Note U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005. |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ___________ Commission file number 0-22916 PHC, INC. (Exact name of Registrant as specified in its charter) Massachusetts 04-2601571 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 Lake Street, Suite 102, Peabody MA 01960 (Address of principal executive offices) (Zip Code) 978-536-2777 (Registrant telephone number) _______________________________________________________________________________ Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes___ No X Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes___ No X Number of shares outstanding of each class of common equity, as of October 21, 2005: Class A Common Stock 17,369,201 Class B Common Stock 776,991 -- 1 -- PHC, Inc. PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements (Unaudited). Condensed Consolidated Balance Sheets - September 30, 2005 and June 30, 2005. Condensed Consolidated Statements of Income - Three months ended September 30, 2005 and September 30, 2004. Condensed Consolidated Statements of Cash Flows - Three months ended September 30, 2005 and September 30, 2004. Notes to Condensed Consolidated Financial Statements. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 3. Quantitative and Qualitative Disclosure About Market Risk. Item 4. Controls and Procedures PART II. OTHER INFORMATION Item 6. Exhibits and Reports on form 8-K Signatures -- 2 -- PART I. FINANCIAL INFORMATION Item 1. Financial Statements PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS September 30, June 30, ASSETS 2005 2005 (unaudited) _______________________________________________________________________________ Current assets: Cash and cash equivalents $1,504,697 $ 917,630 Accounts receivable, net of allowance for doubtful accounts of $2,710,835 at September 30, 2005 and $1,956,984 at June 30, 2005 6,228,354 6,265,381 Pharmaceutical receivables 1,576,637 1,414,340 Prepaid expenses and other current assets 612,888 146,988 Other receivables and advances 361,210 638,654 Deferred income tax assets 1,375,800 1,375,800 ___________ ___________ Total current assets 11,659,586 10,758,793 ___________ ___________ Accounts receivable, non-current 55,000 65,000 Other receivables 81,835 84,422 Property and equipment, net 1,803,166 1,516,114 Deferred financing costs, net of amortization of $80,917 at September 30, 2005 and $62,507 at June 30, 2005 127,528 145,938 Customer relationships, net of amortization of $170,000 at September 30, 2005 and $140,000 at June 30, 2005 2,230,000 2,260,000 Goodwill 2,648,209 2,648,209 Other assets 446,171 417,172 ___________ ___________ Total assets $19,051,495 $17,895,648 ___________ ___________ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 2,189,746 $ 907,569 Current maturities of long-term debt 806,053 769,599 Revolving credit note 2,573,707 2,385,629 Deferred revenue 124,635 85,061 Current portion of obligations under capital leases 18,877 29,777 Accrued payroll, payroll taxes and benefits 1,358,365 1,411,653 Accrued expenses and other liabilities 435,456 1,063,189 ___________ ___________ Total current liabilities 7,506,839 6,652,477 Long-term debt, net of current maturities 1,712,365 1,900,022 Obligations under capital leases, net of current maturities 9,757 12,210 Deferred tax liabilities 229,000 229,000 ___________ ___________ Total liabilities 9,457,961 8,793,709 ___________ ___________ Stockholders' equity: Preferred Stock, 1,000,000 shares authorized, none issued or outstanding -- -- Class A common stock, $.01 par value, 30,000,000 shares authorized, 17,552,799 and 17,490,818 shares issued at September 30, 2005 and June 30, respectively 175,527 174,908 Class B common stock, $.01 par value, 2,000,000 shares authorized, 776,991 issued and outstanding September 30 and June 30, 2005 each convertible into one share of Class A common stock 7,770 7,770 Additional paid-in capital 23,502,361 23,377,059 Treasury stock, 191,098 shares and 181,738 shares of Class A common stock at September 30, 2005 and June 30, 2005 respectively, at cost (173,620) (155,087) Accumulated deficit (13,918,504) (14,302,711) ___________ ___________ Total stockholders' equity 9,593,534 9,101,939 ___________ ___________ Total liabilities and stockholders' equity $19,051,495 $17,895,648 ___________ ___________ See Notes to Condensed Consolidated Financial Statements -- 3 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) Three Months Ended September 30, 2005 2004 ___________ __________ Revenues: Patient care, net $ 6,712,980 $ 6,209,499 Pharmaceutical studies 1,306,009 1,086,590 Contract support services 925,837 661,426 ___________ __________ Total revenues 8,944,826 7,957,515 ___________ __________ Operating expenses: Patient care expenses 3,261,911 3,040,982 Patient care expenses, pharmaceutical 563,154 389,963 Cost of contract support services 597,795 516,909 Provision for doubtful accounts 656,887 254,109 Administrative expenses 2,629,676 2,179,661 Administrative expenses, pharmaceutical 633,999 691,056 ___________ __________ Total operating expenses 8,343,422 7,072,680 ___________ __________ Income from operations 601,404 884,835 ___________ ___________ Other income (expense): Interest income 22,864 17,039 Other income 10,785 12,809 Interest expense (155,218) (113,055) ___________ ___________ Total other expenses, net (121,569) (83,207) ___________ ___________ Income before provision for taxes 479,835 801,628 Provision for income taxes 95,628 26,000 ___________ ___________ Net income applicable to common shareholders $ 384,207 $ 775,628 =========== =========== Basic net income per common share $ 0.02 $ .04 =========== =========== Basic weighted average number of shares outstanding 18,099,342 17,360,604 =========== ========== Fully diluted net income per common share $ .02 $ .04 =========== ========== Fully diluted weighted average number of shares outstanding 19,270,164 18,155,364 =========== ========== See Notes to Condensed Consolidated Financial Statements. -- 4 -- PHC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the Three Months September 30, 2005 2004 ___________ ____________ Cash flows from operating activities: Net income $ 384,207 $ 775,628 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 135,976 99,025 Non-cash interest expense 13,932 -- Non-cash stock-based compensation 75,497 6,926 Deferred tax asset -- (94,600) Changes in operating assets and liabilities: Accounts receivable 164,761 (1,010,959) Prepaid expenses and other current assets (465,900) (365,832) Other assets (33,769) (18,015) Accounts payable 1,282,177 355,976 Accrued expenses and other liabilities (641,447) 117,018 ___________ ____________ Net cash provided by (used in) operating activities 915,434 (134,831) ___________ ____________ Cash flows from investing activities: Acquisition of property and equipment (369,848) (254,804) Costs related to business acquisition -- (18,853) ___________ ____________ Net cash used in investing activities (369,848) (273,657) ___________ ____________ Cash flows from financing activities: Revolving debt, net 188,078 237,678 Long-term debt, net (178,488) (204,772) Deferred financing costs -- (60,000) Proceeds from issuance of common stock, net 50,424 11,600 Purchase of treasury stock (18,533) (13,880) ___________ ___________ Net cash provided by (used in) financing activities 41,481 (29,374) ___________ ____________ Net increase (decrease) in cash and cash equivalents 587,067 (437,864) Beginning cash and cash equivalents 917,630 594,823 ___________ ____________ Ending cash and cash equivalents $1,504,697 $ 156,959 ___________ ____________ SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 155,218 $ 104,927 Income taxes 108,300 77,500 See Notes to Condensed Consolidated Financial Statements. -- 5 -- PHC, INC. and Subsidiaries Notes to Condensed Consolidated Financial Statements September 30, 2005 Note A - The Company PHC, Inc. (the "Company") is a national health care company, which operates subsidiaries specializing in behavioral health services including the treatment of substance abuse, which includes alcohol and drug dependency and related disorders and the provision of psychiatric services. The Company also conducts pharmaceutical research studies, operates help lines for employee assistance programs, call centers for state and local programs and provides management, administrative and online behavioral health services. The Company primarily operates under four business segments: Behavioral health treatment services, including two substance abuse treatment facilities: Highland Ridge Hospital, located in Salt Lake City, Utah, which also treats psychiatric patients, and Mount Regis Center, located in Salem, Virginia, and seven psychiatric treatment locations which include Harbor Oaks Hospital, a 64-bed psychiatric hospital located in New Baltimore, Michigan, Detroit Behavioral Institute, a 30-bed psychiatric hospital (increased to 50 beds October 2005) dedicated to adjudicated juveniles located in Detroit, Michigan and six outpatient behavioral health locations (one in New Baltimore, Michigan operating in conjunction with Harbor Oaks Hospital, two in Las Vegas, Nevada operating as Harmony Healthcare and three locations operating as Pioneer Counseling Center in the Detroit, Michigan metropolitan area); Pharmaceutical study services, including four clinical study sites: two in Arizona, in Peoria and Mesa, one in Royal Oak, Michigan and one in Midvale, Utah. These research sites conduct studies of the effects of specified pharmaceuticals on a controlled population through contracts with major manufacturers of the pharmaceuticals. All of the Company's research sites operate as Pivotal Research Centers; Call center and help line services (contract services), including two call centers: one operating in Midvale, Utah and one in Detroit, Michigan. The Company provides help line services through contracts with major railroads and a call center contract with Wayne County, Michigan. The call centers both operate as Wellplace; and Behavioral health administrative services, including delivery of management and administrative and online services. The parent company provides management and administrative services for all of its subsidiaries and online services for its behavioral health treatment subsidiaries and its call center subsidiaries. It also provides behavioral health information through its website Wellplace.com. Note B - Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending June 30, 2006. The accompanying financial statements should be read in conjunction with the June 30, 2005 consolidated financial statements and footnotes thereto included in the Company's 10-K filed on September 28, 2005. -- 6 -- Note C- Stock Based Compensation The Company issues stock options to its employees and directors and provides employees the right to purchase stock pursuant to stockholder approved stock option and stock purchase plans. Effective July 1, 2005, the Company adopted the provisions of SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS No. 123R), using the Statement's modified prospective application method. Prior to July 1, 2005, the Company followed Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its stock compensation. Under the provisions of SFAS No. 123R, the Company recognizes the fair value of stock compensation in net income, over the requisite service period of the individual grantees, which generally equals the vesting period. All of the Company's stock compensation is accounted for as an equity instrument and there have been no liability awards granted. At June 30, 2005, the Company accelerated the vesting on all previously granted options. Therefore, as of the date of adoption there is no unrecognized expense of these options and the expense recorded in the quarter ended September 30, 2005 is for options issued and vested during that period. The unrecognized expense of awards not yet vested will be recognized in net income in the periods in which they vest. Under the provisions of SFAS 123R, the Company recorded $75,497 of stock-based compensation on its consolidated condensed statement o operations for the three months ended September 30, 2005, included in the following expense categories: Three Months Ended September 30, 2005 __________________ Professional fees $ 5,640 Employee compensation 69,837 ________ Total $75,497 The Company utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted after the adoption of SFAS 123R. The weighted-average fair values of the options granted under the stock option plans for the three months ended September 30, 2005 was $1.21, using the following: Three Months Ended September 30, 2005 __________________ Average risk-free interest rate 4.5% Expected dividend yield None Expected life 5 years Expected volatility 45% The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of our common stock over the period commensurate with the expected life of the options. The risk-free interest rate is the U.S. Treasury rate on the date of grant. The expected life was calculated using the Company's historical experience for the expected term of the option. Based on the Company's historical voluntary turnover rates for individual in the positions who received options in the period, there was no forfeiture rate assessed. It is assumed these options will remain outstanding for the full term of issue. Under the true-up provisions of SFAS 123R, a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated. SFAS 123R requires the presentation of pro forma information for the comparative period prior to the adoption as if all of the Company's employee stock options had been accounted for under the fair value method of the original SFAS 123. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation to the prior-year period. Three Months Ended September 30, 2004 __________________ Net income, as reported $ 775,628 Less: Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (28,025) Pro forma net income (loss) $ 747,603 Earnings (loss) per share: Basic - as reported $ 0.04 Basic - pro forma $ 0.04 Diluted - as reported $ 0.04 Diluted - pro forma $ 0.04 During the three months ended September 30, 2004, the weighted-average fair value of the options granted under the stock option plans was $0.51, using the following: Three Months Ended September 30, 2005 __________________ Average risk-free interest rate 4.0% Expected dividend yield None Expected life 5 years Expected volatility 45% Note D - Business Segment Information The Company's behavioral health treatment services have similar economic characteristics, services, patients and clients. Accordingly, all behavioral health treatment services are reported on an aggregate basis under one segment. The Company's segments are more fully described in Note A above. Residual income and expenses from closed facilities are included in the administrative services segment. The following summarizes the Company's segment data: Pharmaceutical Treatment Study Contract Administrative Services Services Services Services Eliminations Total __________________________________________________________________ For the three months ended September 30, 2005 Revenue-external customers $6,712,980 $1,306,009 $925,837 $ -- $ -- $ 8,944,826 Revenues - intersegment 2,750 -- -- 816,000 (818,750) -- Net income (loss) 684,935 92,828 336,500 (730,056) -- 384,207 -- 7 -- Total assets 10,398,368 5,748,511 411,728 2,492,888 -- 19,051,495 Capital expenditures 333,348 15,495 6,170 14,835 -- 369,848 Depreciation & amortization 86,503 39,863 2,304 7,306 -- 135,976 Goodwill 969,099 1,679,110 -- -- -- 2,648,209 Interest expense 119,479 16,028 -- 19,711 -- 155,218 Income tax expense (benefit) 81,071 -- 14,557 -- -- 95,628 Note D - Business Segment Information (continued) Pharmaceutical Treatment Study Contract Administrative Services Services Services Services Eliminations Total __________________________________________________________________ For the three months ended September 30, 2004 Revenue-external customers $6,209,499 $1,086,590 $661,426 $ -- $ -- $7,957,515 Revenues - intersegment -- -- 11,282 654,000 (665,282) -- Net income (loss) 1,280,646 60,257 138,517 (703,792) -- 775,628 Capital expenditures 211,342 3,895 1,042 38,525 -- 254,804 Depreciation & amortization 41,622 34,862 897 21,644 -- 99,025 Interest expense 93,764 2,314 -- 16,977 -- 113,055 Income tax expense (benefit) 20,000 -- 6,000 -- -- 26,000 For the period ended June 30, 2005 Total Assets 9,333,260 5,596,917 669,229 2,296,242 -- 17,895,648 Goodwill 969,099 1,679,110 -- -- -- 2,648,209 Note E - Debt covenants For the quarter ended September 30, 2005, the Company was not in compliance with its long term debt covenants primarily due to the software failure at the Harbor Oaks facility, which delayed billing and postponed collection effort while the system was being recovered. CapitalSource, the compamny's lender has provided the Company with a waiver of these covenants for the period. Note F - Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123 (R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro-forma disclosure is no longer an alternative. The Company implemented SFAS No. 123 (R) on July 1, 2005. As a result of it's implementation the Company expensed $69,837 in compensation cost based on the Black-Scholes value of the 230,000 options issued this quarter. In May 2005 the FASB issued SFAS No 154 "Accounting Changes and Error Corrections" which replaces APB Opinion No. 20 "Accounting Changes" and FASB Statement No. 3 "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements from the accounting for a reporting of a change in accouting principle. SFAS No. 154 requires retrospective application to prior periods financial statements of changes in accounting principle, unless it is impracticable to determinme either the period specific effects or the cumulative effect of the change. SFAS No. 154 shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date of SFAS No. 154 was issued. At the present time, we do not believe the adoptions of SFAS 154 will have a material effect on our financial position, results of operations or cash flows. -- 8 -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. In addition to historical information, this report contains statements relating to future events or our future results. These statements are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933,as amended, and Section 21E of the Securities Act of 1934, as amended (the "Exchange Act") and are subject to the Safe Harbor provisions created by the statute. Generally words such as "may", "will", "should", "could", "anticipate", "expect", "intend", "estimate", "plan", "continue", and "believe" or the negative of or other variation on these and other similar expressions identify forward-looking statements. These forward-looking statements are made only as of the date of this report. We do not undertake to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements are based on current expectations and involve risks and uncertainties and our future results could differ significantly from those expressed or implied by our forward-looking statements. Overview The Company presently provides behavioral health care services through two substance abuse treatment centers, two psychiatric hospitals and five outpatient psychiatric centers (collectively called "treatment facilities"). The Company's revenue for providing behavioral health services through these facilities is derived from contracts with managed care companies, Medicare, Medicaid, state agencies, railroads, gaming industry corporations and individual clients. The profitability of the Company is largely dependent on the level of patient census and the payor mix at these treatment facilities. Patient census is measured by the number of days a client remains overnight at an inpatient facility or the number of visits or encounters with clients at outpatient clinics. Payor mix is determined by the source of payment to be received for each client being provided billable services. The Company's administrative expenses do not vary greatly as a percentage of total revenue but the percentage tends to decrease slightly as revenue increases. Although the Company has changed the focus and reduced expenses of its internet operation, Behavioral Health Online, Inc. continues to provide behavioral health information through its web site at Wellplace.com but its primary function is technology and internet support for the Company's other subsidiaries and their contracts. As such, the expenses related to Behavioral Health Online, Inc. are included as corporate expenses. The Company's research division, Pivotal Research Centers, Inc., contracts with major manufacturers of pharmaceuticals to assist in the study of the effects of certain pharmaceuticals in the treatment of specific illness through its clinics in Arizona, Michigan and Utah. The healthcare industry is subject to extensive federal, state and local regulation governing, among other things, licensure and certification, conduct of operations, audit and retroactive adjustment of prior government billings and reimbursement. The extent of any future regulatory changes and their impact on the Company's business is unknown. The current administration has put forth proposals to mandate equality in the benefits available to those individuals suffering from mental illness (The Parity Act). If passed, this legislation will improve access to and reimbursement for the Company's programs. Managed care has had a profound impact on the Company's operations, in the form of shorter lengths of stay, extensive certification of benefits requirements and, in some cases, reduced payment for services. As part of the Government Medicare Program, reimbursement rates for behavioral health care have increased. When fully implemented, this increase may have a positive impact on performance at the Company's one Medicare facility, Harbor Oaks Hospital. The Company is exploring the possibility of becoming a Medicare provider at its other in-patient facilities. -- 9 -- Critical Accounting Policies The preparation of our financial statements in accordance with accounting principles generally accepted in the United States of America, requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, we evaluate our estimates and assumptions, including but not limited to those related to revenue recognition, accounts receivable reserves, income tax valuation allowances, and the impairment of goodwill and other intangible assets. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Revenue recognition and accounts receivable: Patient care revenues and accounts receivable are recorded at established billing rates or at the amount realizable under agreements with third-party payors, including Medicaid and Medicare. Revenues under third-party payor agreements are subject to examination and contractual adjustment, and amounts realizable may change due to periodic changes in the regulatory environment. Provisions for estimated third party payor settlements are provided in the period the related services are rendered. Differences between the amounts provided and subsequent settlements are recorded in operations in the year of settlement. Any amounts due as a result of cost report settlements are recorded and listed separately on the consolidated balance sheets as "Other receivables, third party". The provision for contractual allowances is deducted directly from revenue and the net revenue amount is recorded as accounts receivable. The allowance for doubtful accounts does not include the contractual allowances. The Company currently has one "at-risk" contract. The contract calls for the Company to provide for all of the inpatient and outpatient behavioral health needs of the insurance carrier's enrollees in Nevada for a fixed monthly fee per member per month. Revenues are recorded monthly based on this formula and the expenses related to providing the services under this contract are recorded as incurred. The Company provides most of the outpatient care directly and, through utilization review, monitors closely, and pre-approves all inpatient and outpatient services not provided directly. The contract is considered "at-risk" because the payments to third-party providers for services rendered could equal or exceed the total amount of the revenue recorded. Pharmaceutical study revenue is recognized only after a pharmaceutical study contract has been awarded and the patient has been selected and accepted based on study criteria and billable units of service are provided. Where a contract requires completion of the study by the patient, no revenue is recognized until the patient completes the study program. Contract support service revenue is a result of fixed fee contracts to provide telephone support. Revenue for these services is recognized ratably over the service period. All revenues reported by the Company are shown net of estimated allowances and charity care provided. When payment is made, if the contractual adjustment is found to have been understated or overstated, appropriate adjustments are made in the period the payment is received in accordance with the AICPA "Audit and Accounting Guide for Health Care Organizations." Allowance for doubtful accounts: The provision for bad debts is calculated based on a percentage of each aged accounts receivable category beginning at 0-5% on current accounts and increasing incrementally for each additional 30 days the account remains outstanding until the account is over 360 days outstanding, at which time the provision is 80-100% of the outstanding balance. These percentages vary by facility based on each facility's experience in and expectations for collecting older receivables. The Company compares this required reserve amount to the current "allowance for doubtful accounts" to determine the required bad debt expense for the period. This method of determining the required "Allowance for doubtful accounts" has historically resulted in an allowance for doubtful accounts of 20% or greater of the total outstanding receivables balance. -- 10 -- Income Taxes: The Company follows the liability method of accounting for income taxes, as set forth in SFAS No. 109, "Accounting for Income Taxes". SFAS No. 109 prescribes an asset and liability approach, which requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of the assets and liabilities. The Company's policy is to record a valuation allowance against deferred tax assets unless it is more likely than not that such assets will be realized in future periods. The Company considers estimated future taxable income or loss and other available evidence when assessing the need for its deferred tax valuation allowance. During the fiscal year ended June 30, 2005, the Company recognized a tax benefit of approximately $209,000, related to a decrease in its valuation allowance, based on budgeted taxable income for the next fiscal year. The Company's policy is to recognize tax benefit for only the next fiscal year based on the uncertainties surrounding the healthcare industry. Valuation of Goodwill and Other Intangible Assets Goodwill and other intangible assets are initially created as a result of business combinations or acquisitions. The values the Company records for goodwill and other intangible assets represent fair values calculated by independent third-party appraisers. Such valuations require the Company to provide significant estimates and assumptions, which are derived from information obtained from the management of the acquired businesses and the Company's business plans for the acquired businesses. Critical estimates and assumptions used in the initial valuation of goodwill and other intangible assets include, but are not limited to: (i) future expected cash flows from services to be provided, customer contracts and relationships, and (ii) the acquired market position. These estimates and assumptions may be incomplete or inaccurate because unanticipated events and circumstances may occur. If estimates and assumptions used to initially value goodwill and intangible assets prove to be inaccurate, ongoing reviews of the carrying values of such goodwill and intangible assets may indicate impairment which will require the Company to record an impairment charge in the period in which the Company identifies the impairment. The Company uses an outside valuation expert to assess the value of intangibles annually and will continue to do so unless circumstances require an earlier evaluation. Results of Operations The following table sets forth for the periods indicated, our operating results (dollars in thousands): Selected Statements of Income Data: For the three month period ended September 30, 2005 2004 Amount % Amount % _______________________________________________ Revenue $8,945 100.0% 7,958 100.0% Cost and Expenses: Patient care expenses 3,825 42.8% 3,431 43.1% Contract expenses 598 6.7% 517 6.5% Administrative expenses 3,264 36.5% 2,871 36.1% Provision for bad debts 657 7.3% 254 3.2% Interest expense 155 1.7% 113 1.4% Other (income) expenses, net (33) (0.4%) (30) (0.4%) Total Expenses 8,466 94.6% 7,156 89.9% Income before provision for taxes 479 5.4% 802 10.1% Provision for income taxes 96 1.1% 26 .3% Net Income 384 4.3% 776 9.8% -- 11 -- Total net revenue from operations increased 12.4% to $8,944,826 for the three months ended September 30, 2005 from $7,957,515 for the three months ended September 30, 2004. Net patient care revenue increased 8.1% to $6,712,980 for the three months ended September 30, 2005 from $6,209,499 for the three months ended September 30, 2004. This increase in revenue is due primarily to the addition of the 30 adjudicated juvenile beds at Detroit Behavioral Institute which helped to create a 16.0% increase in patient days for the three months ended September 30, 2005 over the same period last year. Without Detroit Behavioral Institute, combined census in our other inpatient facilities would have decreased 5.5% largely due to the economy and increased competition for a more limited number of patients. Renewed marketing efforts have helped increase census in these facilities in the current quarter. Two key indicators of profitability of inpatient facilities are patient days, or census, and payor mix. Patient days is the product of the number of patients times length of stay. Increases in the number of patient days result in higher census, which coupled with a more favorable payor mix (more patients with higher paying insurance contracts or paying privately) will usually result in higher profitability. Therefore, patient census and payor mix are monitored very closely. Revenue from pharmaceutical studies increased 20.2% to $1,306,009 for the three months ended September 30, 2005 from $1,086,590 for the three months ended September 30, 2004. This increase is due to an increased number of studies and higher revenues produced by our Michigan site. Revenues from pharmaceutical studies vary greatly from period to period based on the number of active studies and available qualified participants for each active study. Contract support services revenue provided by Wellplace increased 40.0% to $925,837 for the three months ended September 30, 2005 from $661,426 for the three months ended September 30, 2004. This increase in revenue is due to the October 2004 increase in the Michigan call center contract, which increased the monthly revenue on this contract from $157,000 to $240,000 per month. Patient care expenses in our treatment centers increased 7.3% to $3,261,911 for the three months ended September 30, 2005 from $3,040,982 for the three months ended September 30, 2004. This increase in expenses is due primarily to the increased in patient days noted above with the majority of the increases in expenses directly related to patient census such as payroll, food and pharmacy. Lower census in some facilities tends to result in a higher acuity requiring a higher staffing ratio and higher pharmacy costs. Patient care expenses related to our research division increased 44.4% to $563,154 for the three months ended September 30, 2005 from $389,963 for the three months ended September 30, 2004. This is due to the increased number of study patients receiving stipends for participation in studies. Contract support services expenses increased 15.6% to $597,795 for the three months ended September 30, 2005 from $516,909 for the three months ended September 30, 2004. This increase was a result of the increase in the Michigan call center contract which required increased staff and improved technology to adequately support the services required by the contract. This resulted in increased payroll, rent, telephone and depreciation on new equipment. Administrative expenses increased 20.6% to $2,629,676 for the quarter ended September 30, 2005 from $2,179,661 for the quarter ended September 30, 2004. These changes are a result of the increased administrative payroll and employee benefits related to the set up and opening of Detroit Behavioral Institute. Administrative payroll increased 20.2% and employee benefits increased 42.6%. Fees and Licenses increased 840.8% or $74,657 due to fees related to the JACAHO accreditation at Harbor Oaks and Highland Ridge, the Quality Assurance fee assessed in Michigan and increased consultant fees related to an accounts receivable software failure at Harbor Oaks. The software was replaced and the system brought up to date during the month of October, which resulted in additional costs during the current quarter of approximately $15,000. Insurance expense increased 21.4% for the quarter ended September 30, 2005. Utilities increased approximately 14.4% for the quarter ended September 30, 2005. -- 12 -- Administrative expenses related to the research division decreased 8.3% to $633,999 for the three months ended September 30, 2005 from $691,056 for the three months ended September 30, 2004. This decrease is primarily due to the reduction in salaries expenses related to the elimination of the Nevada location and the reduction in the accrued bonuses. Provision for doubtful accounts increased 158.5% to $656,887 for the three months ended September 30, 2005 from $254,109 for the three months ended September 30, 2004. The Company's policy is to maintain reserves based on the age of its receivables. The increase in the provision for doubtful accounts is largely attributable to the accounts receivable software failure at Harbor Oaks, which is our largest in-patient facility. The software conversion required by the crash slowed the billing process and diverted staff attention from collections, while we reentered the receivables into the new software. This delay in the billing and collection process increased the amount and age of the Company's receivables therefore, increasing the reserves required by formula and the provision for doubtful accounts. The systems are now fully restored and we expect the reserve requirement will decrease in future quarters as collection activity returns to normal. The environment the Company operates in today makes collection of receivables, particularly older receivables, more difficult than in previous years. Accordingly, the Company has increased staff, standardized some procedures for collecting receivables and instituted a more aggressive collection policy. During the current quarter, the previously mentioned receivables software and hardware failure at our largest facility resulted in a delay of billing and collections while the systems were restored. Largely as a result of this delay and increased revenue, the Company's gross accounts receivable from patient care have increased 8.5% over the past three months with equivalent increases in aging. Interest income increased 34.2% to $22,864 for the three months ended September 30, 2005 from $17,039 for the three months ended September 30, 2004. This is a result of a change in the Company's policy, which now charges finance charges when extending credit to patients. Although patients requiring credit to pay for services have always signed an agreement to pay finance charges, the Company recently implemented the policy to charge for credit to discourage long term credit for services. Other income decreased 15.8% to $10,785 for the three months ended September 30, 2005 from $12,809 for the three months ended September 30, 2004. This change is due to a reduced number of requests for medical records which makes up the majority of other income. Interest expense and financing costs increased 37.3% to $155,218 for the three months ended September 30, 2005 from $113,055 for the three months ended September 30, 2004. This increase is due to the interest on Note A of the Pivotal acquisition and financing costs related to the recent refinancing of the Company's long-term debt and receivables financing. The Company's provision for income taxes of $95,628 for the three months ended September 30, 2005 is significantly below the Federal statutory rate of 34% primarily due to the availability of net operating loss carry-forwards. Total income tax expense for the period represents state income taxes for certain subsidiaries with no available net operating loss carry-forwards. The Company has provided a significant valuation allowance against its deferred tax asset based on the volitily of the healthcare industry. Liquidity and Capital Resources The Company's net cash provided by operating activities was $915,434 for the three months ended September 30, 2005 compared to $134,833 of cash used in operations for the three months ended September 30, 2004. Cash flow provided by operations in the three months ended September 30, 2005 consists of net income -- 13 -- of $384,207 plus depreciation and amortization of $135,976, non-cash interest expense $13,932, non-cash equity based charges of $75,497 and an increase in accounts payable and other liabilities of $640,730 less cash used for net changes in accounts receivable and other operating assets of $334,908. Cash used in investing activities in the three months ended September 30, 2005 consisted of $369,848 in capital expenditures compared to $254,804 in capital expenditures during the same period last year and costs related to a business acquisition of $18,853. Cash provided by financing activities of $41,481 in the three months ended September 30, 2005 was from the result of the issuance of common stock for the exercise of options and warrants and an increase in the borrowings on the revolving credit facility offset by required reductions in long term debt and the purchase of treasury shares. A significant factor in the liquidity and cash flow of the Company is the timely collection of its accounts receivable. As of September 30, 2005, accounts receivable from patient care, net of allowance for doubtful accounts, decreased less than one percent to $6,283,354 on September 30, 2005 from $6,330,381 on June 30, 2005. This decrease is a result in a 38.5% increase in our allowance for doubtful accounts. This relates to the previously mentioned system failure at our largest facility, which delayed billing and collections for several months. New systems are in place at this time and we expect increased collections on the recent billings to reduce the allowance considerably in future months. The Company monitors increases in accounts receivable closely and, based on the aging of the receivables outstanding is confident that the increase is not indicative of a payor problem. Over the years, we have increased staff, standardization of some procedures for determining insurance eligibility and collecting receivables and established a more aggressive collection policy. The increased staff has allowed the Company to concentrate on current accounts receivable and resolve any issues before they become uncollectible. The Company's collection policy calls for earlier contact with insurance carriers with regard to payment, use of fax and registered mail to follow-up or resubmit claims and earlier employment of collection agencies to assist in the collection process. Our collectors will also seek assistance through every legal means, including the State Insurance Commissioner's office, when appropriate, to collect claims. At the same time, the Company continues to closely monitor reserves for bad debt based on potential insurance denials and past difficulty in collections. Contractual Obligations The Company's future minimum payments under contractual obligations related to capital leases, operating leases and term notes as of June 30, 2005 are as follows: Year Ending Term Capital Operating June 30 Notes Leases Leases Total _______________________________________________________________________________ 2006 $ 769,599 $29,777 $1,299,529 $2,098,905 2007 808,817 10,087 1,033,996 1,852,900 2008 517,797 2,123 919,895 1,439,815 2009 207,099 -- 861,110 1,068,209 2010 212,609 -- 388,467 601,076 Thereafter 153,699 -- 94,730 248,429 _________ ________ __________ __________ Total minimum payments $2,669,620 $41,987 $4,597,727 $7,309,334 -- 14 -- In addition to the above, the Company is also subject to three contingent notes with a total face value of $2,500,000 as part of the Pivotal acquisition. Of these notes, two totaling $1,500,000, one for $1,000,000 and one for $500,000, bear interest at 6% per annum. These notes are subject to additional adjustment based on the earnings of the acquired operations. Since adjustment can be positive or negative based on earnings, with no ceiling or floor, the liability for only one of these notes was recorded as of September 30, 2005. This treatment is in accordance with SFAS No. 141, "Business Combinations", which states that contingent consideration should be recognized only when determinable beyond a reasonable doubt. Payments on the $1,000,000 note began on January 1, 2005. The above table includes the outstanding balance on this note of $1,068,510 which represents the earn out for the Pivotal acquisition through December 31, 2004 net of payments made through June 30, 2005. No payment is due on the $500,000 note as earn-out requirements have not been attained. The final note for $1,000,000 does not bear interest, is also subject to adjustment based on earnings but has a minimum value of $200,000 to be paid in PHC, Inc. Class A common stock on March 31, 2009. This minimum liability has been recorded with imputed interest of 6% and $159,793 is included in the schedule above. In October 2004, the Company entered into a revolving credit, term loan and security agreement with CapitalSource Finance, LLC to replace the Company's primary lender and provide additional liquidity. Each of the Company's material subsidiaries, other than Pivotal Research Centers, Inc, is a co-borrower under the agreement. The agreement includes a term loan in the amount of $1,400,000 and an accounts receivable funding revolving credit agreement with a maximum loan amount of $3,500,000, including $900,000 available as an overline for growth. The term loan note carries interest at prime plus 3.5%, but not less than 9%, with twelve monthly principal payments of $25,000, 12 monthly principal payments of $37,500, and eleven monthly principal payments of $50,000 beginning November 1, 2004 with balance due at maturity, on October 1, 2007 and is included in the above table. The revolving credit note carries interest at prime plus 2.25%, but not less than 6.75% paid through lock box payments of third party accounts receivable. The revolving credit term is three years, renewable for two additional one-year terms. The balance on the revolving credit agreement as of June 30, 2005 was $2,385,629. For additional information regarding this transaction, see the Company's current report on form 8-K filed with the Securities and Exchange Commission on October 22, 2004. The balance outstanding as of June 30, 2005 is included in the above table. For the quarter ended September 30, 2005, the Company was not in compliance with financial covenants of this agreement primarily due to the software failure at the Harbor Oaks facility, which delayed billing and postponed collection effort while the system was being recovered. CapitalSource, the company's lender, has provided the Company with a waiver of these covenants for the period. The Company has operated ongoing operations profitably for eighteen consecutive quarters with the exception of the litigation settlement and related legal costs incurred in the third quarter of fiscal year 2004. While it is difficult to project, if the current positive business environment towards behavioral health treatment and new business opportunities continue, we are confident that we will see continued improved results. -- 15 -- Off Balance Sheet Arrangements The Company has no off-balance-sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to the Company. Item 3. Quantitative and Qualitative Disclosure About Market Risk The market price of our common stock could be volatile and fluctuate significantly in response to various factors, including: o Differences in actual and estimated earnings and cash flows; o Operating results differing from analysts' estimates; o Changes in analysts' earnings estimates; o Quarter-to-quarter variations in operating results; o Changes in market conditions in the behavioral health care industry; o Changes in market conditions in the research industry; o Changes in general economic conditions; and o Fluctuations in securities markets in general. Our interest expense is sensitive to changes in the general level of interest rates. With respect to our interest-bearing liabilities, all of our long-term debt outstanding is subject to rates at prime plus 2.25% and prime plus 3.5%, which makes interest expense increase with changes in the prime rate. Failure to meet targeted revenue projections could cause us to be out of compliance with covenants in our debt agreements. (For additional information see Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations"). Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified within the SEC's Rules and Forms, and that such information is accumulated and communicated to our management to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was necessarily required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures to meet the criteria referred to above. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective. Change in Internal Controls There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluations. -- 16 -- PART II. OTHER INFORMATION Item 6. Exhibits and reports on Form 8-K. Exhibit List Exhibit No. Description 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Reports on Form 8-K The Company filed one report on form 8-K during the quarter ended September 30, 2005. This report provided the same earnings information to the public as shown in the Company's quarterly press release as required by Item 2.02 of the instructions for form 8-K. -- 17 -- Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PHC, Inc. Registrant Date: November 14, 2005 /s/ Bruce A. Shear ___________________ Bruce A. Shear President Chief Executive Officer Date: November 14, 2005 /s/ Paula C. Wurts ___________________ Paula C. Wurts Controller Treasurer -- 18 --