10-Q 1 q10q2_05.txt SECOND QUARTER REPORT 2005 U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-QSB (Mark One) |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2004. |_| TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ___________ Commission file number 0-22916 PHC, INC. (Exact name of small business issuer as specified in its charter) Massachusetts 04-2601571 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 Lake Street, Suite 102, Peabody MA 01960 (Address of principal executive offices) (Zip Code) 978-536-2777 (Issuer's telephone number) ------------------------------------------------------------------------------- (Former Name, former address and former fiscal year, if changed since last report) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 __ Applicable only to corporate issuers Number of shares outstanding of each class of common equity, as of January 28, 2005: Class A Common Stock 16,742,593 Class B Common Stock 776,991 Transitional Small Business Disclosure Format (Check one): Yes______ No X -- 1 -- PHC, INC. AND SUBSIDIARIES PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - December 31, 2004 (unaudited) and June 30, 2004. Condensed Consolidated Statements of Operations (unaudited) - Three and six months ended December 31, 2004 and December 31, 2003. Condensed Consolidated Statements of Cash Flows (unaudited) - Six months ended December 31, 2004 and December 31, 2003. Notes to Condensed Consolidated Financial Statements (unaudited) - December 31, 2004. Item 2. Management's Discussion and Analysis or Plan of Operation Item 3. Controls and Procedures PART II. OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders Item 6. Exhibits and Reports on Form 8-K Signatures -- 2 -- PART I. FINANCIAL INFORMATION Item 1 Financial Statements PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS December 31, June 30, ASSETS 2004 2004 __________ __________ (unaudited) Current assets: Cash and cash equivalents $ 181,233 $ 594,823 Accounts receivable, net of allowance for doubtful accounts of $1,830,729 at December 31 and $2,025,888 at June 30 5,576,870 5,165,150 Prepaid expenses 468,866 168,542 Other receivables and advances 1,970,857 860,195 Deferred income tax asset 937,407 842,806 __________ __________ Total current assets 9,135,233 7,631,516 Accounts receivable, non-current 80,000 96,052 Other receivable 82,048 94,469 Property and equipment, net 1,513,182 1,353,975 Deferred financing costs, net of amortization of $15,688 at December 31, 2004 182,757 -- Customer relationships, net of amortization of $80,000 at December 31, and $20,000 at June 30 2,320,000 2,380,000 Goodwill (Note F) 2,648,209 1,416,119 Other assets 377,087 339,438 __________ __________ Total assets $16,338,516 $13,311,569 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,723,097 $ 1,668,509 Current maturities of long-term debt 777,275 1,713,395 Revolving credit note 2,241,434 1,714,380 Deferred revenue 82,182 38,151 Current portion of obligations under capital leases 32,421 18,169 Accrued payroll, payroll taxes and benefits 1,355,783 1,305,490 Accrued expenses and other liabilities 868,797 682,567 Convertible debentures 235,750 250,000 __________ __________ Total current liabilities 7,316,739 7,390,661 Long-term debt 2,203,526 529,378 Obligations under capital leases 18,292 24,493 __________ __________ Total liabilities 9,538,557 7,944,532 __________ __________ Stockholders' equity: Class A common stock, $.01 par value, 30,000,000 shares authorized, 16,909,331 and 16,744,848 shares issued at December 31 and June 30, respectively 169,093 167,448 Class B common stock, $.01 par value, 2,000,000 shares authorized, 776,991 issued and outstanding December 31 and June 30, each convertible into one share of Class A common Stock 7,770 7,770 Additional paid-in capital 23,052,362 22,791,637 Treasury stock, 181,738 shares and 168,136 shares of Class A common stock at December 31 and June 30, respectively, at cost (155,087) (141,207) Accumulated deficit (16,274,179) (17,458,611) __________ __________ Total stockholders' equity 6,799,959 5,367,037 __________ __________ Total liabilities and stockholders' equity $16,338,516 $13,311,569 =========== =========== See Notes to Condensed Consolidated Financial Statements -- 3 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Six Months Ended December 31, December 31, _______________________________________________ 2004 2003 2004 2003 _______________________________________________ Revenues: Patient care, net $ 5,951,326 $ 5,547,404 $12,160,825 $10,739,964 Pharmaceutical studies 1,194,552 201,410 2,281,142 344,892 Contract support services 923,323 740,014 1,584,749 1,507,139 __________ ___________ ___________ ___________ Total revenues 8,069,201 6,488,828 16,026,716 12,591,995 _________ ___________ ___________ ___________ Operating expenses: Patient care expenses 3,379,464 3,017,610 6,810,409 5,832,114 Cost of contract support services 558,094 623,445 1,075,003 1,177,374 Provision for doubtful accounts 328,638 422,946 582,747 885,837 Website expenses 48,523 79,651 95,504 146,346 Administrative expenses 3,074,587 2,267,355 5,898,323 4,292,957 __________ __________ ___________ ___________ Total operating expenses 7,389,306 6,411,007 14,461,986 12,334,628 __________ __________ ___________ ___________ Income from operations 679,895 77,821 1,564,730 257,367 __________ __________ ___________ ___________ Other income (expense): Interest income 17,492 2,458 34,531 5,182 Other income 13,683 36,643 26,492 51,414 Interest expense (229,797) (113,142) (342,852) (247,034) __________ __________ ___________ ___________ Total other expenses, net (198,622) (74,041) (281,829) (190,438) __________ __________ ___________ ___________ Income before provision for taxes 481,273 3,780 1,282,901 66,929 Provision for income taxes 72,469 1,121 98,469 11,121 __________ __________ ___________ ___________ Net income applicable to common shareholders $ 408,804 $ 2,659 $1,184,432 $ 55,808 =========== =========== ========== =========== Basic net income per common share $ 0.02 $ 0.00 $ 0.07 $ 0.00 =========== =========== ========== =========== Basic weighted average number of shares outstanding 17,417,238 14,043,665 17,388,921 14,038,877 =========== ========== ========== =========== Fully diluted net income per common share $ .02 $ 0.00 $ 0.06 $ 0.00 =========== =========== ========== =========== Fully diluted weighted average number of shares outstanding 18,471,375 14,921,550 18,274,631 14,804,158 =========== ========== ========== ===========
See Notes to Condensed Consolidated Financial Statements. -- 4 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the Six Months Ended December 31 2004 2003 ____________ ____________ Cash flows from operating activities: Net income $1,184,432 $ 55,808 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 209,525 131,977 Non-cash stock-based compensation 8,081 126,592 Changes in: Accounts receivable (1,493,909) (89,120) Prepaid expenses and other current assets (300,324) (306,897) Other assets (137,020) (45,733) Accounts payable 54,588 413,817 Accrued expenses and other liabilities 280,554 (303,232) ____________ ____________ Net cash used in operating activities (194,073) (16,788) ____________ ____________ Cash flows from investing activities: Acquisition of property and equipment (303,962) (106,767) Costs related to business acquisition (62,258) -- ____________ ____________ Net cash used in investing activities (366,220) (106,767) ____________ ____________ Cash flows from financing activities: Revolving debt, net 527,054 184,044 Long-term debt, net (256,569) (431,409) Deferred financing costs (182,757) 4,000 Costs related to issuance of capital stock (20,000) -- Issuance of common stock 92,855 36,200 Purchase of treasury stock (13,880) (33,711) ____________ ____________ Net cash provided by (used in) financing activities 146,703 (240,876) ____________ ____________ Net decrease in cash and cash equivalents (413,590) (364,431) Beginning cash and cash equivalents 594,823 494,991 ____________ ____________ Ending cash and cash equivalents $ 181,233 $ 130,560 ============ ============ SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 306,441 $ 236,684 Income taxes 113,050 18,713 SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Pivotal Acquisition Note A earn out consideration recorded $1,169,832 $ -- Increase in equity from cashless exercise of warrants 14,250 -- See Notes to Condensed Consolidated Financial Statements -- 5 -- PHC, INC. and Subsidiaries Notes to Condensed Consolidated Financial Statements December 31, 2004 Note A - The Company PHC, Inc. (the "Company") is a national health care company which operates subsidiaries specializing in behavioral health services including the treatment of substance abuse, which includes alcohol and drug dependency and related disorders and the provision of psychiatric services. The Company also conducts pharmaceutical research studies, operates help lines for employee assistance programs, call centers for state and local programs and provides management, administrative and online behavioral health services. The Company primarily operates under four business segments: (1) Behavioral health treatment services, including two substance abuse treatment facilities: Highland Ridge Hospital, located in Salt Lake City, Utah, which also treats psychiatric patients, and Mount Regis Center, located in Salem, Virginia, and seven psychiatric treatment locations which include Harbor Oaks Hospital, a 64-bed psychiatric hospital located in New Baltimore, Michigan, Detroit Behavioral Institute, a 30-bed psychiatric hospital dedicated to adjudicated juveniles located in Detroit, Michigan and five outpatient behavioral health locations (two in Las Vegas, Nevada operating as Harmony Healthcare and three locations operating as Pioneer Counseling Center in the Detroit, Michigan metropolitan area); (2) Pharmaceutical study services, including three clinical study sites: two in Arizona, in Peoria and Mesa, and one Michigan location in Royal Oak, Michigan. These research sites conduct studies of the effects of specified pharmaceuticals on a controlled population through contracts with major manufacturers of the pharmaceuticals. All of the Company's research sites operate as Pivotal Research Centers; (3) Call center and help line services, including two call centers: one operating in Midvale, Utah and one in Detroit, Michigan. The Company provides help line services through contracts with major railroads, a smoking cessation contract with the state of Kansas and a call center contract with the State of Michigan. The call centers both operate as Wellplace; and (4) Behavioral health administrative services, including delivery of management and administrative and online services. The parent company provides management and administrative services for all of its subsidiaries and online services for its behavioral health treatment subsidiaries and its call center subsidiaries. It also provides behavioral health information through its website Wellplace.com. Note B - Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-QSB and Item 310 of Regulation S-B. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six months ended December 31, 2004 are not necessarily indicative of the results that may be expected for the year ending June 30, 2005. The accompanying financial statements should be read in conjunction with the June 30, 2004 consolidated financial statements and footnotes thereto included in the Company's 10-KSB filed on September 24, 2004. Note C- Stock Based Compensation The Company re-priced options to purchase 791,500 shares of Class A common stock in January 2001 of which 50,000 remained outstanding at June 30, 2004 and December 31, 2004 and are subject to variable accounting from the date of the modification. Compensation expense relating to the vested repriced options was $16,435 for the fiscal year ended June 30, 2004. No compensation expense relating to 5,000 vested repriced options at December 31, 2004 was recorded for the three month or six month periods ended December 31, 2004, compared to an expense of $7,096 and $3,181 for the three months and six months ended December 31, 2003, respectively. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 but applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its plans. If the Company had elected to recognize compensation cost for the plans based on the fair value at the grant date for awards granted, consistent -- 6 -- Note C- Stock Based Compensation (Continued) with the method prescribed by SFAS No. 123, the net income per share would have been changed to the pro forma amounts indicated below: Three Months Ended Six Months Ended December 31, December 31, _____________________ _________________________ 2004 2003 2004 2003 _____ ____ ____ ____ Net income, as reported $408,804 $ 2,659 $1,184,432 $ 55,808 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 1,155 16,259 8,081 102,482 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (34,505) (31,897) (90,731) (147,520) ________ ________ __________ __________ Pro forma net income (loss) $375,454 $(12,979) $1,101,782 $ 10,770 ========= ========= ========== ========= Earnings (loss) per share: Basic - as reported $ 0.02 $ 0.00 $ 0.07 $ 0.00 ======== ======== ========== ========= Basic - pro forma $ 0.02 $ 0.00 $ 0.06 $ 0.00 ======== ======== ========== ========= Diluted - as reported $ 0.02 $ 0.00 $ 0.06 $ 0.00 ======== ======== ========== ========= Diluted - pro forma $ 0.02 $ 0.00 $ 0.06 $ 0.00 ======== ======== ========== =========
Note D - Business Segment Information The Company's behavioral health treatment services have similar economic characteristics, services, patients and clients. Accordingly, all behavioral health treatment services are reported on an aggregate basis under one segment. The Company's segments are more fully described in Note A above. Residual income and expenses from closed facilities are included in the administrative services segment. The following summarizes the Company's segment data: Pharmaceutical Treatment Study Contract Administrative Services Services Services Services Eliminations Total ______________________________________________________________________________ For the three months ended December 31, 2004 Revenues - external customers $5,951,326 $1,194,552 $923,323 $ -- $ -- $8,069,201 Revenues - intersegment -- -- 13,413 690,000 (703,413) -- Net income (loss) 715,446 92,495 359,229 (758,366) -- 408,804 For the three months ended December 31, 2003 Revenues - external customers $5,547,404 $ 201,410 $740,014 $ -- $ -- $6,488,828 Revenues - intersegment 69,940 -- -- 808,860 (878,800) -- Net income (loss) 522,400 17,994 173,569 (711,304) -- 2,659 -- 7 -- Note D - Business Segment Information (continued) Pharmaceutical Treatment Study Contract Administrative Services Services Services Services Eliminations Total ____________________________________________________________________________ For the six months ended December 31, 2004 Revenues - external customers $12,160,825 $2,281,142 $1,584,749 $ -- $ -- $16,026,716 Revenues - intersegment -- -- 24,695 1,344,000 (1,368,695) -- Net income (loss) 1,996,092 152,752 497,746 (1,462,158) -- 1,184,432 Identifiable Assets 8,748,318 5,606,002 587,041 1,397,155 -- 16,338,516 For the six months ended December 31, 2003 Revenues - external customers $10,750,064 $ 334,792 $1,507,139 $ -- $ -- $12,591,995 Revenues - intersegment 110,340 -- -- 1,617,720 (1,728,060) -- Net income (loss) 996,742 8,773 443,765 (1,393,472) -- 55,808 Identifiable Assets 7,699,722 226,622 312,379 1,221,109 -- 9,459,832
Note E - Legal Proceedings In April 2004, the Company successfully resolved a medical malpractice lawsuit brought against the Company. As a result of the settlement, the Company made a payment of approximately $463,000, which compares to the previous judgment of approximately $3 million. The Company has not released other parties, including an insurance company. Payments made by insurance and other related parties, if collected, could reduce the Company's financial burden below the $463,000 payment. The financial impact of this settlement and related legal fees is reflected in the operating results during the year ended June 30, 2004. The Company will continue to seek reimbursement from all sources for amounts expended on this case. In fiscal 2004, the State of Nebraska asked the Company to provide the history of payments received from the State of Nebraska and the payments made to a consultant in Nebraska for his work on the smoking cessation contract. In the fourth quarter of fiscal 2004, the Company became aware that the State and the Federal governments are investigating the consultant. The Company is cooperating fully with the investigating agencies on this matter and to date has expended approximately $145,000 in legal fees. Note F - Increase in Intangible Assets For the eight month period ended December 31, 2004, since the acquisition of Pivotal, the income from the acquired operations exceeded the required EBITDA targets set in the acquisition documents to trigger the recording of the earn out as stipulated by Note A. The recording of this liability resulted in an increase in goodwill of $1,169,832. Goodwill was also increase by additional legal costs related to the transaction. Note G - Debt Refinancing In October 2004, the Company entered into a revolving credit, term loan and security agreement with CapitalSource Finance, LLC to replace the Company's primary lender and provide additional liquidity. Each of the Company's material subsidiaries, other than Pivotal Research Centers, Inc, is a co-borrower under the agreement. The agreement includes a term loan in the amount of $1,400,000 and an accounts receivable funding revolving credit agreement with a maximum loan amount of $3,500,000, including $900,000 available as an overline for growth. The term loan note carries interest at prime plus 3.5%, but not less than 9%, with twelve monthly principal payments of $25,000, 12 monthly principal -- 8 -- payments of $37,500, and eleven monthly principal payments of $50,000 beginning November 1, 2004 with balance due at maturity, on October 1, 2007. The balance due on the term loan as of December 31, 2004 was $1,295,000. The revolving credit note carries interest at prime plus 2.25%, but not less than 6.75% paid through lock box payments of third party accounts receivable. The revolving credit term is three years, renewable for two additional one-year terms. The outstanding balance on the revolving credit note as of December 31, 2004 was $2,241,434. In connection with this agreement, the Company issued warrants to purchase up to 250,000 shares of the Company's Class A Common Stock at $1.15 per share. The Warrants vest immediately and expire on the 10th anniversary of issuance. The number of shares issuable upon exercise can be adjusted for certain dilutive events, as defined. The Company valued these warrants using Black-Scholes option pricing model and the following assumptions: a fair market value of $1.15 per share, a risk-free interest rate of 4%, an expected volatility of 45%, an expected life of ten years and an expected dividend yield of zero. The Company allocated the proceeds received from the financing agreement between the related debt and the warrant on the basis of fair value of the individual component at the date of issuance and determined that the warrants value was $167,184. This value was recorded as a discount to the related debt. Also, under the revolving credit agreement, the Company must meet certain financial and administrative covenants, as defined. As of December 31, 2004, the Company was not in compliance with all of the financial covenants. The Company received notification from the lender on February 10, 2005 waiving the covenant non-compliance at December 31, 2004. The Company's failure to meet these covenants was a result of seasonal fluctuations that were not taken into consideration when the covenant was established. The Company and lender are working to adjust the covenants to take seasonality into consideration. Note H - Recent Account Pronouncements In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123 (R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro-forma disclosure is no longer an alternative. The Company expects to adopt SFAS No. 123 (R) on July 1, 2005. -- 9 -- Item 2. Management's Discussion and Analysis or Plan of Operation This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company including statements preceded by, followed by or that include words or phrases such as "believes," "expects," "anticipates," "plans," "trend," "objective," "continue," "remain," "pattern' or similar expressions or future or conditional verbs such as "will," "would," "should," "could," "might," "con," "may" or similar expressions, which are intended to identify "forward looking statement" within the meaning of the Private Securities Litigation Reform Act of 1995. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements. Overview The Company presently provides behavioral health care services through two substance abuse treatment centers, two psychiatric hospitals and five outpatient psychiatric centers (collectively called "treatment facilities"). The Company's revenue for providing behavioral health services through these facilities is derived from contracts with managed care companies, Medicare, Medicaid, state agencies, railroads, gaming industry corporations and individual clients. The profitability of the Company is largely dependent on the level of patient census and the payor mix at these treatment facilities. Patient census is measured by the number of days a client remains overnight at an inpatient facility or the number of visits or encounters with clients at outpatient clinics. Payor mix is determined by the source of payment to be received for each client being provided billable services. The Company's administrative expenses do not vary greatly as a percentage of total revenue but the percentage tends to decrease slightly as revenue increases. Although the Company has changed the focus and reduced expenses of its internet operation, Behavioral Health Online, Inc. continues to provide technology and internet support for the Company's other operations. It also continues to provide behavioral health information and education through its web site at Wellplace.com. The expenses of the internet operation decreased over 30% for the quarter and six months ended December 31, 2004 compared to the same periods last year, as the savings resulting from the change in focus are being realized. The Company's research division, Pivotal Research Centers, Inc., contracts with major manufacturers of pharmaceuticals to assist in the study of the effects of certain pharmaceuticals in the treatment of specific illness through its clinics in Michigan and Arizona. The healthcare industry is subject to extensive federal, state and local regulation governing, among other things, licensure and certification, conduct of operations, audit and retroactive adjustment of prior government billings and reimbursement. In addition, there are on-going debates and initiatives regarding the restructuring of the health care system in its entirety. The extent of any regulatory changes and their impact on the Company's business is unknown. The current administration has put forth proposals to mandate equality in the benefits available to those individuals suffering from mental illness. If passed, this legislation will improve access to the Company's programs. Managed care has had a profound impact on the Company's operations, in the form of shorter lengths of stay, extensive certification of benefits requirements and, in some cases, reduced payment for services. As part of the Government Medicare Program, reimbursement rates for behavioral health care have increased. This increase may have a positive impact on performance at the Company's one Medicare facility, Harbor Oaks Hospital. The Company is exploring the possibility of becoming a Medicare provider at its other in- patient facilities. Critical Accounting Policies The preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America, requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, we evaluate our estimates and assumptions, including but not limited to those related to revenue recognition, accounts receivable reserves, income tax valuation allowances, and the impairment of goodwill and other intangible assets. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. -- 10 -- Revenue recognition and accounts receivable: Patient care revenues and accounts receivable are recorded at established billing rates or at the amount realizable under agreements with third-party payors, including Medicaid and Medicare. Revenues under third-party payor agreements are subject to examination and contractual adjustment, and amounts realizable may change due to periodic changes in the regulatory environment. Provisions for estimated third party payor settlements are provided in the period the related services are rendered. Differences between the amounts provided and subsequent settlements are recorded in operations in the year of settlement. Amounts due as a result of cost report settlements is recorded and listed separately on the consolidated balance sheets as "Other receivables, third party". The provision for contractual allowances is deducted directly from revenue and the net revenue amount is recorded as accounts receivable. The allowance for doubtful accounts does not include the contractual allowances. The Company currently has one "at-risk" contract. The contract calls for the Company to provide for all of the inpatient and outpatient behavioral health needs of the insurance carrier's enrollees in Nevada for a fixed monthly fee per member per month. Revenues are recorded monthly based on this formula and the expenses related to providing the services under this contract are recorded as incurred. The Company provides most of the outpatient care directly and, through utilization review, monitors closely, and pre-approves all inpatient and outpatient services not provided directly. The contract is considered "at-risk" because the payments to third-party providers for services rendered could equal or exceed the total amount of the revenue recorded. Pharmaceutical study revenue is recognized only after a pharmaceutical study contract has been awarded and the patient has been selected and accepted based on study criteria and billable units of service are provided. Where a contract requires completion of the study by the patient, no revenue is recognized until the patient completes the study program. Contract support service revenue is a result of fixed fee contracts to provide telephone support. Revenue for these services is recognized ratably over the service period. All revenues reported by the Company are shown net of estimated allowances and charity care provided. When payment is made, if the contractual adjustment is found to have been understated or overstated, appropriate adjustments are made in the period the payment is received in accordance with the AICPA "Audit and Accounting Guide for Health Care Organizations." Allowance for doubtful accounts: The provision for bad debt is calculated based on a percentage of each aged accounts receivable category beginning at 0-5% on current accounts and increasing incrementally for each additional 30 days the account remains outstanding until the account is over 360 days outstanding, at which time the provision is 70-100% of the outstanding balance. These percentages vary by facility based on each facility's experience in and expectations for collecting older receivables. The Company compares this required reserve amount to the current "allowance for doubtful accounts" to determine the required bad debt expense for the period. This method of determining the required "allowance for doubtful accounts" has historically resulted in an allowance for doubtful accounts of 30% or greater of the total outstanding receivables balance. Income taxes: The Company follows the liability method of accounting for income taxes, as set forth in SFAS No. 109, "Accounting for Income Taxes". SFAS No. 109 prescribes an asset and liability approach, which requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of the assets and liabilities. The Company's policy is to record a valuation allowance against deferred tax assets unless it is more likely than not that such assets will be realized in future periods. The Company considers estimated future taxable income or loss and other available evidence when assessing the need for its deferred tax valuation allowance. Valuation of goodwill and other intangible assets Goodwill and other intangible assets are initially created as a result of business combinations or acquisitions. The values the Company records for goodwill and other intangible assets represent fair values calculated by independent third-party appraisers. Such valuations require the Company to provide significant estimates and assumptions which are derived from information obtained from the management of the acquired businesses and the Company's business plans for the acquired businesses. Critical estimates and assumptions -- 11 -- used in the initial valuation of goodwill and other intangible assets include, but are not limited to: (i) future expected cash flows from services to be provided, customer contracts and relationships, and (ii) the acquired market position. These estimates and assumptions may be incomplete or inaccurate because unanticipated events and circumstances may occur. If estimates and assumptions used to initially value goodwill and intangible assets prove to be inaccurate, ongoing reviews of the carrying values of such goodwill and intangible assets may indicate impairment which will require the Company to record an impairment charge in the period in which the Company identifies the impairment. Results of Operations Total net revenue from operations increased 24.4% to $8,069,201 for the three months ended December 31, 2004 from $6,488,828 for the three months ended December 31, 2003 and 27.3% to $16,026,716 for the six months ended December 31, 2004 from $12,591,995 for the six months ended December 31, 2003. Net patient care revenue increased 7.3% to $5,951,326 for the three months ended December 31, 2004 from $5,547,404 for the three months ended December 31, 2003 and 13.2% to $12,160,825 for the six months ended December 31, 2004 from $10,739,964 for the six months ended December 31, 2003. This increase in revenue is due primarily to a small increase in patient days at our substance abuse facilities for the three months ended December 31, 2004 over the same period last year and the addition of the new beds at our new Detroit facility, Detroit Behavioral Institute. Two of the key indicators of profitability of inpatient facilities are patient days, or census, and payor mix. Patient days is the product of the number of patients times length of stay. Increases in the number of patient days results in higher census, which coupled with a more favorable payor mix (more patients with higher paying insurance contracts or paying privately) usually results in higher profitability. Therefore, patient census and payor mix are monitored very closely. Revenue from pharmaceutical studies increased 493.1% to $1,194,552 for the three months ended December 31, 2004 from $201,410 for the three months ended December 31, 2003 and 561.4% to $2,281,142 for the six months ended December 31, 2003 from $344,892 for the same period last year. This increase is due to the acquisition of Pivotal Research Centers, LLC on April 30, 2004. Contract support services revenue provided by Wellplace increased 24.8% to $923,323 for the three months ended December 31, 2004 from $740,014 for the three months ended December 31, 2003 and increased 5.1% to $1,584,749 for the six months ended December 31, 2004 from $1,507,139 for the six months ended December 31, 2003. The cost of providing these services decreased 10.5% to $558,094 for the three months ended December 31, 2004 from $623,445 for the three months ended December 31, 2003 and 8.7% to $1,075,003 for the six months ended December 31, 2004 from $1,177,374 for the same period last year. This increase in revenue and decrease in expenses are due to the elimination of the Nebraska smoking cessation contract, which carried with it higher costs than the expansion of the Michigan call center contract. Patient care expenses increased by 12.0% to $3,379,464 for the three months ended December 31, 2004 from $3,017,610 for the three months ended December 31, 2003 and 16.8% to $6,810,409 for the six months ended December 31, 2004 from $5,832,114 for the six months ended December 31, 2003. The increases in expenses for the quarter is due primarily to the increase in patient days noted above with the primary increases in expenses directly related to patient census such as payroll, food, hospital supplies and pharmacy. This amount also includes expenses directly related to the increase in Pharmaceutical Research business in the form of patient stipends, which accounts for approximately 25% of the three-month increase and 15% of the six-month increase. During the quarter, the Company also opened the first phase of the new inpatient program, Detroit Behavioral Institute, at the Detroit Medical Center and has experienced increased patient care revenue and expected inflated patient care and administrative expenses related to the start up while the unit census is growing. Website expenses decreased 39.1% to $48,523 for the three months ended December 31, 2004 from $79,651 for the three months ended December 31, 2003 and 34.7% to $95,504 for the six months ended December 31, 2004 from $146,346 for the six months ended December 31, 2003. This is a result of a decrease in depreciation expense as Internet set up is now fully depreciated. -- 12 -- Administrative expenses increased 35.6% to $3,074,587 for the quarter ended December 31, 2004 from $2,267,355 for the quarter ended December 31, 2003 and 37.4% to $5,898,323 for the six months ended December 31, 2004 from $4,292,957 for the six months ended December 31, 2003. This increase is related in part to the addition of Detroit Behavioral Institute, increases in salaries and payroll taxes and a substantial increase in general and professional liability insurance costs. Administrative expenses for the new 30-bed facility, Detroit Behavioral Institute, were $293,751 and $357,202 for the quarter and six months, respectively. Salaries without Pivotal increased 26.8% to $821,157 from $647,559 for the quarter ended December 31, 2004 and 25.7% to $1,486,036 from 1,182,382 for the six months ended December 31, 2004 and general insurance expense without Pivotal increased 42.0% for the quarter ended December 31, 2004 and 50.97% for the six-month period ended December 31, 2004, as compared with the same periods last year. This is due to general increases in property and professional liability insurance and the implementation of a "terrorist acts" surcharge on all policies. Interest expense increased 103.1% to $229,797 for the three months ended December 31, 2004 from $113,142 for the three months ended December 31, 2003 and 38.8% to $342,852 for the six months ended December 31, 2004 from $247,034 for the same period last year. This increase is due in part to the booking of the interest on Note A of the Pivotal acquisition. This Note was contingent on the profitable operations of Pivotal from the acquisition through December 31, 2004; therefore, the Note was not recorded and no interest was accrued until the certainty of profitability could be determined. The increase is also due to financing costs related to the recent refinancing of the Company's long-term debt and receivables financing and the increased borrowing to provide funds for the start up of Detroit Behavioral Institute. The Company's provision for income taxes of $98,469 for the six month period ended December 31, 2004 is significantly below the Federal statutory rate of 34% primarily due to the availability of net operating loss carry-forwards. Total income tax expense for the quarter represents state income taxes for certain subsidiaries with no available net operating loss carry-forwards. The Company has provided a significant valuation allowance against its deferred tax asset due to IRS rules that may limit the accessibility of the loss carry-forwards. Provision for doubtful accounts decreased 22.3% to $328,638 for the three months ended December 31, 2004 from $422,946 for the three months ended December 31, 2003 and 34.2% to $582,747 for the six months ended December 31, 2004 from $885,837 for the six months ended December 31, 2003. This is a result of the Company's recent success in collecting older receivables. The environment the Company operates in today makes collection of receivables, particularly older receivables, more difficult than in previous years. Accordingly, the Company has increased staff, standardized some procedures for collecting receivables and instituted a more aggressive collection policy, which has resulted in improved cash collections. Although the Company's receivables from our treatment facilities have increased 7.5%, approximately 30% percent of the increase is directly related to the new beds of Detroit Behavioral Institute and these receivables are less than 30 days old. The Company continues to reserve for bad debts based on the age of the receivable in consideration of past managed care denials and difficulty in collection of older receivables. The growth of managed care has negatively impacted reimbursement for behavioral health services with a higher rate of denials requiring higher reserves. Liquidity and Capital Resources The Company's net cash used in operating activities was $194,073 for the six months ended December 31, 2004 compared to $16,788 for the same period last year. Cash flow from operations in the six months ended December 31, 2004 consists of net income of $1,184,432 plus depreciation and amortization of $209,525, increase in accounts receivable of $1,493,909, increase in prepaid expenses of $300,324, increase in accrued expenses of $280,554, increase in accounts payable of $54,588, an increase in other assets of $137,020 and non-cash equity based charges of $8,081. Cash used in investing activities in the six months ended December 31, 2004 consisted of $303,962 in capital expenditures compared to $106,767 in capital expenditures in the same period last year and costs related to a business acquisition of $62,258. Cash used in financing activities in the six months ended December 31, 2004 primarily consisted of $270,485 in net debt borrowings which was offset by $182,757 in deferred financing costs, $20,000 in costs related to the issuance of capital stock and $13,880 in the purchase of treasury stock, which was partially offset by $92,855 cash received in the exercise of warrants. -- 13 -- A significant factor in the liquidity and cash flow of the Company is the timely collection of its accounts receivable. Current accounts receivable from patient care, net of allowance for doubtful accounts, increased 7.5% to $5,656,870 on December 31, 2004 from $5,261,202 on June 30, 2004. This increase is due in part to the new receivables being generated by Detroit Behavioral Institute, the new 30 bed adjudicated boys unit in Detroit, and a delay in payment of receivables by one of our State payors due to budget constraints. It is also due to high revenues during the quarter. The minimal increase is a result of better accounts receivable management due to increased staff, standardization of some procedures for collecting receivables and a more aggressive collection policy. The increased staff has allowed the Company to concentrate on current accounts receivable and resolve any issues before they become uncollectible. The Company's collection policy calls for earlier contact with insurance carriers with regard to payment, use of fax and registered mail to follow-up or resubmit claims and earlier employment of collection agencies to assist in the collection process. Our collectors will also seek assistance through every legal means, including the State Insurance Commissioner's office, when appropriate, to collect claims. At the same time, the Company continues to closely monitor reserves for bad debt based on potential insurance denials and past difficulty in collections. The Company has operated ongoing operations profitably for sixteen consecutive quarters with the exception of the litigation settlement and related legal costs incurred in the third quarter of fiscal year 2004. While it is difficult to project, if the current positive business environment towards behavioral health treatment and new business opportunities continue, we are confident that we may see continued improved results. The Company's future minimum payments under contractual obligations related to capital leases, operating leases and term notes as of December 31, 2004 are listed below. Year Ending Term Capital Operating December 31, Notes Leases Leases Total _____________________________________________________________________________ 2005 $1,253,792* $28,202 $1,495,087 $2,777,081 2006 832,145 16,697 1,322,882 2,171,724 2007 817,885 10,647 1,008,456 1,836,988 2008 349,860 2,168 823,136 1,175,164 2009 195,507 -- 810,463 1,005,970 Thereafter 175,312 -- 275,215 450,527 __________ ________ _________ __________ Total minimum payments $3,624,501 $ 57,714 $5,735,239 $9,417,454 =========== ======== =========== ========== * Includes $235,750 in convertible debentures In October 2004, the Company entered into a revolving credit, term loan and security agreement with CapitalSource Finance, LLC to replace the Company's primary lender and provide additional liquidity. Each of the Company's material subsidiaries, other than Pivotal Research Centers, Inc, is a co-borrower under the agreement. The agreement includes a term loan in the amount of $1,400,000 and an accounts receivable funding revolving credit agreement with a maximum loan amount of $3,500,000, including $900,000 available as an overline for growth. The term loan note carries interest at prime plus 3.5%, but not less than 9%, with twelve monthly principal payments of $25,000, 12 monthly principal payments of $37,500, and eleven monthly principal payments of $50,000 beginning November 1, 2004 with balance due at maturity, on October 1, 2007. The balance due on the term loan as of December 31, 2004 was $1,295,000. The revolving credit note carries interest at prime plus 2.25%, but not less than 6.75% paid through lock box payments of third party accounts receivable. The revolving credit term is three years, renewable for two additional one-year terms. The outstanding balance on the revolving credit note as of December 31, 2004 was $2,241,434. Item 3. Controls and Procedures Evaluation of Disclosure Controls and Procedures We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified within the SEC's Rules and Forms, and that such information is accumulated and communicated to our management to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was necessarily required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. -- 14 -- As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures to meet the criteria referred to above. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective. Change in Internal Controls There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluations. -- 15 -- PART II OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders The Company's annual meeting of stockholders was held on December 21, 2004. In addition to the election of directors (with regards to which (i) proxies were solicited pursuant to Regulation 14A under the Securities and Exchange Act of 1934, as amended, (ii) there was no solicitation in opposition to the management's nominees as listed on the proxy statement, and (iii) all of such nominees were elected), the stockholders approved the increase in authorized shares of Class A Common Stock from 20,000,000 to 30,000,000 shares. Because sufficient proxies were not received to hold the vote on the new non-employee director stock option plan to replace the plan expiring in October 2005, the meeting was adjourned and re-convened on January 20, 2005 at which time the 2005 Non-Employee Director Stock Option Plan (the "Plan") was approved. Under the Plan 350,000 shares of Class A Common Stock are available for issuance to non-employee directors only as stipulated in the Plan. Item 6. Exhibits and reports on Form 8-K. Exhibit List Exhibit No. Description 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Reports on Form 8-K The Company filed two reports on form 8-K during the quarter ended December 31, 2004. The first report, filed on October 22, 2004 provided information regarding a material definitive agreement as required by Item 1.01 of the instructions for form 8-K. The second report, filed on November 10, 2004, provided the same earnings information to the public as shown in the Company's quarterly press release as required by Item 2.02 of the instructions for form 8-K. -- 16 -- Signatures In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PHC, Inc. Registrant Date: February 11, 2005 /s/ Bruce A. Shear _________________________ Bruce A. Shear President Chief Executive Officer Date: February 11, 2005 /s/ Paula C. Wurts _________________________ Paula C. Wurts Controller Treasurer -- 17 --