Advanzeon Solutions, Inc. - Quarter Report: 2003 August (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

COMPREHENSIVE CARE CORPORATION

200 South Hoover Blvd, Suite 200, Tampa, FL 33609

(813) 288-4808

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

Yes [X] No [  ]

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

Yes [  ] No [X]

     Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date:

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Index

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PART I. – FINANCIAL INFORMATION

Item 1 — Consolidated Financial Statements

Consolidated Balance Sheets

See accompanying notes.

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Consolidated Statements of Operations
(Unaudited)
(Amounts in thousands, except per share amounts)

See accompanying notes.

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Consolidated Statements of Cash Flows
(Unaudited)

See accompanying notes

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Note 1 – Summary of Significant Accounting Policies

     The consolidated balance sheet as of August 31, 2003, and the related consolidated statements of operations and cash flows for the three months ended August 31, 2003 and 2002 are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments necessary for a fair presentation of such financial statements have been included. Such adjustments consisted only of normal recurring items. The results of operations for the three months ended August 31, 2003 are not necessarily indicative of the results to be expected during the balance of the fiscal year.

     The consolidated financial statements do not include all information and footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. The balance sheet at May 31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statement presentation. Notes to consolidated financial statements included in Form 10-K for the year ended May 31, 2003 are on file with the Securities and Exchange Commission and provide additional disclosures and a further description of accounting policies.

     The Company’s financial statements are presented on the basis that it is a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recovery and classification of assets or the amount and classification of liabilities that may result from the outcome of the uncertainties described in Note 2 — “Basis of Presentation.”

     The Company’s managed care activities are performed under the terms of agreements with health maintenance organizations (“HMOs”), preferred provider organizations (“PPOs”), and other health plans or payers to provide contracted behavioral healthcare services to subscribing participants. Revenue under a substantial portion of these agreements is earned monthly based on the number of qualified participants regardless of services actually provided (generally referred to as capitation arrangements). Such agreements accounted for 87.7%, or $6.9 million, of revenue for the three months ended August 31, 2003 and 86.6%, or $7.2 million, of revenue for the three months ended August 31, 2002. The balance of the Company’s revenues is earned on a fee-for-service basis and is recognized as services are rendered.

Restricted Cash

     As of August 31, 2003 and May 31, 2003, non-current restricted accounts include $0.3 million of cash held in trust in connection with the Company’s Directors and Officers liability insurance policy.

Accrued Claims Payable

     The accrued claims payable liability represents the estimated ultimate net amounts owed for all behavioral healthcare services provided through the respective balance sheet dates, including estimated amounts for claims incurred but not yet reported (“IBNR”) to the Company. The unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors. However, actual claims incurred could differ from the estimated claims payable amount reported as of August 31, 2003. Although considerable variability is inherent in such estimates, management believes that the unpaid claims liability is adequate.

Income Taxes

     The Company calculates deferred taxes and related income tax expense using the liability method. This method determines deferred taxes by applying the current tax rate to net operating loss carryforwards and to the cumulative temporary differences between the recorded carrying amounts and the corresponding tax basis of assets and liabilities. A valuation allowance is established for deferred tax assets unless their realization is considered more likely than not. The Company’s provision for income taxes is the sum of the change in the balance of deferred taxes between the beginning and the end of the period and income taxes currently payable or receivable.

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Stock Options

     In December 2002, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” which amends the disclosure requirements of SFAS 123, “Accounting for Stock-Based Compensation” and provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. As permitted by SFAS 148, the Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations in accounting for its employee stock options. Under APB 25, in the event that the exercise price of the Company’s employee stock options is less than the market price of the underlying stock on the date of grant, compensation expense is recognized. No stock-based employee compensation cost is reflected in net income, as all options granted under the Company’s employee stock options plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

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Per Share data

     In calculating basic earnings (loss) per share, net income (loss) is divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the assumed exercise or conversion of all dilutive securities, such as options, warrants, and convertible debentures. No such exercise or conversion is assumed where the effect is antidilutive, such as when there is a net loss. The following table sets forth the computation of basic and diluted earnings (loss) per share in accordance with Statement No. 128, Earnings Per Share (amounts in thousands, except per share data):

Authorized shares of common stock reserved for possible issuance for convertible debentures and stock options are as follows at August 31, 2003:

Note 2 — Basis of Presentation

     The accompanying consolidated financial statements are prepared on a going concern basis. During the fiscal quarter ended August 31, 2003, net cash used in operations amounted to $90,000. Additionally, the Company used $80,000 in investing activities, which include amounts paid in connection with the Company’s ongoing implementation of its new, customized management information system. The Company’s capital needs during Fiscal 2004 will include additional amounts required to implement this system, which is expected to cost approximately $0.4 million in total and will enable to the Company to meet HIPAA requirements, streamline the Company’s entire clinical and claims functions, and offer service improvements to the Company’s participating providers. Additionally, the Company may be required to repay approximately $0.3 million to Medicare within the current fiscal year in connection with one Medicare cost report settlement (see Note 4 – “Discontinued Operations”). As of August 31, 2003, the Company had a working capital deficiency of $4.8 million and a stockholders’ deficit of $5.3 million. The Company is currently pursuing sources of financing on terms that would support the Company’s capital needs and provide available funds for working capital during Fiscal 2004. Management cannot state with any degree of certainty whether any required additional equity or debt financing will be available to it during Fiscal 2004 and, if available, that the source of financing would be available on terms and conditions acceptable to the Company. These conditions raise substantial doubt about the Company’s ability to continue as a going concern, which is dependent upon its ability

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to continue to generate sufficient cash flow to meet its obligations on a timely basis, obtaining additional financing as may be required and, ultimately, sustaining an operating profit. The accompanying consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

Note 3 — Major Customers/Contracts

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     Although the loss of the customers listed under (1) and (3) above could have a material, adverse effect on the Company’s financial condition and future results of operations, the Company believes that it will be able to reduce its internal cost of servicing this account to minimize any effect on future results of operations.

     In general, the Company’s contracts with its customers are typically for initial one-year terms, with automatic annual extensions. Such contracts generally provide for cancellation by either party with 60 to 90 days written notice.

Note 4 – Discontinued Operations

     Results for the quarter ended August 31, 2003 include a change in estimate resulting in a net charge of approximately $387,000 that has been included under Discontinued Operations in the accompanying financial statements. Such charge is primarily due to the Company’s Fiscal 1999 Medicare cost report for its Aurora, Colorado psychiatric hospital that was owned by the Company until its disposal on March 11, 1999, which completed the Company’s plan to dispose of its hospital business segment. The Fiscal 1999 cost report had recently been under audit by the Medicare fiscal intermediary in the normal course of completing the final settlement for Fiscal 1999. Prior to the intermediary’s completion of the audit, management reviewed proposed adjustments with the Medicare fiscal intermediary and separately with the Company’s cost report consultant. After filing the Company’s response to the proposed adjustments, which included documentation that was accepted by the Medicare intermediary, thereby allowing the intermediary to reverse specific adjustments that would have been unfavorable, and based on continuing discussions with the Medicare intermediary, management believed that no liability existed in relation to this Fiscal 1999 cost report. However, in late September 2003, the Company received notice from the Medicare fiscal intermediary that the intermediary had completed its audit and that various audit adjustments made by the intermediary would result in approximately $400,000 being due back to the Medicare program specific to Fiscal 1999.

     The Company is currently reviewing the audit adjustments to determine if it may have grounds for an appeal. However, management believes it is probable that Medicare will require the Company to repay the full amount of approximately $400,000 specific to Fiscal 1999 less approximately $100,000 in Medicare refunds that are currently due the Company in connection with the Fiscal 1995 and 1996 Medicare cost report settlement specific to the same Aurora, Colorado hospital. Such refunds, of which $13,000 has been recorded in the current quarter and the balance of which had been recorded in the fiscal year ended May 31, 2003, are currently being withheld by the intermediary as an offset to the Fiscal 1999 Medicare overpayment. The Company plans to request an installment payment plan from Medicare, in which case interest would be payable at the current statutory rate. If it is determined that no Medicare installment plan is available to the Company, a lump sum payment in the amount of approximately $300,000 would be due to Medicare during the Company’s fiscal quarter ending November 30, 2003. Such amount is included in accounts payable and accrued expenses in the accompanying balance sheet at August 31, 2003.

Note 5 — Commitments and Contingencies

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     From time to time, the Company and its subsidiaries are also parties and their property is subject to ordinary, routine litigation incidental to their business, in which case claims may exceed insurance policy limits and the Company or any one of its subsidiaries may have exposure to a liability that is not covered by insurance. Management is not aware of any such lawsuits that could have a material adverse impact on the Company’s financial statements.

Item 2 — Management’s discussion and analysis of financial condition and Results of operations

     This quarterly report on Form 10-Q includes forward-looking statements, the realization of which may be impacted by certain important factors discussed below under “Cautionary Statement” and “Risk Factors – Important Factors Related to Forward-Looking Statements and Associated Risks” (page 14).

General

Introduction

     The Company has provided managed behavioral healthcare services and products since 1992. Services are marketed primarily through business development staff who are responsible for developing new sales leads and for preparing responses to formal commercial and public sector Requests for Proposals (“RFPs”). The Company typically has several RFPs in process, with submissions being made to a diverse selection of existing and prospective clients. Current services include a broad spectrum of inpatient and outpatient mental health and substance abuse therapy, counseling, and supportive interventions.

Results of Operations

     The Company reported income from continuing operations of $62,000, or $0.02 basic earnings per share ($0.01 diluted earnings per share), and a net loss of $325,000, or $0.08 basic loss per share ($0.07 diluted loss per share), for the quarter ended August 31, 2003 compared to the loss from continuing operations and net loss of $33,000, or $0.01 loss per share (basic and diluted), for the quarter ended August 31, 2002.

     Results for the quarter ended August 31, 2003 include a change in estimate resulting in a net charge of approximately $387,000 that has been included under Discontinued Operations in the unaudited, consolidated financial statements for the quarter ended August 31, 2003 (See Note 4 – “Discontinued Operations” to the unaudited, consolidated financial statements).

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     The following tables summarize the Company’s operating results from continuing operations for the three months ended August 31, 2003 and 2002 (in thousands):

The three months Ended August 31, 2003 Compared To The three months Ended August 31, 2002:

     The Company reported income from continuing operations of $62,000, or $0.02 basic earnings per share ($0.01 diluted earnings per share), operating income of $114,000, and a net loss of $325,000, or $0.08 basic loss per share ($0.07 diluted loss per share), for the quarter ended August 31, 2003 compared to a net loss of $33,000, or $0.01 loss per share (basic and diluted), and operating income of $6,000 for the quarter ended August 31, 2002. Operating revenues decreased by 5.0%, or approximately $0.4 million, to $7.9 million for the quarter ended August 31, 2003 compared to $8.3 million for the quarter ended August 31, 2002. This decrease is primarily attributable to the loss of one major customer in Florida that accounted for $1.5 million of revenue during the fiscal quarter ended August 31, 2002. However, this decrease was partially offset by the addition of two new customers in Indiana and one new customer in Michigan.

     Healthcare operating expenses decreased by approximately $0.5 million, or 6.8%, for the quarter ended August 31, 2003 as compared to the quarter ended August 31, 2002. This decrease is directly attributable to the loss of revenue as described above. Healthcare operating expense as a percentage of operating revenue decreased by 1.7%, from 88.5% for the quarter ended August 31, 2002 to 86.8% for the quarter ended August 31, 2003. This decrease is primarily due to the termination in January 2003 of one major contract that consistently returned a high medical loss ratio.

     General and administrative expenses increased by $20,000, or 2.3%, for the quarter ended August 31, 2003 as compared to the quarter ended August 31, 2002. This increase is primarily attributable to increased usage of outside professional services during Fiscal 2004. General and administrative expense as a percentage of operating revenue increased from 10.7% for the quarter ended August 31, 2002 to 11.5% for the quarter ended August 31, 2003.

     Other operating expenses decreased by $41,000 for the quarter ended August 31, 2003 compared to the quarter ended August 31, 2002. This decrease is directly attributable to a reduction in depreciation expense as a result of specific assets being fully depreciated.

Seasonality of Business

     Historically, we have experienced consistently low utilization during our first fiscal quarter, which comprises the months of June, July, and August, and increased utilization during our fourth fiscal quarter, which comprises the months of March, April and May. Such variations in utilization impact our costs of care during these months, generally having a positive impact on our gross margins and operating profits during the first fiscal quarter and a negative impact on our gross margins and operating profits during the fourth quarter.

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Liquidity and Capital Resources

     During the fiscal quarter ended August 31, 2003, net cash used in operations amounted to $90,000. Additionally, we made installment payments totaling $80,000 to one vendor in connection with the ongoing implementation of the Company’s new, customized management information system. Our capital needs during Fiscal 2004 will include additional amounts required to implement this system, which is expected to cost approximately $0.4 million in total and will enable us to meet HIPAA requirements, streamline our entire clinical and claims functions, and offer service improvements to our participating providers. Additionally, we may be required to repay approximately $0.3 million to Medicare within the current fiscal year in connection with one Medicare cost report settlement (see Note 4 – “Discontinued Operations” to the unaudited, consolidated financial statements). As of August 31, 2003, the Company has a working capital deficiency of $4.8 million and a stockholders’ deficit of $5.3 million. We are currently pursuing sources of financing on terms that would support our future capital needs and provide available funds for working capital in Fiscal 2004. We cannot state with any degree of certainty whether any required additional equity or debt financing will be available to us during Fiscal 2004 and, if available, that the source of financing would be available on terms and conditions acceptable to us. These conditions raise substantial doubt about the Company’s ability to continue as a going concern, which is dependent upon our ability to continue to generate sufficient cash flow to meet our obligations on a timely basis, obtaining additional financing as may be required and, ultimately, sustaining an operating profit.

     Our unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses. These estimates are subject to the effects of trends in utilization and other factors. Any significant increase in member utilization that falls outside of our estimations would increase healthcare operating expenses and may impact our ability to achieve profitability and positive cash flow. Although considerable variability is inherent in such estimates, we believe that the unpaid claims liability is adequate. However, actual results could differ from the $4.0 million claims payable amount reported as of August 31, 2003.

Summary of Significant Accounting Policies

     Our discussion and analysis of our financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make significant estimates and judgments to develop the amounts reflected and disclosed in the financial statements. On an on-going basis, we evaluate the appropriateness of our estimates and we maintain a thorough process to review the application of our accounting policies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following significant accounting policies involve our most significant judgments and estimates that are material to our consolidated financial statements:

     Accrued Claims Payable — The accrued claims payable liability represents the estimated ultimate net amounts owed for all behavioral healthcare services provided through the respective balance sheet dates, including estimated amounts for claims incurred but not yet reported (“IBNR”) to the Company. The unpaid claims liability is estimated using an actuarial paid completion factor methodology and other statistical analyses and is continually reviewed and adjusted, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors. However, actual claims incurred could differ from the estimated claims payable amount reported as of August 31, 2003. Although considerable variability is inherent in such estimates, we believe that the unpaid claims liability is adequate.

     Revenue Recognition — Our managed care activities are performed under the terms of agreements with health maintenance organizations, preferred provider organizations, and other health plans or payers to provide contracted behavioral healthcare services to subscribing participants. Revenue under a substantial portion of these agreements is earned monthly based on the number of qualified participants regardless of services actually provided (generally referred to as capitation arrangements). The information regarding qualified participants is supplied by our clients and we rely extensively on the accuracy of the client remittance and other reported information to determine the amount of revenue to be recognized. Such agreements accounted for 87.6%, or $6.9 million, of revenue from continuing operations for the fiscal quarter ended August 31, 2003. The balance of our revenues is earned on a fee-for-service basis and is recognized as services are rendered.

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CAUTIONARY STATEMENT FOR THE PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: Certain information included in this quarterly report on Form 10-Q and in other Company reports, SEC filings, statements, and presentations is forward looking within the meaning of the Private Securities Litigation Reform Act of 1995, including, but not limited to, statements concerning the Company’s anticipated operating results, financial resources, increases in revenues, increased profitability, interest expense, growth and expansion, and the ability to obtain new behavioral healthcare contracts. Such forward-looking information involves important risks and uncertainties that could significantly affect actual results and cause them to differ materially from expectations expressed herein and in other Company reports, SEC filings, statements, and presentations. These risks and uncertainties include local, regional, and national economic and political conditions, the effect of governmental regulation, the competitive environment in which the Company operates, and other risks detailed from time to time in the Company’s SEC reports.

Risk Factors

Important Factors Related to Forward-Looking Statements and Associated Risks

     This quarterly report on Form 10-Q contains certain forward-looking statements that are based on current expectations and involve a number of risks and uncertainties. Factors that may materially affect revenues, expenses and operating results include, without limitation, our success in (i) expanding the managed behavioral healthcare operations, (ii) effective management in the delivery of services, and (iii) risk and utilization in context of capitated payouts.

Concentration of Risk

     We currently have contracts with three health plans to provide behavioral healthcare services under commercial, Medicaid, and CHIP plans to contracted members in Connecticut, Florida, and Texas. These combined contracts represent approximately 47.4% and 62.6% of our operating revenue for the fiscal quarters ended August 31, 2003 and 2002, respectively, and include contracts that terminated effective January 1, 2003, which accounted for a combined 18.4% of our operating revenue for the fiscal quarter ended August 31, 2002 (see Note 3(4) to the unaudited, consolidated financial statements – “Major Customers/Contracts”), and agreements that terminated effective February 28, 2003, which accounted for 6.0% of our operating revenues during the fiscal quarter ended August 31, 2002 (see Note 3(1) to the unaudited, consolidated financial statements – “Major Customers/Contracts”). One HMO, whose contract with the Company accounted for approximately $1.8 million, or 23.3%, of our operating revenue for the quarter ended August 31, 2003 and is scheduled to renew in January 2004, has verbally advised us that it is evaluating whether to manage its members’ behavioral healthcare benefits “in house” (see Note 3(1) to the unaudited, consolidated financial statements – “Major Customers/Contracts”). We have not received a formal termination notice, nor has the customer advised the Company of a date by which it will make known its decision. However, at this point in time, we believe there exists a greater risk of non-renewal of this contract, the realization of which rests solely with our customer. Although the loss of this customer could have a material, adverse effect on the Company’s financial condition and future results of operations, we believe the Company will be able to reduce its internal cost of servicing this account to minimize any effect on future results of operations. In general, the terms of each contract are generally for one-year periods and are automatically renewable for additional one-year periods unless terminated by either party. The loss of any one of these customers or changes in any of these State’s Medicaid reimbursement rules could have a material, adverse effect on our working capital and future results of operations (see “Medicaid and Other State Funded Programs” below).

History of Operating Losses – Uncertainty of Future Profitability

     For each of the fiscal years ending May 31, 2003, 2002 and 2001, we had operating losses of approximately $608,000, $774,000 and $1,163,000, respectively. The report of the Company’s independent auditors with respect to their examination of the Company’s financial statements for the years ended May 31, 2003 and 2002 contains an explanatory paragraph relating to the preparation of the Company’s financial statements on a “going concern” basis and states that the Company’s working capital deficiency and stockholder’s deficit raise substantial doubt about its ability to continue as a going concern. At August 31, 2003, the Company’s total current liabilities exceeded its total current assets by approximately $4.8 million and it had an accumulated deficit of approximately $57.3 million, with a total stockholders deficit of approximately $5.3 million. While our management has addressed the conditions giving rise to the going concern uncertainty, there is no certainty that we will be successful in implementing any of the plans

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of management to restore us to profitability, to achieve and maintain positive cash flow on an ongoing basis, or otherwise to ensure that we will be able to continue as a going concern.

Costs of Care — Estimated Claims Incurred But Not Reported

     Our costs of care include estimated amounts for claims incurred but not yet reported (“IBNR”) to us. The IBNR is estimated using an actuarial paid completion factor methodology and other statistical analyses that we continually review and adjust, if necessary, to reflect any change in the estimated liability. These estimates are subject to the effects of trends in utilization and other factors. Although considerable variability is inherent in such estimates, we believe that our unpaid claims liability is adequate. However, actual results may differ materially from the estimated amounts reported.

Need for Additional Funds; Uncertainty of Future Funding

     We believe that our ability to increase business is dependent on our ability to have available working capital and, therefore, we will require additional funding. We are currently pursuing sources of financing on terms that would support our capital needs and provide available funds for working capital in Fiscal 2004. We cannot state with any degree of certainty whether any required additional equity or debt financing will be available to us during Fiscal 2004 and, if available, that the source of financing would be available on terms and conditions acceptable to us.

Uncertainties Related to Pricing, Healthcare Reform, and Related Matters

     Managed care operations are at risk for costs incurred to supply agreed upon levels of service. Failure to anticipate or control costs could have material, adverse effects on the Company. Additionally, the business of providing services on a full-risk capitation basis exposes us to the additional risk that contracts negotiated and entered into may ultimately be determined to be unprofitable if utilization levels require us to deliver and provide services at capitation rates which do not account for or factor in such utilization levels.

     We typically contract with small to medium sized HMO’s who may be adversely affected by the continuing efforts of governmental and third party payers to contain or reduce the costs of healthcare through various means. Our clients may fall under state supervision or otherwise be subject to state discipline placing them at risk of losing membership to their competitors in which case we may be unable to contract with any succeeding HMOs. They may also determine to manage the behavioral healthcare benefits “in house” and, as a result, discontinue contracting with the Company. Additionally, our clients may be acquired by larger HMO’s, in which case there can be no assurance that the acquiring company would renew our contract.

Medicaid and Other State funded Programs

     As of August 31, 2003, we managed approximately 803,000 lives in connection with behavioral and substance abuse services covered through Medicaid in Connecticut, Florida, Michigan and Texas. Any changes in Medicaid reimbursement could ultimately affect the Company through contract bidding and cost structures with the health plans first impacted by such changes. The State of Texas has passed legislation that has reduced the amount of funds allocated to our clients to cover behavioral healthcare services to Medicaid and Children’s Health Insurance Program (“CHIP”) recipients in the State of Texas. Such legislation is subject to pending bills that, if passed, could restore some of the benefits to these programs. Under the recently passed legislation, the outpatient behavioral healthcare benefits available to adult Medicaid and CHIP recipients will be provided by the HMOs and their subcontractors, including the Company, on a very limited basis while the inpatient benefits for CHIP recipients may not be covered by the HMOs and their subcontractors. For the fiscal quarter ended August 31, 2003, we had operating revenue of $1.0 million and $1.4 million, respectively, specific to contracts covering Texas CHIP and Texas Medicaid recipients. These changes to Texas Medicaid and CHIP programs could have a material, adverse impact on our operations. Two current clients have notified us that they will not continue the CHIP portion of their contracts beyond August 31, 2003. However, another current client has negotiated an arrangement with us to continue to service their CHIP members under a reduced fee and benefit arrangement. We continue to closely monitor developments in Texas and we are taking steps necessary to decrease operating costs to offset the expected revenue reductions, although we currently cannot predict the full financial impact that these changes will have on our business and we may be unable to reduce our costs to a level that would allow us to maintain current gross margins specific to our Medicaid and CHIPS programs.

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Seasonality of Business

     Historically and during Fiscal 2003, we have experienced consistently low utilization during our first fiscal quarter, which comprises the months of June, July, and August, and increased utilization during our fourth fiscal quarter, which comprises the months of March, April, and May. Such variations in utilization impact our costs of care during these months, generally having a positive impact on our gross margins and operating profits during the first fiscal quarter and a negative impact on our gross margins and operating profits during the fourth quarter.

Regulatory compliance

     We are subject to extensive and evolving state and federal regulations relating to the nation’s mental health system as well as changes in Medicaid and Medicare reimbursement that could have an effect on the profitability of our contracts. These regulations range from licensure and compliance with regulations related to insurance companies and other risk-assuming entities, to licensure and compliance with regulations related to healthcare providers. These laws and regulations may vary considerably among states. As a result, CompCare may be subject to the specific regulatory approach adopted by each state for regulation of managed care companies and for providers of behavioral healthcare treatment services.

     We hold licenses or certificates to perform utilization review and third party administrator (“TPA”) services in certain states. Certain of the services provided by our managed behavioral healthcare subsidiaries may be subject to such licensing requirements in other states. There can be no assurance that additional utilization review or TPA licenses will not be required or, if required, that CompCare will qualify to obtain such licenses. In many states, entities that assume risk under contract with licensed insurance companies or health plans have not been considered by state regulators to be conducting an insurance or HMO business. As a result, we have not sought licensure as either an insurer or HMO in any state. If the regulatory positions of these states were to change, our business could be materially affected until such time as we are able to meet the regulatory requirements. Currently, we cannot quantify the potential effects of additional regulation of the managed care industry, but such costs will have an adverse effect on future operations to the extent that they are not able to be recouped in future managed care contracts.

     We are subject to the requirements of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). The purpose of the HIPAA provisions is to improve the efficiency and effectiveness of the healthcare system through standardization of the electronic data interchange of certain administrative and financial transactions and, also, to protect the security and privacy of protected health information. Entities subject to HIPAA include some healthcare providers and all healthcare plans. To meet the specific requirements of HIPAA, we will incur costs to insure the adequacy and security of our healthcare information system and communication networks. Additionally, we will incur costs to implement a new clinical information system that will process the specific transaction codes required by HIPAA for claims, payment, enrollment, eligibility, or to become compliant with security and privacy rules, which may be more stringent for providers of certain behavioral healthcare services. The expected timetable for us to be compliant is currently October 15, 2003 for transaction code changes due to our October 2002 filing of a formal compliance plan. The Company has met the deadline for compliance with the privacy rules, which was April 14, 2003. Additionally, we have filed our Electronic Health Care Transactions and Code Sets Standards Model Compliance Plan with the Centers for Medicare and Medicaid Services. While these efforts will be ongoing, we expect to meet all compliance rules and timetables with respect to the HIPAA regulations. Failure to do so may result in penalties and have a material adverse effect on the Company’s ability to retain its customers or to gain new business.

Dependence on Key Personnel

     We currently rely heavily on several key executives and other management, clinical and technical personnel for our business performance and development. Recent new hires have included senior management personnel and other essential employees that are assisting executive management with marketing efforts and enhancements to our clinical system designs. Our future success will depend in large part upon our continued ability to attract and retain highly skilled employees.

Shares Eligible for Future Sale

     As of October 6, 2003, the Company has issued 1,102,724 options, with exercise prices ranging from $0.25 to $4.00. A total of 846,083 options are exercisable and “in the money” as of October 6, 2003 and, accordingly, could be exercised and resold by optionees.

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Anti-takeover Provisions

     The Company’s Restated Certificate of Incorporation provides for 60,000 authorized shares of Preferred Stock, the rights, preferences, qualifications, limitations and restrictions of which may be fixed by our Board of Directors without any vote or action by the stockholders that could have the effect of diluting the Common Stock or reducing working capital that would otherwise be available to the Company. As of August 31, 2003, there are 18,740 remaining shares authorized and available to issue, and no outstanding shares of Preferred Stock. The Company’s Restated Certificate of Incorporation also provides for a classified board of directors with directors divided into three classes serving staggered terms. The Company’s stock option plans generally provide for the acceleration of vesting of options granted under such plans in the event of certain transactions that result in a change of control of the Company. Section 203 of the General Corporation Law of Delaware prohibits us from engaging in certain business combinations with interested stockholders. These provisions may have the effect of delaying or preventing a change in control of the Company without action by the stockholders and therefore could adversely affect the price of our Common Stock or the possibility of sale of shares to an acquiring person.

     Assumptions relating to the foregoing involve judgments that are difficult to predict accurately and are subject to many factors that can materially affect results. Budgeting and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our budgets which may in turn affect the Company’s results. In light of the factors that can materially affect the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that our objectives or plans will be achieved.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     While we currently have market risk sensitive instruments, we have no significant exposure to changing interest rates as the interest rate on our long-term debt is fixed. Additionally, we do not use derivative financial instruments for investment or trading purposes and our investments are generally limited to cash deposits.

Item 4. Controls and Procedures

Evaluation of the Company’s Disclosure Controls and Internal Controls. Within the 90 days prior to filing this report on Form 10-Q, the Company evaluated the effectiveness of the design and operation of its “disclosure controls and procedures” (“Disclosure Controls”), and its “internal controls and procedures for financial reporting” (“Internal Controls”). This evaluation (the “Controls Evaluation”) was done under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Rules adopted by the Securities and Exchange Commission (“SEC”) require that in this section of the quarterly report on Form 10-Q we present the conclusions of the CEO and the CFO about the effectiveness of our Disclosure Controls and Internal Controls based on and as of the date of the Controls Evaluation.

Disclosure Controls and Internal Controls. As provided in Rule 13a-14 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended, Disclosure Controls are defined as meaning controls and procedures that are designed with the objective of insuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, designed and reported within the time periods specified by the SEC’s rules and forms. Disclosure Controls include, within the definition under the Exchange Act, and without limitation, controls and procedures designed to insure that information required to be disclosed by us in our reports is accumulated and communicated to our management including our CEO and CFO, as appropriate, to allow timely decisions regarding disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with generally accepted accounting principles.

Scope of the Controls Evaluation. The evaluation made by our CEO and CFO of our Disclosure Controls and our Internal Controls included a review of the controls’ objectives and design, the controls’ implementation by the Company and the effect of the controls on the information generated for use in this Form 10-Q. In the course of the Controls Evaluation, we sought to identify data errors, control problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will

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be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our quarterly reports on Form 10-Q and Annual Report on Form 10-K. The overall goals of these various evaluation activities are to monitor our Disclosure Controls and our Internal Controls and to make modifications as necessary; our intent in this regard is that the Disclosure Controls and the Internal Controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

Among other matters, we sought in our evaluation to determine whether there were any “significant deficiencies” or “material weaknesses” in the Company’s Internal Controls, or whether the Company had identified any acts of fraud involving personnel who have a significant role in the Company’s Internal Controls. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions” these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions. We also sought to deal with other controls matters in the Controls Evaluation, and in each case if a problem was identified, we considered what revision, improvement and/or correction to make in accordance with our on-going procedures.

The Company’s management, including the CEO and CFO, does not expect that our Disclosure Controls or our Internal Controls will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

In accordance with SEC requirements, our CEO and CFO each have confirmed that, since the date of the Controls Evaluation to the date of this quarterly report on Form 10-Q, there have been no significant changes in Internal Controls or in other factors that could significantly affect Internal Controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

Conclusion. Based upon the Controls Evaluation, our CEO and CFO have each concluded that our Disclosure Controls are effective to ensure that material information relating to the Company and its consolidated subsidiaries is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our Internal Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.

PART II – OTHER INFORMATION

Item 1 — LEGAL PROCEEDINGS

     From time to time, the Company and its subsidiaries may be parties to and their property is subject to ordinary, routine litigation incidental to their business, in which case claims may exceed insurance policy limits and the Company or any one of its subsidiaries may have exposure to a liability that is not covered by insurance. Management is not aware of any such lawsuits that could have a material adverse impact on the Company’s financial statements.

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Item 6 – Exhibits and Reports on Form 8-K

None.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.