HORIZON HEALTH CORP /DE/ - 10-Q Quarterly Report

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HORC
3RD QTR
FY2003

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended May 31, 2003

or

[ ] 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 1-13626

HORIZON HEALTH CORPORATION
(Exact name of registrant as specified in its charter)

Delaware 75-2293354
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1500 Waters Ridge Drive
Lewisville, Texas 75057-6011
(Address of principal executive offices, including zip code)

(972) 420-8200
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

Yes [ ] No [X]

The number of shares outstanding of the registrant's Common Stock, $0.01 par
value, as of June 23, 2003, was 4,964,449.

INDEX

HORIZON HEALTH CORPORATION

PART I - FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS...................................................... 3

HORIZON HEALTH CORPORATION

Consolidated Balance Sheets as of May 31, 2003 (unaudited)
and August 31, 2002 ............................................................. 3

Consolidated Statements of Operations for the three months ended
May 31, 2003 and 2002 (each unaudited) .......................................... 5

Consolidated Statements of Operations for the nine months ended
May 31, 2003 and 2002 (each unaudited) .......................................... 6

Consolidated Statements of Cash Flows for the nine months ended
May 31, 2003 and 2002 (each unaudited) .......................................... 7

Notes to Consolidated Financial Statements (unaudited)........................... 8

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................................................... 20

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................. 33

ITEM 4. CONTROLS AND PROCEDURES................................................................ 34

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS...................................................................... 34

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K....................................................... 35

2

PART I - FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

HORIZON HEALTH CORPORATION

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

3

HORIZON HEALTH CORPORATION

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

4

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

See accompanying notes to consolidated financial statements.

5

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

See accompanying notes to consolidated financial statements.

6

HORIZON HEALTH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(a) Consists of the purchase of EAP International effective November 1, 2002,
the purchase of management contracts of Perspectives Health Management
effective October 1, 2001 and an adjustment to the purchase price paid for
Occupational Health Consultants of America. See Note 4.

See accompanying notes to consolidated financial statements.

7

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. ORGANIZATION

Horizon Health Corporation ("the Company") is a diversified health care
services provider. It is a leading contract manager of clinical and related
services, primarily of mental health and physical rehabilitation programs,
offered by general acute care hospitals in the United States. The
management contracts are generally for initial terms ranging from three to
five years, the majority of which have automatic renewal provisions. The
Company also offers employee assistance programs ("EAP") and behavioral
health services under contracts to businesses and managed care
organizations. Through its acquisition of ProCare One Nurses ("ProCare")
effective June 13, 2002, the Company also provides specialized temporary
nurse staffing services to hospitals. In addition, the Company provides
outcomes information regarding the effectiveness of mental health programs,
psychiatric data base services, and Phase IV clinical trial services. The
Company currently has offices in the Dallas, Texas; Chicago, Illinois;
Tampa, Florida; Orlando, Florida; Denver, Colorado; Philadelphia,
Pennsylvania; Nashville, Tennessee; Los Angeles, California; and Detroit,
Michigan metropolitan areas. The Company's National Support Center is in
the Dallas suburb of Lewisville, Texas.

BASIS OF PRESENTATION AND NEW ACCOUNTING STANDARDS:

The accompanying consolidated balance sheet at May 31, 2003, the
consolidated statements of operations for the three and nine months ended
May 31, 2003 and 2002, and the consolidated statements of cash flows for
the nine months ended May 31, 2003 and 2002 are unaudited. These financial
statements should be read in conjunction with the Company's audited
financial statements for the year ended August 31, 2002. In the opinion of
Company management, the unaudited consolidated financial statements include
all adjustments, consisting only of normal recurring accruals, which the
Company considers necessary for a fair presentation of the financial
position of the Company as of May 31, 2003, and the results of operations
for the three and nine months ended May 31, 2003 and 2002.

Operating results for the three and nine month periods are not necessarily
indicative of the results that may be expected for a full year or portions
thereof.

In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. ("SFAS") 148, "Accounting
for Stock-Based Compensation Transition and Disclosure." This statement
amends SFAS 123, "Accounting for Stock-Based Compensation," and establishes
two alternative methods of transition from the intrinsic value method to
the fair value method of accounting for stock-based employee compensation.
In addition, FAS 148 requires prominent disclosure about the effects of
SFAS 123 on reported net income and requires disclosure of these effects in
interim financial information. The provisions for the alternative
transition methods are effective for fiscal years ending after December 15,
2002, and the amended disclosure requirements are effective for interim
periods beginning after December 15, 2002 and allow for early application.
The Company currently plans to continue accounting for stock-based
compensation under APB 25, an allowable method, with additional disclosures
as required beginning with this, its fiscal 2003 third quarter. See
"Footnote 6. Stock Options" to the consolidated financial statements
included elsewhere within this document.

In January 2003, the FASB issued FASB Interpretation No.46, "Consolidation
of Variable Interest Entities" ("FIN 46") which changes the criteria by
which one company accounts for another entity in its consolidated financial
statements. FIN 46 requires a variable interest entity to be consolidated
by a company if that company is subject to a majority of the risk of loss
from the variable interest entity's activities or entitled to receive a
majority of the entity's residual returns or both. The consolidation
requirements of FIN 46 apply to variable interest entities created after
January 31, 2003, and apply in the first fiscal period beginning after June
15, 2003, for variable interest entities created prior to February 1, 2003.
The Company has a relationship with one variable interest entity as
discussed in Footnote 9, "Commitments and Contingencies". Under the new
guidelines, excluding any modifications to the relationship with the
variable interest entity, the Company is required to consolidate the
variable interest entity effective the fiscal 2003 fourth quarter.

8

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." ("SFAS No. 146"). SFAS No.146
requires that, subsequent to December 31, 2002, all costs associated with
exit or disposal activities be recognized when they are incurred rather
than at the date of a commitment to an exit or disposal plan. The Company
does not expect this statement to materially impact its consolidated
financial statements.

2. SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES

The consolidated financial statements and accompanying notes have been
prepared in accordance with generally accepted accounting principles
applied on a consistent basis. The preparation of these financial
statements requires the use of estimates, judgements and assumptions that
affect the reported amounts of assets and liabilities, and the disclosure
of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. The actual results experienced by the Company may differ
materially from management's estimates.

The Company continually evaluates its accounting policies and the estimates
it uses to prepare the consolidated financial statements. In general, the
estimates are based on historical experience, on information from third
party professionals and on various other assumptions that are believed to
be reasonable under the facts and circumstances. In the Company's opinion,
the significant accounting policies most important to aid in understanding
its financial results are the following:

CONSOLIDATION: The consolidated financial statements include those of the
Company and it's wholly-owned and majority owned subsidiaries. Investments
in unconsolidated affiliated companies are accounted for on the equity
method. All significant intercompany accounts and transactions are
eliminated in consolidation.

CASH AND CASH EQUIVALENTS: Cash and cash equivalents include highly liquid
investments with original maturities of three months or less when
purchased. The carrying amount approximates fair value due to the short
maturity of these instruments.

ALLOWANCES FOR DOUBTFUL ACCOUNTS: The Company maintains allowances for
doubtful accounts for estimated losses which may result from the inability
of its customers to make required payments. Allowances are based on the
likelihood of recoverability of accounts receivable considering such
factors as past experience and taking into account current collection
trends that are expected to continue. Factors taken into consideration in
estimating the reserve are amounts past due, in dispute, or a client which
the Company believes might be having financial difficulties. If economic,
industry, or specific customer business trends worsen beyond earlier
estimates, the Company increases the allowances for doubtful accounts by
recording additional expense. For recoveries associated with previously
written off accounts receivable balances, upon actual receipt of monies,
legal fees expended in the pursuit of the outstanding amounts are
considered "recovered" prior to the reversal of any previously written off
bad debt.

PROPERTY AND EQUIPMENT: Property and equipment are recorded at cost.
Depreciation expense is recorded on the straight-line basis over estimated
useful lives. The useful lives of computer hardware and software are
estimated to be three years. The useful lives of furniture and fixtures,
and transportation equipment are estimated to be five years. The useful
life of office equipment is estimated to be three years. Building
improvements are recorded at cost and amortized over the estimated useful
lives of the improvements or the terms of the underlying lease whichever is
shorter. Routine maintenance, repair items, and customer facility and site
improvements are charged to current operations.

ACCOUNTING FOR INTANGIBLE ASSETS AND GOODWILL: The cost of acquired
companies is allocated first to their identifiable assets based on
estimated fair values, and then to goodwill. Costs allocated to
identifiable intangible assets are generally amortized on a straight-line
basis over the remaining estimated useful lives of the assets. The excess
of the purchase price over the fair value of identifiable assets acquired,
net of liabilities assumed, is

9

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

recorded as goodwill. At May 31, 2003 and August 31, 2002, respectively,
other identifiable intangible assets, net, consists of customer contracts
($2,701,079 and $3,145,605), non-compete agreements ($423,560 and $186,111)
and trade names ($90,968 and $93,056). As described in Note 7, the Company
elected to adopt SFAS No. 141, Business Combinations ("SFAS 141") and SFAS
142, Goodwill and Other Intangible Assets" ("SFAS 142") on a prospective
basis as of September 1, 2001. As a result of implementing these new
standards, the Company discontinued the amortization of goodwill as of
August 31, 2001.

Accounting for these types of assets requires significant estimates and
judgement, especially as to: a) the valuation in connection with the
initial purchase price allocation and b) the ongoing evaluation for
impairment. For each acquisition, a valuation was completed to determine a
reasonable purchase price allocation. Upon completion of the allocation
process an amount was assigned to various identified assets including
intangible assets and the remainder was assigned to goodwill. The purchase
price allocation process requires estimates and judgements as to
expectations for the various businesses and business strategies. For
example, certain growth rates were assumed for each business. Additionally,
different operating margins for each type of service offering were included
in the estimates. If actual growth rates or operating margins, among other
assumptions, differ significantly from the estimate and judgements used in
the purchase price allocation, a possible impairment of the intangible
assets and/or goodwill or an acceleration in amortization expense may
result.

In addition, SFAS 142, Goodwill and Other Intangible Assets ("SFAS 142"),
adopted in 2001, discontinued the amortization of goodwill and generally
requires that goodwill impairment be tested annually using a two-step
process. The first step is to identify a potential impairment. The second
step measures the amount of the impairment loss, if any. However,
intangible assets with indefinite lives are to be tested for impairment
using a one-step process that compares the fair value to the carrying
amount of the asset. Because of the significance of the identified
intangible assets and goodwill to the Company's consolidated balance sheet,
annual or interim impairment analyses are important. Changes in key
assumptions about the business and its prospects, or changes in market
conditions or other external factors, could result in an impairment charge
and such a charge could have a material adverse effect on the Company's
financial condition and results of operations. Contracts represent the fair
value of management contracts and service contracts purchased and are being
amortized using the straight-line method over seven years. Other
intangibles primarily includes the fair value of trade names and
non-compete agreements, which are being amortized over their expected
useful lives. The Company elected to conduct the annual impairment testing
during its fiscal year third quarter. As a result of the May 31, 2003
impairment testing, no impairment adjustments were deemed necessary.

COMMON STOCK REPURCHASE PROGRAMS: As further described in Note 10, on
October 7, 2002 the Board of Directors authorized the repurchase of up to
800,000 shares of its common stock. During the quarter ended May 31, 2003,
the Company repurchased 199,788 shares of its common stock pursuant to such
authorization, which remains in effect. As of May 31, 2003, a total of
437,688 shares have been repurchased of the 800,000 shares authorized to be
repurchased.

MEDICAL CLAIMS: Medical claims payable represent the liability for
healthcare claims reported but not yet paid and claims incurred but not yet
reported ("IBNR") related to the Company's managed healthcare business. The
IBNR portion of medical claims payable is estimated based upon authorized
healthcare services, past claims payment experience for member groups,
enrollment data, utilization statistics and other factors using both
accounting and actuarial methodologies. Although variability is inherent in
such estimates, management believes the recorded liability for medical
claims payable is adequate. Medical claim payable balances are continually
monitored and reviewed. Changes in assumptions for care costs caused by
changes in actual or expected experience could cause these estimates to
change significantly.

RESERVES FOR EMPLOYEE HEALTH BENEFITS: The Company retains a significant
amount of self-insurance risk for its employee health benefits. The Company
maintains stop-loss insurance such that the Company's liability for health
insurance is subject to certain individual and aggregate limits. Each month
end the Company records an

10

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

accrued expense for estimated health benefit claims incurred but unpaid or
not reported at the end of such period. The Company estimates this accrual
based on a number of factors including historical experience, industry
trends and recent claims history. This accrual estimate is subject to
ongoing revision as conditions might change and as new data may be
presented. Adjustments to estimated liabilities are recorded in the
accounting period in which the change in estimate occurs.

SELF-INSURANCE RESERVES: Pursuant to various deductibles and retentions,
the Company is self-insured for certain losses, up to certain individual
and aggregate stop losses, relating to worker's compensation, general
liability, malpractice and professional liability claims. Self-insurance
claims filed and claims incurred but not reported are accrued based upon
management's estimates of the aggregate liability for uninsured claims
incurred using actuarial assumptions followed in the insurance industry and
historical experience. Although management believes it has the ability to
adequately record estimate losses related to claims, it is possible that
actual results could differ from recorded self-insurance liabilities.

REVENUE RECOGNITION: Service revenue is generated by the Company's five
business segments and recognized in the following three categories:

(1) Contract management revenue, generated by Horizon Mental Health
Management and Specialty Rehabilitation Management, is reported in the
period the services are provided at the estimated net realizable
amounts from contracted hospitals for contract management services
rendered. Adjustments are accrued on an estimated basis in the period
they become known and are adjusted in future periods, as final
settlement is determined.

The fees received by the Company for its services under management
contracts are paid directly by its client hospitals. Contract
management revenue is based on various criteria such as a fixed fee
and/or variable components and may include per diem calculations based
on patients per day, the number of admissions or discharges, direct
expenses, or any combination of the preceding, depending on the
specific contract. Generally, contract fees are paid on a monthly
basis.

Some management contracts include a clause, which states that the
Company will indemnify the hospital for third-party payor denials,
including Medicare. At the time the charges are denied or anticipated
to be denied, the Company records an allowance for 100% of the
potential amount. The Company believes it has adequately provided for
potential adjustments that may result from final settlement of
potential denials.

Client hospitals receive reimbursement under Medicare or Medicaid
programs or payments from insurers, self-funded benefit plans or other
third-party payors for the mental health and physical rehabilitation
services provided to the patients of the programs managed by the
Company. As a result, the availability and amount of such
reimbursements, which are subject to change, may impact the decision
of general acute care hospitals regarding whether to offer mental
health and physical rehabilitation services pursuant to management
contract with the Company, as well as whether to continue such
contracts (subject to contract termination provisions) and the amount
of fees to be paid thereunder.

(2) Premium and fees revenue, generated by Horizon Behavioral Services, is
reported in the period services are provided at the estimated net
realizable amounts as defined by client contracts for services
rendered. Adjustments are accrued on an estimated basis in the period
they become known and are adjusted in future periods if and when
necessary.

Revenues are derived from EAP services, administrative services only
contracts and at risk managed behavioral health services. This revenue
consists primarily of capitation payments, which are calculated on the
basis of a per-member/per-month fee, but also includes fee for service
payments. For

11

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

certain capitated managed care contracts the Company is 'at risk' and
bears the economic risk as to the adequacy of capitated revenue versus
the actual cost of behavioral health care services provided to covered
members by third parties. At May 31, 2003, overall capitated revenue
was sufficient to meet these costs.

(3) Service revenues, generated by ProCare and Mental Health Outcomes, are
recognized in the month in which services are rendered, at the
estimated net realizable amounts. These revenues are generated through
the Company's temporary nurse staffing services, its outcomes
measurement, database services, and its Phase IV clinical trial
services.

EARNINGS PER SHARE: Earnings per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share" ("SFAS 128"). Basic earnings per share
are computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period.
Diluted earnings per share reflect the potential dilution that may occur if
the Company's in the money stock options were exercised. Such dilutive
potential common shares are calculated using the treasury stock method.

ACCOUNTING FOR INCOME TAXES: The Company accounts for income taxes in
accordance with SFAS No. 109, "Accounting for Income Taxes", which requires
that deferred tax assets and liabilities be recognized using enacted tax
rates for the effect of temporary differences between the book and tax
basis of recorded assets and liabilities. SFAS No. 109 also requires that
deferred tax assets be reduced by a valuation allowance if it is more
likely than not that some portion or all of the deferred tax assets will
not be realized.

Based upon the Company's estimates of the sources, nature, and amount of
expected future taxable income it determined that it is more likely than
not that its deferred tax assets will be realized, resulting in no
valuation allowance. At May 31, 2003, the Company had deferred tax
liabilities in excess of deferred tax assets of $233,374.

The Company evaluates quarterly the realizability of its deferred tax
assets and accordingly adjusts its valuation allowance, if any as
necessary. The factors used to assess the likelihood of realization include
the Company's estimates of future taxable income and available tax
initiatives that could be reasonably implemented to assure realization of
the net deferred tax assets. The Company has used various appropriate tax
initiatives and alternative tax treatments to realize or to renew net
deferred tax assets in order to avoid the potential loss of tax benefits.

Failure to achieve forecasted taxable income amounts might affect the
ultimate realization of all or portions of net deferred tax assets. Factors
that may affect the Company's ability to achieve sufficient forecasted
taxable income include general business conditions, increased competition,
a change in Medicare or Medicare reimbursement, an increase in medical
services utilization, etc., resulting in a decline in sales or margins.

USE OF ESTIMATES: The Company has made certain estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements
and the amounts of revenues and expenses recorded for the reporting period
in order to prepare the financial statements in conformity with generally
accepted accounting principles. Future actual results could differ from
those estimates.

RECLASSIFICATIONS: Certain prior year amounts have been reclassified to
conform to the current year presentation.

12

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

3. EARNINGS PER SHARE

The following is a reconciliation of the numerators and the
denominators of the basic and diluted earnings per share computations.

During fiscal years 2003 and 2002, certain shares subject to options to
acquire common stock were not included in certain computations of diluted
EPS because the option exercise price was greater than the average market
price of the common shares for the quarter. The computation for the quarter
ended May 31, 2003 excluded 55,413 shares subject to options, with exercise
prices ranging from $16.05 to $23.75. The computation for the quarter ended
May 31, 2002 excluded 4,000 shares subject to options, with an exercise
price of $23.75. The computation for the nine months ended May 31, 2003
excluded an average of 52,871 shares subject to options, with exercise
prices ranging from $14.51 to $23.75. The computation for the nine months
ended May 31, 2002 excluded an average of 4,223 shares subject to options,
with exercise prices ranging from $13.50 to $23.75.

4. ACQUISITIONS

EMPLOYEE ASSISTANCE PROGRAMS INTERNATIONAL, INC.

The Company acquired all of the outstanding capital stock of Employee
Assistance Programs International, Inc. ("EAP International") of Denver,
Colorado, on November 4, 2002, with an effective date of November 1, 2002
for approximately $3.37 million. The Company accounted for the acquisition
of EAP International using the purchase method as required by generally
accepted accounting principles. EAP International provides employee
assistance programs and other related behavioral health care services to
employers. EAP International had total revenues of approximately $4.8
million (unaudited) for the ten months ended October 31, 2002. The purchase
price of approximately $3.37 million exceeded the fair value of EAP
International's tangible net assets by $3,548,004 of which $2,672,951 is
recorded as goodwill and $628,898 as service contract valuation and
$246,155 as non-compete contracts. Tangible assets acquired and liabilities
assumed totaled $756,697 and $935,440, respectively. Pro forma financial
data is not presented because the impact of this acquisition is not
material to the Company's results of operation for any period presented.

13

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

5. PROPERTY AND EQUIPMENT

Property and equipment consist of the following at May 31, 2003 and August
31, 2002:

Depreciation expense for the three months ended May 31, 2003 and 2002
totaled $246,714 and $302,902, respectively, and for the nine months ended
May 31, 2003 and 2002, depreciation expense totaled $800,650 and $907,422,
respectively. Fully depreciated assets, which are no longer in service, are
routinely retired from the Company's balance sheet.

6. STOCK OPTIONS

The 1989, 1995 and 1998 Stock Option Plans for employees and the 1995 Stock
Option Plan for Eligible Outside Directors are collectively referred to as
the "Plans". In accordance with the Plans, as amended, 2,981,843 shares of
common stock have been reserved for grant to key employees, directors and
consultants. The exercise prices of the options granted approximated or
exceeded the market value of the common stock at the date of the grant. The
options generally vest ratably over five years from the date of grant and
terminate 10 years from the date of grant.

The Company accounts for these plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees" and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under
those plans had an exercise price equal to or greater than the market value
of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share of the Company
had the Company applied the fair value recognition provisions of FASB
Statement No. 123, "Accounting for Stock-Based Compensation", relating to
stock-based employee compensation.

14

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

7. GOODWILL AND OTHER INTANGIBLE ASSETS

In July 2001, the FASB issued SFAS 141, Business Combinations and SFAS 142,
Goodwill and Other Intangible Assets. SFAS 141 addresses the initial
recognition and measurement of goodwill and other intangible assets
acquired in a business combination. SFAS 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a
business combination, whether acquired individually or with a group of
other assets, and the accounting and reporting for goodwill and other
intangibles subsequent to their acquisition. These standards require all
future business combinations to be accounted for using the purchase method
of accounting and goodwill relating to an acquisition not to be amortized,
but instead to be subject to impairment tests at least annually.

The costs of certain management contracts and other intangible assets
acquired by the Company remain subject to amortization. Amortization of
recorded values for contracts, non-compete agreements, and trade names for
the nine months ended May 31, 2003 was $1,184,221. During the quarter ended
November 30, 2002, there was a $93,000 acceleration of the final portions
of contract valuation amortization associated with a 1997 acquisition that
has now been fully amortized.

During the quarter ended May 31, 2003, the Company retired five fully
amortized contract valuation balances totaling $7,055,026 from its books,
which explains the net decrease in accumulated amortization between the
periods presented on the face of the balance sheet.

The following table sets forth the estimated amortization expense for
intangibles subject to amortization for the remaining three months in the
2003 fiscal year and for each of the four succeeding fiscal years.

Three months ending August 31, 2003 $ 313,095
For the year ending August 31, 2004 1,243,144
For the year ending August 31, 2005 721,474
For the year ending August 31, 2006 319,600
For the year ending August 31, 2007 270,627
----------
$2,867,940
==========

The following table sets forth by business segment of the Company the
amount of goodwill as of August 31, 2002 that is subject to impairment
tests rather than amortization and the adjustments, if any, to the amount
of such goodwill in the nine months ended May 31, 2003. The Company elected
to conduct the annual impairment testing during its fiscal year third
quarter. As a result of the May 31, 2003 impairment testing, no impairment
adjustments were deemed necessary.

(A) Horizon Behavioral Services provides managed behavioral care and employee
assistance programs. Goodwill acquired or adjusted during the period
relates to the purchase of EAP International.

(B) Horizon Mental Health Management provides mental health contract management
services to general acute care hospitals.

(C) Specialty Rehab Management provides physical rehabilitation contract
management services to general acute care hospitals.

15

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(D) ProCare provides specialized temporary nurse staffing services to hospitals
primarily in California and Michigan. Goodwill adjusted during the period
related to a purchase price accounting reclassification of $157,151 to
"other intangibles", net of a purchase price adjustment of $5,904.

(E) Mental Health Outcomes provides outcome measurement information regarding
the effectiveness of mental health treatment programs, data base services
and Phase IV Clinical Research services.

8. LONG-TERM DEBT

At May 31, 2003 and August 31, 2002, the Company had long-term debt
comprised of a revolving credit facility with outstanding balances of $10.5
million and $10.0 million, respectively.

On May 23, 2002, the Company entered into a Second Amended and Restated
Credit Agreement (the "Second Amended Credit Agreement"), with JPMorgan
Chase Bank, as Agent, and Bank of America, NA which refinanced the loans
then outstanding under the existing credit agreement. The Second Amended
Credit Agreement is a five year facility which consists of a $30 million
three year revolving/two year term credit facility (which has provisions to
allow for its expansion to a $50 million facility) to fund ongoing working
capital requirements, refinance existing debt, and finance future
acquisitions by the Company, and for other general corporate purposes.

The revolving credit facility bears interest at (1) the Base Rate plus the
Base Rate Margin, as defined or (2) the Adjusted Eurodollar Rate, plus the
Eurodollar Margin, as defined. At May 31, 2003, the weighted average
interest rate on outstanding indebtedness under the credit facility was
3.99%. The Eurodollar Margin and Base Rate Margin vary depending on the
debt coverage ratio of the Company. The revolving credit facility matures
on May 31, 2005.

As of October 4, 2002 and April 4, 2003, the Credit Agreement was amended
to allow the Company to finance the redemption or repurchase of its capital
stock, subject to certain conditions. The amendments currently allow the
Company to expend, in the twelve-month period ending April 4, 2004, up to
$7.5 million for the repurchase of shares. As of May 31, 2003, the Company
had repurchased 111,700 shares subject to the $7.5 million limitation, with
a total purchase price of approximately $1.8 million.

9. COMMITMENTS AND CONTINGENCIES

The Company leases various office facilities and equipment under operating
leases. The following is a schedule of minimum rental payments under these
leases, which expire at various dates:

Three months ending August 31, 2003 $ 606,845
For the year ending August 31, 2004 2,063,750
For the year ending August 31, 2005 1,617,317
For the year ending August 31, 2006 967,582
For the years ending August 31, 2007 and
thereafter 417,387
----------
$5,672,881
==========

Rent expense for the nine months ended May 31, 2003 and 2002 totaled
$1,910,053 and $1,878,984, respectively.

Effective September 1996, the Company entered into a lease arrangement with
an unconsolidated variable interest entity (previously also known as a
"special purpose entity"). The lease agreement, which had an initial term
of five years that has been extended to May 2007, is for a building
designed by the Company for use as its National Support Center. In
connection with the transaction, a financial institution loaned to the
variable interest entity approximately $4.4 million. The Company guaranteed
on a limited basis approximately $900,000 of the loan. In addition, the
Company is obligated, if it does not purchase the building (as described
below), and the building is sold to an independent party for less than the
then outstanding debt balance, to pay such shortfall up to $2.8 million in
addition to the $900,000 guarantee. In effect, the Company's obligation is
up to 84% of the then outstanding debt principal. At May 31, 2003, the
outstanding principal balance of the loan was $4.4 million. The loan is due
at the end of the lease term, currently May 2007. The Company also agreed
to purchase the building for approximately $4.4 million at the end of the
lease term if either the building is not sold to a third party or the

16

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Company does not further extend its lease. A recent independent appraisal
indicated the fair market value of the building is at least equal to the
loan amount and purchase price. Under the new guidelines, excluding any
future modifications to the relationship with the variable interest entity,
the Company is required to consolidate the variable interest entity during
the fiscal 2003 fourth quarter. Under FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities", the Company is required to
consolidate the variable interest entity effective the fiscal 2003 fourth
quarter, pending any future modifications to the relationship with the
variable interest entity. The Company is evaluating purchasing the building
and funding the acquisition expenditures with the revolving credit
agreement.

The Company's liability and property risk management program involves a
cost-effective balance of insured risks and self-insured retentions. The
Company carries general liability, malpractice and professional liability,
comprehensive property damage, workers' compensation, directors and
officers and other insurance coverages that management considers reasonable
and adequate for the protection of the Company's assets, operations and
employees. There can be no assurance, however, that the coverage limits of
such policies will be adequate. A successful claim against the Company in
excess of its insurance coverage or several claims for which the Company's
self-insurance components are significant in the aggregate could have a
material adverse effect on the Company.

During the quarter, there were no significant developments in connection
with the civil qui tam lawsuit pending against a subsidiary of the Company
in the District of Columbia described in Item 3 of Part I of the Company's
Annual Report on Form 10-K for the year ended August 31, 2002.

During the quarter, there were no significant developments in connection
with the investigation and unsealed qui tam suit pending in the Northern
District of California described in Item 3 of Part I of the Company's
Annual Report on Form 10-K for the year ended August 31, 2002.

The Company is, and may be in the future, party to litigation arising in
the ordinary course of its business. While the Company has no reason to
believe that any such pending claims are material, there can be no
assurance that the Company's insurance coverage will be adequate to
substantially cover liabilities arising out of such claims or that any such
claims will be covered by the Company's insurance. Any material claim that
is not covered by insurance may have an adverse effect on the Company's
business. Claims against the Company, regardless of their merit or outcome,
may also have an adverse effect on the Company's reputation and business.

10. STOCK REPURCHASES

On October 12, 2000 the Board of Directors authorized the repurchase of up
to 1,000,000 shares of its common stock and on February 15, 2001 the Board
of Directors authorized the repurchase of an additional 325,000 shares of
its common stock. As of August 31, 2002, the Company had repurchased
1,103,563 shares of its common stock pursuant to such authorizations, which
had previously expired. On October 7, 2002 the Board of Directors
authorized the repurchase of up to 800,000 shares of its common stock. As
of May 31, 2003, the Company had

17

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

repurchased 437,688 shares in total of the 800,000 share authorization, of
which 199,788 shares were purchased during the fiscal 2003 third quarter
pursuant to such authorization, which remains in effect. The stock
repurchase plans, as approved by the Board of Directors, authorized the
Company to make purchases of its outstanding common stock from time to time
in the open market or through privately negotiated transactions, depending
on market conditions and applicable securities regulations. The repurchased
shares are added to the treasury shares of the Company and may be used for
employee stock plans and for other corporate purposes. A total of 638,637
and 493,660 treasury shares had been reissued pursuant to the exercise of
certain stock options and in connection with the Employee Stock Purchase
Plan as of May 31, 2003 and August 31, 2002, respectively. The shares were
repurchased utilizing available cash and borrowings under the Company's
credit facility. The Company accounts for the treasury stock using the cost
method.

18

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

11. SEGMENT INFORMATION

The following schedule represents revenues and operating results for the
periods indicated by operating subsidiary:

19

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(A) Horizon Mental Health Management provides mental health contract management
services to general acute care hospitals.

(B) Specialty Rehab Management provides physical rehabilitation contract
management services to general acute care hospitals.

(C) Horizon Behavioral Services provides managed behavioral care and employee
assistance programs.

(D) ProCare provides specialized temporary nurse staffing services to hospitals
primarily in California and Michigan.

(E) Mental Health Outcomes provides outcomes information regarding the
effectiveness of mental health programs, psychiatric data base services,
and Phase IV clinical trial services.

(F) "Other" represents the Company's primary general and administrative costs,
i.e., expenses associated with the corporate offices and National Support
Center located in the Dallas suburb of Lewisville, Texas which provides
management, financial, human resources, and information system support for
the Company and its subsidiaries.

(G) EBITDA is a presentation of "earnings before interest, taxes, depreciation,
and amortization." EBITDA is the unit of measure reviewed by the chief
operating decision makers in determining segment operating performance.
EBITDA may not be comparable to similarly titled measures reported by other
companies. In addition, EBITDA is a non-GAAP measure and should not be
considered an alternative to operating or net income in measuring company
results. For the three months ended May 31, 2003 and 2002, consolidated
EBITDA is derived by adding depreciation and amortization of $581,199 and
$638,700, respectively, to the Company's operating income for the same
periods of $3,984,714 and $3,696,172, respectively. For the nine months
ended May 31, 2003 and 2002, consolidated EBITDA is derived by adding
depreciation and amortization of $1,984,868 and $2,122,532, respectively,
to the Company's operating income for the same periods of $11,932,118 and
$10,824,774, respectively. Consolidated cash flows from operating,
investing, and financing activities for the periods ended May 31, 2003 were
$6,863,848, $(3,508,697), and $(5,154,549) respectively, and for the period
ended May 31, 2002 were $7,126,630, $(3,430,625), and $(3,371,560),
respectively, and are represented on the Statement of Cash Flows elsewhere
herein.

12 SUBSEQUENT EVENT

ACQUISITION OF HEALTH AND HUMAN RESOURCE CENTER, INC., d/b/a INTEGRATED
INSIGHTS: Effective June 30, 2003 the Company purchased all of the capital
stock of privately held Health and Human Resource Center, Inc., d/b/a
Integrated Insights. Integrated Insights, headquartered in San Diego,
California, provides employee assistance programs under contracts directly
with employers. It holds a California Knox-Keene License to operate as a
specialized health care plan. At December 31, 2002, Integrated Insights had
approximately 303 contracts covering approximately 358,000 lives. For the
year ended December 31, 2002, Integrated Insights had revenues of
approximately $4.8 million (audited). The Company will account for the
acquisition by the purchase method as required by generally accepted
accounting principles, and is in the process of determining its purchase
price accounting, a substantial portion of which will be intangible assets,
primarily goodwill. The cash purchase price of approximately $4.3 million
was funded by the Company's revolving credit facility. The acquisition is
expected to be accretive to earnings.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

The Company is a diversified health care services provider. The Company is
a leading contract manager of psychiatric and physical rehabilitation clinical
programs offered by general acute care hospitals in the United States. The
Company also offers employee assistance programs ("EAP") and managed behavioral
health services to employers, HMO's, and insurance companies. Through its
acquisition of ProCare One Nurses ("ProCare"), effective June 13, 2002, the
Company also provides specialized temporary nurse staffing services to
hospitals. In addition, the Company provides outcomes information regarding the
effectiveness of mental health programs, psychiatric data base services, and
Phase IV clinical trial services.

The Company has grown both internally and through acquisitions, increasing
both the variety of its treatment programs and services, and the number of its
contracts. The Company had 144 management contracts as of May 31, 2003, with
contract locations in 36 states. Of its management contracts, 111 relate to
mental health treatment programs and 33 relate to physical rehabilitation
programs. As of May 31, 2003, the Company had 882 contracts to provide EAP and
managed mental health services covering over 2.9 million lives. As of May 31,
2003, ProCare provided, on a monthly average, in excess of 430 nurses to over
100 different general acute care hospitals located throughout California and
Michigan. The Company has also developed a proprietary mental health outcomes
measurement system known as CQI+ and provides outcomes and Phase IV clinical
research services known as "PsychScope". At May 31, 2003 the Company had
contracts to provide outcome measurement services at 115 contract locations as
well as 6 PsychScope outcomes and Phase IV clinical research project contracts.
At this time, the Company is evaluating the further pursuit of PsychScope and
Phase IV contracts.

See Note 11 to the Consolidated Financial Statements, included elsewhere
herein, for additional information concerning the business segments of the
Company.

REVENUES

Contract Management Services (Horizon Mental Health Management and
Specialty Rehabilitation Management)

The fees received by the Company for its services under management
contracts are paid directly by its client hospitals. Generally, contract fees
are paid on a monthly basis. The client hospitals receive reimbursement under
either the Medicare or Medicaid programs or payments from insurers, self-funded
benefit plans or other third-party payors for the mental health and physical
rehabilitation services provided to patients of the programs managed by the
Company. As a result, the availability and amount of such reimbursement, which
are subject to change, impacts the decisions of general acute care hospitals
regarding whether to offer mental health and physical rehabilitation services
pursuant to management contracts with the Company, as well as whether to
continue such contracts (subject to contract termination provisions) and the
amount of fees to be paid thereunder.

On April 3, 2003 the Office of the Inspector General of the Department of
Health and Human Services issued an advisory opinion in which it declined to
provide prospective protection from the Medicare Anti-Kickback Statute to a
proposed contract to manage rehabilitation services under which the compensation
was based on a variable fee. The OIG opinion was only applicable to the specific
situation presented and did not advise that variable fees were improper in and
of themselves. The Company has some management contracts with variable fees. The
Company considers that such management contracts are proper and do not violate
the Medicare Anti-Kickback statute.

Horizon Mental Health Management

In April 2000, the Centers for Medicare and Medicaid Services or
"CMS"(formerly Health Care Financing Administration or "HCFA") adopted new rules
requiring a CMS determination that a facility has provider-based status before a
provider can bill Medicare for the services rendered at the facility. The
Company's contract locations substantially comply with these regulations. On
August 1, 2002 CMS issued final amendments to the provider-based regulations,
which also provided specific requirements for provider based status of
"off-campus" locations and additional

21

specific requirements applicable to "off-campus" locations operational under a
management contract. The Company estimates that the "off-campus" regulations,
while still subject to clarification as to specific applicability, may have an
effect on 5 of its management contracts. In addition, CMS delayed from October
1, 2002 to July 1, 2003, the implementation date of the new regulations for
facilities and organizations treated as provider based prior to October 1, 2000.
The Company believes that the final amendments will not have a significant
impact on its current operations of inpatient psychiatric units located within
general hospitals. In February 2002, it was announced by CMS that inpatient
rehabilitation units do not have to meet provider-based status to bill Medicare
for services rendered to patients. This announcement was confirmed in by the
August 1, 2002 Federal Register.

The Balanced Budget Refinement Act of 1999 mandates that a prospective
payment system ("PPS") for inpatient psychiatric services be developed. The
system is required to include an adequate patient classification system that
reflects the differences in patient resource use and costs, i.e. acuity. In
addition, the act provides that the payment system must be budget neutral and be
a per diem system.

The act outlined that the Secretary shall submit to the appropriate
committees of Congress a report that includes a description of the system no
later than October 1, 2001, and that the system must be implemented by October
1, 2002. Not withstanding these deadlines, both dates have passed and no
description of the system had been presented as of May 31, 2003. In early 2002,
Tom Scully, Administrator for CMS, gave a speech in which he predicted that a
proposed PPS for inpatient psychiatric services would be released in the Spring
of 2003, subject to a comment period, and then implemented in 2004. The
Healthcare Financial Management Association ("HFMA") newsletter on November 22,
2002 stated that CMS had recently informed HFMA that the proposed rules for PPS
will be written and perhaps published by April or May of 2003, with an
implementation date that may take effect January 1, 2004. However, CMS also
indicated that the new PPS rule is likely to generate significant public
response, and recommendations for change could delay its implementation. To
date, CMS has not released proposed rules for PPS, therefore the currently
scheduled January 1, 2004 implementation date will likely be delayed.

A PPS with reimbursement based on a patient classification system may raise
or lower Medicare reimbursement levels to hospitals for inpatient psychiatric
services. To the extent client hospital reimbursement decreases, this could
adversely affect the ability of the Company to obtain and maintain management
contracts for inpatient psychiatric services and the amount of fees paid to the
Company under such contracts.

PPS for Partial Hospitalization Programs ("PHP") was generally effective
August 1, 2000. However, hospitals that are in a designated rural area and have
less than 100 acute care beds will effectively continue cost based reimbursement
for PHP services until December 31, 2003. Effective January 1, 2004, they will
operate under a PPS unless the current law is amended. The current base
reimbursement rate, for programs currently operating under PPS, which rate was
effective January 1, 2003, is a wage-adjusted rate of $240 per day. This change
in reimbursement methodology may lower Medicare reimbursement levels to this
type hospital. The Company currently operates 3 programs in hospitals of this
type.

Specialty Rehabilitation Management

Amendments to the Medicare statutes also provide for a phase-out of
cost-based reimbursement of physical rehabilitation services over a 20-month
period, which began January 1, 2002. Depending on a hospital's Medicare fiscal
year, the phase out period could be from 9 to 20 months. All physical
rehabilitation units in the USA will be under a 100% PPS by September 1, 2003.
The phase in of a PPS with reimbursement based on a functional patient
classification may raise or lower Medicare per patient and/or overall
reimbursement levels to hospitals for physical rehabilitation services, subject
to the subsequent relative changes in per patient costs and patient volumes.
Where lower, this could adversely affect the ability of the Company to obtain
and/or maintain management contracts for physical rehabilitation services and
the amount of fees paid to the Company under such contracts. The Company
believes its hospital based service delivery system is a cost efficient model in
general terms as compared to alternative structures in the marketplace. The
Company is generally not experiencing significant unfavorable consequences as a
result of this change in reimbursement.

22

CMS suspended until October 1, 2003 enforcement of a rule commonly known as
the "75% rule" (established in 1984) for inpatient rehabilitation programs. The
rule states that 75% of all patients in a program must fall into 1 of 10
diagnosis groups, also referred to as the "CMS 10". If less than 75% of the
patients fall within the CMS 10 then the program will be found in non-compliance
and will not be able to bill under the Case Mix Group ("CMG") system. In that
case the hospital will be reimbursed retroactively for that fiscal year under
the Diagnostic Related Group ("DRG") system, which typically provides lower
reimbursement. Enforcement was suspended so CMS could provide clarification as
to the applicability of the ten diagnosis groups. The final rules clarifying
applicability of the 75% rule are not scheduled to be published until August 1,
2003. Various organizations and groups are actively soliciting revisions to the
existing rule and certain legislators have introduced proposed bills to modify
the rule. Until the final rules are published, the Company is unable to
determine what impact there will be, if any, on the rehabilitation programs that
it manages. The final rules may adversely effect the Company in its ability to
maintain current contracts and in obtaining new contracts.

Managed Behavioral Health Care Services and Employee Assistance Programs

Through its subsidiary Horizon Behavioral Services ("HBS"), the Company
offers an array of behavioral health care products to corporate clients,
self-funded employer groups, insurance companies, commercial HMO and PPO plans,
government agencies, and third-party payors. Revenues are derived from employee
assistance program services ("EAP"), administrative services only contracts, and
at risk managed behavioral health services. Generally fees are paid on a monthly
basis.

Revenues from EAP contracts are typically based on a per employee per month
capitated rate applied to the number of eligible employees. The rate for EAP
plans is dependent upon the type and scope of services provided under the
contract terms. Each plan is specifically written to fulfill the clients' needs
and can offer different numbers of counseling sessions and other benefits, such
as work life services (including child care and elder care consultation),
referral resources and critical incident debriefing and intervention.

Revenues for administrative services only contracts relate to the
management of behavioral health benefits and are dependent upon the number of
contracts and the services provided. Fees are usually a case rate or a per
employee per month fee applied to the number of eligible members. The client is
able to benefit from the Company's expertise in clinical case management, the
mental health professionals employed by the Company and the independent health
care providers contracted by the Company at favorably discounted rates.

The primary factors affecting revenues derived from managed care services
are the scope of behavioral health benefits provided and the number of members
covered. Fees are based on a per employee per month capitated fee. The capitated
rate is dependent upon the benefit designs and actuarially determined
anticipated utilization of the customer's covered employees and is set forth in
the contract, usually as a per member per month capitated rate, which is applied
to the number of eligible members to determine a monthly fee.

In October 2000, HBS was awarded a three year, Full Accreditation (the
highest level) from the National Committee for Quality Assurance (NCQA) under
its 2000 standards for managed behavioral health care organizations (MBHOs).
NCQA is an independent, not-for-profit organization dedicated to assessing and
reporting on the quality of managed behavioral health care and other related
organizations. The NCQA accreditation process is a voluntary review that
evaluates how well a managed behavioral health care organization manages all
parts of its delivery system in order to continuously improve health care for
its members and to help organizations achieve the highest level of performance
possible. The Company will be undergoing the reaccredidation process in the fall
of 2003.

Specialized Temporary Nurse Staffing Services

The Company's acquisition of ProCare, in June 2002, expanded the Company's
operations in healthcare services by entering into the specialized temporary
nurse staffing business. The Company provides an on-call, twenty-four hour per
day, seven days a week, specialized temporary nurse staffing services to
hospitals. The fees received by the Company for its services related to
specialized temporary nurse staffing services are paid directly by its client
hospitals. Generally, temporary nurse-staffing fees are determined by the number
of hours worked. Fees are billed and paid on a weekly basis. These hourly rates
vary based on the specialty of nurse required, day of the week, and time of
shift to be filled. Fees are generally billed based on a predetermined rate for
each specialty and shift as specified in a fee schedule with the client

23

hospital. The Company typically provides more than 430 nurses to more than 100
client hospitals monthly. Revenues are recognized in the month in which services
are rendered, at the estimated net realizable amounts.

Mental Health Outcomes

MHO provides outcomes measurement services to acute care hospital-based
programs, free standing psychiatric hospitals, community mental health centers,
residential centers and outpatient clinics. The contracts for outcomes
measurement services are generally for one to two years with an automatic
renewal provision. The rates for the outcomes measurement services are
negotiated based on the module selected and the number of patients and are
generally paid on a monthly basis. In 1999, MHO developed and began marketing
PsychScope research services, which allow pharmaceutical marketers and
researchers to access non-identifiable information on the clinical treatment of
patients in behavioral health programs across the U.S. In addition, PsychScope
research services allow pharmaceutical companies to implement customized
outcomes and Phase IV clinical research within the behavioral health research
network MHO continues to build. The PsychScope contracts are negotiated based on
the number of patients and depth of analysis, and in addition, Phase IV
contracts are based on the number of participating clinical sites. Revenues are
recognized in the month in which services are rendered, at the estimated net
realizable amounts. Contract payments are generally made on a schedule based on
completion stages of the project. At this time, the Company is evaluating the
further pursuit of PsychScope and Phase IV contracts.

OPERATING EXPENSE

In addition to the respective primary expense factors described below,
other operating expenses generally incurred by each of the Company's business
segments include items such as training, continuing professional education and
credentialing services, marketing costs and expenses, consulting, accounting and
legal fees and expenses, employee recruitment and relocation expenses, rent,
utilities, telecommunications costs, and property taxes, as well as bad debt
expense.

Contract Management Services

The primary factors affecting operating expenses for the Company's contract
management business in any period is the number of programs in operation in the
period and the volume of patients at those locations. Operating expenses consist
primarily of salaries and benefits paid to program management, clinicians,
therapists and supporting personnel. Mental health programs managed by the
Company generally have a program director that is usually a psychologist or a
social worker, a community education manager and additional social workers or
therapists as needed. Physical rehabilitation programs managed by the Company
generally have a program director, and additional clinical staff tailored to
meet the needs of the program and the client hospital, which may include
physical and occupational therapists, a speech pathologist, a social worker and
other appropriate supporting personnel. In addition, the Company contracts with
a medical director on an independent contractor basis under which on-site
administrative services needed to administer the program are provided. The
nursing staff is typically provided and employed by the hospital.

Managed Behavioral Health Care and Employee Assistance Programs

Operating expenses for the Company's managed behavioral health care
services and employee assistance programs are comprised primarily of salaries
and benefits for its clinical, operations and supporting personnel and medical
claims from clinical providers. Medical claims, the largest component, include
payments to independent health care professionals providing services to the
covered enrollees under the managed behavioral health care contracts and the
employee assistance programs offered by the Company.

Specialized Temporary Nurse Staffing Services

The primary factor affecting operating expenses for the Company's
specialized temporary nurse staffing business in any period is the number of
shifts filled in the period and the mix of wage rates, including overtime, for
the placed nurses. Operating expenses consist primarily of salaries and benefits
paid to the Company's nursing pool.

24

Mental Health Outcomes

The primary factors affecting operating expenses for the outcome
measurement services and PsychScope services are the number of patients covered
and the number of clinical sites participating in the studies, with the primary
expense being salary and benefit costs for the personnel involved in the
research. In addition, operating costs related to conducting Phase IV studies
are also comprised of direct costs such as patient participation fees, location
fees, and hospital and/or physician coordination and implementation fees.

25

SUMMARY STATISTICAL DATA

NURSING SERVICES

As of May 31, 2003, the Company's temporary nurse staffing subsidiary
provided, on a monthly average, in excess of 430 nurses to over 100
different general acute care hospitals.

RESULTS OF OPERATIONS

The following table sets forth for the three and nine months ended May 31,
2003 and 2002, the percentage relationship to total revenues of certain
costs, expenses and income.

26

THREE MONTHS ENDED MAY 31, 2003 COMPARED TO THE THREE MONTHS ENDED MAY 31,
2002

REVENUE. Total revenue increased $5.3 million, or 15.1%, to $40.5 million
for the three months ended May 31, 2003, as compared to $35.2 million for the
three months ended May 31, 2002. This increase is primarily attributable to the
increase in temporary nurse staffing service revenue as a result of the
acquisition of ProCare, effective June 13, 2002. In addition, revenue increased
in Horizon Behavioral Services, due to the acquisition of EAP International,
effective November 1, 2002, and the commencement of a significant managed care
contract on April 1, 2002, and in Specialty Rehab Management, due to an increase
in the number of average locations in operation. The increases were partially
offset by a decrease in revenue in Horizon Mental Health Management resulting
from a decrease in the average number of locations in operation. Primary factors
by business segment are discussed below. (In addition see "Footnote 11. Segment
Information" to the consolidated financial statements included elsewhere in this
document.)

Horizon Mental Health Management

Revenue associated with contract management of mental health programs
decreased $1.3 million, or 6.6%, to $18.3 million for the three months ended May
31, 2003 as compared to $19.6 million for the three months ended May 31, 2002.
This decrease was primarily attributable to the decline in the number of average
inpatient psychiatric locations in operation from 113.4 for the fiscal quarter
ended May 31, 2002 to 103.4 for the quarter ended May 31, 2003. This decrease
was partially offset by a 2.7% increase in average revenue per location.

Specialty Rehab Management

Revenue associated with contract management of physical rehabilitation
services increased approximately $400,000, or 10.3%, to $4.3 million for the
three months ended May 31, 2003, as compared to $3.9 million for the three
months ended May 31, 2002. This increase was primarily due to an increase in the
average number of locations in operation from 20.5 for the three months ended
May 31, 2002 to 22.2 for the three months ended May 31, 2003

Horizon Behavioral Services

Revenue associated with the managed behavioral health care and employee
assistance program services increased by approximately $900,000, or 8.3%, to
$11.7 million for the three months ended May 31, 2003, as compared to $10.8
million for the three months ended May 31, 2002. Of this increase, $1.4 million
was attributable to the acquisition of EAP International on November 1, 2002 and
$817,000 was due to the commencement of a significant managed care contract on
April 1, 2002. These increases were offset by a decrease of $1.2 million
attributable to the termination of a significant managed care contract on
December 31, 2002.

ProCare One Nurses

Revenue associated with the specialized temporary nurse staffing services
segment was $5.4 million for the three months ended May 31, 2003. The Company
entered into this business segment with the acquisition of ProCare effective
June 13, 2002.

Mental Health Outcomes

Revenue associated with outcomes measurement and PsychScope services
decreased by $150,000, or 15.6%, to $813,000 for the three months ended May 31,
2003, as compared to $963,000 for the three months ended May 31, 2002.
PsychScope revenue decreased $70,000 primarily due to the completion of one
significant PsychScope Phase IV project during the three months ended May 31,
2003. Outcomes measurement revenue decreased $80,000 due to the average number
of CQI+ contracts in operation decreasing from 146.0 for the three months ended
May 31, 2002 to 105.5 for the three months ended May 31, 2003. The decrease in
the average number of CQI+ contracts in operation is primarily due to the
termination of a relationship effective October 2002 with one organization that
had 33 contracts with lower revenue per contract than average.

COST OF SERVICES. Total costs of services provided increased $4.6 million,
or 16.6%, to $32.3 million for the quarter ended May 31, 2003, compared to $27.7
million for the quarter ended May 31, 2002. This increase is primarily
attributable to the increase in nurse wages as a result of the acquisition of
ProCare, effective June 13, 2002, and increases in medical claims of third party
providers associated with the acquisition of EAP International, effective
November 1, 2002, and the commencement of a significant managed care contract
April 1, 2002. These increases were partially offset by a decrease in cost of
services in Horizon Mental Health Management due to a decrease in average number
of locations

27

in operation. As a result, as a percent of revenue, gross profits decreased to
20.3% for the quarter ended May 31, 2003 from 21.4% for the quarter ended May
31, 2002.

Horizon Mental Health Management

Cost of services provided associated with contract management of mental
health programs decreased by $1.3 million, or 9.4%, to $12.6 million for the
quarter ended May 31, 2003, compared to $13.9 million for the quarter ended May
31, 2002. $1.2 million of this decrease was primarily attributable to the
decline in the average number psychiatric locations in operation as described
above, while the average cost of services per psychiatric location in operation
was approximately the same for each quarter. As a percent of revenue, gross
profits on the mix of contracts in operation increased to 31.4% for the quarter
ended May 31, 2003 from 29.0% for the quarter ended May 31, 2002.

Specialty Rehab Management

Cost of services provided associated with contract management of physical
rehabilitation services increased by approximately $400,000, or 14.3%, to $3.2
million for the three months ended May 31, 2003, as compared to $2.8 million for
the three months ended May 31, 2002. The increase is primarily due to an
increase in operating expenses as a result of the increase in the average number
of locations in operation, as described above. $352,000 of this increase is a
result of a rise in salary and benefit costs per full time equivalent employee
of $965 between the periods, as well as an increase of 14.4 full time equivalent
employees necessary to staff several newly opened unit locations. As a percent
of revenue, gross profits decreased to 25.1% for the three months ended May 31,
2003 from 28.2% for the three months ended May 31, 2002.

Horizon Behavioral Services

Cost of services provided associated with managed behavioral health care
and employee assistance program services increased by approximately $800,000, or
7.9%, to $10.9 million for the three months ended May 31, 2003, as compared to
$10.1 million for the three months ended May 31, 2002. $1.1 million of this
increase was attributable to the acquisition of EAP International on November 1,
2002. This increase was reduced by a decrease of $130,000 which was the result
of containing medical claims expense associated with managed behavioral health
care, as well as the termination of a high utilization contract. As a percent of
revenue, gross profits increased to 6.8% for the three months ended May 31, 2003
from 6.5% for the three months ended May 31, 2002.

ProCare One Nurses

Cost of services provided associated with the specialized nurse-staffing
services was $5.0 million for the three months ended May 31, 2003. As a percent
of revenue, gross profits were 7.1% for the three months ended May 31, 2003. The
Company entered into this business segment with the acquisition of ProCare
effective June 13, 2002.

Mental Health Outcomes

Costs of services provided associated with outcomes measurement and
PsychScope services decreased by approximately $304,000, or 31.9%, to $650,000
for the three months ended May 31, 2003, compared to $954,000 for the three
months ended May 31, 2002. $127,000 of this decrease is due to a reduction in
force of 7.2 full time equivalent employees resulting from cost control
initiatives. The remaining decrease is primarily due to being beyond the higher
start up cost segments of the Phase IV clinical research service projects. As a
percent of revenue, gross profits increased to 20.1% for the three months ended
May 31, 2003 from 1.0% for the three months ended May 31, 2002.

SELLING, GENERAL AND ADMINISTRATIVE. Total selling, general, and
administrative expenses, on a net basis, increased approximately $700,000, or
20.0%, to $4.2 million for the three months ended May 31, 2003, compared to $3.5
million for the three months ended May 31, 2002. Salaries and benefits increased
$369,000; sales commissions increased $115,000 primarily due to an increase in
new contract signings from four in the third quarter of 2002 to eleven signed in
the third quarter of 2003; and legal fees increased approximately $145,000
primarily as a result of expenses incurred for HIPAA compliance.

PROVISION FOR DOUBTFUL ACCOUNTS. The provision for doubtful accounts was a
net recovery of $516,000 for the fiscal quarter ended May 31, 2003, as compared
to a net recovery of $303,000 for the fiscal quarter ended May 31, 2002, a
decrease of $213,000. Approximately $482,000 of the recovery during the current
quarter was attributable to the receipt of payment from one Horizon Mental
Health Management contract location that had previously been reserved as bad
debt due to the uncertainty of collectability.

28

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense for
the three months ended May 31, 2003 was $581,000 representing a decrease of
$58,000 or 9.1% as compared to depreciation and amortization expense of $639,000
for the corresponding period in the prior fiscal year. Due to the Company's
limited capital expenditure requirements, depreciation generated from assets
acquired during the period was less than the reduction in depreciation
associated with items becoming fully depreciated.

INTEREST AND OTHER INCOME (EXPENSE), NET. Interest expense, interest income
and other income for the three months ended May 31, 2003 resulted in a net
expense of $58,000, as compared to net income of $14,000 for the corresponding
period in the prior fiscal year. This net change is primarily the result of an
increase in interest expense of $70,000 related to an increase in the weighted
average principal balance outstanding under the credit facility between periods.
The weighted average outstanding credit facility balance for the three months
ended May 31, 2003 was $8.3 million with an ending balance of $10.5 million. The
weighted average outstanding balance for the corresponding period in the prior
fiscal year was $900,000 with an ending balance of $2.9 million.

INCOME TAX EXPENSE. For the three month period ended May 31, the Company
recorded 2003 federal and state income taxes of $1.5 million resulting in a
combined tax rate of 38.8%, compared to 2002 federal and state income taxes of
$1.4 million resulting in a combined tax rate of 38.8%.

NINE MONTHS ENDED MAY 31, 2003 COMPARED TO THE NINE MONTHS ENDED MAY 31,
2002

REVENUE. Total revenue increased $21.1 million, or 20.5%, to $124.1 million
for the nine months ended May 31, 2003, as compared to $103.0 million for the
nine months ended May 31, 2002. This increase is primarily attributable to the
increase in temporary nurse staffing service revenue as a result of the
acquisition of ProCare, effective June 13, 2002. In addition, revenue increased
in Horizon Behavioral Service, due to the acquisition of EAP International,
effective November 1, 2002, and the commencement of a significant managed care
contract on April 1, 2002, and in Specialty Rehab Management, due to an increase
in the number of average locations in operation. The increases were partially
offset by a decrease in Horizon Mental Health Management resulting from a
decrease in the average number of locations in operation.

Horizon Mental Health Management

Revenue associated with contract management of mental health programs
decreased $4.0 million, or 6.7%, to $55.9 million for the nine months ended May
31, 2003 as compared to $59.9 million for the nine months ended May 31, 2002.
This decrease was primarily attributable to the decline in the number of average
number of inpatient psychiatric locations in operation from 114.3 for the nine
months ended May 31, 2002 to 104.8 for the nine months ended May 31, 2003. This
decrease was partially offset by a 1.6% increase in average revenue per
location.

Specialty Rehab Management

Revenue associated with contract management of physical rehabilitation
services increased approximately $1.8 million, or 15.9%, to $13.1 million for
the nine months ended May 31, 2003, as compared to $11.3 million for the nine
months ended May 31, 2002. This increase was primarily due to an increase in the
average number of locations in operation from 20.7 for the nine months ended May
31, 2002 to 21.9 for the nine months ended May 31, 2003, as well as an 8.8%
increase in average revenue per rehabilitation locations in operation which is
primarily attributable to an increase of 7,414 inpatient days between the
periods.

Horizon Behavioral Services

Revenue associated with managed behavioral health care and employee
assistance program services increased by approximately $6.5 million, or 22.3%,
to $35.6 million for the nine months ended May 31, 2003, as compared to $29.1
million for the nine months ended May 31, 2002. Of this increase, $5.3 million
was attributable to the commencement of a significant managed care contract on
April 1, 2002 and $3.3 million was due to the acquisition of EAP International
on November 1, 2002. These increases were offset by a decrease of $2.1 million,
which was attributable to the termination of a significant managed care contract
on December 31, 2002.

ProCare One Nurses

Revenue associated with the specialized temporary nurse staffing services
segment was $17.0 million for the nine months ended May 31, 2003. The Company
entered into this business segment with the acquisition of ProCare effective
June 13, 2002.

29

Mental Health Outcomes

Revenue associated with outcomes measurement and PsychScope services
decreased by $32,000, or 1.2%, to $2.6 million for the nine months ended May 31,
2003. PsychScope revenue increased $169,000 primarily due to work completed on
four significant PsychScope Phase IV projects that commenced prior to the
current fiscal year. Outcomes revenue decreased $201,000 due to the average
number of CQI+ contracts in operation decreasing from 138.9 for the nine months
ended May 31, 2002 to 114.9 for the nine months ended May 31, 2003. The decrease
in the average number of CQI+ contracts in operation is primarily due to the
termination of a relationship, effective October 2002, with one organization
that had 33 contracts with lower revenue per contract than average.

COST OF SERVICES. Total costs of services provided increased approximately
$19.9 million, or 25.5%, to $98.0 million for the nine months ended May 31,
2003, compared to $78.1 million for the nine months ended May 31, 2002. This
increase is primarily attributable to the nurse wages incurred as a result of
the acquisition of ProCare, effective June 13, 2002. An additional increase can
be attributed to an increase in medical claims in Horizon Behavioral Services
associated with the acquisition of EAP International, effective November 1,
2002, and the commencement of a significant managed care contract on April 1,
2002. Specialty Rehab Management also experienced a rise in costs as a result of
an increase in the average number of locations in operation. These increases
were partially offset by a decrease in cost of services in Horizon Mental Health
Management resulting from a decrease in the average number of locations in
operation. As a percent of revenue, gross profits increased to 24.1% from 21.0%
for the nine months ended May 31, 2002.

Horizon Mental Health Management

Cost of services provided associated with contract management of mental
health programs decreased by $3.5 million, or 8.4%, to $38.2 million for the
nine months ended May 31, 2003, compared to $41.7 million for the nine months
ended May 31, 2002. This decrease was primarily attributable to the decline in
the average number psychiatric locations in operation as described above, while
the average cost of services per psychiatric location in operation was
approximately the same for each nine month period. As a percent of revenue,
gross profits increased to 31.7% for the nine months ended May 31, 2003 from
30.4% for the quarter ended May 31, 2002.

Specialty Rehab Management

Cost of services provided associated with contract management of physical
rehabilitation services increased by approximately $1.3 million, or 15.8%, to
$9.5 million for the nine months ended May 31, 2003, as compared to $8.2 million
for the nine months ended May 31, 2002. The increase is primarily due to an
increase in operating expenses as a result of the increase in the average number
of locations in operation, as described above. $791,000 of this increase is a
result of a rise in salary and benefit costs per full time equivalent employee
of $2,614 between the periods, as well as an increase of 9.8 full time
equivalent employees necessary to staff several newly opened unit locations. As
a percent of revenue, gross profits increased slightly to 27.4% for the nine
months ended May 31, 2003 from 27.3% for the nine months ended May 31, 2002.

Horizon Behavioral Services

Cost of services provided associated with managed behavioral health care
and employee assistance program services increased by approximately $7.3
million, or 28.2%, to $33.2 million for the nine months ended May 31, 2003, as
compared to $25.9 million for the nine months ended May 31, 2002. $4.5 million
of this increase was attributable to an increase in medical claim expense
associated with managed behavioral health care, which resulted from a change in
the mix of managed care contracts in operation, including an increase of $1.0
million in medical claims expense due to an increase in the quantity and cost of
services provided. An additional $2.4 million was the result of the acquisition
of EAP International effective November 1, 2002. As a percent of revenue, gross
profits decreased to 6.9% for the nine months ended May 31, 2003 from 10.9% for
the nine months ended May 31, 2002.

ProCare One Nurses

Cost of services provided associated with specialized nurse-staffing
services was $15.5 million for the nine months ended May 31, 2003. As a percent
of revenue, gross profits were 8.5% for the nine months ended May 31, 2003. The
Company entered into this business segment with the acquisition of ProCare
effective June 13, 2002.

Mental Health Outcomes

Cost of services provided associated with outcomes measurement and
PsychScope services decreased by $500,000, or 20.8%, to $1.9 million for the
nine months ended May 31, 2003, compared to $2.4 million for the nine months
ended May 31, 2002. $214,000 of this decrease is due to a decrease of 5.9 full
time equivalent employees related

30

to cost control initiatives. The remaining decrease is primarily due to being
beyond the higher start up cost segments of the Phase IV clinical research
service projects. As a percent of revenue, gross profits increased to 26.3% for
the nine months ended May 31, 2003 from 8.2% for the nine months ended May 31,
2002.

SELLING, GENERAL AND ADMINISTRATIVE. Total selling, general, and
administrative expenses, on a net basis, increased approximately $1.1 million,
or 9.5%, to $12.7 million for the nine months ended May 31, 2003, compared to
$11.6 million for the nine months ended May 31, 2002. Salaries and benefits
increased $228,000; sales commissions increased $352,000 primarily due to an
increase in contract signings in the current period as compared to the same
period last year; legal fees increased $208,000 primarily as a result of
expenses incurred for HIPAA and Sarbanes-Oxley compliance; and consulting fees
increased $133,000 primarily due to the costs associated with a sales approach
and methodology analysis.

PROVISION FOR DOUBTFUL ACCOUNTS. The provision for doubtful accounts
expense was a net recovery of $621,000 for the nine months ended May 31, 2003,
as compared to expense of $244,000 for the nine months ended May 31, 2002, a
decrease of $865,000. The net recovery for the nine months ended May 31, 2003 is
primarily the result of the recovery of amounts expensed in prior periods due to
receiving payments related to old receivables of three contract locations, net
of legal costs. This includes the complete recovery of $720,224 of which
$600,727 was recorded as a bad debt recovery for a hospital that declared
bankruptcy in 1998. These recoveries were partially offset by reserves recorded
for contract locations in which collectability is uncertain including two
locations that filed bankruptcy.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense for
the nine months ended May 31, 2003 was $2.0 million representing a decrease of
approximately $100,000 or 4.8% as compared to depreciation and amortization
expense of $2.1 million for the corresponding period in the prior fiscal year.
Due to the Company's limited capital expenditure requirements, depreciation
generated from assets acquired during the period was less than the reduction in
depreciation associated with items becoming fully depreciated.

INTEREST AND OTHER INCOME (EXPENSE), NET. Interest expense, interest income
and other income for the nine months ended May 31, 2003 resulted in a net
expense of $184,000, as compared to $38,000 for the corresponding period in the
prior fiscal year. This change is primarily the result of an increase in
interest expense of $150,000 related to an increase in the weighted average
principal balance outstanding under the credit facility between periods. The
weighted average outstanding credit facility balance for the nine months ended
May 31, 2003 was $9.6 million with an ending balance of $10.5 million. The
weighted average outstanding balance for the corresponding period in the prior
fiscal year was $3.8 million with an ending balance of $2.9 million.

INCOME TAX EXPENSE. For the nine-month period ended May 31, the Company
recorded 2003 federal and state income taxes of $4.5 million resulting in a
combined tax rate of 38.7%, compared to 2002 federal and state income taxes of
$4.2 million resulting in a combined tax rate of 38.7%.

31

NEWLY ISSUED ACCOUNTING STANDARDS

In December 2002, the FASB issued FAS 148, "Accounting for Stock-Based
Compensation Transition and Disclosure." This statement amends FAS 123,
"Accounting for Stock-Based Compensation," and establishes two alternative
methods of transition from the intrinsic value method to the fair value method
of accounting for stock-based employee compensation. In addition, FAS 148
requires prominent disclosure about the effects on reported net income and
requires disclosure of these effects in interim financial information. The
provisions for the alternative transition methods are effective for fiscal years
ending after December 15, 2002, and the amended disclosure requirements are
effective for interim periods beginning after December 15, 2002 and allow for
early application. The Company currently plans to continue accounting for
stock-based compensation under APB 25, an allowable method, with the additional
required disclosures being included beginning with the financial statements in
this fiscal 2003 third quarter report.

In January 2003, the FASB issued FASB Interpretation No.46, "Consolidation
of Variable Interest Entities" ("FIN 46") which changes the criteria by which
one company accounts for another entity in its consolidated financial
statements. FIN 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. The consolidation requirements of FIN 46
apply to variable interest entities created after January 31, 2003, and apply in
the first fiscal period beginning after June 15, 2003, for variable interest
entities created prior to February 1, 2003. The Company has a relationship with
one variable interest entity as discussed below in "Liquidity and Capital
Resources". Under the new guidelines, excluding any modifications to the
relationship with the variable interest entity, the Company is required to
consolidate the variable interest entity during the fiscal 2003 fourth quarter.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." ("SFAS No. 146"). SFAS No.146
requires that, subsequent to December 31, 2002, all costs associated with exit
or disposal activities be recognize when they are incurred rather than at the
date of a commitment to an exit or disposal plan. The Company does not expect
this statement to materially impact its consolidated financial statements.

LIQUIDITY AND CAPITAL RESOURCES

The Company believes that its future cash flow from operations, which was
$6.9 million for the nine months ended May 31, 2003, along with cash of $2.2
million at May 31, 2003, and its $30 million revolving credit facility (of which
$13.9 million was available at May 31, 2003), will be sufficient to cover
operating cash requirements over the next 12 months, including capital
expenditures. The Company may require additional capital to fund acquisitions.

Effective May 23, 2002, the Company entered into a Second Amended and
Restated Credit Agreement with JPMorgan Chase Bank, as Agent, and Bank of
America, NA to refinance the loans outstanding under the existing credit
agreement and to provide expanded credit availability. The Credit Agreement is a
five year $30.0 million facility consisting of a three-year revolving/two year
term credit facility with provisions to allow for its expansion to a $50.0
million facility. As of May 31, 2003, the Company had borrowings of $10.5
million outstanding against the revolving credit facility (and $5.6 million in
letter of credit commitments outstanding).

The following summary of certain material provisions of the Credit
Agreement does not purport to be complete, and is subject to, and qualified in
its entirety by reference to, the Second Amended Credit Agreement, a copy of
which was previously filed as Exhibit 10.1 in the Company's May 2002 Form 10-Q.

The Company and one of its subsidiaries are the borrowers under the Credit
Agreement, which is unconditionally guaranteed by all material subsidiaries of
the Company. Loans outstanding under the Credit Agreement bears interest at the
"Base Rate" (the greater of the Agent's "prime rate" or the federal funds rate
plus .5%) plus .5% to 1.25% (depending on the Company's Indebtedness to EBITDA
Ratio), or the "Eurodollar Rate" plus 2.00% to 2.75% (depending on the Company's
Indebtedness to EBITDA Ratio), as selected by the Company. The Company pays
interest quarterly and incurs quarterly commitment fees of .5% per annum on the
unused portion of the revolving credit facility.

The Company is subject to certain covenants which include prohibitions
against (i) incurring additional debt or liens, except specified permitted debt
or permitted liens, (ii) certain material acquisitions, other than specified
permitted acquisitions (including any single acquisition not greater than $10.0
million or cumulative acquisitions not in excess of $25.0 million) during any
twelve consecutive monthly periods without prior bank approval, (iii) certain
mergers,

32

consolidations or asset dispositions by the Company or changes of control of the
Company, (iv) certain management vacancies at the Company, and (v) material
change in the nature of business conducted. In addition, the terms of the
revolving credit facility require the Company to satisfy certain ongoing
financial covenants. The revolving credit facility is secured by a first lien or
first priority security interest in and/or pledge of substantially all of the
assets of the Company and of all present and future material subsidiaries of the
Company. As of May 31, 2003, the Company was in compliance with the covenants of
the agreement.

As of October 4, 2002 and April 4, 2003, the Credit Agreement was amended
to allow the Company to finance the redemption or repurchase of its capital
stock, subject to certain conditions. The amendments currently allow the Company
to expend, in the twelve-month period ending April 4, 2004, up to $7.5 million
for the repurchase of shares. As of May 31, 2003, the Company had repurchased
111,700 shares subject to the $7.5 million limitation, with a total purchase
price of approximately $1.8 million.

Effective September 1996, the Company entered into a lease arrangement with
an unconsolidated, unaffiliated variable interest entity (previously also known
as "special purpose entity"). The lease agreement, which had an initial term of
five years that has been extended to May 2007, is for a building constructed to
the Company's specifications for use as its National Support Center. In
connection with the transaction, a financial institution loaned to the variable
interest entity approximately $4.4 million. The Company guaranteed on a limited
basis approximately $900,000 of the loan. In addition, the Company is obligated,
if it does not purchase the building (as described below), and the building is
sold to an independent party for less than the then outstanding debt balance, to
pay such shortfall up to $2.8 million in addition to the $900,000 guarantee. In
effect, the Company's obligation is up to 84% of the then outstanding debt
principal. The loan is payable on an interest only basis with all principal due
at the end of the lease term. The Company also agreed to purchase the building
for approximately $4.4 million at the end of the lease term, currently May 2007,
if either the building is not sold to a third party or the Company does not
extend its lease. A recent independent appraisal indicated the fair market value
of the building is at least equal to the loan amount and purchase price. Under
FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", the
Company is required to consolidate the variable interest entity effective the
fiscal 2003 fourth quarter, pending any modifications to the relationship with
the variable interest entity. The Company is evaluating purchasing the building
and funding the acquisition expenditures with the revolving credit agreement.

Effective June 30, 2003 the Company purchased all of the capital stock of
privately held Health and Human Resource Center, Inc., d/b/a/ Integrated
Insights. Integrated Insights, headquartered in San Diego, California, provides
employee assistance programs under contracts directly with employers. It holds a
California Knox-Keene License to operate as a specialized health care plan. At
December 31, 2002, Integrated Insights had approximately 303 contracts covering
approximately 358,000 lives. For the year ended December 31, 2002, Integrated
Insights had revenues of approximately $4.8 million (audited). The Company will
account for the acquisition by the purchase method as required by generally
accepted accounting principles, and is in the process of determining its
purchase price accounting, a substantial portion of which will be intangible
assets, primarily goodwill. The cash purchase price of approximately $4.3
million was funded by the Company's revolving credit facility. The acquisition
is expected to be accretive to earnings.

Effective June 13, 2002, the Company acquired all of the membership
interests of ProCare for approximately $12.5 million. The acquisition was funded
by incurring debt of $11.5 million under the revolving credit facility, and $1.0
million from existing cash.

The Company acquired all of the outstanding capital stock of Employee
Assistance Programs International on November 4, 2002 with an effective date of
November 1, 2002 for approximately $3.4 million. The acquisition was funded by
incurring debt of $1.5 million under the revolving credit facility and $1.9
million from existing cash.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

See "Management's Discussion and Analysis" of "Critical Accounting
Policies" presented in the Company's August 31, 2002 Form 10-K, as well as
"Significant Accounting Policies and Estimates" described in Note 2 to the
consolidated financial statements included elsewhere herein, both of which are
incorporated herein by reference, for information concerning those accounting
policies and estimates considered critical by the Company.

33

DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS

Certain written and oral statements made or incorporated by reference from
time to time by the Company or its representatives in this report, other
reports, filings with the Commission, press releases, conferences, or otherwise,
are "forward looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such statements include, without limitation, any
statement that may predict, forecast, indicate, or imply future results,
performance or achievements, and may contain the words "believe," "anticipate,"
"expect," "estimate," "project," "will be," "will continue," "will likely
result," or words or phrases of similar meaning. Such statements involve risks,
uncertainties or other factors which may cause actual results to differ
materially from the future results, performance or achievements expressed or
implied by such forward looking statements. Certain risks, uncertainties and
other important factors are detailed in this report and will be detailed from
time to time in reports filed by the Company with the Commission, including
Forms 8-K, 10-Q, and 10-K, and include, among others, the following: general
economic and business conditions which are less favorable than expected;
unanticipated changes in industry trends; decreased demand by general hospitals
for the Company's services; the Company's inability to retain existing
management contracts or to obtain additional contracts or maintain customer
relationships; adverse changes in reimbursement to general hospitals by Medicare
or other third-party payers for costs of providing mental health or physical
rehabilitation or nursing; adverse changes to other regulatory requirements
relating to the provision of mental health or physical rehabilitation or nursing
services; adverse consequences of investigations by governmental regulatory
agencies; adverse judgements rendered in the qui tam lawsuits pending against
the Company; fluctuations and difficulty in forecasting operating results; the
ability of the Company to sustain, manage or forecast its growth; the ability of
the Company to successfully integrate acquired businesses on a cost effective
basis; heightened competition, including specifically the intensification of
price competition; the entry of new competitors and the development of new
products or services by new and existing competitors; changes in business
strategy or development plans; inability to carry out marketing and sales plans;
business disruptions; liability and other claims asserted against the Company;
loss of key executives; the ability to attract and retain qualified personnel;
adverse publicity; demographic changes; and other factors referenced or
incorporated by reference in this report and other reports or filings with the
Commission. Moreover, the Company operates in a very competitive and rapidly
changing environment. New risk factors emerge from time to time and it is not
possible for management to predict all such risk factors, nor can it assess the
impact of all such risk factors on the Company's business or the extent to which
any factor may cause actual results to differ materially from those contained in
any forward looking statements. These forward-looking statements represent the
estimates and assumptions of management only as of the date of this report. The
Company expressly disclaims any obligation or undertaking to disseminate any
updates or revisions to any forward looking statement contained herein to
reflect any change in its expectations with regard thereto or any change in
events, conditions or circumstances on which any statement is based. Given these
risks and uncertainties, investors should not place undue reliance on
forward-looking statements as a prediction of actual results.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In its normal operations, the Company has market risk exposure to interest
rates due to its interest bearing debt obligations, which were entered into for
purposes other than trading purposes. To manage its exposure to changes in
interest rates, the Company uses both variable rate debt and fixed rate debt of
short duration with maturities ranging from 30 to 180 days. The Company has
estimated its market risk exposure using sensitivity analyses assuming a 10%
change in market rates.

At May 31, 2003, the Company had approximately $10.5 million of debt
obligations outstanding with a weighted average interest rate of 3.99%. A
hypothetical 10% change in the effective interest rate for these borrowings,
assuming debt levels as of May 31, 2003, would change interest expense by
approximately $42,000 annually. This would be funded out of cash flows from
operations, which were $13.7 million for the twelve most recent months ended May
31, 2003.

ITEM 4. CONTROLS AND PROCEDURES

Within 90 days prior to the filing date of this report, the Company's Chief
Executive Officer and the Company's Chief Financial Officer evaluated the
effectiveness of the design and operation of the Company's "disclosure controls
and procedures". Based on that evaluation, the Company's Chief Executive Officer
and the Company's Chief Financial Officer have concluded that the Company's
disclosure controls and procedures are effective to ensure that information
required to be disclosed by the Company in the reports that it files and submits
under the Exchange Act is recorded, processed, summarized and reported as and
when required, and are effective to ensure that such information is

34

accumulated and communicated to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer, as appropriate to allow
timely decisions regarding required disclosure. Subsequent to the date of
evaluation, there have been no significant changes in the internal controls or
in other factors that would significantly affect the internal controls, and no
corrective actions were considered necessary or taken with regard to significant
deficiencies and material weaknesses in the internal controls.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

During the quarter, there were no significant developments in connection with
the civil qui tam lawsuit pending against a subsidiary of the Company in the
District of Columbia described in Item 3 of Part I of the Company's Annual
Report on Form 10-K for the year ended August 31, 2002.

During the quarter, there were no significant developments in connection with
the investigation and unsealed qui tam suit pending in the Northern District of
California described in Item 3 of Part I of the Company's Annual Report on Form
10-K for the year ended August 31, 2002.

35

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.

NUMBER EXHIBIT

3.1 Certificate of Incorporation of the Company, as amended (incorporated
herein by reference to Exhibit 3.1 to the Company's Current Report on
Form 8-K dated August 11, 1997).

3.2 Amended and Restated Bylaws of the Company, as amended (incorporated
herein by reference to Exhibit 3.2 to Amendment No. 2 as filed with
the Commission on February 16, 1995 to the Company's Registration
Statement on Form S-1 filed with the Commission on January 6, 1995
(Registration No. 33-88314)).

4.1 Specimen certificate for the Common Stock, $.01 par value of the
Company (incorporated herein by reference to Exhibit 4.1 to the
Company's Current Report on Form 8-K dated August 11, 1997).

4.2 Rights Agreement, dated February 6, 1997, between the Company and
American Stock Transfer & Trust Company, as Rights Agent (incorporated
herein by reference to Exhibit 4.1 to the Company's Registration
Statement on Form 8-A, Registration No. 000-22123, as filed with the
Commission on February 7, 1997).

10.1 Executive Retention Agreement effective May 1, 2003 between the
Company and James Ken Newman (filed herewith).

10.2 Third Amendment to Second Amended and Restated Credit Agreement, dated
as of April 4, 2003 between Horizon Health Corporation and Horizon
Mental Health Management, Inc., as Borrowers and J.P. Morgan Chase
Bank as Agent, and the banks named therein (filed herewith).

11.1 Statement Regarding Computation of Per Share Earnings (filed
herewith).

99.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, signed by James K. Newman, President and Chief Executive
Officer, dated June 30, 2003 (filed herewith).

99.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, signed by Ronald C. Drabik, Senior Vice President, Finance and
Administration, dated June 30, 2003(filed herewith).

(b) The Company filed the following reports on Form 8-K during the quarter
covered by this report:

Current report on Form 8-K filed with the Commission on May 30, 2003.
The items reported were Item 5, Other Events, announcing a publicly
available conference call regarding the Company's second quarter
financial results on June 30, 2003.

36

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.

DATE: JUNE 30, 2003
HORIZON HEALTH CORPORATION

BY: /S/ RONALD C. DRABIK
-------------------------------------
RONALD C. DRABIK
SENIOR VICE PRESIDENT-FINANCE AND
ADMINISTRATION AND TREASURER
(PRINCIPAL FINANCIAL AND ACCOUNTING
OFFICER)

37

CERTIFICATION

I, James K. Newman, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Horizon Health
Corporation;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of the registrant's board of directors (or persons
performing the equivalent functions):

a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: June 30, 2003 /s/ JAMES K. NEWMAN
-------------------------------------
James K. Newman
President and Chief Executive Officer

38

CERTIFICATION

I, Ronald C. Drabik, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Horizon Health
Corporation;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of the registrant's board of directors (or persons
performing the equivalent functions):

a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: June 30, 2003 /s/ RONALD C. DRABIK
-----------------------
Ronald C. Drabik
Chief Financial Officer

39

INDEX TO EXHIBITS

NUMBER EXHIBIT

3.1 Certificate of Incorporation of the Company, as amended (incorporated
herein by reference to Exhibit 3.1 to the Company's Current Report on
Form 8-K dated August 11, 1997).

3.2 Amended and Restated Bylaws of the Company, as amended (incorporated
herein by reference to Exhibit 3.2 to Amendment No. 2 as filed with
the Commission on February 16, 1995 to the Company's Registration
Statement on Form S-1 filed with the Commission on January 6, 1995
(Registration No. 33-88314)).

4.1 Specimen certificate for the Common Stock, $.01 par value of the
Company (incorporated herein by reference to Exhibit 4.1 to the
Company's Current Report on Form 8-K dated August 11, 1997).

4.2 Rights Agreement, dated February 6, 1997, between the Company and
American Stock Transfer & Trust Company, as Rights Agent (incorporated
herein by reference to Exhibit 4.1 to the Company's Registration
Statement on Form 8-A, Registration No. 000-22123, as filed with the
Commission on February 7, 1997).

10.1 Executive Retention Agreement effective May 1, 2003 between the
Company and James Ken Newman (filed herewith).

10.2 Third Amendment to Second Amended and Restated Credit Agreement, dated
as of April 4, 2003 between Horizon Health Corporation and Horizon
Mental Health Management, Inc., as Borrowers and J.P. Morgan Chase
Bank as Agent, and the banks named therein (filed herewith).

11.1 Statement Regarding Computation of Per Share Earnings (filed
herewith).

99.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, signed by James K. Newman, President and Chief Executive
Officer, dated June 30, 2003 (filed herewith).

99.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, signed by Ronald C. Drabik, Senior Vice President, Finance and
Administration, dated June 30, 2003 (filed herewith).

40