UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________________________

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013March 31, 2014

Commission File Number 001-31932

_______________________

CATASYS, INC.

(Exact name of registrant as specified in its charter)

_______________________

11150 Santa Monica11601 Wilshire Boulevard, Suite 1500,950, Los Angeles, California 90025

(Address of principal executive offices, including zip code)

(310) 444-4300

(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 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes☑          No☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    

Yes☑          No☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definitions of “accelerated““accelerated filer,” “large accelerated filer,’’ and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes☐            No☑

As of November 13, 2013,May 14, 2014, therewere 18,835,571shares20,693,046shares of registrant's common stock, $0.0001 par value, outstanding.

TABLE OF CONTENTS

In this report, except as otherwise stated or the context otherwise requires, the terms “we,” “us” or “our” refer to Catasys, Inc. and our wholly-owned subsidiaries. Our common stock, par value $0.0001 per share, is referred to as “common stock.”

Item 1.     Financial Statements

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

* The financial statements have been retroactively restated to reflect the 10-for-1 reverse stock splitthat occurred on May 6, 2013.

See accompanying notes to the financial statements.

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(In thousands, except per share amounts)		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Revenues
Healthcare services revenues		$	109			$	100			$	315			$	226
License and management services revenues			21				40				83				136
Total revenues			130				140				398				362
Operating expenses
Cost of services			221				197				628				618
General and administrative			1,415				1,946				4,651				6,629
Impairment losses			-				-				-				189
Depreciation and amortization			42				69				131				227
Total operating expenses			1,678				2,212				5,410				7,663
Loss from operations			(1,548	)			(2,072	)			(5,012	)			(7,301	)
Interest and other income			-				-				-				-
Interest expense			(1	)			(1	)			(771	)			(2,697	)
Change in fair value of warrant liability			2,231				1,818				2,607				4,127
Income/(Loss) from operations before provision for income taxes			682				(255	)			(3,176	)			(5,871	)
Provision for income taxes			2				2				5				18
Net Income/(Loss)		$	680			$	(257	)		$	(3,181	)		$	(5,889	)
Basic and diluted net income (loss) per share:*
Basic net income (loss) per share*		$	0.05			$	(0.04	)		$	(0.24	)		$	(1.23	)
Basic weighted number of shares outstanding*			14,286				5,908				13,429				4,802
Diluted net income (loss) per share*		$	0.04			$	(0.04	)		$	(0.24	)		$	(1.23	)
Diluted weighted number of shares outstanding*			19,364				5,908				13,429				4,802

* The financial statements have been retroactively restated to reflect the 10-for-1 reverse stock splitthat occurred on May 6, 2013.

See accompanying notes to the financial statements.

CATASYS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)

See accompanying notes to the financial statements.

Catasys, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1. Basis of Consolidation, Presentation and Going Concern

The accompanying unaudited interim condensed consolidated financial statements for Catasys, Inc. and our subsidiaries have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and instructions to Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of financial position, results of operations, and cash flows in conformity with U.S. GAAP. In our opinion, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included.  Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K for the year-ended December 31, 2013, from which the December 31, 20122013 balance sheet havehas been derived.

Our financial statements have been prepared on the basis that we will continue as a going concern. At September 30, 2013,March 31, 2014, cash and cash equivalents amounted to $422,000$723,000 and we had a working capital deficit of approximately $3.5$2.9 million. In October 2013,January 2014, we closed on a financing of approximately $2.6$1.0 million. We have incurred significant operating losses and negative cash flows from operations since our inception. During the ninethree months ended September 30, 2013,March 31, 2014, our cash used in operating activities amounted to $4.3$1.5 million. We anticipate that we could continue to incur negative cash flows and net losses for the next twelve months. The financial statements do not include any adjustments relating to the recoverability of the carrying amount of the recorded assets or the amount of liabilities that might result from the outcome of this uncertainty. As of September 30, 2013,March 31, 2014, these conditions raised substantial doubt as to our ability to continue as a going concern.

Our ability to fund our ongoing operations and continue as a going concern is dependent on our increasing fees from existing contracts and signing and generating fees from newexisting and existingnew contracts for our Catasys managed care programs and the success of management’s plans to increase revenue and continue to control expenses. We operatedare operating our programs in Kansas, Louisiana, Massachusetts, Oklahoma, West Virginia, Kentucky, and Oklahoma duringWisconsin. The Wisconsin program, which represents our first managed care Medicaid health plan customer, commenced enrollment in the thirdfirst quarter of 2013. In2014.In 2013, we signed two agreementsan agreement with a national health plansplan to provide services to their members in New Jersey, and Ohio, West Virginia, Kentucky, and Indiana, respectively. We commenced enrollment for Humana, one of the national insurers in the fourth quarter of 2013, andwhich we expect to continue to expand enrollment with Humana and commence enrollment withby the other national insurer duringend of the fourththird quarter of 2013. During the nine months ending September 30, 2013, we2014. We have generated increased fees from ourthe launched programs over the same period in the prior year, and we expect to continue to increase enrollment and fees from our programs throughout this year both from existing programs and the contracts we signed in 2013. In addition, we are involved in contract negotiations with other potential customers that we expect to sign in the fourth quarter.2014. However, there can be no assurance that we will generate such fees or sign additional contracts. Wefees. In addition, we continue to look for areasseek ways to reducestreamline our operating expenses.

 We and our Chief Executive Officer are party to a litigation in which the plaintiffs assert causes of action for conversion, a request for an order to set aside fraudulent conveyance and breach of contract. A judgment in our favor was entered by the court in November 2012, however the plaintiff has appealed the judgment. While we believe the plaintiffs’ claims are without merit and we intend to continue to vigorously defend the case, there can be no assurance that the litigation will be resolved in our favor. If this case is decided against us or our Chief Executive Officer, it may cause us to pay substantial damages, and other related fees. Regardless of whether this litigation is resolved in our favor, any lawsuit to which we are a party will likely be expensive and time consuming to defend or resolve. Costs of defense and any damages resulting from litigation, a ruling against us or a settlement of the litigation could have a significant negative impact on our liquidity, including our cash flows.

Based on the provisions of our management services agreement (“MSA”) between us and our managed professional medical corporation, we have determined that our managed professional medical corporation constitutes a variable interest entity, and that we are the primary beneficiary as defined in Financial Accounting Standards Board (“FASB”) Interpretation No. 46R “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51” (“FIN 46R”).  Accordingly, we are required to consolidate the revenue and expenses of our managed professional medical corporation. See Management Services Agreement heading under Note 2, Summary of Significant Accounting Policies, for more discussion.

All intercompany transactions and balances have been eliminated in consolidation.

Note 2. Summary of Significant Accounting Policies

Revenue Recognition

Healthcare Services 

        Our Catasys contracts are generally designed to provide revenuescash fees to us on a monthly basis based on enrolled members. To the extent our contracts may include a minimum performance guarantee, we reserve a portion of the monthly fees that may be at risk until the performance measurement period is completed. To the extent we receive case rates that are not subject to the performance guarantees we recognize the case rate ratably over twelve months.

License and Management Services

Our license and management services revenues are primarily derived from our managed treatment center, which we include in our condensed consolidated financial statements, and which are derived from charging fees directly to patients for treatment and are recorded when services are provided. Revenues from patients treated with our proprietary treatment program are recorded based on the number of days of treatment completed during the period as a percentage of the total number treatment days for the treatment program. Revenues for other services are recognized when services are rendered.

Cost of Services

Healthcare Services 

Cost of healthcare services consists primarily of salaries related to our care coaches, healthcare provider claims payments, and fees charged by our third party administrators for processing these claims. Healthcare services cost of services is recognized in the period in which an eligible member receives services. We contract with doctors and licensed behavioral healthcare professionals, on a fee-for-services basis. We determine that a member has received services when we receive a claim or in the absence of a claim, by utilizing member data recorded in the eOnOnTrak^TM database within the contracted timeframe, with all required billing elements correctly completed by the service provider.

License and Management Services

Cost of license and management services primarily represents direct costs associated with providing care to patients that are incurred in connection with our managed treatment center. Costs are recognized in the periods in which medical treatment is provided. Such costs include, but are not limited to, direct labor costs, medical supplies and medications.

Cash Equivalents and Concentration of Credit Risk 

We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. Financial instruments that potentially subject us to a concentration of credit risk consist of cash and cash equivalents, and accounts receivable. Cash is deposited with what we believe are highly credited, quality financial institutions. The deposited cash may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits. At March 31, 2104, cash and cash equivalents exceeding federal insured limits totaled $523,710.

For the ninethree months ended September 30, 2013, one customer accounted for approximately 64% of revenues andMarch 31, 2014, three customers accounted for approximately 91%68% of revenues and two customers accounted for approximately 81% of accounts receivable.

Basic and Diluted Income (Loss) per Share

Basic income (loss) per share is computed by dividing the net income (loss) to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 5,077,6698,717,165 and 4,505,385 incremental common shares for the three months ended September 30,March 31, 2014 and March 31, 2013, respectively, issuable upon the exercise of stock options and warrants have been included in the diluted earnings per share calculation. These shares have not been included for the three and nine month ended September 30, 2012 or the nine months ended September 2013 because their effect is anti-dilutive.

		Three Months Ended September 30								Nine Months Ended September 30
(in thousands, except per share amounts)		2013				2012				2013				2012
Numerator
Net income (loss)		$	680			$	(257	)		$	(3,181	)		$	(5,889	)
Denominator
Weighted-average common shares outstanding			14,286				5,908				13,429				4,802
Shares used in calculation - basic			14,286				5,908				13,429				4,802
Shares issuable for stock options and warrants			5,078				-				-				-
Shares used in calculation - diluted			19,364				5,908				13,429				4,802
Net income (loss) per share
Basic		$	0.05			$	(0.04	)		$	(0.24	)		$	(1.23	)
Diluted		$	0.04			$	(0.04	)		$	(0.24	)		$	(1.23	)

Share-Based Compensation

Our 2010 Stock Incentive Plan, as amended (the “Plan”), provides for the issuance of up to 1,825,000 shares of our common stock. Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the Plan. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. At September 30, 2013,March 31, 2014, we had 482,177 vested and unvested shares outstanding and 1,285,586 shares available for future awards.

Share-based compensation expense attributable to continuing operations amounted to $48,000$13,000 and $165,000$68,000 for the three and nine months ended September 30, 2013,March 31, 2014, compared with $371,000 and $2.0 million, respectively, for the same periodsperiod in 2012.2013.

Stock Options – Employees and Directors

We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the date of grant. We estimate the fair value of share-based payment awards using the Black Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the condensed consolidated statements of operations subsequent to January 1, 2006. We account for share-based awards to employees and directors using the intrinsic value method under previous FASB rules, allowable prior to January 1, 2006. Under the intrinsic value method, no share-based compensation expense had been recognized in our consolidated statements of operations for awards to employees and directors because the exercise price of our stock options equaled the fair market value of the underlying stock at the date of grant.

Share-based compensation expense recognized for employees and directors for the three and nine months ended September 30,March 31, 2014 and 2013, was $12,000 and $47,000, and $141,000, compared with $273,000 and $1.6 million for the same periods in 2012, respectively.

Share-based compensation expense recognized in our condensed consolidated statements of operations for the three and nine months ended September 30,March 31, 2014 and 2013, and 2012, includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro-forma provisions of Statement of Financial Accounting Standards (“SFAS”) 123, and for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of the Accounting Standards Codification (“ASC”) 718. For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our condensed consolidated statements of operations for the three and nine months ended September 30,March 31, 2014 and 2013, and 2012, is based on awards ultimately expected to vest, reduced for estimated forfeitures. Accounting rules for stock options require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

During the three and nine months ended September 30,March 31, 2014 and 2013, there were no options granted to employees, compared with 0 and 50,000 options granted to employees at the weighted average per share exercise price of $0.00 and $0.44, for the same periods in 2012, respectively. All of the options were issued at the fair market value of our common stock on the date of grant.employees. Employee and director stock option activity for the three and nine months ended September 30, 2013March 31, 2014 are as follows:

		Shares				Weighted Avg. Exercise Price
Balance December 31, 2012			486,000			$	26.46
Granted			-			$	-
Canceled			(20,000	)		$	33.72
Balance March 31, 2013			466,000			$	22.73
Granted			-			$	-
Canceled			(1,000	)		$	39.37
Balance June 30, 2013			465,000			$	22.69
Granted			-			$	-
Canceled			(4,000	)		$	379.44
Balance September 30, 2013			461,000			$	19.59

 

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three and nine months ended September 30,March 31, 2014 and 2013, and 2012, reflects the application of the simplified method prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 107 (and as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

As of September 30, 2013,March 31, 2014, there was $92,000$33,000 of total unrecognized compensation costs related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of approximately 0.940.81 years.          

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees for services by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, the expected life of the option or warrant, and the expected volatility of our stock and the expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

There were no options issued to non-employees for the three and nine months ended September 30, 2013 and 2012, respectively.March 31, 2014 or 2013. Share-based compensation expense relating to stock options and warrants recognized for non-employees amounted towas $1,000 and $23,000$20,000 for the three and nine months ended September 30,March 31, 2014 and 2013, and $61,000 and $81,000 for the three and nine months ended September 30, 2012, respectively.

Non-employee stock option activity for the three and nine months ended September 30, 2013,March 31, 2014, are as follows:

		Shares				Weighted Avg. Exercise Price
Balance December 31, 2012			22,000			$	48.97
Canceled			(1,000	)		$	1,953.03
Balance March 31, 2013			21,000			$	45.72
Canceled			-			$	-
Balance June 30, 2013			21,000			$	45.72
Canceled			-			$	-
Balance September 30, 2013			21,000			$	28.40

 

Common Stock

In April 2013,January 2014, we entered into securities purchase agreements (the “April“January Agreements”) with several investors, including Crede CG II, LLCIII, Ltd. (“Crede”), an affiliate of Terren S. Peizer, Chairman and Chief Executive Officer of the Company, and Shamus, LLC (“Shamus”), an affiliate of the Company, relating to the sale and issuance of an aggregate of 2,192,8571,724,141 shares of common stock and warrants (the “April“January Warrants”) to purchase an aggregate of 2,192,8571,724,141 shares of common stock at an exercise price of $0.70$0.58 per share for aggregate gross proceeds of approximately $1.5$1.0 million (the “April“January Offering”). The AprilJanuary Agreements provide that in the event that we effectuate a reverse stock split of our common stock within 24 months of the closing date of the AprilJanuary Offering (the “Reverse Split”) and the volume weighted average price (“VWAP”) of the common stock during the 20 trading days following the effective date of the Reverse Split (the “VWAP Period”) declines from the closing price on the trading date immediately prior to the effective date of the Reverse Split, that we shall issue additional shares of common stock (the “Adjustment Shares”). We effectuated a reverse split on May 6, 2013, and no Adjustment Shares were issued.

There were no shares of common stock issued in exchange for various services or settlement of claims during the three and nine months ended September 30, 2013, compared with 0 and 312,500 valued at $0 and $72,000, for the same period in 2012, respectively.March 31, 2014 or 2013. The costs associated with shares issued for services are being amortized to share-based compensation expense on a straight-line basis over the related service periods. For the three and nine months ended September 30,March 31, 2014 and 2013, share-based compensation expense relating to all common stock issued for consulting services was $1,000$0 and $23,000 compared with $61,000 and $81,000, for the same periods in 2012,$1,000, respectively.

Income Taxes

We have recorded a full valuation allowance against our otherwise recognizable deferred tax assets as of September 30, 2013.March 31, 2014.  As such, we have not recorded a provision for income tax for the period ended September 30, 2013.March 31, 2014.  We utilize the liability method of accounting for income taxes as set forth in ASC 740.740, Income Taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In determining the need for valuation allowances we consider projected future taxable income and the availability of tax planning strategies.  After evaluating all positive and negative historical and perspective evidences, management has determined it is more likely than not that our deferred tax assets will not be realized. 

We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is a greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is less than 50% likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements.  Based on management's assessment of the facts, circumstances and information available, management has determined that all of the tax benefits for the period ended September 30, 2013March 31, 2014 should be realized.   

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I) and the lowest priority to unobservable inputs (Level III). The three levels of the fair value hierarchy are described below:

The following table summarizes fair value measurements by level at September 30, 2013March 31, 2014 for assets and liabilities measured at fair value:

			2013
(in thousands)
		Level I				Level II				Level III				Total
Certificates of deposit		$	175			$	-			$	-			$	175
Total assets		$	175			$	-			$	-			$	175
Warrant liabilities		$	-			$	-			$	14,196			$	14,196
Total liabilities		$	-			$	-			$	14,196			$	14,196

Financial instruments classified as Level III in the fair value hierarchy as of September 30, 2013,March 31, 2014, represent our liabilities measured at market value on a recurring basis which include warrant liabilities resulting from recent debt and equity financings. In accordance with current accounting rules, the warrant liabilities are being marked-to-market each quarter-end until they are completely settled. The warrants are valued using the Black-Scholes option-pricing model, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. SeeWarrant Liabilities below.

The following table summarizes our fair value measurements using significant Level III inputs, and changes therein, for the three and nine months ended September 30, 2013:March 31, 2014:

(Dollars in thousands)		Level III Warrant Liabilities
Balance as of December 31, 2012		$	14,658
Reclassification to equity			(129	)
Change in fair value			(4,360	)
Net realized gains (losses)			-
Balance as of March 31, 2013		$	10,169
Reclassification to equity			(27	)
Change in fair value			3,985
Net purchases (sales)			2,301
Net realized gains (losses)			-
Balance as of June 30, 2013		$	16,428
Reclassification to equity			-
Change in fair value			(2,232	)
Net purchases (sales)			-
Net unrealized gains (losses)			-
Balance as of September 30, 2013		$	14,196

 

As of September 30, 2013,March 31, 2014, the gross and net carrying amounts of intangible assets that are subject to amortization are as follows:

During the three and nine months ended September 30, 2013,March 31, 2014, we did not acquire any new intangible assets and at September 30, 2013,March 31, 2014, all of our intangible assets consisted of intellectual property, which is not subject to renewal or extension. We had no intangible impairment for the three and nine months ended September 30,March 31, 2014 or 2013. We had no intangible impairment for the three months ended September 30, 2012 and $189,000 for the nine months ended September 30, 2012.

Additionally, it is important to note that our overall business model, business operations and future prospects of our business have not changed materially since we performed the reviews and analysis noted above, with the exception of the timing, and annualized amounts of expected revenue.

Estimated remaining amortization expense for intangible assets for the current year and each of the next five years ending December 31 is as follows:

(In thousands)
Year		Amount
2013(3 months)		$	33
2014		$	132
2015		$	132
2016		$	132
2017		$	132

 

Property and Equipment

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

Variable Interest Entities

Generally, an entity is defined as a Variable Interest Entity (“VIE”) under current accounting rules if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

As discussed under the heading Management Services Agreementbelow, we have an MSA with a managed medical corporation. Under this MSA, the equity owner of the affiliated medical group has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of this MSA. We also agree to provide working capital loans to allow for the medical group to pay for its obligations. Substantially all of the activities of this managed medical corporation either involve us or are conducted for our benefit, as evidenced by the fact that under the MSA, we agree to provide and perform all non-medical management and administrative services for the medical group. Payment of our management fee is subordinate to payments of the obligations of the medical group, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of the managed medical corporation do not have recourse to our general credit.

Based on the design and provisions of this MSA and the working capital loans provided to the medical group, we have determined that the managed medical corporation is a VIE, and that we are the primary beneficiary as defined in the current accounting rules. Accordingly, we are required to consolidate the revenues and expenses of the managed medical corporation.

Management Services Agreement

We have an executed MSA with a medical professional corporation and related treatment center. Under the MSA, we license to the treatment center the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

The treatment center retains the sole right and obligation to provide medical services to its patients and to make other medically related decisions, such as the choice of medical professionals to hire or medical equipment to acquire and the ordering of drugs.

In addition, we provide office space to the treatment center on a non-exclusive basis, and we are responsible for all costs associated with rent and utilities. The treatment center pays us a monthly fee equal to the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including salaries, rent, equipment, and tenant improvements incurred for the benefit of the medical group, provided that any capitalized costs will be amortized over a five-year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the treatment center at its sole discretion. The treatment center’s payment of our fee is subordinate to payment of the treatment center's obligations, including physician fees and medical group employee compensation.

We have also agreed to provide a credit facility to the treatment center to be available as a working capital loan, with interest at the Prime Rate plus 2%.  Funds are advanced pursuant to the terms of the MSA described above. The notes are due on demand or upon termination of the MSA. At September 30, 2013,March 31, 2014, there was one outstanding credit facility under which $12.9$13.3 million was outstanding. Our maximum exposure to loss could exceed this amount, and cannot be quantified as it is contingent upon the amount of losses incurred by the treatment center that we are required to fund under the credit facility.

Under the MSA, the equity owner of the affiliated treatment center has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We also agree to provide working capital loans to allow for the treatment center to pay for its obligations. Substantially all of the activities of the managed medical corporation either involves us or are conducted for our benefit, as evidenced by the facts that (i) the operations of the managed medical corporation is conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the treatment center. Payment of our management fee is subordinate to payments of the obligations of the treatment center, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated treatment center or other third party. Creditors of the managed medical corporation do not have recourse to our general credit. Based on these facts, we have determined that the managed medical corporation is a VIE and that we are the primary beneficiary as defined in current accounting rules.  Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment center.

The amounts and classification of assets and liabilities of the VIE included in our condensed consolidated balance sheets as of September 30, 2013March 31, 2014 and December 31, 2012,2013, are as follows:

(in thousands)		September 30, 2013				(audited) December 31, 2012
Cash and cash equivalents		$	3			$	11
Receivables, net			25				19
Total assets		$	28				30
Accounts payable			13				15
Note payable to Catasys, Inc.			12,904				12,267
Total liabilities		$	12,917				12,282

Warrant Liabilities

In April 2013,January 2014, we entered into the AprilJanuary Agreements with several investors relating to the sale and issuance of an aggregate of 2,192,8571,724,141 shares of common stock and warrants to purchase an aggregate of 2,192,8571,724,141 shares of common stock at an exercise price of $0.70$0.58 per share for aggregate gross proceeds of approximately $1.5 million (the “April Offering”).$1.0 million. The AprilJanuary Agreements provide that in the event that we effectuate a Reverse Split and the VWAP period declines from the closing price on the trading date immediately prior to the effective date of the Reverse Split, that we shall issue the Adjustment Shares. We effectuated a reverse split on May 6, 2013, and no Adjustment Shares were issued.

The AprilJanuary Warrants expire in April 2018,January 2019, and contain anti-dilution provisions. As a result, if we, in the future, issue or grant any rights to purchase any of our common stock, or other securities convertible into our common stock, for a per share price less than the exercise price of the AprilJanuary Warrants, the exercise price of the AprilJanuary Warrants will be reduced to such lower price, subject to customary exceptions. In the event that Adjustment Shares are issued, the number of shares that may be purchased under the AprilJanuary Warrants shall be increased by an amount equal to the Adjustment Shares. In addition, the exercise price is subject to adjustment in the event that the VWAP during the VWAP period is less than the exercise price prior to the VWAP Period.

We have issued warrants to purchase common stock in July 2010, October 2010, November 2010, December 2011, February 2012, April 2012, May 2012, September 2012, December 2012, April 2013, October 2013, January 2014, and when we amended and restated the Highbridge senior secured note in July 2008. The warrants are being accounted for as liabilities in accordance with FASB accounting rules, due to provisions in some warrants that protect the holders from declines in our stock price and a requirement to deliver registered shares upon exercise of the warrants, which is considered outside our control.  The warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

For the three and nine months ended September 30,March 31, 2014 and 2013, we recognized a non-operating gain of $2.2$5.1 million and $2.6$4.4 million, compared with a non-operating gain of $1.8 million and $4.1 million for the same periods in 2012, respectively, related to the revaluation of our warrant liabilities.

Recently Issued or Newly Adopted Accounting Standards

In December 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-11,Disclosures about Offsetting Assets and Liabilities(“ASU 2011-11”). The amendments in this update require enhanced disclosures around financial instruments and derivative instruments that are either (1) offset in accordance with either ASC 210-20-45 or ASC 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either ASC 210-20-45 or ASC 815-10-45. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The amendments are effective during interim and annual periods beginning after December 31, 2012. The adoption of ASU No. 2011-11 did not have a material effect on our consolidated financial statements or disclosures.

In February 2013, the FASB issued ASU 2013-02,Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, (“ASU 2013-02”). ASU 2013-02 amends ASC 220,Comprehensive Income (“ASC 220”), and requires entities to present the changes in the components of accumulated other comprehensive income for the current period. Entities are required to present separately the amount of the change that is due to reclassifications, and the amount that is due to current period other comprehensive income. These changes are permitted to be shown either before or net-of-tax and can be displayed either on the face of the financial statements or in the footnotes. ASU 2013-02 was effective for our interim and annual periods beginning January 1, 2013. The adoption of ASU 2013-02 did not have a material effect on our consolidated financial position or results of operations.

In July 2013, the FASB issued ASU 2013-11,Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, (“ASU 2013-02”2013-11”), which eliminates diversity in practice for the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward is available to reduce the taxable income or tax payable that would result from disallowance of a tax position. ASU 2013-11 affects only the presentation of such amounts in an entity’s balance sheet and is effective for fiscal years beginning after December 15, 2013 and interim periods within those years. Early adoption is permitted. We are evaluating the impact, if any, of theThe adoption of ASU 2013-11 did not have a material effect on our balance sheet.consolidated financial position or results of operations.

Note 3. Segment Information

We manage and report our operations through two business segments: healthcare services and license and management services. We evaluate segment performance based on total assets, revenue and income or loss before provision for income taxes. Our assets are included within each discrete reporting segment. In the event that any services are provided to one reporting segment by the other, the transactions are valued at the market price. No such services were provided during the three and nine months ended September 30, 2013March 31, 2014 and 2012.2013. Summary financial information for our two reportable segments are as follows:

 

(in thousands)		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Healthcare services
Revenues		$	109			$	100			$	315			$	226
Income (loss) before provision for income taxes		$	924			$	66			$	(2,441	)		$	(4,714	)
Assets *			1,117				2,068				1,117				2,068
License and management services
Revenues		$	21			$	40			$	83			$	136
Loss before provision for income taxes		$	(242	)		$	(321	)		$	(735	)		$	(1,157	)
Assets *			970				1,603				970				1,603
Consolidated continuing operations
Revenues		$	130			$	140			$	398			$	362
Income (loss) before provision for income taxes		$	682			$	(255	)		$	(3,176	)		$	(5,871	)
Assets *			2,087				3,671				2,087				3,671

		Three Months Ended
(in thousands)		March 31,
		2014				2013
Healthcare services
Revenues		$	199			$	99
Income before provision for income taxes			2,362				2,862
Assets *			1,968				2,291
License and management services
Revenues		$	19			$	36
Loss before provision for income taxes			(221	)			(247	)
Assets *			124				1,042
Consolidated continuing operations
Revenues		$	218			$	135
Income before provision for income taxes			2,141				2,615
Assets *			2,092				3,333

* Assets are reported as of September 30.

* Assets are reported as of March 31.

Healthcare Services

Catasys’ integrated substance dependence solutions combine innovative medical and psychosocial treatments with elements of traditional disease management, case management and ongoing member support to help organizations treat and manage substance dependent populations to impact both the medical and behavioral health costs associated with substance dependence and the related co-morbidities.

We are currently marketing our integrated substance dependence solutions to managed care health plans on a case rate, monthly fee, basis, or fee-for-service basis, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs. We are operating our programs in Kansas, Massachusetts, Louisiana, Oklahoma, Kentucky, West Virginia, and Oklahoma.Wisconsin. In 2013, we signed two agreementsan agreement with national health plans to provide services to their members in New Jersey, and Kentucky, Ohio, West Virginia, and Indiana, respectively. We have launched enrollment in Kentucky and West Virginia in October 2013 and expect to commence enrollment in the remaining states by the end of the fourththird quarter of 2013.2014.

The following table summarizes the operating results for Healthcare Services for the three and nine months ended September 30, 2013March 31, 2014 and 2012:2013:

(in thousands)		Three Months Ended September 30,								Nine Months Ended September 30,
		2013				2012				2013				2012
Revenues		$	109			$	100			$	315			$	226
Operating Expenses
Cost of healthcare services		$	162			$	135			$	454			$	427
General and administrative expenses
Salaries and benefits			916				1,187				2,874				4,275
Other expenses			330				531				1,246				1,662
Depreciation and amortization			7				(2	)			18				6
Total operating expenses		$	1,415			$	1,851			$	4,592			$	6,370
Loss from operations		$	(1,306	)		$	(1,751	)		$	(4,277	)		$	(6,144	)
Interest and other income			-				-				-				-
Interest expense			(1	)			(1	)			(771	)			(2,697	)
Change in fair value of warrant liabilities			2,231				1,818				2,607				4,127
Income/(loss) before provision for income taxes		$	924			$	66			$	(2,441	)		$	(4,714	)

 

License and Management Services

Our license and management services segment primarily represents our managed treatment office, which offers a range of addiction treatment and mental health services.

The following table summarizes the operating results for License and Management Services for the three months ended March 31, 2014 and nine months September 30, 2013 and 2012:2013:

(In thousands)		Three months ended September 30,								Nine months ended September 30,
		2013				2012				2013				2012
Revenues
U.S. licensees		$	-			$	-			$	6			$	14
Managed treatment center			21				40				77				122
Total license and management revenues		$	21			$	40			$	83			$	136
Operating expenses
Cost of license and management services		$	59			$	63			$	174			$	191
General and administrative expenses
Salaries and benefits			114				150				358				465
Other expenses			55				77				173				227
Impairment losses			-				-				-				189
Depreciation and amortization			35				71				113				221
Total operating expenses		$	263			$	361			$	818			$	1,293
Loss from operations		$	(242	)		$	(321	)		$	(735	)		$	(1,157	)
Interest and other income			-				-				-				-
Interest expense			-				-				-				-
Loss before provision for income taxes		$	(242	)		$	(321	)		$	(735	)		$	(1,157	)

Note 4. Related Party Disclosure

In December 2010, we entered into a three-year sublease agreement with Xoftek, Inc., an affiliate of our Chairman and Chief Executive Officer, (“CEO”), to sublease approximately one-third of our office space for a three-year term for a monthly rent of approximately $11,000 per month. The related party receivable as of September 30, 2013March 31, 2014 and December 31, 20122013 was $269,000$0 and $173,000,$115,000, respectively. This is net of an offset of $115,000 and $186,000 payable to our Chairman and Chief Executive Officer against this receivable at March 31, 2104 and December 31, 2013, respectively. We have receivedoffset approximately $81,000$382,000 in payments through September 30, 2013.payables due to our Chairman and Chief Executive Officer as of March 31, 2014.

Crede, an affiliate of our Chairman and CEO, and Shamus, an affiliate of the Company,Chief Executive Officer, participated in our April 2013January 2014 Offering. TheyCrede received approximately 2,055,7151,585,345 shares of our common stock and warrants to purchase an aggregate 2,055,7151,585,345 shares of common stock at a price of $0.70$0.58 per share, for gross proceeds of approximately $1.4 million.$919,500.

Note 5. Restatement of Financial Statements

The financial statements have been retroactively restated to reflect the 10-for-1 reverse stock split that occurred on May 6, 2013.

Note 6. Subsequent Events

In October 2013,Beginning April 1, 2014, we entered into securities purchase agreementsagreed with several investors, including Crede CG III, Ltd. (“Crede III”), an affiliate of Terren S. Peizer, Chairmanthe professional medical corporation to close the practice covered by the MSA.

We and our Chief Executive Officer were party to a litigation in which the plaintiffs asserted causes of action for conversion, a request for an order to set aside fraudulent conveyance and breach of contract. The litigation and subsequent appeals were resolved in our favor. The plaintiff filed a petition for review with the Company, and Shamus, an affiliate of the Company, relating to the sale and issuance of an aggregate of 4,550,002 shares of common stock, and warrants (the “October Warrants”) to purchase an aggregate of 4,550,002 shares of Common Stock at an exercise price of $0.58 per share for aggregate gross proceeds of approximately $2.6 million.California Supreme Court, which was denied in April 2014. The October Warrants expire in October 2018, and contain anti-dilution provisions. Aslitigation is now ended with a result, if we, in the future, issue or grant any rights to purchase any of our Common Stock, or other security convertible into our Common Stock, for a per share price less than the exercise price of the October Warrants, the exercise price of the October Warrants will be reduced to such lower price, subject to customary exceptions.

Among other things, the Agreements provide that in the event that the Company effectuates a reverse stock split of its Common Stock within 24 months of the closing date of the Offering (the “Reverse Split”) and the volume weighted average price (“VWAP”) of the Common Stock during the 20 trading days following the effective date of the Reverse Split (the “VWAP Period”) declines from the closing price on the trading date immediately prior to the effective date of the Reverse Split, that the Company issue additional shares of Common Stock (the “Adjustment Shares"). The number of Adjustment Shares shall be calculated as the lesser of (a) 20% of the number of shares of Common Stock originally purchased by such investor and still heldcomplete victory by the investor as of the last day of the VWAP Period, and (b) the number of shares originally purchased by such investor and still held by such investor as of the last day of the VWAP Period multiplied by the percentage decline in the VWAP during the VWAP Period. All prices and number of shares of Common Stock shall be adjusted for the Reverse Split and any other stock splits or stock dividends.

In November 2013, we signed an office lease for new corporate offices located in Los Angeles, California.defendants.

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

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report.

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive positions, growth opportunities for existing products, plans and objectives of management, markets for stock of Catasys and other matters. Statements in this report that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such forward-looking statements, including, without limitation, those relating to the future business prospects, our revenue and income, wherever they occur, are necessarily estimates reflecting the best judgment of our senior management as of the date on which they were made, or if no date is stated, as of the date of this report. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described in the “Risk Factors” in Item 1A of Part I of our most recent Annual Report on Form 10-K (“Form 10-K”) for the fiscal year ended December 31, 20122013 and other reports we filed with the Securities and Exchange Commission (“SEC”), that may affect the operations, performance, development and results of our business. Because the factors discussed in this report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any such forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We assume no obligation and do not intend to update these forward looking statements, except as required by law.

OVERVIEW

General

We are a healthcare services company, providing specialized health services designed to assist health plans and other third party payors to manage and treat their high cost substance dependence members through a network of healthcare providers and our employees.  The OnTrak substance dependence program was designed to address substance dependence as a chronic disease. The program seeks to lower costs by improvingand improve member health through the delivery of integrated medical and psychosocial interventions in combination with long term “care coaching.”  We also have a company managed psychiatry practice that offers a variety of mental health and substance dependence treatments primarily on a fee-for-service basis out of our offices and via telephonic psychiatry.which we decided to discontinue effective April 1, 2014.

Operations

In the thirdfirst quarter of 20132014 we are operating our integrated substance dependence solutions for third-party payors in Kansas, Louisiana, Massachusetts, Oklahoma, Kentucky, West Virginia, and Oklahoma.Wisconsin. In March 2013, we signed a national agreement with a national health plan to provide the OnTrak program to their commercial members starting in New Jersey. In June 2013, we signed an agreement with a national health plan to provide services to their individually enrolled Medicare Advantage members in Ohio, West Virginia, Kentucky, and Indiana. Implementation is under way and we have launched enrollment in Kentucky and West Virginia in October 2013Jersey and we expect to commence enrollment in the remaining states by the end of the fourththird quarter of 2013.2014. However as our customers control significant portions of implementation, there are no assurances that commencement will not be delayed. Together these two contracts are expected to more than quadruple the number of members covered by our OnTrak programs.We believe that our Catasys offerings address a high cost segment of the healthcare market for substance dependence, and we are currently marketing our Catasys integrated substance dependence solutions to managed care health plans on a case rate, monthly fee, or fee-for-service basis, which involves educating third party payors on the disproportionately high cost of their substance dependent population and demonstrating the potential for improved clinical outcomes and reduced cost associated with using our Catasys programs.

We currently manage,Prior to April 1, 2014, we managed, under a licensing agreement, one professional medical corporation located in Los Angeles, California (dba The Center to Overcome Addiction).  We managemanaged the business components of the professional medical corporation and license a proprietary treatment program in exchange for management and licensing fees under the terms of full business service management agreements. The professional medical corporation offersoffered medical and psychosocial interventions for substance dependencies and mental health disorders. The revenues and expenses of this center are included in our consolidated financial statements under accounting standards applicable to variable interest entities. In July 2012,Effective April 1, 2014, we movedhave agreed with the professional medical corporation offices into our corporate offices, which reduced operating expenses, and as of November 2013to close the majority of services are being delivered telephonically.  We expect revenues associated with the treatment centers to continue to decline and are currently evaluating and considering additional actions to streamline our operations that may impact the managed treatment center.practice. 

RESULTS OF OPERATIONS

Table of Summary Consolidated Financial Information

The table below and the discussion that follows summarizes our results of consolidated operations for the three and nine months ended September 30, 2013March 31, 2014 and 2012:2013: