UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

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

 

For the quarterly period ended September 30, 2004March 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 No. 000-50364

 


 

The Providence Service Corporation

(Exact name of registrant as specified in its charter)

 


 

Delaware 86-0845127

(State or other jurisdiction of

of incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

5524 East Fourth Street,

Tucson, Arizona

 85711
(Address of principal executive offices) (Zip code)

 

(520) 747-6600

(Registrant’s telephone number, including area code)

 


 

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, as amended (the “Exchange Act”), 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.    x  Yes    ¨  No

 

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

 

As of November 8, 2004,May 2, 2005, there were outstanding 9,327,2119,442,269 shares (excluding treasury shares of 146,905) of the registrant’s Common Stock, $.001 par value per share.

 



TABLE OF CONTENTS

 


   Page

PART I—FINANCIAL INFORMATION

   

Item 1.Financial Statements

3

Condensed Consolidated Balance Sheets – September 30, 2004 (unaudited) and December 31, 2003

  3

Consolidated Balance Sheets – December 31, 2004 and March 31, 2005 (unaudited)

  3

Unaudited Condensed Consolidated Statements of Operations – Three and nine months ended September 30,March 31, 2004 and 20032005

  4

Unaudited Condensed Consolidated Statements of Cash Flows – NineThree months ended September 30,March 31, 2004 and 20032005

  5

Notes to Unaudited Supplemental Cash Flow InformationConsolidated Financial StatementsNine months ended September 30, 2004 and 2003March 31, 2005

  6

Notes to Unaudited Condensed Consolidated Financial Statements – September 30, 2004

7
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

  1511

Item 3.Quantitative and Qualitative Disclosures About Market Risk

  3324

Item 4.Controls and Procedures

  3424

PART II—OTHER INFORMATION

   

Item 1.Legal Proceedings

  3425

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

  3425

Item 3.Defaults Upon Senior Securities

  3525

Item 4.Submission of Matters to a Vote of Security Holders

  3525

Item 5.Other Information

  3525

Item 6.Exhibits

  3525

PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

The Providence Service Corporation

Condensed Consolidated Balance Sheets

 

  December 31
2003


 September 30
2004


   December 31,
2004


 March 31,
2005


  (Note 1) (Unaudited)   (Note 1) (Unaudited)

Assets

      

Current assets:

      

Cash and cash equivalents

  $15,004,235  $11,868,499   $10,657,483  $13,478,884

Accounts receivable, net of allowance of $69,000 and $1,162,000

   9,199,114   17,659,148 

Held-to-maturity investments

   3,972,560   —   

Accounts receivable, net of allowance of $221,000 and $156,000

   18,822,881   20,549,481

Management fee receivable

   3,577,287   4,709,032    5,023,405   5,054,787

Prepaid expenses and other

   946,131   2,381,999    3,533,311   3,519,171

Deferred tax asset

   617,444   617,444    474,760   474,760
  


 


  


 

Total current assets

   33,316,771   37,236,122    38,511,840   43,077,083

Property and equipment, net

   1,772,201   2,185,804    2,315,911   2,289,945

Note receivable from not-for-profit affiliate

   407,341   1,282,341 

Notes receivable

   1,282,341   1,282,341

Goodwill

   13,429,270   23,378,619    24,717,145   24,789,289

Intangible assets, net

   985,840   7,336,062    7,510,808   7,376,937

Deferred tax asset

   1,543,050   1,543,050    606,694   606,694

Other assets

   1,833,320   1,024,708    975,917   836,935
  


 


  


 

Total assets

  $53,287,793  $73,986,706   $75,920,656  $80,259,224
  


 


  


 

Liabilities and stockholders’ equity

      

Current liabilities:

      

Accounts payable

  $1,001,315  $1,281,168   $1,243,444  $1,871,617

Accrued expenses

   4,732,060   8,198,274    7,995,425   8,739,686

Deferred revenue

   —     1,206,889    948,434   548,740

Current portion of capital lease obligations

   88,597   102,254    102,507   95,686

Current portion of long-term obligations

   1,493,661   271,987    300,000   400,000
  


 


  


 

Total current liabilities

   7,315,633   11,060,572    10,589,810   11,655,729

Capital lease obligations, less current portion

   139,293   58,685    32,882   15,459

Long-term obligations, less current portion

   2,100,000   800,000    700,000   600,000

Stockholders’ equity:

      

Common stock: Authorized 40,000,000 shares; $0.001 par value; 8,481,839 and 9,472,161 issued and outstanding (including treasury shares)

   8,482   9,472 

Common stock: Authorized 40,000,000 shares; $0.001 par value; 9,486,879 and 9,558,886 issued and outstanding (including treasury shares)

   9,487   9,559

Additional paid-in capital

   51,772,612   65,617,627    65,731,824   67,027,505

Accumulated deficit

   (7,929,665)  (3,260,904)

Accumulated (deficit) earnings

   (844,601)  1,249,718
  


 


  


 

   43,851,429   62,366,195    64,896,710   68,286,782

Less 135,501 and 146,905 treasury shares, at cost

   118,562   298,746 

Less 146,905 treasury shares, at cost

   298,746   298,746
  


 


  


 

Total stockholders’ equity

   43,732,867   62,067,449    64,597,964   67,988,036
  


 


  


 

Total liabilities and stockholders’ equity

  $53,287,793  $73,986,706   $75,920,656  $80,259,224
  


 


  


 

 

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Operations

 

  

Three months ended

September 30


 

Nine months ended

September 30


   

Three months ended

March 31,


 
  2003

 2004

 2003

 2004

   2004

 2005

 

Revenues:

      

Home and community based services

  $10,872,170  $21,894,083  $30,958,479  $49,606,683   $12,973,947  $26,175,502 

Foster care services

   2,424,901   3,357,310   7,573,487   9,866,982    3,258,900   3,358,547 

Management fees

   1,537,097  ��2,967,973   4,396,467   7,879,309    2,221,814   2,499,210 
  


 


 


 


  


 


   14,834,168   28,219,366   42,928,433   67,352,974    18,454,661   32,033,259 

Operating expenses:

      

Client service expense

   11,393,736   20,599,525   33,015,337   49,440,665    13,749,970   24,175,298 

General and administrative expense

   1,547,648   3,618,523   4,384,361   9,026,457    2,563,194   3,959,277 

Depreciation and amortization

   202,328   433,927   688,063   910,160    228,162   370,535 
  


 


 


 


  


 


Total operating expenses

   13,143,712   24,651,975   38,087,761   59,377,282    16,541,326   28,505,110 
  


 


 


 


  


 


Operating income

   1,690,456   3,567,391   4,840,672   7,975,692    1,913,335   3,528,149 

Other (income) expense:

      

Interest expense

   393,037   98,504   1,516,656   326,217    118,555   85,551 

Interest income

   (12,475)  (43,188)  (29,283)  (131,525)   (41,900)  (47,933)

Write-off of deferred financing costs

   412,035   —     412,035   —   

Put warrant accretion

   630,762   —     630,762   —   

Equity in earnings of unconsolidated affiliate

   (22,508)  —     (156,559)  —   
  


 


 


 


  


 


Income before income taxes

   289,605   3,512,075   2,467,061   7,781,000    1,836,680   3,490,531 

Provision for income taxes

   122,255   1,404,670   962,154   3,112,240    734,672   1,396,212 
  


 


 


 


  


 


Net income

   167,350   2,107,405   1,504,907   4,668,760    1,102,008   2,094,319 

Preferred stock dividends

   3,555,814   —     3,749,013   —   
  


 


 


 


  


 


Net income (loss) available to common stockholders

  $(3,388,464) $2,107,405  $(2,244,106) $4,668,760 
  


 


 


 


Earnings (loss) per common share:

   

Earnings per common share:

   

Basic

  $(0.70) $0.22  $(0.73) $0.51   $0.13  $0.22 
  


 


 


 


  


 


Diluted

  $(0.70) $0.22  $(0.73) $0.50   $0.13  $0.22 
  


 


 


 


  


 


Weighted-average number of common shares outstanding:

      

Basic

   4,856,246   9,466,470   3,082,110   9,129,979    8,492,573   9,498,806 

Diluted

   4,856,246   9,584,133   3,082,110   9,265,621    8,785,917   9,659,489 

 

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Condensed Consolidated Statements of Cash Flows

 

  

Nine months ended

September 30


   

Three months ended

March 31,


 
  2003

 2004

   2004

 2005

 

Operating activities

      

Net income

  $1,504,907  $4,668,760   $1,102,008  $2,094,319 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

   

Adjustments to reconcile net income to net cash provided by operating activities:

   

Depreciation

   688,063   511,424    150,742   206,664 

Amortization

   —     398,736    77,420   163,871 

Amortization of deferred financing costs and discount on investment

   44,537   75,818    21,400   31,040 

Stock compensation

   131,018   128,995    43,158   —   

Write-off of deferred financing upon retirement of debt

   412,035   —   

Put warrant accretion

   630,762   —   

Equity in earnings of unconsolidated affiliate

   (156,559)  —   

Changes in operating assets and liabilities, net of effects of acquisitions:

      

Trade accounts receivable, net

   (2,647,812)  (4,228,617)   (1,785,165)  (1,726,600)

Management fee receivable

   (1,094,322)  (1,111,204)   498,087   (31,382)

Prepaid expenses and other

   (541,242)  (713,833)   (176,531)  122,082 

Accounts payable

   (668,744)  4,503    525,049   628,173 

Accrued expenses

   838,253   2,141,548    855,522   744,261 

Deferred revenue

   —     720,382    —     (399,694)
  


 


  


 


Net cash provided by (used in) operating activities

   (859,104)  2,596,512 

Net cash provided by operating activities

   1,311,690   1,832,734 

Investing activities

      

Purchase of property and equipment

   (824,058)  (624,252)   (130,256)  (180,698)

Acquisition of businesses, net of cash acquired

   (2,149,381)  (17,467,872)   (3,475,762)  (102,144)

Redemption (purchase) of held-to-maturity investments

   (3,955,760)  4,000,000 

Note receivable from unconsolidated affiliate

   —     (875,000)

Restricted cash for contract performance

   —     (613,325)

Distributions received from unconsolidated affiliate

   126,000   —   
  


 


  


 


Net cash used in investing activities

   (6,803,199)  (15,580,449)   (3,606,018)  (282,842)

Financing activities

      

Net payments on revolving note

   (3,289,304)  (21,674)   (93,661)  —   

Payments of capital leases

   (130,598)  (66,951)   (20,630)  (24,244)

Proceeds from common stock issued pursuant to stock option exercise, net

   —     887,762    44,649   1,295,753 

Proceeds from common stock offering, net

   36,816,617   12,649,064 

Payment of preferred stock dividends

   (1,071,187)  —   

Proceeds from long-term debt

   3,350,000   —   

Debt financing costs

   (136,782)  (100,000)

Public offering costs

   (84,214)  —   

Repayments of short-term debt

   —     (1,400,000)   (1,400,000)  —   

Repayments of long-term debt

   (12,727,265)  (2,100,000)   (2,100,000)  —   
  


 


  


 


Net cash provided by financing activities

   22,811,481   9,848,201 

Net cash provided by (used in) financing activities

   (3,653,856)  1,271,509 
  


 


  


 


Net change in cash

   15,149,178   (3,135,736)   (5,948,184)  2,821,401 

Cash at beginning of period

   1,019,171   15,004,235    15,004,235   10,657,483 
  


 


  


 


Cash at end of period

  $16,168,349  $11,868,499   $9,056,051  $13,478,884 
  


 


  


 


Supplemental cash flow information

   

Notes payable issued for acquisition of business

  $1,000,000  $—   
  


 


 

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Unaudited Supplemental Cash Flow Information

   Nine months ended
September 30


   2003

  2004

Supplemental cash flow information

        

Common stock issued for put warrant obligation

  $4,200,000  $—  
   

  

Common stock issued for mandatorily redeemable preferred stock

  $4,830,000  $—  
   

  

Conversion of convertible notes to former stockholders of acquired companies

  $2,400,947  $—  
   

  

Note payable for dividends

  $3,500,000   —  
   

  

Notes payable issued for acquisition of businesses

  $1,000,000  $1,000,000
   

  

Common stock issued for acquisitions

  $1,714,290  $—  
   

  

See accompanying notes to unaudited condensed consolidated financial statements

The Providence Service Corporation

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2004Notes to Unaudited Consolidated Financial Statements

March 31, 2005

 

1. Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements 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 Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. Operating results for the ninethree months ended September 30, 2004March 31, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004.2005.

 

The condensed consolidated balance sheet at December 31, 20032004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The condensed consolidated financial statements contained herein should be read in conjunction with the audited financial statements and notes included in The Providence Service Corporation’s annual report on Form 10-K for the year ended December 31, 2003.2004.

 

2. Summary of Significant Accounting Policies and Description of Business

 

Description of Business

 

The Providence Service Corporation (the “Company”) is a privatization company specializing in alternatives to institutional care. The Company responds to governmental privatization initiatives in adult and juvenile justice, corrections, social services, welfare systems, and education by providing home-based and community-based counseling services to at-risk families and children. These human services are purchased primarily by state, city, and county levels of government, and are delivered under contracts ranging from capitation to fee-for-service arrangements. The Company also contracts with not-for-profit organizations to provide management services for a fee. The Company operates primarily in Arizona, California, Delaware, Florida, Illinois, Indiana, Maine, Massachusetts, Michigan, Nebraska, Nevada, New Mexico, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, West Virginia, and the District of Columbia.

 

Cash Equivalents

Cash and cash equivalents include all cash balances and highly liquid investments with an initial maturity of three months or less. The Company places its temporary cash investments with high credit quality financial institutions. At times such investments may be in excess of the Federal Deposit Insurance Corporation (FDIC) insurance limit.

Restricted Cash

 

At December 31, 20032004 and September 30, 2004,March 31, 2005, the Company had $447,500 and $1.1 million$961,000 of restricted cash of which $272,500$786,000 and $885,825$961,000 was included in prepaid expenses and other for December 31, 2004 and March 31, 2005 and $175,000 was included in non-currentnoncurrent other assets for December 31, 2004 in the accompanying condensed consolidated balance sheets. The restricted cash serves as collateral for irrevocable standby letters of credit that provide financial assurance that the Company will fulfill its obligations with respect to certain contracts. At September 30, 2004,March 31, 2005, the cash was held in custody by the Bank of Tucson in the amount of $960,825 and by Key Bank in the amount of $100,000.Tucson. In addition, the cash is restricted as to withdrawal or use, and is currently invested in money market funds.

Impairment of Long-Lived Assets

 

Goodwill

The Company analyzes the carrying value of goodwill at the end of each fiscal year and between annual valuations if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying value. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. When determining whether goodwill is impaired, the Company compares the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying amount, including goodwill. The Company uses valuation techniques consistent with a market approach by deriving a multiple of the Company’s EBITDA (earnings before interest, taxes, depreciation and amortization) based on the market value of the Company’s common stock at year end and then applying this multiple to each reporting unit’s EBITDA for the year to determine the fair value of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of reporting unit goodwill to its carrying amount. In calculating the implied fair value of reporting unit goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. An impairment loss would be recognized when the carrying amount of goodwill exceeds its implied fair value. The Company’s annual evaluation of goodwill completed as of December 31, 2004 resulted in no impairment loss.

Intangible assets subject to amortization

 

In accordance with Statement of Financial Accounting Standards No. 141,Business Combinations(“SFAS No. 141”), the Company separately values all acquired identifiable intangible assets apart from goodwill. In connection with the Company’s recent acquisitions (described in note 3 below), theThe Company allocated a portion of the purchase consideration to certain management contracts and customer relationships acquired in 2004 based on the expected direct or indirect contribution to future cash flows over the useful life of the asset.

The Company assesses whether certain relevant factors limit the period over which an asset isacquired assets are expected to contribute directly or indirectly to future cash flows for amortization purposes. With respect to acquired management contracts, the useful life is limited by the stated terms of the agreements. The useful life of acquired customer relationships is generally limited by the terms and nature of the underlying contracts with state and local agencies to provide social services. The Company determines an appropriate useful life for acquired customer relationships based on the nature of the underlying contracts with state and local agencies and the likelihood that the underlying contracts to provide social services will renew over future periods. The likelihood of renewal is based on the Company’s contract renewal experience and the contract renewal experiences of entities it has acquired.

 

TheUnder certain conditions the Company periodically assessesmay assess the recoverability of the unamortized balance of its intangiblelong-lived assets based on expected future profitability and expected cash flows and their contribution to the Company’s overall operations.flows. Should the review indicate that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of the otherany intangible assets would beasset is recognized as an impairment loss.

 

Stock Compensation Arrangements

 

The Company follows the intrinsic value method of accounting for stock-based compensation plans. The following table reflects net income available to common stockholders and earnings per share had the Company’s stock options been accounted for using the fair value method:

   Three months ended
September 30


  Nine months ended
September 30


   2003

  2004

  2003

  2004

Net income (loss) available to common stockholders as reported

  $(3,388,464) $2,107,405  $(2,244,106) $4,668,760

Add—Recorded stock compensation, net of federal income tax benefit

   26,836   25,751   79,922(1)  77,397

Less—Estimated fair value of stock options assumed vested during the period, net of federal income tax benefit

   242,769   285,315   306,482(1)  692,243
   


 

  


 

Adjusted net income (loss) available to common stockholders

  $(3,604,397) $1,847,841  $(2,470,666)(1) $4,053,914
   


 

  


 

Earnings (loss) per share:

                

Basic—as reported

  $(0.70) $0.22  $(0.73) $0.51
   


 

  


 

Basic—as adjusted

  $(0.74) $0.20  $(0.80)(1) $0.44
   


 

  


 

Diluted—as reported

  $(0.70) $0.22  $(0.73) $0.50
   


 

  


 

Diluted—as adjusted

  $(0.74) $0.19  $(0.80)(1) $0.44
   


 

  


 


(1)During the nine months ended September 30, 2004, the following error was discovered and corrected. For the nine months ended September 30, 2003, the recorded stock compensation and estimated fair value of stock options assumed vested during the period were not presented net of federal income tax benefit in previously issued financial statements. The effect of this correction on the adjusted net income available to common stockholders for the nine months ended September 30, 2003 was an increase of $47,000. The effect on the basic and diluted—as adjusted earnings per share related to this correction was an increase of $0.02.
   

Three months ended

March 31,


   2004

  2005

Net income as reported

  $1,102,008  $2,094,319

Add—Employee stock-based compensation expense included in reported net income, net of federal income tax benefit

   25,895   —  

Less—Total employee stock-based compensation expense determined under fair value based method for all awards, net of federal income tax benefit

   214,826   559,457
   

  

Adjusted net income

  $913,077  $1,534,862
   

  

Earnings per share:

        

Basic—as reported

  $0.13  $0.22
   

  

Basic—as adjusted

  $0.11  $0.16
   

  

Diluted—as reported

  $0.13  $0.22
   

  

Diluted—as adjusted

  $0.10  $0.16
   

  

 

Reclassification

Certain amounts have been reclassified in prior periods in order to conform with the current period presentation.

3. Acquisitions

The following acquisitions have been accounted for using the purchase method of accounting and the results of operations are included in the Company’s condensed consolidated financial statements from the date of acquisition. The cost of these acquisitions has been allocated to the assets and liabilities acquired based on a preliminary evaluation of their respective fair values and may change when the final valuation of certain intangible assets is determined.

Effective January 1, 2004, the Company acquired the remaining 50% member interest in and became the sole member of Rio Grande Management Company, LLC, (“Rio Grande Management”), for cash of $820,000 which was prepaid in December 2003. Rio Grande Management was formed in September 2001 by the Company and the ten agencies whose members comprise the board of directors of Rio Grande Behavioral Health Services, Inc., a not-for-profit organization that provides community based social and mental health network services in New Mexico. As a result of this acquisition, the Company acquired the entire membership interest in Rio Grande Management which has a management agreement with the not-for-profit organization pursuant to which Rio Grande Management manages the not-for-profit organization’s operations in return for a fixed management fee per month.

The following represents the Company’s preliminary allocation of the purchase price:

Consideration:

    

Cash

  $820,000

Estimated costs of acquisition

   5,000
   

   $825,000
   

Allocated to:

    

Property and equipment

  $6,667

Intangibles

   326,000

Goodwill

   492,333
   

   $825,000
   

Currently, the above goodwill is expected to be tax deductible.

On January 1, 2004, the Company acquired all of the outstanding stock of Dockside Services, Inc. (“Dockside”) for cash of $3.4 million (less $300,000 which was placed into escrow as security for any working capital adjustments) and $1.0 million in promissory notes, for a total purchase price of $4.4 million. On August 6, 2004, the working capital adjustments were finalized resulting in an amount due to the Company of $27,930 which was received by the Company in September 2004. This acquisition expands the Company’s operations in the states of Indiana and Michigan.

The following represents the Company’s preliminary allocation of the purchase price:

Consideration:

    

Cash

  $3,400,000

Notes payable

   1,000,000

Estimated costs of acquisition

   44,123
   

   $4,444,123
   

Allocated to:

    

Property and equipment

  $28,984

Intangibles

   1,237,000

Goodwill

   3,178,139
   

   $4,444,123
   

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 15 years.

Currently, the above goodwill is not expected to be tax deductible.

On May 3, 2004, the Company acquired all of the outstanding stock of Pottsville Behavioral Counseling Group, Inc. (“Pottsville”), a Pennsylvania based social services provider, for cash in the amount of $1.8 million (less $184,000 which was placed into escrow as security for any working capital adjustments or any indemnification obligations). The acquisition of Pottsville expands the Company’s home and community based services into the Pennsylvania market.

The following represents the Company’s preliminary allocation of the purchase price:

Consideration:

    

Cash

  $1,840,000

Estimated costs of acquisition

   262,441
   

   $2,102,441
   

Allocated to:

    

Property and equipment

  $52,839

Intangibles

   33,000

Goodwill

   2,016,602
   

   $2,102,441
   

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 10 years.

Currently, the above goodwill is not expected to be tax deductible.Accounting Pronouncements

 

In conjunction with the acquisition of Pottsville, the Company entered into a management agreement with The ReDCo Group (“ReDCo”), a Pennsylvania not-for-profit social services organization, whereby the Company provides certain management services to ReDCo in return for a predetermined management fee.

Effective June 24,December 2004, the Company acquiredFinancial Accounting Standards Board, or FASB, finalized SFAS 123R, “Share-Based Payment”, effective for public companies for annual periods beginning after June 15, 2005. SFAS 123R requires all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value. Retroactive application of the rights under existing management agreementsrequirements of SFAS 123R is permitted, but not required. On April 15, 2005, the Securities and Exchange Commission (“SEC”) issued its final rule in Release No. 34-51558 regarding the compliance date for SFAS 123R related to public companies. The SEC has delayed the requirement for non-small business public companies to comply with Care Development of Maine (“CDOM”) and FCP, Inc. (“FCP”) from Care Development, Inc., a Maine not-for-profit corporation, for cash in the amount of $1.5 million. The Company anticipates paying an additional $1.5 million subject to a definitive agreement. CDOM and FCP are not-for-profit organizations providing foster care and community based services in the States of Maine and Massachusetts, respectively. The acquisition of the management agreements with these organizations expands the Company’s foster care and community based services in Maine and opens a new market in Massachusetts.

The cost of acquiring the management agreements with ReDCo, CDOM and FCP has been allocated to intangible assets as contract acquisition costs and is being amortized on a straight-line basis concurrent with the life of the agreements.

On July 21, 2004, the Company acquired all of the equity interests in Choices Group, Inc., Aspen MSO, LLC and College Community Services, a California mutual benefit corporation (collectively referred to as the “Aspen Companies”) for cash of $10.0 million ($1.0 million of which was placed into escrow as security for any indemnification obligations and any working capital adjustments). According to the provisions of SFAS 123R until the purchase agreement,first interim reporting period of the public company’s first fiscal year beginning on or after June 15, 2005. Accordingly, the Company plans to implement SFAS 123R beginning January 1, 2006 and is in the process of determining the affect this pronouncement will receive $2.0 million in working capital. The acquisition was retroactively effective as of July 1, 2004 in accordance with the terms of the purchase agreement. The acquisition of the Aspen Companies establishes operations in California and Nevada and adds drug court treatment tohave the Company’s array of social services.consolidated financial statements.

 

The following represents the Company’s preliminary allocation of the purchase price:3. Goodwill

 

Consideration:

    

Cash

  $10,000,000

Estimated costs of acquisition

   388,591
   

   $10,388,591
   

Allocated to:

    

Working capital

  $2,429,221

Property and equipment

   85,187

Other assets

   100,008

Intangibles

   3,511,900

Goodwill

   4,262,275
   

   $10,388,591
   

The amount allocated to intangibles represents acquired customer relationships. The Company valued customer relationships acquired in this acquisition based on expected future cash flows resulting from the underlying contracts with state and local agencies to provide social services. No significant residual value is estimated for these intangibles. Amortization of the acquired customer relationships will be recognized over an estimated useful life of 15 years.

In connection with the acquisition of the Aspen Companies, the Company acquired deferred revenue of $489,000 which represents funding for certain services in advance of services actually rendered. The Company has subsequently recognized additional deferred revenue of $410,000 for the three months ended September 30, 2004. These amounts are reflected as deferred revenue in the accompanying condensed consolidated balance sheets.

Currently, the Company is determining whether all or a portion of the goodwill is tax deductible.

Changes in goodwill were as follows:

 

Balance at December 31, 2003

  $13,429,270

Dockside acquisition

   3,178,139

Rio Grande Management acquisition

   492,333

Pottsville acquisition

   2,016,602

Aspen Companies acquisition

   4,262,275
   

Balance at September 30, 2004

  $23,378,619
   

Balance at December 31, 2004

  $24,717,145

Adjustment to costs of the Aspen Companies acquisition

   72,144
   

Balance at March 31, 2005

  $24,789,289
   

The following unaudited pro forma information presents a summary of the consolidated results of operations of the Company as if the acquisition of the Aspen Companies had occurred on January 1, 2003. The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transactions been effected on January 1, 2003.

   

Three months ended

September 30


  

Nine months ended

September 30


   2003

  2004

  2003

  2004

Revenue

  $20,521,354  $28,219,366  $59,989,991  $78,614,002

Net income (loss)

  $(412,535) $2,107,405  $(234,748) $4,472,333

Net income (loss) available to common stockholders

  $(3,968,349) $2,107,405  $(3,983,761) $4,472,333

Diluted earnings (loss) per share

  $(0.71) $0.22  $(1.05) $0.46

4. Long-Term Obligations

 

The Company’s long-term obligations were as follows:

 

   December 31
2003


  September 30
2004


6% unsecured notes to former stockholders of acquired company, interest payable quarterly beginning April 2004 with equal quarterly principal payments of $100,000 beginning April 2005 due July 2007

  $—    $1,000,000

4% subordinated note to stockholder, repaid in January 2004

   3,500,000   —  

$10,000,000 revolving note, prime plus 2% (effective rate of 6% at September 30, 2004) through December 2006, at which time the principal is due

   93,661   71,987
   

  

    3,593,661   1,071,987

Less current portion

   1,493,661   271,987
   

  

   $2,100,000  $800,000
   

  

In connection with the Company’s initial public offering, the Company agreed to pay Eos Partners SBIC, L.P. and Eos Partners SBIC II, L.P., the then holders of the Company’s mandatorily redeemable convertible preferred stock, a consent fee in the aggregate amount of $3.5 million. The consent fee was paid pursuant to subordinated notes which bore interest at the rate of 4% per annum. The notes were prepayable, without penalty, at any time by the Company and on January 27, 2004, the Company prepaid the entire outstanding balance and related accrued interest related to these subordinated notes.

   December 31,
2004


  March 31,
2005


6% unsecured notes to former stockholders of acquired company, interest payable quarterly beginning April 2004 with equal quarterly principal payments of $100,000 beginning April 2005 through July 2007

  $1,000,000  $1,000,000
   

  

    1,000,000   1,000,000

Less current portion

   300,000   400,000
   

  

   $700,000  $600,000
   

  

 

On January 9, 2003, the Company entered into a new loan and security agreement with Healthcare Business Credit Corporation, which provided for a $10.0 million revolving line of credit, a $10.0 million acquisition term loan, and a $1.0 million term loan. The amount the Company may borrow under the revolving line of credit is subject to the availability of a sufficient amount of eligible accounts receivable at the time of borrowing. Advances under the acquisition term loan are subject to the lender’s approval. Proceeds initially borrowed under the revolving line of credit portion of this new credit facility were used to repay and terminate the previous revolving line of credit with a former lender. Until its amendment in September 2003, the Company’s credit facility was secured by substantially all of the Company’s assets as well as certain of its managed entities’ assets.

On September 30, 2003, following the Company’s repayment of the $1.0 million term loan portion of the credit facility, the Company’s loan and security agreement was amended with respect to the remaining $10.0 million revolving line of credit and the $10.0 million acquisition term loan to release the not-for-profit organizations managed by the Company as co-borrowers under the loan and security agreement and extend the maturity date of the acquisition term loan through December 1, 2006. In addition, these not-for-profit organizations established separate stand-alone credit facilities. While the Company does not guarantee any portion of these stand-alone credit facilities, it has agreed to subordinate its management fee receivable in the event of a default under these stand-alone credit facilities. The provisions of the amended loan and security agreement with respect to the revolving line of credit remained the same as set forth in the original loan and security agreement described above. The Company is required to maintain certain financial covenants under the credit facility and, at December 31, 2003 and September 30, 2004, the Company was in compliance with such covenants.facility.

 

At September 30,December 31, 2004 and March 31, 2005, the Company’s available credit under the revolving line of credit was $10.0 million. The Company is required to pay a per annum unused facility fee of 0.5% for any unborrowed amounts under the revolving line of credit and acquisition term loan.

 

5. Common Stock

 

The Company adopted a second amended and restated certificate of incorporation and amended and restated bylaws commensurate with the consummation of the Company’s initial public offering on August 22, 2003. The Company’s second amended and restated certificate of incorporation provides that the Company’s authorized capital stock consists of 40,000,000 shares of common stock, $0.001 par value, and 10,000,000 shares of preferred stock, $0.001 par value. At December 31, 20032004 and September 30, 2004,March 31, 2005, there were 8,481,8399,486,879 and 9,472,1619,558,886 shares of the Company’s common stock outstanding (including 135,501 and 146,905 treasury shares) and no shares of preferred stock outstanding. On April 2, 2004,

During the three months ended March 31, 2005, the Company completed a follow-on offering ofgranted 385,000 ten year options under its 2003 stock option plan to directors, executive officers and key employees to purchase the Company’s common stock at exercise prices equal the market value of the Company’s common stock on the date of grant. The option exercise prices range from $19.60 to $22.89 and the options vest in connection with whichequal installments over time ranging from three to four years. During the Company sold 862,500 shares of common stock. In addition, during the ninethree months ended September 30, 2004,March 31, 2005, the Company issued 120,35827,230 shares of its common stock in connection with the exercise of employee stock options under the Company’s 1997 stock option and incentive plan, and 7,46444,777 shares of its common stock in connection with the exercise of employee stock options under the Company’s 2003 stock option plan.

6. Earnings Per Share

 

The following table details the computation of basic and diluted earnings (loss) per share:

 

   Three months ended
September 30


  Nine months ended
September 30


   2003

  2004

  2003

  2004

Numerator:

                

Net income

  $167,350  $2,107,405  $1,504,907  $4,668,760

Preferred stock dividends

   3,555,814   —     3,749,013   —  
   


 

  


 

Numerator for basic earnings (loss) per share—income (loss) available to common stockholders

   (3,388,464)  2,107,405   (2,244,106)  4,668,760

Numerator for diluted earnings (loss) per share—income (loss) available to common stockholders after assumed conversions

  $(3,388,464) $2,107,405  $(2,244,106) $4,668,760
   


 

  


 

Denominator:

                

Denominator for basic earnings (loss) per share—weighted-average shares

   4,856,246   9,466,470   3,082,110   9,129,979

Effect of dilutive securities:

                

Common stock options

   —     117,663   —     135,642
   


 

  


 

Dilutive potential common shares

   —     117,663   —     135,642
   


 

  


 

Denominator for diluted earnings (loss) per share—adjusted weighted-average shares and assumed conversion

   4,856,246   9,584,133   3,082,110   9,265,621
   


 

  


 

Basic earnings (loss) per share

  $(0.70) $0.22  $(0.73) $0.51
   


 

  


 

Diluted earnings (loss) per share

  $(0.70) $0.22  $(0.73) $0.50
   


 

  


 

   

Three months ended

March 31,


   2004

  2005

Numerator:

        

Net income

  $1,102,008  $2,094,319
   

  

Denominator:

        

Denominator for basic earnings per share—weighted-average shares

   8,492,573   9,498,806

Effect of dilutive securities:

        

Common stock options

   293,344   160,683
   

  

Denominator for diluted earnings per share—adjusted weighted-average shares assumed conversion

   8,785,917   9,659,489
   

  

Basic earnings per share

  $0.13  $0.22
   

  

Diluted earnings per share

  $0.13  $0.22
   

  

 

For the three and nine months ended September 30, 2004,March 31, 2005, employee stock options to purchase 185,000 and 190,0001,387 shares of common stock respectively, were not included in the computation of diluted earnings per share as the exercise price of these options was greater than the average fair value of the common shares for the respective periodsperiod and, therefore, the effect of these options would be antidilutive.

 

7. Income Taxes

 

The Company’s effective income tax rate for the interim periods is based on management’s estimate of the Company’s effective tax rate for the applicable year and differs from the federal statutory income rate primarily due to nondeductible permanent differences and state income taxes.

 

8. Commitments and Contingencies

 

The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.

 

The Company provides management services under long-term management agreements and has relationships with certain tax-exempt organizations under Section 501(c)(3) of the Internal Revenue Code. While recent actions of certain tax authorities have challenged whether similar relationships by other organizations may violate the federal tax-exempt status of not-for-profit organizations, management is of the opinion that its relationships with these tax-exempt organizations do not violate their tax-exempt status and any unfavorable outcomes would not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.

9. Transactions with Related Parties

 

In June 1999, the Company was issued a promissory note by a not-for-profit affiliate in the amount of $461,342. The note bears interest at a rate of 9% per annum and was due in June 2004. On February 20, 2003, a new promissory note in the same amount was issued by the not-for-profit affiliate which extends the due date for repayment of principal and unpaid accrued interest to February 2008 and lowers the interest rate to 5% per annum. Interest income of $5,092 was recorded for the three months ended March 31, 2004 and 2005. The balance of the note at December 31, 2004 and March 31, 2005 was $407,341 and is reflected in the accompanying consolidated balance sheets as “Notes receivable”.

In connection with the acquisition of Pottsville Behavioral Counseling Group, Inc. and the establishment of a management agreement with The ReDCo Group (“ReDCo”), in May 2004, the Company loaned $875,000 to ReDCo to fund certain long-term obligations of the entityReDCo in exchange for a promissory note for the same amount. The note assumes interest equal to a fluctuating interest rate per annum based on a weighted-average of the daily Federal Funds Rate. The terms of the promissory note require ReDCo to make quarterly interest payments over twenty-one months commencing June 30, 2004 with the principal and any accrued and unpaid interest due upon maturity on March 31, 2006. Interest income of $0 and $5,401 was recorded for the three months ended March 31, 2004 and 2005, respectively. The promissory note is collateralized by a subordinated lien to ReDCo’s primary lender on substantially all of ReDCo’s assets. At December 31, 2004 and March 31, 2005, the balance of the note was $875,000 and is reflected in the accompanying consolidated balance sheet as “Notes receivable”.

Beginning in 2004, the Company began using an airplane operated by Las Montanas Aviation, LLC for business travel purposes on an as needed basis. Las Montanas Aviation, LLC is owned by Mr. McCusker, the Company’s chief executive officer. The Company reimburses Las Montanas Aviation, LLC for the actual cost of use currently equal to $1,095 per flight hour. For the three months ended March 31, 2005, the Company reimbursed Las Montanas Aviation, LLC $11,936 for use of the airplane for business travel purposes.

 

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

 

Overview of our business

 

We provide government sponsored social services directly and through not-for-profit social services organizations whose operations we manage. As a result of, and in response to, the large and growing population of eligible beneficiaries of government sponsored social services, increasing pressure on governments to control costs and increasing acceptance of privatized social services, we have increased our capacity to provide services in previously underserved geographic areas through the development of new programs and by consummating strategic acquisitions. As of September 30, 2004,March 31, 2005, we provided services directly and through the entities we manage to over 27,70031,000 clients from 153160 locations in 21 states and the District of Columbia. Our goal is to be the provider of choice to the social services industry. Focusing on our core competencies in the delivery of home and community based counseling, foster care and provider managed services, we believe we are well positioned to offer the highest quality of service to our clients and provide a viable alternative to state and local governments’ current service delivery systems.

 

Our industry is highly fragmented, competitive and dependent on government funding. We depend on our experience, financial strength and broad presence to compete vigorously in each service offering. Challenges for us include competing with local incumbent social services providers in some of the areas we seek to enter and in rural areas where significant growth opportunities exist, finding and retaining qualified employees. We seek strategic acquisitions as one way to enter competitive markets.

 

Our business is highly dependent on our obtaining contracts with government sponsored entities. When we are awarded a contract to provide services, we may incur expenses such as leasing office space, purchasing office equipment and hiring personnel before we receive any contract payments, and, under some of the large contracts we are awarded, we are required to invest significant sums of money before receiving any contract payments. We are also required to recruit and hire qualified staff to perform the services under contract. We strive to control these start-up costs by leveraging our existing infrastructure to maximize our resources and manage our growth effectively. However, with each contract we are awarded, we face the challenge of quickly and effectively building a client base to generate revenue to recover these costs.

 

On August 22, 2003, we completed our initial public offering of common stock in connection with which we sold 3.0 million shares at an offering price of $12.00 per share. Additionally, on September 10, 2003, our underwriters exercised their over-allotment option pursuant to which we sold another 645,000 shares at an offering price of $12.00 per share. We received net proceeds of approximately $36.2 million after deducting the underwriting discounts and offering costs. On April 2, 2004, we completed a follow-on offering of common stock in connection with which we sold 862,500 shares at an offering price of $15.75 including an over-allotment of 112,500 shares exercised by our underwriters on that day. We received net proceeds of approximately $12.2 million after deducting the underwriting discounts and offering costs.

Prior to our initial public offering in 2003, we were largely funded by venture capital and mezzanine debt. We used proceeds from our initial public offering to pay off our then existing long-term debt. Our working capital requirements are now primarily funded by cash from operations. In addition, we have a $10.0 million revolving line of credit and a $10.0 million acquisition term loan with Healthcare Business Credit Corporation or HBCC. Proceeds from our initial public offering and follow-on offering as well as our credit facilities with HBCC provide funding for general corporate purposes and potential acquisitions.

How we earn our revenue

 

Our revenue is derived from our provider contracts with state and local government agencies and government intermediaries and from our management contracts with not-for-profit social services organizations. The government entities that pay for our services include welfare, child welfare and justice departments, public schools and state Medicaid programs. Under a majority of the contracts where we provide services directly, we are paid an hourly fee. In other such situations, we receive a set monthly amount.amount or we are paid amounts equal to the costs we incur to provide agreed upon services. These revenues are presented in our financial statements as either revenue from home and community based services or foster care services.

Where we contract to manage the operations of not-for-profit social services organizations, we receive a management fee that is either based upon a percentage of the revenue of the managed entity or a predetermined fee. These revenues are presented in our financial statements as management fees. Because we are responsible forprovide substantially all of the business operations ofadministrative functions for these entities and our management fees are largely dependent upon their revenues, we also monitor for management and disclosure purposes the revenues of our managed entities. We refer to the revenues of these entities as managed entity revenue. In addition, from time to time, we provide short-term consulting services to other social services organizations for which we receive consulting fees that are a fixed amount per contract. Any such consulting revenues are presented in our statement of operations as management fees.

 

How we grow our business and evaluate our performance

 

Our business grows internally, through organic expansion into new markets and increases in the number of clients served underpursuant to contracts we or our managed entities are awarded, and externally through acquisitions.

 

We typically pursue organic expansion into markets that are contiguous to our existing markets or where we believe we can quickly establish a significant presence. In January 2004, Camelot Community Care, Inc., one of the not-for-profit entities we manage, was awarded a contract by the Florida Department of Children and Families pursuant to Florida’s Community Based Care Initiative, to provide home and community based social services in the Fort Myers area. The term of the contract is February 1, 2004 through June 30, 2008, and provides for contract payments of up to $22.0 million per year, or $97.5 million over the term. Our management fee in relation to this contract is 10% of Camelot Community Care’s revenue from the contract after deducting pass through costs. When we expand organically, we typically have no clients or perform no management services in the market and are required to incur start-up costs, including the costs of space, required permits and initial personnel. These costs are expensed as incurred, and our new offices can be expected to incur losses for a period of time until we adequately grow our revenue from clients or management fees.

 

As an alternative to organic expansion, weWe also pursue strategic acquisitions in markets where we see opportunities but where we lack the contacts and/or personnel to make a successful organic entry. During the nine months ended September 30, 2004, through our acquisitions (described below), we enhanced our presence in Indiana, Maine, Michigan and New Mexico and entered new markets in California, Massachusetts, Nevada and Pennsylvania. Unlike organic expansion which involves start-up costs that may dilute earnings, expansion through acquisitions is generally accretive to our earnings. However, we bear financing risk and where debt is used, the risk of leverage in expanding through acquisitions. We also have to integrate the acquired business into our operations, which could disrupt our business, and we may not be able to realize operating and economic efficiencies upon integration.

 

In all our markets, we focus on several key performance indicators in managing our business. Specifically, we focus on growth in the number of clients served, as that particular metric is the key driver of our revenue growth. We also focus on the number of employees, as that is our most important variable cost and the key to theour management of our margins.

Acquisitions

 

Since December 31, 2003, we have completed the following acquisitions:

On January 1, 2004, we acquired all of the outstanding stock of Dockside Services, Inc., or Dockside, an Indiana based provider of youth services, for cash in the amount of $3.4 million and two subordinated promissory notes each in the principal amount of $500,000, for aggregate consideration of $4.4 million. This acquisition expands our home and community based counseling operations in the states of Indiana and Michigan.

Effective January 1, 2004, we acquired the remaining 50% membership interest in Rio Grande Management Company, LLC, or Rio Grande Management, for cash in the amount of $820,000 which was prepaid in December 2003. Rio Grande Management was originally formed in September 2001, with us owning 50% of its membership interest and the ten agencies whose members comprise the board of directors of Rio Grande Behavioral Health Services, Inc., a not-for-profit social services provider, collectively owning the remaining 50% membership interest. Rio Grande Behavioral Health Services provides community based social and mental health network services in New Mexico, and Rio Grande Management manages those operations in return for a fixed management fee per month. By acquiring the interests of our co-venturers, we now own 100% of the membership interest of Rio Grande Management which maintains a management agreement with Rio Grande Behavioral Health Services.

On May 3, 2004, we acquired all of the outstanding stock of Pottsville Behavioral Counseling Group, Inc., or Pottsville, a Pennsylvania based provider of screening and assessment services to Medicaid eligible children and youth, for a purchase price of cash in the amount of $1.8 million. In conjunction with this acquisition, the Company entered into a management agreement with The ReDCo Group or ReDCo, a Pennsylvania not-for-profit social services organization pursuant to which we provide certain management services to ReDCo in return for a predetermined management fee. The Pottsville acquisition and the new management agreement with ReDCo provide us with a long-term entry into the Pennsylvania social services market.

Effective June 24, 2004, we acquired all of the rights under existing management agreements with Care Development of Maine, or CDOM, and FCP, Inc., or FCP, from Care Development, Inc., a Maine not-for-profit corporation, for cash in the amount of $1.5 million. We anticipate paying an additional $1.5 million subject to a definitive agreement. CDOM and FCP are not-for-profit organizations providing foster care and community based services in the State of Maine and Commonwealth of Massachusetts. The acquisition of the management agreements with these organizations expands our foster care and community based services in Maine and opens a new market in Massachusetts.

On July 21, 2004, we acquired all of the equity interests in Choices Group, Inc., Aspen MSO, LLC and College Community Services, a California mutual benefit corporation, which we collectively refer to as the Aspen Companies, for cash of $10.0 million ($1.0 million of which was placed into escrow as security for any indemnification obligations and any working capital adjustments). According to the provisions of the purchase agreement, we will receive $2.0 million in working capital. The acquisition was retroactively effective as of July 1, 2004 in accordance with the terms of the purchase agreement. The acquisition of the Aspen Companies establishes operations in California and Nevada and adds drug court treatment to our array of social services.

We continue to selectively identify and pursue attractive acquisition opportunities and have developed a pipeline of potential acquisition candidates. There are no assurances, however, that we will complete acquisitions in the future or that any completed acquisitions will prove profitable for us.

Critical accounting policies and estimates

 

General

 

In preparing our financial statements in accordance with accounting principles generally accepted in the United States we are required to make estimates and judgments that affect the amounts reflected in our financial statements. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. However, actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are those policies most important to the portrayal of our financial condition and results of operations. These policies require management’s most difficult, subjective or complex judgments, often employing the use of estimates about the effect of matters inherently uncertain. Our most critical accounting policies pertain to revenue recognition, the allowance for doubtful accounts receivable, accounting for business combinations, goodwill and other intangible assets, and our management contract relationships.

 

Revenue recognition

 

We recognize revenue at the time services are rendered at the amounts stated in our contracts and when the collection of these amounts is considered to be probable.

 

At times we may receive funding for certain services in advance of services actually being rendered. These amounts are reflected in the accompanying condensed consolidated balance sheets as deferred revenuesrevenue until the actual services are rendered.

 

As services are rendered, documentation is prepared describing each service, time spent, and billing code under each contract to determine and support the value of each service provided. This documentation is used as a basis for billing under our contracts. The billing process and documentation submitted under our contracts vary among our payers. The timing, amount and collection of our revenues under these contracts are dependent to a great extent, upon our ability to comply with the various billing requirements specified by each payer. Failure to comply with these requirements could delay the collection of amounts due to us under a contract or result in adjustments to amounts originally due under a contract.billed.

 

The performance of our contracts is subject to the condition that sufficient funds are appropriated, authorized and allocated by each state, city or other local government. If sufficient appropriations, authorizations and allocations are not provided by the respective state, city or other local government, we are at risk of immediate termination or renegotiation of the financial terms of our contract. See “Liquidity and capital resources—Management agreements.”

 

Fee-for-service contracts. Revenues related to services provided pursuant tounder fee-for-service contracts are recognized as revenue at the time services are rendered and collection is determined to be probable. Such services are provided at established billing rates. Fee-for-service contracts represented approximately 70.7%73.4% and 67.5%64.1% of our revenue for the ninethree months ended September 30, 2003March 31, 2004 and 2004.2005.

 

Cost based service contracts. As a result of the acquisition of the Aspen Companies, we acquiredRevenues from our cost based service contracts where revenue isare generally recorded at one-twelfth of the annual contract amount less allowances for certain contingencies such as budgetedprojected costs not incurred, excess cost per service over the allowable contract rate per contract andand/or insufficient encounters. The annual contract amount is based on projected costs to provide services under the contracts with adjustments for changes in the total contract amount. Annually, we submittedWe annually submit projected costs for the coming year which assist the contracting payers in establishing the annual contract amount to be paid for services provided under the contracts. After June 30, which is the contracting payers’ year end, we submit a cost reportreports which isare used by the contracting payers to determine the amount, if any, by which funds paid to us for services provided under the contracts were greater than the allowable costs to provide these services. In cases where funds paid to us exceed the allowable costs to provide services under contract, we may be required to pay back the excess funds.

Our cost reports are routinely audited on an annual basis. We periodically review our provisional billing rates and allocation of costs and provide for estimated adjustments from the contracting payers. We believe that adequate provisions have been made in our consolidated financial statements for any adjustments that might result from the outcome of any cost report audits. Differences between the amounts provided and the settlement amounts are recorded in our consolidated statement of operations in the year of settlement. The Aspen Companies’ costCost based service contracts represented approximately 7.7%0.0% and 17.7% of our revenue for the ninethree months ended September 30, 2004.March 31, 2004 and 2005.

 

Case rate contract. Prior to July 1, 2004, we provided services under one contract underpursuant to which we received a predetermined amount per month for a specified number of eligible beneficiaries. Under this contract, referred to as a case rate contract, we received the established amount regardless of the level of services provided to the beneficiaries during the month and thus recognized this contractual rate as

revenue on a monthly basis. To the extent we provided services that exceeded the contracted revenue amounts, we requested the payer to reimburse us for these additional costs. Historically, the payer had reimbursed us for all such excess costs although it had no ongoing contractual obligation to do so under the case rate contract. Consequently, we did not recognize thesethe excess cost amounts as amounts received in excess of our contracted rates, or additional revenue until the payer actually reimbursed us for such amounts or entered into an agreement contractually committing the payer to pay us the particular amount recognized and collection of such amount was determined to be probable.

 

CommencingEffective July 1, 2004, we began operating under revised terms of the case rate contract. The revised terms provided for the modification of the contract from a case rate contractwas amended to be an annual block contract where we receive and recognize as revenuepurchase contract. In exchange for one-twelfth of the established annual contract amount each month, regardlessthe agreement specifies that we are to provide or arrange for behavioral health services to eligible populations of beneficiaries as defined in the contract. We must provide a complete continuum of services including but not limited to intake, assessment, eligibility, case management and therapeutic services. There is no contractual limit to the number of eligible beneficiaries that may be assigned to us, or a limit to the level of services that must be provided to these beneficiaries. Therefore, we are at-risk if the beneficiaries duringcosts of providing necessary services exceed the month. In addition,associated reimbursement.

We are required to regularly submit service encounters to the annual contract amount we receivepayer electronically. On an on-going basis and at the end of the payer’s June 30 fiscal year, the payer is obligated to monitor the level of service encounters. If at any time the encounter data is not sufficient to support the year-to-date payments made to us, the payer has the right to prospectively reduce or suspend payments to us.

We recognize revenue from this contract was increased by $2.5 million,equal to the lesser of a specified encounter value, which represents the actual level of services rendered, or 25%,the contract amount. For the nine months ended March 31, 2005, revenues under the annual block purchase contract totaled $9.5 million. The payer has not reduced or suspended payments to enhanceus. We believe that our service offeringsencounter data is sufficient to a specialized child welfare population which historically represented a significant portion of our costshave earned all amounts paid to provide servicesus under thisthe amended contract.

The terms of the contract willmay be reviewed quarterlyprospectively and amended as necessary to ensure adequate funding of our service offerings under the contract. Our revenues under the previous case rate contract and since July 1,for the three months ended March 31, 2004 represented 14.6% of our total revenues. Our revenues under the annual block contract and for the three months ended March 31, 2005, represented 19.1% and 13.1%10.4% of our total revenues for the nine months ended September 30, 2003 and 2004.revenues.

 

Management agreements. We maintain management agreements with a number of not-for-profit social services organizations whereby we provide certain management services for these organizations. In exchange for our services, we receive a management fee that is either based on a percentage of the revenues of these organizations or a predetermined fee. Management fees earned under our management agreements represented approximately 10.2%11.0% and 10.8%7.8% of our revenue for the ninethree months ended September 30, 2003March 31, 2004 and 2004.2005.

 

We recognize management fee revenues from our management agreements as such amounts are earned, as defined by the respective management agreement, and collection of such amount is considered probable. We assess the likelihood of whether any of our management fee revenues may need to be returned to help our managed entities fund their working capital needs over the average duration of the entities’ existing contracts with their customers.needs. If the likelihood is other than remote, we will defer the recognition of all or a portion of the management fees received. To the extent we choose to defer management fees as a means of funding any of our managed entities’ losses from operations, such amounts are recorded as a reduction of management fee revenues and are not recognized as management fee revenues until they are ultimately collected from the operating income of the not-for-profit entities.

 

Consulting agreements. We have, commencing in December 2003, enteredFrom time to time we may enter into consulting agreements with other entities that provide government sponsored social services, to, among other things,services. Under the agreements, we evaluate and make recommendations with respect to their management, administrative and operational services, and weservices. We may continue such practiceto enter into consulting agreements on a small scale in the future. In exchange for these consulting services, we receive a fixed fee that is either payable upon completion of the services or on a monthly basis. These consulting agreements rangeare generally short-term in duration from one month to five monthsnature and are subject to termination by either party at any time, for any reason, upon advance written notice. Revenues related to these services are recognized at the time such consulting services are rendered and collection is determined to be probable. Management feesFees earned pursuant to our consulting agreements represented approximately 0.9%1% of our revenue for the nine

three months ended September 30,March 31, 2004.

No such fees were earned for the three months ended March 31, 2005.

The costs associated with generating our management fee revenues are accounted for in client service expense and in general and administrative expense in our condensed consolidated statements of operations.

The Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, or SAB 101, as amended by SAB 104, which requires that four basic criteria be met before recognizing revenue: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed and determinable, and collectibility is reasonably assured. We believe our revenue recognition principles are consistent with the guidance set forth in SAB 101, as amended by SAB 104.

 

Allowance for doubtful accounts receivable

 

We evaluate the collectibility of our accounts receivable on a monthly basis. We determine the appropriate allowance for doubtful accounts based upon specific identification of individual accounts and review of aging trends. Any account receivable older than 365 days is automatically deemed uncollectible. See “—Liquidity and capital resources—Management agreements.”

 

In circumstances where we are aware of a specific payer’s inability to meet its financial obligation to us, we record a specific addition to our allowance for doubtful accounts to reduce the net recognized receivable to the amount we reasonably expect to collect. If the financial condition of our payers were to deteriorate, further additions to our allowance for doubtful accounts may be required.

 

As a result of our acquisition of the Aspen Companies, we acquired cost based service contracts where revenues and accounts receivable are recorded at established billing rates or at the amounts realizable under these contracts. Amounts are currently based on provisional rates and allocation of contract costs to appropriate reimbursement sources that are adjusted retroactively based on annual costs reports filed by us with the contracting payers. The cost reports filed by us with the contracting payers are audited annually. We periodically review our provisional billing rates and allocation of costs and provide for estimated adjustments from the contracting payers. At the time of the acquisition, the Aspen Companies had provided for approximately $1.1 million for doubtful accounts receivable which added to our allowance for doubtful accounts receivable in consolidation. We believe that adequate provisions have been made in our condensed consolidated financial statements for any adjustments that might result from the outcome of any cost report audits.

Our write-off experience for the ninethree months ended September 30, 2003March 31, 2004 and 20042005 was less than 1% of revenue.

 

Accounting for business combinations, goodwill and other intangible assets

 

GoodwillWe analyze the carrying value of goodwill at the end of each fiscal year and intangible assets represent the excess of consideration given overbetween annual valuations if events occur or circumstances change that would more likely than not reduce the fair value of tangible net assets acquired. Certain assumptions and estimatesthe reporting unit below its carrying value. Such circumstances could include, but are employednot limited to: (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. When determining whether goodwill is impaired, we compare the fair value of assets acquired, includingthe reporting unit to which the goodwill and other intangible assets. We adopted Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets, or SFAS No. 142, on July 1, 2001, which discontinued the amortization of goodwill and indefinite life intangibles and requires an annual test of impairment based on a comparison of fair values to carrying values. The evaluation of impairment under SFAS No. 142 requires the use of numerous subjective projections, estimates and assumptions asis assigned to the future performance of the operations. Our determination of fairreporting unit’s carrying value, for purposes of our impairment analysis is based onincluding goodwill. We use valuation techniques consistent with a market approach by deriving a multiple of cash flows.

Actual results could differ from projections resulting in a revisionour EBITDA (earnings before interest, taxes, depreciation and amortization) based on the market value of our assumptionscommon stock at year end and if required, recognizing an impairment loss. We analyze our goodwillthen applying this multiple to each reporting unit’s EBITDA for impairment annually, or more often if events or circumstances arise that indicate that it is more likely than not thatthe year to determine the fair value of the reporting unit. If the carrying value of oura reporting unit exceeds its fair value, then the amount of the impairment loss is measured. The impairment loss would be calculated by comparing the implied fair value of reporting unit goodwill to its carrying value. In calculating the implied fair value of reporting unit goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. An impairment loss would be recognized when the carrying value of goodwill exceeds its implied fair value. We test forOur evaluation of goodwill impairment as of our fiscal year end. We performed the annual impairment testcompleted as of December 31, 2003. The results of this test determined there was2004 resulted in no goodwill impairment.

impairment losses.

In accordance with SFAS No. 141,Business Combinations,When we consummate an acquisition we separately value all acquired identifiable intangible assets apart from goodwill.goodwill in accordance with SFAS No. 141. In connection with our recent acquisitions, (described above), we allocated a portion of the purchase consideration to certain management contracts and customer relationships based on the expected direct or indirect contribution to future cash flows over the useful life of the asset.assets.

 

We assess whether certain relevant factors limit the period over which an asset isacquired assets are expected to contribute directly or indirectly to future cash flows for amortization purposes. With respect to acquired management contracts the useful life is limited by the stated term of the agreement. The useful life of acquired customer relationships is generally limited by the terms and nature of the underlying contracts with state and local agencies to provide social services. We determine an appropriate useful life for acquired customer relationships based on the nature of the underlying contracts with state and local agencies and the likelihood that the underlying contracts to provide social services will renew over future periods. The likelihood of renewal is based on our contract renewal experience and the contract renewal experiences of the entities we have acquired.

 

We periodicallyUnder certain conditions we may assess the recoverability of the unamortized balance of our intangiblelong-lived assets based on expected future profitability and expected cash flows and their contribution to our overall operations.flows. If the review indicates that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of the other intangible assets would beany long-lived asset is recognized as an impairment loss.

Accounting for management agreement relationships

 

Due to the nature of our business and the requirement or desire by certain payers to contract with not-for-profit social services organizations, we sometimes enter into management contracts with not-for-profit social services organizations where we provide them with business development, administrative, program and other management services. These not-for-profit organizations contract directly or indirectly with state and local agencies to supply a variety of community based mental health and foster care services to children and adults. Each of these organizations is separately incorporated and organized with its own independent board of directors.

 

Our management agreements with these not-for-profit organizations:organizations generally:

 

require us to provide management, accounting, advisory, supportive, consultative and administrative services to these organizations;services;

 

require us to provide the necessary resources to effectively manage the business and services of the not-for-profit organizations;provided;

 

require that we hire, supervise and terminate personnel, review existing personnel policies and assist in adopting and implementing progressive personnel policies such as employee enrichment programs; and

 

compensate us with a management fee in exchange for the services provided under these management agreements.provided.

 

All of our management services are subject to the approval or direction of the managed entities’ board of directors.

 

The accounting for our relationships with these organizations is based on a number of judgments regarding certain facts related to the control of these organizations and the terms of our management agreements. Any significant changes in the facts upon which these judgments are based could have a significant impact on our accounting for these relationships. We have concluded that our management agreements do not meet the provisions of Emerging Issues Task Force 97-2, “Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain other Entities with Consolidated Management Agreements,” or the provisions of the Financial Accounting Standards Board Interpretation No. 46,46(R), “Consolidation of Variable Interest Entities,”Entities”, as revised, or Interpretation No. 46,46(R), thus the operations of these organizations are not consolidated with our operations. We will evaluate the impact of the provisions of Interpretation No. 46,46(R), if any, on future acquired management agreements.

Results of operations

 

The following table sets forth the percentage of consolidated total revenues represented by items in our consolidated statements of operations for the periods presented:

  

Three months ended

September 30


 Nine months ended
September 30


   Three months ended
March 31,


 
  2003

 2004

 2003

 2004

   2004

 2005

 

Revenues:

      

Home and community based services

  73.3% 77.6% 72.1% 73.7   70.3% 81.7%

Foster care services

  16.3  11.9  17.7  14.6   17.7  10.5 

Management fees

  10.4  10.5  10.2  11.7   12.0  7.8 
  

 

 

 

  

 

Total revenues

  100.0  100.0  100.0  100.0   100.0  100.0 

Operating expenses:

      

Client service expense

  76.8  73.0  76.9  73.4   74.5  75.5 

General and administrative expense

  10.4  12.8  10.2  13.4   13.9  12.4 

Depreciation and amortization

  1.4  1.6  1.6  1.4   1.2  1.1 
  

 

 

 

  

 

Total operating expenses

  88.6  87.4  88.7  88.2   89.6  89.0 
  

 

 

 

  

 

Operating income

  11.4  12.6  11.3  11.8   10.4  11.0 

Non-operating (income) expense:

   

Non-operating expense:

   

Interest expense, net

  2.6  0.2  3.5  0.3   0.4  0.1 

Write-off of deferred financing costs

  2.8  —    1.0  —   

Put warrant accretion

  4.3  —    1.5  —   

Equity in earnings of unconsolidated affiliate

  (0.2) —    (0.4) —   
  

 

 

 

  

 

Income before income taxes

  1.9  12.4  5.7  11.5   10.0  10.9 

Provision for income taxes

  0.8  4.9  2.2  4.6   4.0  4.4 
  

 

 

 

  

 

Net income

  1.1% 7.5% 3.5% 6.9%  6.0% 6.5%
  

 

 

 

  

 

 

Three months ended September 30, 2004March 31, 2005 compared to three months ended September 30, 2003March 31, 2004

 

Revenues

 

  

Three months ended

September 30


  

Percent

change


   

Three months ended

March 31,


  

Percent

change


 
  2003

  2004

    2004

  2005

  

Home and community based services

  $10,872,170  $21,894,083  101.4%  $12,973,947  $26,175,502  101.8%

Foster care services

   2,424,901   3,357,310  38.5%   3,258,900   3,358,547  3.1%

Management fee

   1,537,097   2,967,973  93.1%   2,221,814   2,499,210  12.5%
  

  

     

  

   

Total revenue

  $14,834,168  $28,219,366  90.2%  $18,454,661  $32,033,259  73.6%
  

  

     

  

   

 

Home and community based services. In January 2004, we consummated theThe acquisition of Dockside from which we expect to add approximately $2.4 million of home and community based services revenue for the year ending December 31, 2004. We added 193 clients as a result of this acquisition and also positioned ourselves for cross selling of foster care services and expansion into other marketsPottsville Behavioral Counseling Group, Inc., or Pottsville, in the states of Indiana and Michigan. For the three months ended September 30,May 2004 Dockside contributed $815,000 to our home and community based services revenue. In addition, we have been awarded contracts to perform home and community based services in Fort Pierce and West Palm Beach, Florida, which we expect will collectively add approximately $5.8 million of annual revenue once the contracts are fully operational, with an estimated $4.4 million contribution to home and community based revenue for the year

ending December 31, 2004. Collectively, these contracts yielded $1.5 millionprovided $540,000 in home and community based services revenue for the three months ended September 30, 2004. Furthermore, in May 2004, we completed the acquisition of Pottsville from which we expect to add approximately $1.5 million of home and community based services revenue for the year ending DecemberMarch 31, 2004.2005. We added 257 clients as a result of this acquisition and entered into the Pennsylvania market. ForThe acquisition of the three months ended September 30,Aspen Companies, in July 2004, Pottsville added $481,000 to ourcontributed $5.7 million in home and community based services revenue. Finally, we completed the acquisition of the Aspen Companies on July 21, 2004 from which we expect to add approximately $5.6 million of home and community based services revenue for the remainder of 2004.three months ended March 31, 2005. We added approximately 5,000 clients as a result of this acquisition and entered into the California and Nevada markets. ForIn addition, start up services in the three months ended September 30,District of Columbia which began in June 2004 the Aspen Companies provided $5.2 million ofyielded additional home and community based services revenue.

revenue of approximately $840,000 for the three months ended March 31, 2005. Excluding the acquisition of Dockside, Pottsville the Fort Pierce and West Palm Beach contracts and the Aspen Companies and start up services in the District of Columbia, our home and community based services provided additional revenue of approximately $3.0$6.1 million for the three months ended September 30, 2004March 31, 2005, as compared to the same prior year period due to client censusvolume increases in new and existing locations. We experienced a net increase of approximately 1,5001,600 new home and community based clients during the three months ended September 30, 2004March 31, 2005 as compared to the same period last year,in 2004, with increases at our existing locations and as a result of the new locations that we opened in Indiana, North Carolina, Tennessee and Tennessee.Virginia.

Foster care services. Foster care services revenue contributed an additional $932,000 to total revenueremained relatively constant with only a moderate increase of approximately $100,000 for the three months ended September 30, 2004,March 31, 2005 as compared to the same period last year. Thisone year ago. In our Tennessee and Nebraska markets, we have experienced a decrease in the number of clients placed in foster homes due to systemic changes at the state level and lower inventory of licensed foster homes. In Tennessee certain systemic changes at the state level have led to a shorter length of stay per client and a lower number of clients eligible to receive care which resulted in a decrease in foster care services revenue of approximately $302,000 for the three months ended March 31, 2005 as compared to the same prior year period. In Nebraska the inventory of licensed foster homes has declined leading to a decrease in the number of clients placed in foster homes and a decrease in foster care services revenue of approximately $79,000 for the three months ended March 31, 2005 as compared to the same period one year ago. We are exploring opportunities to permanently place foster care clients through adoption programs in Tennessee that we expect will mitigate the decline in foster care clients and the decrease in foster care services revenue. In addition, we are increasing our efforts to license additional homes in Nebraska to increase was primarily attributable to organic growthour foster care service offering. In Delaware, where we are expanding our foster care service offering, our foster care services revenue increased approximately $156,000 for the three months ended March 31, 2005 and partially offset decreases in our historical marketsfoster care services revenue in Tennessee and cross-selling efforts inNebraska. In our traditional home and community based markets such as Arizona, Florida and Virginia, where we added 37 newour cross-selling efforts yielded an additional $325,000 of foster care clients that resulted in approximately $430,000 of additional foster careservices revenue for the three months ended September 30, 2004, as comparedfrom period to the same prior year period. We expect cross-selling activities will continue and provide additional revenues in the future as we focus on expandingcontinuous expansion of our foster care services to existing strategic geographic areas. The remaining increase in foster care revenue for the three months ended September 30, 2004, as compared to the same period one year ago was due to an increase in the number of foster care clients from approximately 344 at September 30, 2003 to 384 at September 30, 2004.services.

 

Management fees. Revenue for entities we manage but do not consolidate for financial reporting purposes (managed entity revenue) increased to $35.1$35.9 million for the three months ended September 30, 2004March 31, 2005 as compared to $15.5$20.3 million for the same period oneprior year ago.period. Management fee revenue as a percentage of managed entity revenue decreased to 8.5%7.0% for the three months ended September 30, 2004March 31, 2005 compared to 9.9%10.9% for the same period lastone year ago primarily due to the effect of a predetermined monthly fee we charged The ReDCo Group, or ReDCo, a managed entity, and acomparatively lower management fee percentagepercentages related to the recently acquired management agreements with Care Development of Maine, or CDOM and FCP, which were less than the average percentage of managed entity revenue and the fixed feeInc., or FCP, that we charge other managed entities.acquired in June 2004. The combined effects of business growth the acquisition of the remaining 50% interest in Rio Grande Management, and the acquisition of the management agreements with CDOM, FCP and FCP in June 2004ReDCo yielded approximately $834,000$277,000 in additional management fee revenue for the three months ended September 30, 2004,March 31, 2005 as compared to the three months ended March 31, 2004. The increase in management fee revenue for the three months ended March 31, 2005 as compared to the same prior year period. Furthermore, in February 2004, we began to manage the provision of services in the Fort Myers, Florida marketperiod was partially offset by Camelot Community Care, Inc. pursuant to a contract awarded to it by the State of Florida. This contract provides for $22.0 million of annual payments to Camelot Community Care, and our management fee is 10% of such revenue after deducting pass through costs. This contract accounted for an increasedecrease in management fee revenue of $397,000 for the three months ended September 30, 2004, as compared to the same period one year ago. The contract under which Camelot Community Care will provide these services expires June 30, 2008. In addition, we generated $200,000 in consulting fees under one consulting contract for the three months ended September 30, 2004.

On June 30, 2004,approximately $187,000 from our management agreement with Rio Grande Behavioral Health Services, Inc., or Rio Grande, described below.

On June 30, 2004, Rio Grande, received a notice canceling one of its provider HMO network contracts effective July 31, 2004. Subsequently, Rio Grande commenced negotiations for a new contract. Rio Grande and the payer have agreed to continue their relationship under new terms. In connection with this agreement, we amended the management agreement between us and Rio Grande to change the management fee charged to Rio Grande for management services

from a per member per month based fee to a fixed fee per month. The new fixed fee iswas comparable to the previous per member per month based fee and as a result, we do not expectremained at this predetermined level until January 1, 2005, at which time the fixed fee was reduced. The new fixed fee to materially affectwill decrease our management fee revenue relatedfrom this management services agreement by approximately $400,000 for the first half of 2005 when compared to the six months ending December 31, 2004.

Currently, the State of New Mexico is modifying its behavioral health services delivery system. We expect that the state will finalize the modification of its behavioral health services delivery system by July 1, 2005, at which time new contracts for behavioral health services will be administered by one administrative services entity. We believe this change in the State of New Mexico’s behavioral health services delivery system will be favorable to Rio Grande. We believe that the reduction in our management agreementfee for the first half of 2005 will not significantly affect our total management fee revenue for the year as we expect to renegotiate the management fee with Rio Grande forwhen the remainderState of 2004.New Mexico has completed the modification of its behavioral health services delivery system. While we anticipate a favorable outcome will result from the modification of the State of New Mexico’s behavioral health

services delivery system, there are no assurances that such outcome will materialize or that our negotiations with Rio Grande regarding our management fee will be as expected.

 

Operating expenses

 

Client service expense.Client service expense includes the following for the three months ended September 30, 2003March 31, 2004 and 2004:2005:

 

  

Three months ended

September 30


  

Percent

change


   

Three months ended

March 31,


  

Percent

change


 
  2003

  2004

    2004

  2005

  

Payroll and related costs

  $8,104,081  $15,456,250  90.7%  $9,866,772  $18,170,919  84.2%

Purchased services

   2,019,507   2,557,710  26.7%   2,431,668   3,291,532  35.4%

Other operating expenses

   1,250,532   2,567,022  105.3%   1,432,749   2,712,847  89.3%

Stock based compensation

   19,616   18,543  -5.5%   18,781   —    -100.0%
  

  

     

  

   

Total client service expense

  $11,393,736  $20,599,525  80.8%  $13,749,970  $24,175,298  75.8%
  

  

     

  

   

 

Payroll and related costs.costs. To servicesupport our growth, provide high quality service and meet increasing compliance requirements expected by the government agencies with which we contract to provide services, we must hire and retain employees thatwho possess higher degrees of education, experience and licensures. As we enter new markets, we expect payroll and related costs to continue to increase. As a result of our organic growth, our payroll and related costs increased for the three months ended September 30, 2004,March 31, 2005, as compared to the same prior year period, last year, as we added 272382 new direct care providers, administrative staff and other employees. In addition, we added 396347 new employees in connection with the acquisition of Dockside, Pottsville and the Aspen Companies which resulted in an increase in payroll and related costs of approximately $4.2$4.0 million for the three months ended September 30,March 31, 2005 as compared to the three months ended March 31, 2004. We continually evaluate client census, case loads and client eligibility to determine our staffing needs under each contract in order to optimize the quality of service we provide while managing the payroll and related costs to provide these services. Determining our staffing needs may not directly coincide with the generation of revenue as we are required at times to increase our capacity to provide services prior to starting new contracts. Alternatively, we may lag behind increases in client referrals and revenue as we may have difficulty recruiting employees to staffservice our contracts. Furthermore, acquisitions willmay cause fluctuations in our payroll and related costs as a percentage of revenue from period to period as we attempt to merge new operations into our service delivery system. As a percentage of revenue, payroll and related expense increased from 54.6%53.5% for the three months ended September 30, 2003March 31, 2004 to 54.8%56.7% for the three months ended September 30, 2004March 31, 2005 primarily due to our efforts to increase our capacitythe number of employees to service our growth.

 

Purchased services. Increases in foster parent payments (resulting from an increase in the number of foster care clients) and an increase in the number of referrals requiring pharmacy and support services were partially offset by a decrease in foster parent payments and the number of referrals requiring out-of-home placement accounted for the increase in purchased services for the three months ended September 30, 2004.March 31, 2005 as compared to the same period one year ago. We strive to manage our purchased services costs by constantly seeking alternative treatments to costly services that we do not provide. Although we manage and provide alternative treatments to clients requiring out-of-home placements and other purchased services, we sometimes cannot control the number of referrals requiring out-of-home placement and support services we receive from period to period under our case rateannual block contract. Despite the increase in purchased services for the three months ended September 30, 2004,March 31, 2005, as a percentage of revenue, purchased services decreased from 13.6%13.2% for the three months ended September 30, 2003March 31, 2004 to 9.1%10.3% for the three months ended September 30, 2004.March 31, 2005. Increases in revenue from both organic growth and acquisitions outpaced the growth in purchased services for the three months ended September 30, 2004.March 31, 2005.

 

Other operating expenses. As a result of our organic growth forduring 2004 and the three months ended September 30, 2004March 31, 2005, we added new locations in Indiana, North Carolina, Tennessee and TennesseeVirginia that resulted incontributed to an increase in other operating expenses for that periodthe three months ended March 31, 2005 when compared to the same period one year ago.three months ended March 31, 2004. The acquisition of Dockside, Pottsville and the Aspen

Companies added approximately $765,000$773,000 to other operating expenses

for the three months ended September 30, 2004. Other operating expenses asMarch 31, 2005. As a percentage of revenue other operating expenses increased from 8.4%7.8% to 9.1%8.5% from period to period primarily due to the relatively higher operating costs incurred in our new markets in California and Pennsylvania.

 

Stock based compensation. Stock based compensation of approximately $20,000 and $19,000 for the three months ended September 30, 2003 andMarch 31, 2004, represents the vesting ofstock and stock options granted to employees at prices and exercise prices less than the estimated fair value of our common stock on the date of the grant of such stock and stock options. All such costs were fully amortized by December 31, 2004. Stock options granted to employees under our 2003 stock option plan were granted at exercise prices equal to the market value of our common stock on the date of grant.

 

General and administrative expense.

 

Three months ended

September 30


  

Percent

change


 
2003

  2004

  
$1,547,648  $3,618,523  133.8%

Three months ended

March 31,


  

Percent

change


 
2004

  2005

  
$2,563,194  $3,959,277  54.5%

 

Increased accounting and legal fees, information systems improvements, directors and officers’ insurance, general and professional liability insurance, professional services fees and theThe addition of corporate staff to adequately support our growth and provide services under our management agreements, higher rates of pay for employees as well as increased accounting fees and professional fees related to increased services provided for SEC filings and regulatory compliance accounted for an increase of $1.5 million$822,000 of corporate administrative expenses for the three months ended September 30, 2004. Also contributingfrom period to the increase in general and administrative expense were investor relations costs such as costs associated with meetings and presentations to investors as well as professional fees relating to increased services provided for Securities and Exchange Commission filings and report reviews. Furthermore,period. In addition, as a result of our growth forduring the three months ended September 30, 2004,March 31, 2005, rent and facilities management increased $579,000.$574,000 in part due to our acquisition activities. As a percentage of revenue, general and administrative expense increaseddecreased to 12.8%12.4% for the three months ended September 30, 2004March 31, 2005 from 10.4%13.9% for the same period last year primarily as a result ofthree months ended March 31, 2004. Increases in revenue from both organic growth and acquisitions outpaced the addition of corporate staff and additional professional services fees related to our efforts to comply with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002. As we continue to enhance our infrastructure, comply with additional public company requirements and prepare for future growth we expect that ourin general and administrative expense will trend higher as compared to prior periods for the remainder of 2004.three months ended March 31, 2005.

 

Depreciation and amortization.

 

Three months ended

September 30


  

Percent

change


 
2003

  2004

  
$202,328  $433,927  114.5%

Three months ended

March 31,


  

Percent
change


 
2004

  2005

  
$228,162  $370,535  62.4%

 

The increase in depreciation and amortization from period to period primarily resulted from the amortization of customer relationships of $121,000$86,000 related to the acquisition of Dockside, Pottsville and the Aspen Companies. Also contributing to the increase in depreciation and amortization from period to period was the amortization of the fair value of the acquired management agreements with Rio Grande, CDOM, FCP and ReDCo and increased depreciation expense due to the addition of software and computer equipment during the three months ended September 30, 2004.March 31, 2005. As a percentage of revenues, depreciation and amortization increaseddecreased from 1.4%1.2% for the months ended March 31, 2004 to 1.1% for the three months ended September 30, 2003 to 1.6% for the three months ended September 30, 2004March 31, 2005 primarily due to the amortization of our customer relationships intangible assets.a higher revenue growth rate.

 

Other (income) expenseProvision for income taxes

 

Interest expense, net. Due to a lower level of debt for the three months ended September 30, 2004, pursuant to the repayment of all of the amounts that were due under our loan and security agreements with Healthcare Business Credit Corporation and our mezzanine lenders upon consummation of our initial public offering on August 22, 2003, interest expense decreased in the current period as compared to the same period one year ago. As a percentage of revenue, interest expense from period to period decreased from 2.6% for the three months ended September 30, 2003 to 0.2% for the three months ended September 30, 2004 primarily due to the reduction of our debt and substantial revenue growth rate.

Provision for income taxes.The provision for income taxes is based on our estimated annual effective income tax rate for the full fiscal year equal to approximately 40%. Our estimated effective income tax rate differs from the federal statutory rate primarily due to nondeductible permanent differences and state income taxes.

Nine months ended September 30, 2004 compared to nine months ended September 30, 2003

Revenues

   

Nine months ended

September 30


  

Percent

change


 
   2003

  2004

  

Home and community based services

  $30,958,479  $49,606,683  60.2%

Foster care services

   7,573,487   9,866,982  30.3%

Management fee

   4,396,467   7,879,309  79.2%
   

  

    

Total revenue

  $42,928,433  $67,352,974  56.9%
   

  

    

Home and community based services. The acquisition of Dockside in January 2004 contributed $2.0 million to our home and community based services revenue for the nine months ended September 30, 2004. In addition, our new home and community based services contracts in Fort Pierce and West Palm Beach, Florida collectively yielded $3.0 million in home and community based services revenue for the nine months ended September 30, 2004. The acquisition of Pottsville in May 2004 provided $867,000 in home and community based services revenue for the nine months ended September 30, 2004. Finally, the acquisition of the Aspen Companies in July 2004 contributed $5.2 million in home and community based services for the nine months ended September 2004. Excluding the acquisition of Dockside, Pottsville, the Fort Pierce and West Palm Beach contracts and the Aspen Companies, our home and community based services provided additional revenue of approximately $7.6 million for the nine months ended September 30, 2004, as compared to the same prior year period due to client census increases in new and existing locations.

Foster care services. Foster care services revenue contributed an additional $2.3 million to total revenue for the nine months ended September 30, 2004 as compared to the same period last year. This increase was primarily attributable to organic growth in our historical markets, commencement of operations in Delaware and cross-selling efforts in our traditional home and community based markets such as Arizona, Florida and Virginia where we added approximately $1.3 million. We expect cross-selling activities will continue and provide additional revenues in the future as we focus on expanding our foster care services. The remaining increase in foster care revenue for the nine months ended September 30, 2004, as compared to the same period last year was due to an increase in the number of foster care clients.

Management fees. Revenue for entities we manage but do not consolidate for financial reporting purposes (managed entity revenue) increased to $84.5 million for the nine months ended September 30, 2004 as compared to $45.8 million for the same period one year ago. Management fee revenue as a percentage of managed entity revenue decreased to 9.3% for the nine months ended September 30, 2004 compared to 9.6% for the same period last year primarily due to the effect of a predetermined fee we charged ReDCo, a managed entity, and a lower management fee percentage related to the recently acquired management agreements with CDOM and FCP, which were less than the average percentage of managed entity revenue and the fixed fee we charge other managed entities. The combined effects of business growth, the acquisition of the remaining 50% interest in Rio Grande Management, and the acquisition of the management agreements with CDOM and FCP in June 2004 yielded approximately $1.9 million in additional management fee revenue for the nine months ended September 30, 2004, as compared to the same prior year period. Furthermore, in February 2004, we began to manage the provision of services in the Fort Myers, Florida market by Camelot Community Care, Inc. pursuant to a contract awarded to it by the State of Florida. This contract accounted for an increase in management fee revenue of $961,000 for the

nine months ended September 30, 2004, as compared to the same period one year ago. In addition, under four consulting contracts that we entered into during the nine months ended September 30, 2004, we generated $634,000 in consulting fees.

Operating expenses

Client service expense.Client service expense includes the following for the nine months ended September 30, 2003 and 2004:

   

Nine months ended

September 30


  

Percent

change


 
   2003

  2004

  

Payroll and related costs

  $23,054,306  $36,096,279  56.6%

Purchased services

   6,014,771   7,404,087  23.1%

Other operating expenses

   3,876,706   5,884,432  51.8%

Stock based compensation

   69,554   55,867  -19.7%
   

  

    

Total client service expense

  $33,015,337  $49,440,665  49.8%
   

  

    

Payroll and related costs. To service our growth, provide high quality service and meet increasing compliance requirements expected by the government agencies with which we contract to provide services, we must hire and retain employees that possess higher degrees of education, experience and licensures. As we enter new markets, we expect payroll and related costs to continue to increase. As a result of our organic growth, our payroll and related costs increased for the nine months ended September 30, 2004, as compared to the same period last year, as we added 272 new direct care providers, administrative staff and other employees. In addition, we added 396 new employees in connection with the acquisition of Dockside, Pottsville and the Aspen Companies which resulted in an increase in payroll and related costs of approximately $5.1 million for the nine months ended September 30, 2004. We continually evaluate client census, case loads and client eligibility to determine our staffing needs under each contract in order to optimize the quality of service we provide while managing the payroll and related costs to provide these services. Determining our staffing needs may not coincide with the generation of revenue as we are required at times to increase our capacity to provide services prior to starting new contracts. Alternatively, we may lag behind increases in client referrals and revenue as we may have difficulty recruiting employees to staff our contracts. Furthermore, acquisitions will cause fluctuations in our payroll and related costs as a percentage of revenue from period to period as we attempt to merge new operations into our service delivery system. As a percentage of revenue, payroll and related expense decreased from 53.7% for the nine months ended September 30, 2003 to 53.6% for the nine months ended September 30, 2004 primarily due to an increase in our revenue growth rate from organic growth, acquisitions and management fees.

Purchased services. Increases in foster parent payments (resulting from an increase in the number of foster care clients) and an increase in the number of referrals requiring pharmacy and support services were partially offset by a decrease in the number of referrals requiring out-of-home placement accounted for the increase in purchased services for the nine months ended September 30, 2004. We strive to manage our purchased services costs by constantly seeking alternative treatments to costly services that we do not provide. Although we manage and provide alternative treatments to clients requiring out-of-home placements and other purchased services, we sometimes cannot control the number of referrals requiring out-of-home placement and support services we receive from period to period under our case rate contract. Despite the increase in purchased services for the nine months ended September 30, 2004, as a percentage of revenue, purchased services decreased from 14.0% for the nine months ended September, 2003 to 11.0% for the nine months ended September 30, 2004. Increases in revenue from both organic growth and acquisitions outpaced the growth in purchased services for the nine months ended September 30, 2004.

Other operating expenses. As a result of our organic growth for the nine months ended September 30, 2004 we added new locations in Oklahoma, North Carolina, Tennessee, Texas and the District of Columbia that resulted in an increase in other operating expenses for that period when compared to the same period one year ago. The acquisition of Dockside, Pottsville and the Aspen Companies added approximately $1.0 million to other operating expenses for the nine months ended September 30, 2004. Notwithstanding the

increase in other operating expenses, our revenue growth rate from both organic growth and acquisitions resulted in a decrease in other operating expenses as a percentage of revenue from 9.0% for the nine months ended September 30, 2003 to 8.7% for the nine months ended September 30, 2004.

Stock based compensation. Stock based compensation of approximately $70,000 and $56,000 for the nine months ended September 30, 2003 and 2004, represents stock and stock options granted to employees at prices and exercise prices less than the estimated fair value of our common stock on the date of the grant of such stock and stock options.

General and administrative expense.

Nine months ended

September 30


  

Percent

change


 

2003


  2004

  

$4,384,361

  $9,026,457  105.9%

Increased accounting and legal fees, information systems improvements, directors and officers’ insurance, general and professional liability insurance, professional services fees and the addition of corporate staff to adequately support our growth and provide services under our management agreements accounted for an increase of $3.8 million of corporate administrative expenses for the nine months ended September 30, 2004. Also contributing to the increase in general and administrative expense were investor relations costs such as costs associated with meetings and presentations to investors as well as professional fees relating to increased services provided for Securities and Exchange Commission filings and report reviews. Furthermore, as a result of our growth for the nine months ended September 30, 2004, rent and facilities management increased $891,000. As a percentage of revenue, general and administrative expense increased to 13.4% for the nine months ended September 30, 2004 from 10.2% for the same period last year primarily as a result of the addition of corporate staff and additional professional services fees related to our efforts to comply with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002. As we continue to enhance our infrastructure, comply with additional public company requirements and prepare for future growth, we expect that our general and administrative expense will trend higher as compared to prior periods for the remainder of 2004.

Depreciation and amortization.

Nine months ended

September 30


  

Percent

change


 

2003


  2004

  

$688,063

  $910,160  32.3%

The increase in depreciation and amortization from period to period primarily resulted from the amortization of customer relationships of $121,000 related to the acquisition of Dockside, Pottsville and the Aspen Companies. Also contributing to the increase in depreciation and amortization from period to period was the amortization of the fair value of the management agreements with Rio Grande, CDOM, FCP and RedCo and increased depreciation expense due to the addition of software and computer equipment during the three months ended September 30, 2004. As a percentage of revenues, depreciation and amortization decreased from 1.6% for the nine months ended September 30, 2003 to 1.4% for the nine months ended September 30, 2004 primarily due to a higher revenue growth rate.

Other (income) expense

Interest expense, net. Due to a lower level of debt for the nine months ended September 30, 2004, pursuant to the repayment of all of the amounts that were due under our loan and security agreements with Healthcare Business Credit Corporation and our mezzanine lenders upon consummation of our initial public offering on August 22, 2003, interest expense decreased in the current period as compared to the same period one year ago. As a percentage of revenue, interest expense from period to period decreased from 3.5% for the nine months ended September 30, 2003 to 0.3% for the nine months ended September 30, 2004 primarily due to the reduction of our debt and substantial revenue growth rate.

Provision for income taxes. The provision for income taxes is based on our estimated annual effective income tax rate for the full fiscal year equal to approximately 40%. Our estimated effective income tax rate differs from the federal statutory rate primarily due to nondeductible permanent differences and state income taxes.

Liquidity and capital resources

On August 22, 2003, we consummated our initial public offering of common stock at which time we generated net proceeds of $29.0 million and on September 10, 2003, as a result of the underwriters’ exercise of their over-allotment option, we generated additional net proceeds of $7.2 million, for a total of $36.2 million in net proceeds from that offering. On April 2, 2004, we completed a follow-on offering of common stock at which time we received proceeds of approximately $12.2 million after deducting the underwriting discounts and offering costs.

 

Our balance of cash and cash equivalents was $11.9$13.5 million at September 30, 2004, downMarch 31, 2005, up from $15.0$10.7 million at December 31, 2003,2004, primarily due to several acquisitions completedcash provided by operating activities and proceeds from issuance of stock related to the exercise of outstanding stock options during the nine month period including the Aspen Companiesthree months ended March 31, 2005. At March 31, 2005 and the pay off of the Eos note partially offset by proceeds received from our follow-on offering of common stock. At September 30,December 31, 2004, our debt was $1.1 million compared to $3.6(including two notes issued in connection with the acquisition of Dockside Services, Inc., or Dockside, in January 2004, in the aggregate amount of $1.0 million at December 31, 2003.and our capital lease obligation of $111,145 and $135,389, respectively).

 

Cash flows

 

Operating activities. Net cash from operations of $2.6$1.8 million for the ninethree months ended September 30, 2004,March 31, 2005, were provided primarily from net income of $5.7$2.1 million adjusted forand the add back of non-cash depreciation and amortization expense.expense of approximately $371,000. Working capital increased for the ninethree months ended September 30, 2004March 31, 2005 with nearly $5.3$1.7 million of cash used to finance our accounts receivable and management fee receivable growth and $700,000 of prepaid workers compensation and other insurance premiums as well as prepaid consulting fees partially offset by approximately $2.9$1.4 million increase in accrued expenses and accounts payable due to increased amounts due for audit related fees and purchased services expense, income tax liability, accrued payroll, accrued foster parent payments and audit fees. Revenue which was deferred revenue.in prior periods was earned during the three months ended March 31, 2005 related to our operations in Arizona and California and resulted in a decrease in deferred revenue of approximately $400,000.

 

Investing activities. Net cash used in investing activities totaled $15.6 millionapproximately $283,000 for the ninethree months ended September 30, 2004,March 31, 2005, and included $17.5 million, netadditional acquisition costs of cash acquired, paidapproximately $72,000 related to the Aspen Companies and $30,000 to acquire Dockside, Pottsville, thea management agreementsagreement with CDOM and FCP and the Aspen Companies. In addition, we loaned ReDCo,Triad Family Services, a managed entity, $875,000 in return for a promissory note for the same amount. Furthermore, weCalifornia not-for-profit corporation. We spent $613,000 to fund irrevocable standby letters of credit to ensure contract performance and $624,000approximately $181,000 for property and equipment. Partially offsetting cash used for investing purposes, our Federal Home Loan Mortgage Corporation zero-coupon bond matured yielding $4.0 million on July 15, 2004.

 

Financing activities. DuringFor the ninethree months ended September 30, 2004,March 31, 2005, we generated cash totaling $9.8of approximately $1.3 million in financing activities. Our follow-on offering of common stock and the issuance ofWe issued common stock related to the exercise of outstanding stock options which provided net proceeds of $13.5 million. Conversely, we$1.3 million and repaid a $3.5 million note to Eos Partners representing a consent fee in connection withamounts due under our initial public offering and a financing feecapital lease agreements of $100,000 to Health Care Business Credit Corporation for a contemplated credit facility amendment in order for the Company to increase its borrowing capacity under the line of credit and acquisition loan facilities, and to include the subsidiaries acquired in 2004 as parties to the loan agreement with HBCC.approximately $24,000.

 

Obligations and commitments

 

Credit facilities. Our amended loan and security agreement with Healthcare Business Credit Corporation, or HBCC, provides for a $10.0 million revolving line of credit and a $10.0 million acquisition term loan. The amount we may borrow under the revolving line of credit is subject to the availability of a sufficient amount of eligible accounts receivable at the time of borrowing. Advances under the acquisition

term loan are subject to the lender’s approval. Initial proceeds borrowed under the revolving line of credit portion of this credit facility were used to repay and terminate our revolving line of credit with a former lender. Borrowings under this credit facility bear interest at an annual rate equal to the prime rate in effect from time to time, plus 2.0% in the case of the revolving line of credit and prime plus 2.5% in the case of the acquisition term loan. In addition, we are subject to a 0.5% fee per annum on the unused portion of our credit facility, as well as certain other administrative fees.

 

Until its amendment in September 2003, our credit facility with HBCC was secured by substantially all of our assets as well as certain of our managed entities’ assets. Prior to such amendment, the facility provided for a $1.0 million term loan which we paid in full in August 2003, and for the acquisition term loan to mature on January 1, 2006. On September 30, 2003, our loan and security agreement with HBCC was amended to remove, as co-borrowers under the agreement, certain of the not-for-profit organizations whose operations we manage and to release their assets from those pledged as collateral under the agreement. The amendment also extended the maturity date of our acquisition term loan through December 1, 2006. The December 31, 2006 expiration date for the revolving line of credit, as well as the other provisions of our amended loan agreement remained the same as those set forth in our original January 2003 loan and security agreement. Concurrent with the amendment of our agreement, HBCC established stand-alone credit facilities on behalf of each of the managed entities that were removed from our facility, and, while we do not guarantee any portion of their stand-alone facilities, we have agreed in connection with the amendment of our loan and security agreement to subordinate our management fee receivable to the claims of HBCC in the event one of these managed entities defaults under its credit facility.

At September 30, 2004,March 31, 2005, we had borrowed $72,000no borrowings under the revolving line of credit and no borrowings under the acquisition term loan, available credit of $10.0 million on our revolving line of credit, and we were in compliance with all covenants.

 

In connection with our acquisition of Dockside, we issued two unsecured subordinated promissory notes each in the amount of $500,000 to the former stockholders of Dockside in partial consideration for the purchase of all of Dockside’s outstanding stock. Each note bears interest equal to 6% per annum with interest payable quarterly beginning April 2004 and principal payments of $100,000 beginning April 2005. All principal and accrued but unpaid interest is due July 2007.

 

Transactions with Eos Partners. Prior to the consummation of our initial public offering on August 22, 2003, we were required to obtain the consent of the then holders of our convertible preferred stock. Consequently, in connection with our initial public offering, we agreed to pay Eos Partners SBIC and Eos Partners SBIC II, the then majority holders of our convertible preferred stock, a consent fee in the aggregate amount of $3.5 million. The consent fee was paid pursuant to two subordinated notes bearing interest at the rate of 4% per annum. On January 27, 2004, we prepaid the notes’ aggregate outstanding principal amount of $3.5 million and paid all outstanding accrued interest on the notes, in the aggregate amount of $10,500, with proceeds from our initial public offering. In addition, pursuant to an agreement dated June 1, 2003, Eos Partners SBIC and Eos Partners SBIC II were paid an aggregate financial advisory fee in the amount of $1.0 million upon our initial public offering out of proceeds from the offering.

Management agreements

 

We maintain management agreements with a number of not-for-profit social services organizations that require us to provide the management and administrative services for each organization. In exchange for these services, we receive a management fee that is either based upon a percentage of the revenues of these organizations or a predetermined fee. Additionally, prior to July 1, 2003, these management agreements contained a provision that permitted us to earn bonuses to our management fee dependent upon the managed entities’ operating results. We have historically recognized such bonuses as revenue when they have been approved and authorized by the board of directors of the applicable not-for-profit entity and collection of such amount is determined to be probable. In connection with the renegotiation of our fee arrangement with these entities, our management agreements with them were amended as of July 1, 2003, at which time the bonus provision was removed. Management fees generated under our management agreements represented 10.2%11.0% and 10.8%7.8% of our revenue for the ninethree months ended September 30, 2003March 31, 2004 and 2004. Management fees2005. Fees generated under short term consulting agreements entered into in December 2003 and January - September

during 2004 represented approximately 0.9%1% of our revenue for the ninethree months ended September 30,March 31, 2004. No such fees were generated for the three months ended March 31, 2005. (See “-Critical“—Critical accounting policies and estimates-Revenueestimates—Revenue recognition”). In accordance with our management agreements with these not-for-profit organizations, we have obligations to manage their business and services.

 

Our management fee receivable is comprised of management fees we earn pursuant to our management agreements with certain not-for-profit social services organizations. Management fee receivable at December 31, 20032004 and September 30, 2004March 31, 2005 were $3.6$5.0 million and $4.7$5.1 million, and management fee revenues were recognized on all of these receivables. In order to enhance liquidity of the entities we manage, we, at times, may allow the managed entities to defer payment of their respective management fees. In addition, since government contractors who provide social or similar services to government beneficiaries sometimes experience collection delays due to either lack of proper documentation of claims, government budgetary processes or similar reasons outside the contractors’ control (either directly or as managers of other contracting entities), we generally do not consider a receivable to be uncollectible due solely to its age until it is 365 days old.

 

The following is a summary of the aging of our management fees receivable balances as of March 31, June 30, September 30 June 30,and December 31, 2004 and March 31, 2004 and December 31, 2003:2005:

 

At


  

Less than

30 days


  30-60 days

  60-90 days

  90-180 days

  

Over

180 days


  Less than
30 days


  30-60 days

  60-90 days

  90-180 days

  

Over

180 days


December 31, 2003

  $564,658  $665,578  $485,473  $1,228,304  $633,274

March 31, 2004

  $579,269  $568,310  $498,683  $1,030,772  $422,707  $579,269  $568,310  $498,683  $1,030,772  $422,707

June 30, 2004

  $710,762  $672,588  $585,792  $934,751  $268,689  $710,762  $672,588  $585,792  $934,751  $268,689

September 30, 2004

  $935,749  $916,579  $860,450  $1,402,976  $593,278  $935,749  $916,579  $860,450  $1,402,976  $593,278

December 31, 2004

  $886,440  $866,315  $949,436  $1,945,326  $375,888

March 31, 2005

  $843,523  $848,517  $807,170  $2,210,418  $345,159

 

We adhere to a strict revenue recognition policy regarding our management fee revenues and related receivables. Each month we examine each of our managed entities with regard to its solvency, outlook and ability to pay us any outstanding management fees. If the likelihood that we will not be paid is other than remote, we will defer the recognition of these management fees until we are certain that payment is probable. In keeping with our general corporate policy regarding our accounts receivable, we will also automatically reserve as uncollectible 100% of any management fee receivable that is 365 days old or older.

 

At September 30, 2004,March 31, 2005, none of our management fees receivable were older than 365 days, and our days sales outstanding for our managed entities had decreased from 202181 days at December 31, 20032004 to 181177 days at September 30, 2004.March 31, 2005.

In addition, Camelot Community Care, Inc., which represented $2.4 million, or 51%48.3%, of our total management fee receivable at September 30, 2004,March 31, 2005, and Intervention Services Inc., referred to as ISI, which represented $1.3approximately $734,000 million, or 28%14.5%, of our total management fee receivable at September 30, 2004,March 31, 2005, each obtained its own stand-alone line of credit from HBCC in September 2003. The loan agreements between HBCC and these not-for-profit organizations permit them to use their credit facilities to pay our management fees, provided they are not in default under these facilities at the time of the payment. As of September 30, 2004,March 31, 2005, they were eachnot in compliance with all ofdefault under their loan covenantscredit facilities with HBCC and Camelot Community Care, Inc. had availability of $1.2 million$815,000 under its line of credit as well as $2.8$2.9 million in cash and cash equivalents and ISI had availability of $307,500$24,000 under its line of credit as well as $61,000$298,000 in cash and cash equivalents.

 

Camelot Community Care has also entered into several new contracts, including its new contract with the State of Florida, which provides for payments to Camelot Community Care in the amount of $22.0 million per year commencing as of February 1, 2004. Furthermore, in an effort to enhance liquidity and fund future growth opportunities at ISI, we agreed with the board of directors of ISI to lower our management fee percentage by 3 percentage points effective July 1, 2004. We expect the effect of the decrease in our management fee percentage will be partially offset by the July 1, 2004 Florida Medicaid rate increase from $48.50 per hour to $64 per hour, relating to 46% of ISI’s contract revenues. Furthermore, ISI expects an increase in its projected revenues for the remainder of 2004. Looking ahead, we do not expect a material decrease in our management fee from current levels as a result of the decrease in our management fee percentage.

The remaining $1.0$1.9 million balance of our total management fees receivable at September 30, 2004,March 31, 2005, was due from Rio Grande, RedCo,ReDCo, CDOM, FCP and Family Preservation Services of South Carolina.

 

We have deemed payment of all of the foregoing receivables to be probable based on our collection history with these entities and on our assessment, as the long-term manager of their operations, of their performance outlook for the remainder of 2004. To date, we have not incurred any write-offs of management fee receivable nor have we been required to defer any management fee revenues associated with our management services.operations.

 

Transactions with ReDCo. In connection with the acquisition of Pottsville and the establishment of a management agreement with ReDCo, we loaned $875,000 to ReDCo to fund certain long-term obligations of the entity in exchange for a promissory note for the same amount. The note assumes interest equal to a fluctuating interest rate per annum based on a weighted-average daily Federal Funds Rate. The terms of the promissory note require ReDCo to make quarterly interest payments over twenty-one months commencing June 30, 2004 with the principal and any accrued and unpaid interest due upon maturity on March 31, 2006. The promissory note is collateralized by a subordinated lien to ReDCo’s primary lender on substantially all of ReDCo’s assets.

 

Contractual cash obligations. The following is a summary of our future contractual cash obligations as of September 30, 2004:

   At September 30, 2004

Contractual cash obligations (000’s)


  Total

  Less than
1 Year


  1-3
Years


  3-5
Years


  After 5
Years


Debt

  $1,072  $272  $800  $—    $—  

Leases

   6,117   3,012   2,655   450   —  
   

  

  

  

  

Total

  $7,189  $3,284  $3,455  $450  $—  
   

  

  

  

  

We expect our liquidity needs on a short- and long-term basis will be satisfied by cash flow from operations, the net proceeds from the sale of equity securities and borrowings under debt facilities.

 

Recently issued accounting pronouncements

 

In OctoberDecember 2004, the Financial Accounting Standards Board, or FASB, finalized SFAS 123R, “Share-Based Payment”, effective for public companies for interim and annual periods beginning after June 15, 2005. The FASBSFAS 123R requires all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value. Retroactive application of the requirements of SFAS 123R to the beginning of the fiscal year that includes the effective date is permitted, but not required. We are currently evaluatingOn April 15, 2005, the impact,SEC issued its final rule in Release No. 34-51558 regarding the implementation strategy andcompliance date for SFAS 123R related to public companies. The SEC has delayed the related timing of implementationrequirement for non-small business public companies to comply with the provisions of SFAS 123R until the first interim reporting period of the public company’s first fiscal year beginning on or after June 15, 2005. Accordingly, we plan to implement SFAS 123R beginning January 1, 2006 and we are in the process of determining the affect this pronouncement will have our consolidated financial position and results of operations.statements.

 

Forward-Looking Statements

 

Certain statements contained in this quarterly report on Form 10-Q, such as any statements about our confidence or strategies or our expectations about revenues, results of operations, profitability, contracts or market opportunities, constitute forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on our current expectations, assumptions, estimates and projections about our business and our industry. You can identify forward-looking statements by the use of words such as “may,” “should,” “will,” “could,” “estimates,” “predicts,” “potential,” “continue,” “anticipates,” “believes,” “plans,” “expects,” “future,” and “intends” and similar expressions which are intended to identify forward-looking statements.

 

The forward-looking statements contained herein are not guarantees of our future performance and are subject to a number of known and unknown risks, uncertainties and other factors, some of which are

beyond our control and difficult to predict and could cause our actual results or achievements to differ materially from those expressed, implied or forecasted in the forward-looking statements. These risks and

uncertainties include, but are not limited to, our reliance on government-funded contracts (for instance, changes in budgetary priorities of the government entities that fund the services we provide could result in our loss of contracts or a decrease in amounts payable to us under our contracts); risks associated with government contracting in general, such as the short-term nature of our contracts and the fact that they can be terminated prior to expiration, without cause and without penalty to the payer, and are subject to audit and modification by the payers, in their sole discretion; risks associated with our cost based service contracts and annual block contract such as budgeted costs not incurred, cost per service may exceed allowable rate per contract and we may not encounter the projected number of clients necessary to earn the funds we receive to provide agreed upon social services; challenges resulting from growth or acquisitions; risks involved in managing government business, such as increased risks of litigation and other legal actions and liabilities; dependence on our licensed service provider status as our loss of such status in any jurisdiction could result in the termination of a number of our contracts; our reliance on a few providers for a significant amount of our revenues; legislative, regulatory or policy changes; adverse media exposure; opposition to privitization of government programs by government unions or others; the level and degree of our competition, both for attracting and retaining experienced personnel and in acquiring additional contracts; and legal, economic and other risks detailed in our other filings with the Securities and Exchange Commission.SEC.

 

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained above and throughout this report. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Interest rate and market risk

 

Upon the consummation of our initial public offering, we repaid all of the principal and accrued interest outstanding under our loan and security agreements. As of September 30, 2004,March 31, 2005, we had borrowed $72,000no borrowings under our revolving line of credit and no borrowings under our acquisition term loan. In connection with our acquisition of Dockside, we issued two subordinated notes each in the amount of $500,000 to the sellers. The notes bear a fixed interest rate of 6%.

On September 3, 2003, we purchased a $4.0 million zero-coupon bond, at 98.894%, or $3.9 million, issued by the Federal Home Loan Mortgage Corporation. On July 15, 2004, the bond matured with a market value of $4.0 million.

 

We believe our exposure to market risk related to the effect of changes in interest rates is immaterial at this time. We have not used derivative financial instruments to alter the interest rate characteristics of our debt instruments. We assess the significance of interest rate market risk on a periodic basis and may implement strategies to manage such risk as we deem appropriate.

 

Concentration of credit risk

 

We provide and manage government sponsored social services to individuals and families pursuant to 320 contracts. Among these contracts there are certain contracts under government contracts. Under one contractwhich we generate a significant portion of our revenue. For the nine months ended September 30, 2004, weWe generated approximately $8.8$3.3 million, or 13.1%10.4% of our revenues for the three months ended March 31, 2005, pursuant to aone contract in Arizona with the Community Partnership of Southern Arizona, an Arizona not-for-profit organization. This contract is subject to statutory and regulatory changes, possible prospective rate adjustments and other retroactive contractual adjustments, administrative rulings, rate freezes and funding reductions. Reductions in amounts paid by this contract for our services or changes in methods or regulations governing payments for our services could materially adversely affect our revenue.

Item 4. Controls and Procedures.

 

(a)Evaluation of Disclosure Controlsdisclosure controls and Procedures.proceduresAs

The Company, under the supervision and with the participation of its management, including its principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this report an(March 31, 2005). Based on this evaluation, was carried out under the supervisionprincipal executive officer and with the participation of our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”),principal financial officer concluded

that, as of the effectivenessend of our disclosure controls and procedures. Based on that evaluation, the CEO and CFO have concluded that ourperiod covered by this report, the Company’s disclosure controls and procedures arewere effective at thein reaching a reasonable level of assurance level to timely alert them ofthat information required to be disclosed by usthe Company in the reports that we fileit files or submitsubmits under the Securities Exchange Act of 1934.1934 is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission’s rules and forms.

(b)Changes in internal controls

 

Changes in Internal Controls.DuringThe principal executive officer and principal financial officer also conducted an evaluation of the quarter ended September 30, 2004 there were no changes in ourCompany’s internal control over financial reporting (“Internal Control”) to determine whether any changes in Internal Control occurred during the quarter ended March 31, 2005 that have materially affected or which are reasonably likely to materially affect our internal control over financial reporting.

Sarbanes-Oxley 404 Compliance.We have begun a detailed assessment of our internal controls as called forInternal Control. Based on that evaluation, there has been no such change during the quarter ended March 31, 2005 covered by the Sarbanes-Oxley Act of 2002. We are still in the evaluation of design phase where we have identified what may be control deficiencies in our system of internal controls. As we move to the testing phase of our project, we expect to validate these potential control deficiencies and to assess whether or not they rise to the level of significant deficiencies or material weaknesses. In the meantime, we have established a series of remediation teams to investigate these potential control deficiencies, and, where appropriate, to remediate them. To ensure that we address these issues thoroughly, effectively, and timely, we have supplemented our internal project team with the services of one outside specialist. Although we have made this project a top priority for the Company, there can be no assurances that all control deficiencies identified and validated will be remediated before the end of the Company’s fiscal year or that the remaining unresolved control deficiencies will not rise to the level of significant deficiencies or material weaknesses.report.

 

PART II—OTHER INFORMATION

 

Item 1. Legal Proceedings.

 

Although we believe we are not currently a party to any material litigation, we may from time to time become involved in litigation relating to claims arising from our ordinary course of business. These claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Use of Proceeds from Our Initial Public Offering

On August 22, 2003, we completed an initial public offering of shares of our common stock. We sold 3.0 million shares and selling stockholders sold 1.3 million shares at an offering price of $12.00 per share. On September 10, 2003, our underwriters exercised their over-allotment option pursuant to which we sold an additional 645,000 shares at an offering price of $12.00 per share. The shares were registered under the Securities Act on a registration statement on Form S-1 (Registration No. 333-106286) which was declared effective by the Securities and Exchange Commission on August 18, 2003. The managing underwriters for the offering were SunTrust Robinson Humphrey, Jefferies & Company, Inc. and Avondale Partners, LLC. As of September 30, 2004, we had incurred a total of approximately $7.6 million in expenses in connection with the offering as follows:

Underwriting discounts and commissions

  $3,062,000

Finder’s fees

   —  

Expenses paid to or for underwriters

   —  

Other expenses

   4,522,000
   

Total

  $7,584,000
   

Of the foregoing expenses an advisory fee in the aggregate amount of $1.0 million was paid to Eos Partners SBIC, L.P. and Eos Partners SBIC II, L.P., each of which was then one of our principal

stockholders. Other than the advisory fee paid to Eos Partners SBIC and Eos Partners SBIC II, none of the foregoing expenses were paid or are payable directly or indirectly to our directors, officers or holders of 10% or more of any class of our equity securities.

As of September 30, 2004, the net proceeds to us after deducting the total expenses described above amounted to $36.2 million.

Between August 22, 2003 and September 30, 2004, we used $19.2 million of the net proceeds of our offering to repay indebtedness under our credit facilities, we used approximately $1.1 million to pay accrued and unpaid dividends on our Series A, B, and D preferred stock, we invested $4.0 million in a Federal Home Loan Mortgage Corporation zero coupon bond that matured on July 15, 2004, we paid $820,000 to acquire the remaining 50% interest in Rio Grande Management Company, LLC, a joint venture limited liability company, which we acquired on January 1, 2004, and we used $3.4 million of the net proceeds of our offering and issued an aggregate of $1.0 million promissory notes payable to acquire 100% of the outstanding stock of Dockside Services, Inc., a for-profit provider of social services located in Indiana, on January 1, 2004. Further, on January 27, 2004, we used $3.5 million to prepay all outstanding principal and accrued interest due pursuant to two subordinated notes to Eos Partners SBIC and Eos Partners SBIC II. These notes were issued to pay a consent fee to Eos Partners SBIC and Eos Partners SBIC II, the then holders of our Series A preferred stock, Series B preferred stock and Series D preferred stock in connection with our initial public offering and pursuant to an amended stockholders agreement, and we used $670,000 for general corporate purposes. The remaining proceeds of $3.5 million were used to purchase all of the equity interest in Pottsville Behavioral Counseling Group, Inc., fund the $875,000 loan to The ReDCo Group, Inc., a managed entity, and partially fund our acquisition of certain management agreements with Care Development of Maine in Maine and FCP, Inc. in Massachusetts.

On July 15, 2004, our investment in a Federal Home Loan Mortgage Corporation zero coupon bond referred to above matured yielding a market value of $4.0 million. All proceeds from this investment will be held as cash and used for general corporate purposes, including potential acquisitions.

 

Restrictions Upon the Payment of Dividends

 

Under our credit facility we are prohibited from paying any cash dividends if there is a default under the facility or if the payment of any cash dividends would result in default.

 

Item 3. Defaults Upon Senior Securities.

 

None

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

None

 

Item 5. Other Information.

 

None

 

Item 6. Exhibits.

 

Exhibit
Number


 

Description


10.1Summary Sheet Of Director Fees and Executive Officer Compensation
31.1Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Executive Officer
31.2Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Financial Officer
32.1Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer

32.2Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial Officer
99.1Earnings release issued by The Providence Service Corporation on May 4, 2005.

SIGNATURES

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

THE PROVIDENCE SERVICE CORPORATION

Date: May 4, 2005By:

/s/ FLETCHER JAY MCCUSKER


Fletcher Jay McCusker

Chairman of the Board, Chief Executive Officer

(Principal Executive Officer)

Date: May 4, 2005By:

/s/ MICHAEL N. DEITCH


Michael N. Deitch

Chief Financial Officer

(Principal Financial and Accounting Officer)

EXHIBIT INDEX

Exhibit
Number


Description


10.1Summary Sheet Of Director Fees and Executive Officer Compensation
31.1 Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Executive Officer
31.2 Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Financial Officer
32.1 Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer
32.2 Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial Officer

SIGNATURES

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

THE PROVIDENCE SERVICE CORPORATION
Date: November 9, 2004By:

/s/     FLETCHER JAY MCCUSKER    


Fletcher Jay McCusker

Chairman of the Board, Chief Executive Officer

(Principal Executive Officer)

Date: November 9, 2004By:

/s/     MICHAEL N. DEITCH    


Michael N. Deitch

Chief Financial Officer

(Principal Financial and Accounting Officer)

EXHIBIT INDEX

Exhibit
Number


Description


31.1Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Executive Officer
31.299.1 Certification pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 of the Chief Financial Officer
32.1Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Executive Officer
32.2Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of the Chief Financial OfficerEarnings release issued by The Providence Service Corporation on May 4, 2005.

 

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