Advanzeon Solutions, Inc. - Quarter Report: 2004 February (Form 10-Q)

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:         .

COMPREHENSIVE CARE CORPORATION AND SUBSIDIARIES

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 February 29, 2004, and the related consolidated statements of operations for the three and nine months ended February 29, 2004 and February 28, 2003, and cash flows for the nine months ended February 29, 2004 and February 28, 2003 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 nine months ended February 29, 2004 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 85.9%, or $18.2 million, of revenue for the nine months ended February 29, 2004 and 87.5%, or $22.0 million, of revenue for the nine months ended February 28, 2003. 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 February 29, 2004 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 February 29, 2004. 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

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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.

Stock Options

The Company issues stock options to its employees and non-employee directors (“optionees”) allowing optionees to purchase the Company’s common stock pursuant to shareholder approved stock option plans. As permitted by Statement of Financial Accounting Standards (“SFAS”) No. 148, “ Accounting for Stock-Based Compensation-Transitional Disclosure,” the Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for its employee stock options (“APB 25”). 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 (loss) 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) income and (loss) income per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

Per Share data

     In calculating basic (loss) income per share, net (loss) income is divided by the weighted average number of common shares outstanding for the period. Diluted (loss) income per share reflects 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 (loss) income per share in accordance with SFAS No. 128, Earnings Per Share (amounts in thousands, except per share data):

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Authorized shares of common stock reserved for possible issuance for convertible debentures and stock options are as follows at February 29, 2004:

Note 2 — Basis of Presentation

     The accompanying consolidated financial statements are prepared on a going concern basis. During the nine months ended February 29, 2004, net cash used in continuing and discontinued operations amounted to $1,291,000 and $53,000, respectively. The Company had $949,000 of net cash provided from financing activities, primarily through the sale of an aggregate of 700,000 shares of common stock in a private transaction completed in December 2003. This transaction reduced the Company’s working capital deficiency and stockholders’ deficit each by approximately $972,000. Uses of cash during the nine months ended February 29, 2004 include $140,000 for the Company’s ongoing implementation of its new, customized management information system. The Company’s capital needs during Fiscal 2004 will require additional installments toward the $230,000 that remains to be paid in connection with this system, which has expected total costs of approximately $370,000. Once implemented, this system will enable 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. As of February 29, 2004, the Company had a working capital deficiency of $3.9 million and a stockholders’ deficit of $4.6 million. The Company is continuing to pursue 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 the Company 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 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.

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Note 3 — Major Customers/Contracts

(1) Beginning January 1, 2003, the Company contracted with a new HMO client to provide behavioral healthcare services to contracted Medicaid members in Florida. This business accounted for 20.8%, or $4.4 million, of the Company’s operating revenues during the nine months ended February 29, 2004. During the prior fiscal year, such Medicaid members were serviced by the Company through its contract with another HMO whose agreements with the Company covered Medicaid, Medicare, and commercial members and represented a combined 19.7%, or $4.9 million, of the Company’s operating revenue for the nine months ended February 28, 2003. On December 31, 2002, the Company received a formal termination notice, effective February 28, 2003, from the prior HMO client with respect to the Medicare and commercial business. In addition, the acquiring HMO, whose contract with the Company was scheduled to renew in January 2004, formally advised the Company on October 30, 2003 that it had determined to “insource behavioral health” and, therefore, would not renew its contract with the Company. Accordingly, the Company’s contract with this HMO customer terminated effective December 31, 2003. In response to the loss of revenue specific to this contract, the Company restructured its regional and corporate operations, centralized certain clinical and administrative functions, reduced staffing, and eliminated certain expenses that could not be supported with existing and remaining revenues.

(2) The Company has one contract to provide behavioral healthcare services to Connecticut members under contract with one HMO. This agreement represented approximately 12.7%, or $2.7 million, and 8.6%, or $2.2 million, of the Company’s operating revenue for the nine months ended February 29, 2004 and February 28, 2003, respectively. Additionally, this contract provides that the Company, through its contract with this HMO, receives additional funds directly from a state reinsurance program for the purpose of paying providers. During the nine months ended February 29, 2004 and February 28, 2003, the Company filed reinsurance claims totaling approximately $1.5 million and $2.3 million, respectively. Such claims represent cost reimbursements and, as such, are not included in the reported operating revenues and are accounted for as reductions of healthcare operating expenses. As of February 29, 2004 and May 31, 2003, respectively, the Company has reported $3.0 million and $3.1 million as accrued reinsurance claims payable, with $0.4 million reported as accounts receivable-managed care reinsurance contracts as of each date. In the event that the Company does not collect the amounts receivable related to reinsurance amounts, the Company could remain liable for the costs of the specific services provided to members that qualify for such reimbursements. The difference between the reinsurance receivable amount and the reinsurance payable amount is related to timing differences between the authorization date, the date the money is received by the Company, and the date the money is paid to the provider. In certain cases, providers have submitted claims for authorized services having incorrect service codes or otherwise incorrect information that has caused payment to be denied by the Company. In such cases, there are contractual and statutory provisions that allow the provider to appeal a denied claim. If no appeal is received by the Company within the prescribed amount of time, the Company may be required to remit the reinsurance funds back to the appropriate party. For non-reinsurance claims incurred but not reported under this contract, the Company estimates its claims payable using a similar method as that used for other existing contracts. This HMO has been a customer since March 2001. The original contract term ended December 31, 2002 and, in accordance with its terms, has automatically renewed for two consecutive one-year periods, with the current term ending December 31, 2004.

(3) The Company has contracts with one HMO to provide behavioral healthcare services to contracted commercial, Medicaid, and Children’s Health Insurance Program (“CHIP”) members in Texas. This business accounted for approximately 13.0%, or $2.8 million, and 11.4%, or $2.9 million, of the Company’s operating revenues during the nine months ended February 29, 2004 and February 28, 2003, respectively. Benefits available to Texas CHIP recipients were significantly reduced for the five month period September 1, 2003 to January 31, 2004 as a result of legislative bills passed by the Texas State legislature. Consequently, CHIP business under this contract accounted for approximately $0.9 million, or 4.2%, of operating revenues as compared to $1.7 million, or 7.0% of operating revenues for the nine month periods ended February 29, 2004 and February 28, 2003, respectively. Subsequent legislation has restored the majority of benefits available to CHIP recipients effective February 1, 2004. This HMO has been a customer of the Company since November 1998. The original contract term was for one year and the contract provides for automatic one-year renewal terms.

(4) During the prior fiscal year, the Company had three contracts with one HMO to provide behavioral healthcare services to Florida members. The combined revenue from these contracts accounted for 15.1%, or $3.8 million, of the Company’s operating revenues during the nine months ended February 28, 2003. These contracts covering Florida members terminated effective January 1, 2003. Additionally, the Company has one major contract with an affiliate of this HMO (see Item 2 above).

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Although there can be no assurance that the Company will be able to reduce its costs in an amount sufficient to offset the loss of gross margins associated with the customer listed under (1) above, the Company has undertaken efforts to restructure its regional and corporate operations, including the centralization of certain clinical and administrative functions, generalized staff downsizing, and the elimination of certain expenses that cannot be supported with existing and remaining revenues, 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 nine months ended February 29, 2004 include a change in estimate resulting in a $387,000 charge recorded in August 2003 and included under Discontinued Operations in the accompanying financial statements. Such charge primarily relates to settlement of the Company’s Fiscal 1999 Medicare cost report for its Aurora, Colorado facility that was sold by the Company during Fiscal 1999. The Company has determined not to appeal the Medicare intermediary’s determination and has accepted the settlement requiring the Company to repay $400,000 specific to Fiscal 1999, less approximately $106,000 in Medicare refunds that were due the Company in connection with its Fiscal 1995 and 1996 Medicare cost report settlements for this same Aurora, Colorado hospital. Further, the Medicare intermediary has accepted the Company’s proposed, 24-month, 12.125% installment payment plan to repay the net amount of approximately $300,000, of which $241,000 remains to be paid as of February 29, 2004. Of the remaining amount, approximately $147,000 is included in accounts payable and accrued expenses and $94,000 in long-term liabilities in the accompanying balance sheet at February 29, 2004.

Note 5 — Commitments and Contingencies

(1) A contract with one existing client requires the Company to maintain a performance bond throughout the contract term. At February 29, 2004, the Company maintained a $600,000 performance bond in compliance with this requirement.

(2) Related to the Company’s discontinued hospital operations, Medicare guidelines allow the Medicare fiscal intermediary to re-open previously filed cost reports. Management believes that the Company’s Fiscal 1998 and 1999 cost reports remain eligible for re-opening at some future date, in which case the intermediary may determine that additional amounts are due to or from Medicare.

(3) The Company is 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, the Company recently determined it needed to make a significant investment in its current information system or in a new information system that would better meet the Company’s future needs. As a result, the Company has entered into a Software License Maintenance and Services Agreement with Qualifacts Systems, Inc. (“Qualifacts), a vendor that has provided the Company with an immediate, temporary solution to meet HIPAA compliance rules specific to the Electronic Health Care Transactions and Code Sets Standards Model Compliance Plan with the Centers for Medicare and Medicaid Services and, additionally, to design a new, customized management information system that will enable the Company to continue to meet HIPAA requirements in the future. The Company expects to incur a total of approximately $0.4 million of costs to customize the Qualifacts system and activate the licenses needed for Qualifacts and other, related third-party software.

     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.

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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

     For the nine months ended February 29, 2004, the Company reported a loss from continuing operations of $249,000, or $0.06 loss per share (basic and diluted), and a net loss of $636,000, or $0.15 loss per share (basic and diluted). During the comparable period of the prior fiscal year, the Company recorded a $7,717,000, non-operating gain resulting from an IRS settlement and as a result reported income from continuing operations and net income of $7,980,000, or $2.05 basic income per share ($1.87 diluted income per share).

     For the quarter ended February 29, 2004, the Company reported a net loss of $78,000, or $0.02 basic and diluted loss per share, compared to net income of $7,706,000, or $1.97 basic earnings per share ($1.71 diluted earnings per share) for the quarter ended February 28, 2003, which included the aforementioned $7,717,000 non-operating gain.

     Due to the recent loss of one major customer in Florida and the temporary reduction in CHIP revenue that occurred during the months of September 2003 through January 2004, we reduced our staff by approximately 10% in December 2003. We have since recalled or hired certain staff as a result of the Texas CHIP business reinstatement in February 2004, but do not expect staffing levels to return to prior existing levels or to increase other operating costs significantly as a result of this recent event. Additionally, as part of our ongoing expense reduction program to align costs with expected revenues, we will maintain in effect a temporary salary freeze applicable to all employees and certain other reductions in operating costs associated with the specific contracts that have terminated or otherwise cannot be supported by expected revenues.

     The following tables summarize the Company’s operating results from continuing operations for the three and nine months ended February 29, 2004 and February 28, 2003 (in thousands):

The three months ended February 29, 2004 compared to the three months ended February 28, 2003:

The Company reported a net loss of $78,000 and operating profit of $4,000 for the quarter ended February 29, 2004 compared to net income of $7,706,000 and operating income of $7,000 for the quarter ended February 28, 2003.

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Operating revenues decreased by 21.3%, or $1.7 million, to $6.3 million for the quarter ended February 29, 2004 compared to $8.1 million for the quarter ended February 28, 2003. Reduced revenues from Texas CHIP contracts and the effect of terminated contracts in Florida resulted in lower revenues, but were offset by increased business in Connecticut and Texas, and new business in Michigan.

     Healthcare operating expenses decreased by approximately $1.7 million, or 23.6%, for the quarter ended February 29, 2004 as compared to the quarter ended February 28, 2003. This decrease is directly attributable to the loss of revenue as described above. Healthcare operating expense as a percentage of operating revenue decreased by 2.7%, from 89.7% for the quarter ended February 28, 2003 to 87.0% for the quarter ended February 29, 2004. 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 $28,000, or 3.6%, for the quarter ended February 29, 2004 as compared to the quarter ended February 28, 2003. This increase is primarily attributable to increased usage of outside professional services during the quarter ended February 29, 2004, including approximately $21,000 of legal and consulting services in connection with one unsuccessful bid in Tennessee. General and administrative expense as a percentage of operating revenue increased from 9.6% for the quarter ended February 28, 2003 to 12.6% for the quarter ended February 29, 2004 due to the previously described decrease in operating revenue.

     Other operating expenses decreased by $31,000 for the quarter ended February 29, 2004 compared to the quarter ended February 28, 2003. This decrease is attributable to a reduction in depreciation expense as a result of specific assets being fully depreciated, and a decrease in bad debt expense.

The nine months ended February 29, 2004 compared to the nine months ended February 28, 2003:

     The Company reported an operating loss of $64,000, a loss from continuing operations of $249,000 and a net loss of $636,000 for the nine months ended February 29, 2004 compared to an operating loss of $125,000 and net income of $7,980,000 for the nine months ended February 28, 2003, which included a $7,717,000, non-operating gain related to the IRS Settlement. Operating revenues decreased by 15.0%, or $3.7 million, to $21.3 million for the nine months ended February 29, 2004 compared to $25.0 million for the nine months ended February 28, 2003. This decrease is primarily attributable to terminated contracts in Florida that accounted for $5.3 million of revenue during the nine months ended February 28, 2003 and a decrease in Texas CHIP revenue of approximately $1.5 million during the nine months ended February 29, 2004 compared to the same period in Fiscal 2003. These decreases were partially offset by increased business in Connecticut, Indiana, and Texas, and new business in Michigan.

     Healthcare operating expenses decreased by approximately $3.8 million, or 16.9%, for the nine months ended February 29, 2004 as compared to the nine months ended February 28, 2003. This decrease is directly attributable to the loss of revenue as described above. Healthcare operating expense as a percentage of operating revenue decreased by 2.0%, from 89.4% for the nine months ended February 28, 2003 to 87.4% for the nine months ended February 29, 2004. 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 $66,000, or 2.5%, for the nine months ended February 29, 2004 as compared to the nine months ended February 28, 2003. This increase is primarily attributable to $122,000 of legal and consulting services incurred in connection with one unsuccessful bid in Tennessee, offset by a general reduction in usage of other similar professional services. General and administrative expense as a percentage of

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operating revenue increased from 10.4% for the nine months ended February 28, 2003 to 12.6% for the nine months ended February 29, 2004.

     Other operating expenses decreased by $105,000 for the nine months ended February 29, 2004 compared to the nine months ended February 28, 2003. This decrease is directly attributable to a reduction in depreciation expense as a result of specific assets being fully depreciated, and a decrease in bad debt expense.

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.

Liquidity and Capital Resources

     During the nine months ended February 29, 2004, net cash used in continuing and discontinued operations amounted to $1,291,000 and $53,000, respectively. The Company had $949,000 of net cash provided from financing activities, primarily through the sale of an aggregate of 700,000 shares of common stock in a private transaction completed in December 2003. The December 2003 private transaction reduced our working capital deficiency and stockholders’ deficit each by approximately $972,000. Uses of cash during the nine months ended February 29, 2004 include $140,000 related to the ongoing implementation of our new, customized management information system. Our capital needs during Fiscal 2004 will require additional installments toward the $230,000 that remains to be paid in connection with this system, which has expected total costs of approximately $370,000. Once implemented, this system will enable us to meet HIPAA requirements, streamline our entire clinical and claims functions, and offer service improvements to our participating providers. As of February 29, 2004, the Company had a working capital deficiency of $3.9 million and a stockholders’ deficit of $4.6 million. We are continuing to pursue sources of financing on terms that would support our future capital needs and provide available funds for working capital during 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 $3.6 million claims payable amount reported as of February 29, 2004.

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:

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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 February 29, 2004. 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 85.9%, or $18.2 million, of revenue from continuing operations for the nine months ended February 29, 2004. The balance of our revenues is earned on a fee-for-service basis and is recognized as services are rendered.

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 five health plans to provide behavioral healthcare services under commercial, Medicaid, and CHIP plans to contracted members in Connecticut, Michigan and Texas. These combined contracts represent approximately 44.9%, or $9.5 million, of our operating revenue for the nine months ended February 29, 2004. 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 incurred 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, 2002 and 2001 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 stockholders’ deficit raise substantial doubt about its ability to continue as a going concern. For the nine months ended February 29, 2004, the Company

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reported a loss from continuing operations of $249,000 and a net loss of $636,000. At February 29, 2004, the Company’s total current liabilities exceeded its total current assets by approximately $3.9 million and it had an accumulated deficit of approximately $57.6 million, with a total stockholders’ deficit of approximately $4.6 million. Due to the recent loss of one major customer in Florida and the temporary reduction in CHIP revenue that occurred during the months of September 2003 through January 2004, we had reduced our staff by approximately 10% in December 2003. We have since recalled or hired certain staff as a result of the Texas CHIP business reinstatement in February 2004, but do not expect staffing levels to return to prior existing levels or to increase other operating costs as a result of this recent event. Additionally, as part of our ongoing expense reduction program to align costs with expected revenues, we will maintain in effect a temporary salary freeze applicable to all employees and certain other reductions in operating costs associated with the specific contracts that have terminated or otherwise cannot be supported by expected revenues. While our management has addressed the conditions giving rise to the going concern uncertainty, there is no assurance that we will be successful in implementing any of the plans 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. In December 2003, we raised approximately $1.0 million through a private transaction of an aggregate of 700,000 shares of our common stock thereby reducing our working capital deficiency and stockholders’ deficit each by approximately $1.0 million as a result of this transaction. The shares issued in connection with this private placement have not been registered and may be resold pursuant to Rule 144 under the general rules and regulations of the Securities Act of 1933 as amended assuming that all of the conditions and provisions of the rule have been satisfied. The earliest date that these shares would become eligible for resale without a registration statement would be December 8, 2004. We are continuing to pursue additional 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.

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 HMOs, in which case there can be no assurance that the acquiring company would renew our contract.

Medicaid and Other State funded Programs

     As of February 29, 2004, we managed approximately 657,000 lives in connection with behavioral and substance abuse services covered through Medicaid in California, Connecticut, Florida, Michigan and Texas. Any

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changes in Medicaid reimbursement could ultimately affect the Company through contract bidding and cost structures with the health plans first impacted by such changes. Benefits available to Texas CHIP recipients were significantly reduced for the five month period September 1, 2003 to January 31, 2004 as a result of legislative bills passed by the Texas State legislature. Although subsequent legislation restored the majority of benefits available to CHIP recipients effective February 1, 2004, the temporary reduction in revenues had a negative impact on the Company’s results of operations for the nine months ended February 29, 2004. Further changes to Medicaid and other state funded programs are possible given the current economic conditions negatively affecting the budgets of many states.

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 recently determined we needed to make a significant investment in our current information system or in a new information system that would better meet our future needs. As a result, we entered into a Software License Maintenance and Services Agreement with Qualifacts Systems, Inc. (“Qualifacts), a vendor that has provided us with an immediate, temporary solution to meet HIPAA compliance rules specific to the Electronic Health Care Transactions and Code Sets Standards Model Compliance Plan with the Centers for Medicare and Medicaid Services and, additionally, to design a new, customized management information system that will enable us to continue to meet HIPAA requirements in the future. While these efforts will be ongoing, we believe we have met substantially 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.

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Shares Eligible for Future Sale

     As of April 8, 2004, the Company has issued 1,224,390 options, with exercise prices ranging from $0.25 to $4.00. A total of 937,999 options are exercisable and “in the money” as of April 8, 2004 and, accordingly, could be exercised and resold by optionees. Additionally, in connection with the private transaction that was completed on December 8, 2003, an aggregate of 700,000 shares of our common stock were issued to two private investors. The shares issued in connection with this private placement have not been registered and may be resold pursuant to Rule 144 under the general rules and regulations of the Securities Act of 1933 as amended assuming that all of the conditions and provisions of the rule are complied with. The earliest date that these shares would become eligible for resale without a registration statement would be December 8, 2004.

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 February 29, 2004, 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

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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 accounting principles generally accepted in the United States of America.

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 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. Following the completion of the audit of the Company’s financial statements, the Company’s external auditors issued their management letter to the Board of Directors, which did not identify any significant deficiency or material weakness in the Company’s internal controls but did recommend certain improvements in the Company’s existing internal controls.

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 accounting principles generally accepted in the United States of America.

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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.

Item 2c – CHANGES IN SECURITIES AND USE OF PROCEEDS

     As previously reported in the Company’s Current Report on Form 8-K dated December 9, 2003, the Company, on December 8, 2003, completed the sale of 700,000 shares of its common stock, $.01 par value (the “Shares”), for an aggregate of $1,015,000, of which the Company realized net proceeds of approximately $971,500. The Company intends to utilize the net proceeds for working capital purposes. The Shares were sold to two individuals in a private transaction not involving a public offering. The shares issued in connection with this private placement have not been registered and may be resold pursuant to Rule 144 under the general rules and regulations of the Securities Act of 1933 as amended assuming that all of the conditions and provisions of the rule are satisfied. The earliest date that these shares would become eligible for resale without a registration statement would be December 8, 2004.

Item 6 – Exhibits and Reports on Form 8-K

(b) Reports on Form 8-K — During the quarter ended February 29, 2004, the following reports on Form 8-K were filed by the Registrant:

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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.

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