National Mentor (NMH) 10-Q/A 2006 Q1 Quarterly report (amended)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q/A

Amendment No. 1

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2005

OR

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             

Commission file number: 333-129179

NATIONAL MENTOR HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

Delaware	31-17570886
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
313 Congress Street, 6th Floor Boston, Massachusetts 02210	(617) 791-4800
(Address of Principal Executive Offices, including Zip Code)	(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

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

Large accelerated filer o

Accelerated filer o

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 o  No x

As of February 14, 2006, there were issued and outstanding 10,136,984.82 shares of the registrant’s common stock, $.01 par value.

EXPLANATORY NOTE

This Amendment No. 1 on Form 10-Q/A is being filed solely for the purpose of amending the disclosure in Part I, Item 2 of the Registrant’s report on Form 10-Q for the quarter ended December 31, 2005, filed on February 14, 2006 (the “Original 10-Q”), to reflect that the percentage rate increase in Minnesota was 2.26%. This Amendment No. 1 does not otherwise alter the disclosures set forth in the Original 10-Q. This Amendment No. 1 continues to speak as of the date of the filing of the Original 10-Q, and the Registrant has not updated the disclosures contained in this Amendment No. 1 to reflect any events that occurred at a date subsequent to the filing of the Original 10-Q.

Index
National Mentor Holdings, Inc.

		PAGE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets—December 31, 2005 and September 30, 2005	3
	Condensed Consolidated Statements of Income—Three months ended December 31, 2005 and 2004	4
	Condensed Consolidated Statements of Cash Flows—Three months ended December 31, 2005 and 2004	5
	Notes to Condensed Consolidated Financial Statements—December 31, 2005	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21
Item 4.	Controls and Procedures	21
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	22
Item 1A	Risk Factors	22
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	29
Item 4.	Submission of Matters to a Vote of Security Holders	29
Item 5.	Other Information	29
Item 6.	Exhibits	29

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PART I.      FINANCIAL INFORMATION

ITEM 1.     Financial Statements

National Mentor Holdings, Inc.
Condensed Consolidated Balance Sheets
(In thousands)
(Unaudited)

	December 31 2005				September 30 2005
Assets
Current assets:
Cash and cash equivalents		$	26,317			$	29,307
Accounts receivable, net		88,516				83,528
Deferred tax assets, net		3,806				3,829
Prepaid expenses and other current assets		13,393				12,574
Total current assets		132,032				129,238
Property and equipment, net		113,695				114,166
Intangible assets, net		102,372				104,571
Goodwill		91,394				91,263
Other assets		10,498				10,200
Total assets		$	449,991			$	449,438
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable		$	17,151			$	14,812
Accrued payroll and related costs		37,230				33,678
Other accrued liabilities		18,718				19,957
Current portion of long-term debt		5,113				11,601
Total current liabilities		78,212				80,048
Other long-term liabilities		2,949				3,048
Deferred tax liabilities, net		10,906				10,602
Long-term debt		318,962				319,430
Total liabilities		411,029				413,128
Commitments and contingencies		—				—
Redeemable Class A Preferred Stock		—				—
Shareholders’ equity:
Common stock		101				102
Additional paid-in-capital		42,305				42,252
Deferred compensation		(204		)		(229		)
Note receivable from officer		—				(49		)
Accumulated deficit		(3,240		)		(5,766		)
Total shareholders’ equity		38,962				36,310
Total liabilities and stockholders’ equity		$	449,991			$	449,438

See accompanying notes.

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National Mentor Holdings, Inc.
Condensed Consolidated Statements of Income
(In thousands)
(Unaudited)

	Three Months Ended December 31
	2005			2004
Net revenues	$	184,341		$	168,827
Cost of revenues	139,114			127,734
Gross profit	45,227			41,093
Operating expenses:
General and administrative	25,918			22,286
Depreciation and amortization	5,446			5,350
Total operating expenses	31,364			27,636
Income from operations	13,863			13,457
Other income (expense):
Management fee of related party	(63		)	(63		)
Other income (expense), net	(4		)	(9		)
Interest income	234			186
Interest expense	(7,110		)	(9,618		)
Income before provision for income taxes	6,920			3,953
Provision for income taxes	2,907			1,700
Net income	$	4,013		$	2,253

See accompanying notes.

4

National Mentor Holdings, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)

	Three Months Ended December 31
	2005			2004
Operating activities
Net income	$	4,013		$	2,253
Accounts receivable allowances	1,508			1,791
Depreciation and amortization of property and equipment	3,164			3,198
Amortization of other intangible assets	2,282			2,152
Amortization of deferred debt financing costs	336			1,515
Amortization of excess tax goodwill	142			—
Stock based compensation	78			6
Gain on disposal of business	—			(80		)
Loss on disposal of property and equipment	12			101
Changes in operating assets and liabilities:
Accounts receivable	(6,496		)	940
Other assets	(1,069		)	(1,407		)
Accounts payable	2,339			(1,067		)
Accrued payroll and related costs	3,552			(5,729		)
Other accrued liabilities	(1,239		)	(10,199		)
Deferred taxes	327			3,418
Other long-term liabilities	(99		)	(4,023		)
Net cash provided by (used in) operating activities	8,850			(7,131		)
Investing activities
Cash paid for acquisitions, net of cash received	(350		)	(1,017		)
Purchases of property and equipment	(2,945		)	(2,917		)
Cash proceeds from sale of property and equipment	308			233
Net cash used in investing activities	(2,987		)	(3,701		)
Financing activities
Repayments of long-term debt	(6,956		)	(205,751		)
Redemption of preferred stock	—			(118,453		)
Proceeds from officer notes	—			539
Proceeds from issuance of long-term debt	—			338,000
Repurchase and retirement of common stock	(1,488		)	—
Payments of deferred financing costs	(409		)	(8,161		)
Net cash (used in) provided by financing activities	(8,853		)	6,174
Net decrease in cash and cash equivalents	(2,990		)	(4,658		)
Cash and cash equivalents at beginning of period	29,307			24,416
Cash and cash equivalents at end of period	$	26,317		$	19,758

See accompanying notes.

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National Mentor Holdings, Inc.
Notes to Condensed Consolidated Financial Statements
(Amounts in thousands)
December 31, 2005
(Unaudited)

1.Basis of Presentation

National Mentor Holdings, Inc., through its wholly owned subsidiaries (collectively, the “Company”), is a national provider of home and community-based services to (i) individuals with mental retardation and/or developmental disabilities; (ii) at-risk children and youth with emotional, behavioral or medically complex needs; and (iii) persons with acquired brain injury.

The accompanying condensed consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X and do not include all information and footnotes required by accounting principals generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary to present fairly the financial position at December 31, 2005 and the results of operations and cash flows for the interim period have been included. Operating results for the three month period ended December 31, 2005 are not necessarily indicative of the results that may be expected for the year ending September 30, 2006.

2.Long-Term Debt

On November 4, 2004, the Company refinanced its then-existing senior credit facilities. The new senior credit facilities consist of an $80.0 million revolving credit facility (“senior revolver”) and a $175.0 million term B loan facility (“term B loan,” and collectively with the senior revolver, “senior credit facilities”). In addition, on November 4, 2004, National MENTOR, Inc. (a wholly owned subsidiary) issued $150.0 million in aggregate principal amount of its 95¤8% senior subordinated notes due 2012 (“senior subordinated notes”). These transactions are referred to together as the ‘‘Refinancing.’’ At the time of and in connection with the Refinancing, the Company redeemed all of its outstanding preferred stock, repaid certain of its other subordinated debt, and paid certain of its deferred compensation obligations. In addition, all outstanding interest rate swap agreements were terminated.

Any amounts outstanding under the senior revolver are due six years from the date of the senior credit agreement. The $175.0 million term B loan has a term of seven years and amortizes one percent per year, paid quarterly, for the first six years, with the remaining balance due in the seventh year. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts at any year-end if the Company generates certain levels of cash flow above a pre-determined amount. This amount, which the Company calculates annually, amounted to $5,804 for the period ended September 30, 2005. This amount is reflected in the current portion of long-term debt in the September 30, 2005 consolidated balance sheet, as this amount was paid in December 2005.

The interest rate on the term B loan is equal to LIBOR plus 2.50% or Prime plus 1.50%. The interest rate on the senior term B loan outstanding at December 31, 2005 is based on LIBOR plus 2.50%. The interest rates for any senior revolving credit facility borrowings are equal to either LIBOR plus 3.25% or Prime plus 2.25%. Cash paid for interest amounted to approximately $10,320, and $18,386 for the three months ended December 31, 2005 and 2004, respectively. Included in the cash paid for interest for the three months ended December 31, 2004 is approximately $13,500 related to accrued interest for the subordinated notes payable, which was repaid in connection with the Refinancing.

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2.Long-Term Debt (Continued)

The senior credit facility agreement and the bond indenture contain both affirmative and negative covenants, including limitations on the Company’s ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business, pay dividends, and requires the Company to meet or exceed certain financial ratios. In addition, should the Company seek a repricing of its Senior Term B Loan Facility within a year of March 20, 2005, it will be required to pay the lender group a prepayment fee equal to 1% of the outstanding loan balance. The Company was in compliance with all covenants at December 31, 2005.

The Company’s long-term debt consists of the following:

	December 31			September 30
	2005			2005
Senior Term B Loan, principal and interest due in quarterly installments through September 30, 2011; variable interest rate (6.8% at December 31, 2005)		$	165,289		$	171,945
Senior Revolver, due November 4, 2010; quarterly cash interest payments at a variable interest rate		—			—
Senior Subordinated Notes, due November 4, 2012; semi-annual cash interest payments beginning June 1, 2005 (coupon rate of 95¤8%)		150,000			150,000
Term loan mortgage, principal and interest due in monthly installments through May 20, 2010; variable interest rate (8.75% at December 31, 2005)		5,786			6,086
Note Payable to Seller (Magellan Health Services, Inc.), due March 8, 2007; semiannual cash interest payments at 12% beginning September 2001		3,000			3,000
		$	324,075		$	331,031
Less current portion		5,113			11,601
Long-term debt		$	318,962		$	319,430

The priority with regard to the right of payment on the Company’s debt is such that the senior credit facilities and the term loan mortgage have priority over all of the Company’s long-term debt. The senior credit facilities are secured by substantially all of the assets of the Company.

In conjunction with the registration of the exchange offer for the senior subordinated notes, the Company incurred deferred financing costs of approximately $409 as of December 31, 2005. In conjunction with the Refinancing described herein, the Company incurred deferred financing costs of approximately $8,161 as of December 31, 2004. These costs are being amortized under the effective interest rate method over the expected term of the term B loan, senior revolver and the senior subordinated notes. As of September 30, 2005, the balance sheet included $9,468 for deferred financing costs related to the Refinancing, the repricing of the term B loan and the refinancing of the term loan mortgage facility. The Company charged approximately $336 and $1,515 to interest expense for the three months ended December 31, 2005 and 2004, respectively, related to the amortization of deferred financing costs. Included in this charge as of December 31, 2004 is approximately $1,300 due to the accelerated amortization of deferred financing costs related to the previous senior credit facility.

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3.Stock-Based Compensation

On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004) (SFAS 123 (R)), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), 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 income statement based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. Companies are required to adopt the provisions of SFAS No. 123(R) for annual periods beginning after June 15, 2005.

Under SFAS 123(R), entities that used the minimum-value method to measure compensation cost for stock options under SFAS 123 for financial statement recognition or pro forma disclosure purposes will be required to use the prospective method. Under the prospective method, entities will continue to account for nonvested awards outstanding at the date of adoption of SFAS 123(R) in the same manner as they had been accounted for prior to adoption for financial statement recognition purposes. All awards granted, modified or settled after the date of adoption will be accounted for using the measurement, recognition and attribution provisions of SFAS 123(R).

Effective October 1, 2005, the Company adopted the fair value recognition provisions of SFAS 123(R) using the prospective method. Therefore, the Company continues to account for nonvested awards outstanding at the date of adoption in the same manner it accounted for them prior to adoption. The Company uses the Black-Scholes option valuation to determine the fair value of share-based payments granted after October 1, 2005.

At December 31, 2005, the Company has one stock-based employee compensation plan. Stock-based compensation cost of approximately $25 and $6 is reflected in pre-tax income at December 31, 2005 and 2004, respectively, related to options granted in 2004 and 2002 under the plan that had an exercise price less than the fair value of the underlying common stock on the date of grant.

During the three months ended December 31, 2005, the Company had recorded $53 of stock-based compensation expense as a result of the adoption of SFAS 123(R). The following table illustrates the effect on net income if the fair value based method had been applied to the three months ended December 31, 2004.

	Three Months Ended 2004
Net income, as reported		$	2,253
Add: Stock-based employee compensation included in reported net income, net of related tax effects		3
Deduct: Total stock-based employee compensation expense determined under fair value method of all awards, net of related tax effects		(15		)
Net income, pro forma		$	2,241

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3.Stock-Based Compensation (Continued)

The fair value of the options at the date of grant and assumptions utilized to determine such values are indicated in the following table:

	Three months ended
	December 31 2005	December 31, 2004
Risk-free interest rate	4.39%	1.30%
Expected dividend yield	—	—
Expected life	6.25 years	6.25 years
Expected volatility	64.9%	64.9%
Weighted-average fair value of options granted	$13.72	$7.02

In projecting expected stock price volatility the Company considered historical data of equity instruments of comparable companies. The Company estimated the expected life of stock options using the short-cut method, and estimated stock option forfeitures based on historical experience.

4.Intangible Assets

Intangible assets, resulting from the Company’s acquisition of certain businesses accounted for under the purchase method, consist of identifiable assets, including agency contracts, trade names, noncompete/nonsolicit clauses, an intellectual property model, licenses and permits and relationships with contracted caregivers. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives. Various trade names are classified as indefinite-lived intangible assets due to the length of time the trade names have been in existence and the planned use of the trade names for the foreseeable future.

Intangible assets consist of the following as of December 31, 2005:

Description	Estimated Useful Life	Gross Carrying Value			Accumulated Amortization			Intangible Assets, net
Agency contracts	5–13 years		$	96,098		$	20,045	$	76,053
Non-compete/non-solicit	4–5 years		350			240		110
Relationship with contracted caregivers	3 years		6,184			6,006		178
Trade names	10 years		526			149		377
Trade names	Indefinite life		19,192			—		19,192
Licenses and permits	10 years		8,237			2,158		6,079
Intellectual property models	10 years		550			167		383
			$	131,137		$	28,765	$	102,372

Amortization expense was $2,282 and $2,152 for the three months ended December 31, 2005 and 2004, respectively.

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4.Intangible Assets (Continued)

The estimated remaining amortization expense related to intangible assets with finite lives for each of the five succeeding years and thereafter is as follows:

Year ending September 30,
2006	$	6,775
2007	8,928
2008	8,609
2009	8,458
2010	8,448
Thereafter	41,962
	$	83,180

5.Segment Information

The Company provides home and community-based human services for individuals with mental retardation and other developmental disabilities, at-risk youth and persons with acquired brain injury. The Company operates its business in three operating divisions: an Eastern Division, a Central Division and a Western Division. For the reasons discussed below, the Company’s operating divisions are aggregated to represent one reportable segment, human services, under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). Accordingly, the accompanying consolidated financial statements reflect the operating results of the Company’s reportable segment. The aggregate of the Company’s Eastern, Central and Western operating divisions meets the definition of a segment in SFAS 131 as each of the three divisions engages in business activities that earn revenues and incur expenses, its operating results are regularly reviewed by management (comprising the Company’s chief operating decision-maker) to assess its performance and make decisions about resources to be allocated to the respective division, and discrete financial information is available in the form of detailed statements of income. The Company’s three service lines, which comprise mental retardation and other developmental disabilities, at-risk youth and persons with acquired brain injury do not represent operating segments per SFAS 131 as management does not internally evaluate the operating performance or review the results of the service lines to assess performance or make decisions about allocating resources. Net revenues is the only financial information available by service line and, therefore, discrete financial information is not available by service line at the level necessary for management to assess performance or make resource allocation decisions.

The Company’s Eastern, Central and Western operating divisions are combined into one reportable segment in accordance with the criteria outlined in SFAS 131. The aggregation of the three operating divisions is consistent with the objective and basic principles of SFAS 131 because it provides the users of the financial statements with the same information that management uses to internally evaluate the business. Each of the Company’s operating divisions provide the same types of services discussed above to similar customer groups, principally individuals. All of the operating divisions have similar economic characteristics, such as similar long-term gross margins. All of the operating divisions follow the same operating procedures and methods in managing their operations, as services are provided in a similar manner. In addition, each operating division operates in a similar regulatory environment, as each operating division has common objectives and regulatory and supervisory responsibilities (e.g., licensing, certification, program standards, regulatory requirements).

6.Reserves for Self-Insurance and Other Commitments and Contingencies

The Company maintains professional and general liability, workers’ compensation, automobile liability and health insurance with policies that include self-insured retentions. The Company intends to

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6.Reserves for Self-Insurance and Other Commitments and Contingencies (Continued)

maintain such coverage in the future and is of the opinion that its insurance coverage is adequate to cover potential losses on asserted claims. General and professional liability has a self-insured retention of $1.0 million per claim and $2.0 million in the aggregate. Above these limits the company carries $14.0 million of coverage. For workers’ compensation the Company has a $350 thousand per claim retention with statutory limits. Automobile liability has a $100 thousand per claim retention, with insurance limits totaling $5.0 million above the retention. The Company’s health insurance plan has a $250 thousand retention per claim. For these self-insured plans, costs are accrued as incurred and include an estimated liability for claims incurred but not reported. The reserves may be based on analysis performed internally by management or actuarially determined estimates by independent third parties. While the company believes that the estimates of reserves are adequate, the ultimate liability may be greater or less that the aggregate amount of reserves recorded.

Beginning November 1, 2005, the first $1.0 million per claim and $2.0 million in the aggregate of professional and general liability risk has been transferred to and funded into the Company’s wholly owned subsidiary captive insurance company. The accounts of the captive insurance company are fully consolidated with those of the other operations of the Company in the accompanying financial statements.

The Company issued approximately $22,561 in standby letters of credit as of December 31, 2005 related to the Company’s workers’ compensation insurance coverage. These letters of credit are secured by the senior revolver in the event the letters of credit are drawn upon. The standby letters of credit will increase to $23,926 on March 1, 2006.

From time to time, the Company is involved in litigation in the operation of its business. The Company reserves for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While the Company believes its provision for legal contingencies is adequate, the outcome of the legal proceedings is difficult to predict and the Company may settle legal claims or be subject to judgments for amounts that differ from its estimates.

7.Subsequent Events

On January 31, 2006, the Company acquired the Florida operations of American Habilitation Services, Inc. (AHS). AHS provides residential group home, day program and ICF-MR services. Total consideration for the acquisition was approximately $8.3 million in cash. The Company also entered into a purchase agreement to acquire a company that provides acquired brain injury services.

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ITEM 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion provides an assessment of our results of operations, liquidity and capital resources and should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this document.

Overview

Founded in 1980, we are a leading provider of home and community-based services to individuals with mental retardation and other developmental disabilities, at-risk youth and persons with acquired brain injury. As of December 31, 2005, we provided our services to approximately 20,200 clients in 30 states through approximately 15,000 full-time equivalent employees. Most of our services involve residential support, typically in single-family or small group home settings, designed to promote client independence and participation in community life. Our non-residential services consist primarily of day programs and periodic services in various settings. We derive most of our revenues from state and county government agencies, as well as smaller amounts from private-sector insurers mostly in our acquired brain injury business. For the three months ended December 31, 2005, we generated $184.3 million of net revenues.

The largest part of our business is the delivery of services to individuals with mental retardation or a developmental disability (MR/DD). The MR/DD services we provide include residential support, vocational services, day habilitation and case management. We also provide a variety of services to children with severe emotional, developmental and behavioral disorders, medical complexities and youth under the auspices of the juvenile justice system, all of whom we refer to as at-risk youth (ARY). Our ARY services include family-based services designed to support family preservation and family reunification, as well as case management, adoption assistance and education services. The remaining services we provide are post-acute services to individuals with acquired brain injury (ABI). These services include neurorehabilitation, neurobehavioral rehabilitation and assisted living services.

Our service lines do not represent operating segments per SFAS 131 as management does not internally evaluate the operating performance or review the results of the service lines to assess performance or make decisions about allocating resources. Also, discrete financial information is not available by service line at the level necessary for management to assess the performance or make resource allocation decisions.

We operate our business as one human services reporting segment organized into three divisions, an Eastern Division, a Central Division and a Western Division.

Factors Affecting our Operating Results

Demand for Home and Community-Based Human Services

Our growth in revenues has been directly related to increases in the number of individuals served. This growth has depended largely upon acquisitions, particularly the acquisition of REM, Inc. in May 2003, and development-driven activities, including the maintenance and expansion of existing contracts and the award of new contracts. We also attribute the continued growth in our client base to certain trends that are increasing demand in our industry, including demographic as well as political developments.

Demographic trends have a particular impact on our MR/DD business. Increases in the life expectancy of MR/DD individuals, we believe, have resulted in steady increases in the demand for MR/DD services. In addition, caregivers currently caring for their relatives at home are aging and may soon be unable to continue with these responsibilities. Each of these factors affects the size of the MR/DD population in need of services and, therefore, the amount of residential and non-residential MR/DD programs offered by governments in our markets. In addition, the “baby boom echo” in the early 1990s suggests a similar positive impact on the size of the ARY populations in our markets.

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Political trends can also affect our operations. In particular, budgetary restraints and lobbying from client advocacy groups can dictate the overall level of funding and the preferred settings for many of the services we provide. For example, pressure from advocacy groups for the populations we serve has generally helped our business, as these groups generally seek to pressure governments to fund residential services that use our small group home or host home models, rather than large, institutional models. Furthermore, while in certain states budgetary pressures have reduced the levels of funds available for MR/DD and ARY services, we believe that successful lobbying by these groups has preserved MR/DD and ARY services, and therefore our revenue base, from significant cutbacks as compared with certain other human services. Historically, many state and county governments have also been direct providers of many of our services, generally in institutions. As a result, our operations often depend not only on the success of our care model, but on governments’ general willingness to outsource these services to for-profit entities such as us, sometimes for the first time.

New Program Starts

While our May 2003 acquisition of REM, Inc. significantly increased our revenues, we believe that our future growth will depend more heavily on our ability to expand existing service contracts and to win new contracts. Our organic expansion activities can consist of both new program starts in existing markets or geographical expansion in new markets. Much of our growth in existing markets comes in the form of “cross-selling” new services into existing geographic markets. Depending on the nature of the program and the state or county government involved, we will seek new programs through either unsolicited proposals to government agencies or by responding to a request, generally known as a request for proposal, from a public-sector agency.

Acquisitions

On May 1, 2003, we acquired REM, Inc., including 317 single family homes and 63 intermediate care facilities, as well as an additional 433 leased facilities. This acquisition, which has been fully integrated into our operations, significantly increased our MR/DD market presence. In addition to the REM acquisition, as of December 31, 2005, we have completed 33 acquisitions since 1997, including several acquisitions of rights to government contracts or fixed assets from small providers, which we refer to as “tuck-in” acquisitions. We have pursued strategic acquisitions in markets with significant opportunities, but in which we lack either the necessary government contacts and/or local market knowledge to establish a market presence quickly. We have also acquired businesses or contracts only insofar as the regulatory environment and our level of expertise would allow us to establish a strong market presence quickly. We currently do not intend to pursue any acquisitions as large as the REM acquisition.

Rates and Reimbursement

We derive a majority of our revenues from states, counties or regional government agencies. The payment terms of these contracts vary by jurisdiction and service type, and may be based on flat rates, cost-based reimbursement, per person per diems, hourly rates and/or units of service. We bill most of our residential services on a per diem basis, and we bill most of our non-residential services on an hourly basis. For the first quarter, we derive approximately 15% of our revenues pursuant to cost-based reimbursement contracts, under which the billed rate is tied to the underlying costs plus a margin. Insufficient cost levels may require us to return previously received payments after cost reports are filed, although these amounts have historically been insignificant. Revenues in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be proposed in states where we operate or by the federal government which provides matching funds. We cannot determine the impact of such changes or the effect of any possible governmental actions.

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Our government payors fund most of their payments to us through Medicaid waiver programs, under which $1 of state funding is matched by federal funding of between $1 and $4. These federal matching funds programs enhance the long-term stability of our revenues, as they provide a strong incentive for state and counties to preserve existing programs, even in periods of budgetary restraint.

Occasionally, timing of payment streams may be affected by delays by the state related to bill processing systems, staffing or other factors. While these delays have historically impacted our cash position in particular periods, they have not resulted in long-term collections problems. As of December 31, 2005, our consolidated days sales outstanding was 45.8 days as compared with 44.9 on September 30, 2005.

Labor and Other Costs

Wages and benefits to our employees and per diem payments to our Mentors constitute the most significant operating cost in each of our operations. Our host home caregivers, or Mentors, are paid on a per diem basis, but only if the Mentor is currently caring for a client. Most of our other caregivers are paid on an hourly basis, with hours of work generally tied to client need. Our labor costs are generally influenced by general levels of service and these costs can vary in material respects across regions.

We incur no facilities costs for services provided in the home of a Mentor. Additionally since nearly all of our leased group homes are operated under short-term leases, our ability to reduce these fixed occupancy costs is more flexible than larger institutions. As of December 31, 2005, we owned 416 facilities and leased 866 others.

Expenses incurred in connection with regulatory compliance, liability insurance and third-party claims totaled less than 1.4% and 0.8% of our cost of revenues for the three months ended December 31, 2005 and 2004, respectively. We have incurred professional liability claims and insurance expense of $1.4 million and $1.1 million for the three months ended December 31, 2005 and 2004, respectively. We currently self-insure for amounts of up to $1.0 million per claim and $2.0 million in the aggregate. Above these limits, we have $14.0 million of coverage.

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Results of Operations

The following table sets forth the components of net income as a percentage of net revenues:

	Three Months
	Ended December 31
	2005		2004
Statement of operations data:
Net revenues	100.0	%		100.0	%
Cost of revenues	75.5	%		75.7	%
General and administrative expenses	14.1	%		13.2	%
Depreciation and amortization	3.0	%		3.2	%
Income from operations	7.5	%		8.0	%
Other income (expense)	0.0	%		0.0	%
Interest income	0.1	%		0.1	%
Interest expense	3.9	%		5.7	%
Income before provision for income taxes	3.8	%		2.3	%
Provision for income taxes	1.6	%		1.0	%
Net income	2.2	%		1.3	%

Three months ended December 31, 2005 compared to three months ended December 31, 2004

Net revenues

Net revenues increased by $15.5 million, or 9.2%, from $168.8 million for the three months ended December 31, 2004 to $184.3 million for the three months ended December 31, 2005. Approximately $5.8 million of the increase is as a result of revenue earned from several acquisitions that closed after the three months ended December 31, 2004. In addition, approximately $1.1 million of the increase is as a result of revenue earned from new programs started after the three months ended December 31, 2004. The increase was also due to census growth in our existing service lines, expansion into new markets and the development of new services for our existing customer base. Lastly, there was a 2.26% rate increase in Minnesota, our largest state, which became effective in the first quarter of fiscal 2006.

Cost of revenues

Cost of revenues increased by $11.4 million, or 8.9%, from $127.7 for the three months ended December 31, 2004 to $139.1 million for the three months ended December 31, 2005. The majority of the increase is due to an $8.7 million increase in labor costs, in particular, direct care wages, payroll taxes and fringe benefits. The increase in wages is mostly attributable to increases in our workforce to provide services for additional clients served. Cost of revenues also increased due to a $1.7 million increase in rent and other occupancy expenses related to more homes leased in the first quarter of fiscal 2006.

General and administrative expenses

General and administrative expenses increased by $3.6 million, or 16.1%, from $22.3 million for the three months ended December 31, 2004 to $25.9 million for the three months ended December 31, 2005. The majority of the increase is due to an increase in labor costs. The increase in labor costs consisted of a $1.4 million increase in administrative wages due to an increase in the number of employees as well as salary increases. In addition, during the three months ended December 31, 2005, an analysis of our professional and general liability claims resulted in an increase in our reserve of $0.5 million.

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Interest expense

Interest expense decreased $2.5 million from $9.6 million for the three months ended December 31, 2004 to $7.1 million for the three months ended December 31, 2005. The decrease was primarily due to $2.8 million of one-time interest expense charges recorded in the three months ended December 31, 2004 resulting from a charge of $1.3 million related to the acceleration of amortization for deferred financing costs from the prior senior credit facility and also incurred expense of $1.5 million related to a pre-payment fee on our prior senior credit facility in the three months ended December 31, 2004.

Provision for income taxes

Provision for income taxes increased $1.2 million from $1.7 million for the three months ended December 31, 2004 to $2.9 million for the three months ended December 31, 2005. Although the effective tax rate decreased from 43.0% for the three months ended December 31, 2004 to 42.0% for the three months ended December 31, 2005, provision for income taxes increased due to a higher income before provision for income taxes. The effective tax rate decreased due to a change in our corporate structure in November 2004, resulting in a reduction in the effective state income tax rate.

Liquidity and Capital Resources

The Company’s principal uses of cash are to meet working capital requirements, to fund debt obligations and to finance capital expenditures and acquisitions. Cash flows from operations have historically been sufficient to meet the aforementioned cash requirements.

Net cash provided by (used in) operating activities was $8.9 million and $(7.1) million for the three months ended December 31, 2005 and 2004, respectively. Cash used in operating activities for the three months ended December 31, 2004 included payments associated with the Refinancing. Certain deferred compensation plans were terminated and funds were distributed in the amount of $4.3 million. In addition, in connection with the repayment of the subordinated notes payable in 2004, accrued interest of $13.5 million was paid. Excluding these Refinancing items, net cash provided by operating activities was $10.7 million for the three months ended December 31, 2004. The change in cash provided by operating activities between periods was principally due to changes in operating assets and liabilities. The majority of this increase relates to increases in accounts receivable as days sales outstanding increased by approximately one day between September 30, 2005 and December 31, 2005 from 44.9 to 45.8. In the prior year’s first quarter days sales outstanding decreased by approximately one day between September 30, 2004 and December 31, 2004. In addition, accrued payroll and related costs increased due mostly to an increase in health insurance reserves of $5.1 million. Health insurance reserves increased as the Company did not prepay health claims into the Voluntary Employee Beneficiary Association (VEBA) at December 31, 2005 as it had done as of September 30, 2005.

Net cash used in investing activities was $3.0 million and $3.7 million for the three months ended December 31, 2005 and 2004, respectively. The primary components are purchases of property and equipment, cash paid for acquisitions and cash proceeds from the sale of property and equipment. The change between periods was primarily attributable to a change in cash paid for acquisitions. Cash paid for acquisitions for the three months ended December 31, 2005 of $0.4 million includes the acquisition of three companies engaged in behavioral health and human services. Cash paid for acquisitions for the three months ended December 31, 2004 of $1.0 million includes the acquisition of Bayview in October 2004 for $1.0 million. All acquisitions for both periods were financed with available cash. The Company spent $2.9 million in capital expenditures for the three months ended December 31, 2005 and 2004. Capital expenditures for both periods are primarily related to purchases of single family homes, vehicles and computer equipment.

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Net cash (used in) provided by financing activities in the three months ended December 31, 2005 and 2004 was $(8.9) million and $6.2 million, respectively. The $15.1 million increase in cash used by financing activities was primarily due to the Refinancing transaction noted above. In addition to the Refinancing activities, the Company made scheduled debt maturity payments in accordance with its term loan facilities of $0.5 million for both the three months ended December 31, 2005 and 2004. Also, the Company paid an additional $5.8 million of its outstanding term B loan in the three months ended December 31, 2005. This amount was calculated in accordance with a provision in the senior credit agreement requiring the prepayment of a portion of the outstanding term loan amount at any year-end if the Company generates certain levels of cash flow above a pre-determined amount. The Company also incurred and paid approximately $0.4 million in costs for the three months ended December 31, 2005 in connection with the exchange offer for the senior subordinated notes and $8.2 million in costs for the three months ended December 31, 2004 related to the Refinancing. In addition, for the three months ended December 31, 2005, the Company paid approximately $1.5 million to repurchase 66,121.91 shares of common stock from a member of the Company’s management team who retired on October 1, 2005.

The Company’s principal sources of funds are cash flows from operating activities and available borrowings under the senior credit facilities. The availability under the $80.0 million revolving facility is reduced by outstanding letters of credit totaling $22.6 million. As of December 31, 2005, the availability under this facility was $57.4 million. The Company believes that these funds will provide sufficient liquidity and capital resources to meet the near term and future financial obligations, including scheduled principal and interest payments, as well as to provide funds for working capital, capital expenditures and other needs for the foreseeable future. No assurance can be given, however, that this will be the case.

Commitments Summary

Information concerning our contractual obligations and commitments follows (in thousands):

Payments Due by Period
Twelve Months Ending December 31

	Total		2006		2007- 2008		2009- 2010		2011 and Thereafter
Long-term debt	$	324,075	$	5,113	$	4,142	$	46,823	$	267,997
Operating leases	75,522		24,238		30,169		14,696		6,419
Standby letters of credit	23,986		23,986		—		—		—
Total obligations and commitments	$	423,583	$	53,337	$	34,311	$	61,519	$	274,416

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results will inevitably differ from our estimates. These differences could be material to the financial statements.

We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change. Historically, our application of accounting policies has been appropriate, and actual results have not differed materially from those determined using necessary estimates.

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The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

Revenues are reported net of any state provider taxes or gross receipts taxes levied on services we provide. We follow Staff Accounting Bulletin (SAB) 104, Revenue Recognition, which requires that revenue can only be recognized when evidence of an arrangement exists, the service has been provided, the price is fixed or determinable and collectibility is probable. We recognize revenues for services performed pursuant to contracts with various state and local government agencies and private health care agencies as follows: cost-reimbursement contract revenues are recognized at the time the service costs are incurred and units-of-service contract revenues are recognized at the time the service is provided. For our cost-reimbursement contracts, the rate provided by the payor is based on a certain level and types of costs being incurred in delivering the service. From time to time, we receive payments under cost-reimbursement contracts in excess of the allowable costs required to support those payments. In such instances, we record a liability for such excess payments. At the end of the contract period, any balance of excess payments is maintained as a liability for reimbursement to the payor. Revenues in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be enacted in states where we operate or by the federal government. To date, we have not encountered any rate-setting changes of significance.

Accounts Receivables

Accounts receivable primarily consist of amounts due from government agencies, not-for-profit providers, and commercial insurance companies. An estimated allowance for doubtful accounts receivable is recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, we consider a number of factors, including payment trends in individual states, age of the accounts, and the status of ongoing disputes with third-party payors. Complex rules and regulations regarding billing and timely filing requirements in various states are also a factor in our assessment of the collectibility of accounts receivable. Actual collections of accounts receivable in subsequent periods may require changes in the estimated allowance for doubtful accounts. Changes in these estimates are charged or credited to revenue in the Statement of Income in the period of the change in estimate.

Reserves for Self-Insurance

We self-insure a substantial portion of our health, workers compensation, auto and professional and general liability (“PL/GL”) programs. We record expenses related to claims on an incurred basis, which includes maintaining fully developed reserves for both reported and unreported claims. The reserves for the health and workers compensation, auto and PL/GL programs may be based on analysis performed internally by management or actuarially determined estimates by independent third parties. While we believe that the estimates of reserves are adequate, the ultimate liability may be greater or less than the aggregate amount of reserves recorded. Reserves relating to prior periods are continually reevaluated and increased or decreased based on new information. As such, these changes in estimates are recorded as charges or credits to the income statement in a subsequent period of the change in estimate.

Goodwill and Intangible Assets

Pursuant to SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we review costs of purchased businesses in excess of net assets acquired (goodwill), and indefinite-lived intangible assets for impairment at least annually, unless significant changes in circumstances indicate a potential impairment may have occurred sooner. We are required to test goodwill on a reporting unit basis. We use a fair value

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approach to test goodwill for impairment and recognize an impairment charge for the amount, if any, by which the carrying amount of goodwill exceeds fair value. The impairment test for indefinite-lived intangible assets requires the determination of the fair value of the intangible asset. If the fair value of the intangible asset is less than its carrying value, an impairment loss would be recognized in an amount equal to the difference. Fair values are established using discounted cash flow and comparative market multiple methods. We conduct our annual impairment test on July 1st, and as of the date of the last test, there was no impairment and there have been no indicators of impairment since the date of the test.

Discounted cash flows are based on management’s estimates of our future performance. As such, actual results may differ from these estimates and lead to a revaluation of our goodwill and intangible assets. If updated calculations indicate that the fair value of goodwill or any indefinite-lived intangibles to be less than the carrying value of the asset, an impairment charge would be recorded in the results of operations in the period of the change in estimate.

Impairment of Long-Lived Assets

Pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), we review long-lived assets for impairment when circumstances indicate the carrying amount of an asset may not be recoverable based on the undiscounted future cash flows of the asset. If the carrying amount of the asset is determined not to be recoverable, a write-down to fair value is recorded based upon various techniques to estimate fair value.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under FAS 109, the asset and liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. These deferred tax assets and liabilities are separated into current and long-term amounts based on the classification of the related assets and liabilities for financial reporting purposes. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts.

Legal Contingencies

From time to time, we are involved in litigation in the operation of our business. We reserve for costs related to contingencies when a loss is probable and the amount is reasonably determinable. While we believe our provision for legal contingencies is adequate, the outcome of the legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that differ from our estimates.

Forward-Looking Statements

These statements relate to future events or our future financial performance. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. All written and oral forward-looking statements made in connection with this report which are

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attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “risk factors” and other cautionary statements included herein. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

The information in this report is not a complete description of our business or the risks associated with an investment in the 95¤8% senior subordinated notes due 2012. There can be no assurance that other factors will not affect the accuracy of these forward-looking statements or that our actual results will not differ materially from the results anticipated in such forward-looking statements. While it is impossible to identify all such factors, factors which could cause actual results to differ materially from those estimated by us include, but are not limited to, those factors or conditions described under “Risk Factors.”

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ITEM 3.Quantitative and Qualitative Disclosures about Market Risk

Although we are exposed to changes in interest rates as a result of our outstanding variable rate debt, we do not currently utilize any derivative financial instruments related to our interest rate exposure. At December 31, 2005, we had variable rate debt outstanding of $171.1 million compared to $178.0 million outstanding at September 30, 2005. The variable rate debt outstanding relates to the term loan, which has an interest rate based on LIBOR plus 2.50% or Prime plus 1.50%, the revolver, which has an interest rate based on LIBOR plus 3.25% or Prime plus 2.25%, and term loan mortgage, which has an interest rate based on Prime plus 1.50%. An increase in the interest rate by 100 basis points on the debt balance outstanding as of December 31, 2005, would increase interest expense approximately $1.7 million annually.

ITEM 4.Controls and Procedures

As of the end of the period covered by this report, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) promulgated under the Securities Exchange Act of 1934) was evaluated by our management, with the participation of our Chief Executive Officer and our Chief Financial Officer. Our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective, as of the end of the period covered by this report.

There were no changes in our internal control over financial reporting that occurred during our first fiscal quarter (the quarter ended December 31, 2005) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II.     OTHER INFORMATION

ITEM 1.Legal Proceedings

Information regarding legal proceedings is incorporated by reference from Note 6 to the condensed consolidated financial statements set forth in Part I of this report.

ITEM 1A.   Risk Factors

Risks Related to Our Business

Reductions in Medicaid funding or changes in budgetary priorities by the state and county governments that pay for our services could have a material adverse effect on our revenues and profitability.

During the three months ended December 31, 2005, we derived a majority of our revenues from contracts with state and local governments. These government payors fund a significant portion of their payments to us through Medicaid, a joint federal/state health insurance program through which state expenditures are matched by federal dollars ranging from 50 percent to more than 77 percent of total costs, a number based largely on a state’s per capita income. Our revenues, therefore, are determined by the size of federal, state and local governmental spending for the services we provide. Budgetary pressures, as well as economic, industry, political and other factors, could cause governments to limit spending, which could significantly reduce our revenues, margins and profitability and adversely affect our growth strategy.  Federal, state and local government agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover its contractual obligations with us, it may terminate a contract or defer or reduce our reimbursement. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. Many states in which we operate have experienced budgetary pressures from time to time and, during these times, some of these states have initiated service reductions, rate freezes and /or rate reductions. For example, in the past, our operations in Minnesota and Indiana were subject to rate reductions. The loss or reduction of reimbursement under our contracts could have a material adverse effect on our business, financial condition and operating results.

The nature of our operations could subject us to substantial litigation.

We are in the human services business and therefore we have been and continue to be subject to claims alleging we, our Mentors or our employees failed to provide proper care for a client, as well as claims for negligence or intentional misconduct, including personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seeking to impose monetary penalties on us. We could be required to pay substantial amounts of money to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, in damages, settlement amounts or penalties arising from these legal proceedings. We have incurred professional liability claims and insurance expense of $1.4 million for the three months ended December 31, 2005. We currently self-insure for amounts of up to $1.0 million per claim and $2.0 million in the aggregate. Above these limits, we have $14.0 million of coverage. An award in excess of our third-party insurance limits and self-insurance reserves could have a material adverse impact on our operations and cash flow and could adversely impact our ability to continue to purchase appropriate liability insurance. Even if we are successful in our defense, civil lawsuits or regulatory proceedings could also irreparably damage our reputation. We also are subject to potential lawsuits under a federal whistleblower statute designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards and bounties to private plaintiffs who successfully bring these suits. Finally, we are also subject to employee related claims such as wrongful discharge or discrimination or a violation of equal employment law.

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Many of our contracts with state and county government agencies are subject to audit and modification by the payors.

We derive virtually all of our revenues from state and local government agencies, and a substantial portion of these revenues are state-funded with federal Medicaid matching dollars. As a result of our participation in these government funded programs, we are often subject to governmental reviews, audits and investigations to verify our compliance with applicable laws and regulations. As a result of these reviews, audits and investigations, these government payors may be entitled to, in their discretion:

·terminate or modify our existing contracts;

·suspend or prevent us from receiving new contracts or extending existing contracts because of violations or suspected violations of procurement laws or regulations;

·impose fines, penalties or other sanctions on us;

·reduce the amount we are paid under our existing contracts; and/or

·require us to refund amounts we have previously been paid.

As a result of past reviews and audits of our operations, we have been subject to some of these actions from time to time, and we currently have ongoing audit proceedings in Pennsylvania, Connecticut, New Jersey, Florida, Wisconsin, Oklahoma, Illinois, California and Maryland. While we do not currently believe that these proceedings will have a material adverse effect on our results of operations or significantly harm our reputation, we cannot assure you that similar actions in the future will not do so.

In some states, we operate on a cost reimbursement model in which revenues are recognized at the time costs are incurred. In these states, payors audit our historical costs on a regular basis, and if it is determined that we do not have enough costs to justify our rates, our rates may be reduced, or we may be required to retroactively return fees paid to us. In some cases we have experienced negative audit adjustments which are based on subjective judgments of “reasonableness or necessity” of costs in our service provided to clients. These adjustments are generally required to be negotiated as part of the overall audit resolution and may result in paybacks to payors. We cannot assure you that our rates will be maintained, or that we will be able to keep all payments made to us until an audit of the relevant period is complete.

Negative publicity or changes in public perception of our services may adversely affect our ability to obtain new contracts and renew existing ones.

Our success in obtaining new contracts and renewals of our existing contracts depends upon maintaining our reputation as a quality service provider among governmental authorities, advocacy groups for persons with developmental disabilities and their families and the public. Negative publicity, changes in public perception and government investigations with respect to our operations could damage our reputation and hinder our ability to retain contracts, obtain new contracts, reduce referrals, increase government scrutiny and compliance costs, or generally discourage clients from using our services. Any of these events could have a material adverse effect on our business, financial condition and operating results.

A loss of our status as a licensed service provider in any jurisdiction could result in the termination of existing services and our inability to market our services in that jurisdiction.

We operate in numerous jurisdictions and are required to maintain licenses and certifications in order to conduct our operations in each of them. Each state and county has its own regulations, which can be complicated, and each of our service lines can be regulated differently within a particular jurisdiction. As a result, maintaining the necessary licenses and certifications to conduct our operations can be cumbersome. Our licenses and certifications could be suspended, revoked or terminated for a number of reasons, including: the failure by some of our facilities, employees or Mentors to properly care for clients; the

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failure to submit proper documentation to the government agency, including documentation supporting reimbursements for costs; the failure by our programs to abide by the applicable regulations relating to the provisions of human services; or the failure of our facilities to abide by the applicable building, health and safety codes and ordinances. We have had some of our licenses or certifications temporarily suspended in the past. If we lost our status as a licensed provider of human services in any jurisdiction or any other required certification, we would be unable to market our services in that jurisdiction, and the contracts under which we provide services in that jurisdiction would be subject to termination. Moreover, such an event could constitute a violation of provisions of contracts in other jurisdictions, resulting in other contract terminations. Any of these events could have a material adverse effect on our operations.

We are subject to extensive governmental regulations, which require significant compliance expenditures, and a failure to comply with these regulations could adversely affect our business.

We must comply with comprehensive government regulation of our business, including statutes, regulations and policies governing the licensing of our facilities, the quality of our service, the revenues we receive for our services, and reimbursement for the cost of our services. Compliance with these laws, regulations and policies is expensive, and if we fail to comply with these laws, regulations and policies, we could lose contracts and the related revenues, thereby harming our financial results. State and federal regulatory agencies have broad discretionary powers over the administration and enforcement of laws and regulations that govern our operations. A material violation of a law or regulation could subject us to fines and penalties and in some circumstances could disqualify some or all of the facilities and programs under our control from future participation in Medicaid or other government programs. The Health Insurance Portability and Accountability Act of 1996 (HIPAA), which requires the establishment of privacy standards for health care information storage, retrieval and dissemination as well as electronic transmission and security standards, could increase potential penalties in certain of our businesses if we fail to comply with these privacy and security standards. Furthermore, future regulation or legislation affecting our programs may require us to change our operations significantly or incur increased costs.

Expenses incurred under federal, state and local government agency contracts for any of our services, as well as management contracts with providers of record for such agencies, are subject to review by agencies administering the contracts and services. Representatives of those agencies visit our group homes to verify compliance with state and local regulations governing our home operations. A negative outcome from any of these examinations could increase government scrutiny, increase compliance costs or hinder our ability to obtain or retain contracts. Any of these events could have a material adverse effect on our business, financial condition and operating results.

Our variable cost structure is directly related to our labor costs, which may be adversely affected by labor shortages.

Our variable cost structure and operating profitability are directly related to our labor costs. Labor costs may be adversely affected by a variety of factors, including limited availability of qualified personnel in any geographic area, local competitive forces, the ineffective utilization of our labor force, increases in minimum wages, health care costs and other personnel costs, and changes in client service models, such as the trends toward supported living and managed care. Some of our operating units have incurred higher labor costs in certain markets from time to time because of difficulty in hiring direct service staff. These higher labor costs have resulted from increased wages and overtime and the costs associated with recruitment and retention, training programs and use of temporary staffing personnel and outside clinical consultants. In part to help with the challenge of recruiting and retaining direct care employees, we offer these employees a full benefits package that includes paid time off, health insurance, dental insurance, vision coverage, life insurance and a 401(k) plan, and these costs are significant. Only 15% of our revenue is derived from contracts based on a cost reimbursement model where we are reimbursed for our services based on our costs plus an agreed-upon margin. For those contracts where we do not operate under a

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cost-reimbursement model, we may not be able to pass along these costs, including increased labor costs, to third parties through an increase in our rates, which could have a material adverse affect on our margins and profitability.

We face substantial competition in attracting and retaining experienced personnel, and we may be unable to grow our business if we cannot attract and retain qualified employees.

Our success depends to a significant degree on our ability to attract and retain highly qualified and experienced social service professionals who possess the skills and experience necessary to deliver high quality services to our clients. These employees are in great demand and are likely to remain a limited resource for the foreseeable future. Contractual requirements and client needs determine the number, education and experience levels of social service professionals we hire. Our ability to attract and retain employees with the requisite experience and skills depends on several factors including, but not limited to, our ability to offer competitive wages, benefits and professional growth opportunities. The inability to attract and retain experienced personnel could have a material adverse effect on our business.

If we fail to establish and maintain relationships with officials of government agencies, we may not be able to successfully procure or retain government-sponsored contracts, which could negatively impact our revenues.

To facilitate our ability to procure or retain government-sponsored contracts, we rely in part on establishing and maintaining relationships with officials of various government agencies. These relationships enable us to maintain and renew existing contracts and obtain new contracts and referrals. These relationships also enable us to provide informal input and advice to the government agencies prior to the development of a “request for proposal” or program for privatization of social services and enhance our chances of procuring contracts with these payors. The effectiveness of our relationships may be reduced or eliminated with changes in the personnel holding various government offices or staff positions. We also may lose key personnel who have these relationships. Any failure to establish, maintain or manage relationships with government and agency personnel may hinder our ability to procure or retain government-sponsored contracts.

We depend upon the continued services of certain members of our senior management team, without whom our business operations could be significantly disrupted.

Our success depends, in part, on the continued contributions of our executive officers and other key employees. Our management team has significant industry experience and would be difficult to replace. If we lose or suffer an extended interruption in the service of one or more of our senior officers, our financial condition and operating results could be adversely affected. Moreover, the market for qualified individuals is highly competitive and we may not be able to attract and retain qualified personnel to replace or succeed members of our senior management or other key employees, should the need arise.

The high level of competition in our industry could adversely affect our contract and revenue base.

We compete with a wide variety of competitors, ranging from small, local agencies to large, national organizations, including publicly traded companies. Competitive factors may favor other providers and reduce our ability to obtain contracts, which would hinder our growth. Not-for-profit organizations are active in all states and range from small agencies serving a limited area with specific programs to multi-state organizations. Smaller local organizations may have a better understanding of the local conditions and may be better able to gain political and public acceptance. Not-for-profit providers may be affiliated with advocacy groups, health organizations or religious organizations that have substantial influence with legislators and government agencies. Increased competition may result in pricing pressures, loss of or failure to gain market share or loss of clients or payors, any of which could harm our business.

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Government reimbursement procedures are time-consuming and complex, and failure to comply with these procedures could adversely affect our liquidity, cash flows and operating results.

The government reimbursement process is time consuming and complex, and there can be delays before we receive payment. Government reimbursement, group home credentialing and MR/DD client Medicaid eligibility and service authorization procedures are often complicated and burdensome, and delays can result from, among other reasons, securing documentation and coordinating necessary eligibility paperwork between agencies. These reimbursement and procedural issues occasionally cause us to have to resubmit claims several times before payment is remitted. If there is a billing error, the process to resolve the error may be time consuming and costly. To the extent that complexity associated with billing for our services causes delays in our cash collections, we assume the financial risk of increased carrying costs associated with the aging of our accounts receivable as well as increase potential for bad debts. We can provide no assurance that we will be able to maintain our current levels of collectibility in future periods. The risks associated with third-party payors and the inability to monitor and manage accounts receivable successfully could have a material adverse effect on our liquidity, cash flows and operating results.

Home and community-based human services may become less popular among our targeted client populations and/or state and local governments, which would adversely affect our results of operations.

Our growth depends on the continuation of trends in our industry toward providing services to individuals with MR/DD in smaller, community-based settings and increasing the percentage of individuals with MR/DD served by non-governmental providers. The continuation of these trends and our future success is subject to a variety of political, economic, social and legal pressures, virtually all of which are beyond our control. A reversal in the downsizing and privatization trends could reduce the demand for our services, which could adversely affect our revenues and profitability.

Regulations that require ARY services to be provided through not-for-profit organizations could harm our revenues or gross margin.

Approximately 5% of our revenues for the three months ended December 31, 2005 were derived from contracts with subsidiaries of Alliance Health and Human Services, Inc. or “Alliance,” an independent not-for-profit organization that has a license or contract from several state or local agencies to provide ARY services.

Historically, some state governments have interpreted federal law to preclude them from receiving federal reimbursement under Title IV-E of the Social Security Act for ARY services provided by organizations other than non-for-profit organizations. However, on November 22, 2005 President Bush signed the “Fair Access Foster Care Act of 2005” into law, thereby allowing states to seek reimbursement from the federal government for ARY services provided by proprietary organizations. In some jurisdictions that have interpreted federal law to preclude them from seeking reimbursement for ARY services provided under a contract with a proprietary provider, or in others that prefer to contract with not-for-profit providers, we provide ARY services as a subcontractor of Alliance. We do not control Alliance, and none of our employees or agents has a role in the management of Alliance. Although Edward Murphy, our President and Chief Executive Officer, was an officer and director of Alliance immediately prior to becoming our President in September 2004, Mr. Murphy has no further role in the management of Alliance. Our ARY business could be harmed if Alliance chooses to discontinue all or a portion of its service agreements with us. Our ARY business could also be harmed if the state or local governments that prefer that ARY services be provided by not-for-profit organizations determine that they do not want the service performed indirectly by for-profit companies like us on behalf of not-for-profit organizations. We cannot assure you that our contracts with Alliance will continue, and if these contracts are terminated, it could have a material adverse effect on our business, financial condition and operating results. In addition, our relationship with Alliance could change if state or local governments change their policy regarding the awarding of contracts to non-profit or proprietary providers.

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Alliance and its subsidiaries are organized as non-profit corporations and are recognized as tax-exempt under section 501(c)(3) of the Internal Revenue Code. As such, Alliance is subject to the public charity regulations of the states in which it operates and to the regulations of the Internal Revenue Service governing tax-exempt entities. If Alliance fails to comply with the laws and regulations of the states in which it operates or with the rules of the Internal Revenue Service, it could be subject to penalties and sanctions, including the loss of tax-exempt status, which could preclude it from continuing to contract with certain state and local governments. Our business would be harmed if Alliance lost its contracts and was therefore unable to continue to contract with us.

Changes in federal, state and local reimbursement policies could adversely affect our revenues, cash flows and profitability.

Our revenues and operating profitability depend on our ability to maintain our existing reimbursement levels and to obtain periodic increases in reimbursement rates to meet higher costs and demand for more services. If we do not receive or cannot negotiate increases in reimbursement rates at approximately the same time as our costs of providing services increase, our margins and profitability could be adversely affected. Changes in how federal and state government agencies operate reimbursement programs can also affect our operating results and financial condition. Some states have, from time to time, revised their rate-setting methodologies in a manner that has resulted in rate decreases. In some instances, changes in rate-setting methodologies have resulted in third-party payors disallowing, in whole or in part, our requests for reimbursement. Any reduction or the failure to maintain or increase our reimbursement rates could have a material adverse effect on our business, financial condition and results of operations. Changes in the manner in which state agencies interpret program policies and procedures and review and audit billings and costs could also adversely affect our business, financial condition and operating results and our ability to meet obligations under our indebtedness.

We rely on third parties to refer clients to our facilities and programs.

We receive substantially all of our clients from third-party referrals. Our reputation and prior experience with agency staff, care workers and others in positions to make referrals to us are important for building and maintaining our operations. Any event that harms our reputation or creates negative experiences with such third parties could impact our ability to receive referrals and grow our client base.

We conduct a significant percent of our operations in Minnesota and, as a result, we are particularly susceptible to any reduction in budget appropriations for our services or any other adverse developments in this state.

For the three months ending December 31, 2005, approximately 20% of our revenue was generated from contracts with government agencies in the state of Minnesota. Accordingly, any reduction in Minnesota’s budgetary appropriations for our services, whether as a result of fiscal constraints due to recession, changes in policy or otherwise, could result in a reduction in our fees and possibly the loss of contracts. The concentration of our operations in Minnesota also makes us particularly susceptible to many of the other risks described above occurring in this state, including:

·the failure to maintain and renew our licenses;

·the failure to maintain important relationships with officials of government agencies; and

·any negative publicity regarding our operations.

Any of these adverse developments occurring in Minnesota could result in a reduction in revenue or a loss of contracts which could have a material adverse effect on our results of operations, financial position and cash flows.

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Our success depends on our ability to manage growing and changing operations.

Since 1998, our business has grown significantly in size and complexity. This growth has placed, and is expected to continue to place, significant demands on our management, systems, internal controls and financial and physical resources. In addition, we expect that we will need to further develop our financial and managerial controls and reporting systems to accommodate future growth. This could require us to incur expenses for hiring additional qualified personnel, retaining professionals to assist in developing the appropriate control systems and expanding our information technology infrastructure. The nature of our business is such that qualified management personnel can be difficult to find. Our inability to manage growth effectively could have a material adverse effect on our results of operations, financial position and cash flows.

We may not realize the anticipated benefits of any future acquisitions and we may experience difficulties in integrating these acquisitions.

As part of our growth strategy, we intend to make selective acquisitions. Growing our business through acquisitions involves risks because with any acquisition there is the possibility that:

·we may be unable to maintain and renew the contracts of the acquired business;

·unforeseen difficulties may arise integrating the acquired operations, including information systems and accounting controls;

·operating efficiencies, synergies, economies of scale and cost reductions may not be achieved as expected;

·the business we acquire may not continue to generate income at the same historical levels on which we based our acquisition decision;

·management may be distracted from overseeing existing operations by the need to integrate the acquired business;

·we may acquire or assume unexpected liabilities or there may be other unanticipated costs;

·we may experience problems entering new markets in which we have limited or no experience;

·we may fail to retain and assimilate key employees of the acquired business;

·we may finance the acquisition by incurring additional debt and may become highly leveraged; and

·the culture of the acquired business may not match well with our culture.

As a result of these risks, there can be no assurance that any future acquisition will be successful or that it will not have a material adverse effect on our financial condition and results of operations.

We are controlled by our principal equityholder, which has the power to take unilateral action.

Madison Dearborn controls our business affairs and policies. Circumstances may occur in which the interests of Madison Dearborn could be in conflict with the interests of the holders of the 95¤8% senior subordinated notes due 2012. In addition, Madison Dearborn may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to holders of the notes. See “Item 12. Security Ownership of Principal Shareholders and Management” and “Item 13. Certain Relationships and Related Transactions” in our annual report on Form 10-K for the year ended September 30, 2005.

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

None.

ITEM 3.Defaults Upon Senior Securities

None.

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

None.

ITEM 5.Other Information

None.

ITEM 6.Exhibits

(a) Exhibits

Exhibit No.	Description
3.1	Certificate of Incorporation of National MENTOR Holdings, Inc. (the “Company”) (incorporated by reference to the Company’s Registration Statement on Form S-4, Registration No. 333-129179, filed on October 21, 2005).
3.2	By-Laws of National MENTOR Holdings, Inc. (incorporated by reference to the Company’s Registration Statement on Form S-4, Registration No. 333-129179, filed on October 21, 2005).
31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended.
31.2	Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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 on February 16, 2006.

NATIONAL MENTOR HOLDINGS, INC.
	/s/ EDWARD M. MURPHY
By:	Edward M. Murphy
Its:	President and Chief Executive Officer

	/s/ JOHN W. GILLESPIE
By:	John W. Gillespie
Its:	Executive Vice President, Chief Financial Officer and Treasurer

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