UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31,June 30, 2005

OR

For the transition period from                    to                    

Commission File No. 000-50364

The Providence Service Corporation

(Exact name of registrant as specified in its charter)

(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    ¨  No

As of May 2,August 5, 2005, there were outstanding 9,442,2699,575,891 shares (excluding treasury shares of 146,905) of the registrant’s Common Stock, $.001 par value per share.

TABLE OF CONTENTS

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

The Providence Service Corporation

Consolidated Balance Sheets

See accompanying notes to unaudited consolidated financial statements

The Providence Service Corporation

Unaudited Consolidated Statements of Operations

See accompanying notes to unaudited consolidated financial statements

The Providence Service Corporation

Unaudited Consolidated Statements of Cash Flows

See accompanying notes to unaudited consolidated financial statements

The Providence Service Corporation

Notes to Unaudited Consolidated Financial Statements

March 31,June 30, 2005

1. Basis of Presentation

The accompanying unaudited 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 threesix months ended March 31,June 30, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2005.

The consolidated balance sheet at December 31, 2004 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 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, 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 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 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. Investments in cash equivalents are carried at cost, which approximates fair value. 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, 2004 and March 31,June 30, 2005, the Company had $961,000 and $1.7 million of restricted cash, respectively, of which $786,000 and $961,000$1.7 million was included in prepaid expenses and other for December 31, 2004 and March 31,June 30, 2005 and $175,000 was included in noncurrent other assets for December 31, 2004 in the accompanying consolidated balance sheets. TheOf the total amount of restricted cash at June 30, 2005 of $1.7 million, $961,000 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. Furthermore, $775,000 serves as collateral for an irrevocable standby letter of credit that is restricted to secure any reinsured claims losses under the Company’s workers’ compensation reinsurance program in the event the Company becomes insolvent. At March 31,June 30, 2005, the cash was held in custody by the Bank of

Tucson. In addition, the cash is restricted as to withdrawal or use, and is currently invested in certificates of deposit and money market funds.

Accounts Receivable and Allowance for doubtful accounts

Accounts receivable are stated at the amount the Company expects to collect. The Company evaluates the collectibility of its accounts receivable on a monthly basis. The Company determines 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 and written off or fully allowed for.

In circumstances where the Company is aware of a specific payer’s inability to meet its financial obligation to it, the Company records a specific addition to its allowance for doubtful accounts to reduce the net recognized receivable to the amount the Company reasonably expects to collect. If the financial condition of the Company’s payers were to deteriorate, further additions to the Company’s allowance for doubtful accounts may be required. In addition, in certain of the Company’s markets it also considers historical write-off experience and the likelihood that current receivables will ultimately be written off. Based on this analysis the Company maintains a general reserve for all receivables in certain of its markets by applying a percentage based on the age category of those receivables.

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”), theThe Company separately values all acquired identifiable intangible assets apart from goodwill. The Company allocated a portion of the purchase consideration to certain management contracts and customer relationships acquired in 2004 and during the six months ended June 30, 2005 based on the expected direct or indirect contribution to future cash flows over the useful life of the asset.assets.

The Company assesses whether certain relevant factors limit the period over which acquired 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 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.

Under certain conditions the Company may assess the recoverability of the unamortized balance of its long-lived assets based on expected future cash flows. Should the review indicate that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of any intangible asset 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 and earnings per share had the Company’s stock options been accounted for using the fair value method:

Loss Reserves for Certain Reinsurance and Self-Funded Insurance Programs

General and Professional Liability and Workers’ Compensation

Prior to April 12, 2005, the Company had general and professional liability coverage with a $500,000 self-insured retention for each claim through a third party insurer. In addition, prior to May 16, 2005 the Company had first dollar coverage for workers’ compensation costs with third party insurers. Effective May 16, 2005, the Company began reinsuring a substantial portion of its general and professional liability and workers’ compensation costs and the general and professional liability and workers’ compensation costs of certain designated entities managed by the Company under reinsurance programs through its wholly-owned captive insurance subsidiary, Social Services Providers Captive Insurance Company (“SPCIC”), incorporated under the laws of the State of Arizona. The Company established SPCIC in order to better manage the annual expenditures for general and professional liability and workers’ compensation insurance coverage. It is expected that the formation of SPCIC will enable the Company to provide for: (1) long-term stable insurance programs, (2) increased control over claims management and risk control administration and (3) reduced overall insurance costs associated with general and professional liability and workers’ compensation insurance coverage. The Company primarily utilizes SPCIC as a risk management and cost containment tool.

The Company’s general and professional liability and workers’ compensation reinsurance programs are fronted by two third party insurers for a predetermined amount; one for general and professional liability and one for workers’ compensation liability. These third party insurers also provide coverage to certain designated entities managed by the Company. SPCIC reinsures these two third party insurers for certain claims as described below.

SPCIC reinsures the third party insurer for general and professional liability exposures for the first dollar of each and every loss up to $250,000 per loss with no annual aggregate limit. The reinsurance premium for the first policy year ending April 12, 2006 of approximately $785,000 equals the reinsured portion of the actuarially determined expected losses for the same period. The third party insurer provides general and professional liability coverage for up to $750,000 per occurrence over the $250,000 reinsured limit with an annual aggregate

limit of $3.0 million. Assuming the Company’s actual reinsured losses and the reinsured losses of certain designated entities it manages were to exceed the reinsured portion of the actuarially determined expected losses of approximately $785,000 in the first policy year ending April 12, 2006, the Company’s additional exposure would be recognized as an increase to the Company’s general and administrative expense in its consolidated statements of operations in the period such exposure became known.

Under the Company’s worker’s compensation reinsurance program, SPCIC reinsures a third party insurer for the first $250,000 per occurrence with no annual aggregate limit. The third party insurer provides workers’ compensation coverage up to statutory limits. The reinsurance premium for the first policy year ending May 15, 2006 of approximately $774,000 equals the reinsured portion of the actuarially determined expected losses for the same period. Assuming the Company’s actual reinsured losses and the reinsured losses of certain designated entities it manages were to exceed the reinsured portion of the actuarially determined expected losses of approximately $774,000 in the first policy year ending May 15, 2006, the Company’s additional exposure would be recognized as an increase to the Company’s payroll and related costs in its consolidated statements of operations in the period such exposure became known. The Company’s reserve levels are evaluated on a quarterly basis. Any necessary adjustments are recognized as an adjustment to general and administrative expense in its consolidated statements of operations.

The Company records a provision for losses incurred but not reported, based on the recommendations of an independent actuary and management’s judgment using its past experience and industry experience. The Company (through SPCIC) has restricted cash of $775,000 at June 30, 2005, which is restricted to secure the reinsured claims losses of SPCIC under the workers’ compensation reinsurance program in the event the Company becomes insolvent. The full extent of certain claims may not be fully determined for years. Therefore, the estimates of potential obligations are based on recommendations of an independent actuary and management’s judgment using historical data, and industry and the Company’s experience. Although management believes that the amounts accrued for losses incurred but not reported under the preliminary terms of its reinsurance programs are sufficient, any significant increase in the number of claims or costs associated with these claims made under these programs could have a material adverse effect on the Company’s financial results.

The Company’s liability under its reinsurance programs is based on preliminary terms under binders with the third party insurers and any obligations over the Company’s reinsurance program limits are the responsibility of the Company. Approximately 28% of the total liability assumed by the Company under its reinsurance programs is related to the designated entities it manages that are covered under the Company’s reinsurance programs. It is possible that the Company, under the final terms of its reinsurance programs, will revise its estimates significantly. Any subsequent differences that may arise will be recorded in the period in which they are determined.

Health Insurance

Effective July 1, 2005, the Company began offering its employees and employees of certain entities it manages an option to participate in a self-funded health insurance program. Health claims under this program are self-funded with a stop-loss umbrella policy with a third party insurer to limit the maximum potential liability for individual claims to $150,000 per person and for total claims to $8.0 million for the program year ending June 30, 2006. Health insurance claims are paid as they are submitted to the plan administrator. Beginning July 1, 2005, the Company maintains accruals for claims that have been incurred but not yet reported to the plan administrator and therefore have not been paid. The incurred but not reported reserve is based on the historical claim lag period and current payment trends of health insurance claims which is generally 1 – 2 months. The liability for the self-funded health plan is recorded in accrued payroll and related costs in the Company’s consolidated balance sheet. As of June 30, 2005 no amounts have been reserved in the Company’s consolidated balance sheet for its self-funded health insurance program.

The Company charges its employees and employees of certain entities it manages a portion of the costs of its self-funded and non self-funded health programs, and it determines this charge at the beginning of each plan year based upon historical and projected medical utilization data, along with projected inflationary increases in medical costs. Any difference between the Company’s projections and its actual experience is borne by the Company. The Company is estimating potential obligations for liabilities under this program to reserve what it believes to be a sufficient amount to cover liabilities based on an independent actuary and past experience. Any significant increase in the number of claims or costs associated with claims made under this program above what the Company reserves could have a material adverse effect on its financial results.

Use of Estimates

The Company has made a number of estimates relating to the reporting of assets and liabilities, revenues and expenses and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with accounting principles generally accepted in the United States for interim financial information. Some of the more significant estimates impact accounts receivable, long-lived assets and loss reserves for certain reinsurance and self-funded insurance programs.

New Accounting Pronouncements

In December 2004, the Financial 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 requirements 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 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, the Company plans to implement SFAS 123R beginning January 1, 2006 and is in the process of determining the affecteffect this pronouncement will have on the Company’s consolidated financial statements.

3. GoodwillPrepaid Expenses and Other

Prepaid expenses and other comprise the following:

4. Acquisitions

On June 13, 2005, the Company acquired all of the equity interest in Children’s Behavioral Health, Inc. (“CBH”), a Pennsylvania provider of home and school based social services for children, for a total purchase price of approximately $14.5 million, subject to certain working capital adjustments. The purchase price consisted of $10.0 million in cash, 117,371 shares of the Company’s unregistered common stock valued at $3.0 million, and an unsecured, subordinated promissory note in the principal amount of approximately $776,000 after deducting certain credits related to preliminary working capital adjustments of approximately $724,000. The number of shares of the Company’s unregistered common stock issued in

connection with this transaction and the principal and accrued interest thereon related to the promissory note may be subsequently adjusted in accordance with the terms and conditions of the purchase agreement.

The acquisition has been accounted for using the purchase method of accounting and the results of operations are included in the Company’s consolidated financial statements from the date of acquisition. The cost of this acquisition 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 and acquired working capital is determined.

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

The unregistered shares of the Company’s common stock issued in connection with this transaction were valued at $3.0 million based on certain terms of the purchase agreement for purposes of determining the purchase price. As unregistered shares, they cannot be freely traded on the open market and as a result the value of these unregistered shares for purchase price allocation purposes has been discounted based upon a lack of marketability as determined by an independent third party business valuation firm.

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.

Changes in goodwill were as follows:

The following unaudited pro forma information presents a summary of the consolidated results of operations of the Company as if the acquisition of CBH had occurred on January 1, 2004. 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, 2004.

In May 2005, the Company paid an additional $1.8 million pursuant to certain terms of a definitive agreement whereby the Company acquired all of the rights under an existing management agreement with Care Development of Maine (“CDOM”) in 2004. The additional cost of acquiring the management agreement with CDOM has been allocated to intangible assets as contract acquisition costs and is being amortized on a straight-line basis over the remaining life of the agreement.

4.5. Long-Term Obligations

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

On January 9, 2003,June 28, 2005, the Company entered into aCompany’s loan and security agreement was amended pursuant to a second amended and restated loan and security agreement (“Second Amended Loan Agreement”) with Healthcare Business Credit Corporation which provided(“HBCC”). The Second Amended Loan Agreement provides for a $10.0 millionan increase in the amount the Company may borrow under the revolving line of credit afrom $10.0 million to $25.0 million and an increase in the amount it may borrow under the acquisition term loan and a $1.0from $10.0 million term loan.to $25.0 million subject to certain conditions. 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 HBCC’s approval and are payable in consecutive monthly installments as determined under the lender’s approval. Proceeds initially borrowedSecond Amended Loan Agreement.

Borrowings under the Second Amended Loan Agreement bear interest at a rate equal to the sum of the annual rate in effect in the London Interbank market (“LIBOR”), applicable to one month deposits of U.S. dollars on the business day preceding the date of determination plus 4.0% in the case of the revolving line of credit and 4.5% in the case of the acquisition term loan subject to certain adjustments based upon the Company’s debt service coverage ratio. In addition, the Company is subject to a 0.5% fee per annum on the unused portion of this credit facility were used to repay and terminate the previous revolving line of creditavailable funds as determined in accordance with a former lender. Until its amendment in September 2003, the Company’s credit facility was secured by substantially allcertain provisions of the Company’s assetsSecond Amended Loan Agreement as well as certain of its managed entities’ assets.other administrative fees.

On September 30, 2003, followingThe Second Amended Loan Agreement also extends the Company’s repaymentmaturity date 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 theJune 28, 2010.

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 with HBCC to subordinate its management fee receivable pursuant to management agreements established with certain of the Company’s managed entities, which have stand-alone credit facilities with HBCC, to the claims of HBCC in the event one of a defaultthese managed entities defaults under its credit facility. Additionally, any other monetary obligations of these stand-alonemanaged entities owing to the Company are subordinated to the claims of HBCC in the event one of these managed entities defaults under its credit facilities. facility.

The remaining provisions of the amended loan and security agreement with respect to the revolving line of creditSecond Amended Loan Agreement remained substantially the same as those set forth in the originalfirst amended and restated loan and security agreement described above.agreement. The Company is required to maintain certain financial covenants under the credit facility.Second Amended Loan Agreement.

At December 31, 2004 and March 31,June 30, 2005, the Company’s available credit under the revolving line of credit was $10.0 million. TheIn accordance with certain provisions of the Second Amended Loan Agreement, the Company is required to pay a per annum unused facility fee of 0.5% for any unborrowed amountsmay activate an increase in the available credit under the revolving line of credit and acquisition term loan.subject to certain conditions up to $25.0 million.

5.6. 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, 2004 and March 31,June 30, 2005, there were 9,486,879 and 9,558,8869,722,796 shares of the Company’s common stock outstanding (including 146,905 treasury shares) and no shares of preferred stock outstanding.

During the threesix months ended March 31,June 30, 2005, the Company granted 385,000466,000 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 to 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$25.81 and the options vest in equal installments over time ranging from three to four years. In addition, the weighted-average fair value of the options granted during the six months ended June 30, 2005 totaled $7.04 per share. During the threesix months ended March 31,June 30, 2005, the Company issued 27,23049,636 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 44,77768,910 shares of its common stock in connection with the exercise of employee stock options under the Company’s 2003 stock option plan.

6.7. Earnings Per Share

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

For the three months ended March 31,June 30, 2005, employee stock options to purchase 1,387589 shares of common stock and, for the six months ended June 30, 2005, employee stock options to purchase 1,139 shares of common stock 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 period and, therefore, the effect of these options would be antidilutive.

7.8. 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.

8.9. 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 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.

On May 16, 2005, the Company began reinsuring a substantial portion of its general and professional liability and workers’ compensation insurance coverage under certain reinsurance programs through its wholly-owned captive insurance subsidiary, SPCIC, and, effective July 1, 2005, the Company began self-funding a substantial portion of its employee health insurance program as more fully described in note 2 above.

In connection with the acquisition of CBH on June 13, 2005, the Company issued 117,371 shares of its unregistered common stock and a promissory note in the principal amount of approximately $776,000, after deducting certain credits related to preliminary working capital adjustments of approximately $724,000, with a fixed interest rate of 5%. The number of shares of the Company’s unregistered common stock issued in connection with this transaction and the principal and accrued interest thereon related to the promissory note may subsequently be adjusted in accordance with the terms and conditions of the purchase agreement. With respect to the promissory note, the principal and accrued interest thereon may subsequently be adjusted upwards to $1.5 million or downward to zero in accordance with the terms and condition of the purchase agreement.

The Internal Revenue Service is currently examining the Company’s tax return for the period July 1, 2003 to December 31, 2003. Management believes the ultimate resolution of this examination will not result in a material adverse effect to the Company’s financial position or results of operations.

9.10. 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 lowerslowered the interest rate to 5% per annum. Interest income of $5,092approximately $10,000 was recorded for the threesix months ended March 31,June 30, 2004 and 2005. The balance of the note at December 31, 2004 and March 31,June 30, 2005 was $407,341approximately $407,000 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 ReDCo 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 $0approximately $1,500 and $5,401$12,000 was recorded for the threesix months ended March 31,June 30, 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,June 30, 2005, the balance of the note was $875,000 and is reflected in the accompanying consolidated balance sheet as “Notes“Current portion of 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.Fletcher 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 threesix months ended March 31,June 30, 2005, the Company reimbursed Las Montanas Aviation, LLC $11,936approximately $35,000 for use of the airplane for business travel purposes.

11. Subsequent Events

Effective July 1, 2005, the Company began self-funding a substantial portion of its employee health insurance program as more fully described in note 2 above.

The Company will restrict additional cash in the amount of $1.0 million to secure the reinsured claims losses of SPCIC in the event the Company becomes insolvent related to the Company’s general and professional liability reinsurance program as described in note 2 above. The requirement to restrict cash in the amount of $1.0 million was established upon the execution of a binding agreement between the Company and a fronting third party insurer.

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 March 31,June 30, 2005, we provided services directly and through the entities we manage to over 31,00031,500 clients from 160167 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.

PriorEffective May 16, 2005, we began reinsuring a substantial portion of our general and professional liability and workers’ compensation costs and the general and professional liability and workers’ compensation costs of certain designated entities we manage under reinsurance programs through our wholly-owned captive insurance subsidiary, Social Services Providers Captive Insurance Company, or SPCIC. In addition, effective July 1, 2005, we began self-funding a substantial portion of our employee health insurance program which we also offer to our initial public offeringemployees of certain entities we manage. These decisions were made based on current conditions in 2003, we were largely funded by venture capitalthe insurance marketplace that have

led to increasingly higher levels of self-insurance retentions, increasing number of coverage limitations and mezzanine debt. We used proceeds from our initial public offering to pay off our then existing long-term debt. dramatically higher insurance premium rates.

Our working capital requirements are now primarily funded by cash from operations. In addition, effective June 28, 2005, we haveamended our loan and security agreement with Healthcare Business Credit Corporation, or HBCC, to provide for a $10.0$25.0 million revolving line of credit and a $10.0$25.0 million acquisition term loan with Healthcare Business Credit Corporation or HBCC. Proceedsloan. Borrowings from 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 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 provide substantially all administrative 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 pursuant tounder 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. 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.

We 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. 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 our management of our operating margins.

Acquisitions

On June 13, 2005, we acquired all of the equity interest in Children’s Behavioral Health, Inc., or CBH, a Pennsylvania provider of home and school based social services for children, for a total purchase price of approximately $14.5 million, subject to adjustments. The purchase price consisted of $10.0 million in cash, 117,371 shares of our unregistered common stock valued at $3.0 million, and an unsecured, subordinated promissory note in the principal amount of approximately $776,000 after deducting certain credits related to preliminary working capital adjustments of approximately $724,000. The number of shares of our unregistered common stock issued in connection with this transaction and the principal and accrued interest thereon related to the promissory note may subsequently be adjusted in accordance with the terms and conditions of the purchase agreement.

We continue to selectively identify and pursue attractive acquisition opportunities. 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, theaccounts receivable and allowance for doubtful accounts, receivable, accounting for business combinations, goodwill and other intangible assets, and our management contract relationships.agreement relationships and loss reserves for certain reinsurance and self-funded insurance programs.

Revenue recognition

We recognize revenue at the time services are rendered at thepredetermined 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 consolidated balance sheets as deferred revenue 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 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 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.contracts.

Fee-for-service contracts. Revenues related to services provided under 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 73.4%73.6% and 64.1%62.6% of our revenue for the threesix months ended March 31,June 30, 2004 and 2005.

Cost based service contracts. Revenues from our cost based service contracts are generally recorded at one-twelfth of the annual contract amount less allowances for certain contingencies such as projected costs not incurred, excess cost per service over the allowable contract rate and/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. We 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 cost reports which are 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. Cost based service contracts represented approximately 0.0% and 17.7%17.9% of our revenue for the threesix months ended March 31,June 30, 2004 and 2005.

Case rate contract. Prior to July 1, 2004, we provided services under one contract pursuant 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 the excess cost amounts as additional revenue until the payer actually reimbursed us for such amounts or entered into an agreement contractually committing the payer to pay us and collection of such amount was determined to be probable.

Effective July 1, 2004, the case rate contract was amended to be an annual block purchase contract. In exchange for one-twelfth of the established annual contract amount each month, the 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 costs of providing necessary services exceed the associated reimbursement.

We are required to regularly submit service encounters to the payer 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 equal to the lesser of a specified encounter value, which represents the actual level of services rendered, or the contract amount. For the ninetwelve months ended March 31,June 30, 2005, revenues under the annual block purchase contract totaled $9.5approximately $14.0 million. The payer has not reduced or suspended payments to us. We believe that our encounter data is sufficient to have earned all amounts paid to us under the amended contract.

The terms of the contract may be reviewed prospectively and amended as necessary to ensure adequate funding of our service offerings under the contract. Our revenues under the previous case rate contract and for the threesix months ended March 31,June 30, 2004 represented 14.6%13.8% of our total revenues. Our revenues

under the annual block contract and for the threesix months ended March 31,June 30, 2005, represented 10.4%11.6% of our total 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 11.0%11.5% and 7.8%7.9% of our revenue for the threesix months ended March 31,June 30, 2004 and 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. If the likelihood is other than remote, we defer the recognition of all or a portion of the management fees received. To the extent we defer management fees as a means of funding any of our managed entities’ losses from operations, such amounts are not recognized as management fee revenues until they are ultimately collected from the operating income of the not-for-profit entities.

Consulting agreements. From time to time we may enter into consulting agreements with other entities that provide government sponsored social services. Under the agreements, we evaluate and make recommendations with respect to their management, administrative and operational services. We may continue to 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 are generally short-term in nature 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. Fees earned pursuant to our consulting agreements represented approximately 1%1.1% of our revenue for the

three six months ended March 31,June 30, 2004. No such fees were earned for the threesix months ended March 31,June 30, 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 consolidated statements of operations.

AllowanceAccounts receivable and 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.

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. In addition, in certain of our markets we also consider historical write-off experience and the likelihood that current receivables will ultimately be written off. Based on this analysis we maintain a general reserve for all receivables in certain of our markets by applying a percentage based on the age category of those receivables.

Our write-off experience for the threesix months ended March 31,June 30, 2004 and 2005 was less than 1% of revenue.

Accounting for business combinations, goodwill and other intangible assets

We analyze 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, we compare the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying value,

including goodwill. We use valuation techniques consistent with a market approach by deriving a multiple of our EBITDA (earnings before interest, taxes, depreciation and amortization) based on the market value of our 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 value of a 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. Our evaluation of goodwill completed as of December 31, 2004 resulted in no impairment losses.

When we consummate an acquisition we separately value all acquired identifiable intangible assets apart from goodwill in accordance with SFAS No. 141. In connection with our acquisitions, 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 assets.

We assess whether certain relevant factors limit the period over which acquired assets are expected to contribute directly or indirectly to future cash flows for amortization purposes. 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 will renew over future periods. The likelihood of renewal is based on our contract renewal experience and the contract renewal experiences of the entities acquired.

Under certain conditions we may assess the recoverability of the unamortized balance of our long-lived assets based on expected future cash flows. If the review indicates that the carrying value is not fully recoverable, the excess of the carrying value over the fair value of any 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 generally:

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(R), “Consolidation of Variable Interest Entities”, as revised, or Interpretation No. 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(R), if any, on future acquired management agreements.

Loss reserves for certain reinsurance and self-funded insurance programs

We maintain reserves for obligations related to our reinsurance programs for our general and professional liability and workers’ compensation coverage and our self-funded health insurance program provided to our employees and employees of certain entities we manage. As of June 30, 2005, we had reserves of approximately $1.5 million for the general and professional liability and workers’ compensation programs and no reserves for our self-funded health insurance program which began July 1, 2005. We utilize analyses prepared by third party administrators and independent actuaries based on historical claims information as well as our judgment based on our past experience and industry experience to support the required liability and related expense associated with general and professional liability and workers’ compensation coverage and health insurance coverage. We record claims expense by plan year based on the lesser of the aggregate stop loss (if applicable) or the developed losses as calculated by independent actuaries.

We continually analyze our reserves for incurred but not reported claims, and for reported but not paid claims related to our reinsurance and self-funded insurance programs and believe these reserves to be adequate. However, significant judgment is involved in assessing these reserves such as assessing historical paid claims, average lags between the claims’ incurred date, reported dates and paid dates, and the frequency and severity of claims. We are at risk for differences between actual settlement amounts and recorded reserves and any resulting adjustments are included in expense once a probable amount is known. Any significant increase in the number of claims or costs associated with claims made under these programs above our reserves could have a material adverse effect on our financial results.

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 March 31,June 30, 2005 compared to three months ended March 31,June 30, 2004

Revenues

Home and community based services. The acquisition of Pottsville Behavioral Counseling Group, Inc., or Pottsville,the Aspen Companies in MayJuly 2004 provided $540,000contributed $6.3 million in home and community based services revenue for the three months ended March 31, 2005. We added 257 clients as a result of this acquisition and entered into the Pennsylvania market. The acquisition of the Aspen Companies, in July 2004, contributed $5.7 million in home and community based services for the three months ended March 31,June 30, 2005. We added approximately 5,000 clients as a result of this acquisition and entered into the California and Nevada markets. In addition, the acquisition of CBH in June 2005 added $329,000 to home and community based services revenue for the three months ended June 30, 2005. We added approximately 300 clients as a result of this acquisition and expanded our presence in the Pennsylvania market. Additionally, start up services in the District of Columbia which began in June 2004 yielded additional home and community based services revenue of approximately $840,000$1.0 million for the three months ended March 31,June 30, 2005. Further, we received an additional $1.3 million under our annual block purchase contract with the Community Partnership of Southern Arizona, or CPSA, in the three months ended June 30, 2005 to enhance our service offering. Excluding the acquisition of Pottsville and the Aspen Companies and CBH, start up services in the District of Columbia and the additional payment from CPSA, our home and community based services provided additional revenue of approximately $6.1$5.2 million for the three months ended March 31,June 30, 2005, as compared to the same prior year period due to client volume increases in new and existing locations. We experienced a net increase of approximately 1,6001,400 new home and community based clients during the three months ended March 31,June 30, 2005 as compared to the same period in 2004, with

increases at our existing locations and as a result of the new locations that we opened in Indiana, Maine, North Carolina, TennesseeOklahoma and Virginia.

Foster care services. Foster care services revenue remained relatively constant with only a moderate increase of approximately $100,000$261,000 for the three months ended March 31,June 30, 2005 as compared to the same period one 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$151,000 for the three months ended March 31,June 30, 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$70,000 for the three months ended March 31,June 30, 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 our foster care service offering. In Delaware, where we are expanding our foster care service offering, our foster care services revenue increased approximately $156,000$161,000 for the three months ended March 31,June 30, 2005 and partially offset decreases in foster care services revenue in Tennessee and Nebraska. In our traditional home and community based markets such as Arizona, Florida and Virginia, our cross-selling efforts yielded an additional $325,000$323,000 of foster care services revenue from period to period. We expect cross-selling activities will continue and provide additional revenues in the future as we focus on continuous expansion of our foster care services.

Management fees. Revenue for entities we manage but do not consolidate for financial reporting purposes (managed entity revenue) increased to $35.9$37.4 million for the three months ended March 31,June 30, 2005 as compared to $20.3$29.1 million for the same prior year period. Management feefees revenue as a percentage of managed entity revenue decreased to 7.0%7.5% for the three months ended March 31,June 30, 2005 compared to 10.9%8.4% for the same period one year ago primarily due to the effect of a predetermined monthly fee we charged The ReDCo Group, or ReDCo, a managed entity, and comparatively lower management fee percentages related to the management agreements with Care Development of Maine, or CDOM and FCP, Inc., or FCP, that we acquired in June 2004. The combined effects of business growth and the acquisition of the management agreements with CDOM, FCP and ReDCo yielded approximately $277,000$359,000 in additional management feefees revenue for the three months ended March 31,June 30, 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 was partially offset byJune 30, 2004, net of a decrease in management feefees revenue of approximately $187,000$123,000 from our amended management services agreement with Rio Grande Behavioral Health Services, Inc., or Rio Grande, described below. In addition, we did not earn consulting fees for the three months ended June 30, 2005, which resulted in a decrease in management fees revenue of approximately $250,000 as compared to the same prior year period.

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 services agreement between us and Rio Grande to change the management fee charged to Rio Grande for certain management services from a per member per month based fee to a fixed fee per month. The fixed fee was comparable to the previous per member per month based fee and remained at this predetermined level until January 1, 2005, at which time the fixed fee was reduced. The new fixed fee will decreasehad the effect of decreasing our management feefees revenue from this management services agreement by approximately $400,000 for the first half of 2005 when compared to the six months endingended December 31, 2004. Partially offsetting this decrease was a management fee of $200,000 under the amended management services agreement with Rio Grande for start-up costs related to implementing pending changes to the Rio Grande behavioral health network described below.

Currently,Prior to July 1, 2005, the State of New Mexico is modifying itscontracted with three HMO’s and Rio Grande directly to administer a substantial portion of the state’s behavioral health services delivery system. We expect thatto recipients including Medicaid eligible recipients in southern New Mexico. The three HMO’s, in turn, contracted with Rio Grande which

had subcontracts with several not-for-profit providers in southern New Mexico (many of which comprise the state will finalizeRio Grande behavioral health network) to provide behavioral health services to Medicaid eligible recipients. In addition, Rio Grande contracted with us to provide it with certain management services.

Effective July 1, 2005, the modificationState of New Mexico modified its behavioral health services delivery system, by July 1, 2005, at which timewhereby it contracts with one administrative services entity to administer new and renewing contracts for behavioral health services will be administered by one administrative services entity. We believe this change inservices.

In response to the modification of 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 fee fornot-for-profit members of 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 whenbehavioral health network began contracting directly with the administrative services entity chosen by the State of New Mexico has completed the modification of itsto provide behavioral health services delivery system. While we anticipate a favorable outcome will result from the modification of the State ofto recipients including Medicaid eligible recipients in southern New Mexico’s behavioral health

services delivery system, there are no assurances that such outcome will materialize or that our negotiationsMexico effective July 1, 2005. The then existing subcontracts with Rio Grande regardingto provide the same behavioral health services were not renewed and contracts for certain administrative services to be provided by Rio Grande to the not-for-profit members of the Rio Grande behavioral health network were executed. Certain not-for-profit members of the Rio Grande behavioral health network executed management services agreements with us, effective July 1, 2005, whereby we provide certain management services directly to each not-for-profit member of the Rio Grande behavioral health network for a fee. The management fee pursuant to these management services agreements is either based on a percentage of the managed entities’ revenue or a flat fee and in total is comparable to the per member per month based management fee we previously charged to Rio Grande. As a result, we believe that the lower management fees revenue we earned under our previous amended management services agreement with Rio Grande for the six month period ended June 30, 2005 will not materially affect our management fee will befees revenue for 2005 as expected.compared to 2004.

Operating expenses

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

Payroll and related costs. To support 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 who 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 March 31,June 30, 2005, as compared to the same prior year period, as we added 382351 new direct care providers, administrative staff and other employees. In addition, we added 347514 new employees in connection with the acquisition of Pottsville and the Aspen Companies and CBH which resulted in an increase in payroll and related costs of approximately $4.0$4.3 million for the three months ended March 31,June 30, 2005 as compared to the three months ended March 31,June 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 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 as we may have difficulty recruiting employees to service our contracts. Furthermore, acquisitions may 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 expensecosts increased

from 53.5%52.1% for the three months ended March 31,June 30, 2004 to 56.7%54.7% for the three months ended March 31,June 30, 2005 primarily due to our efforts to increase the number of employees to service our growth.

Purchased services. Increases in the number of referrals requiring pharmacy, and support services partially offset by a decreaseand out-of-home placement under our annual block purchase contract and increases 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 March 31,June 30, 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 under our annual block purchase contract. Despite the increase in purchased services for the three months ended March 31,June 30, 2005, as a percentage of revenue, purchased services decreased from 13.2%11.7% for the three months ended March 31,June 30, 2004 to 10.3%10.7% for the three months ended March 31,June 30, 2005. Increases in revenue from both organic growth and acquisitions outpaced the growth in purchased services for the three months ended March 31,June 30, 2005.

Other operating expenses. As a result of our organic growth during the second half of 2004 and the threesix months ended March 31,June 30, 2005, we added new locations in Indiana, Maine, North Carolina, TennesseeOklahoma and Virginia that contributed to an increase in other operating expenses for the three months ended March 31,June 30, 2005 when compared to the three months ended March 31,June 30, 2004. The acquisition of Pottsvillethe Aspen Companies and the Aspen

CompaniesCBH added approximately $773,000$958,000 to other operating expenses for the three months ended March 31,June 30, 2005. As a percentage of revenue other operating expenses increased from 7.8%9.1% to 8.5%10.0% 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 $19,000 for the three months ended March 31,June 30, 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. 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.

The 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 $822,000$762,000 of corporate administrative expenses from period to period. In addition, as a result of our growth during the threesecond half of 2004 and the six months ended March 31,June 30, 2005, rent and facilities management increased $574,000$572,000 in part due to our acquisition activities. As a percentage of revenue, general and administrative expense decreased to 12.4%11.9% for the three months ended March 31,June 30, 2005 from 13.9%13.8% for the three months ended March 31,June 30, 2004. Increases in revenue from both organic growth and acquisitions outpaced the growth in general and administrative expense for the three months ended March 31,June 30, 2005.

Depreciation and amortization.

The increase in depreciation and amortization from period to period primarily resulted from the amortization of customer relationships of $86,000approximately $102,000 related to the acquisition of Dockside Services, Inc., or Dockside, Pottsville andBehavioral Counseling Group, Inc., or Pottsville, the Aspen Companies.Companies and CBH. Also contributing to the increase in depreciation and amortization was the amortization of the fair value of the acquired management agreements with Rio Grande, CDOM, FCP and ReDCo and increased depreciation expense primarily due to the addition of software and computer equipment during the three months ended March 31, 2005.equipment. As a percentage of revenues, depreciation and amortization decreased fromremained constant at 1.2% for the months ended March 31, 2004period to 1.1% for the three months ended March 31, 2005 primarily due to a higher revenue growth rate.period.

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.

Six months ended June 30, 2005 compared to six months ended June 30, 2004

Revenues

Home and community based services. The acquisition of the Aspen Companies in July 2004 contributed $12.0 million in home and community based services for the six months ended June 30, 2005 as compared to the prior year period. In addition, we acquired CBH in June 2005 which added $329,000 to our home and community based services revenue for the six months ended June 30, 2005. Further, services in the District of Columbia which began in June 2004 yielded additional home and community based services revenue of approximately $1.9 million for the six months ended June 30, 2005. Also, we received an additional $1.3 million under our annual block purchase contract with CPSA in the six months ended June 30, 2005 to enhance our service offering. Excluding the acquisition of the Aspen Companies and CBH, start up services in the District of Columbia and the additional payment from CPSA, our home and community based services provided additional revenue of approximately $11.9 million for the six months ended June 30, 2005, as compared to the same prior year period due to client volume increases in new and existing locations.

Foster care services. Foster care services revenue remained relatively constant with only a moderate increase of approximately $361,000 for the six months ended June 30, 2005 as compared to the same period one 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 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 $453,000 for the six months ended June 30, 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 $150,000 for the six months ended June 30, 2005 as compared to the six months ended June 30, 2004. 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 our foster care service offering. In Delaware, where we are expanding our foster care service offering, our foster care services revenue increased approximately $317,000 for the six months ended June 30, 2005 and partially offset decreases in foster care services revenue in Tennessee and Nebraska. In our traditional home and community based markets such as Arizona, Florida and Virginia, our cross-selling efforts yielded an additional $647,000 of foster care services revenue from period to period. We expect cross-selling activities will continue and provide additional revenues in the future as we focus on continuous expansion of our foster care services.

Management fees. Revenue for entities we manage but do not consolidate for financial reporting purposes (managed entity revenue) increased to $73.3 million for the six months ended June 30, 2005 as compared to $49.5 million for six months ended June 30, 2004. Management fees revenue as a percentage of managed entity revenue decreased to 7.2% for the six months ended June 30, 2005 compared to 9.1% for the same period one year ago primarily due to the effect of a predetermined monthly fee we charged ReDCo, a managed entity, and comparatively lower management fee percentages related to the management agreements with CDOM and FCP that we acquired in June 2004. The combined effects of business growth and the acquisition of the management agreements with CDOM, FCP and ReDCo yielded approximately $820,000 in additional management fees revenue for the six months ended June 30, 2005, as compared to the same prior year period, net of a decrease in management fees revenue of approximately $311,000 from our amended management services agreement with Rio Grande described above under our discussion and analysis of management fees revenue for the three months ended June 30, 2005. In addition, we did not earn consulting fees for the six months ended June 30, 2005, which resulted in a decrease in management fees revenue of approximately $434,000 as compared to the same period one year ago.

Operating expenses

Client service expense.Client service expense includes the following for the six months ended June 30, 2004 and 2005:

Payroll and related costs. To support 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 six months ended June 30, 2005, as compared to the six months ended June 30, 2004, as we added new direct care providers, administrative staff and other employees. In addition, we added new employees in connection with the acquisition of the Aspen Companies and CBH which resulted in an increase in payroll and related costs of approximately $8.2 million for the six months ended June 30, 2005. 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 as we may have difficulty recruiting employees to staff our contracts. Furthermore, acquisitions may 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 costs increased from 52.7% for the six months ended June 30, 2004 to 55.7% for the same current year period primarily due to our efforts to increase the number of employees to service our growth.

Purchased services. Increases in the number of referrals requiring pharmacy, support services and out-of-home placement under our annual block purchase contract and increases in foster parent payments accounted for the increase in purchased services for the six months ended June 30, 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 under our annual block purchase contract. Despite the increase in purchased services for the six months ended June 30, 2005, as a percentage of revenue, purchased services decreased from 12.4% for the six months ended June 30, 2004 to 10.5% for the six months ended June 30, 2005. Increases in revenue from both organic growth and acquisitions outpaced the growth in purchased services for the six months ended June 30, 2005.

Other operating expenses. As a result of our organic growth during the second half of 2004 and the six months ended June 30, 2005, we added new locations in Indiana, Maine, North Carolina, Oklahoma and Virginia that contributed to an increase in other operating expenses for the six months ended June 30, 2005 when compared to the same period one year ago. The acquisition of the Aspen Companies and CBH added approximately $1.7 million to other operating expenses for the six months ended June 30, 2005. As a percentage of revenue other operating expenses increased from 8.5% for the six months ended June 30, 2004 to 9.2% for the six months ended June 30, 2005 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 $37,000 for the three months ended June 30, 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. 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.

The 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 and legal fees, information systems improvements, directors and officers’ insurance, general and professional liability insurance and professional services fees accounted for an increase of $1.6 million of corporate administrative expenses for the six months ended June 30, 2005. 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 related to increased services provided for SEC filings, report reviews and regulatory compliance. Furthermore, as a result of our growth during the second half of 2004 and the six months ended June 30, 2005, rent and facilities management increased $1.1 million in part due to our acquisition activities. As a percentage of revenue, general and administrative expense decreased to 12.1% for the six months ended June 30, 2005 from 13.8% for the same prior year period. Increases in revenue from both organic growth and acquisitions outpaced the growth in general and administrative expense for the three months ended June 30, 2005.

Depreciation and amortization.

The increase in depreciation and amortization from period to period primarily resulted from the amortization of customer relationships of approximately $189,000 related to the acquisition of Dockside, Pottsville, the Aspen Companies and CBH. Also contributing to the increase in depreciation and amortization was the amortization of the fair value of the acquired management agreements with CDOM, FCP and ReDCo and increased depreciation expense due to the addition of software and computer equipment during the second half of 2004 and the six months ended June 30, 2005. As a percentage of revenues, depreciation and amortization remained constant at 1.2% from period to period.

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

Our balance of cash and cash equivalents was $13.5$13.2 million at March 31,June 30, 2005, up from $10.7 million at December 31, 2004, primarily due to cash provided by operating activities and proceeds from the issuance of stock related to the exercise of outstanding stock options during the threesix months ended March 31,June 30, 2005. At March 31,June 30, 2005 and December 31, 2004, our debt was $11.7 million and $1.1 million (including two notes issued in connection with the acquisition of Dockside Services, Inc., or Dockside, in January 2004, in the aggregate principal amount of $1.0 million and the note issued in connection with the acquisition of CBH, in the principal amount of approximately $776,000 and our capital lease obligation of $111,145approximately $83,000 and $135,389,$135,000, respectively).

Cash flows

Operating activities. Net cash from operations of $1.8$4.7 million for the threesix months ended March 31,June 30, 2005, werewas provided primarily from net income of $2.1$4.5 million and the add back of non-cash depreciation and amortization expense and deferred financing costs amortization of approximately $371,000.$874,000. Working capital increased for the threesix months ended March 31,June 30, 2005, with nearlyapproximately $1.7 million of cash used to prepay certain insurance coverage and nearly $1.9 million to finance our accounts receivable, management fee receivable and reinsurance premium receivable growth partially offset by approximately $1.4$3.4 million increase in accrued expenses and accounts payablereinsurance liability reserves due to increased amounts due for purchased services expense, income tax liability, accrued payroll, accrued foster parent payments and audit fees.the required reserves related to our reinsurance programs. Revenue which was deferred in prior periods was earned during the threesix months ended March 31,June 30, 2005 related to our operations in Arizona and California and resulted in a decrease in deferred revenue of approximately $400,000.$496,000.

Investing activities. Net cash used in investing activities totaled approximately $283,000$13.2 million for the threesix months ended March 31,June 30, 2005, and included additionalnet acquisition costs of approximately $72,000$10.1 million related to CBH, additional contract acquisition costs of approximately $1.8 million related to the Aspen Companies and $30,000 to acquire aacquisition of the management agreement with Triad Family Services,CDOM, and $775,000 to fund a California not-for-profit corporation.standby letter of credit which provides funds for the outstanding claims losses of SPCIC. We spent approximately $181,000$393,000 for property and equipment.

Financing activities. For the threesix months ended March 31,June 30, 2005, we generated cash of approximately $1.3$11.0 million in financing activities. We borrowed $10.0 million under our credit facility in connection with the acquisition of CBH and issued common stock related to the exercise of outstanding stock options which provided net proceeds of $1.3 million and repaidmillion. Partially offsetting the increase in cash from financing activities was the repayment of amounts due under our notes payable related to the acquisition of Dockside of $200,000 and capital lease agreements of approximately $24,000.$52,000.

Obligations and commitments

Credit facilities.facilities Our amended

On June 28, 2005, our loan and security agreement was amended pursuant to a second amended and restated loan and security agreement, or Second Amended Loan Agreement, with Healthcare Business Credit Corporation, or HBCC,HBCC. The Second Amended Loan Agreement provides for a $10.0 millionan increase in the amount we may borrow under our revolving line of credit and afrom $10.0 million to $25.0 million and an increase in the amount we may borrow under our acquisition term loan.loan from $10.0 million to $25.0 million subject to certain conditions. 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 borrowedHBCC’s approval and are payable in consecutive monthly installments as determined 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. Second Amended Loan Agreement.

Borrowings under this credit facilitythe Second Amended Loan Agreement bear interest at an annuala rate equal to the primesum of the annual rate in effect from timein the London Interbank market, or LIBOR, applicable to time,one month deposits of U.S. dollars on the business day preceding the date of determination plus 2.0%4.0% in the case of the revolving line of credit and prime plus 2.5%4.5% in the case of the acquisition term loan.loan subject to certain adjustments based upon our debt service coverage ratio. In addition, we are subject to a 0.5% fee per annum on the unused portion of our credit facility,the available funds as determined in accordance with certain provisions of the Second Amended Loan Agreement 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 amendmentSecond Amended Loan Agreement also extendedextends 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 asand acquisition term loan to June 28, 2010.

In order to secure payment and performance of all obligations in accordance with the otherterms and provisions of ourthe Second Amended Loan Agreement, HBCC retained its interests in the collateral described in the first amended loan agreement remained the same as those set forth in our original January 2003and restated loan and security agreement. Concurrentagreement dated as of September 30, 2003, including our management agreements with certain not-for-profit entities, and the amendmentassets of certain of our agreement,subsidiaries. If certain events of default including, but not limited to, failure to pay any installment of principal or interest when due, failure to pay any other charges, fees, expenses or other monetary obligations owing to HBCC established stand-alone credit facilitieswhen due or other particular covenant defaults, as more fully described in the Second Amended Loan Agreement, occur, HBCC may declare all unpaid principal and any accrued and unpaid interest and all fees and expenses immediately due. Under the Second Amended Loan Agreement, any initiation of bankruptcy or related proceedings, assignment or sale of any asset or failure to remit any payments received by us on behalf of each ofaccount to HBCC will accelerate all unpaid principal and any accrued and unpaid interest and all fees and expenses. In addition, if we default on our indebtedness including the managed entities that were removed from our facility, and, while we do not guarantee any portion of their stand-alone facilities, we have agreedpromissory notes issued in connection with completed business acquisitions, it could trigger a cross default under the amendment of our loanSecond Amended Loan Agreement whereby HBCC may declare all unpaid principal and security agreementaccrued and unpaid interest, other charges, fees, expenses or other monetary obligations immediately due.

We agreed with HBCC to subordinate our management fee receivable pursuant to management agreements established with certain of our managed entities, which have stand-alone credit facilities with HBCC, to the claims of HBCC in the event one of these managed entities defaults under its credit facility.

The remaining provisions of the Second Amended Loan Agreement remained substantially the same as those set forth in the first amended and restated loan and security agreement.

At March 31,June 30, 2005, we borrowed $10.0 million under the acquisition term loan and had no borrowings under the revolving line of credit and no borrowings under the acquisition term loan,credit. We had available credit of $10.0 million on our revolving line of credit, and we were in compliance with all covenants. In accordance with certain provisions of the Second Amended Loan Agreement, we may activate an increase in the available credit under the revolving line of credit subject to certain conditions up to $25.0 million.

Promissory notes

In connection with our acquisition of Dockside, we issued two unsecured subordinated promissory notes each in the principal amount of $500,000 to the former stockholders of Docksidesellers 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.

In partial consideration for the purchase of all of CBH’s outstanding stock, we issued an unsecured subordinated promissory note in the principal amount of approximately $776,000 to the seller. The principal and accrued interest thereon related to the promissory note may subsequently be adjusted upwards to a total principal amount of $1.5 million or adjusted downward to zero in accordance with the terms and conditions of the purchase agreement. The promissory note bears interest of 5% with interest payable semi-annually beginning December 1, 2005 and all unpaid principal and any accrued and unpaid interest due June 2010.

Failure to pay any installment of principal or interest when due or the initiation of bankruptcy or related proceedings by us related to the unsecured, subordinated promissory notes issued to the former stockholders of Dockside and CBH, constitutes an event of default under the promissory note provisions. If a failure to pay any installment of principal or interest when due remains uncured after the time provided by the promissory notes, the unpaid principal and any accrued and unpaid interest may become due immediately. In the case of bankruptcy or related proceedings initiated by us, the unpaid principal and any accrued and unpaid interest becomes due immediately.

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. Management fees generated under our management agreements represented 11.0%11.5% and 7.8%7.9% of our revenue for the threesix months ended March 31,June 30, 2004 and 2005. Fees generated under short term consulting agreements entered into in December 2003 and during 2004 represented approximately 1%1.1% of our revenue for the threesix months ended March 31,June 30, 2004. No such fees were generated for the threesix months ended March 31,June 30, 2005. (See “—Critical accounting policies and estimates—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, 2004 and March 31,June 30, 2005 weretotaled $5.0 million and $5.1$5.3 million, and management fee revenues wererevenue was 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 feesfee receivable balances as of March 31, June 30, September 30 and December 31, 2004 and March 31 and June 30, 2005:

We adhere to a strict revenue recognition policy regarding our management fee revenuesrevenue 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 older than 365 days old or older.days.

At March 31,June 30, 2005, none of our management feesfee receivable werewas older than 365 days, and our days sales outstanding for our managed entities had decreased from 181 days at December 31, 2004 to 177180 days at March 31,June 30, 2005.

In addition, Camelot Community Care, Inc., which represented $2.4approximately $2.9 million, or 48.3%54.5%, of our total management fee receivable at March 31,June 30, 2005, and Intervention Services Inc., referred to as ISI, which represented approximately $734,000 million,$913,000, or 14.5%17.2%, of our total management fee receivable at March 31,June 30, 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 March 31,June 30, 2005, they were not in default under their credit facilities with HBCC and Camelot Community Care, Inc. had availability of $815,000approximately $1.0 million under its line of credit as well as $2.9$2.5 million in cash and cash equivalents and ISI had availability of $24,000approximately $476,000 under its line of credit as well as $298,000$57,000 in cash and cash equivalents.

The remaining $1.9$1.5 million balance of our total management feesfee receivable at March 31,June 30, 2005, was due from Rio Grande, 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 as the long-term manager of their 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.

Loss reserves for certain reinsurance and self-funded insurance programs

General and professional liability and workers’ compensation

Prior to April 12, 2005, we had general and professional liability coverage with a $500,000 self-insured retention for each claim through a third party insurer. In addition, prior to May 16, 2005 we had first dollar coverage for workers’ compensation costs with third party insurers. Effective May 16, 2005, we began reinsuring a substantial portion of our general and professional liability and workers’ compensation costs and the general and professional liability and workers’ compensation costs of certain designated entities we manage under reinsurance programs through our wholly-owned captive insurance subsidiary, SPCIC, incorporated under the laws of the State of Arizona. We established SPCIC in order to better manage the annual expenditures for general and professional liability and workers’ compensation insurance coverage. It is expected that the formation of SPCIC will enable us to provide for: (1) long-term stable insurance programs, (2) increased control over claims management and risk control administration and (3) reduced overall insurance costs associated with general and professional liability and workers’ compensation insurance coverage. We primarily utilize SPCIC as a risk management and cost containment tool.

Our general and professional liability and workers’ compensation reinsurance programs are fronted by two third party insurers for a predetermined amount; one for general and professional liability and one for workers’ compensation liability. These third party insurers also provide coverage to certain designated entities we manage. SPCIC reinsures these two third party insurers for certain claims as described below.

SPCIC reinsures the third party insurer for general and professional liability exposures for the first dollar of each and every loss up to $250,000 per loss with no annual aggregate limit. The reinsurance

premium for the first policy year ending April 12, 2006 of approximately $785,000 equals the reinsured portion of the actuarially determined expected losses for the same period. The third party insurer provides general and professional liability coverage for up to $750,000 per occurrence over the $250,000 reinsured limit with an annual aggregate limit of $3.0 million. Assuming our actual reinsured losses and the reinsured losses of certain designated entities we manage were to exceed the reinsured portion of the actuarially determined expected losses of approximately $785,000 in the first policy year ending April 12, 2006, our additional exposure would be recognized as an increase to our general and administrative expense in our consolidated statements of operations in the period such exposure became known.

Under our worker’s compensation reinsurance program, SPCIC reinsures a third party insurer for the first $250,000 per occurrence with no annual aggregate limit. The third party insurer provides workers’ compensation coverage up to statutory limits. The reinsurance premium for the first policy year ending May 15, 2006 of approximately $774,000 equals the reinsured portion of the actuarially determined expected losses for the same period. Assuming our actual reinsured losses and the reinsured losses of certain designated entities we manage were to exceed the reinsured portion of the actuarially determined expected losses of approximately $774,000 in the first policy year ending May 15, 2006, our additional exposure would be recognized as an increase to our payroll and related costs in our consolidated statements of operations in the period such exposure became known. Our reserve levels are evaluated on a quarterly basis. Any necessary adjustments are recognized as an adjustment to general and administrative expense in our consolidated statements of operations.

We record a provision for losses incurred but not reported, based on the recommendations of an independent actuary and our judgment using our past experience and industry experience. We (through SPCIC) have restricted cash of $775,000 at June 30, 2005, which is restricted to secure the reinsured claims losses of SPCIC under our workers’ compensation reinsurance program in the event we become insolvent. We will restrict additional cash in the amount of $1.0 million to secure the reinsured claims losses of SPCIC in the event we become insolvent related to our general and professional liability reinsurance program. The requirement to restrict cash in the amount of $1.0 million was established upon the execution of a binding agreement between us and the fronting third party insurer. The full extent of certain claims may not be fully determined for years. Therefore, the estimates of potential obligations are based on recommendations of an independent actuary and our judgment using historical data, and industry and our experience. Although we believe that the amounts accrued for losses incurred but not reported under the preliminary terms of our reinsurance programs are sufficient, any significant increase in the number of claims or costs associated with these claims made under these programs could have a material adverse effect on our financial results.

Our liability under our reinsurance programs is based on preliminary terms under binders with the third party insurers and any obligations over our reinsurance program limits are our responsibility. Approximately 28% of the total liability assumed by us under our reinsurance programs is related to the designated entities we manage that are covered under our reinsurance programs. It is possible that we, under the final terms of our reinsurance programs, will revise our estimates significantly. Any subsequent differences that may arise will be recorded in the period in which they are determined.

Health Insurance

Effective July 1, 2005, we began offering our employees and employees of certain entities we manage an option to participate in a self-funded health insurance program. Health claims under this program are self-funded with a stop-loss umbrella policy with a third party insurer to limit the maximum potential liability for individual claims to $150,000 per person and for total claims to $8.0 million for the plan year ending June 30, 2006. Health insurance claims are paid as they are submitted to the plan administrator. Beginning July 1, 2005, we maintain accruals for claims that have been incurred but not yet reported to the plan administrator and therefore have not been paid. The incurred but not reported reserve is based on the historical claim lag period and current payment trends of health insurance claims which is generally 1 – 2 months. The liability for the self-funded health program is recorded in accrued payroll and

related costs in our consolidated balance sheet. As of June 30, 2005 no amounts have been reserved in our consolidated balance sheet for our self-funded health insurance program.

We charge our employees and employees of certain entities we manage a portion of the costs of our self-funded and non self-funded health programs, and we determine this charge at the beginning of each plan year based upon historical and projected medical utilization data, along with projected inflationary increases in medical costs. Any difference between our projections and our actual experience is borne by us. We are estimating potential obligations for liabilities under this program to reserve what we believe to be a sufficient amount to cover liabilities based on an independent actuary and past experience. Any significant increase in the number of claims or costs associated with claims made under this program above what we reserve could have a material adverse effect on our financial results.

Tax return examination

The Internal Revenue Service is currently examining our tax return for the period July 1, 2003 to December 31, 2003. We believe the ultimate resolution of this examination will not result in a material adverse effect to our financial position or results of operations.

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 our debt facilities.

Recently issued accounting pronouncements

In December 2004, the Financial 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 requirements of SFAS 123R is permitted, but not required. On April 15, 2005, the 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 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 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 reinsurance and

self-funded insurance programs where we reinsure certain of our general and professional liability and workers’ compensation coverage and self-fund our health insurance program provided to our employees and employees of certain entities we manage, such as claims exceeding our estimated losses which could materially adversely affect our financial position, results of operations and cash flows; risks associated with certain judgments regarding estimates we make related to the sufficiency of our allowance for doubtful accounts, intangible assets subject to amortization and the level of success we anticipate by cross-selling our services in certain of our markets and positioning our operations to offer the highest quality of service; risks associated with our cost based service contracts and annual block purchase contract such as budgeted costs not incurred, costcosts per service which may exceed allowable rate per contract rates, 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 associated with the review of our tax filings with the Internal Revenue Service and state and local taxing authorities, such as assessment of penalties and interest payments that could result in a material adverse effect on our financial results and cash flows; 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 providerspayers 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 SEC.Securities and Exchange Commission.

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 consummationAs of our initial public offering,June 30, 2005, we repaid all of the principal and accrued interest outstandingborrowed $10.0 million under our acquisition term loan and security agreements. As of March 31, 2005, we had no borrowings under our revolving line of credit. Borrowings under the Second Amended Loan Agreement bear interest at a rate equal to the sum of the annual rate in effect in the London Interbank market, or LIBOR, applicable to one month deposits of U.S. dollars on the business day preceding the date of determination plus 4.0% in the case of the revolving line of credit and no4.5% in the case of the acquisition term loan subject to certain adjustments based upon our debt service coverage ratio. In accordance with certain provisions of the Second Amended Loan Agreement, we may activate an increase in the available credit under our revolving line of credit subject to certain conditions up to $25.0 million. A 1% increase in interest rates related to our borrowings under our acquisition term loan. Second Amended Loan Agreement for the six months ended June 30, 2005 would have resulted in an immaterial increase to interest expense.

In connection with our acquisition of Dockside, we issued two subordinated promissory notes each in the principal amount of $500,000 to the sellers. The notes bear a fixed interest rate of 6%. Also, in connection with our acquisition of CBH, we issued a subordinated promissory note in the principal amount of approximately $776,000 to the seller. The note bears a fixed interest rate of 5%.

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 320331 contracts. Among these contracts there are certain contracts under which we generate a significant portion of our revenue. We generated approximately $3.3$7.8 million, or 10.4%11.6% of our revenues for the threesix months ended March 31,June 30, 2005, pursuant to one 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 controls and procedures

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 (March 31,(June 30, 2005). Based on this evaluation, the principal executive officer and principal financial officer concluded

that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective in reaching a reasonable level of assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 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

The principal executive officer and principal financial officer also conducted an evaluation of the Company’s internal control over financial reporting (“Internal Control”) to determine whether any changes in Internal Control occurred during the quarter ended March 31,June 30, 2005 that have materially affected or which are reasonably likely to materially affect Internal Control. Based on that evaluation, there has been no such change during the quarter ended March 31,June 30, 2005 covered by this 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.

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. SubmissionOur annual meeting of Matters to a Vote of Security Holders.stockholders was held on May 19, 2005 for the following purposes:

None