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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

or

For the transition period from                    to                    

Commission File No. 000-50118

VistaCare, Inc.

(Exact name of registrant as specified in its charter)

(480) 648-4545
(Registrant’s telephone number, including area code)

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

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

     As of June 30, 2003, there were outstanding 15,664,207 shares of the registrant’s Class A Common Stock, $0.01 par value per share.

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VistaCare, Inc.

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

VISTACARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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VISTACARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)
(In thousands, except share related
information)

See accompanying notes to condensed consolidated financial statements.

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VISTACARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to condensed consolidated financial statements.

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VISTACARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Description of Business

               VistaCare, Inc. (VistaCare), is a Delaware corporation providing medical care designed to address the physical, emotional, and spiritual needs of patients with a terminal illness and to support their family members. Hospice services are provided predominately in the patient’s home; however, certain patients require inpatient services. These inpatient services are provided by VistaCare at its stand-alone inpatient facility in Cincinnati, Ohio, at its hospital-based inpatient facility in Albuquerque, New Mexico or through leased beds at other unrelated hospitals and skilled nursing facilities on a per diem basis. VistaCare provides services in Alabama, Arizona, Colorado, Georgia, Indiana, Massachusetts, New Mexico, Nevada, Ohio, Oklahoma, Pennsylvania, South Carolina, Texas and Utah.

1. Significant Accounting Policies

Basis of Presentation

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

               The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.

               The balance sheet at December 31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in VistaCare’s annual report on Form 10-K for the year ended December 31, 2002.

Capitalized Software Development Costs

               VistaCare capitalizes certain internal salaries related to the development of computer software used in its operations. Such capitalized software development costs are being amortized over three years. Capitalized software development costs, net of amortization, included in other assets, amounted to $3,965,000 at December 31, 2002 and $4,899,000 at June 30, 2003. Costs incurred during the preliminary project stage and post implementation/operations stage are expensed as incurred.

Goodwill

               During 1998, VistaCare completed the acquisitions of FHI Health Services, Inc. and Vencor Hospice, Inc. (VistaCare USA, Inc.). During 2002, VistaCare completed the acquisition of Palliative Care Concepts, Inc. The difference between the purchase prices and the fair value of assets acquired and liabilities assumed was recorded as goodwill. Prior to January 1, 2002, VistaCare amortized goodwill over a period of 30 years. Amortization related to goodwill totaled $2,408,000 on January 1, 2002 and 2003. No amortization was recognized in the six-months ended June 30, 2002 and 2003.

               In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets,

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which became effective for VistaCare in the first quarter of 2002. Under these rules, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to impairment tests that must be conducted at least annually, or more often if events or circumstances arise that indicate that the carrying value of the goodwill associated with VistaCare’s acquired businesses exceeds its fair market value. VistaCare determined that no impairment of goodwill existed at December 31, 2002 or at June 30, 2003.

Acquisition

               In August 2002, VistaCare completed the acquisition of Palliative Care Concepts, Inc., a hospice program in Albuquerque, New Mexico. VistaCare paid $2,500,000 in cash and issued a $250,000 unsecured promissory note to the seller in connection with the acquisition. The purchase price was allocated primarily to goodwill. The promissory note was paid in full in July 2003.

Net Patient Revenue

               Net patient revenue is the amount VistaCare believes it is entitled to collect for its services, adjusted as described below. The amount VistaCare believes it is entitled to collect for its services varies depending on the level of care provided, the payor and the geographic area where services are rendered. Net patient revenue includes adjustments for charity care and estimated payment denials (which VistaCare experiences from time to time for reasons such as its failure to submit complete and accurate claim documentation, its failure to provide timely written physician certifications as to patient eligibility, or the payor deems the patient ineligible for insurance coverage), contractual adjustments, amounts VistaCare estimates it could be required to repay to Medicare, such as payments that VistaCare would be required to make in the event that any of its programs exceed the annual per-beneficiary cap, and subsequent changes to initial level of care determinations. VistaCare adjusts its estimates from time to time based on its billing and collection experience. VistaCare believes that it can reasonably estimate such adjustments to net patient revenue because it has significant historical experience and because it has a centralized billing and collection department that continually monitors the factors that could potentially result in a change in estimate. There were no material changes in estimates to net patient revenue for the year ended December 31, 2002 or the six-month periods ended June 30, 2002 and 2003. VistaCare recognizes net patient revenue once the patient’s hospice eligibility has been certified, the patient’s coverage from a payment source has been verified and services have been provided to that patient.

               Approximately 95% and 96% of VistaCare’s net patient revenue was derived from the Medicare and Medicaid programs for the six-month periods ended June 30, 2002 and 2003, respectively. VistaCare operates under arrangements with Medicare, Medicaid and other third-party payors pursuant to which these payors reimburse VistaCare for services it provides to hospice-eligible patients these payors cover, subject only to VistaCare’s submission of adequate and timely claim documentation. VistaCare has a patient intake process that screens patients for hospice eligibility and identifies whether their care will be covered by Medicare, Medicaid, private insurance, managed care or self-pay. Whether Medicare or Medicaid continue to provide reimbursement for hospice care is dependent upon governmental policies.

Medicare and Medicaid Regulation

               VistaCare is subject to certain limitations on Medicare payments for services. Specifically, if the number of inpatient care days of care any hospice program provides to Medicare beneficiaries exceeds 20% of the total days of hospice care such program provides to all patients for an annual period beginning September 28, the days in excess of the 20% figure may be reimbursed only at the routine home care rate. None of VistaCare’s hospice programs exceeded the payment limits on inpatient services in the six-month periods ended June 30, 2002 or 2003.

               VistaCare is also subject to a Medicare annual per-beneficiary cap. Compliance with the Medicare per-beneficiary cap is measured by comparing the cost of services provided to each Medicare beneficiary by each hospice program during the Medicare fiscal year ending October 31 to the per-beneficiary cap amount for each Medicare beneficiary in such program who elects to receive the Medicare hospice benefit for the first time during such fiscal year. VistaCare recorded reductions to net patient revenue of approximately $1,262,000 for the eight months ended June 30, 2003 as estimates for exceeding the Medicare per-beneficiary cap for the 2003 fiscal cap year that began on November 1, 2002. VistaCare did not record any reduction to net patient revenue for the eight months ended June 30, 2002 as an estimate for exceeding the per-

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beneficiary cap for the 2002 fiscal cap year that began November 1, 2001. As of the date of this report, VistaCare had not been assessed any amounts for exceeding the per-beneficiary cap for the assessment periods that began on November 1, 2001 and November 1, 2002. VistaCare management believes that as of June 30, 2003 adequate reserves had been established for this potential liability.

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

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

Charity Care

               VistaCare provides care at no cost to patients who are not eligible for insurance coverage and meet certain financial need criteria established by VistaCare. Charity care totaled approximately $305,000 and $722,000 for the three months ended June 30, 2002 and 2003, respectively, and $818,000 and $1,388,000 for the six months ended June 30, 2002 and 2003, respectively. Because VistaCare does not pursue collection of amounts determined to qualify as charity care, these amounts are not recorded in net patient revenue. Costs VistaCare incurs in providing charity care are recorded as patient care expenses.

Nursing Home Costs

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

               Nursing home costs totaled approximately $6,351,000 and $7,623,000 for the three months ended June 30, 2002 and 2003, respectively, and $10,002,000 and $15,108,000 for the six months ended June 30, 2002 and 2003, respectively. Nursing home revenue totaled approximately $6,014,000 and $7,191,000 for the three months ended June 30,2002 and 2003, respectively, and $9,505,000 and $14,307,000 for the six months ended June 30, 2002 and 2003, respectively.

Income Taxes

               VistaCare accounts for income taxes under the liability method as required by SFAS No. 109, Accounting for Income Taxes. Under the liability method, deferred taxes are determined based on temporary differences between financial statement and tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for years in which the related taxes are expected to be paid or recovered.

Medical Malpractice

               VistaCare is covered by claims-made general and professional liability insurance coverage with limits of $1,000,000 per claim and $3,000,000 in the aggregate. VistaCare has not experienced any uninsured medical

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malpractice losses.

Use of Estimates

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

Stock-Based Compensation

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

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

Initial Public Offering

               On December 23, 2002, VistaCare completed its initial public offering of common stock (IPO) at $12.00 per share. VistaCare sold 4,500,000 shares and received $48,145,000 in net proceeds from the IPO. The remaining proceeds will be used to finance potential acquisitions of hospices and for other corporate purposes. Upon the closing of the IPO in December 2002, all of VistaCare’s redeemable and convertible preferred stock was converted into 5,603,111 shares of VistaCare’s Class A common stock. The accumulated dividends on VistaCare’s Series B,

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C and D preferred stock of $16,486,000, which were not payable in the event of a mandatory conversion, were reclassified as additional paid-in-capital and no additional dividends will be accrued or recorded subsequent to the IPO.

Earnings Per Share

               Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of shares outstanding during the period plus the effect of dilutive securities, including outstanding warrants, employee stock options (using the treasury stock method) and shares of Series A-1 Preferred Stock (using the if-converted method).

Recent Accounting Pronouncements

               In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. This statement eliminates accounting treatment for reporting gains or losses on debt extinguishments and amends certain other existing accounting pronouncements. The adoption of this standard is not expected to have a material effect on VistaCare’s consolidated financial position or results of operations.

               In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 nullifies the guidance in EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. Under EITF No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS No. 146, the FASB acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to the other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activities be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS No. 146 will be effective for exit or disposal activity that are initiated after December 31, 2002. The adoption of this standard is not expected to have a material effect on VistaCare’s financial position or results of operations.

               In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 requires certain guarantees to be recorded at fair value. FIN No. 45 also requires a guarantor to make certain disclosures about guarantees even when the likelihood of making any payments under the guarantee is remote. FIN No. 45 is effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of this interpretation did not have a material effect on VistaCare’s consolidated financial position or results of operations.

               In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation and provides alternative methods of transition for a voluntarily change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. While SFAS No. 148 does not amend SFAS No. 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS No. 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of SFAS No. 123 or the intrinsic method of APB Opinion No. 25. As allowed by SFAS No. 123, VistaCare has elected to continue to utilize the accounting method prescribed by APB Opinion No. 25 and has adopted the disclosure requirements of SFAS No. 123 as of December 1, 2002.

               In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities. FIN No. 46 addresses the consolidation and financial reporting of variable interest entities. FIN No. 46 is effective for financial statements of interim or annual periods beginning after June 15, 2002 for variable interest entities created before February 1, 2003, or immediately for variable interest entities created after February 1, 2003. The adoption

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of this interpretation is not expected to have a material effect on VistaCare’s consolidated financial position or results of operations.

2. Accrued Expenses

               A summary of accrued expenses follows (in thousands):

3. Income Taxes

               VistaCare’s provisions for income taxes for the six-month periods ended June 30, 2002 and 2003 reflect its estimates of the effective tax rate applicable for the full year. This estimate is re-evaluated by management each quarter based upon forecasts of income before taxes for the year. VistaCare’s effective tax rate in these periods was lower than the federal statutory rates primarily due to its use of tax credits and net operating loss carryforwards.

4. Long-Term Debt

               In April 2001, VistaCare entered into a $30,000,000 revolving line of credit and a $3,000,000 term loan (credit facility). The credit facility is collateralized by substantially all of VistaCare’s assets including cash, accounts receivable and equipment. Loans under the revolving line of credit bear interest at an annual rate equal to, at VistaCare’s option, either the “prime rate” in effect from time to time, as reported in the “Money Rates” section of the Wall Street Journal, plus 1.5%, or the one-month London Interbank Borrowing Rate in effect from time to time, plus 3.0%. Accrued interest under the revolving line of credit is due (i) weekly, if VistaCare opts to pay interest at the prime rate, or (ii) on the last business day of the month, if VistaCare opts to pay interest at the London Interbank Borrowing Rate based rate.

               Under the revolving line of credit, VistaCare may borrow, repay and reborrow an amount equal to the lesser of: (i) $30,000,000 or (ii) 85% of the estimated net value of eligible accounts receivable. As of June 30, 2003, approximately $26.2 million was available for borrowing under the revolving line of credit. The maturity date of the revolving line of credit is April 30, 2005. As of June 30, 2003, there was no balance outstanding on the revolving line of credit.

               The credit facility contains certain customary covenants including those that restrict the ability of VistaCare to incur additional indebtedness, pay dividends under certain circumstances, permit liens on property or assets, make capital expenditures, make certain investments, and prepay or redeem debt or amend certain agreements relating to outstanding indebtedness.

               In connection with its acquisition of Palliative Care Concepts, Inc., VistaCare issued a $250,000 unsecured promissory note. The promissory note bears interest at a rate of 4.0% per annum and was paid in full in July 2003.

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5. Dilutive Securities

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

6. Allowance for Denials

               The allowance for denials for patient accounts receivable is as follows (in thousands):

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7. Litigation

               VistaCare and one of its former employees are currently defendants in an action initiated on February 5, 2003 in the United States District Court in the District of Nevada. The action, Bradeen et al. v. Vista Hospice Care, Inc. and Edward Raymond Lowe, relates to a fatal motor vehicle accident involving a VistaCare former employee. The plaintiffs in the action allege that the former employee, while acting within the scope of his employment by VistaCare, negligently and recklessly caused a motor vehicle collision that resulted in the death of two people. The plaintiff’s seek pecuniary and punitive damages in an unspecified amount. VistaCare maintained aggregate liability insurance of $4.0 million at the time of the accident. VistaCare has determined, without considering any possible insurance recovery, that a loss in connection with this matter is possible, but not probable and estimable. Accordingly, VistaCare has not recorded any liability relating to this matter.

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

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

Overview

               During the quarter ended June 30, 2003, we experienced significant growth in patient census and net patient revenue. In particular:

	•		our patient census at June 30, 2003 was approximately 4,700, compared to our patient census of approximately 4,300 at March 31, 2003; and
	•		our net patient revenue for the quarter was $46.1 million, compared to our net patient revenue of $42.0 million for the quarter ended March 31, 2003.

This growth resulted primarily from an increase in average daily census from 4,125 for the quarter ended March 31, 2003 to 4,569 for the quarter ended June 30, 2003 and the opening of a new program in Phenix City, Alabama in June 2003.

               Our net income before accrued preferred stock dividends for the quarter ended June 30, 2003 was $3.8 million, compared to $1.5 million for the quarter ended June 30, 2002. Our increase in net income before accrued preferred stock dividends for the quarter ended June 30, 2003 was impacted by, among other things, increased labor expenses resulting from a wage increase of approximately 3.3% per employee that went into effect in April and approximately $100,000 in start-up costs related to the opening of a new program in Phenix City, Alabama that were charged to expense during the quarter. Our cash flow from operations for the six months ended June 30, 2003 was $7.7 million, compared to cash flow from operations of $2.9 million for the six months ended June 30, 2002.

               In July 2003, the Centers for Medicare and Medicaid Services announced that Medicare base hospice reimbursement rates for the Medicare fiscal year October 1, 2003 through September 30, 2004 will increase by 3.4% over current base rates. We expect that this increase will have a positive impact on our net patient revenue in the fourth quarter of 2003.

               On May 16, 2003, we completed a secondary offering of common stock. All of the 6,325,000 shares sold in the offering were sold by selling stockholders, and we did not receive any of the proceeds. We incurred costs and expenses of $191,000 in connection with the offering, and we recorded such costs and expenses as additional paid-in-capital.

Net Patient Revenue

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

	•		estimated payment denials and contractual adjustments;
	•		patients who do not have insurance coverage and who are deemed financially in need of charity care;
	•		amounts we estimate we could be required to repay to Medicare, such as amounts that we would be required to repay if any of our programs exceed the annual per-beneficiary cap, as described below under “Critical Accounting Policies and Significant Estimates — Adjustments to Net Patient Revenue for Exceeding the Medicare Per-Beneficiary Cap”; and
	•		subsequent changes to initial level of care determinations.

          We adjust our estimates from time to time based on our billing and collection experience. Only after a patient’s hospice eligibility has been determined, a payment source has been identified and services have been provided do

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we recognize net patient revenue for services that we provide to that patient.

     We derive net patient revenue from billings to Medicare, Medicaid, private insurers, managed care providers, patients and others. We operate under arrangements with those payors pursuant to which they reimburse us for services we provide to hospice eligible patients they cover, subject only to our submission of adequate and timely claim documentation. Our patient intake process screens patients for hospice eligibility and identifies whether their care will be covered by Medicare, Medicaid, private insurance, managed care or self-pay. Medicare reimbursements account for the majority of our net patient revenue. Our net patient revenue is determined primarily by the number of billable patient days, the level of care provided and reimbursement rates. The number of billable patient days is a function of the number of patients admitted to our programs and the number of days that those patients remain in our care (length of stay). We exceeded the industry average in achieving an average length of stay of 86 days and 88 days for the year ended December 31, 2002 and the three months ended June 30, 2003, respectively. We attribute our ability to exceed the industry average in terms of length of stay to several factors. First, our percentage of non-cancer patients has been increasing and those patients have a higher average length of stay than cancer patients. Second, we believe that our open access philosophy and our efforts to educate referral sources about hospice care is encouraging earlier transfers of patients to hospice care. Finally, a significant amount of our growth in recent periods has been in rural markets where more patients turn to hospice care because access to intensive care hospitals or other alternative sites for hospice-eligible patients is more difficult.

     The table below sets forth the percentage of our net patient revenue for the three and six-month periods ended June 30, 2002 and June 30, 2003 derived from Medicare, Medicaid, private insurers and managed care payors:

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

     Typically, each October, Medicare adjusts its base hospice care reimbursement rates for the following year based on inflation and other economic factors. Effective April 1, 2001, the Medicare base rates were increased 5.0% over the base rates then in effect. Such rates were further increased by 3.2% effective October 1, 2001, 3.4% effective October 1, 2002 and will be increased an additional 3.4% effective October 1, 2003. These increases have favorably impacted our net patient revenue. Medicare’s base rates are subject to regional adjustments based on local wage levels. These regional adjustments are not necessarily proportional to adjustments in the base rates.

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

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

Expenses

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

     Patient care expenses consist primarily of salaries, benefits, payroll taxes and travel costs associated with our hospice care providers and program level administrative and marketing personnel. Patient care expenses also include the cost of pharmaceuticals, durable medical equipment, medical supplies, inpatient arrangements, nursing home costs, net, and purchased services such as ambulance, infusion and radiology. We incur inpatient facility costs primarily through per diem lease arrangements with hospitals and skilled nursing facilities where we provide our services. We also operate a 12-bed, stand-alone inpatient hospice facility and a 10-bed, hospital-based inpatient facility. Patient length of stay impacts our patient care expenses as a percentage of net patient revenue. Patient care expenses are generally higher during the initial and latter days of care. In the initial days of care, expenses tend to be higher because of the initial purchases of pharmaceuticals, medical equipment and supplies and the administrative costs of determining the patient’s hospice eligibility, registering the patient and organizing the plan of care. In the latter days of care, expenses tend to be higher because patients generally require more services, such as pharmaceuticals and nursing care, due to their deteriorating medical condition. Accordingly, if lengths of stay decline, those higher costs are spread over fewer days of care, which increases patient care expenses as a percentage of net patient revenue and negatively impacts profitability. Patient care expenses are also impacted by the geographic concentration of patients. Labor expenses, which represent the single largest category of patient care expenses, tend to be less if patients are geographically concentrated and hospice care providers are required to spend less time traveling and can care for more patients.

     For our patients who receive nursing home care under state Medicaid programs in states other than Arizona, Oklahoma, Pennsylvania and South Carolina, the applicable Medicaid program pays us an amount equal to no more than 95% of the Medicaid per diem nursing home rate for room and board services furnished to the patient by the nursing home in addition to the Medicare or Medicaid routine home care per diem payment. We pay the nursing home for these room and board services at a rate between 95% and 100% of the full Medicaid per diem nursing home rate, depending on the terms of the contract between us and the nursing home. We include the difference between the amount we pay the nursing home and the amount we receive from Medicaid in patient care expenses. We refer to this difference as “nursing home costs, net”. Our nursing home costs, net, were $0.3, and $0.4 million for the three months ended June 30, 2002 and 2003, respectively, and $0.5 million and $0.8 million for the six months ended June 30, 2002 and 2003, respectively.

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

     In April 2003, we increased employee salaries by an average of 3.3% per employee, which impacts both patient care expenses and general and administrative expenses.

Stock-Based Compensation

     Certain employee stock options which we granted in 2001 and 2002 have resulted in and will continue to result in stock-based compensation charges. In accordance with Accounting Principles Board Opinion No. 25 and related interpretations, if an employee stock option is granted with an exercise price which is less than the deemed fair value

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of the underlying stock, the difference is treated as a compensation charge that must be recognized ratably over the vesting period for the option. As a result of employee option grants made in 2001 and 2002 with exercise prices determined to be less than the deemed fair value of our common stock on the respective grant dates, we recognized stock-based compensation expense of $88,000 and $102,000 in the three months ended June 30, 2002 and 2003, respectively, and $137,000 and $1,149,000 in six months ended June 30, 2002 and 2003, respectively. In addition, a stock option granted to our Chief Executive Officer in November 2002 was subject to variable accounting due to the vesting provisions contained in the option. We accelerated the vesting on this option in February 2003, and recorded stock-based compensation expense in relation to this option of $9,000 in 2002 and $953,000 in the three months ended March 31, 2003. As of June 30, 2003, we had accrued a total of $1.2 million of deferred stock-based compensation relating to the foregoing options.

Capitalized Software Development Costs

     We have capitalized certain internal costs related to the development of software used in our business. We capitalize all qualifying internal costs incurred during the application development stage. Costs incurred during the preliminary project stage and post-implementation/operation stage are expensed as incurred. We had total capitalized software development costs, net of amortization, of approximately $4.9 million as of June 30, 2003. We amortize the capitalized software development costs related to particular software over a three-year period commencing when that software is substantially complete and ready for its intended use. We are currently testing our billing module that includes approximately $3.5 million of capitalized software development cost as of June 30, 2003. We expect that this application will be substantially complete in October 2003.

Goodwill

     Goodwill from our 1998 and 2002 acquisitions, net of accumulated amortization of $2.4 million, was $20.6 million as of December 31, 2002 and June 30, 2003. Prior to 2002, we were amortizing the goodwill from our 1998 acquisitions over 30 years. Rules issued by the Financial Accounting Standards Board, effective for 2002, require that we no longer amortize goodwill. These rules require that we analyze our goodwill for impairment annually, or more often if events or circumstances arise that indicate that the carrying value of our goodwill exceeds its fair market value. We applied these rules beginning January 1, 2002. We have concluded that no basis for impairment of our goodwill existed as of June 30, 2003.

Adjusted EBITDA

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

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     The following table reconciles our net income before accrued preferred stock dividends to adjusted EBITDA and also shows cash flows from operating, investing and financing activities for the periods indicated:

Critical Accounting Policies and Significant Estimates

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

     Adjustments to Net Patient Revenue for Estimated Payment Denials

     More than 95% of our net patient revenue is derived from Medicare and Medicaid programs. The balance of our net patient revenue is derived primarily from private insurers and managed care programs. We operate under arrangements with these payors pursuant to which they reimburse us for services we provide to hospice-eligible patients they cover, subject only to our submission of adequate and timely claim documentation. In some cases, these payors deny our claims for reimbursement for reasons such as:

	•		our claim documentation is incomplete or contains incorrect patient information;
	•		the payor deems the patient ineligible for insurance coverage; or
	•		we have failed to provide timely written physician certifications as to patient eligibility.

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

	•		our experience of claim denials by payor class;
	•		the strength and reliability of our billing practices; and
	•		changes in the regulatory environment.

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     We reflected reductions to net patient revenue for estimated claim denials of $0.6 and $1.0 million for the three months ended June 30, 2002 and 2003 respectively, and $1.2 and $1.8 million for the six months periods ended June 30, 2002 and 2003, respectively.

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

     Each of our hospice programs is subject to the annual Medicare per-beneficiary cap. In effect, the per-beneficiary cap imposes a limit on the amount of payments per beneficiary that we can receive from Medicare with respect to services provided during the twelve-month period between November 1 of one year and October 31 of the following year. To determine whether we have exceeded the per-beneficiary cap at any of our programs, Medicare first multiplies the number of Medicare hospice beneficiaries in that program who have elected Medicare hospice coverage for the first time in that twelve-month period by the annual per-beneficiary cap amount. If actual Medicare reimbursements to that program with respect to services provided during the period exceed that amount, Medicare requires that we repay the difference to Medicare.

     We actively monitor each of our programs to determine whether they are likely to exceed the Medicare per-beneficiary cap. If we determine that a program is likely to exceed the cap, we attempt to institute corrective action, such as a change in patient mix. However, to the extent we believe our corrective action will not be successful, we estimate the amount that we could be required to repay to Medicare and accrue that amount as a reduction to net patient revenue. Factors that impact our estimate include:

	•		our success in implementing corrective measures; and
	•		possible enrollment of beneficiaries in our programs who, without our knowledge, may have previously elected Medicare hospice coverage through another hospice provider.

     We recorded reductions to net patient revenue of $0.9 million for the year ended December 31, 2002 and $1.0 million for the six-month period ended June 30, 2003, respectively, for exceeding the per-beneficiary cap in those periods.

     Goodwill Impairment

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

	•		significant under-performance of our acquired businesses relative to historical or projected operating results;
	•		significant negative industry trends; or
	•		significant changes in regulations governing hospice reimbursements from Medicare and state Medicaid programs.

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

     In the event we determine that the value of our goodwill has become impaired, we are required to write down the value of the goodwill to its fair market value on our balance sheets and to reflect the extent of the impairment as an expense on our statements of operations. We have determined that no impairment of goodwill existed as of June 30, 2003.

     Income Taxes and Deferred Tax Assets

     As of December 31, 2002, we had net operating tax loss carryforwards to offset future taxable income of approximately $5.9 million for federal income tax purposes and $6.3 million for state income tax purposes. These carryforwards begin to expire in 2011 for federal income tax purposes and began to expire in 2002 for state income

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tax purposes. Future utilization of our net operating tax loss carryforwards may be limited under Internal Revenue Code Section 382 based upon changes in ownership that may occur in the future. We had net deferred tax assets of $6.1 million as of December 31, 2002, of which approximately $2.4 million related to net operating tax loss carryforwards, which were partially offset by a valuation allowance of $3.9 million and further by net deferred tax liabilities of $2.2 million. We recorded a valuation allowance at December 31, 2002 to reduce our net deferred tax assets to the amount that we believed is more likely than not to be realized based upon our recent operating results. During the three months ended June 30, 2003, we estimated the valuation allowance for net deferred tax assets given our operating performance.

     Our effective income tax rate for 2003 is expected, at present, to be 16.7% due primarily to the use of net operating loss carryforwards and tax credits. We expect that our effective tax rate for 2004 will be more normalized due to the use of the majority of the net operating loss carryforwards and tax credits in 2003.

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Results of Operations

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