of 106
percent of the volume-weighted average selling price (the ASP), rather than 95 percent 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) 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 Secretary determines to have the largest savings potential. 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, although Medicares Conditions of Participation for home health are being revised, CMS
has announced that their publication will be delayed until at least Spring 2006. There can be no assurance that these and other changes will not adversely impact our operations and profits.



In addition to federal initiatives to decrease Medicaid spending, many of the
states in which we operate are discussing alternatives which could have the effect of restricting eligibility for Medicaid benefits or increasing managed care administration of benefits. 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.



18



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##### Table of Contents

Company Events & Updates



On November 11, 2005, we terminated our credit agreement with General
Electric Capital Corporation. The credit agreement, consisting of $10.0 million revolving credit facility and $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 three months ended December 31, 2005.



On November 18, 2005, we concluded 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 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.



On December 30, 2005, we redeemed in full the remainder of 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 three months ended December 31, 2005.



We have made significant progress in terms of building our Private Duty Nursing Acquisition Pipeline and we have identified
a number of opportunities and are currently working through the letter of intent stage. However, we intend to proceed in a measured manner in order to ensure we are completing only high quality transactions.



On January 17, 2006, the Company was notified by Cigna Healthcare that
effective May 1, 2006 it has 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. This agreement will cause us
to 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 estimate the impact to our
RTES segment would have been a reduction of net revenue of approximately $2.3 million. As a result, we will review our cost structures in those markets and make whatever reductions are deemed appropriate.



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 in accounting for our employee stock options 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 months ended December 31, 2004, 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 months ended December 31, 2005 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, Internal Audit, 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.



19



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##### Table of Contents

Operations



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



In the Nursing segment, we
continue to see pressures on both reimbursement levels and wage rates in key markets. During the three months ended December 31, 2005, we continued to experience reductions in authorized levels of services from select key Medicaid states. This
trend in reduced authorized levels of care for specific patients continues to be an obstacle to this segments future contribution margin expansion. 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 incentivize 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.



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 overwhelmingly positive. In North Carolina 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 state has yet to remove the obstacles to patient access which severely limits our census levels. We are hopeful that with the impending structural changes to the Medicaid program recently
announced by the Governor, these obstacles can be removed.



In
the RTES segment, we continue to invest in and expand our sales and marketing program. We are focusing our sales and marketing efforts upon the higher acuity respiratory patients to leverage our clinical competencies and more actively manage the
core product mix. As a result, we have begun to see increases in target referrals from managed care payors in select markets. 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. In addition, we have improved managerial oversight of local purchasing decisions and our internal process for
re-allocating surplus items between branch offices.



Source & Availability of Clinical Personnel



We believe that case hours staffed is the most appropriate measurement of nursing activity. During the 13 weeks ending December 31, 2005, our case hours staffed decreased to approximately 779,000 as compared to
785,000 in the 13 weeks ended October 1, 2005. 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 new local market nurse recruiters to help reduce unstaffed hours.



CRITICAL ACCOUNTING POLICIES



This Form 10-Q reflects newly enacted 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 in accounting for our employee stock options 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 months ended December 31, 2004, 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 months ended December 31, 2005 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).



20



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##### Table of Contents

RESULTS OF OPERATIONS



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



|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|----------------------------------------------------------------------------- |  | ------------------------------ | -- |  | ----------------------------------------------- | - |  | ---- | --
|                                                                              |  | Percentage of Net Revenue      |    |  | Period-to-Period Percentage Increase (Decrease) |  
|                                                                              |  | Three Months EndedDecember 31, |    |  | Three Months EndedDecember 31, 2005             |  
|                                                                              |  | 2005                           |    |  | 2004                                            |   | 
|Net Revenue                                                                   |  | 100.0                          | %  |  | 100.0                                           | % |  | (2   | )%
|Costs of goods and services                                                   |  | 51.0                           |    |  | 50.3                                            |   |  | (1   | ) 
|Other operating costs and expenses                                            |  |                                |    |  |                                                 |   |  |      |   
|Salaries, wages and benefits                                                  |  | 21.3                           |    |  | 20.8                                            |   |  | 0    |   
|Business insurance                                                            |  | 3.9                            |    |  | 3.1                                             |   |  | 21   |   
|Overhead                                                                      |  | 8.7                            |    |  | 8.0                                             |   |  | 6    |   
|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|Other operating costs and expenses                                            |  | 33.9                           |    |  | 31.9                                            |   |  | 3    |   
|Corporate, general and administrative                                         |  |                                |    |  |                                                 |   |  |      |   
|Salaries, wages and benefits                                                  |  | 8.9                            |    |  | 7.7                                             |   |  | 13   |   
|Business insurance                                                            |  | 0.2                            |    |  | 0.1                                             |   |  | 113  |   
|Professional services                                                         |  | 2.1                            |    |  | 1.9                                             |   |  | 11   |   
|Overhead                                                                      |  | 1.7                            |    |  | 1.5                                             |   |  | 8    |   
|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|Corporate, general and administrative                                         |  | 12.9                           |    |  | 11.2                                            |   |  | 13   |   
|Provision for doubtful accounts                                               |  | 1.0                            |    |  | 1.4                                             |   |  | (27  | ) 
|Depreciation and amortization                                                 |  | 2.4                            |    |  | 2.3                                             |   |  | 2    |   
|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|Operating income (loss)                                                       |  | (1.2                           | )  |  | 2.9                                             |   |  | (138 | ) 
|Other income                                                                  |  |                               |    |  |                                                |   |  | 100  |   
|Loss on early extinguishment of debt                                          |  | (2.0                           | )  |  |                                                |   |  | 100  |   
|Interest income                                                               |  | 0.9                            |    |  | 0.1                                             |   |  | 817  |   
|Interest expense                                                              |  | (1.3                           | )  |  | (1.4                                            | ) |  | (7   | ) 
|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|Income (loss) from continuing operations, before income tax expense (benefit) |  | (3.6                           | )  |  | 1.6                                             |   |  | (312 | ) 
|Income tax expense (benefit)                                                  |  | (0.7                           | )  |  | 0.8                                             |   |  | (193 | ) 
|                                                                              |  |                                |    |  |                                                 |   |  |      |   
|Income (loss) from continuing operations                                      |  | (2.9                           | )% |  | 0.8                                             | % |  | (417 | )%
|                                                                              |  |                                |    |  |                                                 |   |  |      |   



21



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##### Table of Contents

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:



|                                           |  |              |   |  |             |  
|------------------------------------------ |  | ------------ | - |  | ----------- | -
|                                           |  | December 31, |  
|                                           |  | 2005% Total  |   |  | 2004% Total |  
|Pediatric Home Health Care                 |  |              |   |  |             |  
|Nursing                                    |  | 53.7         | % |  | 54.4        | %
|PPEC                                       |  | 6.1          | % |  | 5.6         | %
|Respiratory Therapy Equipment and Services |  | 18.6         | % |  | 18.6        | %
|                                           |  |              |   |  |             |  
|Total Pediatric Home Health Care           |  | 78.4         | % |  | 78.6        | %
|Adult Home Health Care                     |  |              |   |  |             |  
|Nursing                                    |  | 6.4          | % |  | 6.7         | %
|Respiratory Therapy Equipment and Services |  | 15.2         | % |  | 14.7        | %
|                                           |  |              |   |  |             |  
|Total Adult Home Health Care               |  | 21.6         | % |  | 21.4        | %
|                                           |  |              |   |  |             |  
|Total                                      |  | 100.0        | % |  | 100.0       | %
|                                           |  |              |   |  |             |  



22



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##### Table of Contents

Three Months Ended December 31, 2005 Compared to Three Months Ended December 31, 2004



Net revenue decreased $1.0 million, or 2%, to $42.2 million in the three
months ended December 31, 2005 from $43.2 million in the three months ended December 31, 2004. For the Nursing segment, net revenue decreased $1.0 million, or 4%, to $25.4 million in the three months ended December 31, 2005 from $26.4
million in the three months ended December 31, 2004. Of this decline, the Louisiana markets were the primary cause as Hurricane Katrina related disruptions persisted which led to a significant decline in patient census. For the PPEC segment,
net revenue increased $0.1 million, or 5%, to $2.6 million in the three months ended December 31, 2005 from $2.4 million in the three months ended December 31, 2004. RTES segment net revenue decreased $0.1 million, or 1%, to $14.3 million
in the three months ended December 31, 2005 from $14.4 million in the three months ended December 31, 2004. In the three months ended December 31, 2005, we derived approximately 38% of our net revenue from commercial insurers and
other private payors, 54% 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 decreased $0.2 million, or 1%, to $21.5 million in the
three months ended December 31, 2005 from $21.7 million in the three months ended December 31, 2004. Costs of goods and services of the Nursing segment decreased $0.3 million, or 2%, to $16.8 million in the three months ended
December 31, 2005 from $17.1 million in the three months ended December 31, 2004. Costs of goods and services as a percentage of the Nursing segment net revenue increased to 66% in the three months ended December 31, 2005 compared to
65% in the three months ended December 31, 2004. For the PPEC segment, cost of goods and services remained relatively constant at $0.1 million in the three months ended December 31, 2005 as compared to the three months ended
December 31, 2004. PPEC segment costs of goods and services as a percentage of net revenue increased to 6% in the three months ended December 31, 2005 from 5% in the three months ended December 31, 2004. For the RTES segment, cost of
goods and services increased $0.1 million, or 1%, to $4.6 million in the three months ended December 31, 2005 from $4.5 million in the three months ended December 31, 2004. Costs of goods and services as a percentage of net revenue
remained relatively constant at 32% in the three months ended December 31, 2005 as compared to the three months ended December 31, 2004.



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 $0.5 million, or 3%, to $14.3 million in the three months ended December 31, 2005 from $13.8 million in the three months ended December 31, 2004. In the Nursing
segment, other operating costs and expenses increased $0.3 million, or 5%, to $5.9 million in the three months ended December 31, 2005 from $5.6 million in the three months ended December 31, 2004 primarily as a result of increased
business insurance costs and nurse recruiting costs. As a percentage of net revenue, the Nursing segment costs were 23% in the three months ended December 31, 2005 as compared to 21% in the three months ended December 31, 2004. In the PPEC
segment, other operating costs and expenses remained relatively flat at $1.9 million in the three months ended December 31, 2005 as compared to the three months ended December 31, 2004. As a percentage of net revenue these costs declined
to 76% in the three months ended December 31, 2005 from 78% in the three months ended December 31, 2004. In the RTES segment, other operating costs and expenses increased $0.2 million, or 2%, to $6.5 million in the three months ended
December 31, 2005 from $6.3 million in the three months ended December 31, 2004 primarily as a result of increased administrative salaries. As a percentage of net revenue these costs increased to 45% in the three months ended
December 31, 2005 as compared to 44% in the three months ended December 31, 2004.



Corporate, general and administrative costs increased $0.6 million, or 13% to $5.4 million in the three months ended December 31, 2005 as compared to $4.8 million in the three months ended December 31, 2004
primarily due to compensation cost for employee stock options of approximately $0.4 million in the three months ended December 31, 2005 relating to the adoption of FAS 123(R). Our percentage of net revenue, corporate, general and administrative
costs increased to 13% in the three months ended December 31, 2005 from 11% in the three months ended December 31, 2004.



Provision for doubtful accounts decreased $0.2 million, or 27%, to $0.4 million in the three months ended December 31, 2005 from $0.6 million in the
three months ended December 31, 2004. Cash collections as a percentage of net revenue were 101% and 100% in the three months ended December 31, 2005 and 2004, respectively. As a percentage of net revenue, provision for doubtful accounts
remained relatively constant at 1% in the three months ended December 31, 2005 as compared to the three months ended December 31, 2004.



Depreciation and amortization remained relatively constant at $1.0 million in the three months ended December 31, 2005 as compared to the three
months ended December 31, 2004.



Interest expense remained
relatively constant at $0.6 million in the three months ended December 31, 2005 as compared to the three months ended December 31, 2004 (See Liquidity and Capital Resources below for further discussion).



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Income tax expense from continuing operations decreased $0.6 million, or 193%, to a benefit of $0.3
million in the three months ended December 31, 2005 from an expense of $0.3 million in the three months ended December 31, 2004.



LIQUIDITY AND CAPITAL RESOURCES



Operations



On November 11, 2005, we terminated our credit agreement with General Electric Capital Corporation. The credit agreement, consisting of $10.0 million
revolving credit facility and $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 three months ended December 31, 2005.



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 three months ended December 31, 2005.



Cash collections as a percentage of net revenue for the three months ended
December 31, 2005 and 2004 was 101% and 100%, respectively. While we anticipate that we will continue to achieve our cash collection targets, there can be no assurance that disruptions to cash flow will not occur.



For the three months ended December 31, 2005, 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 three months ended December 31, 2005, we had a current income
tax expense of $16.2 million and a deferred income tax benefit of $0.1 million resulting in a total income tax expense of $16.1 million.



Asset Sales



On November 18, 2005, we concluded 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).



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. 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
December 31, 2005 and September 30, 2004 was $4.1 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 $1.7 million to satisfy our workers compensation program requirements for our former insurance carrier. As of December 31, 2005, the surety bonds were collateralized by $1.5 million cash posted to
a third party escrow account. In January 2006, the insurance carriers reduced the loss fund by $0.3 million and refunded this amount to us. The surety bonds which collaterize this balance were also reduced by $0.3 million.



On January 1, 2006, we renewed our self-insured employee medical benefit
plans. Our claim experience during the three months ended December 31, 2005 improved measurably. As we move forward into 2006 we are making minor design changes to our benefit plans and analyzing the impact of the removal of the employees who
will be transitioning 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 December 31, 2005, 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



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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 condition or liquidity position.



Capital Resources



We intend to invest the excess 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.



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.



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 8).



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
December 31, 2005 and September 30, 2005 was approximately $1.7 million and $1.6 million, respectively.



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The following table represents a schedule of our contractual obligations and commitments as of
September 30, 2005:



|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|------------------------ |  | ------------------------------------- | ------ | --------------- | - | --------- |  | --------- | ----- | ---------------- | - | ----- |  | - | -----
|                         |  | Payments Due by Period (In thousands)
|                         |  | Total                                 |        | Less Than1 Year |   | 1-3 Years |  | 3-5 Years |       | More than5 Years
|Contractual Obligations: |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|Operating leases         |  |                                       | 13,012 |                 |   | 3,819     |  |           | 4,561 |                  |   | 2,769 |  |   | 1,863
|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      
|                         |  | $                                     | 13,012 |                 | $ | 3,819     |  | $         | 4,561 |                  | $ | 2,769 |  | $ | 1,863
|                         |  |                                       |        |                 |   |           |  |           |       |                  |   |       |  |   |      



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. We perform periodic evaluations of the relative credit standing of these financial institutions. As part of our corporate cash
management program we will be investing the retained proceeds from the sale of the Pharmacy business in accordance with established investment policies. We will be investing in a portfolio of highly liquid investment grade securities which may be
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.



(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.



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ITEM 6. EXHIBITS.



The
following exhibits are filed with this report:



|     |  |                                             
|---- |  | --------------------------------------------
|     | 
|31.1 |  | Rule 13a-14(a)/15d-14(a) Certification (CEO)
|     | 
|31.2 |  | Rule 13a-14(a)/15d-14(a) Certification (CFO)
|     | 
|32.1 |  | Section 1350 Certification (CEO)            
|     | 
|32.2 |  | Section 1350 Certification (CFO)            



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SIGNATURES



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



|                       |  |     |  |                                                                                                                                                   
|---------------------- |  | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|                       |  |     |  | PEDIATRIC SERVICES OF AMERICA, INC. (Registrant)                                                                                                  
|                       |  |    
|Date: February 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)



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