Vasta Platform 10Q 2004 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended June 30, 2004


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

For the transition period from to

Commission File No. 000-50118

VistaCare, Inc.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		06-1521534 (I.R.S. Employer Identification No.)

4800 North Scottsdale Road, Suite 5000 Scottsdale, Arizona (Address of principal executive offices)		85251 (Zip code)

(480) 648-4545
(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, as amended (the “Exchange Act”), 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.x Yeso No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).x Yeso No

As of July 26, 2004, there were outstanding 16,192,666 shares of the issuer’s Class A Common Stock, $0.01 par value per share.

PART I — FINANCIAL INFORMATION


Item 1.	Financial Statements.

VISTACARE, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share information)


	June 30,			December 31,
	2004			2003
	(Unaudited)			(see note 1)
ASSETS
Current assets:
Cash and cash equivalents	$	66,585		$	47,193
Patient accounts receivable, net		18,038			24,266
Patient accounts receivable room & board, net		8,979			10,041
Deferred tax assets		8,136			5,488
Prepaid expenses and other current assets		3,990			3,679

Total current assets		105,728			90,667
Equipment, net		4,946			4,537
Goodwill, net of amortization		20,564			20,564
Other assets		6,289			6,453

Total assets	$	137,527		$	122,221

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,741		$	338
Accrued expenses		39,206			30,321
Current portion of capital lease obligations		41			88

Total current liabilities		41,988			30,747
Deferred tax liability		3,399			3,398
Stockholders’ equity:
Class A Common Stock, $0.01 par value; authorized 33,000,000 shares; 16,111,810 and 15,967,281 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively.		161			159
Additional paid-in capital		105,125			103,253
Deferred compensation		(790	)		(1,024	)
Accumulated deficit		(12,356	)		(14,312	)

Total stockholders’ equity		92,140			88,076

Total liabilities and stockholders’ equity	$	137,527		$	122,221

See accompanying notes to consolidated financial statements.

VISTACARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share information)


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net patient revenue	$	48,069		$	46,050		$	101,718		$	88,050
Operating expenses:
Patient care expenses		33,202			27,713			64,286			51,799
General and administrative expenses, exclusive of stock based compensation charges reported below		16,565			13,142			31,726			26,493
Depreciation and amortization		955			370			1,918			714
Stock based compensation		76			102			158			1,149

Total operating expenses		50,798			41,327			98,088			80,155

Operating income (loss)		(2,729	)		4,723			3,630			7,895

Non-operating income (expense)
Interest income		113			108			212			209
Interest expense		(19	)		(29	)		(49	)		(77	)
Other expense		(11	)		(36	)		(30	)		(51	)

Total non-operating income		83			43			133			81

Net income (loss) before income taxes		(2,646	)		4,766			3,763			7,976

Income tax expense (benefit)		(895	)		944			1,807			1,330

Net income (loss)	$	(1,751	)	$	3,822		$	1,956		$	6,646

Net income (loss) per common share:
Basic	$	(0.11	)	$	0.24		$	0.12		$	0.43

Diluted	$	(0.11	)	$	0.23		$	0.12		$	0.40

Weighted average shares outstanding:
Basic		16,167			15,633			16,112			15,595

Diluted		16,167			16,913			16,867			16,800

See accompanying notes to consolidated financial statements.

VISTACARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)


	Six Months Ended
	June 30,
	2004			2003
Operating activities
Net income	$	1,956		$	6,646
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,821			714
Amortization of deferred compensation related to stock options		158			1,149
Loss on disposal of assets		—			23
Deferred tax assets		232			—
Patient accounts receivable		7,291			(2,185	)
Prepaid expenses and other		(2,535	)		(3,296	)
Accounts payable and accrued expenses		11,244			4,692

Net cash provided by operating activities		20,167			7,743
Investing activities
Purchases of equipment		(1,164	)		(1,178	)
Internally developed software expenditures		(616	)		(1,019	)
Other assets		(286	)		(444	)

Net cash (used in) investing activities		(2,066	)		(2,641	)
Financing activities
Cost associated with common stock offering		—			(191	)
Proceeds from issuance of common stock from options		1,291			519

Net cash provided by financing activities		1,291			328

Net increase in cash and cash equivalents		19,392			5,430
Cash and cash equivalents, beginning of period		47,193			39,104

Cash and cash equivalents, end of period	$	66,585		$	44,534

See accompanying notes to consolidated financial statements.

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Description of Business

VistaCare, Inc. (VistaCare), is a Delaware corporation providing medical care designed to address the physical, emotional, and spiritual needs of patients with a terminal illness and the support of their family members. Hospice services are provided predominately in the patient’s home; however, certain patients require inpatient services. VistaCare provides services in Alabama, Arizona, Colorado, Georgia, Indiana, Massachusetts, New Mexico, Nevada, Ohio, Oklahoma, Pennsylvania, South Carolina, Texas and Utah.

1. Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements include accounts of VistaCare and its wholly-owned subsidiaries: VistaCare USA, Inc., Vista Hospice Care, Inc., and FHI Health Services, Inc. (including its wholly-owned subsidiaries). Intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 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 of normal recurring accruals considered necessary for a fair presentation have been included. Operating results for the three- and six-month periods ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in VistaCare Inc.’s annual report on Form 10-K for the year ended December 31, 2003.

Capitalized Software Development Costs

VistaCare capitalizes certain internal salaries related to the development of computer software used in its operations. Such capitalized software development costs are being amortized over three years. Capitalized software development costs, net of amortization, included in other assets, amounted to $5.2 million at June 30, 2004 and $5.3 million at December 31, 2003. Costs incurred during the preliminary project stage and post implementation/operations stage are expensed as incurred.

Net Patient Revenue

Net patient revenue is the amount VistaCare believes it is entitled to collect for its services, adjusted as described below. The amount VistaCare believes it is entitled to collect for its services varies depending on the level of care provided, the payor and the geographic area where services are rendered. Net patient revenue also includes adjustments for charity care and estimated payment denials (which VistaCare experiences from time to time for reasons such as its failure to submit complete and accurate

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

claim documentation, its failure to provide timely written physician certifications as to patient eligibility, or the payor deems the patient ineligible for insurance coverage), subsequent changes to initial level of care determinations, contractual adjustments, and amounts VistaCare estimates it could be required to repay to Medicare, such as payments that VistaCare would be required to make in the event that any of its programs exceed the annual per-beneficiary cap. VistaCare adjusts its estimates from time to time based on its billing and collection experience and other factors. VistaCare recognizes net patient revenue once the patient’s coverage from a payment source has been verified and services have been provided to that patient.

Approximately 97% and 96% of VistaCare’s net patient revenue was derived from the Medicare and Medicaid programs for the six-month periods ended June 30, 2004 and June 30, 2003, respectively. VistaCare operates under arrangements with Medicare, Medicaid and other third-party payors pursuant to which these payors reimburse VistaCare for services it provides to hospice-eligible patients these payors cover, subject only to VistaCare’s submission of adequate and timely claim documentation. VistaCare has a patient intake process that screens patients for hospice eligibility and identifies whether their care will be covered by Medicare, Medicaid, private insurance, managed care or self-pay. Whether Medicare or Medicaid continue to provide reimbursement for hospice care is dependent upon governmental policies.

Medicare and Medicaid Regulation

VistaCare is subject to certain limitations on Medicare payments for services. Specifically, if the number of inpatient care days of care any hospice program provides to Medicare beneficiaries exceeds 20% of the total days of hospice care such program provides to all patients for an annual period beginning September 28, the days in excess of the 20% figure may be reimbursed only at the routine home care rate. None of VistaCare’s hospice programs exceeded the payment limits on inpatient services in the six-month periods ended June 30, 2004 or June 30, 2003.

VistaCare is also subject to a Medicare annual per-beneficiary cap. Compliance with the Medicare per-beneficiary cap is measured by comparing the total Medicare payments received under a Medicare provider number with respect to services provided to all Medicare hospice care beneficiaries in the program or programs covered by that Medicare provider number with respect to services provided during the twelve-month period between November 1 of one year and October 31 of the following year, and the product of the per-beneficiary cap amount and the number of Medicare beneficiaries electing hospice care for the first time from that hospice program or programs during the relevant period. The company’s operations are conducted under 35 separate provider numbers, many of which have not experienced cap limitations. However, since cap regulations apply only at the provider number level, several of our operations under various provider numbers have been subject to cap limitations due to demographics of our patient base in such operations. VistaCare recorded reductions to net patient revenue of approximately $6.2 million for the three months ended June 30, 2004 and $0.6 million for the three months ended June 30, 2003 as estimates for exceeding the Medicare per-beneficiary cap. As of the date of this report, VistaCare had been assessed $0.4 million for exceeding the per-beneficiary cap for the assessment period that began on November 1, 2002 however, this is only a small portion of the locations where we believe we will receive an assessment. A determination as to this liability had not yet been made by the Medicare fiscal intermediary with respect to many of VistaCare’s programs. VistaCare management believes that as of June 30, 2004 adequate reserves had been established for this potential liability.

VistaCare monitors each of its programs to determine whether such programs are likely to exceed the foregoing limitations and estimates the extent to which it could be required to repay Medicare. At the time that management estimates the potential impact of having exceeded the Medicare limitations, the estimated assessment is deducted from net patient revenue and recorded as an accrued expense until such time as an actual payment is assessed by Medicare.

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

Laws and regulations governing the Medicare and Medicaid program are complex and subject to interpretation. VistaCare believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing which would have a material impact on VistaCare’s consolidated financial condition or results of operations. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs.

Charity Care

VistaCare provides care at no cost to patients who are not eligible for insurance coverage and meet certain financial need criteria established by VistaCare. Charity care totaled approximately $0.4 million and $0.7 million for the three-month periods ended June 30, 2004 and June 30, 2003, respectively. Because VistaCare does not pursue collection of amounts determined to qualify as charity care, these amounts are not recorded in net patient revenue. Costs VistaCare incurs in providing charity care are recorded as patient care expenses.

Nursing Home Costs

For patients receiving nursing home care under state Medicaid programs who elect hospice care under Medicare or Medicaid, VistaCare contracts with nursing homes for the nursing homes’ provision to patients of room and board services. In most states, the applicable Medicaid program must pay VistaCare, in addition to the applicable Medicare or Medicaid hospice daily or hourly rate, an amount equal to at least 95% of the Medicaid daily nursing home rate for room and board furnished to the patient by the nursing home. In some states, the Medicaid program pays the nursing home directly for these costs or has created a Medicaid managed care program that either reduces or eliminates this room and board payment. Under VistaCare’s standard nursing home contracts, VistaCare pays the nursing home for these room and board services at predetermined contract rates. Nursing home costs are offset by nursing home revenue and the net amount is included in patient care expenses.

Nursing home costs totaled approximately $11.8 million for the three months ended June 30, 2004 and $7.6 million for the three months ended June 30, 2003. Nursing home revenue totaled approximately $10.2 million for the three months ended June 30, 2004 and $7.1 million for the three months ended June 30, 2003. Revenues are less than 95% of costs due to provisions for estimated uncollectible amounts.

Income Taxes

VistaCare accounts for income taxes under the liability method as required by Financial Accounting Standards Board Statement No. 109,Accounting for Income Taxes.Under the liability method, deferred taxes are determined based on temporary differences between financial statement and tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for years in which the related taxes are expected to be paid or recovered. No valuation allowances existed at June 30, 2004 due to VistaCare’s assessment that it is more likely than not that it will be able to recover all of its deferred tax assets.

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

General and Professional Liability Insurance and Auto Insurance

VistaCare is covered by claims made professional liability insurance coverage with limits of $1,000,000 per medical incident and $3,000,000 in the aggregate, and by occurrence-based general liability insurance with limits of $1,000,000 per occurrence and $3,000,000 in the aggregate, each with a $25,000 deductible. VistaCare also maintains a policy insuring hired and non-owned automobiles with a $1,000,000 limit of liability, with a $1,000,000 deductible. In addition, VistaCare maintains an umbrella policy of liability insurance with a $10,000,000 limit of liability over the underlying professional liability, general liability and hired and non-owned automobile liability policies.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Stock-Based Compensation

VistaCare has elected to follow Accounting Principles Board Opinion No. 25 (APB No. 25),Accounting for Stock Issued to Employeesand related interpretations, in accounting for its employee stock options rather than the alternative fair value accounting allowed by Statement of Financial Accounting Standards No. 123 (SFAS 123),Accounting for Stock-Based Compensation. Under APB No. 25, if the exercise price of VistaCare’s stock options equals or exceeds the estimated fair value of the underlying stock on the dates of grant, no compensation expense is recognized. However, if the exercise prices of VistaCare’s stock options are less than the estimated fair value, on the date of grant, then compensation expense will be recognized for the difference over the related vesting periods.

If compensation for options granted under VistaCare’s stock option plan had been determined based on the deemed fair value at the grant date consistent with the method provided under SFAS 123, then VistaCare’s net income would have been as indicated in the pro forma table below (in thousands, except per share information).


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net income (loss) to common stockholders:
As reported:	$	(1,751	)	$	3,822		$	1,956		$	6,646
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		76			102			158			1,149
Deduct: Total stock-based compensation expense determined under fair value method for all awards		(817	)		(831	)		(1,507	)		(1,618	)

Pro forma net income (loss) to common stockholders	$	(2,492	)	$	3,093		$	607		$	6,177

Basic net income (loss) per common share:
As reported	$	(0.11	)	$	0.24		$	0.12		$	0.43
Pro forma		(0.15	)		0.20			0.04			0.40
Diluted net income (loss) per common share:
As reported	$	(0.11	)	$	0.23		$	0.12		$	0.40
Pro forma		(0.15	)		0.18			0.04			0.37
Weighted average shares used in computation:
Basic		16,167			15,633			16,112			15,595
Diluted		16,167			16,913			16,867			16,800

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

Earnings Per Share

Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period plus the effect of dilutive securities, including employee stock options (using the treasury stock method). Diluted earnings per share for the quarter ended June 30, 2004 are equal to the primary earnings per share, since the inclusion of the 511,000 shares of common stock equivalents would be antidilutive.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, (“FIN 46”),Consolidation of Variable Interest Entities, Interpretation of ARB No. 51, which addresses consolidation by business enterprises of variable interest entities (“VIEs”) either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (“Revised Interpretations”) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretations. For VIEs created or acquired prior to February 2, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after December 15, 2003. Certain disclosures are effective immediately. VIEs created after January 1, 2004 must be accounted for under the Revised Interpretations. We currently have no contractual relationship or other business relationship with a variable interest entity and therefore the adoption of FIN No. 46 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In March 2004, the FASB issued a Proposed Statement,Share Based Payments, an amendment ofFASB Statements No. 123 and 95on accounting for share-based payments, that would eliminate the ability to account for share-based payments using Accounting Standards Board Opinion No. 25,Accounting for Stock Issued to Employees, and require all such transactions to be accounted for using a fair value based method. The Proposed Statement would become effective for awards granted, modified, or settled in years beginning after December 15, 2004 and would require the recognition of compensation expense for any portion of awards granted or modified after December 15, 1994 that are not vested as of the Proposed Statement’s effective date. VistaCare has not determined the effect of adopting the Proposed Statement on its consolidated financial position, results of operations or cash flows.

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

2. Accrued Expenses

A summary of accrued expenses follows (in thousands):


Accrued Expenses	June 30, 2004		December 31, 2003
Patient care expenses	$	12,183	$	11,932
Self-insurance health costs		2,641		3,087
Salaries and payroll taxes		5,671		3,157
Medicare cap accrual		12,915		5,915
Income taxes payable		1,927		1,926
Accrued vacation and sick leave		2,049		2,274
Accrued administrative expenses		1,820		2,030

	$	39,206	$	30,321

3. Income Taxes

VistaCare’s provisions for income taxes for the six-month periods ended June 30, 2004 and June 30, 2003 reflect its estimates of the effective tax rate for the applicable full years. This estimate is re-evaluated by management each quarter based upon forecasts of income before taxes for the year. For the six-month period ended June 30, 2004, we recorded $1.8 million in income tax expense. The amount was comprised of tax at our estimated 39% effective rate expected for 2004 and an additional $0.3 million relating to taxes due in certain states in 2003 based upon a change in our assessment of the amounts due. Our effective rate of 39% differs from the statutory rate due primarily to state income taxes net of their federal income tax benefit. For the six-month period ended June 30, 2003, income tax expense was $1.3 million, which was below the statutory rate of $3.2 million due to the utilization of net operating loss carryforwards and corresponding reduction in the valuation reserve for deferred tax assets.

4. Long-Term Debt

VistaCare has a $30.0 million revolving line of credit collateralized by substantially all of VistaCare’s assets including cash, accounts receivable and equipment. Loans under the revolving line of credit bear interest at an annual rate equal to, at VistaCare’s option, either the “prime rate” in effect from time to time, as reported in the “Money Rates” section of theWall Street Journal, plus 1.5%, or the one-month London Interbank Borrowing Rate in effect from time to time, plus 3.0%. Accrued interest under the revolving line of credit is due (i) weekly, if VistaCare opts to pay interest at the prime rate, or (ii) on the last business day of the month, if VistaCare opts to pay interest at the London Interbank Borrowing Rate based rate.

Under the revolving line of credit, VistaCare may borrow, repay and reborrow an amount equal to the lesser of: (i) $30.0 million or (ii) 85% of the estimated net value of eligible accounts receivable. As of June 30, 2004, approximately $20 million was available for borrowing under the revolving line of credit. The maturity date of the revolving line of credit is April 30, 2005. As of June 30, 2004, there was no balance outstanding on the revolving line of credit.

VISTACARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
JUNE 30, 2004
(Unaudited)

VistaCare’s revolving line of credit facility contains customary covenants including those that restrict the ability of VistaCare to incur additional indebtedness, pay dividends under certain circumstances, permit liens on property or assets, make capital expenditures, make certain investments, and prepay or redeem debt or amend certain agreements relating to outstanding indebtedness. As of June 30, 2004, VistaCare was in compliance with the terms of such covenants.

5. Dilutive Securities

The following table presents the calculation of basic and diluted net income per common share (in thousands, except per share information):


	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2004			2003		2004		2003
Numerator
Net income (loss)	$	(1,751	)	$	3,822	$	1,956	$	6,646

Numerator for basic and diluted earnings (loss) per share	$	(1,751	)		3,822		1,956	$	6,646

Denominator
Denominator for basic net income (loss) per weighted average shares		16,167			15,633		16,112		15,595
Effect of dilutive securities
Employee stock options		—			1,260		755		1,185
Common stock warrant		—			20		—		20

Denominator for diluted net income (loss) per share-adjusted weighted average shares		16,167			16,913		16,867		16,800
Net income (loss) per common share
Basic	$	(0.11	)	$	0.24	$	0.12	$	0.43

Diluted	$	(0.11	)	$	0.23	$	0.12	$	0.40

6. Allowances for Denials

The allowances for denials for patient care and room and board accounts receivable are as follows (in thousands):


	Balance at				Write-offs, net of			Balance at end of
	beginning of period		Provision for Denials		recoveries			period
Year ended December 31, 2002	$	4,490	$	2,748	$	(2,876	)	$	4,362
Year ended December 31, 2003		4,362		7,140		(5,452	)		6,050
Six months ended June 30, 2004		6,050		4,503		(3,798	)		6,755

7. Litigation

VistaCare is involved in various litigation and administrative proceedings arising in the normal course of business. In the opinion of management, any liabilities that may result from pending litigation and administrative proceedings will not, individually or in the aggregate, have a material adverse effect on VistaCare’s consolidated financial position, results of operations or cash flows.


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

Overview

Net patient revenue increased to $48.1 million for the three months ended June 30, 2004 from $46.1 million for the three months ended June 30, 2003. However, due to Medicare cap reserve, net patient revenue for the three months ended June 30, 2004 was less than net patient revenue for the three months ended March 31, 2004 of $53.6 million and net patient revenue for the three months ended December 31, 2003 of $53.6 million. The recent decline in patient admissions, coupled with our increasing average length of stay of patients, has increased significantly our liability exposure related to the Medicare per-beneficiary cap limitation. This required us to accrue $6.2 million in the three months ended June 30, 2004 for our Medicare cap reserve, which at June 30, 2004 totaled $12.9 million. We expect that we may be required to accrue up to a similar amount in the quarter ending September 30, 2004.

We have undertaken a number of initiatives to reduce our Medicare cap exposure. These initiatives include restructuring our sales management, increasing the size of our sales force, accelerating the development of new programs and seeking shorter length of stay patients by targeting our marketing efforts on hospital referral sources. These initiatives, the implementation of which in some cases was delayed, have increased patient care and general and administrative expenses and impacted our bottom line. We incurred a net loss of $1.8 million for the quarter ended June 30, 2004.

Net Patient Revenue

Net patient revenue is the amount we believe we are entitled to collect for our services, adjusted as described below. The amount we believe we are entitled to collect for our services varies depending on the level of care provided, the payor and the geographic area where the services are rendered. Net patient revenue includes adjustments for:

	•		estimated payment denials (excluding payment denials related to Medicaid reimbursements for nursing home room and board charges) and contractual adjustments;

	•		amounts we estimate we could be required to repay to Medicare, such as amounts that we would be required to repay if any of our programs exceed the annual per-beneficiary cap, as described below under “Critical Accounting Policies and Significant Estimates — Potential Adjustments to Net Patient Revenue for Exceeding the Medicare Per-Beneficiary Cap”;

	•		patients who do not have insurance coverage and who are deemed financially in need of charity care; and

	•		subsequent changes to initial level of care determinations.

We adjust our estimates from time to time based on our billing and collection experience and other factors. Only after a patient’s payment source has been determined, a payment source has been identified and services have been provided do we recognize net patient revenue for services that we provide to that patient.

We derive net patient revenue from billings to Medicare, Medicaid, private insurers, managed care providers, patients and others. We operate under arrangements with those payors pursuant to which they reimburse us for services we provide to hospice eligible patients they cover, subject only to our submission of adequate and timely claim documentation. Our patient intake process screens patients for hospice eligibility and identifies whether their care will be covered by Medicare, Medicaid, private insurance, managed care or self-pay. Medicare reimbursements account for the majority of our net patient revenue. Our net patient revenue is determined primarily by the number of billable patient days, the level of care provided and reimbursement rates. The number of billable patient days is a function of the number of patients admitted to our programs and the number of days that those patients remain in our care.

Our average length of stay was approximately 114 days and our median length of stay was 33 days for the three months ended June 30, 2004, which we believe significantly exceed the industry averages. We attribute our ability to exceed the industry averages in terms of average and medium length of stay to several factors. First, by hospice industry standards, we have a relatively high percentage of non-cancer patients, who have a higher average length of stay than cancer patients. Second, we believe that our open access philosophy and our efforts to educate referral sources about hospice care encourages earlier transfers of patients to hospice care. Finally, a significant

amount of our growth in recent periods has been in rural markets where access to intensive care hospitals or other alternative sites for hospice-eligible patients is more difficult.

The table below sets forth the percentage of our net patient revenue for the three- and six-month periods ended June 30, 2004 and 2003 derived from Medicare, Medicaid, private insurers and managed care payors:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Medicare		93.0	%		93.6	%		93.5	%		92.6	%
Medicaid		4.1	%		3.6	%		3.9	%		3.6	%
Private insurers and managed care		2.9	%		2.8	%		2.6	%		3.8	%

Medicare, Medicaid and most private insurers and managed care providers pay for hospice care at a daily or hourly rate that varies depending on the level of care provided. The table below sets forth the percentage of our net patient revenue generated under each of the four Medicare levels of care for the periods indicated:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
Level of Care	2004			2003			2004			2003
Routine Home Care		96.2	%		93.0	%		95.7	%		93.0	%
General Inpatient Care		3.4	%		6.5	%		3.9	%		6.4	%
Continuous Home Care		0.3	%		0.3	%		0.3	%		0.4	%
Respite Inpatient Care		0.1	%		0.2	%		0.1	%		0.2	%

Typically, each October, Medicare adjusts its base hospice care reimbursement rates for the following year based on inflation and other economic factors. Effective October 1, 2003, the Medicare hospice reimbursement rates were increased 3.4% over the base rates then in effect. This increase has favorably impacted our net patient revenue. Medicare’s hospice reimbursement rates are subject to regional adjustments based on local wage levels. These regional adjustments are not necessarily proportional to adjustments.

Medicaid reimbursement rates and hospice care coverage rates for private insurers and managed care plans tend to approximate Medicare rates.

Because we generally receive fixed payments for our hospice care services based on the level of care provided to our hospice patients, we are at risk for the cost of services provided to our hospice patients. We cannot assure you that Medicare and Medicaid will continue to pay for hospice care in the same manner or in the same amount that they currently do. Reductions in amounts paid by government programs for our services or changes in methods or regulations governing payments, which would likely result in similar changes by private third-party payors, could adversely affect our net patient revenue and profitability.

Expenses

We recognize expenses as incurred. Our primary expenses include those we classify as either patient care expenses or general and administrative expenses.

Patient care expenses consist primarily of salaries, benefits, payroll taxes and travel costs associated with our hospice care providers. Patient care expenses also include the cost of pharmaceuticals,

durable medical equipment, medical supplies, inpatient arrangements, nursing home costs, net, and purchased services such as ambulance, infusion and radiology. We incur inpatient facility costs primarily through per diem lease arrangements with hospitals and skilled nursing facilities where we provide our services. We also operate one inpatient hospice facility under a rental agreement.

Patient length of stay impacts our patient care expenses as a percentage of net patient revenue. Patient care expenses are generally higher during the initial and latter days of care. In the initial days of care, expenses tend to be higher because of the initial purchases of pharmaceuticals, medical equipment and supplies and the administrative costs of determining the patient’s hospice eligibility, registering the patient and organizing the plan of care. In the latter days of care, expenses tend to be higher because patients generally require more services, such as pharmaceuticals and nursing care, due to their deteriorating medical condition. Accordingly, if lengths of stay decline, those higher costs are spread over fewer days of care, which increases patient care expenses as a percentage of net patient revenue and negatively impacts profitability. Patient care expenses are also impacted by the geographic concentration of patients. Labor expenses, which represent the single largest category of patient care expenses, tend to be less if patients are geographically concentrated and hospice care providers are required to spend less time traveling and can care for more patients.

For our patients who receive nursing home care under state Medicaid programs in states other than Arizona, Oklahoma, and South Carolina, the applicable Medicaid program pays us an amount equal to no more than 95% of the Medicaid per diem nursing home rate for room and board services furnished to the patient by the nursing home in addition to the Medicare or Medicaid routine home care per diem payment. We pay the nursing home for these room and board services at a rate between 95% and 100% of the full Medicaid per diem nursing home rate, depending on the terms of the contract between us and the nursing home. We include the difference between the amount we pay the nursing home and the amount we receive from Medicaid (net of estimated room and board reimbursement claim denials) in patient care expenses. We refer to this difference as “nursing home costs, net”. Our nursing home costs, net, were $1.6 million and $0.4 million for the three-month periods ended June 30, 2004 and June 30, 2003, respectively, and $2.6 million and $0.8 million for the six-month periods ended June 30, 2004 and June 30, 2003, respectively.

General and administrative expenses primarily include salaries, payroll taxes, benefits and travel costs associated with our staff that is not directly involved with patient care, bonuses for all employees, marketing, office leases, and professional services.

Stock-Based Compensation

Certain employee stock options which we granted in 2001 and 2002 have resulted in and will continue to result in stock-based compensation charges. In accordance with Accounting Principles Board Opinion No. 25 and related interpretations, if an employee stock option is granted with an exercise price which is less than the deemed fair value of the underlying stock, the difference is treated as a compensation charge that must be recognized ratably over the vesting period for the option. In addition, the vesting of a stock option granted to our Chief Executive Officer in November 2002 was accelerated in full in February 2003, resulting in $1.1 million of compensation expense, which was recognized in the first quarter of 2003. As of June 30, 2004, we had expensed a total of $0.8 million of deferred stock-based compensation relating to the foregoing options.

Capitalized Software Development Costs

We have capitalized certain internal costs related to the development of software used in our business. We capitalize all qualifying internal costs incurred during the application development stage. Costs incurred during the preliminary project stage and post-implementation/operation stage are expensed as incurred. As of June 30, 2004, we had total capitalized software development costs, net of amortization, of approximately $5.2 million. We amortize the capitalized software development costs related to particular software over a three-year period commencing when that software is substantially complete and

ready for its intended use. Approximately $3.7 million of our capitalized software development cost as of June 30, 2004 related to our new billing software, which we started to amortize in the fourth quarter of 2003.

Goodwill

Goodwill from our 1998 and 2002 acquisitions, net of accumulated amortization, was $20.6 million as of June 30, 2004. Prior to 2002, we were amortizing the goodwill from our 1998 acquisitions over 30 years. Rules issued by the Financial Accounting Standards Board, effective beginning in 2002, require that we no longer amortize goodwill. These rules require that we analyze our goodwill for impairment annually, or more often if events or circumstances arise that indicate that the carrying value of our goodwill exceeds its fair market value. We have concluded that no basis for impairment of our goodwill existed as of June 30, 2004.

Adjusted EBITDA

Adjusted EBITDA consists of net income (loss), excluding net interest, taxes, depreciation and amortization and stock-based compensation charges. We present adjusted EBITDA to enhance the understanding of our operating results. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles. Items excluded from adjusted EBITDA are significant components in understanding and assessing financial performance. Adjusted EBITDA is a key measure we use to evaluate our operations. In addition, we provide our adjusted EBITDA because we believe that investors and securities analysts will find adjusted EBITDA to be a useful measure for evaluating our cash flows from operations, for comparing our operating performance with that of similar companies that have different capital structures and for evaluating our ability to meet our future debt service, capital expenditures and working capital requirements. Adjusted EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by operating, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Because adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations, adjusted EBITDA as presented may not be comparable to other similarly titled measures of performance of other companies.

The following table reconciles our net income (loss) to adjusted EBITDA (deficit) and also shows cash flows from operating, investing and financing activities for the periods indicated:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
	(in thousands)
	(unaudited)
Net income (loss)	$	(1,751	)	$	3,822			1,956		$	6,646
Plus:
Interest income		(113	)		(108	)		(212	)		(209	)
Interest expense		19			29			49			77
Income tax expense (benefit)		(895	)		944			1,807			1,330
Depreciation and amortization		955			370			1,918			714
Stock-based compensation charges		76			102			158			1,149

Adjusted EBITDA (deficit)	$	(1,709	)	$	5,159		$	5,676		$	9,707

Net cash provided by operating activities	$	11,204		$	6,396		$	20,167		$	7,743
Net cash used in investing activities	$	(893	)	$	(1,481	)	$	(2,066	)	$	(2,641	)
Net cash provided by financing activities	$	131		$	108		$	1,291		$	328

Critical Accounting Policies and Significant Estimates

To understand our financial position and results of operations, you should read carefully the description of our significant accounting policies set forth in “Part I — Item 1. Financial Statements — Notes To Consolidated Financial Statements — Note 1” of this report. You should also be aware that application of our significant accounting policies requires that we make certain judgments and estimates, which are subject to an inherent degree of uncertainty.

Adjustments to Net Patient Revenue for Estimated Payment Denials

Substantially all of our net patient revenue is derived from Medicare and Medicaid programs. The balance of our net patient revenue is derived primarily from private insurers and managed care programs. We operate under arrangements with these payors pursuant to which they reimburse us for services we provide to hospice-eligible patients they cover, subject only to our submission of adequate and timely claim documentation. In some cases, these payors deny our claims for reimbursement for reasons such as:

	•		our claim documentation is incomplete or contains incorrect patient information;

	•		the payor deems the patient ineligible for insurance coverage; or

	•		we have failed to provide timely written physician certifications as to patient eligibility.

We adjust our net patient revenue to the extent we estimate these payors will deny our claims. This estimate is subject to change based on information we receive or data we compile concerning factors such as:

	•		our experience of claim denials by payor class;

	•		the strength and reliability of our billing practices; and

	•		changes in the regulatory environment.

Recorded net patient revenue reflected reductions of $1.1 million and $1.0 million for the three-month periods ended June 30, 2004 and June 30, 2003, respectively, and $1.9 million and $1.8 million for the six-month periods ended June 30, 2004 and June 30, 2003, respectively.

Potential Adjustments to Net Patient Revenue for Exceeding the Medicare Per-Beneficiary Cap

Our hospice programs are subject to the annual Medicare per-beneficiary cap. In effect, the per-beneficiary cap imposes a limit on the amount of payments per beneficiary that we can receive from Medicare with respect to services provided during the twelve-month period between November 1 of one year and October 31 of the following year (the “Medicare fiscal year”). Compliance is measured by calculating the total Medicare payments received under a Medicare provider number during that Medicare fiscal year with respect to services provided to all Medicare hospice care beneficiaries in the program or programs covered by that Medicare provider number and comparing the result with the product of the per-beneficiary cap amount and the number of Medicare beneficiaries electing hospice care for the first time from that hospice program or programs during the relevant period. Medicare fiscal intermediaries do not typically determine whether the per-beneficiary cap has been exceeded and make the associated assessment for at least six months after the end of the relevant period.

We actively monitor each of our programs to determine whether they are likely to exceed the Medicare per-beneficiary cap. If we determine that the program or programs covered by a Medicare

provider number are likely to exceed the cap, we attempt to institute corrective action, such as a change in patient mix or concentrate on increasing census. However, to the extent we believe our corrective action will not be successful, we estimate the amount that we could be required to repay to Medicare and accrue that amount (the “cap actual amount”) as a reduction to net patient revenue. Factors that impact our estimate include:

	•		anticipated average length of stay of patients within our programs;

	•		anticipated number and timing of patient admissions;

	•		information regarding assessments related to prior Medicare fiscal years;

	•		anticipated per-beneficiary cap amount for a given year, which amount is generally not established until the second half of Medicare’s fiscal year; and

	•		our success in implementing corrective measures; and

	•		enrollment of beneficiaries in our programs who may have previously elected Medicare hospice coverage through another hospice provider, thus reducing the cap amount for the applicable provider number.

Cap accrual amount estimates are difficult to make and such estimates may change significantly from quarter to quarter. Set forth below are the cap accrual amounts for the periods indicated:


Quarter Ended:	Cap Accrual Amount
March 31, 2003	$	0.4 million
June 30, 2003	$	0.6 million
September 30, 2003	$	0.6 million
December 31, 2003	$	3.1 million
March 31, 2004	$	0.8 million
June 30, 2004	$	6.2 million

The cap accrual amount for the quarter ended June 30, 2004 reflects, in part, the decline in patient admissions over the last several quarters coupled with increasing average patient length of stay. To understand the sensitivity of patient admissions to cap exposure, consider that the admission of 71 patients on September 15 of a given year would yield a cap credit for that year of at least $1 million, even if those patients were not discharged until after October 31, the end of the Medicare fiscal year.

We have recently undertaken a number of actions to increase patient admissions and thereby reduce our cap exposure. Those actions include restructuring our sales management, increasing the size of our sales force, accelerating the development of new programs and seeking shorter length of stay patients by targeting our marketing efforts on hospital referral sources.

Our reserve for Medicare cap liability was $12.9 million at June 30, 2004, as compared to $5.9 million at December 31, 2003. These liability balances included current year and prior year estimates not yet assessed and paid. As of August 1, 2004, we had been assessed a total of $0.4 million in respect of cap liability for the Medicare fiscal year ended October 31, 2003. While we believe that our current reserve for Medicare cap liability is adequate, it is possible that our current reserve is not adequate. We are waiting for assessments from several other locations which comprise a larger portion of our estimated liability.

Estimate of Patient Care Expenses

We are required to make certain significant judgments regarding patient care expenses. In any given financial reporting period we purchase goods and services from a large number of vendors. Many of such purchases involve relatively small amounts individually. Accordingly, we are required to a certain extent to estimate the amount of those expenses. In making such estimates we take into account, among other things, our experience with those expenses as a percentage of net patient revenue given the level of care, the information we actually have available to us from patient care expense logs, and the value of vendor invoices we have received in relation to the time period for which patient care expenses are being determined. Our accrual for patient care expenses was $12.2 million as of June 30, 2004.

Goodwill Impairment

On January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets, which requires that we conduct a review to determine whether the carrying value of the goodwill associated with our acquired businesses exceeds its fair market value. We are required to conduct such a review annually, or more often if events or circumstances arise that indicate the fair market value of such goodwill may have materially declined. Such events or circumstances could include:

	•		significant under-performance of our acquired businesses relative to historical or projected operating results;

	•		significant negative industry trends; or

	•		significant changes in regulations governing hospice reimbursements from Medicare and state Medicaid programs.

To determine the fair market value of our goodwill, we make estimates regarding future cash flows and the potential sale and liquidation values of our acquired businesses.

In the event we determine that the value of our goodwill has become impaired, we are required to write down the value of the goodwill to its fair market value on our balance sheets and to reflect the extent of the impairment as an expense on our statements of operations. We have determined that no impairment of goodwill existed as of June 30, 2004.

Results of Operations

The following table sets forth selected consolidated financial information as a percentage of net patient revenue for the periods indicated:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2004			2003			2004			2003
Net patient revenue		100	%		100	%		100	%		100	%
Operating expenses:
Patient care:
Salaries, benefits and payroll taxes		47.2	%		40.6	%		43.3	%		39.3	%
Pharmaceuticals		5.7	%		6.0	%		5.3	%		6.0	%
Durable medical equipment and supplies		5.8	%		4.6	%		5.2	%		4.6	%
Other (including inpatient arrangements, nursing home costs, net, purchased services and travel)		10.4	%		9.0	%		9.4	%		8.9	%

Total patient care		69.1	%		60.2	%		63.2	%		58.8	%
General and administrative (exclusive of stock-based compensation charges reported below):
Salaries, benefits and payroll taxes		20.7	%		15.5	%		18.7	%		15.4	%
Office leases		2.6	%		2.0	%		2.4	%		2.1	%
Other (including severance, travel, marketing and charitable contributions)		11.2	%		11.1	%		10.1	%		12.6	%

Total general and administrative		34.5	%		28.6	%		31.2	%		30.1	%

Depreciation and amortization		1.9	%		0.8	%		1.8	%		0.8	%
Stock-based compensation		0.2	%		0.2	%		0.2	%		1.3	%
Operating income (loss)		-5.7	%		10.2	%		3.6	%		9.0	%
Non-operating income		0.2	%		0.1	%		0.1	%		0.1	%
Income tax expense (benefit)		-1.9	%		2.0	%		1.8	%		1.6	%
Net income (loss)		-3.6	%		8.3	%		1.9	%		1.9	%
Adjusted EBITDA (deficit)(1)		-3.6	%		11.2	%		5.6	%		11.0	%

(1)

capital requirements. Adjusted EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by operating, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Because adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations, adjusted EBITDA as presented may not be comparable to other similarly titled measures of performance of other companies.

Three and Six Months Ended June 30, 2004, Compared to Three and Six Months Ended June 30, 2003

Net Patient Revenue

Net patient revenue increased $2.0 million, or 4.0%, to $48.1 million for the three months ended June 30, 2004 from $46.1 million for the three months ended June 30, 2003. Net patient revenue increased $13.7 million, or 15.6%, to 101.7 million for the six months ended June 30, 2004 from $88.1 million for the six months ended June 30, 2003. These increases were due to:

•

increases in billable patient days, which increased to 474,631 for the three months ended June 30, 2004 from 415,623 for the three months ended June 30, 2003, and increased to 942,729 for the six months ended June 30, 2004 from 786,876 for the six months ended June 30, 2003, and

•

the 3.4% Medicare reimbursement rate increase effective October 1, 2003,

These increases were offset by increases in the Medicare cap accrual amount to $6.2 million for the three months ended June 30, 2004 from $0.6 million for the three months ended June 30, 2003 and to $7.0 million for the six months ended June 30, 2004 from $1.0 million for the six months ended June 30, 2003.

Net patient revenue per day of care decreased to approximately $102 for the three months ended June 30, 2004 from approximately $111 for the three months ended June 30, 2003. Net patient revenue per day of care decreased to approximately $109 for the six months ended June 30, 2004 from approximately $112 for the six months ended June 30, 2003. These decreases were primarily due to the increase in the Medicare cap accrual in the three months ended June 30, 2004 and a lower mix of general inpatient care patients, partially offset by the October 1, 2003 Medicare reimbursement rate increase.

Our average daily census of patients increased 14.2% to 5,216 for the three months ended June 30, 2004 from 4,569 for the three months ended June 30, 2003. This increase was attributable to an increase in the average length of stay to 114 days for the three months ended June 30, 2004 from 88 days for the three months ended June 30, 2003, partially offset by a decline in patient admissions. We believe that at 114 days our average length of stay is significantly higher than the industry average and is due in part to our relatively high mix of non-cancer patients, by hospice industry standards, though in line with total cancer deaths in the country. Such patients generally have a higher average length of stay than cancer patients.

The table below shows the number of our patient admissions for the periods indicated:


Quarter ending:	Number of Admissions:
March 31, 2003		3,734
June 30, 2003		3,919
September 30, 2003		3,995
December 31, 2003		4,031
March 31, 2004		3,842
June 30, 2004		3,754

The decline in patient admissions in recent quarters has adversely impacted net patient revenue, which decreased 10.1% from $53.5 million for the three months ended March 31, 2004 to $48.1 million for the three months ended June 30, 2004. Net patient revenue decreased 1.8% from $103.6 million for the six months ended December 31, 2003 to $101.7 million for the six months ended June 30, 2004. The decline in patient admissions has been attributable to changes in our program directors, higher than anticipated turnover among our marketing and sales personnel, market saturation by some of our programs in rural areas, and increased competition for patients from other hospice service providers. Such decline also reflects a shift in our marketing priorities in some of our programs impacted by the Medicare per-beneficiary cap. In those programs we have been de-emphasizing community marketing initiatives in favor of developing hospital-based referral sources in an effort to reduce patient length of stays and potential Medicare per-beneficiary cap exposure. Marketing programs focused on hospital-based referral sources typically require more time to generate patient admissions than community marketing efforts.

Patient Care Expenses

As a result of average daily census increase, patient care expenses increased $5.5 million, or 19.9%, to $33.2 million for the three months ended June 30, 2004, from $27.7 million for the three months ended June 30, 2003. Of this increase, $4.1 million was attributable to increased salaries, benefits, payroll taxes and travel costs of hospice care providers, which increased as a result of the hiring of additional nurses, social workers and chaplains to accommodate actual and anticipated patient care growth, increased employee health insurance costs and the annual wage increase for all employees effective April 1, 2004 and new program costs. This increase in patient care expenses was also due to a $0.6 million increase in durable medical equipment expense and a $0.4 million increase in nursing homes costs, net. Patient care expenses increased $12.5 million, or 24.9%, to $64.3 million for the six months ended June 30, 2004 from $51.8 million for the six months ended June 30, 2003. Of this increase, $9.5 million was attributable to increased salaries, benefits, payroll taxes and travel costs of hospice care providers, and the balance was due to an increase in durable medical equipment expense and nursing home costs, net.

As a percentage of net patient revenue, patient care expenses increased to 69.1% for the three months ended June 30, 2004 from 60.2% for the three months ended June 30, 2003 and increased to 63.2% for the six months ended June 30, 2004 from 58.8% for the six months ended June 30, 2003. These increases were primarily due to the increases in salaries, benefits and payroll cost of hospice care providers and, to a lesser extent, the increases in durable medical equipment and supplies expense and nursing homes costs, net. The increase to patient care expenses as a percent of net patient revenue was the result of these expenses, combined with the reduction to net patient revenue due to the Medicare cap accrued.

General and Administrative Expenses (Exclusive of Stock-Based Compensation)

General and administrative expenses increased $3.5 million, or 26.7%, to $16.6 million for the three months ended June 30, 2004 from $13.1 million for the three months ended June 30, 2003. As a percentage of net patient revenue, general and administrative expenses increased to 34.5% for the three months ended June 30, 2004 from 28.1% for the three months ended June 30, 2003.

General and administrative expenses increased $4.7 million, or 17.4%, to $31.7 million for the six months ended June 30, 2004 from $27.0 million for the six months ended June 30, 2003. As a percentage of net patient revenue, general and administrative expenses increased to 31.2% for the six months ended June 30, 2004 from 30.7% for the six months ended June 30, 2003.

Of the increase in general and administrative expenses from the three months ended June 30, 2003 to the three months ended June 30, 2004, $2.5 million was due to an increase in salaries, benefits and payroll taxes associated with our staff not directly involved with patient care, which resulted from the hiring of additional marketing personnel and the 4% employee wage increase effective April 1, 2004. The remainder of the increase was due to increased office leasing costs associated with our new corporate headquarters and new program sites. Of the increase in general and administrative expenses from the six months ended June 30, 2003 to the six months ended June 30, 2004, $4.8 million was due to the increase in salaries, benefits and payroll taxes associated with our staff not directly involved with patient care, with the remainder being primarily due to increased office leasing costs. The increase in general and administrative expenses as a percentage of net patient revenue was the result of these expenses, combined with the reduction to net patient revenue due the Medicare cap accrual.

Depreciation and Amortization

Depreciation and amortization expense increased $0.6 million to $1.0 million for the three months ended June 30, 2004 from $0.4 million for the three months ended June 30, 2003. Depreciation and amortization expense increased $1.2 million to $1.9 million for the six months ended June 30, 2004 from $0.7 million for the six months ended June 30, 2004. The increases were primarily due to the $3.7 million of capitalized software development costs associated with our new billing system which was completed in the fourth quarter of 2003, which we began to amortize in the fourth quarter of 2003.

Stock-Based Compensation

Stock-based compensation expense was approximately $0.1 million for each of the three-month periods ended June 30, 2003 and 2004. Stock-based compensation expense for the six months ended June 30, 2004 was $0.2 million, compared to $1.1 million for the six months ended June 30, 2003. Of the $1.1 million of stock based compensation expense we incurred in the six months ended June 30, 2003, $1.0 million related to the acceleration of vesting of a stock option.

Income Tax

For the three months ended June 30, 2004, we recorded $0.9 million of income tax benefit in connection with our net loss for that period. The amount was comprised of a tax benefit at our estimated 39% effective rate expected for 2004 and $0.3 million relating to additional taxes due in certain states in 2003 based upon a change in our assessment of the amounts due. Our effective rate of 39% differs from the statutory rate due primarily to additional state income taxes net of their federal income tax benefit. For the three month period ended March 31, 2003, income tax expense was $0.4 million, which was below the statutory rate due to the utilization of net operating loss carryforwards and corresponding reduction in the valuation reserve for deferred tax assets.

Liquidity and Capital Resources

Our principal liquidity requirements have been for working capital and capital expenditures. We have financed these requirements primarily with cash flow from operations. In December 2002, we completed our initial public offering of common stock in which we raised net proceeds of $48.1 million. As of June 30, 2004, we had cash and cash equivalents of $66.6 million, working capital of approximately $63.7 million and the ability to borrow an additional $20.0 million under our revolving credit facility described below.

Net cash provided by operating activities for the six months ended June 30, 2004 was $20.2 million, compared to $7.7 million for the six months ended June 30, 2003. This increase resulted from overall profitability, improved collections of patients accounts receivable and an increase in the Medicare cap accrual.

Net cash used in investing activities was $2.1 million for the six months ended June 30, 2004 and related primarily to continued investment in internally developed software and its implementation, as well as the purchase of office equipment for new programs being developed and our headquarter offices.

Net cash provided by financing activities was $1.3 million for the six months ended June 30, 2004 and resulted from the exercise of employee stock options.

We currently maintain a revolving line of credit with Healthcare Business Credit Corporation, or HBCC, under which we may borrow, repay and re-borrow from time to time up to $30 million, based on the amount of our eligible accounts receivable. As of June 30, 2004, there were no borrowings under this facility and there was $20 million available for borrowing.

Advances under the HBCC revolving line of credit bear interest at an annual rate equal to, at our option, either the “prime rate” in effect from time to time, as reported in the “Money Rates” section of the Wall Street Journal, plus 1.5%, or the one-month London Interbank Borrowing Rate in effect from time to time, plus 3.0%. The applicable interest rate increases by 3.5% if there is an event of default. Accrued interest is due and payable weekly on advances under the revolving line of credit bearing interest at the prime rate. Accrued interest on advances bearing interest at the London Interbank Offering Rate is due and payable on the last business day of the month. The maturity date for the revolving line of credit is April 30, 2005. As of June 30, 2004, the effective interest rate for borrowings under this facility was 4.37% per annum.

The HBCC credit facility is collateralized by substantially all of our assets. In addition, our credit agreement with HBCC contains customary covenants including covenants restricting our ability to incur additional indebtedness, permit liens on property or assets, make capital expenditures, make certain investments, pay dividends or make restricted payments, and prepay or redeem debt or amend certain agreements relating to our indebtedness.

Our hospice programs are subject to the annual Medicare per-beneficiary cap. If we are found by Medicare to have exceeded the per-beneficiary cap, Medicare will require that we make restitution for payments made to us in excess of the per-beneficiary cap. We were required to repay Medicare $0.6 million in 2000 and $1.0 million in 2001 for exceeding the per-beneficiary cap. As of August 1, 2004, we had been assessed $0.4 million for one site for exceeding the per-beneficiary cap for the twelve month period that began on November 1, 2002. We maintain a reserve for Medicare cap liability, which at June 30, 2004 totalled $12.9 million. This reserve amount is expected to increase in the future.

We expect that our principal liquidity requirements will be for working capital, the development of new hospice programs, the acquisition of other hospice programs and capital expenditures. We expect that our existing funds, cash flows from operations and borrowing capacity under our credit agreement will be sufficient to fund our principal liquidity requirements for at least the next twelve months. Our future liquidity requirements and the adequacy of our available funds will depend on many factors, including payment for our services, regulatory changes and compliance with new regulations, expense levels, capital expenditures and future development of new hospice programs and acquisitions.

Interest Rate and Foreign Exchange Risk

Interest Rate Risk

We do not expect our cash flow to be affected to any significant degree by a sudden change in market interest rates. We have not implemented a strategy to manage interest rate market risk because we do not believe that our exposure to this risk is material at this time. We invest excess cash balances in money market accounts with average maturities of less than 90 days.

Foreign Exchange

We operate our business within the United States and execute all transactions in U.S. dollars.

Payment, Legislative and Regulatory Changes

We are highly dependent on payments from the Medicare and Medicaid programs. These programs are subject to statutory and regulatory changes, possible retroactive and prospective rate adjustments, administrative rulings, rate freezes and funding reductions. Reductions in amounts paid by these programs for our services or changes in methods or regulations governing payments for our services could materially adversely affect our net patient revenue and profitability.

Inflation

The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. In addition, suppliers pass along rising costs to us in the form of higher prices. We have implemented control measures designed to curb increases in operating expenses. To date, reimbursement rate increases and our increasing patient census have offset increases in operating costs. However, we cannot predict our ability to cover or offset future cost increases.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, (“FIN 46”),Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, which addresses consolidation by business enterprises of variable interest entities (“VIEs”) either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (“Revised Interpretations”) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretations. For VIEs created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after December 15, 2003. Certain disclosures are effective immediately. VIEs created after January 2, 2004 must be accounted for under the Revised Interpretations. We currently have no contractual relationship or other business relationship with a variable interest entity and therefore the adoption of FIN No. 46 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In March 2004, the FASB issued a Proposed StatementShare Based Payments an amendment ofFASB Statements No. 123 and 95on accounting for share-based payments that would eliminate the ability to account for share-based payments using Accounting Standards Board Opinion No. 25,Accounting for Stock Issued to Employees, and require all such transactions to be accounted for using a fair value based method. The Proposed Statement would become effective for awards granted, modified, or settled in years beginning after December 15, 2004 and would require the recognition of compensation expense for any portion of awards granted or modified after December 15, 1994 that are not vested as of the Proposed Statement’s effective date. We have not determined the effect of adopting the Proposed Statement on our consolidated financial position, results of operations or cash flows.

Forward-Looking Statements

This quarterly report on Form 10-Q contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have included important factors in the cautionary statements below under the heading “Factors That May Affect Future Results” that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors That May Affect Future Results

We are dependent on payments from Medicare and Medicaid. Changes in the rates or methods governing these payments for our services could adversely affect our net patient revenue and profitability.

Approximately 97% of our net patient revenue for the six months ended June 30, 2004 consisted of payments from Medicare and Medicaid programs. Because we generally receive fixed payments for our hospice care services based on the level of care provided to our hospice patients, we are at risk for the cost of services provided to our hospice patients. We cannot assure you that Medicare and Medicaid will continue to pay for hospice care in the same manner or in the same amount that they currently do. Reductions in amounts paid by government programs for our services or changes in methods or regulations governing payments, which would likely result in similar changes by private third-party payors, could adversely affect our net patient revenue, profitability and cash flow.

Our profitability may be adversely affected by limitations on Medicare payments.

Medicare payments for hospice services are subject to an annual per-beneficiary cap, which for the twelve months ended October 31, 2003 was $18,661. Compliance with the cap is measured by calculating the annual Medicare payments received under a Medicare provider number with respect to services provided to all Medicare hospice care beneficiaries in the program or programs covered by that provider number between November 1 of each year and October 31 of the following year and comparing the result with the product of the per-beneficiary cap amount and the number of Medicare beneficiaries electing hospice care for the first time from that program or programs during that year. We reflected as a reduction to net patient revenue approximately $7 million in the six-month period ended June 30, 2004 and $1 million in the six-month period ended June 30, 2003, as a result of estimated reimbursements in excess of the per-beneficiary cap in those periods. Our ability to comply with this limitation depends on a number of factors relating to the hospice program or programs under a given Medicare provider number, including the amount and timing of patient admissions, the average length of stay and the mix in level of care. Our profitability, net patient revenue and cash flow may be adversely affected if, in the future, we are unable to comply with this and other Medicare payment limitations.

If our costs were to increase more rapidly than the fixed payment adjustments we receive from Medicare and Medicaid for our hospice services, our profitability could be negatively impacted.

We generally receive fixed payments for our hospice services based on the level of care that we provide to patients and their families. Accordingly, our profitability is largely dependent on our ability to manage costs of providing hospice services and to maintain a patient base with a sufficiently long length of stay to attain profitability. We are susceptible to situations, particularly because of our “open access” philosophy, where we may be referred a disproportionate share of patients requiring more intensive and

therefore more expensive care than other providers. Although Medicare and Medicaid currently provide for an annual adjustment of the various hospice payment rates based on the increase or decrease of the medical care expenditure category of the Consumer Price Index, these hospice care increases have historically been less than actual inflation. If these annual adjustments were eliminated or reduced, or if our costs of providing hospice services, over one-half of which consist of labor costs, increased more than the annual adjustment, our profitability could be negatively impacted. In addition, cost pressures resulting from shorter patient lengths of stay and the use of more expensive forms of palliative care, including drugs and drug delivery systems, could negatively impact our profitability.

We may be adversely affected by governmental decisions regarding our nursing home patients.

For our patients receiving nursing home care under certain state Medicaid programs, the applicable Medicaid program pays us an amount equal to no more than 95% of the Medicaid per diem nursing home rate for “room and board” services furnished to the patient by the nursing home in addition to the applicable Medicare or Medicaid hospice per diem payment.

We, in turn, are generally obligated to pay the nursing home for these room and board services at a rate between 95% and 100% of the full Medicaid per diem nursing home rate. In the past, we have experienced situations where both the Medicaid program and we have paid a nursing home for the same room and board service and the Medicaid program has imposed on us the burden of recovering the amount we previously paid to the nursing home. There can be no assurance these situations will not recur in the future or that if they do, we will be able to fully recover from the nursing home.

In addition, many of our patients residing in nursing homes are eligible for both Medicare and Medicaid benefits. In these cases, the patients’ state Medicaid program pays their nursing home room and board charges and Medicare pays their hospice services benefit. Government audits conducted in the last several years have suggested that the reimbursement levels for these dual-eligible hospice patients as well as for Medicare-only patients living in nursing homes may be excessive. Specifically, the government has expressed concerns that hospice programs may provide fewer services to patients who reside in nursing homes than to patients living in other settings due to the presence of the nursing home’s own staff to address problems that might otherwise be handled by hospice personnel. Because hospice programs are paid a fixed daily amount, regardless of the volume or duration of services provided, the government is concerned that by shifting the responsibility and cost for certain patient care or counseling services to the nursing home, hospice programs may inappropriately increase their profitability. In the case of these dual-eligible patients, the government’s concern is that the cost of providing both the room and board and hospice services may be significantly less than the combined reimbursement paid to the nursing homes and hospice programs as a result of the overlap in services.

From time to time, there have been legislative proposals to reduce or eliminate Medicare reimbursement for hospice patients residing in nursing homes and to require nursing homes to provide end-of-life care, or alternatively to reduce or eliminate the Medicaid reimbursement of room and board services provided to hospice patients. The likelihood of this type of change may be greater when the federal and state governments experience budgetary shortfalls. If any such proposal were adopted, it could significantly affect our ability to obtain referrals from and continue to serve patients residing in nursing homes.

Medical reviews and audits by governmental and private payors could result in material payment recoupments and payment denials, which could negatively impact our business.

Medicare fiscal intermediaries and other payors periodically conduct pre-payment or post-payment medical reviews or other audits of our reimbursement claims. In order to conduct these reviews, the payor requests documentation from us and then reviews that documentation to determine compliance with applicable rules and regulations, including the eligibility of patients to receive hospice benefits, the appropriateness of the care provided to those patients, and the documentation of that care. We cannot

predict whether medical reviews or similar audits by federal or state agencies or commercial payors of our hospice programs’ reimbursement claims will result in material recoupments or denials, which could have a material adverse effect on our financial condition and results of operations.

We have a limited history of profitability and may incur substantial net losses in the future.

Although we recorded net income of $15.2 million for the year ended December 31, 2003, and $2.0 million for the six months ended June 30, 2004, we recorded a $1.8 million loss in the second quarter of 2004 and had an accumulated deficit of $12.4 million at June 30, 2004. We cannot assure you that we will operate profitably in the future. In addition, we may experience significant quarter-to-quarter variations in operating results. We are pursuing a growth strategy focused primarily on same-store growth but also involving the development of new programs and acquisitions. Our growth strategy may involve, among other things, increased marketing expenses, significant cash expenditures, debt incurrence and other expenses that could negatively impact our profitability on a quarterly and an annual basis. Our net patient revenue could be adversely impacted by a number of factors, in particular, reductions in Medicare payment rates, the medicare cap accrual and patient lengths of stay, which may not be within our control.

If we are unable to attract qualified nurses and other healthcare professionals at reasonable costs, it could limit our ability to grow, increase our operating costs and negatively impact our business.

We rely significantly on our ability to attract and retain qualified nurses and other healthcare professionals who possess the skills, experience and licenses necessary to meet the Medicare certification requirements and the requirements of the hospitals, nursing homes and other healthcare facilities with which we work. We compete for qualified nurses and other healthcare professionals with hospitals, nursing homes, other hospices and other healthcare organizations. Currently, there is a shortage of qualified nurses in most areas of the United States. Competition for nursing personnel is increasing, and nurses’ salaries and benefits have risen.

Our ability to attract and retain qualified nurses and other healthcare professionals depends on several factors, including our ability to provide attractive assignments and competitive benefits and wages. We cannot assure you that we will be successful in any of these areas. Because we operate in a fixed reimbursement environment, increases in the wages and benefits that we must provide to attract and retain qualified nurses and other healthcare professionals or increases in our reliance on contract nurses or temporary healthcare professionals could negatively affect our profitability. We may be unable to continue to increase the number of qualified nurses and other healthcare professionals that we recruit, decreasing the potential for growth of our business. Moreover, if we are unable to attract and retain qualified nurses and other healthcare professionals, we may have to limit the number of patients for whom we can provide hospice care to maintain the quality of our hospice services.

We may not be able to attract and retain a sufficient number of volunteers to grow our business or maintain our Medicare certification.

Medicare requires certified hospice programs to recruit and train volunteers to provide patient care services or administrative services. Volunteer services must be provided in an amount equal to at least five percent of the total patient care hours provided by all paid hospice employees and contract staff of a hospice program. If we are unable to attract and retain volunteers, it could limit our potential for growth and our hospice programs could lose their Medicare certifications, which would make those hospice programs ineligible for Medicare reimbursement.

If we fail to cultivate new or maintain established relationships with existing patient referral sources our net patient revenue may decline.

Our success is heavily dependent on referrals from physicians, nursing homes, assisted living facilities, hospitals, managed care companies, insurance companies and other patient referral sources in the

communities that our hospice programs serve. Because we and many of our referral sources are dependent upon Medicare, we are limited in our ability to engage in business practices that are commonplace among referring businesses in other industries such as referral fees, or bonuses and long-term exclusive contracts.

Our growth and profitability depend significantly on our ability to establish and maintain close working relationships with patient referral sources and to increase awareness and acceptance of hospice care by our referral sources and their patients. We cannot assure you that we will be able to maintain our existing referral source relationships or that we will be able to develop and maintain new relationships in existing or new markets. Our loss of existing relationships or our failure to develop new relationships could adversely affect our ability to expand our operations and operate profitably. Moreover, we cannot assure you that awareness or acceptance of hospice care will increase.

Investor confidence and share value may be adversely impacted if there are adverse findings by us or our independent auditors the adequacy of our internal controls over financial reporting as of December 31, 2004, as required by Section 404 of the Sarbanes-Oxley Act of 2002.

The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on the company’s internal controls over financial reporting in its annual reports on Form 10-K that contain an assessment by management of the effectiveness of the company’s internal controls over financial reporting. In addition, the company’s independent auditors must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. This requirement will first apply to our Annual Report on Form 10-K for the fiscal year ending December 31, 2004. Although we intend to diligently and vigorously review our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, if our independent auditors report identify deficiencies with our internal controls over financial reporting or the level at which these controls are documented, designed, operated or reviewed, or if the independent auditors interpret the requirements, rules or regulations differently from us, then they may not agree with management’s assessment. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares.

Our growth strategy may not be successful, which could adversely impact our growth and profitability.

The primary focus of our growth strategy is same-store growth. To achieve this growth, we intend to increase our marketing and other expenditures. If our resources are not deployed effectively and we do not achieve the same-store growth we seek, it could adversely impact our profitability.

Our growth strategy also involves the development of new programs. When we develop new programs, we first engage a small staff and obtain office space, contracts and referral sources. Then we admit a small number of patients and request a Medicare certification survey. Following Medicare certification, we spend significant management and financial resources in an effort to increase patient census of that program. This aspect of our growth strategy may not be successful, which could adversely impact our growth and profitability. In this regard, we cannot assure you that we will be able to:

•		identify markets that meet our selection criteria for new hospice programs;

•		hire and retain a qualified management team to operate each of our new hospice programs;

•		manage a large and geographically diverse group of hospice programs;

•		become Medicare and Medicaid certified in new markets;

•		generate sufficient hospice admissions in new markets to operate profitably in these new markets; or

•		compete effectively with existing hospice programs in new markets.

Competition for acquisition opportunities may restrict our future growth by limiting our ability to make acquisitions at reasonable valuations.

In addition to same-store growth and the development of new programs, our business strategy includes increasing our market share and presence in the hospice care industry through strategic acquisitions of companies that complement or enhance our business. We have historically faced competition for acquisitions. In the future, this could limit our ability to grow by acquisitions or could raise the prices of potential acquisition targets and make them less attractive to us.

Our ability to grow through acquisitions may be limited by increasing government oversight and review of sales of not-for-profit healthcare providers.

Approximately 69% of hospice programs in the United States are not-for-profit programs. Accordingly, it is likely that a substantial number of acquisition opportunities will involve hospice programs operated by not-for-profit entities. In recent years, several states have increased review and oversight of transactions involving the sale of healthcare facilities by not-for-profit entities. Although the

level of oversight varies from state to state, the current trend is to provide for increased governmental review, and in some cases approval, of transactions in which a not-for-profit entity sells a healthcare facility or business to a for profit entity. This increased scrutiny may increase the difficulty of completing or prevent the completion of acquisitions in some states in the future.

As with our past acquisitions, we may face difficulties integrating businesses that we may acquire in the future. Our efforts to acquire other businesses may be unsuccessful, involve significant cash expenditures or expose us to unforeseen liabilities.

Our 1998 acquisitions, which were closed nearly simultaneously and increased our patient census approximately five-fold, presented significant integration difficulties. Due to the size and complexity of these transactions, immediately following the transactions our resources available for integration efforts were limited. In time, as we were able to focus on the integration of the acquired businesses, we spent substantial resources on projects such as:

•		implementing consistent billing and payroll systems across a large number of new programs;

•		instituting standard procedures for ordering pharmaceuticals, medical equipment and supplies; and

•		re-training staff from the acquired businesses to complete properly our standard claim documentation and to conform to our service philosophy and internal compliance procedures.

Our future acquisitions could require that we spend significant resources on some of the same types of projects. In addition, our future acquisitions could present other challenges such as:

•		potential loss of key employees or referral sources of acquired businesses;

•		potential difficulties in obtaining required regulatory approvals; and

•		assumption of liabilities and exposure to unforeseen liabilities of acquired businesses, including liabilities for their failure to comply with healthcare regulations.

Our future acquisitions may also involve significant cash expenditures, debt incurrence and integration expenses that could have a material adverse effect on our financial condition and results of operations. Any acquisition may ultimately have a negative impact on our business and financial condition.

The loss of key senior management personnel could adversely affect our ability to remain competitive.

We believe that the success of our business strategy and our ability to operate profitably depends on the continued employment of our senior management team. If key members of our senior management team become unable or unwilling to continue in their present positions, our business and financial results could be materially adversely affected. In particular, we believe the continued employment of each of Richard R. Slager, the Chairman of our Board of Directors and our Chief Executive Officer, Mark E. Liebner, our Chief Financial Officer, and Carla Davis Hughes, our Chief Operating Officer, is important to our future growth and competitiveness. We have entered into management agreements with Messrs. Slager and Liebner and Ms. Hughes to provide them with incentives to remain employed by us. However, there can be no assurance that any of these individuals will continue to be employed by us.

If any of our hospice programs fail to comply with the Medicare conditions of participation, that hospice program could lose its Medicare certification, thereby adversely affecting our net patient revenue and profitability.

Each of our hospice programs must comply with the extensive conditions of participation to remain certified under Medicare guidelines. If any of our hospice programs fails to meet any of the Medicare conditions of participation, that hospice program may receive a notice of deficiency from a state surveyor designated by Medicare to measure the hospice program’s level of compliance. The notice may require the hospice program to prepare a plan of correction and undertake other steps to ensure future compliance with the conditions of participation. If a hospice program fails to correct the deficiencies or develop an adequate plan of correction, the hospice program may be required to suspend admissions or may have its Medicare or Medicaid provider agreement terminated. In June 2000, the Medicare provider agreement for our Odessa, Texas hospice program was terminated. We cannot assure you that we will not lose our Medicare certification at one or more of our other hospice programs in the future. Any such loss could adversely affect our net patient revenue and profitability as well as our reputation within the hospice care industry.

We may not be able to compete successfully against other hospice care providers, and competitive pressures may limit our ability to maintain or increase our market position and adversely affect our profitability.

Hospice care in the United States is competitive. In many areas in which we maintain hospice programs, we compete with a large number of organizations, including:

•

community-based hospice providers;

•

national and regional companies;

•

hospital-based hospice and palliative care programs;

•

nursing homes; and

•

home health agencies.

Our largest competitors include Vitas Healthcare Corporation, a subsidiary of RotoRooter, Inc., Odyssey Healthcare, Inc., Manor Care, Inc. and SouthernCare Hospice, Inc.

Some of our current and potential competitors have or may obtain significantly greater financial and marketing resources than we have or may obtain. Various healthcare companies have diversified into the hospice market. Relatively few regulatory barriers to entry exist in our local markets. Accordingly, other companies, including hospitals and other healthcare organizations that are not currently providing hospice care, may expand their services to include hospice care. We may encounter increased competition in the future that could negatively impact patient referrals to us, limit our ability to maintain or increase our market position and adversely affect our profitability.

A significant reduction in the carrying value of our goodwill could have a material adverse effect on our profitability.

A substantial portion of our total assets consists of intangible assets, primarily goodwill. Goodwill, net of accumulated amortization, accounted for approximately 15.1% of our total assets as of June 30, 2004. Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets. As a result, we no longer amortize goodwill and indefinite lived intangible assets. Instead, we review them at least annually to determine whether they have become impaired. If they have become impaired, we charge the impairment as an expense in the period in which the impairment occurred. Any event which results in the significant impairment of our goodwill, such as closure of a hospice program or sustained operating losses, could have a material adverse effect on our profitability.

We are dependent on the proper functioning of our information systems to efficiently manage our business.

We are dependent on the proper functioning of our information systems in operating our business. Critical information systems used in daily operations perform billing and accounts receivable functions. Our information systems are vulnerable to fire, storm, flood, power loss, telecommunications failures, physical or software break-ins and similar events. If our information systems fail or are otherwise unavailable, these functions would have to be accomplished manually, which could impact our ability to identify business opportunities quickly, to maintain billing and clinical records reliably, to pay our staff in a timely fashion and to bill for services efficiently.

We may experience difficulties in transitioning to a new billing software system which may result in delays and errors in billing for our services.

We are in the process of replacing our billing software, which we believe to be inadequate to support our growth. During 2003 we began replacing the billing system with our proprietary software running on our CareNation operating platform. The full conversion to the proprietary software will continue throughout 2004. Accurate billing is crucial to reimbursement from third-party payors. If any unforeseen problems emerge in connection with our migration to the new billing software, billing delays and errors may occur, which could significantly increase the time that it takes for us to collect payments from payors and in some cases, our ability to collect at all. Any such increase in collection time or inability to collect could have a material adverse effect on our cash flows or result in a financial loss.

A material write-off of our capitalized software development costs and costs and problems related to the implementation of new software applications could have a material adverse effect on our profitability.

As of June 30, 2004, our capitalized software development costs, net of amortization, was approximately $5.2 million, most of which amount related to the development of CareNation, our proprietary software platform, and related application modules. If one or more of the application modules do not function as anticipated, we may be required to write off a significant amount of capitalized software development costs and we may experience significant disruptions in our operations, all of which could have a material adverse effect on our profitability. In addition, the costs associated with training our employees to use these new applications effectively and errors arising from being unfamiliar with the new applications could have a material adverse effect on our operations and profitability.

We may need to raise additional capital in the future to fund our operations and finance our growth, which may be unavailable or which may result in dilution to our stockholders and restrict our operations.

We may seek to sell additional equity or debt securities or obtain new credit facilities in order to finance our operations, or acquire other businesses, which we may not be able to do on favorable terms or at all. If we are unable to obtain financing, we may be unable to continue with our strategy to increase same-store growth, develop new hospice programs and acquire existing hospice programs. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities or preferred stock, these securities could have rights that are senior to the our common stock and any debt securities could contain covenants that would restrict our and our subsidiaries’ operations.

We operate in a regulated industry and changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce our revenues and profitability.

The healthcare industry is subject to extensive and complex federal and state laws and regulations related to professional licensure, conduct of operations, payment for services and payment for referrals. If

we fail to comply with the laws and regulations that are directly applicable to our business, we could suffer civil and/or criminal penalties, be subject to injunctions or cease and desist orders or become ineligible to receive government program payments.

In recent years, Congress and some state legislatures have introduced an increasing number of proposals to make significant changes in the United States healthcare system. Changes in law and regulatory interpretations could reduce our net patient revenue and profitability. Recently, there have been heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry. There has also been an increase in the filing of actions by private individuals on behalf of the federal government against healthcare companies alleging the filing of false or fraudulent healthcare claims. This heightened enforcement activity increases our potential exposure to damaging lawsuits, investigations and other enforcement actions. Any such action could distract our management and adversely affect our business reputation and profitability.

In the future, different interpretations or enforcement of laws, rules and regulations governing the healthcare industry could subject our current business practices to allegations of impropriety or illegality or could require us to make changes in our operations and personnel and distract our management. If we fail to comply with these extensive laws and government regulations, we could become ineligible to receive government program payments, suffer civil and criminal penalties or be required to make significant changes to our operations. In addition, we could be forced to expend considerable resources responding to an investigation or other enforcement action under these laws or regulations.

Many states have certificate of need laws or other regulatory provisions that may adversely impact our ability to expand into new markets and thereby limit our ability to grow and to increase our net patient revenue.

Many states have enacted certificate of need laws that require prior state approval to open new healthcare facilities or expand services at existing facilities. Currently, fourteen states have certificate of need laws that apply to hospice programs. Those laws require some form of state agency review or approval before a hospice may add new services or undertake significant capital expenditures. In addition, two states in which we do not currently operate, Florida and New York, have additional barriers to entry. Florida places restrictions on the ability of for-profit corporations to own and operate hospices, and New York places restrictions on the corporate ownership of hospices. Accordingly, our ability to operate in Florida and New York and the states with certificate of need laws is restricted. The laws in these states could affect our ability to expand into new markets and to expand our services and facilities in existing markets.

To comply with new laws and regulations regarding the confidentiality of patient medical information, we may be required to expend substantial sums on acquiring and implementing new information systems, which could negatively impact our profitability.

There are currently numerous legislative and regulatory initiatives at both the state and federal levels that address patient privacy concerns. In particular, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, contains provisions that may require us to implement expensive new computer systems and business procedures designed to protect the privacy of each of our hospice patient’s individual health information. Final regulations addressing the security of patient health information were modified and published in final form on February 20, 2003. We must be in compliance with these regulations by April 21, 2005. We have not yet fully evaluated and cannot fully predict the total financial or other impact of these regulations on us. Compliance with these rules could require us to spend substantial sums, which could negatively impact our profitability.

Our net patient revenue and profitability may be constrained by cost containment initiatives undertaken by payors.

Initiatives undertaken by private insurers, managed care companies and federal and state governments to contain healthcare costs may affect the profitability of our hospice programs. We have a number of contractual arrangements with private insurers and managed care companies to provide hospice care for a fixed fee. These payors often attempt to control healthcare costs by contracting with hospices and other healthcare providers to obtain services on a discounted basis. We believe that this trend may continue and may limit payments for healthcare services, including hospice services in the future. In addition, there may be changes made to the Medicare program’s Medicare HMO component, which could result in managed care companies becoming financially responsible for providing hospice care. Currently, Medicare pays for hospice services outside of the Medicare HMO per-member per-month fee so that managed care companies do not absorb the cost of providing these services. If such changes were to occur, a greater percentage of our net patient revenue could come from managed care companies and these companies would be further incentivized to reduce hospice costs. As managed care companies attempt to control hospice-related costs, they could reduce payments to us for hospice services. In addition, states, many of which are operating under significant budgetary pressures, may seek to reduce hospice payments under their Medicaid programs or Medicaid managed care programs may opt not to continue providing hospice coverage. These developments could negatively impact our net patient revenue and profitability.

Professional and general liability claims may have an adverse effect on us either because our insurance coverage may be inadequate to cover the losses or because claims against us, regardless of merit or eventual outcome, may adversely affect our reputation, our ability to obtain patient referrals or our ability to expand our business.

In recent years, participants in the healthcare industry have become subject to an increasing number of lawsuits, including allegations of medical malpractice. Many of these lawsuits involve large claims and substantial defense costs. The medical malpractice claims we have faced relate to our patients in inpatient facilities where we were named as a defendant together with the operator of the inpatient facility.

We maintain general liability insurance coverage on an occurrence basis with limits of $1.0 million per occurrence and $3.0 million in the aggregate. We maintain healthcare professional liability insurance coverage on a claims-made basis with limits of $1.0 million per occurrence and $3.0 million in the aggregate. We also maintain a policy insuring hired and non-owned automobiles with a $1.0 million limit of liability, with a $1.0 million deductible. In addition, we maintain umbrella coverage with a limit of $10.0 million excess over general, healthcare professional liability coverage and hired and non-owned auto insurance. Nevertheless, some risks and liabilities, including claims for punitive damages or claims based on the actions of third parties, may not be covered by insurance. In addition, we cannot assure you that our coverage will be adequate to cover potential losses. While we have generally been able to obtain liability insurance in the past, insurance can be expensive and may not be available in the future on terms acceptable to us, or at all. Moreover, claims, regardless of their merit or eventual outcome, may also adversely affect our reputation, our ability to obtain patient referrals or our ability to expand our business, as well as divert management resources from the operation of our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. We have not entered into derivative or hedging transactions to manage any market risk. We do not believe that our exposure to market risk is material at this time.

Item 4. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures.

Our management, with the participation of our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) evaluated the effectiveness of our disclosure controls and procedures (as defined in

Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of June 30, 2004. In designing and evaluating our 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 their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our CEO and CFO concluded that, as of June 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our CEO and CFO by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities Exchange Commission’s rules and forms.

(b) Changes in Internal Controls.

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

None.


Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.

(a) Modification of Rights of Registered Securities.None.

(b) Limitation of Rights of Registered Securities.None.

(d) Use of Proceeds from Registered Securities.

On December 23, 2002, we completed an initial public offering of shares of our Class A common stock. The shares were registered under the Securities Act of 1933 on a registration statement on Form S-1 (Registration No. 333-98033), which was declared effective by the Securities and Exchange Commission on December 17, 2002. Our net proceeds from the offering were $48.1 million, none of which were used in the quarter ended June 30, 2004.

(e) Repurchases of Securities.

We did not repurchase any of our securities during the quarter ended June 30, 2004.

(f) Restrictions Upon the Payment of Dividends.

We are prohibited under our credit facility from paying any cash dividends if there is a default under the facility or if the payment of any cash dividends would result in default.

Item 3. Defaults Upon Senior Securities.

None


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

We held our annual meeting of stockholders on May 18, 2004. At the annual meeting, the stockholders voted on the following proposals:

To elect two directors of the company to terms expiring in 2007. Each nominee was elected by a vote of the stockholders as follows:


	Affirmative Votes		Votes Withheld
Perry G. Fine, M.D.		14,977,641		40,530
William J. McBride		14,939,285		78,886

In addition, the terms of Messrs. David W. Faeder, Pete A. Klisares, Ronald A. Matricaria and Richard R. Slager and Ms. Geneva Bolton Johnson continued after the meeting.

To ratify the selection of Ernst & Young LLP as the Company’s independent accountant for the year ending December 31, 2004. The proposal was approved by a vote of stockholders as follows:


For			14,822,514
Against			188,060
Abstain			7,597
Broker Non-Vote			0

To approve an amendment and restatement of the VistaCare, Inc. 1998 Stock Option Plan, primarily for the purposes of (i) increasing the number of shares issuable under the plan from 3,200,000 to 4,000,000, (ii) permitting the grant of restricted stock awards in addition to stock options and (iii) expressly providing that re-pricing of outstanding stock options may not be accomplished without stockholder consent. The proposal was approved by a vote of stockholders as follows:


For			6,304,940
Against			2,003,559
Abstain			28,258
Broker Non-Vote			6,681,414

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits:

The exhibits listed in the Exhibit Index immediately preceding such exhibits are filed as part of this report.

(b) Reports onForm 8-K:

On May 11, 2004, we furnished a Current Report on Form 8-K under Item 12 (i) containing a press release dated May 6, 2004 announcing our financial results for the period ended March 31, 2004 and (ii) making reference to certain statements made during a live conference call that we held on May 7, 2004. The press release contained our consolidated balance sheets as of December 31, 2003 and March 31, 2004 and our statements of liabilities and stockholders’ equity, statements of operations and statements of cash flows for the three-month periods ended March 31, 2004, in each case without footnotes.

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.


	VISTACARE, INC.
	By:	/s/ Richard R. Slager
Date: August 9, 2004		Richard R. Slager
		President and Chief Executive Officer (principal executive officer)



	By:	/s/ Mark E. Liebner
Date: August 9, 2004		Mark E. Liebner
		Chief Financial Officer (principal financial officer and chief accounting officer)

EXHIBIT INDEX


Exhibit
Number		Description
10.40		Management Agreement dated May 17, 2004 by and between VistaCare, Inc. and Ronald F. Watson
10.41		Management Agreement dated May 17, 2004 by and between VistaCare, Inc. and Kris Jamsa
31.1		Certification pursuant to Exchange Act Rules 13a-14 and 15d-14 of the Chief Executive Officer
31.2		Certification pursuant to Exchange Act Rules 13a-14 and 15d-14 of the Chief Financial Officer
32.1		Certification pursuant to 18 U.S.C. Section 1350 of the Chief Executive Officer
32.2		Certification pursuant to 18 U.S.C. Section 1350 of the Chief Financial Officer

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Good

Vasta Platform Inactive 10-Q2004 Q2 Quarterly report

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