UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended September 30, 2005

Commission File Number 1-32203

PROSPECT MEDICAL HOLDINGS, INC.

 

(310) 338-8677

(Registrantís telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes   x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. o Yes   x No

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrantís knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o Yes   x No

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

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

The aggregate market value of common stock held by non-affiliates of the Registrant as of March 31, 2005 (the last business day of our most recently completed second fiscal quarter) was approximately $17,795,127 based upon the closing price for shares of our common stock as reported by the American Stock Exchange on such date.

As of December 20, 2005, 6,840,362 shares of the Registrantís common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the Registrantís 2006 annual stockholders meeting, which will be filed with the Commission on or before January 28, 2006, are incorporated by reference in Part III of this report.

Table of Contents
Form 10-K

PART I
Item 1.			Business		3
Item 1A.			Risk Factors		38
Item 1B.			Unresolved Staff Comments		50
Item 2.			Properties		51
Item 3.			Legal Proceedings		52
Item 4.			Submission of Matters to a Vote of Security Holders		53
PART II
Item 5.			Market for Registrantís Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		54
Item 6.			Selected Financial Data		55
Item 7.			Managementís Discussion and Analysis of Financial Condition and Results of Operation		57
Item 7A.			Quantitative and Qualitative Disclosures About Market Risk		73
Item 8.			Financial Statements and Supplementary Data		74
Item 9.			Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		75
Item 9A.			Controls and Procedures		75
Item 9B.			Other Information		75
PART III
Item 10.			Directors and Executive Officers of the Registrant		76
Item 11.			Executive Compensation		76
Item 12.			Security Ownership of Certain Beneficial Owners and Management		76
Item 13.			Certain Relationships and Related Transactions		76
Item 14.			Principal Accounting Fees and Services		76
PART IV
Item 15.			Exhibits and Financial Statement Schedules		77
Signatures					99

 

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PART I

Item 1.                        Business.

Prospect Medical Holdings, Inc. is a health care management services organization. We provide management services to affiliated physician organizations that operate as independent physician associations (ìIPAsî) or medical clinics. Our affiliated physician organizations enter into agreements with health maintenance organizations (ìHMOsî) to provide enrollees of the HMOs with a full range of medical services in exchange for fixed, prepaid monthly fees known as ìcapitationî payments.

The IPAs contract with physicians (primary care and specialist) and other health care providers to provide all of their medical services. The medical clinics employ their primary care physicians, which provide the vast majority of their medical services, while contracting with specialist physicians and other health care providers to provide other required medical services.

Through our two management subsidiariesóProspect Medical Systems and Sierra Medical Managementówe have entered into long-term agreements to provide management services to each of our affiliated physician organizations in exchange for a management fee. The management services we provide include negotiation of contracts with physicians and HMOs, physician recruiting and credentialing, human resources services, claims administration, financial services, provider relations, member services, case management including utilization management and quality assurance, data collection, and management information systems. For further discussion of these services, see Item 1, ìBusinessóManagement Services Agreements.î

Our two management subsidiaries currently provide management services to twelve affiliated physician organizations, including Prospect Medical Group, ten other affiliated physician organizations that Prospect Medical Group owns or controls, and one affiliated physician organization that is a joint venture in which Prospect Medical Group owns a 50% interest. We have utilized Prospect Medical Group, which was our first affiliated physician organization, to acquire the ownership interest in all of our other affiliated physician organizations. Thus, while Prospect Medical Group is itself an affiliated physician organization that does the same business in its own service area as all of our other affiliated physician organizations do in theirs, Prospect Medical Group also serves as a holding company for our other affiliated physician organizations.

Physician organizations, by California law, may only be owned by physicians. We have designated Jacob Y. Terner, M.D., our Chairman and Chief Executive Officer, to be the owner of all of the capital stock of Prospect Medical Group. As such he indirectly controls Prospect Medical Groupís ownership interest in each of our other affiliated physician organizations. Dr. Terner is also the Chief Executive Officer of Prospect Medical Group and all of our other affiliated physician organizations that Prospect Medical Group owns. Dr. Terner is the Chief Executive Officer of one of the two general partners of our joint venture affiliated physician organization.

We control each affiliated physician organization through an assignable option agreement that we have entered into through our management subsidiary, Prospect Medical Systems, with Dr. Terner and Prospect Medical Group. The assignable option agreement gives us the right to designate a successor physician to buy the capital stock of Prospect Medical Group from Dr. Terner for nominal consideration. The assignable option agreement allows us to control who owns the stock of Prospect Medical Group and indirectly control each affiliated physician organization that Prospect Medical Group controls. We refer to this arrangement as a ìsingle shareholder model.î

For financial reporting purposes, we are deemed to control Prospect Medical Group under U.S. Generally Accepted Accounting Principles (see Item 7, ìFinancial InformationóManagementís Discussion and Analysis of Financial Condition and Results of OperationsóCritical Accounting
PoliciesóConsolidation of Financial Statementsî) and are therefore required to consolidate the financial statements of Prospect Medical Group with those of our management subsidiaries.

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The thirteen affiliated physician organizations that we currently manage through our subsidiaries include Prospect Medical Group, which is an IPA wholly owned by Dr. Terner, eight IPAs wholly owned by Prospect Medical Group, two medical clinics wholly owned by Prospect Medical Group, one IPA in which Prospect Medical Group has a 55% controlling interest, and one IPA which is a joint venture in which Prospect Medical Group owns a 50% interest through another affiliated physician organization. In July 1999, we entered into the joint venture partnership agreement with an unrelated third party, AMVI/IMC Health Network, Inc. (ìAMVIî), in order to aggregate sufficient Medicaid enrollees to qualify for participation in the CalOPTIMA Medicaid (Medi-Cal in California) program in Orange County, California. We own a 50% interest in the joint venture partnership, although our portion of the business is operated autonomously. In accordance with the joint venture partnership agreement, profits and losses are not split in accordance with the partnership ownership interest, but rather, are directly tied to the results of our portion of the business. Separate from any earnings we generate from our portion of the business within the joint venture, we also earn fees for management services we provide to our partner in the joint venture. We account for our interest in the joint venture using the equity method of accounting. We include in our financial statements only the net results attributable to those Medicaid enrollees specifically identified as assigned to us, together with the management fee that we charge for managing those Medicaid enrollees specifically assigned to the other joint venture partner. Operations for the joint venture are similar to our other affiliated physician organizations, with the distinction that all enrollees are Medicaid beneficiaries.

Information about our thirteen affiliated physician organizations is listed in the table below:

Affiliated Physician Organizations of Prospect Medical Holdings

(1)          Prospect Medical Systems and Sierra Medical Management are wholly owned direct subsidiaries of Prospect Medical Holdings.

(2)          Acquired November 1, 2005. Operations will be included in our financial statements beginning November 1, 2005.

Our affiliated physician organizations provided medical services to a combined total of approximately 172,000 HMO enrollees at September 30, 2005. AMVI Prospect Health Network enrollees include approximately 5,600 enrollees that we manage for our own economic benefit, and 7,300 enrollees that we

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manage for the economic benefit of our partner in this joint venture, for which we earn management fee income. Genesis HealthCare of Southern California (ìGenesisî), which was acquired effective November 1, 2005, has a total of approximately 16,000 HMO enrollees. Currently, our affiliated physician organizations have contracts with approximately twelve HMOs, from which our revenue is primarily derived. HMOs offer a comprehensive health care benefits package in exchange for a monthly capitation fee per enrollee, which does not vary regardless of the quantity of medical services required or used. HMOs enroll members by entering into contracts with employer groups or directly with individuals to provide a broad range of health care services for a prepaid charge, with minimal deductibles or co-payments required of the members. All of the contracts between our affiliated physician organizations and the HMOs provide for the provision of medical services to the HMO enrollees by the affiliated physician organization to the HMO enrollees in consideration for the prepayment of the fixed monthly capitation fee paid by the HMOs.

We, through our management subsidiaries, control the expense for the medical component of the costs of our affiliated physician organizations by ìsub-capitatingî all primary care physicians and many of the specialist physicians that provide the medical services to the HMO enrollees. Sub-capitation is an arrangement that exists when an organization being paid under capitated contracts with an HMO, in turn contracts with other providers on a capitated basis, for a portion of the original capitated premium. For those specialties for which we cannot, or do not, choose to obtain a sub-capitated contract, we negotiate discounted fee-for-service contracts. By contract, our affiliated physician organizations generally do not assume responsibility for the costs of providing medical services (ìmedical costsî) that occur outside of their service area, which has been defined as a 30-mile radius around the office of the HMO enrolleeís primary care physician. All non-emergent care requires prior authorization, in order to limit unnecessary procedures and to direct the HMO enrollee requiring care to the physicians of our affiliated physician organizations, and the most cost effective facility. Our affiliated physician organizations utilize board certified pulmonologists and internists, trained in intensive care to maintain control over the patientís stay in the hospital, reducing unnecessary consultations and facilitating the patientís treatment and discharge. We also review medical costs monthly on a region by region basis and compare those costs to the trend of patient utilization of medical services in each region. In those instances where the patient utilization is trending very low, we determine whether it would be less expensive for our affiliated physician organizations to pay their providers on a discounted fee-for-service basis rather than a fixed capitation payment for each enrollee per month. See Item 1, ìBusinessóRisk Management.î

Our consolidated business has grown through the acquisition of IPAs by Prospect Medical Group. Our plan is for Prospect Medical Group to continue to acquire additional IPAs. We currently do not intend to further acquire any individual or small medical practices, clinics or medical group practices.

We believe that different IPAs present different medical cultures and are best served by local medical management. Therefore, we typically attempt to retain the senior medical management of the entities that we acquire or with which we affiliate.

We have chosen to concentrate our growth geographically by limiting our acquisitions to IPAs in Orange County, California and Los Angeles County, California.

Our profit growth as a consolidated business is primarily driven by increasing our revenue through acquisitions by Prospect Medical Group, and in parallel, reducing the administrative expenses of our affiliated physician organizations and management subsidiaries. We select our acquisition candidates based in large part on a history of profitable operations or where we can foresee a synergy, such as, opportunities for economies of scale through a consolidation of management functions, a competitive environment with respect to hospital and physician services, and a geographic proximity to current operations or a material share of the potential acquisition candidateís own local market. Upon completion of every IPA acquisition, one of our management subsidiaries enters into a long-term management services agreement with the newly-acquired physician organization.

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In effecting an acquisition, our affiliated physician organizations generally acquire medical assets, including such things as HMO contracts, provider contracts and patient records. If related non-medical assets are to be acquired as part of the acquisition, such as, management contracts, furniture, fixtures or equipment, non-medical personnel or real property leases, these are acquired by one of our management subsidiaries. In some cases, the stock of an acquisition candidate is acquired rather than its assets.

With respect to any acquisition of assets or stock of an acquisition candidate that is being acquired by one of our affiliated physician organizations, we, or one or more of our affiliated entities, may advance cash, or, in some cases, stock to that affiliated physician organization, for use in consummating the acquisition.

Advances from our management subsidiaries to the affiliated physician organization are covered by the terms of the respective management services agreement, which obligate the affiliated physician organization to repay the advance. Specifically, our management services agreements give the manager the authority to advance funds to the affiliated physician organization in order for the affiliated physician organization to meet its financial obligations. The management services agreements allow the manager and the affiliated physician organization to set the terms of such advances. The advances are deemed loans that are reflected as a payable or receivable, as applicable, in the financial statements of each entity and are repayable upon demand. Cash advances among our affiliated physician organizations are inter-company in nature and are eliminated in consolidation in our financial statements.

Furthermore, Prospect Medical Group, our affiliate physician organization which is the owner of all or a significant portion of the capital stock of each of our other affiliated physician organizations, has executed a security agreement with its manager, Prospect Medical Systems, covering all of Prospect Medical Groupís obligations to Prospect Medical Systems under its management services agreement. The collateral pledged under such security agreement is all accounts and other assets of Prospect Medical Group. The manager could technically foreclose on such collateral if its loan was not repaid. However, because of our affiliate relationship with the physician organizations that we manage, we are able to control the timing of the repayment of any loans by our affiliated physician organizations. The security interest of Prospect Medical Systems has, however, been subordinated to our loans under our senior secured credit facility until such time as the loans under that facility have been paid in full.

Advances from our affiliated physician organization to us or one of our management subsidiaries are covered by the terms of a cash management agreement, which obligates the recipient of the advance to repay it. These advances, like advances from our management subsidiaries to our affiliated physician organizations, are reflected in the financial statements of each entity as a payable or receivable, as applicable.

Our executive management team consists of seasoned operational, physician, financial, contracting, and administration executives, who have extensive experience in the healthcare industry. Jacob Y. Terner, M.D., our Chairman, Chief Executive Officer and a Director since November 1996, has held positions as a physician, medical professor, and corporate executive. Dr. Terner was a member of the voluntary faculty at the University of Southern California, School of Medicine for approximately thirty years and holds the title of Emeritus Clinical Professor of Obstetrics and Gynecology. Prior to his tenure with our company, Dr. Terner served as Chairman of the Board and Chief Executive Officer of Century MediCorp, Inc., a publicly-traded HMO and vertically integrated health-management organization until its October 1992 merger with Foundation Health Corporation. Each of our senior executives has more than ten years of general business and/or health care experience.

Our principal executive offices are located at 400 Corporate Pointe, Suite 525, Culver City, CA, 90230. Our telephone number is (310) 338-8677. Our web site address is www.prospectmedicalholdings.com. A copy of this filing is posted on our web site.

A chart of the organizational structures of both the company and Prospect Medical Group is set forth on the next page.

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ORGANIZATIONAL STRUCTURE OF OUR BUSINESS

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Summary of the Structure of our Business

1.                 Jacob Y. Terner is the nominee shareholder of PMG; CEO of PMH, SMM, and PHR; Secretary and Director of Nuestra Familia Medical Group, which is 55% owned by Prospect Medical Group; and CEO of Santa Ana-Tustin Physicians Group, which is a 50% joint venture partner in AMVI/Prospect Health Network.

2.                 PMG is an affiliated physician organization and owns 100% of the stock of all of our other affiliated physician organizations, 55% of Nuestra Familia Medical Group, and a 50% interest in AMVI/Prospect Health Network.

3.                 PMS, PMG and Dr. Terner are parties to an Assignable Option Agreement whereby PMS can change the owner/shareholder of PMG at any time. PMS and PMH are deemed to control all the affiliated physician organizations, except AMVI/Prospect Health Network, for financial accounting purposes, dictating a consolidation of the financial statements of all these entities with PMH and its management subsidiaries. We account for our interest in AMVI/Prospect Health Network using the equity method of accounting and we record only the net results derived from our specifically identified portion of the joint ventureís operations. In addition, we record the management fee revenue we earn for providing management services to our partnerís specifically identified portion of the joint venture operations.

4.                 All of the affiliated physician organizations operate as independent physician associations (IPAs) except Sierra Primary Care Medical Group and Pegasus Medical Group, which operate as medical clinics.

Managed Care Industry Overview

We operate our business in the rapidly evolving managed health care industry. Historically, the substantial majority of medical services were provided on a fee-for-service (indemnity) basis, with insurance companies or individuals assuming responsibility for paying all or a portion of such fees. The costs of medical services have historically risen at a higher rate than the consumer price index. As a result, insurers, employers, state and federal governments and other health insurance payers have sought to reduce or control the sustained increases in health care costs. The response to these cost increases has been a shift away from the traditional fee-for-service method of paying for health care to managed health care models, such as HMOs, that rely on the concept that pre-payment based on prior negotiation is an effective way of controlling health care costs.

HMOs offer a comprehensive health care benefits package in exchange for a fixed prepaid monthly fee or premium per enrollee that does not vary regardless of the quantity of medical services required or used. HMOs enroll members by entering into contracts with employer groups or directly with individuals to provide a broad range of health care services for a prepaid charge, with minimal deductibles or co-payments required of the members. HMOs contract directly with medical clinics, independent physician associations, hospitals and other health care providers to provide medical care to HMO enrollees. In California, it is customary for the HMOs to delegate the responsibility for managing the provision of medical services to independent physician associations or medical clinics with which the HMOs have contracts. In states such as California, a provider can only accept risk from an HMO for those services that the provider is authorized to perform within the scope of its licensure. For example, a physician organization cannot accept risk for the provision of hospital services, and a hospital cannot accept risk for professional medical services. The affiliated physician organization contracts with the HMOs provide for payment to the affiliated physician organizations of a fixed monthly fee per enrollee, which is called a capitation payment. Once negotiated, the total payment is based on the number of enrollees covered, regardless of the actual need for and utilization of covered services. Under these contracts, we, through our affiliated physician organizations and management subsidiaries, assume the financial risk that all

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necessary health care services and the management costs associated with the provision of those services can be provided at a cost less than the amount paid to our affiliated physician organizations by the HMOs.

The management services we provide, through our management subsidiaries, include the negotiation of contracts with physicians and HMOs, physician recruiting and credentialing, human resources services, claims administration, financial services, provider relations, member services, medical management including utilization management and quality assurance, data collection and management information systems. Physicians have not been equipped by training or experience to handle all of these functions. Accordingly, physicians have either hired staff and purchased the necessary equipment to support these functions within their practice, or hired an outside management company.

Physicians, including those in small to mid-sized physician groups, find themselves at a competitive disadvantage in the current managed care environment. They generally do not have a significant market presence and lack the capital to purchase sophisticated management information systems required to manage risk arrangements. Administrative burdens have been exacerbated by the presence of multiple HMOs, requiring physicians to comply with multiple formats for claims processing, credentialing and medical management. Additionally, a proliferation of state and federal regulations has increased the paper-work burden and hampered the application of the traditional controls used by managed care organizations. Physicians increasingly are responding to these pressures within the managed care industry by affiliating with organizations such as our company to mitigate their economic risk and perform the non-medical management and administrative tasks that arise from the delegated managed care model.

Our Strategy

Our business strategy is to target geographical regions with many IPAs and to achieve growth and scale within those regions, primarily through the acquisition of selected IPAs by Prospect Medical Group.

As of December 1, 2005, there were approximately 160 small, medium and large IPAs in California. Many of these IPAs cannot obtain or have been unwilling to pursue the acquisition of capital with which to enhance their facilities or the human resources and information technology in order to grow. Smaller IPAs are disadvantaged in that they have fewer members and revenue over which to spread high fixed costs and the increasing cost of governmental regulation. Additionally, and because of their size, many smaller IPAs do not have as much leverage in physician and HMO contracting. Owners of IPAs that fall into this category likewise may be more amenable to considering fair offers for their businesses.

As Prospect gets larger in the markets in which we operate, our increasing size should allow us to absorb the high fixed costs and cost of governmental regulation, while also providing additional leverage in our physician and HMO contracting.

To date, we have focused on acquisition candidates in Southern California. We have identified potential IPA acquisition candidates in Southern California having an aggregate of approximately 200,000 HMO enrollees, although no assurance can be given of our ability to acquire any of those IPAs. We select acquisition candidates based in large part on the following broad criteria:

…        A history of profitable operations or a predictable synergy such as opportunities for economies of scale through a consolidation of management functions;

…        A competitive environment with respect to a high concentration of hospitals and physicians; and

…       A geographic proximity to current operations or a material share of the potential acquisition candidateís own local market.

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Our subsidiary Prospect Medical Systems conducts substantially all of its operations in Orange and Los Angeles Counties of Southern California, while our subsidiary Sierra Medical Management conducts certain medical management operations in the Antelope Valley region in northern Los Angeles County, and shares some functions with Prospect Medical Systems in Orange County. Our affiliated physician organizations are listed below: