UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

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

Commission file number: 333-129179

NATIONAL MENTOR HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

Delaware		31-1757086
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)
313 Congress Street, 6th Floor
Boston, Massachusetts 02210		(617) 790-4800
(Address of principal executive offices,		(Registrant’s telephone number,
including zip code)		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 o No þ

The Company is a voluntary filer of reports required of companies with public securities under Sections 13 or 15(d) of the Securities Exchange Act of 1934 and has filed all reports which would have been required of the Company during the past 12 months had it been subject to such provisions.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ		Smaller reporting company o
				(Do not check if smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of February 11, 2010, there were 100 shares outstanding of the registrant’s common stock, $.01 par value.

 

 

Index
National Mentor Holdings, Inc.

		Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of December 31, 2009 and September 30, 2009			3
Condensed Consolidated Statements of Operations for the three months ended December 31, 2009 and 2008			4
Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2009 and 2008			5
Notes to Condensed Consolidated Financial Statements			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
Item 3. Quantitative and Qualitative Disclosures about Market Risk			20
Item 4. Controls and Procedures			21
Item 4T. Controls and Procedures			21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			23
Item 1A. Risk Factors			23
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			32
Item 3. Defaults Upon Senior Securities			33
Item 4. Submission of Matters to a Vote of Security Holders			33
Item 5. Other Information			33
Item 6. Exhibits			33
Signatures			34

PART I. FINANCIAL INFORMATION

Item 1.		Financial Statements

National Mentor Holdings, Inc.

Condensed Consolidated Balance Sheets

(In thousands)

(Unaudited)

		December 31,				September 30,
		2009				2009
Assets
Current assets
Cash and cash equivalents		$	35,529			$	23,650
Restricted cash			6,040				5,192
Accounts receivable, net			117,795				118,969
Deferred tax assets, net			12,485				13,897
Prepaid expenses and other current assets			16,921				16,868
Total current assets			188,770				178,576
Property and equipment, net			143,715				145,876
Intangible assets, net			431,710				440,202
Goodwill			207,172				206,699
Other assets			15,246				16,047
Investment in related party debt securities			9,301				8,210
Total assets		$	995,914			$	995,610
Liabilities and shareholder’s equity
Current liabilities
Accounts payable		$	18,074			$	19,819
Accrued payroll and related costs			57,916				58,388
Other accrued liabilities			48,340				45,000
Obligations under capital lease, current			100				118
Current portion of long-term debt			3,713				7,415
Total current liabilities			128,143				130,740
Other long-term liabilities			13,971				13,462
Deferred tax liabilities, net			122,724				125,237
Obligations under capital lease, less current portion			1,661				1,680
Long-term debt, less current portion			503,532				500,763
Total liabilities			770,031				771,882
Shareholder’s equity
Common stock			—				—
Additional paid-in-capital			250,152				250,038
Other comprehensive loss, net of tax			(5,034	)			(7,115	)
Accumulated deficit			(19,235	)			(19,195	)
Total shareholder’s equity			225,883				223,728
Total liabilities and shareholder’s equity		$	995,914			$	995,610

See accompanying notes.

National Mentor Holdings, Inc.

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)

		Three Months Ended
		December 31,
		2009				2008
Net revenues		$	251,828			$	241,233
Cost of revenues			191,842				183,089
Gross profit			59,986				58,144
Operating expenses:
General and administrative			34,666				34,602
Depreciation and amortization			14,422				13,054
Total operating expenses			49,088				47,656
Income from operations			10,898				10,488
Other income (expense):
Management fee of related party			(276	)			(223	)
Other income (expense), net			58				(361	)
Interest income			12				116
Interest income from related party			476				—
Interest expense			(11,880	)			(12,439	)
Loss from continuing operations before income taxes			(712	)			(2,419	)
Benefit for income taxes			(635	)			(36	)
Loss from continuing operations			(77	)			(2,383	)
Income from discontinued operations, net of tax			37				42
Net loss		$	(40	)		$	(2,341	)

See accompanying notes.

National Mentor Holdings, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

		Three Months Ended
		December 31,
		2009				2008
Operating activities
Net loss		$	(40	)		$	(2,341	)
Adjustments to reconcile net loss to cash provided by operating activities:
Accounts receivable allowances			2,626				2,196
Depreciation and amortization of property and equipment			5,920				4,937
Amortization of other intangible assets			8,502				8,211
Amortization of deferred financing costs			791				825
Accretion of investment in related party debt securities			(242	)			—
Stock based compensation			114				498
Loss on disposal of property and equipment			93				59
Gain on disposal of assets			(43	)			(38	)
(Gain) loss from sales of discontinued operations			(62	)			245
Interest income from related party			(234	)			—
Changes in operating assets and liabilities:
Accounts receivable			(1,449	)			103
Other assets			(162	)			6,785
Accounts payable			(1,746	)			(2,763	)
Accrued payroll and related costs			(823	)			(7,724	)
Other accrued liabilities			5,981				4,030
Deferred taxes			(2,264	)			(1,114	)
Restricted cash			(848	)			112
Other long-term liabilities			509				213
Net cash provided by operating activities			16,623				14,234
Investing activities
Cash paid for acquisitions, net			(14	)			(13,106	)
Purchases of property and equipment			(3,930	)			(11,046	)
Cash proceeds from sale of assets			43				76
Cash proceeds from sale of discontinued operations			39				83
Cash proceeds from sale of property and equipment			88				220
Net cash used in investing activities			(3,774	)			(23,773	)
Financing activities
Repayments of long-term debt			(933	)			(934	)
Repayments of capital lease obligations			(37	)			(62	)
Dividend to parent			—				(48	)
Payments of deferred financing costs			—				(30	)
Net cash used in financing activities			(970	)			(1,074	)
Net increase (decrease) in cash and cash equivalents			11,879				(10,613	)
Cash and cash equivalents at beginning of period			23,650				38,908
Cash and cash equivalents at end of period		$	35,529			$	28,295

See accompanying notes.

National Mentor Holdings, Inc.

Notes to Condensed Consolidated Financial Statements

December 31, 2009

(Unaudited)

1. Basis of Presentation

National Mentor Holdings, Inc., through its wholly owned subsidiaries (collectively, the “Company”), is a leading provider of home and community-based human services to adults and children with intellectual and/or developmental disabilities, acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges. Since the Company’s founding in 1980, the Company has grown to provide services to approximately 24,000 clients in 34 states. The Company designs customized service plans to meet the unique needs of its clients in home- and community-based settings. Most of the Company’s services involve residential support, typically in small group home or host home settings, designed to improve the clients’ quality of life and to promote client independence and participation in community life. Other services that the Company provides include day programs, vocational services, case management, early intervention, family-based services, post-acute treatment and neurorehabilitation services, among others. The Company’s customized services offer its clients, as well as the payors of these services, an attractive, cost-effective alternative to human services provided in large, institutional settings.

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the applicable rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal and recurring accruals) necessary to present fairly the financial statements in accordance with GAAP. All significant intercompany balances and transactions between the Company and its subsidiaries have been eliminated in consolidation. The unaudited condensed consolidated financial statements herein should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2009, which is on file with the SEC. Operating results for the three months ended December 31, 2009 may not necessarily be indicative of results to be expected for any other interim period or for the full year.

The preparation of financial statements in conformity with GAAP requires the appropriate application of certain accounting policies, many of which require the Company to make estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and the impact of those events cannot be determined with certainty, the actual results may differ from the Company’s estimates. These differences could be material to the financial statements.

2. New Accounting Pronouncements

In December 2007, the FASB issued guidance in Accounting Standards Codification 805, Business Combinations (“ASC 805”). This update defines the acquirer as the entity that obtains control of a business in the business combination. This update also establishes principles and requirements for the recognition and measurement of identifiable assets acquired, the liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. Some of the changes, such as the accounting for contingent consideration and expensing transaction costs for business combinations may introduce more volatility into earnings. The Company adopted this guidance on October 1, 2009 and the statement applies prospectively for business combinations incurred on or after that date. The adoption of ASC 805 resulted in $0.5 million of expensed transaction costs as of December 31, 2009, which are no longer capitalized under ASC 805.

In September 2006, the FASB issued guidance in Accounting Standards Codification 820, Fair Value Measurements and Disclosures (“ASC 820”). The standard defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. In February 2008, the FASB deferred the effective date of the standard to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. The Company adopted this guidance on October 1, 2009 for nonfinancial assets and liabilities, which include goodwill and intangibles. The adoption did not have a material impact on the condensed consolidated financial statements of the Company.

3. Comprehensive Income (loss)

The components of other comprehensive income (loss) and related tax effects are as follows:

		Three Months Ended
		December 31,
(in thousands)		2009				2008
Net loss		$	(40	)		$	(2,341	)
Changes in unrealized gain (losses) on derivatives			2,876				(9,576	)
Changes in unrealized gain on available-for-sale debt securities			617				—
Income tax effect			(1,412	)			3,872
Comprehensive income (loss)		$	2,041			$	(8,045	)

4. Long-Term Debt

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

		December 31,				September 30,
(in thousands)		2009				2009
Senior term B loan, principal and interest due in quarterly installments through June 29, 2013
—fixed interest rate of 7.32%		$	86,205			$	88,988
—fixed interest rate of 6.89%			206,872				220,117
—variable interest rate of 2.26% and 2.29% at December 31, 2009 and September 30, 2009, respectively			30,198				15,008
Senior revolver, due June 29, 2012; quarterly cash interest payments at a variable interest rate			—				—
Senior subordinated notes, due July 1, 2014; semi-annual cash interest payments due each January 1st and July 1st (interest rate of 11.25%)			180,000				180,000
Term loan mortgage, principal and interest due in monthly installments through June 29, 2012; variable interest rate (4.75% at December 31, 2009 and September 30, 2009)			3,970				4,065
			507,245				508,178
Less current portion			3,713				7,415
Long-term debt		$	503,532			$	500,763

Senior secured credit facilities

The Company’s senior credit facility consists of a $335.0 million seven-year senior secured term B loan facility (the “term B loan”), a $125.0 million six-year senior secured revolving credit facility (the “senior revolver”) and a $20.0 million six-year senior secured synthetic letter of credit facility (together, the “senior secured credit facilities”).

The priority with regard to the right of payment on the Company’s debt is such that the senior secured credit facilities and the term loan mortgage have priority over all of the Company’s other long-term debt. The senior credit facilities are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary, and are secured by substantially all of the assets of the Company. The results of operations of the captive insurance subsidiary are not material to the Company’s consolidated results of operations.

Total cash paid for interest on the Company’s debt amounted to approximately $5.8 million and $6.5 million for the three months ended December 31, 2009 and 2008, respectively.

Term B loan

The $335.0 million term B loan amortizes one percent per year, paid quarterly, for the first six years, with the remaining balance due in the seventh year. The senior credit agreement also includes a provision for the prepayment of a portion of the outstanding term loan amounts at any year-end equal to an amount ranging from 0-50% of a calculated amount, depending on the Company’s leverage ratio, if the Company generates certain levels of cash flow. The variable interest rate on the term B loan is equal to LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option.

To reduce the interest rate exposure, the Company entered into interest rate swap agreements whereby the Company fixed the interest rate on approximately $221.2 million of its $335.0 million term B loan, effective as of August 31, 2006 and maturing on June 30, 2010 and fixed the interest rate on approximately $113.3 million of its remaining $335.0 million term B loan, effective as of August 31, 2007 and maturing on September 30, 2010. In total, as of December 31, 2009, the Company fixed the interest rate on approximately $293.1 million of its $323.3 million term B loan.

The table below provides information about the Company’s interest rate swap agreements and remaining variable rate debt related to the term B loan.

		December 31,								September 30,
		2009								2010
(in thousands)		Swap								Swap
Interest Swap effective date		Value				Rate				Value				Rate
August 31, 2006(1)		$	86,205				5.32	%		$	—				—
August 31, 2007(1)			206,872				4.89	%			—				—
Variable rate debt(1)			30,198				0.26	%			320,763				—
Total term B loan		$	323,275				—			$	320,763				—

The swap is a derivative and the fair value of the swap agreements, representing the price that would be paid to transfer the liability in an orderly transaction between market participants, was approximately $9.6 million or $5.7 million after taxes at December 31, 2009 and approximately $12.4 million or $7.4 million after taxes at September 30, 2009. The fair value was recorded in current liabilities (under Other accrued liabilities) and was determined based on pricing models and independent formulas using current assumptions.

Since the Company has the ability to elect different interest rates on the debt at each reset date, the hedging relationship does not qualify for use of the shortcut method. Therefore, the effectiveness of the hedge relationships is assessed on a quarterly basis during the term of the hedge by comparing whether the critical terms of the hedge continue to match the terms of the debt. Under this approach, the Company exactly matches the terms of the interest rate swap to the terms of the underlying debt and, therefore, assumes 100% hedge effectiveness. The entire change in fair market value is recorded in shareholder’s equity, net of tax, on the condensed consolidated balance sheets as other comprehensive loss.

Senior revolver and synthetic letter of credit facility

The Company had approximately $27.7 million in standby letters of credit outstanding as of December 31, 2009 related to the Company’s workers’ compensation insurance coverage. Of these letters of credit, $20.0 million were issued under the Company’s synthetic letter of credit facility, and $7.7 million were issued under the Company’s $125.0 million senior revolver. Letters of credit in excess of the $20.0 million synthetic letter of credit facility reduce availability under the Company’s senior revolver. The Company had no borrowings and $117.3 million of availability under the $125.0 million senior revolver as of December 31, 2009. The interest rates for any senior revolver borrowings are equal to either LIBOR plus 2.00% or Prime plus 1.00%, at the Company’s option, and subject to reduction depending on the Company’s leverage ratio.

Senior subordinated notes

The Company issued $180.0 million of 11.25% senior subordinated notes due 2014 (the “senior subordinated notes”). The senior subordinated notes are guaranteed by the Company’s subsidiaries, except for the captive insurance subsidiary. The results of operations of the captive insurance subsidiary are not material to the Company’s result of operations.

Term loan mortgage

In January 2010, the Company entered into an agreement to extend the term of its mortgage facility through June 29, 2012, the maturity date of the senior credit agreement. As a result of this subsequent extension, the majority of the term loan mortgage balance has been classified as long-term debt. The term loan mortgage is secured by certain buildings and land of the Company.

Covenants

The senior credit agreement and the indenture governing the senior subordinated notes contain both affirmative and negative financial and non-financial covenants, including limitations on the Company’s ability to incur additional debt, sell material assets, retire, redeem or otherwise reacquire capital stock, acquire the capital stock or assets of another business, pay dividends, and, in the case of the senior credit agreement, require the Company to meet or exceed certain financial ratios. At December 31, 2009, the Company is in compliance with all covenants.

5. Related Party Transactions

Investment in Related Party Debt Securities

During fiscal 2009, the Company purchased approximately $11.5 million in aggregate principal amount of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) for approximately $6.6 million. The security was classified as an available-for-sale debt security and was recorded on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. The NMH Holdings notes were issued by NMH Holdings. Cash interest on the NMH Holdings notes accrues at a rate per annum, reset quarterly, equal to LIBOR plus 6.375%, and PIK Interest (defined below) accrues at the cash interest rate plus 0.75%. NMH Holdings may elect to pay interest on the NMH Holdings notes (a) entirely in cash, (b) entirely by increasing the principal amount of the NMH Holdings notes or issuing new notes (“PIK Interest”) or (c) 50% in cash and 50% in PIK Interest.

NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including the Company, and all of its operations are conducted through the Company and the Company’s subsidiaries. As a result, NMH Holdings will be dependent upon dividends and other payments from the Company to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by the Company.

NMH Holdings has paid all of the interest payments to date on the NMH Holdings notes entirely in PIK Interest which increased the principal amount by $47.1 million. The Company recorded $0.5 million of interest income related to the NMH Holdings notes for the three months ended December 31, 2009, which is recorded under Interest income from related party on the condensed consolidated statements of operations. Interest income from related party includes PIK Interest as well as the accretion of the purchase discount on the securities.

As of December 31, 2009, the Company’s investment in related-party debt securities had a carrying value of $8.2 million, and an approximate fair value of $9.3 million. As a result, the Company has recorded $1.1 million of unrealized holding gain in other comprehensive loss, $0.6 million of which was recorded in the first quarter of fiscal 2010. The fair value is reflected on the Company’s condensed consolidated balance sheets as Investment in related party debt securities. The debt security is scheduled to mature on June 15, 2014, but actual maturities may differ from the contractual or expected maturities since borrowers have the right to prepay obligations with or without prepayment penalties.

The Company evaluates available-for-sale securities for other-than-temporary impairment at least quarterly. If the fair value of a security is less than its cost, an other-than-temporary impairment is required to be recognized if either of the following criteria is met: (1) if the Company intends to sell the security; or (2) if it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis less any current period credit loss.

6. Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

A three-level hierarchy for disclosure has been established to show the extent and level of judgment used to estimate fair value measurements, as follows:

Level 1:		Unadjusted quoted market prices in active markets for identical assets or liabilities.
Level 2:		Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
Level 3:		Unobservable inputs for the asset or liability. These values are generally determined using pricing models which utilize management estimates of market participant assumptions.

Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach, and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data. These unobservable inputs are only utilized to the extent that observable inputs are not available or cost-effective to obtain.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

						Unadjusted Quoted				Significant Other				Significant
						Market Prices				Observable Inputs				Unobservable Inputs
(in thousands):		Total				(Level 1)				(Level 2)				(Level 3)
Cash and cash equivalents		$	35,529			$	35,529			$	—			$	—
Interest rate swap agreements		$	(9,563	)		$	—			$	(9,563	)		$	—
Investment in related party debt securities		$	9,301			$	—			$	9,301			$	—

Cash and cash equivalents. Cash equivalents consist primarily of money market funds and bank deposits and the carrying value of cash equivalents approximates fair value.

Interest rate swap agreements. The fair value of the swap agreements was approximately $(9.6) million, or approximately $(5.7) million after taxes and was recorded in current liabilities (under Other accrued liabilities). The fair value of these agreements was determined based on pricing models and independent formulas using current assumptions that included swap terms, interest rates and forward LIBOR curves.

Investment in related party debt securities. The fair value of the investment in related party debt securities was approximately $9.3 million and was recorded in long-term assets (under Investment in related party debt securities). The fair value measurements consider observable market data that may include, among other data, credit ratings, credit spreads, future interest rates and risk free rates of return.

At December 31, 2009, the carrying values of cash and cash equivalents, accounts receivable and accounts payable approximated fair value. The carrying value and fair value of the Company’s debt instruments is as follows:

		December 31, 2009								September 30, 2009
		Carrying				Fair				Carrying				Fair
		Amount				Value				Amount				Value
Senior subordinated notes		$	180,000			$	183,600			$	180,000			$	175,500

The Company estimated the fair value of the debt instruments using market quotes and calculations based on current market rates available.

7. Income Taxes

The Company files a federal consolidated return and files various state income tax returns and, generally, the Company is no longer subject to income tax examinations by the taxing authorities for years prior to September 30, 2003. The Company’s effective income tax rate for the interim periods was based on management’s estimate of the Company’s annual effective tax rate for the applicable year. For the three months ended December 31, 2009, the Company’s effective income tax rate was 89.2% compared to an effective tax rate of 1.5% for the three months ended December 31, 2008. These rates differ from the federal statutory income tax rate primarily due to nondeductible permanent differences such as meals and nondeductible compensation, net operating losses not benefited and changes in the applicability of certain employment tax credits. The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits as income tax.

As of October 1, 2007, the Company has recorded a reserve for uncertain tax positions. The Company’s reserve for uncertain income tax positions at December 31, 2009 is $5.0 million. There has been no change in unrecognized tax benefits in the three months ended December 31, 2009 and the Company does not expect any significant changes to unrecognized tax benefits within the next twelve months.

8. Segment Information

The Company has two reportable segments, Human Services and Post Acute Specialty Rehabilitation Services (“SRS”).

The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. Human Services is organized in a reporting structure composed of two operating segments which are aggregated into one reportable segment based on similarity of the economic characteristics and services provided.

The SRS segment provides a mix of health care and community-based human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses. This segment is organized in a reporting structure composed of two operating segments which are aggregated based on similarity of economic characteristics and services provided. Activities classified as “Corporate” in the table below relate primarily to unallocated home office items.

The Company generally evaluates the performance of its operating segments based on income from operations. Segment disclosures for the three months ended December 31, 2008 have been conformed to reflect the composition of the Company’s reportable operating segments. The following is a financial summary by reportable operating segment for the periods indicated.

						Post Acute
						Specialty
(in thousands)		Human				Rehabilitation
For the three months ended December 31,		Services				Services				Corporate				Consolidated
2009
Net revenue		$	224,932			$	26,896			$	—			$	251,828
Income (loss) from operations			20,388				2,485				(11,975	)			10,898
Total assets			820,320				104,785				70,809				995,914
Depreciation and amortization			11,311				1,947				1,164				14,422
Purchases of property and equipment			2,839				374				717				3,930
2008
Net revenue		$	220,234			$	20,999			$	—			$	241,233
Income (loss) from operations			19,519				2,764				(11,795	)			10,488
Depreciation and amortization			10,595				1,498				961				13,054
Purchases of property and equipment			4,144				5,363				1,539				11,046

9. Accruals for Self-Insurance and Other Commitments and Contingencies

The Company maintains employment practices liability, professional and general liability, workers’ compensation, automobile liability and health insurance policies that include self-insured retentions. The Company intends to maintain such coverage in the future and is of the opinion that its insurance coverage is adequate to cover potential losses on asserted claims. Employment practices liability is fully self-insured and professional and general liability has a self-insured retention of $1.0 million per claim and $2.0 million in the aggregate, with additional insurance coverage above the retention. In connection with the Merger on June 29, 2006, subject to the same retentions, the Company purchased additional insurance for certain claims relating to pre-Merger periods. For workers’ compensation, the Company has a $350 thousand per claim retention with statutory limits. Automobile liability has a $100 thousand per claim retention, with additional insurance coverage above the retention. The Company purchases specific stop loss insurance as protection against extraordinary claims liability for health insurance claims. Stop loss insurance covers claims that exceed $300 thousand on a per member basis.

Beginning November 1, 2005, the Company’s self-insured portion of professional and general liability claims was transferred into the Company’s wholly-owned subsidiary captive insurance company. The captive insurance company also provides coverage for the Company’s employment practices liability beginning October 1, 2007. The accounts of the captive insurance company are fully consolidated with those of the other operations of the Company in the accompanying condensed consolidated financial statements.

The Company is in the human services business and, therefore, has been and reasonably expects it will continue to be subject to claims alleging that the Company, its Mentors, or its employees failed to provide proper care for a client, as well as claims by the Company’s clients, Mentors, employees or community members against the Company for negligence, intentional misconduct or violation of applicable law. Included in the Company’s recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that the Company’s programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on the Company. The Company could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if the Company does not prevail, the Company could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.

The Company accrues for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While the Company believes the provision for contingencies is adequate, the outcome of the legal and other such proceedings is difficult to predict and the Company may settle claims or be subject to judgments for amounts that differ from the Company’s estimates.

10. Subsequent Events

The Company has evaluated subsequent events up to the time of its filing with the Securities and Exchange Commission on February 11, 2010, which is the date that these financial statements were issued. Subsequent to quarter end, the Company acquired two companies complimentary to its business. Aggregate consideration for these acquisitions was approximately $12.2 million.

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

The following discussion of our financial condition and results of operations should be read in conjunction with the historical consolidated financial statements and the related notes included elsewhere in this report. This discussion may contain forward-looking statements about our markets, the demand for our services and our future results. We based these statements on assumptions that we consider reasonable. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed in the “Risk factors” and “Forward-looking statements” sections of this report.

Overview

Founded in 1980, we are a leading provider of home and community-based human services to adults and children with intellectual and/or developmental disabilities (“I/DD”), acquired brain injury and other catastrophic injuries and illnesses; and to youth with emotional, behavioral and medically complex challenges, or at risk youth (“ARY”). As of December 31, 2009, we provided our services to approximately 24,000 clients in 34 states through approximately 16,900 full-time equivalent employees. Most of our services involve residential support, typically in small group homes, ICFs-MR or host home settings, designed to improve our clients’ quality of life and to promote client independence and participation in community life. Our non-residential services consist primarily of day programs and periodic services in various settings. We derive most of our revenues from state and county governmental payors, as well as smaller amounts from non-public payors, mostly for services provided to persons with acquired brain injury and other catastrophic injuries and illnesses.

The largest part of our business is the delivery of services to adults and children with intellectual and/or developmental disabilities. Our I/DD programs include residential support, day habilitation, vocational services, case management, home health care and personal care. We also provide a variety of services to youth with emotional, behavioral and medically complex challenges. Our ARY services include therapeutic foster care, independent living, family reunification, family preservation, alternative schools and adoption services. We also provide a range of post-acute specialty rehabilitation treatment and care services to adults and children with an acquired brain injury and other catastrophic injuries and illnesses. Our specialty rehabilitation services range from post-acute care to assisted independent living and include neurobehavioral rehabilitation, neurorehabilitation, adolescent integration, outpatient or day treatment and pre-vocational services.

We operate our business in two reportable segments, Human Services and Post Acute Specialty Rehabilitation Services(“SRS”). The Human Services segment provides home and community-based human services to adults and children with intellectual and/or developmental disabilities and to youth with emotional, behavioral and medically complex challenges. The SRS segment provides a mix of health care and community-based human services to individuals with acquired brain injuries and other catastrophic injuries and illnesses.

Factors affecting our operating results

Demand for Home and Community-Based Human Services

Our growth in revenues has historically been related to increases in the rates we receive for our services as well as increases in the number of individuals served. This growth has depended largely upon development-driven activities, including the maintenance and expansion of existing contracts and the award of new contracts, and upon acquisitions. We also attribute the continued growth in our client base to certain trends that are increasing demand in our industry, including demographic, medical and political developments.

Demographic trends have a particular impact on our I/DD business. Increases in the life expectancy of individuals with I/DD, we believe, have resulted in steady increases in the demand for I/DD services. In addition, caregivers currently caring for their relatives at home are aging and may soon be unable to continue with these responsibilities. Each of these factors affects the size of the I/DD population in need of services. Similarly, growth for our ARY services has been driven by favorable demographics. Demand for our specialty rehabilitation services has also grown as faster emergency response and improved medical techniques have resulted in more people surviving a traumatic brain injury.

Political and economic trends can also affect our operations. In particular, state budgetary pressures, especially within Medicaid programs, may influence the overall level of payments for our services, the number of clients and the preferred settings for many of the services we provide. In recent months our government payors in several states have responded to deteriorating revenue collections by implementing provider rate reductions, including in the states of Arizona, California and Minnesota where we have significant market presence. We cannot be certain whether there will be further rate reductions in the coming months as state governments address revenue shortfalls.

Historically, pressure from client advocacy groups for the populations we serve has generally helped our business, as these groups generally seek to pressure governments to fund residential services that use our small group home or host home models, rather than large, institutional models. In addition, our ARY services have historically been positively affected by the trend toward privatization of these services. Furthermore, we believe that successful lobbying by these groups has preserved I/DD and ARY services and, therefore, our revenue base, from significant cutbacks as compared with certain other human services. In addition, a number of states have developed community-based waiver programs to support long-term care services for survivors of a traumatic brain injury.

Expansion

We have grown our business through expansion of existing markets and programs as well as through acquisitions.

Organic Growth

We believe that our future growth will depend heavily on our ability to expand existing service contracts and to win new contracts. Our organic expansion activities consist of both new program starts in existing markets and geographical expansion in new markets. Our new program starts typically require us to fund operating losses for a period of approximately 18-24 months. If a new program start does not become profitable during such period, we may terminate it. During the 12 months ended December 31, 2009, losses on new program starts for programs started within the last 18 months that generated operating losses were $3.6 million.

Acquisitions

As of December 31, 2009, we have completed 29 acquisitions since 2004, including several acquisitions of rights to government contracts or fixed assets from small providers, which we integrate with our existing operations. We have pursued larger strategic acquisitions in markets with significant opportunities. Acquisitions could have a material impact on our consolidated financial statements.

Divestitures

We regularly review and consider the divestiture of underperforming or non-strategic businesses to improve our operating results and better utilize our capital. We have made divestitures from time to time and expect that we may make additional divestitures in the future. Divestitures could have a material impact on our consolidated financial statements.

Net revenues

Revenues are reported net of allowances for unauthorized sales, estimated sales adjustments by business units and changes in the allowance for doubtful accounts. Revenues are also reported net of any state provider taxes or gross receipts taxes levied on services we provide. For the three months ended December 31, 2009, we derived approximately 90% of our net revenue from state and local government payors. The payment terms and rates of these contracts vary widely by jurisdiction and service type, and may be based on per person per diems, rates established by the jurisdiction, cost-based reimbursement, hourly rates and/or units of service. We bill most of our residential services on a per diem basis, and we bill most of our non-residential services on an hourly basis. Some of our revenues are billed pursuant to cost-based reimbursement contracts, under which the billed rate is tied to the underlying costs. Lower than expected cost levels may require us to return previously received payments after cost reports are filed. In addition, our revenues may be affected by adjustments to our billed rates as well as write-offs of previously billed amounts. Revenues in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be proposed in states where we operate or by the federal government which provides matching funds. We cannot determine the impact of such changes or the effect of any possible governmental actions.

Occasionally, timing of payment streams may be affected by delays by the state related to bill processing systems, staffing or other factors. While these delays have historically impacted our cash position in particular periods, they have not resulted in long-term collections problems.

Expenses

Expenses directly related to providing services are classified as cost of revenues. Direct costs and expenses principally include salaries and benefits for service provider employees, per diem payments to our Mentors, residential occupancy expenses, which are primarily comprised of rent and utilities related to facilities providing direct care, certain client expenses such as food, medicine and transportation costs for clients requiring services. General and administrative expenses primarily include salaries and benefits for administrative employees, or employees that are not directly providing services, administrative occupancy and insurance costs, as well as professional expenses such as consulting, legal and accounting services. Depreciation and amortization includes depreciation for fixed assets utilized in both facilities providing direct care and administrative offices, and amortization related to intangible assets.

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

Occupancy costs represent a significant portion of our operating costs. As of December 31, 2009, we owned 405 facilities and one office, and we leased 900 facilities and 277 offices. We incur no facility costs for services provided in the home of a Mentor.

Expenses incurred in connection with liability insurance and third-party claims for professional and general liability totaled approximately 0.5% and 0.4% of our net revenues for the three months ended December 31, 2009 and 2008, respectively. We have incurred professional and general liability claims and insurance expense for professional and general liability of $1.2 million and $0.9 million for the three months ended December 31, 2009 and 2008, respectively. We currently insure through our captive subsidiary professional and general liability claims for amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Above these limits, we have limited additional third-party coverage. We also insure through our captive subsidiary employment practices liability claims of up to $240 thousand per claim and up to $1.0 million in the aggregate.

Our ability to maintain our margin in the future is dependent upon obtaining increases in rates and/or controlling our expenses. In fiscal 2008 and 2009, we invested in our infrastructure initiatives and business process improvements, which had a negative impact on our margin. As we continue to invest in our infrastructure initiatives and business process improvements our margin may continue to be negatively impacted.

Results of Operations

The following table sets forth the percentages of net revenues that certain items of operating data constitute for the periods indicated:

						Post Acute Specialty
Three Months Ended December 31,		Human Services				Rehabilitation Services				Corporate				Consolidated
(in thousands)
2009
Net revenue		$	224,932			$	26,896			$	—			$	251,828
Income (loss) from operations			20,388				2,485				(11,975	)			10,898
Operating margin			9.1	%			9.2	%			—				4.3	%
2008
Net revenue		$	220,234			$	20,999			$	—			$	241,233
Income (loss) from operations			19,519				2,764				(11,795	)			10,488
Operating margin			8.9	%			13.2	%			—				4.3	%

Three months ended December 31, 2009 compared to three months ended December 31, 2008

Consolidated

Consolidated revenue for the three months ended December 31, 2009 increased by $10.6 million, or 4.4%, compared to revenue for the three months ended December 31, 2008. Revenue increased approximately $9.4 million related to acquisitions that closed during fiscal 2009. In addition, revenue increased approximately $3.7 million related to organic growth, including growth related to new programs that began operations during fiscal 2009 and the first quarter of fiscal 2010. Revenue growth was partially offset by a reduction in revenue of approximately $2.5 million from businesses we divested in fiscal 2009.

Consolidated income from operations increased from $10.5 million for the three months ended December 31, 2008 to $10.9 million for the three months ended December 31, 2009 while operating margins remained constant at 4.3%. Our operating margin was positively impacted by our ongoing cost-containment efforts, including a decrease in overtime costs of $0.7 million. Offsetting our cost-containment efforts were an increase of $1.2 million in workers’ compensation costs, an increase of $1.4 million in depreciation and amortization expense and an increased investment in growth initiatives.

Human Services

Human Services revenue for the three months ended December 31, 2009 increased by $4.7 million, or 2.1% compared to the three months ended December 31, 2008. Revenue increased approximately $6.2 million related to acquisitions that closed during fiscal 2009. In addition, revenue increased approximately $1.0 million related to organic growth, including growth related to new programs that began operations during fiscal 2009 and the first quarter of fiscal 2010. Human Services revenue growth was partially offset by a reduction in revenue of approximately $2.5 million from businesses we divested in fiscal 2009.

Operating margin increased from 8.9% during the three months ended December 31, 2008 to 9.1% during the three months ended December 31, 2009. Our operating margin was positively impacted by our ongoing cost-containment efforts, including a decrease in our overtime costs of $0.8 million. Offsetting our cost-containment efforts were a $1.1 million increase in workers’ compensation costs and a $0.7 million increase in depreciation and amortization expense.

Post Acute Specialty Rehabilitation Services

Post Acute Specialty Rehabilitation Services revenue for the three months ended December 31, 2009 increased by $5.9 million, or 28.1%, compared to the three months ended December 31, 2008. This increase was primarily due to growth of $3.2 million related to acquisitions that closed during fiscal 2009. In addition, organic growth contributed additional revenue of $2.7 million.

Operating margin decreased from 13.2% for the three months ended December 31, 2008 to 9.2% for the three months ended December 31, 2009 primarily due to increased investment in growth initiatives, namely $0.6 million related to increased infrastructure and $0.4 million related to new or expanded facilities.

Corporate

Corporate represents corporate general and administrative expenses. Total corporate expense increased by approximately $0.2 million from the three months ended December 31, 2008 to $12.0 million for the three months ended December 31, 2009. Corporate expense increased approximately $0.5 million during the three months ended December 31, 2009 primarily due to expensed transaction costs related to acquisitions. Offsetting this increase was a $0.4 million decrease in stock based compensation expense.

Liquidity and Capital Resources

Our principal uses of cash are to meet working capital requirements, fund debt obligations and finance capital expenditures and acquisitions. Cash flows from operations have historically been sufficient to meet these cash requirements. Our principal sources of funds are cash flows from operating activities and available borrowings under our senior credit facilities.

Operating activities

Cash flows provided by operating activities for the three months ended December 31, 2009 were $16.6 million compared to $14.2 million for the three months ended December 31, 2008. The increase was primarily due to an increase in operating income. Our days sales outstanding decreased approximately half a day from 46.2 days at September 30, 2009 to 45.5 at December 31, 2009.

Investing activities

Net cash used in investing activities, primarily consisting of purchases of property and equipment and cash paid for acquisitions, was $3.8 million for the three months ended December 31, 2009 compared to $23.8 million for the three months ended December 31, 2008.

Cash paid for property and equipment for the three months ended December 31, 2009 was $3.9 million, or 1.6% of net revenue, and included approximately $0.2 million related to the implementation of a new billing system. Cash paid for property and equipment was $11.0 million, or 4.6% of net revenue, for the three months ended December 31, 2008 and included $4.3 million related to the purchase of real estate and $0.8 million related to the implementation of a new billing system.

Cash paid for acquisitions for the three months ended December 31, 2008 was $13.1 million, primarily reflecting the earnout payment of $12.0 million associated with the CareMeridian acquisition and the acquisition of RIA, Inc. for approximately $0.9 million. Cash paid for acquisitions for the three months ended December 31, 2009 was immaterial and related to the finalization of the purchase price for acquisitions.

Financing activities

Net cash used in financing activities was $1.0 million for the three months ended December 31, 2009 compared to $1.1 million for the three months ended December 31, 2008. Our financing activities primarily included the repayment of long term debt of $0.9 million for the three months ended December 31, 2009 and 2008.

During fiscal 2009, we purchased $11.5 million of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) from our indirect parent company, NMH Holdings, Inc. (“NMH Holdings”). We may seek to purchase a portion of our outstanding debt or the debt of NMH Holdings from time to time. The amount of debt that may be purchased, if any, would be decided at the discretion of our Board of Directors and management and will depend on market conditions, prices, contractual restrictions, our liquidity and other factors.

As mentioned above, our principal sources of funds are cash flows from operating activities and available borrowings under the $125.0 million senior revolver. As of December 31, 2009, we did not have any borrowings under our senior revolver. The availability on the senior revolver was reduced by $7.7 million to $117.3 million as letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding. For a description of the senior credit facilities, see note 4 in the condensed consolidated financial statements. We believe that these funds will provide sufficient liquidity and capital resources to meet our near term and future financial obligations, including scheduled principal and interest payments, as well as to provide funds for working capital, capital expenditures and other needs for the foreseeable future. No assurance can be given, however, that this will be the case.

Contractual Commitments Summary

The following table summarizes our contractual obligations and commitments as of December 31, 2009:

						Less than												More than
(in thousands)		Total				1 year				1-3 years				3-5 years				5 years
Long-term debt obligations(1)		$	507,245			$	3,713			$	10,306			$	493,226			$	—
Operating lease obligations(2)			137,583				35,401				50,309				27,834				24,039
Capital lease obligations			1,761				100				127				144				1,390
Standby letters of credit			27,663				27,663				—				—				—
Total obligations and commitments		$	674,252			$	66,877			$	60,742			$	521,204			$	25,429

Off-balance sheet arrangements

We do not have any off-balance sheet transactions or interests.

Critical Accounting Policies

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

We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change.

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

Revenue Recognition

Revenues are reported net of any state provider taxes or gross receipts taxes levied on services we provide. Revenues are also reported net of allowances for unauthorized sales and estimated sales adjustments by business units. Sales adjustments are estimated based on an analysis of historical sales adjustments and recent developments in the payment trends in each business unit. Revenue is recognized when evidence of an arrangement exists, the service has been provided, the price is fixed or determinable and collectibility is reasonably assured.

We recognize revenue for services performed pursuant to contracts with various state and local government agencies and private health care agencies as follows: cost-reimbursement contract revenues are recognized at the time the service costs are incurred and units-of-service contract revenues are recognized at the time the service is provided. For our cost-reimbursement contracts, the rate provided by the payor is based on a certain level of service and types of costs incurred in delivering the service. From time to time, we receive payments under cost-reimbursement contracts in excess of the allowable costs required to support those payments. In such instances, we estimate and record a liability for such excess payments. At the end of the contract period, any balance of excess payments is maintained as a liability until it is reimbursed to the payor. Revenues in the future may be affected by changes in rate-setting structures, methodologies or interpretations that may be enacted in states where we operate or by the federal government.

Accounts Receivable

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

Accruals for Self-Insurance

We maintain employment practices liability, professional and general liability, workers’ compensation, automobile liability and health insurance with policies that include self-insured retentions. We record expenses related to claims on an incurred basis, which includes estimates of fully developed losses for both reported and unreported claims. The accruals for the health and workers’ compensation, automobile and professional and general liability programs are based on analyses performed internally by management and may take into account reports by independent third parties. Accruals relating to prior periods are periodically reevaluated and increased or decreased based on new information. Changes in estimates are charged or credited to the statement of operations in a period subsequent to the change in estimate.

Goodwill and Indefinite-lived Intangible Assets

We review costs of purchased businesses in excess of net assets acquired (goodwill), and indefinite-life intangible assets for impairment at least annually, unless significant changes in circumstances indicate a potential impairment may have occurred sooner.

We are required to test goodwill on a reporting unit basis, which is the same level as our operating segments. We use a fair value approach to test goodwill for impairment and potential impairment is noted for a reporting unit if its carrying value exceeds the fair value of the reporting unit. For those reporting units that have potential goodwill impairment, we determine the implied fair value of goodwill. If the carrying value of goodwill exceeds its implied fair value, an impairment loss is recorded.

The impairment test for indefinite-life intangible assets requires the determination of the fair value of the intangible asset. If the fair value of the indefinite-life intangible asset is less than its carrying value, an impairment loss is recognized in an amount equal to the difference. Fair values are established using discounted cash flow and comparative market multiple methods. We conduct our annual impairment test on July 1 of each year. As of the date of the last test, there was no impairment and there have been no indicators of impairment since the date of the test.

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

Impairment of Long-Lived Assets

We review long-lived assets for impairment when circumstances indicate the carrying amount of an asset may not be recoverable based on the undiscounted future cash flows of the asset. If the carrying amount of the asset is determined not to be recoverable, a write-down to fair value is recorded based upon various techniques to estimate fair value.

Income Taxes

We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. These deferred tax assets and liabilities are separated into current and long-term amounts based on the classification of the related assets and liabilities for financial reporting purposes. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts.

We also recognize the benefits of tax positions when certain criteria are satisfied. We follow the more likely than not recognition threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return.

Stock-Based Compensation

NMH Investment, LLC adopted an equity-based compensation plan, and issued units of limited liability company interests pursuant to such plan. The units are limited liability company interests and are available for issuance to our employees and members of the Board of Directors for incentive purposes. For purposes of determining the compensation expense associated with these grants, management values the business enterprise using a variety of widely accepted valuation techniques which considered a number of factors such as our financial performance, the values of comparable companies and the lack of marketability of our equity. We then used the option pricing method to determine the fair value of these units at the time of grant using valuation assumptions consisting of the expected term in which the units will be realized; a risk-free interest rate equal to the U.S. federal treasury bond rate consistent with the term assumption; expected dividend yield, for which there is none; and expected volatility based on the historical data of equity instruments of comparable companies. The Class B and Class E units vest over a five-year service period. The Class C and Class D units vest over a three-year period based on service and on certain performance and/or investment return conditions being met or achieved. The estimated fair value of the units, less an assumed forfeiture rate, is recognized in expense on a straight-line basis over the requisite service/performance periods of the awards.

Derivative Financial Instruments

We report derivative financial instruments on the balance sheet at fair value and establish criteria for designation and effectiveness of hedging relationships. Changes in the fair value of derivatives are recorded each period in current operations or in shareholder’s equity as other comprehensive income (loss) depending upon whether the derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction.

We, from time to time, enter into interest rate swap agreements to hedge against variability in cash flows resulting from fluctuations in the benchmark interest rate, which is LIBOR, on our debt. These agreements involve the exchange of variable interest rates for fixed interest rates over the life of the swap agreement without an exchange of the notional amount upon which the payments are based. On a quarterly basis, the differential to be received or paid as interest rates change is accrued and recognized as an adjustment to interest expense in the accompanying condensed consolidated statement of operations. In addition, on a quarterly basis the mark to market valuation is recorded as an adjustment to other comprehensive income (loss) as a change to shareholder’s equity, net of tax. The related amount receivable from or payable to counterparties is included as an asset or liability in our consolidated balance sheets.

Available-for-Sale Securities

Our investments in related party marketable debt securities have been classified as available-for-sale securities and, accordingly, are valued at fair value at the end of each reporting period. Unrealized gains and losses arising from such valuation are reported, net of applicable income taxes, in other comprehensive income (loss).

Legal Contingencies

From time to time, we are involved in litigation and regulatory proceedings in the operation of our business. We reserve for costs related to contingencies when a loss is probable and the amount is reasonably estimable. While we believe our provision for legal contingencies is adequate, the outcome of our legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that differ from our estimates. In addition, legal contingencies could have a material adverse impact on our results of operations in any given future reporting period. See “Part II, Item 1A. Risk Factors” for additional information.

Forward-Looking Statements

Some of the matters discussed in this report may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

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

The information in this report is not a complete description of our business or the risks associated with our business. There can be no assurance that other factors will not affect the accuracy of these forward-looking statements or that our actual results will not differ materially from the results anticipated in such forward-looking statements. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to, those factors or conditions described under “Part II. Item 1A. Risk Factors” in this report as well as the following:

•

changes in Medicaid funding or changes in budgetary priorities by state and local governments;

•

our significant amount of debt, our ability to meet our debt service obligations and our ability to incur additional debt;

•

current credit and financial market conditions;

•

legal proceedings;

•

the size of our self-insurance accruals and changes in the insurance market that affect our ability to obtain coverage at reasonable rates;

•

our ability to control operating costs and collect accounts receivable;

•

our ability to maintain, expand and renew existing services contracts and to obtain additional contracts;

•

our ability to attract and retain experienced personnel, including members of our senior management team;

•

our ability to acquire new licenses or to maintain our status as a licensed service provider in certain jurisdictions;

•

government regulations and our ability to comply with such regulations or the interpretations thereof;

•

our ability to establish and maintain relationships with government agencies and advocacy groups;

•

increased or more effective competition;

•

changes in reimbursement rates, policies or payment practices by our payors;

•

changes in interest rates;

•

successful integration of acquired businesses; and

•

possible conflict between the interests of our majority equity holder and those of the holders of our notes.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we do not assume responsibility for the accuracy and completeness of the forward-looking statements. All written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the “Risk Factors” and other cautionary statements included herein. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

Item 3.		Quantitative and Qualitative Disclosures about Market Risk

We are exposed to changes in interest rates as a result of our outstanding variable rate debt. To reduce our interest rate exposure, we entered into interest rate swap agreements whereby we fixed the interest rate on approximately $221.2 million of our $335.0 million term B loan, effective as of August 31, 2006 and maturing on June 30, 2010 and fixed the interest rate on approximately $113.3 million of our remaining $335.0 million term B loan, effective as of August 31, 2007 and maturing on September 30, 2010. In total, as of December 31, 2009, we fixed the interest rate on approximately $293.1 million of our $323.3 term B loan.

The table below provides information about the Company’s interest rate swap agreements and remaining variable rate debt related to the term B loan.

		December 31,								September 30,
		2009								2010
(in thousands)		Swap								Swap
Interest Swap effective date		Value				Rate				Value				Rate
August 31, 2006(1)		$	86,205				5.32	%		$	—				—
August 31, 2007(1)			206,872				4.89	%			—				—
Variable rate debt(1)			30,198				0.26	%				320,763				—
Total term B loan		$	323,275				—			$	320,763				—

As a result of the interest rate swap agreements, the variable rate debt outstanding was effectively reduced from $327.2 million outstanding to $34.2 million outstanding as of December 31, 2009. The variable rate debt outstanding relates to the term B loan, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, the senior revolver, which has an interest rate based on LIBOR plus 2.00% or Prime plus 1.00%, subject to reduction depending on our leverage ratio, and the term loan mortgage, which has an interest rate based on Prime plus 1.50%. A 1% increase in the interest rate on our floating rate debt would increase cash interest expense of the floating rate debt by approximately $0.3 million.

Item 4.		Controls and Procedures

None.

Item 4T. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. As of December 31, 2009, the end of the period covered by this Quarterly Report on Form 10-Q, our management, with the participation of our principal executive officers and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on that evaluation, our principal executive officers and principal financial officer concluded that our disclosure controls and procedures were not effective as of December 31, 2009, because they are not yet able to conclude that we have remediated the material weaknesses in internal control over financial reporting identified in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009.

As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, our management, with the participation of the principal executive officers and principal financial officer, evaluated the effectiveness of our internal control over financial reporting as of September 30, 2009 (the last management’s assessment of internal control over financial reporting). In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In connection with this assessment, management identified material weaknesses in our internal control over financial reporting as of September 30, 2009.

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. Our material weaknesses relate to our revenue and accounts receivable balances, as detailed below:

Revenue

As reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, as of fiscal year-end, we had ineffective controls over the accuracy of revenue and accounts receivable balances. As of December 31, 2009, we continued to have the following material weaknesses.

•

We have insufficient segregation of duties within our new billing and accounts receivable system and insufficient controls to ensure appropriate access to our new billing and accounts receivable system and data. This material weakness increases the risk that erroneous or unauthorized revenue transactions could occur and the risk that they would not be detected on a timely basis if they do occur. Management is currently designing processes and controls to limit system access to appropriate personnel and segregate incompatible duties.

•

We have insufficient controls over the accuracy and validity of the billing rates used to calculate revenues recorded in our consolidated financial statements. We previously addressed this material weakness within our legacy accounts receivable system. However, our new billing and accounts receivable system is not yet able to generate timely reports to identify changes to billing rates for periodic review. Therefore, as of December 31, 2009, we have insufficient controls to verify that changes to billing rates entered into the new system were valid and accurate. This control deficiency increases the risk of errors in the invoicing and recording of billings to payors.

•

During the fourth quarter of fiscal 2009, we completed implementation of our new billing and accounts receivable system, operating in a majority of our operations, with the introduction of the system and related controls in multiple locations representing a substantial portion of our revenue. As of December 31, 2009, these controls had not yet been determined to be operating effectively. Because we have not yet conducted our review and testing of revenue controls for the revenue associated with these new locations, we are unable to conclude that these controls are operating effectively, and there can be no assurance that there are not additional material weaknesses relating to revenue.

The following item was first disclosed in our Form 10-Q for the quarterly period ended December 31, 2007. It has not been fully remediated and continues to exist.

•

We have insufficient controls over revenue recognition and revenue reserves for unauthorized sales. We maintain a revenue recognition policy in accordance with U.S. generally accepted accounting principles. However, we lacked controls to ensure definitive, consistent and documented application of the revenue recognition criteria regarding varying local payor contract requirements, specifically with respect to payor service authorization requirements. During the quarter ended September 30, 2009, management undertook a process to remediate the control design by documenting, reviewing and approving local application of revenue recognition requirements and developing a process to assess contract terms in each state to ensure that revenue recognition criteria are being consistently and appropriately interpreted and applied. However, we continue to have insufficient controls to ensure that all unauthorized sales are identified and reserved appropriately in the consolidated financial statements. Generally, if we provide services without a current, valid authorization from the payor agency to provide those services, revenue associated with the unauthorized services may need to be either reserved until such authorization is received, or ultimately written off if authorization is not granted. Management expects our new billing and accounts receivable system, when remediated, to capture more complete and accurate data related to authorizations, which will improve our controls over identifying and reserving for unauthorized sales.

(b) Changes in Internal Control over Financial Reporting

As discussed above, during the quarter ended September 30, 2009, we completed implementation of our new billing and accounts receivable system in a majority of our operations. This billing and accounts receivable system has affected, and will continue to affect, the processes that impact our internal control over financial reporting. As we optimize and remediate the system, we will review the related controls and may take further steps to ensure that they are effective and integrated appropriately.

In addition, during the quarter ended December 31, 2009, we began to consolidate the processing of vendor invoices from disparate field locations to one centralized location. In connection with this effort, we have redesigned our processes and our controls over the payment of invoices.

Except for the continuing optimization and remediation of our billing and accounts receivable system and consolidation of invoice processing, during the most recent fiscal quarter, there were no significant changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are in the human services business and, therefore, we have been and continue to be subject to claims alleging that we, our Mentors or our employees failed to provide proper care for a client. We are also subject to claims by our clients, our Mentors, our employees or community members against us for negligence, intentional misconduct or violation of applicable laws. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings.

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

See “Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II. Item 1A. Risk Factors” for additional information.

Item 1A. Risk Factors

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

We derive substantially all of our revenues from contracts with state and local governments. These governmental payors fund a significant portion of their payments to us through Medicaid, a joint federal/state health insurance program through which state expenditures are matched by federal funds ranging from, for federal fiscal year 2010, 65% to more than 82% of total costs, a number based largely on a state’s per capita income. Our revenues, therefore, are determined by the level of federal, state and local governmental spending for the services we provide. Budgetary pressures, particularly during recessionary periods, as well as other economic, industry, political and other factors, could cause the federal and state governments to limit spending, which could significantly reduce our revenues, margins and profitability and adversely affect our growth strategy. Governmental agencies generally condition their contracts with us upon a sufficient budgetary appropriation. If a government agency does not receive an appropriation sufficient to cover its contractual obligations with us, it may terminate a contract or defer or reduce our reimbursement. In addition, there is risk that previously appropriated funds could be reduced through subsequent legislation. Many states in which we operate are experiencing unprecedented budgetary pressures and have implemented or are considering initiating service reductions, rate freezes and/or rate reductions, including the state of Minnesota, where 16% of our revenues are derived, which, in July 2009, enacted a 2.58% rate cut. Similarly, programmatic changes such as conversions to managed care with related contract demands regarding billing and services, unbundling of services, governmental efforts to increase consumer autonomy and reduce provider oversight, coverage and other changes under state Medicaid plans, may cause unanticipated costs and risks to our service delivery. The loss or reduction of or changes to reimbursement under our contracts could have a material adverse effect on our business, financial condition and operating results.

Reductions in reimbursement rates or failure to obtain increases in reimbursement rates could adversely affect our revenues, cash flows and profitability.

Our revenues and operating profitability depend on our ability to maintain our existing reimbursement levels and to obtain periodic increases in reimbursement rates to meet higher costs and demand for more services. Approximately 12% of our revenue is derived from contracts based on a cost reimbursement model where we are reimbursed for our services based on our costs plus an agreed-upon margin. If we are not entitled to, do not receive or cannot negotiate increases in reimbursement rates, or are forced to accept a reduction in our reimbursement rates at approximately the same time as our costs of providing services increase, including labor costs and rent, our margins and profitability could be adversely affected. Changes in how federal and state government agencies operate reimbursement programs can also affect our operating results and financial condition. Some states have, from time to time, revised their rate-setting or methodologies in a manner that has resulted in rate decreases. In some instances, changes in rate-setting methodologies have resulted in third-party payors disallowing, in whole or in part, our requests for reimbursement. Any reduction in or the failure to maintain or increase our reimbursement rates could have a material adverse effect on our business, financial condition and results of operations. Changes in the manner in which state agencies interpret program policies and procedures or review and audit billings and costs could also adversely affect our business, financial condition and operating results and our ability to meet obligations under our indebtedness.

Our level of indebtedness could adversely affect our ability to raise additional capital to fund our operations, and limit our ability to react to changes in the economy or our industry.

We have a significant amount of indebtedness. As of December 31, 2009, we had total indebtedness of approximately $509.0 million, no borrowings under our senior revolver and $117.3 million of availability under our senior revolver. The senior secured credit facilities also include a $20.0 million synthetic letter of credit facility, all of which has been fully utilized. The availability under our senior revolver was reduced from $125.0 million as $7.7 million of letters of credit in excess of $20.0 million under our synthetic letters of credit facility were outstanding under the senior credit agreement.

Our substantial degree of leverage could have important consequences, including the following:

•

it may limit our ability to obtain additional debt or equity financing for working capital, capital expenditures, debt service requirements, acquisitions, and general corporate or other purposes;

•

a substantial portion of our cash flows from operations will be dedicated to the payment of principal and interest on our indebtedness and will not be available for other purposes, including our operations, future business opportunities and capital expenditures;

•

the debt service requirements of our indebtedness could make it more difficult for us to satisfy our financial obligations;

•

a portion of our variable interest rate borrowings under the senior secured credit facilities has not been hedged, exposing us to the risk of increased interest rates;

•

it may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to our competitors that have less debt and a lower degree of leverage; and

•

we may be vulnerable if the current downturn in general economic conditions continues or if there is a downturn in our business, or we may be unable to carry out activities that are important to our growth.

In addition to our indebtedness noted above, our indirect parent company, NMH Holdings had $208.2 million aggregate principal amount of senior floating rate toggle notes due 2014 (the “NMH Holdings notes”) outstanding as of December 31, 2009 (including the $12.3 million of which was held by us). NMH Holdings is a holding company with no direct operations. Its principal assets are the direct and indirect equity interests it holds in its subsidiaries, including us, and all of its operations are conducted through us and our subsidiaries. As a result, NMH Holdings will be dependent upon dividends and other payments from us to generate the funds necessary to meet its outstanding debt service and other obligations, including its obligations on the notes held by us. NMH Holdings has paid all of the interest payments to date on the notes entirely in PIK Interest (defined below) which increased the principal amount by $47.1 million, including the PIK Interest issued to us. NMH Holdings currently expects to elect to make interest payments entirely by increasing the NMH Holdings notes or issuing new notes (“PIK Interest”) through June 15, 2012.

Subject to restrictions in the indentures governing our senior subordinated notes and the NMH Holdings notes and the credit agreement governing our senior secured credit facilities, we may be able to incur more debt in the future, which may intensify the risks described in this risk factor. All of the borrowings under the senior secured credit facilities are secured by substantially all of the assets of the Company and its subsidiaries. The NMH Holdings notes are structurally subordinated to the senior subordinated notes and the senior secured credit facilities.

In addition to our high level of indebtedness, we have significant rental obligations under our operating leases for our group homes, other service facilities and administrative offices. For the three months ended December 31, 2009, our aggregate rental payments for these leases, including taxes and operating expenses, was approximately $10.7 million. These obligations could further increase the risks described above.

Current credit and economic conditions could have a material adverse effect on our cash flows, liquidity and financial condition.

Due to the tightening of the credit markets, our government payors or other counterparties that owe us money could be delayed in obtaining, or may not be able to obtain, necessary funding and/or financing to meet their cash-flow needs. Moreover, tax revenues are down in many jurisdictions due to the economic recession and high rates of unemployment, and government payors may not be able to pay us for our services until they collect sufficient tax revenues. Delays in payment could have a material adverse effect on our cash flows, liquidity and financial condition. In addition, in the event that our payors or other counterparties delay payments to us, our financial condition could be further impaired if we are unable to borrow additional funds under our senior credit agreement to finance our operations.

Our variable cost structure is directly related to our labor costs, which may be adversely affected by labor shortages, a deterioration in labor relations or increased unionization activities.

Our variable cost structure and operating profitability are directly related to our labor costs. Labor costs may be adversely affected by a variety of factors, including a limited supply of qualified personnel in any geographic area, local competitive forces, the ineffective utilization of our labor force, increases in minimum wages, health care costs and other personnel costs, and adverse changes in client service models. We have incurred higher labor costs in certain markets from time to time because of difficulty in hiring qualified direct service staff. These higher labor costs have resulted from increased wages and overtime and the costs associated with recruitment and retention, training programs and use of temporary staffing personnel. In part to help with the challenge of recruiting and retaining direct care employees, we offer these employees a benefits package that includes paid time off, health insurance, dental insurance, vision coverage, life insurance and a 401(k) plan, and these costs can be significant.

Although our employees are generally not unionized, sixteen of our employees were represented by a labor union until September 30, 2009, when our only unionized program closed. Future unionization activities could result in an increase of our labor and other costs. The Employee Free Choice Act (“EFCA”) of 2009 (H.R. 1409) seeks to amend the National Labor Relations Act to make it easier for workers to be represented by labor unions. If the EFCA or a variation of this legislation becomes law, it could result in increased unionization activities. We may not be able to negotiate labor agreements on satisfactory terms with any future labor unions. If employees covered by a collective bargaining agreement were to engage in a strike, work stoppage or other slowdown, we could experience a disruption of our operations and/or higher ongoing labor costs, which could adversely affect our business, financial condition and results of operations.

Covenants in our debt agreements restrict our business in many ways.

The credit agreement governing the senior secured credit facilities and the indentures governing the senior subordinated notes and the indenture governing the NMH Holdings notes contain various covenants that limit our ability and/or our subsidiaries’ ability to, among other things:

•

incur additional debt or issue certain preferred shares;

•

pay dividends on or make distributions in respect of capital stock or make other restricted payments;

•

make certain investments;

•

sell certain assets;

•

create liens on certain assets to secure debt;

•

enter into agreements that restrict dividends from subsidiaries;

•

consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and

•

enter into certain transactions with our affiliates.

The credit agreement governing the senior secured credit facilities also contains restrictive covenants and requires the Company and its subsidiaries to maintain specified financial ratios and satisfy other financial condition tests. Our ability to meet those financial ratios and tests may be affected by events beyond our control, and we cannot assure you that we will meet those tests. The breach of any of these covenants or financial ratios could result in a default under the senior secured credit facilities and the lenders could elect to declare all amounts borrowed thereunder, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness.

The nature of our operations could subject us to substantial claims, some of which may not be fully insured against or reserved for.

We are in the human services business and, therefore, we have been and continue to be subject to claims alleging that we, our Mentors or our employees failed to provide proper care for a client, as well as claims by our clients, our Mentors, our employees or community members against us for negligence, intentional misconduct or violation of applicable law. Included in our recent claims are claims alleging personal injury, assault, battery, abuse, wrongful death and other charges. Regulatory agencies may initiate administrative proceedings alleging that our programs, employees or agents violate statutes and regulations and seek to impose monetary penalties on us. We could be required to incur significant costs to respond to regulatory investigations or defend against civil lawsuits and, if we do not prevail, we could be required to pay substantial amounts of money in damages, settlement amounts or penalties arising from these legal proceedings. We currently insure through our captive subsidiary amounts of up to $1.0 million per claim and up to $2.0 million in the aggregate. Above these limits, we have limited additional third-party coverage. Awards for punitive damages may be excluded from our insurance policies either contractually or by operation of state law.

We also are subject to potential lawsuits under the False Claims Act or other federal and state whistleblower statutes designed to combat fraud and abuse in the health care industry. These lawsuits can involve significant monetary awards and bounties to private plaintiffs who successfully bring these suits. Finally, we are also subject to employee-related claims under state and federal law, including claims for discrimination, wrongful discharge or retaliation; claims for wage and hour violations under the Fair Labor Standards Act or state wage and hour laws; and novel intentional tort claims.

A litigation award excluded by, or in excess of, our third-party insurance limits and self-insurance reserves could have a material adverse impact on our operations and cash flow and could adversely impact our ability to continue to purchase appropriate liability insurance. Even if we are successful in our defense, civil lawsuits or regulatory proceedings could also irreparably damage our reputation.

Because a substantial portion of NMH Holdings’ and our indebtedness bears interest at rates that fluctuate with changes in certain prevailing short-term interest rates, we are vulnerable to interest rate increases.

A substantial portion of our indebtedness, including borrowings under the senior revolver, the portion of our borrowings under the senior secured term loan facility for which the Company has not hedged its interest rate exposure under interest rate swap agreements, and the indebtedness of NMH Holdings under the NMH Holdings notes, bears interest at rates that fluctuate with changes in certain short-term prevailing interest rates. If interest rates increase, our and NMH Holdings’ debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same.

As of December 31, 2009, we had approximately $34.2 million of floating rate debt outstanding after giving effect to interest rate swaps. As of December 31, 2009, NMH Holdings had $206.8 million of floating rate debt outstanding, net of discount, excluding the debt of its subsidiaries. A 1% increase in the interest rate on our floating rate debt would have increased cash interest expense of the floating rate debt by approximately $0.3 million, and a 1% increase in the interest rate on the NMH Holdings notes would increase NMH Holdings’ interest expense on those notes by approximately $2.1 million. If interest rates increase dramatically, NMH Holdings and the Company and its subsidiaries could be unable to service their debt.

The counterparties to our derivative financial instruments are substantial multi-national financial institutions. Although we consider the risk of counterparty nonperformance to be low, we cannot assure you that our counterparties will not default. If a counterparty defaulted, the effect on our results of operations could be material.

The nature of services that we provide could subject us to significant workers’ compensation related liability, some of which may not be fully reserved for.

We use a combination of insurance and self-insurance plans to provide for potential liability for workers’ compensation claims. Because of our high ratio of employees per client, and because of the inherent physical risk associated with the interaction of employees with our clients, many of whom have intensive care needs, the potential for incidents giving rise to workers’ compensation liability is relatively high.

We estimate liabilities associated with workers’ compensation risk and establish reserves each quarter based on internal valuations, third-party actuarial advice, historical loss development factors and other assumptions believed to be reasonable under the circumstances. As reported in Part I, Item 2 of this Quarterly Report on Form 10-Q for the three months ended December 31, 2009, in the first quarter of fiscal 2010, we recorded an increased charge for workers’ compensation expense compared to the first quarter of fiscal 2009. Our results of operations have been adversely impacted and may be adversely impacted in the future if actual occurrences and claims exceed our assumptions and historical trends.

If any of the state and local government agencies with which we have contracts determines that we have not complied with our contracts or have violated any applicable laws or regulations, our revenues may decrease, we may be subject to fines or penalties and we may be required to restructure our billing and collection methods.

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

•

require us to refund amounts we have previously been paid;

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terminate or modify our existing contracts;

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suspend or prevent us from receiving new contracts or extending existing contracts;

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impose referral holds on us;

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impose fines, penalties or other sanctions on us; and

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reduce the amount we are paid under our existing contracts.

As a result of past reviews and audits of our operations, we have been subject to some of these actions from time to time. While we do not currently believe that our existing audit proceedings will have a material adverse effect on our financial condition or significantly harm our reputation, we cannot assure you that similar actions in the future will not do so. In addition, such proceedings could have a material adverse impact on our results of operations in a future reporting period.

In some states, we operate on a cost reimbursement model in which revenues are recognized at the time costs are incurred. In these states, payors audit our historical costs on a regular basis, and if it is determined that our historical costs are insufficient to justify our rates, our rates may be reduced, or we may be required to return fees paid to us in prior periods. In some cases we have experienced negative audit adjustments which are based on subjective judgments of reasonableness, necessity or allocation of costs in our services provided to clients. These adjustments are generally required to be negotiated as part of the overall audit resolution and may result in paybacks to payors and adjustments of our rates. We cannot assure you that our rates will be maintained, or that we will be able to keep all payments made to us, until an audit of the relevant period is complete. Moreover, if we are required to restructure our billing and collection methods, these changes could be disruptive to our operations and costly to implement.

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

To facilitate our ability to procure or retain government-sponsored contracts, we rely in part on establishing and maintaining relationships with officials of various government agencies. These relationships enable us to maintain and renew existing contracts and obtain new contracts and referrals. The effectiveness of our relationships may be reduced or eliminated with changes in the personnel holding various government offices or staff positions. We also may lose key personnel who have these relationships and such personnel are generally not subject to non-compete or non-solicitation covenants. Any failure to establish, maintain or manage relationships with government and agency personnel may hinder our ability to procure or retain government-sponsored contracts, and could negatively impact our revenues.

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

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

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

Our success depends to a significant degree on our ability to attract and retain qualified and experienced human service professionals who possess the skills and experience necessary to deliver quality services to our clients and manage our operations. We face competition for certain categories of our employees, particularly service provider employees, based on the wages, benefits and other working conditions we offer. Contractual requirements and client needs determine the number, education and experience levels of human service professionals we hire. Our ability to attract and retain employees with the requisite credentials, experience and skills depends on several factors, including, but not limited to, our ability to offer competitive wages, benefits and professional growth opportunities. The inability to attract and retain experienced personnel could have a material adverse effect on our business.

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

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

•

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

•

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

•

we may not achieve operating efficiencies, synergies, economies of scale and cost reductions as expected;

•

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

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

•

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

•

we may encounter unanticipated regulatory risk;

•

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

•

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

•

we may finance the acquisition by incurring additional debt and further increase our leverage ratios; and

•

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

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

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

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

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the failure by our employees or Mentors to properly care for clients;

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the failure to submit proper documentation to the applicable government agency, including documentation supporting reimbursements for costs;

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the failure by our programs to abide by the applicable regulations relating to the provision of human services; or

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the failure of our facilities to comply with the applicable building, health and safety codes and ordinances.

From time to time, some of our licenses or certifications are temporarily placed on probationary status or suspended. If we lost our status as a licensed provider of human services in any jurisdiction or any other required certification, we would be unable to market our services in that jurisdiction, and the contracts under which we provide services in that jurisdiction would be subject to termination. Moreover, such an event could constitute a violation of provisions of contracts in other jurisdictions, resulting in other contract, license or certification terminations. Any of these events could have a material adverse effect on our operations.

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

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

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

We have identified material weaknesses in our internal control over financial reporting.

In connection with our internal controls assessment required by the Sarbanes-Oxley Act of 2002 and as reported in Item 9A(T) of our Annual Report on Form 10-K for the fiscal year ended September 30, 2009, we identified material weaknesses in our internal control over financial reporting. Management concluded that as of September 30, 2009, our internal control over financial reporting was not effective and, as a result, our disclosure controls and procedures were not effective. Descriptions of the material weaknesses are included in Item 4(T) of this Quarterly Report on Form 10-Q. We also reported material weaknesses in our prior year assessment, for the fiscal year ended September 30, 2008, including a material weakness in controls to verify the existence of our fixed asset balances. In connection with this material weakness, we identified errors during the quarter ended June 30, 2009 which resulted in an adjustment to reduce property and equipment by $1.8 million. While we have taken action and continue to take actions to remediate our identified material weaknesses, our new policies and procedures, when implemented, may not be effective in remedying all of the deficiencies in our internal control over financial reporting. The decentralized nature of our operations and the manual nature of many of our controls make compliance with the requirements of Section 404 and remediation of our material weaknesses especially challenging. The continuing optimization and remediation of our new billing and accounts receivable system and the consolidation of invoice processing at one centralized location have affected and will continue to affect a number of processes that impact our internal control over financial reporting, and we may identify additional material weaknesses or significant deficiencies in connection with these changes. A failure to remedy our material weaknesses in internal control over financial reporting could result in material misstatements in our financial statements and could impede an upgrade to our credit rating, even if our creditworthiness otherwise improves. Moreover, any future disclosures of additional material weaknesses, or errors as a result of those weaknesses, may result in a negative reaction in the financial markets if there is a loss of confidence in the reliability of our financial reporting.

We have extensive work remaining to remedy the material weaknesses in our internal control over financial reporting, and until our remediation efforts are completed, management will continue to devote significant time and attention to these efforts. We will continue to incur costs associated with implementing additional processes, including fees for additional auditor services and consulting services, and may be required to incur additional costs in improving our internal controls and hiring additional personnel, which could negatively affect our financial condition and operating results.

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

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

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

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

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

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

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

Approximately 2% of our net revenues for the three months ended December 31, 2009 were derived from contracts with affiliates of Alliance Health and Human Services Inc., or “Alliance,”, an independent not-for-profit organization that has licenses and contracts from several state and local agencies to provide ARY services.

Historically, some state governments interpreted federal law to preclude them from receiving federal reimbursement under Title IV-E of the Social Security Act for ARY services provided under a contract with a proprietary organization. However, in 2005 the Fair Access Foster Care Act of 2005 was signed into law, thereby allowing states to seek reimbursement from the federal government for ARY services provided by proprietary organizations. In some jurisdictions that interpreted the prior federal law to preclude them from seeking reimbursement for ARY services provided under a contract with a proprietary provider, or in others that prefer to contract with not-for-profit providers, we provide ARY services as a subcontractor of Alliance. We do not control Alliance, and none of our employees or agents has a role in the management of Alliance. Although Edward Murphy, our Chief Executive Officer, was an officer and director of Alliance immediately prior to becoming our President in September 2004, Mr. Murphy has no role in the management of Alliance. Our ARY business could be harmed if Alliance chooses to discontinue all or a portion of its service agreements with us. Our ARY business could also be harmed if the state or local governments that prefer that ARY services be provided by not-for-profit organizations determine that they do not want the service performed indirectly by for-profit companies like us on behalf of not-for-profit organizations. We cannot assure you that our contracts with Alliance will continue, and if these contracts are terminated without our consent, it could have an adverse effect on our business, financial condition and operating results. Alliance and its subsidiaries are organized as non-profit corporations and are recognized as tax-exempt under section 501(c)(3) of the Internal Revenue Code. As such, Alliance is subject to the public charity regulations of the states in which it operates and to the federal regulations governing tax-exempt entities. If Alliance fails to comply with the laws and regulations of the states in which it operates or with the federal regulations, it could be subject to penalties and sanctions, including the loss of tax-exempt status, which could preclude it from continuing to contract with certain state and local governments. Our business could be harmed if Alliance lost its contracts and was therefore unable to continue to contract with us.

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

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

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

For the three months ended December 31, 2009, approximately 16% of our revenues were generated from contracts with government agencies in the state of Minnesota. Accordingly, any reduction in Minnesota’s budgetary appropriations for our services, whether as a result of fiscal constraints due to recession, changes in policy or otherwise, could result in a reduction in our fees and possibly the loss of contracts. Minnesota recently enacted a rate cut of 2.58%, which took effect July 1, 2009, and we cannot assure you that we will not receive further rate reductions in the future. The concentration of our operations in Minnesota also makes us particularly susceptible to many of the other risks described above occurring in this state, including:

•

the failure to maintain and renew our licenses;

•

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

•

any negative publicity regarding our operations.

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

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

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

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

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

We may be more susceptible to the effects of a public health catastrophe than other businesses due to the vulnerable nature of our client population.

Our primary clients are individuals with developmental disabilities, brain injuries, or emotionally, behaviorally or medically complex challenges, many of whom may be more vulnerable than the general public in a public health catastrophe. For example, in a flu pandemic, such as the 2009 H1N1 pandemic, we could suffer significant losses to our client population and, at a high cost, be required to hire replacement staff and Mentors for workers who drop out of the workforce in very tight labor markets. Accordingly, certain public health catastrophes such as a flu pandemic could have a material adverse effect on our financial condition and results of operations.

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

Vestar controls our business affairs and policies. Circumstances may occur in which the interests of Vestar could be in conflict with the interests of our debt holders. In addition, Vestar may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to our debt holders. Vestar is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Vestar may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. So long as investment funds associated with or designated by Vestar continue to own a significant amount of our equity interests, even if such amount is less than 50%, Vestar will continue to be able to significantly influence or effectively control our decisions.

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

Unregistered Sales of Equity Securities

No equity securities of the Company or of its indirect parent, NMH Investment, LLC, were sold during the three months ended December 31, 2009.

Repurchases of Equity Securities

No equity securities of the Company were repurchased during the three months ended December 31, 2009.

The following table sets forth information in connection with repurchases made by NMH Investment of its common equity units during the quarterly period ended December 31, 2009:

(d) Maximum

Number (or

(c) Total Number

Approximate Dollar

of Units Purchased

Value) of Shares (or

(a) Class and

as Part of Publicly

Units) that May Yet

Total Number of

(b) Average Price

Announced Plans

be Purchased Under

Units Purchased

Paid per Unit

or Programs

the Plans or Programs

Month #1 (October 1, 2009 through October 31, 2009)

—

—

—

N/A

Month #2 (November 1, 2009 through November 30, 2009)

—

—

—

—

Month #3 (December 1, 2009 through December 31, 2009)

481.25 B Units

$

0.05

—

N/A

505.00 C Units

$

0.03

—

N/A

535.00 D Units

$

0.01

—

N/A

The Company did not repurchase any of its common stock as part of an equity repurchase program during the first quarter of fiscal 2010. NMH Investment purchased all of the units listed in the table from one of our employees upon her departure.

Item 3. Defaults Upon Senior Securities

None.

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

On December 4, 2009, by consent in lieu of annual meeting, the Company’s sole stockholder voted to increase the size of the Board of Directors from six to seven members and to elect the following persons as directors: James L. Elrod, Jr., Pamela F. Lenehan, Kevin A. Mundt, Edward M. Murphy, Daniel S. O’Connell, Guy Sansone and Gregory T. Torres.

Item 5. Other Information

None.

Item 6. Exhibits

The Exhibit Index is incorporated herein by reference.

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.

EXHIBIT INDEX

Exhibit No.				Description
	3.1			Amended and Restated Certificate of Incorporation of National Mentor Holdings, Inc.		Incorporated by reference to Exhibit 3.1 of National Mentor Holdings, Inc. Form 10-Q for the quarterly period ended March 31, 2007 (the “March 2007 10-Q”)
	3.2			By-Laws of National Mentor Holdings, Inc.		Incorporated by reference to Exhibit 3.2 of the March 2007 10-Q
	10.1	*		National Mentor Holdings, LLC Executive Deferred Compensation Plan, Third Amendment and Restatement Adopted Effective as of December 4, 2009.		Incorporated by reference to Exhibit 10.11 of National Mentor Holdings, Inc. Form 10-K for fiscal year ended September 30, 2009 (the “2009 10-K”).
	10.2	*		The MENTOR Network Incentive Compensation Plan effective October 1, 2009.		Incorporated by reference to Exhibit 10.17 of the 2009 10-K.
	31.1			Certification of principal executive officer.		Filed herewith
	31.2			Certification of principal executive officer.		Filed herewith
	31.3			Certification of principal financial officer.		Filed herewith
	32			Certifications furnished pursuant to 18 U.S.C. Section 1350.		Filed herewith