10-Q 1 q10_0506.txt THIRD QUARTER 2006 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006. | | 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 0-22916 PHC, INC. (Exact name of registrant 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 (Registrant's telephone number) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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___ 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 _____ Accelerated filer ______ Non accelerated filer X Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ____ No X APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Number of shares outstanding of each class of common equity, as of May 4, 2006: Class A Common Stock 17,674,666 Class B Common Stock 776,962 -- 1 -- PHC, Inc. PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements. Condensed Consolidated Balance Sheets - March 31, 2006 (unaudited) and June 30, 2005. Condensed Consolidated Statements of Operations (unaudited) - Three and nine months ended March 31, 2006 and March 31, 2005. Condensed Consolidated Statements of Cash Flows (unaudited)- Nine months months ended March 31, 2006 and March 31, 2005. Notes to Condensed Consolidated Financial Statements - March 31, 2006. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 3. Quantitative and Qualitative Disclosure About Market Risk. Item 4. Controls and Procedures PART II. OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders Item 6. Exhibits Signatures -- 2 -- PART I. FINANCIAL INFORMATION Item 1. Financial Statements PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS March 31, June 30, ASSETS 2006 2005 ___________ ___________ (unaudited) Current assets: Cash and cash equivalents $ 957,437 $ 917,630 Accounts receivable, net of allowance for doubtful accounts of $3,117,247 at March 31,2006 and $1,956,984 at June 30, 2005 6,601,905 6,265,381 Pharmaceutical receivables 1,977,983 1,414,340 Prepaid expenses 521,297 146,988 Other receivables and advances 612,196 638,654 Deferred income tax asset 1,415,344 1,375,800 ___________ ___________ Total current assets 12,086,162 10,758,793 Accounts receivable, non-current 45,000 65,000 Other receivable 97,350 84,422 Property and equipment, net 1,865,042 1,516,114 Deferred financing costs, net of amortization of $110,910 at March 31, 2006 and $76,234 June 30, 2005 126,262 145,938 Customer relationships, net of amortization of $230,000 at March 31, 2006 and $140,000 at June 30, 2005 2,170,000 2,260,000 Goodwill 2,704,389 2,648,209 Other assets 506,139 417,172 ___________ ___________ Total assets $19,600,344 $17,895,648 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $1,618,948 $ 907,569 Current maturities of long-term debt 881,832 769,599 Revolving credit note 2,040,605 2,385,629 Deferred revenue 225,290 85,061 Current portion of obligations under capital leases 59,265 29,777 Accrued payroll, payroll taxes and benefits 1,414,659 1,411,653 Accrued expenses and other liabilities 763,093 1,063,189 ___________ ___________ Total current liabilities 7,003,692 6,652,477 Long-term debt 1,281,275 1,900,022 Obligations under capital leases 75,446 12,210 Deferred tax liability 244,874 229,000 ___________ ___________ Total liabilities 8,605,287 8,793,709 ___________ ___________ Stockholders' equity: Preferred Stock, 1,000,000 shares authorized, none issued or outstanding -- -- Class A common stock, $.01 par value, 30,000,000 shares authorized, 17,617,764 and 17,490,818 shares issued at March 31, 2006 and June 30, 2005, respectively 176,178 174,908 Class B common stock, $.01 par value, 2,000,000 shares authorized, 776,962 and 776,991 issued and outstanding at March 31, 2006 and June 30, 2005, respectively, each convertible into one share of Class A common Stock 7,769 7,770 Additional paid-in capital 23,623,983 23,377,059 Treasury stock, 199,098 shares and 181,738 shares of Class A common stock at March 31, 2006 and June 30, 2005 respectively, at cost (191,700) (155,087) Accumulated deficit (12,621,173) (14,302,711) ___________ ___________ Total stockholders' equity 10,995,057 9,101,939 Total liabilities and stockholders' equity $19,600,344 $17,895,648 =========== =========== See Notes to Condensed Consolidated Financial Statements -- 3 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Nine Months Ended March 31, March 31, 2006 2005 2006 2005 ________________________________________________ Revenues: Patient care, net $7,292,804 $6,734,949 $20,471,140 $18,895,774 Pharmaceutical studies 1,523,277 1,103,205 3,913,370 3,384,347 Contract support services 1,137,878 925,528 3,216,788 2,510,277 ___________ ___________ ___________ ___________ Total revenues 9,953,959 8,763,682 27,601,298 24,790,398 ___________ ___________ ___________ ___________ Operating expenses: Patient care expenses 3,787,166 3,533,279 10,341,470 9,541,581 Patient care expenses, pharmaceutical 552,477 444,999 1,626,465 1,247,106 Cost of contract support services 713,438 520,475 1,898,300 1,595,478 Provision for doubtful accounts 334,248 217,756 1,466,903 800,503 Administrative expenses 2,815,164 2,410,474 8,193,940 7,008,636 Administrative expenses, pharmaceutical 638,486 653,827 1,810,776 2,049,492 ___________ ___________ ___________ ___________ Total operating expenses 8,840,979 7,780,810 25,337,854 22,242,796 ___________ ___________ ___________ ___________ Income from operations 1,112,980 982,872 2,263,444 2,547,602 ___________ ___________ ___________ ___________ Other income (expense): Interest income 11,281 15,004 49,542 49,535 Other income 25,309 31,568 57,357 58,060 Interest expense (153,594) (148,988) (483,150) (491,840) ___________ ___________ ___________ ___________ Total other expenses, net (117,004) (102,416) (376,251) (384,245) ___________ ___________ ___________ ___________ Income before provision for taxes 995,976 880,456 1,887,193 2,163,357 Provision for income taxes 45,427 -- 205,655 98,469 ___________ ___________ ___________ ___________ Net income $ 950,549 $ 880,456 $ 1,681,538 $2,064,888 =========== =========== =========== =========== Basic net income per common share $ 0.05 $ 0.05 $ 0.09 $ 0.12 =========== =========== =========== =========== Basic weighted average number of shares outstanding 18,187,750 17,648,412 18,145,789 17,474,155 =========== =========== =========== =========== Fully diluted net income per common share $ 0.05 $ 0.05 $ 0.09 $ 0.11 =========== =========== =========== =========== Fully diluted weighted average number of shares outstanding 19,212,589 18,690,012 19,242,777 18,234,480 =========== =========== =========== ===========
See Notes to Condensed Consolidated Financial Statements. -- 4 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the Nine Months Ended March 31 2006 2005 ___________ ____________ Cash flows from operating activities: Net income $1,681,538 $2,064,888 Adjustments to reconcile net income to net cash provided by (used in)operating activities: Depreciation and amortization 543,991 324,397 Non-cash interest expense 41,796 41,796 Deferred income tax provision (23,670) -- Non-cash stock-based compensation 118,286 78,656 Changes in: Accounts receivable (866,637) (2,313,451) Prepaid expenses and other current assets (374,309) (133,921) Other assets (103,277) (144,057) Accounts payable 711,379 52,777 Accrued expenses and other liabilities (156,861) 199,942 ___________ ____________ Net cash provided by operating activities 1,572,236 171,027 ___________ ____________ Cash flows from investing activities: Acquisition of property and equipment (753,933) (359,407) Costs related to business acquisition -- (62,258) ___________ ____________ Net cash used in investing activities (753,933) (421,665) ___________ ____________ Cash flows from financing activities: Revolving debt, net (345,024) 806,709 Proceeds from borrowings on long-term debt 7,309 1,406,201 Principal payments on long-term debt (462,895) (1,986,847) Deferred financing costs (15,000) (164,348) Costs related to issuance of capital stock -- (30,000) Issuance of common stock 73,727 190,854 Purchase of treasury stock (36,613) (13,880) ___________ ____________ Net cash (used in) provided by financing activities (778,496) 208,689 ___________ ____________ Net increase (decrease) in cash and cash equivalents 39,807 (41,949) Beginning cash and cash equivalents 917,630 594,823 ___________ ____________ Ending cash and cash equivalents $ 957,437 $ 552,874 =========== =========== SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 483,150 $ 485,659 Income taxes 253,109 118,550 SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Pivotal Acquisition Note A earn out consideration recorded $ -- $1,169,832 Issuance of common stock in cashless exercise of warrants 24,242 14,250 Issuance of common stock in cashless exercise of options 18,577 -- Value of warrants issued in connection with the Pivotal acquisition 51,860 -- See Notes to Condensed Consolidated Financial Statements. -- 5 -- PHC, INC. and Subsidiaries Notes to Condensed Consolidated Financial Statements March 31, 2006 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: 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 eight psychiatric treatment locations which include Harbor Oaks Hospital, a 64-bed psychiatric hospital located in New Baltimore, Michigan, Detroit Behavioral Institute, a 50-bed psychiatric facility dedicated to adjudicated juveniles located in Detroit, Michigan and six outpatient behavioral health locations (one in New Baltimore, Michigan operating in conjunction with Harbor Oaks Hospital, two in Las Vegas, Nevada operating as Harmony Healthcare and three locations operating as Pioneer Counseling Center in the Detroit, Michigan metropolitan area); Pharmaceutical study services, including four clinical study sites: two in Arizona, in Peoria and Mesa, one in Royal Oak, Michigan and one in Midvale, Utah. 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; Call center and help line services (contract 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 a major defense contractor and a call center contract with Wayne County Michigan. The call centers both operate under the name Wellplace; and 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-Q and Rule 10-01 of Regulation S-X. 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 nine months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending June 30, 2006. The accompanying financial statements should be read in conjunction with the June 30, 2005 consolidated financial statements and footnotes thereto included in the Company's 10-K filed on September 28, 2005. The Company bills for its behavioral healthcare services at its inpatient and outpatient facilities using different software platforms for each type of service; however, in all cases the charges are contractually adjusted at the time of billing using adjustment factors based on agreements or contracts with the insurance carriers and the specific plans held by the individuals. This method may still require additional adjustment based on ancillary services provided and deductibles and copays due from the individuals which are estimated at the time of admission based on information received from the individual. Adjustments to these estimates are recognized as adjustments to revenue during the period identified, usually when payment is received. The Company's policy is to collect estimated co-payments and deductibles at the time of admission. Payments are made by way of cash, check or credit card. If the patient does not have sufficient resources to pay the estimated co-payment in advance, the Company's policy is to allow payment to be made in three installments one third due upon admission, one third due upon discharge and the balance due 30 days after discharge. At times the patient is not physically or mentally stable enough to comprehend or agree to any financial -- 6 -- arrangement. In this case the Company will make arrangements with the patient once his or her condition is stabilized. At times, this situation will require the Company to extend payment arrangements beyond the three payment method previously outlined. Whenever extended payment arrangements are made, the patient, or the individual who is financially responsible for the patient, is required to sign a promissory note to the Company, which includes interest on the balance due. 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. The Company's days sales outstanding ("DSO") are significantly different for each type of service and each facility based on the payors for each service. Overall, the DSO for the combined operations of the Company were 92 days for the nine months ended March 31, 2006 and 90 days the fiscal year ended June 30, 2005. The table below shows the DSO by segment for the same periods. Period Treatment Pharmaceutical Contract End Services Services Services 03/31/2006 87 139 46 06/30/2005 89 114 62 This increase in the Pharmaceutical Services DSO's is related to the high DSO's normally associated with research receivables coupled with the recent start up of a large research contract. Contract Services DSO's fluctuate dramatically by the delay in payment of a few days for any of our large contracts. There was such a delay in payments for the Michigan call center at the end of fiscal 2005, artificially inflating the DSO's for the period. Note C- Stock Based Compensation The Company has three active stock plans: a stock option plan, an employee stock purchase plan and a non-employee directors' stock option plan. The stock option plan provides for the issuance of a maximum of 1,300,000 shares of Class A common stock of the Company pursuant to the grant of incentive stock options to employees or nonqualified stock options to employees, directors, consultants and others whose efforts are important to the success of the Company. Subject to the provisions of this plan, the compensation committee of the Board of Directors has the authority to select the optionees and determine the terms of the options including: (i) the number of shares, (ii) option exercise terms, (iii) the exercise or purchase price (which in the case of an incentive stock option will not be less than the market price of the Class A common stock as of the date of grant), (iv) type and duration of transfer or other restrictions and (v) the time and form of payment for restricted stock upon exercise of options. The employee stock purchase plan provides for the purchase of Class A common stock at 85 percent of the fair market value at specific dates, to encourage stock ownership by all eligible employees. A maximum of 500,000 shares may be issued under this plan. The non-employee directors' stock option plan provides for the grant of nonstatutory stock options automatically at the time of each annual meeting of the Board. Under the plan a maximum of 350,000 shares may be issued. Each outside director is granted an option to purchase 20,000 shares of Class A common stock annually at fair market value on the date of grant, vesting 25% immediately and 25% on each of the first three anniversaries of the grant and expiring ten years from the grant date. The Company issues stock options to its employees and directors and provides employees the right to purchase stock pursuant to stockholder approved stock option and stock purchase plans. Effective July 1, 2005, the Company adopted the provisions of SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123R), using the Statement's modified prospective application method. Prior to July 1, 2005, the Company followed Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its stock compensation. -- 7 -- Under the provisions of SFAS No. 123R, the Company recognizes the fair value of stock compensation in net income, over the requisite service period of the individual grantees, which generally equals the vesting period. All of the Company's stock compensation is accounted for as an equity instrument and there have been no liability awards granted. Any income tax benefit related to stock compensation will be shown under the financing section of the Cash Flow Statement. Based on experience the Company has not adjusted the compensation expense for estimated forfeitures. Any forfeitures in the future will be recognized when they occur. At June 30, 2005, the Company accelerated the vesting on all previously granted options. Therefore, as of the date of adoption there is no unrecognized expense of these options and the expense recorded in the nine months ended March 31, 2005 is for options issued and vested during that period. The unrecognized expense of awards not yet vested will be recognized in net income in the periods in which they vest. Under the provisions of SFAS 123R, the Company recorded $27,413 of stock-based compensation on its consolidated condensed statement of operations for the three months ended March 31, 2006 and $112,625 for the nine months ended March 31, 2006, which is included in administrative expenses as follows: Three Months Ended Nine Months Ended March 31, 2006 March 31, 2006 Directors fees $21,000 $ 21,000 Employee compensation 6,413 91,625 _________ ________ Total $27,413 $112,625 ========= ======== Based on the Company's historical voluntary turnover rates for individuals in the positions who received options in the period, there was no forfeiture rate assessed. It is assumed these options will remain outstanding for the full term of issue. Under the true-up provisions of SFAS 123R, a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated. SFAS 123R requires the presentation of pro forma information for the comparative period prior to the adoption as if all of the Company's employee stock options had been accounted for under the fair value method of the original SFAS 123. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation to the prior-year period. Three Months Ended Nine Months Ended March 31, 2005 March 31, 2005 Net income, as reported $ 880,456 $2,064,888 Less: Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (23,200) (105,850) Less: Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects $ 857,256 $1,959,038 ========= ========== Net income per share: Basic - as reported $ 0.05 $ 0.12 ========= ========== Basic - pro forma $ 0.05 $ 0.11 ========= ========== Diluted - as reported $ 0.05 $ 0.11 ========= ========== Diluted - pro forma $ 0.05 $ 0.11 ========= ========== -- 8 -- The Company had the following activity in its stock option plans for the nine months ended March 31, 2006: Number Weighted-Average Intrinsic Value of Exercise Price at Shares Per Share March 31, 2006 __________ ________________ ______________ Balance - June 30, 2005 1,138,250 $0.85 Granted 345,000 $2.44 Exercised (47,250) $0.83 Expired (30,000) $1.73 __________ ________________ ______________ Balance - March 31, 2006 1,406,000 $1.22 $ 1,518,480 ========== The total intrinsic value of options exercised during the nine-months ended March 31, 2006 was $79,967. The following summarizes the activity of the Company's stock options that have not vested for the nine months ended March 31, 2006. Number Weighted- of Average Shares Fair Value __________ __________ Nonvested at July 1, 2005 0 $0.00 Granted 258,750 $1.19 Expired 0 $0.00 Vested 0 $0.00 _________ Nonvested at March 31, 2006 258,750 $1.19 ========= The compensation cost related to the fair value of these shares of $308,000.00 will be recognized when these options vest. The Company utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted after the adoption of SFAS 123R. The weighted-average fair values of the options granted under the stock option plans for the three months and nine months ended March 31, 2006 was $1.29 and $1.19, respectively using the following: Three Three Nine Nine Months Months Months Months Ended Ended Ended Ended March 31, March 31, March 31, March 31, 2006 2005 2006 2005 _________ _________ _________ _________ Average risk-free interest rate 4.50% 4.00% 4.44% 4.44% Expected dividend yield None None None None Expected life 8.52 years 8.64 years 5.87 years 5.69 years Expected volatility 50.0% 47.0% 47.8% 50.7% The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of our common stock over the period commensurate with the expected life of the options. The risk-free interest rate is the U.S. Treasury rate on the date of grant. The expected life was calculated using the Company's historical experience for the expected term of the option. -- 9 -- 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: Treatment Pharmaceutical Contract Administrative Services Study Services Services Services Eliminations Total __________________________________________________________________________ For the three months ended: March 31, 2006 Revenues - external customers $7,292,804 $1,523,277 $1,137,878 $ -- $ -- $ 9,953,959 Revenues - intersegment 16,600 -- 22,615 816,000 (855,215) -- Net income (loss) 1,129,901 317,240 416,891 (913,483) -- 950,549 Capital Expenditures 52,939 14,738 53,474 5,006 -- 126,157 Depreciation & Amortization 121,764 42,738 19,304 13,513 -- 197,319 Interest Expense 123,801 15,074 1,246 13,473 -- 153,594 Income tax expense 39,000 -- 6,303 124 -- 45,427 March 31, 2005 Revenues - external customers $ 6,734,949 $1,103,205 $ 925,528 $ -- $ -- $ 8,763,682 Revenues - intersegment 5,940 -- 15,437 690,000 (711,377) -- Net income (loss) 1,186,896 59,042 399,053 (764,535) -- 880,456 Capital Expenditures 46,065 5,194 794 -- -- 52,053 Depreciation & Amortization 65,098 35,979 966 12,829 -- 114,872 Interest Expense 115,830 2,337 -- 30,821 -- 148,988 Income tax expense (7,600) -- 6,000 1,600 -- -- For the nine months ended: March 31, 2006 Revenues - external customers $20,471,140 $3,913,370 $3,216,788 $ -- $ -- $27,601,298 Revenues - intersegment 34,250 -- 66,895 2,448,000 (2,549,145) -- Net income (loss) 2,382,277 407,712 1,287,953 (2,396,404) -- 1,681,538 Capital Expenditures 510,642 41,029 138,618 63,644 -- 753,933 Depreciation & Amortization 313,555 123,548 38,551 68,337 -- 543,991 Interest Expense 379,651 64,577 3,675 35,247 -- 483,150 Income tax expense 171,231 3,840 26,860 3,724 -- 205,655 Identifiable Assets 10,247,509 6,165,910 734,846 2,452,079 -- 19,600,344 Goodwill 969,099 1,735,290 -- -- -- 2,704,389 -- 10 -- Note D - Business Segment Information (continued): Treatment Pharmaceutical Contract Administrative Services Study Services Services Services Eliminations Total __________________________________________________________________________ March 31, 2005 Revenues - external customers $18,895,774 $3,384,347 $2,510,277 $ -- $ -- $24,790,398 Revenues - intersegment 5,940 -- 40,132 2,034,000 (2,080,072) -- Net income (loss) 3,182,988 211,794 896,799 (2,226,693) -- 2,064,888 Capital Expenditures 293,881 10,137 1,836 50,161 -- 356,015 Depreciation & Amortization 169,157 105,785 2,829 46,626 -- 324,397 Interest Expense 349,559 46,955 -- 85,326 -- 481,840 Income tax expense 76,400 -- 18,000 4,069 -- 98,469 For the period ended June 30, 2005: Identifiable assets 9,333,260 5,596,917 669,229 2,296,242 -- 17,895,648 Goodwill 969,099 1,679,110 -- -- -- 2,648,209
Note E - Debt covenants For the quarter ended March 31, 2006, the Company was not in compliance with one of its long term debt covenants related to the Harbor Oaks operations. The Company continues to make progress in recovering from the software failure at this facility, which delayed billing and postponed collection effort while the system was being recovered and the water damage at the facility which slowed admissions and reduced revenue. CapitalSource, the Company's lender, has provided the Company with a waiver of this covenant for the period. Note G - Recent Accounting 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 implemented SFAS No. 123 (R) on July 1, 2005. As a result of its implementation, the Company expensed $27,413, $15,375 and $69,837 in compensation cost in the quarters ended March 31, 2006, December 31, 2005 and September 30, 2005, respectively, based on the Black-Scholes value of the 85,000 options issued in the quarter ended March 31, 2006, 30,000 options issued in the quarter ended December 31, 2005 and 230,000 options issued in the quarter ended September 30, 2005. Transactions involving the employee stock purchase plan are not recorded until the stock is issued as they are immaterial. In May 2005, the FASB issued SFAS No. 154 "Accounting Changes and Error Corrections," which replaces APB Opinion No. 20 "Accounting Changes," and FASB Statement No. 3 "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period specific effects or the cumulative effect of the change. SFAS No. 154 shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date SFAS No. 154 was issued. At the present time, we do not believe that adoption of SFAS No. 154 will have a material effect on our financial position, results of operations or cash flows. Note H - Subsequent Events On April 20, 2006, in conjunction with the agreement the Company entered into with Medical Information Technologies, Inc., ("Meditech"), as previously disclosed, the Company signed a Master Lease Agreement with Bank of America to finance the acquisition of the software and the required hardware which will provide the Company with enhanced billing, collection and clinical reporting capabilities. -- 11 -- The agreement provides separate components for hardware and software: * Under the first component Bank of America has agreed to purchase hardware that is necessary for the Company to use the Meditech software. This hardware is expected to be delivered in August 2006. The Company has agreed to lease the hardware from Bank of America with 36 payments beginning in July 2006. Scheduled lease payments on the hardware are $6,065.11 with the final payment made in advance upon the signing of the lease. The lease includes an option for the Company to purchase the hardware at fair market value at the lease termination. Based on required disbursements by Bank of America in the amount of $200,000 to purchase the hardware, and the expected fair market value at lease termination, the lease payments over the term are equivalent to financing the purchase of the hardware at an annual interest rate of 6.13%. * Under the second component Bank of America has agreed to disburse $462,431 to Meditech to purchase software that the Company would otherwise be obligated to purchase under its agreement with Meditech. The schedule of Bank of America's purchase is based on the software delivery and implementation plan included in the Meditech agreement with the Company. The Company has entered into a capital lease with Bank of America to lease the software for a total of 60 payments beginning in October 2006. Scheduled payments under the lease begin with four payments of $3,000 followed by 56 payments of $9,868.71 with the final payment made in advance upon the signing of the lease. The Company has an option to purchase the software for one dollar at lease termination. The lease payments over the term are equivalent to financing the purchase of the software at an annual interest rate of 8.03%. The Company expects full implementation of the software at its treatment facilities by March 2007. -- 12 -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. In addition to historical information, this report contains statements relating to future events or our future results. These statements are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Act of 1934, as amended (the "Exchange Act") and are subject to the Safe Harbor provisions created by the statute. Generally words such as "may", "will", "should", "could", "anticipate", "expect", "intend", "estimate", "plan", "continue", and "believe" or the negative of or other variation on these and other similar expressions identify forward-looking statements. These forward-looking statements are made only as of the date of this report. We do not undertake to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements are based on current expectations and involve risks and uncertainties and our future results could differ significantly from those expressed or implied by our forward-looking statements. Overview The Company presently provides behavioral health care services through two substance abuse treatment centers, two psychiatric hospitals and six 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 behavioral health information through its web site at Wellplace.com but its primary function is technology and internet support for the Company's other subsidiaries and their contracts. As such, the expenses related to Behavioral Health Online, Inc. are included as corporate expenses. Contract Support services are provided by the Company through two call centers located in Utah and Michigan. Services provided include employee assistance programs for major railroads, smoking cessation services, credentialing services for professionals and mental health registration and reference services for the residents of Wayne County, Michigan. 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 Arizona, Michigan and Utah. 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. The extent of any future 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 (The Parity Act). If passed, this legislation will improve access to and reimbursement for 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's newly implemented prospective payment system, reimbursement rates for behavioral health care have increased. When fully implemented, this increase should 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 -- 13 -- 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. 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. When amounts are due as a result of cost report settlements, they are 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. All revenues from treatment services reported by the Company are shown net of estimated contractual adjustments and charity care provided. When payment is made, if the contractual adjustment is found to have been understated or overstated, appropriate adjustments are made to either increase or decrease revenue in the period the payment is received in accordance with the AICPA "Audit and Accounting Guide for Health Care Organizations." Based on amounts recorded as adjustment to reserves for the period listed and the company's current DSO's for the treatment segment of 87 days, the Company estimates adjustments to revenue recorded in the periods presented for services provided and revenues booked in prior periods at: $372,000 Fiscal year ended June 30, 2005 $486,000 For the nine months ended March 31, 2006 The increase for the current nine months over last year is primarily attributable to the new rates under the Medicare prospective payment system mentioned above, which provided higher reimbursement than the revenues booked. Revenues for the current year are also increased by cost report settlements for prior years. No cost report settlement was received in the fiscal year ended June 30, 2005; however, a Medicare cost report settlement of $158,100 was recorded during the period ended March 31, 2006. Presented below is a breakdown of net revenue by payor for the periods presented. Net Revenue by Payor (in thousands) For the three For the nine For the fiscal months ended months ended year ended 03/31/2006 06/30/2005 Amount Percent Amount Percent Amount Percent ______ ____ _______ ____ _______ ____ Private Pay $ 326 5 $ 922 5 $ 1,212 5 Commercial 4,569 64 13,044 64 17,608 67 Medicare 227 3 671 3 999 4 Medicaid 2,013 28 5,676 28 6,268 24 ______ ____ _______ ____ _______ ____ Net Revenue * $7,135 * $20,313 $26,087 ====== ======= ======== * excludes Medicare cost report settlement revenue of $158,100 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. -- 14 -- 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. Allowance for doubtful accounts: The provision for bad debts 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 80-100% 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 20% or greater of the total outstanding receivables balance. The following is a breakdown of receivables by payor net of all allowances for the periods presented. Accounts Receivable Aging (Net of allowance for bad debts - in thousands) For the Nine Months Ended March 31, 2006 __________________________________________ Over Over Over Over Over Over Over Payor Current 30 60 90 120 150 270 360 Total _______________________________________________________________________________ Private Pay $ 143 $ 115 $121 $ 67 $ 67 $ 473 $ 74 $ 30 $ 1,090 Commercial 1,609 721 422 226 175 680 47 120 4,000 Medicare 68 26 15 17 31 54 -- -- 211 Medicaid 696 87 81 81 62 339 -- -- 1,346 ______ _____ ____ ____ ____ ______ ____ ____ ______ Total $2,516 $ 949 $639 $391 $335 $1,546 $121 $150 $6,647 Fiscal Year Ended June 30, 2005 Over Over Over Over Over Over Over Payor Current 30 60 90 120 150 270 360 Total _______________________________________________________________________________ Private Pay $ 247 $ 139 $ 98 $ 64 $ 75 $154 $127 $ 32 $ 936 Commercial 1,708 645 389 239 216 379 208 26 3,810 Medicare 121 16 7 -- -- 1 -- -- 145 Medicaid 556 277 94 74 96 342 -- -- 1,439 ______ _____ ____ ____ ____ ______ ____ ____ ______ Total $2,632 $1,077 $588 $377 $387 $876 $335 $ 58 $6,330 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 basis 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. During the fiscal year ended June 30, 2005, the Company recognized a tax benefit of approximately $209,000, related to a decrease in its valuation allowance, based on budgeted taxable income for the next fiscal year. The Company's policy is to recognize tax benefit for only the next fiscal year based on the uncertainties surrounding the healthcare industry. 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 -- 15 -- information obtained from the management of the acquired businesses and the Company's business plans for the acquired businesses. Critical estimates and assumptions 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. The Company uses an outside valuation expert to assess the value of intangibles annually and will continue to do so unless circumstances require an earlier evaluation. The Company currently amortizes goodwill allocated to customer relationships acquired in the acquisition of Pivotal using the straight line method. Since there is no true "consumption" of the relationship that can be defined, the Company believes the straight line method of amortization best reflects the use of the intangible asset. Results of Operations The following table sets forth for the periods indicated, our operating results (dollars in thousands): Selected Statements of Income Data: For the three months ended For the nine months ended March 31, March 31, 2006 2005 2006 2005 Amount % Amount % Amount % Amount % ____________________________________________________________________ Revenue $ 9,954 100.0 $8,764 100.0 $27,601 100.0 $24,790 100.0 Cost and Expenses: Patient care expenses 4,340 43.6 3,978 45.4 11,968 43.4 10,789 43.6 Contract expenses 713 7.2 521 5.9 1,898 6.9 1,595 6.4 Administrative expenses 3,454 34.7 3,064 35.0 10,005 36.3 9,058 36.5 Provision for bad debts 334 3.4 218 2.5 1,467 5.3 801 3.2 Interest expense 154 1.5 149 1.7 483 1.7 492 2.0 Other (income) expenses, net (37) (0.4) (46) (0.5) (107) (0.4) (108) (0.4) Total Expenses 8,958 90.0 7,884 90.0 25,714 93.2 22,627 91.3 Income before provision for taxes 996 10.0 880 10.0 1,887 6.8 2,163 8.7 Provision for income taxes 45 0.5 -- 0.0 205 0.7 98 0.4 Net income 951 9.5 880 10.0 1,682 6.1 2,065 8.3
Results of Operations Total net revenue from operations increased 13.6% to $9,953,959 for the three months ended March 31, 2006 from $8,763,682 for the three months ended March 31, 2005 and 11.3% to $27,601,298 for the nine months ended March 31, 2006 from $24,790,398 for the nine months ended March 31, 2005. Net patient care revenue increased 8.3% to $7,292,804 for the three months ended March 31, 2006 from $6,734,949 for the three months ended March 31, 2005 and 8.3% to $20,471,140 for the nine months ended March 31, 2006 from $18,895,774 for the nine months ended March 31, 2005. This increase in revenue is due to a 14.5% increase in patient days, primarily due to a 4.0% increase in patient days at our substance abuse facilities for the three months ended March 31, 2006 over the same period last year and the addition of the 20 new beds at our Detroit facility. 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. -- 16 -- Revenue from pharmaceutical studies increased 38.1% to $1,523,277 for the three months ended March 31, 2006 from $1,103,205 for the three months ended March 31, 2005 and increased 15.6% to $3,913,370 for the nine months ended March 31, 2006 from $3,384,347 for the same period last year. This increase in revenue is due primarily to a large research contract signed and started in this quarter. This kind of fluctuation in revenue is expected in the pharmaceutical research business. We cannot always predict study starts or delays but attempt to keep an adequate backlog of studies and resources to affect a more stable revenue flow from research. Contract support services revenue provided by Wellplace increased 22.9% to $1,137,878 for the three months ended March 31, 2006 from $925,528 for the three months ended March 31, 2005 and increased 28.1% to $3,216,788 for the nine months ended March 31, 2006 from $2,510,277 for the nine months ended March 31, 2005. This increase in revenue is primarily due to the start-up of a new smoking cessation contract in October 2005. Patient care expenses increased by 7.2% to $3,787,166 for the three months ended March 31, 2006 from $3,533,279 for the three months ended March 31, 2005 and 8.4% to $10,341,470 for the nine months ended March 31, 2006 from $9,541,581 for the nine months ended March 31, 2005. 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 lab fees. During the second quarter of fiscal 2006, the Company also opened the second phase of the new inpatient program, Detroit Behavioral Institute, at the Detroit Medical Center and has experienced increased patient care revenue and expected increased patient care and administrative expenses related to the start up and new operations. Patient care expenses related to our pharmaceutical research division increased 24.1% to $552,477 for the three months ended March 31, 2006 from $444,999 for the three months ended March 31, 2005 and 30.4% to $1,626,465 for the nine months ended March 31, 2006 from $1,247,106 for the nine months ended March 31, 2005. This is due to the increased number of patient vists, with increases in payroll, medical consultants and patient stipends related to increased visits. Contract support services expenses increased 37.1% to $713,438 for the three months ended March 31, 2006 from $520,475 for the three months ended March 31, 2005 and 19.0% to $1,898,300 for the nine months ended March 31, 2006 from $1,595,478 for the nine months ended March 31, 2005. This increase is primarily due to the addition of a new call center contract, which required increased staff and improved technology to adequately support the services required by the contracts. This resulted in increased payroll, rent, telephone expenses and increased depreciation on new equipment and the build-out of the new space. Provision for doubtful accounts increased 53.5% to $334,248 for the three months ended March 31, 2006 from $217,756 for the three months ended March 31, 2005 and 83.3% to $1,466,903 for the nine months ended March 31, 2006 from $800,503 for the nine months ended March 31, 2005. The increase in the provision for doubtful accounts is attributable to the accounts receivable software failure at Harbor Oaks, which is our largest in-patient facility. The software conversion, required by this software crash, slowed the billing process and diverted staff attention from collections while we reentered the receivables into the new software. Since the Company's policy is to maintain reserves based on the age of its receivables, this delay in the billing and collection process increased the amount and age of the Company's receivables thereby increasing the reserves required by formula and the provision for doubtful accounts. The system is now operating and we expect the reserve requirement will decrease in future quarters as collection activity has now returned to normal. The percentage of bad debt expense to net patient care revenue decreased from 9.8% for the quarter ended September 30, 2005, to 7.4% for the quarter ended December 31, 2005 to 4.6% for the current quarter ended March 31, 2006. Administrative expenses increased 16.8% to $2,815,164 for the quarter ended March 31, 2006 from $2,410,474 for the quarter ended March 31, 2005 and 16.9% to $8,193,940 for the nine months ended March 31, 2006 from $7,008,636 for the nine months ended March 31, 2005. These changes are a result of the increased administrative payroll and employee benefits partially related to the set up and opening of Detroit Behavioral Institute and pre-construction expenses for the Las Vegas hospital. Administrative payroll increased 42.7% for the quarter ended March 31, 2006 and 19.6% for the nine months ended March 31, 2006. Fees and licenses decreased 12.9% for the quarter but increased 105.9% for the nine months ended March 31, 2006, due to fees related to the JACAHO accreditation at Harbor Oaks and Highland Ridge and a Quality Assurance fee assessed in Michigan. Director fees increased 160.0% for the quarter ended March 31, 2006 and 93.7% for the nine months ended March 31, 2006 due to the recognition of expense for options issued as required by SFAS No.123R (see Note C - Stock based Compensation on page nine of this report). Accounting fees increased 20% for the quarter ended March 31, 2006 and 72.7% for the nine months ended March 31, 2006 due to increased audit and review costs and more frequent audits required by the Company's agreement with CapitalSource, the Company's primary lender. Rent expense increased 13.9% for the quarter ended March 31, 2006 and 12.0% for the nine months ended March 31, 2006 due to routine lease payment increases called for by existing leases. Insurance expense increased approximately 6.5% for the quarter ended March 31, 2006 and 10.5% for the nine months ended March 31, 2006. Administrative expenses related to the research division decreased 2.4% to $638,486 for the three months ended March 31, 2006 from $653,827 for the three months ended March 31, 2005 and 11.7% to $1,810,776 for the nine months ended March 31, 2006 from $2,049,492 for the nine months ended March 31, 2005. This -- 17 -- decrease is primarily due to the reduction in salary expenses related to the elimination of the Nevada location and the reduction in the accrued bonuses and a decrease in insurance expense. 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. During the previous two quarters, the previously mentioned receivables software and hardware failure at our largest facility resulted in a delay of billing and collections while the systems were restored. Largely as a result of this delay and the increase in revenue, the Company's gross accounts receivable from patient care have increased 17.8% over the past nine months with corresponding increases in the aging of these receivables. Interest income decreased 24.8% to $11,281 for the three months ended March 31, 2006 from $15,004 for the three months ended March 31, 2005 and remained stable at approximately $49,500 for the nine months ended March 31, 2006 and March 31, 2005. This decrease is a result of increased collections at the time of admission leaving fewer accounts on payment plans and lower interest income on the payment plans. Although patients requiring credit to pay for services have always signed an agreement to pay which included finance charges, in an effort to encourage payment at the time of service, over the last couple of years the Company implemented the policy to charge interest on patient accounts to discourage long term credit for services. Other income decreased 19.8% to $25,309 for the three months ended March 31, 2006 from $31,568 for the three months ended March 31, 2005 and 1.2% to $57,357 for the nine months ended March 31, 2006 from $58,060 for the nine months ended March 31, 2005. This change is due to a reduced number of requests for medical records which makes up the majority of other income. Interest expense increased 3.1% to $153,594 for the three months ended March 31, 2006 from $148,988 for the three months ended March 31, 2005 and decreased 1.8% to $483,150 for the nine months ended March 31, 2006 from $491,840 for the same period last year. These changes are minimal and are primarily due to the changes in the prime rate which is the basis for interest on our primary long term and revolving debt and the booking of the interest on Promissory Note A of the Pivotal acquisition during the quarter ended December 31, 2005. The Note was contingent on the profitable operations of Pivotal from the acquisition through December 31, 2005; therefore, the Note was not recorded and no interest was accrued until the certainty of profitability could be determined. Acquisition earnings for the year ended December 31, 2005 resulted in a negative adjustment of approximately $200,000, which was recorded on April 1, 2006. The Company's provision for income taxes of $205,655 for the nine month period ended March 31, 2006 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 the volatility of the healthcare industry. Liquidity and Capital Resources The Company's net cash provided by operating activities was $1,572,236 for the nine months ended March 31, 2006 compared to $171,027 for the same period last year. Cash flow from operations in the nine months ended March 31, 2006 consists of net income of $1,681,538 plus depreciation and amortization of $543,991, non-cash interest expense of $41,796, non-cash stock based compensation of $118,286 and a $711,379 increase in accounts payable, offset by a $23,670 increase in deferred tax asset, a $866,637 increase in accounts receivable, $374,309 increase in prepaid expenses, $103,277 increase in other assets and a $156,861 decrease in accrued expenses and other liabilities. Cash used in investing activities in the nine months ended March 31, 2006 consisted of $753,933 in capital expenditures compared to $359,407 in capital expenditures and $62,258 in business acquisitions in the same period last year. -- 18 -- Cash used in financing activities in the nine months ended March 31, 2006 primarily consisted of $800,610 in net debt repayment, $15,000 in deferred financing costs and $36,613 used to purchase treasury stock, offset by $73,727 from the issuance of common stock. A significant factor in the liquidity and cash flow of the Company is the timely collection of its accounts receivable. As of March 31, 2006, accounts receivable from patient care, net of allowance for doubtful accounts, increased 5.0% to $6,646,905 on March 31, 2006 from $6,330,381 on June 30, 2005. This increase is due to increases in patient care revenues and the residual increase from the previously mentioned system failure at our largest facility, which delayed billing and collections for several months. We have seen some progress on the collection of these old accounts and will continue to review the status of old accounts daily. The Company monitors increases in accounts receivable closely and, based on the aging of the receivables outstanding, is confident that the increase is not indicative of a payor problem. Over the years, we have increased staff, standardized some procedures for determining insurance eligibility and collecting receivables and established 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. Our collectors also focus on collecting required patient co-payments at the time of admission whenever possible, therefore eliminating the requirement for costly patient billing, statements and follow-up. At the same time, the Company continues to closely monitor reserves for bad debt based on potential insurance denials and past difficulty in collections. Contractual Obligations The Company's future minimum payments under contractual obligations related to capital leases, operating leases and term notes as of March 31, 2006 are as follows (in thousands): YEAR OPERATING ENDING TERMS NOTES CAPITAL LEASES * LEASES TOTAL March 31 Principal Interest Principal Interest 2007 $ 798 $110 $ 59 $ 9 $1,426 $2,402 2008 681 48 58 4 1,236 2,027 2009 297 22 10 1 1,213 1,543 2010 55 17 4 1 1,147 1,224 2011 213 13 4 -- 621 851 2012 49 9 -- -- -- 58 Thereafter 70 4 -- -- -- 74 Total $2,163 $223 $135 $15 $5,643 $8,179 *see Note H - Subsequent events on page 11 of this report for details on a master lease entered into subsequent to Quarter end. In addition to the above, the Company is also subject to three contingent notes with a total face value of $2,500,000 as part of the Pivotal acquisition. Of these notes, two totaling $1,500,000, one for $1,000,000 and one for $500,000, bear interest at 6% per annum. These notes are subject to additional adjustment based on the earnings of the acquired operations. Since adjustment can be positive or negative based on earnings, with no ceiling or floor, the liability for only one of these notes was recorded as of March 31, 2006. This treatment is in accordance with SFAS No. 141, "Business Combinations" which states that contingent consideration should be recognized only when determinable beyond a reasonable doubt. Payments on the $1,000,000 note began on January 1, 2005. The above table includes the outstanding balance on this note of $852,157 which represents the earn out for the Pivotal acquisition through December 31, 2004 net of payments made through March 31, 2006. The earn-out for the period ended December 31, 2005 required a negative adjustment to the note of approximately $200,000 and was recorded on April 1, 2005. No payment is due on the $500,000 note as earn-out requirements have not been attained. The final note for $1,000,000 does not bear interest, is also subject to adjustment based on earnings but has a minimum value of $200,000 to be paid in PHC, Inc. Class A common stock on March 31, 2009. This minimum liability has been recorded with imputed interest of 6% and $164,647 is included in the schedule above. 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 -- 19 -- 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 and is included in the above table at its March 31, 2006 balance of $761,408. 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 balance on the revolving credit agreement as of March 31, 2006 was $2,040,605. down from $2,385,629 on June 30, 2006. For additional information regarding this transaction, see the Company's report on Form 8-K filed with the Securities and Exchange Commission on October 22, 2004. On the term loan and the revolving credit note, each 25 basis point increase in the prime rate will affect an annual increase in interest expense of approximately $7,100. For the quarter ended March 31, 2006, the Company was not in compliance with financial covenants of this agreement primarily due to the software failure at the Harbor Oaks facility, which delayed billing and postponed collection effort while the system was being recovered. CapitalSource, the Company's lender, has provided the Company with a waiver of these covenants for the period. The Company has operated ongoing operations profitably for twenty-one 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 will see continued improved results. Off Balance Sheet Arrangements The Company has no off-balance-sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to the Company. Item 3. Quantitative and Qualitative Disclosure About Market Risk The market price of our common stock could be volatile and fluctuate significantly in response to various factors, including: o Differences in actual and estimated earnings and cash flows; o Operating results differing from analysts' estimates; o Changes in analysts' earnings estimates; o Quarter-to-quarter variations in operating results; o Changes in interest rates effecting the interest expense of the company o Changes in market conditions in the behavioral health care industry; o Changes in market conditions in the research industry; o Changes in general economic conditions; and o Fluctuations in securities markets in general. Our interest expense is sensitive to changes in the general level of interest rates. With respect to our interest-bearing liabilities, all of our long-term debt outstanding is subject to rates at prime plus 2.25% and prime plus 3.5%, which makes interest expense increase with increases in the prime rate. On these notes, each 25 basis point increase in the prime rate will result in an annual increase in interest expense of approximately $7,100. Failure to meet targeted revenue projections could cause us to be out of compliance with covenants in our debt agreements. (For additional information see Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations"). Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures -- 20 -- 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. 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. Subsequent to quarter end we became aware of a loss from a theft of funds by an individual in our smallest in-patient facility who had responsibility for the collection of patient payments. We immediately began an investigation to determine the extent of the theft and to gauge the adequacy of our internal controls. We do not believe the total amount of the theft is material; we have, however, taken an additional provision for bad debt of $20,000 as a precaution. While our investigation is being conducted, in order to avoid any similar event, we have strengthened our internal controls at that facility by establishing dual responsibility for processing of patient payments and making bank deposits. This is already the practice at our other facilities. At the conclusion of our investigation, we may implement additional measures beyond those we have taken since the discovery of the theft, to mitigate the risk of a similar event. Change in Internal Controls Except as noted above, 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 evaluation. -- 21 -- 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 20, 2005. In regards to the election of class B 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. Because sufficient proxies related to class A shares were not received to hold the vote on the election of the class A directors and the approval of the new employee stock plan to replace the plan which expired in October 2005 and the increase in the annual grant of options to board members, the meeting was adjourned and re-convened on January 31, 2006 at which time the nominated class A directors were elected and the 2005 Employee Stock Purchase Plan and the change in the 2005 Non-Employee Director Stock Option Plan (the "Plan") were approved. Under the new Employee Stock Purchase Plan 500,000 shares of Class A Common Stock are available for issuance to eligible employees. (a) Annual Meeting of Shareholders, December 20, 2005 and re-convened on January 31, 2006 (b) Directors elected to serve one year terms: Bruce A. Shear William F. Greico David E. Dangerfield Donald E. Robar Howard W. Phillips (c) (1) Election of Class B directors on December 20, 2005 to serve one year terms Bruce A. Shear 721,756 for 0 withheld William F. Grieco 721,756 for 0 withheld David E. Dangerfield 721,756 for 0 withheld Election of Class A directors to serve one year terms: Donald E. Robar 14,855,563 for 51,920 withheld Howard W. Phillips 14,855,573 for 51,910 withheld (2) Proposal to approve a new employee stock purchase plan to replace the current plan, which expired on October 18, 2005. 8,443,149 for 729,778 against 16,850 abstained 9,326,486 broker non-vote (3) Proposal to approve the increase in the grant of options to directors under the Non-Employee Director option plan from 10,000 to 20,000. 8,163,804 for 995,573 against 30,400 abstained 9,189,777 broker non-vote Item 6. Exhibits Exhibit List Exhibit No. Description 10.49 Agreement to purchase licensed software by and between PHC, Inc., and Medical Information Technology, Inc., dated March 31, 2006. -- 22 -- 10.50 Master lease agreement by and between PHC, Inc., and Banc of America Leasing & Capital, LLC, dated April 20, 2006, effective April 1, 2006. 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. -- 23 -- Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PHC, Inc. Registrant Date: May 22, 2006 /s/ Bruce A. Shear __________________________ Bruce A. Shear President Chief Executive Officer Date: May 22, 2006 /s/ Paula C. Wurts __________________________ Paula C. Wurts Treasurer Chief Financial Officer -- 24 --