10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended February 28, 2006

or

o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _____ to _____

Commission File Number 000-19364

HEALTHWAYS, INC.

(Exact Name of Registrant as Specified in its Charter)

Delaware	62-1117144
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation or Organization)	Identification No.)

3841 Green Hills Village Drive, Nashville, TN 37215

(Address of Principal Executive Offices) (Zip Code)

615-665-1122

(Registrant’s Telephone Number, Including Area Code)

American Healthways, Inc.

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x          No o

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

Large accelerated filer x       Accelerated filer o            Non-accelerated filer o

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

Yes o         No x

As of April 3, 2006 there were outstanding 34,515,322 shares of the Registrant’s Common Stock, par value $.001 per share.

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Healthways, Inc.

Form 10-Q

Table of Contents

			Page
Part I
	Item 1.	Financial Statements	4
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30
	Item 4.	Controls and Procedures	30
Part II
	Item 1.	Legal Proceedings	31
	Item 1A.	Risk Factors	31
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	31
	Item 3.	Defaults Upon Senior Securities	31
	Item 4.	Submission of Matters to a Vote of Security Holders	32
	Item 5.	Other Information	32
	Item 6.	Exhibits	32

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Part I

Item 1. Financial Statements

HEALTHWAYS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

ASSETS

	February 28, 2006			August 31, 2005 (1)
Current assets:
Cash and cash equivalents	$	101,781		$	63,467
Restricted cash		—			3,811
Accounts receivable, net		48,494			40,697
Prepaid expenses and other current assets		7,891			5,681
Income taxes receivable		1,162			—
Deferred tax asset		3,783			3,305
Total current assets		163,111			116,961
Property and equipment:
Leasehold improvements		13,826			12,836
Computer equipment and related software		70,574			61,772
Furniture and office equipment		16,933			16,294
		101,333			90,902
Less accumulated depreciation		(60,960	)		(51,114	)
		40,373			39,788
Other assets		2,203			2,065
Intangible assets, net		14,154			16,120
Goodwill, net		96,090			96,020
Total assets	$	315,931		$	270,954

⁽¹⁾ Certain items have been reclassified to conform to current classifications.

See accompanying notes to the consolidated financial statements.

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HEALTHWAYS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

(Unaudited)

LIABILITIES AND STOCKHOLDERS’ EQUITY

	February 28, 2006		August 31, 2005 (1)
Current liabilities:
Accounts payable	$	4,458	$	3,622
Accrued salaries and benefits		28,426		26,845
Accrued liabilities		3,904		5,006
Contract billings in excess of earned revenue		22,724		8,037
Income taxes payable		—		660
Current portion of long-term debt		171		163
Current portion of long-term liabilities		2,063		1,984
Total current liabilities		61,746		46,317
Long-term debt		329		416
Long-term deferred tax liability		2,955		8,236
Other long-term liabilities		9,799		9,055
Stockholders’ equity:
Preferred stock    $.001 par value, 5,000,000 shares     authorized, none outstanding		—		—
Common stock    $.001 par value, 75,000,000 shares authorized,     34,463,535 and 33,808,518 shares outstanding		34		34
Additional paid-in capital		129,808		109,425
Retained earnings		111,260		97,471
Total stockholders’ equity		241,102		206,930
Total liabilities and stockholders’ equity	$	315,931	$	270,954

⁽¹⁾ Certain items have been reclassified to conform to current classifications. 

See accompanying notes to the consolidated financial statements.

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HEALTHWAYS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except earnings per share data)

(Unaudited)

	Three Months Ended February 28,				Six Months Ended February 28,
	2006		2005		2006		2005
Revenues	$	100,021	$	75,337	$	190,612	$	146,523
Cost of services		70,859		48,132		134,703		94,103
Gross margin		29,162		27,205		55,909		52,420
Selling, general and administrative expenses		10,919		7,287		21,042		13,460
Depreciation and amortization		5,825		5,493		11,488		10,955
Interest expense		257		472		512		1,114
Income before income taxes		12,161		13,953		22,867		26,891
Income tax expense		4,828		5,512		9,078		10,687
Net income	$	7,333	$	8,441	$	13,789	$	16,204
Earnings per share:
Basic	$	0.21	$	0.26	$	0.40	$	0.49
Diluted	$	0.20	$	0.24	$	0.38	$	0.46
Weighted average common  shares and equivalents:
Basic		34,321		33,073		34,140		32,997
Diluted		36,300		35,490		36,136		35,390

See accompanying notes to the consolidated financial statements. 

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HEALTHWAYS, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

For the Six Months Ended February 28, 2006

(In thousands)

(Unaudited)

	Preferred Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Total
Balance, August 31, 2005	$	—	$	34	$	109,425	$	97,471	$	206,930
Net income		—		—		—		13,789		13,789
Exercise of stock options and other		—		—		4,484		—		4,484
Tax benefit of option exercises		—		—		9,342		—		9,342
Share-based employee compensation expense		—		—		6,557		—		6,557
Balance, February 28, 2006	$	—	$	34	$	129,808	$	111,260	$	241,102

See accompanying notes to the consolidated financial statements. 

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HEALTHWAYS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended February 28,
	2006			2005(1)
Cash flows from operating activities:
Net income	$	13,789		$	16,204
Adjustments to reconcile net income to net cash provided by   operating activities:
Depreciation and amortization		11,488			10,955
Amortization of deferred loan costs		237			272
Share-based employee compensation expense		6,557			295
Excess tax benefits from share-based payment arrangements		(8,935	)		2,878
Increase in accounts receivable, net		(7,797	)		(7,073	)
Increase in other current assets		(3,372	)		(2,490	)
Increase (decrease) in accounts payable		836			(5,678	)
Increase in accrued salaries and benefits		1,581			6,175
Increase (decrease) in other current liabilities		22,269			(3,818	)
Deferred income taxes		(5,762	)		—
Other		2,051			1,048
Decrease in other assets		206			319
Payments on other long-term liabilities		(1,221	)		(650	)
Net cash flows provided by operating activities		31,927			18,437
Cash flows from investing activities:
Acquisition of property and equipment		(10,108	)		(5,035	)
Business acquisitions, net of cash acquired		(70	)		1,176
Proceeds from sale of investments		—			2,000
Purchases of investments		—			(2,000	)
Net cash flows used in investing activities		(10,178	)		(3,859	)
Cash flows from financing activities:
Decrease (increase) in restricted cash		3,811			(1,930	)
Proceeds from issuance of long-term debt		—			48,000
Deferred loan costs		(581	)		(730	)
Excess tax benefits from share-based payment arrangements		8,935			—
Payments of long-term debt		(79	)		(78,150	)
Exercise of stock options		4,479			1,601
Net cash flows provided by (used in) financing activities		16,565			(31,209	)
Net increase (decrease) in cash and cash equivalents		38,314			(16,631	)
Cash and cash equivalents, beginning of period		63,467			45,147
Cash and cash equivalents, end of period	$	101,781		$	28,516

⁽¹⁾ Certain items have been reclassified to conform to current classifications.

See accompanying notes to the consolidated financial statements.

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HEALTHWAYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1) Interim Financial Reporting

        The accompanying consolidated financial statements of Healthways, Inc. (formerly American Healthways, Inc.) and its wholly-owned subsidiaries for the six months ended February 28, 2006 and 2005 are unaudited. However, in our opinion, the financial statements reflect all adjustments consisting of normal, recurring accruals necessary for a fair presentation. We have reclassified certain items in prior periods to conform to current classifications.

        We have omitted certain financial information that is normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States but that is not required for interim reporting purposes. You should read the accompanying consolidated financial statements in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2005.

(2) Restricted Cash

        Restricted cash at August 31, 2005 represented funds held in escrow in connection with a contractual requirement with a customer (see Note 7). In accordance with the terms of the contract, in January 2006 the entire $3.8 million was released from escrow and reclassified to cash and cash equivalents as our first-year results were validated with the customer.

(3) Share-Based Compensation

        We have several shareholder-approved stock incentive plans for employees. We currently have three types of share-based awards outstanding under these plans: stock options, restricted stock, and restricted stock units. We believe that such awards align the interests of our employees with those of our stockholders. Prior to September 1, 2005, we accounted for these plans under the recognition and measurement provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS” or “Statement”) No. 123, “Accounting for Stock-Based Compensation.”

        For the three and six months ended February 28, 2005, we recorded compensation expense under APB No. 25 of approximately $0.1 million and $0.3 million, respectively. This expense resulted primarily from the grant, which was subject to stockholder approval, of stock options to two new directors of the Company in June 2003. We obtained such approval at the Annual Meeting of Stockholders in January 2004, at which time we issued the options. We generally recognize compensation expense related to fixed award stock options with graded vesting on a straight-line basis over the vesting period.

        Effective September 1, 2005, we adopted SFAS No. 123(R), “Share-Based Payment,” using the modified prospective transition method. Under the modified prospective transition method, recognized compensation cost for the six months ended February 28, 2006 includes 1) compensation cost for all share-based payments granted prior to, but not yet vested as of, September 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of Statement 123; and

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2) compensation cost for all share-based payments granted on or after September 1, 2005, based on the grant date fair value estimated in accordance with Statement 123(R). In accordance with the modified prospective method, we have not restated prior period results.

        For the three and six months ended February 28, 2006, we recognized share-based compensation costs of $3.3 million and $6.6 million respectively, which consisted of $1.6 million and $3.2 million in cost of services and $1.7 million and $3.4 million in selling, general and administrative expenses, respectively. We also recognized a total income tax benefit in the income statement for share-based compensation arrangements of $1.3 million and $2.6 million for the three and six months ended February 28, 2006. We did not capitalize any share-based compensation costs.

        As a result of adopting Statement 123(R), income before income taxes and net income for the three months ended February 28, 2006 were $3.3 million and $2.0 million lower, respectively, than if we had continued to account for share-based compensation under APB 25. These amounts were $6.6 million and $4.0 million lower, respectively, for the six months ended February 28, 2006. The effect of adopting Statement 123(R) on basic and diluted earnings per share for the three months ended February 28, 2006 was $0.06 and $0.05 per share, respectively. The resulting reduction in basic and diluted earnings per share for the six months ended February 28, 2006 was $0.12 and $0.11 per share, respectively.

        Prior to adopting Statement 123(R), we presented the tax benefit of stock option exercises as operating cash flows. Statement 123(R) requires that tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options be classified as financing cash flows.

        Statement 123(R) also requires companies to calculate an initial “pool” of excess tax benefits available at the adoption date to absorb any tax deficiencies that may be recognized under Statement 123(R). The pool includes the net excess tax benefits that would have been recognized if the company had adopted Statement 123 for recognition purposes on its effective date.

        We have elected to calculate the pool of excess tax benefits under the alternative transition method described in FASB Staff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards,” which also specifies the method we must use to calculate excess tax benefits reported on the statement of cash flows. The excess tax benefits from share-based payment arrangements classified as a financing cash inflow for the six months ended February 28, 2006 of $8.9 million would not have been materially different if we had not adopted Statement 123(R); however, they would have been classified as an operating cash inflow rather than as a financing cash inflow.

        The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation for the three and six months ended February 28, 2005:

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	Three Months Ended February 28, 2005		Six Months Ended February 28, 2005
(In $000s, except per share data)
Net income, as reported	$	8,441	$	16,204
Add: Stock-based employee compensation
expense included in reported net
income, net of related tax effects		89		178
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards, net
of related tax effects		(1,597)		(3,228)
Pro forma net income	$	6,933	$	13,154
Earnings per share:
Basic - as reported	$	0.26	$	0.49
Basic - pro forma	$	0.21	$	0.40
Diluted - as reported	$	0.24	$	0.46
Diluted - pro forma	$	0.20	$	0.37

As noted above, we have several stockholder-approved stock incentive plans for employees under which we have granted non-qualified stock options, restricted stock, and restricted stock units. We typically grant options under these plans at market value on the date of grant. The options generally vest over or at the end of four years. Options granted on or after August 24, 2005 expire seven years from the date of grant, while options granted before August 24, 2005 expire ten years from the date of grant. Restricted share awards generally vest at the end of four years. Certain option and restricted share awards provide for accelerated vesting upon a change in control or normal or early retirement (as defined in the plans). At February 28, 2006, we have reserved approximately 627,000 shares for future equity grants.

As of February 28, 2006, there was $30.6 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the stock incentive plans. That cost is expected to be recognized over a weighted average period of 2.7 years.

Stock Options

In June 2005, we changed from the Black-Scholes option valuation model (“Black-Scholes model”) to a lattice-based binomial option valuation model (“lattice binomial model”), which we consider preferable to the Black-Scholes model because the lattice binomial model considers characteristics of fair value option pricing, such as an option’s contractual term and the probability of exercise before the end of the contractual term, that are not available under the Black-Scholes model. For the three and six months ended February 28, 2006, we contracted with a third party to assist in developing the assumptions, noted in the table below, used in estimating the fair values of stock options. For the three and six months ended February 28, 2006, we based expected volatility on both historical volatility and implied volatility from traded options on the Company’s stock. The expected term of options granted was derived from the output of the lattice binomial model and represents the period of time that options granted are expected to be outstanding. We used historical data to estimate expected option exercise and post-vesting employment termination behavior within the lattice binomial model.

For the three and six months ended February 28, 2005, we estimated the fair value of each option award on the date of grant using the Black-Scholes model. We based expected volatility on historical

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volatility. We estimated the expected term of stock options using historical exercise and employee termination experience.

The following table shows the weighted average grant-date fair values of options and the weighted average assumptions we used to develop the fair value estimates under each of the option valuation models for the three and six months ended February 28, 2006 and 2005:

	Three Months Ended		Six Months Ended
	February 28,		February 28,
	2006	2005	2006	2005
Weighted average grant -
date fair value of options	$22.84	$20.81	$20.78	$19.48
Assumptions:
Expected volatility	47.67%	59.46%	47.67%	59.64%
Expected dividends	—	—	—	—
Expected term (in years)	5.3	7.6	5.3	7.5
Risk-free rate	3.77%	4.18%	3.77%	4.13%

A summary of option activity as of February 28, 2006 and changes during the six months then ended is presented below:

Options	Shares (000s)	Weighted Average Exercise Price	Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value ($000s)
Outstanding at September 1, 2005	6,485	$16.53
Granted	56	40.89
Exercised	(313)	7.74
Forfeited or expired	(13)	19.85
Outstanding at November 30, 2005	6,215	17.18
Granted	53	45.16
Exercised	(341)	6.02
Forfeited or expired	(22)	19.74
Outstanding at February 28, 2006	5,905	18.06	6.7	$150,564
Exercisable at February 28, 2006	3,037	10.29	6.0	$101,033

The total intrinsic value, which represents the difference between the underlying stock’s market price and the option’s exercise price, of options exercised during the three months ended February 28, 2006 and 2005 was $13.4 million and $4.5 million, respectively. The total intrinsic value of options exercised during the six months ended February 28, 2006 and 2005 was $23.6 million and $7.3 million, respectively.

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Cash received from option exercises under all share-based payment arrangements for the six months ended February 28, 2006 and 2005 was $4.5 million and $1.6 million, respectively. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $9.3 million and $2.9 million for the six months ended February 28, 2006 and 2005, respectively.

Restricted Stock and Restricted Stock Units

The fair value of restricted stock and restricted stock units (“nonvested shares”) is determined based on the closing bid price of the Company’s common stock on the grant date. The weighted average grant-date fair value of nonvested shares granted during the three months ended February 28, 2006 was $46.35. Nonvested shares were not granted during the three months ended February 28, 2005. The weighted average grant-date fair value of nonvested shares granted during the six months ended February 28, 2006 and 2005 was $45.83 and $27.10, respectively.

The following table shows a summary of our nonvested shares as of February 28, 2006 as well as activity during the six months then ended. No shares vested during the six months ended February 28, 2006 or 2005.

Nonvested Shares	Shares (000s)	Weighted Average Grant-Date Fair Value
Nonvested at September 1, 2005	94	$43.38
Granted	2	41.79
Vested	—	—
Forfeited	—	—
Nonvested at November 30, 2005	96	43.35
Granted	12	46.35
Vested	—	—
Forfeited	—	—
Nonvested at February 28, 2006	108	43.68

(4) Goodwill

The change in the carrying amount of goodwill during the six months ended February 28, 2006 is shown below:

(In $000s)
Balance, August 31, 2005	$	96,020
Health IQ purchase price adjustment		70
Balance, February 28, 2006	$	96,090

On June 8, 2005, we acquired certain assets from Health IQ Diagnostics, LLC (“Health IQ”), a health support company that uses a proprietary model to provide enrollees of employer-sponsored health plans and their dependents with a personal health risk assessment and score as well as the information they need to maintain or improve their health status. The Health IQ purchase price adjustment for the six months ended February 28, 2006 relates to an earn-out agreement under which we are obligated to pay the

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former stockholders of Health IQ additional purchase price equal to a percentage of revenues recognized from Health IQ’s programs in each of the fiscal quarters during the three-year period ending August 31, 2008.

(5) Intangible and Other Assets

        Intangible assets subject to amortization at February 28, 2006 consist of the following:

	Gross Carrying Amount		Accumulated Amortization		Net
(In $000s)
Acquired technology	$	10,163	$	5,082	$	5,081
Customer contracts		9,217		4,638		4,579
Other		200		50		150
Total	$	19,580	$	9,770	$	9,810

        Acquired technology, customer contracts, and other intangible assets are being amortized on a straight-line basis over a five-year estimated useful life. Total amortization expense for each of the six months ended February 28, 2006 and 2005 was $2.0 million. Estimated amortization expense for the remainder of fiscal 2006 and the following four fiscal years thereafter is $2.0 million, $3.9 million, $3.9 million, $40,000, and $10,000, respectively. We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.

        Intangible assets not subject to amortization at February 28, 2006 consist of a trade name of $4.3 million associated with the StatusOne Health Systems, LLC (“StatusOne”) acquisition. We review intangible assets not subject to amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired.

        Other assets consist primarily of deferred loan costs net of accumulated amortization.

(6) Long-Term Debt

        On October 29, 2004, we amended our previous revolving credit and term loan agreement dated September 5, 2003 (the “Former Credit Agreement”) by entering into a First Amended and Restated Revolving Credit Loan Agreement (the “First Amended Credit Agreement”). The First Amended Credit Agreement provided us with up to $150.0 million in borrowing capacity, including a $75.0 million sub facility for letters of credit, under a senior revolving credit facility that was to expire on October 29, 2009. We repaid the outstanding principal on the term loan under the Former Credit Agreement of $48.0 million with $23.0 million in cash and a $25.0 million draw on the revolving credit facility under the First Amended Credit Agreement.

        The First Amended Credit Agreement required us to repay the principal on any loans at the maturity date of October 29, 2009. Borrowings under the First Amended Credit Agreement bore interest, at our option, at the prime rate plus a spread of 0.0% to 1.0% or LIBOR plus a spread of 1.25% to 2.25%, or a combination thereof. The First Amended Credit Agreement also provided for a fee ranging between 0.25% and 0.5% of unused commitments.

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        On September 19, 2005, we entered into a Second Amended and Restated Revolving Credit Loan Agreement (the “Second Amended Credit Agreement”). The Second Amended Credit Agreement provides us with a $250.0 million revolving credit facility, including a swingline sub facility of $10.0 million and a $75.0 million sub facility for letters of credit, together with an uncommitted incremental accordion facility of $50.0 million, and expires on September 19, 2010. As of February 28, 2006, our available line of credit totaled $249.3 million.

        The Second Amended Credit Agreement requires us to repay the principal on any loans at the maturity date of September 19, 2010. Borrowings under the Second Amended Credit Agreement generally bear interest, at our option, at LIBOR plus a spread of 0.875% to 1.5% or at the prime rate. The Second Amended Credit Agreement also provides for a fee ranging between 0.175% and 0.3% of unused commitments. The Second Amended Credit Agreement is secured by guarantees from our active domestic subsidiaries and by security interests in substantially all of our and our subsidiaries’ assets.

        The Second Amended Credit Agreement contains various financial covenants, which require us to maintain, as defined, ratios or levels of (i) total funded debt to EBITDA, (ii) fixed charge coverage, and (iii) net worth. It also restricts the payment of dividends and limits the amount of repurchases of the Company’s common stock. As of February 28, 2006, we were in compliance with all of the financial covenant requirements of the Second Amended Credit Agreement.

        As of February 28, 2006, there were letters of credit outstanding under the Second Amended Credit Agreement for $0.7 million primarily to support our requirement to repay fees under one health plan contract in the event we do not perform at established target levels and do not repay the fees due in accordance with the terms of the contract.

(7) Commitments and Contingencies

        In conjunction with contractual requirements under one contract that began on March 1, 2004, we funded an escrow account in the amount of approximately $3.8 million, which was classified as restricted cash. We were required to deposit a percentage of all fees received from this customer during the first year of the contract into the escrow account to be used to repay fees under the contract in the event we did not perform at target levels. In accordance with the terms of the contract, in January 2006 the entire $3.8 million was released from escrow and reclassified to cash and cash equivalents as our first-year results were validated with the customer.

        Pursuant to an earn-out agreement executed in connection with the acquisition of certain assets of Health IQ, we are obligated to pay the former stockholders of Health IQ additional purchase price equal to a percentage of revenues recognized from Health IQ’s programs in each of the fiscal quarters during the three-year period ending August 31, 2008.

        In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government. Subsequent to its review of this case, the federal government determined not to intervene in the litigation. The employee sued Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.

        Healthways, Inc. has since been dismissed as a defendant; however, the case is still pending against AHSI before the United States District Court for the District of Columbia. In addition, WPMC

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has settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached with the United States government.

        The complaint alleges that AHSI, the client hospitals and the medical directors violated the federal False Claims Act by entering into certain arrangements that allegedly violated the federal anti-kickback statute and provisions of the Social Security Act prohibiting physician self-referrals. Although no specific monetary damage has been claimed, the plaintiff, on behalf of the federal government, seeks treble damages plus civil penalties and attorneys’ fees. The plaintiff also has requested an award of 30% of any judgment plus expenses. In February 2006, WPMC filed an arbitration claim seeking indemnification from us for certain costs and expenses incurred by it in connection with the case. Substantial discovery has taken place to date and additional discovery is expected to occur. No trial date has been set. The parties have had initial discussions regarding their respective positions in the case; however, no resolution of this case has been reached or can be assured prior to the case proceeding to trial.

        We believe that we have conducted our operations in full compliance with applicable statutory requirements and that we have meritorious defenses to the claims made in the case and the related arbitration proceeding, and intend to contest the claims vigorously. Nevertheless, it is possible that resolution of these legal matters could have a material adverse effect on our consolidated results of operations in a particular financial reporting period. We believe that we will continue to incur legal expenses associated with the defense of these matters, which may be material to our consolidated results of operations in a particular financial reporting period. However, we believe that any resolution of this case and all related matters will not have a material effect on our liquidity or financial condition.

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

Overview

        Founded in 1981, Healthways, Inc. (the “Company”) provides specialized, comprehensive health and care support programs and services, including disease management and care enhancement services to health plans, the Centers for Medicare & Medicaid Services (“CMS”), and hospitals in addition to wellness programs to health plans and employers, in all 50 states, the District of Columbia, Puerto Rico, and Guam. These services include, but are not limited to:

• providing members with educational materials and personal interactions with highly trained nurses designed to create and sustain healthier behaviors;

• incorporating current evidence-based clinical guidelines in interventions to optimize patient care;

• developing care support plans and motivating members to set attainable goals for themselves;

• providing local market resources to address acute episode interventions; and

• coordinating members’ care with local health-care providers.

        Our integrated health and care support programs serve entire health plan populations through member and physician health and care support interventions, advanced neural network predictive modeling, and a confidential, secure Internet-based application that provides patients and physicians with individualized health information. Our programs enable health plans to develop relationships with all of their members, not just the chronically ill, and to identify those at highest risk for a health problem, allowing for early interventions.

        Our programs are designed to help people lead healthier lives by making sure they understand and follow doctors’ orders including medication compliance, are aware of and can recognize early warning signs associated with a major health episode, and are setting achievable goals for themselves to exercise more, lose weight, quit smoking or otherwise improve their current health status.

        We believe that our patient and physician support regimens, delivered and/or supervised by a multi-disciplinary team, have demonstrated that they assist in providing more effective care for the enrollee populations diagnosed with one or more diseases or conditions, which will improve the health status of the enrollee populations with the disease or condition and reduce both the short-term and long-term health-care costs for these enrollees. In addition, our consumer-directed health support services enable health plans and employers to reach and engage everyone in their covered populations through interventions which are sensitive and specific to each individual’s health risks and needs, thereby motivating behavior change and generating measurable cost savings.

        Our integrated health and care support product line includes programs for people with diabetes, coronary artery disease, heart failure, asthma, chronic obstructive pulmonary disease, end-stage renal disease, cancer, chronic kidney disease, depression, tobacco addiction, high-risk obesity, acid-related stomach disorders, atrial fibrillation, decubitus ulcer, fibromyalgia, hepatitis C, inflammatory bowel disease, irritable bowel syndrome, low-back pain, osteoarthritis, osteoporosis, and urinary incontinence, as well as high-risk population management. We design our programs to create and maintain key desired behaviors of each program member and of the providers who care for them in order to improve member health status, thereby reducing health-care costs. The programs incorporate interventions necessary to optimize member care and are based on the most up-to-date, evidence-based clinical guidelines.

        The flexibility of our programs allows customers to enter the health and care support market at the level they deem appropriate for their organization. Customers may select a single or multiple chronic

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disease approach, a total-population, or high-risk approach, in which people with more than one disease or condition receive the benefit of multiple programs at a single cost.

        In December 2004, we were selected by CMS to participate in two Medicare Health Support (“MHS”) pilots awarded under the Chronic Care Improvement Program authorized by the Medicare Modernization Act of 2003. We began operating one pilot in August 2005 to serve 20,000 Medicare fee-for-service beneficiaries in Maryland and the District of Columbia. All fees under this pilot are performance-based. In addition, in September 2005 we began serving 20,000 beneficiaries in Georgia in collaboration with CIGNA HealthCare, Inc. The majority of our fees under our contract with CIGNA are performance-based. Both of the pilots are for complex diabetes and congestive heart failure disease management services and are operationally similar to our programs for commercial and Medicare Advantage health plan populations.

Highlights of Performance for the Six Months Ended February 28, 2006

• Revenues increased 30.1% compared to the six months ended February 28, 2005.

• Actual lives under management at February 28, 2006 increased 36.3% from February 28, 2005, which included a 66.2% increase in self-insured employer actual lives under management to 811,000 at February 28, 2006 from 488,000 at February 28, 2005.

        Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which are based upon current expectations and involve a number of risks and uncertainties. Forward-looking statements include all statements that do not relate solely to historical or current facts, and can be identified by the use of words like “may,” “believe,” “will,” “expect,” “project,” “estimate,” “anticipate,” “plan,” or “continue.” In order for us to use the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution you that the following important factors, among others, may affect these forward-looking statements. Consequently, actual operations and results may differ materially from those expressed in the forward-looking statements. The important factors include but are not limited to:

• our ability to sign and implement new contracts for health and care support services;

• our ability to accurately forecast performance and the timing of revenue recognition under the terms of our health plan contracts and/or our cooperative agreement with CMS ahead of data collection and reconciliation in order to provide forward-looking guidance;

• the timing and costs of implementation, and the effect, of regulations and interpretations relating to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003;

• our ability to anticipate the rate of market acceptance of health and care support solutions and the individual market dynamics in potential international markets and our ability to accurately forecast the costs necessary to implement our strategy of establishing a presence in these markets;

• our ability to effectively manage any growth that we might experience;

• our ability to retain existing customers if they are acquired by other health plans which already have or are not interested in health and care support programs;

• the risks associated with a significant concentration of our revenues with a limited number of customers;

• our ability to effect cost savings and clinical outcomes improvements under health and care support contracts and reach mutual agreement with customers and/or CMS with respect to cost savings, or to effect such savings and improvements within the time frames contemplated by us;

• our ability to collect contractually earned performance incentive bonuses;

• the ability of our customers and/or CMS to provide timely and accurate data that is essential to the operation and measurement of our performance under the terms of our health plan contracts;

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• our ability to favorably resolve contract billing and interpretation issues with our customers;

• our ability to integrate the operations of Health IQ and other acquired businesses or technologies into our business;

• our ability to develop new products and deliver outcomes on those products;

• our ability to effectively integrate new technologies and approaches, such as those encompassed in our health and care support initiatives or otherwise licensed or acquired by us, into our health and care support platform;

• our ability to renew and/or maintain contracts with our customers under existing terms or restructure these contracts on terms that would not have a material negative impact on our results of operations;

• our ability to implement our health and care support strategy within expected cost estimates;

• our ability to obtain adequate financing to provide the capital that may be necessary to support the growth of our operations and to support or guarantee our performance under new contracts;

• unusual and unforeseen patterns of health care utilization by individuals with diabetes, cardiac, respiratory and/or other diseases or conditions for which we provide services, in the health plans with which we have executed a health and care support contract;

• the ability of the health plans to maintain the number of covered lives enrolled in the plans during the terms of our agreements with the health plans;

• our ability to attract and/or retain and effectively manage the employees required to implement our agreements;

• the impact of litigation involving us and/or our subsidiaries;

• the impact of future state and federal health-care and other applicable legislation and regulations on our ability to deliver our services and on the financial health of our customers and their willingness to purchase our services;

• current geopolitical turmoil and the continuing threat of domestic or international terrorism;

• general worldwide and domestic economic conditions and stock market volatility; and

• other risks detailed in our other filings with the Securities and Exchange Commission.

We undertake no obligation to update or revise any such forward-looking statements.

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Customer Contracts

Contract Terms

        We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of members covered by our services during the month. We set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company. In some contracts, the PMPM rates may differ between the health plan’s lines of business [e.g. Preferred Provider Organizations (“PPO”), Health Maintenance Organizations (“HMO”), Medicare Advantage]. Contracts with health plans generally range from three to seven years with provisions for subsequent renewal; contracts between our health plan customers and their self-insured employer accounts typically have one-year terms. Some contracts allow the health plan to terminate early under certain conditions.

        Some contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s health-care costs and selected clinical and/or other criteria that focus on improving the health of the members. Approximately 10% of revenues recorded during the six months ended February 28, 2006 were performance-based and remain subject to final reconciliation. We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts, revenue recognition associated with performance-based fees, and the timing of data reconciliation, which varies according to contract terms. A limited number of contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.

Information Systems

        Our contracts require sophisticated management information systems to help us manage the care of large populations of health plan members with targeted chronic diseases or other medical conditions and to report clinical and financial outcomes before and after we implement our programs. We have developed and are continually expanding and improving our proprietary clinical, data management, and reporting systems, to continue to meet our information management needs for our health and care support services. Due to the anticipated expansion and improvement in our information management systems, we expect to continue making significant investments in our information technology software and hardware and in our information technology staff.

Contract Revenues

        Our contract revenues depend on the contractual terms we establish and maintain with health plans to provide health and care support services to their members. Some contracts allow the health plan to terminate early under certain conditions. Restructurings and possible terminations at or prior to renewal could have a material negative impact on our results of operations and financial condition.

        Approximately 39% of our revenues for the six months ended February 28, 2006 were derived from two customers that each comprised more than 10% of our revenues for the period. The loss of either of these customers or any other large health plan customer or a reduction in the profitability of any contract with these customers would have a material negative impact on our results of operations, cash flows, and financial condition.

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Actual Lives under Management

        We measure the volume of participation in our programs by the actual number of health plan members and hospital patients who are benefiting from our services, which is reported as “actual lives under management.” Annualized revenue in backlog represents the estimated annualized revenue at target performance associated with signed contracts at February 28, 2006 for which we have not yet begun providing services. The number of actual lives under management and annualized revenue in backlog are shown below at February 28, 2006 and February 28, 2005.

At February 28,	2006		2005
Actual lives under management		2,027,000		1,487,000
Annualized revenue in backlog (in $000s)	$	5,215	$	14,360

        Employers typically make decisions on which health insurance carriers they will offer to their employees and may also allow employees to switch between health plans on an annual basis. These annual membership disenrollment and re-enrollment processes of employers (whose employees are the health plan members) from health plans can result in a seasonal reduction in actual lives under management during our second fiscal quarter.

        Historically, we have found that a majority of employers and employees make these decisions effective December 31 of each year. An employer’s change in health plans or employees’ changes in health plan elections may cause a decrease in our actual lives under management for existing contracts as of January 1. Although these decisions may also cause a gain in enrollees as new employers sign on with our customers, the identification of new members eligible to participate in our programs is based on the submission of health-care claims, which lags enrollment by an indeterminate period.

        As a result, historically, actual lives under management for existing contracts have decreased between 6% and 8% on January 1 and have not been restored through new member identification until later in the fiscal year, thereby negatively affecting our revenues on existing contracts in our second fiscal quarter. In recent years, the decrease in actual lives under management resulting from health plans’ seasonal enrollment and disenrollment has been offset by growth from self-insured employer accounts as many of these accounts have implemented new health and care support programs as of January 1, resulting in a sequential quarter increase in lives under management.

        Another seasonal impact on actual lives could occur if a health plan decided to withdraw coverage altogether for a specific line of business, such as Medicare Advantage, or in a specific geographic area, thereby automatically disenrolling previously covered members. Historically, we have experienced minimal covered life disenrollment from such decisions.

        We have seen increasing demand for our health and care support services from self-insured employer accounts for which our health plan customers do not assume medical cost risk but provide primarily administrative claim and health network access services. Signed contracts between these self-insured employers and our health plan customers are incorporated in our contracts with our health plan customers, and these program-eligible members are included in the lives under management or the annualized revenue in backlog reported in the table above, as appropriate.

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Business Strategy

        Our primary strategy is to create value for governments, health plans, employers and consumers through health and care support programs and services that improve the quality and affordability of health-care. We plan to use our scaleable state-of-the-art care enhancement centers and medical information content and proprietary technologies to gain a competitive advantage in delivering our health and care support services.

        We expect to continue adding services to our product mix that extend our programs beyond a chronic disease focus and provide services to individuals who currently have, or face the risk of developing, one or more additional medical conditions. We believe that we can achieve improvements in care, and therefore significant cost savings, by addressing care and treatment requirements for these additional selected diseases and conditions, which will enable us to address a larger percentage of a health plan’s population and total health-care costs. In addition, we expect to continue developing proprietary, proactive health support for whole populations across the continuum of care, including next generation wellness solutions.

        We anticipate that we will incur significant costs during the remainder of fiscal 2006 to enhance and expand our clinical programs and data and financial reporting systems, pursue opportunities in international markets, enhance our information technology support, and open additional or expand current care enhancement centers as needed. We may add some of these new capabilities and technologies through strategic alliances with other entities, one or more of which we may make minority investments in or acquire for stock and/or cash.

Critical Accounting Policies

        We describe our accounting policies in Note 1 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2005. We prepare the consolidated financial statements in accordance with U.S. generally accepted accounting principles, which require us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.

        We believe the following accounting policies to be the most critical in understanding the judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows.

Revenue Recognition

        We generally determine our contract fees by multiplying a contractually negotiated rate per member per month (“PMPM”) by the number of members covered by our services during the month. We set the PMPM rates during contract negotiations with customers based on the value we expect our programs to create and a sharing of that value between the customer and the Company. In some contracts, the PMPM rate may differ between the health plan’s lines of business (e.g., PPO, HMO, Medicare Advantage). Contracts with health plans generally range from three to seven years with provisions for subsequent renewal; contracts between our health plan customers and their self-insured employer accounts typically have one-year terms.

        Some contracts provide that a portion (up to 100%) of our fees may be refundable to the customer (“performance-based”) if our programs do not achieve, when compared to a baseline year, a targeted percentage reduction in the customer’s health-care costs and selected clinical and/or other criteria that

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focus on improving the health of the members. Approximately 10% of revenues recorded during the six months ended February 28, 2006 were performance-based and remain subject to final reconciliation. We anticipate that this percentage will fluctuate due to the level of performance-based fees in new contracts, revenue recognition associated with performance-based fees, and the timing of data reconciliation, which varies according to contract terms. A limited number of contracts also provide opportunities for us to receive incentive bonuses in excess of the contractual PMPM rate if we exceed contractual performance targets.

        We bill our customers each month for the entire amount of the fees contractually due for the prior month’s enrollment, which typically includes the amount, if any, that is performance-based and may be subject to refund should we not meet performance targets. Contractually, we cannot bill for any incentive bonus until after contract settlement.

        We recognize revenue as follows: 1) we recognize the fixed portion of the monthly fees as revenue during the period we perform our services; 2) we recognize the performance-based portion of the monthly fees based on our performance to date in the contract year; and 3) we recognize additional incentive bonuses based on our performance to date in the contract year, to the extent we consider such amounts collectible.

        We assess our level of performance based on medical claims and other data that the health plan customer is contractually required to supply each month. A minimum of four to six months’ data is typically required for us to measure performance. In assessing our performance, we may include estimates such as medical claims incurred but not reported and a health plan’s medical cost trend compared to a baseline year. In addition, we may also provide contractual reserves, when appropriate, for billing adjustments at contract reconciliation.

        If data from the health plan is insufficient or incomplete to measure performance, or interim performance measures indicate that we are not meeting performance targets, we do not recognize performance-based fees subject to refund as revenues but instead record them in a current liability account “contract billings in excess of earned revenue”. Only in the event we do not meet performance levels by the end of the contract year are we contractually obligated to refund some or all of the performance-based fees. We would only reverse revenues that we had already recognized if performance to date in the contract year, previously above targeted levels, dropped below targeted levels due to subsequent adverse performance and/or adjustments in contractual reserves. Historically, any such adjustments have been immaterial to our financial condition and results of operations.

        During the settlement process under a contract, which generally occurs six to eight months after the end of a contract year, we settle any performance-based fees and reconcile health-care claims and clinical data. As of February 28, 2006, performance-based fees that have not yet been settled with our customers but that have been recognized as revenue in the current and prior years totaled approximately $48.3 million. Of this amount, $29.8 million was based entirely on actual data received from our customers, while $18.5 million was based on calculations which include estimates such as medical claims incurred but not reported and/or a health plan’s medical cost trend compared to a baseline year. Data reconciliation differences, for which we provide contractual allowances until we reach agreement with respect to identified issues, can arise between the customer and us due to health plan data deficiencies, omissions, and/or data discrepancies.

        Performance-related adjustments (including any amounts recorded as revenue that were ultimately refunded), changes in estimates, data reconciliation differences, or adjustments to incentive bonuses may cause us to recognize or reverse revenue in a current fiscal year that pertains to services

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provided during the prior fiscal year. During the six months ended February 28, 2006, we recognized a net increase in revenue of $1.5 million that related to services provided prior to fiscal 2006.

Impairment of Intangible Assets and Goodwill

        In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we review goodwill for impairment on an annual basis or more frequently whenever events or circumstances indicate that the carrying value may not be recoverable.

        If we determine that the carrying value of goodwill is impaired based upon an impairment review, we calculate any impairment using a fair-value-based goodwill impairment test as required by SFAS No. 142. Fair value is the amount at which the asset could be bought or sold in a current transaction between two willing parties. We estimate fair value using a number of techniques, including quoted market prices or valuations by third parties, present value techniques based on estimates of cash flows, or multiples of earnings or revenues performance measures.

        We amortize other identifiable intangible assets, such as acquired technologies and customer contracts, on the straight-line method over their estimated useful lives, except for trade names, which have an indefinite life and are not subject to amortization. We review intangible assets not subject to amortization on an annual basis or more frequently whenever events or circumstances indicate that the assets might be impaired. We assess the potential impairment of intangible assets subject to amortization whenever events or changes in circumstances indicate that the carrying values may not be recoverable.

        If we determine that the carrying value of other identifiable intangible assets may not be recoverable, we calculate any impairment using an estimate of the asset’s fair value based on the projected net cash flows expected to result from that asset, including eventual disposition.

        Future events could cause us to conclude that impairment indicators exist and that goodwill and/or other intangible assets associated with our acquired businesses are impaired. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

Share-Based Compensation

        On September 1, 2005, we adopted SFAS No. 123(R), which requires us to measure and recognize compensation expense for all share-based payment awards based on estimated fair values at the date of grant. Determining the fair value of share-based awards at the grant date requires judgment in developing assumptions, which involve a number of variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, and expected stock option exercise behavior. In addition, we also use judgment in estimating the number of share-based awards that are expected to be forfeited. In June 2005, we changed the method we use to estimate the fair values of stock options from the Black-Scholes model to a lattice binomial model, which we consider preferable to the Black-Scholes model because the lattice binomial model considers characteristics of fair value option pricing, such as an option’s contractual term and the probability of exercise before the end of the contractual term, that are not available under the Black-Scholes model. We contract with a third party to assist in developing the assumptions used in estimating the fair values of stock options.

Results of Operations

        The following table shows the components of the statements of operations for the three and six months ended February 28, 2006 and 2005 expressed as a percentage of revenues:

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	Three Months Ended February 28,				Six Months Ended February 28,
	2006		2005		2006		2005
Revenues	100.0	%	100.0	%	100.0	%	100.0	%
Cost of services	70.8	%	63.9	%	70.7	%	64.2	%
Gross margin	29.2	%	36.1	%	29.3	%	35.8	%
Selling, general and administrative expenses	10.9	%	9.7	%	11.0	%	9.2	%
Depreciation and amortization	5.8	%	7.3	%	6.0	%	7.5	%
Interest expense	0.3	%	0.6	%	0.3	%	0.7	%
Income before income taxes	12.2	%	18.5	%	12.0	%	18.4	%
Income tax expense	4.9	%	7.3	%	4.8	%	7.3	%
Net income	7.3	%	11.2	%	7.2	%	11.1	%

Revenues

        Revenues for the three months ended February 28, 2006 increased 32.8% compared to the three months ended February 28, 2005, primarily due to the following:

• existing health plan customers adding or expanding 22 new programs since the beginning of the second quarter of fiscal 2005;

• an increase in the number of self-insured employer actual lives under management from 488,000 at February 28, 2005 to 811,000 at February 28, 2006;

• increased membership in our customers' existing programs;

• the commencement of six new health plan contracts since the beginning of the second quarter of fiscal 2005; and

• revenues from the MHS pilots of $1.5 million during the three months ended February 28, 2006.

        Revenues for the six months ended February 28, 2006 increased 30.1% compared to the six months ended February 28, 2005, primarily due to the following:

• existing health plan customers adding or expanding 23 new programs since the beginning of fiscal 2005;

• an increase in the number of self-insured employer actual lives under management from 488,000 at February 28, 2005 to 811,000 at February 28, 2006;

• the commencement of six new health plan contracts since the beginning of fiscal 2005;

• increased membership in our customers’ existing programs; and

• revenues from the MHS pilots of $3.1 million during the six months ended February 28, 2006.

        We anticipate that total revenues for the remainder of fiscal 2006 will increase over fiscal 2005 revenues primarily due to the expansion of existing contracts, increasing demand for our health and care support services from self-insured employers who contract with our health plan customers, anticipated new health plan contracts, and revenues from the MHS pilots.

Cost of Services

        Cost of services as a percentage of revenues for the three months ended February 28, 2006

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increased to 70.8% compared to 63.9% for the same period in fiscal 2005. This increase is primarily related to the following costs during the three months ended February 28, 2006 which were not incurred during the comparable period in fiscal 2005:

• costs of servicing the two MHS pilots, which began in August and September of 2005, respectively. A substantial majority of our fees under the MHS pilots are performance-based and, consistent with our policy with new contracts which include performance-based fees, have not yet been recognized as revenue because we are not yet able to measure performance. For the three months ended February 28, 2006, we recorded revenues of $1.5 million, which represent the non-performance-based portion of our fees under one of the MHS pilots, and costs of $4.9 million attributable to the MHS pilots; and

• long-term incentive compensation costs of $1.8 million incurred during the second quarter of fiscal 2006, including share-based compensation expensed under SFAS No. 123(R) and cash-based awards issued in lieu of share-based awards that were historically granted to certain levels of management.

        Excluding the revenues and costs associated with the MHS pilots and the long-term incentive compensation costs noted above, cost of services as a percentage of revenues would have increased to 65.1% from 63.9% for the three months ended February 28, 2006 and 2005, respectively, primarily due to the following:

• an increase in the employee performance bonus accrual during the three months ended February 28, 2006 compared to the three months ended February 28, 2005; and

• increased expenditures for product development activities for the three months ended February 28, 2006 compared to the three months ended February 28, 2005.

These increases were somewhat offset by decreases related to increased capacity utilization, economies of scale, and productivity enhancements during the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005.

        Cost of services as a percentage of revenues for the six months ended February 28, 2006 increased to 70.7% compared to 64.2% for the same period in fiscal 2005. This increase is primarily related to the following costs during the six months ended February 28, 2006 which were not incurred during the comparable period in fiscal 2005:

• costs of servicing the two MHS pilots, which began in August and September of 2005, respectively. A substantial majority of our fees under the MHS pilots are performance-based and, consistent with our policy with new contracts which include performance-based fees, have not yet been recognized as revenue because we are not yet able to measure performance. For the six months ended February 28, 2006, we recorded revenues of $3.1 million, which represent the non-performance-based portion of our fees under one of the MHS pilots, and costs of $9.7 million attributable to the MHS pilots; and

• long-term incentive compensation costs of $3.5 million incurred during the six months ended February 28, 2006, including share-based compensation expensed under SFAS No. 123(R) and cash-based awards issued in lieu of share-based awards that were historically granted to certain levels of management.

        Excluding the revenues and costs associated with the MHS pilots and the long-term incentive compensation costs noted above, cost of services as a percentage of revenues would have increased to 64.9% from 64.2% for the six months ended February 28, 2006 and 2005, respectively, primarily due to

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the following:

• an increase in the employee performance bonus accrual during the six months ended February 28, 2006 compared to the six months ended February 28, 2005;

• a new enterprise agreement for software licensing and servicing entered into in November 2004, which enhanced and expanded a previous agreement that expired in August 2004; and

• increased expenditures for product development activities for the six months ended February 28, 2006 compared to the six months ended February 28, 2005.

These increases were somewhat offset by decreases related to increased capacity utilization, economies of scale, and productivity enhancements during the six months ended February 28, 2006 compared to the six months ended February 28, 2005.

        We anticipate that cost of services for the remainder of fiscal 2006 will increase over fiscal 2005 primarily as a result of share-based payments required to be expensed under SFAS No. 123(R) and other long-term employee incentive costs, operating costs related to the MHS pilots, increases in operating staff required for expected increases in demand for our services, increases in indirect staff costs associated with the continuing development and implementation of our health and care support services, and increases in information technology and other support staff and costs.

Selling, General and Administrative Expenses

        Selling, general and administrative expenses as a percentage of revenues for the three and six months ended February 28, 2006 increased to 10.9% and 11.0%, respectively, compared to 9.7% and 9.2% for the same periods in fiscal 2005. These increases are primarily related to the following costs:

• costs attributable to pursuing opportunities in international markets, which totaled $0.8 million and $1.4 million, respectively, for the three and six months ended February 28, 2006 compared to no corresponding costs during the three and six months ended February 28, 2005; and

• long-term incentive compensation costs of $1.9 million and $3.7 million during the three and six months ended February 28, 2006, respectively, which consisted of share-based compensation expensed under SFAS No. 123(R) and cash-based awards issued in lieu of share-based awards that were historically granted to certain levels of management, compared to $0.1 million and $0.3 million of share-based compensation costs during the three and six months ended February 28, 2005, respectively.

        Excluding the costs above, selling, general and administrative expenses as a percentage of revenues would have decreased to 8.3% for the three and six months ended February 28, 2006, compared to 9.5% and 9.0%, respectively, for the same periods in fiscal 2005 primarily due to our ability to more effectively leverage our selling, general and administrative expenses as a result of growth in our operations.

        We anticipate that selling, general and administrative expenses for the remainder of fiscal 2006 will increase over fiscal 2005 primarily due to share-based payments required to be expensed under SFAS No. 123(R) and other long-term employee incentive costs, anticipated investments in international initiatives, and increases in indirect support costs for our existing and anticipated new and expanded health plan contracts.

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Depreciation and Amortization

        Depreciation and amortization expense for the three and six months ended February 28, 2006 increased 6.0% and 4.9%, respectively, over the same periods in fiscal 2005 primarily due to increased depreciation and amortization expense associated with equipment, software, leasehold improvements, and computer-related capital expenditures. We made these capital expenditures to enhance our health plan information technology capabilities, expand our corporate office, and increase calling capacity at existing care enhancement centers.

        We anticipate that depreciation and amortization expense for the remainder of fiscal 2006 will increase over fiscal 2005 primarily as a result of additional capital expenditures associated with expected increases in demand for our services and growth and improvement in our information technology capabilities.

Interest Expense

        Interest expense for the three and six months ended February 28, 2006 decreased 45.6% and 54.0%, respectively, compared to the three and six months ended February 28, 2005 primarily due to a reduction in our long-term debt balance resulting from net repayments of $18.0 million of revolving debt since February 28, 2005.

        We anticipate that interest expense for the remainder of fiscal 2006 will decrease over fiscal 2005 primarily as a result of a lower balance of long-term debt.

Income Tax Expense

        Our effective tax rate increased to 39.7% for the three and six months ended February 28, 2006 compared to 39.5% for the three months ended February 28, 2005 and 39.7% for the six months ended February 28, 2005, primarily as a result of our geographic mix of earnings, which impacts our average state income tax rate, and other factors. The differences between the statutory federal income tax rate of 35% and our effective tax rate are due primarily to the impact of state income taxes and certain non-deductible expenses for income tax purposes.

Liquidity and Capital Resources

        Operating activities for the six months ended February 28, 2006 generated cash flows of $31.9 million compared to $18.4 million for the six months ended February 28, 2005. The increase in operating cash flow of $13.5 million resulted primarily from 1) payments during the six months ended February 28, 2005 related to accounts payable accrued at August 31, 2004 associated with capital expenditures for upgrades to hardware in support of core business functions and 2) an increase in cash collections recorded to contract billings in excess of earned revenue for the six months ended February 28, 2006 compared to the same period in fiscal 2005, primarily related to the MHS pilots. These increases were somewhat offset by a higher employee bonus payment during the six months ended February 28, 2006 compared to the six months ended February 28, 2005.

        Investing activities during the six months ended February 28, 2006 used $10.2 million in cash, which primarily consisted of the purchase of property and equipment associated with the addition of information technology hardware and software.

        Financing activities for the six months ended February 28, 2006 generated $16.6 million in cash primarily due to proceeds from the exercise of stock options and the related tax benefit. In addition, the

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entire $3.8 million that was previously classified as restricted cash and held in escrow due to contractual requirements with a customer was released from escrow and reclassified to cash and cash equivalents as our first-year results were validated with the customer.

        On September 19, 2005, we amended and restated the First Amended Credit Agreement and entered into the Second Amended Credit Agreement, which provides us with a $250.0 million revolving credit facility, including a swingline sub facility of $10.0 million and a $75.0 million sub facility for letters of credit, together with an uncommitted incremental accordion facility of $50.0 million, and expires on September 19, 2010. As of February 28, 2006, our available line of credit totaled $249.3 million.

        The Second Amended Credit Agreement requires us to repay the principal on any loans at the maturity date of September 19, 2010. Borrowings under the Second Amended Credit Agreement generally bear interest, at our option, at LIBOR plus a spread of 0.875% to 1.5% or at the prime rate. The Second Amended Credit Agreement also provides for a fee ranging between 0.175% and 0.3% of unused commitments. The Second Amended Credit Agreement is secured by guarantees from our active domestic subsidiaries and by security interests in substantially all of our and our subsidiaries’ assets.

        The First Amended Credit Agreement provided us with up to $150.0 million in borrowing capacity and contained various financial covenants, which required us to maintain, as defined, ratios or levels of (i) total funded debt to EBITDA, (ii) interest coverage, (iii) fixed charge coverage, and (iv) net worth. The Second Amended Credit Agreement contains similar financial covenants with the exclusion of the interest coverage ratio. Both agreements restrict the payment of dividends and limit the amount of repurchases of the Company’s common stock. As of February 28, 2006, we were in compliance with all of the financial covenant requirements of the Second Amended Credit Agreement.                 

        As of February 28, 2006, there were letters of credit outstanding under the Second Amended Credit Agreement totaling $0.7 million primarily to support our requirement to repay fees under one health plan contract in the event we do not perform at established target levels and do not repay the fees due in accordance with the terms of the contract.

        In conjunction with contractual requirements under one contract that began on March 1, 2004, we funded an escrow account in the amount of approximately $3.8 million, which was classified as restricted cash. We were required to deposit a percentage of all fees received from this customer during the first year of the contract into the escrow account to be used to repay fees under the contract in the event we did not perform at target levels. In accordance with the terms of the contract, in January 2006 the entire $3.8 million was released from escrow and reclassified to cash and cash equivalents as our first-year results were validated with the customer.

        We believe that cash flow from operating activities, our available cash, and our available credit under the Second Amended Credit Agreement will continue to enable us to meet our contractual obligations and to fund the current level of growth in our operations for the foreseeable future. However, if expanding our operations requires significant additional financing resources, such as capital expenditures for technology improvements, additional care enhancement centers and/or letters of credit or other forms of financial assurance to guarantee our performance under the terms of new contracts, or if we are required to refund performance-based fees pursuant to contract terms, we may need to raise additional capital by expanding our existing credit facility and/or issuing debt or equity. If we face a limited ability to arrange such financing, it may restrict our ability to expand our operations.

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        In addition, if contract development accelerates or acquisition opportunities arise that would expand our operations, we may need to issue additional debt or equity to provide the funding for these increased growth opportunities. We may also issue equity in connection with future acquisitions or strategic alliances. We cannot assure you that we would be able to issue additional debt or equity on terms that would be acceptable to us.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

        We are subject to market risk related to interest rate changes, primarily as a result of the Second Amended Credit Agreement and the First Amended Credit Agreement, which bear interest based on floating rates. Borrowings under the First Amended Credit Agreement bore interest, at our option, at the prime rate plus a spread of 0.0% to 1.0% or LIBOR plus a spread of 1.25% to 2.25%, or a combination thereof. Borrowings under the Second Amended Credit Agreement generally bear interest, at our option, at LIBOR plus a spread of 0.875% to 1.5% or at the prime rate. We do not execute transactions or hold derivative financial instruments for trading purposes.

        Because there was no variable rate debt outstanding during the six months ended February 28, 2006, a one-point interest rate change would not have caused interest expense to fluctuate for the six months ended February 28, 2006.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

        Our chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of February 28, 2006. Based on that evaluation, the chief executive officer and chief financial officer have concluded that our disclosure controls and procedures effectively and timely provide them with material information relating to the Company and its consolidated subsidiaries required to be disclosed in the reports the Company files or submits under the Exchange Act.

Changes in Internal Control over Financial Reporting

        There have been no changes in our internal controls over financial reporting during the quarter ended February 28, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II

Item 1. Legal Proceedings.

        In June 1994, a former employee whom we dismissed in February 1994 filed a “whistle blower” action on behalf of the United States government. Subsequent to its review of this case, the federal government determined not to intervene in the litigation. The employee sued Healthways, Inc. and our wholly-owned subsidiary, American Healthways Services, Inc. (“AHSI”), as well as certain named and unnamed medical directors and one named client hospital, West Paces Medical Center (“WPMC”), and other unnamed client hospitals.

        Healthways, Inc. has since been dismissed as a defendant; however, the case is still pending against AHSI before the United States District Court for the District of Columbia. In addition, WPMC has settled claims filed against it as part of a larger settlement agreement that WPMC’s parent organization, HCA Inc., reached with the United States government.

        The complaint alleges that AHSI, the client hospitals and the medical directors violated the federal False Claims Act by entering into certain arrangements that allegedly violated the federal anti-kickback statute and provisions of the Social Security Act prohibiting physician self-referrals. Although no specific monetary damage has been claimed, the plaintiff, on behalf of the federal government, seeks treble damages plus civil penalties and attorneys’ fees. The plaintiff also has requested an award of 30% of any judgment plus expenses. In February 2006, WPMC filed an arbitration claim seeking indemnification from us for certain costs and expenses incurred by it in connection with the case. Substantial discovery has taken place to date and additional discovery is expected to occur. No trial date has been set. The parties have had initial discussions regarding their respective positions in the case; however, no resolution of this case has been reached or can be assured prior to the case proceeding to trial.

        We believe that we have conducted our operations in full compliance with applicable statutory requirements and that we have meritorious defenses to the claims made in the case the related arbitration proceeding, and intend to contest the claims vigorously. Nevertheless, it is possible that resolution of these legal matters could have a material adverse effect on our consolidated results of operations in a particular financial reporting period. We believe that we will continue to incur legal expenses associated with the defense of these matters, which may be material to our consolidated results of operations in a particular financial reporting period. We believe that any resolution of this case and all related matters will not have a material effect on our liquidity or financial condition.

Item 1A. Risk Factors.

         Not Applicable.

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

         Not Applicable.

Item 3. Defaults Upon Senior Securities.

         Not Applicable.

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

       (a)        The Annual Meeting of Stockholders of Healthways, Inc. was held on January 19, 2006.

       (c)        The following proposals were voted upon at the Annual Meeting of Stockholders:

(i) Nominations to elect Henry D. Herr, Dr. Jay Bisgard, and Dr. Mary Jane England as Directors of the Company. The results of the election of the above-mentioned nominees were as follows:

	For	Against		Withheld
Henry D. Herr	28,929,038		--	3,094,733
Dr. Jay Bisgard	30,898,816		--	1,124,955
Dr. Mary Jane England	30,899,875		--	1,123,896

(ii) Approval to amend the Company’s Certificate of Incorporation and change the name of the Company from American Healthways, Inc. to “Healthways, Inc.” The voting results of the above-mentioned amendment were as follows:

For	Against	Abstain from Voting
31,210,311	800,784	12,676

(iii) Ratification of the appointment of Ernst & Young LLP as the Company’s independent registered public accounting firm. The voting results were as follows:

For	Against	Abstain from Voting
31,962,683	43,849	17,239

Item 5. Other Information.

         Not Applicable.

Item 6. Exhibits.

(a) Exhibits

10 1996 Stock Incentive Plan, as amended

11 Earnings Per Share Reconciliation

31.1 Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., President and Chief Executive Officer

31.2 Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002 made by Mary A. Chaput, Executive Vice President and Chief Financial Officer

32 Certification Pursuant to 18 U.S.C section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 made by Ben R. Leedle, Jr., President

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and Chief Executive Officer and Mary A. Chaput, Executive Vice President and Chief Financial Officer

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SIGNATURES

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

		Healthways, Inc. —————————————— (Registrant)
Date        April 7, 2006          ——————————	By	/s/ Mary A. Chaput —————————————— Mary A. Chaput Executive Vice President Chief Financial Officer (Principal Financial Officer)
Date        April 7, 2006          ——————————	By	/s/ Alfred Lumsdaine —————————————— Alfred Lumsdaine Senior Vice President and Controller (Principal Accounting Officer)

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EX-10

AMERICAN HEALTHWAYS, INC.

1996 STOCK INCENTIVE PLAN

SECTION 1. Purpose; Definitions.

        The purpose of the American Healthways, Inc. 1996 Stock Incentive Plan (the “Plan”) is to enable American Healthways, Inc. (the “Corporation”) to attract, retain and reward key employees of and consultants to the Corporation and its Subsidiaries and Affiliates, and directors who are not also employees of the Corporation, and strengthen the mutuality of interests between such key employees, consultants and directors by awarding such key employees, consultants and directors performance-based stock incentives and/or other equity interests or equity-based incentives in the Corporation, as well as performance-based incentives payable in cash. The creation of the Plan shall not diminish or prejudice other compensation programs approved from time to time by the Board.

        For purposes of the Plan, the following terms shall be defined as set forth below:

A.     “Affiliate” means any entity other than the Corporation and its Subsidiaries that is designated by the Board as a participating employer under the Plan, provided that the Corporation directly or indirectly owns at least 20% of the combined voting power of all classes of stock of such entity or at least 20% of the ownership interests in such entity.

B.     “Board” means the Board of Directors of the Corporation.

C.     “Common Stock” means the Corporation’s Common Stock, par value $.001 per share.

D.     “Code” means the Internal Revenue Code of 1986, as amended from time to time, and any successor thereto.

E.     “Committee” means the Committee referred to in Section 2 of the Plan.

F.     “Corporation” means American Healthways, Inc., a corporation organized under the laws of the State of Delaware or any successor corporation.

G.     “Covered Officer” shall mean at any date (i) any individual who, with respect to the previous taxable year of the Company, was a “covered employee” of the Company within the meaning of Section 162(m) of the Code; provided, however, that the term “Covered Officer” shall not include any such individual who is designated by the Committee, in its discretion, at the time of any award under the Plan or at any subsequent time, as reasonably expected not to be such a “covered employee” with respect to the current taxable year of the Company and (ii) any individual who is designated by the Committee, in its discretion, at the time of any award or at any subsequent time, as reasonably expected to be such a “covered employee” with respect to the current taxable year of the Company or with respect to the taxable year of the Company in which any applicable award hereunder will be paid.

H.     “Disability” means disability as determined under the Corporation’s long-term disability insurance policy.

I.     “Early Retirement” for purposes of this Plan, shall be deemed to have occurred if  (i) the sum of the participant’s age plus years of employment at the Company as of the proposed early retirement date is equal to or greater than 70, (ii) the participant has given  written notice to the company at least one year prior to the proposed early retirement date of his or her intent to retire and  (iii) the Chief Executive Officer shall have approved in writing such early retirement request prior to the proposed early retirement date, provided that in the event the Chief Executive Officer does not approve the request for early retirement or the Chief Executive Officer is the participant giving notice of his or her intent to retire, then in both cases, the Board of Directors shall make the determination of whether to approve or disapprove such request.

J.     “Exchange Act” means the Securities Exchange Act of 1934, as amended from time to time, and any successor thereto.

K.     “Fair Market Value” means with respect to the Stock, as of any given date or dates, unless otherwise determined by the Committee in good faith, the reported closing price of a share of such class of Stock on The Nasdaq Stock Market (“Nasdaq Stock Market”) or such other exchange or market as is the principal trading market for such class of Stock, or, if no such sale of a share of such class of Stock is reported on the Nasdaq Stock Market or other exchange or principal trading market on such date, the fair market value of a share of such class of Stock as determined by the Committee in good faith.

L.     “Incentive Stock Option” means any Stock Option intended to be and designated as an “Incentive Stock Option” within the meaning of Section 422 of the Code.

M.     “Non-Employee Director” shall have the meaning set forth in Rule 16b-3(b)(3)(i) as promulgated by the Securities and Exchange Commission (the “Commission”) under the Securities Exchange Act of 1934, as amended, or any successor definition adopted by the Commission.

N.     “Non-Qualified Stock Option” means any Stock Option that is not an Incentive Stock Option.

O.     “Normal Retirement” means retirement from active employment with the Corporation and any Subsidiary or Affiliate on or after age 65.

P.     “Other Stock-Based Award” means an award under Section 8 below that is valued in whole or in part by reference to, or is otherwise based on, Stock.

Q.     “Outside Director” means a member of the Board who is not an officer or employee of the Corporation or any Subsidiary or Affiliate of the Corporation.

R.     “Outside Director Restricted Stock” shall have the meaning provided in Section 9.

S.     “Participant” shall mean any person who is eligible under Section 4 of the Plan and who receives an award under the Plan.

T.     “Performance Award” shall mean any Award granted under Section 8(C) of the Plan.

U.     “Plan” means this American Healthways, Inc. 1996 Stock Incentive Plan, as amended from time to time.

V.     “Restricted Stock” means an award of shares of Stock that is subject to restrictions under Section 7 below.

W.     “Restricted Stock Unit” shall mean any unit granted under Section 7(E) of the Plan.

X.     “Restriction Period” shall have the meaning provided in Section 7.

Y.     “Retirement” means Normal or Early Retirement.

Z.     “Stock” means the Common Stock.

AA.     “Stock Appreciation Right” means the right pursuant to an award granted under Section 6 below to surrender to the Corporation all (or a portion) of a Stock Option in exchange for an amount equal to the difference between (i) the Fair Market Value, as of the date such Stock Option (or such portion thereof) is surrendered, of the shares of Stock covered by such Stock Option (or such portion thereof), subject, where applicable, to the pricing provisions in Section 6(b)(ii), and (ii) the aggregate exercise price of such Stock Option (or such portion thereof).

BB.     “Stock Option” or “Option” means any option to purchase shares of Stock (including Restricted Stock, if the Committee so determines) granted pursuant to Section 5 or Section 9 below.

CC.     “Subsidiary” means any corporation (other than the Corporation) in an unbroken chain of corporations beginning with the Corporation if each of the corporations (other than the last corporation in the unbroken chain) owns stock possessing 50% or more of the total combined voting power of all classes of stock in one of the other corporations in the chain.

        In addition, the terms “Change in Control,” “Potential Change in Control” and “Change in Control Price” shall have the meanings set forth, respectively in Sections 10(b), (c) and (d) below and the term “Cause” shall have the meaning set forth in Section 5(j) below.

SECTION 2. Administration.

        The Plan shall be administered by one or more committees of Non-Employee Directors who shall also be independent directors, as defined by applicable rules and regulations of the Commission and the Nasdaq Stock Market or such other exchange or market on which the Corporation’s Stock is traded, and “Outside Directors” as defined in the Code for purposes of Section 162(m) thereof, designated from time to time by the Board (individually and collectively, the “Committee”).

        The Committee shall have authority to grant, pursuant to the terms of the Plan, to officers, other key employees and consultants eligible under Section 4: (i) Stock Options, (ii) Stock Appreciation Rights, (iii) Restricted Stock, and/or (iv) Other Stock-Based Awards.

        In particular, the Committee shall have the authority, consistent with the terms of the Plan:

(a) to select the officers and other key employees of and consultants to the Corporation and its Subsidiaries and Affiliates to whom Stock Options, Stock Appreciation Rights, Restricted Stock, and/or Other Stock-Based Awards may from time to time be granted hereunder;

(b) to determine whether and to what extent Incentive Stock Options, Non-Qualified Stock Options, Stock Appreciation Rights, Restricted Stock, and/or Other Stock-Based Awards, or any combination thereof, are to be granted hereunder to one or more eligible employees;

(c) to determine the number of shares to be covered by each such award granted hereunder;

(d) to determine the terms and conditions, not inconsistent with the terms of the Plan, of any award granted hereunder (including, but not limited to, the share price and any restriction or limitation, or any vesting acceleration or waiver of forfeiture restrictions regarding any Stock Option or other award and/or the shares of Stock relating thereto, based in each case on such factors as the Committee shall determine, in its sole discretion); and to amend or waive any such terms and conditions to the extent permitted by Section 11 hereof;

(e) to determine whether and under what circumstances a Stock Option may be settled in cash or Restricted Stock under Section 5(m) or (n), as applicable, instead of Stock;

(f) to determine whether, to what extent and under what circumstances Option grants and/or other awards under the Plan are to be made, and operate, on a tandem basis vis-a-vis other awards under the Plan and/or cash awards made outside of the Plan;

(g) to determine whether, to what extent and under what circumstances Stock and other amounts payable with respect to an award under this Plan shall be deferred either automatically or at the election of the participant (including providing for and determining the amount (if any) of any deemed earnings on any deferred amount during any deferral period); and

(h) to determine whether to require payment withholding requirements in shares of Stock.

        The Committee shall have the authority to adopt, alter and repeal such rules, guidelines and practices governing the Plan as it shall, from time to time, deem advisable; to interpret the terms and provisions of the Plan and any award issued under the Plan (and any agreements relating thereto); and to otherwise supervise the administration of the Plan.

        All decisions made by the Committee pursuant to the provisions of the Plan shall be made in the Committee’s sole discretion and shall be final and binding on all persons, including the Corporation and Plan participants. Subject to the terms of the Plan and applicable law, the Committee may delegate to one or more officers or managers of the Company or of any Subsidiary or Affiliate, or to a committee of such officers or managers, the authority, subject to such terms and limitations as the Committee shall determine, to grant awards under the Plan to, or to cancel, modify or waive rights with respect to, or to alter, discontinue, suspend, or terminate such awards held by Participants who are not officers or directors of the Company for purposes of Section 16 of the Exchange Act or who are otherwise not subject to such provision of law.

        Notwithstanding the foregoing, the Committee shall have no authority to determine the terms or conditions of awards to Outside Directors, which shall be governed solely by Section 9 hereof.

SECTION 3. Shares of Stock Subject to Plan.

        The aggregate number of shares of Stock reserved and available for distribution under the Plan shall not exceed 9,040,000 shares. Any number of shares of Stock may be awarded so long as the total shares of Stock awarded does not exceed 9,040,000 shares. Such shares of Common Stock may consist, in whole or in part, of authorized and unissued shares or treasury shares.

        If any shares of Stock that have been optioned cease to be subject to a Stock Option, or if any shares of Stock that are subject to any Restricted Stock or Other Stock-Based Award granted hereunder are forfeited prior to the payment of any dividends, if applicable, with respect to such shares of Stock, or any such award otherwise terminates without a payment being made to the participant in the form of Stock, such shares shall again be available for distribution in connection with future awards under the Plan.

        In the event of any merger, reorganization, consolidation, recapitalization, extraordinary cash dividend, Stock dividend, Stock split or other change in corporate structure affecting the Stock, an appropriate substitution or adjustment shall be made in the aggregate number of shares reserved for issuance under the Plan, in the number and option price of shares subject to outstanding Options granted under the Plan, in the number of Non-Qualified Stock Options granted to Outside Directors pursuant to Section 9 of the Plan and in the number of shares subject to other outstanding awards granted under the Plan as may be determined to be appropriate by the Committee, in its sole discretion, provided that the number of shares subject to any award shall always be a whole number. Such adjusted option price shall also be used to determine the amount payable by the Corporation upon the exercise of any Stock Appreciation Right associated with any Stock Option. The maximum number of shares that may be awarded to any participant under Section 4 and Section 8(c) of this Plan will be adjusted in the same manner as the number of shares subject to outstanding Options.

SECTION 4. Eligibility.

        Officers and other key employees of and consultants to the Corporation and its Subsidiaries and Affiliates (but excluding members of the Committee and any person who serves only as a director, except as otherwise provided in Section 9) who are responsible for or contribute to the management, growth and/or profitability of the business of the Corporation and/or its Subsidiaries and Affiliates are eligible to be granted awards under the Plan. No officer or key employee shall be eligible to receive awards relative to shares of Stock which exceed 450,000 shares during any year.

SECTION 5. Stock Options.

        Stock Options may be granted alone, in addition to or in tandem with other awards granted under the Plan and/or cash awards made outside of the Plan. Any Stock Option granted under the Plan shall be in such form as the Committee may from time to time approve.

        Stock Options granted under the Plan may be of two types: (i) Incentive Stock Options and (ii) Non-Qualified Stock Options. Incentive Stock Options may be granted only to individuals who are employees of the Corporation or any Subsidiary of the Corporation.

        The Committee shall have the authority to grant to any optionee Incentive Stock Options, Non-Qualified Stock Options, or both types of Stock Options (in each case with or without Stock Appreciation Rights).

        Options granted to officers, key employees and consultants under the Plan shall be subject to the following terms and conditions and shall contain such additional terms and conditions, not inconsistent with the terms of the Plan, as the Committee shall deem desirable.

(a) Option Price. The option price per share of Stock purchasable under a Stock Option shall be determined by the Committee at the time of grant but shall be not less than 100% of the Fair Market Value of the Stock at grant, in the case of both Incentive Stock Options and Non-Qualified Stock Options (or, in the case of any employee who owns stock possessing more than 10% of the total combined voting power of all classes of stock of the Corporation or of any of its Subsidiaries, not less than 110% of the Fair Market Value of the Stock at grant in the case of Incentive Stock Options).

(b) Option Term. The term of each Stock Option shall be fixed by the Committee, but no Incentive Stock Option or Non-Qualified Stock Option shall be exercisable more than ten years after the date the Option is granted (or, in the case of an employee who owns stock possessing more than 10% of the total combined voting power of all classes of stock of the Corporation or any of its Subsidiaries or parent corporations, more than five years after the date the Option is granted in the case of Incentive Stock Options).

(c) Exercisability. Stock Options shall be exercisable at such time or times and subject to such terms and conditions as shall be determined by the Committee at or after grant; provided, however, that except as provided in Section 5(g) and (h) and Section 10, unless otherwise determined by the Committee at or after grant, no Stock Option shall be exercisable prior to the first anniversary date of the granting of the Option. The Committee may provide that a Stock Option shall vest over a period of future service at a rate specified at the time of grant, or that the Stock Option is exercisable only in installments. If the Committee provides, in its sole discretion, that any Stock Option is exercisable only in installments, the Committee may waive such installment exercise provisions at any time at or after grant in whole or in part, based on such factors as the Committee shall determine, in its sole discretion. The Committee may establish performance conditions or other conditions to the exercisability of any Stock Options, as determined by the Committee in its sole discretion, which conditions may be waived by the Committee in its sole discretion.

(d) Method of Exercise. Subject to whatever installment exercise restrictions apply under Section 5(c), Stock Options may be exercised in whole or in part at any time during the option period, by giving written notice of exercise to the Corporation specifying the number of shares to be purchased.

        Such notice shall be accompanied by payment in full of the purchase price, either by check, note or such other instrument as the Committee may accept. As determined by the Committee, in its sole discretion, at or (except in the case of an Incentive Stock Option) after grant, payment in full or in part may also be made in the form of unrestricted Stock already owned by the optionee or, in the case of the exercise of a Non-Qualified Stock Option or Restricted Stock, subject to an award hereunder (valued at the Fair Market Value of the Stock on the date the option is exercised, as determined by the Committee). If payment of the exercise price is made in part or in full with Stock, the Committee may award to the employee a new Stock Option to replace the Stock which was surrendered.

        If payment of the option exercise price of a Non-Qualified Stock Option is made in whole or in part in the form of Restricted Stock, such Restricted Stock (and any replacement shares relating thereto) shall remain (or be) restricted in accordance with the original terms of the Restricted Stock award in question, and any additional Stock received upon the exercise shall be subject to the same forfeiture restrictions, unless otherwise determined by the Committee, in its sole discretion, at or after grant.

        No shares of Stock shall be issued until full payment therefor has been made. An optionee shall generally have the rights to dividends or other rights of a stockholder with respect to shares subject to the Option when the optionee has given written notice of exercise, has paid in full for such shares, and, if requested, has given the representation described in Section 13(a).

(e) Non-Transferability of Options. No Stock Option shall be transferable by the optionee otherwise than by will or by the laws of descent and distribution, and all Stock Options shall be exercisable, during the optionee’s lifetime, only by the optionee.

(f) Bonus for Taxes. In the case of a Non-Qualified Stock Option, the Committee in its discretion may award at the time of grant or thereafter the right to receive upon exercise of such Stock Option a cash bonus calculated to pay part or all of the federal and state, if any, income tax incurred by the optionee upon such exercise.

(g) Termination by Death. Subject to Section 5(k), if an optionee’s employment by the Corporation and any Subsidiary or (except in the case of an Incentive Stock Option) Affiliate terminates by reason of death, any Stock Option held by such optionee may thereafter be exercised, to the extent such option was exercisable at the time of death or (except in the case of an Incentive Stock Option) on such accelerated basis as the Committee may determine at or after grant (or except in the case of an Incentive Stock Option, as may be determined in accordance with procedures established by the Committee) by the legal representative of the estate or by the legatee of the optionee under the will of the optionee, for a period of one year (or such other period as the Committee may specify at or after grant) from the date of such death or until the expiration of the stated term of such Stock Option, whichever period is the shorter.

(h) Termination by Reason of Disability. Subject to Section 5(k), if an optionee’s employment by the Corporation and any Subsidiary or (except in the case of an Incentive Stock Option) Affiliate terminates by reason of Disability, any Stock Option held by such optionee may thereafter be exercised by the optionee, to the extent it was exercisable at the time of termination or (except in the case of an Incentive Stock Option) on such accelerated basis as the Committee may determine at or after grant (or, except in the case of an Incentive Stock Option, as may be determined in accordance with procedures established by the Committee), for a period of (i) three years (or such other period as the Committee may specify at or after grant) from the date of such termination of employment or until the expiration of the stated term of such Stock Option, whichever period is the shorter, in the case of a Non-Qualified Stock Option and (ii) one year from the date of termination of employment or until the expiration of the stated term of such Stock Option, whichever period is shorter, in the case of an Incentive Stock Option; provided however, that, if the optionee dies within the period specified in (i) above (or other such period as the committee shall specify at or after grant), any unexercised Non-Qualified Stock Option held by such optionee shall thereafter be exercisable to the extent to which it was exercisable at the time of death for a period of twelve months from the date of such death or until the expiration of the stated term of such Stock Option, whichever period is shorter. In the event of termination of employment by reason of Disability, if an Incentive Stock Option is exercised after the expiration of the exercise period applicable to Incentive Stock Options, but before the expiration of any period that would apply if such Stock Option were a Non-Qualified Stock Option, such Stock Option will thereafter be treated as a Non-Qualified Stock Option.

(i) Termination by Reason of Retirement. Subject to Section 5(k), if an optionee’s employment by the Corporation and any Subsidiary or (except in the case of an Incentive Stock Option) Affiliate terminates by reason of Normal or Early Retirement, any Stock Option held by such optionee may thereafter be exercised by the optionee, to the extent it was exercisable at the time of such Retirement or (except in the case of an Incentive Stock Option) on such accelerated basis as the Committee may determine at or after grant (or, except in the case of an Incentive Stock Option, as may be determined in accordance with procedures established by the Committee), for a period of (i) three years (or such other period as the Committee may specify at or after grant) from the date of such termination of employment or the expiration of the stated term of such Stock Option, whichever period is the shorter, in the case of a Non-Qualified Stock Option and (ii) three months from the date of such termination of employment or the expiration of the stated term of such Stock Option, whichever period is the shorter, in the event of an Incentive Stock Option; provided however, that, if the optionee dies within the period specified in (i) above (or other such period as the Committee shall specify at or after grant), any unexercised Non-Qualified Stock Option held by such optionee shall thereafter be exercisable to the extent to which it was exercisable at the time of death for a period of twelve months from the date of such death or until the expiration of the stated term of such Stock Option, whichever period is shorter. In the event of termination of employment by reason of Retirement, if an Incentive Stock Option is exercised after the expiration of the exercise period applicable to Incentive Stock Options, but before the expiration of the period that would apply if such Stock Option were a Non-Qualified Stock Option, the option will thereafter be treated as a Non-Qualified Stock Option.

(j) Other Termination. Subject to Section 5(k), unless otherwise determined by the Committee (or pursuant to procedures established by the Committee) at or (except in the case of an Incentive Stock Option) after grant, if an optionee’s employment by the Corporation and any Subsidiary or (except in the case of an Incentive Stock Option) Affiliate is involuntarily terminated for any reason other than death, Disability or Normal or Early Retirement, the Stock Option shall thereupon terminate, except that such Stock Option may be exercised, to the extent otherwise then exercisable, for the lesser of three months or the balance of such Stock Option’s term if the involuntary termination is without Cause. For purposes of this Plan, “Cause” means (i) a felony conviction of a participant or the failure of a participant to contest prosecution for a felony, or (ii) a participant’s willful misconduct or dishonesty, which is directly and materially harmful to the business or reputation of the Corporation or any Subsidiary or Affiliate. If an optionee voluntarily terminates employment with the Corporation and any Subsidiary or (except in the case of an Incentive Stock Option) Affiliate (except for Disability, Normal or Early Retirement), the Stock Option shall thereupon terminate; provided, however, that the Committee at grant or (except in the case of an Incentive Stock Option) thereafter may extend the exercise period in this situation for the lesser of three months or the balance of such Stock Option’s term.

(k) Incentive Stock Options. Anything in the Plan to the contrary notwithstanding, no term of this Plan relating to Incentive Stock Options shall be interpreted, amended or altered, nor shall any discretion or authority granted under the Plan be so exercised, so as to disqualify the Plan under Section 422 of the Code, or, without the consent of the optionee(s) affected, to disqualify any Incentive Stock Option under such Section 422.

        No Incentive Stock Option shall be granted to any participant under the Plan if such grant would cause the aggregate Fair Market Value (as of the date the Incentive Stock Option is granted) of the Stock with respect to which all Incentive Stock Options issued after December 31, 1986 are exercisable for the first time by such participant during any calendar year (under all such plans of the Company and any Subsidiary) to exceed $100,000.

        To the extent permitted under Section 422 of the Code or the applicable regulations thereunder or any applicable Internal Revenue Service pronouncement:

(ii) if (x) a participant’s employment is terminated by reason of death, Disability or Retirement and (y) the portion of any Incentive Stock Option that is otherwise exercisable during the post-termination period specified under Section 5(g), (h) or (i), applied without regard to the $100,000 limitation contained in Section 422(d) of the Code, is greater than the portion of such Option that is immediately exercisable as an “Incentive Stock Option” during such post-termination period under Section 422, such excess shall be treated as a Non-Qualified Stock Option; and

(iii) if the exercise of an Incentive Stock Option is accelerated by reason of a Change in Control, any portion of such Option that is not exercisable as an Incentive Stock Option by reason of the $100,000 limitation contained in Section 422(d) of the Code shall be treated as a Non-Qualified Stock Option.

(l) Buyout Provisions. The Committee may at any time offer to buy out for a payment in cash, Stock or Restricted Stock an Option previously granted, based on such terms and conditions as the Committee shall establish and communicate to the optionee at the time that such offer is made.

(m) Settlement Provisions. If the option agreement so provides at grant or (except in the case of an Incentive Stock Option) is amended after grant and prior to exercise to so provide (with the optionee’s consent), the Committee may require that all or part of the shares to be issued with respect to the spread value of an exercised Option take the form of Restricted Stock, which shall be valued on the date of exercise on the basis of the Fair Market Value (as determined by the Committee) of such Restricted Stock determined without regards to the forfeiture restrictions involved.

(n) Performance and Other Conditions. The Committee may condition the exercise of any Option upon the attainment of specified performance goals or other factors as the Committee may determine, in its sole discretion. Unless specifically provided in the option agreement, any such conditional Option shall vest immediately prior to its expiration if the conditions to exercise have not theretofore been satisfied. The shares of Common Stock acquired pursuant to any conditional Option shall not be transferable by an Optionee subject to Section 16(a) of the Exchange Act within six months of the date such Option first becomes exercisable.

SECTION 6. Stock Appreciation Rights.

A.     Grant and Exercise. Stock Appreciation Rights may be granted in conjunction with all or part of any Stock Option granted under the Plan. In the case of a Non-Qualified Stock Option, such rights may be granted either at or after the time of the grant of such Stock Option. In the case of an Incentive Stock Option, such rights may be granted only at the time of the grant of such Stock Option.

        A Stock Appreciation Right or applicable portion thereof granted with respect to a given Stock Option shall terminate and no longer be exercisable upon the termination or exercise of the related Stock Option, subject to such provisions as the Committee may specify at grant where a Stock Appreciation Right is granted with respect to less than the full number of shares covered by a related Stock Option.

        A Stock Appreciation Right may be exercised by an optionee, subject to Section 6(b), in accordance with the procedures established by the Committee for such purpose. Upon such exercise, the optionee shall be entitled to receive an amount determined in the manner prescribed in Section 6(b). Stock Options relating to exercised Stock Appreciation Rights shall no longer be exercisable to the extent that the related Stock Appreciation Rights have been exercised.

B.     Terms and Conditions. Stock Appreciation Rights shall be subject to such terms and conditions, not inconsistent with the provisions of the Plan, as shall be determined from time to time by the Committee, including the following:

(i) Stock Appreciation Rights shall be exercisable only at such time or times and to the extent that the Stock Options to which they relate shall be exercisable in accordance with the provisions of Section 5 and this Section 6 of the Plan; provided, however, that any Stock Appreciation Right granted to an optionee subject to Section 16(a) of the Exchange Act subsequent to the grant of the related Stock Option shall not be exercisable during the first six months of its term. The exercise of Stock Appreciation Rights held by optionees who are subject to Section 16(a) of the Exchange Act shall comply with Rule 16b-3(e) thereunder, to the extent applicable. In particular, such Stock Appreciation Rights shall be exercisable only pursuant to an irrevocable election made at least six months prior to the date of exercise or within the applicable ten business day “window” periods specified in Rule 16b-3(e)(3).

(ii) Upon the exercise of a Stock Appreciation Right, an optionee shall be entitled to receive an amount in cash and/or shares of Stock equal in value to the excess of the Fair Market Value of one share of Stock over the option price per share specified in the related Stock Option multiplied by the number of shares in respect of which the Stock Appreciation Right shall have been exercised, with the Committee having the right to determine the form of payment. When payment is to be made in shares, the number of shares to be paid shall be calculated on the basis of the Fair Market Value of the shares on the date of exercise. When payment is to be made in cash, such amount shall be calculated on the basis of the average of the highest and lowest quoted selling price, regular way, of the Stock on the Nasdaq Stock Market or such other exchange or market as is the principal trading market for the Stock, or, if no such sale of Stock is reported on such date, the fair market value of the Stock as determined by the Committee in good faith.

(iii) Stock Appreciation Rights shall be transferable only when and to the extent that the underlying Stock Option would be transferable under Section 5(e) of the Plan.

(iv) Upon the exercise of a Stock Appreciation Right, the Stock Option or part thereof to which such Stock Appreciation Right is related shall be deemed to have been exercised for the purpose of the limitation set forth in Section 3 of the Plan on the number of shares of Stock to be issued under the Plan.

(v) The Committee, in its sole discretion, may also provide that, in the event of a Change in Control and/or a Potential Change in Control, the amount to be paid upon the exercise of a Stock Appreciation Right shall be based on the Change in Control Price, subject to such terms and conditions as the Committee may specify at grant.

(vi) The Committee may condition the exercise of any Stock Appreciation Right upon the attainment of specified performance goals or other factors as the Committee may determine, in its sole discretion. Unless specifically provided in the applicable award agreement, any such conditional Stock Appreciation Right held by a grantee subject to Section 16(a) of the Exchange Act shall not be exercisable until the expiration of six months following the satisfaction of the condition giving rise to such Stock Appreciation Right.

SECTION 7. Restricted Stock and Restricted Stock Units.

A.     Administration. Shares of Restricted Stock may be issued either alone, in addition to or in tandem with other awards granted under the Plan and/or cash awards made outside the Plan. The Committee shall determine the eligible persons to whom, and the time or times at which, grants of Restricted Stock will be made, the number of shares of Restricted Stock to be awarded to any person, the price (if any) to be paid by the recipient of Restricted Stock (subject to Section 7(b)), the time or times within which such awards may be subject to forfeiture, and the other terms, restrictions and conditions of the awards in addition to those set forth in Section 7(c).

        The Committee may condition the grant of Restricted Stock upon the attainment of specified performance goals or such other factors as the Committee may determine, in its sole discretion.

        The provisions of Restricted Stock awards need not be the same with respect to each recipient.

B.     Awards and Certificates. The prospective recipient of a Restricted Stock award shall not have any rights with respect to such award, unless and until such recipient has executed an agreement evidencing the award and has delivered a fully executed copy thereof to the Corporation, and has otherwise complied with the applicable terms and conditions of such award.

(i) The purchase price for shares of Restricted Stock shall be established by the Committee and may be zero.

(ii) Awards of Restricted Stock must be accepted within a period of 60 days (or such shorter period as the Committee may specify at grant) after the award date, by executing a Restricted Stock Award Agreement and paying whatever price (if any) is required under Section 7(b)(i).

(iii) Each participant receiving a Restricted Stock award shall be issued a stock certificate in respect of such shares of Restricted Stock. Such certificate shall be registered in the name of such participant, and shall bear an appropriate legend referring to the terms, conditions, and restrictions applicable to such award.

(iv) The Committee shall require that the stock certificates evidencing such shares be held in custody by the Corporation until the restrictions thereon shall have lapsed, and that, as a condition of any Restricted Stock award, the participant shall have delivered a stock power, endorsed in blank, relating to the Stock covered by such award.

C.     Restrictions and Conditions. The shares of Restricted Stock awarded pursuant to this Section 7 shall be subject to the following restrictions and conditions:

(i) In accordance with the provisions of this Plan and the award agreement, during a period set by the Committee commencing with the date of such award (the “Restriction Period”), the participant shall not be permitted to sell, transfer, pledge, assign or otherwise encumber shares of Restricted Stock awarded under the Plan. Within these limits, the Committee, in its sole discretion, may provide for the lapse of such restrictions in installments and may accelerate or waive such restrictions in whole or in part, based on service, performance and/or such other factors or criteria as the Committee may determine, in its sole discretion.

(ii) Except as provided in this paragraph (ii) and Section 7(c)(i), the participant shall have, with respect to the shares of Restricted Stock, all of the rights of a stockholder of the Corporation, including the right to vote the shares, and the right to receive any cash dividends. The Committee, in its sole discretion, as determined at the time of award, may permit or require the payment of cash dividends to be deferred and, if the Committee so determines, reinvested, subject to Section 14(e), in additional Restricted Stock to the extent shares are available under Section 3, or otherwise reinvested. Pursuant to Section 3 above, Stock dividends issued with respect to Restricted Stock shall be treated as additional shares of Restricted Stock that are subject to the same restrictions and other terms and conditions that apply to the shares with respect to which such dividends are issued. If the Committee so determines, the award agreement may also impose restrictions on the right to vote and the right to receive dividends.

(iii) Subject to the applicable provisions of the award agreement and this Section 7, upon termination of a participant’s employment with the Corporation and any Subsidiary or Affiliate for any reason during the Restriction Period, all shares still subject to restriction will vest, or be forfeited, in accordance with the terms and conditions established by the Committee at or after grant.

(iv) If and when the Restriction Period expires without a prior forfeiture of the Restricted Stock subject to such Restriction Period, certificates for an appropriate number of unrestricted shares shall be delivered to the participant promptly.

D.     Minimum Value Provisions. In order to better ensure that award payments actually reflect the performance of the Corporation and service of the participant, the Committee may provide, in its sole discretion, for a tandem performance-based or other award designed to guarantee a minimum value, payable in cash or Stock to the recipient of a restricted stock award, subject to such performance, future service, deferral and other terms and conditions as may be specified by the Committee.

E.     Restricted Stock Units. Subject to the provisions of the Plan, the Committee shall have sole and complete authority to determine the Participants to whom Restricted Stock Units shall be granted, the number of Restricted Stock Units to be granted to each Participant, the duration of the period during which, and the conditions under which, the Restricted Stock Units may be forfeited to the Company, and the other terms and conditions of such awards. The Restricted Stock Unit awards shall be evidenced by award agreements in such form as the Committee shall from time to time approve, which agreements shall comply with and be subject to the terms and conditions provided hereunder and any additional terms and conditions determined by the Committee that are consistent with the terms of the Plan.

        Each Restricted Stock Unit award made under the Plan shall be for such number of shares of Stock as shall be determined by the Committee and set forth in the award agreement containing the terms of such Restricted Stock Unit award. The agreement shall set forth a period of time during which the grantee must remain in the continuous employment of the Company in order for the forfeiture and transfer restrictions to lapse. The Award Agreement may, in the discretion of the Committee, set forth performance or other conditions that will subject the Restricted Stock Units to forfeiture and transfer restrictions. The Committee may, in its discretion, waive all or any part of the restrictions applicable to any or all outstanding Restricted Stock Unit awards.

        Each Restricted Stock Unit shall have a value equal to the Fair Market Value of a share of Stock. Restricted Stock Units shall be paid in cash, shares of Stock, other securities or other property, as determined in the sole discretion of the Committee, upon the lapse of the restrictions applicable thereto, or otherwise in accordance with the applicable award agreement. A Participant shall be credited with dividend equivalents on any vested Restricted Stock Units credited to the Participant’s account at the time of any payment of dividends to shareholders on shares of Stock. The amount of any such dividend equivalents shall equal the amount that would have been payable to the Participant as a shareholder in respect of a number of shares of Stock equal to the number of vested Restricted Stock Units then credited to the Participant. Any such dividend equivalents shall be credited to the Participant’s account as of the date on which such dividend would have been payable and shall be converted into additional Restricted Stock Units (which shall be immediately vested) based upon the Fair Market Value of a share of Stock on the date of such crediting. No dividend equivalents shall be paid in respect of Restricted Stock Units that are not yet vested. Except as otherwise determined by the Committee at or after grant, and subject to the “retirement” exceptions, Restricted Stock Units may not be sold, assigned, transferred, pledged, hypothecated or otherwise encumbered or disposed of, and all Restricted Stock Units and all rights of the grantee to such Restricted Stock Units shall terminate, without further obligation on the part of the Company, unless the grantee remains in continuous employment of the Company for the entire restricted period in relation to which such Restricted Stock Units were granted and unless any other restrictive conditions relating to the Restricted Stock Unit Award are met.

SECTION 8. Other Stock-Based Awards and Performance Awards.

A.     Administration. Other Stock-Based Awards, including, without limitation, performance shares, convertible preferred stock, convertible debentures, exchangeable securities and Stock awards or options valued by reference to earnings per share or Subsidiary performance, may be granted either alone or in addition to or in tandem with Stock Options, Stock Appreciation Rights or Restricted Stock granted under the Plan and/or cash awards made outside of the Plan; provided that no such Other Stock-Based Awards may be granted in tandem with Incentive Stock Options if that would cause such Stock Options not to qualify as Incentive Stock Options pursuant to Section 422 of the Code.

        Subject to the provisions of the Plan, the Committee shall have authority to determine the persons to whom and the time or times at which such awards shall be made, the number of shares of Stock to be awarded pursuant to such awards, and all other conditions of the awards; provided that for Other Stock-Based Awards that do not contain a three-year restriction period on vesting, the number of shares of Common Stock to which such Other Stock-Based Awards relate shall not exceed 10% of the total number of shares of Common Stock authorized for issuance under the Plan. The Committee may also provide for the grant of Stock upon the completion of a specified performance period.

        The provisions of Other Stock-Based Awards need not be the same with respect to each recipient.

B.     Terms and Conditions. Other Stock-Based Awards made pursuant to this Section 8 shall be subject to the following terms and conditions:

(i) Shares subject to awards under this Section 8 and the award agreement referred to in Section 8(b)(v) below, may not be sold, assigned, transferred, pledged or otherwise encumbered prior to the date on which the shares are issued, or, if later, the date on which any applicable restriction, performance or deferral period lapses.

(ii) Subject to the provisions of this Plan and the award agreement and unless otherwise determined by the Committee at grant, the recipient of an award under this Section 8 shall be entitled to receive, currently or on a deferred basis, interest or dividends or interest or dividend equivalents with respect to the number of shares covered by the award, as determined at the time of the award by the Committee, in its sole discretion, and the Committee may provide that such amounts (if any) shall be deemed to have been reinvested in additional Stock or otherwise reinvested.

(iii) Any award under Section 8 and any Stock covered by any such award shall vest or be forfeited to the extent so provided in the award agreement, as determined by the Committee, in its sole discretion.

(iv) In the event of the participant’s Retirement, Disability or death, or in cases of special circumstances, the Committee may, in its sole discretion, waive in whole or in part any or all of the remaining limitations imposed hereunder (if any) with respect to any or all of an award under this Section 8.

(v) Each award under this Section 8 shall be confirmed by, and subject to the terms of, an agreement or other instrument by the Corporation and the participant.

(vi) Stock (including securities convertible into Stock) issued on a bonus basis under this Section 8 may be issued for no cash consideration. Stock (including securities convertible into Stock) purchased pursuant to a purchase right awarded under this Section 8 shall be priced at least 85% of the Fair Market Value of the Stock on the date of grant.

C.     Performance Awards. The Committee shall have sole and complete authority to determine the participants who shall receive a Performance Award, which shall consist of a right that is (i) denominated in cash or shares of Stock, (ii) valued, as determined by the Committee, in accordance with the achievement of such performance goals during such performance periods as the Committee shall establish, and (iii) payable at such time and in such form as the Committee shall determine. Notwithstanding anything in the Plan to the contrary, Performance Awards shall be subject to the terms and provisions of this Section 8(C).

        The Committee may grant Performance Awards to Covered Officers based solely upon the attainment of performance targets related to one or more performance goals selected by the Committee from among the goals specified below. For the purposes of this Section 8(C), performance goals shall be limited to one or more of the following Corporation, Subsidiary, operating unit or division financial performance measures:

(i) earnings before interest, taxes, depreciation and/or amortization;

(ii) operating income or profit;

(iii) operating efficiencies;

(iv) return on equity, assets, capital, capital employed, or investment;

(v) after tax operating income;

(vi) net income;

(vii) earnings or book value per share;

(viii) cash flow(s);

(ix) total sales or revenues or sales or revenues per employee;

(x) production;

(xi) stock price or total shareholder return;

(xii) dividends;

(xiii) strategic business objectives, consisting of one or more objectives based on meeting specified cost targets, business expansion goals, and goals relating to acquisitions or divestitures;

or any combination thereof. Each goal may be expressed on an absolute and/or relative basis, may be based on or otherwise employ comparisons based on internal targets, the past performance of the Corporation or any Subsidiary, operating unit or division of the Corporation and/or the past or current performance of other companies, and in the case of earnings-based measures, may use or employ comparisons relating to capital, shareholders’ equity and/or shares of Stock outstanding, or to assets or net assets.

With respect to any Covered Officer, the aggregate maximum number of shares of Stock in respect of which all Performance Awards and Stock Options may be granted under Sections 5 and 8(C) of the Plan in each year of the performance period is 450,000, and the maximum amount of the aggregate Performance Awards denominated in cash is $1,000,000 in each year of the performance period.

        To the extent necessary to comply with Section 162(m) of the Code, with respect to grants of Performance Awards to Covered Officers, no later than 90 days following the commencement of each performance period (or such other time as may be required or permitted by Section 162(m) of the Code), the Committee shall, in writing, (1) select the performance goal or goals applicable to the performance period, (2) establish the various targets and bonus amounts which may be earned for such performance period, and (3) specify the relationship between performance goals and targets and the amounts to be earned by each Covered Officer for such performance period. Following the completion of each performance period, the Committee shall certify in writing whether the applicable performance targets have been achieved and the amounts, if any, payable to Covered Officers for such performance period. In determining the amount earned by a Covered Officer for a given performance period, subject to any applicable Performance Award agreement, the Committee shall have the right to reduce the amount payable at a given level of performance to take into account additional factors that the Committee may deem relevant to the assessment of individual or corporate performance for the performance period.

SECTION 9. Awards to Outside Directors.

A.     General. The provisions of this Section 9 shall apply only to awards to Outside Directors in accordance with this Section 9. The Committee shall have no authority to determine the timing of or the terms or conditions of any award under this Section 9. On and after the date of the Corporation’s 2004 Annual Meeting of Stockholders, no grants shall be made to Outside Directors pursuant to Sections 9(B) through 9(I) hereof, but awards to Outside Directors shall only be made pursuant to Sections 9(J) through 9(T) hereof.

B.     On the date of each Annual Meeting of Stockholders of the Corporation, commencing with the 1996 Annual Meeting of Stockholders, each Outside Director will receive an automatic grant of restricted stock pursuant to this Section 9 (the “Outside Directors Restricted Stock”) in a number of shares of stock which will be determined by dividing:

(i) $10,000 by

(ii) the average of the daily closing bid price of the Stock for the first five (5) trading days of the month in which the Annual Meeting is held (as reported in The Wall Street Journal), rounding up or down any fractional share of Stock to the nearest whole share.

The Outside Director Restricted Stock award shall be adjusted annually on the date of the Annual Meeting of Stockholders by the percentage change from the previous year in the Consumer Price Index, Urban Wage Earners and Clerical Workers (1982-1984 = 100), All Cities Average; provided, however, that such annual increase shall not exceed six percent.

C.     The Outside Director Restricted Stock shall vest as follows:

(i) Of the aggregate number of shares of Outside Director Restricted Stock granted on the date of each Annual Meeting of Stockholders, one-third of the Outside Director Restricted Stock shall immediately vest on the date of grant;

(ii) At the first Annual Meeting of Stockholders following the Annual Meeting at which the Outside Director Restricted Stock was granted, if the grantee is still serving as a director of the Corporation, the Outside Director Restricted Stock shall vest with respect to one-half of the remaining shares of the Outside Director Restricted Stock; and

(iii) At the second Annual Meeting of Stockholders following the Annual Meeting at which the Outside Director Restricted Stock was granted, if the director is still serving as a director of the Corporation, the Outside Director Restricted Stock shall vest with respect to the remaining shares of the Outside Director Restricted Stock.

D.     Until the earlier of (i) five years from the date of grant and (ii) the date on which the Outside Director ceases to serve as a director of the Corporation (the”Outside Director Period of Restriction), no Outside Director Restricted Stock may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, otherwise than by will or by the laws of descent and distribution.

        Each certificate representing Outside Director Restricted Stock granted pursuant to this Section 9 shall bear the following legend:

“The sale or other transfer of the shares represented by this certificate, whether voluntary, involuntary, or by operation of law, is subject to certain restrictions on transfer set forth in the American Healthways, Inc. 1996 Stock Incentive Plan (the “Plan”), and rules of administration adopted pursuant to such Plan. A copy of the Plan and the rules of such Plan may be obtained from the Secretary of American Healthways, Inc.”

Once the Outside Director Period of Restriction has lapsed, the grantee shall be entitled to have the legend required by this Section 9 removed from such stock certificate(s); provided however, that such certificate shall be subject to any legend required by applicable state or federal law.

E.     From the date on which the Outside Director Restricted Stock is granted, grantees awarded such Stock may exercise full voting rights with respect to the Outside Director Restricted Stock.

F.     Grantees holding Outside Director Restricted Stock that has vested in accordance with Section 9(c) hereof, shall be entitled to receive all dividends and other distributions paid with respect to such shares of Stock while they are so held. If any such dividends, or distributions are paid in Stock, such shares of Stock shall be subject to the same restrictions on transferability as the shares of Outside Director Restricted Stock with respect to which they were paid.

G.     Grantees of Outside Director Restricted Stock shall enter into a Restricted Stock Award Agreement with the Corporation setting forth the restrictions imposed on the Stock granted to him or her.

H.     All restrictions imposed on the Outside Director Restricted Stock shall expire automatically upon a Change in Control, but shall not otherwise be subject to Section 10 hereof.

I.     All shares of Outside Director Restricted Stock which have not vested in accordance with Section 9(c) hereof, at the time of a grantee’s resignation, removal or failure to be elected as a member of the Board of Directors shall be forfeited and such forfeited shares shall again be available for award hereunder.

J.     The Board may not amend or alter this Section 9, except as provided in Section 11, without the approval of the holders of a majority of the issued and outstanding shares of Common Stock, and in no event shall this Section 9 be amended more than once every six months, other than to comply with changes in the Exchange Act, Code or the Employee Retirement Income Security Act of 1974, as amended, or the regulations thereunder.

K.     Grant of Stock Options. Non-Qualified Stock Options will be awarded under this Plan pursuant to the following formula:

(i) On the date of his or her initial election to the Board, whether such election is by the Board or by the Corporation’s stockholders, each Outside Director shall be granted a Non-Qualified Stock Option (an “Initial Option”) to purchase up to 15,000 shares of the Corporation’s Common Stock, the amount of shares to be determined by the Board, subject to adjustment as provided in Section 3, provided that such Optionee has not received an Initial Option on any previous date.

(ii) Commencing with the 2004 Annual Meeting of Stockholders and continuing in effect for each subsequent Annual Meeting, each Outside Director who has served as a director of the Corporation for at least twelve (12) months will be automatically granted on the date of each such Annual Meeting a Non-Qualified Stock Option to purchase up to 5,000 shares of the Corporation’s Common Stock, the amount of shares to be determined by the Board, subject to adjustment as provided in Section 3.

(iii) Each Outside Director, other than directors elected to the Board in 2003, will be granted on the date of the 2004 Annual Meeting of Stockholders a Non-Qualified Stock Option (the “2003 Option”) to purchase 5,000 shares of the Corporation’s Common Stock, subject to adjustment as provided in Section 3, at an exercise price of $35.77 per share (the closing price of the Corporation’s Common Stock on September 2, 2003).

L.     Stock Option Price. Except for the 2003 Options granted pursuant to subsection (k)(iii) above, each Non-Qualified Stock Option granted pursuant to this Section 9 shall represent the right to purchase the shares of Common Stock represented thereby at the Fair Market Value on the date the Non-Qualified Stock Option is granted.

M.     Stock Option Agreement. The grant of any Non-Qualified Stock Option shall be evidenced by a written Stock Option Agreement executed by the Corporation and the Optionee. The Stock Option Agreement shall contain the number of shares of Common Stock subject to the Non-Qualified Stock Option evidenced thereby, the other essential terms of the Non-Qualified Stock Option determined in accordance with Section 9 hereof, and other terms that are not inconsistent with requirements of this Plan.

N.     Exercisability. With respect to Non-Qualified Stock Options granted prior to December 31, 2004:

(i) One-third of the Non-Qualified Stock Options granted pursuant to Section 9(k) shall vest immediately as of the date of grant.

(ii) One-third of the Non-Qualified Stock Options granted pursuant to Section 9(k) shall vest on the first anniversary of the date of grant, provided that the grantee is still serving as a director of the Corporation on such date.

(iii) The remaining one-third of the Non-Qualified Stock Options granted pursuant to Section 9(k) shall vest on the second anniversary of the date of grant, provided that the grantee is still serving as a director of the Corporation on such date.

With respect to Non-Qualified Stock Options granted on or after January 1, 2005, 100% of the Non-Qualified Stock Options granted pursuant to Section 9(k) shall vest on the second anniversary of the date of grant, provided that the grantee is still serving as a director of the Corporation on such date.

O.     Term. All Non-Qualified Stock Options shall have a term of ten years from the date of grant, subject to earlier termination as hereinafter provided.

P.     Forfeiture. Non-Qualified Stock Options that have not become exercisable on the date the Optionee ceases to serve as a director of the Corporation for any reason shall be forfeited and terminated immediately upon termination of service.

Q.     Termination of Stock Options. Non-Qualified Stock Options may vest and be exercisable following the termination or expiration of the Optionee’s position as a director as follows:

             (i)     Termination or Resignation from Board following Two Terms as a Director

        If the Optionee shall cease to be a director of the Corporation for any reason other than involuntary removal by the stockholders for cause and if the Optionee has (x) (a) served at least two full three-year terms as a director, or (b) served at least two terms as a director of the Corporation (the first of which may be a partial term and the last of which shall be a full three-year term) and offered to resign from the Board on or after such Optionee’s 70^th birthday, which offer to resign has been accepted by the Corporation, and (y) in the event of the Optionee’s retirement from the Board, given the Corporation at least nine months’ prior written notice of the Optionee’s intent not to stand for re-election at the end of the Optionee’s then-current term, each Non-Qualified Stock Option granted to Optionee shall vest and become immediately exercisable at the end of the Optionee’s then-current term and may be exercised by the Optionee for a period of one year from the end of such term or until the expiration of the stated term of the Option, whichever period is shorter (the “Exercise Period”); provided, however, that if the Optionee dies during the Exercise Period, any unexercised Non-Qualified Stock Option held by such Optionee shall thereafter be exercisable for a period of three years from the date of such death or until the expiration of the stated term of the Option, whichever is shorter.

             (ii)     Retirement or Disability

        If the Optionee shall cease to be a director of the Corporation by reason of retirement or Disability without meeting the requirements of subsection Q(i) above, the Optionee may exercise the Non-Qualified Stock Option if and to the extent it was exercisable on the date of such cessation. Such Non-Qualified Stock Option may be exercised for a period of one year from the date of such cessation or until the expiration of the stated term of such Non-Qualified Stock Option, whichever period is shorter.

             (iii)     Death

        If the Optionee shall cease to be a director of the Corporation by reason of death at any time, the Non-Qualified Stock Option shall vest and become immediately exercisable. Such Non-Qualified Stock Option may be exercised for a period of three years from the date of such death or until the expiration of the stated term of such Non-Qualified Stock Option, whichever period is shorter.

             (iv)    Termination for any other reason

        If the Optionee shall cease to be a director of the Corporation for any reason (including removal by the stockholders for cause) other than retirement, Disability, or death without meeting the requirements of subsection Q(i) above , the Optionee may exercise the Non-Qualified Stock Option, to the extent it was exercisable on the date of such cessation. Such Non-Qualified Stock Options, if exercised, must be exercised within the lesser of three months from the date of cessation or until the expiration of the stated term of the Non-Qualified Stock Option, whichever period is shorter.

R.     Method of Exercise. A Non-Qualified Stock Option shall be exercised by delivering to the Corporate Secretary of the Corporation a written notice of exercise in the form prescribed by the Corporate Secretary for use from time to time. Such notice of exercise shall indicate the number of shares for which the Non-Qualified Stock Option is exercised and shall be accompanied by the full exercise price for the Non-Qualified Stock Options exercised.

S.     Payment of Exercise Price. The exercise price may be paid in cash (including certified or cashier’s check, bank draft or money order), Common Stock, or a combination of Common Stock and cash. The Common Stock so delivered shall be valued at the Fair Market Value of the Common Stock on the date of exercise. No shares of Common Stock shall be issued or delivered until full payment has been made.

T.     Transferability. Non-Qualified Stock Options shall not be transferable without the prior written consent of the Committee other than (i) transfers by the Optionee to a member of his or her Immediate Family or a trust for the benefit of Optionee or a member of his or her Immediate Family, or (ii) transfers by will or by the laws of descent and distribution. For purposes of this Section 9(t), “Immediate Family” shall mean any child, stepchild, grandchild, parent, stepparent, grandparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, and shall include adoptive relationships.

SECTION 10. Change in Control Provisions.

A.     Impact of Event. In the event of:

(1) a “Change in Control” as defined in Section 10(b) or

(2) a “Potential Change in Control” as defined in Section 10(c), but only if and to the extent so determined by the Committee or the Board at or after grant (subject to any right of approval expressly reserved by the Committee or the Board at the time of such determination),

the following acceleration and valuation provisions shall apply if so determined by the Board in its sole discretion:

(i) Any Stock Appreciation Rights (including, without limitation, any Limited Stock Appreciation Rights) outstanding for at least six months and any Stock Option awarded under the Plan not previously exercisable and vested shall become fully exercisable and vested.

(ii) The restrictions applicable to any Restricted Stock and Other Stock-Based Awards, in each case to the extent not already vested under the Plan, shall lapse and such shares and awards shall be deemed fully vested.

(iii) Except as otherwise provided in Section 10(a)(iv) below, the value of all outstanding Stock Options, Stock Appreciation Rights, Restricted Stock and Other Stock-Based Awards, in each case to the extent vested, shall, unless otherwise determined by the Committee in its sole discretion at or (except in the case of an Incentive Stock Option) after grant but prior to any Change in Control, be cashed out on the basis of the “Change in Control Price” as defined in Section 10(d) as of the date such Change in Control or such Potential Change in Control is determined to have occurred or such other date as the Committee may determine prior to the Change in Control.

(iv) In the case of any Stock Options, Stock Appreciation Rights, Restricted Stock and Other Stock-Based Awards held by any person subject to Section 16(a) of the Exchange Act, the value of all such Stock Options, Stock Appreciation Rights, Restricted Stock or Other Stock-Based Awards, in each case to the extent that they are vested and have been held for at least six months, shall (unless otherwise determined by the Committee in its sole discretion) be cashed out on the basis of the “Change in Control Price” as defined in Section 10(d) as of the date of such Change in Control or such Potential Change in Control is determined to have occurred, but only if the Change in Control or Potential Change in Control is outside the control of the grantee for purposes of Rule 16b-3(e)(3) under the Exchange Act, or any successor provision promulgated by the Securities and Exchange Commission.

B.     Definition of Change in Control. For purposes of Section 10(a), a “Change in Control” means the happening of any of the following:

(i) any person or entity, including a “group” as defined in Section 13(d)(3) of the Exchange Act, other than the Corporation or a wholly-owned subsidiary thereof or any employee benefit plan of the Corporation or any of its Subsidiaries, becomes the beneficial owner of the Corporation’s securities having 35% or more of the combined voting power of the then outstanding securities of the Corporation that may be cast for the election of directors of the Corporation (other than as a result of an issuance of securities initiated by the Corporation in the ordinary course of business); or

(ii) as the result of, or in connection with, any cash tender or exchange offer, merger or other business combination, sales of assets or contested election, or any combination of the foregoing transactions, less than a majority of the combined voting power of the then outstanding securities of the Corporation or any successor corporation or entity entitled to vote generally in the election of the directors of the Corporation or such other corporation or entity after such transaction are held in the aggregate by the holders of the Corporation’s securities entitled to vote generally in the election of directors of the Corporation immediately prior to such transaction; or

(iii) during any period of two consecutive years, individuals who at the beginning of any such period constitute the Board cease for any reason to constitute at least a majority thereof, unless the election, or the nomination for election by the Corporation’s stockholders, of each director of the Corporation first elected during such period was approved by a vote of at least two-thirds of the directors of the Corporation then still in office who were directors of the Corporation at the beginning of any such period.

C.     Definition of Potential Change in Control. For purposes of Section 10(a), a “Potential Change in Control” means the happening of any one of the following:

(i) The approval by stockholders of an agreement by the Corporation, the consummation of which would result in a Change in Control of the Corporation as defined in Section 10(b); or

(ii) The acquisition of beneficial ownership, directly or indirectly, by any entity, person or group (other than the Corporation or a Subsidiary or any Corporation employee benefit plan (including any trustee of such plan acting as such trustee)) of securities of the Corporation representing 5% or more of the combined voting power of the Corporation’s outstanding securities and the adoption by the Committee of a resolution to the effect that a Potential Change in Control of the Corporation has occurred for purposes of this Plan.

D.     Change in Control Price. For purposes of this Section 10, “Change in Control Price” means the highest price per share paid in any transaction reported on the Nasdaq Stock Market or such other exchange or market as is the principal trading market for the Stock, or paid or offered in any bona fide transaction related to a Potential or actual Change in Control of the Corporation at any time during the 60 day period immediately preceding the occurrence of the Change in Control (or, where applicable, the occurrence of the Potential Change in Control event), in each case as determined by the Committee except that, in the case of Incentive Stock Options and Stock Appreciation Rights relating to Incentive Stock Options, such price shall be based only on transactions reported for the date on which the optionee exercises such Stock Appreciation Rights or, where applicable, the date on which a cash out occurs under Section 10(a)(iii).

SECTION 11. Amendments and Termination.

        The Board may amend, alter, or discontinue the Plan, but no amendment, alteration, or discontinuation shall be made which would impair the rights of an optionee or participant under a Stock Option, Stock Appreciation Right, Restricted Stock, Other Stock-Based Award or Outside Director Restricted Stock theretofore granted, without the optionee’s or participant’s consent or which, without the approval of the Corporation’s stockholders, would:

(a) except as expressly provided in this Plan, increase the total number of shares reserved for the purpose of the Plan;

(b) materially increase the benefits accruing to participants under the Plan; or

(c) materially modify the requirements as to eligibility for participation in the Plan.

        The Committee may amend the terms of any Stock Option or other award theretofore granted, prospectively or retroactively, but, subject to Section 3 above, no such amendment shall impair the rights of any holder without the holder’s consent. The Committee may also substitute new Stock Options for previously granted Stock Options (on a one for one or another basis), provided that the Committee may not modify any outstanding Stock Option so as to specify a lower exercise price or accept the surrender of an outstanding Stock Option and authorize the granting of a new Stock Option in substitution therefor specifying a lower exercise price. Subject to the above provisions, the Board shall have broad authority to amend the Plan to take into account changes in applicable securities and tax laws and accounting rules, as well as other developments.

SECTION 12. Unfunded Status of Plan.

        The Plan is intended to constitute an “unfunded” plan for incentive and deferred compensation. With respect to any payments not yet made to a participant or optionee by the Corporation, nothing contained herein shall give any such participant or optionee any rights that are greater than those of a general creditor of the Corporation. In its sole discretion, the Committee may authorize the creation of trusts or other arrangements to meet the obligations created under the Plan to deliver Stock or payments in lieu of or with respect to awards hereunder; provided, however, that, unless the Committee otherwise determines with the consent of the affected participant, the existence of such trusts or other arrangements is consistent with the “unfunded” status of the Plan.

SECTION 13. General Provisions.

A.     The Committee may require each person purchasing shares pursuant to a Stock Option or other award under the Plan to represent to and agree with the Corporation in writing that the optionee or participant is acquiring the shares without a view to distribution thereof. The certificates for such shares may include any legend which the Committee deems appropriate to reflect any restrictions on transfer.

        All certificates for shares of Stock or other securities delivered under the Plan shall be subject to such stock-transfer orders and other restrictions as the Committee may deem advisable under the rules, regulations, and other requirements of the Securities and Exchange Commission, any stock exchange upon which the Stock is then listed, and any applicable Federal or state securities law, and the Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions.

B.     Nothing contained in this Plan shall prevent the Board from adopting other or additional compensation arrangements, subject to stockholder approval if such approval is required; and such arrangements may be either generally applicable or applicable only in specific cases.

C.     The adoption of the Plan shall not confer upon any employee of the Corporation or any Subsidiary or Affiliate any right to continued employment with the Corporation or a Subsidiary or Affiliate, as the case may be, nor shall it interfere in any way with the right of the Corporation or a Subsidiary or Affiliate to terminate the employment of any of its employees at any time.

D.     No later than the date as of which an amount first becomes includible in the gross income of the participant for Federal income tax purposes with respect to any award under the Plan, the participant shall pay to the Corporation, or make arrangements satisfactory to the Committee regarding the payment of, any Federal, state, or local taxes of any kind required by law to be withheld with respect to such amount. The Committee may require withholding obligations to be settled with Stock, including Stock that is part of the award that gives rise to the withholding requirement. The obligations of the Corporation under the Plan shall be conditional on such payment or arrangements and the Corporation and its Subsidiaries or Affiliates shall, to the extent permitted by law, have the right to deduct any such taxes from any payment of any kind otherwise due to the participant.

E.     The actual or deemed reinvestment of dividends or dividend equivalents in additional Restricted Stock (or other types of Plan awards) at the time of any dividend payment shall only be permissible if sufficient shares of Stock are available under Section 3 for such reinvestment (taking into account then outstanding Stock Options and other Plan awards).

F.     The Plan and all awards made and actions taken thereunder shall be governed by and construed in accordance with the laws of the State of Delaware.

G.     The members of the Committee and the Board shall not be liable to any employee or other person with respect to any determination made hereunder in a manner that is not inconsistent with their legal obligations as members of the Board. In addition to such other rights of indemnification as they may have as directors or as members of the Committee, the members of the Committee shall be indemnified by the Corporation against the reasonable expenses, including attorneys’ fees actually and necessarily incurred in connection with the defense of any action, suit or proceeding, or in connection with any appeal therein, to which they or any of them may be a party by reason of any action taken or failure to act under or in connection with the Plan or any option granted thereunder, and against all amounts paid by them in settlement thereof (provided such settlement is approved by independent legal counsel selected by the Corporation) or paid by them in satisfaction of a judgment in any such action, suit or proceeding, except in relation to matters as to which it shall be adjudged in such action, suit or proceeding that such Committee member is liable for negligence or misconduct in the performance of his duties; provided that within 60 days after institution of any such action, suit or proceeding, the Committee member shall in writing offer the Corporation the opportunity, at its own expense, to handle and defend the same.

H.     In addition to any other restrictions on transfer that may be applicable under the terms of this Plan or the applicable award agreement, except as otherwise set forth in subsection 9(T) of this Plan or the applicable award agreement, no Option, Stock Appreciation Right, Restricted Stock award, or Other Stock-Based Award or other right issued under this Plan is transferable by the participant other than by will or the laws of descent and distribution or pursuant to a qualified domestic relations order as defined under the Code or Title I of the Employee Retirement Income Security Act of 1974, as amended. The designation of a beneficiary will not constitute a transfer.

SECTION 14. Effective Date of Plan.

        The Plan shall be effective as of the date of approval of the Plan by a majority of the votes cast by the holders of the Corporation’s Stock.

SECTION 15. Term of Plan.

        No Stock Option, Stock Appreciation Right, Restricted Stock award, Other Stock-Based Award or Outside Director Restricted Stock award shall be granted pursuant to the Plan on or after October 25, 2011, but awards granted prior to October 25, 2011 may be extended beyond that date.

EX-11

Exhibit 11

Healthways, Inc.

Earnings Per Share Reconciliation

February 28, 2006

(Unaudited)

(In thousands, except earnings per share data)

The following is a reconciliation of the numerator and denominator of basic and diluted earnings per

share:

	Three Months Ended February 28,				Six Months Ended February 28,
	2006		2005		2006		2005
Numerator:
Net income - numerator for basic earnings per share	$	7,333	$	8,441	$	13,789	$	16,204
Effect of dilutive securities		—		—		—		—
Numerator for diluted earnings per share	$	7,333	$	8,441	$	13,789	$	16,204
Denominator:
Shares used for basic earnings per share		34,321		33,073		34,140		32,997
Effect of dilutive stock options outstanding		1,979		2,417		1,996		2,393
Shares used for diluted earnings per share		36,300		35,490		36,136		35,390
Earnings per share:
Basic	$	0.21	$	0.26	$	0.40	$	0.49
Diluted	$	0.20	$	0.24	$	0.38	$	0.46

EX-31

Exhibit 31.1

CERTIFICATION

I, Ben R. Leedle, Jr. certify that:

1. I have reviewed this quarterly report on Form 10-Q of Healthways, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

         a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

         b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

         c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

         d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

         a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

         b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: April 7, 2006

/s/ Ben R. Leedle, Jr.
——————————
Ben R. Leedle, Jr.
President and Chief Executive Officer

EX-31

Exhibit 31.2

CERTIFICATION

I, Mary A. Chaput, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Healthways, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

         a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

         b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

         c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

         d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

         a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

         b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: April 7, 2006

/s/ Mary A. Chaput
—————————————
Mary A. Chaput
Executive Vice President and Chief Financial Officer

EX-32

Exhibit 32

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Healthways, Inc. (the “Company”) on Form 10-Q for the period ended February 28, 2006, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), we, Ben R. Leedle, Jr., President and Chief Executive Officer of the Company, and Mary A. Chaput, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

         (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

         (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Ben R. Leedle, Jr.
——————————
Ben R. Leedle, Jr.
President and Chief Executive Officer
April 7, 2006

/s/ Mary A. Chaput
——————————
Mary A. Chaput
Executive Vice President and Chief Financial Officer
April 7, 2006